CHICAGO -- Although traditional banking is in a state of decline, the industry can play a prominent role in the evolving financial services market. That was the consensus at the Federal Reserve Bank of Chicago's annual conference held here last week.

The meetings contained both warning signs and seeds of hope for an industry facing an uncertain future.

On the one hand, experts predict banks will lose important chunks of traditional lending business to myriad lesser-regulated entities. At the same time rising rates are eroding the forgiving economic environment of the past few years.

New Frontiers

On the other hand, fresh evidence surfaced that the banking industry is progressing in its transition from an antiquated taker of deposits and issuer of loans to a fee-driven provider of financial services.

The upshot is that although further painful transitions apparently lie ahead, adaptable banking institutions still can finds ways to keep abreast.

"It is abundantly clear that the means by which banks perform their economic functions are changing, often at a breathtaking pace," said Alan Greenspan, chairman of the Federal Reserve System. But "it is far from clear that banking, considered in its widest context, really is a declining industry."

To be sure, much of the news about traditional banking was gloomy. According to the Chicago Fed, at yearend the industry held only 25.4% of balance sheet assets controlled by all U.S. financial institutions - the lowest figure in the last 133 years.

Vulnerable Area

And further erosion could be in the offing. Cynthia A. Glassman, a managing director of Washington, D.C.-based consulting firm Furash & Co., warned that securitization, non-bank competition, and regulation could cause banks to lose ground in small-business lending, much in the way banks lost parts of the large corporate loan market.

What the industry must recognize, said Norwest Corp. chief executive Richard Kovacevich, in an otherwise upbeat address, is that "revenues from traditional activities are insufficient to support a viable strategy."

On top of that, the forgiving rate envir6nment of recent years probably has masked some deterioration in competitiveness, engendering a degree of false confidence, said Larry A. Frieder, a professor at Florida A&M University.

Making Headway

"All the inputs to the banking profit model are on a long-term decline," said Mr. Frieder in an interview. "An inversion of the yield curve would rather quickly bring home the message that current results probably aren't sustainable."

However, Federal Reserve Bank of Minneapolis economist John H. Boyd and Professor Mark Gertler of New York University presented a study suggesting that banks are making headway in the transition from lending to fee-based activities.

Using a technique that caught the attention of Mr. Greenspan, Mr. Boyd and Mr. Gertler estimated the amount of earning assets needed to generate current levels of noninterest income in the banking industry.

When capitalized fee income is added to balance sheet assets, they found, the banking industry appears to be holding its ground in terms of market presence.

The study did not address the question of whether banks are getting their fair share of the most profitable financial services businesses, however, and at least one anecdote indicated that can't be taken for granted.

William E. Odom, chairman of $70 billion-asset Ford Motor Credit Co., said his institution racked up a hearty 1.7% return on average assets last year, openly saying that its lesser-regulated status and strong parent gave it an advantage over banks.

Mr. Odom reminded the audience, however, that banks enjoy deposit insurance, and said community reinvestment and regulatory obligations are "quid pro quo" for that protection.

Indeed, the long-running debate on deposit insurance quickly resurfaced at the Chicago Fed conference, with several speakers contending that the banking industry will never gain the full spectrum of powers it seeks until federal deposit guarantees are scaled back.

Given all the governmental intrusions made in the name of protecting depositors and fair credit allocation, "it now is only modestly absurd to say the government has nationalized the banking industry through the back door," said Carter H. Golembe, chairman emeritus of Washington-based Secura Group.

Undermining the need for massive federal guarantees is the steady erosion in value placed by the public on insured deposits and bank loans, said Robert Litan, a deputy assistant attorney general in the Justice Department.

Said Mr. Litan: "If the specialness of banking has eroded, why don't we think seriously about shrinking the safety net?"

Edward E. Furash, chairman of Furash & Co., said his firm has done a number of studies for some large banks about the feasibility of dropping banking charters, finding "it is not only possible, but it improves profitability."

The catch, said Mr. Furash, is negotiating the move to 100% noninsured funding. "There are problems in managing the transition to the new structure," he said, alluding to the difficulty many banks have maintaining customer confidence as the terms of depositor accounts are changed.

Though the deposit insurance issue cries out for resolution, there are many profitable strategies banks can embark upon now, said Mr. Kovacevich of Norwest, who cited specialization as a key to coping with heightened competition.

Aside from traditional lending, Mr. Kovacevich said, banks can explore intermediation services, such as mortgage banking and securitization, investment management, insurance, data processing and cash management, securities and currency trading, and equity investments.

"There are many ways to win," said Mr. Kovacevich.

Wall Street Is Watching

At the same time, banks should be aware that Wall Street can balk at a progressive strategy, said Thomas Theobald, chairman and chief executive of Continental Bank Corp., which earlier this year agreed to sell itself to BankAmerica Corp.

"Specialization does reduce diversification, and the market had trouble with that," said Mr. Theobald, who reorganized Chicago-based Continental around corporate banking but won less than full support from investors.

"Analysts believe prospects for traditional banks are limited, but few are prepared to embrace banks that have carved out a unique approach."

John B. McCoy, chairman and chief executive of Banc One Corp., predicted further massive consolidation in the banking industry, saying acquisitions of banks in the $20 billion to $40 billion asset size category will occur with increasing frequency.

The executive downplayed the possibility of a national bank emerging within five years, however, saying "it takes time" to assimilate newly acquired units. "You can only grow so fast," said Mr. McCoy.

In the meantime, Mr. McCoy said, the banking industry faces an immediate challenge of managing a fresh credit expansion.

Climbing rates, and resulting pressure on net interest margins, "traditionally causes aggressive lending," said Mr. McCoy. "I've been in the business long enough to know this is precisely the time in the business cycle when many banks will stretch and start to put on the next portfolio of bad loans, which won't start to show until the next economic downturn."

Mr. McCoy said risk management is a higher priority than ever in the banking industry, given the growing diversity of financial markets.

'Fundamental Mission'

In fact, engaging and managing risk for the second year running was mentioned by Alan Greenspan as the banking industry's "fundamental mission," one crucial to the health of the economy.

The key to understanding the evolution of the banking industry, Mr. Greenspan suggested, lies in understanding that many emerging activities simply are accelerated electronic permutations of traditional risk management functions. Banking judement is required, but so too are technological and information management skills.

"Risk information processing now lies visibly closer to the core of the banking business," said Mr. Greenspan.

Instead of a world in which technology quickly obviates the need for bankers, Mr. Greenspan outlined a future in which bankers build on traditional skills through mastery of computers, telecommunications, and data analysis.

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