Steeper Climb

By Sean Ryan

Bank earnings should remain healthy overall this year against an economic backdrop of steady growth with low inflation, but gains will be increasingly hard–won. Loan growth continues to outstrip deposit growth at most banks, pressuring net interest margins and crimping growth in net interest income.

Fee revenues will vary widely by bank, of course, depending on the business mix and operational abilities of each individual institution. Expense growth should remain under control, with the important caveat that many banks will continue to be mesmerized by the siren song of technology. It has unfortunately become common practice in the industry to spend hundreds of millions of dollars on visionary projects that yield few, if any, bottom–line benefits.

We do expect loan–loss provisions to increase steadily, but this trend appears to reflect a reversion to the mean from low levels seen in the '90s rather than the onset of a prolonged cyclical downturn. As a result, the rate of problem loan recognition and provisioning may actually plateau during 2000, thus ceasing to be a drag on earnings. Stock buybacks will likely remain modest by the standards of recent years, both because banks are less overcapitalized than a few years ago, and because many will be focused on using pooling–of–interest accounting for their acquisitions while that method is still available.

There can be little doubt that online banking will increase in importance by virtually every measure. In particular, it represents another major force flattening margins, making life still more difficult for those banks that relied on strong economic tailwinds for their recent prosperity, rather than improved operational skills.

However, online banking is no more likely to displace branch transactions than did automated teller machines, which instead of displacing branches actually generated additional transaction volume. Studies showing that fully one–third of customers who begin banking online subsequently abandon the service attest to the staying power of traditional distribution channels.

Those banks that have found ways to create value for customers, and win market share through service, should continue to prosper as the Internet transition progresses. Banks that try to rely on eroding traditional information and distribution advantages should continue to struggle. The Internet doesn't change this process so much as intensify it.

The macro–environment, then, is likely to exhibit a "steady as she goes" mode, without any wrenching dislocations. But the pain exerted by slower growth and higher credit losses will begin to separate the industry's "haves" from the "have–nots." And this time, the haves will be distinguished not by asset size and market cap, but rather by their flexible operating style and sophisticated use of customer information.

In this context, it's helpful to consider the experience of credit card issuers. In the early '90s, card portfolios were considered the "crown jewels" of many bank franchises. At the same time, however, Falls Church, Va.-based Capital One Financial Corp. and other monoline firms were doing to credit card lending what John Meriwether did to bond trading at Salomon Brothers two decades earlier – transforming the industry from an art based on gut feeling into a quantitative science. Capital One developed an ability to measure and price credit card risk much more accurately than anyone had done before. Thus, when bankruptcies began to surge in 1995–96, many banks faced mounting losses and some were ultimately driven out of the business. Chargeoffs at the monolines, however, leveled off while their earnings continued to grow.

It turned out that the banks, unable to gauge risk as precisely as the monolines, had been undergoing adverse customer selection for years. It took only modest stress amid an economic boom to reveal that fact. We believe this is now happening across the bank product line, with one cohort of banks prepared to sustain earnings growth in a more adverse environment, and another group increasingly at risk even in the current benign conditions.

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