Why Loan Participations Still Work For Banking

community-banks-9-19-16.pngOne consequence of the relaxation of branching restrictions in recent decades has been the near demise of correspondent banking, and specifically “overline lending,” where a community bank looks to a larger, geographically distant bank to extend credit to a customer of the community bank in excess of that bank’s legal lending limit.

The spread of branch banking, though, has enabled larger banks to compete for customers once the sole province of community banks. Further, large banks are under increased regulatory pressure to lend to smaller businesses. Consequently, traditional overline lending has largely disappeared. Community banks must now look elsewhere to place that portion of a loan exceeding the bank’s lending limit.

At the same time, technology is leveling the playing field between large and small banks in assessing and managing credit risk of business customers. Although customer relationships are still at the heart of community banking, not only does computerized process-based lending reduce costs, but it can lead to better lending decisions when, for example, data analysis provides a defensible rationale for rejecting a loan request from a customer who has a strong relationship with the bank. Community banks should utilize this technology to strengthen their relationship with existing customers as well as to attract new customers.

The Transformation of Community Bank Lending
Today, community banks find much of their traditional business lending imperiled by changes in banking technology, structure and regulation:

  • Credit-risk evaluation techniques have become more sophisticated;
  • Branching restrictions no longer protect local lending markets;
  • Computerized, process-based lending increasingly drives small-business lending, reducing the importance of relationship banking;
  • Business customers can still outgrow the lending capacity of their community bank;
  • Overline lending through correspondent banks has largely disappeared; and
  • Regulatory compliance costs have risen while becoming more complex, increasing compliance risk.

Because of these irreversible trends, much traditional business lending has left community banks, with the consequence that they have become more dependent on commercial real estate (CRE) and construction and development (C&D) lending than is the case at larger banks.

Community bank CRE and C&D lending usually is limited to a bank’s immediate market area, leading to a concentration of geographical credit risk that can be dangerous, if not fatal, to the bank during an economic downturn. CRE and C&D loan losses were a major factor in the failure of many community banks following the 2008 financial crisis. Although community banks have been increasing their commercial and industrial (C&I) lending, they still are too heavily concentrated in CRE and C&D lending.

How Community Banks Can Compete More Effectively Today as Lenders
A major challenge facing many community banks today is how to reduce their dependency on CRE and C&D lending while profitably attracting and retaining other types of business customers and borrowers. Community banks, though, still have many advantages they can capitalize on?proximity to their customers, local market knowledge, the ability to develop and maintain personal customer relationships, and speed and flexibility in tailoring banking solutions to a particular customer’s needs.

Community banks must implement new techniques to increase their non-real estate business lending, especially when a customer’s credit needs outgrow the bank’s balance-sheet capacity to accommodate all of those needs. Selling participations in loans that the bank has originated represents an effective way to retain customers with growing credit needs; loan participations are the modern-day equivalent of overline lending. At the same time, buying loan participations represents an effective way for a community bank to diversify its loan portfolio, both geographically as well as by customer type.

Key, though, to selling and buying participations in business loans is efficiently evaluating credit risk as well as monitoring and servicing a loan over its life. Working collaboratively with third-party providers of specialized banking services who are not competitors represents an excellent way for a community bank to profitably and safely engage in both buying and selling loan participations.

Community banks have been burdened in recent years by increased regulation while technology has enabled large banks and some emerging non-bank firms to divert business lending away from community banks. Nonetheless, relationship banking still is a valuable service that community banks can and do provide. However, they need to collaborate with other community banks to create the scale necessary to compete against the big banks by utilizing new technology to make their lending processes more efficient and to enhance the banking experience for their customers. Using technology in buying and selling loan participations represents an important way to accomplish that objective.

Does the Future of Community Banking Rest on Technology?

technology-9-2-16.pngIn Bank Director’s 2016 Technology Survey, the participants identified the following as the greatest business concerns in terms of the growth and profitability of their banks: regulatory compliance (59 percent), becoming more efficient (38 percent), competition from other banks (30 percent), regulations from the Consumer Financial Protection Bureau (28 percent), weak economic growth in their market (28 percent) and the ability to implement new technology (27 percent).

