The Dark Side of Banking Reform

Suddenly, a lot of people are investing in banks rather than just talking about it.

Nontraditional, high-profile investors like Warren Buffett, the Tisch family, Saudi Prince Waleed bin Talal, Henry Kaufman, Kohlberg Kravis Roberts & Co., and Lazard's Corporate Partners are making big, opportunistic bank deals - some of which look sweet indeed.

And smaller investors, watching the big players, are themselves beginning to think that this could be the time to buy into the industry.

There are certainly many ways to buy in. Depending on his resources, an investor today can: buy a failed bank, in whole or in part; invest in or buy a marginal bank, which either doesn't meet, or only marginally meets, capital requirements; invest in the listed securities of J.P. Morgan, Banc One, or the few other banking blue chips, or invest in or buy any of the remaining thousands of banks.

Priced to Sell

Moreover, the prices seem very good indeed. After a decade of poor results - and with more on the way, considering the state of many existing commercial loan portfolios - even the blue chips have suffered in the financial markets. Thousands of institutions are scrambling for additional capital to comfortably exceed or in many cases just meet new capital rules.

So, new offerings are priced low to sell, and many bank CEOs now stand ready to negotiate extreme dilutions to current shareholders in return for large investments, rather than face the severe regulatory consequences.

Lawmakers Sweeten the Pot

Our legislators are working to make the deals sweeter still. The banking reform legislation moving through Congress aims to encourage the recapitalization of the industry, partly through an open-arms attitude toward non-traditional investors and the promise of exciting "new" powers such as interstate branching and the broadening of the banking charter to include such businesses as insurance and securities.

This package enjoys far stronger support than the Financial Institutions Reform, Recovery, and Enforcement Act had at the same stage of evolution in 1989, and its passage seems inevitable. Many believe that it will save the industry, by attracting a flood of new capital.

Look Before Leaping

But before they jump in, wise investors will look hard at the total reform package, the overall economics of a bank deal, and at the individual bank itself. For while the package will encourage recapitalization, it will also accelerate consolidation of the industry.

And sweet deals will have so many strings attached, both regulatory and otherwise, that only a small percentage of them will actually yield the 20% to 30% annual returns that optimists are projecting. Thus, before making commitments, investors should consider the following:

1 Picking a winner is hard, and getting harder. Investors are attracted to banking now partly because it is so fragmented, and so overloaded with excess capacity. They understand that the radical downsizing that has been talked about since the 1970s will finally materialize in the 1990s - and they understand from the experience of other consolidating industries that intracity, intrastate, and interstate combinations can yield quantum-level efficiency improvements that translate into very attractive returns on investment.

But in a marginally capitalized industry with over 12,000 banks, these opportunities will be the exception rather than the rule. Most analysts agree that this industry will shrink and continue to forfeit share to non-bank financial institutions, as has happened in the Northeast during the past two years.

Certainly, the uniquely clean, well-managed, and well-positioned banks will continue to attract capital and prosper through well-designed and executed acquisition programs. But the majority will disappear.

Sorting Winners from Losers

For those acquiring banks, the due diligence process is designed to help us distinguish the winners from the losers. But in an industry where most of the assets are represented by pieces of paper, even the most expert examiners have trouble evaluating with high levels of confidence the quality of a loan portfolio during the standard 90-day review period.

KKR hedged its due diligence in the Fleet/Norstar deal for Bank of New England by negotiating a 3-year period in which it can turn over to the government any bad loans it finds.

But the same hedge will not be available to buyers of banks that haven't failed. And smaller investors not afforded a due diligence review can get little meaningful information about the real quality of an institution's loan portfolio.

Also, industry change is often so fast that events external to the bank could drastically affect its own potential. In New England, for example, the value of the Bank of Boston has been dramatically impaired because one of its chief rivals has gotten permission to expand right into its back yard via the KKR/Fleet deal for Bank of New England.

