Magazine article New Zealand Management

Banking : Working the Numbers - Who Will Pass the Test? That's the $64,000 Question as Our Major Banks Attempt to Confront the Ongoing Effects of a Contracting Global Economy and the Bite of an International Credit Crunch

Magazine article New Zealand Management

Banking : Working the Numbers - Who Will Pass the Test? That's the $64,000 Question as Our Major Banks Attempt to Confront the Ongoing Effects of a Contracting Global Economy and the Bite of an International Credit Crunch

Article excerpt

Byline: Mark Peart

Business advisory firm KPMG summed up the issues facing banks in its annual analysis of banking sector performance earlier this year: "The global credit crunch, slowing asset growth, and an increase in doubtful debts all underscore the sharp turnaround in the banks' underlying agenda from asset-led growth to a more conservative (of necessity) process of balance sheet management."

Couple this with the demands key commercial and corporate clients put on their relationship and account managers to provide a ready source of capital for business development and in some cases, short to medium-term survival, and there is no doubt this is no climate for the faint-hearted.

As has been well documented in the mainstream media, the wariness of investors towards financial institutions with potential sub-prime exposures has led to the 'credit crunch' with the result that many financial institutions cannot source medium- to long-term funding or can only do so at much higher interest rates.

Credit spreads steadily increased during the first three months of 2008. Even banks rated 'AA' were required to pay credit spreads of approximately 90 basis points (over the interbank swap rate) for three-year funds during March 2008.

KPMG says the core risks omnipresent in banking - credit, market, and liquidity risk - all require strong management experience and capability. These skills are certainly prized commodities in one of the more challenging economic environments in years.

Ross Verry, general manager of corporate banking for ANZ National Bank, is only too aware of this.

"We are a relationship business. When the business climate is benign, relationships are easy, but when times are challenging, that's when business and banking relationships really show their worth."

Verry agrees that for his bank's corporate customers, availability and certainty of funding and risk management solutions are critical.

"We are making sure we are in a position to meet the needs of our customers."

He says the Australasian banking system is doing better than almost all other western financial systems as the major banks are profitable and well-capitalised.

He points out that ANZ is amongst the top 50 banks in the world by market capitalisation and one of just 18 double-A rated banks in the world.

Nevertheless, there is no doubt the ripple effects of global events are being felt here, and tightening liquidity is the major factor for businesses and for their banks.

"The market turmoil means that the cost of credit has increased and banks are paying more for their funding which means that borrowers will too," Verry says.

The good news is businesses are still seeing growth, acquisition, and successful opportunities despite the contraction in the world economy, especially in Asia.

Tempering this is an undeniable decline in business confidence and an easing in the ambition of many business expansion plans.

A characteristic of New Zealand business is the degree of fragmentation within some industries, says Verry.

"This economic cycle lends itself to consolidation and we expect to see more of that kind of acquisitional transaction."

Verry says other customers are responding to the environment by looking for opportunities to maximise returns in their cashflow management.

"For example, we have recently worked with an exporting company that has put in place a funding line with us based on the creditworthiness of its overseas customer. In volatile times it's more important than ever that bankers and their clients communicate regularly."

Coming back to that $64,000 question, KPMG says short term, banking sector results are unlikely to be materially affected. Longer term, the acid test will be: how prepared are banks to adjust their strategies to the flow-on effect of changing market dynamics?

"It could be anything up to two years before they can answer that question," says KPMG.

In these conditions, those who manage their costs and risks best will be the ones who will triumph, spawning heated competition for talent and systems superiority.

KPMG says the quality of risk management becomes the point of differentiation.

"The significance of interest rate margins and managing liquidity risk means liability managers are as important as risk managers."

James Mitchell, head of relationship banking and financial services at ASB Bank, says: "We aim to ensure our customers can make informed decisions from sound information - short and long term. It may be prudent to create certainty of export receipts by taking foreign exchange cover and/or interest rate cover to lock in finance costs or manage lower than forecast cash flows."

