How Banks Can Profit from SBA Lending

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4-7-14-SBA.pngAll community banks are looking for ways to leverage their staff, maximize profit, minimize expense and build flexibility into their loan portfolios.

One effective way to do this is to participate in SBA lending and to use an SBA outsource provider to provide your bank with a simple and cost effective way to offer this product.

The primary SBA lending program, the SBA 7(a) guaranty loan, allows the bank to make small business loans and receive a 75 percent guarantee from the U.S. government. The guaranteed portions of these loans can be sold in the secondary market, with current gain on sale premiums of 13.5 percent net to the bank. So if a bank makes a $1 million SBA loan and sells the $750,000 guaranteed portion, it will generate a premium or fee income of $101,250.

In addition, when the guaranteed portion of an SBA loan is sold, the investor buys the guaranty at a rate that is 1 percent less than the note rate. In this example, if you have a $1 million SBA loan at an interest rate of 6 percent and the bank sells the $750,000 guaranteed piece, the investor buys it at a 1 percent discount off the note rate and receives a yield of 5 percent. This means that the bank will earn 6 percent on the $250,000 portion that they retained and 1 percent on the $750,000 or $7,500 per year, not accounting for amortization of the loan. If you compare that $7,500 per year in servicing income to the $250,000 that the bank retains on its books, you can see that it represents an additional 3 percent yield on the retained portion. That 3 percent of servicing, plus the note rate of 6 percent, shows that the bank’s gross yield on the retained portion of the loan is now 9 percent. This additional yield is something to consider if your bank is competing for a loan with a larger bank that is trying to undercut your bank on pricing. The added servicing income will enable you to maintain your yield even on loans that have lower pricing.

While SBA lending can be very profitable, it should be viewed as more than just a profit center for your bank.

The SBA loan guarantee can be used to refinance existing loans to mitigate risk in your loan portfolio or to help retain clients who are close to the bank’s legal lending limits. Using SBA lending to refinance existing bank loans can be helpful in reducing real estate concentrations since properties like hotels, mini storage facilities and care facilities are included as investment properties by regulators. If a bank has these types of properties on their books, they can often refinance the loan and sell the guaranteed portion to reduce a concentration and free up capital. Using the SBA guaranty to make loans that fall into an investment property category is a good way of managing portfolio concentrations.

Why does SBA outsourcing make sense?
Outsourcing your SBA lending department eliminates the need to allocate resources and budget for an SBA department since there are no upfront or overhead costs associated with it. Outsourcing eliminates the risk of hiring an SBA team and then not generating sufficient loan volume to support the cost of that staff. SBA personnel costs are high, and it can be difficult to find qualified people. Also, without an experienced and dedicated SBA group, your loan officers will typically avoid handling SBA loan applications for fear of dealing with the complex SBA rules and process.

Outsourcing also enables a community bank to acquire, through the outsource provider, an experienced staff, which in turn enables it to provide an accurate and efficient process to its SBA borrowers. An SBA outsource provider can efficiently process, document, close, sell to the secondary market and service your loans. Typically these services charge between 0.6 percent to 2 percent of the loan amount.

Conclusion
In today’s competitive market, the SBA program offers too many profit enhancement and risk mitigation opportunities to simply ignore its value. In order to maximize success, bankers need to have every tool available to them.

Top Three Recommendations for Valuing and Accounting for Acquired Loans

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bsns-man-binoculars.jpgAs acquisitions of troubled and failed institutions continue, understanding the accounting for acquired loans is more critical than ever. The most often overlooked area in any transaction is the alignment of internal and external resources with accounting systems to facilitate a smooth transition of recordkeeping for loans—the most significant asset class acquired.

Acquired loans are accounted for at fair value at the date of acquisition, and accounting for those loans going forward presents a multitude of complexities for accounting personnel and senior management responsible for asset quality and financial reporting. Highlighted here are three best practices an acquirer can use to efficiently manage through acquired loan accounting and limit surprises.

