Wrestling with a tiger: How to manage your relationship with your bank / by Adam Howard

Let's talk about banking.  Come on!  It'll be fun...

But before we start, I gotta warn you, this is a long 'un...

I am a banker.  My Dad was a banker.  Between the two of us we have 50 years of banking behind us.  I think about banking.  I read about banking.  I know banking.

Banking has actually been around for over 4,000 years ago in Assyria and Babylonia where merchants made grain loans to farmers who ran short, or traders who travelled between cities.

Modern banking has it's origins in the Middle Ages in the Italian cities of Florence, Venice and Genoa where Jews, fleeing persecution elsewhere in Europe, settled due to the wealth of those cities.

Oh, if you want to skip all this history guff and get to the good stuff you can always come back and click on the following link later:

History of Banking

The Jews were not allowed to own land in Italy, so they became traders and, in time, merchant bankers issuing bills (promisory notes, the precursors to modern fiat currency) secured by crops, or precious items.

The term "bank" is derived from the Italian word for bench, as the Jewish traders used to sit on wooden benches.  Interestingly the word "bankrupt" is derived from the Italian for "broken bench", which is what happened when one lost their traders' deposits.

The reason behind the success of the Jewish merchant bankers was their ability to charge high rates of interest on riskier loans, as Judaism placed no restrictions on doing so.

Both Christianity and Islam considered this a sin, called usury, which was punishable by death.

So, the Jews went on there merry way, with the emergence of the Jewish dominated Goldsmiths of London in the 17th and 18th centuries marking the start of the fractional banking system.

Then the Rothschild family revolutionised merchant banking in the early 19th century.

It wasn't really until about that time that the spread of Protestantism meant that the old religious restrictions on lending and charging interest started to fade away.

And now here we are....

Banks now dominate the Australian economy.  Financial stocks make up 50% of the total market capitalisation of the Australian sharemarket.  The last 6 years have arguably been the best for our banks in a long time, however things are changing.

Banking is one of the most tightly regulated industries in Australia, if not on the planet.  The rules surrounding lending are so tight that many employees simply work on the "Say no first and work backwards from there" mentality.

In addition, business credit growth is negative, consumer credit growth is still positive, but there are concerns about Australia's level of household debt.

And it's in that context that I want to talk about the relationship between business owners and their bank.

Small to Medium Enterprises (SMEs) are defined as having annual turnover of less than $50 million, and less than 250 employees, with the SME Association of Australia estimating these enterprises make up about 95% of all businesses in Australia.

I like to call this area the middle markets.  

It's not retail banking where the customers are PAYG earners, or businesses taking out home loans in company names, and its not corporate banking where the customers are larger private or listed entities.

Typically these businesses will be customers of a major bank's business bank division;  trading accounts, credit cards, asset finance, overdrafts and maybe some term debt.

Sounds familiar?

NAB "created" the modern Australian business bank under it's CEO from 1985 to 1990, Neil "Nobby" Clark.  In fact, NAB still has the largest business bank in Australia by total assets.

But for the past 10 years all the banks have struggled with the middle markets.  They seem endlessly caught in a credit cycle, which goes a little like this:

1. We really want to grow our assets.  We want to catch NAB and be No. 1!

2. So, let's do some serious lending.  Let's hire staff, put aside a big wad of cash to lend, slash our rates and declare we are open for business!

3. But let's also make sure that we tell everyone our credit standards are going to remain as high as ever.

4. Assets grow.  Executives state that the average risk grade of the book is actually improving.

5. An event occurs.  A mining industry slowdown.  A property bust.  A currency traders scandal. Something.

6. The bank loses money.  Usually a lot.

7. Risk becomes a key focus (a little too late as the money has been lost) and lending becomes excruciatingly difficult and time consuming.

8. Credit policies tighten, despite the message being that credit policies haven't changed.

9. Loans are called in, bad debts are cleared.  Good customers follow bad ones out the door.

10.  Recovery, and in time, repeat.

I speak from experience as I have worked at banks during all parts of the cycle, and seen the impact on staff and customers.

Given we are now seeing a sharp slowdown in the mining sector in Australia, which will naturally have a flow on effect on the rest of the economy, I thought the timing was right to provide some insight.

Now, the first thing to point out is most people have the wrong picture in mind when they think of the bank.  This appears to be a legacy from the days when the bank manager was a pillar of the local community who had been around for years.

Back then, going to see the bank manager required one's best attire and a formal, if not meek attitude.

A quick aside:  When making any sort of lending decision any bank will ask a banker to consider the three Cs.  

Credit - can the borrower actually repay the debt.

Character - is the borrower willing to repay the debt.

Collateral - what security can the borrower provide to underpin the debt.

And in the days of yesteryear when the local manager made a lot if not all of the lending decisions you had some regions which had big balance sheets and experienced minimal losses, and other regions with inconsistent balance sheets that experienced high losses, because not all local managers were good at making lending decisions.

