BankAmerica's Stress Test

By Kenneth Cline

The new BankAmerica stumbled at the starting gate. Can it recover its footing?

David A. Coulter merged his bank in a quest for synergy, but found conflict instead. The question is whether his recent ouster reflects just a temporary crisis at BankAmerica Corp. or points to deeper strategic flaws in the formation of the new colossus.

On April 13, the former chief executive of BankAmerica inked a deal with NationsBank Corp. CEO Hugh L. McColl Jr. to create the second largest banking company in the United States. The $600 billion-asset institution lags only Citigroup domestically and ranks fourth among the world's financial institutions. Particularly on the retail side, the new BankAmerica enjoys unprecedented scale, controlling 8% of U.S. deposits and a branch network that sprawls from coast to coast.

But the merger ran into trouble right from the start. In its first earnings report as a combined entity, the new BankAmerica revealed $1.2 billion of surprise losses on emerging market securities trading, a mortgage-servicing portfolio, and a troubled New York-based hedge fund. Profitability fell to a dismal 0.26% return on assets. The October 14 announcement battered the bank's stock, which fell 11% that day, and sent analysts scrambling to lower earnings estimates for next year. A week later, with most of these problems traced back to the old BankAmerica, Coulter himself resigned as president.

Coulter's resignation occurred just as this magazine went to press, and he could not be reached for comment. But in earlier interviews he expressed the hope that combining his predecessor BankAmerica with NationsBank would not only cut costs but actually overcome banking's traditional constraints on revenue growth, leading the new institution to a higher level of performance. "We have a chance to be a leading edge financial institution," Coulter said during happier times. "We have the resources to make it happen."

The merger may still produce useful -- perhaps even powerful -- synergies. The new BankAmerica remains financially sound, and its core consumer and commercial operations still perform well.

But the company's inauspicious debut highlights an enduring fragility in banking. BankAmerica's special qualities don't make it invulnerable to larger industry forces, which carries an implication for other recent mega-mergers. An economy that appeared bulletproof in the spring suddenly looks very fragile, given the current turmoil in world financial markets. Credit quality problems may soon reach beyond emerging market bonds and hedge funds. Are risk managers adequately preparing their institutions for stormy weather?

In truth, numerous major deals have been struck hastily in recent years as predators snapped up trophy banks amidst a booming economy and stratospheric stock market. The short-lived C&S/Sovran Corp., thrown together in 1989, serves as a reminder of how mergers can sometimes create problems rather than solve them. That bank became so weakened by credit problems and executive infighting that it eventually succumbed to a takeover offer from NationsBank in 1991.

Coulter's personal drama, however, should not obscure the fundamental business case behind this deal. At the end of the day, this is a strategy issue, not an executive soap opera. Once McColl and his team work their way through the immediate crisis, they still have a chance to prove that this merger really can produce sustained revenue growth. The hurdle, however, is high.

Merger partners like to tout the revenue enhancements that will flow from the combination of their two companies, citing operating synergies, economies of scale, and improved pricing power. But there's scant evidence that sheer size really helps in banking, or that mergers do more than provide a temporary earnings boost from cost saves. More often than not, the completion of one transaction finds acquirers looking for the next deal to revive stalled revenue growth.

BankAmerica should put the bigger-is-better theory to its ultimate stress test. Assuming the current rash of credit problems can be surmounted, the new BankAmerica ought to possess sufficient size to reap significant economies of scale, with its 4,800 branches and 30 million customer households. "Just because nobody has ever harnessed the advantages that ostensibly flow from scale doesn't mean nobody ever will," Ryan says. "If any bank can, the new BankAmerica is probably the best positioned to do it."

Hopes for achieving such gains at the new BankAmerica rest largely on the retail side, the bank's predominant business line. Plans call for grafting NationsBank's retail operating platform, known as Model Bank, on to the old BankAmerica's hodgepodge of systems. By pacing the transition over a two-year period, strategists hope to avoid the systems conversion problems that have hobbled other mergers.

Execution risk is huge, however, and failure to reap expected productivity gains would threaten the merger's goal of creating a company stronger than the two predecessor organizations were on their own. "If one plus one is going to equal more than two, the Model Bank must work at the old BankAmerica," says Michael L. Mayo, an analyst at Credit Suisse First Boston.

Re-weighting the Barbell

While Coulter himself will no longer influence events at BankAmerica, he deserves credit for setting the deal in motion. The story of the merger begins with an evolution in his strategic thinking about the banking industry and his own company's place in that industry.

