There has been a lot written recently about the increasing inability of lenders to make money on commercial loans due to narrowing spreads, looser covenants, and too much competition.

One hears a lot about inadequate returns for the risk, banks cutting back on commercial lending, and even regulators' repeated warnings against the lowering of credit standards.

In spite of this rhetoric, we still see an emphasis on commercial lending as evidenced by the entrance of nontraditional competitors, new investors, 11 new loan funds, continuing growth in loan syndication, and more sophisticated structures and participants.

Commercial lenders have recognized the need to reduce costs and redesign the credit process to improve efficiency. They have recognized that the market will not permit a premium for inefficiency and are to be commended for their efforts on this front.

However, simply cutting costs will not solve the profitability problem and over time will produce marginally diminishing benefits.

Pricing for Risk

Most of the dire statements about the inadequacy of loan pricing to compensate for risks are based on the narrowing of spreads. Lenders frequently complain that spreads relative to prime have narrowed and their current customers don't warrant the prices being offered.

Let's examine this proposition in more detail.

There was a time when the prime rate was available only to the industry's most creditworthy customers. Today, the prime rate is often for those who can't qualify for pricing based on the London interbank offered rate.

While spreads relative to prime may be narrowing, the prime to Libor spread has actually widened by more than 100 basis points over the last decade. So, while the risk associated with prime-based lending has increased, so has the compensation.

The notion that loan pricing is inadequate to compensate for risk is a paradox that seems unresolved.

We feel that pricing for risk will prove to be the most important and daunting challenge for the future. Commercial lenders will have to learn to apply technology in new and innovative ways to capture and deliver actionable information.

They will have to learn to embrace new, complex, and sophisticated analytics and deliver the results in a clear, intuitive, and actionable format to users. Furthermore, to the extent that there are increased risks, the industry is arguably better positioned to absorb losses without a significant number of failures than it has been in quite a long time.

Earnings, capital, and the allowance for credit losses are all at historically high levels and concentrations are lower and better managed. Lenders will not be able to survive by focusing primarily on the spread for profitability (having a good offense) and mitigating losses with structure (having a good defense).

Lenders, for example, must learn to more fully appreciate, and actually value, the embedded options in the loan agreement. Lenders have long underappreciated the economic value of structure.

For example, lenders are migrating into Libor-based pricing with prime- based structures. Developing the information and analytical capability to value the key components of structure is admittedly complex, but it can be done.

The resultant pricing, however, is much more complex, and hence, internal risk rating systems must also be more finely tuned. The true expected loss from two loans with the same spread but with different structures can vary dramatically.

Currently, it's not unusual for us to find 65% of a given bank's funded exposure in two risk ratings. We also have observed a difference in spread of more than 250 basis points within one grade in the lower range of acceptable ratings. Excessive bunching in the lower grades precludes efficient pricing.

Without the appropriate tools, the bank is susceptible to adverse selection by overpricing the lower risk segments within any given grade and underpricing higher-risk segments.

Lenders that continue with many of their current practices will be adversely selected by their borrowers. They will capture more than their fair share of the higher-risk segment within a credit grade and less of the lower-risk segment.

It seems that those without the capability to accurately price for risk on a more discrete basis have to ultimately disappear.

What's to Worry About?

It depends upon how important survival is. The current challenges are more opaque than eroding margins, more complex to address than cutting costs, and will require time to develop and implement.

When competing in the open market, one of the most powerful tools a bank has is structure, and without using it, the bank effectively loses the ability to compete for profit.

We feel that the commercial lending business is in the midst of a Darwinian process that will probably eliminate more of the current participants than have historical credit losses. As the evolution continues, we will see a new species of loans emerging that is highly structured so as to capture as much of the economic value as possible.

Old-fashioned, prime-based loans with little attention to structure will, of necessity, go the way of the dinosaurs.

In summary, the real threat to some in the industry is far more complex than the damage that may be done by increasing credit losses.

Those who think an increase in chargeoffs will result in less competition and a return to richer spreads will probably be disappointed.

The most serious threat is primarily from within. Commercial lenders have historically been slow to innovate and as an industry have embraced a culture that is often resistant to change.

This is hardly a description of a group that one would expect to thrive in a period of Darwinian evolution.

The Opportunity

Banks that address the inefficiencies in the credit process, by knowing their costs in each segment of the business, and can develop the capability to price for risk and learn to compete on the value of structure (as well as price), may enjoy the benefits of how rich an asset class the commercial loan can really be.

Additionally, it has long been observed that participants who have superior information and analytical capability, and can execute, really like-and profit from-inefficient markets.

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