Relationship and Risk in Financial Services

The lack of trust between retail banks and their customers is a major source of inefficiency both to the bank’s financial operations as to the overall consumer driven economy.

With all the turmoil in the capital markets industry due to major write-downs in subprime mortgages, it is easy for us to lose sight in the importance and effect that relationships have on the efficiency and effectiveness of the retail banking system.

1. The relationship between Lender and Borrower
2. The relationship between Regulators and Banks

The outcome of the credit meltdown is that loan securitization (the process of pooling business, home, and other loans in credit products that can be sold to other investors has become a very challenging business.

Commercial banks will need to keep the loans they make and not move them off their balance sheets. According to the Wall Street Journal on Friday, April 18th, last month marked fastest growth rate in bank assets in 28 years.

Securitization became a problem because it gave lenders less reason to focus on whether the borrowers paid the loans back. Securitization depersonalized the lending business and moved the financial effects for the lenders off their books.

Regulators and Investors will force lenders to keep a higher percentage of their loans.

As relationship entities, Regulators, Banks, Businesses and Consumers will be more tightly integrated together. Not just financially, but from a relationship capital viewpoint.

According to Margaret Jane Miller from “The Role of Relationships in Financial Intermediation: Empirical Evidence from the United States Small Business Credit Markets”;

“The relationship that exists between Lender and Borrower is an important factor in determining the loan quality and the interest rate charged on the loan.”

Highlights

1. The variable indicating a personal relationship between firm owners or managers and bank staff was found to be statistically significant for small firms (at the 95-percent confidence interval). The interest rate paid by small firms that did banking in person or by telephone was reduced by more than three¬-quarters of a point in several of the statistical estimations.
2. Firms within close proximity to the bank received credit on more favorable terms. All other things being equal, small firms that received loans from banks located within one¬-half mile of their place of business paid approximately three¬-quarters of a point less in interest.
3. Some other variables that measured the closeness of the relationship between the bank and business, and which did not perform as well, included funds in a checking or savings account, the total amount of credit outstanding with an institution, and the number of years they have done business together. None of these relationships proved to be significant at the 90-percent confidence level.
4. The empirical results were strongest for smaller firms. When the sample firms in the NSSBF were divided into percentiles in terms of number of employees and total firm assets, the interest rate model performed best for the lowest 75th percentile of firms by number of full¬time employees, indicating the bank¬ business relationship is of greatest value to smaller firms.

With respect to relationships between Regulators and Banks, the CPA JOURNAL states: The relationship between bank regulators and independent public accountants has not always been smooth even though they often find themselves examining the financial soundness of the same thrift institution. A sense of distrust and second-guessing sometimes arise because the two camps do not always share their findings with one another. To help bridge this “communication gap” between regulators and CPAs, the New York State Society of CPAs sponsored a panel discussion in which bank regulators were invited to share their views on the performance of independent auditors. The regulators expressed serious concern about the CPAs' insufficient scope of work, deficiencies in reporting on internal control, failure to exercise professional skepticism and lack of documentation. Despite these observations, the regulators believed that the present performance of CPAs is better than their past work

In conclusion, the current stresses in the credit markets will focus Regulators, Banks, and Borrowers to focus not only on improving the traditional credit risk scorecards, but also those develop stronger Personal Relationship Key Performance Indicators. The personal relationship between small business lender and borrower appears to be a strong indicator of loan quality and lower interest rate. The “distrust” between regulators and banks due to a communication gap must be corrected. Stronger interactions and collaboration between these Risk Stakeholders will go a long way in mitigating future financial credit risk.

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