By understanding the levers banks pull to sustain their business, we can increase our bargaining chips to better manage our banking relationships.
Let’s decompose banks’ returns on equity (ROE) to understand the key drivers behind banking business.
If you have heard of DuPont Analysis, you would know that ROE [Net-Profit-After-Tax/Equity] is a function of three key drivers. Mathematically, they are
[Net-Profit-After-Tax/Revenue] x [Revenue/Assets] x [Assets/Equity];
or in financial terms:
[Profitability] x [Operating Efficiency] x [Leverage].
In essence, to increase ROE, banks need to lift each driver. Unfortunately, in recent times, there are cyclical and structural impacts to these three key elements. Banks are actively managing these levers and are showing it through their behaviour in the market.
Profitability, in banks’ management, is best measured by their Net Interest Margin (NIM) which has been in a deteriorating trend in the last 16 years, apart from a small climb between 2008-09, when you may recall there was market-wide repricing by banks.
No matter how much we disliked the upward repricing experience, it was, unfortunately, required in Australia to avoid the risk of the banking failure crisis that occurred in Europe and the U.S.
Besides repricing, banks also protect NIM by altering their own funding strategy.
Unfortunately, the total cost of capital soared ten-fold over the last six years. Pre-2008, Aussie major banks used to raise capital from offshore wholesale market at around 15bps over BBSW. But, since then the costs have gone as high as 200bps before returning to the current level of around100-150bps. Examples include NAB’s €1bn ten-year unsecured notes at 220bps over BBSW and ANZ’s US$750m ten-year sub-debt at 325bps.
To alleviate pressure from wholesale funding, Australian banks shifted their funding sources from a ratio of 60:40 overseas wholesale versus local depositor sources to the current 40:60.
However, this only helped firm funding certainty, not cost.
Banks have started making this increase in funding costs transparent and called it “liquidity premium (LP)”, passing on the cost in every way they can to borrowers. In the high-end corporates, you will now see pricing quotes in the form of “BBSY + Margin + LP” or “Cost of Funds + Margin” where Cost of Funds is effectively BBSY + LP.
In these quotes, you have one more variable – LP which is different among banks. Whilst you could not hedge LP as you would with BBSY, you definitely can compare apples to apples to ensure you are not conned into lower margin, but higher LP.
Another way for banks to improve profitability is to decrease costs by rationalising work processes and reducing administration costs, coupled with increasing revenue from non-interest rate related products, such as transaction banking, hedging, etc.
The banks’ cost reduction initiatives have been successful through the implementation of technology and outsourcing. As observed, the Cost-to-Income ratio has decreased from 54% to 44% in a short six-year period. By investing in technology platform to slash operating costs, banks will see further improvement in its cost-to-income ratio in the next few years.
But, to my mind, the repercussion of this exercise caused serious damage to customer relationships. Whilst the technology is aimed at improving the speed and organisation of information flow and outsourcing to improve work process and costs, the desired results have been compromised by the bank’s overly fast rationalisation of its workforce.
There is a marked decrease in staff-to-customer ratio and constant new faces in client-facing roles. Despite how great the technology is in retaining client information and process work, it is only as good as the banking staff that are using it. This, as a result, becomes the root cause of the bank’s “memory lapse” syndrome – banks lose memory of their customers and disregard all relationship history.
What does this all mean to us? These are variables not within our control. We cannot lessen banks’ funding costs; we cannot stop implementation of technology and outsourcing. Banks will continue to pull these levers to sustain their business, their ROE. But, what we can do is to increase our bargaining chips by dressing ourselves up to be the “attractive” customer that banks want to chase after.
This can be achieved via better communication of our business to the banks and offering lucrative cross-sell (non-interest related products) in return for better services. The strategy is to get your bank to put the best relationship team forward to look after your business and to ensure all pricing quotes are transparent and are opened to negotiation.