Professional Documents
Culture Documents
Robert B. Albertson
Vice President, u.s. Banking Research
Goldman, Sachs & Company
Decisions about investing in banking stocks should be made in the context of the recent
history of bank performance, the cyclical drivers of bank stocks, and the structural
challenges-including consolidation-the industry faces.
Capital Ratios
The banking industry is probably the most leveraged industry in the country. Figure 1 traces almost 60 years of the equity-asset ratio for insured
commercial banks. The history of capital has been
quite dramatic. It has fallen a long way, but most of
the fall took place a long time ago. In the mid-1930s,
the equity-asset ratio exceeded 13 percent. Walter
Wriston was right: High capital ratios did not prevent carnage and failure. The ratio was even higher
before the Great Depression. It hit its recent nadir in
1979, and it has been in a slow but steady recovery
ever since.
The world conclave in 1990 that produced the
Basle Accord decided to look at assets in a more
sophisticated way. The assembled conferees provided guidelines that say the minimum capital ratio
should be 4 percent "Tier I," which is a euphemism
for common equity and some preferred. Most banks
in the United States are well above 4 percent, and
those that are not are very close to that level. Five
and one-half percent is actually the practical limit on
capital-that is to say, what is necessary to try to do
acquisitions.
Capital is probably the most important factor
explaining valuation differences in banking. Capital
is timeless. Capital collects the past, the present, and
the future. It cumulates past sins, reflects them in the
current condition of the bank, and tells what the
future opportunities are going to be for that bank. It
is more important than growth and profitability.
Figure 2 shows how value correlates with capital
levels in 1990 and October 1991. Although the R2
was 0 in 1980, and 0.38 in October 1991, it was as high
as 75 prior to the 1987 market crash. In recent years,
it has been the single most influential variable in
explaining price--earnings and price-book differ7
,--------------------~
140
13
~
12
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100
90
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80
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70
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2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5
Common Equity-Assets Ratio (%)
1990 Year End
120
~ 110
11
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230,----------------.---------,
220
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200
180
160
~ 140
~
8 120
100
J, 100
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80
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3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
Common Equity-Assets Ratio (%)
October 1991
Source: Goldman, Sachs & Company
20
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18
110
17
16
100
15
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13
12
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'72 '73 '74 '75 '76 '77 '78 '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91
Industry Structure
Banking has been the most discriminatedagainst industry in the United States. For the past 50
years, banks have been unable to modernize their
existing product, unable to broaden into other financial services, and unable to sell their archaic wares
except in very tight geographical areas. They have
been burdened with all sorts of community responsibilities. What banks have achieved in this environment is amazing. Think about any other industry or
stock and apply the same rules. For example, suppose Apple Computer could only sell its computers
in California. Suppose it could only sell its first-generation computer, one with a black and white screen
Item
Change in
Treasuries at
Constant Maturity
ofIO Years
Federal
Funds
Rate
Change in
Federal Funds
Rate
Treasuries at
Constant Maturity
of 10 Years
0.00
-0.03
-0.11
0.01
1.39
1.39
0.00
0.38
1.00
0.00
-1.72
-0.79
0.01
5.14
1.50
0.05
-3.14
-3.56
0.00
-0.03
-0.13
0.00
0.20
0.20
0.00
-0.29
-0.76
0.01
-2.76
-1.27
0.01
-4.64
-1.36
0.07
-3.67
-4.29
0.00
0.08
0.32
0.00
0.31
0.34
0.02
-0.69
-1.94
0.00
-1.59
-0.79
0.08
-13.66
-4.28
0.13
-4.49
-5.80
0.01
-2.59
-1.83
0.00
-1.83
-0.34
0.00
1.00
0.49
0.02
-24.60
-2.10
0.01
20.79
1.12
0.04
15.23
3.19
0.02
-3.27
-2.37
0.00
-2.39
-0.45
0.00
-1.93
-0.95
0.01
-15.49
-1.33
0.00
8.21
0.45
0.03
13.52
2.89
0.03
-3.45
-2.42
0.00
-1.91
-0.35
0.01
-3.37
-1.62
0.00
-9.72
-0.83
0.00
-1.24
-0.06
0.01
8.22
1.72
Yield
Curve
Proxt
Spread
proxl
R2
6-month lag
Coefficient
t-statistic
Coincident
Coefficient
t-statistic
R2
R2
6-month lead
Coefficient
t-statistic
R2
6-month lag
Coefficient
t-statistic
Coincident
Coefficient
t-statistic
R2
R2
6-month lead
Coefficient
t-statistic
The types of products offered by financial institutions in the 1980s is presented in Figure 4. Commercial banks competed in five products. In contrast, Sears, Transamerica, RCA, Gulf & Western, and
some of the others offered considerably more products. This provides a clear picture of the competition,
and it has been tough on bank product. Fleet Financial, one of the earliest to seriously diversify, said,
"We are the largest bank in the smallest state, so we
better do something." They got into nonbank subsidiaries that were near-banking, allowing them to
get a little bit outside of the product and geographic
restriction mold. Subsidiaries that are in mortgage
banking, asset-based commercial finance, and consumer finance are good ways around geographical
10
Source: Citicorp.
