Guest commentary by Heiner Herkenhoff, published in the “Zeitschrift für das gesamte Kreditwesen” on 2 January 2024
Mastering the economic transition with the help of a principal bank
Technical terms are ubiquitous in the finance industry. So it is hardly surprising that in German, the term “Hausbankbeziehung” (the relationship a business has with their principal bank) is widespread. Although the term is somewhat unwieldy, the concept it refers to is lively and vibrant: a long-term, stable relationship between the bank and the business, built on trust. A relationship that has grown over time and is likely to persist through both good times and bad. Metaphorically: a company’s principal bank will not demand that the borrowed umbrella be returned when it starts to rain, but will wait until the company has found lasting shelter.
However, a strong relationship between a business and their principal bank is often viewed as having an air of complacency about it, leading to suspicions that such a relationship cannot do justice to our current dynamic market situation. Should a business really rely primarily on a single institution in a world that presents so many options, particularly since the principal bank may not offer the most favourable interest rates? And besides, isn’t it much easier for businesses today to arrange financing via the many digital channels available to them? As we look towards the future, isn’t it true that soon, various platforms will take over as intermediaries, heralding the end of the traditional banking industry and eliminating the concept of a principal bank entirely?
More than just a financial relationship
To answer these questions (and refute the underlying theses), we must first examine what, exactly, a principal bank is, doing away with common misconceptions in the process. Of course, credit is the most important financial product connecting a business to their principal bank. But it would be wrong to reduce the relationship between corporate clients and banks to financing alone. Banks offer a wide range of products and services that are useful for businesses: deposit banking, payment transactions, cash management, investment services, hedging and even support for complex issues such as business succession planning. When taken together, these products and services offer true added value to businesses.
There is no question that many mid-sized businesses, to say nothing of large corporations, have business relationships with more than one bank. As competition increases and new digital offers emerge, it is also clear that relationships with a principal bank are under more scrutiny than ever before. Businesses of all sizes can now find financing offers from a variety of providers online.
However, larger corporations, in particular, have consultation needs that FinTechs and other digital providers are simply unable to meet. That is because a bank is more than just an intermediary to call on when raising capital; corporate clients benefit significantly from intensive consultation services. These may involve digital tools, but only in a supporting role. It is the personalised contact with the bank that really counts. And there are obvious advantages to having a relationship to a single bank that understands the business like no other and feels a particular responsibility towards them.
In light of all that, it is hardly surprising that the structure of customer relations between businesses and individual banks has changed only slightly, despite the significant technological advances made over the last 20 years. There is also currently no plausible evidence that the stable relationship between businesses and their principal banks could be eroded by digitalisation. To make a long story short, having a principal bank is a tried and tested concept and will continue to characterise the business relationship between banks and corporate clients for a long time to come.
Principal banks in times of crisis
A few years ago, before the pandemic, it might not have made sense to make such a clear and unwavering prediction. But during the many months of lockdown, and particularly considering the dramatic drop in profits experienced by some industries, businesses once again came to understand the value of having a stable relationship with their principal bank. Whether the principal was a private bank, savings bank or cooperative bank, these banks operated as the first point of contact for their clients and were essential to providing much needed credit. Funding schemes offered in Germany during the pandemic by the KfW (German Reconstruction Loan Corporation) and state development banks, which were vital for ensuring liquidity during the crisis, were also paid out via the relevant principal banks. While it is true that the development banks were responsible for a large percentage of the liability risks associated with these programmes (100 percent of the risk, in fact, for the KfW Schnellkredit programme), the loan application, review, payment and maintenance were carried out by principal banks.
In times of crisis, in particular, businesses receive a great deal of support from their consultant at the bank – a fact that has been evident during more than just the coronavirus crisis. After all, relationships between a business and a bank are based on mutual trust. And the trust invested in these relationships yields excellent returns, especially when times get tough. Principal banks did not simply provide loans to their clients during the pandemic; in many cases they allowed clients to defer payments on existing loans. They were only able to do this because they had known their clients for years and trusted that their goodwill would be returned in kind.
And in times of change
Of course, even though the current situation is marked by crises, that does not mean that principal banks’ only value is to support their clients in difficult times – even though this aspect of the relationship was once again essential to surviving the energy crisis. The next few years – decades even – will be a time of change and transformation. They will have to be, if Germany is to achieve its climate goals while remaining competitive on an international scale. German businesses are at home on the global markets. They are currently working hard to manufacture innovative products, build stable supply chains and continue to prepare their businesses for the digital future, all while simultaneously investing in climate friendly technologies. They will almost certainly not be able to do so unless they are able to maintain a stable relationship with well positioned banks.
