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Understanding Banking Industry Basics
Robert B
lbertson
Vice President
u
anking Research
Goldman
Sachs
Company
Decisions about investing in banking stocks should be made in the context ofthe recent
history of
bank
performance, the cyclical drivers of
bank
stocks, and the structural
challenges including consolidation the
industry faces.
People have a great many misconceptions about
banks
and
banking. For example, consider the fol
lowing simple, reasonable-sounding propositions:
III Bank capital ratios have deteriorated
during the past decade.
III Banks have been displaced from corpo
rate lending
by
other forms of finance.
Consumer debt is increasing an d is
threatening profitability in banking be
cause of high loan losses.
III Consolidation is the new wave
but
mergers
must
be done primari ly in a
market with a lot of branch overlap to
make
them
work well.
III Bankearningsdo not foretell what stock
prices are really going to do.
III
Bank stocks are interest rate sensitive.
At the risk of oversimplification, all of these be
liefs are largely wrong I will discuss some of them
and
present a broader view of three topics in the
banking industry: the recent history of bank perfor
mance; the cyclical drivers of bank stocks; and the
structural challenges the industry faces basically
consolidation.
Recent
History
of
Banking
The recent history of banking is rather straightfor
ward. There are only three dates to remember: In
1978
interest rate deregulation got under way; in
1985
the Supreme Court said mergers were all right
but states
had
to approve them; and in 1990, the
famous
BIS
(Basle) ratio came together, leading ev
eryone to decide they knew
how
to legislate the
correct capital ratio for banking. I will
go
through
these dates in order of importance, beginning with
the most recent.
Capital Ratios
The banking industry is probably the most lev
eraged industry in the country.
igure
traces al
most
60
years of the equity-asset ratio for insured
commercial banks. The history of capital has been
quite dramatic.
has fallen a long way, but most of
the fall took place a long time ago. In the mid-1930s,
the equity-asset ratio exceeded 13 percent. Walter
Wriston was right: High capital ratios did not pre
vent carnage and failure. The ratio was even higher
before the Great Depression.
hit its recent nadir in
1979, and it has been in a slow but steady recovery
ever since.
The world conclave in 1990 that produced the
Basle Accord decided to look at assets in a more
sophisticated way. The assembled conferees pro
vided guidelines that say the minimumcapital ratio
should
be
4 percent Tier I, which is a euphemism
for common equity
and
some preferred. Most banks
in the United States are well above 4 percent, and
those that are
not
are very close to that level. Five
and one-half percent is actually the practical limit on
capital that
is to say,
what
is necessary to try to
do
acquisitions.
Capital is probably the most important factor
explainingvaluationdifferences in banking. Capital
is timeless. Capital collects the past, the present, and
the future.
cumulates
past
sins, reflects them in the
current condition of the bank,
and
tells what the
future opportunities are going tobe for that bank.
is more impor tant than growth and profitability.
igure
2 shows
how
value correlates with capital
levels in 1990
and
October
1991
Although the R
was 0 in 1980,and 0.38 inOctober 1991, itwas as high
as 75 prior to the 1987 market crash. In recent years,
i t has been the single most influential variable in
explaining price--earnings and price-book differ-
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Figure 2.
Value
Correlates
to
capital
7.0 7.5
.
.
.
. .
'
.
.
150
140 I
1301-
120
110
o
:g
100
90
o
Jl 80
I
70
60
50
4 : L: L_. . I . . . . l _ L . : : . L. . J L L_. . . . l l
2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5
Common
Equity-Assets Ratio
)
1990
Year End
14 - - - - - - - - - - - - - - - - - - - - ~
13
12
11
Figure 1. History of
capital Equity Asset
Ratio
Insured Commercial
Bank
:::
1
OJ
9
8
7
6
5
l-- . . . L-- -- ----L---l_. l . . . - . .L---L----L----L---- . JL-L -. . . l . .. ---l
S 4 S 8 ~ 2 ~ 6 ~ 0 ~ 4 ~ 8 ~ 2 ~ 6 r o ~ ~ ~ ~ 6 ~ 0
ource Goldman, Sachs Company
10.0.0
.
.
.
..
.
.
..
4.0 5.0 6.0 7.0 8.0
Common
Equity-Assets Ratio
)
October 1991
the hard way. Banks have always tr ied not to have
too m uc h g ap in their margins; they have always
tried not to be too interest rate sensitive.
