Community Banks Collaborate on C&I Lending

lending-12-23-15.pngThe traditional community banking model, while still viable, is being challenged because of economic, competitive, technological and regulatory forces—many of which are beyond the control of any individual community bank. The largest banks have used their massive size, product set, and more recently, technology, to make dramatic gains in market share at the expense of community banks. I believe that progressive community banks should be considering new ways of doing business, especially in regards to their lending strategies.

Community banks do many things far better than their larger competitors, while enjoying a degree of trust and resiliency that the megabanks may never achieve. But those big banks boast something the community banks, standing alone, cannot match: the scale to operate the lending platforms which are now necessary in most lines of business—including commercial & industrial (C&I) lending. Many American businesses now require loan amounts of $50 million or more, a loan size that typically defines the low end of the “middle market.” Those loans required by middle market borrowers, companies providing goods and services serving a wide range of industries, far exceed the individual lending capacity of the typical community bank. The teams required to source, screen, underwrite and manage these larger loans are typically out of reach for a community bank.

To date, those megabank advantages have clearly outweighed the strengths of community banking in C&I lending. Without the ability to deliver many of the commercial loans that middle market businesses require, community banks are stuck in a quandary in which they often have to turn away customers with successful, growing businesses. The numbers are clear: In 1990, community banks with under $10 billion in assets accounted for over one-third of C&I loans held on the balance sheets of banks. By the end of 2014, community banks’ share of the C&I market has dropped to just over 15 percent of the market. The continuation of this trend will likely limit the profitability and growth of community banks as well as their ability to positively affect their communities in other lines of business. Equally important, it also subjects those banks to less diversified loan portfolios and the risk associated with loan concentrations, particularly in commercial real estate.

While each community bank may individually struggle to match the scale of the mega-banks, it is important to keep in mind that the biggest banks are saddled with their own challenges such as bureaucracy, legacy systems, resistance to change, customer fatigue and burdensome regulatory oversight.

Community banks, but for their individual lack of scale, ought to be well positioned to capitalize on these opportunities and to outcompete the megabanks. The innovation required for community banks to break this logjam—to free them to focus on their strengths—is here, and its essence is this: community banks no longer need to stand alone.

They can prosper by working together, particularly in gaining access to middle market lending. Community banks do have the scale enjoyed by the biggest banks, they just don’t have it on their own. Together, community banks hold $2.3 trillion in assets—13 percent of the assets held by US banks, and just shy of the assets of JPMorgan Chase & Co., the largest US bank. The question is how to leverage that scale while preserving the individuality, proximity to the customer and legendary service that contribute to their unique value.

Community banks should consider joining together in alliances or cooperatives in order to gain access to C&I loans, including diversified sectors such as manufacturing, healthcare, technology, and business services. In addition to using such partnerships to successfully source these loans on a national basis, other benefits such as diversification (size, geography, and industry type), access to larger customers, and combined expertise in underwriting and loan management can be achieved. One such cooperative, BancAlliance, consists of over 200 community bank members and has sourced over $2 billion in such loans.

Through partnerships such as these, community banks can succeed in delivering loans to job-creating middle market businesses throughout our country at a reasonable cost to each community bank, while adding to their net interest margin and diversifying their balance sheet.

Seven Things to Think About When Considering Loan Participations

partner.jpgFaced with heightened competition, a slow economic recovery, and tepid loan demand, community banks are looking to enhance profitability through prudent lending with attractive yields, often outside of the real estate sector where they have significant concentrations. Commercial and industrial loan participation arrangements may offer one answer, but it’s important to choose a participation partner carefully. Here is a list—by no means exhaustive—of what you might look for in potential partners.

1.  Consider your bank’s business objectives.

Your bank’s core mission is to serve your community. Before joining a participation organization, ensure that you understand how a relationship with that group will align with that mission. Look for an organization that will help you meet your bank’s strategic goals and benefit you in terms of enhanced profitability and asset diversification. Of course, you should consult with your own advisors to ensure that all of your questions are satisfactorily answered.

2. Look beyond size.

Loan participation arrangements offer community banks more than just the opportunity to serve clients with credit needs that are otherwise too large for the bank. Participations also offer the potential for geographic and industry diversification, which can be especially beneficial to community banks facing protracted regional recoveries. Participations can offer a buffer against fluctuating local economic conditions without increasing banks’ existing overhead costs.

3. Communicate with your regulators, and look for a partner who does the same.

Community bank examiners may review closely any loan participation arrangements. Open and early communication with examiners may help avert potential concerns and improve their understanding of the business line. An ideal loan participation partner regularly communicates with all applicable banking regulators and provides support to banks looking to satisfy applicable guidance and regulations.

4. Remember that loan participations may involve a relationship with a third-party service provider and involve certain risks.

