DRIVERS OF CHANGE, INNOVATION, AND CONSOLIDATION IN THE FINANCIALSERVICES INDUSTRY

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CHAPTER 2

• DRIVERS OF CHANGE, INNOVATION, AND CONSOLIDATION
  IN THE FINANCIAL-SERVICES INDUSTRY

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Learning Objectives

• To understand
• 1. The drivers of change in the FSI as the
  components of TRICK
• 2. Innovation as a diffusion process and the
  technological and contractual aspects of
  innovation
• 3. Consolidation and corporate restructuring in
  the FSI, especially bank mergers

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Chapter Theme

• Heraclitus, the Greek philosopher, said All is
  flux, nothing stays still. Nothing endures but
  change.
• This chapter focuses on change in banking and the
  FSI and what drives it
• Innovation and consolidation, among other things,
  reflect the effects of the changes driving
  banking and the FSI

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COMPONENTS OF A DYNAMIC MODEL OF CHANGE TRICK

• Transparency
• Risk exposure
• Information technology
• Competition for customers
• Kapital adequacy
• Model TRICK Rational Self-Interest
  Financial Innovation

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TRANSPARENCY

• Readily understood, clear, or easily detected
  with regard to financial statement information,
  disclosure, monitoring and discipline by holders
  of debt and equity contracts, market valuations,
  and accountability of managers, directors, and
  safety-net managers

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RISK EXPOSURE (leads to)

• Risk-Management Techniques
• Asset-Liability Management (ALM)
• Credit Analysis
• Derivatives Futures, Forwards, Options, and
  Swaps
• Securitization

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Exposure to What?

• The risks of banking
• 1. Credit risk
• 2. Interest-rate risk
• 3. Liquidity risk
• 4. Foreign-exchange risk
• 5. Operational risk
• 6. Solvency (capital-adequacy) risk depends on
  the risks above

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INFORMATION TECHNOLOGY

• The information standard has replaced the gold
  standard as the basis for world finance
• - Walter Wriston

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COMPETITON FOR CUSTOMERS

• Basic Ingredients to Attract Customers
• Price
• Convenience
• Confidence (federal safety net/guarantee)

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KAPITAL ADEQUACY

• Market Discipline
• Costs of financial distress and cost of funds
• Regulatory Discipline
• Risk-based capital requirements
• Graham-Leach-Bliley Act of 1999
• Community Reinvestment Act (modernization tied to
  fairness)

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INNOVATION AS A DIFFUSION PROCESS

• Innovation -- the introduction of something new
• Ex 1961 introduction of the first negotiable
  certificate of deposit
• Preliminary Distinctions
• Invention (discovery) vs. innovation (profitable)
• Autonomous innovation vs. induced innovation
• Market-induced innovation vs. regulation-induced
  innovation

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NEW TECHNOLOGY AND PRODUCT DIFFUSION

• August 2000 Internet Penetration for U.S.
  Households 41
• Top Ten Cities for Penetration
• San Francisco (66)
• Seattle (64)
• San Diego (62)
• Portland (62)
• Washington D.C. And Boston (59)
• Denver and Kansas City (57)
• Orlando (56)
• Baltimore (55)

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DIFFUSION OF E-BANKING

• Except for ATMs, diffusion rate has been slow
• Paper currency and checks are still used for the
  overwhelming majority of consumer payments, while
  electronic transfer, such as those made over the
  ACH, account for a very small fraction. In
  contrast, for the major money and securities
  markets in this country, electronic payments are
  the rule rather than the exception
• -- Edward W. Kelley, Jr.

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INNOVATION AND THE DESIGN OF FINANCIAL CONTRACTS

• Two Basic Contracts of Banking
• 1. Deposit Account
• Checking Accounts
• Savings Accounts
• Certificate of Deposits
• Individual Retirement Accounts
• 2. Loan Agreement
• Fixed or Adjustable Rate Mortgages
• CI Term Loans
• Automobile Loans
• Credit-Card Loans

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CREDIT EXTENTION BUILDING BLOCKS

• The Blocks
• Zero Coupon
• Fixed Rate
• Variable Rate
• Amortized

• Can Be Viewed In Terms Of
• Present Value
• Future Value
• Payment
• Interest Rate
• Number of Periods

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Background TVM Formulas

• Panel B of Table 2-2 presents the
  time-value-of-money (TVM) formulas on a pair-wise
  basis
• 1. PV and FV of a lump sum
• 2. FV of an annuity (payment) and annuity
  repaying a future amount
• 3. PV of an ordinary annuity and annuity repaying
  a present value (loan-recovery factor, e.g., for
  a mortgage payment)

