Banking according to Brown

During ABA's Annual Convention this fall, Editor-in-Chief Bill Streeter had the opportunity to meet with Donaldson, Lufkin & Jenrette Senior Vice-President Thomas K. Brown, the respected and outspoken regional bank stock analyst. Brown had just given a presentation on the future of banking, and the interview covered a range of topics suggested by his comments. (See next page for presentation highlights.)

The dialog that follows is a partial transcript of the interview, edited for length and clarity. In it, Brown moves easily from electronic banking to funding, modeling, and merger premiums.

ABABJ: What's your sense of how the Internet will develop in terms of banking applications?

Brown: A big impact will be felt in corporate banking. One of the reasons I'm less excited about that line of business going forward is that I see the Internet eliminating whole layers of distribution. We're not going to have as many distribution points, and therefore the level of inventory that has to be maintained--and financed--is going to be a lot lower. That has very negative implications for the commercial side of the bank.

"I'd rather see a bank spend a year getting its business right, and then get back on the acquisition track"

ABABJ: What about retail?

Brown: On the consumer side, we're seeing an explosion today in on-line banking. At Wells Fargo, 40% of [new] customers are Internet users; 40% are Quicken users, and 20% are everything else. I just think those numbers are going to continue to grow. There are about 250,000 on-line customers today at Wells Fargo. Eighteen months ago there were 30,000.

ABABJ: You've referred to deposits as a "wasting asset." Why?

Brown: Deposits are why banks haven't had to move as fast as they should move. They've got the inertia of these below-market-rate deposits. But deposits are gradually going to diminish through inheritance. When these funds get passed from generation to generation, they're not going back into the same accounts.

ABABJ: What implications does that have for funding?

Brown: What it says is that these banks are going to have to match fund all their incremental assets going forward. So their new business is going to be at a lower spread than their existing business.

ABABJ: A lot of attention was paid in '96 to consumer credit quality--both by regulators and analysts. Was that overblown?

Brown: If you really believe in managing the business, then you don't manage just one line item. Companies shouldn't manage to have the lowest level of net chargeoffs. It's good for the consumer and good for the bank if they manage the level of chargeoffs relative to risk. So just because my portfolio has a 3% chargeoff rate and your portfolio has a 6% chargeoff rate, it doesn't mean my portfolio is better or more profitable than yours.

Wells Fargo went after a high-risk, high-return credit card customer and had very high loss rates. But when you compare that to going after a low-risk, low-return customer it was a better strategy than the one that apparently had less risk.

ABABJ: Is Wells' small-business strategy of offering pre-approved lines by mail the same thing in principle?

Brown: Oh yeah. When you ask [Vice Chairman] Terri Dial, the head of that business, what is your expected loss rate? She'll say, I don't know, because we do prime plus one and we do prime plus eight. So it all depends on the mix of business that we're going to do. But we've got the product priced for the risk.

ABABJ: But some people have questioned whether the application of predictive modeling and scoring to small business lending--such as Wells is using--has been tested yet.

Brown: Everybody thinks that you have to go through a recession to test losses. But the vast majority of your losses, whether it be consumer or commercial, come from the activities of individual consumers and individual businesses that are not connected to general economic conditions. In other words,"I overborrowed" or "I had the wrong business strategy," and so forth. What I'm saying is you'll know the core amount of losses that will determine product profitability just by doing it. And Wells Fargo's been doing this since 1991.

Tom Brown's Recipe for Success

Donaldson, Lufkin & Jenrette's regional bank stock analyst, Thomas K. Brown, recently finished his third annual state-of-banking report entitled, The Future of Banking Part III. He's used the report as the basis for numerous presentations including a major one at the ABA's Annual Convention this fall. Brown's main conclusion: "The future of banking is marketing and the future of marketing is exchanging value with individual customers." Other highlights: There will be two types of winners: companies that win by being product focused (so-called "category killers"), and companies that win by being customer focused. The vast majority of banks will be of the second type. There is no advantage to size today and no benefit to incumbancy. If there was, how could an Olympic Financial jump from startup to $3 billion in auto loans since 1990?

Banks, and all companies, must become learning organizations. The front-line people are your eyes and ears to what's going on, what works and what doesn't. Traditional skills--managing expenses, controlling risk, managing capital--will let you stay in the game for a while, but won't be enough to let you thrive. To thrive, banks must excel in sales and marketing--must focus on customers, and understand customer profitability. Banks now realize that about half their individual customer relationships are unprofitable. The bad news is nobody at the point of customer contact knows this yet. Therefore the industry continues to offer undifferentiated products and undifferentiated prices. The successful banks will use customer information to build loyalty programs and reduce the turnover among their most profitable customers. Don't worry about having the most sophisticated sytem to measure customer profitability. Even if you just used revenues to start out with and didn't use cost you would still be more effective than today when you treat everybody the same with undifferentiated pricing.

ABABJ: You didn't say much about merger potential in your Future of Banking presentation, other than to note that size isn't what's important. Are there still significant merger-driven savings out there?

Brown: What's happened is that Wall Street has done a good job of being able to estimate those potential cost savings and then transfer the value of those cost savings to the shareholder of the institution being acquired. Using NationsBank's assumptions in the Boatmen's deal, for example, 80% of the value created under the transaction went to Boatmen's shareholders and 20% went to Nations' shareholders.

ABABJ: But isn't it true that even when a bank is criticized about an overpriced acquisition, after a period of time, their stock price comes right back?

Brown: I show two charts when I'm making presentations. One is the relative price/performance of dilutive acquirers. It takes all the banks in the [DLJ] universe and compares the six banking companies I've identified as dilutive acquirers. It shows how their stocks have done versus the bank universe. What you notice is terrible performance. But then you look at the absolute price performance of these stocks and because we've been in this phenomenal bull market for stocks and bull market for bank stocks since 1990, the absolute price performance is up.

I'm a real believer that if we get into a correction or a bear market for equities in general or bank stocks in particular, you're going to see deal activity stop sharply. One of the reasons is there won't be this rising tide to lift all boats. Right now if I underperform because I've overpaid for acquisitions, my shareholders aren't all that upset. Why? Because my stock was up 10% last year, instead of 20%. But next year if the average bank stock is down 10% and I'm down 20%, my shareholders are going to be mighty upset about it.

ABABJ: That's the cost side of the equation. What about revenue potential from mergers?

Brown: Banks like Barnett, Wells Fargo--the ones that are changing the way they do business--will be able to acquire somebody else and significantly improve the revenue generation or the net income from the customer base because they will have determined, how do I maintain my most profitable customers? I think you could see acquisition pricing go higher, and a guy like me who's been skeptical of deals at today's prices may like them better at tomorrow's [higher] prices. The difference is that tomorrow's acquirers will have demonstrated what they can do with those customers.

One of the biggest risks that I see in deals today is that they take management's attention away from fixing the way they do business to integrating another acquisition. I'd rather see a bank spend a year getting its business right, and then get back on the acquisition track. I think that's what Banc One is going to do.