Breaking the Bounds

The Citicorp-Travelers merger begs the question: How high can banks fly?
Ellen BenoitJuly 1, 1998

As usual, the headlines heralding yet another attempt to repeal the Glass- Steagall Act miss the mark. While lawmakers dither, federal regulators already have lowered barriers between commercial and investment banking. Indeed, the businesses of lending money and underwriting securities have successfully coexisted under the act’s Section 20 subsidiary rule 1987. So legislative action to kill the weak prohibitions left in the 1933 law seems almost redundant.

What has not been tested, however, is the mixture of banking and commerce–if anything, a more controversial proposition because it expands the number of areas in which banks can get into trouble. The test case, of course, is the Citicorp/Travelers Group merger, which will combine commercial banking, securities, and insurance underwriting within a single entity to be known as Citigroup. The deal challenges not only Glass-Steagall, but also the Bank Holding Company Act of 1956 (BHCA), which limits bank affiliates to activities that are “closely related to banking”– activities that do not include insurance.

True, the legislation recently passed by the House of Representatives–the Financial Services Competition Act of 1998, commonly known as H.R. 10– would “permit affiliations between commercial banks, securities firms, insurance companies, and, subject to certain limitations, other commercial enterprises.” But even H.R. 10 does not allow nationally chartered banks to underwrite insurance, a prohibition that would seem to prevent Citigroup from keeping Travelers’s property and casualty lines. Citigroup does have other options, such as switching to a thrift charter to take advantage of regulations that permit unitary thrift holding companies to engage in insurance and real estate activities. However, this plan is only viable if H.R. 10 doesn’t become law, because the bill as it stands now would eliminate the unitary thrift structure. So pressure is on the Federal Reserve Board to decide whether and how to approve the formation of Citigroup and whatever like- minded deals follow in its wake as the financial services industry continues to consolidate.

Clearly, the banks do not want to wait for Congress, and, so far, regulators have been willing to help them push against existing boundaries. The entire situation raises questions of risk and conflict of interest, provoking memories of why banks were regulated in the first place, after the so-called New Era of unfettered capitalism in the 1920s, when scores of banks failed as the result of unsound practices.

Back when the likes of J.P. Morgan and his West Coast counterpart, Bank of America’s A.P. Giannini, dominated the financial landscape, commercial banks made loans to their investment affiliates to finance stock purchases and accepted the stock as collateral, for example. They also tied up demand-deposit funds in illiquid or long-term investments, such as real-estate loans. And some enticed wealthy corporations to contribute surplus capital for lending by promising higher interest rates and sometimes even guaranteeing the loans. This recklessness helped produce the 1929 stock market crash.

It Must Be Different This Time

Will the repeal of Glass-Steagall and the BHCA bring back the bad old days? Perhaps a cautionary case is the $6.75 million in fines recently paid by NationsBank Corp. for allegedly misrepresenting risky bond funds as insured deposits to a number of investors. These were individual consumers, but couldn’t corporate clients be at equivalent risk of unfair behavior by unfettered banks? Economist Henry Kaufman recently went on record with fears that current trends make it easier for banks to implicitly guarantee a market for the commercial paper of clients that issue securities through them. What, after all, is to prevent a bank from promising that its money managers will buy those securities even if that doesn’t suit other customers?

The answer, to be sure, is the Fed’s Section- 20 firewalls, now known by the gentler term “operating standards.” But these grant banks greater discretion than ever. While the Fed requires banks to adopt internal controls, including “exposure limits,” governing their participation in Section-20 affiliate transactions, the limits themselves and other control mechanisms are apparently left up to the individual banks. While the Fed isn’t likely to allow banks to get really reckless, might there be reason to worry that weaker walls will not hold in the event of a recession?

“Probably not,” says Jim Hanbury, an analyst at Schroder & Co., an investment bank in New York. “The people underwriting both equities and fixed income are pretty substantial entities.” However, he adds, “you’re not really going to know [how well they work] until after a recession hits.”

In short, the question is, What kind of regulatory environment is needed in the new New Era of corporate financial services to head off what experts call “systemic risk”– that is, the chance that the nation’s entire payment system will be endangered by even a single large-bank failure because of the interlocking nature of deposits and transactions among our financial institutions?

