The Key to Understanding How Your Banker Thinks is a 4-Letter Word

The banking relationship is critical to any business that relies on bank credit for their liquidity, working capital, and financing needs. Without this access to credit, the business may at be unable to meet its current obligations and face bankruptcy and liquidation, or be forced into a mode where it cannot take advantage of growth opportunities and/or pare back its existing operations.

Because of this, there is a dynamic involved whereby the bank has seemingly a lot more power in the relationship than the business. After all, the bank does not go out of business if they do not provide a loan or line of credit to us. They go on their merry way with seemingly endless funds stuffed in their coffers.

If we are able to get past this seeming discrepancy, we can help put ourselves in a better position to make our bank relationships a lot more productive and a lot less discomforting. Putting ourselves in our banker’s shoes is one way to go about doing this.

Banks Are a Business Too

One critical thing to understand is that a bank is a business too. While we might imagine all our problems would be solved if we had billions at our disposal to dispense as we saw fit, for the bank this is the central business question.

These billions are actually liabilities on the banker’s balance sheet. The funds that they acquire come from deposits in various products such as checking accounts, savings accounts, money market accounts, short-term loans, long-term loans and equity.

A loan or line of credit supplied to a business is an asset from the banks point of view. And just like any business, it needs to earn enough on its assets to provide an acceptable rate of return to its investors.

Bank Capital Requirements

For every loan a bank makes, be it to a company, a consumer credit card account, etc. it is required to keep some funds in reserve to provide a buffer or cushion against losses. Often this buffer has a mandated minimum that is set via the regulatory process.

The newest regulations coming into effect with respect to this are the Basel III accords. These specify a series of capital requirements that are going to be phased in over the years until 2018.

We are not going to delve into Basel III at this point because it’s not really required to understand a banker’s thinking from a strategic perspective, which is the aim of this post.

Example

So let’s take a simple example. Bank X provides a line of credit to Farmer Joe’s Agricultural Empire in the amount of ²1 million (the symbol ² stands for Treasury Café Monetary Units, or TCMU’s) in order to provide working capital funding. It is a 5-year credit facility.

Given the credit rating of Farmer Joe’s and the assessment of Loss Given Default (LGD), Probability of Default (PD), and Exposure at Default (EAD), the bank is required to hold 15% of its equity capital against this line of credit.

Bank X charges Farmer Joe’s 2% annually for this credit facility. Given Farmer Joe’s credit rating, its Credit Default Swaps currently trade at around 2% as well (for information on pricing Credit Default Swaps, see “Into the Belly of the Whale: Hedging and Credit Default Swaps”).

A Necessary Tangent on Arbitrage and Market Pricing

The fact that the credit facility costs and the CDS pricing is the same is not a coincidence – if there was a big difference between the credit facility cost and the “market” there would be an ability to arbitrage, which would ultimately lead to a narrowing of the price gap.

Why is this the case? If Bank X were to propose charging Farmer Joe 5%, while CDS prices were 2%, Bank Y would come along and propose to Farmer Joe that they will give him a Line of Credit for 4.75%. Since CDS prices are 2%, Bank Y would net 2.75% risk free by turning around and selling this exposure in the CDS market. Bank Y would end up with no exposure to Farmer Joe (since it sold the exposure in the CDS market for 2%), while receiving 4.75% by providing the credit.

Seeing the chance for “free money”, Bank Z would gladly provide Farmer Joe with credit for 4.5%, since it could offload this risk onto the market for 2%, and therefore get 2.5% of money-for-nothing in the transaction.

You can see where this is going – any bank offering credit to Farmer Joe above the market price of the credit risk will be undercut by another bank, since free money in any amount is attractive.

Conversely, the number of banks offering Farmer Joe less than 2% for the line of credit will be few, as they will be locking in a loss on the provision of credit versus the cost of that credit in the market.