Cyclical Drivers
Banks have three cyclical drivers: credit demand,
interest rates, and loss cycles. These drivers are deceptively simple in theory but sometimes complex to
assemble.
Credit Demand
Credit demand is of two major types-eonsumer
and corporate. Banks always have a much sharper
loss cycle on the corporate side than on the consumer
side, primarily because consumers are debt maximizers and corporations are debt minimizers. For
debt maximizers, it is the Los Angeles freeway phenomenon: being so scared you drive carefully. The
minimizers-akin to "Sunday drivers"-only go
into debt when they have to, which is probably when
they should not: at the end of a recession or coming
into a recession. They get into trouble.
Consumer lending is very simple: Consumers
borrow based on strength of income. The appropriate debt level according to the average consumer is
as much as he can carry as long as he can service it.
Figure 5 shows consumer credit and disposable personal income growth during the past 15 years. They
track pretty well. In 1980, however, consumer credit
growth dropped like a rock. That was when President Carter was in office, and credit controls were
imposed. In 1984 and 1985, consumer credit took off
11
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'76
Interest Rates
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'78
'80
'82
'84
'86
'88
'90 '91
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'76
'78
'80
'82
'84
'86
'88
'90 '91
- - Consumer Credit
Source: Goldman, Sachs & Company.
like a rocket again as it became decontrolled. Basically, consumer borrowers will be back as soon as
their incomes come back.
Corporations borrow according to a simple algorithm that sums inventories plus spending minus
cash flow. This financing requirements "proxy" in
Figure 6 tracks very tightly with the growth in business loans. The statistics get treacherous in corporate
lending because we tend to focus business credit on
the Federal Reserve statistics on how much is outstanding in the banks.
Banks are more arrangers of credit than holders
of credit. (Many people still believe banks have been
replaced by commercial paper.) Figure 7 shows the
sum of all of the outstanding bank loans in all of the
corporate sectors in the United States-their liability
side-as a percent of total long-term debt. The percentage has actually gone up. If anything, I am concerned about the deleveraging phase we are facing
on the corporate side.
12
Loss Cycles
The loss cycle is the third cyclical driver. Figure
10 shows consumer loan losses for the past 60 years
20
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-5
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'76
'78
'80
'82
'84
'86
'88
- - Business Loans
- - - Financing Requirements Proxy
Source: Goldman, Sachs & Company.
'90 '91
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33
32
31
30
29
28
27
26
25
24
23
22
21
73
75
77
'81
79
'83
'85
'87
'89
'91
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'84
'85
'86
'87
'88
'89
'90
Structural Challenges
'91
The banking industry is trying to solve some problems by cutting costs-alone and through consolida-
- - Prime Rate
- - - Three-Month CD Rate
- - - - - Money Market Rate
Bank Margins/Spreads
6,----------------------,
.5
~ 400
.~
300
100
O'----...L-----'-------'-_ _L-_--'----_---L_----.l_----l
'84
'85
'86
'87
'88
'89
'90
'91
O'------'----"'-------'-_.L......---'--_-'-----'-_-'-----'-_--'------'---.J
'80 '81
'82 '83 '84 '85 '86 '87 '88 '89 '90 '91
- - Prime--Discount Rate
- - - Prime--Cost-of-Funds Proxy
- - - - - Prime--Federal Funds
13
5
4
3
2
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'80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91
- - Price Differential
'80
'84
'85 '89
ca
:0
1.3
1.2
1.1
1.0
0.9
~ 0.8
~ 0.7
P-. 0.6
0.5
0.4
0.3
0.2
0.1
0'48
'53
Conclusion
'45
'88'90
$millions mix
Percent mix
Retail
Branches
Commercial
Banking
47.5
37
10.1
8
Trust
8.6
7
Corporate
Overhead
EDP&
Operations
37.2
29
25.3
20
Systems
Operations
BankAmerica/Security Pacificb
Consumer
Delivery
$millions mix
Percent mix
350
35
Wholesale
Delivery
Other
150
15
100
10
200
20
200
20
Chemical/Manufacturers Hanover c
Branches &
Real Estate
$millions mix
Percent mix
100
15
Staff
Technology &
Operations
350
200
31
54
NCNB/C&S Sovran d
In-Market
Branches
$millions mix
Percent mix
Marketing
Business
Lines
25
7
47
13
Branch
Banking
Other
Line
Staff!
Support
20
8
55
21
108
31
Corporate
Overhead
44
13
Support Services
& Operations
126
36
$millions mix
Percent mix
100
38
Systems &
Operations
90
34
15
16
17