Inside track: a banker’s view
Rebecca McNeil, Managing Director of Debt Product and SME Lending at Barclays, explains what underpins the lending costs that businesses can expect to pay when borrowing money.
The Bank of England base rate has held steady at 0.5%, a record low since March 2009. When compared to the BoE base rate of 14.875% in October 1989, it’s clear that this continues to be a relatively good time to borrow money.
Nevertheless, interest rates can change fast, and understanding what drives these fluctuations could be useful for business owners and managers – particularly when contemplating taking out a new loan or business finance product.
So what makes up a bank's interest rate charges to private and business customers?
By far the most important driver is how much it costs a bank to borrow the money it then passes on to its business customers in the form of a loan or other finance facility.
In reality, a bank’s funding costs comprise the amount it pays to its saving customers, the cost of going to the money markets, and the cost of capital.
The cost of funds via the money markets is significant, and can be driven up by the prevailing economic climate. During periods of Eurozone instability, for example, market participants may be nervous about the economic health of certain European countries, and also the major banks – meaning even AAA-rated entities can be required to pay a high cost for funding. The cost will also be influenced by the length of time the loan needs to be funded. Funding a loan over 20 years will cost more than funding over 1 year as saving customers and money markets demand higher returns when money is tied up for longer periods.
Regulatory capital, meanwhile, concerns the level of capital that banks have to hold separately in reserve in order to reduce the risk of their collapse. Under Basel III, this cost will increase significantly, with local regulatory scrutiny further affecting the requirements. The more banks lend, the more regulatory capital they must hold.
Impairment and other costs
Alongside funding costs, a second key factor driving the interest rate charged to bank customers is the cost of impairment. At the time of applying for finance a bank will make a risk assessment of the borrower. A small number of borrowers may find themselves in a financially distressed position in the future, although at the time of applying, it is not possible to determine which borrowers will find themselves in this position. Where borrowers are unable to repay their loan, the bank clearly loses money. This cost is reflected in the interest rates charged, and will be proportional to the initial risk assessment.
Additionally, when businesses take out bank loans, there are servicing costs to be covered, including the cost of providing statements or periodic reviews of the loan terms. There are also costs associated with the use of shared bank facilities – buildings, computers, other assets and typical business services – and with the human resource cost of providing business finance services. Again, these may be reflected in the interest rate or in a separate lending fee.
A relatively small element of the interest rate will be contributed by acquisition costs – the costs of attracting business finance customers, though this is often covered in part by an arrangement fee. Associated costs in this category would include the banks’ marketing and account opening activities.
Tax and profit
As with all other businesses, tax is a cost banks bear. There will, therefore, be an element of the interest rate charged that reflects the corporation tax paid by the bank, which brings us finally to a bank’s profit.
Banks want to lend and attract more deposits – this is a fundamental part of their business. Naturally they need to factor the costs of lending into the interest rates charged, together with an element of profit, as would any other commercial enterprise. The banking market is competitive and customers are willing to shop around for the best deal.
These broad cost categories apply to all core business finance products and services, but the specific level of each does vary according to the type of bank product being accessed. For example, where a loan is secured against an asset, as with a commercial mortgage, the impairment cost will typically be lower than for an unsecured loan where the bank has more exposure to bad debts. However, the cost of acquiring these funds tends to be higher for secured loans, reflecting the fact that the money being supplied is tied up for longer. Secured loans and commercial mortgages will usually require funding for a longer period than an unsecured loan.
Raising business finance clearly comes with costs, and business owners and managers need to understand how they are being charged – assessing interest rates and lending fees in the light of the business impact they can deliver.
If a well-timed funding injection could trigger a new phase of business growth, the associated costs could be recovered many times over. The best advice for any business thinking about borrowing funds is to consult with their accountant and bank managers to ensure they secure the right solution for them.
Watch Barclays economist Henk Potts’ bite-sized ‘UK outlook’ video for his view on when interest rates could rise.