July 08, 2002
The FT's Peter Martin Talks About the Increasing Power of Commercial Banks

Peter Martin thinks that banks have become and will become more and more powerful in their voice in corporate management changes over the next year or so. Why? Because banks have cash, and because the risk environment has changed so that anyone seeking to raise cash from the financial markets themselves is seen as likely to be facing a short-term cash-flow crunch. So managers will have to persuade commercial banks that their firms are or can become "fundamentally sound" in order to gain access to resources and liquidity.


Peter Martin: Bankers Regain Powers

The driving force in corporate transformation was no longer the company's shareholders, advised by high-priced investment bankers. Instead, it was a collection of commercial bankers holding that most crucial ingredient in the post-bubble economy: cash.

Cash matters because companies now have severely diminished access to other sources of short- term finance, such as commercial paper, bond and equity markets and asset sales. The commercial paper market, which freed big companies from dependence on banks for short-term working capital needs, has shrunk in recent years.

In any case, the extent to which it gave issuers independence from the banks turned out to be more illusory than real, since much of it was underwritten by bank lines of credit. During late 2001 and early 2002, US banks began gently tightening the terms they applied to back-up lines...

Peter Martin: Bankers regain powers

Call it the revenge of the nerds. Track down those long-discarded supplies of drip-dry shirts. Toss aside the tasselled loafers. After years of getting no social or sartorial respect, the boring, old-fashioned commercial banks - not the dealmakers, or the derivatives whiz-kids - are back as heavyweights on the financial block.

The key to the new era is the way the commercial banks have reasserted their role as the enforcers of the financial system. Recent crises at Vivendi, Kirch, Fiat, even Enron, have moved towards resolution only as the commercial banks have imposed their will.

A recent, smaller-scale example was this weekend's stand-off over Energis, the UK alternative telecommunications carrier. A consortium of 16 banks rejected a bid from some of the recent masters of the investment universe, two private equity managers and a global investment bank, as too low.

The exact outcome of the Energis drama is yet to be resolved. But at Vivendi, for example, a protracted change of management came about only after the company's biggest lenders made it clear that they wanted stability restored to the boardroom.

The driving force in corporate transformation was no longer the company's shareholders, advised by high-priced investment bankers. Instead, it was a collection of commercial bankers holding that most crucial ingredient in the post-bubble economy: cash.

Cash matters because companies now have severely diminished access to other sources of short- term finance, such as commercial paper, bond and equity markets and asset sales. The commercial paper market, which freed big companies from dependence on banks for short-term working capital needs, has shrunk in recent years.

In any case, the extent to which it gave issuers independence from the banks turned out to be more illusory than real, since much of it was underwritten by bank lines of credit. During late 2001 and early 2002, US banks began gently tightening the terms they applied to back-up lines.

A few high-profile wobbles over commercial paper programmes in the spring of 2002 coincided with the clear realisation that the equity market was no longer a source of fresh finance. In response, big companies turned to the bond markets with great enthusiasm. But the scope for further expansion of bond issuance is limited, given the speed with which overall corporate creditworthiness has been deteriorating.

The renewed power of the banks is reinforced by their relative lack of enthusiasm for what used to be called "loan production". Though most US banks have not been reporting any sharp reduction in willingness to lend, some are undoubtedly tightening their requirements for loans to big business, citing their concerns about the economic environment and the need to protect their own financial strength.

At the heart of this process is a shift back towards an intermediated financial system, which restores power to the commercial banks. This comes after a decade in which every aspect of a company's financial position - both sides of its balance sheet, its operating assets, even the risk it was imposing on its creditors - seemed to have moved into a world of constantly variable market pricing.

In a disintermediated environment, everything could be bought or sold. If a subsidiary was not producing its cost of capital, the company could find another owner for it. Such owners - trade buyers or private equity firms - are now harder to find, at least at acceptable prices.

Similarly, if conventional short-term finance was not available, new instruments such as asset-backed commercial paper could be used to restructure the risk and returns offered to financial counterparties. But asset-backed commercial paper issuance, after growing at breakneck pace, has started to slow.

Last, if banks were unwilling to take the risk of lending to a company on to their own books, they could lay off the risks either through a thriving secondary market for loans, or through the new markets for credit insurance. The latter would offer them substitute assets if the original lender defaulted. Again, this form of innovation is slowing. Re-enter the commercial banker, drawing on techniques that go back hundreds of years.

This shift in power has significant implications for everyone else involved in the financial system, including shareholders, bond investors, providers of credit insurance and incumbent management. The fundamental shift is from a transactional mentality, with instant pay-offs, to one in which potentially long-running personal and institutional risks assume a much higher salience.

To an investment banker, a transaction brings immediate revenues, in the form of fees. To a commercial banker, a new loan may indeed generate fees. But most of the lending decisions commercial bankers now have to take are nothing like so attractive. They generally relate to implementation, or rolling over, of lending decisions taken years ago.

That means that a commercial banker has less motive to be co-operative. The loan production bonuses have long been paid, the syndication dinners held and the dinky Perspex memorial desk-weights distributed. There is little upside in extending the exposure to a company in crisis.

From a corporate manager's point of view, the most important implication of this shift in power is the need to retain control over cash flows, to avoid power shifting to the supplier of emergency finance. From a shareholder or bond investor's point of view, there is another important consideration.

Conventional external analysis of a company's business may fail to signal the moment at which a cash crisis is about to arise. The huge litter of contingent obligations left behind by the frantic dealmaking of the past few decades has made it far harder to gauge a company's underlying financial strength. This was a critical issue in precipitating both the Kirch and Vivendi crises. And Enron, of course, could best be seen as one giant contingent liability.

That leaves many investors facing a double uncertainty. Not only may the company in which they have a stake face a sudden cash crisis but the response of its bankers is also hard to predict. So here is a tip for investors. If trouble strikes, wear drip-dry shirts and unglamorous shoes. It may improve your chances with the financial world's recently restored masters.

Posted by DeLong at July 08, 2002 01:32 PM | Trackback

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