Can banks provide loan accommodations to their middle-and upper-middle-market customers in the mid- to late '90s at prices that will ensure profitable performance? Are they currently providing these accommodations for sufficient compensation?

It is now understood that, in order to preserve viability, banks must earn a risk-adjusted return or equity that is at least great as, or greater than, their hurdle rate. A bank's hurdle rate is equal to Rf+b(Rm-Rf). That is, to hold on to the stock, the bank shareholder must earn the risk-free rate (Rf), plus the market price of risk, which is the return over the risk-free rate normally garnered by stock-market investors (Rm-Rf), as adjusted for the individual riskiness of the bank, or the bank's beta (b). For a bank with a beta of one (it is just as risky as the general market), the prevailing level of interest rates implies the need to earn approximately 14% to 15% after tax.

To earn this after-tax return, the bank must be able to achieve an all-in loan yield that is equal to the pretax hurdle rate times the amount of economically needed equity (which is the cost of equity), plus the cost of matched-maturity funds, adjusted for the fact that some of these funds are interest-free equity monies, plus the noninterest expenses of making and monitoring the loan, plus the loan's expected-loss risk.

A Sobering Thought

Although the concept of an average return is of necessity an artificial one, the evidence gathered on gross margins for "typical" middle-market loan extensions, inclusive of spreads, fees, balance income, and noncredit revenues, suggests that, as of last year, these margins fell about 50 basis points short of what would have been necessary to cover the costs enumerated above - that is, the cost of equity, the cost of funds, the noninterest expenses, and the cost of expected loss (335 basis points vs. a needed 385 basis points).

Therefore, the presumption is that the average lender failed to earn enough to satisfy his shareholders' reasonable expectations, even in a year of especially buoyant pricing.

Doubtless, few banks would admit to being average. And many institutions are indeed capable of realizing above-average revenues, credit or noncredit, or of capturing above-average customer balances. Others have below-average functional costs.

And still others target a relatively low-risk type of borrower, enabling them to allocate less than the average bank for the cost of expected risk (the mean loss in a given loan category) and a lower amount of capital to cover the cost of unexpected risk (the likely variance of losses from their mean values). These banks may be able to translate "average" gross margins into quite satisfactory risk-adjusted returns.

Nevertheless the fact that the so-called typical middle-market lending bank apparently earned less than its shareholders needed is a sobering thought. What are the trends that are likely to influence the earning power of this hypothetical institution for the rest of the decade?

Robust Data, Feeble Banks

A logically prior question is: What were the factors that have enfeebled the existing earning power of such a bank? Without dwelling ovelrong on the celebrated crisis in U.S. banking, about which everyone in the business now knows a good deal, the essence of this crisis can be summarized in the following parsimonious points.

1. The health of a country's banking industry is inversely proportional to the speed and efficiency of information transfer. That is, the more reliable information that is readily available to credit-market participants, the weaker are the banks.

2. The increased availability of good credit information in the U.S. market has facilitated a migration of erstwhile bank borrowers to the public markets.

3. In reaction to the narrowing of their borrower base, banks moved downscale - that is, they greatly intensified their efforts to serve those who could not yet access the public markets. Thus a narrowing of the borrower base produced a glut of lending capacity competing for the remaining business - a circumstance that tended to savage spreads.

4. This trend interacted with another - the fact that the U.S. and world economies seem to have become increasingly volatile. As volatility increases, the half-life of usable credit information shortens. That is, the business fortunes of borrowers change more rapidly than in the past, requiring banks to update credit data more frequently. Yet, as spread compression pinched profits, banks sought to cut costs, and very often did so across the board. Thus, in a period in which they should have been spending more to keep their credit files currnt, they in fact spent less. Lacking up-to-date information, banks could not identify credit problms as quickly as they were once able to do.

Assessing the Supply Situation

Whether these problems will worsen or ameliorate in the next few years depends in large part on the supply/demand balance for commercial loans. Will the excess supply of lending capacity, which has persisted to some extent because the regulators impeded its exodus, begin to recede? And if it does, will the demand for bank loan services decline at an even more rapid rate, making it difficult for the surviving lenders to raise prices to the levels needed for the required return on equity?

Superficially, it would appear that the lending supply has already declined and is likely to fall still further in the near future. There are, after all, many fewer banks in the U.S. than there were in the '80s, and most observers agree that the industry is slated for increased consolidation. Additionally, many U.S. banks have significantly curtailed their corporate lending activities in the last two years, as have some, though by no means all, foreign banks.

