From Market Value Of Equity To Potential Value Of Equity

The market capitalization of a universal bank is what it is, a product of a broad spectrum of quantifiable and not-so-quantifiable factors such as those discussed in the previous section. Looking ahead, managing for shareholder value means managing for return on investment, in effect maximizing the 'potential value equity' (PVE) that the organization may be capable of achieving. In the merger market this would be reflected in the 'control premium' that may appear between the bank's market capitalization and what someone else in a position to act thinks the bank is worth.

The Chase is Dead. Long Live the Chase

Take the case of Chase Manhattan. The bank had suffered for years from a reputation for underperformance and mediocrity, despite some improvement in its results, better strategic focus, improved efficiency levels and a cleaned-up balance sheet. In January 1995, Chase's stock price was $34, with a return on assets a bit under 1 per cent, a return on equity of about 15 per cent, a price-to-book ratio of about 1.2 and a price to earnings multiple of 7.0. Exhibit 9.9 shows Chase's stock price performance relative to the S&P 500 and the S&P Money Center Banks during 1991-94.

In April 1995, investment manager Michael Price, Chairman of Mutual Series Fund, Inc., announced that funds under his management had purchased 6.1 per cent of Chase's stock, and that he believed the Chase board should take steps to realize the inherent values in its businesses in a manner designed to maximize shareholder value. At the bank's subsequent annual meeting, Price aggressively challenged the bank's management efforts: 'Dramatic change is required. It is clear that the sale of the bank is superior to the company's current strategy . .. unlock the value, or let someone else do it for you'.11 Chase's Chairman, Thomas Labreque, responded that he had no intention of selling or breaking up the bank. By mid-June 1995 the Mutual Series Fund and other institutional investors, convinced that Chase stock was undervalued, were thought to have accumulated approximately 30 per cent of the bank's outstanding shares and the stock price had climbed to about $47 per share. Labreque announced that the bank was continuing its efforts to refocus the bank's businesses and to reduce costs.

During June and July of 1995, Chase and BankAmerica talked seriously

900 800 700 600 500 400 300 200 100 0

Source: Bloomberg.

Exhibit 9.9 Comparative return analysis: Chase Manhattan Bank, 1991-1995

about a merger in which the BankAmerica name would be retained. Then BankAmerica suddenly backed out for reasons that were not totally clear to outsiders at the time.12 Chemical Bank followed quickly with a proposal for a 'merger of equals'. According to Chemical's chairman, Walter Shipley, 'This combined company has the capacity to perform at benchmark standards. And when we say benchmark standards, we mean the best in the industry.'13 Labreque agreed, and the negotiations were completed on 28 August 1995. Chemical would offer to exchange 1.04 shares of its stock for every Chase share outstanding, an offer reflecting a 7 per cent premium over the closing price of Chase shares on the day before the announcement.

The combined bank retaining the Chase name thus became the largest bank in the United States and 13th largest in the world in terms of assets. The new Chase also became the largest US corporate lending bank, one of the largest credit card lenders, and the largest player in trust, custody and mortgage servicing. Shipley became chief executive, and Labreque became president. Substantial cost-reduction efforts were quickly launched (including large-scale layoffs and branch closures) aimed at reducing the combined overhead of the two banks within three years by 16 per cent. In the month following the announcement of the merger, Chemical Bank's stock rose 12 per cent.

Labreque denied that shareholder pressure had anything to do with the merger. Michael Price asserted that he had not played a major role, but was happy to have been in the 'right place at the right time'. Nevertheless, adjusting for the exchange offer and the post-merger run-up in Chemical's share price, Chase shares more than doubled their value in a little over six months based on the market's assessment of the potential value embedded in the merger. What was the source of the added value?

Realizing the Potential Value of Equity

Clearly, merger transactions in contestable markets for corporate control are - as in the case of Chase Manhattan - aimed at unlocking shareholder value. The intent is to optimize the building-blocks that make up potential value of equity as depicted in Exhibit 9.2 - realizable economies of scale, economies of scope, X-efficiency, market power and too-big-to-fail (TBTF) benefits, while minimizing value losses from any diseconomies that may exist as well as avoiding to the extent possible conflict-of-interest problems and any conglomerate discount. Evidently the market agreed in this case, amply rewarding shareholders of both banks, especially those of the old Chase.

