Few businesses have the luxury to be able to turn down customers, but some banks are doing exactly that. If a client does not fit a bank's long term relationship strategy, it will be politely told to go elsewhere for its financing needs. The reasons for turning away customers are increasingly varied, but all motivated by one governing principle - return on equity. Toby Fildes reports on a new era of relationship banking, in which banks are finding it easy to just say no.
The link between the banking industry and the world of haute couture may not be an obvious one. But when Julien Macdonald, the UK designer, shocked the fashion world by saying that he would only make dresses for beautiful women he was only mirroring the banking industry's new attitude to relationship banking.
When Macdonald made his outburst - whether in seriousness or for shock value - what he was trying to say was that he wants to choose who his customers are. Banks are increasingly trying to do the same and, although few will admit it publicly, are turning down more existing and prospective customers than ever before.
Rather than the fashion industry, banks much prefer to compare themselves to supermarkets, where customers - or clients as they are now being called - can pitch up, choose between a myriad of services, and take away the product, or products, most suitable for them. Bigger is better, they say, and the bigger banks are the more they can offer their customers. One-stop shopping, despite being a tiresome expression, remains the ultimate goal for most.
But the glaring difference between supermarkets and banks is that supermarkets will take anyone into their stores. Banks will not. This, in itself, is not a new phenomenon - banks have always had the option of turning down potential customers - but what is new is the rationale behind this attitude. Whereas five years ago, banks might have turned down customers either because they operated in morally challenging sectors - such as military hardware or tobacco - or political hotspots - such as the Middle East or sub-Saharan Africa - the ultimate deciding factor now is return on equity. If a company's financing needs cannot generate the yield needed for banks to hit their targets, the company is more often than not asked to stump up more business or even told to look elsewhere.
This does not mean to say that banks will now do business in difficult sectors such as funding arms sales or extending finance to fascist regimes as long as the price is right. Indeed, the provision of credit has never been more scrutinised by regulatory bodies and shareholders. But it does mean that many customers that have enjoyed strong and lengthy relationships are having to adjust their financing sights. To the old adage that "the customer is always right" has been added the caveat "as long as the bank wants it to be its customer".
With return on equity the main driver of a bank's activities, products that have traditionally produced low yields are those that are under the closest scrutiny. The loans business, whether bilateral or syndicated, is one area that has, over the past few years, been constantly reviewed, reshaped and reworked to make it more profitable. Not that you would notice by looking at loan volumes over the past few years. Indeed, after several years of corporates taking out record breaking debt facilities, it would appear that banks have never been so generous with their precious balance sheets.
In 2000 alone, almost $700bn was raised from the European loan market. France Télécom raised a staggering Eu70bn of commitments in the co-arranger phase when it was in the process of raising its record Eu30bn facility arranged by a sextet of Barclays, BNP Paribas, Citibank/Salomon Smith Barney, Credit Suisse First Boston, Morgan Stanley Dean Witter and SG. Vodafone also launched a deal at Eu30bn but reduced it to Eu24bn, not because it could not raise that amount - it could have taken Eu60bn according to most bankers - but because of asset disposals and bond financings that limited its requirements. And Unilever, making a rare visit to the loans market in a year dominated by telecoms borrowers, raised Eu22bn from its relationships banks with hardly a murmur from the loan market.
However, despite the sizes of individual loans and the record volumes being achieved, some simple calculations show that for a bank to make a double-digit return on a loan, the all-in pricing has to be somewhere around 250bp over Libor. And double-digit returns are sometimes not enough, with an increasing number of banks now targeting 20% return on equity.
Looking through EuroWeek's syndicated loan sections, the only facilities that offer 250bp or above are either leveraged loans or transactions for emerging market borrowers. Plain vanilla lending to investment grade corporates, such as revolvers and five year term loans, rarely carries pricing over the 85bp mark, and even big ticket acquisition deals do not usually carry all-in terms of over 125bp.
But banks cannot just stuff their loan portfolio with leveraged and emerging market paper. That would be asking for trouble.
Because of the low yields on offer in the high grade market - or rather the high RoE targets that have to be achieved - some banks have, over the past three to five years, flirted with the idea of exiting the lending business altogether. In June 1999 Marcel Ospel, then chief executive officer and latterly chairman of UBS, was publicly keen to play down the role of the loan product in the bank's overall investment and corporate banking strategy. In an interview for that month's edition of Euromoney Magazine, he said: "Traditional bank lending is not a business we belong to. Our experience suggests that making loans is not the driving element in a client relationship."