But these facts do not necessarily presage a decline in lending supply, at least not a permanent one. For example, although it might be expected that bank mergers would result in a net withdrawal of capacity, the evidence suggests that this is not the case. In fact, when banks merge, the new entity generally ends up with as many commercial loan footings as, or more than, the previous combined total of the two merger partners.

A Stimulus to Aggression

Mergers have historically been a stimulus to increased aggressiveness in commercial lending, not a harbinger of retrenchment. And while it is always dangerous to extrapolate historical trends into the future, there is as yet no evidence that the future will not replicate the past.

Nor can we have much confidence that those banks that have curtailed their loan activity in the past two years will continue to do so. These cutbacks were a direct consequence of deteriorating credit quality and the consequent erosion of capital positions. But credit quality and capital positions are on the mend, at least for the immediate future.

As this occurs, many currently reluctant lenders will reactivate their warehoused lending capacity. Indeed, goaded by political and, in many cases, regulatory pressure, a goodly number of institutions that all but withdrew from the business lending market are now poised to reenter.

An Excess of Short Funding

There is, moreover, the question of where banks that don't lend can put their money. The data suggest that many have been loading up on Treasuries. Since it is virtually impossible to make money on Treasuries with a match-funded posture, a fair number have been short-funding - in effect substituting interest rate for credit risk. This behavior is untenable. Sooner or later, banks that are loath to reduce their take in the deposit markets will return to commercial lending.

Whether the decline in lending supply is merely a cyclical interlude or a secular trend also depends on the behavior or foreign banks. Some of thse have recently bowed out of the American marketplace, while others, taking advantage of the decline in the credit ratings of large U.S. banks, have actually redoubled their efforts, greatly increasing their market share of C&I loans.

A good case can be made that foreign banks should be withdrawing from the U.S. market, or at least should be debating the wisdom of continuing to participate as supplemental, standalone business lenders. These banks, in the aggregate, have never made enough in this capacity to justify employing the required equity.

Wedded to Market Share

But many foreign banks have never viewed return on equity - and certainly not risk-adjusted return on equity - as the relevant criterion for business participation. And while this attitude is changing, it may not be changing fast enough to benefit their U.S. companies in the '90s

Although foreign banks remain wedded to the goal of increasing market share, many of the lading U.S. institutions now understand that growth is important only if their risk-adjusted return on equity exceeds the cost of that equity.

And herein lies some reason for optimism. If loan prices are not high enough to secure the target risk-adjusted ROE, which is now frequently the case, will not these institutions curtail their lending for some protracted period, and by this action contribute to the necessary price improvements?

It can be expected that many large banks will be pricing rationally in the future. Yet comparatively few actually do so currently, or indeed possess the analytic methodologies to do so.

A survey of the top 100 U.S. institutions conducted last year by my firm revealed that only about a third of the respondents presently assign a risk charge or provision to the individual corporate facility, note, or customer. And while, then levied, this charge usually covers the loss of principal, it rarely covers the operating or workout costs, which can be a preponderant part of the loss, especially in the middle market.

Even fewer large banks (less than 15%) assign capital to individual corporate loans or customers. And among those that do, only about half earmark the right kind of capital, which should be economic equity, not Tier 1 regulatory or book capital.

How fast these large banks will acquire the necessary expertise in risk pricing is unknown. And whether, having acquired it, they will refrain from lending if prevailing prices are inadequate to cover computed risk costs is equally unknown.

A Two-Edged Sword

Even if, in the future, the majority of large U.S. banks refuse to lend at prices that do not cover their total costs, including that of risk, the conequences for the industry may not prove wholly benign. The capacity to make a price rise stick obviously depends on whether the borrower is a prisoner of the intermediated market or can escape to the public market.

Assuming equal risk charges, the relevant consideration is the difference in transactions costs. If many more borrowers can access the public markets at a reasonable transactions cost, the banks may be able to enforce full-cost pricing for only a small proportion of their existing borrower populations.

Thus the advent of risk-based pricing may raise the risk-adjusted ROE, but at the same time accelerate the trend toward a very much smaller bank sector, greatly lowering the volume of profits.

A Question of Assimilation

It is sometimes argued, however, that the banks need not fear further encroachments by the public markets in the '90s. Evidence derived from the commercial paper market suggests that while the market has expanded, the proportion of paper issued by smaller companies has remained more or less constant. The hypothesis is that the public markets cannot easily assimilate many more small entrants - that is, assimilate them without an expenditure for fact finding that would raise transactions costs to unacceptable levels.

Yet, to argue that banks will shortly be able to price accurately for risk while not losing customers to the public markets is, in some important sense, contradictory. The reason is that in order to price risk accurately banks must increasingly use methodologies that rely on public market data, which suggests that, given familiarity with these same methodologies, public investors may be able to price loans just as efficiently as, if not more efficiently than, the banks.