2 The costs of doing a deal are high, and getting higher. The new legislation will permit commercial companies to own major bank stakes, and you would expect regulators to do everything in their power to encourage investment in an undercapitalized bank or thrift.

But the regulations that govern bank ownership are so complex that an investor who buys a control stake in a bank for the first time will have to spend 2% to 3% of the total deal size on legal, accounting, and other advisory fees, in order to sort out an investment structure that meets regulatory muster. That will come on top of the usual expenses for due diligence, investment banking, and other transaction costs.

There also is the opportunity cost of doing a deal in banking, since you are rarely allowed to buy a single bank with borrowed money, and equity is harder to obtain.

Banking industry authorities typically discourage leverage in bank acquisitions. Their main reason is that high leverage would put the depositors and the FDIC's Bank Insurance Fund at risk, if the cash flow from bank operations is insufficient to service its debt and the bank fails.

But they also resist approving transactions under the federal control regulations when there is a possibility that lenders in a leveraged deal might end up with the bank's stock in the event of default.

3 The bank you invest in may have unexpected strings attached. Those who thought that FIRREA brought thrifts under uncomfortable scrutiny will be shocked to find that the worst is yet to come. Today, there is little communication among the four regulatory agencies - the Office of the Comptroller of the Currency, the FDIC, the Office of Thrift Supervision, and the Federal Reserve - and standards differ dramatically.

When the four bodies are restructured into one primary regulator, the Office of Depository Institution Supervision, many institutions that have dealt for years with the same examiner may well find that their previous examinations have been discounted and that new, stricter standards are being applied by new examiners intent on putting teeth into regulation.

This happened in the thrift industry after the passage of FIRREA.

Limits of Due Diligence

In the worst case, a bank that under current regulation is "marginal" could be reclassified as a failed bank. More likely, though, is that a new examiner could impose additional conditions on operations, ranging from restricting dividends, to requiring changes in management, to prohibiting growth and business diversification, to requiring the use of an outside consultant, to mandating a bank's sale!

The best due diligence cannot foresee the additional strings that could be attached to a banking investment as a result of regulatory restructuring.

4 Reforms will increase the costs of doing business. Banks that escape costly new examiner-imposed conditions will find that the reforms already in place and soon to come will make it harder to earn attractive returns even on a discounted investment.

* Adherence to a rigid risk-based system for setting deposit insurance premiums and calculating capital ratios will cause many banks to shift their asset origination and investment appetites from, for example, local community business lending to Treasury bill investing.

* Changes in deposit insurance rules to restrict maximum coverage to $200,000 per depositor per institution will increase deposit-raising costs for banks that cater to businesses and high net-worth customers. And perpetuating "too big to fail" will increase these costs for all but the 35 large regional and money-center banks as large depositors siphon off funds from small banks to these failure-proof sanctuaries.

* Federal Deposit Insurance premiums will be going up more and probably often.

* The cost of more frequent examinations will rise.

* Mounting capital requirements outpacing new sources of earnings will reduce returns.

* Permitted entry into insurance, securities, and mutual-fund underwriting is not really the carrot that drafters of the banking bill claim because startup costs and skill requirments for these businesses are nearly prohibitive.

5 You will be scrutinized. Nobody questions that banking reform is needed, and nobody questions the importance of tougher regulatory oversight for the protection of both individual depositors, the payments system in general, and ultimately the taxpayers. But it looks like the next few years will bring regulatory overreaction to the easygoing early 1980s.

Investors getting into this business for the first time will be appaled when they see the time and effort it takes to comply with the new regulations. The effort will likely discourage many.

Investment opportunities are going to be unprecedented in number and rich in diversity. And when that's true, savvy investors tend to make a lot of money. Beware, however, of Big Brother's promised help along the way.

Mr. Stock, formerly of Mellon Bank and McKinsey & Co., is chairman and chief executive officer of First Financial Partners Inc., a New York management consulting and investment advisory firm.

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