Jumping Off The Foreign Bandwagon
Until very recently, nothing seemed more seductive to bank executives than a foreign climate. From the Sixties on, U.S. financial institutions trekked abroad in prodigious numbers. And beginning in the Seventies, non-U.S. banks began returning the favor, cross-investing in the American market. Now in the Nineties, the allure of foreign banking operations has materially abated and should abate further in the next few years.
The motivation for all the overseas banking investment of the last 30 years has been endlessly debated and undoubtedly has varied from one firm to another and from one time to another. Some went foreign to provide service to their nationals abroad, others because domestic growth opportunities were thought to be limited. And still others migrated for perhaps less justifiable reasons -- e.g., glamour and faddism, which might otherwise be described as oligopolistic imitation.
Whatever the reason, making a success of the foreign venture has not been easy. It is often argued that this is because most locals tend to be ethnocentric, preferring their own institutions to foreign ones. While there is some truth in this observation, the point is often overstated.
Frequently, the barrier to success has not been "foreignness" but rather "newness." Despite widespread perceptions to the contrary, corporate banking remains in large part a relationship-driven business. And these relationships tend to be astonishingly stable. It's simply far too difficult for most foreign, and even domestic, bank entrants to outcompete entrenched market participants.
Morgan Made It
That foreign nationality per se is not an inherent obstacle to success is illustrated by the example of J.P. Morgan, which is a much more accepted performer in the French market than its chief U.S. rivals. No doubt this is owing to the fact that Morgan has been in France for over a hundred years -- far longer than other U.S. giants.
Notwithstanding the difficulty of elbowing aside established institutions, this is sometimes possible if the market entrant brings something unique to the party: e.g., a new technology, superior management, or a differentiated product. Many U.S. banks met this requirement in the past.
When U.S. banks first migrated to Europe, they had product and service skills that were greatly superior to those of their local counterparts. They understood cash-flow lending; the locals did not. They engaged in nonrecouse leasing and project financing; the competition did not. And, later, when currency and interest rate swaps were introduced, they embraced the new financial technology far faster than did indigenous rivals. Possessed of skill advantages, many U.S. interlopers were able to carve out a significant niche in the European market.
In the last few years, however, the once-vaunted advantages of U.S. banks have receded. In most developed countries, local or house banks now can do nearly, though not quite, everything that the U.S. institutions can do, thanks in some considerable part to the training local bankers got from the U.S. banks, where many were once employed.
Few Get to Lead
As skill levels coalesced, the essential disadvantage of "newness" reasserted itself. This disadvantage is summarized in the illustrative chart, which shows the number of major corporate customers of selected banks in a typical OECD country on the horizontal axis and the percent of customers for whom each of these banks is the lead institution on the vertical axis.
Well-established banks are clustered in the upper right of the chart, while the new foreign entrants, even the most prestigious, are confined to the lower left. That is, local banks end up serving many more top corporate customers in a more meaningful fashion than do the foreign institutions.
This pattern is repeated in every market where there are a few local banks with strong nationwide market power. It is not repeated, however, in countries where market power is more fragmented and local institutions tend to be preeminent in only one or two regions. Thus in Portugal, for example, Citibank, while a comparatively new entrant, is as competitive in corporate banking as any indigenous institution.
The situation in the U.S. conforms to the typical OECD pattern. Here the attraction of recently arrived foreign banks was not so much their superior financial skills -- though there were certain exceptions -- but rather their willingness to shave price. Despite these price-cutting tactics, none of the foreign banks in the U.S. has been able to secure an appreciable share of the corporate market, or at least not one comparable to the U.S. majors'.
The inertia of corporate banking relationships translates into a structural cost disadvantage, which can be measured in the U.S. by the much higher number of foreign-bank sales calls per principal customer than that of their top local competitors. Given this cost factor, it would appear insuperably difficult for most foreign entrants to build a significant corporate franchise in the U.S.
As one U.S. banker notes: "The foreign banks shouldn't be in this market. Originating corporate business is poisonously expensive for them. My bank makes money agenting deals. I cannot see how a foreign bank can make money other than by buying somebody else's originations."