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TVM pair

• Formula
• FVPV((1i)n)
• FVnA(((1i)n-1)/i)
• PVA((1-(1/(1i)n))/i)

• Reciprocal
• PVFV/((1i)n)
• AFVn(i/((1i)n-1))
• APV/i(1-(1/(1i)n)))

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THE COSTS OF INNOVATIVE FINANCIAL PRODUCTS AND
REPUTATIONAL CAPITAL

• Legal, accounting, regulatory, and tax advisors
• Computer systems for pricing and trading
• Capital and personnel to support market-making,
  and
• Educating issuers, investors, and traders

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BACKGROUND TO BANK CONSOLIDATION

• Within an industry within a country
• Across industries within a country
• Across countries but in the same industry
• Across countries and industries

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MOTIVES FOR CONSOLIDATION

• Cost Economies
• Economies of Scale
• Economies of Scope
• Market Power
• Managerial Agency Costs
• Exploitation of the Federal Safety Net

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Alternative Merger Hypotheses

• Hypothesis Source of value creation
• Information ID Undervaluation
• Market power Horizontal mergers
• Synergy Cost efficiencies
• Taxes Tax (financial) synergy
• Inefficient mgmt Mismanagement
• Earnings diversification Higher cash flows

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MA in Banking and the FSI

• Citigroup merger (1998) predated GLB Act (1999)
  and helped force passage of the act
• JPM and Chase (2000)
• Bank of America and NationsBank (1998)
• Wells Fargo and Norwest (1998)
• Hostile takeovers (SunTrust failed in its bid for
  Wachovia First Union won the battle but lost
  its name)

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View Consolidation in Terms of the ROE Model

• ROE (Return on Equity) ROA x EM
• ROA (Return on Assets) PM x AU
• (ROEPM x AU x EM)
• Profitability (accounting) measures are PM
  (Profit Margin), ROA, ROE
• Sales, turnover, or utilization measure is AU
  (Asset Utilization)
• Leverage factor is EM (Equity Multiplier)

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BANK ORGANIZATIONAL FORMS IN THE US

• Independent Banks
• One-Bank Holding Companies
• Multi-Bank Holding Companies
• Together, BHCs and independent banks are referred
  to as BANKING COMPANIES

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PHENOMENA DRIVING DECLINE IN OF BANKING
COMPANIES

• Mergers among BHCs
• BHCs acquiring viable independent banks
• The failure of independent banks during the 1980s
  and 1990s
• The whole banking structure is turning into an
  oligopoly in which four or five institutions
  dominate any particular geographic-based market
• -- Furash

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A Long View

• Year Unit banks Branch banks Total
• 1935 13,329 796 14,125
• 2000 2,733 5,848 8,581
• Change -10,596 5,052 -5,544
• Counting ATMs, point-of-sale systems, automated
  clearing houses (for direct deposit), and
  opportunities for home banking via the Internet
  numerous e-based systems for delivering financial
  services also exist, besides the traditional
  brick-and-mortar banks and branches

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CONSOLIDATION

• Mergers
• Takeovers and Hostile Takeovers
• Anti-Takeover Strategies
• Shark Repellants (offering company to friendlies)
• Poison Pills (offering low-cost share to owners)
• Greenmail (borrowing money-creating debt)
• Golden Parachutes (buyer to pay big to execs)

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Competition and Access to Financial Services

• The Fed favors the industrial-organizational (IO)
  model, which has the following linkages, given
  the conditions of supply and demand
• Market structure Conduct Performance

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MERGER AND ACQUISITION STRATEGIES

• Hit em where they aint
• Ex KeyCorp and Interstate Banking
• Buck the Merger Trend
• Ex SunTrust but then a failed hostile-takeover
  attempt

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OPPORTUNTIES FOR COMMUNITY BANKS IN THE MERGER
ENVIRONMENT

• Businesses are Worried About
• Fewer Local Banks (16)
• Fewer Customized Services (18)
• Less Responsive to Community (26)
• Decline in Customer Service (28)

• Community Banks are
• Worried About
• Credit Unions (78)
• Brokerage/Securities Firms (63)
• Other Community Banks (60)
• Mutual-Fund Companies (52)
• Regional / Money-Center Banks (41)
• Farm-Credit Banks (40)

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Regulatory Concerns

• Safety
• Stability
• Structure (competition)

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Chapter Summary

• TRICK Rational self-interest Financial
  Innovation
• T Transparency
• R Risk exposure ( risk management)
• I Information technology
• C Competition for customers
• K Kapital adequacy