Maximising the return on a relationship starts at origination

Clive Smith

Russell Investments

The process of banking often relies on the development of an ongoing relationship between the bank and the borrower. This relationship not only provides the bank with additional information but may impact on the pricing of loans. In turn this can create issues for investors purchasing such loans directly from the bank’s balance sheet.

Information asymmetry is the major risk for any lender

There are many risks faced when lending money but the main one is the lender’s ability to control the level of information asymmetry. Information asymmetry has two aspects namely where:

  • a borrower has more information regarding the state of its business/finances than the lender and
  • one lender is privy to more information regarding a borrower than the other lenders.

The drivers of the level of information asymmetry between borrowers and lenders is ultimately determined by the trade-off between:

  • costs, both direct and indirect, associated with the borrower making increased amounts of potentially proprietary information available to lenders and
  • the reduction in borrowing costs associated with the provision of additional information.

Ultimately, any borrower manages the trade-off between the cost, both direct and indirect, associated with providing additional information to lenders and the reduction in borrowing costs associated with providing the additional information; i.e. the borrower seeks to minimise the ‘all in’ costs of obtaining a loan. Tension may occur between borrower and lender when the borrower feels there is no need to provide additional information to the bank than the bank ‘needs’ or provides selective information to minimise borrowing costs.

Relationship loans aim to reduce information asymmetry

As with all relationships between parties there is a knowledge associated with repeated interactions over an extended period which creates an intimacy and various levels of trust, or distrust, between the parties. This principle underlies relationship lending which utilises proprietary information and repeated interactions over time to reduce the level of information asymmetry between the borrower and the bank. This is the essence of banking where relationship lending comes to the fore as a means of managing the level of information asymmetry in a more cost-effective manner. What it ultimately means is that often the bank originating a loan will be in possession of proprietary information regarding the lender beyond the standard financial details.

Banks cross subsidise loans

The ongoing interaction between the borrower and the bank also means that the relationship may often be broader than that of borrower and lender which may distort the rate the bank charges for a loan. The development of a more broadly based relationship between the bank and borrower is referred to as relationship banking. Relationship banking is where a bank provides a more diverse range of fee paying services to a client. Where a broader relationship exists the rate charged on a loan may be distorted due to cross subsidisation arising from the provision of other banking services. The existence of other fee generating services provided by banks can make it more problematic taking the origination return on a loan as an unbiased assessment of the appropriate return for the underlying risks assumed.

Buying into the relationship makes you the ‘Outsider’

The impacts of a broader banking relationship with the borrower are relevant when a non-bank investor seeks to buy an existing loan from a bank as the non-bank investor is now the ‘outsider’. The danger is that any ‘outsider’ becoming part of an existing relationship is at a potential disadvantage with respect to knowledge regarding a range of factors about the parties involved in the original transaction and their motivations. This is critical as an ‘outsider’ will have more limited transparency into :

  • What proprietary information derived by the bank may be available or if it exists at all.
  • The extent to which the loan is subsidised.
  • The rationale behind the bank’s desire to sell down their exposure to the borrower.
  • The actual borrower as they may not be publicly listed companies which in turn may reduce the information available to ‘outsiders’ from sources other than the originating bank.

Given these uncertainties, and accordingly the potentially higher level of information asymmetry, the ‘outsider’ should be requiring a higher return than that required by the originating bank.

How to deal with the ‘Outsider’ dilemma as a non-bank investor

Ensuring that one is being adequately compensated for risk is not as simple as buying a loan from a bank at the yield reflected on the bank’s balance sheet. Making this particularly relevant now is the changing regulatory environment for banks which has meant that to maximise returns banks need to more proactively manage their balance sheets. Part of this process has seen banks look to actively sell loans they have already originated to other banks and non-bank investors. When buying into such loans non-bank investors need to be aware that they are the ‘outsiders’ in the relationship and that the bank’s concept of what constitutes a reasonable return on the loan may differ from their own (1). Given this anyone investing in such loans should put in place suitable processes to assess that they are being adequately compensated for being an ‘outsider’ in a relationship which is designed to reduce the level of information asymmetry between the bank and the borrower.

Often a higher level of information asymmetry will mean that non-bank investors should be seeking a higher return than that required by the originating bank. As the originating bank is unlikely to realise losses on the existing loans it on-sells this creates a dilemma for such non-bank investors. The way to address this dilemma is to ensure that as a non-bank investor you are co-originating loans alongside the bank. By doing so the non-bank investor is ensuring that they are privy to the same information and have input to the pricing of the loan at origination. For non-bank investors wanting to tap into this part of the loan market being part of the origination process is an important step towards minimising the risks associated with being a potential ‘outsider’ and thereby making the most from investing in relationship loans.

(1) A further complicating factor in terms of non-bank investors pricing an existing loan is that banks consider the making of non-tradeable loans as ‘part and parcel’ of their business and accordingly do not generally charge what non-bank investors would view as a liquidity premium; i.e. an additional return premium to compensate for the lack of a secondary market in a loan. This is something which non-bank investors need to keep in mind if using such loans to access a liquidity premium; i.e. the bank’s concept of a liquidity premium may differ materially from the non-bank investors.

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Clive Smith
Senior Portfolio Manager
Russell Investments

Clive Smith is a senior portfolio manager for Russell Investments and a senior member of the firm’s Alternatives research group. Based in the Sydney office, responsibilities include researching Australian and global fixed income and property...

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