What is “Corporate Banking”?
Corporate Banking is a specialized division of a commercial bank that offers a varied range of banking solutions that are tailor-made for clientele. This can range from large corporations, and small and medium-sized enterprises to governments, among others.
The banking solutions offered tend to include: providing corporate loans and credit products, loan syndication, cash management services through which companies can manage their working capital requirements, risk management services, customized loans and lease agreements to purchase fixed assets, project finance, trade finance, treasury services, and advisory services including debt and equity restructuring, mergers and acquisitions, taxation, and portfolio analysis.
Commercial banks may also have investment banking divisions that provide larger corporates with asset management services, underwriting IPOs (initial public offerings to raise capital from stock markets), mergers and acquisitions, etc.
Key Learning Points
- Corporate banking solutions generally include credit, asset, cash and loan management, and corporate finance
- Corporate lending is usually the biggest source of revenue and profits for banks
- Corporate loans and credit products include asset-based lending, structured finance, and cash-flow lending
- In loan syndication, a group of lenders collaborates together to provide credit to a single large borrower, which could be a conglomerate, multinational, etc
- In project finance, banks offer specific loans for infrastructure and other projects to corporates
- If banks’ underestimate credit risk, it will adversely impact their balance sheets and profitability
Types of Management and Some Core Corporate Banking Solutions
Corporate banking solutions offered by lenders largely include credit, asset, cash and loan management, and corporate finance (or lending). Banks not only give credit, but they can also be involved in the credit management process that involves laying down the terms and conditions of the loans, assessing risk factors, and taking into account concerns of liquidity, safety, and profitability while lending to firms.
In asset management, this segment of corporate banking is concerned with directing and investing money owned by corporates. In cash management, managing the cash flow is of paramount concern and is focused on the efficient collection, distribution, and investment of the cash flow of firms.
Loan management: this includes issues such as the process of granting loans to corporates, matters relating to compliance vis-a-vis credit regulation policies, and other related functions that are overseen by the loan department of the bank.
In Corporate Banking, lending happens to be the biggest source of revenue and profits for banks.
Corporate loans and credit products: the same include asset-based lending (i.e. secured lending against collateral), structured finance, and cash-flow lending (i.e. unsecured loans for meeting immediate cash requirements). In structured finance, securitization is used – where non-tradable assets are packaged and then converted into financial security. Thereafter, the same is sold to institutional investors.
Loan syndication: a group of lenders collaborates together to provide credit to a single large borrower. The collaboration is usually through an intermediary which organizes and administers the syndicated loan and is a lead financial institution. In loan syndication, the risk vis-a-vis the loan is shared by the group of lenders and each lender contributes part of the loan amount.
Project finance: banks do offer specific loans for large infrastructure and other projects. In such loans, repayment is based on the revenue that is generated by the project.
Treasury services: the same include foreign exchange services, money market, fixed income products related services, interest rate management products, and yield-enhancing investment strategies.
Trade Finance: supports exporters and importers through securing and financing their international trade transactions via trade finance solutions. Letters of credit, documentary collections, and bank guarantees form the essence of such solutions.
Credit Risk – Bad Loans Impact on a Bank’s Balance Sheet and Profits
Given below is a workout of how bad loans can adversely impact a bank’s balance sheet and profits.
The key assumption in this example is that a bank (Bank A) underestimated the risk vis-a-vis some of the corporate loans that it made and 10% of the high-risk loans went bad. Further, the bank has US$1bn of Risk-Weighted Assets (RWA), which are the sum of loans in its loan portfolios (comprising both high risk and low-risk loans). As per the BASEL Accord, a lending institution or a bank’s common equity TIER 1 Capital must be greater than 4.5% of its Risk-Weighted Assets (RWA’s).
Having stated the above, we start with TIER 1 Capital on the Balance Sheet as US$45m (i.e. US$1bn (Risk-Weighted Assets) * 4.5%). Further, the bank has excess cash of US$20m.
Next, if 10% of loans go bad, then these loans are written off of equity, so TIER 1 Capital goes down to US$35m from US$45m. The maximum Risk-Weighted Assets (RWA) go down which means that the new balance sheet of the bank requires it to dump a part of its loan portfolio to maintain an adequate ratio. So, post adjustment, three things happen: 1) the excess cash goes up (which doesn’t fetch any returns), 2) the Risk-Weighted Assets go down (i.e. US$777.8m) and 3) the Tier 1 Capital reduces to US$35m (as stated below).
Next, another adverse result of 10% of the high-risk loans going bad is that the new loan portfolio brings the bank less return. In other words, in the old loan portfolio, the loans were generating net interest income on loans of US$55m (initial income statement) and net interest income was US$45.3m.
Now, in the new loan portfolio, the bank is generating net interest income on loans of only US.9m (adjusted income statement) and net interest income reduces to US.1m. In essence, a loss of US$10m i.e. 1% of risk-weighted assets due to bad loans reduced the net income of the bank by US$16.1m (or 35.6% of the bank’s profits).