However, I believe that future success using this strategy will depend more on developing new customer and ‘sticky’ relationships than new or better transactions.
In other words, banks have ‘suddenly’ discovered that lending is a low-margin and risky business. As a result, they are seeking new ways to sell services that are more profitable on a risk-adjusted basis, to give them the growth in earnings their investors require.
This approach is not new.
Having started his career on the banking side (JP Morgan, Bankers Trust company), the writer came to banking when ‘success’ was all about building ‘relationships’ – where a bank tried to be a full service vendor to its customer and provided lending, cash management, fiduciary and foreign exchange (FX) and more.
The payoff from a relationship came when a customer liked their bank so much they rewarded it by keeping millions on deposit. This policy was used, for example, by EXXON so the bank would answer its calls promptly. The value of these excess deposits made the relationship very profitable, but was more a reward for service than product.
Customers often stayed with their banks for years because of service and responsiveness by their banker. The bottom line was that banks had a steady source of income and customers felt ‘happy’ and comfortable with their relationship manager.
As deregulation came into its own years ago and US depression-era regulations were repealed, banks focused on transactions, such as leveraged buyouts (LBOs), loan sales and others. Furthermore the larger and more creditworthy customers started to bypass the banks to go to the credit market for some or all of their needs. Relationships started to decline, evincing the following responses:
- Banks started offering more loans at London Interbank Offered Rate (LIBOR)+ instead of the old US prime rate. The result was that loan margins declined, while risk went up. Customers looked for the best price, regardless of the bank.
- Bankers Trust was one of the first banks to syndicate loans, although it’s unclear how much this helped the customer. This strategy of reducing assets increased a bank’s return on assets (ROA) and return on equity (ROE), but meant the bank cared less about a customer’s loan. After all, once they had sold it where was the relationship?
- Basel regulations made banks focus on regulatory capital: As a result, banks looked at their lending from a risk perspective to find that lending was a high volume/low margin business. To boost income, they needed to ask what else they could sell.
- To support profit growth Bankers Trust invented the idea of cash management services as a profit centre, because transaction services used little regulatory capital/were less risky. In combination with lending, the overall businesses supported a higher risk adjusted return on capital (RAROC).
Over time banking income, especially fee income, from all types of transactions grew to spectacular heights – but so did risk as banks became highly levered, exposed to the market and each other via loan purchases.
Eventually, financial gravity took over.
Benefits and Pitfalls
The recent Great Recession exacerbated the bank’s ability to create and maintain relationships; customers looked to different banks after hearing ‘no’ too many times, as so many were licking their (often self-inflicted) wounds.
Also, customers wanted banks they could depend on. The more creditworthy companies with sufficient liquidity from operating cash flow either bypassed banks or borrowed less. To overcome lower loan growth, banks would lower their rates to sell more, taking on the same, if not more, risk. The latest Basel III capital adequacy rules only reinforced the idea that lending had become more risky.
As a result, transaction banking remained one of the few businesses that banks could offer at reasonable, risk adjusted returns. After all, payment execution provides a steady stream of income. A transaction banking strategy is inherently more profitable for banks; for one thing fees come upfront while interest income is over the life of a loan; however, this strategy has its own flaws:
- All banks will want to do it: Many banks selling standard transaction services will mean prices – and income – will decline over time. How much can a bank charge for a SWIFT payment when everybody offers it? Also, most payment transactions look the same to a company, so what is the advantage of selecting bank A over bank B?
- Banks are bad at offering bespoke services: Bespoke services can generate higher margins but require a keen insight into a company’s operations, almost as if the sale were a consultative assignment. Also there is a constant need for investment in research and development (R&D) to design state-of-the-art, but limited use services. Furthermore, companies may not be able to use these services without themselves investing in changes to policies and procedures so they can take advantage of these new services to track cash, work, accounting flows, etc. Finally, bespoke products require the bank to hire and retain highly skilled product specialists, not just salesman selling the ‘product du jour’.
- Paying for services by leaving cash on deposit may no longer be ‘best’: Banks will find that seeking customer deposits as a method of payment may be restricted under the new Basel III liquidity rules, unless the company can clearly relate their deposit levels to operational needs. This link is something even companies may not know (i.e. it requires them to produce accurate cash forecasts). Also, rising interest rates will cause companies to find better uses for their ‘excess’ cash. Consequently, the value of any income derived from deposit balances will decline – forcing banks to carefully price each service, so it clearly exceeds their own global operational costs and provides an appropriate profit margin. Lower deposit levels will require companies to pay more in fees. Higher fees will make companies demand more transparent pricing, something that could hurt a bank’s ability to raise its prices.
- New transaction business will become more difficult to attract: Transaction processing is a double-edged sword. Once a company has hooked up its back office to a bank’s transaction services it will be loath to change. As a result, winning new business will be difficult as well as costly for the new bank. What company would change banks and risk loss of control over their payment processing just to achieve a modest saving? Banks could be sucked into heavily discounting services upfront just to attract new business.
On the positive side, any bank that can offer high-quality standard or bespoke services and properly tracks each customers’ ‘relationship income’ (transaction services + lending + FX + trade + fiduciary + card) can boost ROA and ROE, since transaction services require little ‘A’ or ‘E’. Also, the use of contractual language and multi-year contracts can be used to ensure a steady, if not spectacular, stream of income for years.
Truth be told, bankers are better at this transaction type of strategy than corporates are. Indeed, how many corporates today can tell you what they spend globally at their banks and for what, or if they received the service quality they paid for.
Given this new strategy, the French express it best: plus ça change, plus c’est la même chose!
While many still think the banking sector is characterised by legacy systems and lack of innovation, this could not be further from the truth. 2018 marks the year when a multitude of external factors will shake up the industry once and for all and reinvent the way people bank. Inevitably, this presents a threat, but also an opportunity.
The global economy has seen about eight years of growth, but we are starting to see the end of this which is triggering some volatility in global markets, Stefan Bielmeier, DZ Bank, argued in his keynote speech at the Bellin annual 1TC conference. Other speakers discussed blockchain, cyber crime and netting.
A series of governments are now very worried about the idea of bitcoin and these currencies because customers would be able to make sustainable ongoing transactions and payments without having to ever introduce the use of a typical financial model or banking system. To combat this potential threat, several countries including major central banks like the Bank of England and the Bank of Israel will be launching their own version of a cryptocurrency. This could bring big advantages to customers.
When it comes to the relationship between Europe and Britain – uniformity isn’t a word that currently springs to mind. And that’s not just a reference to Brexit. Whilst the Europe and Britain do find themselves in the midst of a political break-up – their monetary policies are also showing signs of divergence.