Who's a Better Monitor?

At issue is whether banks have a monopoly of credit information on borrowers that enables them to assess and monitor creditworthiness with unrivaled accuracy. It is clear that banks hold such a monopoly in the small-loan market because of their unique ability to track the borrower's business fortunes through his checking-account activity.

Many mom-and-pop borrowers transact between 50 and 300 credits and debits monthly, enabling a bank lending officer to easily grasp the contours of their commercial activity.

But for larger borrowers, and especially for those operating in several geographies or employing more than one bank, credit assessment through checking-account surveillance is a much more difficult task. Banks may be no better positioned to spot the incipient credit problems of these borrowers that are non-banks or the public markets. Indeed, they may be worse positioned.

A Dangerous Method

It is increasingly being recognized that banks can do a better job than is now being done of initially assessing and subsequently monitoring the risks of their larger borrowers through the use of models that extract information from public sources. Consider the task of pricing the risk of borrowers with publicly traded equity - those whose paper accounts for between 30% and 40% of the dollar value of all C&I loans now on the balance sheets of banks.

Normally, a banks will assign any individual loan to a particular grade or risk rating based on borrower financial characteristics. Presumably, the risk charges or provisions to be included in the loan price will reflect the loss probabilities in each risk rating, as established by historical average default data.

There are, however, at least two problems with this method. First, the use of historical default is a second-best approach. What one needs is a orward-looking rather than a backward-looking method of determining likely defaults - that is, a leading indicator, based on current market data, of future creditworthiness.

Second, the loan-risk-rating systems of most banks have only recently been put in place. So there is a dearth of historical data on expected defaults in each risk-rating category.

A model developed by my firm's joint-venture partner, the KMV Corp. of San Francisco, can help solve these problems. It enables banks to rate and review the creditworthiness of some 5,000 publicly traded corporations based on recent movement of their stock prices.

Basically the model determines default probabilities by measuring the amount of negative stock-price volatility that would be needed to reduce the value of the borrower's equity to the point where, together with the associated reduction in the value of his noncurrent debt, the market value of his assets is no greater than the face amount of his current debt - a circumstance that normally triggers default.

Supplementing this tool for analyzing public companies are a number of other models that are designed to capture the default potential of privately held companies. One uses multiple regression to predict the future "shadow" stock-price volatility of the private borrower. Although less accurate than the model that employs actual stock-price data, this tool is at least as good as the default predictors used by many major banks.

Finding a Surrogate

Additionally, it may soon be possible to analyze the credit quality of private firms through "comparables" analysis - that is, by finding among the universe of public companies one that operates largely in the same industry and has roughly the same financial characteristics as the target private firm. The expected loss probability of this public firm can be viewed as an approximate surrogate for that private firm under analysis.

These models also permit a bank to determine the amount of capital needed to cover the unexpected-loss risk of the borrower. That risk is a function of the expected-loss risk, the extent to which this loss risk is correlated with that of the other exposures in the portfolio, and the size of the loan in relation to that of the portfolio. The models compute loan-loss correlations from observed or derived stock-return correlations.

No More Lemons

The nub of this analysis is that it is becoming increasingly feasible to price the risk in wholesale loans from data obtained from the equity markets. This capacity will enable banks to surmount the "lemons" problem - the fact that there is an asymmetry of information between loan seller and loan buyer that effectively prevents the latter from knowing when he is being victimized by the former.

With the lemons problem conquered, commercial loans can be securitized for sale to ultimate investors. In turn, the ability to securitize will greatly improve bank diversification and thus reduce the likelihood of bank failure.

The flip side of this coin is that a great many borrowers who are now locked into the intermediated sector will be able to escape its confines via, say, securitized commercial paper issuance. As noted, this argues for a banking industry that may have a higher ROE, but will also be smaller than it now is.

And let us remember that a company's market-to-book ratio depends on how much business it can generate at an ROE above the equity cost. If the ROE is below that cost, then shareholder value is being destroyed, and the faster the growth the greater the destruction. However, if the ROE is above th equity cost but there is no growth, then comparatively little incremental value will be created.

It may seem to some that the above scenario is entirely too futuristic, that while the underlying trend is valid, the scenario cannot be realized in this millennium. After all, though it is now possible to price the risk of publicly traded companies accurately by using information obtained from the equity markets, it is not yet possible to price the risk of privately held borrowers with the same reliability. Therefore, there is no immediate danger that droves of middle-market firms will rapidly migrate to the public markets.

