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Bank of America: The turnaround challenge of the century

January 26, 2012: 9:23 AM ET

Bank of America has been in perpetual damage control mode since the 2008 financial crisis. But it's now crunch time. The bank can't just cut its way to profitability; it needs to grow its revenues too.

By Cyrus Sanati, contributor

FORTUNE -- Bank of America has set some lofty cost-cutting and revenue-enhancing goals, but it remains unclear how it is going to achieve them. The bank has yet to post any measurable declines in operating costs, despite it already entering the second phase of its self-induced cost-cutting bonanza. Meanwhile, the firm has seen its top line shrink quarter-after-quarter with no relief in sight. Brian Moynihan, Bank of America's chief executive, will need to show investors some results quickly.

Bank of America's stock has rallied in the last month on optimism that the company can turn things around this year. Nevertheless, it is still trading below where it was in August when solvency rumors caused its shares to tank. At the time, a cash infusion by Warren Buffett and a debt exchange helped boost the firm's capital cushion to levels that placated nervous investors concerned about the billions of dollars of bad mortgages on its books. At the same time, the bank had assembled a task force of executives and consultants charged with cutting the fat and streamlining the bank's disparate operational silos.

The cost-cutting undertaking, which the company calls Project New BAC, would be implemented in two phases. The first phase would target cuts in the retail banking, credit card and back office while the second would target the investment bank and the front office. The first phase had a target of $5 billion in net expense reductions to be achieved by the end of 2014, while the second phase had a target of less than $5 billion on a little longer time frame. News reports say that Phase II will be targeted at $3 billion in cuts, but Bank of America (BAC) has yet to confirm that number, saying just that it will be less than the cuts achieved in Phase 1 of the project.

But the bank has been cryptic as to what specifically it will cut. It has said that it wanted to slash 30,000 of its 280,000-strong workforce as part of the first phase, but noted that it would achieve that goal over several years, with the majority of the cuts coming from normal attrition and by not filling vacated roles. Beyond that, it was normal synergy stuff, like combining data centers and consolidating operations.

The second phase of the plan started up in October and is expected to continue through March of this year. The bank has been even more enigmatic about what it plans to cut on this end, saying only that it will target those operations not covered in Phase 1. Reducing banker pay should be top on this list. There is talk that the bank is set to announce a 25% pay cut across the board for employees in its investment banking unit, but the bank would not confirm those reports.

Top line challenge

So how is the New BAC doing on the cost cutting front? The company gave pink slips to 7,000 employees, closed 13 branches and started combining their data networks in the fourth quarter. But instead of falling, operating expenses at the bank actually rose by a whopping $1.8 billion in the fourth quarter compared to the previous quarter to $18.8 billion. Most of the extra costs were lumped under a obscure line item called "other expenses." The increase in costs might have been excusable if operating profits were up, but they weren't, they were actually down, way down. The bank posted a $32 million operating loss for the quarter compared with a gain of $6.9 billion in the previous quarter. A number of one-time gains brought it into the black.

It might be unfair to judge the New BAC so early in the process, but first impressions count for a lot. Bank of America is expected to post significant cost cuts down the road as it begins to pare down its special mortgage assistance unit. But it is unclear when the bank will be able to do that as customers continue to need help with their troubled mortgages.

But Bank of America can't just cut its way to profitability; it needs to grow its revenues too. This is where things get a bit hairy. New regulations have cost the firm billions in revenue, which will never return. The Durbin Amendment, which reduces the bank's take from debit card transaction, is costing it $500 million a quarter in lost revenue. The Volcker Rule, which bars depository banks from engaging in proprietary trading and limits investments in hedge funds and private equity ventures, is slated to cost the bank a large sum of cash in the coming years.

Bank of America's earnings have also been hit very hard from the sharp decrease in net interest income. Low interest rates, instituted by the US Federal Reserve, have squeezed margins on the firm's loan business. Things won't get any better on this front until at least the middle of 2013, which is the earliest the Fed said it would consider raising rates. Until then, the bank's net interest margins will be severely depressed.

Despite the gloomy outlook, Bank of America management continues to plug on. A Bank of America spokesman told Fortune one way the bank hopes to grow its revenue is by cross selling various financial products across business lines. For example, the bank will try to incentivize its Bank of America checking account customers to open a brokerage account with Merrill Lynch through giveaways and freebies. The bank wants to create a seamless platform so its customers can manage their mortgage, checking, savings and brokerage accounts in one place. They believe this will be a major draw for clients and will increase client retention.

Similar financial supermarket models have been tried in the past and failed to yield positive results for the bottom line. The bank also said that it wanted build out its investment banking business abroad. There is a lot of money potentially locked up in places like Latin America and the Middle East where capital markets are booming. But bankers aren't cheap, so Bank of America might find that it will need to spend more, considerably more, if it plans on growing this business.

Bank of America has been in perpetual damage control mode since the 2008 financial crisis. But it's now crunch time. The bank is done selling off assets, so it can't count on those big-ticket sales to pad the firm's bottom line next quarter. It needs to find innovative solutions and invest in growth areas. So far, the firm has been successful in grabbing market share from the other banks in some key areas, like mergers and acquisitions. It will need to be far more aggressive in other areas if it hopes to stay in the black, or else it might find itself needing another big loan from a wily billionaire.

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