CHAPTER 5
Managing Bank Relationships
This chapter covers these topics:
- Analysis of current trends in banking relationship management.
- Mobilization of cash in a multibank network.
- General terms of credit agreements.
- Specific issues of importance in arrangements for credit.
- Ongoing bank relationship concerns.
CHAPTERS 2 AND 3 DISCUSSED considerations relating to cash and credit. Those working capital concerns are closely aligned with decisions about banking—which financial institution to use, how to make the selection, how to determine if your prices and services are what your business needs, and how to manage the relationship with your banker. We'll review those issues in this chapter.
THE CHANGING FINANCIAL LANDSCAPE
At some point in a company's history, a bank account was opened that began either a happy or a troubled relationship. A predecessor in the company's finance group may have walked over to the closest bank office, or knew someone from high school who was working at a bank, or asked a friend, relative, or associate for a recommendation. Those days are over; changes in the regulation of financial institutions have completely altered the competitive landscape and, as a result, how a bank treats its customers.
Financial Deregulation
There were prohibitions on interstate banking in the United States from the 1920s until the mid-1990s.1 Congress also imposed strict limitations on the business activities of banks, with the most restrictive being the forced separation of investment and commercial banking from 1933 to 1999.2 The current financial services structure of the United States is significantly smaller in terms of the number of institutions; for example, there were nearly 15,000 commercial banks in 1980; there are now about 6,800.3
The friendly neighborhood banker has suffered as the result of this competitive change. Fewer banks, more products, the integration of technology into the delivery of services (see Chapter 10), and the globalization of business have forced banks to merge or become more knowledgeable, and a handshake has given way to a formal relationship. If a company is still using a bank from 10 or 20 years ago, it may be time to reexamine the situation. In the next sections we will review the functions of the principal banking relationship; in the chapter appendix we will discuss a process frequently used in reviewing banks and financial institutions.
BANK RELATIONSHIP MANAGEMENT
Bank relationship management is a comprehensive approach to the bank-corporate partnership, involving all of the credit and noncredit services4 offered by financial institutions and required by their business customers. Elements of relationship management include the following:
- Credit arrangements to meet short- and longer-term financing requirements.
- Appropriate noncredit services for U.S. and global transactions.
- Reasonable pricing.
- Acceptable service quality.
- Consideration for financial institution risk.
Prior to recent financial deregulation, companies often had affiliations with several banks to provide the services they required. To some extent, it was a “buyer's market,” with bankers selling their products through every possible marketing device, including but not limited to the following:
- Constant calling to build brand recognition.
- Entertainment to build personal contact and a sense of “obligation.”
- Aggressive pricing, often at or even below fully loaded costs.
- A regular rollout of new product offerings.
- The intertwining of the bank's systems with the company's systems, to make separation as difficult as possible.
Twenty-First-Century Banking
The traditional bank calling strategy worked as long as banks could generate adequate revenues from all of their corporate business, particularly as most financial institutions had a poor understanding of profitability by customer or product line. Furthermore, commercial banks were restricted in the use of capital, and could not pursue more lucrative financial business, such as investment banking or insurance.
The new regulatory environment allows banks and other financial service companies to pursue a much broader range of opportunities, reducing their reliance on marginally profitable services. Like all for-profit shareholder-owned companies, banks require a reasonable return-on-equity from each customer and may terminate a relationship if there is little prospect of acceptable returns in the long run. A proactive relationship management plan is necessary for companies to satisfy their financial institutions and for bankers to justify the business to their management.5
Finance as the Gatekeeper to Banking Services
Bank contact with companies has traditionally been through the treasurer, whose responsibilities include the safeguarding of the cash and near-cash assets of the company. However, access has been extended through other business functions in recent years as banks have broadened their product offerings. Too often, treasury staff remains unaware of the resulting dilution of its responsibility. For example:
- Purchasing and accounts payable are often the entry for e-commerce and purchasing cards.
- The payroll department or human resources may invite discussions concerning the direct deposit of payroll and payroll ATM cards (paycard).
- The investment or real estate departments may be interested in such specialized services as stock loan, custody, and escrow or tax services.
- Systems or information technology (IT) often initiates discussions about any of the more technology-oriented bank services.
Given the current credit environment, it is essential that the finance organization be the gatekeeper for all financial institution contact. This will ensure that an attractive package of profitable business is assembled for the relationship banks, and prevent unauthorized negotiations or contracting between the company and other banks.
