Tuesday, 3 December 2013

Billy's Eighth Law: When it comes to the bank, they guy who writes the ads ain’t the guy that writes the loans.

Business owners, media, politicians and the public in general, are in the dark when it comes to business banking. I am not talking about complex derivatives, credit default swaps and currency futures. These are incomprehensible to most bankers, hence this little thing called the credit crisis!  (I actually know what those things are and they never help me in my dealings with small and medium sized enterprises.)  No, I am talking about good old fashioned borrowing and lending.
Banking, to quote the Canadian Bankers Association, is a low risk, low margin, high volume business.  Banks raise money two ways...debt and equity.  A bank incurs debt when it issues a bond or takes deposits from customers.  A bank finances through equity by issuing shares or retaining earnings in the business.  The government requires a certain ratio between debt and equity known as the reserve requirement.
But let's make this easy... we will start-up our own bank.  We'll call it the Entrepreneurship Bank and lend money to struggling entrepreneurs who want to start and expand their businesses. 
Step One:  Capitalize the Bank
To begin we capitalize the bank with $100,000. (It's a small bank for small business)  The rules allow us to raise $1,000,000 in debt.  This is a total of $1,100,000.  We keep side $100,000 in cash float, and have one-million dollars left.  We can now begin to lend money.

Step Two:  Borrowing and Lending
We can now look at the bank’s revenue & expenses under the following assumptions.

Our lending rate averages 6%.
  We pay, on average 2% on deposits
  We generate $20,000 in fees
  Our overhead costs are $30,000
We can look at the income statement:


Notice, we have a profit of $30,000 per year…not bad for an investment of $100,000.  However I have forgotten one small detail...bad loans.  Banks and other financial institutions must make reserves for those loans that will never be repaid.  When I ask participants in small business seminars for an estimate of the percentage of loan loss (sometimes known as PCL, provision for credit loss), they usually tell me, “I guess it’s around 10%” In this example, if the bank would lose $70,000, wiping out most of the capital in the bank and forcing it into insolvency. In our example, a loan loss of 3% would leave the bank without a profit and 4% would create a loss!
In real life, the numbers are much larger, the Net Interest Income is a bit higher and the loan loss provision is between .5% and 1%. Regardless, if a bank makes a net profit of 2% on loan assets after loan loss, they are doing well.  Banks are lenders, not investors. If your bank seems to be somewhat conservative, then it is another reminder that banking is a low risk, low margin high volume business.  
Understanding your bank, and how bank financing works, is essential if you want to be successfully apply for bank financing.  Unfortunately, most bank lending to Small and Medium Enterprises...loans under $250,000 are written by personal and not commercial lenders,  The implications of this fundamental flaw in the banking system is a topic for another law. 

So the next time you apply for bank financing remember, your banker must be right 99% of the time in order to preserve his or her bank. 

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