Rethinking large corporate banking: Part I—what did the past decade teach us?

John Walenta

Major trends of the last decade have taken subtle hold in shaping how different banks view their large corporate banking strategies. Although recent announcements of significant loan losses suggest nothing has been learned, equally compelling evidence points to a permanent withdrawal of excess lending capacity, abandonment of the buy-and-hold banking model, and a far greater understanding of when and where capital should be committed in support of large corporate relationships. This first article in a three-part series sets the stage for the question: Does lending pay?

Well before the latest credit meltdown, many banks had begun to rethink their wholesale banking strategies in general and their commitment to large corporate lending in particular. For the first time, evidence suggests, capacity and capital are leaving the system permanently, and banks remaining active in this sector will do so only with much greater discipline around defining core relationships.

It is easier to understand how the industry arrived at this point when we review some of the major trends and issues of the past decade. Far from being a staid sector of the banking industry, the large corporate segment has been extraordinarily dynamic, reacting to many fundamental changes. Among the most significant changes are the following:

* The gradual yet now widespread acceptance of economic capital and relationship RAROC as the primary means to gauge the success of a lending book.

* The initial excitement--and subsequent disenchantment--with integrated corporate lending and investment banking strategies.

* The rapid development of secondary markets--especially the credit derivative market--as additional channels to manage and offload risk.

* The attendant development of active loan portfolio management as the primary means by which banks reengineer the composition of their loan books.

All of these changes occurred against the backdrop of corporate America's relentless balance-sheet leveraging, continued deregulation of such key industries as energy and telecommunications, and the ongoing globalization of investment sources, trading partners, and operations.

Impact of Economic Capital

Economic capital exerted a major influence on corporate banking in the past decade because it created a common analytical framework for lenders to assess portfolio performance and client-level profitability on a fully loaded, risk-adjusted basis. Few had employed economic capital prior to this time and thus generally measured their large corporate lending businesses on a pure cash-accrual basis, with all the distortions to normalized performance that implies. Also, the information needed to determine whether deployment of lending capital could be justified in the context of a broader wholesale banking relationship was now available through such additional refinements as including contributions from adjacent cross-sell product areas (that is, relationship RAROC).

Sophisticated institutions--often those at the top of the underwriting league tables--were able to use this information, in part to rationalize offering ever tighter spreads on corporate credits to their best clients. This exacerbated a situation whereby prevailing credit spreads almost invariably became inadequate to permit participant banks to reach an acceptable hurdle rate on a standalone basis. In other words, market pricing for investment-grade credits was basically being set at the margin by leading banks that could capture the most ancillary revenue and syndication skim. Only in the leveraged BB - BBB market does stand-alone credit pricing occasionally cover risk charges and the typical direct and overhead costs of an average lender. (See Figure 1.)

Moreover, the development of the commercial paper market precipitated a change in the role of banks in providing credit to large corporate customers. Many of these large corporate customers had credit ratings equal to or stronger than the credit ratings of their banks. These strong financial positions enabled them to go directly into the financial markets to raise capital. Banks became the providers of backup lines. Given the purpose of these lines and the high credit quality of the obligor, these lines were inadequately priced to cover their inherent risk.

Few banks have achieved anything higher than a 13-14% stand-alone lending RAROC on their global large corporate loan portfolios, even when including results from their strong domestic operations (in the case, for example, of Europeans and Canadians). When those domestic results were excluded, returns have occasionally dropped into the single digits. Ironically, the development of economic capital as a measurement, management, and decision-making tool did little in the immediate short term to dissuade participant banks from lending at below-hurdle rates.

Universal Banking Model

This apparent dichotomy is explained when we appreciate the major countervailing trend during this time: the often exuberant adherence on the part of some banks to the integrated corporate-investment banking strategy model, sometimes referred to as the universal banking model. Between 1990 and 2000, lured by the prospect of securing the lucrative fees of the investment-banking sector, corporate banking institutions acquired more than 45 full-service or boutique investment banks representing some $106 billion in value. On the surface, it is easy to see why tapping into this prize was considered so attractive. In normal years, pretax profit from pure customer-driven investment banking operations (that is, excluding earnings from institutional investor relationships) nearly equals the combined pretax profit for all forms of large corporate lending. The attraction is further heightened because significantly less capital is required to generate such earnings.

Certainly, some banks did lay the foundation for what ultimately may prove to be valuable and sustainable universal banking strategies. For the majority of North American and European banks the strategy has been a bust. In retrospect, it's easy to see that many of these moves were ill conceived or self-deluding. Many institutions forgot--or chose to ignore--that the investment-banking market is inherently volatile and that many specific product markets--and hence the anticipated earnings-remain dominated by the major "bulge bracket" firms, such as Merrill Lynch, Goldman Sachs, and Morgan Stanley. In addition, vast bonus payments and other incentives to corporate finance and investment banking staff left precious little for bank shareholders. Many failed to realize the time and resources required to build an investment bank. Investment banking, after all, is a mature industry with well-established bulge bracket firms. At the same time, many of the investment banks are developing loan portfolios that will enabl e them to be more effective in competing with the commercial banks

