There are multiple drivers that banks consider when pricing your deal. These drivers are put through a model that projects an overall Return on Equity (ROE). Each bank has a ROE minimum which must be met.
These drivers are influenced significantly by your deal structure and its presentation to the banks. The best pricing is achievable when your deal is structured correctly to meet your objectives, presents professionally and favourably against the banks pricing drivers and has an appropriate overlay of competitive tension.
The main drivers are
- Customer Rating or Credit Score
- Loan Term
- Security
- Other Revenue Sources
- Competition
The first three customer rating | loan term | security relate to risk. The fourth other revenue sources relate to additional revenue sources from your banking relationship that can improve or detract from the bank’s ROE. The fifth competition creates leverage or in economic terms buyer power in your favour encouraging and indeed empowering the bank to reduce their ROE down as close as possible to their minimum required level.
The customer rating also called credit score is complex but has a number of key components which are:
- History
- Cashflow
- Management Capacity
- Industry
Understanding and presenting these components in their best light goes a long way to providing not only a very competitively priced deal but also a correctly structured deal for your forward outlook which has significant value in and of itself. I achieve this by having the skills and taking the time to understand your business, your management team, suppliers, buyers, contracts, forward outlook, key risks and mitigants.
However, there are a couple of things that can be done day to day that can also benefit significantly. One easy oversight I saw that had a significant and disproportionate effect on the customer rating was minor overdrawn accounts. For example, by a few dollars.
The overall risk of an overdrawn account by a few dollars is a non-event however they are recorded as historical account conduct and are highly likely to be a detractor. If an account is regularly overdrawn or it extends beyond 30 days, it begins to become quite material and adverse. Yes, it can be explained away in the application coupled with processes to prevent recurrence in the future so an approval will be forthcoming, however the pricing may need to be higher for the banks to achieve their ROE minimums.
Another item which can adversely affect the rating is continuous loan applications which are officially recorded on the rating system. Continuous loan applications may not be a sign of a higher risk business, but rather a growing business whose forward outlook and funding requirements have not been structured properly, thereby requiring regular increases or restructures. Having an experienced broker who has the skills and has taken the time to understand your business and forward outlook to correctly structure the deal makes a difference. Not only to the pricing, but your ability to focus on your customers and not be distracted by a poorly functioning banking structure.
The loan term relates to risk and establishment costs for the bank. Time is risk. This means the longer the term the greater the risk. The pricing models factor this in, and it often directly relates to increased capital allocation requirements imposed upon banks by the banking regulator, which has the effect of reducing the ROE. Additionally, there are loan establishment costs. This is the cost of assessing the application, setting up the loans, loading them onto the internet banking platform etc. This is also programmed into the model.
In my experience, if your deal is greater than $5m, loan term can begin to be a material factor. Feedback I have received recently from the treasury department representative of a major bank is the loan term sweet spot is still generally around the two-to-three-year mark. This is long enough to overcome the establishment costs, yet short enough to prevent the risk factor of time becoming a major detractor.
A question then is how to manage interest rate risk, that is fixing rates (if appropriate) beyond a potentially shorter expiry date. This is still achievable by taking out a derivative limit and fixing for a term beyond the expiry date. This requires advice and assessment from the particular banks interest rate risk management division, however, becomes a central part of structuring and aligning deals to your requirements. Essentially it means interest rate risk management and loan terms can be structured appropriately to provide the best structured solution to meet your needs, plus also be structured to allow the best possible interest rate from the bank.
Security is another risk related component. Simply the higher the security value relative to the debt the lower the risk. The lower the risk the less capital that is required to be allocated by the bank to satisfy the regulator and the lower the price that needs to be charged to achieve their minimum ROE. The type, quality, and saleability of the security also come into play.
Other Revenue Sources is all other means that a bank can make money from the banking relationship with you. These things include, margin earned on your deposit funds, margin earned on foreign currency transactions, margin on merchants or other trade facilities just to name a few. The greater the alternative revenue sources the more revenue support for their ROE.
The other revenue sources are an area commonly overlooked by customers, with the headline loan interest rate taking centre stage. As an example, in my banking career for a period of year or more, the highest earning customer in my team’s portfolio was a deposit only customer. The team I managed at the time had over $1 billion in loans written with a number of single exposures of >$40m. We further had $600m in credit funds from where the single largest revenue earner was.
The final driver is competition. A well communicated and structured deal places you in the best position to achieve the required ROE with the lowest possible price. The competition overlay adjusts the buyer | supplier relationship in your favour. This means making sure the bank is duly motivated to price the deal near or on their minimum ROE hurdle.
Together, a well understood, structured and communicated deal places you in the box seat. One of the best outcomes is the ability to look forward in your business dealings and not worry about the bank, as this is what you are in business for.
If you would like to talk with someone regarding your commercial or specialist banking requirements, please reach out. My contact details are below. I enjoy banking and business and would be pleased to understand your business and banking relationship.
