The Forecast For Banking: Partly Cloudy

Against a backdrop of rising interest rates, growing credit concerns, and underperforming bank stocks, Bank Director asked two of the industry`s leading equity analysts to talk about what lies ahead for banking. In the midst of such uncertain times, they found many bright spots: Internet banking, business-to-business, and ever-expanding fee income opportunities, to name just a few. Their bottom-line advice for directors? Focus on improving revenue growth by ensuring their organizations are offering the product breadth and customer service bank customers demand today. And in the midst of all this strategic ramping up, they remind board members that a prudent risk management program is as important as ever. Joining us for Bank Director`s eighth annual Analyst Forum in New York in late May were Joseph C. Duwan, senior vice president and research analyst for Keefe, Bruyette & Woods, and David B. Hilder, principal and bank equity analyst for Morgan Stanley Dean Witter.

Bank Director:

Let`s begin by talking about the future for bank stocks over the next 12 months

Joe Duwan:

One of the overhangs has been the interest rate environment. What are we up to, six increases now? Bank stocks underperformed in 1998 and 1999, and this year, they were underperforming the overall market until recently. In fact, I`m not sure when the crossover occurred, but our Keefe bank index is up 6% to 7% for the year, and I think the S&P 500 is down 4% or 5% [as of late May]. So actually the bank group has begun to outperform for the year, which is a switch from what we saw earlier. If you look back to 1994, which was the last time the Fed went through a series of rate increases, the bank group did bottom out almost 60 days before the last Fed increase in February 1995. There is a consensus building that the Fed may be close to the end of its rate increases. So investors are beginning to look out beyond the last 50 basis points or 75 basis points and feel that the end may be in sight. Also, some investors are concerned that Fed Chairman Alan Greenspan may lean too hard on the rate side and push the economy into a recession, rather than the soft landing he managed in 1994 and 1995. This could result in credit declines that investors still remember with bank stocks back in the early `90s.

David Hilder:

Morgan Stanley Dean Witter has had a market underperform rating on the group since last December, which was probably a little later than it should have been. As I looked out at what was likely to happen during 2000, it seemed to me that the catalysts for bank stocks were more likely to be negative than positiveu00e2u20ac”mostly consisting of the Fed raising interest rates. Over the long term, bank earnings may not be particularly susceptible to movements in rates. But in the short term, earnings are impacted by rising rates because, on the whole, banks tend to be more liability-sensitive than asset-sensitive. Net interest margins have compressed in the banks we follow by about 15 basis points over the last two quarters. And history has shown that bank stocks tend to underperform in the early stages of a Fed tightening campaign. We have a group of 30 bank stocks that we track as the Morgan Stanley Bank Index, which, interestingly enough, is still down 4% year-to-dateu00e2u20ac”very close to the 5% decline in the S&P 500. It`s an equally weighted index of 30 banks, so it tends to be driven a bit more by the performance of smaller banks. So because of capital markets activities, the banks included in those indexes have tended to do a bit better. I would agree with Joe that the overhangu00e2u20ac”or the overall worry in the marketu00e2u20ac”has been about rising rates, with a longer term fear about rising credit costs. We feel it`s unlikely that the bank stocks will outperform in a rising rate environment, because revenue growth is tougher. The massive improvements in profitability that happened in the `90s have ended. In the last year or two, the better performing bank stocks have been those that have had better revenue growth. Revenue growth overall is going to be slowed by decreasing growth in spread income. So this is not an environment in which we would overweight the banks. On the other hand, we would not underweight them, because we don`t think that credit costs are going to be as big a problem as some other market participants believe. I think valuations today are reasonable. The growth rates of earnings implied by the valuations today are not excessive. I don`t think the group is screamingly cheap, because although it is trading at a big discount, as much as a 55% discount to the overall S&P 500, it`s trading at a much smaller discount to the S&P 500 if you strip out the top 10% by multiple. Various analysts have looked at ways of adjusting the S&P 500 to make a good comparison to bank stocks. Some people strip out selected technology names; some people strip out all technology names. What I`ve done is strip out the mathematical “Nifty 50,” which is the top 10% of the S&P 500 by multiple. If you look at banks today relative to the bottom 90% of the S&P 500 by multiple, they are trading at about a 55% to 60% relative multiple. The average over the last seven to eight years has been about 70%. So banks are cheaper than they have been, but not to the degree suggested by the 45% relative multiple you get if you compare banks to the S&P 500.

