Bank Mergers & Acquisitions, May 1999

PLAYERS Susan Webber

An Interview with Susan Webber

"One of the most difficult things to manage - what nobody really wants to manage - is a business in decline. Banking is in structural decline."
- Susan Webber, Aurora Advisors Inc.

Susan Webber has been skeptical of the logic behind huge bank mergers for some time. She cites research that suggests greater efficiency can be achieved in the industry without the mergers that disrupt operations and sometimes even work against the greater efficiency that they supposedly promote.

Her skepticism seems to be validated by the recent announcement by First Union Corp. that it would not meet its earnings estimate for 1999, and by other bumps on the consolidation road. But could it be that Wall Street looks only a few months ahead, not far enough for consolidation to prove its merits? Webber considers that, too.

She is president of Aurora Advisors Inc., a New York management consulting firm specializing in finance and financial institutions. Her consulting practice focuses on corporate and business-unit strategy, mergers and acquisitions, new business entry, asset management, wholesale and investment banking and securities businesses.

Bank Mergers & Acquisitions Editor Mary Beausoleil discussed industry trends with her recently; this is an edited transcript of that conversation.

BMA: In 1997, you said in article in U.S. Banker that there was not much evidence to support the rationale for the merger boom that was going on then, and the boom certainly has continued. Has anything happened since then to change your mind?

Webber: No. In fact, the recent earnings disappointments announced by some of the leading banks, if anything, confirm that the financial logic of large bank acquisitions is questionable. For example, First Union Revised its earnings lower twice. Ed Crutchfield, a former M&A maven, now is going on the record saying he doesn't think that any combination of traditional banks makes a lot of sense. That's a radical change.

NationsBank-Bank of America - you've got them discovering the D.E. Shaw problem, then that the branches needed to be rewired, then the Russian loan problem, which admittedly is more of a market event. You can point to some specific events that are fairly dramatic with those institutions.

I don't say there is no logic to these deals, but the logic is not an economically justified logic if you look at the industry data. FDIC data shows that the banks with the best efficiency ratios are in the $1 billion to $10 billion range. Every academic study ever done shows that beyond a certain size threshold, banks exhibit a slightly increasing cost curve. The studies vary as to where that kicks in; some say as low as $100 million, but more commonly I've seen it in the $5 billion to $10 billion range.

Again, that doesn't mean that certain businesses don't exhibit strong scale economies - things like mutual funds do, securities processing does. Some studies indicate that the whole fund-raising side - the combination of market fund raising plus branches - may even be subject to scale economies. But, the offsetting fact is that banks haven't really sorted out where scale makes sense and where it doesn't.

So the simplistic argument that is made for these deals - that consolidation makes the industry more efficient - just doesn't hold water.

We hear all the time about the overcapacity that's a legacy of the old patterns of regulation, that there's a lot of excess that needs to be wrung out of the system. Aren't mergers a good way to do it?

But nobody's presenting them that way. The fact that banks exhibit an increasing cost curve says that these banks could have gotten these costs out without merging - and done a better job. They could have gotten to a lower cost point.

Yes, if you look at the industry as a whole, it has become more efficient. We all remember the times when for a bank to have an efficiency ratio in the low 60s was a good job. Now the benchmark has moved to the mid-to-low-50s. So there's no question the industry has become more efficient.

I think a lot of this merger activity is driven by behavioral issues. One of the most difficult things to manage - what nobody really wants to manage - is a business in decline. Banking is in structural decline. If you look at the banks' share of total financial services, those trends are straight-line down from the '80s. Banks have been losing share to other financial intermediaries for a very long time. And that, from an organizational perspective, is something nobody really wants to manage.

It's easier to manage growth. Even when growth is produced by mergers, Wall Street tends to give people credit for it - even though it shouldn't.

On top of that, you've got a whole worldview that doesn't want to question this logic. You've got investment bankers pushing deals - that's their job. You've got a recognition that the industry is inefficient. There is a bunch of people who profit from this line of argument - lawyers, various consultants, and frankly, the bank CEOs. CEO pay is correlated with asset size of banks. So there's every reason in the world to want to do deals.