A recent Oliver, Wyman & Company study on the European wholesale banking market noted that two-thirds of every investment banking dollar went to the bankers themselves, with less than one-third falling to the bottom line. The numbers are not dramatically different in the U.S. More to the point, despite the best efforts by many corporate treasurers and CEOs to parcel out fee income as a quid pro quo for credit commitments, the hard quantitative reality is that there are seldom enough fees to go around once the lead underwriters are paid. OWC's analysis from client work with second-tier corporate and investment banks repeatedly reveals that even when investment-banking product fees are received from credit clients, they seldom raise aggregate loan portfolio returns by more than two to three percentage points. This modest uplift, when coupled with already depressed lending returns, is simply insufficient to reach most banks' stated hurdle rates and, in any case, is well below comparable returns from other lines of business. (This cross-sell uplift can make a difference in a bank's domestic market, where other cross-sell revenue may be generated and higher spreads might prevail, but it simply doesn't make the grade for those banks looking to crack the U.S. market.)

Secondary Loan Markets and ALPM

Two other major trends started to gain traction as the decade progressed: the explosive growth of secondary loan and credit markets and the adoption of active loan portfolio management (ALPM) as a means to reengineer a loan book. The credit default swap market- which, by some estimates, has now ballooned to over $3 trillion in notional outstandings--often receives the most attention. However, similarly striking growth was recorded in the smaller collateralized loan obligation (CLO) market and the par and subpar secondary loan markets. (See Figure 2.) The key point here for corporate lenders is that these markets provided a new means to hedge loan exposure and to benchmark pricing for stand-alone credits, while enabling banks--albeit at a cost--to rapidly alter the profile of their loan books. To be certain, the markets are not perfect. However, liquidity--particularly for single-name credit default swaps--has improved dramatically for higher-quality investment-grade names while prices are also being quoted fo r more and more companies further down the credit spectrum. At the same time, the frequently observed psychological barrier to buy protection because of its high cost has eroded steadily. Banks that loathed hedging in the past have established, or are actively debating the establishment of, explicit hedging budgets. OWC estimates, for example, that one North American regional bank allocated the equivalent of about 2% of its RAROC in defensive hedging activities last year. Other banks, like Europe's UBS, are leading the way in disclosure on this issue by publishing high-level summaries of their credit hedging activities in their annual financial statements--a trend that equity analysts undoubtedly will try to encourage.

The growth of these secondary markets helped enable ALPM to achieve its full promise. ALPM grew out of the simple realization that a loan portfolio is fundamentally no different from a fixed-income or equity portfolio in that profitable relationships need to be sought and retained as unprofitable ones proactively are avoided or dropped. For most banks, the analytical foundation for ALPM is relationship RAROC (a few use mark-to-market), while the tactical means to rebalance a portfolio frequently is made possible only by accessing the relatively new secondary markets.

Although leading practitioners established portfolio management units in the early 1990s, the momentum for change rapidly picked up toward the end of the decade as unexpected losses began to pile up and senior executives began to realize that the buy-and-hold model was simply devastating to shareholder value. Today, it is safe to say that virtually every major North American bank active in the large corporate lending market has established a loan portfolio management unit to run profitability models, assess portfolio skews and diversification benefits, and prepare recommendations on different ways to shed unprofitable lending clients.

[FIGURE 1 OMITTED]

Figure 2

Wholesale Credit Instrument Overview

Instrument                          Market Size

CDOs                                $101 Billion Issuance
 * Senior                           (Moody's rated global issuance
 * Mezzanine                         2001)
 * Equity

Vanilla Credit Default Swaps        $375 Billion U.S. Notional
                                    Outstanding (Risk Magazine, 2001)

                                    $900 Billion Global Notional
                                    Outstanding (BBA, 2002)

Fixed-income Asset Swaps            $90 Billion Notional Outstanding
                                    (BBA, 2002)
Corporate Debt                      $5.2 Trillion U.S. Underlying
                                    Fixed Income/Public Debt
                                    Outstanding (Fed, 2001)

Near-Par Secondary Loan Market (2)  $76 Billion Trading Volume
                                     (Loan Pricing Corp., 2001)

Distressed Debt                     $42 Billion Trading Volume
                                     (Loan Pricing Corp., 2001)

B&C Loan Tranches                   $29 Billion Issuance
                                    (Loan Pricing Corp., 2001)

Instrument                          5 Year CAGR  Liquidity  Volatility

CDOs                                    40%         **
 * Senior                                                       **
 * Mezzanine                                                    #
 * Equity                                                       #

Vanilla Credit Default Swaps            63%          @          @





Fixed-income Asset Swaps                 4%          @          @

Corporate Debt                          16%



Near-Par Secondary Loan Market (2)      18%          @          @


Distressed Debt                         47%          @          #


B&C Loan Tranches                        3%          @          @


(1) Growth rate from 1999-2001 based on BBA surveys

(2) Secondary loans priced above 90

** Low

@ Medium

# High

Copyright 2000 Oliver, Wyman & Company

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

[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.

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