"These can all be used together or alone to protect the business' income stream and allow the client to work on securing the next order and running their business."

Mitchell says the bank's business managers have access to international and local market intelligence and research, which it shares with customers to help them make more informed decisions.

"Regardless of the economic climate, many of our customers include us in their decision-making process to provide input on consolidations, mergers, acquisitions and a range of other opportunities and challenges they face."

Mitchell says the volatility that has been apparent around the world in the past year has presented some clients with greater risks, and others with greater opportunities, which is where tools to manage FX risk, interest rate risk and cashflow assistance become imperative.

He says higher relative growth in developing economies, as against contracting developed economies, and their demand for oil, food, and steel to fund their growth and affluence has played a strong part in higher world prices.

The high level of oil prices, in particular, poses a challenge for developed and developing countries alike. Central banks around the world are weighing up the dual impacts of sharp spikes in inflation against the dampening impact on economic growth.

Mitchell says while increasing commodity prices can be a bone of contention for the household, they also provide opportunities for New Zealand businesses involved in export.

"Our agricultural exporters are experiencing strong gains from the increased international prices for these products and from the weakening Kiwi dollar."

He says the global credit crunch, which was sparked by the collapse in the US sub-prime mortgage market, will continue to affect New Zealand for some time.

"Global risk premiums remain high and as a consequence domestic lending rates are higher than they would otherwise be."

However, Mitchell says there are a number of influences that will gradually pick the economy up from its current downturn:

* Tax cuts coming into effect from 1 October this year.

* Lower interest rates as the Reserve Bank steadily cuts the Official Cash Rate.

* Moderation of the high New Zealand dollar, which will improve the competitiveness of exporters and local manufacturers that compete with imported goods.

* Support in dairy-intensive regions from the high level of export incomes.

He insists there is no one-size-fits-all solution.

"The way we quickly respond to these changes is through our international connections and our team of economists who interpret this information and work with our business banking people to ensure we are keeping our customers in the loop.

"It's about knowing our customers and their business and applying our expertise and market intelligence to give them the best business protection and management tools appropriate for their specific situation."

David Tripe, director of banking studies at Massey University, has been monitoring events in Australia, where most New Zealand banks have their parents.

"Australian banks have been under quite significant pressure to provide funding to other corporations whose lines of credits have dried up. Accordingly, there has been some growth in corporate loan portfolios," says Tripe.

"What's also happening alongside that is some of what has been observed in times of historic pressure: banks also get something of an inflow of funds from people who used to invest elsewhere and who are no longer keen to. So there's almost something of a flight to quality.

"The banks get all concerned because they have this additional loan demand and suddenly find that they get additional deposit flows as well. In the Australian context, that would be people who are investing in commercial paper no longer being keen to do so," Tripe said.

Because New Zealand banks depend on funding from other sources, that's not enough to satisfy their funding requirements.

"If you are wanting to borrow big or fund a major development, that will cost you big bucks. Because of the general climate and credit conditions, banks are going to be less keen and other things being equal, they prefer to provide you with a smaller facility rather than a larger one."

Tripe counsels corporate customers to "shop around, because you might effectively pick up the money in small bits from a variety of sources".

He agrees the culture change is temporary. "One shouldn't assume that this will be the way things are forever."

However, it could be at least a couple of years before things change, he warns.

KPMG somewhat cheekily sees the challenges facing banks as a test of who will "power up" and who will "blow" as market pressure intensifies.

Almost certainly, further market volatility and credit issues will test the industry.

"For some, this environment will be seen as an opportunity to reset the risk-return equation and differentiate through better cost management and proactive credit management. Who will pass the test with flying colours? Time will tell."

The Reserve Bank's last six-monthly assessment of financial stability, published in May, said New Zealand banks appeared "well positioned" to absorb the range of credit losses that could reasonably be expected during the current economic cycle.

