Wednesday, June 27, 2012

The Bank Fee Paradox: Can Less Be More and More Be Less?

We ended our last post, “The Key to Understanding How Your Banker Thinks is a 4-Letter Word”, with the question about whether or not it is wise to “beat your bank down” on fees.
While everybody likes to save money, when we look at our banking relationships from a holistic organizational perspective, things can become a little more complicated.

It is Possible To Lower Our Bank Fees
If we have opened up a copy of our favorite finance publication in the past year, be it Treasury & Risk, CFO, the AFP Exchange, etc., chances are there will have been an article or some advice about reducing the fees we pay to our bank.
We can do this in a number of ways.
·         We can bid out the business using a Request For Proposal (RFP) process at regular intervals, such as every three years or so.
·         We can use market studies such as Phoenix-Hecht’s annual reports or the Association of Finance Professional’s resources as a way to determine where fees are out of line and negotiate our fees down.
·         We can use third party firms, who have their own fee databases, who will evaluate our banking activity and are compensated through a percentage of the fee reduction they obtain.

There Are Powerful Incentives to Lower Our Fees
Any of these approaches will likely result in reduced fees, and there are a number of factors which encourage us to undertake this endeavor.
First and foremost is the fact that fee reduction is tangible. We paid x last year, and we paid y this year (y being lower than x), and therefore we saved x - y. The numbers are on the page and cannot be disputed. We have proof that we have done a good job.
Secondly, there is often the organizational push to “beat the budget”. The leadership approaches the business units and support areas with the “The year has been tough so far, can you give me an extra 1%, or 3%, or 10% cost reduction so we can still hit our performance targets by year end?” Bank fee reduction, usually one of the significant Treasury budget line items after personnel, is a tempting pot from which to meet this challenge.

Let’s Review RAROC
Some would claim that the Treasurer’s job #1 is “Don’t run out of cash”. Part of how we accomplish this is to rely on a certain amount of credit capacity so that we have sufficient liquidity and capital available for the needs of the business during the course of the year. That being the case, it is crucial that we consider things from the bank perspective in order to secure this source of funding.
As discussed in “The Key to Understanding How Your Banker Thinks is a 4-Letter Word”, banks utilize RAROC (Risk Adjusted Return on Capital) models when making their credit deployment decisions.
One way we can put ourselves in our banker’s shoes is to work the RAROC process in reverse. We can calculate our credit capacity as follows:
·         Figure Out What You Spend with the Bank - Let’s say that we spend in total ²1 million per year on banking activities with our bank or banks (for those new to Treasury Café, the symbol ² stands for Treasury Café Monetary Units, or TCMU’s).
·         Estimate What Goes to Their Bottom Line – Through industry studies and our network of contacts, we believe that the bank’s margin on these products is about 50%, so ²500,000 goes to the bottom line.
·         Estimate the Amount of Capital Our Bank Holds Against Our Credit - Finally, through a thorough review of Basel III and our country’s banking regulations, we know that the bank needs to hold 15% of capital against their line of credit to us.
·         Determine an Acceptable Return on Capital for Our Bank’s Investors – through a market and cost of capital analysis, we calculate that our bank needs to earn at least 11.11% on their capital (though of course they will tell us they would like to earn more!).

Figure A
Putting all of the above together, our bank will extend us ²30 million in credit. The calculation is shown in Figure A.

What’s The Catch?
So what is the problem with all this?
Let’s say that for our organization the ²30 million in credit is exactly what we need.
The following day our CFO comes around, after having been badgered by HR, IT and others that those other departments have contributed more budget cuts than the finance and accounting group, and insists that we look at cutting our bank fees.
We dutifully call up the bank, throw reams of fee data at them, threaten them with an RFP, and consequently they reduce their fees by 10%, so that we now pay ²900,000 annually for their cash management services.
Now our CFO can hold his/her head up high at the next meeting with the other organizational groups. “Hey, I contributed a ²100,000 reduction to our goals!”

Figure B
However, when our line of credit comes up for renewal, our bank is unwilling to extend us the ²30 million we require. Should we be surprised? Figure B tells us we should not. Given our tendency towards fee reduction, the bank will put some buffer into the number calculated, and will say that ²25 million is the most they can do at this time.
While we have cut our fees, we now do not have the credit we need to conduct our business.

Can Paying More Fees Reduce Costs?
What this example shows is that there is a trade-off between credit capacity and bank fees.
Absent any line of credit, in order to ensure adequate liquidity is to set aside cash in a “rainy day fund”. Since this is permanent, we can look at this through a combination of debt and equity issuance.
Looking at our ²5 million gap due to our fee capacity, if we have an 8% weighted average cost of capital (the cost of both debt and equity at our “target capital structure”), then raising this will cost us ²400,000 annually to raise our liquidity need. This would be offset by the return on investing this cash, since we would have it most of the time unless we experienced the “rainy day”.
At today’s rates, this return would be negligible, perhaps ½%, so we might earn ²25,000 per year on investing this cash.
As discussed in our last post, a line of credit will cost a market rate comparable to our Credit Default Swap rate, so for sake of this example let’s say that is 4%. If we could raise this in credit it would cost us $200,000.
Comparing the two:
·         Cost of Financing Alternative – ²375,000 (²400,000 cost of capital – ²25,000 investment return)
·         Cost of Credit Facility – ²200,000
·         Difference – ²175,000
Now let’s compare this to the last section. In that, we saved ²100,000 annually by beating our bank down on fees, though this will cost us credit capacity.
Replacing this credit capacity will cost us ²175,000, so in aggregate we pay more than if we had left the bank fees alone!

So why isn’t everyone running around increasing the fees they pay to banks in order to secure adequate liquidity?
Some of the reasons are:
The Balance Between Short-Term and Long-Term - Line of Credit Agreements are usually for a set term, so the credit capacity you give up does not occur right away, but sometime in the future. For this reason, if the immediate need is short-term cost reduction, bank fees are fair game because the increased cost offset of obtaining more liquidity discussed in the last section does not happen until later.
This is Not an Exact Science – RAROC calculations require a number of adjustments, each of which may be “tweaked”, so there is no such thing as an absolute minimum hurdle to get across.
It’s All About the Future – The banking relationship is somewhat long-term in nature (with most bankers, anyway). Thus, the bank will have some willingness to earn sub-optimal returns in expectation of a bonanza later. One means corporations have at their disposal to accomplish this is capital market deals. They may happen sporadically, but the fees on these can make up for years of skinny returns.
Bankers are Dime a Dozen – if we have a bank that dials back their credit commitment, new banks may be enticed to take their place, and face it, there are plenty of fish in the sea. Getting a new bank on-board will require the future potential of fees but there is an acknowledgment that this will take time to occur. After 4 or 5 years, if it doesn’t pan out, they drop you and a new bank takes their place, all gushy about the new relationship with stars in their eyes. After 4 or 5 years….

Key Takeaways
Bank fees cannot be taken in isolation, they need to be viewed in a holistic organizational context, with the understanding that there is a relationship between fees and credit capacity. Because there are mitigating factors and the time required for this relationship to fully play out occurs over many years, it can be easy to lose sight of this relationship or reduce its priority in favor of other more pressing items. However, to those that possess the desire to establish honest, straight-forward, win-win long-term relationships, it is a dynamic that needs to be carefully considered.

·         How important is the long-term relationship to you versus other short-term objectives?
·         Which of the caveats are most important to you or your organization?
·         How much credit does your organization require vs. its capacity to support it through fees?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!


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