Money matters: Valuation of the commercial & investment banking industry

Weekly Corporate Growth Report, May 6, 2002 by Bailey, John

Commercial banking and investment banking provide much of the financial fuel required by businesses to drive the U.S. economy. When the economy slows down, as it did in 2001, especially in the last quarter of 2001, less fuel is needed. According to Value Line composite statistics, investment bankers suffered through their worst year in over a decade with revenues falling 10% in 2001 and net profit dropping 33%. The securities industry's most important earning drivers (M&A transactions, equity underwriting and valuations, trading volumes, and margin balances) were weak in 2001 and remained weak in early 2002.

For commercial banks the picture was only slightly brighter. The largest banks, generally federally chartered, managed a modest 6% gain in net interest income (a bank's revenues) in 2001, but suffered a 26% decline in net income following a series of years with rising profits. The big banks incurred big losses on loans to Enron and some other well-known companies like Kmart, as well as on loans to Argentina. In 2001 the smaller, generally state chartered banks were a safer bet as they have little or no exposure to large national and international credit risks. Small banks as measured by Value Line's composite for Midwest Banks experienced a 17% gain in net interest income and a 25% gain in net profit.

The financial service industry also includes a number of sectors that provide financing and services primarily to individuals. Savings institutions, credit unions, mortgage bankers, and investment advisors each provide important functions for savers and investors. In fact, the largest transaction in the DoneDeals database of small-cap transaction in 2001 was the October 2001 $477 million acquisition by Affiliated Managers Group of Friess Associates, LLC, the investment manager and advisor to the Brandywine family of no-load mutual funds.

The DoneDeals results for the financial services industry has shown remarkable consistency over the past six years despite the differences among the sectors that compose the industry. In 2001, 70% of the deals done in the industry were in the banking and savings sectors and 30% in the securities and investment sectors.

Outlook

The outlook for 2002 for each sector differs, as well, depending upon exposure to loan losses and their mix of business. The risks to regional banks are the economic conditions within their own regions. The risks to the larger banks are the likelihood of even more Enrons, closer to home perhaps as the SEC has recently taken a closer look at transactions that some banks have used to remove loans from their books. All banking and credit institutions are concerned that interest rates have bottomed out and will start rising higher pushing up the cost of the banks. Finally, the questions for the securities brokerage companies are how long it will take for the equity markets to rebound and bring back the equity investors and when the M&A market will return.

By John Bailey

Contributing Editor