Comment: Neutralizing Middle-Market Profit Pressures

Recent concern expressed by the regulators over the riskiness of bank lending once again raises the question of whether banks can earn a satisfactory risk-adjusted return on the equity assigned to wholesale banking businesses.

Our view is that while shareholder value is coming under pressure in several business segments for the average institution, the best banks will continue to turn in superior returns, despite the possibility of some short-term erosion in profitability.

The corporate banking business can be roughly divided into five sectors - large corporate, middle market, small business, specialty industries, and loan sales and purchases.

The keys to success in each sector differ. For example, in specialty industries, success depends on tailoring products appropriate to a given industrial segment; in small businesses, it depends on attracting enough liabilities (generally at least $2 to $2.50 for every dollar of loans); and in the classic middle market, it depends on the bank's skill in relationship management.

This review will focus on the current situation and outlook in the upper middle market, which is the preferred area of operation for the country's principal regional and superregional banks.

Conditions in the middle market in the last year typify the cyclical nature of the business. In late 1993, margins were strong and volume was weak. Today, margins are weak and volume is unusually strong.

Spreads over the London interbank offered rate on new loans to noninvestment-grade borrowers tumbled 40 basis points in 1994, from 170 to 130. Fees on new unused loan commitments halved during the same period, from 60 to 30 basis points. At the same time, overall C&I loans grew at a 10% annual rate, after experiencing negative real growth in the previous two years.

We estimate that for the average bank profitability in the middle market continues to exceed the shareholder's hurdle rate of return on equity of some 14% to 15%, in large measure because of a decline in the required loan loss provision. With a needed provision of 75 basis points, the net income for the typical middle-market customer sums to about 100 basis points per dollar of assets, roughly a 17% return on the needed equity base.

This return, while adequate, may easily become something less than that if spreads compress further or the loss provision rises to what it was a few years ago. For example, if spreads drop about another 30 basis points, then, all other things being equal, the return on equity would fall below the hurdle rate. In other words, the middle-market business, which is today a contributor to shareholder value, will begin eroding it.

It should be emphasized, however, that this may become the predicament of the typical or average market participant. Profit pressures are not so severe for those banks that stubbornly refuse to obey the law of averages. While the average bank garners a 17% return on equity in the middle market, the top quarter of banks earn a figure of about 23%.

Why are a substantial fraction of banks able to top the average lender by some six percentage points of ROE? The answer is that these banks understand and manage the skewness in customer profitability. While some 40% of middle-market customers are typically unprofitable, providing banks with ROEs of less than 5%, another 45% offer the alert banker the opportunity to garner an ROE greater than 20%. The top-quartile institutions gravitate to the latter, the right side of the barbell.

How do they accomplish this feat? In part, by understanding the salient characteristics of high-profit customers. Generally, these are customers who have needs beyond traditional loans. Bank relationship managers or teams must be able to sell services in investment, risk, and cash management.

They must initiate and maintain a dialogue that emphasizes the bank's ability to provide total solutions to financial problems. They must represent themselves as advisers on (and even partners in) the company's business future, much as the best investment banks do with larger corporations. To achieve this, the relationship manager must do as is done in the large corporate area - i.e., he must interact not just with an assistant treasurer but also with the chief executive, or at minimum a highly regarded chief financial officer.

When a bank's contact with the company is primarily through the treasurer's office, it is unlikely to develop a deep enough relationship with that company to earn a superior relationship manager's return. Therefore, one way of identifying customers with a penchant for being in the right side of the profit barbell is to locate those with CEOs who insist on playing an active role in financing and therefore want to interact with credit suppliers. Such individuals have a propensity to respond favorably to a well-executed bank relationship management strategy.

The purpose of such a strategy is to enable the bank to "own" the relationship. A top-tier position with a customer can mean, among other things, much higher loan syndication fees and the right of first refusal on ancillary products.

The ability to reach such an "ownership" position with enough customers presupposes:

1. A bank modeling capability that accurately depicts risk-adjusted profitability at the customer level, facilitates the aggregation of customers into like segments, and helps to reveal insights about the formulas that meet each segment's needs while providing high returns to the bank.

2. A cadre of relationship managers whose performance is measured by customer profitability, who are able to upgrade themselves by studying the behavior of better-performing colleagues, and whose compensation is determined not by the number of customers or the volume of assets under management but rather by the amount of shareholder value created.

3. The development of a strong product capability, including the ability to provide, either directly or through an alliance with a third party: loans, senior or mezzanine; private placements; public debt and equity underwriting; cash management and trust services; loan sales; commercial paper distribution; risk management products; and foreign exchange and trade finance.

Our prognosis is that banks endowed with the above attributes can make between 20% and 30% on equity and grow earnings at between 3% and 8% per year over the next three years. Assuming the midpoint of the ranges for both ROE and earnings growth, such a bank will likely have a business that, were it set up as an independent activity, would qualify for a stock price equal to twice its book value.

Mr. Zizka is managing vice president of First Manhattan Consulting Group, New York. Mr. Rose, formerly senior columnist for this newspaper, is associated with the same firm.

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