1. Valuation Due Diligence

Many acquirers apply generic rules of thumb when valuing an acquired balance sheet and make broad assumptions about how earnings will be affected by valuation adjustments during the due diligence phase. When time permits, as part of the due diligence process, acquirers should perform a preliminary valuation of the loan portfolio being acquired. In a failed-bank acquisition, however, there typically is not sufficient time to conduct this level of valuation. Given the recent slowdown in closings, though, potential acquirers are finding themselves with more time.

In a normal bank transaction, there typically is enough lead time to perform a preliminary valuation since the acquirer has more control over the timing of the transaction closing. By performing a preliminary valuation, management is able to work through vendor selection prior to closing and can align expectations on valuation methodologies and deliverables to eliminate surprises after an acquisition. Third-party audit firms can review overall methodologies and deliverables well in advance of closing.

By doing this dry-run valuation work ahead of time, accounting personnel can start formulating the appropriate accounting policies and gain a deeper understanding of the financial reporting effect of yet-to-be-made accounting policy elections. Well in advance of closing, the bank should determine how best to construct pools of performing and problem loans for efficient accounting going forward, how to effectively align acquired loans into the existing credit monitoring and allowance methodologies, and which loans are most effectively valued and accounted for individually as opposed to pooled.

2. Early Assessment of Capabilities

Acquirers should identify resources that will be needed within the accounting, loan operations and credit administration functions in order to support the appropriate day-to-day application of accounting for the acquired loan. In addition to assessing personnel, acquirers should evaluate existing accounting systems to identify potential weaknesses in facilitating acquired loan accounting going forward. The acquiring institution’s current software vendor should know its system limitations in applying acquired loan accounting, and these discussions should start early in the process.

Acquirers should also address conversion protocols and timelines for a particular acquisition while discussing system capabilities. This assessment and education process should help determine resources and systems needed to perform the accounting going forward. It also will result in more accurate projections of the value of any particular acquisition since information systems and personnel costs can be more accurately forecast by assessing these areas early.

3. Post-Closing Valuation

Acquirers should perform another review of the acquired portfolio prior to providing final data for the loan valuations. This review should allow acquirers to revisit loan grades and take into account changes in collateral value and credit scores following the initial due diligence. Loan grading and collateral values change over time, and given the limited scope for review under due diligence timelines and the potential for credit deterioration or improvement, acquirers should strive to provide the most up-to-date information to be used in valuing the portfolio. Starting off with an accurate set of assumptions will help minimize surprises going forward.

Originally published on April 23, 2012.

Loan Notes: Big Banks Lose Ground

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The largest banks trailed the rest of the industry in terms of loan growth in the third quarter compared to the same period a year ago, according to SNL Financial.

Loan growth among the top 25 bank holding companies was just 3.27 percent during the quarter, compared to 4.2 percent for all bank holding companies above $1 billion in assets in the United States.

SNL called it a sign of how competitive the industry has been. The most active lending segments are commercial and industrial, as well as mortgage and housing-related lending. Credit card and auto lending also has been strong.

Among big banks, the leader in loan growth was TD Bank US Holding Co., the U.S. subsidiary of The Toronto-Dominion Bank of Toronto, Canada, which had 16 percent growth. Tied for second place was BB&T Corp. in Winston-Salem, North Carolina, and Discover Financial Services of Riverwoods, Illinois.

Among banks that saw declining loan portfolios were JPMorgan Chase & Co. in New York, Capital One Financial Corp. in McLean, Virginia, and Regions Financial Corp. in Birmingham, Ala.

Bank Assets Loan Growth Y/Y 3Q (%)

JPMorgan Chase & Co.

$2.3 trillion

-2.87

Bank of America Corp.

$2.2 trillion

-4.27

Citigroup

$1.9 trillion

.13

Wells Fargo & Co.

$1.4 trillion

3.27

U.S. Bancorp

$352 billion

7.46

Source: SNL Financial

Groping Toward Mortgage Compensation Rules

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cutting-money.jpgRecently the Consumer Financial Protection Bureau (CFPB) issued a set of proposed rules on mortgage loan originations that include restrictions on compensation that will make it difficult for banks to structure bonus plans for their mortgage loan originators.