This is where the move away from the old bank manager/pillar of the community began.

In an attempt to minimise risk and even out performance credit decisions were centralised.  There was a focus on having a credit policy for everything.  Business banking and retail (home loan) banking were split.

This all happened about the same time banking became computerised, making it a lot easier to share those policies and make sure everyone was towing the party line.

The last piece of banking history that I will use for context is the introduction of the Basel Accords from 1988 onwards, which have required banks to do 2 things:

- maintain an exact dollar value for their total Risk Weighted Assets; and

- adhere to capital adequacy ratios where at least 8% but these days preferably 10% of the Risk Weighted Assets are covered by tier 1 capital.

Sounds complicated, but it basically means for every $100 in loans, after averaging out their respective riskiness, banks have to hold at least $10 in cash.

For banks, an asset is a loan.  And different loans carry different levels of risk, which bankers refer to as PD, or Probability of Default.

A fully secured home loan is a lot less risky than a partially secured overdraft for a small business.  PD measures how risky each is.

These days all banks use a risk grading system to calculate the PD of your business.  These systems will punch out an alpha numeric index that is attached to your business that shows the credit risk and security risk you represent....and that is how a bank sees you.

A number and letter illustrating your relative strength or weakness, which really determines if you are a candidate for more debt.

It would probably be helpful to know what factors went into making this determination, wouldn't it? And to know in broad strokes what was "strong", just "OK" and what was "weak".  We will discuss this in more detail later.

I just want to provide a couple of final details regarding the banks and how they decide who looks after your business accounts.  

It would make sense for it to be based on turnover, or maybe risk, determined by debt to EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation), but it is a decision made based solely on total loan limits.

Once again, in broad strokes, if debt is below $1 million you will be with small business banking, between $1 million and $10 million with commercial or business bank, and between $10 and $30 million with emerging corporate or complex business bank.

Obviously the number of businesses looked after by a banker will differ based on where they are working, with the numbers roughly as follows:

- Small Business Bank: between 100 and 400 customers;

- Business or Commercial Bank:  between 30 and 60 customers; and

- Emerging Corporate or Complex Commercial Bank: between 20 and 35 customers.

And the experience and overall skill of bankers is as inconsistent as skill levels in any other industry.

For someone to be good at what they do, they need to enjoy it.  That way they will use leisure time to learn about it, understand it.  Work ceases to be work because you are enjoying what you are doing.

That's rare.  I would venture that the split is roughly 80/20: 80% of people find themselves doing something they don't enjoy, hence they aren't very good at it.  The other 20% are lucky and enjoy their work.

In addition, employees and companies are chronically afflicted by short-termism, where results need to be delivered NOW.  Company's profits need to go up quarter by quarter and employees need to get paid more every year.  This means companies slash staff numbers to keep operating costs down, while employees jump from job to job seeking higher pay.

The result?  Regardless of sector, within professional services, customers are lucky to deal with the same person for more than a year.

Now, the final point to make is this:  these days 70% or thereabouts of our economy is service-based, but a lot less than 70% of employees have a service mentality.  For many,  serving gets mixed up with servitude, where the customer is placed on a pedestal and the position of servant is seen as lower.  Often this results in an attitude like "I will serve you, but just so you know I am doing you a huge favour."

For those that enjoy service it is an opportunity to take care of someone; to guide them through a difficult and anxiety laden process and deliver them out the other side with what they needed at the price they wanted.

So, why provide such a ridiculously long explanation of banking, when I am meant to be talking about how to manage YOUR relationship with the banks?

Well, my old mate Sun Tzu always said "Every battle is won before it's fought."  The best way to plan for a good outcome is to know your opponent.

So, how should you see the banks?

- a bunch of old white guys whose job it is to lend money but only to the best borrowers, preferably as home loans, but in an inconsistent fashion depending on how recently they lost money;

- enormous bureaucracies that, like the public sector, are governed and run according to millions of different rules and processes, with only a handful of quality insiders aware of most, but not all, those rules and processes ;

- heavily regulated businesses where compliance is regarded as more important than customer service;

- organisations with sales driven cultures where short-termism and pressure results in high staff turnover;

- and that this staff turnover has meant most front line staff are relatively inexperienced;

- businesses where risk is treated as being at the centre of every transaction, resulting in staff knowing a lot about risk grading, but not a great deal about SMEs and their various sectors and industries.

It's not a very flattering picture, and I acknowledge it is also massive generalisation...but like most generalisations it is also generally true.

So, what can a business owner do to navigate a path here?  To ensure you have a good bank manager, support when you need it, good pricing, the right advice?

Simple.  Take charge of the process.  

Find a good bank manager the same way you would hire a high level employee.  Make calls.  Ask friends.  Interview them...without telling them you are interviewing them.

Don't confuse hustle and persistence for substance and integrity.  A tip here.  Google "Hustle As Strategy."  It's a great piece I read in the Harvard Business Review about banks and they way they try to fool customers into believing persistence and hustle are actually a defined business strategy.

