With deteriorating interest margins and lower deposit growth, can banks develop value for shareholders?

Shareholder value can be increased only by investing in opportunities whose expected returns exceed long-term funding costs, or "costs of capital." The longer these excess returns can be sustained, the more they add to shareholder value. Investments returning only the costs of capital, and no more, neither add to nor detract from shareholder value.

Transitory jumps in earnings, perhaps from trading profits, provide only transitory contributions to shareholder value. Much of the recent increase in bank earnings may be in this category.

Even a long-term increase in earnings may result in only a one-time boost rather than continued growth in value. Cost reduction programs are possible examples.

Competition erodes excess investment returns. Maintaining growth in shareholder value thus requires outrunning rivals through continuing innovation, such as with new technologies, products, or marketing techniques.

Some bankers accept that challenge. Others try only to maintain shareholder values, obtaining marginally satisfactory returns on their capital. In an era of rapidly changing technologies and markets, just maintaining shareholder values is challenging. An easier option is to seek an acquirer.

Earnings patterns can be difficult to interpret, even apart from significant measurement problems. Shareholder values can begin to deteriorate, even while earnings are positive and growing. The earnings may represent inadequate returns on capital, or investors may expect a forthcoming earnings decline.

Stable shareholder values suggest distributing earnings as dividends. If values are declining, downsizing, share repurchases, and perhaps gradual divestment and liquidation, may be appropriate. Deferring taxes may be the best reason for many banks to retain earnings.

How can financial analysts and investors identify banking enterprises likely to develop value-building opportunities? It requires analyzing the underlying sources of bank equity values - their assets, intangible as well as tangible.

A Sept. 12 report by Lehman Brothers, "Bank Franchise Value: Highlighting Hidden Values and Uncovering Investment Opportunities," indicates more focus on value components among financial analysts. Correspondingly, earnings and book values are losing significance.

A typical bank balance sheet suggests very few opportunities to develop shareholder value. Investment represented by the recorded assets are, for the most, fungible. Loans tend to be the least fungible, but Federal Reserve Functional Cost Analysis data suggest that bank lending overall has actually been less profitable than investing in bank securities portfolios.

Indeed, few banks can so much earn adequate returns on their capital solely from pure intermediation - obtaining and employing funds apart from any service function, with the spread representing compensation for assuming intermediation risk. For example, a bank might obtain money market funding for investment in longer-term securities, taking advantage of an upward-sloping yield curve. However, the available interest margins are usually small and volatile. Only the largest banks have sufficient access to the financial markets to rely on intermediation alone.

Some banks have boosted profits by trading securities, including derivatives, and foreign exchange for their own account, as distinguished from dealing and brokering for customers. Whether trading profits warrant the risks is debatable. Even if they do, building equity value requires continuously outperforming the market.

Finally, some large banks have increased shareholder values with acquisition programs. Because many banks have high costs and weak markets for their stocks, they are often acquirable on terms representing less than their full potential values. Excess value from each acquisition enriches the consideration an acquirer can offer in successive acquisitions, creating a ratchet effect. Shareholder value nevertheless will continue to grow only by continuous acquisition.

For the most part, bankers should look beyond their balance sheets in seeking opportunities to develop shareholder values. In this respect, banking is like any service enterprise, with market relationships contributing much of the shareholder value.

Developing customer relationship is an investment process substantively identical to investing in fixed assets. Relationship investment creates most of the premium in bank acquisitions. To build bank shareholder values is therefore to build customer relationships.

Bankers traditionally could give little thought to the service characteristics of banking. Relationship banking has mainly been deposit banking.

Deposit services attract and retain most bank customers and are the source of most bank premium value. Nevertheless, declining deposit growth and more nondeposit substitutes must reduce returns from investing in depositor relationships. Banks continuing to rely on depositor relationships as in the past face growing difficulty simply in maintaining shareholder values.

As deposit relationships weaken, financial analysts have understandable concerns about what alternatives will take their place. Banking institutions (including thrifts) generally can expect chronic excess capacity and depressed share prices.

Many innovations are easy for rivals to match. Nevertheless, exceptions will emerge by developing new relationship strategies. How should analysts go about identifying the exceptions?

They might begin by identifying institutions that actually have matched relationship strategies with emerging market and technological realities. Relationship strategies are not simply appointing "relationship managers," cross-selling services, and adding new services.

Rather, they are understanding and exploiting the value characteristics of banking relationships. They involve targeting the types of relationships that a bank seeks to develop, given its own capabilities and limitations; and adopting decision frameworks that build shareholder values from those relationships. Few banks today have taken these steps.

Relationship strategies clearly require structuring decisions around customers and their attributes rather than around products and services. They treat market relationships as long-term investments. Correspondingly, they recognize the limited and short-term significance of performance measures defined in terms of products and services. They thus require customer information files and income- and expense-allocation systems that identify customer characteristics.

A customer focus is particularly important in multiproduct environments. Some services attract valuable customer relationships while directly contributing no value or profit. Customer relationships often last longer and contribute more value when they include more services. Yet, expanding relationships involves more risk. Customer dissatisfaction with one component may result in termination of an entire relationship.

Market relationship values do not always imply contributions to shareholders' values. As with specialized expertise, customer relationships sometimes adhere to individuals rather than to institutions. They are prone to move with the individuals, should they depart. Even more complex situations arise when banks seek to offer new services, such as mutual funds and annuities, by means of outsourcing or partnership arrangements with nonbank providers. Part of the challenge of relationship banking is therefore maintaining claim to market relationships once they develop.

Mr. Morgan, a consultant in financial economics, is based in Falls Church, Va.

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