Some say the grass is greener on the other side, others say the grass is greener where you water it, both are partially true when it comes to bank margins. You can water your grass for many years but find yourself paying the hidden ‘bank loyalty’ tax. On the contrary, you could leave your patch of grass only to later to discover out it could have been greener all along.
Where is the grass the greenest?
This is a simple question with a difficult answer. Margins are heavily dependent on your bank relationship but are derived from complex underlying market sources. So, it is hard to know if your grass is green, brown, or on fire.
To add to this, each customer-bank relationship is unique and evolves overtime through good times and the not so good. Often, we hear of increasingly frequent changes in account managers that further complicates your ability to get a handle on where you stand.
When there is material switching costs and a lack of relevant market reference points there is the potential for margin pricing to drift away from underlying risk transfer principles and towards what we call a ‘loyalty tax’. In consumer home loan lending, this has a more subtle term, the ‘back book’; those customers either unaware of the potential or unwilling to act to improve their deal. It is a strategic decision to weigh up the value from customer complacency in the back-book against the propensity of a customer to refinance.
Cost of complacency
This begs the question, how prevalent is the ‘back-book’ across the SME and mid-market banking that suffers from not only higher switching costs but also business risk profiles that are difficult to compare?
The cost of complacency becomes salient once the financial decision maker catches wind that their peers could be getting sharper margins. This valuable intel may come from a board member or from a trusted business colleague. And despite suffering the pricing consequences from deteriorating business performance, superior performance often does not actualise into pricing improvements. Unfortunately, despite margins being based upon risk transfer and market pricing principles, the most common way to achieve a margin improvement is to threaten to leave. This can damage longstanding relationships and introduce financing risk if the bluff is called.
We believe there are alternatives to threatening the bank relationship and productive ways to elevate your bank conversations.
Watering the grass
Learn some vocabulary
Margin negotiations invariably end up in the bankers’ domain. It can seem like they are speaking a different language, and sometimes that is the point! “Trust us, we know this stuff” is the subtext to the discussion. We recently highlighted the sometimes-intentional confusion between wholesale funding and cost of funds.
Knowing some bank jargon ensures you can better participate in a pricing discussion. Also, don’t assume the ‘other side of the table’ truly understands the intricacies of pricing. Risk-based pricing is a specialist area that run the models providing these outputs for your account manager.
Try asking a pre-prepared question on ‘risk-weighted assets’ or ask how Basel III+ could impact pricing, then observe the response. Here are some explainers:
Know the market
‘Knowing the market’ is easier said than done, but a small degree of pre-positioning will help. Ahead of your meetings, ask for the bank’s economic update pack. Request some data displaying the cost of credit which would typically be provided via a chart with three and five-year Credit Default Swap [CDS] pricing. Check out the bank’s half and full year reporting packs for any funding cost charts.
The act of asking for this information alone is a powerful signal.
With an understanding of some market dynamics, you can cut through the non-specific market commentary for better negotiation outcomes or, in keeping with our theme, greener grass.
Just asking for market information shows power and thorough preparation. Some market indicators to ask for include:
- Economic Update Packs
- Timeseries of Credit charts, 3 & 5yr CDS
- Data for recent wholesale funding issuances by bank
Knowing your business and your bank relationship
Banks need to receive fair compensation for their risk-taking and businesses should have access to reasonably priced credit. A risk to this equilibrium arises from the uneven distribution of power as the bank inherently knows more about banking and its complexities than even the most expert CFO or business owner.
In the absence of external monitoring, the business must rely on trust that incremental changes higher really are necessary pass through of underlying factors.
Without water your grass will wilt
A productive bank relationship requires nurturing from both sides and should result in the appropriately priced risk transfer based on market pricing principles. Familiarising oneself on some banking vocabulary and market updates can help to achieve and maintain transparent and fair negotiations.
If you want more information on how to prepare for your next negotiation, reach out to our banking experts. For more content on managing your bank relationship, check out our blog.