You were sure you were paying too much on your lending so you embarked on a bank tender process. After receiving several offers, you made the decision to refinance. Lower financing costs and better terms; what’s not to like?
Sure, the tender process took a lot of time and effort. And then the actual switching was a bit of a nightmare – just ask the two from your finance team who are still working it through!
You don’t dare quantify all the staff hours, your own time and the various other costs, plus the stress and frustration. One thing you’re sure of though is that you aren’t switching banks for a very long time to come.
Life is full of transaction costs, like those described in the above scenario. Much of what we do isn’t an end in itself, it’s simply part of achieving some bigger goal.
The business of transactions
Transaction cost analysis comes out of New Institutional Economics, an economic school which attempts to add realism to modern economics. It analyses institutions and market problems such as transaction costs and asymmetric information to make economics better reflect the real world.
When we buy a house we research the market, view countless properties, pay for a building inspection, engage solicitors, make repeated trips to the property, and pay stamp duty on the purchase. And of course, the marketing and agents’ fees for the seller [up to 3%].
They are all transaction costs: inherent to the transaction but add additional friction.
Financial costs stand out as the most obvious category, but there is also time, the mental energy, stress and hassle. Some transaction costs we simply can’t avoid, others we do to try to fix information asymmetries, discussed in a previous Policy Bite. We want to spend as little time and money on transaction costs as possible, and preferably would avoid them altogether.
Transaction costs are also found everywhere in business; they can be summed up as all those things that are distracting you from the main game. This includes time spent hiring staff, courting new clients, travelling for meetings, dealing with HR problems, negotiating with suppliers, dealing with landlords and property maintenance.
A perfect transaction
And here’s the poke in the eye. Mainstream (neoclassical) economic models historically assumed transaction costs don’t exist, despite it being blindingly obvious that they do. For example, the idea of easy market entry and exit in the perfect competition model implies there are no transaction costs. That said, mainstream economists do now at least acknowledge their existence.
Types of Transaction Costs
Transaction costs appear in many ways but can be broken down into three main categories.
Search and information costs
The cost of finding information and filling information asymmetries. For example, searching between phone plans, or trying to compare those very different facility offers receive through your bank tender process. BankEdge was envisaged to short cut this process; you already have a bank relationship, facility arrangements so if uncompetitive margins are the issue then a tender could be avoided altogether with the BankEdge service.
Bargaining and decision costs
The cost of negotiating to come to an agreement. For example, strategy meetings debating next steps, or the bank negotiations to arrive at acceptable lending terms. BankEdge’s margin reports and automated strategy generation helps minimise these, however nothing can substitute the human element of a negotiation.
Policing and enforcement costs
The cost of making sure everyone is fulfilling their contractual obligations. For example, audits and performance reviews, or the compliance with bank facility terms such as covenants and adherence to reporting requirements. The BankEdge timeline and automated notifications assists with proactive monitoring and alerts for key facility, covenants and reporting requirements.
Nobel Prize winning economist Douglass North estimated that a staggering 45% of US GDP was generated by dealing with transaction costs – which he defined as ‘the transaction sector’.
How to avoid Bank Loyalty Taxes
High transaction costs make moving banks difficult, as do information asymmetries. A competing facility offer must be sufficiently attractive and worth the time effort to justify a move. In the retail home loan market, longstanding customers are called the ‘back-book’ and pay materially higher home loan rates than their bank-switching friends in the ‘front book’. Banks’ provide sufficiently discounted specials and even cash offers to offset switching costs and grow their market share. Unfortunately, the back-book loyal customers are the losers in this game and pay a what we call a Bank Loyalty Tax.
BankEdge – just another transaction cost?
Yes – you would be correct in saying that BankEdge is ‘another transaction cost’. But transaction costs always exist, and in trying to avoid them you may have to compromise on the transaction outcome.
All action, including inaction, has a cost.
The CFO’s decision tree goes like this…
Option A: do nothing
CFOs that would rather not challenge their bank relationship and margins.
Stay with your bank
Stay with your incumbent bank and accept margins with minimal pushback, incurring the loyalty tax. Despite this being the easiest option, a higher margin is a hit to profitability and a real cost – many multiples higher than the cost of a margin Health Check.
Option B: do something
CFOs with proactive awareness and a desire to reduce financing costs.
- Highest transaction costs.
- High financial, significant time, information and decision costs to choose the best offer.
- Decisions are influenced by the customer-bank relationship.
- The prospect of losing valuable relationship history and familiarity.
- Medium transaction cost.
- Low financial cost but high information and bargaining costs to form argument for margin reduction and negotiate effectively.
- Negotiations are influenced by bank’s familiarity of the business and its anticipated response, and ‘give the client a win’ margin hand-back will be baked into initial offers.
BankEdge Review + Negotiation
- Low transaction costs.
- Low financial, little time, information and decision costs as facility offer is compared to the market to give clear strategies.
- Clear cost structure with capped transaction costs and ability to further reduce costs with success-based pricing structure.
- Only ‘bottom up’ pricing review available in the market resulting in ‘true returns’ insights rather than ‘market consensus’ discovery.
So, there you have it. BankEdge is a transaction cost that is comparatively low, time and resource efficient. Most importantly, the review process occurs sufficiently early in the decision tree to achieve the same financial outcome that often results from a tender – that is a revised margin with incumbent bank, without the high transaction costs and uncertainty that comes with a new bank.
The key takeaway: early intervention avoids larger transaction costs later on, and reduces current transaction costs.
At BankEdge, we equip businesses with relevant insights so they spend less on transaction costs, and facilitate a productive bank-customer relationship.