Managing financial relationships in challenging times: research from Greenwich Associates turns up recommendations for companies needing credit and other services in a world with fewer banks. (Banking).

Improved prospects for the U.S. economy have yet to trickle up to the largest corporations, who amid rising consumer confidence and declining unemployment find themselves in the first half of 2002 struggling to maintain their composure as menacing clouds gather on their horizon. The ledger of troubles is long, and their nature bafflingly varied and complex.

One of the most unsettling developments for the large business community -- and one that our research consultancy, Greenwich Associates, has watched become more acute in recent years -- is the problem of obtaining credit. As bank directors grow more nervous about the status of their would-be borrowers, they have tightened already-taut credit reins and stiffened return requirements for large corporate borrowers. "Lenders are more prone to strongly request fee-based business," says David L. O'Brien, treasury operations head for the global information technology firm EDS.

Adds Michael L. McKeever, assistant treasurer for the Ethyl Corp., a chemicals business: "They are looking for opportunities to increase margins."

The crunch has become especially acute in the last year, particularly among the top 10 banks in the U.S., where willingness to extend credit as rated by corporate financial executives fell by more then a third in a single year (see chart on page 29). Behind this stark drop-off are a variety of issues:

* First, weakening corporate financial performance, accompanied by a rising burden of non-performing loans, has made banks more wary in extending credit.

* Second, banks are focusing more closely than ever on relationship profitability. Because bank capital is allocated based on risk-adjusted return on capital, bankers are less interested in "plain vanilla" lending unless more attractive ancillary business is also offered. Some lenders view credit as a "loss leader," to be used only as leverage to obtain advisory, underwriting or other high-margin business. One corporate finance manager who asked not to be named said his company had "caved on term structure and covenants." "Adequate return cannot be made on credit products, so ancillary fee business is a must, or else," he said.

* Third, widespread nervousness about lax accounting practices in the wake of Enron Corp.'s collapse and the uneven quality of financial disclosure has added an extra layer of caution.

* Finally, a consolidation in the number of banks serving the large corporate market -- the market segment most roiled by negative earnings surprises, rating agency downgrades and debt defaults -- has further restricted the supply of credit.

During the 1990s, companies were largely in a position to choose their financial service providers. With credit becoming a more scarce resource after a wave of banking consolidations, the tide has shifted in the credit providers' favor, and financial executives must work considerably harder to fulfill their liquidity requirements. They can no longer count on finding banks willing to fill third- and fourth-tier slots in hopes of "up-tiering" someday.

"The banking market is becoming more selective as [banks] focus on a smaller group of key clients in a given sector," says Randy Miller, vice president of finance for Aquila, an energy and risk management company.

This isn't surprising, since Greenwich data shows that in large corporate banking, the one or two banks in the coveted lead tier derive some 50 percent of client revenues, or share of wallet, while the third and fourth tiers combined pocket only 20 percent.

To a certain extent, the tightening of credit and widening of spreads has been a cyclical phenomenon. After a sustained economic boom fueled by plentiful credit, an economic downturn, coupled with slumping profits, typically causes lenders to retrench. During the economic upswing, as financial scars heal, normal credit flows resume. While this pattern will repeat itself for small and middle-market companies, recent structural changes in the financial services industry militate against any rapid return to a more normal lending environment for large corporations.

For banks, assessing financial risk has become a more formidable task. Two decades of financial engineering -- i.e., off-balance financings, ratings triggers and transactions designed to inflate reported earnings -- have come under intense scrutiny. What would happen if a significant portion of the estimated $4 trillion in off-balance sheet debt was included in reported statements? A large volume of high-yield debt and loan syndication issued in the late 1990s will mature in the next few years. How will this debt be re-financed?

Banks strive to leverage their balance sheets with their most profitable and potentially profitable clients, whom they believe will offer the greatest opportunity to cross-sell products, primarily capital market and advisory services. At the same time, they aim to minimize credit availability to more marginal clients. Companies, for their part, are trying to better balance the portfolio of products and services they purchase from banks to implement a system that rewards access to credit with a greater share of mind and wallet.

A byproduct of the wave of commercial bank mergers during the 1990s has been a trend toward consolidation in the number of corporate banking relationships. From 1994 to 2001, the average number of banks used by large companies slipped from 15.4 to 10.5. The reduction was most pronounced with respect to very large companies (annual sales in excess of $5 billion), who typically have twice as many banking relationships as companies with sales below $1 billion. For this segment, the average number of banks used fell from 15.7 to 13.8 from 2000 to 2001. On the other hand, when companies were asked to tally their "important" bank relationships, the average number of relationships rose slightly between 1994 and 2001, from 6.8 to 7.4.

Banks are no longer shy about telling clients that they need noncredit business as a precondition to maintaining credit commitments, or of their willingness to provide access to their balance sheet if companies give them a mandate for non-credit fee business such as debt issuance or foreign exchange trading. While some of the arrangements hinge on an implicit understanding between the parties, others are more explicit.

"Our largest lenders call frequently to make sure that investment banking business is being offered, where possible," says Martha Richey, debt and investments director at Hallmark Cards Inc. "Certainly the expectations for investment banking business are made clear during syndication discussions. The key to successful bank partnering in this market is to manage the fee expectations properly and size your syndication needs responsibly."

