Financial Institutions, Grown Fat and Lazy, Now Must Slim Down : Banks: In the 1980s, only lean and productive manufacturers survived; now it’s the financial-services industry’s turn on the block.
The just-announced blockbuster merger between Bank of America and Security Pacific to form the nation’s second biggest bank is emitting seismic rumbles throughout the financial services industry, coming as it does on the heels of the pending merger of Chemical Bank and Manufacturers Hanover, which the principals thought would be the country’s second biggest bank. The rumbles seem all the more ominous because these bank mergers are coming almost simultaneously with a proposed French takeover of Executive Life Insurance Co. and a billion-dollar capital infusion from another French group into the venerable Equitable Life Assurance Society.
With more than 12,000 banks, thousands of insurance companies, hundreds of regional brokerage firms--almost all weak and undercapitalized--U.S. financial services are technologically obsolete, overstaffed, overpaid and weighted down with grandiose headquarters buildings, grandiose executives and grandiose illusions. A massive wave of consolidations and restructurings is about to break over the industry. The sooner the process gets over with, the better.
Financial services is in much the same position that American Rust Bowl manufacturing found itself in at the start of the 1980s. The manufacturing restructuring that ensued was savage, although the best companies emerged stronger, leaner and with enviable productivity records. But the process was no fun at all, and now it’s financial services’ turn.
For 30 years after the war, American financial services was a classic protected industry. The price of a stock trade, or interest on a savings account, was set by law or regulation. A network of local-preference rules limited competition and created a genteel affirmative-action program for children of the upper classes. Since everyone’s services and prices were identical, a firm handshake, a polished golf game and a ready repertory of country-club chatter was the path to success.
Then two new realities emerged in the mid-1970s, shattering the industry’s comfortable assumptions. The first was that interest rates suddenly turned volatile. The second was the personal computer.
The impact of volatile interest rates is the easiest to see. Savings and loans were the first casualty. S&Ls; took in money via low-interest savings accounts and lent it back out in long-term mortgages at slightly higher interest. When rates soared in the mid-1970s, depositors took a couple of years to decide that the new rates were for real, then switched their money into high-interest money-market accounts. Gasping for deposits, S&Ls; were forced to pay higher passbook rates than they were getting for their mortgages, and were instantly insolvent.
Most people blame the S&L; crisis on lack of regulation. Not true. It was an intentional regulatory cover-up conspired in by a Democratic Congress and a Republican Administration. When an insolvent industry started lobbying Congress in the early 1980s, the cumulative deficit was about $10 billion. Instead of taking the industry behind the barn and shooting it in the head, Washington changed the accounting rules to hide the insolvencies and increased depositor insurance, almost guaranteeing that insolvencies would spiral out of control.
The interest-rate fuse on the insurance industry is far slower. For decades, insurance companies wrote policies that guaranteed a steady stream of premium income and a low-interest payout. They invested the premiums in long-term bonds that paid a slightly higher return than their payout obligations and waxed fat and lazy on the profits.
When interest rates spiked in the 1970s, insurance executives sold policies at almost any price to invest the premiums in high-interest short-term paper. Profits rolled in, until rates dropped again, and they were suddenly stuck with a lot of new policies generating low premiums. For a while, investing in high-interest junk bonds looked like a way out, but the First Executive Life fiasco scotched that. The industry now faces a bleak future of learning to live within its income.
The impact of the personal computer is more subtle. One of the first programs written for the original Apple was a financial spreadsheet. Within just a couple of years, instantly available financial computing power took the mystery out of borrowing and lending.
In efficient financial markets, the “spread” between borrowing and lending rates is razor-thin. Banks were making high profits precisely because lending markets were inefficient. But as young financial MBAs armed with spreadsheets took over corporate treasurers’ offices, they steadily chipped away at the banks’ profitable businesses. Instead of borrowing from banks, for example, big companies found they could borrow more cheaply from each other--and the commercial paper market was born. Instead of using banks for working capital, big companies found they could bundle their credit-card receivables into brand new securities and sell them directly, at a better price. Michael Milken’s much-maligned junk-bond market provided growing companies a ready source of new capital outside the banking system.
By the mid-1980s, all banks’ best customers had a wealth of new funding sources to draw from--most of them cheaper than bank credit. Bankers had a choice: streamline operations to comport with a rigorous new era of financial competition, or look for riskier customers who could pay the high spreads the bankers’ life style required. The choice, unfortunately, was never in doubt.
Finally, it was Wall Street’s turn. Desktop computer power made it profitable for big institutional stockholders to engage in ever-more-complex trading operations. The massed power of the institutional traders broke through Wall Street’s long resistance to negotiated fees, and trading commissions were cut to mere pennies. The big market moves by institutional traders frightened away individuals, who switched money into mutual funds, cutting off the richest source of trading income.
For a time, Wall Street masked the erosion of income by engineering high-risk leveraged buyout transactions, putting firm capital at risk to generate high fees. But when Milken and Drexel Burnham Lambert Inc. fell from grace, there was nowhere left to hide.
Over the next five years or so, the entire industry will undergo a traumatic restructuring. The country can support, at most, a couple of hundred banks. Ten companies already control more than half of mutual-fund assets. Thousands of little insurance companies will disappear or merge into a small number of big players. All but a handful of big brokerages are living on borrowed time.
The process will certainly be unpleasant, but the longer it is delayed, the more painful it will be.
