It's 3 a.m. in Detroit. Having treated five of his most important bankers to dinner and a day at the North American International Auto Show, a finance executive invites them to a poker game in his hotel room — where he takes them for $220.
Call it the new face of relationship banking. Not dinner and the auto show (though they're an annual tradition for this executive, who asked that his name not be used), but the poker game — friendly perhaps, but marked by mutual wariness, bluffing, and careful conjecture about the other hands. And one with increasingly significant stakes, as regulators eliminate anti-tying laws and give banks greater control over capital reserves. Also in the cards: a California court case, ultimately bound for the U.S. Supreme Court, that may yet decide whether shareholders can hold banks liable for Enron-style skullduggery.
Not that the relationship hasn't already weathered decades of dramatic restructuring. "Twenty years ago, any bank would be totally state-focused," says Bank of America CFO Marc Oken. "We could tell you all day long how much we made in North Carolina, but we couldn't tell you a whole lot about private bank customers." Oken's historical milestone, the mid-1980s, was also when corporate customers began to discover alternatives to bank credit — notably commercial paper, securitization (see chart, below), and an increasingly efficient bond market.
It's no coincidence, then, that 1984 marked the start of the consolidation that all but wiped out state-based banking. From 1975 to 1984, the number of commercial banks insured by the Federal Deposit Insurance Corp. grew by 112, to 14,496. The following decade, however, it plunged by more than 4,000, to 10,452 in 1994. There are now 7,660, according to the latest available count.
Tie Me Up, Tie Me Down
In theory, these trends should have long ago put to rest the nagging 30-year issue of whether banks illegally make credit dependent on the purchase of other products. Under general antitrust laws, tying is illegal only if the perpetrator has sufficient market power to stifle competition.
But banks have been held to a higher standard since 1970. At the time, Congress feared that state-level dominance would let banks tie products to credit, and amended the Bank Holding Company Act with bank-specific prohibitions.
Banks have long argued that the capital markets and the large number of national and international banks deny them a monopoly. But tying charges have intensified as state banks have given way to megabanks. And the issue exploded in 1999 when the Gramm-Leach-Bliley Act formally repealed the separation of commercial and investment banking mandated by the Depression-era Glass-Steagall Act.
In a survey issued last June by the Association for Finance Professionals (AFP), in Bethesda, Maryland, more than half of 370 financial executives reported that they had been denied credit or had seen their borrowing terms altered in apparent retaliation for not awarding investment banking services to a commercial lender. Under existing rules, that's tying.
Not us, say the banks. "We don't tie," says a Bank of America spokesperson.
In fact, both the Federal Reserve and the Office of the Comptroller of the Currency have concluded that bank tying is not an issue. But the Government Accountability Office has complained that neither regulator contacted any corporate borrowers or analyzed loan pricing before drawing that conclusion.
Complicating the issue, clients themselves regularly (and legally) engage in tying — demanding, for example, syndicate participation in exchange for underwriting work. As one investment banker wrote to CFO, "I was in a meeting recently where a treasurer of a $50 billion-plus market-cap company told us that participation in its credit facility was a requirement to take part in related permanent financing to take out the drawn facility. So it clearly works both ways. Companies are clearly using the carrot of potential banking fees to get inexpensive loans."
Indeed, Greg Lyons, of the finance-services practice of Boston-based Goodwin Procter LLP, argues that at least some tying accusations may reflect corporate misunderstanding of banks' efforts to compete successfully against the capital markets by providing superior service. "Banks are increasingly working to understand their customers' industries and tailor products and services accordingly," observes Lyons, "and that could be perceived by a customer as pushing too hard. There are no bright lines between proper cross-marketing and improper tying."
But the debate may soon be moot. In November 2003, the Department of Justice sent a letter to the Fed urging the bank regulator to exempt all large corporate relationships from anti-tying regulations on the grounds that banks' market power is insufficient for tying to be anticompetitive. "Borrowers in [the syndicated loan] market are large corporations with well-trained and sophisticated staff fully capable of negotiating favorable terms," wrote assistant attorney general R. Hewitt Pate.
If, as widely expected, the Fed adopts the DoJ's suggestion this year, those sophisticated staffs had better sharpen their negotiating skills. "The banks clearly have pushed as hard as they could," says Lyons, "and this would obviously allow them to push farther."
Many borrowers are already used to a tough negotiating environment. The most widespread complaint among AFP survey respondents was banks' requiring that they generate a set amount of banking fees. That's legal, although no less irritating to some treasurers.
Moreover, larger banks increasingly market themselves as one-stop shops. The repeal of Glass-Steagall and the mergers in its wake have created what Oken calls "three universal banks" — BofA, Citigroup, and JPMorgan Chase — "that have significant products and capital and can offer one-stop shopping to middle-market and corporate customers."
Such claims aren't necessarily welcomed by treasurers, who in recent years have also seen banks walk away from their business entirely if denied a lead role in a transaction.
A bank that insists it's a one-stop shop is "the number-one turnoff for me," says Rob Zimmerman, treasurer of Greif Inc., a Delaware, Ohio-based global industrial-packaging firm with more than $2 billion in revenues. "There are a handful that can do most of the things you need, but they also have their weaknesses."