I wrote about this issue back in May, after the bureau had issued guidance stating that banks are permitted to make contributions to a mortgage loan originator’s 401(k) or some other type of qualified plan out of a profit pool derived from mortgage loan originations. However, the CFPB declined to indicate at the time whether banks could pay bonuses to originators based on the profitability of a pool of mortgage loans as part of a non-qualified incentive compensation plan. The distinction is important because in the case of a qualified plan like a 401(k) we’re talking about an individual’s future retirement income, while with a non-qualified bonus plan we’re talking about cash in their pocket today.

First a little bit of important background. Underlying this issue of mortgage originator bonuses is the focus of federal regulatory agencies—including the CFPB—on so-called compensation risk. During the subprime mortgage boom, originators often received extra compensation if they steered borrowers to higher cost loans, which often meant low-income borrowers paid more for their loans than they should have. The Federal Reserve Board proposed stricter rules on mortgage origination compensation in September 2010 under the Truth in Lending Act. Rulemaking authority for the Act was transferred to the bureau under the Dodd-Frank Act, and now the bureau is finishing what the Fed started.

Mortgage originators aren’t the only bankers impacted by all this attention on compensation risk. Banks are also being forced to change their incentive compensation practices for other kinds of lending activity, including commercial real estate and C&I lending. Generally speaking, the regulators don’t want lenders to be rewarded purely on volume; they want to see bonus payments spread out over a longer period of time than, say, just one quarter; and they want the size of the payout tied to the performance of the underlying loan portfolio over some reasonable period of time so lenders don’t get paid upfront for loans that later go bad. And in the case of mortgage originators, regulators don’t want them to be incentivized to screw their customers by pushing them unwittingly into high cost loans when they would qualify for a cheaper loan.

It was not clear last May whether the CFPB would allow banks to pay its mortgage originators any kind of bonus that wasn’t tied to a qualified plan. “Every bank is trying to do a better job of tying compensation to the profitability of the underlying business,” says Kristine Oliver, vice president at Pearl Meyer & Partners. But the bureau has now issued a proposed rule for non-qualified bonus plans that will make that goal much more difficult. Under the latest proposal, banks may pay employees a bonus derived from a pool of mortgage loans only if three conditions are met:

  • Compensation may not be based on the terms of the loans that were originated, so an employee can’t be rewarded for producing more of one kind of loan versus another.
  • The employee can’t have originated more than five mortgage transactions during the last 12 months.
  • However, if the individual’s transactions exceed five, the bonus pool can based on mortgage revenue limited to 25 or 50 percent of the overall revenue in the pool. The bureau has proposed two percentage cap alternatives, 25 percent and 50 percent.

The proposal does address the concern some people had that branch managers who originate an occasional mortgage might not be allowed to receive a bonus based on the profitability of their branches if the branch’s revenue included, say, points or mortgage origination fees. Now those individuals can receive a bonus even if the branch’s revenue includes some mortgage related revenue.

“The bureau has proposed a diminutive exemption,” says Richard Andreano, Jr., a partner in the Washington, D.C. office of Ballard Spahr LLP. “That would work for [occasional originators] but doesn’t work for someone who does more than five but still doesn’t do a whole lot of originations.” An example might be someone manages a mortgage production office and originates more than five loans a year, but is still a low volume producer compared to their rest of their team, so they don’t qualify for a bonus based on mortgage revenue.

More importantly, the proposed cap on the percentage of mortgage-derived revenue that can be included in a bonus or profit-sharing plan will make it impossible for banks to structure incentive compensation plans that will reward their originators solely on the profitability of their business. To get around the cap, banks will have to enlarge the categories of revenue that bonus payments are based on to include other kinds of loans in the mix. That would make it more of a company-wide incentive plan—especially if the cap is as low as 25 percent—which might be what the regulators prefer, but could be a less powerful incentive than a plan where mortgage originators were the only participants.

“That’s where the bureau wasn’t willing to go,” says Andreano.

Banks and other financial services companies that are impacted by the proposed rules have until Oct. 16 to submit their comments to the CFPB. Dodd-Frank requires the bureau to adopt final mortgage originator rules by Jan. 21, 2013, so banks should expect a final rule by then. Unfortunately, as Oliver points out, “People are starting to pull together their incentive plans for 2013,” so any assumptions they make now—like, for example, will the allowable cap be 25 percent or 50 percent—could be subject to change.