"The banks are less favourably positioned to withstand a scenario under which funding becomes more difficult to access in global markets. Although such funding has been readily available in the past, recent events show it may not always be as accessible as previously thought."

The Reserve Bank said the banking system is "very reliant" on non-resident funding given the country's high net external indebtedness and ongoing large current account deficits.

However, one positive spin-off of the downturn is the degree to which banks are willing to communicate more regularly and transparently with their clients.

Ant Grayson, general manager of corporate and institutional banking for Bank of New Zealand, says this is something all New Zealand banks can take credit for.

"More regular conversation is happening with business customers and it is changing, in a broad sense. Different banks will have different degrees of risk, and that will come back to their own strategies and the clients that underpin them. When you're talking about different markets, some banks have been in those markets for a long time and will be more comfortable extending credit in light of what's going on globally. New banks looking at those markets would obviously be looking at that quite differently, but would be unlikely to make an investment or go beyond traditional forms of risk appetite," Grayson says.

Corporate and institutional customers with a BBB credit rating can access capital markets, thereby diversifying their funding away from a banking group.

Grayson says most standard corporate bank customers have a BBB credit rating.

"If you go back 12 to 18 months, because there's a highly competitive and contestable market here, customers were getting customer-friendly terms. Things have gone back towards something that all banks are comfortable with, in light of what's happened. The further you go down the ratings scale, the increased risk is. Banks are being prudent about where they place capital and are making sure they are getting the appropriate returns for their investment."

Grayson says banks recommend their customers don't concentrate their exposure to just one or two financiers.

"If they can diversify their risk across as many different entities as possible that's prudent risk management."

Yes, says Grayson, that advice might appear that banks are turning away business. However, many banks have a long-term view of their customer relationships and dispense advice with that in mind.

Brent Malcolm, head of commercial banking for HSBC New Zealand, says the "rapidly changing" environment is one in which business will need to move quickly to take advantage of opportunities and/or to mitigate risk.

In recent years companies have assumed more risk in terms of debtor collection and creditor payments, moving away from traditional bank trade-related facilities.

Business had sought simplicity and reduced processing costs but had been prepared to assume greater payment risk, Malcolm said.

With so much market uncertainty, companies should be reviewing their risk management policies, and talking to banks about relevant products to reduce risk.

Malcolm said the term 'relationship', was arguably "over- hyped" when it comes to banking.

However, it was timely for companies to work with their bankers to minimise risk; which included not being wary about locking into longer-term commitments.

This did not mean companies should be locking into fixed rates but related more to the actual term commitment that banks were prepared to offer.

"In this current environment banks are more capital-conscious and as such return expectations have increased, so a client is competing for the bank's capital like nothing in recent history. If a term commitment is secured it is another variable a company does not have to concern itself over," Malcolm said.

Westpac's general manager business banking Ian Blair says that despite the pain sections of the New Zealand economy are experiencing, from that comes opportunity.

"When you look at some of the underlying principles, there's a lot of strength that other economies don't necessarily have, which means that we're not going to be in this situation for ever.

"Different economists have got different views, but by the back end of next year, we'll absolutely see things improve. Those that have positioned themselves well for that upturn in the economy have taken advantage of opportunities while things are down.

"It is a cycle, and that creates pain and opportunity," says Blair.

He believes a powerful way through the current global downturn will be for businesses to grasp those opportunities and for banks to have the foresight to support those that are "doing it tough" by understanding their business.

"For those who are looking for opportunities - and we're starting to see more and more now entering that phase - we should be there to support

our good customers."

Blair says Westpac is keen to help customers looking to expand because it has the liquidity resources to do so.

"Staying really close and working very tightly with those that are experiencing difficult times is important, because in many cases their cash needs are actually going up - on both sides - those that are expanding and those that are facing difficulties."

Mark Peart is a Dunedin-based freelance writer.

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