Rethinking large corporate banking: part II—The search for a profitable strategy

RMA Journal, The, June, 2003 by John Walenta

This second of three articles looks at how banks have tried to respond to the economic challenges of large corporate lending. Financial institutions generally have pursued one of four basic wholesale banking strategies; regardless of the strategy chosen, however, few client relationships exceed hurdle rates of return and represent good use of a bank's capital--even when cross-sell revenue is added to the equation. The current economic environment has caused many banks to shrink to a profitable core and to exercise much greater discipline over where to commit lending capital.

The first article in this series on large corporate banking examined some of the major trends and issues that have shaped the market over the past decade, such as the advent of economic capital, disenchantment with universal banking, rapid development of secondary credit markets, and the introduction of active loan portfolio management. This article shows how banks are responding.

Basic Strategies

Banks that are active in the large corporate market have tended to follow one of four strategies based both on their ability to cross-sell fee-based products and services and their balance sheet appetite to underwrite and hold corporate credit. For example, bulge bracket corporate banks like Citibank, JPMorgan Chase, and Bank of America have the ability to underwrite and distribute large credits while maintaining very credible investment banking capabilities on par with some of their dedicated investment banking competitors. Although current market conditions are causing some cutbacks by these institutions, the bulge bracket corporate banks arguably have come the furthest in developing a successful integrated platform to offer the breadth and depth of services necessary to make money in large corporate lending. Their strategic model is underpinned by the ability to price credit at the margin yet still generate sufficient revenue to meet hurdle rates of return through syndication fee skims and the cross-sell o f other products.

Similarly, the top-tier investment banks started from a somewhat privileged position with a strong franchise in equity and debt capital markets and in M&A. Their challenge essentially has been the inverse of the universal banks in that they have had to advance credit to defend and retain valuable investment banking clients. So far, the evidence suggests that they have been able to do this without facing huge unexpected losses or taking on excessive exposure to large corporate names. (The universal banks, for example, have loan commitments of well over $100 billion on average while the dedicated investment banks generally have not exceeded $30 billion in aggregate.)

Regional banks, which include the Canadians and many Europeans, have had the toughest row to hoe in the large corporate market. Many of these players were assembling the pieces of an integrated corporate lending and investment banking strategy when markets started to deteriorate. Common approaches included leading with their balance sheets, participating in uneconomic standby facilities for highly rated companies, and targeting specific industry sectors only to experience enormous unexpected losses due to concentration risk. Even before conditions changed, however, many were finding themselves caught in an indefensible position-neither having the scale to make a serious and sustained dent in the bulge brackets' market share for investment banking nor the direct client relationships on the lending side that could be levered into more lucrative mandates. The sheer enormity of the revenue gap, for example, between bulge bracket firms and regional players is telling. We estimate that the leading investment banks generate, in a normal year, between $2 billion and $3 billion per annum in client-related capital markets and M&A revenue and that even the major universal banks pull in between $1 billion and $1.5 billion on average from their investment banking arms versus an average of just over $200 million for a typical regional bank. (1)

On the other end of the spectrum are niche players, characterized by a relatively modest commitment of lending capital but with other distinct capabilities that generate a less volatile stream of fee-based revenue to enhance wholesale lending income. Notable examples of this strategy include banks like Mellon, Bank of New York, and even State Street, which dominate such areas as custody and transaction services while maintaining a relatively healthy loan book. The principal attraction of their business model is that cross-sell revenue tends to be more stable and less susceptible to the boom-bust cycles of the investment banking market.

The Cold Reality of Lending Economics

Regardless of the strategy chosen, the economics of large corporate banking remain severely challenging for most players, especially for regional and foreign banks without a dominant franchise in the U.S. market. The previous article noted that standalone lending returns for participants are typically below most banks' hurdle rates. It is important to underscore an additional salient point about lending economics: A bank that can not count itself as a tier I or lead financial services provider to a client faces almost insurmountable odds in generating decent return from that client. Unfortunately, as Figure 3 indicates, very few banks realistically can qualify as a lead bank. In this case, a major U.S. chemical company allocated virtually all of the most lucrative investment banking fees to independent bulge bracket banks, while banks in the company's lending syndicate received "tip" fees that were largely insufficient to generate an above-hurdle-rate return for the particpants.