Recently, a lot of attention has been given to the rebound in commercial banking. After the collapse of the real estate markets at the beginning of the decade and the subsequent asset quality problems experienced by many banks, the industry is well capitalized and earning record profits.

Loan volume is increasing, bankers are active in markets that a few years ago were dominated by only a few, and the "credit crunch" is long over. In fact, the volume of syndicated loans completed in the third quarter of 1994 reached record levels ($203 billion), and the fourth quarter was nearly as active ($192 billion). The first quarter of 1995 saw only a slight decrease to $190 billion.

Commercial lending is very competitive today. In many market segments, pricing (both spreads and fees) continues to contract as more banks compete to serve the same commercial customers.

Banks are also giving nonprice concessions to borrowers - longer tenors, more unsecured loans, looser covenants, and early suggestions of increased credit risk.

Thus, the pendulum has swung - yet again - in favor of the borrower. Readers of today's business press regularly find stories of more aggressive lending practices by banks, and significantly, Alan Greenspan, the chairman of the Federal Reserve, has warned bankers against returning to the excesses of the 1980s. Most recently, Eugene Ludwig, the comptroller of the currency, established the National Credit Committee, to ensure that credit quality supervision is satisfactory.

What bankers are witnessing does not surprise the savviest and most experienced. Alternating periods of "credit crunches" and "easy capital" have characterized commercial lending for some time. One only has to look at the cyclical nature of commercial real estate to be reminded of this phenomenon.

The easy-capital phase typically involves one or more lending fads, such as loans to lesser-developed countries, energy, commercial real estate, or leveraged buyouts. Here, bankers have a sense of euphoria, and short memories. Loan markets are highly liquid with lots of capital, loan pricing is thin and highly competitive, and structural features favor the borrower.

Acquisition financings have made up much of the current expansion of loan volume, particularly in the broadly syndicated loan market. In fact, leveraged loan volume rose substantially in 1994 from the prior year, in part replacing junk bonds as sources of capital for acquisitions.

Lending to real estate investment trusts also has grown significantly in recent years. Of course, much of this new loan volume occurred in the non-investment-grade sector, where the risk of default and loss is higher than in the investment-grade market.

Credit crunches are characterized by periods of diminished sales efforts by banks, since many are dealing with significant asset quality concerns. Resources are devoted to working out troubled credits and preserving customer relationships, leading to capital contraction in the market. As a result, loan pricing is rich and structural features of loans favor the lender (e.g., short tenors, more collateral, tighter covenants).

Interspersed between credit crunches and easy-capital periods are two transitory steps.

First, there is an "upswing," or "rising," stage characterized by good lending revenues, rising volume, increased availability to weaker borrowers, deteriorating structure, and narrowing loan pricing, which precedes the period of easy capital. The rising stage attracts other lenders that create the lending fads mentioned earlier.

Second, a period of "downturn" or "crisis" often occurs, as in 1989-90, where a market or regulatory event causes the easy capital to flee from the market and the weakest borrowers to default. Credit crunches usually follow these crises.

The lending cycle is rooted in the nature of the market and the product: The market is large and fragmented with many lenders; the banking system has overcapacity. Further, the loan product is complex, with many pricing and structural elements and many options available to the borrower for which the lender typically is not compensated.

Most important, though, is the nature of credit risk. Credit crises are relatively rare, though predictable, events.

The infrequency of these events, which devastate the profit dynamics of commercial lending when they occur, has historically seduced banks into not considering the long-term costs of making a commercial loan.

When markets heat up, competition often drives down credit quality along with prices, and few banks say "stop" when the market price for a loan falls below the intrinsic value of the asset. Consequently, credit quality in the market is effectively set by the most aggressive bank.

Clearly, this question cannot be answered with precision. However, research conducted at Loan Pricing Corp. has revealed the following:

*As more bank capital enters a market, pricing on loans (both spreads and fees) contracts quickly. Out-of-market lenders typically are the most aggressive in offering favorable pricing to borrowers.

*Competitive pressures between banks allow borrowers to negotiate longer tenors, more relaxed covenants, and frequently, no pledges of collateral.

*Overbanked markets also see compromised credit quality (low interest coverage ratios, high leverage ratios, or both).

*There is a strong correlation between growth of debt capital and borrower defaults and loan losses, albeit with a two-to-four-year lag.

As more capital enters the bank markets in 1995 and lenders seek to maintain or expand their loan portfolios, bankers may well sow the seeds of problems that may emerge in the last years of the decade.

It is unlikely that the next period of crisis will be as severe as the last one in the early '90s, since the speculative boom in commercial real estate in the '80s has not been matched in any sector in the recent expansion. Nevertheless, the concerns of senior bankers and regulators about declining credit quality must be taken seriously.

The risk of another credit crisis increases geometrically as banks move down-market in pursuit of loan volume.

Next: How are the best banks responding to this risk?

Mr. Stevenson is vice president and director of portfolio valuation at Loan Pricing Corp. in New York.

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