RETAIL RISK AND CORPORATE RISK

Let us ask a question: Is retail credit riskier that corporate credit?

It might be argued that a retail credit customer has more probability of default than a corporate customer. However, in retail banking, we consider not only the individual customer but also the overall portfolio, which can be a huge number of customers since retail banking applies the ‘law of large numbers’. We then could easily say that retail credit is by far a lower credit risk than corporate credit, as we apply the law of large numbers, where we have a large number of borrowers, and the amounts are of a small nature. Therefore, the possibility that a big share of the retail portfolio would default is very rare: it would require a major economic crisis.   

Market forces for risk

There are four major market forces that affect the economy and can have an impact on bank risk. Those major market forces are the government, supply and demand, speculation, and international flows of funds.

Government

The Government has influence over markets through tools including fiscal policy, which is government spending and taxation. Central banks control monetary policies including interest rates and generally aim to control inflation and keep prices stable. In theory, central banks are independent of government but in practice the government exercises considerable influence over the central bank, and the level of central bank independence varies from country to country. When a government issues restrictions on real estate markets, those restrictions would affect bank credit for houses and mortgage loans. Such policies may boost the economy or may also cool down the market. An increase in government spending will generally reduce unemployment and stabilize prices. The central bank can deliver a similar impact by increasing and decreasing interest rates.

Supply & Demand

The supply and demand of products, services and investments has a direct impact on the market. An increase of demand over supply can result in inflation, while the increase in supply over demand can cause deflation.

International flow of funds

The flow of funds from one country to another can boost the economy and local currency. The more a country has an inflow of funds, through for example an increase in exports or an increase in inbound tourism greater than the outflow of funds such as an increase in imports, the more an economy should show growth.

Speculation and Rumours

Sometimes speculation by market commentators or the media and others may affect the economy until otherwise proven right or wrong.

Historical view of corporate vs retail credit

The banking business has migrated over time from corporate lending towards retail lending, reducing the market share of corporate credit and increasing the market share for retail lending. As the market developed, the growth of retail banking during recent decades has resulted in the retail bank being able to provide most of the individual customer’s needs, reducing the market share for corporate lending relative to retail lending.

For example, if a bank finances a car factory with $100 million, the factory may use the money to finance the following:

1– Spending $10 million towards financing the purchase of machinery, other assets, or building construction.

2 – Spending $90 million for financing credit sales to their agents or distributors.

When banks finance individuals to purchase cars in cash from car dealers, the dealer would get the sales proceeds in cash – which results in cancelling lines of credit with corporate banks.

A wholesale bank credit facility of $90 million for financing credit sales to agents wouldn’t be needed any more. That would decrease or eliminate the lending portion from corporate banks toward retail banks. This is how retail credit can grow, and increase its share over corporate credit.