It’s hardly a surprise that regulatory compliance was the top concern of the 199 survey participants, a group that included bank CEOs, board chairs, independent directors, chief financial officers and senior technology executives. Fifty-eight percent of the respondents represent banks with $1 billion in assets or less, and this group has been disproportionately impacted by the significant increase in regulations that has occurred since the 2008 to 2009 financial crisis. In many respects, this is actually a money problem—hence the respondents’ concern about the impact of regulation on their profitability. While banks of all sizes have seen their compliance costs go up, small banks lack the scale or revenue base to absorb those higher costs as efficiently as large ones can.

Most of these issues are actually interrelated. The increased regulatory burden is one of several reasons why banks need to become more efficient, since this would help ease the pressure on their profitability from higher compliance costs. And one of the ways in which they will become more efficient will be through the implementation of new technology. For example, as banks place greater emphasis on digital distribution, in response to customer demand, they will be able to reduce the number of branches they have—which will lead to significant cost savings. Weak economic demand is one reason why banks worry about competition from other banks. Banking has become a zero sum game in the current economy, with everyone scratching and clawing to get what they can.

Another possible answer to this question was competition from nonbank entities, and only 22 percent of the respondents chose this as one of their top three concerns. However, when we asked later in the survey to identify the nonbank competitors that worried them the most, online marketplace lenders received the most votes, at 48 percent. And when we asked them how they felt about competition from these online lenders, 60 percent said they should be more highly regulated and 41 percent worried that these lenders could siphon off loans from their banks.

There is a definite theme that emerges from these questions. The survey participants are worried about the higher cost of regulation and its impact on the profitability of their banks. A majority of them also believe it’s unfair that banks are more heavily regulated than marketplace lenders, which are hardly regulated at all and yet compete with banks for business. Of course, banks are also experiencing lots of competition from other banks, as well as their old nemesis the credit unions. But the rise of marketplace lenders as a competitive threat is especially troublesome because it’s been enabled by advances in technology that banks are scrambling to keep pace with.

I am one who believes that marketplace lenders are here to stay. Individual companies will wax and wane, but the underlying dynamic that supports them—data driven loan underwriting technology—is growing in usage. And it’s beginning to go mainstream. Goldman Sachs, the gold-plated investment bank, has launched a marketplace lending operation called Marcus that will compete with the likes of Lending Club and SoFi for unsecured consumer loans. And JP Morgan Chase & Co., the country’s largest bank, has teamed up with On Deck Capital to target the small business loan market.

My sense is that most community banks under $1 billion in assets have yet to feel the full effects of competition from marketplace lenders because they are tightly focused on commercial real estate and C&I lending opportunities in their local markets, while marketplace lenders have focused mostly on unsecured personal and small business loans. But for how long? I’d be very surprised if data-driven underwriting technology doesn’t begin to find a place in the CRE and C&I loan markets as well because the efficiency advantages are too great to ignore.

There is some talk that marketplace lenders should be regulated just like the banks, and the Office of the Comptroller of the Currency has even raised the possibility of a federal charter for nonbank marketplace lenders. That might create more of a level playing field when it comes to the regulatory burden issue, but financial reform moves slowly in Washington, so I wouldn’t expect the feds to ride to the industry’s rescue anytime soon. I think community banks will have to solve this problem on their own, primarily through the implementation of new technology that will significantly improve their efficiency.

Only 27 percent of the survey respondents included technology as one of their three greatest business concerns, but it should have been at the top of the list.

A Second Life for an American Bank

bank-rebirth-8-18-16.pngThere were 437 bank failures in the United States between 2009 and 2012, according to the Federal Deposit Insurance Corp., most of them victims of the financial crisis and the sharpest economic downturn since the Great Depression. CalWest Bancorp was not one of them, despite experiencing some financial difficulties of its own during the crisis years, and today it faces a bright future with a successful recapitalization and reconstituted board.

