“There is an element of truth in the assumption that corporates are borrowing more in a low interest rate environment,” says Gordon Scott, an analyst at Fitch Ratings. “However, for the banks this does not automatically translate into a hit on the revenue line. There is a difference in funding cost and lending rate, and so far banks have been able to hold up their margins pretty well. In fact, you can argue that this is a more attractive time for the banks to be lending, as there is less pressure on asset quality.” Low rates also cut both ways, as they reduce a bank’s borrowing costs.
The issue for banks is where they obtain their spread of returns, regardless of interest rate movements.
One could argue that since unsecured lending brings the highest rate of return on capital, the banks should be collecting deposits and lend out on credit cards. But since the last recession, UK banks have learned that this involves massive risk implications. So the key lies in a proper diversification of risk, which brings areas such as corporate lending into the picture.
If HBOS, which has the leading share of retail savings among UK banks, is pulling in deposits at 10 basis points and lending out to a corporate at 50bp to 200bp over prime, this can be a reasonable business providing the bank has done a proper credit appraisal.
The banks are certainly not showing any signs of closing their balance sheets to corporate customers. Royal Bank of Scotland, the UK’s biggest lender to the corporate sector with more than a 35% market share thanks to its acquisition of NatWest, looks to be poised for an upswing in this segment of the business. The bank’s lending was up 15% in the first half of last year, but then slowed to 9% growth over the past 12 months. Now the group’s chief executive, Fred Goodwin (pictured), has indicated that the time may be ripe for credit expansion in the corporate sector. “The foot is going back on the accelerator in corporate banking and we will probably put our foot down a little harder if the credit metrics allow it,” he said recently.
A low interest rate scenario inevitably implies some margin compression, as the impact becomes more visible. But the banks have largely come to terms with the problem of the past, which in the recession of the early 1990s virtually brought a shutdown in lending business. That problem was the inability to price credit properly.
Since then, all the high street banks have done a lot of work to build credit worthiness models, and this has paid off in higher margins on lending. As a result, asset quality has remained stable and has even shown signs of improvement.
Banks can also protect themselves against falling rates by borrowing in the market at fixed rate and swapping that into floating, in effect, hedging at a better rate for payment.
If corporates are not beating a path to their lending banks, this reflects the fact that credit demand is more closely tied to robustness of earnings than interest rates, according to Walter Pompliano, director of financial services ratings at Standard & Poor’s.
“Bank lending is now more selective, banks are careful on pricing and they are better assessing their risks,” he says. This has had a salubrious effect on non-performing loans. “We don’t see a deterioration in the corporate book or any significant increase in provisioning,” says Pompliano. On the other hand, he points out that corporates still don’t have much of a business case for borrowing. “I don’t see the banks overburdened with credit requests,” he says.
It may still be too early to call the bottom of the market, and this is largely due to the disintermediation effect of companies side-stepping their traditional bank lenders to issue debt. The bond markets are not as developed in Britain as they are in the US, which had more than $4 trillion in corporate debt outstanding at the end of the first quarter of this year. But it is growing and corporate treasurers need to keep an eye on cash flow because banks can spring nasty surprises on customers who have more debt than equity.
Such was the case of Playtex Products, which recently ended up in hot water when its lenders imposed a higher rate on one of its loans and the company was found to be cash flow negative. So far, this problem has not surfaced to a worrisome level in the UK market.
By and large, corporates that have survived the UK restructuring have learned how to manage their debt burden. Hence, banks’ lending margins are holding up well, and the coming months should bring a return to growth in corporate lending.