Risk, Return and Getting Money Out of a Bank... / by Adam Howard

Welcome back to another update, and this time I want to return to a topic I have discussed before, but just hopefully do a better job this time.

In fact, this time I want to combine two topics: risk, and how to manage your relationship with your bank.

Before we start I want to have a bit of a rant.

There are so many newspaper columns, TV segments, newsletters and talking heads who want to give people advice on how to invest, how to manage your super or where to look for your next investment property…

But almost nothing out there on how to manage debt, or rather, how to manage banks.

That seems strange given the relative size of the following markets, which I will label by class:

  • As of 2015 the Australian stock market had a total value of $1.6 Trillion. 

  • As of Feb 2015 the total value of Australian superannuation assets was between $1.9 Trillion and $2 Trillion.

  • As of 2015 Australian GDP (the dollar value of EVERYTHING bought and sold in Australia) was $1.56 Trillion. 

  • The total value of residential housing assets in Australia in 2015 was estimated at $5.7 Trillion. 

  • The total value of Australian residential home and investment debt in 2015 was estimated at $1.4 Trillion. 

  • The total value of Australian business debt in 2015 was estimated at $800 Billion. 

I found a cool website, link attached below, somewhat scarily called The Australian Debt Clock.

It actually estimates total Australian private debt today at $2.6 Trillion; 50% larger than the total value of the ASX or our GDP and 25% larger than total super assets.

Frightening, huh?

http://www.australiandebtclock.com.au/

Now, I am not here to frighten anyone, or talk about a looming debt-fuelled Armageddon.  I’ll leave that to the idiots on the TV.

But, in summary and to conclude my rant, the total value of the private debt market in Australia exceeds GDP, the stockmarket and total super assets, but there is an almost total absence of dialogue about how to handle that debt or manage your relationship with lenders?  Strange….

Rant over.

So, I thought it would help to adjust some expectations, bust some myths and correct mistaken beliefs.  Here goes:

  1. You have been a customer of a bank for a long time, so that bank will take care of you.

Wrong!  I mean, couldn’t be more wrong if you climbed the wrongtree, picked a wrongberry and bit into it.

This belief is a legacy of a bygone era, when the bank manager and lending manager at your local branch had been working there for 3,000 years and new everyone in the suburb or town.

As a result, they knew a lot about the three Cs of almost everyone in their community.  Those Cs are Character, Capacity and Collateral.

Quick segue:

Character:  your willingness and intention to pay your debts when they fall due.

Capacity:  your income, and lifestyle, and the amount of surplus cash that can be put towards debt commitments.

Collateral:  what assets you have, such as a house, that could be used to secure a loan.

Now, my Dad worked in the banking industry during this bygone era…and what happened was some branches and areas made money for the banks, and some lost lots of money.  Not surprising as not everyone is good at making rational decisions about a person’s creditworthiness, even if they DO know them and their context very well.

That’s why the ability to approve or decline loan requests was then split in two; to make sure the quality of loans written by banks was generally consistent across all areas of the bank.

These days half of this authority sits with the front line lender.  This could be the in store lender, the business bank Relationship Manager, or the Corporate and Institutional Lending Executive.   They recommend the loan for approval.

The other half of this power sits with the impartial observer within the bank:  the credit manager.

So, nowadays, ability to secure an approval from a bank depends on the skill of the front line lender to gather all the information, make sense of that information and turn it into a compelling story that is explained clearly and briefly enough for an impartial observer to look at it and think “Yeah, man.  That’s a good deal.  I’d lend that guy or girl my OWN money.”

A small part of this story is to explain how long the borrower has been a customer of the bank, and that they have always conducted their accounts well.  Made their payments on time, never overdrawn their accounts.  But it’s not a big part of the story.

  1. The bank would be stupid to turn me down.  I am offering them all my business.

Not a bank’s primary concern.  Just not.

First and foremost, as a borrower, you need to tick all their boxes.

IF you do, and that’s a big if, then the bank will try to get all your business, regardless of whether you offer it to them.

