PNC Financial Services Group is getting to look more and more like its Pittsburgh neighbor, Mellon Financial Corp. PNC's fee income is rising and its dependence on lending is falling. It is getting more deeply into asset management and back office processing. And while its p/e hasn't yet reached Mellon's lofty levels, it is pulling away from the pack. Between year-end 1999 and late October, PNC's stock climbed 36%, trailing only State Street Corp. and edging out such superstars as Mellon and the Bank of New York Co. James E. Rohr, PNC's 51-year-old chief executive, attributes the stock's climb to the tilt away from dependence on interest income to greater reliance on fee income. But unlike some of its successful competitors, Rohr sees traditional corporate and retail banking continuing to play an important role. Following is an interview with Robert A. Bennett, editor-in-chief of U.S. Banker.

USB: I see that your stock hit an all-time high today [Oct. 3] of $67.69. Can it go further?
ROHR: We have some opportunity for the stock to go higher yet. We've created a mix of businesses that gives us a very good chance of delivering on our objective: to deliver a consistent, double-digit net income growth over a long period of time. Those kinds of companies trade with multiples of 20.

USB: Is it really possible to do that--for any company? Can you get a 10% to 12% increase indefinitely?
ROHR: It's a real challenge, and not many companies have done it in the financial services sector. Part of our opportunity is the mix of businesses that we have. Take the asset management world. We have the private bank, BlackRock, and PFPC, which is our mutual fund processing company. These companies have been growing at a 20%-plus pace for a number of years. We have other businesses, like capital markets and treasury management, that grow in the high teens. And then you've got businesses like the basic deposit business--if you're able to grow net income in the community bank at 8% to 9%, you're getting pretty close to best in class.
So we are trying to build a mix of businesses that will be able to perform over time and deliver that kind of growth. Consistency is the most important thing.

USB: It seems all banks want to get into asset management. As you know, often in the past banks rushed into areas they thought very lucrative, pushing down profits for everyone. And in asset management, much seems to depend on the continued exuberance of the market.
ROHR: Asset management is a very competitive field, like a lot of others. We have two asset management businesses. We have PNC Advisors, our private bank, which is the traditional asset management business that a lot of banks have been in for many years, and we think we do it particularly well. Our Advantage portfolio has beaten the S&P 500 for a number of years, so that's allowed us to perform well.
Our second asset management business, BlackRock, had been a pure fixed-income manager when we acquired it. It had about $25 billion in assets under management. It's now taken over our mutual fund activity, liquidity and risk management for ourselves and clients, and it's grown dramatically: It has $191 billion in assets under management. It's done phenomenally well. Now we've taken it public, so it really is a pure asset manager. Its people are paid like asset managers. And they're not like, as some people put it, "bank" asset managers.

USB: When did you buy BlackRock?
ROHR: Early 1995.

USB: And when did you sell part of it to the public?
ROHR: Last fall [1999]. We sold 15% of the company to the employees and we sold 15% of the company to the public.

USB: Why did you do it?
ROHR: One reason was because asset managers need to be paid an incentive based on how they perform. One problem over the years has been that banks say to an employee: "You be an asset manager, and we're going to pay you like a banker." And so the asset managers leave the bank and go somewhere where they get paid like an asset manager.
With BlackRock, we made sure that these people will have the opportunity to own part of the company, and to be recognized and rewarded based upon their own performance. So the people that we brought in--the partners of BlackRock that came with us when we acquired the company--all of them are still with us, which is unusual for an asset manager that's been taken over by a bank. Larry Fink [BlackRock's CEO] and Ralph Schlosstein [Blackrock's president] and their people run the company and run it exceedingly well.
We do a lot between the bank and BlackRock. We work together on a lot of things; we have a lot of joint customers. Larry is in my staff meeting every Monday morning. I'm on the BlackRock board, as is Walter Gregg, [vice chairman of PNC], and so we spend a lot of time and work very closely together. But the compensation piece really is tied to how they perform.

USB: How much of BlackRock's assets are in equities?
ROHR: Equities in the portfolio are now around $23 billion.

USB: Still fairly small.
ROHR: Fairly small percentage in equities. It's about 85% fixed income.

USB: It seems to me you're beginning to look more and more like your neighbor across the street, Mellon. Would you agree?
ROHR: Mellon has some strong fee-income business. We, too, have strong fee-income businesses. Fees have grown to 59% of our revenue base; Mellon is at approximately 70%. Bank of New York is about 62%. But we look at our business differently than Mellon in that we say we've got to have a diversified set of revenue streams. Mellon's consumer bank is down to 15% of their total revenues, and so they've really reduced that business rather dramatically.

