Today, despite an increasingly difficult profit environment for bank loans, many banks continue to pursue C&I lending. Reacting to more aggressive competitors and a more demanding commercial customer, bank management often fails to enforce appropriate criteria for pursuing targets or retaining current customers. The net result is little differentiation (other than low rates and loose structures) and a failure by these banks to provide their clients and targets with a meaningful reason for banking with them (other than low rates and loose structures).
Low Rates and Loose Structures
Let’s start by looking at the current environment for lending. Spreads are low across all markets, fees are being whittled away, and “free” deposits are harder than ever to retain from current customers or obtain from new ones. Multiple factors have created this difficult environment; some factors may be temporary while others indicate a fundamental change in the banking environment.
Importantly, spreads should improve. However, the questions related to this include “When?” and “At what cost?” Regarding the “when,” simply read Bruce Rattner’s column cited on the left of our newsletter. Titled “The Coming Credit Meltdown,” Rattner focuses on the lemming-like desire of bankers and investors to buy junk loans. As an indication of the current financing frenzy, he writes, “In recent months, lower credit bonds…have traded at a smaller risk premium (as compared to U.S. treasuries) than ever before in history…less than 8% money for high-risk borrowers.”
To underscore the eagerness of lenders, repricing is rampant: “So robust has the mood now become that providers of loans now rush to offer ‘repricing’ at even lower rates, terrified that borrowers will turn to others to refinance their loans, leaving the original lenders with cash on which they will earn even less interest.”
Obviously, the above situation is more centered in the high-yield world than elsewhere. The creativity and seeming willingness of lenders to create a noose and place their own necks in it seems truly remarkable (Example: the increasing phenomenon of “covenant light” loans.) That said, virtually all our clients talk of competitors further cutting already low rates and reducing various lending restrictions. Comments come from across the spectrum, whether small business, middle market, or large corporate.
No one knows when what Rattner terms the credit meltdown will occur, but every experienced banker believes it will occur. How severe? Again, unknowable today, although when the “meltdown” does occur, we may look back and recognize the signs with 20/20 hindsight.
Bank Options in a Tough Environment
Of course, most banks are not making loans to highly leveraged companies and, in any case, bankers are unable to withdraw from the market and await a better day. However, the current environment (difficult competitively and increasingly dangerous from a risk management perspective) provides banks of all sizes and types with a critical opportunity to reexamine their market focus and ensure that that they are maximizing the potential of their lending activity. How?
It was well over ten years ago that I read a speech by Dick Kovacevich of Wells Fargo in which he said that commercial lending was a loss leader, much like the cheap toothpaste that drug stores use to entice customers into their stores. Yes, they purchase the cheap, low-margin item but also purchase other higher margin items as well. To this day, many banks are just selling the toothpaste, failing to sell more deeply into the client relationship.
Here are three near-term actions your bank should consider:
* Establish a quid pro quo. For banks, lending is a means to an end (profitability and high returns), not the end itself. If a bank provides financing, it should insist on the business account and the personal account of the owners. Management has to provide discipline in the face of bankers who offer explanations concerning why deposits are not available currently but will be obtained in the future.
* Promote segments. Being a vanilla C&I lender condemns most banks to mediocre returns. Banks need to develop a market focus based upon an attribute such as product knowledge (for example, SBA or real estate lending), industry expertise, or demographic focus (for example, women or Hispanics). Increasingly, trying to differentiate yourself based on strong service will be insufficient, since even the biggest banks are providing improved customer service. Even the smallest banks have a segmentation opportunity based upon factors such as location and their current client base. Example: when we evaluated one client’s portfolio we found, to their surprise, that they had a strong concentration in a certain industry. They embraced their initial and unexpected exposure and decided to build it into a more significant business.
* Set a non-loan goal. One of our clients has set a goal of increasing fee income to a higher level over the next few years. As that goal becomes part of the fabric of the institution, banker focus should change to support the sale of products and services that, ultimately, leverage the lending relationship. We are not necessarily suggesting that banks do less commercial lending; rather they should be using the loan as a relationship wedge that allows them to sell other products and lock in the customer.
Concluding Thoughts
The near-term picture for C&I lending suggests continued margin compression and growth challenges. But throwing away pricing and structure standards under competitive pressure will only lead to longer-term problems. Instead, develop a consistent and disciplined approach for positioning your bank in the commercial lending space and make certain that lending is viewed as part of a product/service array rather than an end goal.