Twilight of Empire

By Sean Ryan

A challenging economy may impede the largest vertically–integrated banks, but smaller rivals can use their agility and sales cultures to leap ahead.

A turning point is looming for the banking industry, and newly–formed titans likely will be the ones most affected. After nearly a decade of low inflation and interest rates, robust economic growth and soaring stock valuations, the good times are likely to top out this year, leaving institutions with an even tougher revenue growth challenge.

The implications are not good for the banks that rode the crests of spectacular M&A and technology spending waves to become giant conglomerates in the 1990s.

This might seem counter-intuitive, given all of the hoopla about big-bank diversification and economies of scale. But smaller, nimbler competitors are likely to have a better shot at revenue growth. The reason? Some of them used this recent holiday from the business cycle to fundamentally change the way they do business. They are now using data mining techniques to deliver useful customer information to front-line personnel. Those employees, equipped with proper training and rational incentives, in turn are able to sell more products and improve relationships with customers. Such banks are well positioned to sustain strong earnings gains in a more adverse economic environment.

Viewed from another angle, the robust economy of the last decade masked the weaknesses of the very largest institutions. Mega-banks talked a good game on data mining, cross–selling and customer relationship management. But many remained mired in the status quo, pursuing product–centric strategies with bloated cost structures. Their real strategic emphasis was capitalizing on strong trading multiples to gobble up competitors in stock-swap transactions. But some have reached the point where the price paid in weakened managerial controls has exceeded whatever gains were achieved in cost efficiencies.

These weaknesses will become more evident in an era when managers must move quickly and nimbly to meet the changing needs of their customers. Even in the current benign economic environment, mega-banks find it increasingly difficult to sustain growth rates. Their short-term options are unappetizing: either accept slower growth; or sustain growth by taking on greater risk; or weave an illusion of steady growth through accounting wizardry.

Longer-term, the large banks do have some remedies, if only they have the will to pursue them. Most fundamentally, they must cut through the hype surrounding information technology and product development and pay dramatically more attention to human resources management. Underscoring the point, many banks known for their technological savvy saw their earnings (and stock prices) deflate during 1999. Meanwhile, earnings and valuations generally have remained strong for banks whose commitment to employees runs deep.

Consider the example of First Tennessee National Corp. Under CEO Ralph Horn, the Memphis-based banking company instituted a formal program to measure employee satisfaction and diagnose areas of dissatisfaction. Improving worker morale and slowing turnover have been critical in First Tennessee's rising market share, sustained performance, and, ultimately, premium stock valuation. Two additional points worth noting are that First Tennessee has done this at a modest size (under $20 billion in assets), and without wrenching mega-mergers that can distract both management and employees.

With 2000 marking the transition into a very different banking environment from what we saw in the '90s, the successful competitors will be those that cultivate a motivated and skilled workforce and stay focused on serving customers.

Race for Size

It's almost as if big banks merged their way into a state of competitive disadvantage. That raises questions about how the industry came to its current state of consolidation.

A lot of it has to do with market conditions. During the halcyon 1990s, most banks rebounded from the early-decade recession to attain unprecedented levels of profitability. Disquieting questions about revenue growth still surrounded many institutions. But favorable conditions lifted the profitability of most banking companies, and investors did not sharply differentiate among management teams. Inefficient, poorly-run banks were accorded trading multiples that approached those of the industry's top operators, and this stock market phenomenon created dangerous real–world distortions. Takeover bidding was generally won by the biggest, dumbest suitors – exceedingly aggressive banks willing to water down the interests of their shareholders and commanding the largest bases over which to spread acquisition-related dilution.

Another factor driving the race for bigness was a growing emphasis on conglomeration. Managers were eager to develop new business lines, and they capitalized on weakening regulatory restrictions to buy their way into a variety of businesses, including brokerage, insurance, mutual funds and subprime consumer finance. Imbued with a faith that technology had solved the problems that bedeviled the conglomerates of the 1960s and 1970s, and often afflicted with plain old hubris, many of these institutions embraced vertical integration enthusiastically, attempting both to manufacture and distribute the full gamut of financial products and services.

Technology worship further emboldened the empire–builders, who thought computer information systems could simultaneously enable them to manage much larger enterprises while improving customer service, even in the face of massive layoffs and merger-related dislocations. The technical aspects of information – profiles, ratios, trends and statistical probabilities – seemed to take precedence over employee and customer relationships.

In fact, the industry's top-heaviness could become even more pronounced in the near term. The recent elimination of Glass-Steagall restrictions on cross-sector financial mergers, along with the prospective elimination of pooling–of–interests accounting by yearend, will create a temporary "window of opportunity" for aggressive acquirers. Insurance now represents fresh territory for commercial banks, broadening the range of potential deals. And the regulatory approval of recent big in-market bank mergers has pushed the antitrust envelope farther than would have seemed possible only a few years ago.

Size does not translate into strategic vindication, however. One way or another, the coming year is likely to provide further compelling evidence of the irrelevance of scale to banking success.

Conventional wisdom holds that banks can lower unit costs and lift profitability by running more volume through their largely fixed–cost systems. This is wrong. A mountain of academic research and empirical evidence illustrates that skill, not scale, determines success in banking. Though economies of scale do exist, they are largely exhausted at low thresholds – perhaps a few billion dollars of assets. Beyond this size, diseconomies begin to creep in and management is put under increasing strain.

