Will The C&I Boom Be Just Another Bust?

Old Point Financial Corp. in Hampton, Virginia, the holding company for Old Point National Bank of Phoebus, faced a critical decision about five years ago. Like other community banking companies, it had bulked up on commercial real estate, which had declined in value and wasn’t growing as a loan category. Nearby credit unions dominate consumer lending in the Hampton Roads market, which boasts a heavy military presence, offering rates as low as 1.99 percent on an 8- year auto loan.

“We can’t compete with that,” says Joseph Witt, Old Point National Bank’s senior executive vice president and chief administrative officer and a longtime board member of the $891-million asset institution. He was hired about five years ago to help change the bank’s strategy.

After a series of planning sessions and intense discussions in management about the future of the bank, Old Point decided to expand into commercial lending. Witt started by introducing treasury services to the bank’s product line and has since hired about 15 experienced people for lending, credit, treasury, payroll administration and other services for business customers. “This is the future of our bank,” Witt says. “I’ll go up against the big banks any day for the $50 million [in annual revenue] customers.”

As banks try to diversify away from the heavy concentration in commercial real estate that led to so many failures during the financial crisis, they are looking to add other, more profitable lines of business, including commercial loans. And commercial and industrial (C&I) lending is an alluring prospect. It tends to offer higher yields than other types of loans, and even more importantly, brings with it the cross-selling opportunities and access to core deposits that banks are striving for these days. Banks can expect higher deposit balances from business borrowers than consumers. Banks can also generate fee income by selling asset management, trust services and 401(k) management services to the same borrowers. Plus, regulators haven’t scrutinized business lending to the same degree as consumer lending, keeping compliance costs lower.

Given all these benefits, what bank wouldn’t want to add C&I loans? However, entry to the business of commercial lending has proven difficult indeed. Big banks are taking the lion’s share of growth in C&I loans and competition has been tough, especially for the best borrowers. The heated market for C&I loans is raising questions about the inherent risk, and whether banks are overextending themselves in the relentless pursuit of growth.

Claude Hanley, a partner in Washington, D.C.-based management consulting firm Capital Performance Group, says nearly all the banks he’s worked with recently on strategic plans are trying to grow their C&I portfolios.

Some consultants are trying to jump into the sphere. “As we are out in the marketplace, especially for our community bank clients, we kept hearing over and over, ‘we have to start moving into the small business space,”’ says George Noga, a senior vice president at Fiserv Inc., based in Brookfield, Wisconsin. The company recently launched a consulting initiative to help regional and community banks improve the efficiency and profitability of commercial and small business lending. Fiserv is projecting C&I growth of 5 percent annually for the next five years, compared to about 1 percent annual growth for consumer lending.

Recovering from the financial crisis, commercial and industrial loans for all banks grew 28 percent in the two-year period that ended in the fourth quarter of 2012, according to Federal Deposit Insurance Corp. data adjusted for mergers and bank failures. However, part of the growth is a result of big domestic banks stealing market share from foreign banks that have pulled back in the midst of Europe’s financial woes, as revealed by Federal Reserve Board data. “You have a lot of banks going after a small pie,” says Joshua Carter, principal and Chicago-based banking leader for PricewaterhouseCoopers LLP. “Your choice is to adjust your pricing or not get in the game. The quality borrowers are able to name their terms.”

Interest rates on commercial loans from the top 25 banking institutions fell from more than 7 percent in 2006 to less than 3 percent as of mid-April, according to the Federal Reserve. Smaller banks offered an average rate of 4.5 percent in mid-April. The biggest banks tend to do business with the largest commercial customers, who pay lower rates on loans than small businesses do. The decline in rates is squeezing yields for C&I loans, which fell among FDIC-insured commercial banks from 5.17 percent in the fourth quarter of 2010 to 4.36 percent in the fourth quarter of 2012, according to Charlottesville, Virginia-based research firm SNL Financial.

Not only are rates and yields dropping, but covenants are being relaxed. The competition seems fiercest for large and middle market companies. Some banks are offering “covenant lite” business loans to their largest and best commercial borrowers. For example, they might drop the requirements that the borrower maintain certain financial performance metrics to avoid having to go back to the bank and renegotiate collateral or other terms, says New York-based CIT Group Inc.’s Burt Feinberg, the head of commercial lending for the $33-billion asset commercial and specialty lender, one of the largest commercial lenders in the country. The Office of the Comptroller of the Currency (OCC) has also confirmed the trend, saying in its fall 2012 semiannual risk report that “the underwriting for middle-market commercial and industrial lending is showing signs of slippage as banks compete for lending opportunities in these markets.”