On the subject of what actually drives a client relationship, Ospel may have been right. A customer will not always need loan facilities and will eventually want to move up the financing ladder. But what Ospel perhaps underestimated about the loan business was how it can bring in new customers and create new business. There was intense speculation at the time that Ospel was reminded of this by his M&A bankers. "My understanding is that he was told that the loans business is a necessary evil," says one New York banker who worked for UBS team at the time but has since moved to a US house. "How can you expect to make new clients when you cannot offer them something that they desperately need? M&A was booming three years ago and the best way of launching a successful acquisition bid was to put cash up front. If you decide to get out of the loans business and not stretch your balance sheet, you lose any advantage your rocket scientists in the M&A department give you."
Happily for UBS Warburg, and for Ospel, the lending division was taken off the executioner's block and has since gone from strength to strength, not only in the US but also in Europe. It is no coincidence that UBS' positions in the equity and bond league tables have also improved.
UBS Warburg is one example of a bank seeing the light in the loan market. But it has, since Ospel's recantation, concentrated almost exclusively on big ticket acquisition financings and leveraged loans - the higher yielding end of the loans business - and has let other customers that do not fit with its overall strategy slip away. "When UBS and SBC joined up there was a huge loan portfolio full of every type of product you can think of," says one banker who worked in the loan syndications team at UBS before and during the merger with SBC. "At UBS we made loans to lots of customers, not all of them high yielding. But that was the bank's strategy.
"Once SBC was in charge it was made very clear to us that the old way of doing things was to stop and that there was a much more focused method of using the bank's balance sheet. Customers that we had looked after for decades were told their facility was not going to be refinanced by us. Some took it well and went elsewhere, while others took it badly and shouted down the phone. But they still went elsewhere."
UBS Warburg is a textbook example of how over the past five years banks have grown through mergers and takeovers rather than organic growth. The motivation behind financial services consolidation is that once merged, the end product will be stronger and therefore better equipped to serve customers. And once merged, return on equity targets have to be strictly adhered to, so that shareholders are kept sweet and aggressors kept at bay.
While cynics may argue that the prime reason to merge or takeover is not so much to provide better customer service but to defend oneself against aggressors, banks have done a pretty good job of trying to convince the world that mergers are a good thing and that customers will benefit. "The idea is to be in a position to offer more to clients," says Atiqur Rehman, managing director and global head of syndicated loans at Citibank/Schroder Salomon Smith Barney in London. "The mergers that the bank has been through over the past three years have, to some extent, been motivated by that." Citibank joining up with Travelers meant the convergence of balance sheet banking and insurance. Merging with Salomon Brothers and latterly Schroders led to the addition of a world class M&A franchise as well as a bond and structured products business.
This model seems to paying off. The bank sits atop Capital Data Bondware's league table of bookrunners of all international bonds - leading second placed Morgan Stanley by some $16bn - after finishing top of Capital Data Loanware's Euroloan market arrangers league table in 2000. It sits in fourth place for the year to date.
Citibank is not alone with this model of banking. JP Morgan is another that is attempting to become a complete one-stop shop. Latest figures supplied by Capital Data show that the bank, after the merger with Chase Manhattan, is top of the Euroloan market arrangers league table as well as lying a more than creditable third in the bond bookrunners table.
For Fergus Elder, managing director and head of European debt products, the bank's leading position in the loan league table and its strong showing in the bond league table are no mere coincidence. "The more products you sell to a client, the more money you make,' he says. "For example, if from a loan mandate you win the subsequent bond mandate then you obviously make more money than you would do just on the loan. But if you land more than two pieces of business out of the loan, you make infinitely more money."
So, on the face of it, banks openly admit that they want to be financial supermarkets so that they can cover customers at all levels of products - bilateral lending, through syndicated loans and corporate bonds, to IPOs and M&A advisory.
Or at least that is what they want you to believe. An increasing number of borrowers see through this strategy. Indeed, some corporates believe top tier banks are taking on clients with the sole aim of pushing them up the product scale, away from capital intensive business such as bilateral and syndicated lending, and more towards the top end of the product ladder where the fat fees are - irrespective of whether the customer wants to remain on the bilateral or syndicated loan rung.
"One-stop shopping is all well and good for the bank," says the chief financial officer of one UK company that has been a regular visitor to the syndicated loan market over the past year, "but it might not be the best solution for the company." This particular CFO has had a tough year, operating in a debt laden sector that has fallen from grace, and the last thing he needs, he says, is constant advice from his bankers that it is time for his company to issue a bond or set up an MTN programme. "I sometimes get the feeling that issuing a bond would be more suitable for our bankers that it would be for us," he says. "While there are of course advantages for us in issuing a bond - the cost of financing would perhaps be lower, for example - we actually like the flexibility and confidentiality that a syndicated facility has to offer. In a sector where consolidation is still a big factor, having flexibility is extremely useful. I don't really care if it is cheaper for a bank to offer a bond rather than a loan, I want something that is most suitable for my company."