Bureaucratic inertia, particularly, is a direct function of size, as senior management becomes ever more removed from customers and frontline employees. In such an environment, even the most promising initiatives can fizzle. Energy can dissipate while waiting for various parts of the organization to buy-in. Business mixes also grow increasingly complex, taxing management's ability to understand each unit's activities.

High Water Mark?

Technology–related rationales for size appear similarly suspect. We commonly hear the refrain that banks must grow in order to afford the technology investments needed to remain competitive. While this is true in a handful of individual business lines, it rings hollow at the company-wide level. Twenty years ago, the ability to afford mainframe computing power may have separated haves from have–nots. Thanks to advances in microchip technology, today's marginal cost of computing power is effectively zero. Banks of every size can afford more computing power than they can effectively deploy.

In too many cases, the greater sums that larger banks generally spend on technology projects engender waste, not competitive advantage. In an environment in which two-thirds of banks can't discern the impact of their spending on customer relationship management systems, larger IT outlays often end up effectively going down the drain. Even when breakthroughs are produced, resulting competitive advantages tend to subside quickly as competitors eagerly replicate them. At their worst moments, big technology spenders merely create benefits for their competitors by functioning as industry beta sites.

New technology is also cited as an instrument of management control by empire-building banks. "This time is different," they say, meaning that IT gives them the ability to manage larger, more complex enterprises. But advances in IT, real as they are, have not been matched by a reduction in the possibility of human error.

Today's bankers are no better able to master multiple crafts than their 1960s predecessors. The unusually long economic expansion of the last 16 years, marred by only one recession to cull uneconomic firms, disguised that truth. It has permitted market participants to indulge in the conceit that only they, at this moment in history, are free from folly and able to see the future clearly. In reality, the risk exposure of many banks is increasing in lockstep with their degree of vertical integration, steadily lowering the threshold of economic dislocation required to knock them on their backs.

Should the U.S. suffer some unforeseen economic shock, we anticipate that the current wave of conglomerates will meet the same fate as their industrial predecessors – namely, dismemberment, either at the hands of a management that sees the light, or activist shareholders convinced that management never will.

This year, in fact, may represent the high water mark for financial consolidation in this cycle. Once this wave has passed, we can expect to see some divestitures, possibly followed by a de–conglomeration wave that may dwarf that of the '80s. Thus the twilight of the age of empire looms near. Already, the independence of three of the nation's six largest banks – First Union Corp., Charlotte; Chicago-based Bank One Corp., and New York's J.P. Morgan & Co. Inc. – looks increasingly tenuous.

We also should see the beginning of turnover in the ranks of top banks. Superior operators who just a few years ago were not even among the fifty largest banks will displace some of today's leviathans. Front-runners will include previously obscure names such as BB&T Corp., Winston-Salem, N.C.; AmSouth Bancorp., Birmingham, Ala.; and Centura Banks Inc., Rocky Mount, N.C. – companies that have demonstrated the ability to win market share, rather than a mere compulsion to buy it.

The Human Dimension

The major obstacle to success in banking is not lack of scale or inadequate technology, but rather the difficulty of building a sales culture. Banks historically have focused on pleasing regulators, not customers or shareholders. Most banks have only a primitive understanding of their production and distribution costs, and the profitability of products and customers. Without this information, even the best management teams are flying blind. It's true that new technology can help supply that information, but that's only the ante to get in the game.

The real challenge, overlooked by too many managers, has to do with human resources. It is not enough to give employees advanced tools; they also must be taught to use them. Then incentive compensation must be revamped in a way that rewards employees for using the tools effectively on the frontline. Only a small (but growing) cohort of banks has shown success in this. As their financial performance pulls away from the pack, their stock valuations are following suit.

Asset management exemplifies the deficiencies afflicting banks in their approach to human resources. Rare is the bank that does not aspire to a more prominent role in this business, lured by fee revenues and high returns on equity. The trouble is, money flows from performance in asset management, and high-performing people are expensive. In fact, one key reason for high returns in this industry is that capital primarily is used to cover heavy compensation expenses for excellent personnel, rather than to support balance sheet assets.

Unfortunately, banks frequently choke on the operating costs of this business. In an attempt to impose a more "disciplined" cost structure, they often drive away some of their best investment managers. Studies have shown that banks generally pay investment professionals one-third less than mutual funds and brokerages. Who, then, can be surprised that banks have failed to grow their share of the asset management business outside of acquisitions and trust conversions?

The future of banking belongs to those institutions that can master the human resources issues. However, this category is not likely to include most of the vertically integrated empire builders, who are subject to severe diseconomies of scale. Instead, the lead will be taken by a small group of high-performing banks of varying size who can harness the potential of data warehouses to cross–sell more effectively, boost customer profitability and retention, and gain profitable market share. The stocks of these banks will likely trade at higher multiples than their larger rivals, allowing them to become the dominant acquirers.

While some exemplary banks also were active acquirers in the 1990s, there is a crucial difference between them and the leviathans. Many of today's giants put the cart before the horse, pursuing ambitious acquisitions before developing strong sales and service cultures. Now, precisely because of their massive scale, top banks have much greater difficulty bringing about cultural shifts, since bureaucratic inertia tends to increase geometrically with size.

Banks that emphasized superior sales and service skills, by contrast, first concentrated on dominating the list of high–performers, and only then sought to leverage their expertise over a larger base of operations. Looking into the not–too–distant future, it should prove much easier for the high performers to match the giants' market capitalization than for the giants to approach the high performers' skill levels.

Mr. Ryan is president of Byrne, Ryan & Co. in New York City.

Copyright © 2003 by Banking Strategies, published by BAI.

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