“Don’t bring a knife to a gunfight”, The Untouchables (1987)
We’ve all been there in some way or another. The realisation that you are under prepared and out gunned in this negotiation. Despite your best efforts, the reality is you can’t access what you need. The information is simply inaccessible.
You sit down opposite the team of bankers to talk margins. You notice their black folders, each one bursting with information that you won’t get to see, unless of course – that’s the point. As you look down at your notebook, you already feel this is slipping away from you.
Conversation begins with last quarter’s good results and business outlook. But as sure as night follows day, the conversation heads down a well-rehearsed narrative all too familiar to meeting rooms around the country.
It’s a good story, littered with banker terms – ‘funding cost pressures’, ‘Basel regulatory changes’, ‘return on risk weighted assets’, and of course, ’global economic factors’. In one smooth action, their folders open and you are handed economic chart packs that appear to confirm it all.
In the age of excessive data and information, why is this so hard to check for yourself?
Playing on uneven ground
That familiar scenario is an example of asymmetric information and how it makes the playing field so uneven. The bank simply has much more information than you, and they control what information you receive, how you receive it and the context it is put in.
They have teams of people analysing interest rates and know their funding costs. They assess your business risk and set the risk factors. They know how their pricing and algorithms work. They know what margins other businesses are paying. They write the terms and conditions and optimise them based on their years of experiences with defaults and losses. They can set the market price, because in a market dominated by few – they are the market.
It fits neatly into the adage known as ‘The Golden Rule of Banking’; whoever has the gold, makes the rules.
Is life just unfair?
Life is littered with asymmetric information. We can find numerous examples of transactions that are fraught and uncertain because of an information imbalance. Think of asking a mechanic to find the fault in your car and fix it. Whether we can trust a real estate agent to give us the relevant information about a house we’re interested in and whether the price really reflects the market and the condition of the house.
As products and services get more complex and our available time further stretched, we see more and more information asymmetry – electrical items, tradies, mobile phones, buying property, investment products, online shopping, the list goes on. It hinders markets and is one of the problems with the perfect competition model.
Asymmetric information is found across the business world too. Think about the uncertainty when you take a new CFO role, or whether a new software solution will perform as well as you’ve been told, or the uncertainty of buying a business, or entering a joint venture.
Opacity of the banking industry
Like in other complex, heterogenous markets, challenges arise in bank pricing discussions. By definition, ‘risk-based pricing’ is individually determined by the bank based on specific obligor risk characterisation on the banks’ models. There is no publicly available data to shed light on this, nor any guides that even the savviest CFO could follow to reverse engineer a reasonable risk estimate.
Further complications appear when deriving an underlying ‘cost of funds’ for a given financier. Banks find the most cost-efficient funding sources within market and regulatory constraints. There is no public market index or financial instrument that tells the full story. Those charts presented to you during the pricing discussion oversimplify and over exaggerate costs and tend to focus on the highest profile (and most expensive) sources of funds.
There are few viable options for overcoming asymmetric bank margin information available for the business. Engaging financial consultants will tap into their broader market intel but is often costly for most and fails to provide a transparent ‘bottom-up’ fundamentals-based result. Alternatively, price discovery via a bank tender is an option many have pursed and sounds good in theory but seldom achieves its stated aims; costing reputation, relationship and potentially significant resourcing time.
What the bank doesn’t know
Of course, this is a two-way street, and banks can have real difficulty being certain they have all the information they need from the business. All those information requests, regular reporting of financials, management forecasts, need for current valuations, audit requirements and the ever-contentious directors guarantees is aimed at fixing that information gap (or at a minimum a very big stick for the directors).
But it isn’t foolproof, some businesses still manage to hide information and a few get away with out-and-out fraud which is a topic for another forum.
The Market for “Lemons“
Despite the problem having existed forever, the study of Asymmetric Information only really began with a 1970 paper by the New Keynesian economist George Akerlof (husband of Janet Yellen, the current US Secretary to the Treasury). Akerlof’s paper looked at the difficulty of pricing the used car market because only the owner of a vehicle can really know if it is a good car or a ‘lemon’.
Although Akerlof’s Lemons (as the paper came to be known) was talking about adverse selection, which is a particular form of information asymmetry, further research and theorising over the decades has led to the term being used for any situation where there is a mismatch in crucial information.
Often when we feel ripped off it’s a result of information asymmetry. Think of those nagging doubts about whether the car really did need all that work, or whether you were completely upsold on the new TV you got. Sometimes we find out for definite – like when you discover a friend got the same car as you with optional extras for a lower price, or a fellow CFO refinanced with a sharper margin.
Despite all this there are ways of fixing some of these problems, or at least starting to level the playing field. To give a few examples: engaging mechanics to check over a second-hand car, solicitors to conduct various legal searches on a house, electrical items have a green star rating, we read customer reviews online and there has been a proliferation of product comparison websites.
Similarly in business there are ways to fix information asymmetries, whether that is market disclosure rules, financial product comparisons like Canstar, our networks of business contacts, using trusted advisors like our accountant, M&A specialists, Credit Ratings Agencies. These can be time-consuming and/or expensive, adding to the transaction costs of doing business.
The first bank margin benchmarking platform
The market solves market failures, and so BankEdge was founded. It was built upon the vision of leveling the playing field between banks and businesses with transparent pricing and market information. We have worked for several years sourcing the data and decoding bank pricing algorithms to create our margin reviews and a service platform.
So next time you are faced with compendiums and chart packs, pull out your tablet and turn the tables on discussions with unprecedented access to relevant pricing information.