When Coulter took over at the old BankAmerica in January 1996, he focused much of his energies on rationalizing what had become an unwieldy collection of operations under his empire-building predecessor, Richard Rosenberg. Reflecting his background as a financial consultant, Coulter applied rigorous performance and financial metrics. He used, for example, the concept of risk-adjusted returns on allocated capital to determine whether particular business units should be retained. Between 1996 and this year, BankAmerica either sold or divested some 12 units, including institutional trust, consumer finance, and banking subsidiaries in Australia, Hong Kong, and Hawaii.

Along the way, the company noticeably lifted its profitability and standing on Wall Street. A 1.35% return on assets in the second quarter compares with a 1.07% return in 1995, and an 18.2% return on equity rose from 14.5%. By the end of the first quarter, the stock had appreciated 155% from the start of Coulter's tenure.

But cost cutting can carry a company only so far. By late 1997, Coulter was concerned about BankAmerica's ability to maintain its core growth rate. Though many of his peers sought that growth in acquisitions, Coulter worried about pricing. And ironically, given the current situation, he fretted about hidden risks in target portfolios. "I've never seen a positive due diligence surprise," he says. Ultimately, a "merger of equals," where no premium is paid to either side, seemed to him the best way to improve BankAmerica's competitive positioning.

Coulter believes in the "barbell" theory of banking -- that survivors will migrate to distant ends of the continuum, with a few enormous institutions at one end, thousands of community banks at the other, and very few in between. "I've always worried about getting caught in the middle, where you have too much infrastructure to compete as a niche player but are not really big enough to provide services on a global basis," he says.

While Coulter had developed some ambitious plans to improve BankAmerica's retail operations, he knew implementation would take time. Meanwhile, his company was in danger -- if it can be called that -- of slipping in the market capitalization and asset size rankings as rivals continued to expand. "I would have been thrilled just to step back and have the world stand still while we improved our quality of service. But the world's not standing still," he says. "If you have only a few strategic options, it's better to act than wait."

Underscoring that point, Bank One Corp. and First Chicago NBD Corp. announced their union the same day as BankAmerica and NationsBank -- and in the same New York hotel. Citicorp had joined with Travelers Group the week before, and the Norwest Corp./Wells Fargo announcement followed shortly thereafter.

Anticipating this trend, Coulter and his senior managers were looking at prospective merger partners by the end of 1997. Charlotte-based NationsBank topped the list because the combined organization could deliver retail dominance in the fast-growing Sunbelt, from Maryland to Florida and then out west to California. "Demographically, it is the best-positioned American banking franchise, hands-down," Coulter says.

Coulter called McColl in February, and the two men quickly got down to business, holding their first face-to-face meeting on April Fool's Day at San Francisco's Mandarin Hotel. In a sense, the two organizations were returning to the bargaining table, because Rosenberg had held tentative discussions with McColl in 1995. Rosenberg, however, held out for more control than McColl was willing to concede.

This time around, Coulter agreed to serve as president under McColl and accept Charlotte as the new headquarters. BankAmerica, however, is the surviving name, with Bank of America used at the branch level.

A Model Bank?

While technically a merger of equals, the deal clearly left the former NationsBank team in the commanding position. Not only is McColl serving as chairman and CEO, but former NationsBank directors also possess a two-vote majority on the 20-member board. "From day one, the merger was more of a NationsBank story," says analyst Mayo.

The power imbalance percolates throughout the organizational chart, where former NationsBank chief financial officer James Hance retains that key role and NationsBank president Kenneth D. Lewis heads the retail group, which combines consumer and small commercial banking. Even the western branches, representing the old BankAmerica network, are run by a NationsBank hand, R. Eugene Taylor. BankAmerica executives retain control of wholesale banking and global operations.

NationsBank's retail dominance was to be expected. NationsBank operated more branches than BankAmerica, nearly 3,000 versus 1,800. Even more importantly, NationsBank had gradually moved towards one operating system during the '90s, the Model Bank. BankAmerica, with four deposit systems, hadn't even started and faced the prospect of spending several hundred million dollars and several years of work to reach an equivalent level of systems integration.

Now BankAmerica's retail platforms can be integrated into Model Bank at far less cost. When that is accomplished, in two years time, employees across the entire merged retail franchise will have access to the same detailed customer information. The result should be higher cross-sell ratios and deeper customer relationships. "The bank will be able to perform in a much more effective fashion by getting everybody on the same operating platform," Coulter says.

