Part III—the emerging business model

Rethinking large corporate banking: Part III—the emerging business model

John Walenta

This conclusion to a three-part series looks at the emerging business model for large corporate banking and discusses some of the major imperatives that financial institutions must address to have a profitable line of business. Also discussed are whether the techniques used in portfolio management are paying off equally for all banks, whether the new approach is sustainable in the long term, and the more fundamental issue of whether wholesale credit markets have truly changed and whether it is realistic for all banks to take advantage of those changes.

The first two articles in this three-part series examined major trends and issues that have shaped the market over the past decade, while taking a closer look at how banks have tried to respond to the economic challenges of large corporate lending. So what does the emerging business model look like–and where are the opportunities?

Mercer Oliver Wyman sees four major components to the emerging large corporate banking model, as indicated in Figure 1. These components include the core loan book, the noncore or runoff portfolio, the underwriting or syndication warehouse, and the relative-value balancing book.

1. The core loan book, as the name implies, is composed of those clients that exceed a bank’s established hurdle rate or have the potential to do so in the near future. Put another way, these are the Tier I clients for which a bank needs to be the lead lender and have additional cross-sell revenue to augment returns.

2. Conversely, the noncore portfolio is made up of credits that record below-hurdle rate returns and, in the best estimation of the bank’s lending and credit specialists, offer little chance to up-tier the relationship or generate additional cross-selling opportunities.

3. The underwriting warehouse is really another name for a bank’s syndication or distribution activities, although, as we shall discuss, the demands being placed on syndication desks are increasing and the metrics used to gauge success are changing.

4. The relative-value balancing book is the newest component for most banks. It supplements traditional lending income by, for example, taking advantage of increasingly liquid and attractively priced credit markets to sell default swap protection, capitalize on the frequently wide spreads between fixed-income instruments and traditional corporate loans, and invest in and trade a host of other credit products–like synthetic collateralized debt obligations.

Four Sets of Challenges

Each component of this business model presents its own challenges or imperatives. First, the distinction between the core loan book and the noncore loan book is not trivial. Identifying clients that generate clearly superior returns and those that are significantly below hurdle is not terribly difficult, but slotting clients that are near hurdle into the appropriate book is pretty challenging. No bank wants to give up on a client that has the potential to become a Tier I account. As described in the sidebar, this challenge was well understood by Bank One with appropriate procedures needing to be established and adhered to for the process to be successful.

Simply establishing core and noncore designations is not the end of the game. The core book clients need to be covered aggressively, since-by definition- these names will constitute a bank’s best opportunity to generate sustained superior returns. Nonetheless, many banks have revisited their limit structures even for their best clients to drive down hold positions to levels much lower than those prevailing in the 1990s. Similarly, the noncore loan book needs to be monitored intensively to ensure that capital is repatriated with all due alacrity. In many cases, that may simply mean waiting for loans to reach maturity to run off the balance sheet. In other instances, however, it may be possible to accelerate the freeing of capital by engaging in secondary market operations, such as creating or contributing to a collateralized loan obligation (CLO). Many banks have now established specific risk mitigation budgets for their loan portfolio management groups to engage in defensive hedging activities. In some cases, these budgets have exceeded $100 million for institutions with sizable large-corporate exposure. At current credit default swap prices, that kind of budget can remove up to $5 billion in exposure depending on credit quality of the names involved.

The other area where significant changes have occurred for many banks is in loan distribution or syndication. Many banks have now done what the global banks have done for some time: turn their syndication desks into separately measurable profit centers that have much greater accountability for reaching hold levels. Indeed, several even use mark-to-market accounting on a shadow basis for syndication overhangs. Because capacity has been gradually withdrawn from the market, the other challenge syndicators face is broadening their distribution networks to include not just other banks but also institutional investors, loan funds, and others that may take slices of credit.

The fourth component–creation of an alternative wholesale investment book–offers the most promise. The relative-value book contains mainly long credit default swap positions and fixed-income asset swaps. In late 2002, Mercer Oliver Wyman conducted a survey of select North American, European, and Australian institutions to gauge the extent of relative-value operations in the market. With a couple of notable exceptions, most banks have only dabbled in the creation of alternative wholesale investment books and then mainly as buy-and-hold investors. Most of these operations were created in the past two to five years–paralleling the rapid increase in trading volumes and liquidity for credit default swaps–and frequently were motivated by a desire to build a revenue pool to offset the cost of defensive hedging. To dare, the majority of banks engaged in this activity have built modest portfolios ranging in size from $500 million to $5 billion, representing just a small percentage of their underlying corporate loa n books.