FDIC Lawsuits: Avoiding the Worst Outcome

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hard-hat.jpghard-hat.jpghard-hat.jpgIn the wake of over 400 bank failures since the beginning of 2008, the Federal Deposit Insurance Corp. is well underway with its process of seeking recoveries from directors and officers of failed banks who the FDIC believes breached their duties in the course of managing those institutions. As of mid-May 2012, the FDIC had filed lawsuits against almost 30 groups of directors and officers alleging negligence, gross negligence and/or breaches of fiduciary duties. While the litigation filed by the FDIC tends to sensationalize certain actions of the directors and officers in order to better the FDIC’s case, there are lessons to be learned.

Some of the take-aways from the FDIC lawsuits are fairly mechanical:  carefully underwrite loans, avoid excessive concentrations and manage your bank’s transactions with insiders. However, there are two major themes that are more nuanced and which are present in almost all of the lawsuits. Those themes relate to the loan approval process and director education.

Develop a thoughtful loan approval process. As evidenced by the recent piece published on BankDirector.com, a spirited debate among industry advisors is currently taking place with respect to whether directors should approve loans or not. On the one hand, many attorneys believe directors have a duty to consider and approve (or decline to approve) certain credits that are or would be material to their banks. Regulation O requires approval of certain credits, the laws of some states require approval of some loans, and there is a general feeling among many bank directors that they should be directly involved in the credit approval process. In addition, many bank management teams believe that directors should “buy in” with them to material credit transactions.

On the other hand, the FDIC litigation clearly focuses on loan committee members who approved individual loans that did not perform. This should give pause to directors in general and loan committee members in particular. It is now the belief of many legal practitioners that the practice of approving individual loans when the loans are not otherwise required to be approved by the directors paints a target on the backs of the loan committee members. The FDIC may be able to target directors who participated in the underwriting of a credit (or were deemed to have done so given their involvement in the approval process) when they did not have the expertise necessary to do so. Some practitioners argue that the directors should instead focus on the development and approval of loan policies that place appropriate limits on the types of loans—and the amounts—that the bank is willing to make. This policy would be consistent not only with safe and sound banking principles but also with the board’s risk tolerance, and it would be appropriate to seek guidance from management and outside advisors on the development of the policy. The idea is that it is much more difficult to criticize a policy than an individual credit decision with the benefit of hindsight.

No matter the approach that your board chooses, the common theme is that the board and the loan committee should expect and receive all relevant information from management about material credits. If directors are actually approving loans, they should get detailed information in a timely fashion that allows them to review and approve the underwriting of the credit. If the directors aren’t approving loans, they should still get information that confirms that the loans conform to the bank’s loan policy and the board’s risk appetite.

Directors should be educated and informed. Above all else, the FDIC lawsuits make clear that the bank board is certainly no longer a social club. Bank directors are charged with very real responsibilities and face the very real prospect of personal liability if their banks are not successful. Indeed, being a bank director is a job.

Because the bank’s shareholders and regulators demand that the directors do a job for the bank, the bank should offer appropriate training to do that job well. Bank directors should be offered the opportunity to engage outside consultants to provide training for the directors to develop the skills they need, particularly at the committee level. In addition, directors should attend conferences that allow them to familiarize themselves with industry trends and best practices. We suggest that there is no better expense for the bank than ensuring that its directors are equipped with the education and tools they need to fulfill their duties.

In addition to more general training, the FDIC lawsuits bring focus to the fact that some directors simply did not understand the material risks to their banks. We have encountered directors who do not fully understand the material risks their institutions face, even at high performing banks. As a result, we recommend that at least annually the directors have a special session to focus on enterprise risk management and discuss the key risks that face the institution. These sessions can be conducted by the chief risk officer or, at smaller banks, by an outside consultant who has helped to manage the enterprise risk management process. This understanding of material risks should better inform the decision making of the board.

