To Meet Tough Standards, Think Small

The 1992 capital guidelines have put many bankers in a vise, caught between capital requirements and shareholder demands for adequate returns.

Bankers have not faced such challenges since the 1930s.

Capital adequacy standards set up by the Basel accord are changing the fundamentals of the business. The overall goal is to force bankers to better understand their profitability and risk by product and by line of business.

As we approach the date when a final 8% ratio comes into effect, every day counts. Industry-wide the capital gap is huge.

The Treasury in June 1990 estimated an overall deficit of $12.8 billion. More recently, the Federal Deposit Insurance Corp., in requesting a $25 billion line of credit with the Federal Reserve for the Bank Insurance Fund, has defined an expected upper limit.

Regardless of the exact number, the industry must raise a great deal of money.

Equity issuance alone is unlikely to solve the shortage. Though issuance set a record in the first half, this money went mostly to institutions that are building a war chest to use during the balance of the decade.

The exceptions were MBNA's sale of its crown jewels and the millions that Citicorp received from a Saudi prince. But there probably aren't enough Saudi princes - or other willing equity investors - to solve the industry's capital problems.

Another source of capital is income. Yet judging from recent history, income is also unlikely to provide the answer. In fact, banks paid out more in dividends than they received in income - and margins have been fairly slender since.

What are the alternatives?

Firstly, banks may work off their risk-weighted assets. To do this, they can limit asset additions; securitize loans; sell subsidiaries, properties, or securities for capital gains; reallocate assets across the asset-risk weightings of the Bank for International Settlements; or grow businesses that require only limited capital, such as government-backed and mortgage securities.

(In the same vein, investment bankers are creating new risk-adjusted products. Outside the United States, for example, there is a product that packages commercial loans as a guaranteed trust that is then sold back to the bank, reducing capital requirements by about 50%.)

Efficient Operations

Secondly, banks can find ways to operate more efficiently.

On the revenue side, this means taking advantage of new opportunities for risk-adjusted pricing, increasing revenues from fees, and investing in high-yield businesses. Increasingly, banks are pulling capital out of their low-earning businesses and products and are reinvesting in more profitable ventures.

On the cost side, banks are starting to realize that they must identify low-cost funding, leave unprofitable businesses, and "right-size" remaining operations.

Each bank's capital position will dictate which of these strategies is most appropriate.

* Banks with deficiencies of more than 4% can expect to be sold or merged.

* Those with a 2% to 4% deficiencies may decide to break up, recapitalize, and form new businesses, much as MBNA did with its credit card portfolio and Citibank tried to do with AmBac.

* For those with 2% to 3% deficiencies, the goal is drastic asset and cost reductions.

* Those with 1% to 2% deficiencies will aim for moderate reductions in assets or costs while strengthening their basic business.

Less Is More

At Cresap, we urge bankers to "think small" - that is, to focus less on asset growth and more on asset management.

We have helped a number of institutions with severe capital deficiencies rebuild around profitable core businesses, trimming assets 33% to 50%.

This trend will grow. For example, a bank with $14 billion in assets two years ago may have only $5 billion or $8 billion by 1992.

It's the only way to survive.

Mr. McNees leads the financial services practice in the New York office of the management consulting firm Cresap, a subsidiary of Towers Perrin. This article is based on a speech at an American Banker conference.

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