The economic health of any industry is proxied by the extent to which its discounted-cash-flow value exceeds its book value. This excess, in turn, varies inversely with the industry's competitive intensity.

Given perfect competition, the shareholder should expect to earn no more than the riskless rate and the going market price of risk. In other words, the ratio of discounted-cash-flow value to book value should approximate one-to-one, which is about what it was in banking five years ago.

Indeed, an American Banker article that summarized First Manhattan Consulting Group's 1990 analysis ("Why Banking Is a Zero-Sum Game," Aug. 23, 1990) noted that the banking industry was a wash: the amount of shareholder value added in attractive businesses was almost precisely counterbalanced by the amount destroyed in unattractive businesses. On net, banking was becoming almost entirely commoditized.

Now, five years later, the story is different. The ratio of discounted- cash-flow value to book value sums to about 150%, not 100%. To be sure, the forces working to commoditize banking are still in evidence. But they are being held at bay. For example, on a risk-adjusted basis, banks are earning more than they did five years ago in the middle-market segment. This is in large part because of secularly higher spreads between prime and the cost of funds - spreads that some banks are now locking in for several years through prime-Libor swaps. In addition, banks are either broadening their product lines, or selectively disinvesting, in businesses where they no longer enjoy any distinctive advantages - e.g., large corporate and commercial real estate.

Currently, the discounted-cash-flow value of the banking industry approximates $375 billion. Which businesses are the biggest contributors to this total? The top performer is small business banking, which, for the average institution, earns among the highest returns on allocated equity of any business (around 37%) and as a result accounts for nearly $60 billion in shareholder value and about $46 billion in shareholder value added - defined as discounted-cash-flow value minus book value. (It should be pointed out that some activities - for example, segments of the trust business - fetch ROEs of considerably more than 37%. It should also be pointed out that there is a substantial variance of equity returns in all businesses mentioned here. Those banks with the most efficient business systems can take advantage of the price umbrellas created by the marginal producers to boost equity returns and market-to-book values much above the indicated averages.)

The second largest contributor to value is trust and investment management, with $49 billion in gross and some $35 billion in net value. This business is a potpourri of custodial and asset management activities. Among the latter is one, personal trust, which tops all others in value productivity. It generates about $22 billion in value on a capital base of only $4 billion - an implied market-to-book ratio of over 500%.

The show slot in the value derby belongs to consumer deposit gathering. The deposit-gathering business is only a mite behind trust in gross value, with just shy of $49 billion. But it is much behind in value added, with about $25 billion. This business has had an eventful odyssey over the past five years. In 1990 it contributed greatly to shareholder wealth. By 1993, it created virtually no value added - i.e., its value was not measurably greater than the capital required to support it. And by late 1994, it was once again adding value at a healthy clip.

Why these oscillations? The answer is that since retail deposit gathering is among the most leveraged activities in the bank (after trust, that is), small changes in branch net income produce a magnified effect on ROE. When the value of free funds falls and spreads tighten, as occurred in 1992 and 1993, the business' contribution of shareholder value craters; when value and spreads rise, as in late 1994, its contribution soars.

Of late, the business is once again experiencing interest-rate problems. But quite apart from its cyclical vicissitudes, the branch business faces secular woes, in large part stemming from a slowing in the rate of growth in deposits and a continuing shift in the mix of these deposits from high- to low-spread categories. These problems mandate urgent attention to delivery costs, which are far too high in relation to the reduced revenue potential. Hence, unless banks can improve their targeting of profitable customers and upgrade the unprofitable ones through repricing actions or by changing methods of service delivery, the deposit business' contribution to shareholder value will be marked by erratic fluctuations around a slowly declining trend line.

Fourth place among value generators goes to the middle-market business, which is worth $45 billion in total. The business, however, consumes nearly $29 billion in capital, so its ratio of discounted- cash-flow value to book value is appreciably lower than that of small business and retail branch.

Rounding out the five most valuable businesses is credit card, reports of whose demise persist but are a bit premature. Performance in credit card is becoming increasingly skewed, however, as the skilled data-base marketers target the better customers and account for a disproportionate share of business growth.

Besides the five just reviewed, those businesses that generate value greater than their book equity totals include: mortgage banking (but not the funding side of the business, with a ratio of DCF to book value of only around 45%); most installment lending businesses (but not indirect auto lending, which, like mortgage funding, earns less than the minimally required ROE for the average bank); and the "commodity" portion of large corporate lending, which, assuming just an average noncredit cross-sell ratio, just manages to reach the hurdle rate.

For most banks, there are also three businesses that earn less than the shareholder's hurdle rate. These include: interest-rate-risk positioning, a separable activity that needs so much equity because of its outsize earnings volatility (more, in fact, than any other bank business) that its ROE comes to only 10%; commercial real estate (the second largest capital consumer in the bank); and the investment portfolio, which, while it doesn't chew up much capital, does not generate very large spreads either. (Interest-rate-risk positioning, of course, represents a variety of activities, ranging from the assumption of basis and option risk to conscious short-term betting on rate changes. First Manhattan Consulting Group believes that banks that specialize in basis and selective types of option risk have a much better chance of achieving a hurdle-rate return than those concentrating on short-term rate bets.)

In summary, at the level of the individual businesses, the major points of difference with our 1990 analysis are: both middle market and large corporate banking have improved, in large degree because of reduced risks and some measure of oligopolistic pricing. So have most installment lending businesses, which, on net, destroyed value in 1990 but create it today.

The major similarities between 1990 and 1995 are: for the average bank mortgage funding and the interest rate risk business don't create enough value to support their required investments. And despite a growing number of problems, most of which are only just beginning to be addressed, the two branch-oriented businesses, small-business and retail deposit gathering, still account for approximately 30% of banking's discounted-cash-flow value.

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

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