While the FDIC lawsuits paint a picture of inattentive, runaway directors and officers, a number of the practices that the FDIC found objectionable could be found at many healthy institutions. By learning from the situations that led to many of these lawsuits, even the best performing banks can enhance the performance of their boards, which will ultimately result in greater value to the shareholders of the bank.

Should Bank Directors Approve Loans?

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Following several lawsuits where the Federal Deposit Insurance Corp. sued directors of failed banks who serve on the loan committee, Bank Director decided to ask bank attorneys for their insight on whether directors should be involved in approving loans. It turns out there are a variety of opinions on this. Some think the FDIC’s lawsuits clearly point to the hazards of bank directors getting involved in loan decisions. Others say with a prudent approach, directors need to be involved in a way that shows their due diligence and expertise.

Q. Should directors be directly involved in approving loans, and what are the important liability issues to keep in mind?

Harold-Reichwald.jpgNo. Given recent experience with the FDIC, directors who served on a directors’ loan committee and actually approved loans (as opposed to a mere recommendation) are being singled out for allegations of liability while other non-loan committee directors get a pass. A theory of liability being espoused by the FDIC is that directors’ loan committee members acted in a quasi-executive role when approving loans and hence should be treated differently with perhaps a standard of care of mere negligence, not gross negligence.

—Hal Reichwald, Manatt, Phelps & Phillips, LLP

Heath-Tarbert.jpgTo involve directors in directly approving individual loans that are not to insiders or are otherwise routine can needlessly conflate the role of directors with that of management. As the institution grows in size, such a practice is a recipe for diminished—rather than enhanced—corporate governance. What is critically important, however, is that every director become confident that the bank’s overall lending and credit policies are sound in substance and in practice.

—Heath Tarbert, Weil, Gotshal & Manges LLP

Chip-MacDonald.jpgMany loans require director approval to comply with Regulation O and securities exchange corporate governance rules, among other things. It is customary bank practice to require director approval of larger credits. Board or director loan committee consideration of loan requests are the first line of risk control and corporate governance, and properly conducted, provide better assurance of compliance with laws and bank policies, including credit quality and asset concentrations. Loan decisions are subject to the business judgment rule and generally should not be second-guessed by the courts. The recent Integrity Bank decision that held directors cannot be liable for negligence should be very helpful in limiting liability in this area.

—Chip MacDonald, Jones Day

Jonathan-Wegner.jpgState law often drives whether or not directors are required to be involved in large loan approvals, but the reality is that—whether required by law or not—bank directors often do become involved in approving loans. If you’re engaged in approving loans, the most important thing to understand is that you are going to have a Monday-morning quarterback looking over what you’ve done, so it is crucial that you strictly adhere to your bank’s lending and risk management policies, as well as any laws or regulations applicable to your bank’s loans (such as loan limits or transactions with affiliates). If a loan goes bad that complies with law and fits within your bank’s policy parameters, chances are regulators will find something to blame besides your decision to authorize the loan.

—Jonathan Wegner, Baird Holm, LLP

Mark-Nuccio.jpgIn light of the FDIC’s publicized lawsuits against former directors of failed banks, it has become fashionable to suggest that directors curtail their involvement in lending decisions that are not specifically required by law. In my mind, that’s like throwing the baby out with the bath water. Directors would be unwise to eschew responsibility for a business unit that is the key revenue driver for most banks. Directors first need to focus on establishing sound credit and risk policies appropriate for the size and complexity of their organization. Those policies should delineate when a board level loan committee is required and what it should do. A recent spate of lawsuits by the FDIC against directors involved in lending approvals is probably more about shaking a recovery out of a directors & officers insurer than it is about trying to take personal assets away from bank directors.

—Mark Nuccio, Ropes & Gray LLP

Kathryn-Knudson.jpgWhile directors should have a significant role in establishing loan policies and procedures, especially from a risk management perspective, they should not have additional potential liability from “approving” loans. This is particularly true when the director has no specific loan underwriting training and his or her involvement with a given loan may be a 5- to 15-minute presentation by the bank’s senior loan officer. It is still appropriate for directors to have factual input. For example, at the directors’ loan committee meeting, if a director has information concerning a borrower that may not have been available to the lending team, the director should tell the team. The lending team still makes the ultimate decision. Moreover, the directors should verify with the lending team (and have documented) that the loan meets all of the legal and risk appetite parameters set forth in the bank’s loan policy.