In fairness to bankers, they are faced with a very difficult set of problems. Their industry is in decline. They've got more regulatory freedom than they've had in the past, but they still don't have full regulatory freedom.

And probably the biggest factor is the whole banking culture. Banks, historically, have not been very entrepreneurial. That's the whole reason they're not very effective against investment banks, and when they acquire investment banks, they tend to screw it up. They've got time-and-grade promotion; they can't really pay for performance. The measure for success in commercial banking is how many people you manage.

That's not to say there might not be a way to change some of these basic behaviors, but most bank executives grew up in the industry and for them to manage an institution into a shape that they're not used to managing - it's quite a visionary leap.

Aren't some of them - including First Union, actually - getting better at that? At imposing a sales culture and changing the system of rewards?

Yes, but its a matter of degree vis-a-vis their competitors. If you look at First Union as a specific case, when they acquired CoreStates, one of the places they lost business big time was in the Philadelphia market when specialty lenders began calling aggressively on their accounts. Where were the First Union people when Heller and G.E. Capital were picking off their business? Something was dropped there.

They may be much more aggressive than they were, but the whole world has gotten more sales-oriented. The bar has been raised. It's just hard for them to move fast enough as the world gets more and more competitive.

And ironically enough, it's harder to make changes in a big organization, even with the recognition that it needs to be done. Implementation is more difficult with 15,000 employees than with 1,500.

Exactly. You've got procedures and processes and computer systems and a whole myriad of issues. So it's not that these guys aren't up against something very difficult.

Again, I'm talking about mergers as if it's mainly a cost issue, because that's where the data is clearest. But some of the proposed benefits like, "We'll offer a broader scope of products," sounds very good, but the experience in cross-selling has been mixed at best.

A lot of institutions have been down that one-stop shopping road, and maybe somebody's got the magic bullet somewhere, but nobody seems to have found it. For a lot of institutions to be following a vision that doesn't really work in practice, or that they haven't found out how to make work in practice - it's an open question how that's going to be pulled off.

Of all the recent deals, the one that seems to be going about it most sensibly - and again, we'll see if they make it work - is Wells Fargo-Norwest. Part of it is, they've got the biggest institutional stretch; they're trying to marry high-tech with high-touch. They're systematically going out and trying to find and preserve best practices in both organizations.

But they've had to move back their expense-reduction targets. They were targeting to achieve 50% of their total reductions this year, and they've got an institution genuinely struggling with how to do this better, and they're not meeting their numbers.

Do banks, even ones like Norwest or First Union that have done a lot of deals, continually underestimate the difficulties of integration?

A lot of analysts think First Union, to justify the price they paid, was way too optimistic. Some of these problems were self-created. They were simultaneously predicting revenue increases and big cost cuts. To hit both at once is very difficult. And we are in an environment where people have to justify their numbers. That's just the way it is with Wall Street.

There's a technology writer, Michael Schrage, an expert in prototyping and simulation, who talks about how the culture of how deals are done really changed with the computerized spreadsheet. I've observed this, too, with the deals that I'm in. The spreadsheets and the numbers, when you're putting a deal together, somehow assume a life of their own. It's so easy to talk yourself into pushing the assumptions a little bit too far.

There were complaints about the Wells Fargo-Norwest deal that they were only projecting cost takeouts of 18% of the smaller institution. There's a perception that around 30% has become more the norm. But it's not just cost takeouts. The question really should be, how does the bottom line of the combined institution look? So much of the emphasis is making sure that we tell the cost-cutting story.

If anything, academic work suggests that the real opportunities for banks to improve their profitability lie more on the revenue side. There's that old Journal of Finance study that says banks ought to be able to get to ROAs of 2.7%, 3.7%. There are - admittedly very isolated - cases where they have. Bank of Granite Corp. in North Carolina, they've got an ROA of 2.7%. They're a very lean bank, the tellers know everybody's name, and they charge customer more. They charge more because they're nice, and they're responsive, and people will pay more. What a novel concept!

