During construction of First National Bank of Chicago's headquarters some years ago, a bank executive asked the elevator company's president how much it cost to build and install the lifts.
"Why do you want to know?" he replied.
"Because we want to determine what a fair profit would be on this project and pay you that amount," the banker said.
"Are you crazy?" was the response. "Where did you get that idea from?"
Turns out that he got the idea from the elevator company. Earlier that day a manager from the company had asked a similar question of the First National executive as they discussed the company's account.
"You weren't stupid enough to tell him your costs, were you?" the elevator exec asked.
Unfortunately, the answer was "yes."
The moral of the story is that banking should be like other industries, in which customers are told a price and have no business knowing how it is derived. Finally, it looks like we are getting to be that way.
Banks have often revealed their costs and then said to a customer, "Here they are. Let's negotiate a profit for us."
And for decades, most banks had a policy of "costing" rather than "pricing," offering services at cost to corporate customers.
How could they earn a living? Because customers left deposits in the bank as loan compensation or regular working balances. The bank would pay some low amount as an earnings credit and make its money on the spread between that ridiculous rate and the deposit money's earnings in the open market.
It was like a railroad taking passengers from New York to Chicago for $2.50 and making its money by charging $100 for a hamburger in the dining car.
But borrowers wised up. They took out loans at cost, but whittled their balances-putting the funds into higher yielding Treasuries instead.
Of course most banks are getting away from the concept of earning compensation for loans from balances.
I used to ask bankers what would they do if they were buying10 yo-yos for a kids' party and the retailer said, "We have to keep one as a compensating balance."
You do just that in banking. And since balances have to be supported by non-earning reserves at the Federal Reserve, bankers as well as borrowers know it is more efficient to put excess funds in the markets and reward the bank with a straight fee for a loan.
So, while banks entered kicking and screaming into the world of no mandatory compensating balance requirements, most now realize that banking is better off if prices are set and not negotiated.
Were the president of the elevator company to ask the banker today if he revealed his costs, the banker would be able to reply, "Of course not. You build elevators, and we'll worry about what it costs to get the money we loaned you." Mr. Nadler, an American Banker contributing editor, is a professor of finance at Rutgers University Graduate School of Management.