CASH MOBILIZATION IN A MULTIBANK NETWORK
Where multiple collection and disbursement accounts exist, cash needs to be mobilized into and funded from a principal bank relationship.6 That bank is the main provider of credit and noncredit services to a company, but other banks may be used in field or office locations due to long-standing relationships or because no national bank yet covers certain regions. Companies in this situation may use one of the U.S. national banks with wide market coverage.7
Example of industries with a multibank structure include retailing and branch offices that require local financial depositories to receive checks, currency, and credit card receipts. As a result, funds often accumulate in collection accounts. In order to use the funds most effectively, the financial manager needs to mobilize the balances.
Funds Mobilization
There are a number of options for a company to move funds into the principal account:
- Company-initiated. Large companies may develop their own reporting systems for cash mobilization. The technology used involves computer processing, with automated notification from the local office to company headquarters using specified protocols. For example, the stock brokerage industry uses proprietary systems to report each day's activity at branches. Some of these systems require the branch to input the transit routing numbers8 of client checks to determine when collected funds will be received at the local depository for inclusion in cash mobilization. Financial managers prepare the necessary wire transfers or ACHs based on a cost–benefit calculation for each method.
- Standing instructions. The administrative effort necessary to concentrate funds can be minimized by the issuance of instructions to the depository or principal banks to effect transfers based on specific rules. These criteria could be based on:
- Frequency: for example, daily or at some other time interval
- Amount: for example, any collected funds or only funds exceeding a predetermined target
- Deposit reporting services. A deposit reporting service (DRS) assists in the mobilization of funds in local accounts to the principal bank account. The office manager contacts the DRS through a toll-free telephone number or a point-of-sale (POS) terminal and, following a series of prompts, reports the location number, the time and amount of the deposit, and any detail required by the company (such as the coin and currency subtotal).
The DRS accumulates all of the calls for the company, creates an ACH file to draw down the deposited funds, and transmits the ACH through the banking system. The all-in daily cost per store is approximately $1. The effectiveness of a DRS system relies on the local manager to report accurate and timely information, and to actually make the bank deposit! The company can be notified if any store does not contact the DRS, allowing a rapid follow-up to determine the reason for the failure.
Too Many Bank Accounts?
A company's financial staff may have only limited data on daily receipts and deposits in local accounts. The complexity and cost of a cash mobilization system, including the burden placed on the local office manager for notifying the home office and making the deposit, must be weighed against the value of funds transferred. Rather than a minor change to the banking system, it may pay to consider a complete redesign to eliminate local banks and the funds mobilization process.
Companies with more than 25 bank accounts should examine why these accounts are open. Idle accounts often exist that are infrequently used, and their balances can be moved into a single bank account earning a higher return. The idle accounts can then be closed, saving the monthly maintenance charge and other fees. Each idle bank account closed, assuming the balances are $15,000, is worth about $1,500 a year ($1,000 for the value of the earnings and $500 a year for maintenance and other charges). Closing 15 accounts could save between $20,000 and $25,000 a year and significantly reduce the possibility of fraud.
If a credit line is constantly being used for working capital (as discussed in Chapter 4), move money back to the lender whenever there is an excess of cash to minimize interest costs. Having the same bank for credit and cash management services allows excess funds to repay borrowing through an intrabank transfer, saving about four percentage points (the difference between the bank's ECR and the line of credit borrowing cost). These transfers cost about 50 cents.
Selecting the Bank
The importance of carefully selecting a bank cannot be overemphasized. A company should want a financial institution that has well-trained staff, the right mix of products, adequate credit facilities, and any noncredit services that your business will require to succeed. The consolidation within the banking industry and more difficult regulatory requirements has turned the banking/corporate relationship into a seller's market, with companies finding it somewhat more difficult to find willing lenders.
- Is the company selling in global markets? Letters of credit and foreign exchange will be required (discussed in Chapter 9).
- Should the bank handle collection and disbursement activity? The company will need lockbox and/or controlled disbursing (discussed in Chapter 3).
- Is there consideration of outsourcing of the payables function? The company will need comprehensive payables (discussed in Chapter 8).
- Is bond or equity financing being considered? The company will want to work with a bank with access to and expertise in the capital markets.
- Does a company just need good, objective advice? The banker and the resources that support him or her are critical to businesspeople in these difficult economic times.
Issues relating to noncredit services are reviewed in the appendix to this chapter.
GENERAL TERMS OF CREDIT FACILITIES
Credit facilities are normally not bid through an organized bidding process; the company usually requests a loan from a financial institution based on past and projected financial statements, a business plan, booked and anticipated sales, and other relevant data. Lenders review various information from prospective corporate borrowers, as noted in Exhibit 5.1.
