Gearing Ratios: Trading Company vs Bank

[Snoopy]

Snoopy, I think the first thing you need to consider is what "risk" is. From the firm's point of view, the risk you are considering is the risk of not being able to meet their debt obligations, or default risk.

Generally, I agree that the risk I am interested in is 'default risk'. However, I see a bank 'default risk' and a trading company 'default risk' as different.

A trading company is the much simpler case. A trading company have negotiated their own bank loan terms. A trading company knows all about trading in their own sphere. Thus a trading company uses their market knowledge to manage their profits and cashflows in light of their pre-negotiated bank loan obligation.

OTOH a bank must manage risk on two fronts.

FRONT 1: If a bank makes a loan to a trading company, then the bank is taking on a risk outside of their own sphere. Yes a bank will have industry knowledge. But this knowledge is gained from many customers, and thus represents an 'industry average knowledge', rather than 'customer specific knowledge'. Looking at one specific loan case , IMO it is the bank that is taking far more risk than the trading company taking out that loan from the bank. But of course the bank isn't just making one loan to one customer. The bank is making many loans to that same industry. And many loans in one industry portfolio lowers the overall portfolio risk (provided there is indeed diversification of conditions across the many loans).

FRONT 2: A bank is taking in funds from the public (term deposits), whereas a trading company does not (except for maybe long term company specific bonds that might be traded on the debt markets - not an issue in the day to day running of the trading company). Let's say our bank is making a loan to a company producing an automated production line for making fridges in China. Suddenly NZ gets foot and mouth disease, consumer confidence collapses, and consumers as group need their deposit money to pay down debt of other members of this consumer group. Now I think we can agree there is very likely no connection between building a production line for making washing machines in China and foot and mouth on New Zealand farms. But because these two have nothing in common, this introduces a 'funding risk' for the bank loans. A risk where one side wants out of the loan contract for reasons completely unrelated to the project the funds are being used for. I would argue there is no such equivalent risk for an ordinary trading company.

So a trading company must deal with a 'default risk' on one front. The trading company can reduce their risk by having fewer transactions in compatmentalised markets, in which they can use their expertise for better understanding of the business dynamics.

A bank must deal with a 'default risk' on two fronts, either subtley different (Front 1) or completely different (Front 2) from the trading company. The bank can reduce their risk by having many borrowing and lending contracts across many customers on different terms.

SNOOPY