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Financial institutions in the year 2000.

Financial Institutions In the Year 2000

The nation's financial system is in the midst of its greatest upheaval and restructuring since the 1930s. Analogous to one battle in a war, it is certainly difficult to predict the final outcome.

The FIRREA legislation passed in August 1989 represents the legislative response to the thrift crisis of the 1980s and establishes the financial environment for the 1990s. Like most major pieces of financial legislation passed by Congress, it is a reaction to a set of problems rather than a well-thought-out plan for the future. Responses to the legislation are mixed. Of course, Congress and its staff believe they have found the ideal compromise solution. Industry response is more negative; indeed, some argue that FIRREA is the congressional vehicle intended to take revenge on the industry by "shooting the survivors." Outside observers have mixed reactions. Those supplying consulting, legal, and investment banking services to thrifts are delighted. Some academics observe that, for several reasons, FIRREA is one of the worst pieces of legislation passed in recent history. It creates another huge bureaucracy, severely penalizes healthy institutions, forces savings institutions back into a highly specialized mode with a restrictive QTL test, provides "solutions" for issues that are not problems, and fails to address the root cause of the problem itself, namely, excessive federal deposit insurance that is also badly mispriced.

In any event, FIRREA and the resulting regulatory structure have established the regulatory environment for the 1990s and beyond. However, it is important to realize that fundamental forces are at work in the economy and in the financial markets that will exert even greater forces on the thrift industry over the next decade.


Consolidation and Geographic Expansion

The safest prediction one can make for the year 2000 is a dramatic consolidation of the thrift industry. During the next decade, we will witness a continuation of the trend of reduction in the number of thrift institutions. Several factors are driving this trend.

First, similar to the consolidation trend in banking where we observe large numbers of mergers and acquisitions of healthy banks, we will see an increase in merger and acquisition activity among healthy thrifts and between banks and thrifts. There are advantages to larger size, including the benefits of geographic diversification, increased market share, and immediate entry into new markets with a significant presence.

Second, there will be a dramatic drop in the number of institutions as the effects of FIRREA unfold. The approximately 500 insolvent institutions will (we hope) receive their long overdue burial. Hundreds of barely solvent institutions will be closed, sold, merged, or otherwise eliminated due to their inability to raise capital and demonstrate viability. Modestly healthy institutions will voluntarily choose to merge with other institutions rather than remain independent and struggle in an increasingly competitive environment.

If asked to project how many will survive to the year 2000, I suggest that not more than 1,000 thrifts will witness the beginning of the twenty-first century. This means that some 2,000 institutions currently operating will not be here in 10 years for the reasons outlined in this article. However, those remaining should be viable economic entities. Most will be stock companies (either publicly traded or closely held), with the remaining mutuals having a substantial net worth cushion. In the year 2000, there will be no role for the thinly capitalized (say, less than 8%) mutual institution.

Paralleling the consolidation trend will be a continuation of the market expansion trend by viable institutions. Many successful banks and thrifts already have statewide or interstate activities in the form of branches, LPOs, servicing activities, subsidiaries, credit cards, insurance, and the like. Simply put, rational diversification into closely related lines of business and expansion into other geographic markets add value to the firm.

This does not mean that every institution will become part of a regional or national organization, although many will. There will always be community banks and niche banks, but to survive they must successfully differentiate their products and services from those of the larger entities. Furthermore, the small entity will always be more vulnerable to the risk of operating in only one market as opposed to several geographic markets.

Reduced Role for Thrifts in the Financial System

Thrifts will have a diminished role in the financial system of the year 2000. The disappearance of hundreds of individual institutions ensures this, and other aspects of the FIRREA legislation will accentuate this trend. Higher capital requirements will limit growth for all institutions, especially those with modest capital positions. The more stringent QTL test will make the thrifts of the year 2000 look more like the thrifts of the 1970s in terms of asset composition. Whether this implies an increase in the value of the firm as a result of doing a few things very well, or a reduction in value as a result of too narrow specialization, is an open question. However, there is a certain credibility to the view that we may have put the thrifts back into the asset box of the earlier era, or as Yogi Berra might have said, "Deja vu all over again."

