Over the last few years, expansion of or into commercial and industrial lending has been the strategic cornerstone of almost every community bank.
According to a recent article in American Banker, C&I lending grew by more than 2% last year among banks with less than $10 billion in assets. That rate of growth was higher in some regions.
That's good news. The business remains one of the few intermediation activities that will bolster net interest margins in a low-rate environment. There are certainly a multitude of lenders eager for the business.
But enthusiasm for welcome signs of growth must be tempered by the cautionary notes sounded about unrealistic terms and pricing. We cannot predict how pervasive these practices will become, but it's a sure bet that the seeds of future loan problems are sown in the credit decisions of today.
It is worth remembering that the average net charge-offs on C&I loans spiked as high as 2.62% in 2009. Today, net charge-offs on C&I loans exceed 3% at several banks. While many banks have the requisite risk management discipline to navigate the current credit environment, many others do not. Assuming C&I lending remains the focus for many banks and that competition continues to intensify, there are a few critical credit and pricing disciplines that will determine which banks will safely navigate the waters of C&I lending.
A rigorous risk-rating methodology is crucial. This sounds like a truism, but too often the risk-rating framework at banks is inadequate. There is too much reliance on a one-size-fits-all narrative description to assign the risk rating irrespective of loan type (e.g., C&I, commercial real estate, etc.). Consequently, the majority of borrowers are lumped under one rating, resulting in a "default" risk rating (e.g., most loans are simply graded "acceptable"). To be effective, the risk rating methodology must have a sufficient number of "pass" categories to provide true differentiation. At a minimum the bank's risk-rating framework should have six pass categories. The guidance for assigning the risk ratings should include objective factors that are specific to each loan type. This will contribute to a consistent application of the risk rating, and it facilitates more informative portfolio analyses, such as tracking over time of the migration, or movement of loans from one risk rating category to another.
Ideally, the bank should adopt a dual risk-rating framework that incorporates the probability of default and loss given default. It includes risk ratings for both the borrower and the credit facility. By explicitly capturing both the probability of default and the loss given default, it provides the bank's management team with a better sense of the true risk in its loan portfolio.
Underwriting methodologies should be explicit and uniform. This is important because some banks are new to the C&I business or have reassigned loan officers to focus on C&I. This might lead to improper analysis. For instance, lenders that previously concentrated on CRE or consumer lending might be unaccustomed to the global cash flow analysis necessary for C&I loans. These lenders also may not be familiar with the concept of working capital and the financing demands associated with growth. Banks should document specific underwriting guidelines tied to factors in the risk-rating methodology. Ideally, loan officers and other credit personnel should be provided with templates to facilitate analysis as well as to reinforce standardization. This degree of uniformity in underwriting methodologies simply is not commonplace today.
A more robust risk-rating-framework is the foundation from which banks can set prices to be adequately compensated for risk. A disciplined and objective methodology to set loan prices based on risk is a necessity. Many banks pay lip service to this requirement but too often cite the need to match the competition as a reason not to abide by it. To be effective, loan pricing should take into account the entire customer relationship, the loan loss provision and cost of risk, an equity allocation, the duration of the credit and its funding cost, and the risk rating of the credit. A secondary benefit to a disciplined approach to loan pricing based on objective factors is that it provides a solid defense from charges of unfair or discriminatory pricing in small business lending.
For the foreseeable future, the C&I credit environment will be characterized by aggressive competition. It is incumbent upon executives at community banks to have the appropriate credit risk disciplines to avoid future loan problems. The foundation is a robust risk-rating methodology supported by clear and consistent underwriting guidelines and risk-based pricing capabilities. Without this foundation, a community bank is ill-prepared to effectively manage C&I loan risk and be compensated for it.
Claude A. Hanley, Jr. is a partner at Capital Performance Group LLC. John R. Barrickman is a consulting associate at Capital Performance Group and the president of New Horizons Financial Group LLC.