“Evolution leads us to assume that mergers such as Citicorp and Travelers will take place,” says Dimitri Papadimitriou, executive director of the Jerome Levy Economics Institute of Bard College. “But to make sure we don’t have systemic risk, we must have regulations that are uniform and transactions that are transparent, so that regulators can evaluate the risks that all the subsidiaries have and what that might entail vis-à-vis moving assets from one corporation to the other to cover losses.” He believes such regulations will come, but perhaps not soon enough. “My only concern is that we are pushing fast on repealing Glass-Steagall and allowing commercial industrial firms to own banks without also bringing together a system of regulation.”

H.R. 10 does impose some limits on bank ownership by nonfinancial companies. For example, a nonfinancial company may control only one bank, and only through a holding company. In addition, the bank’s consolidated assets may not exceed $500 million when acquired, its gross revenues may not exceed 15 percent of the acquiring firm’s consolidated domestic gross revenues, and it must have been chartered for at least five years. These constraints are good, says Papadimitriou, because they require established banks of small enough size to minimize the dangers of systemic risk. On the other hand, he adds, $500 million can grow rather quickly, especially if the entity that owns the bank is in, say, the auto industry, which does a lot of lending.

Corporate finance executives do not seem particularly worried that huge banks with multiple financial businesses will pose any risks to their pension funds’ stability or their company’s condition. Especially for large global companies, the appeal of a single provider for a range of financial needs generally outweighs mild concerns about whether mergers will drive up financing costs and complicate banking relationships.

“We will have to be a little more careful in choosing our counterparties,” says Geoffery Merszei, vice president and treasurer of The Dow Chemical Co., the chemical and agro- science giant in Midland, Michigan. “The real issue is increased counterparty risk exposure to one institution.”

Overall, however, Merszei sees bank consolidation as a positive development and does not see any major changes for large corporations. “But that may not apply to smaller corporates,” he adds. “For them, in fact, this [trend] may not be ideal, because they will have less leverage to secure competitive pricing. On the other hand, when we have a situation like that, a free market with demand and supply, we will probably have niche players come out of the woodwork and provide smaller players with more personalized service.”

On the question of increased costs, the jury is still out. “To us, as an A-rated company, the most valuable financing product the banks offer are their credit lines, which we use to back up our commercial paper for the least- expensive funding,” says Purchase, New York­ based International Paper Co. treasurer William Boehmler. “Competition has caused those rates to get down below 10 basis points, and I don’t think anybody regards that as an adequate return for the banks. So they are underpricing one of their most valuable products. Whether concentration in the industry will result in raising those rates or not is not clear to me. There will still be a lot of banks out there.”

Don’t Call Them Lenders

Many executives tend to think that the economies of scale created by megamergers will temper any rise in prices–not for credit lines, but for other products, such as cash management accounts. Indeed, they see consolidation as a corrective trend in an overcrowded bank market. “One reflection of the relatively low returns banks have had is that many of them are not terribly anxious to lend money anymore,” says Boehmler. Stiff competition and the proliferation of specialized credit vehicles, both fueled by the convergence of commercial and investment banking, have made the traditional commercial loan one of the weakest risk/reward entities in the business. And not surprisingly, shrinking margins at the top end of the credit- quality scale have driven banks to what they call the “middle market,” where corporate borrowers have more complicated needs and bankers can “add value” and generate better returns.

“But,” says Boehmler, “in dealing with people like us, they often don’t. We recently tried to raise money from banks for a special purpose at what seemed to me to be attractive rates, and I thought it was interesting that the European banks found it attractive and participated, while half the domestic banks did not.”

From a corporate finance perspective, letting banks underwrite insurance is quite logical and forward-looking. There are clearly potential synergies here, as is apparent from moves by insurance companies into areas initially controlled by banks.

A case in point involves Honeywell Inc., the controls-systems maker in Minneapolis, which recently implemented an integrated risk- management program put together by insurance giant American International Group Inc. What’s innovative about the system is that it is designed to protect the company against both traditional hazards (property/casualty and workers’ compensation, for example) and such financial risks as currency exposures. “It takes the traditional insurance piece and adds the financial side,” says Tom Seuntjens, who handles risk management in Honeywell’s treasury department. He recognizes that the program does increase Honeywell’s reliance on one insurer, but is not overly concerned about it.

