Banks are constantly on the lookout for ways to squeeze more revenue out of their corporate clients, complaining that margins on big ticket lending are less than half what they earn on lending to small businesses and personal customers. So, should large corporates feel sorry for their banks? And should they take advantage of the new products banks are offering in the spirit of working together for ‘mutual advantage’? The answer to the first question is no; to the second, perhaps.
Most banks have traditionally regarded large corporate assets as unprofitable. They used to look at their absolute return on equity (ROE) and set this against the Basle minimum regulatory capital requirement of 4%, or more realistically 5% to keep the Bank of England happy. So, if a bank provided a £100 loan it needed to set £5 in equity against it to comply with the regulations. At this time, banks were earning returns below their cost of capital, which is estimated as being at least 9% per year on big company lending.
The issue today for the banks when working out the profitability of a loan is whether to look at the regulatory or the economic capital requirement. The latter, which has come into use in the past five years or so, is generally defined as shareholders’ equity less certain items such as the cost of equity. It enables a bank to look squarely at its cost base and is perceived as core, or pure capital. As such, it allows a bank to allocate less capital for loans to large corporates. Certainly, banks can use economic capital when lending to a company such as ICI where the risk is so small it eliminates all worries about meeting regulatory requirements. As a result, banks are beginning to allocate less capital to large corporates – they can get away with £2 or £3, instead of £5, against that £100 loan. Hence, their returns are not now as low as they would like their customers to believe.
Philip Middleton, head of banking strategy at consultancy KPMG, points out that the pressure to achieve a high return from large corporate customers was a driving force behind the UK banks’ diversification. ‘The entire thrust has been to improve returns from corporate relationships,’ he says. ‘For one thing, the banks have been looking at automating part of their relationship, providing clients with electronic platforms. This ties the client in and it is he who does the work rather than the bank. Banks are also looking at innovative instruments, derivatives, risk and cash flow management. They are even toying with the consultancy approach by taking on the role of adviser to their corporate clients.’
It should be noted, however, that banks are withdrawing fairly rapidly from this latter role as margins in banking are better than in consultancy, and there are also litigation risks, particularly in the US. Outsourcing is perhaps the outstanding up-and-coming area that banks are pushing – and they are trying to woo corporates with promises of working together as allies, suppliers and customers.
There is also a sound argument for farming out complex operations involving derivatives to the banks. ‘It is a good idea for corporates to be able to hedge their foreign exchange risk and use interest rate swaps,’ says Trevor Pitman, corporate managing director at rating agency Fitch IBCA. ‘Where they can run into trouble is in perceiving the treasury function as a profit centre rather than as a servant of the company. The treasurer’s role is to arrange financing for acquisitions, for instance, not to take positions in the market.’ It was only a decade or so ago that Allied Lyons got itself into hole in the derivatives market, and these days the banks are moving away from plain vanilla products to offer complex risk management, such as leasing facilities. In these areas it is better to let the banks deal with the risks and not try to replicate their business.
The flavour of the month in outsourcing is treasury management. Here the decision is essentially one of company size. It is to the advantage of small companies to outsource, but for large corporates it is important to retain control over treasury operations as a part of their strategy. Outsourcing can reduce a company’s reliance on banks, though. Indeed, large companies should focus on credit rating upgrades, since many have better ratings than their banks and can borrow money cheaper in the wholesale market.
Then there is the question of which bank does what best. Barclays and NatWest got into investment banking in the 1980s – both failed because shareholders were unhappy with the returns earned and would not tolerate pouring in the capital required to compete with the global investment banks. Today, many UK corporates use German or Dutch banks as providers of these services because they are more advanced than their British rivals and because their shareholders are used to 10% returns. Indeed, for many European banks, corporate banking represents nearly half of their business and they do it well. As a result, there is every reason for a UK corporate to take this part of its business abroad.
Jules Stewart is a freelancejournalist.
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