Rethinking large corporate banking: Part I—what did the past decade teach us?

RMA Journal, The, May, 2003 by John Walenta

Major trends of the last decade have taken subtle hold in shaping how different banks view their large corporate banking strategies. Although recent announcements of significant loan losses suggest nothing has been learned, equally compelling evidence points to a permanent withdrawal of excess lending capacity, abandonment of the buy-and-hold banking model, and a far greater understanding of when and where capital should be committed in support of large corporate relationships. This first article in a three-part series sets the stage for the question: Does lending pay?

Well before the latest credit meltdown, many banks had begun to rethink their wholesale banking strategies in general and their commitment to large corporate lending in particular. For the first time, evidence suggests, capacity and capital are leaving the system permanently, and banks remaining active in this sector will do so only with much greater discipline around defining core relationships.

It is easier to understand how the industry arrived at this point when we review some of the major trends and issues of the past decade. Far from being a staid sector of the banking industry, the large corporate segment has been extraordinarily dynamic, reacting to many fundamental changes. Among the most significant changes are the following:

* The gradual yet now widespread acceptance of economic capital and relationship RAROC as the primary means to gauge the success of a lending book.

* The initial excitement--and subsequent disenchantment--with integrated corporate lending and investment banking strategies.

* The rapid development of secondary markets--especially the credit derivative market--as additional channels to manage and offload risk.

* The attendant development of active loan portfolio management as the primary means by which banks reengineer the composition of their loan books.

All of these changes occurred against the backdrop of corporate America's relentless balance-sheet leveraging, continued deregulation of such key industries as energy and telecommunications, and the ongoing globalization of investment sources, trading partners, and operations.

Impact of Economic Capital

Economic capital exerted a major influence on corporate banking in the past decade because it created a common analytical framework for lenders to assess portfolio performance and client-level profitability on a fully loaded, risk-adjusted basis. Few had employed economic capital prior to this time and thus generally measured their large corporate lending businesses on a pure cash-accrual basis, with all the distortions to normalized performance that implies. Also, the information needed to determine whether deployment of lending capital could be justified in the context of a broader wholesale banking relationship was now available through such additional refinements as including contributions from adjacent cross-sell product areas (that is, relationship RAROC).

Sophisticated institutions--often those at the top of the underwriting league tables--were able to use this information, in part to rationalize offering ever tighter spreads on corporate credits to their best clients. This exacerbated a situation whereby prevailing credit spreads almost invariably became inadequate to permit participant banks to reach an acceptable hurdle rate on a standalone basis. In other words, market pricing for investment-grade credits was basically being set at the margin by leading banks that could capture the most ancillary revenue and syndication skim. Only in the leveraged BB - BBB market does stand-alone credit pricing occasionally cover risk charges and the typical direct and overhead costs of an average lender. (See Figure 1.)

Moreover, the development of the commercial paper market precipitated a change in the role of banks in providing credit to large corporate customers. Many of these large corporate customers had credit ratings equal to or stronger than the credit ratings of their banks. These strong financial positions enabled them to go directly into the financial markets to raise capital. Banks became the providers of backup lines. Given the purpose of these lines and the high credit quality of the obligor, these lines were inadequately priced to cover their inherent risk.

Few banks have achieved anything higher than a 13-14% stand-alone lending RAROC on their global large corporate loan portfolios, even when including results from their strong domestic operations (in the case, for example, of Europeans and Canadians). When those domestic results were excluded, returns have occasionally dropped into the single digits. Ironically, the development of economic capital as a measurement, management, and decision-making tool did little in the immediate short term to dissuade participant banks from lending at below-hurdle rates.

Universal Banking Model

This apparent dichotomy is explained when we appreciate the major countervailing trend during this time: the often exuberant adherence on the part of some banks to the integrated corporate-investment banking strategy model, sometimes referred to as the universal banking model. Between 1990 and 2000, lured by the prospect of securing the lucrative fees of the investment-banking sector, corporate banking institutions acquired more than 45 full-service or boutique investment banks representing some $106 billion in value. On the surface, it is easy to see why tapping into this prize was considered so attractive. In normal years, pretax profit from pure customer-driven investment banking operations (that is, excluding earnings from institutional investor relationships) nearly equals the combined pretax profit for all forms of large corporate lending. The attraction is further heightened because significantly less capital is required to generate such earnings.