USB: Where is it here?
ROHR: Here it's around 40% to 45%. Our return on that business is more than 20%.

USB: What about other aspects of commercial banking?
ROHR: Mellon has reduced its traditional banking businesses dramatically. We have a much larger percentage of our profitability tied up in regional banking activities. Those give us a very stable and a diversified set of income streams. Mellon's a little different than us. Their income streams are narrower and more focused in asset management.

PNC’s Metamorphosis

  1996 2000
Net interest income $2.40 $2.20
Noninterest income 1.4 3.2
·Total revenue ($B) 3.8 5.4
·Noninterest income/ total revenue 36% 59%
·ROCE 17% 22%
·ROA 1.40% 1.67%
·Efficiency 57% 57%

2000 reflects first six months annualized
Source: PNC

USB: But, again, its P/E ratio is significantly higher than yours--I suspect partly because it isn't as exposed in commercial banking. I see in your own presentations, you emphasize that you're less risky because you are becoming far less dependent on lending.
ROHR: If you went back five years or so, you would find that about 75% of our net income was tied to some form of credit risk. Today it's less than a third. And in the world that we're in today, because of capital markets and how many banks and foreign banks and different credit or capital requirements there are, you don't get paid for taking credit risk. We see it as an issue of how you manage credit risk as opposed to getting out of it. We've eliminated a lot of risk where we weren't getting paid an appropriate return, and then we've simply eliminated certain activities where the risk isn't justified.
But our middle-market banking is still a strong focus. We have a large market share in that business. The treasury management business is growing in the high teens--it's double the industry average, primarily because of the technology that we have in the place. And it's doingfabulously well.
The capital markets business last year grew over 30%. So parts of the corporate banking business are very, very attractive--high returns on capital and good growth opportunities. But you're not getting paid enough if you're only providing credit.USB: Bank of New York claims that its corporate banking is an integral part of its other businesses. Would you say it's similar here?
ROHR: We generate a lot of different types of revenue streams from the corporate bank. It's a matter of managing the relationships for the entire company, but you've got to manage the credit risk first because if you're not happy with the credit then the rest of the income streams really don't justify the risk.

USB: Speaking of credit quality, the regulators certainly are sending up the warning flags. Do you have any concerns in that area?
ROHR: I've been around long enough to know that we will continue to have business cycles. Whether we have a massive recession or not I'm not sure, but we'll have a downturn. And when we do, there will be more problem credits than we have today. As far as PNC is concerned, we just have to continue to focus so that when that happens we still will have the ability to grow our net income numbers without the problems that banks have had in the past.

USB: I see that all your businesses have been showing returns of more than 20%, except for the one you just got rid of--mortgage.
ROHR: We are selling our residential mortgage business. We were an $85 billion servicer, small by industry standards. In the last two or two-and-a-half years, the industry has consolidated. The top five players have $300 billion or more in servicing, and we had $85 billion, and it's an economy-of-scale game.
We looked at the business and said, "Okay, we thought a couple of years ago that we would have to get to $150 billion to reach their scale" to be a top-five player. This year we came back and said, "The numbers have changed--now it's $300 billion," which meant that we were going to have to spend about $2 billion in capital to get to that size. And when you get to that size, all you are is that size; you aren't best in class, you're just there. Tell me we're going to spend $2 billion on our lowest-return business, with the most volatile earning stream we have in the company, and we're not even best in class. So the decision really was to not invest that money and to put it somewhere else, where it would make more sense.

USB: Couldn't you apply the issue of scale to some of your PFPC businesses, too?
ROHR: PFPC is today the largest transfer agent for mutual funds. It is the second-largest fund accounting and administrator for mutual funds. It is larger than State Street, for example, in the transfer business, and it's second to State Street in fund accounting and administration. So, from a scale point of view, and from a technology point of view, we are at the top of the business.
For example, if you have a Schwab account, we do all the fund accounting for Schwab, all the administration. We do the transfer agency business. There's a number of big-name players like that for whom we do the back-office. That's a very, very good business for us, and a growing business, and really a processing business. We'll compete with anybody globally in that business.

