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AmericasJune 1 2000

Accounting for diverse interests

As merger and acquisition activity in the US banking sector slows and foreign heavyweights circle, major players are choosing to diversify their portfolio of interests. Michael Blanden reports.
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Despite a continuing run of excellent results, boosted sometimes by strong performances in international capital markets, US banks have fallen out of favour with investors.

Bank stock prices dropped like a stone last year amid growing concern over the increasingly over-ambitious targets set during mergers and several misjudged acquisitions. Such worries have combined with increasing concern over rising domestic interest rates to make stock market investors think again.

This weakness has been largely responsible for slowing down dramatically the wave of consolidation in the financial sector. One significant deal was last year’s merger of Fleet Financial and BankBoston to form regional powerhouse FleetBoston. Compared with two or three years ago, though, the market has been quiet.

Analysts suggest activity could pick up again. It tends to be seasonal because banks and their chief executives prefer to get their annual results and report to shareholders out of the way before starting the next round of expansion.

So far this year, however, neither the general pressure towards consolidation nor the immediate spur of the expected withdrawal of advantageous "pooling of interests” accounting has been enough to prompt a round of major activity.

The reasons are plain. Until recently, the wave of mergers and acquisitions was applauded by investors, who were promised cost savings and substantial improvements in earnings. In a number of cases, the banks failed to deliver. There have been instances where specific problems emerged, notably with Bank One in Chicago and First Union in Charlotte.

On a more general level, new groupings have been grateful for the “safe harbour” language in disclosure documents: “actual results may differ materially from anticipated results”. Keefe Bruyette & Woods looked at the issue ahead of last year’s results, examining the largest deals to be closed during 1997–1998.

It stated: “Of the 15 deals, forecasted earnings per share for this year have been reduced in 13 cases, and for 10 of these the reduction was 10 per cent or more. Predictably, buyer share prices have underperformed in each case.” In some cases, market disenchantment with bank shares has left chief executives looking at prices that are 50 per cent below their all-time highs.

This discourages banks from using shares to buy rivals. It also deters them from selling at levels which look historically low even when at a significant premium to current valuations. Moody’s Investors Service spelt out the history and reasons, stating: “Bank consolidation slowed in 1999 because the value of bank stocks plummeted. This created confusion in the banks’ managerial ranks because a previously proven game-plan had to be shelved.”

In the 1990s, managements seeking incremental earnings in mature markets fuelled bank consolidation by cutting costs through acquisitions. Moody’s adds: “Between 1993 and early 1998, the strategy was well-received by the equity market, and bank stocks outperformed industrial stocks. Meanwhile, we saw the emergence of powerful broad banking franchises. In the latter stages of this period, the premiums paid by banks when purchasing other banks rose. To justify the price, managements had to be more optimistic in forecasting revenue gains from the acquired bank.

These revenue estimates were often too optimistic because managements still intended to cut a high percentage of costs out of the acquired bank. “Two mismanaged mergers (Wells Fargo/First Interstate and First Union/Corestates) intensified doubts over the premiums paid for acquisitions – they were judged to be too high. Concern grew when two banks faltered when trying to acquire non-bank assets.

They were First Union’s acquisition of The Money Store (the $2bn plus investment was written off) and Bank One’s acquisition of First USA.” While mergers between banking groups have slowed, there has been a move towards diversification as the barriers between commercial and investment banking have finally broken down.

Most conspicuously, Citigroup, which brought the only US-based international retail banking outfit together with insurance underwriting interests and a leading investment bank, has started to bear fruit. The initial grouping, in particular Salomon Smith Barney’s investment banking business, has now been extended with the acquisition of the investment banking activities of London’s Schroders.

The deal was closed last month, and one of the first acts of the new company was to bring out a tasteful range of “Schroder Salomon Smith Barney” T-shirts and embark on an expensive advertising campaign. Even in commercial and investment banking cross-fertilisation, though, progress has been slower than many predicted. Citigroup’s lead has not been followed extensively.

Chase Manhattan has been extending its investment banking operations through acquisitions in both the US (Hambrecht & Quist) and UK (Flemings). Meanwhile, Bankers Trust has been swallowed up by Deutsche Bank. Yet widespread speculation over possible large-scale mergers and takeovers – which linked a variety of names including Chase and Merrill Lynch – has died down. The Wall Street rumour mill has been surprisingly quiet, even though any remaining obstacles to financial conglomerates have been removed.