Terms are also getting longer. One-year lines of credit are being extended to three-year lines of credit, says Christopher Myers, the president and chief executive officer of CVB Financial Corp., a $6.3-billion asset business banking company in Ontario, California. However, he has not seen banks ditch underwriting standards for weaker borrowers. “I’m seeing some stretching,” he says. “Banks will loosen their covenants and release guarantees here or there to stronger companies.”

Lending standards have been eased for the past four quarters, according to the Fed’s senior loan officer survey. Pricing has been declining for even longer. Non-bank lenders financed by private equity money hungry for a place to put cash have started entering the market. “They get minted every couple of weeks,” says Feinberg. “A lot of institutions are looking to enter the space, both bank and nonbank institutions.” Some non-bank lenders are financing leveraged buyouts or refinancings where the owners cash out equity to fund dividend payments to themselves, noted the CEO of the $8.6-billion asset Los Angeles-based commercial lender CapitalSource Bank, James Pieczynski. He won’t do such deals because he likes borrowers to maintain equity in their corporations.

“It’s a highly competitive market,” says PwC’s Carter. “It’s a problem that there is potentially more cash in the economy than there are good assets to buy. You start to go out on the risk curve. We are starting to see people step further out there.”

Aside from the OCC, which is keeping an eye on the risks involved as competition heats up in C&I lending, the Federal Reserve has also taken note of the trend. “We are seeing very aggressive competition for strong commercial and industrial loans,” says Julie Stackhouse, senior vice president in Banking Supervision and Regulation for the Federal Reserve in St. Louis. She noted it is possible to hedge interest rate risk, but she did have some concerns, particularly for community banks trying to stretch into C&I lending. “Community banks should serve their community and underwrite their loans soundly. Where you see problems is when they go outside their communities, or make exceptions to their underwriting guidelines,” she says.

Hanley says he knows of some banks that are transitioning CRE lenders to C&I and he worries those loan officers won’t have the experience or knowledge to do loans properly. He knows some loan officers who are straddling both CRE and C&I lending. “Historically, if banks go into something they don’t know, they usually make bad credit decisions,” he says.

Loan officers and management need to thoroughly understand C&I lending; so, too, does the bank’s credit department, Hanley says. Banks should carefully analyze the credit risk of each loan, assigning meaningful ratings based on real financial metrics, he says. Too often, many community banks have no standardized way to rate loans or even make sure their lenders are calculating financial ratios the same way. Almost every loan gets a high rating, say a 4 on a 5-point scale, for example. “Banks won’t readily admit this,” he says. Moody’s, Sageworks Inc. and other companies have software to help banks standardize their loan assessments. Even an Excel spreadsheet for all C&I loans with standard formulas for calculating ratios is better than nothing to make sure loan officers are doing calculations in a uniform way, he says.

From the board level, transitioning into a new line of business such as C&I carries with it new risks, says John Depman, national leader of regional and community banking for audit and consulting firm KPMG LLP. The board can work with management to assess the different risks of the various business lines and products, making sure the bank has the capital it needs and is pricing products appropriately for the risk involved, Depman says. For instance, regulatory risk will change based on the type of business a bank is in. Cash management services for commercial customers will be heavily scrutinized for Bank Secrecy Act/anti-money laundering compliance, so the bank needs to make sure it has the appropriate level of expertise in that area. The board also should assess the quality of internal controls, asking questions such as: Who is monitoring loan certifications; who is handling loan review; and who is making sure the commercial customers are submitting financial statements on time?

“The board members don’t need to become experts but they need to educate themselves sufficiently,” Depman says.

He thinks more banks are looking at C&I loans because that asset class had fewer losses during the recession than real estate. More than a decade of rising real estate values lulled community banks into growing more dependent on it. As banks ramped up commercial real estate, they reduced consumer lending and mortgages in the face of competition from bigger banks. Between 1984 and 2011, residential real estate loans fell from 47 percent of community bank loans to 32 percent, while commercial real estate loans rose from 21 percent of loans to 42 percent, according to the FDIC’s Community Banking Study published in December 2012. The percentage of community banks that specialized in commercial and industrial lending, meaning they had more than one-third of their assets in C&I loans, also fell during that time, from 11 percent of institutions in 1984 to 2 percent in 2011, according to the FDIC.

As community banks become more dependent on CRE, they slowly gave up other lending categories including C&I to larger competitors. The consequences are now obvious. The failure rate of banks that specialized in commercial real estate was more than five times that of banks who specialized in C&I lending, according to the FDIC study.

Community banks tend to like the collateral of real estate lending. In many ways, it feels more secure than a C&I loan, normally unsecured and underwritten based on the underlying value of the business, Depman says. That’s why many community banks offer owner-occupied commercial loans based on the value of the building. C&I lending is different. “You are basing monthly advances on what their business is doing,” he says.