USB: Now, if I understand it correctly, PFPC also does back-office outsourcing for others. Because I noticed you made some arrangement with Prudential.
ROHR: No, that's not PFPC, that's our retail bank. They do online home-equity loans and auto loans. We have the ability to create those kinds of loans within 10 minutes. And so we won the competition to do it for Prudential. We do it for others, too. We do the home-equity side of American Express' online service. We also do all the back-office processing for NetBank, an Internet-only bank.
USB: Does that include checking accounts?
ROHR: Yes.

USB: What will you do with the proceeds from the sale of your residential mortgage business?
ROHR: The proceeds will be about $605 million. We won't get the cash until the first quarter, probably, when the closing takes place. So in the release we named a series of things we might do: We may reposition our balance sheet and reduce our leverage; we may buy back some stock; we may invest in other businesses. We've got the whole fourth quarter to figure it out.

USB: Considering your mix of businesses, would you consider PNC a bank?
ROHR: We're a financial services company, really, that has a bank, and a very good bank. When we look at our various businesses, we try to compare each with the best-in-class in that particular business. So we would look at PNC Advisors, for example, and compare it to U.S. Trust. PNC Advisors manages about the same amount of money as U.S. Trust does, and makes almost double the net income.

USB: What role does capital play in a financial services company? How do you determine how much capital PNC needs?
ROHR: You have to look at the risks in your business. We always want to be a well-capitalized bank from a regulatory point of view. Their risk analytics are logical. We do the same thing. We allocate capital to different businesses that we think those businesses need to run their business.
PFPC and BlackRock have capital allocations that would be similar to a publicly held firm. Obviously, BlackRock does stand on its own, and we might consider an IPO.

USB: What would be the primary reason for that?
ROHR: Processing companies trade at 30 to 40 times earnings, and to get best-in-class people and reward them competitively with people in their industry, it's better that they own stock in their unit.

USB: So it's largely for internal incentives?
ROHR: To a great extent. Also, if you would do an acquisition with PFPC stock or with BlackRock stock, you would have a stronger currency. BlackRock trades at about 26 times 2001 consensus estimates now, and PFPC could have the potential to trade at a level comparable to its peers.

USB: Might another reason be to impress the general investing public that this very high-earning unit is a significant part of PNC?
ROHR: Certainly. Absolutely. When you look at asset management and the mutual fund processing business, you're really talking about industries that, given the demographics we have in our country, really have the wind to their back. So it does help make the market more aware that PNC does have these businesses.

USB: What happens to these businesses if there's a significant downturn in the markets and people start putting their money back into CDs?
ROHR: Well, that would be great! The attractiveness of various financial instruments differs with the times. In the last few years, it's been mutual funds. They'll continue to be good instruments, but other instruments come and go depending on the cycle.
If you look at the business in our case, the equity piece is relatively small compared with most of our competitors. If the Dow were to drop precipitously, frankly we're 85% fixed income. So you might argue that it actually would allow us to grow that business more rapidly than normal.

USB: How is it that you do so well on your traditional corporate banking, earning a 22% return on capital, with an efficiency ratio of 51%? Can it get much better?
ROHR: Oh, I think so. We've changed the business so much that now 51% of our corporate bank is fees. You don't have to go back too many years before, when it was 25% or 30%. If we didn't have best-in-class technology for our treasury management, if we didn't have our niches in the capital markets business, in the derivatives business, and other areas, things would be different. We've looked at other banks whose corporate bank is predominantly lending and we find it difficult to generate enough of a risk/return ratio if that's all you get.

USB: Might you do any big acquisitions in the future?
ROHR: Absolutely. We look at acquisitions on a business-by-business basis. At the end of last year, for example, we acquired ISG [Investor Services Group], which was a subsidiary of First Data; we merged it into PFPC. PFPC went from being the third-largest transfer agent to the largest transfer agent, and it went from being a distant second on managed fund administrator/accounting to a very solid No. 2. When we put them together, it tripled the size of the company, revenue-wise. The conversion is going exceedingly well. Again, we're trying to create a best-in-class business in that area.
PNC Advisors bought Hilliard Lyons a few years ago, a brokerage firm that's in 19 states, and brought it into Pennsylvania. It had a technology platform with a ticketless entry system, excellent people, and it's an upscale broker. We expanded our distribution very nicely for PNC Advisors. It's doing very well. We also acquired a company called ABD, which is blue-sky technology for mutual funds, and put that into PFPC.
So, business by business, we're acquiring companies that give us best-of-class opportunities. Large acquisitions? I don't know. Sometimes they come along and sometimes they don't.