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EXHIBIT 5.1 Information Required in Establishing a Credit Facility
The Basic Provisions
The first portion of a loan agreement details the type of loan being made, its amount of the bank's commitment, fees and interest to be paid, the repayment schedule, and any restrictions that may be applied on the use of loan proceeds by the borrower. For example, in Exhibit 5.3 it is stated that the purpose of the loan is to finance the working capital requirements of the borrower, and the amount is $10 million with a maturity date one year from the execution date of the agreement. Payments are due monthly by long-standing practice. For purposes of this book, the types of loans that will be used are lines of credit (up to one year in duration but renewable), and term loans and revolving credits that can convert to term loans with durations of three years or more.
The second part of a loan agreement, reflecting its essentially contractual nature, details “conditions precedent” whereby one party, namely the bank, is not required to perform its duties and obligations—namely, lend the borrower the money, until the borrower has satisfied certain requirements, namely the conditions precedent to allow the loan to be executed.
Obviously, depending on the structuring features of the loan agreement, the conditions precedent will vary (e.g., is the loan to be guaranteed?). If so, then a satisfactory guarantee and a satisfactory legal opinion about its enforceability will be required as a condition precedent before loan proceeds can be disbursed.
Representations and Warranties
Following the conditions precedent section, there is a detailed listing of representations and warranties to be made by the borrower. These “reps and warranties” involve commentary on the borrower's legal status—that is, its ability to enter into said obligations. Other representations often involve statements on litigation and defaults; a listing of subsidiaries of the borrower, where they are incorporated and what percentage of ownership the borrower has for those subsidiaries; outstanding liens; and the borrower's compliance with the Employee Retirement Income Security Act (ERISA).9 Representations can also be stated regarding the borrower and its subsidiaries filing tax returns and having paid taxes owed.
Restrictions in Lines of Credit
Loan covenants apply to lines of credit and other types of credit agreements, which are affirmative or negative restrictions that require certain performance by borrowers. These may include limitations on new debt beyond current borrowings, changes in business strategies or senior management, and various financial compliance requirements, often as measured by standard ratios in such categories as liquidity, leverage, activity, and profitability. Exhibit 5.2 lists illustrative loan covenants.
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Affirmative
Negative
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EXHIBIT 5.2 Illustrative Loan Covenants
SPECIFIC TERMS IN CREDIT FACILITIES
In situations where the credit is questionable, the bank may demand collateral and protective covenants to secure the loan. Exhibit 5.3 provides the details of a loan agreement. In this example, the bank has a security interest in leasehold improvements, accounts receivable, inventory, equipment, furniture and fixtures, and all cash and noncash proceeds. In addition, banks require that their borrowers stay out of the bank—that is, not use the line—for a minimum number of months each year, usually two consecutive months, so that the line is not part of its permanent financing.
| This letter will serve as the offer of the Last National Bank (the Bank) to provide financing on the following terms and conditions: | |
| Purpose: | Working capital line of credit |
| Amount: | $10,000,000 |
| Maturity: | One year |
| Interest rate: | Prime rate of bank plus one percent (1%) per annum |
| Payments: | Monthly payments of accrued interest, outstanding balance and accrued interest due and payable in full at maturity |
| Collateral: | A valid, perfected first security interest in all leasehold improvements, accounts receivable, inventory, equipment, furniture and fixtures, and all cash and noncash proceeds thereof, now owned or hereafter acquired by Borrower |
| Financial statements: | The Borrower shall furnish to the Bank within 45 days of the end of each quarter one copy of the financial statements prepared by the Borrower. The Borrower will also furnish to the Bank within 90 days of the end of each fiscal year one copy of the financial statements audited by an independent public accountant. Borrower shall furnish to the Bank within 15 days after the end of each month an aging of the Borrower's accounts receivable in 30-day incremental agings.1 |
| Financial covenants: | During the term of the note, Borrower shall comply with the following financial covenants:
Net Worth. Maintain a Net Worth of not less than the sum of $15,000,000 at all times. Debt to Assets. Maintain a ratio of Total Debt to Total Assets equal to or less than 40%. |
| Expiration: | This commitment shall automatically expire upon the occurrence of any of the following events:
Borrower's failure to close the loan by April 15, 20XX, or such later date as Bank may agree to in writing. Any material adverse change2 in Borrower's financial condition or any occurrence that would constitute a default under Bank's normal lending documentation, or any warranty or representation made by Borrower herein is false, incorrect, or misleading in any material respect. |
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The foregoing terms and conditions are not inclusive and the loan documents may include additional provisions specifying events of default, remedies and financial and collateral maintenance covenants. This commitment is conditional upon Bank and the Borrower agreeing upon such terms and conditions. Oral agreements or commitments to loan money, extend credit or forbear from enforcing repayment of a debt, including promises to extend or renew such debt, are not enforceable. To protect the borrower(s) and the bank from misunderstanding or disappointment, any agreements reached covering such matters are contained in this document, which is the complete and exclusive statement of the agreement between the parties. The bank may later agree in writing to modify the agreement. Additional requirements of the borrower are as follows:
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1 An aging schedule shows the quality of a company's receivables by listing the amount of outstanding invoices by groupings of days. A schedule may show a large amount of unpaid receivables more than 30 or 60 days old, which would be of concern to a lender dependent on that revenue source. See Chapter 6 for a more complete explanation.