Interest rates are not as powerful a predictor of
bank stockperformanceas someanalysts think, how
ever. The shaded areas in Figure 3 are theperiods in
which ou r lOa-bank index outperformed themarket.
During theperiods where
bank
stocks outperformed
the market, interest rates were either rising, falling,
or indifferent.
Table1 shows the resultsofa regressionanalysis
of the relationship between
bank
stock prices
an d
interest rates during the past two decades. The
upper
portion is based
on
relative price performance
of bank stocks,
an d
the lower portion is absolute
price performance. The independent variables are
short-term rates the Federal funds rate , change in
short-term rates, long-term rates la-year Treasur
ies , changein long-termrates, the yield curve proxy
the yield on lO-year Treasury securities versus the
Federal funds rate ,
an d
the spread proxy the prime
lending rate versus the cost of funds,
or
yield on
three-month certificates of deposit . The regressions
230 .
220
200
180
o
g
160
140
~
8 120
1
J 100
u
;E
80
6
40
20
L _
_ l _ L .l...-_---.J
3.0
Interest Rate Deregulation
Interest rates are often thought to be a n import
an t factor in the valuation of bank stocks. Figure 3
compares movements
in
interest rates
an d
bank
stock prices from 1972 to 1991 Interest rate deregu
lation began in 1978, causing quite a change in the
banking industry. At that point, money market de
positsbegan to appear
an d
consumer depositsbegan
to show significant interest rate sensitivity. Up until
then, interest rates on consumer deposits were fixed;
they were the anchor to windward for the banks.
I f
anything, b an ks d id be tt er in high-rate environ
ments, as some asset yields were rate sensitive while
deposits were not, although they never went too far
ou t
on that curve. In the late 1970s, interest rates on
consumer deposits became variable, causing the lia
bilitystructure to change. In fact, to some people, the
liability structure was the tail wagging the dog. In
1981
came the big interest rate spike, an d banks got
creamed on margin. They ha d to learn that lesson
ource Federal Deposit Insurance Corporation.
ences. Capital isthe mostpowerful influence for four
simple reasons:
III
Capital is a risk buffer, particularly in
ba d times.
III
A high capital ratio allows a bank to
recover from a recession faster an d gain
in loan market share.
III
Capital is an absolute prerequisite to
doing acquisitions. With increased con
solidation
in
the industr y capital is
going to be more important.
III
Capitalwill be a requirement for success
in a more liberal environment.
It
will be
the entry ticket to
ne w
products
an d
ventures i f banks ever get enabl ing,
rather than punitive, legislation.
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Figure 3. Stocks versus
Rates Relative
Price Index
January
1972
20
19
18
17
16
15
14
13
12
10
en
9
2
S
8
7
6
5
4
3
0 = = ~ L ~ ~ . . . L . . ~ . L m
c , . J L , ~ J L . . ~ , L ,
.
lwm : t d , U L . L ~ = . . . L . .
~ = = = = ~ ~ = ~ ~ l ~ = = ~
72 73 7 4 75 7 6 7 7 78 79 80 81 8 2 83 8 4 85 86 87 88 89 9 0 91
January 1972
=
100
120
70
100
11
60
Shaded areas
represent
periods
of
bank
stock outperformance.
Relative Bank Price
Index
- - - Federal Funds
. - - - - - 1 0-Ye ar T re as ur ie s
ource
Goldman Sachs
Company
were estimated on a coincident six-month lead an d
six-month lag basis. In all cases the R
2
s are virtually
zero. These stocks have very little consistent interest
rate sensitivity; although there are periodic relation
ships with sho rt-term rates
on an
absolute basis
none persevere.
Industry Structure
Banking ha s
been
the most
discriminated-
against industry in the United States. For the
past
5
years b an ks h av e been u nable to m od ernize their
existing product unable to broaden into other finan
cial services an d unable to sell their archaic wares
except in very tight geographical areas. They have
been burdened with all sorts of community respon
sibilities. What banks have achieved in this environ
ment is amazing. Think about an y other industry or
stock an d apply the same rules. For example sup
pose Apple Computer could only sell its computers
in California. Suppose it could only sell its first-gen
eration computer one with a black an d white screen
an d less than 10 megabytes of memory. Suppose it
had to offera d isco un t to any on e o ver the age of 55
Wh at d o y ou think w ould happen to A ppl e Com
puter?
