Bank rankings – The Aftermath

The Question:

How well does banking “prestige” predict the structural soundness of a bank through this financial crisis?

The Background:

Anyone who’s ever been remotely interested in going into finance, law, or management consulting has likely heard of Vault. Vault is a “provider of information and solutions for professionals and students who are pursuing and managing high-potential careers”. Although their website has many useful features such company message boards and resume advice, Vault is best known for the annual rankings they produce on many of the high profile industries. Many young professionals use these reviews and rankings as a major factor for their own job hunts. As a result, Chief Marketing Officers in all of these industries spend numerous hours working to improve their company’s “prestige” ranking in Vault and other equivalent publications in order to acquire the best talent.

The Discussion:

But how representative are these prestige rankings in the context of the current financial crisis? In particular, have “prestigious” banks been able to navigate this crisis more effectively than lower ranked banks? The image below lists the Top 25 Most Prestigious Banks from the latest survey published in May 2008. The timing couldn’t be more perfect, since every major collapse or merger occurred immediately following. Let’s go to the board.

Source: Vault

Let’s look at how these rankings fit into the credit crisis aftermath:

• #1 Goldman Sachs and #3 Morgan Stanley are both alive and kicking, but have lost tremendous value on their stock and have converted to bank holding companies to join government programs.
• #4 Lehman Brothers no longer exists
• #6 Merrill Lynch got bought out by #16 Bank of America
• #11 Citigroup lost out on the Wachovia bid to #28 Wells Fargo and is planning to cut over 50,000 people
• #16 Bear Stearns got bought by #5 JP Morgan Chase
• #18 Wachovia got bought by #28 (not listed) Wells Fargo

The Conclusion:

First, the “pure” investment banks that traditionally filled the top 10 were more deeply affected by the credit crisis. The only “winner” we can pick out in that group may be JP Morgan Chase. Unlike most of the other top 10 banks, JP Morgan had a much more diversified balance sheet through its retail banking and credit card lines under the Chase name. Merrill and Lehman were some of the biggest losers coming out of this credit crisis because they lacked this diversification.

Second, the “Plain Jane” retail banks are some of this year’s biggest winners. Bank of America and Wells Fargo both have huge capital bases supported by customer deposits. As bank holding companies they used much less leverage in their investments, resulting in much lower risk during the crisis. Although bumped and bruised, they were able to complete major acquisitions at dirt cheap prices and are in great position to become industry leaders in the years to come.

Ultimately, our analysis suggests that the prestige of a banking institution offers no indication of structural soundness during a potential downturn.

The Nutshell:

Prestige rankings offer no indication of the fundamental soundness of a banking institution. As always, make your banking and employment decisions based on your own due diligence.

Reflections on the Financial Crisis (Part 2 of 3 – The next step)

The Question:

Now that banks can no longer leverage to their traditional levels, how will they make up the gap in their capital base?

The Background:

My most recent article discussed why leverage is a key topic right now and how the banks will need to adjust from the recent financial crisis. However, it offered little insight in what the next steps will be to replace that capital that was so easy to acquire in the past. Banks will need to find a new way to raise money so that they can minimize the volume loss for their loans, mortgages, and complex financial products.

The Discussion:

Banks do have several options for raising money. The easiest options however will piss off their shareholders and employees. Divesting assets to a willing buyer will raise capital, but it will also lead to a smaller bank and fewer jobs. Alternatively, they could issue new common stock, but this will result in diluted ownership for preexisting shareholders.

One option that looks much more appealing though is to raise capital the old-fashioned way, but acquiring new customer deposits. Retail deposit products such as CDs, checking, savings, and money market accounts, offer several advantages that are especially important following this financial crisis:

1. A steady supply of cash from customers who won’t make the effort to find a better deal
2. Fixed interest rate payments to customers that offer little risk of major adjustments
3. Cross-sell opportunities

During a time when risk is a 4-letter word (yes I know it already is), this product line will improve a banks’ capital base for low cost and minimal leverage. Many banks have already made strategic decisions that will allow them to improve their retail deposits businesses in the near future.

Effect of Acquisitions

Banks with retail arms such as Bank of America and Wells Fargo are big “winners” from this financial crisis because of the major acquisitions they’ve made at huge discounts (Merrill Lynch and Countrywide for BoA and Wachovia for Wells). Of course, each newly acquired company comes hat in hand with their existing customer base as well. In every case, the new and improved retail bank will have synergies galore by selling existing products to their new customers, and cross-selling new products to their existing customer base.

The end result:

bigger bank + greater capabilities + new customers = ideal growing conditions

The I-Bank Factor

Although the number of banks has decreased due to the crisis, the number competing for retail deposits is only going to increase. In particular, existing banks will need to consider two new potential entrants: Goldman Sacs and Morgan Stanley. Now that they are classified as holding companies, GS and MS will have the opportunity to collect deposits just like any other retail bank. Withdrawing cash from a Goldman Sacs ATM used to be a lame finance joke, but it could quickly become a reality.

