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.

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.