With its new -- though still not fully implemented -- financial policy, the U.S. government is betting that the huge Eurocurrency markets, relying on new technologies and dominated by giant industrial concerns, can replace a large portion of bank funding of the economy.
It is assumed that the large corporations can gain access to enough capital in the world markets to stimulate economic expansion.
Given the experience of the past few years, when virtually all incremental debt came from nonbank sources, this is a reasonable gamble. If it works, the benefits to the United States could be substantial. Government subsidies would not be needed to drive the economy. Private-sector monies would be adequate for the task.
The negative aspects of wrenching change are now history. The positive aspects are well toward realization. The profit opportunities are enormous for those who understand these changes and properly position themselves.
Two Bush administration programs meant to foster this national financial policy -- the subject of this and two previous commentaries -- have not been passed by Congress. However, the battle over both is likely to continue.
The first is the capital gains tax reduction. At present, it is less costly for U.S. companies to issue debt than to raise equity because the interest payments on loans and bondsd are tax-deductible, while dividend payments on stock are not.
Influence on Equity's Value
In addition, the recipient of the stock dividend must pay income tax on it, just as on interest income.
Therefore, issuing equity becomes a benefit to the corporation or the investor only if the equity's value rises to a point where it could be issued at the same all-in price as debt. Reduction of capital gains taxes would help increase the value of equity.
The second unrealized Bush program would allow industrial corporations to own banks. The administration feels the risk to the government from bank failures would be reduced if large corporations owned them. Further, perhaps banks would help their corporate parents in raising funds overall.
The United States is likely to persist in its new financial policy even if these two initiatives are not enacted. There are substantial risks, however:
* The safety net protecting the financial system is being lowered, and the risk of an old-fashioned financial collapse has been substantially increased.
* At no time in U.S. history has a sustained, internally generated economic recovery been achieved without bank funding. There are numerous examples, though, of foreign-funded (Euro-currency?) recoveries.
4 Groups of Winners
This, then, is the game: Get the banks out of the way so that the large corporations can use international monies to revive the U.S. economy. Four clear groups of winners emerge if this policy succeeds:
* The banks themselves, which are likely to become substantially more profitable.
* Any corporation with a solid equity base and a sound bond rating. It could grow at above-average rates by funding the nation's credit needs.
* Companies that aid the $3.5 trillion-asset banking industry in reducing costs.
* New, fast-growth industries that flourish by offering services once provided at no cost by the banking industry.
The Cost of Mispricing
Banks have had a dismal risk-analysis record in recent years. Their failure to price loans properly has been well documented in numerous studies and in Sanford Rose's columns in the American Banker.
The cost of poor loan underwriting has been staggering: Federal Reserve figures indicate that the U.S. banking industry made $182.6 billion in loan-loss provisions from 1985 to 1991.
The 100 largest bank holding companies recorded a 5.8% return on equity in 1991 as a result of their poor loans, according to an April 27 Business Week report. Their earnings had declined at a rate of 13.7% per year in the preceding five years.
Those figures actually overstate the top 100's performance because they are from today's list of the largest banking companies - not including those that failed during the five years.
Capital-Ratio Incentive
If the new financial policy suceeds, banks will find it very difficult to continue to operate so poorly.
Constant rises in required capital-to-asset ratios have forced the industry to slow its acquisition of loans. In l989, Fed data show, loans were 61.3% of the national bank balance sheet. In 1991, this ration was 60.1%
Meanwhile, banks have been increasing their securities portfolios at a rapid rate. Securities holdings of all types (primarily in mortgage pools) rose by $103 billion from 1989 to 1991, from 16.7% of bank assents to 18.7%
Keep in mind that banks cannot generate losses from the loans they have shed nor from those that they do not make. Moreover, government-guaranteed securities do not generate losses. Thus, earning assets are growing, and nonaccruing assets are about to plummet.
Assuming Business Week's top 100 banks would be able to cut their loan-loss provisions by 50% in the next two years (a realistic assumption in a growing economy as banks' troubled loans decline), then net bank income would jump by 100%. The probability of this happening is quite high.
Consider further what might happen to bank stocks under such a scenario, since they sell in general at discounted multiples to the market and noting that industrial companies are not projected to have similar earnings growth.
As bank stock prices soar, the ability of these companies to build their equity bases will grow, and this should fuel reduced liability cost and more earnings growth.