At least in the United States, bank acquisitions have occurred at price-to-book-value ratios of about 2.0, sometimes as high as 3.0 or even more. In eight of the eleven years in a recent study (Smith and Walter, 1996), the average price-to-book ratio for the US banking industry acquisitions was below 2.0, averaging 1.5 and ranging from 1.1 in 1990 to 1.8 in 1985. In two years, the price-to-book ratio exceeded 2.0 - in 1986 it was 2.8 and in 1993 in was 3.2. These values presumably reflect the opportunity for the acquired institutions to be managed differently and to realize the incremental value needed to reimburse the shareholders of the acquiring institutions for the willingness to pay the premium in the first place. If in fact the value-capture potential for universal banks exceeds that for US-type separated commercial banks, this should be reflected in higher merger premiums in banking environments outside the United States.

Pressure for shareholder value optimization may not, of course, be triggered by an active and contestable market for corporate control, but it probably helps. Comparing cost, efficiency and profitability measures across various national environments that are characterized by very different investor expectations and activism suggests that external pressure is conducive to realizing the potential value of shareholder equity in banking. In terms of Exhibit 9.2 and the empirical evidence available so far, the management lessons for universal banks appear to include the following:

• Don't expect too much from economies of scale.

• Don't expect too much from supply-side economies of scope, and be prepared to deal with any diseconomies that may arise.

• Exploit demand-side economies of scope where cross-selling makes sense, most likely with retail, private and middle-market corporate clients.

• Optimize X-efficiencies through effective use of technology, reductions in the capital intensity of financial services provided, reductions in the workforce, and other available operating economies.

• Seek out imperfect markets that demonstrate relatively low price elasticity of demand, ranging from private banking services, equity transactions that exploit 'fault lines' across capital markets, and leading-edge emerging-market transactions that have not as yet been commoditized, to dominant 'fortress' market-share positions in particular national or regional markets, with particular client segments, or in particular product lines. The half-lives of market imperfections in banking differ enormously, and require careful calibration of delivery systems ranging from massive investments in infrastructure to small, light, entrepreneurial and opportunistic SWATs (Special Weapons Action Team). The key managerial challenge is to accommodate a broad array of these activities under the same roof.

• Specialize operations using professionals who are themselves specialists.

• Where possible, make the political case for backstops such as under-priced deposit insurance and TBTF support. Although this is a matter of public policy, shareholders clearly benefit from implicit subsidies that don't come with too many conditions attached.

• Pay careful attention to limiting conflicts of interest in organizational design, incentive systems, application and maintenance of Chinese walls, and managerial decisions that err on the side of caution where potential conflicts arise.

• Minimize the conglomerate discount by divesting peripheral non-financial shareholdings and non-core businesses, leaving diversification up to the shareholder. The gain in market value may well outweigh any losses from reduced scope economies and earnings diversification. Pursuing this argument to its logical conclusion, of course, challenges the basic premise of universal banking as a structural form.

• Get rid of share-voting restrictions and open up shareholdings to market forces.

• Pay careful attention to the residual 'franchise' value of the bank by avoiding professional conduct lapses that lead to an erosion of the bank's reputation, uncontrolled trading losses, or in extreme cases criminal charges against the institution. It is never a good idea to cut corners on compliance or building an affirmative 'culture' which employees understand and value as much as the shareholders.

Exhibit 9.2 shows some of these as a 'recapture' of shareholder-value losses in universal banks associated with diseconomies of scale and scope, conglomerate discount not offset by the benefits of a universal structure, and potential conflict of interest and reputational losses. The balance of any further potential gains involves ramping up key elements of the production function of the bank, capitalizing on market opportunities, and an intense focus on maximizing franchise value and reputation.

If a strategic direction taken by the management of a universal bank does not exploit every source of potential value for shareholders, then what is the purpose? Avoiding an acquisition attempt from a better-managed suitor who will pay a premium price, as in the case of Chase Manhattan, does not seem as unacceptable today as it may have been in the past. In a world of more open and efficient markets for shares in financial institutions, shareholders increasingly tend to have the final say about the future of their enterprises.

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