As much as anything, the story of CalWest, a $136.6 million asset bank holding company based in Rancho Santa Margarita, California, is a strong vote of confidence for the potential of community banking. It is often said that small banks, especially those under $500 million and even $1 billion in assets, won’t be able to survive in a consolidating and increasingly competitive industry. The story of CalWest is about a group of professional investors who put $14 million into the bank and joined the board without compensation because they believe in the long-term future of their small community bank and are ready to roll up their sleeves and get to work.

Formed in 1999, CalWest has four branches in Southern California’s Orange County that uses three different names: South County Bank in Rancho Santa Margarita, where it has two branches, Surf City Bank in Huntington Beach and Inland Valley Bank in Redlands. President and Chief Executive Officer Glenn Gray says CalWest provides “white glove service” to a small and midsized businesses. “These are companies with probably $30 million or less in annual revenue, mostly family owned,” says Gray. “We focus on C&I lending, although we do commercial real estate [lending] as well.”

CalWest’s biggest problems during the recession were primarily bad commercial real estate loans and loans guaranteed by the Small Business Administration. The bank tried “quite a few different attempts” to either recapitalize or sell itself without success, according to Gray, although it did take approximately $5 million in Troubled Asset Relief Program (TARP) funds from the federal government in 2009. Attracted by the challenge of reviving a flagging franchise, Gray signed on as CEO in 2012, leaving a different Orange County community bank where he had been the CEO for six years. “I made the move primarily because of the opportunity to come into something that clearly needed to be fixed,” he explains. “I had a pretty good idea that it could be fixed. I like doing turnaround situations.” Gray was also drawn in by the chance to invest personally in the bank’s recovery.

The bank had entered into a consent agreement with its primary regulator, the Office of the Comptroller of the Currency, in January 2011, that among other things required it to raise its regulatory capital ratios. Gray spent the next couple of years cleaning up the loan portfolio and shrinking the bank’s balance sheet to improve its capital ratios, but wasn’t ready to raise new capital until 2015 when it retained Atlanta-based FIG Partners to manage a recapitalization of the bank. The effort ended up raising $14 million in fresh capital in December of last year from a group of private investors, although it actually had commitments for $30 million, according to Gray. The funds will be used to strengthen the company’s regulatory capital ratios, support its growth plans and retire the TARP funding. The consent order with the OCC was terminated in May.

One of those investors is Ken Karmin, chairman and CEO of Ortho Mattress Inc., a bedding retailer located in La Marada, California, and a principal in High Street Holdings, a Los Angeles-based private equity firm. Karmin had first met Gray shortly after he took over at CalWest in 2012 and they talked about Gray’s plans for the bank. “It was just too early in the process for new capital to come in,” Karmin recalls. “He had work to do to get the bank in a position to be recapitalized. But I was impressed from the moment we met. I knew he was the real deal; a very capable CEO…in control of the situation and every facet from BSA [Bank Secrecy Act] to credit quality, the investment side, lending, the relationship with the regulators. It was an amazing opportunity for investors like me to put money behind someone like Glenn, who can really do it all.”

Karmin came in as a lead investor and today serves as CalWest’s board chair. (All but two members of the previous CalWest boardGray and Fadi Cheikha—voluntarily resigned when the decision was made to raise capital by bringing in new investors.) Other investors, who also received a board seat, were William Black, the managing partner at Consector Capital, a New York-based hedge fund; Jonathan Glaser, managing member at Los Angeles-based hedge fund JMG Capital Management; Clifford Lord, Jr., managing partner at PRG Investment and Management, a real estate investment company in Santa Monica, California; Richard Mandel, founder and president of Ramsfield Hospitality Finance, a New York-based hotel real estate investment firm; and Jeremy Zhu, a managing director at Wedbush Asset Management in Los Angeles.

Although Gray and Cheikha did stay on as directors, the current board is really a new animal. The rest, with the exception of Zhu, were people that Karmin already knew. The new CalWest board also has an awful lot of intellectual and experiential horsepower for a small community bank. “A board for a bank of this size, we have the luxury of intellectual talent basically at our finger tips,” says Karmin. The composite knowledge base of the CalWest board includes extensive experience in C&I lending, BSA, investing, commercial real estate and the capital markets. “We have the talent to make intelligent, thoughtful decisions and support management,” Karmin says.