USB: You didn't mention commercial banks. Do you think you've had your fill of commercial banks?
ROHR: I don't know. You have to look at them one by one and see what it does to your franchise, see what it does to your business mix. We have a business mix that allows us to aspire to double-digit net income growth. If we become too dependent upon any one thing, I think it could hurt that. And the community banking business is difficult to grow rapidly. It's a very good business, with excellent returns, and the risk/reward relationship there is very good because you don't have a lot of risks in the deposit-taking business. So we like that part of it. But if it becomes too large a part of the company, then you really have a difficult time reaching those growth aspirations.

USB: How important is your venture capital business?
ROHR: It's a wonderful business; it's done very well. There are two parts to it. The main arm is PNC Equity Management, which has about $750 million invested. It does second- and third-stage financings. It doesn't invest in grass-root, high-technology firms. I would say less than a quarter of its business is in high-tech-type businesses. It does a lot of mezzanine financing for buy-outs and things like that. They're not in the "angel" money.

USB: Is it an extension of your middle-market corporate bank?
ROHR: It is and it isn't. It has a relationship with the middle-market corporate bank, but it really acts as a venture capital firm, not as a bank.
We also have a company called the VentureBank. It's part of our corporate bank. It does invest small dollars in high-technology start-up companies and bank them. And those pieces are very small: $100,000, $200,000 and $300,000 investments.

USB: So it's not like Chase.
ROHR: No, it's not like Chase. Neither one of our entities would be like Chase, where they spend hundreds of millions of dollars, billions of dollars, in start-up technology. It really isn't that. As a result, our returns have been much more consistent over the last five years.

USB: So that means when the NASDAQ goes down, your shares aren't hurt too badly.
ROHR: When the NASDAQ goes down, we're not as happy as we are when the NASDAQ goes up. But people aren't going to see a hole in our floor if that market drops.

USB: How does electronic banking fit into your overall strategy?
ROHR: You have to go business by business. We have a company called BillingZone, a joint venture with Perot Systems, that really is a state-of-the-art electronic bill presentment payer. We're the only one that actually has customers up and running. We made that announcement earlier this year. It's doing very well.

USB: So you have your own bill presentment program? That's very unusual.
ROHR: It is unusual, and it's going very, very well. We'll have more announcements pretty soon.

USB: What about the consumer side?
ROHR: I've already touched on the electronic processing we do for NetBank and Prudential. But we also have a penetration rate of more than 20% in our customer base in terms of online banking. I believe that number is second among all banks, based on a DLJ survey.

USB: Why do you think you've done so well there?
ROHR: I think it's because we have a lot of products. We've totally revamped our Web site; we've got online banking.

USB: Do you think that your online banking business will allow you to further thin your branch network?
ROHR: I think over time. The vast majority of our customers are multiple-channel users. We coordinate our channels to assure that our customers really feel they are part of us. We measure customer satisfaction every single quarter in every single business we're in. And we measure it down to every branch, every calling officer; it affects people's income. That's turned around our retention numbers and enhanced our profitability. It's the people doing the work that makes the difference.

USB: When banking industry stocks were hurt earlier this year, PNC was pulled down with the rest. Is there any way you can separate yourself from the crowd?
ROHR: The industry as a whole is interesting. You can't take the industry as a whole anymore because these different companies have different mixes of businesses, and you really have to look at the companies one by one. If you look at a Bank One with a giant credit card portfolio, and you look at us, and we have none, how do you compare those two companies? Look at Wells Fargo. It has a $350 billion or $400 billion mortgage portfolio, and we have none. On the other hand, we manage more money than Wells does, almost $240 billion. It takes time for the market to recognize the differences.

USB: Has the change in your business mix had any ill effect on earnings?
ROHR: Last year we grew our core business by 13%, yet we took about 6 cents a share this year out of the corporate bank by reducing risk. Also we sold part of BlackRock to the public; that cost us about 5 cents a share. We bought ISG; that was a dilutative acquisition, especially in the first half of the year. So we've done some things to position ourselves to grow, but at some short-term cost. And we've told the Street that next year earnings will be reduced by the sale of the mortgage company, which will earn about 20 cents a share this year. But it positions us better to deliver the kind of growth that the shareholders want.

USB: Now we're going to see what kind of diplomat you are. What do you think of the investment analysts?
ROHR: First of all, I think it's a very, very difficult job. Generally speaking, they work pretty hard. And the ones that I speak to have done their homework and understand the company fairly well. A couple of them have been burned so often by people that they really trusted, I think they're a little gun-shy, and I think it's our job to build their confidence in our company as opposed to the whole industry.

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