By Sean O’Malley and Vlad Byalik

  

During the last 10 years, U.S. banks rode a tidal wave of good fortune. Falling interest rates, favorable regulatory reform and cost improvements from consolidation allowed even weak banks to deliver remarkable profits and shareholder returns.

But the tide appears to be turning. Interest rates are rising, regulations are tightening and consolidation opportunities are diminishing. These and other looming changes have many bank executives wondering where the next 10 years of profitable growth will come from.

In this article, we examine the trends that produced such a hospitable environment for banks and how these trends are likely to shift in the coming years. We then explain what banks must do to match or exceed their stellar performance of the last decade: more deeply mine revenues from their existing customers, a strategy that most banks have struggled to master for years. With the wind no longer at their backs, banks that cannot do so will find that average industry performance no longer produces market-beating results.

A Rising Tide
The last decade was a good one for American banks and their shareholders. For the 10 years ending December 31, 2003, U.S. banks posted an impressive total return of 16% annually versus 11% for the S&P 500 (see Figure 1),¹ fueled primarily by a healthy rise in economic profit,¹ which grew from $15 billion to $33 billion (8.2% CAGR). This performance was propelled by the convergence of three trends, each of which seems poised for reversal or deceleration.

Accounting for Acquisitions in the 1990s As consolidation accelerated in the late 1990s, banks increasingly turned to an accounting method known as pooling as a way to make acquisitions without lowering their earnings per share (EPS) or return on equity (ROE). Under this method, balance sheets were simply merged, and therefore the premium the acquiring bank paid was not reflected in the combined bank’s balance sheet. The purchase acquisition method, by contrast, included the premium paid as goodwill (an asset) on the new balance sheet. Goodwill was then amortized against earnings over a period of years. Thus, pooling transactions had the dual accounting benefit of greater earnings on the P&L (no amortization) and less equity on the balance sheet (due to lower assets) – hence higher ROE. To fully understand the economics of bank consolidation, one must look at bank performance on an economic basis – i.e., by treating pooling transactions as if they were conducted under the purchase method. The impact of such an adjustment on Citigroup – a voracious acquirer over the last decade – is shown in Figure 1. As the decade wore on, Citigroup no longer was capturing the benefits of consolidation. Either the premiums it paid were becoming too high or competition eroded the benefits more quickly. Many other bank consolidators showed the same result (see Figure 2). Clearly, the economic benefits of bank M&A declined during the latter part of the decade. In June 2001, due in part to its distorting of financial statements, pooling was eliminated as an allowable accounting treatment for acquisitions. This did not change the economic landscape. But today it does require management to adjust for the impact of pooling when trying to make apples-to-apples comparisons of banks’ or the industry’s economic performance over time.

• Interest Rates – Despite some fluctuation, interest rates declined over the last decade and were low relative to prior periods. In 1993, the 10-year Treasury yield stood at 5.8%. By the end of 2003, it had fallen to 4.2%. Where rates will settle over the next decade remains unknown, but at current levels they have nowhere to go but up. When they do, banks will face the near-term likelihood of reduced net interest margins as their payments on interest-bearing liabilities (deposits) rise faster than yields on interest-bearing assets (loans). More critically, rising rates will put pressure on top-line growth. Bolstered by low rates, unsecured consumer borrowing (such as credit cards and consumer loans) grew 9% annually from 1995 to 2002. Similarly, the mortgage-refinancing boom of the last two years drove growth of highly profitable home loan origination and servicing fees.

  But rising interest rates are likely to chill mortgage lending and make it less profitable as banks fight over a fixed or even shrinking pie. In what may be a sign of things to come, Washington Mutual, one of the nation’s largest mortgage lenders, reported disappointing earnings in the second quarter of 2004, due in part to the negative effect of rising interest rates on loan growth, servicing income and overall net interest margins.

• Deregulation – The relaxation and reform of industry regulations in the 1990s gave banks increased pricing flexibility and, more importantly, the opportunity to offer a more sophisticated suite of products. The erosion and ultimate repeal of the Glass-Steagall Act allowed banks to compete in higher-return, fee-based businesses, such as brokerage and investment banking. As banks also entered insurance and asset management, interest income became a less dominant part of their P&Ls. Fees, as a fraction of bank income, increased from 32% in 1993 to 40% in 2002.

  Now, another wave of profit-enhancing regulatory reform of the sort experienced in the last decade seems unlikely. Some of the most onerous restrictions have already been removed and current political sentiment appears to oppose further deregulation, particularly for financial institutions.

  That said, banks could stand to profit handsomely if Social Security is partially privatized. This could create a huge source of new growth for asset management and brokerage products. However, it is impossible to predict whether such reform will occur and whether banks will be positioned to profit from it.

• Consolidation From M&A – The 1990s brought a wave of consolidation, in part spurred by deregulation. Besides being allowed to acquire and integrate new businesses outside of their core activities, bank holding companies were permitted to acquire banks in any state by 1994. As a result, consolidation began accelerating. At the end of 1993, there were 12,216 commercial banks and savings institutions. Ten years later, the number had fallen to 8,584. Consolidation enabled banks to build scale and gain access to millions of new customers. New technology let them serve more customers with more products in more locales, increasing bank size while maintaining efficient and effective service to customers. As evidence, consider that the industry’s efficiency ratio (non-interest expense/revenue) improved from 65% to 59% between 1993 and 2001, even though the average bank presided over a much bigger customer base.

  For much of the 1990s, banks retained their efficiency gains in the form of higher profits. But despite the likelihood of further industry consolidation ahead, such efficiency gains will be difficult to replicate. The large financial institutions have reached efficient scale. Some observers even argue that the largest institutions are beginning to experience diseconomies of scale as the costs of complexity and lack of focus outweigh the benefits of size.

  Recently, several banks have launched acquisitions to snare customers in new geographic markets – "filling out the footprint" – or to gain new products and capabilities (e.g., asset management), rather than buying in-state rivals and eliminating overhead such as bank branches and data processing centers. To be sure, financial institutions like Bank of America (which purchased FleetBoston earlier this year) are wringing out costs from such deals. However, this typically only covers the premium paid, if all goes well. To create value from consolidation in the coming decade, banks will have to do more than remove redundant costs.2 Indeed, the economics of bank consolidation have been deteriorating since the late 1990s (see sidebar, "Accounting for Acquisitions in the 1990s"). Until banks identify new ways to create value from M&A, further consolidation will only have a neutral to modestly positive impact on industry profit growth.