Assessing the new do-it-yourself approach to corporate borrowing

The structural reforms imposed on global banks after the global financial crisis of 2008 are affecting banks in ways that create new challenges and opportunities for corporate borrowers.

As a result of that crisis, banks are required to reserve an increasing amount of equity as buffer for potential future credit losses. The size of that buffer is calculated as a percentage of total loans and other credit instruments weighted by the risk of default for each loan or credit obligation. 

Regulation encourages banks to outsource credit decision-making

Rather than maintain their own systems and data to support credit risk assessment and loan portfolio monitoring and keep up to date with changing regulations, banks can rely on external providers. The main ones are credit rating agencies S&P and Moody’s, which are in an ideal position to provide this service because they also provide the risk rating frameworks and data used by national and international regulators.

Banking is highly leveraged. Until 2010, banks needed only $2 of equity at risk to be allowed to use $100 of a depositor’s money in their credit-related businesses. After the financial crisis, the minimum was increased to $4.50 and it will rise to $7 in 2019. Banks will have to significantly raise their margins on credit-related products if they are to sustain the returns to shareholders they have achieved in the past.

Banks track return on capital for every product and service

Banks are trying to calculate the return on capital for every credit product and service they offer. For large borrowers, the calculations are part of the credit approval process and drive the pricing required to meet the bank’s targets.

Services, such as cash management, trade finance and other fee-based services, require little or no equity for the bank to sell them and can appear to be much more profitable. From time to time a bank will instruct its sales force to push the products and services that require less capital and restrict sales of capital-intensive ones such as loans.

When a bank sees its quarterly earnings as coming from the sale of products and services to customers instead of from long-term relationships with clients, loans that are not profitable will be rejected even if the relationship is profitable.

This can be happening inside any bank, and the challenge to borrowers is understanding when it might be a significant factor affecting the way their bank deals with their banking requirements.

Standardization across banks creates opportunity for borrowers

The opportunity for corporate borrowers comes from the way credit assessment is being standardized across banks. Because it is essentially that which is used by the major credit rating agencies, who in turn are required to make their rating methodologies and much of their information public, borrowers can find out the key issues, benchmarks and comparisons that apply to their company and industry to get an idea of where they stand.

The do-it-yourself credit application

When considering a major transaction or seeking to avert trouble in the relationship with its lender, it makes sense for a company to prepare what is effectively a do-it-yourself bank credit application, with all of the information, financial data and forecasts that a lender would have to prepare to get a loan approved on its behalf.

Leaving it to the bank to prepare a credit application from scratch is inefficient and prone to errors that the company might never know about because banks typically don’t share their analysis with borrowers. By coming to the first meeting with a comprehensive draft application, a borrower can be confident that facts are accurate and presented in the best possible way.

Your banker will thank you

Your banker will be grateful, because writing up even a $1 million loan application is the most time-consuming part of the process.

The credit manager who reviews your application will also thank you. Having to fix applications that the credit analyst started from scratch and finished in a hurry is the bane of their existence. If they see the basis for a sound loan, and have the time, they will often do it, but why would a prudent borrower take that risk?

The risk is not reduced by simply going to multiple banks. Without a borrower-prepared draft they would also have to start from scratch to prepare an application that would have less chance of being accepted, so their motivation is commensurately less.

Of course, if a borrower has done the work of preparing that draft credit application, the effort required for the alternative lender is much less, and they will be able to provide a proposal conditional on the details of the draft application being confirmed in due diligence.

The DIY approach to financing is now available to borrowers who want to have a deeper understanding of how they are perceived by prospective lenders and are serious about reducing the risk that financing might not be available when they need it.

Guy Heywood is a Vancouver-based finance and treasury consultant. He is giving a talk entitled The ABC&Ds of Credit Ratings on October 19 at a luncheon hosted by the Vancouver chapter of the Association of Financial Professionals.