The Financial Services Modernization Act – generally known after its progenitors as Gramm-Leach-Bliley (GLB) – finally swept away restrictions under the Glass-Steagall Act and the Bank Holding Company Act. Banks, insurance companies, securities firms and other financial institutions can affiliate under common ownership, though there are concerns over proposed new rules relating to personal privacy (see page 53).

Significantly, the legislation validated the merger of Citicorp and the Travelers Group to create Citigroup; divestments should no longer be necessary. The response, however, has so far been muted. There has been no rush to follow down the path of large-scale cross-sector conglomeration.

Most of what the big commercial banks wanted to achieve in investment banking had already been made possible through reinterpretations of Glass-Steagall. While banks might like to cross-sell insurance products, there is little attraction to buying life assurance businesses. One change GLB has brought about is the opportunity to move in the other direction: securities firms entering the commercial banking industry – Merrill Lynch being among the leaders.

Moody’s summarised its view of GLB: l Firms will be cautious about cross-industry mergers because cross-sales are elusive and the risk of cultural conflict is high; l Holding companies and their affiliates still face many regulatory constraints; l Only a limited number of domestic firms have the financial capacity to complete acquisitions or mergers that might change industry structures or competitive dynamics; l Financial modernisation may accelerate foreign institution’s purchases of US companies. The last point has proved controversial.

In April, Laurence Meyer of the US Fed (central bank) felt obliged to respond to anxieties expressed by the European Commission. In a letter to John Mogg, director-general of the internal market and financial services directorate, he went to considerable lengths to allay concerns that foreign banks would be less favourably treated than their domestic counterparts. Mr Meyer insisted the Act merely put into effect the long-established principle of “national treatment” – applying comparable standards of capital and management to foreign and domestic banks.

Moody’s looked at things the other way round, stating: “Universal banks no longer have to choose between conducting banking or insurance in the US. Some foreign institutions have lower targets for return on investments than domestic companies do. It is possible – but by no means inevitable – that foreign institutions could trigger a ‘feeding frenzy’ of consolidation by offering generous prices for US firms.”

There have been two recent and conspicuous examples of New York banks being swallowed up. Bankers Trust (now Deutsche) moved away from commercial banking operations to focus on investment banking, while last year Republic New York, which concentrated on private banking, went to the UK’s HSBC Holdings. A significant number of banks across the US are owned by foreign companies.

Despite a number of failures in the past, quite a few foreign banks have succeeded in building successful retail banking businesses, as well as securities operations. The top 50 list of the biggest 200 US banks (page 54) includes HSBC North America, which now ranks number 15 in the US, with UnionBanCal of California (owned by Bank of Tokyo-Mitsubishi) at 20.

ABN Amro North America comes in at 21, with Bankmont Financial (Bank of Montreal) at 28, TD Waterhouse (Toronto-Dominion) at 36, CIBC Delaware (Canadian Imperial Bank of Commerce) at 37, Taunus (Deutsche) at 39, Allfirst (Allied Irish) at 43, Bancwest (Banque Nationale de Paris has 45 per cent but management control) at 44, and Citizens Financial (Royal Bank of Scotland) at 45. Amid the cross-fertilisation of commercial and investment banking, Citigroup can claim to be ahead of the game.

There has been a certain amount of fall-out – notably Jamie Dimon, former right-hand man to Travelers’ Sandy Weill, who ended up at the helm of troubled Bank One – and a good deal of scepticism on the street. Yet so far this seems to have been confounded.

Last year’s good results – the first after the merger – were followed by a strong first quarter this year. Citigroup achieved a record core income of $3.6bn, up 49 per cent on the previous year, with a substantial contribution from equities operations.

The group admits there have been problems, but believes the merger of the Citicorp and Salomon Smith Barney businesses has been successful. The process involved combining activities where there was an overlap of interests, while maintaining two brand names. The group argues that it may have set a pattern for others to follow.

It is now working on the new Schroders link, which Mr Weill, chairman and chief executive, says “will enhance our ability to benefit from the major structural changes occurring in Europe”. Elsewhere, the group is pleased with its Nikko Salomon Smith Barney joint venture. Mr Weill says: “It has celebrated its first anniversary by attaining the number one position in Japanese M&A and number two in equities.” Chase Manhattan, Citigroup’s main commercial banking rival in New York, has followed a different route by eschewing retail banking operations outside the US.

