Thursday, 28 February 2013

The Insidious Arrangement Fee

The excellent post by John Carney on the basics of a bank loan hit a chord with me and brought into focus something that has been worrying me for a long time.

John's post shows that although banks are notionally capital constrained and reserve constrained, it is fairly straightforward to create loans that are self-financing or partially self-financing.

The trick is to realise that banks fund their capital by converting a deposit into a capital instrument. And the easiest way to do that is to create the required capital instrument at the point the deposit is created - when the loan is advanced.

So you issue a loan in the standard fashion - but you charge an 'arrangement fee' and roll it into the loan. That arrangement fee goes straight to the bottom line. The bottom line is the profit and loss account and the profit and loss account is regulatory capital.

Here's a self-funding bank making a £20K loan under the UK regulatory system - covering the cash deposit ratio of 0.11% and an 8% capital requirement with a £1600 arrangement fee.

Self Funding Bank
Assets
Liabilities
CB Reserves 24 Inter Bank Loan 24
Loans 21600 Deposit 20000


Profit 1600

Now we're not quite at the fully self-funding stage. But the general upward creep in the size of arrangement fees suggests that partial self-funding is already here. Here's today's top buy from my local building society (which incidentally has a reserve account at the Bank of England).


I know as a fact it doesn't cost them that much to set up the loan - even at a fixed rate.

So are there Gresham dynamics at work here. Is a tight capital market and the tyranny of the 'best buy' tables forcing the rise and rise of the arrangement fee - which then undermines the regulatory capital constraints.

Warren is very fond of saying that capital is always available at a price. That price may be somewhat lower than many imagine.

(Full reservist might like to reflect on the fact that bank capital is converted to deposits by the loan process, and those deposits are then converted back into capital based on bank demand. Rinse and repeat. It's an infinite spiral constrained by price in that system too. There's no magic. Just a change in price.)