Inside your banker’s head: companies are starting to figure out how their banks make money. Banks actually like that
July 10th, 2007 by moniesBut, alas, even the banks getting bupkis wouldn’t budge. With nary a word about losing money, they all signed on.
Welcome to the loose end of the credit cycle. But beware. Bankers obviously expect something in return for the favorable five-year backup credit lines they’ve been handing out lately. And when the credit cycle turns tight, complaints about hurdle rates will again make life awkward for companies that try to maintain access to credit through a diverse bank group. Such discussions have strained personal banking relationships in the past, yet they’ve also increased corporate awareness about the way banks calculate their returns. Going forward, companies that adopt this sort of quantitative analysis for themselves may find that it not only supplements traditional relationships, but strengthens them. Indeed, banks are surprisingly willing to help CFOs build models that can distinguish between legitimate gripes and sales pitches.
RAROC and a Hard Place
Some 20 years ago, Bankers Trust Co. first began using a risk-adjusted return on capital–or RAROC–model to evaluate the profitability of a transaction given the risk profiles of its commercial borrowers and the resulting return on the bank’s capital. Today, such return models have become all but ubiquitous in the banking industry. So accepted are they that regulators are in the process of allowing banks to determine for themselves how much regulatory capital they must set aside for each transaction (see “Basel Faulty?” page 51).
For many corporate customers, however, RAROC has a bad reputation. Most first heard the term used as a cudgel, with bankers telling them that they weren’t profitable customers and then pressing for other business in exchange for credit.
“Most banks began to internalize the idea that large corporate lending is unprofitable about five years ago,” says Nick Studer, head of the North American corporate and institutional banking practice at Mercer Oliver Wyman. The 1999 repeal of the Glass-Steagall Act, which had formerly separated investment and commercial banking, was quickly followed by flameouts in the M&A market, the IPO market, and the last generous credit cycle. “It’s these last five years that made bankers realize that cross-selling is not a luxury, it’s a necessity,” says Studer.
But handled clumsily, particularly by the investment banking arms of newly formed universal banks, cross-selling irked many corporate customers. Indeed, in the past few years, the Association for Financial Professionals has been surveying its members about such practices, strongly hinting that they might constitute illegal tying. “Cross-selling is what retail bankers do well,” notes Studer. “On the investment banking side, honestly, it’s not something they do well. It’s boring, and not as sexy as chasing deals.”
Nor was the reputation of RAROC helped when some banks simply stopped lending to certain companies–even whole industries–based on their risk profiles. “We actually had a lead bank drop us in 2000,” recalls Jeff Burchill, CFO of commercial property insurer FM Global. “They decided to drop all insurance companies because they didn’t like the risk profile.”
“Up until this time, banks and companies have had a combative relationship,” observes Studer. Indeed, banks have had reason to complain as well. Corporate customers, after all, didn’t hesitate to tie their banking business to demands for credit. And they rarely showed any understanding of their bankers’ needs. “Clients used to haul out a spreadsheet listing all their banks in descending order of credit commitment and noncredit fees,” says Bradley A. Hardy, senior vice president of corporate banking at Wells Fargo Bank N.A. “But they were only looking at the revenue line; they were not looking at profit at all. You can imagine profitability in an M&A transaction is vastly different than a cash-management business.”
Show Me the Model
Increasingly, however, RAROC-style return models are contributing to improved corporate banking relationships. “Corporates are getting more sophisticated,” says Studer. Bankers agree. “Clients are developing a better understanding and appreciation for the return models that we use,” notes George Calfo, head of Citigroup’s national corporate bank. “We think that’s positive.”
Author: Tim Reason
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