understanding banking industry basics

7/24/2019 Understanding Banking Industry Basics

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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-

7


2/11

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.

8


3/11

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.

9


4/11

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


5/11

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


6/11

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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understanding banking industry basics

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