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 and security, relate to risk. The fourth, other revenue sources, relates 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 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:
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. At JDP Capital, we achieve this by taking the time to understand your business, 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 that can have a significant and disproportionate effect on the customer rating is 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 taken the time to understand your business and forward outlook to correctly structure the deal makes a difference, not only to the pricing, but to your ability to focus on your customers without being distracted by a poorly functioning banking structure.
The loan term relates to risk and establishment costs for the bank. Time is risk, meaning 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 involved in assessing the application, setting up the loans, and loading them onto the internet banking platform.
In our experience, if your deal is greater than $5m, loan term can begin to be a material factor. Feedback received recently from the treasury department of a major bank suggests the loan term sweet spot is still generally around the two-to-three-year mark; long enough to overcome 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 bank’s interest rate risk management division; however it 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 solution to meet your needs, while also allowing for the best possible interest rate from the bank.
Security is another risk-related component. Simply put, the higher the security value relative to the debt, the lower the risk. The lower the risk, the less capital 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 refers to all other means a bank can make money from the banking relationship with you, including margin earned on deposit funds, foreign currency transactions, merchants or other trade facilities, and more. The greater the alternative revenue sources, the more revenue support for their ROE.
Other revenue sources are an area commonly overlooked by customers, with the headline loan interest rate taking centre stage. As an example, in our experience in banking, the highest earning customer in a portfolio was a deposit-only customer, illustrating just how significant non-lending revenue can be to a bank’s overall return.
The final driver is competition. A well-communicated and structured deal places you in the best position to achieve the required ROE at the lowest possible price. The competition overlay adjusts the buyer/supplier relationship in your favour, ensuring the bank is duly motivated to price the deal near or at their minimum ROE hurdle.
Together, a well-understood, structured, and communicated deal places you in the box seat, with the ability to look forward in your business dealings without being distracted by banking concerns.
If you would like to discuss your commercial or specialist banking requirements, please don’t hesitate to get in touch. At JDP Capital, we enjoy banking and business, and would be pleased to understand your situation and explore the right solutions for you.
Contact us: 0448 383 117 | jenny@jdpcapital.com.au
Written by Paul McLellan | Telmah Group