—Kathryn Knudson, Bryan Cave LLP

Delinquency rates tick upward: Blame the Government

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pastdue.jpgConsumer delinquencies on loans moved higher in the second quarter of this year, as high unemployment continues to hurt the loan portfolios of banks, according to the latest analysis of the American Bankers Association.

As if you hadn’t heard the refrain enough lately: the country needs more jobs.

“The most important factor in whether or not someone can repay their debt is whether or not they have a job,’’ says ABA Chief Economist James Chessen, in the understatement of the year.

It hasn’t helped matters, as Chessen points out, that the national unemployment rate ticked upward from 9 percent to 9.2 percent during the second quarter. (The latest unemployment rate for September, released by the U.S. Department of Labor today, shows a 9.1 percent unemployment rate.)

The ABA survey of 300 commercial banks about their auto, personal, home equity and credit card portfolios found that nine out of 11 categories of loans had higher delinquency rates in the second quarter than the quarter before.  The exception was a slight improvement in credit card portfolios and mobile home loans.

The overall, seasonally adjusted, composite index rose 17 basis points to 2.88 percent from 2.71 percent in the first quarter. The ABA defines its delinquency rate as the percent of loans that are 30 days or more past due.

Interestingly enough, the private sector has been adding jobs quarter-to-quarter since 2010. It’s the public sector, pressured by low tax revenues, that has been shedding jobs this year and through much of last year. (The latest figures for September show this trend continuing.)

In an ABA chart that uses its own loan survey data and data from the Bureau of Labor Statistics, the delinquency rate starts to drop as jobs pick up in the private sector. But you can almost see the delinquency rate on consumer loans begin to climb slightly after a series of layoffs in the public sector.

payroll-chart.png

“(Governments) spent a lot (of money) and thought revenue coming from property taxes or income and sales taxes were going to continue at that level,’’ Chessen says. “But when property taxes started to fall relating to home prices and when income fell, and sales were off, their revenue fell quickly but their expenses were locked in. To get expenses back in line has meant layoffs.” 

Unlike the federal government, most states must balance their operating budgets and not spend more than they collect in taxes, so the layoffs seem almost inevitable.

It appears that this time around, the public sector is a real drag on the economy, keeping unemployment high even as the private sector tries to get its footing.

What Have We Wrought? How Can We Atone?

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training.jpgI know, I know, this may not be the time or the venue for industry self-flagellation, but like the twelve-step programs and most religious admonitions, one cannot change or eliminate bad habits or poor behavior without first acknowledging the problem. That one key problem for community banking—both relative to this crisis and the continuation of our business model—is the dearth of classically trained credit talent remaining in our industry.

We know the primary culprit: the big bank fixation on the efficiencies of the hunter-skinner template for credit delivery. Are we not now paying exponentially for those “savings” now? I’ve said for years that I knew of no other industry that has been successful putting people on the street selling a product or service with such limited knowledge or training.  Most devastatingly, adherence to that model has ended the en masse credit training that had been the font of credit talent that ultimately found its way to the community banks. Even without this economic tsunami, our niche of the industry was facing a crisis over how to staff lending functions with people who actually knew credit. These are the people who provide value to both risk management and the borrowing customer—knowledge that is arguably at the heart of community banking’s popularity and viability. Simply put, due to big bank strategies and retirement factors, there’s less credit talent per capita in banking today than ever before.

What can be done? Like the so-called aging infrastructure of America, rebuilding our depleting credit talent pool needs significant investment and high profile support—support at the highest levels of our banks, including boards and CEOs.  Credit training can no longer be seen as just a discretionary non-interest expense item available for the budget balancing axe. Even at Credit Risk Management, L.L.C. (CRM), training revenue has been down about 25 percent since the onset of the crisis in ’08—understandable for the times, but a trend that must be reversed. Credit training, of course, can take many forms: in-bank, trade association-sponsored, and vendor-directed. Each bank needs to devise a strategy that works best for its talent needs.