The appeal of creating a relative-value operation is readily apparent. A well-diversified relative-value balancing book with manageable single-name exposures implies an optimal portfolio size of approximately $5-6 billion. This equates to top line revenue of around $75-80 million. At first glance this may not seem significant relative to most large corporate loan portfolios. However, this revenue can help defray other defensive portfolio hedging costs and replace revenue from the noncore portion of a lender’s book that is being run off or exited. In addition, even a modest relative-value portfolio is useful in keeping a bank’s loan origination team on its toes by allowing senior management and RMs to realize that there is another reasonable RAROC alternative for committing the bank’s capital to a given corporation. In essence, this facilitates a wider, more integrated approach to the credit product that includes the use of capital for franchise (i.e., relationship) revenue and pure investment purposes.

Does It Work?

Does this emerging business model really work, and does it offer hope to banks that want to maintain a presence in the large corporate banking market? Experience suggests significant improvement in returns and mitigation or avoidance of crushing unexpected losses if banks adhere to the basic elements of the model. This can be true regardless of a given bank’s starting point or the amount of capital it has committed historically to wholesale lending. Figure 2 shows a compilation of large corporate lending returns from a select sample of Mercer Oliver Wyman clients over the past several years. The chart compares the returns of banks that essentially pursued a traditional buy-and-hold wholesale lending model against those that pursued the more dynamic model described here. Buy-and-hold players typically generated lackluster stand-alone lending returns of 7-12% with cross-sell contribution adding another 2-3%. In contrast, banks that pursued aggressive portfolio management tactics were able to display above-hurdl e rate returns and with considerably less earnings volatility.

As discussed throughout this series, there are certain critical ingredients that enable the model to work. At the most basic level, key success factors include:

* Having the appropriate information and analytical models to understand where value is created in a loan portfolio and where it is destroyed.

* Using that MIS to develop portfolio segmentation (core and noncore credits) together with detailed tactical plans for enhancing the return of SVA-neutral names while exiting those names that destroy or detract from economic value.

* Willingness to access the credit derivative and other secondary markets to hedge “tall tree” exposures and reshape portfolio composition.

* Prudent investment in alternative wholesale credit instruments to augment returns, provide a reserve for defensive hedging, or replace revenue from the runoff of noncore loans.

* Embedding an organizational framework–typically in the form of loan portfolio management groups–to check new originations for profit potential and to make certain that the overall portfolio is composed overwhelmingly of value-enhancing relationships.

For many banks, corporate loan books will never again reach the size they did during the halcyon days of the past decade. With patience, common sense, and disciplined adherence to the principles discussed during this series, however, the chances for success are greatly enhanced.

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RELATED ARTICLE: Defining Core and Noncore: The Bank One Case

Paige Kurtz and James Baldino lead the portfolio management initiative at Bank One and are familiar with the challenges of establishing core and noncore portfolios for large corporate exposures.

“One of the first tasks of our loan portfolio management group when it was set up several years ago was to define what constituted key relationships for the bank,” explains Kurtz. “Economic factors were just one consideration in that process. We conducted a name-by-name analysis of the portfolio with that in mind but also looked at other factors like the length of time a client had been with the bank and how the company itself was growing.”

Kurtz points out that relationship managers need to be intimately involved in the review process yet held accountable for developing and executing a tactical plan to improve relationship returns. Typically, six to nine months are provided to demonstrate progress against the plan, otherwise the accounts are liable to be exited.

“We noticed an increase in our customer-related capital markets activity of many fold when the RMs were held accountable more for name level profitability,” Kurtz observes. “For those accounts that we do decide to exit for strategic reasons, the RM knows what the process has been and is never surprised or uninformed if that is the final decision.”

[c] 2003 by RMA. John Walenta is head of North American Corporate and Commercial Banking at Mercer Oliver Wyman, a consultancy specializing in financial services strategy and risk management consulting

Contact Walenta at jwalenta@mow.com; visit Mercer Oliver Wyman’s Web site at www.merceroliverwyman.com.

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