Despite growing geopolitical unrest and justified calls for de-risking, a universal retreat from global markets is not a viable alternative, particularly for the German economy. Local businesses will continue to focus on foreign markets and expansion. To do so, they will need support and help from their principal banks.
Private banks dominate in foreign business, and have a great deal of expertise to offer: They support their clients as they gather information on foreign markets, assess the risks of international business, hedge and finance exports. In the future, as many businesses concentrate on diversifying sales markets and creating new supply chains, they will continue to rely on a close working relationship with their principal bank.
And the expertise listed above does not even take into account the major challenge we are all faced with: financing climate change mitigation and the green economic transition. Of course, banks will not be able to take on this monumental mission alone. It will require a mix of financing options, including both funding from capital markets and seed capital from public grants. It is important to note here, however, that bank loans remain the most important source of financing for mid-sized businesses in Germany, and that subsidies are applied for and granted via a company’s principal bank. So there can really be no doubt as to the relevance of the banks, and the responsibility they bear.
ESG and sustainability
In the end, businesses need their principal banks to work with them as they navigate the new ESG and sustainability paradigms. Right now, many businesses are facing a great deal of uncertainty, as they are not sure how, exactly, the debate surrounding sustainability will affect them. Many of them are unsure as to whether or not they will be able to take out loans at all, and if so, what the conditions of such loans will be in the event that they do not meet taxonomy criteria or are unable to provide the data required to prove that they do so.
These worries as expressed by corporate clients are often unfounded, and yet it is clear that they will have to delve into the issue of sustainability – among other things, because ESG factors will become a core factor in the lending business. This is unavoidable, as many banks, particularly the larger ones, have committed to aligning their portfolios with the Paris Agreement goals. In the years since the signing of the agreement, these goals have been added to, with specifications for intermediate goals and in some cases even concrete methods for the reduction of CO2. The strategic positioning of these banks will, in the future, be reflected even more strongly in their lending portfolio. Not only that, banking regulation is also increasingly aimed at steering capital towards sustainability and anchoring ESG in risk management procedures.
German and European banking supervision regulations, as well as the European Banking Authority (EBA), have now established specific requirements regarding how banks are to integrate ESG risks, climate risks in particular, into their risk management processes. The expectation is that a client’s ESG profile will be taken into account when deciding to grant a loan, evaluating collateral and ultimately, also reflected in the terms of the loan. In the future, ESG is to be integrated into the assessment of a client’s credit worthiness.
Data are important
What does that mean in practice? In addition to well-established financial information, banks will need to collect sustainability data from their corporate clients. These are collected in a variety of ways: via public sources, sustainability reports, external data providers and credit assessment forms. In doing so, banks will not be required to collect individual data on every single client; from a supervisory standpoint, it is possible to use sector averages for both small and micro businesses. Many banks are already taking advantage of this ruling. As a general rule, however, many corporate clients will already have been asked to provide ESG data to their banks. And of course, many businesses are required to report on ESG, will be required to do so in the future, or will be asked to provide such data due to their position within a supply chain. As such, it makes a lot of sense for businesses to examine the data requirements as early as possible.
When it comes to granting loans, it is true that many banks operate with ESG scoring metrics specially developed to assess a businesses’ ESG profile. However, at present these are merely an additional source of information for assessing credit worthiness. There is currently – given the short time series – no direct connection between a client’s ESG score and the probability of default on a loan. How banks handle problematic ESG scores differs: there is no standardised procedure for such cases. In general, the bank will simply examine the loan more closely. The ESG score is often the start of a more intensive dialogue with a corporate client, in which both parties discuss challenges and possible solutions against the backdrop of sustainability.
Mastering the economic transition together
The taxonomy is another matter entirely. There is no question that the EU regulation will introduce new obligations for businesses: businesses subject to reporting under the taxonomy must provide qualitative information regarding the scope to which their economic activities are sustainable as per the taxonomy objectives. However, the taxonomy in its current state cannot be used as a KPI by banks. This is because only a small percentage of economic activities are included in the taxonomy at all, and the number that meet the relevant criteria is even smaller.
Of course, banks are responsible for funding more than just these ‘dark green’ portions of the taxonomy; they provide financing for the economy as a whole. The economic transition will take a long time, and banks want to support their clients on the journey – particularly when they are in the beginning stages of transforming their business to conform with the taxonomy. Corporate clients do not need to worry about the taxonomy, because banks do not use it as a KPI.
But banks do have to understand how businesses are reacting to changing circumstances, and which climate mitigation measures they are planning on taking. In the end, of course, it is the clients who are the experts on the path they will take towards climate neutrality. But banks want to raise awareness of the issue, at least for those businesses who are not already working towards conformity. Above all else, however, banks want to work together with their clients to master the economic transition – as lenders, advisors and partners. In other words: they want to act as principal banks, ready to help their clients overcome the challenges the future will bring.