Consider a business in which:
- You make 12% return on capital if your decisions are right 100% of the time.
- Your return drops to 4% if just 1 out of 100 decisions goes wrong.
- You are in loss if 2 out of 100 decisions go wrong.
- Your capital is wiped out if 12 out of 100 decisions are wrong.
Doesn’t sound like a very attractive business, does it?
Yet, all banks do it; they call it corporate banking.
The math is simple.
Let us say you lend Rs1 crore to each of 100 corporates, thereby acquiring a loan book of Rs100 crore. If they are sound businesses, your gross interest margin on the money you have lent (i.e., the interest on the loan, minus the interest you pay on the deposits that provide the money to lend) is at best 2%. If it is anything more than that, the corporate is too risky to lend to, because no sound business will pay more than that.
From the 2%, you deduct 0.5% for the costs involved in providing service to your corporate clients. You are left with just 1.5%, i.e., Rs1.5 crore.
If one, just one, loan, goes bad, you lose Rs1 crore, and your net income drops to just 0.5%. Two bad loans, and you are in a 'loss' situation.
To support your loan book of Rs100 crore, you need capital of Rs12 crore in order to maintain a capital adequacy ratio of 12%. Twelve bad loans and your capital will be wiped out – that is a non-performing asset (NPA) of just 12%.
Wait, you may say. What about security? Don’t banks have collateral for the loans? If a loan goes bad, the bank can recover its money from the security.
Sorry, my friends, collateral is actually a big joke as far as corporates are concerned.
The best collateral, you may think, is ‘land and buildings’, solid assets that cannot be taken away or stolen. But if the company goes bust, often this is worth nothing. What, for example, was the factory in West Bengal worth after the Tatas abandoned it? Nothing. No other corporate would dream of taking it over to run a business when Tata had failed. Even the land was worth nothing, because it could not be cultivated any more.
The most common collateral that banks show on their books is called ‘hypothecation of stocks’. That is a big laugh. Long before you find out that the company is in trouble, all the stocks are gone and there is nothing left for you to seize. Yes, the bankers know this all too well; yet, they go through the charade.
I am reminded of an occasion when a room-full of bankers, me included, had gathered to sign a hypothecation agreement with a large corporate borrower. One of the bankers suddenly asked “Why are we doing this?”
Everyone else was surprised, but the explanation that followed was clear. “If everything goes well, we will not need this document anyway. If things go badly, this document will be worth nothing.”
Everyone had to agree, but we all signed because that was the norm.
But surely, bankers are wise and smart and careful and watchful and all of that, so surely they make the right decisions about lending, right?
Unfortunately, even if the original decision to lend was absolutely correct – strong balance sheet, good profitability, and market leader in its business – things can, and do, change, over the years.
There can be myriad reasons for a good loan turning bad: changes in consumer behaviour, new competition, downturns in the economy, corrupt staff in the bank – the list is endless.
And once you have lent to a corporate, it is very hard, if not impossible, to get out. By the time the warning signs begin to appear, the company has already lost its ability to pay you back and no other bank will step in to bail you out.
Corporate banking relationships are the ‘until death do us part’ type, easy to get into, hard to get out of. Remember the brave Abhimanyu?
Then why do banks lend to corporates?
This is a question I have asked myself many times during my long banking career but have never found a cogent answer. Possible answers exist, though, such as:
- Banks have to lend the money they collect from depositors; otherwise, there is no banking. Corporates absorb large chunks of money with relatively less staff than is needed to make personal loans, for example.
- Corporate banking is classy. You wear tailored suits and fashionable ties, hobnob with big businessmen, chief executives officers (CEOs) and chief financial officers (CFOs), and wine and dine at five-star hotels. Corporate bankers are the ‘executive class’ of the banking community, a cut above the operations and retail loan chaps.
- Apart from the plain-vanilla ’interest on loans’, corporate banking has other income streams – fees from letters of credit (LCs) and guarantees, margins on foreign exchange, and interest-free current accounts. These boost the net interest margin (NIM) on the money lent and, without lending money one does not get all this ancillary business.
I must mention that this ancillary income is not assured. CFOs are notorious philanderers where their relationships with banks are concerned. A rival bank offers them a slightly cheaper rate on a one-off large LC, for example, and they will grab it, leaving you to process the small transactions where your fee income will be small.
The next obvious question to ask is: what will banks do with their money if corporate banking is not viable?
John Reed demonstrated the answer many decades ago when he steered Citibank, a long-standing corporate bank, into a completely new ocean – retail banking. Soon Citibank became the world’s envy with its hugely profitable retail business. Other banks followed suit, some with disastrous results, others with a lot of success.
Today, banks are into consumer loans, auto loans, credit cards, housing loans, selling insurance, and selling investment products, business lines that did not exist in India right until the early-1990s. Mind you, they have their own dangers, too, but margins are much higher than in corporate banking and you do get security.
In housing loans, for example, you get a mortgage over the property, and the last thing any borrower wants to do is to deprive his family of a roof over the head. So, they pay. Besides, selling insurance policies and mutual funds generates fee income without having to lend any money or take any risk.
Probably, the best answer is to balance corporate banking and retail banking. And handle both with a lot of caution and care.
(Deserting engineering after a year in a factory, Amitabha Banerjee did an MBA in the US but returned to India to be a ‘first-class citizen in a second-class country’, rather than the other way around. Choosing work-to-live over live-to-work he joined banking and worked for various banks in India and the Middle East. Post retirement he returned to his hometown Kolkata and is now spending his golden years travelling the world (until Covid, that is), playing bridge, befriending streaming services and writing in his wife’s travel blog.)