In addition, thrifts will no longer dominate the mortgage market. Commercial banks and mortgage bankers are and will be as active in loan origination as thrifts. Reduced growth potential for thrifts in a growing mortgage market will accentuate this trend.

Finally, mortgage markets are now truly integrated into the national capital markets because of the active secondary market and the tremendous expansion of the mortgage-backed securities market with all of its various whole, stripped, and multiple-class securities. In short, securitization of mortgage credit has dramatically reduced the economic need for mortgage portfolio lenders. This is not to say that there is no need for portfolio lenders, but the asset securitization trend has made a specialized financial intermediary less vital to the effective operation of a mortgage and housing market.

Indeed, the trend toward securitizing various types of credit, including consumer type credit and commercial credit, as well as mortgage credit, has reduced the economic role for all traditional depository intermediaries. As previously illiquid loans are packaged, securitized, credit enhanced, and sold in capital markets, the traditional financial intermediation process has been circumvented and the need for its services diminished. As a result, financial intermediaries are left to serve those market where credit securitization is difficult (or not yet "solved"), compete directly and with lower spreads as a portfolio lender in a securitized market, or learn to operate in a securitized world but not necessarily as a portfolio lender. The dominant force in the reduced role for thrifts is the market force of securitization. It is an irreversible trend with the likelihood of further acceleration. FIRREA provisions are merely superimposed on this trend to make the environment even more difficult for thrifts.

Financial Innovation

Closely related to the securitization trend is the explosion of financial innovation that has occurred in the past decade. Essentially, financial innovation means (a) the development of new financial instruments that allow for risk reallocation and for yield reduction in capital markets, (b) the development of new, more efficient methods of dealing with current transactions and providing existing services at lower cost, and (c) the design of creative solutions to corporate finance problems. Thrifts have been impacted dramatically by financial innovation. The tremendous growth in whole, stripped, and multiple-class mortgage-backed securities exemplifies the development of new instruments. Each one of these instruments represents an alternative method of packaging and securitizing cash flows from the underlying mortgage instrument. Each new security created has found a niche in the market because some investor group in the capital market has a need for that particular packaging of cash flows and is willing to pay a higher price (i.e., accept a lower yield) than if the cash flows were packaged in the traditional fashion. The effect on thrifts is twofold: on the negative side, the resulting lower yields on mortgage credit create a more difficult financial environment in which to be profitable; on the positive side, the new instruments provide new vehicles for managing interest rate and prepayment risk in the institution.

The adjustable rate mortgage is also a financial innovation with pros and cons. ARMs enable thrifts to shift risk to the borrower, either partially or wholly, but at the expense of severe reductions in rates and interest margins. Coupled with bizarre teaser-rate pricing in the ARM market, the instrument has been a mixed, albeit essential blessing.

The primary source of financial innovation, of course, has been the investment banking firms on Wall Street. Motivated by the financial returns of developing new instruments and processes, they continually devise new ways securitize previously illiquid credit and to rebundle cash flows from loans and already existing securities. Thrifts have not contributed to innovation; rather, they have been put in the position of reacting to each new instrument that has been marketed by investment bankers. Again, financial innovation is one of those trends that cannot be and should not be reversed. Innovation is the life blood of a market economy. Unfortunately for thrifts, much of the recent financial innovation has made life more difficult.

Reduced Role for Deposit Insurance

Despite the panting of the media, the causes of the thrift crisis were not deregulation and incompetent, unscrupulous thrift managers. Clearly, however, the latter contributed to the size of the problem.

The root cause of the thrift crisis is the federal deposit insurance system. Simply put, too much insurance is available, and it is not priced to reflect the risk of the institution offering the insured liabilities. This combination has produced a notorious lack of discipline for both depositors and management. Depositors care little about the health of the institution because their funds are insured. Managers of thinly capitalized institutions are "encouraged" to take on high-risk activities as a means of possibly saving the institution while turning over the losses to the insurance fund. Until this problem is solved, financial reform is seriously incomplete.

The only way to have a viable thrift and banking system with healthy institutions able to compete is for the regulatory environment to consist of the following features:

* Reduced amount of deposit insurance--say, one account per household or per Social Security number with a limit of $50,000--or some sharing of risk over a minimum amount--say, 80% insurance on accounts between $40,000 and $60,000 and nothing after $75,000.

