Executive Summary: In recent years, many banks focused heavily on commercial real estate (CRE) lending, largely ignoring or underinvesting in commercial and industrial (C&I) loan activities. Given the CRE loan problems that banks are now addressing, senior management is increasingly interested in meeting the C&I needs of its small business or lower end middle market customers (SMEs). But, banks focusing on C&I may need to develop a new skill set.

 

 

Since 1987 if not before, the banking industry has strongly favored CRE lending over C&I lending. In that year each generated 34 percent of net loans. In less than 20 years those percentages diverged dramatically to almost 60 percent of net loans from CRE and less than 25 percent as a result of C&I activity.

 

CRE Focus

The emphasis in CRE lending occurred for at least four reasons:

 

* “Easy” origination process

 

* Attractive returns

 

* Strong track record

 

* “Hard” assets preference

 

By “easy” we mean that the transaction environment was rich with deals. Frequently, the borrowers or their loan syndicators came knocking on the banks’ doors rather than requiring the bank to conduct a long sales process; deals were there for the picking. The returns were attractive because, while the borrowers were hardly rate insensitive, oftentimes they were willing to pay more for “flexible” or “creative “structures (many of which subsequently blew up). Beyond net interest margin income, significant opportunity existed for fee generation.

 

While the “strong track record” turned out to be illusory and a trap for some banks, nonetheless, for a number of years CRE results were solid. Many banks in the “sun belt” came to believe that what was probably a once in a lifetime phenomenon was, in fact, the standard operating environment. The first ways out, refinancing or sale of a completed project, performed well for many years. The personal guarantees increased in value as appraisals rose and paper wealth soared.

 

Contrast the glamour and growth of CRE lending with the world of C&I transactions. Most small and mid-sized companies grow slowly, if at all. Personal net worth, tied up in the business, is also limited. The analysis required to support a loan demands close evaluation of equipment, receivables, inventory as well as cash flow; the end liquidation of these assets depends on many variables, resulting in senior management uncertainty related to value as well as how to liquidate, if necessary.

 

Current Status

Today, for more than one bank we know, the commercial real estate and workout areas are now the same group: some CRE projects limp toward completion and the hope of unit sales; others show absorption rates that will keep the bank on the hook for an undetermined time and with undeterminable losses; the once impressive personal guarantees have decreased or disappeared in value. The result is that the majority of banks are actively shifting their emphasis to C&I activities. In addition, there are an increased number of credit unions responding to their members’ requests, and some hedge funds are also focusing their efforts here.

 

As more competitors enter this area, the demand for C&I lending remains reduced. Why?

 

* Small businesses are wary of borrowing. A July survey by Discover Financial Services reported that 75 percent of business owners said it is likely or highly likely that the economy will slip into another recession before it fully recovers.

 

* Borrowers say funds are not available. In its survey, the National Federation of Businesses states that 41 percent of companies could not raise as much money as they needed, the highest number in 17 years.

 

* Companies have redesigned how they do business. In a recent Financial Times column, the writer, an entrepreneur, describes himself as a “recovering debtaholic.” He says he is changing how he finances transactions: “Acquisitions my firm is considering are being financed with 50 percent or even 100 percent equity ? transactions that three years ago would have needed just 25 percent equity…Long live equity: RIP too much debt.”

 

Retooling for C&I

Add to the need to change focus and the increased competition, the fact is that many banks lack sufficient expertise in C&I lending. Trying to switch from an emphasis on CRE to C&I without substantial personnel, product, and marketing changes as well as IT and related support is doomed to failure.

 

C&I lending differs from CRE lending in several fundamental ways:

 

* Loan structure. The requirements related to underwriting and managing a working capital loan demand distinct risk management and monitoring capabilities, involving an increased need for strong cash flow analysis and asset based finance skills. Banks also need to be able to dispose of equipment and other assets.

 

* Time to sell. Often, C&I requires a longer and more proactive sales cycle versus CRE; relatively few borrowers are borrowing for growth; quality borrowers renewing current facilities need a strong reason to change banks that, for many, will go beyond rate.

 

* Relationship sale versus transaction sale. Increasingly, C&I loans will be sold as part of an overall relationship package or solution.

 

* Profitability. Going forward we expect all commercial loan profitability to be reduced. Reasons include: increased capital requirements and more “touching” of each loan both before approval and on an ongoing basis, among other factors. Risk management costs will continue to grow.

 

Concluding Thought

Next time we will outline some approaches banks need to consider as they rev up their C&I activities. One of them involves working with third party vendors to provide clients with products and capabilities that many banks will be unable or unwilling to develop for themselves.