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The latest cycle of transactional activity has been private equity driven and, especially in Europe where markets for speculative debt remain thin, bank lending has been an important source of leverage for these deals. However, current trends are triggering major changes in corporate banking.

First, there are improving standards of corporate governance and a greater emphasis on the creation of shareholder value. In the wake of the excesses of the information technology bubble, equity and bond-holders are requiring banks to do more than simply generate growth in assets and accounting revenues. Banks have to be much more transparent, demonstrating that assets are of acceptable quality and offer sufficient margins to compensate for risk.

Second, there is the erosion of the boundaries between illiquid bank loans and tradable debt markets. Banks can actively manage their portfolio risks, adjusting exposures to sovereigns and larger corporations, either in the markets for credit derivatives such as credit default swaps (CDS), or through the trading of syndicated loans.

This greater liquidity imposes a new market reference, providing an alternative and more demanding credit-risk adjusted benchmark for assessing loan returns. A line of credit to a triple-B corporate may offer an apparently decent margin over the cost of inter-bank funding, but it is much less attractive when compared with the yield that a similar class of credit obtains when transferred on to public credit markets. Today, every banking transaction must earn enough to pay its own way.

Paradoxically, as banking has become more transactional, loan managers are increasingly seeking to justify otherwise marginal deals by appealing to prospective ancillary sales from corporate borrowers, such as fees from cash and foreign currency management services. But such ancillary benefits are highly uncertain and only rarely justify the granting of credit when there is an insufficient risk-adjusted return.

The Basle II accord

The Basle committee, the group of bank regulators from the G10 and leading financial centres, is struggling to keep up with these industry changes. The job of the Basle committee is to ensure that banking regulation operates in a consistent fashion across the global financial system. But practitioners are concerned about the committee’s most recent proposals: a major overhaul of the framework for bank capital regulation known as the Basle II accord.

One aim of Basle II is to update bank capital regulation so that it maps the quantitative models of risk now used by most major banks to guide their decision making. The new accord is complex, but it is reinforcing current changes in the conduct of corporate banking, especially the more quantitative assessment of risk. Regulators are encouraging the development of rigorous systems of internal loan ratings, providing a similar distinction between classes of credit risk on internal corporate loan books just as public rating agencies such as S&P, Moody’s and Fitch-IBCA provide for most traded debt. This new approach to regulation is highlighting the scale of potential credit losses. Banks are less able to cross-subsidise weaker corporate customers through a relatively flat schedule of interest charges that makes inadequate adjustment for credit risks.

These changes have been especially dramatic in continental European. In the late 1980s, corporate lending was largely conducted by banks either in state ownership or backed by state guarantees, paying little regard to credit or other risks and, sometimes, without any commercial disciplines at all (for example, the uncontrolled expansion of Credit Lyonnais). Since then, the state has largely withdrawn from the banking sector (except for some occasional interference in bank M&As). The creation of the euro has also supported a dramatic expansion of corporate debt markets.

The effects of regulation and a quantitative approach to risk

What are the implications of tighter bank regulation and the more quantitative approaches to assessing corporate credit risk for the conduct of transactions? Two myths should be dispelled.

The new disciplines on corporate banking limit the funding available for transactions. In fact, the reverse is true. For the major deals accounting for the large proportion of transactions by value, it is cash and corporate bonds that provide the bulk of long-term financing. Where bank finance is used, for example, with a syndicated loan, this is often followed by a bond issue to payoff relatively expensive bank loans.

For smaller transactions, syndicated or individual bank loans are still an important source of long-term finance. But the new discipline on corporate banking is a matter of correct pricing to risk, not of loan availability. There is no shortage of bank funding, just a shortage of lending opportunities that offer a sufficient risk-adjusted return. Viable and well-structured deals will find no shortage of banks willing to finance them.

If there is a gap in the debt financing spectrum, it is for mid-sized speculative-grade credit ratings, with too high an expected loss to be easily accommodated in bank corporate portfolios but too small a size to support a speculative bond issue. But this is a challenge to be met through the use of alternative capital instruments, not through unsecured bank finance.

The new risk tools and regulatory requirements give a major competitive advantage to large megabanks and will trigger a major restructuring of the industry. It is true that megabanks have a competitive advantage in some markets. For example, the intensity of competition is such that only large well-diversified institutions can compete effectively in the provision of credit to large corporate customers.

But this is also relatively low-margin banking. Most commercial bank returns are earned in middle corporate, SME and retail loan markets, and in deposit and transactions services, where size is not a critical competitive asset. Cost reduction will drive further rationalisation of the banking industry, but smaller institutions, provided they are efficient, can remain competitive.

Under Basle II, large banks may obtain greater reductions in regulatory capital than small banks. But such a reduction in regulatory capital has only minor business impact. Banks all have more than enough shareholder capital to support their loan portfolios, even under current capital rules. Banks today are pricing according to portfolio risk, not pricing off regulatory capital. Once again, size is not critical.

Conclusion

Overall, while the new risk and regulatory controls are leading to more accurate pricing of bank corporate lending, they are not fundamentally changing the business. The primary attractions of bank finance are its flexibility and that it can be offered to borrowers too small to support the costs of entering public debt markets. Banks can accept some risk of loss through default, but companies that want to borrow beyond these limits can do so only on a secured basis. All companies have to pay an appropriate risk-adjusted price for bank credit.

The challenge to transactions financing is to meet these market realities. It will sometimes be more difficult than in the past for a deal to generate enough returns to meet the pricing requirements for bank funding. If so, this is an indication that the deal itself is either not viable or not yet efficiently structured. Availability of bank finance is not a critical barrier when there is an underlying business case.

Alistair Milne is a senior lecturer in banking and finance at Cass Business School and director of the Centre for Research into European Financial Markets and Institutions.

Copyright The Financial Times Limited 2017. All rights reserved.
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