underwriting, commercial banks of various sizes are beginning to whittle away at their share. For example, the six major investment banks' share of stock and bond underwriting has dropped from approximately 69% in 1989 to 63% in 1994. Some commercial banks are finding that operating a section 20 subsidiary allows them to meet more of the funding needs of their midsize corporate customers, increase the likelihood of account retention, and create inroads with selected targets. However, despite their potential, today many section 20s are generating subpar returns. Too often, buying market share is taking precedence over profitability. In determining the likely success of a section 20 subsidiary, senior bank managers must address several critical questions related to the success of this subsidiary: *What are the needs of their current and potential customer base? *How effectively can they market section 20 products to their corporate contacts? *What are the capabilities of the bank's distribution system? Section 20 of the Glass-Steagall Act effectively bars banks, especially commercial banks, from being a "principal" agent in the securities business. But since 1987, the Fed has granted section 20 powers to a handful of banks, allowing them to underwrite and deal in securities as long as these activities are conducted in an "arm's-length transaction." However, these powers came with the proviso that today limits revenues from underwriting activities to 10% of the section 20's gross revenues. This section 20 business is one of the most heavily regulated areas in banking, and not all section 20 units possess the same underwriting powers. A Tier 1 section 20 is allowed to underwrite commercial paper, municipal bonds, and asset-backed securities. Tier 2 section 20s can underwrite corporate equities and bonds. Another category of section 20s can engage in private placement of securities, financial advising, and structured finance. Aside from different underwriting powers, revenue constraints, and investor protection and disclosure rules, regulators have set up firewalls that prevent banks from taking full advantage of their resources to compete against investment banks. Currently, more than 20 firewalls exist for Tier 2 section 20s. Restrictions relate to areas including management, cross- selling practices, and use of proceeds. Section 20s allow banks to diversify their revenue sources through new product lines that include corporate bonds, commercial paper, and asset- backed securities. They are also expected to provide banks with adequate "ammunition" to compete with securities firms that are vying for wallet share of bank customers. In the past decade, banks have experienced an erosion of their deposit and customer base, due in large part to their inability to compete with other nonbank companies in terms of product offerings. For example, banks' share of lending activities has decreased from approximately 39% in 1980 to 33% in 1994. At the same time, banks have watched as the underwriting business continues to grow in volume. For example, the compounded annual growth rate of corporate bond issues and commercial paper between 1983 and 1993 was 13% and 12%, respectively. In dollar volume, approximately $2,270 billion of corporate bond issues and $554 billion of commercial paper were traded in 1993. Although section 20s may allow banks to regain lost market share, they will not guarantee increased market share or profitability for banks that do not have a focused strategy. To successfully manage a section 20, banks must focus on three business fundamentals: strategic focus, skills base, and distribution. Strategic focus remains critical. The increased competition in the investment banking business has forced players to reevaluate and refocus their strategies. Section 20s, most of which lack the strong global presence of a Morgan Stanley or Goldman Sachs, must focus on profitable niches where they can gain or defend market share. These niches can be defined either by product and industry type, market base, or geography. For example, product niches would include, among others, a focus on investment and non-investment-grade products, derivatives, structured finance, mergers and acquisitions, or fixed-income products, while market base niches might be a particular segment of the middle market or large corporation customer. The section 20 arm of Bankers Trust New York Corp., for example, has built a reputation as a powerhouse in trading and derivatives. First Union Corp., on the other hand, formed its capital markets group in 1994 to focus on serving its existing customer base to prevent them from going to investment banks. First Union is leveraging its strength as a commercial lender by expanding its portfolio of services to its middle-market customers. A strategy focused on slowly building its business and know-how has led Citibank to become a strong opponent in bidding tables. In an interview with Fortune magazine, Alan MacDonald, head of Citi's North American global finance group, said, "We looked at it and decided that we are not willing to spend the amount of money necessary to make a real frontal assault on the bulge-bracket guys (the top six investment banks). We have a more focused strategy." To make this business a success, banks need to avoid a syndrome they have fallen victim to in the past. As Merrill Lynch's Barry Friedberg observed, "Ultimately, the banks will impact our business by raising the costs to get people and cutting the price to get business. That is how the banks have always run their business." Banks' skills must be improved. Banks have to build "underwriting credibility" to show customers that they possess the skills and expertise needed to be considered in a league with investment banks. To this end, banks have resorted to opportunistic hiring from investment banks. However, external hiring, especially of traders and salespeople who command high salaries and bonuses have led to conflicts in banks' more conservative compensation structure. Relationship managers, more than ever, will be important in helping banks make the transition to section 20 activities. Banks such as J.P. Morgan & Co. have made the most of their relationship managers by using them to source deals. As new products evolve, relationship managers are becoming more active in cross-selling new product offerings. This refocusing of the relationship manager demands a shift in his or her responsibilities from administration and monitoring to selling. Improved distribution also is critical. Just as real estate is a business of "location, location, location" a successful section 20 requires "distribution, distribution, distribution." Effective distribution will grow out of successfully resolving the strategy and staffing issues mentioned above. A mediocre distribution system will result in stunted growth and increased profit volatility. Due to the concentration of the underwriting business in the hands of very few players, banks face formidable obstacles in breaking though the entry barriers and surviving intense competition. Potential customers often award deals to companies that have acquired the prestige that comes with past successful transactions. Section 20s have a limited performance history. "Selecting" customers and ensuring initial wins is of critical importance to long-term success. Understandably, customers prefer to work with companies that possess industry or regional expertise relevant to their business. A firm grounding in the local market will be important to many players. The large investment required may prevent section 20s from fully competing against investment banks with deeper pockets that allow them to hire experienced bankers. A focused effort is needed to counter this. Banks also have to confront culture clashes between their commercial banks and section 20s. A potentially successful marketing effort can be shut down by the commercial banker handling the core corporate relationship. Team-based incentives can enhance the spirit of internal cooperation. Though further reform or repeal of section 20 may be stalled for now, Congress and the Fed cannot stop the sea change that banks are experiencing. Banks' retail and corporate customers will continue to look for more sophisticated products and services offered by investment banks. Banks must provide them or lose market and wallet share. Section 20s allow banks to increase product offerings while building a base of business that can be expanded as regulations change and as internal capabilities grow. Mr. Wendel is president of and Ms. Masuyama is an associate with Financial Institutions Consulting in New York.
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