Three kinds of diversity are important. Geogra
ph y was a limitation for banks until the mid-1980s.
Then some regional compacts were created an d a
lot of merger action took place in the Northeast an d
Southeast. Th e first b ig o ne was Sun Tru st wh ich
wa s
a m erger o f equals. These region al com pacts
w er e a st ep i n the ri ght direction bu t m or e t ha n
anything they intensified concentration albeit in
somewhat broader geography. Nevertheless it still
kept most ba nks concentrated in one place; they
could not cross the country. The reason banks in
New England have beenfailing is because they were
onlyin
New
England rather than in several regions.
Without this geographical restriction the industry
could have avoided most of the Texas and New
England disasters because the larger banks would
have diversified ou t of those regions.
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Table 1 Regression
Results
Bank tock Prices on Interest Rates 9 7 ~
Change in
Federal
Change
in
Treasuries at
Treasuries
at
Yield
Funds Federal Funds
Constant Maturity
Constant Maturity
urve
Spread
Item
Rate Rate
of 10 Years
ofIO Years
Proxt
proxl
Relative bank stock index
R
0.00
0 01
0.00
0.00
0 01 0.05
6-month lag
Coefficient -0.03
1.39
0.38
-1.72
5.14 -3.14
t-statistic
-0.11
1.39 1.00
-0.79
1.50 -3.56
R
2
0.00 0.00
0.00
0 01
0 01 0.07
Coincident
Coefficient -0.03 0.20
-0.29 -2.76
-4.64 -3.67
t statistic
-0.13 0.20
-0.76 -1.27
-1.36
-4.29
R
2
0.00
0.00 0.02
0.00
0.08 0.13
6-monthlead
Coefficient 0.08
0 31
-0.69 -1.59
-13.66
-4.49
t statistic
0.32
0.34
-1.94
-0.79
-4.28 -5.80
Absolute
bank
stock index
R
2
0 01 0.00
0.00 0.02
0 01 0.04
6-month lag
Coefficient -2.59 -1.83
1.00 -24.60
20.79 15.23
t-statistic -1.83
-0.34
0.49 -2.10
1.12
3.19
R
2
0.02
0.00 0.00
0 01
0.00
0.03
Coincident
Coefficient
-3.27
-2.39 -1.93
-15.49
8 21
13.52
t-statistic -2.37
-0.45 -0.95 -1.33
0.45 2.89
R
2
0.03 0.00
0 01 0.00
0.00 0 01
6-month lead
Coefficient -3.45 -1.91 -3.37
-9.72 -1.24
8.22
t
-statistic
-2.42
-0.35 -1.62 -0.83
-0.06 1.72
Source
Goldman, Sachs Company.
ote R
2
measures the success of the regression in predict ing the values of the dependent variable. An
R
is 1 00 i the
regression fits perfectly, and 0.00 i it fits no betterthan the simplemeanof the dependent variable. The coefficientmeasures
the contribution of its independent variable to the prediction. the coefficient is zero or very small, the regression indicates
the variable is not helping the forecast. The t-statistic is the ratio of the regression coefficient
to
its standard error. the
t-statistic is large, it is unlikely that the true value of the coefficient is actually zero. More specifically, i this value is greater
than 2 it is more than
95
percent likely that the coefficient is not zero. A t-statistic below 2 in absolute terms) indicates the
variable is not considered significant
and
should
be
disregarded.
aRatio: yield on Treasuries at constant maturity of 10years to Federal funds rate.
bSpread between prime lending rate and yield on three-month certificates of deposits.
The types of products offered
by
financial insti
tutions in the 1980s is presented in
igure 4
Com
mercial banks competed in five products. In con
trast,Sears,Transamerica,RCA,Gulf
Western,
and
some of the others offered considerably more prod
ucts. This providesa clear picture ofthe competition,
and
it has been tough
on
bank product. Fleet Finan
cial, one of the earliest to seriously diversify, said,
We are the largest bank in the smallest state, so we
better do something. They got into nonbank sub
sidiaries that were near-banking, allowing them to
get a little bit outside of the product
and
geographic
restriction mold. Subsidiaries that are in mortgage
banking, asset-based commercial finance,
and
con
sumer finance are good ways around geographical
1
restrictions and should get some of the credit for
saving banks like Fleet
and
Norwest.