At this point, the national financial policy will be first tested. Banks strengthened with major infusions of retianed earnings and equity sales would be able to fund substantial loan growth.
But if the government holds true to its new policy, unrestricted loan growth would be prevented by raising required bank capital ratios to between 10% and 12%. Fed Governor Wayne Angell, in a recent speach at Wake Forest University, indicated this is possible.
Opening for Credit Companies
This discussion is not meant to imply that banks will make no loans. The point is that banks will make relatively fewer loans.
Banks will continue to dominate labor-intensive lending markets where service needs are high and where underwriting standards for securitization are as yet impossible to develop. They will dominate the small-business lending sector. Chemical Banking Corp. and Nations-Bank Corp. have and will develop attractive franchises in this regard.
Other types of credit will remain the preserve of competitors that operate at lower cost than banks or avoid the structural costs of being a traditional bank. The commercial paper or Eurocurrency markets are examples of sectors where nonbanks can operate more cheaply than banks. These markets are highly automated and generally function with fewer structural impediments than the banking markets.
The keys to operating successfully in the nonbank credit markets are a strong balance sheet, a high level of equity, and superior credit ratings. Large industrial companies, therefore, have substantial advantages in all parts of the credit markets. However, niche companies can also do very well.
The names are relatively well] known - MBNA and Advanta in the personal loan and credit card markets, Contrywide Credit Industries and Margaretten in the mortgage sector, Bankers Trust New York Corp. and J.P. Morgan & Co. in commercial loan markets, and a number of brokerage firms in the capital markets.
The move toward outsourcing in banking is being driven by a number of compelling factors. Technology keeps improving and dropping in price. Old systems therefore rapidly become expensive or inefficient. It is dfficult for one banking institution to keep upgrading its hardward to stay on the cutting edge.
And a bank failing to obtain the best software is condemned to use its hardware inefficietly.
The Tech Czar as Interloper
Technology, which is complex and costly to develop, lends itself to the same economies of scale obtainable in a factory. Thus, banks unable to spread technology costs over a large number of transactions make a major error if they buy their own computers.
In addition, technology creates major "social problems" within a banking company. It can become a power center not accountable to the president's office and not easily controlled. Well-publicized conflicts at Citicorps, BankAmerica Corp., Mellon Bank Corp., and CoreStates Financail Corp., showed the difficulties that an in-house technology czar can create for the traditional bank president.
As State Street Boston Corp. and Marshall & Ilsley Corp. have demonstrated, the technology chief's success can be great enough to unseat the traditional banking leadership.
Every dollar invested in proprietary technology, given the points just raised, tends to be a low-return use of capital. Out-sourcing is most likely to be less expensive and considerably less capital-intensive.
Banks will be driven by the national financial policy to make the most efficient use of each capital dollar. They would be best advised to put those dollars to work in attractive products, not high-cost technology.
Only banks with more than $10 billion in assets should make direct investments in technology. But even in these cases, it seems to make little sense to develope proprietary softwafe, given the alternatives.
Charging for |Free' Services
As banks are forced to respond to the new financial policy, they will abandon businesses once believed attractive. These will be picked up by others and rationalized to operate efficiently and profitably on their own merits. Examples are master trust, now dominated by State Street Boston, or automated teller machine networks, like Core-States' Mac system.
These businesses' new operators will not give away their services in order to generate demand deposits and loan business. A good example is the merchant credit card business - authorizing, processing, and accounting for card transactions at retailers.
For 25 years, virtually any bank could get into the market by selling the service to local merchants. Most banks gave away the product at cost as part of a full-service approach to the merchant - that is, to capture its deposits and loan business.
Virtually very bank below a certain size, meaning 95% of those in the business, may be losing money on merchant processing. And these banks may lack the capital bases required to make new loans to, or take deposit from, their merchant customers.
Oligopoly's Effect on Pricing
The net result is that merchant credit card banks are losing money to obtain business they cannot handle.
The result is predictable - these banks are selling out.
An oligopoly is forming among the specialists moving in, most prominently First Financial Management of Atlanta. As concentration grows, pricing could stabilize or go higher. Bigger profits will stimulate innovation, letting these companies enter the point-of-sale payments arena with money making, proprietary products that will make a tired old business new.
In short, the forces that began to reshape banking if the 1960s have become revolutionary in the past three years.
Mr. Bove is a banking consultant with the Bove Group in Chatham, N.J.