There is a gradual shift in how companies allocate their value-added business when it is linked to credit commitments. Most companies compensate credit commitment with cash management contracts and, secondly, foreign exchange business; in 2001, this foreign exchange linkage rose from 39 percent to 46 percent.

Cross-sell linkages also rose in other categories, such as loan syndications, debt underwriting and short-term and excess balance investments. Some financial services traditionally have a weaker link to credit commitments, yet these are ones banks care strongly about. They include custody services, M&A advice, investment management and structured finance.

In considering M&A mandates, credibility with the CEO and an investment bank's proven merger expertise continue to rank highest on the list of key drivers in selecting lead bankers. Nonetheless, a willingness to provide credit has become increasingly significant (see chart on page 30).

In addition, more than 50 percent of the companies cited participation in credit facilities as either "extremely important" or "very important" in designating M&A business. Not surprisingly, companies carrying BB or lower credit ratings placed a very high level of importance on credit when making M&A advisory decisions. Recent research into the investment bank selection process indicates that, among credit providers, the "bulge bracket" institutions with the heftiest balance sheets are winning market share from those with a skimpier appetite for lending.

Credit is also an increasingly decisive factor in choosing lead managers in debt issuance. Some 55 percent of companies expect firms to be a lead credit provider in order to earn consideration to lead their bond offerings. Conversely, only 21 percent said a bank did not have to provide credit in order to head a bond offering. For both debt and M&A business, a bank's willingness to offer credit can become a "tie breaker" for lead manager status.

What can CFOs do to address a constrained credit environment and strengthen their banking relationships? Following are some recommendations based on discussions with key participants on both the buy and sell sides of the market:

* Assess what kind of information transparency is desirable, both in terms of what you need to know about your banks as well as what information you should provide to them. Honest and open communication is at the heart of a strong relationship.

* Redouble efforts to educate your bankers on the company's strategy, culture and financing needs. To become a trusted adviser and true partner, bank relationship managers should have access to senior operating management and talk to them frequently. Says Randy Miller at Aquila: "We have been in very regular dialogue with our bank group and have found out who is committed to the relationship and who may not see the opportunities going forward to justify the commitment. We prefer a smaller group of strong banks rather than a large group of less committed banks."

* Determine how important you are to your key lenders or advisers and how you want to position yourself. If dissatisfied with your positioning, consider what you might do to raise it, including concentrating your business with fewer banks.

* Conduct annual relationship reviews (only about 30 percent do) with bank relationship managers and key product specialists. Formal reviews, most common in the large corporate market, are generally bank-driven. But you can take the initiative, as well. Hallmark's Richey says the company performs annual bank reviews with each of its nine main partners.

* Don't become overly dependent on a single relationship manager. In the new breed of large universal banks, senior relationship managers may be spread too thin and can't cover all the bases. Personnel turnover is inevitable, and can be quite disturbing. Widen contact with your banks, especially senior management.

* Know what you have offer to your banks, especially in the way of non-credit business. Make an effort to understand both the revenue component and profitability to the bank of each service you use. With fewer banks seeking your credit business, you have to be more selective in sharing premium business such as advisory, underwriting and derivatives business.

* Take a hard look at potential conflicts of interest within your organization and ask yourself how outsiders might perceive them. A conflict-of-interest audit might spotlight ethical issues that should be addressed. For example, will hiring treasury staff from your accounting firm be perceived negatively?

* Conduct financial stress tests on the company's capital structure as part of contingency planning. Examine a variety of possible down-side scenarios -- not just problems arising within the normal business planning framework but also on the capital markets side. How, for example, would you cope with a major rating downgrade, activation of rating trigger in a bank covenant or bankruptcy of a key vendor in your supply chain? By anticipating problems and having a frank dialogue with your banker, you may be able to mitigate crises should they arise.

Reduced Willingness to Lend

                2001  2000  1999

Top 10 Banks     29%   47%   47%
Banks ranked 1   12%   23%   22%

Note: Table made from bar graph
Cross-Sell Linkage and Credit Commitments

                       2001  2000

Cash Management         58%   62%
Foreign Exchange        46%   39%
Arranger of             41%   35%
Syndications
Derivatives             36%   34%
Debt Underwriting       32%   26%
Short-term and excess   26%   17%
Balance investments
Structured Finance      25%   30%

Note: Based on companies that award business due to credit
commitment--35% in 2001, 32% in 2000.

Note: Table made from bar graph
Key Factors--Lead Investment Banking Relationships

                              2001  2000

Credibility with CEO           66%   69%
and Board of Directors
Capability in advising on      63%   72%
M&A transactions
Capability of corporate        54%   57%
finance relationship manager
Capability and willingness     37%   24%
to provide credit
Capability in equity           37%   40%
research and underwriting
Capability in long-term        34%   40%
debt underwriting

Note: Based on 458 respondents in 2001 and 472 in 2000 citing each
factor as most important.

Note: Table made from bar graph

Jay Bennett is a managing director and Robert Neuhaus is a Principal with Greenwich Associates, based in Greenwich, Conn. Both consult with the firm's corporate banking clients.