A contrary hypothesis is that if a more reliable method of pricing privately held borrowers is not soon developed, a lage number of thse borrowers will surmount the difficulty by electing to become public firms. The reason is that they thereby will obtain lower loan prices.

Consider that every bank, no matter how large, is seriously underdiversified -- a fact that can be demonstrated by comparing the volatility of loan losses at lage banks with the much lower loan-loss volatility for the banking industry as a whole.

And because they are underdiversified, these banks must incorporate into their loan prices a charge that reflects risk which is in principle diversifiable. Although most banks have not been pricing adequately, at least in the middle market, to cover this risk, the implication is that, in the near future, they will begin doing so.

But banks may not have to raise the prices of loans to publicly traded borrowers because, given the current technology, these loans can be securitized. And the securitization process will press out the diversifiable risk.

That is, ultimate investors will be willing to accept lower yields on securitized pools of loans because these pools will have a much lower loss-volatility risk than loans housed on bank balance sheets.

Hence, private firms will have an incentive to go public because only by so doing can they obtain loan prices that do not include a premium for risk that is eminently diversifiable but cannot be diversified away by geographically confined bank lenders.

And End to the Subsidy

The foregoing obviously implies that securitization will play a larger role in banking developments in the '90s than most bankers believe. Let us, however, assume that this won't be the case. Are there any other trends that might produce the same result - a reduction in the demand for bank credit sevices that, given the inertia on the supply side, will make it singularly difficult to enforce full-cost pricing?

It can be argued that by failing to price adequately for risk, banks have been subsidizing debt issuance. It can also b argued that because banks will henceforth be pricing more rationally and because nonfinancial corporations already have too much debt, there will, in the near future, be an accelerating movement toward the equity markets, which may be another reason for privately held companies to seek public status.

Moreover, as nonfinancial companies issue more equity, they will become better known to the public markets, which simultaneously increases their capacity to issue bonds and commercial paper debt. Thus there will not only be a substitution of equity for debt but also, to some extent, a conversion of bank loans into bond or commercial paper debt.

So, the fact that banks must raise their prices would seem to suggest that they inevitably will lose customers, whether or not securitization takes off.

Partners with the Customer

Based on the trends we have been discussing, it is possible to outline in broad brush the likely future configuration of the banking sector. What might be called the top tier of the sector will consist of banks that aspire to the role of strategic partner to their wholesale customers.

Because these customers will be issuing more equity, their banks will be underwriting equity, which some already can do. And because the customers will also be issuing more bonds. their strategic-partner banks will bid for that business as well. In short, the first-tier banks will assume the character and guise of investment banks, which is hardly surprising.

They will also underwrite traditional loans, but they won't keep many, which is also no surprise. In fact, being long origination capability but short core deposits, they will originate almost exclusively for securitization or bilateral distribution.

Logical Loan Buyers

A second tier will consist of banks whose role as credit analysts and credit monitors, primarily for small-business borrowers, cannot be efficiently preempted by the public markets. Being long core deposits but short origination capability, these community-type institutions will become buyers of loans or shares of loan pools originated or created by the first tier of banks or by nonbank securitizers - e.g., Fidelity.

They will have to buy loans because the scope of their own origination capacity will be confined to a given area, creating a vital need for diversification.

A third type of bank is probably only a transitional entity. It encompasses the average lender alluded to at the start of this article. More than likely a regional bank, this institution will have some small-business borrowers, which given their credit opacity, will be hugely profitable. But, in general, this type of institution will be too big to have many small borrowers (big banks generally do a bad job of administering small loans).

It will probably continue to have some middle-market business, but, because of the likelihood of an unfavorable supply-demand balance, will be unable to price high enough to recoup total costs. Hence, for this type of bank, most loans are apt to remain the loss leaders they are today.

Focusing on Noncredit Services

Some banks of this type will instead rely on the capacity to provide payments and risk management services to their customers, the revenues from which may not now, but could in the future, raise ROEs to tolerable levels. Ultimately, as they become known as premier service providers, and as secondary markets for middle-market paper develop further, some of these banks will try to concentrate exclusively on the delivery of payments and/or risk management products.

One implication of this scenario is that there will no longer be any great need for banks to purchase funds, since most loans that formerly would have been funded with bought money will now be financed by ultimate investors (via mutual funds that invest in securitized loan pools) or by banks with a surfeit of core deposits.

Interestingly, it is only the second and, to a lesser extent, the third tier of banks that will need depoist insurance protection. That's because they will be the only banks still engaged in the transformation of liquid deposits into a sizable number of credit-opaque and therefore illiquid loans - a role that subjects them to the possibility of deposit runs.

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