* Adequate capital in the institutions--say, at least 8% of assets, with no necessary relationship to asset risk.

* Timely, competent monitoring and examination by the regulatory agencies.

* A meaningful closure rule in which institutions are closed immediately when the value of assets falls to the value of liabilities.

If these four conditions are met, nothing else matters. Let the institutions make commercial real estate loans on shopping centers, buy high-yield bonds, make mortgage loans, or originate consumer loans. Market discipline and regulatory oversight will ensure viability under these conditions.

I believe Congress will address the deposit insurance question in the near future. Once the issue is addressed, the only meaningful outcome will be a reduction in the availability of insured deposits. As much, thrifts must ask themselves the question, "Can my firm be viable in a market where the umbrella of protection of deposit insurance is substantially reduced and where the rules of closure are unequivocal?"

In such a world, managers will pay much more attention to asset quality, interest rate risk, and the market value of assets and liabilities. Indeed, in this world, regulations like TB-13 and risk-based capital are superfluous because the market will penalize those firms that do not monitor their own risk exposure.

Problems Facing Survivors in Post-FIRREA World

At this point, one might legitimately ask, "Why would I wish to operate in the world described above?" Survivors will have no choice; they must be prepared to deal with these issues. The problems facing survivors in the 1990s are serious. They include the following:

* Reduced value of the thrift charter. Extraordinary

deposit insurance premiums, reduced powers, higher

capital requirements, and a more stringent QTL test

will combine to put pressure on the value of any form

of thrift charter.

* Securitization and increased competition in the

mortgage market will make the interest margins

increasingly thin.

* Raising capital in public markets will be difficult,

especially for thinly capitalized mutual (and stock)

companies. This will lead to more private, closely held

stock companies as well as more mergers.

* Developing and maintaining the ability to operate

efficiently will become increasingly important. The

disturbing trend of rising operating expense ratios and

shrinking interest margins must be halted. Since spreads are

unlikely to rise, institutions must reduce their cost

ratios. They should strive to reduce their ratio of

operating expenses to assets to the 150-basis-point level or

below if they are operating in the most competitive

lending markets. The 150-basis-point cost ratio is not

unattainable. In a recent study of cost ratios of individual

thrift institutions, those thrift institutions that fall into

the lowest cost quartile (25% of all GAPP-solvent

institutions) have an average operating-cost-to-total-asset ratio

of approximately 140 basis points.

Survivors in the Year 2000

Of the 3,000-plus institutions currently in existence which will survive? Specific numerical estimates are more like wild guesses than meaningful forecasts. It is more logical to assess the likelihood of survival of different institutions based on their capital positions. Using this approach, I segment the thrift industry into four distinct components.

The first components, whose outcome is easiest to predict, is the group of approximately 500 institutions currently insolvent on a GAAP basis and dead on an economic value basis. The probability of survivorship in this group is zero. No one from this group will survive as a free-standing, independent institution unless it is acquired in whole or part from the RTC and recapitalized as part of the acquisition.

A second component is the group of institutions that are currently well capitalized, with positions beyond the level required by the new OTS capital regulations. I suggest that anyone with GAAP and tangible capital in excess 8% of assets falls into this category. Unless these institutions do something that is absolutely stupid at the managerial level, they can classified as "slam-dunk" survivors. The likelihood of survival here is nearly 100%, unless they choose to sell the healthy francise to another thrift, a commercial bank, or other investor.

A third group consists of those institutions with GAAP capital in the less-than-3% (but still positive) range and whose tangible capital may be below the GAAP amount. These institutions fall into the area of "highly uncertain survivor" with a likelihood of survival as an independent institution of less than 25%. Those that do survive as independent institutions will have raised capital either by a public offering (difficult for these thinly capitalized companies) or by private recapitalization in which individual or investor group has injected new capital into the institution. The majority of firms in this group will be merged into institutions with more capital, be acquired by nonthrift competitors like banks, or become a regulatory resolution case.

