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Corporate Banking Deal Screening

Written by a corporate banker at a global bank

Why Are Loans Screened?

For front office corporate banking professionals, additional credit (new money to be committed to a client) is screened by two divisions. The first division is the same as any other part of commercial banking – the risk management division.

The loan is adjudicated by the risk division to assign a credit score. Each credit score will include some component that speaks to the probability of the loan defaulting. Another component will speak to the loss given default – just because a borrower defaults does not mean that the lender loses all of what it has lended out – there is a recovery factor. The probability of default multiplied by the loss given default (LGD) is the expected loss.

Given the expected loss of the loan, the interest rate the bank receives must be high enough to compensate them for the capital that is committed to the loan. For some proposed loans, the bank will simply not lend.

In commercial banking – and especially small business banking at the retail banking level that lends to local operations such as the nearby bouldering gym or bakery – the loan decision is a hard yes or no. The loan will be assigned a credit score based on a very rigid criteria and the interest rate must be x in order for the loan officer to approve the loan. The loan either hurdles or it does not.

The more valuable the company, the more room for negotiation there is in terms of extending credit.

At the highest level, there is corporate or institutional banking for the Pfizers and Cheung Kong Holdings of the world. These companies will require plenty more credit than the average small business and are far more creditworthy – however, the interest rate they demand may not meet bank lending hurdles as measured by return on equity, return on regulated capital and return on risk-weighted assets.

So as a standalone, banks would in theory say no to these loans. In reality, banks will often approve the loans.

Why Do Corporate Loans Not Hurdle For Banks

A lot of corporate loans do hurdle for banks. Term loans and construction loans which pay LIBOR + 300 bps on drawn money can clear standalone hurdles for the bank – in which case there is no real need for deal screening. It hurdles as a loan with all the criteria – approved if credit is approved just like a commercial banking loan.

However, most large corporates are spoiled for diversity in terms of loan options, and bank debt is rarely the cheapest or most ideal in terms of capital structure. Bank debt is onerous in terms of restrictions such as financial covenants while it is much more expensive than the commercial paper market while serving as less permanent capital to term loan Bs or long-term bonds. So when corporates tap banks for credit, this is usually for flexibility – undrawn operating lines or commercial paper backstop (when the commercial paper market freezes up, they can use the bank line as an emergency reserve).

As such, banks have to commit a large amount of capital to the loan despite it not being drawn and paying an adequate interest rate with the expectation that if the draw, it is because the company is already in trouble (if commercial paper freezes up either the economy is in trouble, the company is in trouble or both).

Unfortunately, banks have to pay to play.

Sometimes it is less about the hurdles and more because the bank is breaching concentration risk limits. For instance, if an agricultural company wants $200 million and the bank is overexposed to agricultural firms beyond what internal risk procedures stipulate is acceptable, it needs to be given approval by higher-ups.

Likewise, banks may also have single or group exposure limits. If a major company already has ample credit from the bank (or the borrowers subsidiaries and affiliates) beyond their size limits, there will also need to be a strong business case to be made for this.

Corporate Banking as a Loss Leader

Corporate banking is not commercial banking, however, and is instead an arm of the investment bank in a fully integrated product suite.

As such companies will expect that in order to be in the syndicate for issuing equity or debt – or to be tapped as an execution advisor for mergers and acquisitions, the bank needs to be supportive in the lending syndicate (where they may lose money). Much of the time, economics for other investment banking business is predicated on the pro-rata commitment to lending facilities.

Loan Deal Screening

The solution is that banks will do a big song and dance charade called deal screening or deals committee or whatever.

So assuming that Activision Blizzard wants to upsize their corporate revolver by $1 billion and the return on risk weighted assets is 13% while the internal hurdle is 20%, the corporate banker will have to do some digging to support the capital markets story.

As a corporate banking analyst, this job can range from simple to tedious.

The simple version is to flip an email out to each product group and ask what expected revenues are. This will include equity capital markets, debt capital markets, investment banking coverage/mergers & acquisitions, interest rate solutions, foreign exchange, commodities, securitizations, equity derivatives, money markets, trading, treasury and trade solutions/cash management, trade finance – pretty much everything other than restructuring. Sometimes this extends to other parts of the universal bank outside of capital markets, including private wealth management and credit cards.

The analyst punches in all of these returns to find the return on various metrics and puts together a memorandum for the deal screening team members.

The hard version is where the analyst has to come up with reasonable expectations himself. This means reading the financials and investor presentations to ascertain expected debt issuance. Upcoming debt maturities over the next five years must be refinanced. The debt is investment grade and issuance costs will be 35 bps. There is $12 billion outstanding of which Barclays can expect 10%. $1,200 million * 0.0035 is your expected DCM revenue.

But wait, they are undergoing a large capex program where there will be an expected free cash flow deficit for the next 3 years of $15 billion. The corporate presentation has said that they expect to fund 60% with debt and 20% with preferred shares and 20% with equity. Estimate economics for all of those.

From there, if the analyst sees equity compensation in the form of stock units like RSUs – they may need to have a conversation with the equity derivatives team.

If there is room for leasing or securitization, the analyst may have to get on the phone with a VP from that side.

Once the inputs are submitted, the meeting is scheduled and the corporate bankers convince the deal screening team to lend.

The various product groups will also chime in about how they are a franchise client, competing banks are trying to move up in the syndicate and how this is important signalling to the client universe.

Sometimes the bank will loan even if it does not have a good reason to believe hurdles will be met in order to show the broader market that they are here with dry powder to support clients. Sometimes banks are chasing after a marquee client and want to get into the syndicate before things start to happen in a few years. For major issuances with prestigious titles (think firms such as Apple Inc or Chevron), banks may be willing to lend big in order to grab league table credit for deals (which can be used in firm marketing) even though the fees on the bond issuance are as tiny as the fees on the credit.

If supportive, the deal goes through despite the inadequate hurdle.

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ex investment banking associate

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