A friend of mine narrated this anecdote. My friend said that 10 years ago he purchased an apartment in a prime area in Bengaluru and planned to let this house on rent to earn some rental income. He said but the rents in that area are fairly high and even though his own apartment is 20 years old, it still fetches a good rent.

My friend has read economic books and understands supply and demand. During Covid when most employees worked from home, demand dropped and his house was vacant for 3 months. Without much emotion, he dropped rents by 30% to attract new tenants. He says, renting a house is like selling perishable inventory and that if the house stays empty for a month, that inventory is lost forever. And therefore, cutting prices is the right thing to do. Nowadays, demand has come back strong and he has raised the rents above the Covid times.

My friend is also like a conservative banker. He knows that he can earn a rent of say Rs 25,000 per month. And the people who can afford it are usually a working couple. And the rent signals self selection. Those who can afford it will step forward and those who can’t will step away. But to select among those who come forward, my friend turns into a conservative banker. Let’s take a small detour on banking.

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Here is how a bank works:

• The bank has some money of it’s own, which is the equity. But it also borrows money from say depositors. For example, HDFC Bank has a Debt to Equity ratio of 7. And let’s say the combined cost of Equity and Debt is say 5%.
• Any banker, when he lends money expects to earn an interest of say 10%. That means that the bank earns a spread of 5% (10% – 5%).
• And let’s say the bank lends Rs 100 as a loan at a rate of say 10%. That means that 100 Rs comprises of Rs 87.5 of debt and Rs 12.5 of Bank’s own equity (7:1)
• Suppose the borrower defaults on that loan. What is the bank’s loss? Its all of Rs 100. That is the bank will have to still repay it’s own debt of Rs 87.5 and write off the bank’s gain? Rs 5.
• So, we have a situation for the bank where if they do all the due diligence on the borrower and lend conservatively, they earn Rs 5. But if they make a mistake or are unlucky, they lose all of Rs 100. This is an asymmetric deal where the upside is really small and downside is really big. And the bank has to work hard to minimize the chances of the downside.
• Which means, the bank is more likely to say No than it would say Yes. In the process, a lot of budding entrepreneurs are likely to have their loan application rejected, even if they were to go on to build successful empires later on. I have seen this in the movie The Founder (based on Ray Kroc) and read in the book The Shoe Dog (based on Phil Knight). Why does this happen? Because the banker’s incentives are to play safe. His upsides are small when he is right and his downsides are large if he is wrong.

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Coming back to my friend and why I call him a conservative banker. When he lets out the house after doing all the due diligence on the renters, he tells me that rental yield is just 4%. Whereas, if the renters turn out to be bad, he stands to lose a lot; in the worse case he may lose the house. So, he tells me, people hate me when I say No to prospective renters and they take it personally. He says: “But I have to be careful in who I say yes to. I can afford to say “No” to right people, but I can’t afford to say “Yes” to even one wrong renter“. And hence a lot of people are going to get offended.

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His experience made me appreciate the nuances of banking. If you watch business movies or read business books, you will usually see the struggling entrepreneur being denied loans by the conservative banker. And mind you, we are seeing only one side of the story- that of the struggling entrepreneur and we wonder why bankers can’t have more imagination. That’s because no one told us the banker’s side of the story, until now: heads I gain very little; tails I lose a lot.

Sandeep Bakhshi often reminds his team that the bank makes 3 per cent money when it does a right risk exposure in a loan, and loses 100 per cent in a bad loan deal.

-An excerpt from a Business Today article on ICICI Bank’s CEO Sandeep Bakhshi

If you understand the incentives, you will judge conservative bankers differently.

-Cheers