Commercial and industrial (C&I) lending—especially to small businesses—has become increasingly attractive to community bankers. When managed properly, C&I lending offers a lucrative earnings opportunity for banks, while providing constructive benefits to the broader economy.
C&I portfolios have grown moderately over the past year, during a time when demand for other loan types has remained relatively weak. However, competition for C&I loans also has intensified. Larger banks that reduced their C&I lending are once again aggressively competing for C&I loans. As competition grows more aggressive and banks continue to suffer from weak earnings, supervisors will be concerned that some bankers may respond by expanding their C&I portfolios without putting sound risk management practices into place, resulting in unduly relaxed loan covenants, overly thin loan spreads, or excessive concessions to attract new and retain existing clients.
In a recent speech, Federal Reserve Governor Elizabeth Duke emphasized the need for a balanced approach, but expressed concerns as well, stating, “Moreover, to generate loan volume without increasing real estate lending, many banks are now targeting growth in commercial and industrial (C&I) loans, a type of lending with which they may have less expertise. In fact, banks have generally experienced higher loss rates on C&I loans than on commercial real estate secured loans (excluding construction loan losses), even through the crisis. So this portfolio shift has the potential to increase rather than decrease expected losses.”1
Community bankers have worked hard to make inroads into C&I lending, and many view it as an area with future growth potential. It is important that bankers, particularly those who are newly entering or expanding C&I lending programs, understand the inherent risks in this lending niche and possess the expertise to ensure long-term success.
The term “commercial and industrial (C&I) loan” is commonly used to designate loans to a corporation, commercial enterprise, or joint venture that are not ordinarily maintained in either the real estate or consumer installment loan portfolios. According to the Federal Reserve's Commercial Bank Examination Manual (the examination manual), commercial loans are typically a state member bank's largest asset concentration. They offer banks the most complexity and require the greatest commitment from bank management to monitor and control risks. The examination manual defines such loans, stating, “Commercial loans are extended on a secured or unsecured basis with a wide range of purposes, terms, and maturities. While the types of commercial and industrial loans can vary widely depending on the purpose of loans made and market characteristics where the bank operates, most commercial and industrial loans will primarily be made in the form of a seasonal or working-capital loan, term business loan, or loan to an individual for a business purpose.”2
Analysis of balance sheet data of commercial banks indicates that in December 2011, C&I loans were more than 10% higher than in December 2010. A monthly breakdown of the data shows that the recent pace of year-over-year percentage change at the largest 25 banks was higher (15%) than at the smaller domestic banks (5%).
C&I Loans in Bank Credit
The overall C&I loan portfolios at Third District commercial banks and state savings banks increased during 2011 as well. Notably, the growth was stronger among banks with less than $1b in assets than at their larger counterparts, a trend that was evident in the District throughout the financial crisis.
The Federal Reserve's January 2012 Senior Loan Officer Opinion Survey suggests continued growth in C&I lending.3 About 15 percent of domestic banks, on net, reported increased demand for C&I loans from small firms, the largest net percentage that has been reported since 2005. Survey respondents reported a general increase in the number of potential borrowers, and respondents attributed this increase to a more optimistic business outlook. However, while the outlook is improving, confidence levels remain low, and plans for hiring and capital expansion remain modest.
Although banks are making more C&I loan commitments, line utilization remains relatively low. Many businesses are flush with cash, and operating efficiency levels are strong. The National Federation of Independent Business's (NFIB's) December 2011 survey of more than 900 small-business owners showed that nearly 93% said their credit needs were either met, or they weren't interested in borrowing. This survey also determined that “Money is available, but most owners are not interested in a loan to finance the purchase of equipment they don't need.”4
Regulators encourage prudent lending to creditworthy borrowers. As outlined in the Interagency Statement on Meeting the Needs of Creditworthy Borrowers, the regulatory agencies “expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers. It is essential that banking organizations provide credit in a manner consistent with prudent lending practices and continue to ensure that they consider new lending opportunities on the basis of realistic asset valuations and a balanced assessment of borrowers' repayment capacities.”5
The Federal Reserve's July 2011 Senior Loan Officer Opinion Survey shed some light on current lending standards in the industry.6 One question asked respondents to report how their current lending stance stood, relative to the range defined by the easiest and tightest standards applied by their bank since 2005. This survey noted that, “For different types of C&I loans, between 25 and 50 percent of domestic respondents indicated that their bank's current lending standards were near the middle of that range. Of the remaining domestic respondents, more indicated that their current levels of standards on C&I loans were tighter than the middle of the range, compared with the number that indicated that standards were easier than the middle of the range.”
