Reform Law or No, Bankers Need to Refocus

"Smart bankers don't wait for an act of Congress" may seem an odd aphorism.

Recently, the House Banking Committee passed a banking bill. The Bush administration has demonstrated a commitment to passing major reform legislation. And optimism in Washington on prospects for major banking reform has been running higher than at any time since 1984.

This optimism is in sharp contrast to a year ago and even six months ago. One year ago, we were coming down the home stretch of an election year, with incumbent members of Congress finding great outrage among their constituents at the cost of the thrift industry bailout.

Attention was focused on "punishing the crooks" and figuring out who was to blame for the enormous cost to the public of the thrift bailout.

Lobbyists Keep the Fire Simmering

Following the election, when it was clear that no members of Congress were defeated by the issue, it seemed likely that avoiding a legislative battle on banking issues would be this year's priority.

It is a tribute to the lobbying capability of the banking industry that legislation has moved this rapidly. But there are still good reasons why smart bankers don't wait for an act of Congress.

Reforms of the banking industry that require legislation occur episodically, in segments, not at regular or timely intervals. We may get anywhere from minimal to major reform in this Congress -- and we may get none at all.

Also, there are clear differences in priorities among the banking industry, Congress, and the Bush administration.

Bush Administration's Point of View

The administration clearly outlined its four priorities when this legislation was introduced:

* Restoring competitiveness in the banking system through diversification of product, reduced operating costs, and reducing the overextension of insurance coverage -- which they have addressed by limiting Federal Deposit Insurance Corp. coverage.

* Encouraging increased capital. Indeed, a reading of the bill reveals all the ways that capital is emphasized -- capital-based supervision, capital-based insurance premiums, capital-based expanded activities, and capital adjustment for interest rate risk -- it is hard to miss the importance that priority is receiving in the administration proposal.

* Streamlining the regulatory system by consolidating the Office of the Comptroller of the Currency and the Office of Thrift Supervision within the Department of Treasury. Some supervisory responsibility of the Federal Deposit Insurance Corp. would be allocated to the new financial services regulator and also the Federal Reserve Board.

* Recapitalizing the Bank Insurance Fund.

Slower Tempo on Capitol Hill

By contrast, Congress seems to embrace only one, or perhaps two, of those issues as priorities.

Clearly, BIF recapitalization is a congressional priority. House Banking Committee Chairman Henry Gonzalez is seeking to separate that portion of the bill and move it expeditiously. Support of increased capital is also an important congressional priority.

But, at this point, streamlining the regulatory process does not appear to be on the front congressional burner. And Congress will only pay attention to increased competitiveness and lower operating costs with regard to the relative strengths of competing special-interest groups.

And this legislation has yet to encounter a major hurdle -- the battle over congressional priority of committee turf, primarily in the House of Representatives. Because of this holdup, it has now been nine years since Congress passed a major banking bill enabling new product opportunities.

Federal Legislation Is Crucial

Although hard to believe, most of today's banking legislation came out of the Roosevelt administration. Why would our lawmakers permit an industry, so fundamental to the economic health of this country, to play by rules designed to address problems identified almost 60 years ago?

Opponents of banking legislation like to focus debate on the perceived conflict of combining securities in banking. Or else they define securities powers for banking as primarily a "big bank" issue.

Both arguments sidestep the real problem. Under current statute, the banking industry -- unlike any of its brethren in the financial services industry -- is unable to adjust as the market changes. As examples, look at three very basic banking industry products.

The passbook savings account has long been a faithful banking industry friend. Although available virtually on demand, that deposit base was very stable.

The interest rate, for years, remained at an unvarying 5%. A loyal customer base found great comfort in maintaining idle funds in that account.

Changing Face of the Passbook

Beginning in the late 1970s, three changes to the basic product reflected marketplace priorities: third-party access, or check-writing privileges; payment of a flexible market rate of interest; and the opportunity for equity appreciation.

To achieve those changes, the securities industry needed no enabling legislation or regulation. It simply responded to consumer needs.

Banks, however, needed an act of Congress to achieve the first two of those improvements; they still cannot offer the third.

Remember the days when banks were the low-cost provider of automobile loan financing? They were very good at analyzing consumer credit, careful in monitoring loan performance, and, most importantly, could provide the lowest-cost funding source.

As everybody knows, banks are no longer the low-cost provider. The automobile captive financing companies (GMAC, Ford Motor Credit, and Chrysler Credit) quickly matched, if not exceeded, the banking industry expertise in credit approval and monitoring.

The greatest competitive advantage was their utilization of a funding tool which the banks could never match: securitizing the loans.

Mortgage Loans Split Three Ways

Or consider mortgage loans. Through the miracle of advanced technology, what had been a single product is now a three-part product.

Origination, funding, and processing can now be three different loan products. Each has its own pricing opportunity, income stream, and market value.

While the banking industry can still participate in each separate product, virtually all of these loan products are less expensive and carry lighter regulatory burdens outside the banking system.