One initiative that banks should consider is re-invigorating the formal or informal peer group training programs, where costs can be shared and curriculum can be customized. Also, look for schools with graduated levels of complexity in the two primary branches of commercial lending: C&I (commercial & industrial) and CRE (commercial real estate). Community banking in particular needs diversity away from real estate. Focus on schools where the curriculum will be focused totally on credit underwriting and analysis, using case studies, mock presentations, and computer tools—not ancillary issues like loan review or effective officer call programs. And to ensure the cost justification for the bank’s investment in sending students, ensure that the program include at certain stages some testing and certification. 

Even with all the turmoil and economic pain our industry is currently experiencing, I subscribe to the Chinese adage that within every problem lays an opportunity. Our opportunity is to begin now to build the next version of the business model for community banking, and credit training must be a vital part of that re-building strategy. Accordingly, I implore you community banking leaders—executive management and board directors—to first acknowledge this depleted credit talent problem, and then to see some way to budget for training opportunities as not only investments in enhanced risk management, which we obviously need, but as investments, too, in the marketing and survival of our niche in the broader industry.

Has Lending Turned a Corner?

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One of the more depressing aspects of this long-running post-recession malaise has been the continued shrinkage of bank loan portfolios. Consumers and business aren’t asking for many loans, and many of the people who do ask aren’t getting any. That impacts the economy’s ability to grow, if businesses aren’t investing and consumers aren’t spending.

But loan growth seemed to turn a corner in the second quarter, and interestingly, small and mid-sized banks are leading the way, according to an analysis by investment bank Keefe, Bruyette & Woods, Inc.

Total loans and leases increased 0.9 percent in the second quarter, or by $64.4 billion, according to the Federal Deposit Insurance Corp. (FDIC), the first actual growth in three years. The government’s statistics include all FDIC-insured institutions, both public and private. Commercial and industrial loans (C&I) increased for the fourth consecutive quarter, by 2.8 percent, while auto loans rose 3.4 percent, the FDIC said. Credit card balances rose by 0.8 percent and first lien residential mortgages rose by 0.2 percent.  Loans for construction fell for the 13th consecutive quarter, this time by 7 percent.

A deeper look from KBW of publicly traded banks shows that mid-cap banks had the largest growth in loan portfolios. Large-cap banks saw total loan balances decline by 0.2 percent during the second quarter, while mid-cap and small-cap banks grew their total loans by 5.9 percent and 0.7 percent, respectively.

The investment bank and research firm reported:

  • Among the loan categories at mid-cap banks, C&I loans posted the largest quarter–to–quarter increase, gaining 13.9 percent.
  • Large-cap banks posted quarter-to-quarter loan shrinkage across all loan categories except C&I, which increased 2.0 percent.
  • Only Puerto Rico and the Southwest saw aggregate quarter-to-quarter loan shrinkage. Total loans fell 4.9 percent sequentially for Puerto Rico, and 1.6 percent for the Southwest.
  • The Midwestern and Southeastern regions posted the strongest quarter-to-quarter loan growth as total loans increased 9.5 percent for the Midwest and 6.1 percent for the Southeast.
  • Loan portfolios still are down from a year ago. On a year-over-year basis, total loans (excluding consumer loans) have declined annually for seven consecutive quarters, most recently falling 0.5 percent in the second quarter, according to KBW.
  • The commercial and industrial loan category, which accounts for 18 percent of total loans, is the only loan category to post both quarter–over–quarter and year–over–year loan growth of 2.7 percent and 4.6 percent, respectively.

Commercial and industrial loans to businesses clearly remain a source of strength, even as real estate is soft. The growth in loan portfolios among small and mid-sized banks is a welcome sign, even though large-cap banks account for 90 percent of aggregate loans, according to KBW. Banks have been giving investors something to be happy about: Higher profits, better loan credit quality and even some loan growth during the second quarter. But with the wild swings in the market and plummeting bank stocks lately, it may be that investors still are too worried about the economy to care.