Finally, those institutions with capital in the 3% to 8% range fall into the "possible survivor" category, with survivorship as a 50-50 proposition, obviously higher for those in the high end of the range and lower for those close to the lower limit. Most of these institutions have the capability of raising capital in the market if they cannot generate adquate capital via retained earnings. Some, of course, will choose to be acquired or merged or will make enough mistakes to fall into the "highly uncertain" category below 3%. Few, if any, in this group will be the acquiring entity; most, if not all, will fall into the acquired or merged side of any transaction.

By now, it should be clear that the likelihood of survival is not based on whether the institution is now a stock or mutual, but rather is based on the size of the capital base. The implications, however, are clear. Well-capitalized mutuals can survive as easily as well-capitalized stock institutions. Thinly-capitalized stock institutions are as vulnerable as thinly-capitalized mutuals. Mutual institutions that need capital to survive must undertake whatever capital market transaction is necessary to enhance the capital base. Obviously, this means some type of conversion transaction, including the conventional conversion, a voluntary supervisory conversion, or a merger conversion. Stock institutions in need of capital will be obligated to return to the capital market for additional equity or sell to another entity if the capital market is not receptive to a new equity offering.

In the final analysis, capital adequacy determines survivability in the thrift and banking industry. Meeting the regulatory requirement must be viewed as the bare minimum. Viability of the institution may warrant capital in excess of the required minimum.


From the management perspective, there are a number of important implications resulting from the trends identified above. The increasingly competitive market and the increasing complexity of financial management make it imperative for managers to operate with a focus on creating value in their franchise, developeing a better understanding of risk management, and using the tools available to manage risk.

Increased Emphasis on Risk Management

Survivors in the year 2000 will have successfully navigated the treacherous waters of managing the most important risks in their institutions. Notice the emphasis on risk management rather than risk avoidance, for an institution without any risk is an institution without any return. The key to survival will be to understand which risks can be successfully managed and which should be avoided.

All financial institutions must deal with at least four primary types of risk, any one of which can devastate an institution if it is mismanaged. Most of these risks are well known but warrant repeating. They are:

* Interesting rate risk--the risk that unexpected changes

in interest rates will endanger the market value (and

viability) of the firm.

* Credit risk--the risk that asset quality deterioration

will adversely affect the viability of the institution.

* Capital risk--the risk that the institution will have

inadequate capital to meet its business need and its

regulatory requirements.

* Regulatory risk--the risk of not complying with

certain regulations that may lead to substantial penalties

or closure.

In the "bank of the future," these risks will be successfully managed. There will be little, if any, interest rate risk because the market places virtually no value on returns generated by taking on rate risk. Credit risk will be prudently managed and will be the major factor determining the size of the net interest margin. Viable firms will be capitalized, probably beyond the regulatory minimum. Regulatory risk will be minimal if interest rate, credit, and capital risk are under control.

Strategic Planning With a Focus on Value Creation

From a strategic planning perspective, the most important questions management and directors should ask today are, "Is my institution viable for the 1990s? If not, what must we do to make it viable? If it cannot be made viable on an independent basis, how can we best package the institution for sale or merger so as to maximize the value for all stakeholders?"

For those institutions that achieve viability as an independent entity, strategic planning must focus on questions of value creation and risk-reward ratios. For example, many managers focus too much on regulatory requirements and accounting conventions. They typically ask, "Do I have enough capital to meet the new requirements?" and "What will be the net accounting earnings that result from this particular activity?"

The more appropriate questions are, "Do I have adequate capital to meet the business needs of the company in my market area with my business plan? Am I adequately compensated for the risk that I am taking in this particular activity? What impact will this policy or decision, if implemented, have on the value of the firm?"

Simply put, managers of thrifts in the year 2000 must manage using the decision framework of corporate finance so commonly used by successful firms in other industries. Successful corporate managers understand that every major decision has value implications--and the capital market is a harsh and swift judge. Bad decisions translate into reduced firm value, but good decisions produce value enhancement and increase in firm value.