When asked what kind of culture he would like to create on his board, Karmin mentioned a couple of things. First, he says the current directors are “willing to serve and do the work and the heavy lifting.” And from an investment perspective, they are taking the long view. Karmin says they will not receive any fees or compensation for their board service “until the bank is right where we want it, operating at the highest possible level.” Nor will the directors be taking personal loans from the bank. “If you want to borrow from our bank, this is the wrong board for you,” he says. “We’re not going to do any Reg O loans.”

More importantly, perhaps, Karmin wants a board that is very focused on performance. “We want a culture of first quintile performance,” he says. “That means that we expect our financial performance on the most important metrics to be in the first quintile of banks of our size in our geographic area.”

Given the strong private equity and investor background of all of the new directors, it’s logical to assume they will be looking for an exit strategy at some point. Karmin suggests that day, when it finally arrives, will be well off into the future. For one thing, Karmin and Gray are jazzed about the potential of the Southern California market. With about 9 percent of the country’s population, “We expect that it’s going to be one of the most important growth areas in the United States,” Gray says. “Whether the [national] economy grows 2 percent or 1 percent, it’s not going to matter to us. We’re going to be a first quintile performer under all those scenarios.”

“We have instructed Glenn to run the bank for the long haul,” Karmin says. “We were making this investment for a lot of different reasons, but that we expected to be investors and to be on the CalWest board for a long time. We have real plans to grow the bank in a controlled strategic fashion. [The directors want to] use our contacts to make new contacts, use our contacts to make new loans, use our contacts to gather new deposits. We are the kind of a board that can really help on all those metrics.”

Gray says this is the fourth bank board that he has participated on and the CalWest board is very different from all the others. “It’s a board that is very involved,” he says. “They ask good questions. They ask tough questions. If you wanted to be a CEO of a bank [that has] the old country club atmosphere, this would not be the place to be.”

Growing Your Loan Portfolio

As banks look to fuel their loan growth in this highly challenging market, many are trying to diversify away from a heavy commercial real estate portfolio by looking to other profitable business lines. However, growing the loan portfolio has proven difficult and this session, filmed during Bank Director’s 2014 Growth Conference, shows approaches banks are taking.

Video Length: 45 minutes

About the Speakers

Douglas H. BowersPresident & CEO, Square 1 Bank
Doug Bowers is president and CEO of Square 1 Financial and Square 1 Bank. He has over 30 years of banking experience from Bank of America and its predecessors, where he held a wide range of leadership positions, including head of commercial banking, head of foreign exchange, head of large corporate banking, president of EMEA (Europe, Middle East and Africa) and president of Bank of America’s leasing business.

Wayne Gore, Senior Vice President, BancAlliance
Wayne Gore is a senior vice president of Alliance Partners and has been with the group since its formation. Prior to joining Alliance Partners, Mr. Gore held leadership roles in the financial institutions group with McKinsey & Co. and served as managing director at the corporate executive board. Previously, Mr. Gore was an investment banker with Merrill Lynch and Goldman Sachs as a member of the mergers & acquisitions teams.

Jim Mitchell, President & CEO, Puget Sound Bank
Jim Mitchell is president & CEO for Puget Sound Bank. After spending over 30 years in executive banking roles in the Seattle area, he assembled the team that started Puget Sound Bank. Past local positions include senior vice president and manager of the Seattle corporate banking office of Sterling Savings Bank and senior vice president of U.S. Bank in Seattle.

George Teplica, Senior Vice President and Director of Commercial Banking, The Bryn Mawr Trust Company
George Teplica is the senior vice president and director of commercial banking at The Bryn Mawr Trust Company. He leads Bryn Mawr Trust’s Commercial Banking Group, which delivers credit and other financial services to closely-held businesses, professional firms and not-for-profit organizations in metropolitan Philadelphia.

