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Capital Markets

How Much Money Banks Expect to Make to Be in Your Facility

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May 03, 2019

Calculators to help treasury understand how banks decide what they must earn to be in a revolver.

Accounting-MoneyTreasurers managing share of wallet issues with their banks know too well the subtle and unsubtle ways bankers let them know they need to generate more revenue (fees) from the relationship to meet internal return targets. And, no surprise, these conversations often take place when treasury is renewing its revolving credit facility. No quid pro quo, of course. But pressure is pressure.

Knowledge is power. To relieve some of that pressure, NeuGroup’s Scott Flieger, a former Wall Street capital markets executive, put together two calculators designed to help arm treasurers with knowledge before they talk to bankers about the fees treasury pays. The calculators provide back-of-the-envelope, ballpark figures of what banks expect to earn when committing capital to a revolver. Mr. Flieger unveiled the tools at a recent meeting of NeuGroup’s Assistant Treasurers’ Group of Thirty.

Sausage ingredients. Before plugging numbers into the calculator, it helps to know some basics about what’s going into the sausage. The first calculator, shown below, computes return on equity from a core Tier 1 capital (CT1) ratio perspective, the dish we’ll digest today. We’ll discuss the ingredients used to cook up return on equity from a leverage ratio perspective in a future article.

The corporate. For the multinational, the relevant variables to use this calculator include the size of the revolver and the notional commitment for the bank. The maturity of the revolver also matters (most are five years) and whether it will be used or “drawn” (most never are). Last are the bank’s internal ratings of the company’s credit worthiness and its sector (some sectors are obviously riskier than others). For this exercise, we’ve assumed a commitment of $100 million for five years and an internal rating of A.

The banks. Banks want to make enough money to meet so-called capital productivity hurdles, often expressed as a return on equity (RoE) objective. We’ve assumed 10% for this exercise. To figure out how much revenue the bank will have to make to justify a $100 million revolver, we start by calculating the impact of the commitment on the bank’s risk-weighted assets (RWA), an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses.

In this example, RWA impact is computed by multiplying the amount of the revolver by a percentage that’s based on that internal credit rating discussed above that is the basis of calculating RWA. In our example, you end up with $15 million in RWA impact; and we’ve tacked on another $5 million in additional RWA. 

ROE Model

The context. Banks calculate RWA because of regulatory reforms codified in the Basel III accord following the financial crisis that required them to increase the level and quality of capital they must maintain. RWA is used primarily to calculate a bank’s core Tier 1 capital ratio. Tier 1 capital is comprised primarily of common stock (equity) and retained earnings. The core Tier 1 capital ratio = CT1/RWA. Our calculator assumes the bank has a CT1 target ratio of 12%.

The upshot. Basel III was designed to ensure that banks maintained an adequate amount of CT1 relative to the risks of their business; so the more CT1 capital a bank needs to maintain, the more revenue it needs to achieve its ROE target. After accounting for the bank’s cost-income ratio (how much it spends to earn every dollar of revenue) and its tax rate, we calculate the bank would expect to generate $1.23 million in gross revenue for the hypothetical MNC examined here. Some members at the AT30 meeting expressed frustration that the bank’s overall cost structure would affect how much it expects to earn from one relationship.

The caveats. This is a very simple way of understanding how to estimate how much banks need to earn when they commit to a credit facility. And as discussed above, another article will explore the other way banks approach capital productivity, namely by looking at return on equity from a leverage ratio perspective. That’s the other capital ratio affected significantly by Basel III. To be sure, as Mr. Flieger said at the AT30 meeting, the decision-making process for a bank evaluating a revolving credit facility almost always involves both qualitative and quantitative variables. What’s in this calculator is just part of the possible quantitative piece of the process.

Want to use the calculator? For more information about this calculator and how banks view capital productivity, please contact Mr. Flieger at sflieger@neugroup.com.

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