High Yields Can Undermine Value

The succession of bad loans experienced by banks in recent years has been caused in part by their pursuit of high yields on loans without asking whether such yields create value.

In the current crisis in banking, it is more important than ever for management to understand the relationship between value and strategy - to understand how much value is being created or destroyed by operating policies at business units as diverse as wholesale lending, retail banking and trust management.

Without a clear understanding, scarce capital will continue to be misallocated. High yields do not necessarily create high value.

An Example

To illustrate the difference between yield and value, suppose that your bank can raise funds at an average cost of 7% and that the money can be invested either in short-term Treasuries that earn 6.5% or long-term Treasuries that earn 8%. Which investment creats more value for your shareholders?

The answer is that neither creates value. They are both zero net-present-value investments because their yield is exactly the same as the required risk-adjusted rate of return for investing in them. With Treasuries, you get what you pay for. There is zero spread. A $1,000 investment buys you a stream of cash flows with a $1,000 present value. The net present value is zero because the present value of your expected inflows equals the value of your outlay.

Now shift gears. Suppose we are comparing an investment in a low-quality loan that yields 15% with a middle-market loan that yields 12%. Your cost of funds is still 7%.

Ask the same question: Which investment creates more value for your shareholders? The answer depends on whether your risk-adjusted spread is positive or negative. The 7% cost of funds is irrelevant for deciding whether value is created in the wholesale lending business.

Three Separate Businesses

This assertion may seem odd at first, but our point of view is that the strategy of the bank requires that we look at three businesses separately: the retail side that pays 7% for funds and must earn a higher return given its risk; the wholesale side that must earn yields above its opportunity cost (not merely higher than the cost of funds on the retail side); and a treasury unit that stands between the two.

It is impossible to think about a bank's strategy without understanding which business units create or destroy value. Let's cover the retail side of the business, the wholesale side, then put it all together to talk about value and strategy.

Banks, and other financial institutions such as insurance companies, differ from most other corporations because they can create value on both the assets and the liabilities side of their balance sheets. Nonfinance companies generally cannot create value on the liabilities side. When IBM borrows, the net present value of so doing is approximately zero because the present value of the cash payments expected to be made to creditors (interest and principal) is about equal to the present value of the cash borrowed.

Demand Deposits Create Value

Not so for banks. Take noninterest-bearing demand deposits, for example. Although the bank may provide 4 cents or 5 cents of services for each dollar deposited, the opportunity cost to the depositor - what could be earned on the money elsewhere at comparable risk - may be 7% or 8%. In effect, the bank gets to keep, net of all costs, perhaps 3% on every dollar deposited. Hence, the demand deposits are value creating.

The bank can create value by borrowing - a neat trick if it's done right. I wish I could do it, but the government won't let me. I don't have the deposit franchise. It is even possible to imagine a pure retail bank that creates all of its value by efficiently collecting deposits at a positive spread and placing all of its assets in government securities at a zero spread.

A necessary condition for creating value in deposit collection is that the opportunity cost of deposits must be greater than the cost of providing those deposits. Yet too often troubled banks destroy value by the desperate policy of overpaying for brokered deposits or CDs. About 36% of insured CDs pay more than Treasuries of equivalent maturity.

Even the best-managed banks struggle with their retail banking strategies because the opportunity cost of deposits (the matched fund rate, MFR, that should be credited to the retail bank) is not well understood.

The Value in Assets

Banks can also create value on the assets side of their balance sheet. Once again, the key is earning a positive spread, but a spread over what? The answer is always the same - a spread over the opportunity cost of funds.

Too often, though, this rule is misinterpreted. The opportunity cost is not the cost of raising funds on the liabilities side of the balance sheet. It should be the risk-adjusted return that could be earned outside the bank by investing in assets with the same risk.

Take junk bonds as an example. The promised yield to maturity might be 13%, while the bank can raise depository funds at a before-tax cost of only 7%. Let's see why the junk bond loan might destroy value.

The Wrong Cost Factor

First, 7% is the wrong opportunity cost. It is irrelevant for understanding the value of loan operations. As we saw earlier, it is part of the decision about whether or not value is created at the retail bank - part of the retail bank spread.

Second, to evaluate the junk bond loan, we need to know what promised rate of return is required in the marketplace for loans with the same default and interest-rate risk. Suppose the required yield is 15% in an apples-to-apples comparison. Then the loan would destroy value since it would have a spread of minus 2%.

The secret to understanding value creation in the banking business is understanding that the opportunity cost of making risky loans is different from the opportunity cost of gathering deposits. Failure to understand the correct opportunity cost for risky loans has led banks to seek higher earnings and higher return by making loans for lesser-developed countries, highly leveraged transactions, and commercial real estate.

Because many lenders lacked the skill to price high-risk credits, many of these loans were made at negative spreads from the day of their origin. The banks' propensity to make value-destroying loans was exacerbated by many factors. Profits were reduced when Regulation Q was phased out. FDIC insurance provided a safety net that kept deposits in the banks at low opportunity cost even while they were pursuing risky loans.

Discipline Is Needed

And the Federal Reserve changed policy to stabilize the money supply while allowing greater fluctuations in interest rates. To correctly manage lending activities, banks need strict discipline to require positive spreads on loans.

They need to categorize loans by duration (that is, interest rate risk) and credit rating (default risk), then require that loans in each category earn a positive spread over the risk-adjusted opportunity cost. One can easily imagine a profitable lending institution with no deposit franchise whatsoever that creates value for its shareholders.

Putting it all together, it is critical that the bank's strategy should be governed by understanding the value created (or destroyed) by its business units. The retail side and the wholesale side should be considered as stand-alone businesses.

Relevance Is Limited

The cost of funds on the retail side is relevant for the retail business, not for the wholesale business. The value of highyield loans can be measured only by comparing their expected return with investments in other assets of equivalent risk.

Value created at the retail side must be measured by comparing its all-in costs of collecting funds with the risk-adjusted opportunity cost of fund providers. A pure retail bank that invests all of its money in treasuries can create value if it manages its deposit business well, and a pure wholesale bank with no deposit franchise can create value if it lends at a risk-adjusted positive spread.

The bank's treasury function also plays an important role in managing value. It must monitor duration risk for the bank as a whole and decide when to hedge. It also must determine the mismatch profits between funds provided by the retail bank and those borrowed by the wholesale bank - and decide whether or not those profits are sustainable (and, therefore, create value) or whether they are illusory because of the shape of the yield curve.

Difference in Rates Booked

If we use some of the same numbers that were mentioned earlier, for example the opportunity cost of funds on the wholesale side might be 15% (because the loans are high risk) while on the retail side it might be 7%. Treasury would book the 8% difference on all funds "lent" by the retail bank to the wholesale bank.

But the crucial question is, how much of this "profit" creates value? The answer is, not all of it. Part of the spread is a credit risk premium required to make up for expected losses on the high-risk loans. The expected value of this component is zero.

And another large part of it is illusory because of the upward-sloping term structure and the fact that loan portfolios usually have longer duration than deposit portfolios.

This mismatch profit creates no value either, because short-term funds when rolled over have roughly the same cost as longer-term funds. Only the sustainable portion of mismatch profits crates value.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.