| Upward
Spiral
By Steve Klinkerman
Frank Newman's plan for revitalizing
Banker's Trust
Frank Newman knows what it's like
when a financial institution is on the defensive. In 1986,
he was on board at BankAmerica Corp. while it was fighting
a severe earnings slump and a takeover attempt by the
former First Interstate Bancorp. More recently, he watched
as a derivatives crisis drove out the larger part of the
senior management team at Bankers Trust New York Corp.
"One difficulty leads to another, and
that leads to a loss of momentum," says Newman, who succeeded
Charles S. Sanford Jr. as chairman and chief executive
of Bankers Trust this spring. "Then you lose customers,
which hurts morale and further hurts the business. The
institution spirals down and down, and you have to do
something to stop it from spiraling down forever."
So it was with a great deal of relief
that Newman in June apparently capped the crisis phase
at the $115 billion-asset Bankers Trust (BT).
Following two years of strife and ruinous
publicity, he reached an out-of-court settlement on a
$195 million lawsuit filed by former derivatives client
Proctor & Gamble, concluding all major litigation
launched by former derivatives customers.
Then, investigators wrapped up a lengthy,
expensive and hugely distracting probe into the conduct
of BT's derivatives business between 1991 and 1994. While
flaying BT over past derivatives sales and operating practices,
attorneys Derrick D. Cephas and Benjamin R. Civiletti
also concluded that "the vast majority of BT's employees
performed their jobs in accordance with the highest standards."
Further regulatory action, if any, would be confined to
Securities and Exchange Commission discipline of certain
former BT employees.
Now Newman, 54, is focusing on rebuilding
BT's momentum. "I don't have any specific time frame,"
he says. "I just want to keep the spiral going up."
There is much to be done.
Excluding a copper-related trading
loss, BT's former flagship operation, risk management
services, posted annualized earnings of just $4 million
in the first half down from $163 million in 1994
and $332 million in 1993.
Waning customer interest in exotic,
high-margin derivatives products accounts for a goodly
portion of the decline. But the company also saw a big
slowdown in the flow of new business. "The number one
question about Bankers Trust is whether it can rebuild
its risk management clientele," says Tanya Azarchs, director
of financial institutions research at Standard & Poor's
Ratings Group.
Coming To Grips
Even that falls short of the full challenge.
The company's core strategy is capitalizing on the globalization
and securitization of financial services. But in practice,
BT over-emphasized certain business lines, most notably
complex derivatives and proprietary trading, while under-emphasizing
advisory relationships and internal controls. These distortions
came at the expense of reliability, which is key in winning
client and investor support. A real organizational transformation
is required, not just a rapprochement with major publics
on business-as-usual terms.
BT's second quarter earnings of $151
million rose 66% from a year ago. However, the banking
company's 0.47% annualized return on average assets was
less than half the 1.11% ROA benchmark of its seven-bank
peer group, according to Keefe, Bruyette & Woods Inc.
A 12.9% annualized return on average equity compared with
a 17.8% peer average and peers achieved their returns
on sharply higher proportionate common equity bases.
Though daunting, the situation spells
opportunity for Newman. A former deputy secretary of the
Treasury, he is positioned to lead a turnaround at one
of the nation's largest banking companies. A squeaky-clean
image no doubt helped his candidacy for the job, given
the reputational repairs needed at BT. But the Harvard
University graduate also has solid banking credentials.
Before joining the Treasury Department in 1993, Newman
held the chief financial officer's post at BankAmerica.
The executive has a number of factors
working in his favor. Perhaps most importantly, healthy
growth is foreseen in BT's key markets. According to estimates
by Boston Consulting Group (see page 35), annual derivatives
and trading revenues for the entire U.S. wholesale banking
market are expected to rise by $5.3 billion, or 19%, over
the last half of this decade. Annual asset management
revenues will climb by $5.7 billion, or 58%, according
to BCG; underwriting revenues will climb by $2.7 billion,
or 43%.
What is more, Bankers Trust already
has some great strengths in place. The company's investment
banking unit is riding the crest of a strong market. Client
processing operations are profitable and stable, as is
a major outpost in Australia. And, significantly, the
company already has the global reach needed to support
its strategy.
