Furthermore, banks are facing higher expected loss ratios, as most corporate credit ratings have deteriorated as part of a bigger global trend over the past decade. Only four companies, all headquartered in the US, still retain an AAA credit rating, these being Microsoft, Johnson & Johnson, ExxonMobil and ADP. There were more than 60 AAA-rated companies back in 1979, only 21 in 1992 and two years later in 1994 this figure had reduced further to 14.
Banks’ Core Business and Ancillary Services
Regulatory requirements such as Basel III are introducing new measures to ensure that banks are able to survive in a stressed financial market environment. For that reason, capital and liquidity ratios need to be increased and less leverage is permitted, decreasing interest margins and profitability on the credit a bank provides.
All these developments cumulatively have a significant negative impact on the risk-adjusted return on capital (RAROC) of a bank. At the same time, banks’ shareholders are requiring a higher return on equity (ROE) due to the higher business risk associated with the banking industry. To create shareholder value (i.e. RAROC > ROE), banks will therefore need to be very selective in their supply of already scarce credit and will try to cross-sell ancillary banking services. For that reason, traditional transaction banking products such as payments, cash management and investment solutions are nowadays very attractive from a banking perspective, because these products have limited, if any, impact on capital requirements on the bank’s balance sheet.
Furthermore, transactional banking is considered a gateway business into foreign exchange (FX), trade finance, corporate finance, merger and acquisition (M&A) advisory and investment banking. As a rule of thumb, for every €1 made in transactional banking there could be up to €5 made across a banking group.
Challenging Corporate-to-Bank Environment
When one looks at the demand for credit, more than €130bn-worth of corporate debt has already matured or is maturing in 2014 in the Europe, the Middle East and Africa (EMEA) region. This implies that refinancing is a critical topic for a vast amount of corporates, which want to ensure they are able to meet their financing needs in the near future.
The gap between a low supply of and a high demand for credit will lead to a challenging corporate-to-bank relationship. It is therefore essential for a corporate to carefully select its core banking partners both in the number of core banks it selects and as to what business it assigns to each bank, making a distinction between treasury, risk and finance requirements. One of the key questions is how this can be done effectively.
Pre-crisis, a multinational corporation (MNC) could have a few or even one single ‘house bank’ that would take care of all its regional and/or global banking requirements. However, from a counterparty risk and diversification point of view this situation is no longer acceptable post-crisis. For evaluating multiple banking partners, a frequently used methodology is wallet distribution, in which the amount of corporate banking business assigned to a banking partner – both direct and indirect banking fees – is compared to the provided credit commitment of that banking partner.
This strategic approach allows a corporate to evaluate whether each banking partner’s reward balances its commitments and to compare the relative performance of different banking partners. Banks from their side will calculate a wallet-adjusted return on capital (WAROC) on a corporate client. This WAROC concept is derived from a traditional RAROC, but improves the performance metric by measuring the credit commitment against the total direct and indirect banking revenues, which include the revenue from ancillary services.
Building Long-Term ‘Win-Win’ Relationships
The use of the wallet distribution methodology and WAROC in a bank evaluation and selection process can provide a corporate with the required insight into the revenue expectations of a banking partner and also bring objective arguments to the table. Corporates can select those balanced banking partners that best provide the required banking products and services in combination with a fair amount of credit. Furthermore, they can challenge or even eliminate those banks that receive an imbalanced return in excess of the credit they commit.
It is, however, important not to limit the discussion to this ‘reward versus commitment’ trade-off, but to account for other, less quantifiable variables as well – considering that a successful corporate-to-bank relationship involves multiple points of contact. It is possible that a banking partner underperforms in terms of wallet distribution, but can provide a strategic insight into the corporate’s industry or business and recognises specific supply chain funding (SCF) requirements or is offering complementary value-adding services. In such cases it may not be wise to end the relationship merely based on a mismatch in the Wallet Distribution approach. However, being an efficient credit provider or payment processor will no longer be enough in itself. Banking partners are increasingly required to take on the role of strategic business partner, who can bring new and innovative ideas to the table.
Building long-term banking relationships does not exclude building profitable relationships. If a corporate has a decent understanding of the revenue expectations of its banking partners, the corporate-to-bank dialogue is significantly improved. The ranking of the bank relative to others may be shown and the reasons why it earned more or less than other banking partners can be clarified. Keeping in mind the fundamentals of any good working relationship – commitment, mutual respect and trust – is essential. Eventually, banking relationships could become ‘win-win’ partnerships, with the banking partner having a commitment to provide credit facilities and deliver outstanding products and services. For these facilities, it is rewarded correctly via a corporate’s banking
Capital Markets are Disrupting the Traditional European Banking Landscape
In Europe, corporates are still very tightly connected to their banking partners, as 70% to 80% of corporate funding is still provided by banks. However, over the past couple of years, more corporates have been looking to diversify their sources of funding through disintermediation, attracting funds directly from investors in the debt capital markets (DCM). This practice is well established with US corporates, which rely for a large part on a market-based funding model instead of a traditional bilateral or syndicated bank debt funding approach, which is
the more common approach in Europe
As the tightening of credit and Basel III are making the available credit more expensive, more corporates are turning to DCM to issue bonds, for example, to meet their funding needs. This is creating significant revenue opportunities for investment banks, facilitating a disintermediation role. According to a recent Deutsche Bank report, investment banking revenues – a major source of ancillary income – could rise as high as €6bn in the long run.
As a result of risk management concerns, the pre-crisis trend towards a limited number of banking partners has been reversed. While corporates are looking for core banking partners who recognise their specific funding requirements, banks have to be selective about whom they are supplying credit to, as they are facing decreasing margins because of tense market conditions and higher capital requirements. Each corporate-to-bank relationship will be evaluated on the total revenue it brings in for the bank versus the credit commitment for the corporate. Ancillary services are becoming more important as they provide a steady stream of income without raising expensive capital requirements.
Although credit commitment and price competition remain important measures and must be key factors when selecting core banking partners, corporates should extend their analysis to include other factors such as customer service, banking technology, geographical footprint and the ability to offer value-added advice on a strategic level. Ideally a corporate will have a diversified mix of different types of funding, with bank funding coming from a core group of partners who are committed for the long-term and rewarded accordingly. Constructing this core group will be a challenging but valuable and inevitable operation.