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  • Return on Risk-Adjusted Capital: What’s the bank earning on you?

    Keeping track of the return on risk-adjusted capital (“RORAC”) that a bank is making on you, can help you to negotiate better banking deals. It can assist you in cementing relationships with your key banks at the same time. The RORAC model offers you the supporting tool to achieve this.


    Background

    An old Chinese proverb says: “may we live in interesting times.” I suppose that is the case for corporate treasurers today, as far as bank funding is concerned. For despite accommodative central bank policies and historically low interest rates it seems that the provision of credit to corporates is, in certain situations at least, becoming increasingly scarcer.

    Figure 1: interest rates are at historical lows

    This lending adjustment by banks did not happen unexpectedly. The European Banking Authority has been pressing 71 key European banks to raise residual core tier one capital as a proportion of risk weighted assets to 9% by June 2012. By and large banks have met that target, on the one hand by increasing equity via retained earnings, the suspension of dividends, the conversion of debt instruments into equity ‒ and by rights issues when other measures failed (or were insufficient). In addition there have been cost reductions at banks.

    However, there has also been an element of reducing risk weighted assets. Essentially that has meant portfolio sales, adjusting the calculation of risk weighted assets (some would call this gaming) and a shrinkage in lending to corporates and households alike. That trend will not go away, as the phased implementation between 2013 and 2022 of Basel III, gains momentum.

    At Treasury Services we do see evidence in practice of banks re-evaluating their priorities and lending relationships with clients. That varies from institutions which have decided to continue their presence in a certain market on “a redefined (i.e. a much reduced) footing”, to a lack of appetite to renew financing commitments when they become due, or even in one case to pro-active requests from a bank to obtain prepayment on lease obligations, as the bank needed to urgently shed assets.

    Corporate treasurers should therefore acknowledge that going forward, banks will want to earn more income from them, whilst putting less capital at their company’s disposal.

    It is encouraging in this respect to see a growing trend of disintermediation in Europe, where corporates go to debt capital markets directly without having to depend on bank balance sheets. In the first half of 2012, bond issuance in Europe amounted to EUR 93 billion, which while still well below issuance volumes in the US, represented a growth rate of 59.9% year-on-year and was 22.8% above the 2000-2010 average (source: Dealogic, Deutsche Bank).

    That being said, smaller companies in particular will continue to be reliant on bank funding for the foreseeable future.

    So what should you as a corporate treasurer do? The answer is: to increase your focus on bank relationship management. A risk-adjusted return on capital or RORAC model can be a useful tool in that regard.

    Bank relationship management and the RORAC tool

    Your objective as a corporate treasurer, arguably, is to keep your key banks close to your company for the long term. That means that whilst not paying too much for their services, and certainly whilst not becoming overly dependent on one or two banks (committing in your lending documentation to bring all ancillary business to one bank obviously does not help in future negotiations), you will probably wish to ensure that your core banks are able to generate an acceptable return on the relationship over the longer term, whether in line with the 15% target frequently used in the past ‒ or the 12% that is becoming more prevalent today.

    A tool that will help you keep track of what your bank earns on you is the RORAC model.

    So what does this model entail?

    Figure 2: RORAC approach

    As described in Figure 2, the RORAC model should allow you to capture the fees and margins that you are paying to your key relationship banks, across the geographies that you operate in and across the banking services that you purchase. It will mean the inclusion of cash management fees and foreign exchange volumes and interest rate swaps where applicable, in addition to arrangement fees on term loans and fees and margins on L/C facilities. It will also include M&A advisory fees. Obviously the tool should be tailored to your company’s situation, as the type of banking services used can vary significantly from one company to another.

    The tool will compare the returns made by banks against the lending exposure the banks have against your company, from group revolving credit facilities to cash management related overdrafts and working capital financing arrangements. It differentiates according to risk weightings attached to separate exposure categories.

    Figure 3 below shows that, when filled with data over a period of several quarters, the RORAC tool will tell you what percentage return each bank is generating on its relationship with you.

    For instance, in this simplified example, Bank 1 has generated cumulative total returns (see Total returns column) of EUR 5.6 million compared to its exposure (see Total exposure column) of EUR 112.5 million, translating into a return ratio (at 8% capital allocation) of 18%. Given a general 12-15% target, Bank 1 can be considered well rewarded on doing business with you.

    By contrast however, over the same Q1 2009-Q2 2012 period, Bank 8 has recorded EUR 0.2 million in returns compared to EUR 87.5 million of exposure. Its return ratio on the relationship is 1%, probably far short of its internal targets. You may wish to consider steering additional business towards Bank 8, if you count on them to be a loyal partner for your organisation over the longer term.

    Figure 3: illustrative example of a RORAC tool’s output table

    Why the RORAC tool can help you to negotiate better banking deals and cement relationships

    Keeping track of your banking business using a RORAC tool can help you to negotiate better banking deals and cement relationships at the same time, for several reasons:

    1. Tracking returns versus banks’ lending commitments to your organisation is likely to increase your understanding as a treasurer of how well your banks are doing, both in absolute terms (the percentage ratio, e.g. 12% for Bank 6 in the example above) and compared to each other (Bank 4 is best rewarded in the dealings with your company; Bank 10 has earned the least). The tool’s fact base will provide you with arguments in case your bank advises you that it feels under-rewarded. Having it at your disposal will overall make your discussion with your relationship manager vis-à-vis awarding ancillary business, more objective.

    2. The RORAC tool will also indicate to you on a factual basis which of your relationship banks are under-rewarded (in the example above that probably applies to Banks 3, 9, 8 and 10). It will allow you to timely put those banks on your internal watch list, so you can steer more business towards them when the next available opportunity presents itself.

    3. The model will furthermore offer you an integrated picture across banking product lines (in the example above: treasury fees and margins, M&A fees, treasury operations volumes and local/trade related business; it can include other categories, depending on your business) and geographies over the duration of your key bank facilities. You will be able to monitor and manage return levels for your entire banking group over time. In other words: the tool will help you to keep the overall picture in mind. Careful management to ensure that your banking wallet is fairly divided and that your closest banks are sufficiently though not overly rewarded, will increase chances that they will renew their commitments the next time you need to refinance.

    4. The RORAC tool will provide clarity on the match between your organisation’s banking needs and your existing banking group. For instance, while you do want a banking group that can adequately cover your business’s needs, it may make you realise that you do not need 30 international and local banks. Better to have fewer but stronger relationships (10 banks in the example above), than to have (too) many superficial ones.

    5. Finally the tool will enhance your internal processes: regular tracking of fees paid will add discipline for your team and will force you to put your benchmarking hat on and think harder about your key banking services purchasing decisions.

    To summarise, as in many business areas, also in dealings with your banks it’s about the relationship and about “the numbers telling the tale”. Our advice to corporate treasurers is: bear that in mind, and it will pay you dividends.


  • Posted on May 20, 2015