The Pay-For-Risk Model versus Relationship Banking Model

Relationship Banking

In a recent blog (HERE), we discussed why now may be an inopportune time for banks to rely on a pay-for-risk banking model. In a pay-for-risk model, banks emphasize generating revenue by charging for risks that they take. Banks succeed by assessing and underwriting this risk and capitalize on opportunities where risk is overpriced.  Unfortunately, the adage applies risk-for-pay: you can only be as successful as your most irrational bank competitor.  Today’s credit and interest risk market is not properly compensating the exposure that banks are taking for many risks (credit and interest risk being just two).  A more appealing model for many community banks may be to embrace relationship banking.  While most community banks already think that they are emphasizing relationship banking that may not be the case and now is a good time to revisit the differences between these two common banking models. 

 

What is Relationship Banking?

 

Relationship banking focuses on a consultative approach with customers, and selling services and advice based on the customer’s particular situation and needs, and adapting those services based on changes in the customer’s financial or business lives.  The relationship banking approach is premised on high-touch service and product cross-sell.  Despite so many community banks embracing this model, relationship banking is not easy to execute well.  Some banks state that they are relationship driven, but deliver risk-for-pay products.  Other banks attempt to deliver relationship banking but fail because they may not understand what is involved and how to effectively differentiate from competitors.


Which Model is Best?

 

Either the risk-for-pay and relationship banking models can be long-term profitable, and there are clear examples of community banks succeeding under both models.  However, success does not occur by happenchance.  Therefore, bankers need to decide which model will work best for their bank based on their mission, management’s competence, local competition and customer demand.

 

We contrast the two models on various parameters in the table below.

 

Relationship Banking

 Relationship Banking

 

Both banking models can work successfully for community banks.  Most community banks achieve greater success with relationship banking because it is not dependent on a few bets made during challenging economic times.  Profitability in pay-for-risk model is much easier in a declining economy because competition for credit retracts and banks can find opportunities to earn above average return for risk.  However, in non-recessionary periods, it takes much more effort to find niche markets or customers where risk is properly priced and mistakes made during these periods lead to bank failures in the next recession. 

 

Conclusion

 

While relationship banking is almost universally promoted by community banks, the model is not easy to deliver effectively.  With the right talent, education, product mix and executive support, banks can succeed with either the risk-for-pay or relationship banking models.  However, it is not easy for commercial bankers to develop the expertise to become insightful financial advisers supporting the relationship banking model.  In a blog next week we will consider a simple strategy that commercial bankers may use to develop this expertise and become better relationship managers.  The strategy has worked well for some bankers at our institution, and we will share sample sales and marketing material our bankers used to gain this knowledge and expertise.