A strident attitude that probably strikes a chord with many CFOs and treasurers. However, it is an attitude that might not work for too long. Bank consolidation - there have been more than 50 mergers in Europe alone since 1997 - has meant that there are fewer institutions that can provide retail liquidity in the syndicated loan market - the place where the majority of bank-corporate relationships are forged. With fewer institutions there are to provide money, borrowers have less of a choice when it comes to what sort of relationship they want with their banks.
So borrowers find themselves in a paradoxical situation. On the one hand, they see their banks merging into global powerhouses that, they are repeatedly told, can offer every product under the sun. On the other hand, they are encouraged to move away from the very products that helped forge the relationship in the first place.
"It is the end of mañana banking," says the head of European syndicated loans at a US bank. "Before two or three years ago, banks were happy to lend to their traditional clients at cheap levels and not ask for much in return. Margins and fees would be at a minimum and ancillary business, perhaps hinted at during mandate discussions and wafted under our noses, was not really enforced after signing." Indeed, the maintenance of the relationship, at whatever cost, was all-important. The type of relationship was never questioned - that was almost sacrilege in the European loan market. But times have changed."
"Many banks have moved from an intuitive to a qualitative approach as to what constitutes a relationship," says Christopher Baines, managing director and head of European loan distribution in the debt finance group at SG in London. "Beforehand, knowing a client and knowing you have lent money to them was enough to constitute a relationship. Now banks look at the relationship a lot more closely and and try to quantify the nature of their relationship. If banks decide that the returns on that relationship are insufficient and/or unlikely to improve in the future then they may exit the relationship." It is a harsh reality for borrowers, but one that can potentially be avoided if they are prepared to offer a little more to their banks. Ancillary business, such as foreign exchange, is one carrot corporates can dangle in front of their bankers. But as return on equity targets are more tightly enforced and steadily rise, the lure of foreign exchange on its own diminishes. "The big difference between now and three or four years ago is that lending banks are more prepared to say no," says the head of syndications at a UK clearer.
"Nowadays, banks want to see the ancillary business written into their contracts and they will want to see it implemented. The bank will want to bag future bond issues and M&A advisory contracts to create more value out of the initial loan facility. And if it is not big business, they will offload some of their exposure into the secondary markets and when it is time to refinance the facility, or take out a new one, they might even drop the client. The overall return on capital employed against the strength of the relationship is the key driver in modern day international banking."
Rehman at Citibank agrees: "You have to look at each relationship more carefully and build a well thought out strategy towards generating the desired return on equity over time."
So how do banks work out which clients they want and which ones they don't? Many banks classify their clients into three categories: key or core clients; prospect clients; and exit clients.
For the key or core clients, banks, through relationship managers, origination and distribution staff, and sector and regional analysts, will have analysed and estimated how much business they will be able to get out of the relationship - including foreign exchange, fixed income, securitisations, M&A advisory and equity - and found that lending is a worthwhile pursuit.
Much the same process applies to prospective clients, although sector analysts usually play a bigger part in the decision making process. But as companies grow larger and their financing needs increase - sometimes overnight as a result of merger or takeover - the danger of underestimating prospective clients grows. "The danger of quantifying relationships is underestimating the value of prospective clients," says Baines at SG. "Banks need to continue to take a view on prospects. This is key when historicaly cash-rich borrowers make large debt financed corporate acquisitions which give rise to new banking opportunities for the enlarged company."
The trickiest classification for banks is the exit client. Not because banks find it hard to tell their clients that their once important business is no longer needed, but in case the bank has not done its analysis properly and that client goes on to become a market leader and a big user of debt and equity products. Once a bank has turned away a client, it will find it almost impossible to woo them back.
"If you have told a customer that you will no longer be working with them it takes a long, long time to get back into their good books," says JP Morgan's Elder. "The only conceivable way you can get back in with a client is by coming up with something that really grabs their attention, like an M&A idea. But even then the client will want to involve their relationship banks so will you have to share the business."
This is the big drawback of such a strict approach to relationship banking - banks have been known to be wrong in their judgement. "You can't be right all the time," says one London-based banker. "Companies are merging as quickly as banks and are becoming huge very quickly. All you can do you is take a view on who are going to be the winners of tomorrow. Sometimes you get it wrong and you either have to live with it and wait for the client to forgive you, or come up with such a fantastic idea that the client cannot afford to ignore you."
Four years ago, before the telecoms sector began to dominate the loan and bond markets, few analysts predicted that Vodafone would be a market leader. But by April 2001, it was the largest UK company by market capitalisation and also briefly held the record for the largest syndicated loan - Eu30bn - to back its successful takeover bid of Germany's Mannesmann. Many banks stayed away as Vodafone was growing, believing that it would never be a market leader, and preferring to lend to existing clients such as British Telecom. "A lot of banks lost out with Vodafone," says the banker. "Vodafone got so big so fast that some banks got it wrong and lost out on some good business, including not only bonds but also equities. But that is the risk banks now take in their aim to become super-efficient." *