Nearly a year ago the core of Salomon Brothers' highly touted financial institutions group moved to UBS Securities, lured by million-dollar salaries and the prospect of building an investment bank from scratch.

In the last year, the team has scored some impressive victories, including structuring the sale of National Westminster Bank's U.S. retail operations to Fleet Financial Group. By yearend 1995, UBS ranked 10th among bank merger advisers; in 1994, it didn't even place in the top 50.

And two weeks ago, the firm stunned Wall Street by hiring CS First Boston's highly regarded banking analyst, Thomas H. Hanley.

American Banker sat down with the group just a few days after Mr. Hanley's arrival to discuss the past year and the future.

Critics have questioned the ability of high-profile investment bankers to maintain their success at a new firm, particularly one with headquarters in Europe.

On the other hand, this new group has access to the assets and capital of one of the world's largest banks, and to date the group reports few obstacles.

Participating in the interview were Richard Barrett, director of the group; Gerard Smith, Allan Ginsberg, Thomas Hanley, and Matthew Grayson, all managing directors; and Tod Perkins, a vice president.

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What have the first 11 months been like?

BARRETT: The last 11 months has been a particularly exciting and productive period for the group. We are up to about 25 individuals and have also managed to involve ourselves in a number of key transactions.

We have at this point had major assignments from 15 major bank holding companies and several other of the key financial institutions out there.

Are the assignments merger related?

BARRETT: They are mostly merger related, but they have been in all areas. Our approach is across all the product lines, so we are not just an M&A boutique inside of an investment banking house. We are trying to sell a full line of products including debt and equity, and we are heavily involved in derivatives products in both of these areas.

What are the major financing problems in the banking industry?

SMITH: It is a curious state of affairs that in 1996 the single biggest problem the banks have is excess capital. Three years ago, the system was on the verge of insolvency and today. To put it in perspective, there is now $100 billion of capital in excess of 6% tangible in the system.

You can relate $100 billion to a couple of things: All the deals done last year had a market value of $69.5 billion. All the banks that are left with a market cap of a half a million dollars to $4 billion add up to only $75 billion. All of the mortgage banks, investment banks, publicly traded asset managers - you name it - the value of all those companies combined doesn't come close to $100 billion.

The reason it is a problem is there are costs associated with this capital. You can observe where the market concludes there is excess capital, risk has been assigned to that bank, the beta (a volatility indicator) is going up, and the observable cost of capital is going up.

Our guess is that all of this excess capital is going to lead to a series of hostile or semi-hostile transactions, where companies in effect are going to buy institutions, very much like Wells (Fargo & Co.) bought (First) Interstate, just to extend the life of the institution through this low-growth period. Anybody running with excess capital is going to be bait for a predator.

What about traditional capital management tools?

SMITH: You will see increased dividends, but that is insufficient to the task, banks cannot have an 80% payout ratio without risking substantial downward valuations. They can buy in their stock, and the large banks bought in $10 billion of stock last year and might buy in as much as $20 billion this year. But at the end of this year, the amount of excess capital in the system will have gone up, not down. So they are running in front of a tidal wave of capital.

Managements are going to have to drive toward managing their capital very much the way they manage their asset-liability relationships.

This is an environment that plays to the unique competencies of UBS. Capital is going to be engineered with (products like) equity derivatives. If you don't have a real triple-A credit rating, you are going to have a hard time playing in this game.

One of the big thrusts of our group is to help banks create engineering devices that will allow them to reduce or increase their capital on demand to reflect the size and risk of their balance sheet, if necessary on a daily basis.

Why have bank mergers slowed?

PERKINS: Many of the more acquisitive institutions are in a digestive mode. A lot of banks made large strategic moves, as opposed to fill-in acquisitions, so they want to make sure they integrate them correctly.

Also, if you look at what drove these deals last year, it was banks hitting a revenue wall, and if you look at a couple of regions in the country where the revenue wall problems started earlier, like the West and the Northeast, consolidation is somewhat completed.

HANLEY: Historically, for mergers, the last couple of months of a year have been very, very quiet, and concurrently the first couple months in a new year have been very, very quiet. My own sense is that as we get closer to the second half of the year activity will indeed pick up. There is something magical in this group about Labor Day. You get there and we see some real fireworks.

BARRETT: It would be wrong also to look at only bank-to-bank deals. There is a great deal of work being done on the nonbank strategic side. The focus of our group has shifted a little bit.

If we are not watching what the banks are doing with regard to nonbanks, like insurance, we are missing too much of the strategic picture. If this business were as simple as saying how to do purchase or pooling accounting, the business would have been internalized a long time ago.

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