European and American banks will have to cut costs, deepen customer relationships and search for new opportunities in order to weather the US slowdown.

Conventional wisdom number one: the US slowdown will not develop into a recession; indeed economic activity will pick up by the second half of the year.

Conventional wisdom number two: there is no upside for banks in such an economic environment.

Conventional wisdom number three: European banks are virtually immune to the US economic slowdown.

This article does not aim to debunk the above theories, rather it aims to inject a dose of realism into the discussion. First, economics has proven to be, at best, an uncertain science. A consensus about an increased growth rate in the last six months of the year may be excessively optimistic.

Second, there are always opportunities for clever banks during a downswing in the business cycle. Third, the financial system is now too global to allow European banks to escape the consequences of a deceleration in the world’s most powerful economy.

US banks are in the process of seeing the slowdown reflected in their results. Problem loans and the need for extra provisions are turning into a repeat message from the banking sector, one that analysts expect to continue hearing.

“The uppermost concern now is credit quality. We have had 10 years without a recession and a lot of dry rot has built on bank balance sheets, as the slowdown has made clear,’’ said Bert Ely, a Washington-based banking consultant.

Bank of America and First Union are among the first to announce increased loss provisions. They will not be the last. They both said – as have most banks – that they are improving their risk management systems in order to improve credit quality The source of the current problems is mainly corporate loans.

Consumer credit quality is not a concern at the moment. Following major problems with bad loans in the mid-1990s, financial services companies tightened up their procedures in 1997-98. Improved consumer performance is now feeding through.

Although it is not enough to offset the corporate deterioration, it does help, say analysts. However, the consumer side could deteriorate if the slowdown continues for too long. Those are the problems. The opportunities are there as well, best illustrated by an anecdote reportedly told by Bill Harrison, chief executive of JP Morgan Chase.

At an investor presentation, he said the bank is visiting investment grade companies whose ratings have been downgraded and telling them that as the largest debt house in the world they can help in refinancing debt, raising money and restructuring operations. He estimated the bank would make $100m this year from a corporate, whose name he refused to reveal, by selling it these services. Generally, the bank would expect to make a maximum of $4m annually from that customer.

The paradox is that often it is the big blue-chip companies that are among the most troubled in the current slowdown. This will hit banks’ loan books, but will also provide the sort of business Mr Harrison spoke about. JP Morgan Chase also looks to benefit from its expertise in dealing with companies in Chapter 11, a US form of temporary bankruptcy.

Although this is not necessarily high-margin, it represents a new opportunity to make money and possibly form a new relationship which long term might lead to other business. Loan demand increases as an economy slows which provides opportunities. Nonetheless, banks have the tricky task of managing to accommodate customers without increasing their risks too much, pointed out Ray Soifer, chairman of Soifer Consulting.

Good banks can also gain market share in more basic things, not only in slowdown-related work. “A quality bank in a downturn should gain market share. It is an ideal time when weaker players cannot compete on price,’’ said Andy Maguire, a partner at Boston Consulting Group.

His view is echoed by the experience of US behemoth Citibank. “The reality is that every time we hit volatility we benefit from a flight to quality on the asset side from people who want a bank that will stay the course, and on the deposit side from people who want a secure home for their savings,’’ Victor Menezes, chairman and chief executive officer of Citibank told The Banker.

In addition, a well-capitalised bank can put more resources into customer service at a time when others may well be forced to cut back. Acquisition opportunities are also thrown up by a downturn. Wachovia Corporation, for example, North America’s 16th largest bank, recently intimated its credit card business was up for sale. “It could have made that decision anyway, but would they really be looking at selling it if they didn’t have the experience of rising commercial loan problems?’’ queried David Berry, director of research at New York-based Keefe, Bruyette & Woods.

Branches also tend to go on the block allowing a rival bank to make selective acquisitions without spending too much money. When it comes to buying another bank, the universe of acquirers is becoming smaller because lower share prices are making bank currencies worth less, said Mr Ely.

Also, investors are more sceptical about cost-cutting from mergers as they are tending to take longer than promised. Still, a number of mid-sized and larger US banks remain acquisition targets, such as Bank One and Cleveland-based KeyCorp. Wells Fargo, US Bancorp (after it completes its merger with Firstar) and Wachovia have all been mentioned as possible acquirers.

The shake-out may take some time and is partly dependent on how long the downturn lasts. “I am not anticipating it will be like 10 years ago when banks were sold at give-away prices. On the other hand, the most effective way to go after costs is to merge,’’ said Mr Berry. Foreign banks that have increased their assets in the US by 12% last year will also play a role in the game, although more subdued. German banks have the most bank assets of any foreign country in the US: $219bn, while banks in the Netherlands have seen their US assets increase 65% in the last year.