Commercial lending is underwritten based on the cash flow of the borrowers rather than the value of real estate. Instead of understanding real estate, the lender has to understand the intricacies of different kinds of financial metrics and industries, their accounts payable and the collateral. Unlike real estate, inventory?which serves as collateral?can disappear seemingly overnight, says Michael Fuchs, director of commercial lending for Minneapolis-based Wolters Kluwer Financial Services. Borrowers must submit financial statements to the bank at least quarterly and the lender has to understand those statements well enough to react to changes, he said. For someone with years of experience in commercial lending, that’s no problem. For someone trying to learn it for the first time, that’s not easy.

“The concept of a [commercial real estate] lender becoming a C&I lender overnight is a not a good one,” says Geri Forehand, the national director of strategic services for Austin, Texas-based Sheshunoff Consulting + Solutions. Unfortunately, high-quality training programs are few and far between, he says.

Old Point National Bank in Virginia is trying to fill the gap. The bank’s CRE lenders have been trained in C&I lending by the Virginia Bankers Association. Three people inside the bank are dedicated full-time to training other employees, even though the bank only has about 300 employees. Witt says his philosophy is to hire the right people, give them the resources and training they need, and reward them appropriately.

With more banks trying to recruit commercial lenders, and their experience in high demand, the salaries of commercial loan officers have soared. The average pay rose 26 percent from 2008 to 2012, to $94,798, according to a survey of 405 financial institutions by Crowe Horwath LLP. It’s not just base pay; total compensation has risen as well, by 39 percent from 2008 to 2012, to $101,376. Most of the survey respondents were banks with assets of less than $500 million.

Forehand says both large and regional banks have done a good job retaining commercial lenders and making them happy in their jobs than in years past, so it’s harder for community banks to steal them. Another challenge for community banks trying to do C&I loans is outdated product options, Forehand says. Business borrowers will need additional services rather than just a loan and a checking account, such as cash management services, he says. Business borrowers expect technological improvements that increase convenience, such as remote deposit capture.

The difficulties smaller banks face expanding C&I lending are borne out in data from the FDIC. Very small banks, those with less than $1 billion in assets, have missed out on the phenomenal growth in C&I loans post-recession. Commercial lending at very small banks grew just 3.2 percent from 2010 through 2012, in figures provided by the FDIC adjusted for mergers and bank failures. Compare that to big banks, those with assets above $100 billion, which saw C&I loan growth of 32 percent during the same time frame. Mid-sized banks, or those with assets between $10 billion and $100 billion have done even better, with growth of 35 percent post-recession.

Rich Brown, the chief economist for the FDIC, says that larger banks serve large commercial customers who have done better financially following the financial crisis than many small businesses. Small businesses, which are more likely to be served by small banks, are more worried about slow economic growth and are therefore still hesitant to borrow, he says. Another factor discouraging small business borrowers may be that they often borrow against the value of their real estate buildings and that collateral may be underwater still.

The good news for community banks trying to serve small businesses, though, is that borrowers who need a loan of $250,000 or less aren’t as rate sensitive as larger borrowers, according to PwC’s Carter. “One of the things that community banks should do is pick a product and be good at that product,” he says. “Below $1 million loans, most [big] banks offer cookie cutter loans because they are high volume. You have an opportunity to offer something different.” For example, there is an untapped opportunity to get borrowers who don’t want to fund their business with a credit card, but might not qualify for a loan at 3 percent interest from a big bank, either. “If it’s a competitive landscape, and a lot of people are playing in the sandbox, so you might want to play in a different sand box,” Carter says.

Community banks need to pick their niche and not try to serve all customers all the time because, Forehand says, they simply don’t have the resources to do so. Offering credit to small companies is a sweet spot for smaller banks, he says. Specializing in a niche such as property management or doctor and health care offices is way to gain knowledge and contacts in a particular field. “We are just beginning to acknowledge that the community bank can’t be all things to all people,” Forehand says.

He encourages his clients not to abandon real estate if they are good at it. For example, some businesses own their buildings and might need a commercial real estate loan.

“I think it’s possible to diversify,” he says. “But I would never abandon [commercial real estate]. It’s driven by the talent in your organization. If you can’t attract the talent, it wouldn’t be prudent [to expand commercial lending].”

The good news is that many community banks are able to excel at C&I lending, especially for small business customers. Serving a niche and doing it well are linchpins of such a strategy. However, with the hard work and potential risks involved, not all banks will succeed at growing commercial lending, and many of them may be taking on too much risk.

“A lot of banks say we’re going to do C&I lending, but are they really acquiring experienced teams who know how to do this?” asks Meyers, the CEO of CVB and a longtime commercial lender. “If not, that could be a dangerous game.”