By Joseph Neu
A recurring presentation by treasurers following a financial crisis is to recount the benefits of having solid relationship banks. Crises are what test these relationships, the story goes, and treasurers say they have long memories when it comes time to reward the solid and penalize the fleeting relationships.
While a good bonding story makes for a memorable conference presentation, few treasurers will find only solid relationship banks in their bank group, nor should they always want this. Relationships come with a cost for commitment. For most treasurers, therefore, an optimal bank group will mix in some less solid transactional banks to lower their overall cost of credit. How do you determine the right mix for your firm?
Key Modeling factors
A recent working paper from the Bank of International Settlements, “Relationship and Transaction Lending in a Crisis,” offers a framework to help model your mix of relationship and transactional lending banks.
No surprise: Determining the right mix will depend on how well your firm is set up to weather a crisis, the extent you rely on bank financing, plus the appetite your firm has for risk. And what if your assessments of the above, and the strength of your “relationship” banks’ commitments, prove wrong?
However, it also will be driven by two other fundamental bank relationship factors:
1) Your willingness to pay up for credit and the services that support that credit during good times so that the relationship bank has a vested interest in remaining committed when times are bad.
Ideally, the relationship bank, so compensated at the upside of the cycle, should not jack up its pricing as substantially as do the transaction-oriented banks that priced themselves low to win your business when everyone was flush. Put another way, the optimal mix should deliver a favorable all-in cost of credit over a full cycle, with some account for the risk or insurance premium your firm is willing to pay to have more banks willing to stand with them in a crisis.
2) Your willingness to share information with your banks and your banks’ understanding of this information to mitigate your perceived credit risk. This aspect of banking relationship management, where relationship banks often have a distinct role in learning about a borrower’s type over time, is central to the model the BIS working paper developed to assess relationship versus transactional bank lending.
The good news is that the paper’s empirical analysis confirmed its basic prediction: (1) that relationship banks charged a higher spread before the crisis; but (2) offered more favorable continuation-lending terms in response to the crisis; and (3) suffered fewer defaults. This confirmed for the authors the informational advantage of relationship banking.
The bad news is that the study was of Italian banks (before and after the Lehman crisis). More importantly, the model is biased to smaller, privately owned firms that have limited access to capital markets and where the information advantage of relationships banks is arguably highest.
Having said this, treasurers wishing to apply some quantitative rigor to the fine art of bank relationship management may want to explore the model math the paper presents.
Risk goes both ways
Also worth considering is the paper’s assessment of bank risk. Paying relationship banks a bit more in good times makes them less risky, if they manage themselves right, in good times and bad. Consistent with emerging bank regulation, banks should build up a capital cushion in good times to help sustain them (and their lending and other economically important activities) in bad times.
The paper’s empirical analysis indicated that part of a relationship bank’s offering of superior loan pricing post-crisis, relative to transaction banks, is driven by their financial position. Thus, treasurers who care about relationship banking should probe their banks on capital and encourage retaining earnings for capital cushions. The information flow should go both ways.
Unfortunately, the paper’s authors conclude that the aggressiveness of less well-capitalized and lower-cost banks (and they should include non-banks) will continue to undermine true relationship banking. This, they imply, is why regulation is needed.