Determining pricing
Given all of the factors involved in determining pricing and granting approval it is a wonder that a bank ever makes any loans. Adam Smith’s “invisible hand” plays a major role in pricing. This is more apparent in the bond market where information and terms on issues are in the public domain. Bonds are also issued in a standardized form. Term spreads and credit spreads can both be inferred from market prices. Banks hide behind secrecy laws and a desire to keep potentially price-sensitive information on the loans that they are making to themselves. The best sources of information on actual loan pricing (rather than published rates such as Prime) are the borrowers themselves and the syndicated loan market. Customers may tell one bank what another is offering to try to get the best terms available.
Over the past 50 years or so there has been a shift away from “relationship” banking to “transaction” banking with customers always taking the deal with the lowest price. Relationship banking was arguably helped by the presence of local monopolies in some countries and by regulated lending rates in others. Their breakdown has led to an increased level of price-based competition.
While this shift has certainly occurred relationship banking is not yet dead. Maintaining banking relationships with a relatively small number of banks has its advantages. Account managers at these banks build up a better understanding of the company’s longer-term financing requirements, seasonality and cyclicality of cashflows. Credit decisions can be made relatively quickly.
These banks are likely to be able to approve requests for credit faster than banks that lack that experience. The acid-test, however, comes from the actions that the bank takes when a company is going through a difficult period, whether this is due to external factors such as a change in the macro-level environment or changes in industry structure or competition. A bank that cuts credit lines to a company at the first signs of trouble is likely to find itself frozen out in the future.
Management at most banks have to deal with the reality that corporate loans have very little product differentiation. Barriers to entry are low and there is a wide range of substitutes. Under such conditions banks in most countries are price-takers. The best they can do is to get their operating and appraisal costs down and to get the optimal balance between the costs of attracting cheaper funding and the costs of those funds.