But offering them all your business (transaction accounts, credit cards, insurance, etc) in exchange for them more loosely enforcing their lending standards is just not a trade that exists in the debt market.

What IS possible is seeking a better rate or lower fees in exchange for moving all your business to a single bank.  But that only becomes a discussion once your request for funding has been approved.

See, banks work on a Return on Equity method for working out what they can offer you with rate and fees.

The “equity” bit as far as the bank is concerned is the cash they have to hold in their accounts in order to lend you the money.  Briefly, recall that banks need to hold roughly 10% of the value of their loans as tier 1 capital (won’t go into what that is here, as it is boring and makes my eyes water).

So, if you take out more products with a bank that don’t have a link to lending, like transaction accounts, insurance, EFTPOS terminals…stuff like that, they can then offer you a better interest rate, as they make money out of those side products.

But they are NOT going to stamp APPROVED on a loan because you offer them your home loan as well as the business loan you have asked for.

  1. Banks need to support entrepreneurial Australians.

No, they don’t.  Not at all. 

Now, I am not a defender of banks, or an apologist.  What I am doing here is trying to adjust expectations.

The risk associated with a start-up business is high; the likelihood of failure can be as high as 50% in the first year and 66% within the first 3 years.

But the return on capital for a start-up can also be very high.  Sometimes it can be 10 x, or even 100 to 10,000 x, if you are Uber or YouTube.

But realistically, the long term average return on capital is about 5 to 10%.

If you compare that to the risk of a home loan failing (going into default and the bank needing to use its mortgage to sell the property), which runs at less than 1%, or a business loan failing, which runs at between 3 and 5%, you can see why major commercial banks would be reluctant to lend money to a genuine start-up.

But they do lend to start-ups…sometimes.

That’s the funny thing.  Everyone just needs to know in what circumstances.

If you have existing income; a job, or a business that can show profitability based on last year’s tax returns; and you need funds to start a new business, or expand your current business.

But you don’t have any property to offer as security, you will probably be able to find a major bank who will lend you money.

If you have property, with low levels of debt against it and equity you can offer as security for a new loan, but no income, then if you provide a bank with cash flow forecasts that seem reasonable, once again you will probably be able to find a major bank that will lend you the money.

But if you lack both; no profits or existing income and no property to secure the debt.  Well, that’s when you will need to look elsewhere.

The interesting thing is there are still lenders who can help, but just not the major banks.

I will briefly go back to something I have spoken about before.  The risk and return matrix.

The risk free rate of return is about the same as the rate of interest paid on a government bond (specifically a US Treasury Bond or Australian Government Bond), which is about 2% or less.

Now, banks are lending money for home and investment loans at 4 – 5%; not that far above the risk free rate.

And then lending it for business purposes at 5 – 7%.  Maybe for our unsecured loans or loans based on cash flow forecasts this rate increases to 9 – 12 %.

Still not that high.

So, once again, some expectations adjustment here.

If you have a good idea, some people who will pay for that good idea, but no profits or equity, you are going to have to pay for your debt.

Expect to pay between 30% and 50% per annum.

This type of debt is not long term.  Really, the maximum term offered by the lender is usually 12 mths, but most of the time it is paid out between 3 and 6 mths from the time it is taken out.

Yep, it’s high.  Not as high as payday loans, which can carry an effective rate of interest of between 400 and 4000% per annum, but high.

So, there you go.  Some urban myths exposed.

Here is what a bank really is.

  • A large bureaucracy governed by strict rules and policies that will more often than not tell you “No” first, and work from there;

  • A safe and conservative business designed to generate long term return on capital of about 5%;

  • A difficult place to work, with long hours, high pressure and demanding targets.  All this results in high staff turnover, and/or staff moving from job to job frequently; and

  • A retailer of money.  Like Coles or Woolies, the banks are the most visible and least personal places to buy your debt.  If you want gourmet money or money served in a nicer way, you will pay more.

So, hope that helps.  Hope that leads to a few “Aha!!” moments.  Hope that is food for thought…