Remember, banking has been a commodity industry for ages, going back to when they were regulated. You had a small number of banks offering basically the same products and services, and they had regulated prices and guaranteed profits if they were reasonably prudent. Then the world dramatically changed, with volatile interest rates, competition and a whole bunch of things banks historically never had to deal with.

There are some trends afflicting the entire industry that the merger process seems to make worse. There was A First Manhattan study that showed that 60% to 80% of the business that banks originate is on unprofitable terms. The study suggests that the merger process makes this worse by putting the emphasis on costs. Behaviorally, if you're in a cost-cutting environment, how are people going to try to protect themselves? They're going to want to be associated with more revenues. So you've got people trying to make it up with volume instead of sitting down and saying, "Gee, what's wrong with our origination model?"

The second trend that was pointed out in the study is that the whole industry is losing profitable customers. Profitable customers are the ones that are going to be sought and picked off. That's worse in an acquisition environment because people get nervous about what's going to happen to their branch, what's going to happen to their loan officer, and they're more susceptible to invitations to leave. There are things banks could be doing now in terms of understanding their product profitability and customer profitability. It's basic blocking and tackling, and that's getting lost in this merger shuffle.

Certainly fee income is part of what you're talking about, and many banks have increased that dramatically. Some people even say, at least on the retail side, they've about reached the saturation point.

That's a fair point. The question becomes more on the loan product side, what the model is there. Some academic studies suggest the lending process becomes less efficient with scale. It appears that the old model of the banker who knew his customers may work better than the multi-layered review process.

Nobody's really answered the question for me: whether know-your-customer works better than by-the-numbers, or whether the multilayered review adds enough costs that it becomes less cost efficient. That gets back to a cost-side question.

On the income side, you've got a channel conflict that I see banks flip-flopping on. Here you've got the branch, which is their most expensive selling channel, and banks have been trying to drive more volume to ATMs. On the one hand that improves their cost numbers, but on the other hand that degrades the customer relationship. How do you play at that? And then you've got banks sending mixed signals in terms of how they charge for ATM usage. If this is a channel you prefer, that's not a place you should charge fees.

Same with the Internet.

Yes. Why are you charging people? You should want to encourage usage; this is a cheap channel. The question is, 'What are we trying to accomplish here on a macro customer level?'

Maybe there is a certain subset of customers we want to get very close to, and everybody else we want to drive to the cheapest channel.

Is it just that they haven't thought this through enough? Or they're playing follow the leader?

Some of it's follow the leader. Some of it's that you've got different imperatives happening at different points in time. Managing channel conflict is not an easy issue, so I don't want to say that bankers haven't thought about the trade-offs. But what's the name of the game we're trying to play here? I see enough things happening on an atomistic level that suggest that some of the institutions don't have a clear vision of how they're going to maximize profits from the customers. They seem to be wanting to pick off low-lying fruit. That works short term, but there are all these second-order effects, making the customer less loyal.

There's a real generational shift. People in their 50s and 60s still want to have a relationship with their banks. Banks have basically created the situation, with baby boomers and younger, where we don't feel that way. It's much more prevalent in the younger age cohort; they don't really care who their bank is, as long as the rates are fair and they don't screw up. And that puts you at a very disadvantaged position, in terms of trying to extract anything extra.

We're moving to an environment where banks have got to look at the service question if they want to differentiate themselves. And they may choose not to. Banks' record with customer service has not been very good. Again, back to the historical model, banks are used to having power in the relationship vis- -vis the client. As much as they talk about promoting customer service, I don't see that happening. There's an expression, 'They've changed their minds but not their hearts.' I think there's a lot of that going on. There's intellectual recognition, but the degree of follow-through isn't adequate.

The implication of all of this is that these bankers aren't doing a very good job. But they're in a very difficult situation. It's extremely hard, particularly in an environment where you have to be so responsive to Wall Street, to do something radically different from what everybody is doing. You have to be extremely confident in your judgment to do that.