It recently took another modest step in this direction by selling its 11 branches in Panama to HSBC. As a consequence, the group has become even more dependent on non-interest income, benefiting – like others – from strong markets. First-quarter pre-tax profits were up 15 per cent at $2.1bn. Of its total revenue, net interest income was down 11 per cent at $2bn, with non-interest income 35 per cent higher at just less than $4bn.

While Chase has been linked with some top names, its investment banking purchases have so far been on a relatively modest scale. The group says its acquisition of Hambrecht & Quist has worked well, with the new member gaining business from Chase’s client base. Now it is looking to the gains from Robert Fleming. The purchase brings strength in asset management – which is particularly attractive in Asia because Fleming has an extensive research capacity there.

Last month, the group announced another purchase: Chase Global Private Bank’s acquisition of Goldman, Lichtenburg Wasserman & Grossman – a privately owned, California-based company specialising in personal financial management for high net worth clients. With Bankers and Republic now in foreign hands, other New York-based banks have taken a more specialised route.

JP Morgan is an investment banking operation in all but name, and the balance is reflected clearly in its income figures. In the first quarter of this year, pre-tax income was modestly higher at $981m, against $924m. Net interest income reached $453m, with non-interest income – at $2.4bn – accounting for 84 per cent of the $2.8bn total.

Bank of New York, while retaining a retail banking franchise, has specialised increasingly in global custody and services to the securities industry. Tom Perna, senior executive vice-president, highlights the changing balance. “In 1995, 25 per cent of our revenue came from businesses we are no longer in,” he says. He adds that the group has no plans to develop its capital market business. “We are not going to compete with our customers.”

It has recently expanded through a considerable number of relatively modest acquisitions. Last year, for example, the group made 10 purchases. The most significant by far was RBS Trust Bank, from the Royal Bank of Scotland, which brought more than $600bn in custody assets and made the Bank of New York the world’s biggest custodian ahead of State Street and Chase (The Banker 4/00, p95).

Despite the challenges faced by the investment banking sector, there is no dispute that – at both an international and domestic level – the new “supra” bulge bracket of leading houses consists of three players: Goldman Sachs, Morgan Stanley Dean Witter and Merrill Lynch. Moody’s comments: “These firms possess the proven advisory expertise, established US franchises, international platforms and execution skills that are prerequisites to success.”

Even here there are growing signs of differentiation.Goldman has taken advantage of its decision to go public by offering more widespread and generous payments to staff and by expanding its operations – notably through the acquisition of leading equity derivatives trading firm The Hull Group.

It has also taken a step towards becoming a European retail brand by taking over the management of $4.9bn worth of retail funds from the UK arm of Lincoln Financial. Morgan Stanley, meanwhile, has benefited from a merger that increased its share of the most lucrative and strategic products: M&A advisory and equities.

Merrill is going in a different direction by building on its expertise in the securities industry to gain a foothold in the banking business – using its own client base. The breakdown of barriers could pose a major threat to the commercial banks. Merrill’s most spectacular recent initiative is an equal partnership with the UK’s HSBC to create a global online banking and investment services company.

With up to $1bn in start-up capital, Merrill Lynch HSBC (as it is currently known) will be based in London, with launches planned in Australia, Canada, Germany, Hong Kong and Japan – and more to come. For all their dominance, the big firms still face a challenge. JP Morgan is in the running, while others – including Lehman Brothers – are making a strong play.

Lehman had to reposition and rebuild itself after escaping American Express’s embrace, and has succeeded in changing the balance. From being a business known for its debt expertise, it has reached a position where revenues are split equally between debt, equity and investment banking.

This year, it has struck an alliance with ANZ Investment Bank of Australia to originate and distribute capital market products in each other’s established markets. Arguably the strongest challenge is coming from Swiss-owned Credit Suisse First Boston (CSFB).

It is aggressively building its global presence through recruitment and acquisitions, including the European equity and investment banking business of the UK’s BZW and leading Brazilian investment bank Banco Garantia.

And CSFB would like to see further growth in Japan. US commercial and investment banking is taking on a new shape. The winners seem clear, but there are plenty of others waiting in the wings to take advantage should they slip up.

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