Everyone involved is mindful of the disastrous systems conversion problems that plagued Wells Fargo when it tried to integrate First Interstate two years ago. Lewis insists that can't happen here, pointing out that NationsBank and BankAmerica engineered a friendly transaction, compared with Wells Fargo's hostile bid for First Interstate. NationsBank also has converted several previous acquisitions to its Model Bank platform and can deploy an experienced cadre of technical experts for this job.

But to guard against problems, Model Bank conversions will take place in stages. Texas and New Mexico go first, because that's where NationsBank and BankAmerica had branch overlap, with Arizona and Nevada following early next year. The Northwest region is scheduled for the latter part of 1999. It won't be until early in the year 2000 that installation finally begins in California, and that will be done in two stages. Lewis says other initiatives will be put on hold until all of this is accomplished.

"Things in the like-to-do category will just have to wait because we'll have so many resources focused on getting this company on one operating platform," Lewis says, vowing that executives "will have the discipline to prioritize things, so that we don't compromise the conversion."

The implication of Lewis's statement is that sales productivity improvements at the new BankAmerica will be slow in coming. In the initial years, at least, much of the merger benefits will derive from cost cutting. The bank pegs after-tax cost savings on the retail side at $750 million annually by the year 2000, much of that derived from branch closings and staff reductions. Lewis also is counting on significant "vendor leverage" -- the ability of the combined entity to use its buying power to extract discounts from suppliers.

The Scale Debate

To achieve major productivity gains, however, is to buck the historical trend. Numerous studies have shown that size in banking brings no advantage. Regulatory data spanning a decade, for example, underscore that efficiency ratios invariably tend to be higher (therefore indicating less efficiency) for the larger banks (chart, this page). "A lot of people believe the scale argument, but based on every piece of empirical data I can find, it doesn't hold up," says analyst Ryan.

James M. McCormick, president of First Manhattan Consulting Group, says his own studies suggest that bank mergers can actually exacerbate two of the long-term negative trends operating in banking today. The first has to do with the ineffectiveness of bank selling. First Manhattan's research indicates that between 60% and 80% of new accounts are originated on unprofitable terms. The second structural problem is an accelerating attrition of profitable customers.

McCormick hypothesizes that the inevitable focus on systems integration and cost cutting during a merger tends to delay efforts to improve marketing and customer segmentation strategies. When closing branches is part of that cost-cutting effort, as it usually is, customer alienation heightens attrition risk. Even though the old NationsBank enjoyed one of the industry's better records for retaining acquired depositors, those challenges remain in the BankAmerica merger, McCormick says.

Coulter agrees that size isn't everything in banking and that acquisitions usually provide more benefit to an acquiree's shareholders. But he says "substantial structural change" in the industry requires the very largest institutions to bulk up even more. There is increased competition, for example, particularly from nonbank technology companies. The new BankAmerica will be a formidable player in transaction processing and electronic banking, two businesses now vulnerable to nonbank inroads. "You have to ensure that you have both the capital and the people resources to meet that challenge," Coulter says. "If you're big, it's proportionally easier to add people and product capacity."

He cites investment banking as another area where size helps. In late 1997, BankAmerica bought the San Francisco-based Robertson Stephens brokerage firm for $340 million, based on a belief that the industry was moving to a "one-stop shopping" model in capital markets activities. "That's an easier bet to make if you're a $260 billion institution than if you're $5 billion. You can leverage that new product or service capability across a very big customer base and be comfortable about the payback," Coulter says.

The precise limits of effective size, however, seem rather elastic at the new BankAmerica. McColl was recently quoted as expressing an interest in expanding the company's geographic reach even further by acquisition. Coulter, interviewed in early October, was at a loss to define exactly what McColl meant, saying, "I have not had a chance to talk to Hugh directly" on that topic.

Coulter, 51, had known from the beginning that ceding control of the old BankAmerica would place his fate in the hands of others. For a start, the merger agreement had given him a less-than-ironclad assurance of replacing the 63-year-old McColl as CEO. Veto power rests in the hands of a board dominated by former NationsBank directors.

"Life was a lot simpler a year ago," Coulter conceded, when questioned about the ambiguities of his position. As credit problems begin to ripple across the industry, that statement may hold true for other top bank executives as well.

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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