BD:

As far as the banks` trading discount relative to the rest of the market, how much of it is due to investors moving toward tech-related stocks and leaving the banks out in the cold? Or are today`s tech investors not the same ones interested in bank stocks to begin with?

Duwan:

Investors are much more focused on earnings growth and the revenue stream the business makes. So they are differentiating among companies in terms of the growth prospects in these businesses. If you look at the divergence and price earnings multiples within the bank group, it seems to be as broad today as it ever has been. Years ago there might have been a 50% or even 30% to 40% premium for some high-quality names. Today it`s 100%, if not higher. State Street, for instance, is over 30 times earnings at this point, Fifth Third is at 23 times earnings, and I think the average bank stock today is at about a 12 times earnings multiple.

Hilder:

I echo that with slightly different numbers. I tend to look at cash earnings, adding back in the amortization of intangibles. On that basis, on 2000 earnings, the group that I follow has a median multiple of about 10 times 2000 earnings. But Bank of New York is trading at more than twice that multiple; Mellon is trading at more than 150% of that multiple; and State Street and Fifth Third, as Joe pointed out, are off the charts. There is a money flow issue in the overall market that has affected the valuation of bank stocks. Earlier this spring I was having discussions with bank executives during which one of the more perceptive of them said, “It looks like the market has raised our cost of capital.” If you think about it, that`s true. The market has depressed bank stock valuations because money has flowed, over a period of time, out of banks and into sectors with higher earnings growth rates. That`s undeniable. This has had the effect of lowering the multiple and, in effect, raising the cost of capital for banks. What`s happened since then, to some extent, has been a reversal. There have been many days with significant declines in the Nasdaq composite or any sort of technology index and, at the same time, you`ve seen the banks recover: bank stocks going up as money has flowed out of the high-growth, riskier names and into some of the more favorable new economy stocks. For that to happen on a regular basis the market has to be more comfortable that the Fed is close to the end of its tightening campaign. And that may or may not be true. As we sit here at the end of May with bank stocks rallying, it does seem that large segments of the investment community believe that perhaps the next 50 basis points of Fed tightening may be the last for some time. Morgan Stanley`s global economist doesn`t believe this, however. He thinks the Fed will embark on a much more aggressive campaign to slow down the economy. Depending on who`s right, there is a real opportunity. BD: Could you discuss how banks` size and scale affect their opportunities today?

Duwan:

One of the challenges for smaller banks is that a higher proportion of their earnings comes from spread. And a significant portion of the spread comes from the deposit base. So a challenge for those companies continues to be that the deposit business as such is a slow-growth business, and that, for years, many banks have not paid a competitive rate of return. They have chosen to have that business as a cash cow, sacrificing growth for profitability. In a higher rate environment, depositors tend to become more price-conscious. Demographic issues also affect deposits. Depositors tend to be older and less interested in the investment side, and, clearly, the mutual fund industry and even direct equity investing has taken a lot of money out of the traditional deposit base for the industry. There`s even competition on the loan sideu00e2u20ac”margins are being squeezed from competitive factors and from the slower growth rate of deposits relative to loans. Then there is the issue of liability sensitivity. I`m surprised at the number of companies that have discovered that they are somewhat more liability-sensitive and exposed to higher interest rates than they had previously assumed. The good news is that most have tightened their tolerances in the last six months, but that is still an issue. The bottom line is that many of the small, community banks and smaller regional banks are still reliant on spread banking. The challenge for them is to diversify their revenue and earnings stream.