The pending bill does not specifically identify those three products. But, in a very fundamental sense, bankers are asking Congress for the capability to change when markets change. Lacking this ability, banking is a dying industry.

Some Problems Won't Wait

The economic uncertainty of the '80s and the resulting weaknesses in banking industry credit quality will not be addressed or resolved by Congress. The trend toward increased competition, witnessed in the '80s, will undoubtedly continue in the '90s.

The anticipated conversion of S&Ls to banks, the increased penetration of foreign banks in the United States, and the likely impact of further interstate banking will assure a heightened competitiveness for banking in this decade.

Without waiting for federal legislation, bankers must focus on three immediate management challenges: maintaining asset quality, reducing the cost of product delivery, and identifying a core business strategy.

Maintaining Asset Quality

In the early '80s the lumber-producing states of the Pacific Northwest experienced a severe economic downturn, resulting in loan problems and bank closings. By the mid-'80s it had reached the Midwest in the form of agricultural loan problems and the Southwest in energy loans.

By the end of the decade it had reached the East Coast, principally in the form of commercial real estate problems. At each end of the decade, the problems were exacerbated by cyclical economic downturns.

Banks with the greatest losses geared their criteria for loan quality to match loan performance in the best of times.

Most bankers will learn from the experience of the '80s. But if they use rapid growth in loan portfolios to reach for growth, market penetration, or earnings, they are bound to relive the nightmares of the '80s.

Some banks have adopted new approaches to credit-exposure management: qualification of risk at the board level, assuming consistent loan approvals among branches, and identifying problem credits while the borrower still has options.

Keeping Loan Options Alive and Kicking

Through call-report data and other sources, banks now have the ability to measure historic loss experience in virtually every category of credit exposure.

Surprisingly, however, few bankers utilize that data when developing a loan strategy. Very often, we find vast differences between historic loss experience and the provision the bank the bank is using to consider credit-risk exposure.

In today's economy, a bank board must quantify the risk level that can be absorbed by the bank's earnings and capital. This capacity must then be compared with the historic loss experience in the loan portfolio. Careful risk management requires consistency of approvals among branches.

Perhaps the greatest frustration of lending comes with the realization that when a credit goes sour, the borrower has almost no remaining options. Many bankers are now developing early warning systems.

The problems of the '80s have emphasized that prior experience is not a sufficient indicator of loan quality. Macroforces such as real estate values and regional economic recessions have made problem credits out of customers with great prior loan experience.

The administration has dealt with this issue, in part, by proposing to allow interstate branching and expanded interstate banking ownership.

Cost savings would certainly result from enactment of that provision of the bill, which Congress has supported thus far.

But much of the excess overhead burden of the banking industry will be unaffected by any portion of the bill. Indeed, it may be exacerbated by any resulting increase in deposit insurance premiums or by altering the formula for assessment.

Cutting costs has became a popular management goal in the past few years. We have seen examples of successful cuts -- and we have seen some disasters.

One common mistake is cutting overhead expense without considering the implications on revenue or operating control. Some banks have identified either a percentage or a fixed dollar amount of savings as a target -- and begun slashing away. Only after the cuts have been made do they realize the full impact on their revenue stream. The mistake was relying on existing financial information to make that assessment.

Very few banks, including the nation's largest, have developed cost accounting and management information data that accurately reflect the relationships between cost centers and revenue flows. We strongly urge banks not to undertake downsizing or "rightsizing" without first making the proper cost/revenue assessment.

Another mistake is assuming that the most fertile cost-cutting opportunities are in areas containing the largest number of bodies. Sustained savings do not result from eliminating a handful of clerks or tellers. They require careful examination of the economies of entire departments or functions. Also, this approach to cost cutting is fundamental to identifying a core business strategy.

As the administration proposal offers new opportunities for product diversity, we must remind ourselves of one of the oldest axioms of management: You cannot make money in a new business until you know how to make money in your basic business.

For some banks, identification of a core business strategy is very easy. A bank in a rural town, serving only that marketplace and a largely agrarian economy, has a very clear core business strategy. As demographics and loan opportunities in your marketplace become more varied, identification of a core business strategy becomes more complex.

We strongly urge businesses to understand the economic dynamics, risk characteristics, marketplace dynamics, and management needs of their core businesses. Economic dynamics may be a problem, because the management information generated by your current general ledger system probably does not give you the ability to make that analysis.

The Core Business Component

A core business evaluation is a critical component of every business plan. Properly done, it identifies "core competence" -- what a bank does best.

It also identifies how a bank really makes money. An important corollary is that every noncore activity becomes a candidate for sale, outsourcing, downsizing, or outright elimination.

While legislative initiatives deserve the attention of bankers, they are not a panacea. Successful management of a bank requires critical management areas which the pending bill does not address.

Mr. Olson is national director of regulatory relations for financial services industries at Ernst & Young.

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