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The 3 C's driving Bank Margins

Why is it that when you receive news of your bank lending margin, it rarely aligns with your expectations or intuition?

Capital   |    Cost of Funds    |     Credit Worthiness




ost of Funds


redit Worthiness

You’ve seen improvements in business performance, you’ve read the narrative in the financial press and heard CFO peers boasting about their recent margin reductions.  It is likely that the only time you have received a material reduction in lending margins was as a result of a tender or refinance.  And anyone who has run this process for a business of scale will agree it is disruptive, time consuming and switching banks is a generally painful exercise.

You could be forgiven for thinking your bank margins behave in a counter-cyclical irrational fashion and just increase until serious refinancing talk occurs. It can feel like negotiating with the monopoly man Rich Uncle Pennybags who holds the cash and deals the cards.

What Determines your Margin?

Lending margins are based on risk principles and financial mathematical rationale. There is method and fairness in their theoretical determination.

It becomes unfair when the driving factors of prices are unclear and prices seem almost non-negotiable meanwhile banks achieve world leading profit returns.

But how much is too much?

Australian banks have consistently generated returns on equity significantly higher than banks in other countries, averaging 17.5% for the 15 years prior to 2008 and moderating to 15% to 2017, as the RBA pointed out a few years back.  This was around the time of the phrase ‘bank super profits’ became politicised and the introduction of the bank levy. In reality, Australian banks are charging customers more.

With this misbalance of power, it seems necessary to resort to take-it-or-leave-it negotiation to get a fair margin.

We believe knowledge is power. BankEdge combines banking knowledge, market sources and financial modelling to make financial information and insights accessible to all businesses. We help you get a fair margin – and that can start today with the ‘Three C’s driving Bank Margins’.


Banks must hold some capital for everything considered a ‘risky asset’. For simplicity we will assume that capital refers to shareholder equity capital. Shareholders require a return on their capital, and hence it is considered expensive relative to other funding.

Your company’s loan (your liability) is the bank’s asset, and there is a risk that the some or all the loan is not repaid. Capital acts as a buffer to absorb any unexpected losses and ensure that deposit providers are protected.

All else being equal, an increase in regulatory capital requirements (how much capital the bank must hold) translates to more capital set aside for your lending. This will mean an increase to your margin.

  • Increased capital requirements = higher margin

Cost of Funds

A bank is a financial intermediary. Your bank borrows funds which they then lend your company. The cost of this action is known as the cost of funds, which is typically used synonymously with the cost of term wholesale funding. However, term wholesale funding is only one source of funds and is expensive compared to other sources. Bankers are happy to explain term wholesale funding with pretty charts and confusing market jargon while downplaying other, more stable and inexpensive sources. These other sources make up 70% of cost of funding while wholesale funding only contributes 30%.

A better understanding of the cost of funds is to consider the approximate blend of bank funding;

  • ~8% Capital
  • 60-65% customer deposits
  • ~14% short term wholesale funding
  • ~16% long term wholesale funding

So, whilst banks focus on term wholesale funding, in reality it has a relatively muted impact on cost of funds. The RBA did some superb data crunching on this here.

Currently, the RBA’s is providing all wholesale funding at near 0%, courtesy of the taxpayer.

  • Cost of funds = blended cost of all forms of funding (capital, customer deposits, short-term and long-term wholesale funding

Credit Worthiness

The final C relates to your company’s financial performance and collateral provided. The basic (but rather difficult to compute) concept is;

  • what is the probability your company cannot repay its debts causing default, and
  • in the event of default, what is the potential financial loss to the bank.

The probability factors in quantitative financial measures such as your company financials and forecasts as well as qualitative industry, competitive and management capability overlays.

The loss in event of default relates to the security held by the bank and ranges from fully secured to partially secured to unsecured lending.

These credit measures combine to determine the amount of capital required for your company’s ‘risky assets’, otherwise meaning loans and limits.

  • Stronger financial performance = lower chance of default = less capital = lower margin
  • Increased security = lower loss potential = less capital = lower margin

Bank margins should not be viewed as a mystery stacked against you. They are driven by transfer of risk and financial market pricing principles that can be understood without a career in banking.

That’s not to downplay the complexities in the matter. Within the banks, entire floors across many office buildings are devoted to these models. And without these teams of bankers dedicated to correctly pricing credit risk and funding costs we would live in a world of constant banking crises and collapses.

The challenge is identifying the win-win fair price that is a profitable deal for bank shareholders whilst simultaneously a fair margin for the borrower.

You can use the 3 Cs to better understand your bank margin and better prepare for your next margin negotiation. Maybe it is time to ask yourself ‘am I getting a fair margin for my business?’

And for the bankers reading along, you can file this next to your copy of the 4 C’s of Credit Lending…


  • Dan is the Managing Director at BankEdge. He has a unique end-to-end combination of banking technical valuation skills and client-sales-advisory experience gained over nearly two decades of managing client accounts whilst working in a major Australian bank followed by as an independent banking consultant.

Daniel Chalmers

AboutDaniel Chalmers

Dan is the Managing Director at BankEdge. He has a unique end-to-end combination of banking technical valuation skills and client-sales-advisory experience gained over nearly two decades of managing client accounts whilst working in a major Australian bank followed by as an independent banking consultant.

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