Risk Management Tools in Successful Institutions

Risk management in the thrift industry has often been characterized as "horse-and-buggy" management in a "Ferrari" world. For many managers, daring risk management has consisted of making ARM loans rather than fixed-rate loans and trying to lengthen liabilities by selling 2 1/2-year rather than 6-month deposits. Successful institutions that survive to the year 2000 will have developed an understanding of the new instruments and techniques available for managing risk. Concepts like modified and Macauley duration, convexity, option-adjusted spreads, LIBOR-based lending, and basis swaps will be the jargon of day-to-day management. If you find this to be unrealistic, consider that these concepts are routinely taught in senior-level financial markets classes at most universities today.

Successful managers will be able to, or will have CFOs who can, effectively utilize the instruments already available for managing risk and whatever else comes down the innovation pipeline of the 1990s. These include IOs, POs, all forms of interest rate swaps, caps, options, futures, whatever risk management products are sold that have embedded options, and various forms of securities generated by the credit securitization. The basic point in this regard is that successful institutions will offer whatever asset and liability products are demanded by their customer. If the risk position that results from the strategy is unacceptable, the institution must use its financial management skills to manage or hedge that risk successfully at the lowest possible cost (preserving as much yield as possible). The ultimate irony of the ARM product is that it forces the interest rate risk on the one party even less able than thrifts to bear interest rate risk, namely the typical consumer household.

Director Responsibility

In the world of the 1990s, directors will enter a new era of responsibility and accountability. Prudence combined with increased pressures and expectations by regulators will force savings institution directors to be much more aware of risk exposure and activities in the institutions.

Many directors have little or no understanding of the risks in the institutions and risk management practices available to and undertaken by management. In the next decade, this information gap must be closed because regulators expect directors and management to be knowledgeable of the institution and accountable (and liable) for its economic well-being.

The implications of the increased accountability and liability are clear. Boards must become more informed about the institution but without interfering in the management of the institution. Boards must also be restructured in cases where board members do not wish to acquire the necessary knwoledge or bear the risk. Restructuring will include a discontinuation of the common practice of having board members well beyond normal retirement age and the addition of board members with specific knowledge and capabilities that will be valuable to the institution. Also, since a strong capital base is the best protection for directors as well as for the federal deposit insurance agency, boards in the year 2000 will be much more willing to do what is necessary to enhance and preserve the capital base of the institution.


If one were asked to summarize the key characteristics of the successful surviving firm in the year 2000, the following terms and phrases would apply:

* Well capitalized

* Efficiently operated

* Sound risk management programs in place

* Understands the concepts and instruments of modern


* Able to survive with less deposit insurance

Several thousand firms have already disappeared because of inadequacies in at least one of the above areas and hundreds more will do so in the 1990s for the same reason. The key to being on the survivor list is capital. With capital, there is a chance, without capital, or with low capital, there is no chance of surviving.

Those with capital in place already have a great advantage over those that do not have it. Look to the equity market pricing for verification of this point. Those companies with strong capital positions trade at higher multiples of earnings and higher market-to-book ratios than those with low capital ratios.

Restructuring of a firm or industry is always a painful ordeal; but in a dynamic economy, changes is necessary. In reality, the restructuring of the thrift industry has been going on for some time--too much deposit insurance and horrible regulatory mistakes kept it from going as fast as market forces would have suggested. Financial innovation and the changing competitive structure combined to generate substantail overcapacity in the housing finance industry, which is now being eliminated in a painful and expensive process.

Many have asked the question, "Why do we need thrifts in the future? Why don't we simply shut down the saving and loan industry that has become the dinosaur of the financial services industry?" These are the wrong questions. The more appropriate question is, "Is there a role in the restructured financial system for efficient institutions that specialize in housing-related finance and consumer credit?" I believe the question can be answered affirmatively, but the survivors will be more sophisticated risk managers with well-defined strategic plans who fully understand where their niche exists in the financial services industry.

Dr. Verbrugge is chairman of the Department of Finance at the University of Georgia and holds the E.W. Hiles Professorship of Financial Institutions. He is also a consulting associate with Financial Strategy Group, Inc., a Washington, D.C.-based consulting firm. This article is reprinted with the permission of, and copyrighted 1990 by, the Financial Managers Society, Inc., 111 E. Wacker Drive, Chicago, IL 60601.
COPYRIGHT 1990 University of Memphis
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Author:Verbrugge, James A.
Publication:Business Perspectives
Date:Jun 22, 1990
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