Control the negotiations. Don't confuse this with being aggressive and demanding, but assume you know more about this process than the bankers, instead of vice versa. 

Know what a reasonable interest rate and fee structure is, rather than just demanding your rate be lower.  It's easier to get a result when you are specific about your desired outcome.

And what about the terms? 

Terms...what are terms? I hear you ask?

Well, how tightly are you prepared to be locked up by a bank?  Directors guarantees, a charge over the trading entity as well as any other related entity, quarterly monitoring requiring the provision of management accounts, aged debtors and creditors and any other relevant data?  Is that OK with you?

Or would you prefer what is known as "non-recourse lending"?  (The above is the opposite of non-recourse, which, surprisingly, is called full recourse lending).

Non-recourse lending is a loan in the borrower's name, with a mortgage over a title, or titles.  Nothing more.

Hopefully you can see that these two different sets of terms are at opposite ends of the spectrum.  No prizes for guessing which one banks prefer.

Now, only very strong borrowers will be in a position to reasonably expect non-recourse terms.

But, and this is where a little bit of case-by-case analysis is needed, not all full recourse borrowers will be weak.  They may just be risky in other ways.

And granting full recourse terms may be OK with the borrowers if it means they get what they need.

Now, rate and terms are going to depend to a HUGE degree on the relative strength of your business, as measured by a risk grading system.  So, here is my insider information.  

What factors impact the outcome of a risk grade assessment?

- Quality of financial data:  Must be accountant prepared financials and tax returns for the most recently completed financial year.  Anything less, such as draft financials or management accounts will generate a poor result.  Anything stronger, such as audited financials will have negligible impact but may actually be required in some cases (lending to Self Managed Super Funds.)

- Industry Analysis:  What ANZSIC code is used for your business.  Some industries and codes have higher historical rates of default then others.  This can impact the outcome.  It is also important the correct ANZSIC code is used, and it is common that it is not.  Research this area to ensure you have a clear idea regarding your code.  Industry norms for various margins and metrics are also examined.  eg Gross Profit Margin for restaurants is usually between 65 and 70%.  Are you better or worse than that?

- Financial Analysis:  This is a broad area, with the basic metrics considered including Interest Cover Ratio (ICR: Earnings Before Interest, Tax, Depreciation and Amortisation / Interest Costs), Debt Service Cover Ratio (DSCR: Cash Available for Debt Servicing / Total Debt Commitments), Debt to EBITDA, Current Ratio/Liquidity and Working Capital Requirements.

Probably a good idea to list the good, bads and uglies for these metrics.

ICR (shows ability to easily cover interest costs from pre-tax earnings)

5 times coverage and better - good to very good.

2.5 times to 5 times - moderate.

1.5 times to 2.5 times - marginal.

Less than 1.5 times - no deal.

DSCR (shows ability to meet debt repayments from post tax earnings)

3 times coverage and better - good to very good.

1.5 times to 3 times - moderate.

1.2 times to 1.5 times - marginal.

Less than 1.2 times - no deal.

Debt to EBITDA (indicates the degree to which cashflow is leveraged.  How long will it really take to repay this debt?)

1 times or less - good.

1 times to 2.5 times - moderate.

2.5 times and higher - marginal.

Current Ratio/Liquidity (indicates ability to meet all immediate commitments from cash or other liquid assets.  Particularly important for capital intensive businesses)

2 times or higher - very good.

1 times to 2 times - moderate to good.

Less than 1 times - marginal.

Working Capital (WC) Requirements

WC assessment indicates need for an overdraft (ie WC shortfall) but no OD in place nor has one ever been used. - Good.  Indicates strong control of cashflow and terms of trade.

WC assessment indicates OD limit and WC requirements are appropriately matched. - Moderate.

WC assessment indicates minimal need for OD (ie WC surplus), but OD in place and balance is regularly near OD limit - Poor.  Indicates cashflow is loosely controlled and debtors/creditors are not being monitored.

- Management Ability: the great variable.  How good is the owner and others at running their business?  How long have they run it for and what evidence of wealth creation do we have?  Is this the first business they have run?  How are things travelling?  Do they set goals and targets and then measure their performance against these?

A quick confession.  I have self-declined (said no to customers without going to the bank, or in a handful of cases, even when the bank said yes) deals before because the people behind the deal just seemed to have no clue what they were doing.

Well, that's it!!!  That's the recipe.

My final advice would be this.

Draw up a one-pager about your business.  Should only take 30 minutes.  One paragraph on you and your past.  One paragraph on your business and what it does.  Primary customers, margins you aim for, what you are hoping to achieve.

Then work out your business' ratios for the above metrics.  If you need help give me a call.

That should tell you where you sit...and what you should be aiming for in any negotiations.

Then send it off to your new bank manager and tell them to absorb it; memorise it; don't call you until they can repeat it underwater with a mouthfull of marbles.

Now, are you ready to wrestle a tiger?

Food for thought...