Banks should examine the risks of third-party arrangements just as they would examine the risks of their own activities. Third-party arrangements require thorough risk management to carefully evaluate and continuously monitor potential partners. Therefore, if you are seeking out a loan participation partner, look for one who offers comprehensive disclosure materials and historical credit performance data. Ask for and review all documentation that explains the risks involved. Remember that not all partners are the same. Some are Registered Investment Advisers with fiduciary duties to their clients and are paid for providing advice. Others generate income predominately by reselling assets.   

5. Strong communication is essential in any relationship.

Loan participation organizations should put their clients’ needs first. Bankers should be attentive to potential sources of conflicting interests and what, if anything, the organization does to align its interests with its clients’ interests. Ideally, bankers participating in the loans should help govern the organization’s direction, operations and credit policies. If participants would like an increased focus on a particular loan type, they can work together to achieve that objective.  They should be able to regularly communicate with each other, and all bankers aligned with such an organization should have the opportunity to learn from each other and to express opinions on relevant matters.

6. Be selective, and expect the same from your partner.

Not every loan is right for every bank. Loan participation organizations should thoroughly evaluate potential loans on a variety of criteria and only recommend those loans that meet every criterion. They should also have some type of risk retention procedure. Banks should always have the option, whatever the reason, not to participate in a particular loan. No bank should be compelled to make a loan that doesn’t align with its business objectives.

7. Establish lending policies and procedures and ensure that an independent credit decision is made on each loan.

Expect your loan participation partner to maintain lending policies, and be sure to also have your own. Such policies should define limits around participation loans and identify the bank employees responsible for managing the business and reporting the results to senior management. The credit information necessary to both underwrite and conduct ongoing monitoring of borrowers should be easily available through a secure document delivery system. Banks should use this information to make their own, independent decisions about which loans they fund.

Opportunities in a Neglected Field

solar.jpgThe large financial institutions that were heavily involved in equipment financing have reduced the size of their portfolios from pre-crisis days. Does that mean there is an opportunity for smaller banks, even with soft growth in the U.S. economy? BancAlliance thinks so. The Washington, D.C.-based network of member banks pool their resources to access national commercial and industrial loans, gaining access to larger loans than they might otherwise be able to finance. It recently added a new equipment finance team lead by Jay Squiers, who talks about trends in the sector.

Why did BancAlliance get into equipment financing?

Our members have told us that they would like to see a variety of C&I loan opportunities, including equipment finance. We are focusing on larger equipment loans to larger companies—these loans just would not fit on the balance sheet of a community bank. We have a lot of experience with the underwriting and collateral associated with these loans, and many community banks don’t have the resources to access this asset class on their own. It is a solid asset class that community banks will appreciate—with tangible collateral—but still very different from commercial real estate loans.

Why is it a good asset class?

It is a market in which many of the larger players have exited. A few years ago, a number of large financial companies were active in this space, building significant portfolios. As a result of the financial crisis, the capacity of these financial players has diminished, and capital costs have increased. We believe that we will be able to go into the market and access good loans that are well structured and acquire them on behalf of our member banks, and we can be a significant player in this market.

Are you essentially buying loans from these big lenders?

As we get this asset class up and running, we are working with agents who already have loans in the pipeline. As we continue to grow, we will have the capacity to originate our own loans. We will base our strategy on member preferences.

What does the market look like, economically speaking?

We’re in a replacement cycle—not a growth cycle. Companies have tightened their belts for the last few years. The equipment that needs financing right now is absolutely an essential part of a company’s ongoing business. As a lender, you want to finance essential equipment for a business because you know they’ll take care of their equipment and stay current on the loan. When you’re talking about real estate, that’s all about location and the local economy. When you’re talking about equipment, it runs on a different economic cycle than local real estate.

What are the special challenges for doing these loans?

You have to be comfortable with collateral valuations, including a sense for projected valuations. If depreciation dramatically exceeds amortization, you’re going to end up with an underwater loan that is not covered by your collateral. The valuation is affected by a lot of factors: Can this equipment be redeployed? Is it going to maintain its value? How comfortable am I that the market is going to be there in three to five years? To answer these questions, we use an independent evaluator, with strong credentials, who performs detailed analysis. It is analogous to the appraisal process on real estate loans. The appraisers are independent, experienced and knowledgeable about the type of equipment we’re asking them to value.

You underwrite both the collateral and the borrower?

Yes. You want someone who is a good operator and is generating sufficient cash flow to repay you. We look at the downside scenario as part of the underwriting. We need to be comfortable that we are lending to an experienced operator who is not prone to mistakes. Equipment loans are typically structured on a full recourse basis. In addition, a secured claim with priority in bankruptcy exists against particular pieces of equipment if that scenario ever occurs.

What types of equipment are we talking about?

We will cover a broad range of sectors, including manufacturing, oil and gas, trucks and railcars, cargo carriers, tankers or barges, and equipment used to process and haul commodities. Medical equipment is a really competitive space right now, but we will do it if we find the right opportunities. I think we’ll very much focus initially on the U.S. middle market and larger loans, $5 million to $100 million.