So because there is a market, the cost of credit is generally set via the classic Supply and Demand curve as depicted in Figure A. The pricing occurs where the Demand for Credit (line “D”) intersects the Supply of Credit (line “S”).

Getting to the Four Letters

Given that Bank X is required to hold ²150,000 of equity against its line of credit provided to Farmer Joe, and knowing that its equity investors require some sort of economic return on their investment, Bank X will calculate a Return on Capital just like any other business would do.

Since the amount of equity it is required to hold depends on the risk of the loan, the acronym most important to the bank from the business perspective is the Risk Adjusted Return On Capital, or RAROC (the acronym has 4-letters, one is used twice).

If real estate is "location, location, location", the banking business is "RAROC, RAROC, RAROC".

Something Does Not Add Up

But wait…in the prior section we just determined that Bank X will charge 2% because the market cost of credit is 2%, so this is a wash. Where does the bank earn its return?

The RAROC calculation the bank performs is done on the basis of relationship or product. An example of relationship would be their line of credit with Farmer Joe’s Agricultural Empire. An example of product would be a consumer credit card business.

Since Bank X provides Farmer Joe credit, and there is a strong relationship between the two institutions, Farmer Joe does its cash management activity (checking accounts, investment sweep accounts, etc.) with Bank X as well. Let’s say that this activity results in fees being paid to Bank X every month in the amount of ²3,000.

Let’s go on further to say that Bank X’s costs associated with this cash management business (IT, personnel, taxes, etc.) is 50%, or ²1,500. Thus, ²1,500 goes to the “bottom line” (²3,000 - ²1,500). Annually, Bank X earns ²18,000 on its banking activity with Farmer Joe.

Bank X’s RAROC is therefore 12% - calculated by its net earnings of ²18,000 divided by its capital deployed of ²150,000 (from the line of credit).

What would be Bank X’s RAROC if Farmer Joe did not do its cash banking with Bank X? As established earlier, since the provision of credit will generally offset the market cost of that credit, there is nothing that goes to the bottom line for that activity, therefore it would be ²0 divided by ²150,000, or 0%!

Imagine You are a Bank Investor

If you are an investor in bank stocks, which bank would you want to buy shares of: Bank X, earning 12% on its equity, or Bank Y, earning 0% on its equity?

The critical distinguishing feature we introduced in the last section, and the reason we go from 0% to 12% return on equity, is the fact that Bank X is doing other banking activities with Farmer Joe’s that does not require capital but earns fees. In the banking world this is known as “ancillary business”.

Because lending requires the bank to set aside equity, banking activities that require this “use the bank’s balance sheet”. There is only so much equity on the bank’s balance sheet that it can use, so this is a finite resource for the bank.

On the other hand, the ancillary business the bank performs is not restricted by the balance sheet, so the crux of the banking business hinges on maximizing the ancillary business vs. the use of the balance sheet.

Imagine yourself as an investor again. If two banks each use ²1 billion of their balance sheet, then the bank that derives more income from ancillary business than the other will be the more profitable, and the one you will want to invest in (all other things being equal).

This being the case, Bank X, faced with the choice of lending to one of two companies, will lend to the one where the chance of ancillary business is higher and will not lend to the one where the chance is lower. This is how they maximize the use of their balance sheet.

Implications

Now that we understand the RAROC concept, and how this drives a bank to maximize the ancillary business vs. the use of the balance sheet, we can understand some of the thinking that occurs.

When Congress passes laws restricting late fees on credit cards, this causes the ancillary business to be lower. What must the bank do to stay even? Either find new fees to charge to offset what they are losing, or curtail the use of the balance sheet (e.g. lending) to keep the ancillary business vs. balance sheet ratio the same.

Key Takeaways

Banks, in order to earn adequate returns for their investors, seek to maximize the generation of ancillary business opportunities given their balance sheet capability.

Questions

·         If credit is vital to your business, does it make sense to "beat your bank down" on the fees it charges?

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