ABN Amro is a possible candidate for further acquisitions, having said that the mid-west is one of its key markets. Analysts also think Royal Bank of Scotland, HSBC and Allied Irish might be active to further consolidate their chosen positions in the US market. However, they will also suffer from the worsening US economy, as will banks such as Barclays, since Barclays Capital has a corporate operation with a large number of US clients or BNP Paribas, also with an exposure to the US corporate sector.

“The unanswered question is how exposed banks are to the technology sector in the US,’’ said John Hitchins, a partner at PriceWaterhouseCoopers. Another question mark hangs over European companies’ exposure to the US, furthering doubts that European banks will be virtually immune to the US slowdown. Take the UK. Exports of UK company goods to the US are low, but sales of UK affiliates in the US reached $151bn last year.

For many European investment banks, such as UBS, Credit Suisse and Deutsche Bank, the US is even more critical. Soft markets are already affecting them. But again, there are some opportunities. Credit Suisse, for instance, should do well out of its expertise in the re-opened high-yield market. And securities firms can make money through their trading books by going short.

For the investment banks – from any country – a flexible cost base is crucial at this time. Although a spate of recent stories suggests guaranteed bonuses are being paid to retain staff, this only applies to key personnel. “If you look at their fourth quarter results, revenues fell sharply but the profitability was fine as they cut compensation,’’ said Peter Nerby, an analyst at Moody’s Investors Service. Admittedly all banks mention cost-cutting.

Like motherhood and apple pie, no-one can object to it. Citibank’s Mr Menezes mentioned several initiatives to manage costs better and increase productivity, including setting up a global credit card processing centre in Singapore and having back office operations for the Middle East and Africa in India. Rijkman Groenink, chairman of ABN Amro, told The Banker that loan provisioning in North America has gone up. “On the cost side we have an agreement with the North American management team that cost growth will be kept at 2% below revenue growth, whatever happens.”

He also said the bank is concentrating on a smaller universe of higher quality wholesale customers around the globe so that the risk profile of the bank improved whether on not there is a recession. Spending more on technology is also something banks with deep pockets can do in a downturn, while weaker rivals are forced to use revenues for provisions against non-performing loans, thus giving the stronger bank an advantage in the good times as well.

Chris Potter, a partner specialising in e-business and financial services at PriceWaterhouseCoopers in London, mentioned a couple of enabling technologies that can help cut costs. “XML has been extended to a new standard which allows the exchange of data more easily in a web environment, while growth in the use of digital certificates will help by leading to a standardised security architecture,’’ he said. Asian banks are starting to suffer the effect of the US slowdown, especially economies that have depended on exports to grow out of the Asian crisis.

Thailand is already seeing its exports falter. In January it recorded a $400m trade deficit as opposed to two and a half years of trade surpluses. Same with the rest of East Asia: Taiwan and Korea and Japan, where currencies are low and stock markets are faltering. “Companies in the electronics sector are working at between 60% to 80% of capacity, while the price of what they make is also dropping. Many of them still have high gearing and their cash flows are under pressure,’’ said Ashok Shah, head of emerging market equities at Old Mutual Asset Management.

“It is a recipe for a few tears, if not many tears, for the banking sector,’’ he added. The only upside for the Asian banks from a US slowdown is a long-term one: it may finally force them to complete restructuring and cleaning up their balance sheets. As for Latin American banks, it all depends on the contagion effect – if any - from Turkey’s problems, and the extent of the US economic problems.

As The Banker went to press it was not yet clear whether Turkey’s devaluation would have an effect on capital flows to emerging markets. As for the US economy, the signals are mixed, with two expert bodies coming up with very different estimates.

The International Monetary Fund has downgraded its forecast for US growth this year to just 1.7% from an estimate last autumn of 3.2%. The Federal Reserve has higher expectations of between 2% and 2.6% this year. But financial markets are counting on an upturn in the second half of 2001.

What will be most damaging to markets, according to Avinash Persaud, a managing director at State Street Bank, would be “an increasing belief that the recovery will be later.’’ He said: “If consumer confidence and bank confidence remain low, the effect is more than [Alan] Greenspan’s rate cut and tax cuts.”

A longer bout of economic malaise should not make a big difference to bank strategy. Managing an extended slowdown, and possibly a recession, involves basically the same course of action as managing a short slowdown. Look to cut costs, deepen customer relationships and search for new opportunities.

European banks, just as much as American banks, should be seeking to apply this policy since a number will not be immune from the US travails.

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