When some foreign banks had a capital advantage over U.S. institutions -- e.g., the Japanese and the French banks, which operated with paper-thin capital cushions -- buying the paper originated by the top locals might conceivably have been a marginally profitable strategy. But now that capital rules have in theory been commonized worldwide, this kind of capital arbitrage no longer seems viable.
The BIS capital rules, the surfacing of large loan losses for foreign banks operating in both the U.S. and British markets, domestic deregulation, and the growing realization that capital must be husbanded for possible in-market and cross-industry acquisitions have all combined to raise serious questions in the minds of many European bankers as to the wisdom of their foreign strategies. This questioning has already resulted in some retrenchment, though not yet enough.
The Unvarnished Truth
The plain fact is that most foreign operations, be they those of European and Japanese banks in the U.S., European banks in other European countries, or U.S. banks in Europe, are either unprofitable or less than adequately profitable, after appropriate cost and capital allocations are made. What's more, it is extremely unlikely that these operations will ever prove adequately remunerative, especially since cartel arrangements, which once provided a comforting price umbrella, are collapsing.
Indeed, Oliver, Wyman research reveals that the capital employed in foreign operations by many, if not most, banks can be more profitably employed at home, even if these banks do nothing more than invest in their domestic bond markets.
As this fact becomes increasingly apparent to bank CEOs, one can look forward to a more drastic retrenchment than has thus far occurred. This retrenchment should be fueled by the growing sophistication of bankstock investors throughout the world. For example, whereas Japanese bank-stock investors were once content to take their dividends in the form of additional stock, they now show signs of demanding cash disbursements -- a circumstance that should cause Japanese bankers to reflect on whether their U.S. operations are capable of generating their appropriate share of the required cash flow.
A Liquidity Hedge
Will the prospective pullback of foreign operations culminate in discrete, perhaps even autarchical, banking marketplaces? In the basic lending business some semblance of autarchy might indeed result. Still, despite their perception that foreign banks are in general less desirable than local ones, U.S. corporations continue to express a need for one or more foreign relationships, if only as a liquidity hedge. But most of these relationships will probably be confined to the first-tier foreign banks, which include perhaps three Swiss, three Canadian, two British, two French, one German, and often no Japanese institutions.
The other foreign entrants, should they remain, will likely continue to be relegated to the role of buying participations, fleshing out their books with money-market placements, and conducting foreign exchange operations as disadvantaged and therefore unprofitable market makers.
What is true for the secondtier foreign banks in the U.S. is equally true for many of the operations of European banks in other European countries -- e.g., the French in Germany or the British banks in France. Most have less than buoyant prospects.
The outlook for U.S. banks in Europe is essentially similar, except that the U.S. banks retain at least two advantages. One stems from the key role of U.S. corporations in Europe and the continued use of the dollar as the primary vehicle for world trade and investment.
Another relates to the fact that while many local banks have caught up with U.S. institutions in basic technology, much of the product innovation in banking still comes from the Americans, especially in the areas of cross-product and cross-border transactions. While these advantages may not be sufficient to sustain a great many U.S. banking networks in Europe, they may be adequate to support perhaps three or four cost-conscious franchises.
In summary, the worldwide pressure on bank earnings and the slow, though inevitable, emergence of more professional, profit-conscious management, averse to the continued cross-subsidization of loss-leader foreign operations, is stimulating a long-overdue reassessment of a flawed multinational strategy. The upshot should be some considerable pruning of excess banking capacity, recognizing that corporate banking is essentially a relationship-based local activity and that most markets will support only a few new players -- foreign or domestic -- many of which must become increasingly specialized.
A number of banks may even abandon a direct investment strategy in developed countries, perhaps gravitating to the portfolio investment approach embraced by institutions like Banco Santander. As a result, banking spreads should be impacted favorably in areas like the U.S., unless foreign participants, preoccupied with the need to save face, elect only to truncate temporarily the excess capacity they should be eliminating altogether.