2 A material adverse change is a provision often found in financing agreements (and merger and acquisition contracts) that enables the lender to refuse to complete the financing if the borrower suffers such a change. The rationale is to protect the lender from major adverse events that make the borrower a less attractive client.
EXHIBIT 5.3 Illustrative Bank Loan Agreement
Pricing the Loan
Banking continues to be a highly competitive business despite the substantial reduction in the number of financial institutions in recent years. As a result, loan pricing is based on a cost-plus calculation, with the benchmark rate used as the underlying cost of funds (CF), to which are added increments for the bank's operating costs, including the necessary spread above the benchmark rate (OC), the risk of the borrower (RB), and the designated profit margin for the bank (PM). This formula can be expressed as:
Loan interest rate = CF +OC + RB + PM
A typical situation prior to the 2008 credit crisis may have involved a CF of 4 percent, OC of 1¾ percent, RB of 1 percent, and PM of ¾ of 1 percent, for total pricing of 7½ percent. Pricing in 2014 would be significantly less due to the low cost of funds, with a rate of perhaps 4 percent depending on the risk of the borrower. The standard reference on loan pricing is a Thomson Reuters publication called Gold Sheets, which provides reporting and analysis of the global loan markets.10 As we discussed in Chapter 4, the cost-plus approach to loan pricing has little to do with establishing a rate that will fully compensate the bank on a comprehensive basis.
ONGOING BANK RELATIONSHIP CONCERNS
Once the loan has been completed, the company must actively monitor compliance, maintain accurate records on bank activity, and arrange for periodic reviews of current activities and business conditions.
Monitoring Compliance
Borrower and lenders must constantly monitor compliance to avoid default; if business deteriorates, the financial institution should immediately be informed of the situation. The bank has the right to call the loan any time that the borrower is not in compliance with a loan provision, such as a lower current ratio (or other ratio) than the loan agreement requires. Banks will work with borrowers to adjust expectations as required, but expect to be notified of any material change in business activity.
Control of Banking Records
The company should assign the task of updating banking records to a specific manager. Finance staff is often lax in performing this duty. It was previously noted that covenants in loan agreements must be constantly monitored for compliance. Here are other examples:
- Companies often fail to delete approved signatures from their bank's records, even though an employee may have long departed the company.
- Lockbox requirements may change, such as new company names or the preferred processing of nonstandard items (such as foreign currency checks), but no one informs the bank.
- Controls may be weak on the use of confidential data and access codes from remote locations. Your financial managers may be entering or downloading this information from home or a branch office, but are there any logs or other controls to protect the company?
It is important to keep such information up-to-date and secure, to protect the company and the bank.
Periodic Relationship Reviews
Given the partnership orientation of banks and companies, there has been a growing trend toward periodic relationship reviews. There are several objectives of the review:
- Ensure that the relationship is profitable to the bank while providing added value to the company.
- Develop a consultative attitude between the bank and the company to improve current processes and increase efficiencies.
- Deliver quality customer service and the timely implementation of new products and services.
- Understand the future requirements of the company.
The review is often supported by a document discussing the expectations of each party during the coming period, usually one year, and supported by specific calendar targets. A typical annual review cycle might consist of the following:
- First quarter: Formal meeting of company management and bank officers to:
- Discuss the strategic and financial results for the previous year.
- Outline the next year's goals and objectives.
- Schedule the implementation of new initiatives.
- Second quarter: Calling by the bank's relationship manager to:
- Update the company on service and technology initiatives.
- Introduce product specialists.
- Third quarter: Informal meeting of company management and bank officers to:
- Review the status of the year's goals.
- Determine which initiatives to emphasize to meet critical objectives.
- Fourth quarter: Senior-level social event to:
- Discuss current year.
- Plan for the next year and beyond.
At each step in the cycle, adjustments can be made by either party to meet the requirements of the “partnership” between the company and the bank.
SUMMARY
The recent credit crisis and changes in the regulation of financial institutions have altered the competitive landscape and how banks treat their customers. There are now fewer banks and more bank products, resulting in the development of relationship management as a comprehensive approach to the bank–corporate partnership, including all of the credit and noncredit services offered by financial institutions. Banking involves situations where multiple collection and disbursement accounts exist and cash must be mobilized into and funded from a main bank account. A company must be vigilant in managing its banking relationship(s) to ensure a continuing partnership and access to credit.