When banks finally hit on a solid earner, politi
cians invariably get upset: The credit card is
an
amazing product. Everyone thinks banks are paying
off their losses
on
loans to less developed countries
with usurious rates to the consumer
on
their credit
cards. The average return
on
the creditcard business
is
300
basis points pretax. The average yield is
18 9
percent
per
card. n
an
aftertax basis, this might be
150
basis point return, which I do not think is sinful
for the banks,
but
it makes banks into vulnerable
targets.
Loan portfolios.also pose diversification prob
lems, although progress has been made,
and
banks
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Figure
4
Product Possibilities Through
t
198 s
ource Citicorp.
have been much more disciplined. Actually the
highly leveraged transactionbusiness helped reduce
credit concentrations. In the mid-1970s there was a
constant streamofbig creditswith problems and the
banks seemed to always have big pieces of these
problems. Legal lending limits do not mean much
anymore; banks usually
do
not even get close to
them. In fact loans retained on highly leveraged
transactions are typically about 0.5 percent of the
legal lending limit in many banks. This is one place
where lending limits have worked.
Lending limits have not worked in commercial
real estate. Unfortunately that is the basic funda
mental driver of the U.s. economy. Bankswent from
8
to
percent of their assets in real estate. I find
that in and of itself not a bizarre
number
for an
entire loan category. I am stunned that we read little
in the newspapers about the real estate developers
who
did the bad deals compared to the banks that
lent to them. This is an industry that attracts
an
enormous amount of criticism which becomes pro
gressively more unfair and unbalanced.
Cyclical Drivers
Banks have three cyclical drivers: credit demand
interest rates and loss cycles. These drivers are de
ceptively simple in theory bu t sometimes complex to
assemble.
Credit Demand
Credit demand isof twomajor types-eonsumer
and corporate. Banks always have a much sharper
losscycleon the corporate side than on the consumer
side primarily because consumers are debt maxi
mizers
and
corporations are debt minimizers. For
debt maximizers it is the Los Angeles freeway phe
nomenon: being so scared you drive carefully. The
minimizers-akin to Sunday drivers
-only go
into
debt
when they have to which is probablywhen
they should not:
at
the
end
of a recession
or
coming
into a recession. They get into trouble.
Consumer lending is very simple: Consumers
borrow based on strength of income. The appropri
ate
debt
level according to the average consumer is
as
much
as he can carry as long as he can service it.
Figure 5 shows consumer credit and disposable per
sonal income growth during the past 5 years. They
track pretty well. In 1980 however consumer credit
growth
dropped
like a rock. That was when Presi
dent Carter was in office and credit controls were
imposed. In 1984 and 1985 consumer credit took off
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Consumer
Credit
Consumer
Credit
Outstanding
- - - Di sposable Pe rsona l I ncome
Figure
Consumer
Credit OUtstanding versus
Disposable
Personal Income
Interest Rates
Just as bank stock prices do not relate much to
interest rates, bank net interest margins are surpris
ingly stable as well. The
upper
panel in Figure 8
shows two mega-interest rate cycles,
and
the lower
panel shows bank margins. I
do
not see any power
ful correlation betweenthe interestrate cycle
and
the
bank margin cycle here, either. This is not an indus
try that bounces around from net interest margin.
The lower panel of Figure 8 also shows two
spreads: the pr ime rate versus money market ac
count rates,
and
the pr ime rate versus the three
month wholesale certificate of deposit rates. Basi
cally,the prime to retailfund spread iscomingdown;
the other has been going up. Thus, we are basically
neutral on
our
margin outlook; the primary forces
should largely offset each other.
You hear about the Federal funds rate
and
the
discount rate going
down
a lot, while banks have not
dropped their lending rates. Banks do not use Fed
funds as a source offunds unless they have a serious
problem. Most of them are net placers,
and
the dis
count rate is a dirty word.
Figure 9
shows that the
spread
between the
prime rate and the Fed funds rate has been going
up
during the past couple ofyears. Thespread between
theprimerate and the truecostof funds hasbeen flat,
however. Banks really just move their rates in line
with their true costs of funds. This is the proverbial
orange cart: They were paying whatever it costs to
buy the orange, and then selling it at a spread.
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