Better Deals On Insurance?

Seuntjens initially was concerned about the precedent that the Citicorp/Travelers merger might set for reduced competition. “My first impression was that they made the deal so that Citicorp could get into insurance and vice versa,” he says. “But now I don’t believe so much that they will do that–or can do that– as much as I think they want access to each other’s customer bases. That doesn’t concern us as buyers as much as if they were to offer joint services.”

So at the moment, at least, Seuntjens is not concerned about potential conflicts of interest there. “I don’t think we have to be concerned about one area reaching into the other,” he says. “Government regulations prevent that, and, while I’m sure those will melt away with time, there’s so much capacity on both sides–insurance and banking–that we’re a long way from concern.”

As a corporate consumer of insurance, Seuntjens is more worried about consolidation among insurance brokers–now down to two major and two minor players, which raises questions about how independent the insurance companies themselves can be. “If insurers have to work through one or two brokers to get business, that puts brokers in a stronger position to influence where those insurers can go in the marketplace,” he says. Presumably, the entry of banks into this situation will serve to strengthen competition, even if the first player is as massive as Citigroup.

Lessons From Abroad

It is often argued that expanding and deregulating banking would simply mean that the United States is catching up with Japan and Europe, where so-called universal banks are well known. Indeed, H.R.10 would foster universal banks by allowing nonfinancial corporations to own banks.

But universal banks get mixed reviews as a model for the United States. Proponents argue that letting banks expand into new businesses will make them safer by diversifying their risks. “The U.S. is really out of step with most of the rest of the industrial world with respect to what banks are allowed to do in insurance and real estate and the mixing of banking and commerce,” says James Barth, finance professor at Auburn University, adding quickly that even here there is something of a universal banking system, through Section 20 subsidiaries and the fact that regulators permit some state-chartered and even a few national banks to get into insurance activities. “The lines over which banks have been permitted to cross have been moving forward over time, but we are still much more restrictive than Germany and other countries. Whether theirs is a good model or not, to me it’s simply a matter of being sure the bank is adequately capitalized and trying to prevent conflicts of interest.”

Precisely. Owning large equity stakes in companies can pose risks to banks’ reserve capital and would seem to present conflicts of interest if the banks also lend to the firms they own. If a company gets into trouble, for example, its bank’s equity interest gives it incentive to extend the company credit on overly favorable terms.

More generally, a lender that controls a company is likely to be more cautious than investors with only equity at stake. But banks more often take on too much risk. Papadimitriou points to Japan’s recent crisis as an object lesson. “The Japanese case is the most obvious,” he says. “A lot of loans have been made through interlocking relationships to industrial concerns or to real estate corporations. Ultimately, those debts or loans have been deflated because of nonperformance. Liberalizing financial structure is one way to help banks manage such risks, but one needs to be wary of the extent of deregulation to be sure there are transparent standards so that examiners can evaluate the risks entailed among the various interlocking subsidiaries.”

Proponents of freewheeling consolidation of financial services anticipate that in the post- Glass-Steagall era, there will be a greater burden on the market to police itself. So long as banks maintain adequate capital, the argument goes, their own self-interest and their growing use of sophisticated risk- management systems will preserve their safety and protect their corporate clients. This is especially true, say some, if banks are allowed to diversify both geographically and productwise. Thus, even during a recession, for example, a bank could offset regional losses with good loans in other parts of the country, and difficulty in one product sector would not necessarily spill over into others.

“Historically, risk management was not a major operating issue for banks,” says Paul Reilly, national managing partner for financial services at KPMG Peat Marwick LLP in New York. But Reilly points out that banks have increased their capitalization dramatically as a result of industry consolidation and earnings growth, and argues that all financial institutions have learned how to diversify their capital exposure to market segments and cycles.

More controversial is banks’ increasing reliance on derivatives to manage their risk exposure, a practice that depends on sophisticated conceptual models to measure the value of assets at risk. As banks expand into new areas of business, their challenge will be to integrate the various “risk philosophies” of insurance products, commercial loans, and so on. Put another way, U.S. banks need to expand their focus on risk from the level of the trading desk to that of the institution as a whole, says Mark Rodrigues, head of global risk practice at American Management Systems Inc., an IT consultancy in Fairfax, Virginia. Europe provides a more positive example to follow. “Europeans haven’t had Glass-Steagall, so their banks had to deal with international currency rates, as well as being brokers, insurers, and retail banks,” says Rodrigues. “Long ago, they were forced to consider transaction-level risk and groupwide perspective.”