Reputational Risk
There are several important components
to Newman's turnaround campaign. One is instilling organizational
discipline. While BT rose to creative heights under Sanford,
it also became a place where certain teams of people operated
with little independent scrutiny and senior management
oversight. That is changing. For example, Frank L. Minard,
managing director of BT's investment management group,
recalls joining the company last December and discovering
60 people who together command $10 million of annual
compensation working full time on control issues.
But Newman is going beyond organizational
charts and documentation, urging associates to assume
personal responsibility for BT's risk profile.
"This firm prides itself on its
risk management capabilities, but we haven't defined risk
management broadly enough," says Newman. "Risk not only
extends to credit, liquidity and markets, but it includes
reputational risk, legal risk, and operational risk. I
am pushing our managers to think in terms of the entire
set of risks that they need to manage for each business."
At the same time, BT's senior managers
are trying to avoid gridlock. "We've worked mightily to
put in enhanced policies, procedures and controls, but
you can get to a point where you're filling rooms with
manuals," says vice chairman George J. Votja. "An organization
can ossify. I worry about that more than anything else."
Another thrust is focusing on advisory
relationships and integration of derivatives transactions
with other services.
In peak years such as 1993, derivatives
were as much speculative vehicles as risk management tools.
Instead of hedging transactions, corporate treasurers
invested outright in derivatives, whose values are derived
from changes in the values of other securities, seeking
to capitalize on a trend of steadily declining rates.
Spicing up the proceedings, BT concocted lucrative and
exotic instruments susceptible to dramatic swings in value.
Painful
Lesson
Not only did the market collapse when
rates began rising, but BT learned a painful lesson about
the hazards of dealing in proprietary instruments. "Technically
speaking, we act as an intermediary, incurring risk on
one contract and laying off that risk with another contract,"
says Alex Mason, a managing director at BT's global investment
bank. "But should things go wrong, clients tend to look
across the table at us, instead of at the financial instrument."
Now, the speculative end of the derivatives
business "is essentially dead," says Newman. "Our customers
don't want leveraged derivatives, and we don't want to
deliver them." Reflecting BT's retreat from exotic derivatives,
employment in risk management is being cut back to 300
people, compared with a 1994 peak of 415.
As model of where Newman wants to go,
he holds out two 1995 privatization transactions in France,
under which hitherto state-owned companies were transferred
to private ownership. In addition to advising Lafarge,
which produces building materials, and Usinor Sacilor,
a steel producer, Bankers Trust created equity derivatives
that put floors on the trading values of newly-issued
stock owned by employees of the firms.
Underscoring the importance he places
on multi-dimensional customer relationships, Newman in
August rolled out a program offering grants of restricted
stock to officers who steer clients into significant engagements
with BT business units other than their own.
As a further means of capitalizing
on BT's expertise, Newman wants to provide derivatives
services to other financial institutions. For example,
BT is supporting the interest rate derivatives business
of Abbey National, London. And in August, BT won a contract
to provide proprietary portfolio risk management software
to Sumitomo Bank, Tokyo, one of the world's
largest banking companies.
However, no one is promising a rapid
turnaround in BT's risk management unit. "Many long-time
clients stayed with us amid the lawsuits and publicity,
but we lost some of our ability to attract new clients,"
says Richard H. Daniel, BT's chief financial officer.
Although BT is winning some measure of new risk management
business, regaining strong momentum "will take some time,"
he says.
Lowering Exposures
As part of his effort to lower the risk
profile at Bankers Trust, Newman also shifted BT's focus
in trading and sales. Mindful of the $95 million loss
the unit posted in 1994, he is de-emphasizing currency
trades in major markets. Instead, Newman is emphasizing
trading in less-established markets in various parts of
the world, where BT can take advantage of its local presence
and knowledge.
At an annualized $82 million, BT's
first half trading income is exactly in line with 1995.
The figure is down considerably from the $468 million
peak BT realized in 1993. But Newman hopes returns will
prove more predictable. And if trading can be made more
efficient, so much the better. BT is studying ways to
streamline the unit.
The risk profile of BT's Latin America
operation has similarly been reviewed, according to company
officers. The unit lost $120 million amid the sovereign
debt crisis of 1995. But it rebounded to deliver $55 million
of earnings in the first half of 1996.
In investment banking, Newman clearly
is building on strength. Bankers Trust has done very well
advising on highly leveraged transactions, for example,
zooming to the top of the 1995 league tables. First half
investment banking income of $186 million already exceeds
what the unit earned in all of 1994.
