The New York Times, March 12, 1995
Basic Business Loans May Undo Banks
by Susan Webber
Once again, worries are growing that banks may be lending themselves
into trouble. The danger is not the debt of emerging nations, as it
was in the early 1980's, or huge real estate loans, as it was later
in the decade.
Instead, bankers and others point to a wide array of bank businesses,
from credit card accounts to commercial real estate loans to automobile
leasing. All of these may pose risks. But one area traditionally viewed
as low risk for banks is where the greatest excesses are occurringroutine
lending to large corporations.
The basic problem is an extreme imbalance of power favoring corporate
borrowers. This imbalanceunhealthy not just for banks, but for
their customers and for taxpayers, tooarises from many factors.
As products, these loans have gradually become less attractive than
bonds as a way for companies to raise day-to-day operating funds. For
one, bonds are cheaper, especially for companies with good credit ratings.
McKinsey & Company, the consulting firm, estimates that the processing
cost of a bond is five-tenths of 1 percent of its face amount, compared
with 2 percent for a loan.
Bonds can also be a faster way to get financing; companies can prepare
much of the documentation required by the Securities and Exchange Commission
in advance, and, as a result, gain access to the bond markets in as
little as 15 minutes.
And bonds carry fewer restrictions, or covenants, than loans. For the
latter, many companies that borrow from banks must agree to maintain
certain financial ratios, like total debt to net worth.
These shortcomings of corporate loans have contributed to banks' declining
share of the market for corporate finance. In 1970, banks accounted
for 65 percent of all short-term corporate borrowing; in 1992, they
accounted for 32 percent The erosion has been greatest among borrowers
of high credit quality.
Lending to large corporations is not only in a secular decline but under
cyclical pricing pressure, too. Banks' loan prices roughly move with
the business cycle. They are high early on, when loan demand rises but
supply stays thin because banks, remembering the recent recession, proceed
with caution. But when the business cycle agesas it now hasloan
prices decline as demand moderates and supply grows.
And the banks also have chronic excess capacity, both in processing
ability and in funds available. For example, Arthur Andersen estimates
that in 1993, banks would have been able to handle 25 million commercial
loans, but the actual number was just 15 million. And while banks had
$25 billion more capital in 1993 than they could deploy at attractive
returns, that surplus will nearly quadruple by 1996 to $90 billion,
according to First Manhattan Consulting, which specializes in the financial
Low prices are a result of this weak demand and large and growing supply.
According to one common measure, the gap between the rates on loans
and the London interbank offered rate, which is the interest rate paid
on large deposits, loan prices for mainstream corporate borrowers have
fallen nearly 40 percent in the last two years.
This drop brings many corporate loans into the danger zone for banks.
In many cases, mainstream corporate borrowers are getting five years
of revolving credit for less than one-tenth of 1 percent interest, with
very skimpy or no up-front fees. Such prices, are hardly enough to cover
transaction costs, let alone capital costs and a decent profit margin.
Covenants have also deteriorated, becoming fewer in number and shifting
from cash-flow calculations to more easily manipulated balance-sheet
If bank loans to big companies are bad business, why don't banks do
something else? There is a compelling reason.
As banks struggle to develop new sources of revenue, they confront corporations'
common practice of making the extension of credit a requirement for
access to their other business. Sometimes the pressure is explicit;
sometimes it is subtle. But it is seldom applied to nonbanks. While
companies often speak positively of their so-called relationship banks,
they do not require their other financial institutionsinvestment
banks, pension fund advisers, insurersto provide a product at
a loss in order to have a shot at other business that the companies
can throw their way.
There is nothing wrong with powerful buyers extracting a good deal.
But when banks broadly engage in unprofitable activities, the public
usually pays. As taxpayers, they pay for the rescue of failed or failing
banks; as consumers they pay more for banking services or earn less
interest so that banks' money-losing corporate loans can be subsidized.
What can be done? The Federal Reserve prohibits banks from "tying,"
or requiring customers to buy other banking services in order to get
a loan. Logically, we must also prohibit powerful corporate borrowers
from "reverse tying," or requiring banks to extend credit to get other,
more lucrative business.
If this practice is banned, more banks will exit the corporate-credit
business and find other niches of profit. Their departure would reduce
the market's excess capacity, giving the remaining banks more power
over prices. Of course, higher loan prices might spur companies to seek
funds elsewhere, but there is no reason banks cannot provide these new
products as well.