Untested Techniques

What worries some is that the derivatives- based risk management techniques are too new to have been tested in a recession. “The problem with these models is that they require constant iterations and refinements,” says Rodrigues. “And, unfortunately, the only way you find out if your models are any good is to have a real recession or a shock. For example, people learned a lot by what happened in Asia; that shock was a way to test the models without bringing down the whole financial system. But there is a danger of so-called model risk–What kinds of insights am I acting on?–and there is just so much regulators can do.” One thing they’ve done is enact new accounting rules that require banks to mark their derivatives contracts to market starting next fiscal year, raising concerns over the stability of their balance sheets and earnings.

Not surprisingly, therefore, pressure is on to improve the reliability of derivatives-driven risk management. “We joke that the only accurate thing on a bank balance sheet is the date,” says Rodrigues, because it is difficult to determine the value of the privately negotiated OTC contracts commonly used, and they are not easily captured on the balance sheet. As Martin Mayer, a guest scholar in economic studies at the Brookings Institution, recently pointed out at a conference on the Asian crisis: “Not the least of the reasons why the Asian currencies and markets fell so far so fast was that nobody knew the extent of the contingent liabilities the banks and their counterparties had assumed in OTC derivatives contracts.”

One recommendation is to require banks to use only exchange-traded derivatives, but Rodrigues believes clever bankers will simply “engineer their way around the exchanges.” He suggests instead a common clearer, similar to the London Clearing House. Such a body most likely would be owned by member banks. It would provide multilateral netting, and would pool default capacities by becoming a counterparty to every transaction among its members, charging them margins to cover its risk. So, banks would retain their flexibility by avoiding the exchanges, but would reduce much of the uncertainty connected with undisclosed counterparty risk.

There is also the fact that risk-evaluation models can become more difficult to employ as the size of the enterprise increases. The most skillful users so far are “small, fluid, fast- moving boutiques like hedge funds,” says Rodrigues. “I think the big, big banks are still grappling with how to use decision analytics. And there definitely is a possibility that they will merge before getting a handle on it. But then, smart CFOs may be able to take advantage of some arbitrage opportunities. I wouldn’t be surprised, for example, if you could get one swap price from the insurance side and have the same swap priced differently out of the brokerage arm.”

Arguably, all that can be said for certain at this point is that the United States is not likely to adopt the universal-bank model à la Europe and Japan. As for the myriad other questions, only time–and the next recession– will provide the answers.

———————————————– ——————————— How Worried Should You Be?
Corporate Finance executives seem generally sanguine about bank consolidation, but they do have a couple of things to worry about. One is that they’ll get stuck replacing pieces of syndicated loans as agent banks acquire secondary players that have bought their unwanted credit exposure.

Recall press reports that NationsBank Corp., when it acquired Barnett Banks Inc. this year, got $20 million in added credit exposure it had previously sold to Barnett. The corporate issuer, Catalina Marketing Corp., in St. Petersburg, Florida, then had to refinance that part of the debt.

An isolated case or a harbinger? “In the short run, there could be some disruptions as banks examine what exposures they have as the result of taking over another bank,” says Jim Davis, president and CEO of Loan Pricing Corp., in New York, which tracks syndicated lending. But longer term, Davis says, two countervailing factors may smooth things out. The greater capital base of a consolidating bank probably means it can keep a larger piece of the loan, he says, while continued interest from nonbank investors could keep the secondary market for the rest of the loan “quite robust.”

Another concern, given the widespread use of derivatives, is increased counterparty risk. While mergers have had little effect on bank credit ratings, the potential for greater risk concentration and volatility may encourage large companies in particular to be more cautious.

For example, says Wilson Ervin, a managing director in structuring and corporate marketing in New York at London-based Credit Suisse Financial Products, “Big dealers like us often have collateral or credit-support provisions that limit our exposure to another big dealer and enable us to do an enormous amount of business with them. That fact is something big corporations historically have not had to bother with. But they may have more interest in a world with fewer large banks.”