The simple business of lending to a corporate institution and sitting on the credit risk is not profitable these days. In principle, loan margins are meant to cover the expected loss given the riskiness of the asset, cover the administrative and legal costs, and generate an acceptable return on capital for a bank subject to the regulatory regime introduced with the Basel Accord of 1988. Margins of that magnitude are not available for most asset classes, and as a result bank management has focused on the concept of relationship banking, whereby the loan origination business brings additional non-risk business, such as cash management, foreign exchange, trade finance, etc. The fees generated here effectively subsidize the loan business, and the total relationship may well generate sufficient income to yield an attractive return on capital for the bank. Relationship banking requires an efficient management information system, where total income under relationship is measured along with the capital required to support the on-balance sheet assets.
Some banks pursue a pure return-on-equity (ROE) strategy, where the denominator is simply the regulatory capital required to support the assets on the balance sheet; this typically leads to a deterioration in the average quality of assets, since all corporate assets attract 8% capital. In the short term, though, a pure ROE strategy will undoubtedly increase earnings per share. Others use more sophisticated methods to measure the amount of economic capital necessary to support the assets.
The standard strategy can be refined by buying protection against the performance of the asset via a credit default swap. If this protection is bought off-balance sheet from an Organisation for Economic Co-Operation and Development bank, the capital requirement is reduced to 20% of that required for a corporate asset. If the protection is funded (say, via a credit-linked note) there is no capital requirement at all, so even if the entire loan margin is spent buying this protection, the return on equity (or earnings per share) for this relationship would be infinite. In theory, a bank could hedge all its credit risk away and still make a healthy living off of the difference between the risk-free rate and its cost of funds obtained via a branch network, in addition to the fees brought in via the loan origination business.
Niche banking is an extension of relationship banking. Suppose a bank has a natural advantage in a certain industry with products especially suited for the needs of such firms, with experience generated by years of fostering relationships with the dominant firms, and with a reputation for understanding the industry. Typically, when the exposure increases beyond a given level, the credit officers will refuse further lending to this industry. Some advanced banks may accept further lending, but only if the new loan carries a significantly higher margin to justify the exponentially increased risk that follows the higher concentration within that particular industry.
The clients, however, would expect a reduced margin as their relationship grows, and this paradox has always created gray hairs for relationship managers. Previously, the extreme solution for the bank was to purchase another bank with a different risk profile, thereby creating diversification, but more often than not, this strategy gives rise to major cultural and managerial pains. The emphasis must lie on avoiding concentration, rather than creating diversification; it doesn't seem reasonable if a bank that faces large exposures in Korean semiconductor firms hires a team of bankers specializing in the Swedish car industry just to create diversification.
The answer to this quandary is, of course, risk mitigation techniques, such as credit derivatives or asset securitization, which give the banks the freedom to pursue their areas of expertise while at the same time hedging concentration risk to an acceptable level. This strategy would in fact feed off the bank's reputation within the niche; as an expert in that industry, the bank would have a natural advantage in the distribution as well as the origination of such risks.
While this strategy is realistic within the current regulatory framework, the credit derivative markets have only recently demonstrated the depth necessary to execute such a strategy. 1999 has arguably been the year when the credit derivatives market has caught up with the sometimes wild expectations expressed through most of the 1990s. Not only has the credit default swap market grown, the market has seen explosive use of securitization techniques, such as collateralized debt obligations, where the credit risk of large pools of assets are transferred to investors, but the assets remain with the originating bank, thereby retaining the client relationships. The leading U.S. banks now are building centralized credit risk management departments to take advantage of this technology. As investors are getting more familiar with such risks, leading to lower risk premiums, and investment banks and rating agencies are competing for CDO business, in turn squeezing their fees, the costs of credit mitigation strategies are coming down to levels where all banks can participate.
This week's Learning Curve was written by Anders Haagen, v.p. of structured credit products at Bank of Americain Hong Kong.