The 2011 survey also found that a large net fraction of domestic banks reportedly eased pricing terms on C&I loans to firms of all sizes over the past three months. A moderate net fraction of banks also indicated a reduction in their use of interest rate floors. Domestic banks that reported having eased terms on C&I loans unanimously cited increased competition from other banks and nonbank lenders as a reason for doing this.
Banks must understand the potential risks of C&I lending and monitor those risks at both the borrower and the portfolio level. Examiner expectations pertaining to C&I lending are outlined in section 2080 of the examination manual.
Supervisors will seek to ensure that appropriate due diligence is performed, that effective ongoing monitoring takes place, and that prompt actions are taken to mitigate risks. While this article is not meant to provide an all-encompassing list, below are some general principles and best practices to consider.
C&I lending can present challenges to loan officers unfamiliar with this business line and can heighten the risk of loss to a bank's portfolio. The skills required for commercial real estate lending may not equate fully with C&I lending. The lenders and support teams need to have expertise in the nuances of C&I. Formally trained and experienced professionals in the C&I niche can be scarce. Suitable talent is sometimes times hard to find, expensive to develop, and difficult to retain. Banks should take necessary actions to ensure that lending and credit administration functions have both the experience and resources needed to successfully conduct C&I lending business.
Upholding the basic principles behind sound underwriting standards is crucial for ensuring superior long-term performance and maintaining safety and soundness. There should be reasonable assurance of repayment in a timely manner. Prudent underwriting practices should reflect many credit factors, including the borrower's overall creditworthiness, the capacity of business income to service the debt, and the value and quality of the collateral. The lender should know when a business has systematic peaks and contractions so that loans are suitably structured with regard to funding needs and the timing of cash flows. A bank should also adhere to SBA guaranty requirements when applicable.
The basics still matter. Common contributors to loss include the failure to perfect liens, value collateral properly, or understand the value of guarantees. A bank should analyze the secondary sources of repayment, such as the guarantor or collateral strength, and the ability of the borrower to provide additional capital support.
C&I growth should be defined and approved by the board of directors and management and should be well-documented in the loan policy. A bank's loan policy should be critically evaluated for suitability with C&I lending, and exceptions should be monitored closely. Internal controls on limits should be adequate to ensure that loan quality is not being compromised in favor of growth. The policy should cover prudent diversification through measurements of loan types, collateral support, and borrower types as a percentage of capital. For example, bank management should monitor credit concentrations by North American Industry Classification System (NAICS) codes. Ongoing credit review and monitoring with useful and timely data are essential. Concise and useful information should be conveyed periodically to board members. In addition, an engaged and well-informed board of directors is crucial to ensuring that the activity remains aligned with the organization's risk appetite.
It is well-known in the industry that cash flow is the single most important element in determining whether a business has the ability to repay debt. Section 3050 of the examination manual states that, “The accrual conversion method is the preferred method because it is the most reliable. The second and less reliable method is the supplemental or traditional cash-flow analysis; however, the information needed for this analysis is usually easier to obtain.” Analysis of cash flow should be balanced and reflect expectations for the borrower's performance over a reasonable range of future conditions.
Borrowers should provide current, complete, and accurate financial statements at least annually. Management should also request personal tax returns. Knowledge and understanding of the borrower's business is essential.
Bankers must pay close attention for potential signs of trouble. The examination manual outlines some symptoms to watch for, including the following:
Bankers should ask themselves what would happen to C&I performance and capital levels if various adverse scenarios were to unfold. There should be an appropriate level of capital. A variety of stress factors should be considered, and a variety of analytical techniques can be applied. The important element is that senior management and the board of directors understand the risk to the portfolio and their bank under unexpectedly stressful conditions.7
As the recovery gains traction, greater opportunities for business lending will arise. Banks of all sizes should be well prepared to serve the credit needs of their communities. While C&I lending can provide potential earnings opportunities for banks, it should be conducted in a balanced manner with a prudent decisionmaking process and proper credit risk management practices in place.