Of bigger banks, which ones are better at service?

Go back to what Norwest is trying to do. Norwest really prided itself on buying community banks and trying to preserve the community banking culture. And Wells is trying to preserve that while layering the Wells systems in. If they can make it work, they may have a winning model. But it's not proven yet.

Citibank has done it internationally with their retail strategy. That's a very explicit cherry-picking strategy, where they're going after the internationally oriented, high-net-worth individuals, and offering superior service in terms of extending hours, flexible products. You can's point in the U.S. to a foreign bank that's had a successful retail entry. The fact that they've done it, they get kudos for that.

I'm surprised that you haven't seen more retail banks looking at models from the retail industry. Finally, now you see banks looking at data mining. That was done in retail many years ago. Another retail model is having people have the same branch experience. That's something that Citibank has thought a lot about. Citibank has done that internationally; in the U.S. they're stuck with more legacy real estate so its harder to implement. But you walk in a branch and physically things are roughly in the same place. That gives people a sense of consistency of brand image, and they feel more taken care of.

You noted in 199 that the market loved all these mergers, and that may be one thing that has changed. We need only look at the Zions deal of a couple days ago, to name only one, where the stock of a well-regarded acquirer took a pretty bad beating after announcing an acquisition. Do you think that's a temporary thing?

I think it may be driven more by the prices to which bank stocks have climbed, particularly after the first quarter. With bank stocks trading where they are, you throw the acquisition premium on top of that and it just becomes very difficult to justify. If you see bank values relative to the market as a whole change, I could see this changing back.

Does Wall Street, with its notoriously short horizon, give these banks enough time to see whether these mergers are going to work or not?

That's a fair question. The banks are pressured to deliver fast, and they may do things that are expedient in terms of meeting the numbers but aren't in their long-term best interest.

Wall Street only looks 18 months ahead. And if you're talking about something on the scale of Citigroup, Citibank doesn't even expect to have its international systems from the old Citibank merged for years, let alone the Travelers-Citibank systems integrated. You've got pieces of this that are just so far beyond the analysts' time horizons. that's an extreme case, because it's such a large, complex integration but it may be true in other cases, too.

You also don't have the same degree of analysts' objectivity that you had in the past. I hate to say it, but it's true. A major part of analysts' compensation now is based on their involvement in investment banking, in terms of proposing deal ideas. I don't see how you can pretend that there are really firewalls. There's also the mundane fear that analysts will be frozen out of meetings, cut off from information by the companies if they take a critical stance. The industry didn't used to be that way, with the analysts so involved in the transactions, although in fairness I think that's less true of bank analysts than of, say, analysts in technology, where there's just such rampant deal activity.

Where do you see these trends headed?

I don't see bankers' mindsets changing, although given the current price environment, the current Wall Street environment - if your stock trades down after you announce something, that will have a chilling effect.

You've had a few years where the activity has been at a lot higher level than you've had in the past. Earlier in the decade the transaction level was a notch lower, and that level was considered to be a pretty heated pace. I happened to sit next to a money manager on the plane yesterday and he was saying, "Who's going t buy First Union?" because Crutchfield has clearly signaled that he is open to a merger of equals. The only logical party is BankAmerica Corp., who would love to do it, but they can't right now.

There are doubtless other institutions that are ripe to be acquired, but the timing is off. You've got tax and value considerations arguing against deals, at least until values correct. The institutions have gotten bigger, and there are fewer big guys to sell to but the biggest players.

You can see people doing fill-in acquisitions, and you're going to have the usual branch sales and branch acquisitions. So that doesn't mean there aren't going to be deals. But those are not the sort of things that are going to capture Wall Street's attention.

But, in my mind, there's been no change in the fundamental industry assumption that consolidation is good for the industry. Given the number of other factors going on, you're going to see a slowdown. How long is the slowdown going to last? I don't know. Certainly until relative values correct.