Fee income is not the sorcerer's stone. The growth of fee income as a proportion of bank revenue is a trend most often invoked by analysts to justify higher P/E valuations. Some analysts have a fetish for fee income. They argue that since it is not driven by credit and is not capital-intensive, fee revenue should command a higher multiple than traditional banking revenues. This is true as far as it goes, but I would argue that fee income is not the unmitigated positive that many analysts believe.
It all depends on what kind of businesses generate that income.
I see three problems with the market's fee-income fixation. First, too many banks have simply substituted one kind of risk for another, moving into mortgage banking or, conspicuously, into equity securities brokerage. Not that anyone seems to have noticed, but these are two industries whose P/E's are even lower than those of banks and whose earnings are much more volatile. One of the big risks for some banks in this cycle is that so much of their earnings comes from stock-market-sensitive sources: brokerage commissions, trading, derivatives, principal investments, mutual fund sales, etc. Banks have built in huge overhead to support these businesses.
The second problem is that too many banks have overpaid to buy their way into fee-based businesses; presumably they will continue to overpay. Then, even if they have bought good businesses, the shareholders will not benefit.
Third, many banks have mismanaged some of these businesses so badly after buying them that they have destroyed the value of what they bought.
All in all, though, the growth in fee income has certainly been a good thing. Much derives from traditional banking products that are simply better managed today.
Many big-bank apologists argue that banks need scale to be competitive. The truism that bigger is better has driven consolidation for the past 20 years. But there is no evidence I know of that points to any economies of scale in banking. To the contrary, I believe that there can be huge diseconomies of scale. If you believe as I do that risk management and operational control are the keys to running a bank, then you will always prefer a bank that operates in one time zone, one language, one currency, dealing with customers it has known for decades in businesses it understands.
Convergence means the bank whose stock you own will overpay to buy a less profitable company in an industry it does not understand. That may not bode well for bank stocks. If the market has no faith in banks' abilities to integrate acquired banks, there is no reason to think it will applaud deals taking banks into other industries.
But the fact is that convergence will proceed whether you and I - that is, the shareholders - like it or not. Lots of people stand to make lots of money if convergence steamrolls forward - investment bankers, lawyers, consultants, corporate executives - and I would not bet against them. I'm not sure where we shareholders fit in this food chain, but we probably are not first in line.
Not surprisingly, most banks plan to be buyers of companies in other industries. But there is a problem with fulfilling some of these expectations; even if convergence made sense, there are not enough good properties to go around.
If a bank wants to get into life insurance in a big way, the pickings become pretty slim after the top 10 insurers bite the dust. And foreign banks and insurers are certain to be bidders too. In game theory there is a phenomenon known as the "winner's curse." The winner's curse theorem proposes that in any competitive bidding process in which all bidders have the same information, the winner will always pay more than the property is worth. It looks as though the winner's curse will be every bit as operative in the convergence arena as it has been in banking. So I want to own the sellers, not the buyers. Period.
Technology has revolutionized banking in the past three decades. The the plain fact is that so far technology has never conferred more than a temporary competitive advantage to any particular bank. With rare exceptions, any proprietary technology developed by one bank could be bought off the shelf by any other bank a year later for a fraction of the cost. Though the Internet seems to be a different animal from previous technological advances, I think the historical pattern will hold true.
Though I am certain that every bank must have a credible on-line banking channel to be competitive, I do not think on-line banking will enable any one institution to differentiate itself from another in a meaningful way. On-line banking will be a necessary, but not sufficient, condition for success. Accordingly I am concerned that the potential payoff for pursuing a leading-edge strategy will not justify the risk. I am concerned that even though the Internet is unlikely to endow any single bank with a big edge it could engender price-cutting that sucks profitability out of the industry.
But the biggest, scariest imponderable is nonbank competition. As long as the competitive landscape looks pretty much as it does today, I think the Internet's earnings impact is likely to be muted. But what if someday Microsoft or America Online or AT&T, either through regulatory change or an alliance, gets access to the payments system and insured deposits and figures out a truly convenient, secure way to deliver financial services on-line?
With their millions of customers and hundreds of billions of dollars in market capitalization, these giants could spread their technology costs over a huge base and offer prices that banks could not touch. I do not see this as an immediate threat, but it is something that could drastically alter the industry's competitive balance. Mr. Cranmer is a senior analyst and principal at Keefe Managers Inc. in New York. This article is adapted from a speech he made to bank stock analysts.