You may have watched on television how surgical and cosmetic treatments can quickly turn plain citizens into attractive eye catchers. Apparently this TV-show has inspired banks, although they have reversed the metamorphosis, from exciting to plain. In bank terms this is called a transformation from transaction banking to relationship banking.
In the decade before the credit crisis, transaction banks have grown tremendously. Their business model is based on trade in financial instruments. Transaction banks are funded using money or bond market instruments and invest the proceeds in more or less risky assets, such as the notorious toxic securities. In good times, transaction banking facilitates quicker and stronger balance sheet growth than relationship banking, whereby non-tradable loans are funded using deposits. Key to the relationship model is local market knowledge and a strong, long-term customer orientation. Most economists would hold that this is the real competitive advantage of banks. Capturing the full benefits of long-term relationships is, however, a slow process, which explains why relationship banks have been the wallflowers of banking for so long.
As we have seen, transaction banks are extremely vulnerable to shocks in financial markets. The simultaneous drying up of market and funding liquidity has put holes in their balance sheets. As a result, the confidence in this type of banking has quickly eroded. So it was high time for an extreme makeover. Around the world banks are paying visits to the beauty parlor. Below I will discuss the case of the small Dutch merchant bank NIBC, which gives some insights into the world of beauty specialists, in this case the accountants and the government.
In October 2008 the International Accounting Standards Board has amended the accounting standards, to the effect that certain financial assets can be classified and valued in a different way. Credit portfolios in which banks traded actively prior to the crisis (classified under “held for trading” and “available for sale”) can now be classified under “loans and receivables”. The markets in which these assets were traded have dried up and as a result banks intend to hold them for the foreseeable future. For these assets fair value can be replaced by amortised cost valuation, which avoids large asset writedowns. NIBC has quickly used this opportunity. As a result the value of NIBC’s trade portfolio has been reduced by approximately € 5 billion (3rd Quarter 2008). The biggest item on NIBC’s balance sheet is now “corporate lending”, which equals almost € 7 billion on a balance sheet total of about € 27 billion (again 3rd Quarter, 2008). This may sound like relationship banking, but obviously it isn’t.
Next the liability side of NIBC’s balance sheet has been shored up. NIBC was one of the first Dutch banks to have used the Dutch state’s € 200 billion guarantee scheme. In December 2008, the bank raised € 1.25 billion using a state-guaranteed medium term note. It raised another state-guaranteed € 1.5 billion in February 2009. A maybe even more important form of state support has been the widening of the deposit insurance scheme to € 100,000 in October 2008. This has enabled NIBC to enter the Dutch savings market and cream off interest-sensitive savers from other Dutch banks. In five months, it raised € 1 billion under the brand of NIBC Direct. The new savers go for the high interest rates and feel sufficiently protected by the deposit guarantee system. In February 2009 NIBC announced that it would extent its internet banking operations to the German savings market, through its Frankfurt branch. These German operations fall under the Dutch deposit guarantee and are meant to raise another substantial amount of savings.
NIBC argues that a small internet bank is able to offer higher rates than traditional banks because of a cost advantage. But this argument is incomplete at best. Traditional relationship banks have indeed invested “bricks and mortar” in local market presence and knowledge. But the reason for doing so is their expectation that these investments can be recouped through a higher margin on lending to small- and medium-sized businesses. Just looking at the cost side, as NIBC does, is superficial.
The NIBC case raises a number of questions. First, the Dutch state has mispriced the fees for state guarantees. NIBC paid approximately a 1% fee for the guarantees on the medium term notes. Yet for the deposit guarantee (de jure by the other Dutch banks, de facto by the Dutch state) the fee is 0%. This bias provides an incentive towards deposit funding.
The second question is how NIBC will earn the rates it pays to deposit holders. By setting interest rates high, an internet bank can raise funds quickly. Transaction banks would reinvest these funds as quickly in the capital markets. In contrast, relationship banks need time to screen loan applicants in order to ensure that the funds are lent profitably. Even if an internet bank would like to emulate this, it couldn’t do so for lack of manpower and a local network. An internet bank might thus be tempted to take on more risk. This was the problem with ING in the United States. Its subsidiary ING Direct USA attracted savings faster than it could originate mortgages. The surplus funds found their way in a large portfolio of Alt-A securities, which was recently guaranteed by the Dutch government. With regard to NIBC the Dutch taxpayer still needs an answer to the above question.
Related to this, one can question the stability of internet bank business model in general. Internet banks attract the most interest-sensitive customers. This reduces their ability to play the game of price discrimination which traditional banks play. Initially, savers are attracted through high teaser rates but over time the rate starts to lag behind market rates. In contrast, internet banks need to offer competitive rates to all clients all of the time, as most of their clients are “hit-and-run” savers. ING Direct UK has some experience with this, when between 2006 and 2008 its deposits dropped from € 37 billion to € 19 billion due to uncompetitive rates. Having an interest-sensitive customer base builds an intrinsic instability in internet bank funding.
But the biggest worry in the current economic climate should be that internet banks tap savings from the real relationship banks. Especially during a recession, the bond between a bank and his client is of great importance. Relationship banks are in the best position to guide their debtors through difficult times. This important task isn’t made any easier when relationship banks loose savings to internet banks or experience a deterioration of interest margins due to internet competition.
The Dutch government argues that NIBC has a banking license and is free to enter the Dutch and German savings markets. With regard to the German market the government refers to the EU rules on branch banking. But an appeal to the free market lacks credibility in a sector which is kept alive by government support. And EU rules can be changed. I suppose that the German authorities too are not so keen on the market activity of NIBC, for reasons mentioned above. So it shouldn’t be too hard to agree on a change in the EU rules. In the meantime, the Dutch government has enough tools to force NIBC to change its strategy. The Minister of Finance decides on qualification for the € 200 billion guarantee package and can change the deposit guarantee system. In addition, the supervisor has its own arsenal of instruments.
Beauty is within. A trip to the beauty parlor will not make a beautiful human being. Similarly, accounting reclassifications and internet savings don’t make a relationship bank. On the contrary. NIBC’s recent metamorphosis to internet bank constitutes a threat to the real relationship banks, who are right now dearly needed to offer life lines to small- and medium sized firms. Seems like a clear case for government intervention