Online Accounts

The increased expansion of branches and ATMs will be great for acquiring new customers. Unfortunately, these branches have huge overhead costs to pay for land, construction, employees, supplies, and utilities. As competition among “brick and mortar” banks increases, some branches will undoubtedly become unprofitable primarily because of the overhead.

To adapt, banks will be looking for ways to acquire retail deposits through alternative distribution channels (or ADCs for short). We’ve already seen a big ADC push through the emergence of online accounts. Online accounts such as HSBC-Direct and ING-Direct allow customers to manage checking and savings accounts strictly on the internet. Banks love these because there are no branches to support and no employees to pay (except a small call center or two), significantly reducing overhead costs. In return for the bare-bones service, the banks offer significantly higher savings rates than they traditionally offer in a branch.

The Conclusion:

With the rise in ATM use and the emergence of online banking, it’s very difficult to tell the difference between one bank and another. Most retail banks offer very similar, standard services to meet our basic banking needs. In other words, retail deposits are quickly becoming a commoditized product.

Increased competition and the lower priority placed on personalized service for basic banking will emphasize “quantity over quality”. Instead of hiring new meter/greeters in branches, banks will reduce their overhead costs as much as possible in order to offer customers a higher savings rate. The reduced margins will be bad news for the banks, but greater news for customers.

The Nutshell:

The following trends will be most likely regarding retail deposits:

1. Consolidation in the banking sector results in high retail deposit growth
2. ATMs and branch count will increase to encourage customer growth
3. Reduction in overhead costs through expansion of bare-bones banking services
4. Increased competition will lead to higher savings rates for customers and lower margins for banks

Reflections on the Financial Crisis (Part 1 of 3 – Leverage)

The Question:

What is leveraging and why is it so important in the context of the current financial crisis?

The Background:

The recent months in the financial services industry is leading to nothing short of a transformation in how surviving banks will conduct business. One of the biggest ways this will change is how banks acquire the capitalization needed to lend money and create financial products.

The Discussion:

In the past, investment banks were able to sell products at a very large multiple of their capital base because there the risk of losing your entire investment was not very high. An example of this would be for you to purchase one share of the S&P 500 index fund. Although this fund can gain or lose significant value, it is extremely unlikely that all 500 stocks in the index fund will go completely bust and wipe out your entire investment. Banks take advantage of this in their products by leveraging their investments, so that they can multiply their earnings. So a leverage ratio of 2 would mean that if the S&P 500 were to gain 1%, the bank portfolio would gain 2%. Likewise if the S&P 500 were to drop 1%, the bank portfolio would lose 2%.

Bottom line: Leverage = higher risk and higher reward

Commercial and retail banks that are regulated by the Federal Reserve, have their leverage ratios closely monitored to make sure their portfolios aren’t too risky. Investment banks, however, do not fall under such stringent regulation. They can leverage to much higher ratios. During bull markets this added leverage resulted in higher profits (and bigger bonuses) for the investment banks.

But what happens when something goes wrong in, say…oh I don’t know…the subprime retail mortgage market? Well, a 1% drop in mortgage value will cause a 10% drop in a 10-times leveraged mortgage product. A tough loss, but certainly recoverable. What about 2.5%? That drops the bank’s capital base by 25%. Ouch.

Now, how about a 10% drop in mortgage values?

Busto.

The Concluson:

The banks that survive the financial crisis are now well aware that huge leverage ratios are a thing of the past. The good news is shareholders and regulators will prevent banks from taking such risky positions due to recent lessons learned. The bad news, the US investment bank as we know it is now dead. With the fall of Lehman and the sales of Bear Stearns and Merrill Lynch, the only two US investment banks that remained were Morgan Stanley and Goldman Sacs. In the recent turmoil, both MS and GS sought protection from the Fed and converted into bank holding companies. This now places both banks under the regulation of the Federal Reserve, as well as the resulting leverage ratio limits.

So lower leverage ratios now mean less risk, but now it also means banks will have a lower capital base to work with. So how will they make up for this gap? Part 2 in this three part series will address my thoughts on where banks will be heading next…

The Nutshell:

Leverage allows banks to use multiples of their capital base when selling products such as loans and mortgages. Banks with higher leverage have a higher risk profile, but can also offer relatively higher returns. The recent financial crisis is forcing banks to become more conservative, and as a result, lower their leverage ratios.

Why the Financial Crisis happened (in a nutshell)

Consider this an entertaining preview for the rest of the week. Some of you may have already seen this, but it’s always good for a laugh.

The Subprime Primer

I’ll be posting a much more in-depth analysis this week regarding the financial services sector. It will be a 3-part series that answers the following questions:

1. What is leveraging and why is it so important in the current financial crisis?
2. What steps will the banks take next in order to improve their capital base?
3. As a customer, how can I take advantage of the transformation in financial services?