The banking industry is suffering from record losses and collapsing share prices. Institutions are focusing on short-term survival efforts, including dilutive capital raising and cost cuts, that they hope will allow them to outlast the crisis and then return to business as usual.

The industry, however, faces a long-term strategic crisis in adapting to a structurally changed business environment.

The financial and credit problems are merely symptoms of a decline in the underlying business model for banks. Failure to recognize this and develop appropriate responses will depress long-term returns.

The search for a solution to this problem requires a clear understanding of what happened.

The 1990s stock bubble was followed by the 21st-century residential property boom. Inflation-adjusted housing values grew at five times their historical average from 2000 to 2006. Bank earnings rose, driven by mortgage and construction lending. During this period banking stocks as a percentage of the overall Standard & Poor's 500 more than doubled, to over 20%.

Strong GNP growth, moderate inflation, limited regulation, and ample liquidity helped fuel this growth, but technological innovations were equally important.

Internet-based automated underwriting techniques and structured finance-driven distribution ushered in the originate-to-distribute business model, which greatly expanded the mortgage industry's capacity. Nationwide operations like Countrywide and Washington Mutual arose, and the number of mortgage brokers grew to over 50,000. This crowded out traditional originators, including community and regional banks, who moved into residential construction and development loans to replace their income.

The OTD model's advantage over traditional portfolio lending was based on two factors. First, capital velocity increased, allowing institutions to release funds for reinvestment. Second, the underwriting or warehouse risk for individual mortgages awaiting distribution was deemed low. Consequently, the model enjoyed favorable regulatory capital treatment.

Eventually, competition outgrew the market opportunities. Profit margins were pressured, and growth slowed. Preoccupied with continued earnings growth, institutions embarked on a higher-risk, asset-heavy carry trade strategy. This involved taking large concentrations in illiquid, high-risk, long-duration assets. Large banks focused on structured products like collateralized debt obligations, while small institutions concentrated on C&D loans. The excess competition for these products strained margins, requiring banks to increase leverage levels.

Institutions moved further out on the risk curve to manufacture nominal earnings growth. Risk was deemed under control because of the twin illusions of liquidity and risk distribution. In fact, rather than distributing risk, banks had concentrated it. Liquidity evaporated once the leveraged positions began losing value in mid-2007.

Shareholders, rating agencies, and regulators missed the higher-risk strategic shift. Earnings were at record levels, and risk models failed to register increasing risk levels. As a result, the capital required to support the increased risk was underestimated.

The current $150 billion-plus capital raising indicates the level of undercapitalization. Boards evaluating the new strategies failed to assess their risk of ruin, and whether the higher returns were appropriate for the increased risk.

The downsizing and recapitalization efforts at many institutions are remedies, not strategies. Capital alone is insufficient, as evidenced by the continued stock declines after record capital increases. Investors require new strategies to generate revenue to offset the declining structured finance business at large institutions and the C&D declines at community banks. These discredited business models had generated the majority of income growth at these institutions.

Complicating this effort is the reduction of leverage formerly used to maintain and increase returns.

Paradoxically, though many institutions are undercapitalized, the industry is overcapitalized in relation to available return opportunities. Until this excess capacity is eliminated through consolidating acquisitions or failures, earnings growth will be limited. Banks can grow only by taking market share from others.

The difficult operating environment will depress short-term returns and reduce dividends. New shareholders who have infused over $65 billion of capital this year have already suffered significant losses. Besides complicating future efforts to raise capital, these shareholders will undoubtedly press for governance actions to improve performance. This could include asset dispositions and management changes.

An additional development is the decline of the OTD model in relation to portfolio lending. The factors underlying the OTD model's rise have been significantly reduced. Capital velocity is falling as investment opportunities diminish, and regulatory capital requirements will undoubtedly increase in response to warehouse losses. Finally, regulatory concerns will cause wholesale funding, including securitization and trust-preferred securities, to decline in importance. This will pressure banks to develop more stable, higher-cost core deposit funding.

Subprime mortgages may have been the trigger, but they are not the cause of the problem. Instead of following the urge to blame someone or some group, we need to address the underlying strategic issues. This recognition is required to begin the process of rebuilding shareholder value.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.