The Loan Conundrum

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Steve-Trager.jpgSteve Trager is president and CEO of Republic Bancorp, Inc., a Louisville, Kentucky-based, $3.1 billion-asset publicly traded company with 43 bank branches in Kentucky, Florida, Indiana and Ohio. Despite the crummy economic environment, poor loan demand and high regulatory demands, Republic Bancorp has maintained high profitability; even with half its loans in residential mortgages, and most of the rest in commercial real estate, construction, business and consumer loans.

Republic Bancorp had the second and third highest return on average assets and return on average equity last year, and the fifth best performance overall in Bank Director magazine’s ranking of the top 150 banking companies in the nation.

To be sure, the bank has experienced problems, too.  Its non-performing assets are 1.28 percent of total loans as of the second quarter, a decline from previous quarters, and it took a $2 million charge in second quarter earnings over a civil penalty from the Federal Deposit Insurance Corp. relating to its IRS tax refund anticipation loan service.  (The company says it will contest the fine before an administrative law judge and will work to make sure its tax firm clients comply with applicable banking regulations).

Trager talked to Bank Director recently about how he’s handling the challenges of the current regulatory and economic environment.

Can you talk about what sort of lending you do?

The challenge for us in residential mortgages is we compete with a government product that is a 15- and 30-year fixed rate at 3.5 percent for 15 years and 30 years at 4.25 percent and only the government would make a 15- or 30-year fixed rate loan at those kind of rates, with that kind of interest-rate risk. We are proud to be able to offer that government product to our customers as well and we service that product as a competitive edge. Every single one of our products is delivered by a Republic Bank banker as opposed to a broker and that is competitive difference for us. We sell those (government-backed) loans on the secondary market so we don’t keep them on our books.

So what kind of residential mortgages do you keep in your portfolio?

There’s an expanding universe of people who aren’t able to comply with the government’s rigid requirements. Some of those requirements don’t reflect credit quality. Some folks are very capable with good debt service characteristics, low loan-to-value. They might want to buy a condo and the secondary market is very difficult for condos.

We would love to expand our offering to an even bigger group of customers who are very credit worthy, if we could get a little better pricing. The biggest risk today is regulatory risk. The mortgages we do, the rates we do, and whom we make them to, is just subject to so much scrutiny, that we can’t take a chance to expand our portfolio credit offering to those who need it.

Didn’t your $2.2 billion loan portfolio grow a little bit in the second quarter, by 2 percent?

Absolutely, (it grew) by about $50 million. That was a little bit more than half commercial and some residential. I think customers see Republic Bank and our financial health as a stable, long-term option.

We’re still in the market for residential mortgages because we have enough size and enough volume. The risks are so great that it has pushed a lot of other lenders out of the market. Any mortgage loan we make, we’ve got to gather tons of fields of demographic information, for thousands of loans per year. It frustrates customers.

Have you loosened your underwriting standards recently?

We have not. Our underwriting standards have remained relatively stable over the last five years. I do worry that in this market, where there is not much loan demand and a lot of banks in desperate need of loans that that’s a dynamic that might cause some to stretch their underwriting models. We’re never going to sacrifice the long-term viability of Republic Bank or our customers for short-term gain.

Your focus has been maintaining a highly profitable bank. You saw profits rise 50 percent in the first half of the year compared to the same time a year ago to $80 million. How?

I think it’s a combination of the stability that our core bank provides. We haven’t been haunted by credit quality. We have had good demand from both the deposit and loan side. It’s just trying to do the right thing over and over again for a long period of time, and having the right people do it. We’ve got 780 associates and they do a spectacular job.

We also have niche businesses that supplement our bottom line. We are the largest provider of electronic tax refunds in the country. We service folks like Jackson Hewitt, Liberty and other tax services around the country, processing electronic refunds for their customer base. A small percentage of the customers would like to get an advance on their refund within 24 or 36 hours. That represented about 700,000 of our four million tax refund customers in the first quarter.  For the rest, when the IRS pays it, we make sure our customers get it quickly.

What advice do you have for other bankers in this difficult time to grow lending?

Go out and encourage and support a good lending staff. Get out and pound the pavement. Our lending staff is very incentivized to do that. Their incentives are tied to loan quality. Part of their annual bonus is determined by production and delinquency. We are fortunate enough to have had a lot of folks who have been with us for a long period of time, and that helps.