"Why should I put our fund's money into bank shares?" the money manager queried. "With capital requirements likely to rise to 10% of assets over time under today's regs, it will be impossible for most banks to earn 15% on capital, so I am sticking to industries where companies can make such returns."
It is hard to answer such pessimism toward bank equities. Yet an answer must be provided.
After all, growth in the industry will be at risk if professionals look at bank stocks mainly as short-term plays on takeover prospects and as yield-bearing equities when interest rates on fixed-income securities are low.
But answers are available. Here are a few:
First, many banks have been working to reduce costs and curb noncredit expenses in order to generate better returns on assets and capital.
One of the cost-cutting programs has been downsizing, with many jobs eliminated and never replaced. Sure banks could have been streamlined before. But the motivation was never as great as it is now. And many banks say they are functioning just as well with staffs slashed by two-thirds.
The industry is also becoming more selective in what services it offers. One CEO of a major Western bank reported recently to a group of bank analysts that his institution has reduced its services from 70 to about 25, including the new money managing vehicles like annuities.
In addition, many banks are telling their customers who want costly but unprofitable services like international funds transfer, "Why not go to the bank across the street -- they offer this service."
This is much the same as when the owner of a steel warehouse goes to a competitor for a small supply of a specific metal and sells it to a good customer at cost because that is cheaper than moving a whole stack of steel in the warehouse to get the needed pieces on the bottom.
Lessons from Retailers
Bank managers also could learn a lesson from successful retailers like Wal-Mart and Price Club, which stock far fewer sizes of popular brands and fewer brands of popular products to reduce inventory and save both shipping costs and shelf space.
To boost return on capital, when banks do offer new services, they are trying to promote those that do not require heavy capital backing. Annuities, trust services, financial advisory services, and other products that do not involve the bank's commitment of large amounts of money all fit into this category.
Origination, securitization, and sale of every type of asset from mortgage loans to credit card receivables provide the bank with up-front income without having to tie up money in assets that require heavy capital backing under new laws and regulations.
Finally we have the obvious reaction to today's capital requirements -- banks are stressing investments over loans. This is why the volume of investments is exceeding the volume of loans for the first time in 27 years.
Why shouldn't banks take this route? Government securities are considered rickless under risk-capital requirements, can be placed on the books with little transaction cost, and are liquid assets that can be sold quickly if the bank wants to make new loans or reduce its size.
So we are seeing more and more banks look at their deposit bases as conduits for cheap funds. Then they place the funds in government securities and other quality bonds with modest spreads that largely flow to the bottom line because the capital requirement drain is so low.
Income Through Services
Analysts predict the day will soon come when some banks will give up deposit insurance altogether, dedicating deposit inflows only to those riskless assets to maintain public confidence, and make the bulk of their earnings from the sale of services and talent.
By becoming almost nonbanks, they will handle their capital requirements through the back door by simply pulling their operations out of the regulatory loop.
But what about American individuals and small businesses that still want and need bank credit? If banks start to favor investments and noncredit services over loans, won't banks hurt individuals and small businesses -- and hurt them badly?
Back to the Past
Not so: If people really want loans, they will be willing to pay what the money is worth, something we have not seen for a long time.
In other words, the days of rewarding the borrower with low rates and punishing the saver with the same low yields are likely to be over.
Let's face it: Bank capital's basic role is to back loans, and if bank capital remains so expensive, then obviously the borrowers should bear the cost of providing the capital to meet regulatory standards.
It is even within the realm of possibility that when Congress sees who eventually pays for the higher capital standards -- the individuals and smaller business borrowers who can't turn to the commercial paper market and other impersonal fund sources -- it may begin to relax the new capital standards.
All these developments may not bring return on capital for banks back to the levels of 15% compounded that money managers want, but they are steps in the right direction.
Mr. Nadler is a contributing editor of the American Banker and professor of finance at the Rutgers University Graduate School of Management.