In Search of Equilibrium
A risk-based model to evaluate the profitability of each banking relationship
Based on a quantitative model that incorporates all the requisite inputs for banks to assess credit risk, our approach to optimizing banking relationships provides an advantage to our clients for future negotiations with their banking partners.
Maintaining a well-balanced relationship with all banking partners is a must for companies that need support, particularly during businesses’ growth phases.
Obviously, a bank satisfied with its relationship with a client will be more likely to offer it financing in the future relative to those corporate relationships that fall short of the bank’s profitability targets. This approach makes even more sense in the prudential context of Basel III, which encourages banks to be more selective in their equity allocations.
Measuring RAROC (Risk Adjusted Return On Capital) involves analyzing the equity return achieved by each banking partner from the financial services supplied to the group. Results are generated on a like-for-like basis, enabling comparisons to be made between banks. This quantitative assessment provides an optimized understanding of the banking relationship, which is regularly subject to subtle cost changes, particularly like those we are seeing in the current market environment.
The quantitative model developed by Redbridge establishes a minimum level of RAROC based on a risk measurement defined by the company’s rating, as internally calculated by the bank. This model has the advantage of producing results based on individualized data inputs for each company, yet offering a standardized comparison of levels of profitability achieved by each banking partner, representing very valuable information.
As well as an assessment of the overall relationship, the measurement of RAROC can be used to prepare for future bank financing negotiations. It is particularly useful for assessing the bank’s level of commitment and service to which the treasury group is entitled from its partners. It creates clarity for banking relationships, giving treasury teams a benchmark for costs and services by allowing teams to accurately gauge not only a bank’s overall profitability on a relationship, but the marginal difference in profitability considering different financing terms and conditions.