That's a big issue for treasurers whose growing responsibilities demand that they rely heavily on their banks' ancillary services. At Greif, for example, the three-person treasury department manages a working-capital initiative to standardize business and administrative practices around the world. "We literally spend 15 percent of our time performing treasury functions," says Zimmerman. Daily cash management, he says, is reduced to a five-minute funding decision. "It is critical to have a good core group of banks that we can almost turn on autopilot, because we don't have time to handle it."
Greif, says Zimmerman, also seeks long-term partners. "If you are constantly rolling your bank group, it's risky and costly. There's a lot of behind-the-scenes pain and cost associated with constantly moving services around."
A natural wariness of putting all banking business in one basket leads to what he calls his second-biggest turnoff: "The bank that is always crying and whining that it deserves more ancillary business." His complaint: "They should earn it."
How? By justifying their fees. Yet this is rarely done. "No one will tell you what their model is," says Zimmerman. "The hard part is trying to figure out their cost structure for each of those services." That, however, may be changing.
Oken, for example, says bluntly that BofA will cut off unprofitable relationships, but also points out that its cost structure is no secret. "Our cost of capital is 11 percent," he says. "We will either give a customer our model or tell them why their model is wrong."
And more companies are building such models. In 2001, for instance, Columbus, Ohio-based Worthington Industries, a diversified metal-processing company with revenues of more than $2 billion, convinced a handful of its closest banks to help it quantify the return on regulatory capital for each piece of banking business, including nontraditional offerings such as insurance brokerage services and freight payment systems that have grown since the repeal of Glass-Steagall. "We have worked diligently to shift business away from nonbank providers when the same is available within our bank group," says treasurer Randal Rombeiro. The resulting model, he says, is now the "centerpiece" of Worthington's bank relationship management strategy.
Not only is it easier to plan changes in ancillary services, he says, "we can show each one of our banks their own page of the report, with the trailing 12 months and pro forma returns vis-à-vis the consolidated bank group." Indeed, he says the model has dramatically decreased the "solicitation noise level" and improved "the quality of our conversations."
With Friends Like These
Soon, however, such models will have to be risk-adjusted, as the degree of risk posed by a corporate customer will play an increasingly important role in credit decisions. In three years' time, the 8 largest banks in the United States, as well as about 20 others, will adopt Basel II, an international banking accord that allows banks to set capital-reserve levels according to their own risk models, and that can't help but affect pricing.
True, Basel II banks will be able to offer good corporate risks cheaper credit, but that will also squeeze smaller, non-Basel banks. Treasurers can only hope Fed chairman Alan Greenspan means what he said in testimony last April, pledging Fed action if it appears that Basel II "will distort the balance of competition."
Overall, however, Greenspan praised Basel II as the right response to the banking industry's own improvements in risk management, including "the growth in secondary markets for weak or problem assets [that results] in greater liquidity for this segment of bank loan portfolios and the earlier removal of weakening credits from bank balance sheets." Such developments, he continued, make existing regulatory capital requirements obsolete, "although [they] have sometimes helped banks circumvent existing rules."
That last remark is a typically circumspect allusion to the fact that Basel II's dependence on self-regulation may leave unwary borrowers vulnerable to questionable financing schemes. Many of the same basic structures that Greenspan praises for helping banks manage their risk were also abused in the Enron era — helping, and even encouraging, companies to move debt off their balance sheet and inflate cash flows.
JPMorgan Chase and Citigroup, of course, paid fines of $135 million and $82 million, respectively, for "aiding and abetting" Enron. They may have to pay far more to settle shareholder suits — total litigation reserves at just those two banks are $4.7 billion and $6.7 billion, respectively. "One situation can wipe out a tremendous amount of profit," observes banking attorney Rodgin Cohen of New York's Sullivan & Cromwell LLP. "Hundreds of transactions where banks made money are threatened just by Enron. If banks were to settle today, it would require very large amounts of money," he says. But banks are unlikely to do that anytime soon. The Private Securities Litigation Reform Act of 1995 denies shareholders a private right of action against aiders and abettors of securities fraud.
That has focused attention on an otherwise unrelated case called Simpson v. Homestore.com. At issue is whether shareholders can sue Cendant, L90 Inc., and the America Online division of Time Warner for engaging in transactions that helped Homestore.com inflate its reported revenues. Shareholders argue that participation in the scheme by these companies was so deliberate that it makes them "primary actors" in Homestore's fraud — and thus liable. Enron shareholders and groups representing the banking and financial-services industry have filed opposing amicus briefs. Cohen, whose firm wrote the brief for the banks and securities firms, says which-ever side loses is virtually guaranteed to appeal to the Supreme Court. "Enron is going to go on for a long time," he says.
Regardless of the outcome, Lyons predicts that the resulting interest in bank relationships from shareholders' attorneys makes corporate bank deals far more subject to the limelight going forward. "That is going to complicate relationships as banks try to provide all these great products, [yet] try to protect themselves from lawsuits, meritorious or not."
Tim Reason is a senior writer at CFO.