Angling to boost BT's ties with investment-grade
clients and muscle up in the merger and acquisition advisory
arena, Newman in May agreed to buy Wolfensohn & Co.,
New York, an M&A advisory firm. According to Securities
Data Co., the 140-person unit ranked seventh among the
world's top merger and acquisition advisers in 1995, participating
in deals worth $50 billion. By itself, by contrast, BT
ranked 53rd, with $2 billion worth of deals.
Instead of confining itself to providing
loan and bond financing for highly leveraged transactions,
Mason says, BT wants to be in the position of offering
any combination of services corporate finance clients
want, including equity underwriting and M&A advisory.
Newman does not rule out further investment banking-related
acquisitions. For example, the executive says he would
like to build equity distribution channels in Asia and
Latin America.
In other areas, Newman is looking for
steady results. Client processing services reels off about
$100 million of income per year. BT's Australian sub-
sidiary slumped in 1995 but seems capable of regaining
the $150-million-a-year form it exhibited in the early
90s. BT's investment management unit is climbing from
break-even and may take several years to reach full strength.
Investors' Response
In the meantime, Newman is making progress
on Wall Street. On the fixed income side, the yield on
BT's 10-year subordinated debt in mid-August was hovering
between 70 and 75 basis points above the comparable Treasury
security. That compares with a 95 basis-point credit spread
seen in the first quarter of 1995, when BT announced a
loss of $157 million. This is especially meaningful in
light of the fact that 61% of BT's capital consisted of
long-term debt at midyear, according to Salomon Brothers
Inc., compared with 49% banking industry median.
What is more, the common stock of Bankers
Trust was nudging $80 per share in mid-August, up a strapping
60% from a nadir of $50 per share in March 1995. The company's
historical high closing price is $82.50, recorded in the
first quarter of 1994, according to SNL Securities LP,
Charlottesville, Va. In a recent SEC filing, BT said Newman's
team had set a goal of reaching 1994 earnings levels ($615
million) again in 1996. That would represent a more than
175% increase from 1995.
At roughly 5% as of mid-August, however,
BT's dividend yield was much higher than the banking industry
median of roughly 3.5%, indicating that the company has
yet to win the full measure of investor support. Analysts
want to see more evidence of customer growth, particularly
in risk management, and improved overall performance.
One impediment in assessing BT's results
is its balance sheet structure. To satisfy regulatory
requirements that underwriting revenues do not exceed
10% of total revenues in its Section 20 subsidiary, Bankers
Trust balloons the balance sheet with Treasury securities
and other low-risk assets, financing the exercise with
extra borrowings. As a result, everyone from Newman on
down at BT shrugs off the company's ROA statistics as
being "almost meaningless," in Newman's words.
However, ROE statistics also are impacted
by this exercise. Changes in financial leverage provoke
even greater proportionate changes in the variability
of equity returns. Thus, BT's high leverage (its 3.8%
ratio of common equity to assets is one of the lowest
in the entire U.S. banking industry, according to SNL)
adversely impacts its risk-adjusted earnings performance.
The Federal Reserve System proposes
raising the Section 20 underwriting revenue ceiling to
25%, offering significant relief on this issue, although
it remains to be seen how much de-leveraging would occur
at Bankers Trust and how the company's returns would compare
with peers.
Delivering The Goods
Of course, an earnings revival would
brighten BT's financial picture all the way around. And
senior management has a powerful motivation to deliver
the goods. In the first quarter, Newman unveiled an incentive
plan potentially worth $200 million for roughly 40 key
executives. The full value of the plan is unlocked the
day Bankers Trust stock trades at $100 per share.
Ultimately, Newman's fortunes rest
with BT's employees and customers. It will take time for
the company to demonstrate convincingly that its risk
profile has changed for the better; that its focus has
shifted from transactions to clients. And even after the
last reputational aftershock of the company's derivatives
crisis fades away, BT still will be confronted with the
challenge of regaining valuable market share lost to competitors
during the crisis years.
"We are in the process of rebuilding
the reputation of the firm," says Newman. "A client orientation
means doing the homework, trying to understand the customer,
identifying problems and opportunities. The more we deliver
on that agenda, the more value the customer derives, and
the more profitable and successful we will be.
Mr. Klinkerman
is editor-in-chief of Banking Strategies.
Copyright © 2003 by Banking
Strategies, published by BAI.
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