Hilder:

I think it`s the banks in the middle that are likely to come under the greatest pressure over the next several years. The very large banks, whether they be capital markets banks, money-center banks, superregionals, or multiregionalsu00e2u20ac”or trust and processing banksu00e2u20ac”have enough size and scale, revenue growth, product extension, and customer base to make the necessary investments to develop their products and technology to survive. At the much smaller end of the scale, there will always be a role for the community bank that is very close to its customersu00e2u20ac”that has a specific identity driven by a locality. But banks in the middle are in danger of being squeezed because they are not as close to their customers as the small community banks, yet they can`t afford to invest in the technology development that fuels the largest banks. The Internet is a great crucible for looking at this issue. There are seven large banks that are clear potential beneficiaries of the Internet: Citigroup, Chase, Bank of America, First Union, Wells Fargo, Bank One, and FleetBoston. Those companies are spending roughly 1% of their noninterest expense base per year on developing Internet products and servicesu00e2u20ac”that`s between $150 million and $400 million a year. With that kind of budget, you can do a lot. For many smaller banks, even medium-sized banks with $30-billion to $50-billion balance sheets, 1% of noninterest expenses can be as little as $10 million, and maybe no more than $15 million to $20 million. Although that`s sufficient to develop Internet products that are delivered off-the-shelf from technology vendors, it`s not enough to develop a broad set of differentiated products. I think those companies are at risk of falling behind.

Duwan:

The Internet could pierce the geographic barriers that some of the regional and smaller community banks have enjoyed historically, particularly with their high-profit customers. The challenge not only will be for these companies to protect those relationships by focusing on customer service, but also to have the product base and breadth to offer the range of products that their customers are demanding. BD: From what you`ve just described, it sounds as if the Internet, far from being a leveler of the industry, instead will require huge budgets, such that larger institutions will always be able to outspend smaller competitiors.

Hilder:

Not completely. I think there is an opportunity for some institutions that have been geographically focused to expand to a broader customer base. So far, those experiments are of mixed success.

Duwan:

Today, most customers appear to want “bricks and clicks.” Many of the larger U.S. companies David cited do offer robust banking sites for their retail base, and their customer penetration rates are increasing, up to 20% in some cases. You mentioned the Internet as an equalizer, and, yes, there is that opportunity. Smaller banks do have the opportunity to outsource and purchase turnkey Internet banking products for their customers, but it remains to be seen whether the product breadth and functionality will be sufficient to hold on to their better customers.

Hilder:

Customers in the United States have shown that they want multiple access points to their financial institution. Hence, the banks with the largest number of Internet customers are the traditional banks like Wells Fargo, First Union, and Citigroup. They not only offer Internet access but also ATMs, branches, 24-hour/7-day-a-week phone service centers, and all the rest. Those companies have Internet customer bases approaching two million each, which dwarfs the 100,000 or so customers of the Internet-only banks. That`s clearly the way customers want to do business today. An example of what Joe has talked about is Synovus, a bank holding company based in Columbus, Georgia that has 39 banks in the Southeast and a majority ownership in a large credit card processor called Total Systems Services. It`s announced plans for an Internet-only bank targeted at couples who are planning to get married or who are recently married. This niche make sense, since the marriage decision often triggers a review of financial resources and financial relationships, and causes you to, at a minimum, create a joint account or change the names on an account, which often triggers a greater discussion about financial planning, insurance, and so forth. Synovus is doing this in connection with an Internet site called The Knot, which is focused on wedding planning. This is a very interesting idea; it is a way for a bank that was focused primarily on one region to gain a national or even global audience. BD: These are really front-and-center issues today. How strongly do you look at a bank`s technology strategy when you are valuing its stock?

Hilder:

I think about the Internet and how it affects banks every dayu00e2u20ac”it is literally part of my daily approach to my job, which it wasn`t 18 months ago. I`m engaged in weekly, if not daily, discussions with executives at banks about their technology strategies.

Duwan:

It`s critical in all facets of the business. We`ve been focused primarily on the retail banking side in this discussion, but we should not overlook the commercial side of the business as well. For example, payment processing for corporations on the Internet can be a very valuable tool for customer service. I think it all gets back to customer service: providing information in a convenient way for your customers that is also cost effective for the bank. The Internet is all-encompassing; every business line needs to have a strategy as it relates to the Internet.

Hilder:

I am fond of reminding people that commercial banking is probably one of the world`s original B2B enterprises. And increasingly, since the advent of the electronic digital computer, a lot of commercial banking has been electronic in one fashion or another. So for many banks, the challenge is to take an existing electronic delivery system of a commercial banking product and turn that into an Internet delivery system. BD: Changing focus a little, what is your view of management today, and are you proponents of stock-based incentive plans?

