Bank Financial Management and International Banking BFMIB_L17.pptx

Banking and corporate relationship

1. Banking and Corporate Relationships Part I Stuart Farquhar

2. Motivation The nature of banking is such that it suffers from agency problems The principal agent theory can be applied to explain the nature of contracts between: the shareholders of a bank (principal) and its management (agent); the bank (principal) and its officers (agent); the bank (principal) and its debtors (agent); and the depositors (principal) and the bank (agent) Incentive problems arise because the principal cannot observe and/or have perfect information about the agent’s actions. For example: bank shareholders cannot oversee every management decision; depositors cannot be expected to monitor the activities of the bank. Bank management can plead bad luck when outcomes are poor.

3. Motivation cont … Because of Asymmetric information, or differences in information held by principal and agent: banks face the problem of adverse selection because the bank, the principal, normally has less information about the probability of default on a loan than the firm or individual, the agent. Adverse selection is the reason why the supply curve is discontinuous or even backward-bending (with respect to certain borrowers), and shows that bankers are more reluctant to supply loans at very high rates because as interest rates rise, a greater proportion of riskier borrowers apply for loans. The problem of adverse incentives (higher interest rates encouraging borrowers to undertake riskier activities) is another reason why banks will reduce the size of a loan or even refuse loans to some individuals or firms.

4. Relationship Banking and Relational Contract Relationship banking can help to minimise principal agent and adverse selection problems. Lender and borrower are said to have a relational contract if there is an understanding between both parties that it is likely to be some time before certain characteristics related to the contract can be observed. Over an extended period of time, the customer relies on the bank to supply financial services. The bank depends on long-standing borrowers to repay their loans and to purchase related financial services. A relational contract improves information flows between the parties and allows lenders to gain specific knowledge about the borrower. It also allows for flexibility of response should there be any unforeseen events. However, there is more scope for borrower opportunism in a relational contract because of the information advantage the borrower normally has.

5. Relationship Banking This involves important skills and disciplines: Dealing with Customers Dealing with Banks Developing Relationships Communications Strategy Customer Relationship Management Bank Relationship Management

6. Relationship Banking Bank can give customer bad credit rating Bank credit ratings influenced by large corporate exposures ‘Relationship Banking' of concern to bankers in respect of: Development of business External relations Investor relations Other corporates

7. Complexity of Relationships New area of competition because: Increasingly competitive capital markets Slowdown in loan demand from companies Reduction in cheap retail deposits Deregulation: non-banking competition in traditional markets Technological innovation: reduced margins outside competitors

8. Banking Relationships Benefits of good relationship: Customer assured preferential access to credit Less perceived risk of purchases of complex or new products Bank has better access to privileged information about customer's plans and needs Bank gains: competitive advantage increased bargaining power on sales by making a bank privy to its secrets, customer drastically reduces bank's research costs longer term: relationship provides bank with cheap, valuable information According to Marketing Academic, Philip Kotler said: '(banking) marketing thinking is shifting from trying to maximise the (bank's) profit from each transaction to maximising the mutual profit from each relationship'

9. Banking Relationships – Close and Arms Length Close relationships: rich flows of information between both parties a regular level of business at low margins privileged access by the bank to large deals strong loyalty and commitment between both parties expectations for fair and long term relationship Parties in close relationship usually: have unique information about each other have power and influence vis à vis each other seen as principal or agent for other party Arms length or Transaction relations poor or restrictive flows of information business being mostly affected by price temporary links between parties (i.e. without much expectation for future)

10. Banking Relationships Short-term Benefits: Good Relations and Reputation Support: Success and growth of mutual business Long-term Benefits: borrower unlikely to prejudice relationship through bad behaviour Reputations and repeat business relevant to: High-growth companies with intangible assets little collateral Sovereign debt (international government borrowers) no collateral or punishment

11. Relationship banking (relational contract) vs Transactional banking (arms-length transactional contract) Read the following cases to compare the relational contract vs transactional contract in banking

12. Thank you!