C&I and Commercial Real Estate Lending Still Growing for Community Bankers

12-13-13-Emily.pngJames Tibbetts, vice chairman and former president and CEO of $260-million asset First Colebrook Bank, based in Colebrook, New Hampshire, credits a strengthening New Hampshire economy for the growth he’s seeing at his bank. The bank has locations throughout the state, and the rural economy at the bank’s home in northern New Hampshire depends on tourism and timber harvesting, with Tibbetts seeing increased investment in property and equipment purchases among the small businesses that comprise the core of the bank’s customer base. “Our growth is coming from commercial real estate and C&I lending,” he says. “We do quite a bit of equipment lending.”

With competition for loans and deposits stiff, many community bank executives and boards are looking for the right formula for growth. Many banks are sticking to mortgages, despite rising interest rates and lower volume, instead vying for an increased share of the mortgage market. Still others are focused on the growth they are seeing in commercial real estate and commercial and industrial (C&I) lending.

Industry-wide, C&I loans grew 8.1 percent in the third quarter compared to the same period a year ago, according to the Federal Deposit Insurance Corp. Meanwhile, residential loans secured by real estate fell by .8 percent. Home equity lines of credit fell 8.8 percent.

In November, Bank Director informally polled over 30 bank directors and executives by email to get their views on lending and saw similar trends. In what areas are institutions seeing loan growth? Most of those polled, 73 percent, reported growth in commercial real estate in 2013 and 65 percent reported growth in commercial and industrial lending.

In contrast, the mortgage market remains stagnant, with many reporting a flat market for home mortgage purchase loans in 2013 and almost half seeing a decline in home mortgage refinancing. Looking ahead to 2014, how will the new ability-to-repay rule and creation of “qualified mortgages” impact the mortgage business? Most bankers polled that already offer mortgages indicate that they will continue to be part of their banks’ business in the near future, though some may no longer consider it to be a core part of the business.

Kevin Lemke, a director at Grand Forks, North Dakota-based Alerus Financial Corp., a financial holding company with $1.3 billion in assets, says that while mortgages have slowed a bit, it’s still a strong business for his company, which as of the third quarter of 2013 reported an increase of 4 percent in mortgage originations and loan servicing from the previous year. “I don’t know if we’ll have a record year in originations this year,” says Lemke, “but it will be close.”

Alerus’s broad geographic reach, in Arizona, Minnesota and the bank’s home base in North Dakota help the bank take advantage of strong demand in some areas even as the mortgage business wanes in others. The Minneapolis/St. Paul area of Minnesota is strong for mortgages, and Alerus plans to expand in Arizona.

Lemke feels that his bank is prepared for the qualified mortgage rule, and doesn’t expect an adverse impact on business at his bank. He’s more concerned about rising interest rates. “I think interest rates will have an impact, and already are. I think we will see a decrease in our volume,” he says. “There’s no doubt about it.”

Competition with other banks for loan business continues to be a key concern. To address this, many are hiring new loan staff, offering more attractive loan terms or looking to technology to make the loan process more efficient for clients.

Tibbetts says his bank doesn’t see a lot of competition in northern New Hampshire, but the southern part of the state is a tough market. Pricing is competitive. “It’s all about developing relationships, and that’s how we’re able to grow the amount we have grown,” he says. “We’ve developed those relationships and we price competitively.”

First Colebrook, like many banks, is emerging from a challenging four years. A lot of the bank’s business development and commercial lending staff was stuck tackling problem loans, Tibbetts says, but now the bank can devote more personnel to growing business. “We’re now able to focus on the future and the strengthening economy,” he says.

What to Consider When Exploring C&I Lending

Last year, commercial and industrial (C&I) lending increased by 12 percent according to the FDIC. With community bankers planning for growth in the area, industry experts are predicting C&I lending will continue to rise.  Jason M. Fish, co-founder and credit committee chairman of Alliance Partners, shares, with Lori Bettinger, president, BancAlliance, his experience on what makes a good C&I loan and what the future holds for corporate lending in 2013.