Hilder:

Ten years ago, there was very little incentive compensation, even at the top. Today, the more successful companies have implemented such programs even at the teller level. I don`t think the caliber of people managing banks has changed dramatically. I do think the market forces surrounding the banks have become much clearer in the sense that, yes, there is more pay for performance, there is more compensation through equity-based incentive plans and less compensation based purely on the size of a bank`s balance sheet. There is a much greater focus throughout the banking industry on expense efficiency and capital efficiency, which stems from the fact that the market has rewarded banks that are better managed on an expense efficiency basis or a capital efficiency basis. I think the focus in the last couple of years has been a switch toward revenue growth. That will affect the way bank managements perform going forward.

Duwan:

I would agree that there is more focus on revenue growth, but what`s particularly important is to maintain the appropriate risk management parameters while you are focused on growth. In the last 10 years, there has been a dramatic improvement in the risk management tools used by senior management. Of course the economy has been fairly robust in recent years and we haven`t been tested by fire through a recession. But management needs to stay focused on risk management, and while that obviously means credit risk management, it also means interest rate risk management and other aspects of operational risk.BD: We keep hearing concerns about banks` credit portfolios, but nothing ever seems to materialize. Is this because banks have better risk management in place?

Duwan:

It`s been a contributing factor, but there`s no denying that the economic strength of the country has been a very important factor as well.

Hilder:

Nine years of steady economic growth will do wonders for nonperforming asset and charge-off levels. I think it`s a little too early to tell, because it`s been nine years since the banking industry has been through a recession. Three years ago, the analysts around this table were worried about credit risks because you always worry about credit risks in the banking industryu00e2u20ac”it`s historically the greatest source of earnings volatility. But we also said back then that we couldn`t really see signs of excess. There wasn`t a particular part of the overall industry portfolio or the economy that we were worried about. The scares since then have been in places like Asia, Latin America, and Eastern Europe. BD: You`ve both talked about the importance of revenue growth. Do either of you have a formula for the percentage of noninterest revenue that you look for?

Duwan:

: Noninterest revenues have been increasing overall in the banking industry for a number of years, and I think for the top 50 banks, it`s approaching 40%. But some companies are obviously much further along than othersu00e2u20ac”it depends on their business mix. The market does appear to value fee revenue more highly that spread revenue, for a number of reasons. One is that growth rates in many fee businesses are stronger than the traditional spread banking businesses. Many of these businesses are not capital-intensive either, and generally there is no credit risk. So the market does favor fee income relative to spread revenue. BD: Is there a ratio you feel comfortable with?

Duwan:

: Not necessarilyu00e2u20ac”if you are looking at traditional regional banks, it tends to be a third of the total revenues, on average. Larger companies tend to have a higher proportion, but many smaller community banks, I suspect, are probably less than 20%.

Hilder:

: Of the 30 banks in our index, for the last quarter, fees were 48% of net revenue. Again, there is a bias toward some of the larger banks, because our index includes Mellon, Bank of New York, and State Street, as well as the Bank of America and Chase. My two strong buy ratings these days are Bank of New York and Mellonu00e2u20ac”both have 60% to 70% of their revenues from fees, but that is a result of their business mix. I don`t have a particular percentage that I would look for in smaller banks before recommending them, but in general, more is better. BD: Are there issues that boards of directors should have on their radar screen that you think they may be overlooking?

Duwan:

Yes, interest rate risk. It has been surprising that a number of companies have taken on a little bit more liability sensitivity than was prudent. The market these days does not look favorably on leveraged balance sheets. And there are a number of companies that have booked thin spread assets by leveraging the balance sheet. So the board of directors should certainly review the interest rate risk management process in this environment.

Hilder:

I think credit risk is at the top of the list and interest rate risk is second. But I think directors also need to look at technology risk, and they should address it formally. What is our technology platform? What are we doing to it? How do we intend to improve it? How are we relative to our competitors? Are there things in technology that we are not doing at all that we need to focus on? Finally, something that I think all bankers should continue to look at is how well they know their customers. Understand compliance risks and make sure that bank employees obey the appropriate laws and regulations. It only takes one significant event to really harm an institution`s reputation.