Smaller banks are ramping up commercial lending to pad their bottom lines. But those banks must be mindful of the risks tied to commercial lending.
Unlike other types of loans that community banks have historically made, commercial and industrial loans require ongoing monitoring, along with sound models and concentration caps, industry experts say. These requirements can be tough for small banks with limited resources and personnel.
"Lenders have to have expertise in certain industries" for commercial lending, says Alan Thompson, a partner at Bank Solutions Group. Small banks "are more challenged than bigger banks at becoming more diversified, but they know their customers well."
Community banks have traditionally focused on mortgages and commercial real estate. Since 2007, property values have plummeted and loan demand has remained soft, prompting more small banks to look at C&I loans.
There are signs that smaller banks are making headway. At banks with $20 billion or less in assets, C&I loans grew 3% from the third quarter and 9% from a year earlier, to $346 billion at Dec. 31, according to the Federal Deposit Insurance Corp.
"There's been a shift especially in the last few years with the calming of the credit crisis," says Anand Shah, managing director in Accenture's financial services group. "Banks have continued to lend cautiously … and are getting more stringent on models with how they measure for risk."
Unlike mortgages that are often resold, banks usually keep commercial loans on their books, so it is important to monitor the loans. It is also important for banks to be proactive to make sure borrowers stay current with payments, says Terry Keating, managing director at Amherst Partners.
The best banks have "a robust review process to make sure their borrowers are still in good standing," Shah says. "You need to make sure the loan is no more risky now than when you originally loaned the money."
This involves receiving regular financials, such as balance sheets and cash flow statements, from borrowers, industry experts say. C&I loans are often backed by non-real estate collateral, such as inventory, accounts receivables and equipment. Banks usually want to avoid seizing those items, says John Depman, KPMG's national leader of regional and community banking.
Banks "are not in the business of selling inventory," Depman says. "You need to be able to understand the metrics of whether the business is healthy and generates sufficient cash flow to lend on. That is a different business acumen."
When put into practice, the collection of financial statements often falls short of what is dictated in loan policies and procedures, industry experts say. Small banks have limited resources, and there are fewer people to track down and analyze data. Commercial lenders often sacrifice time they could spend on generating new business when they focus on collecting financial data.
Businesses also may be reluctant to provide financial statements to a lender, especially if the borrower is struggling. It can become awkward for the bank, which may have to end the relationship with the borrower or push for the required information.
Banks "often skip basic discipline when it comes to following their own loan policy," Keating says. "Loan policies get written but, when you look at a loan file, the banks haven't been following it."
To make sure that employees of Level One Bank are following its loan policies, Patrick Fehring, the bank's chairman and chief executive, meets with his corporate lenders every quarter to review each loan file.
The loans are graded and, during the review, the ones that that pose more risk, either due to their size or a low grade, receive extra attention. "Just as our lenders are close to our clients, we are close to our lenders," Fehring says.
The bank, a Farmington Hills, Mich., unit of Level One Bancorp, positions itself as a consultant and adviser to its borrowers, Fehring says. Having this relationship allows the $495 million-asset bank to engage in difficult discussions when a borrower is facing challenges. It is "much more effective to do that earlier rather than later" so the bank can focus on developing a culture of "getting out in front of concerns," he says.
The difficulty for community bankers, whether it involves C&I loans or other types of less familiar products, is a lack of "experience to assess the risk, the borrower's cash flow or the ability of the borrower to repay," Keating says. Level One, chartered in 2007 to primarily handle business banking, has focused on hiring experienced lenders to round out its team. An increasing number of community banks are making key hires to support their moves into C&I lending.
But this isn't enough if a bank is expanding or entering a new line of business, industry experts warn. A bank's senior management — and even its board — needs to have a firm understanding of the loan portfolio and any associated risks.
Managing for risk "starts with sponsorship and governance from the top," Shah says. A board, which often has a separate committee focused on risk, must know the details of its largest lending relationships and any loans where credit is deteriorating, Thompson says.
"The board doesn't need to be experts, but they need to educate themselves so they can provide corporate governance," Depman says.
Fehring, who was a commercial lender for several years, also touts Level One's credit department for helping it manage and control for risk. "Our strength comes from our experience," he says. "We have a strong credit department to provide advice to management and lenders."
It is critical to have these checks and balances in place, Keating says. Typically, lenders are heavily compensated to grow a bank's book of business, but senior management must make sure that the bank is comfortable with the level of risk embedded in the newly originated loans, he adds.
Generally, a bank will have a credit approval function that scrutinize the loans. Some bigger banks will also have an internal audit process.
It may be cost prohibitive for smaller banks to have all of these functions in house. But there are outside contractors that a bank can hire, as needed, to review a loan portfolio and conduct audits, Keating says.
The leadership of community banks, including directors, also need to make sure that they have diversity within their C&I portfolios, industry experts say. Diversity could include the maturity and duration of loans, geographic areas and industries. Concentrations are not always obvious and can "sneak up on people," Depman warns.
Commercial borrowers also face more volatility in their risk assessment, compared to individual borrowers, because business conditions can change quickly, Keating says. This makes analytics and modeling essential for commercial lending, industry experts say.
Banks must be aware of larger emerging trends within their communities. For instance, if a bank makes a loan to a small retailer, it must watch for large retailers or the possibility of layoffs at a big area employer. Those types of events can change a "business's fortunate overnight" and influence whether the retailer will be able to make loan payments, Keating says.
It is also important for banks to complete modeling for their entire balance sheet. This can help management determine if the bank has an appropriate level of liquidity, which can also help them manage for risk, Thompson says.
Since the financial crisis, banks have started using "more severity in their worst-case scenarios," Thompson says. "There's a little more focus on the liquidity side."
Banks should have a way to capture data about market conditions and adjust accordingly, though this type of information can be difficult and costly for smaller banks to obtain, says Sandeep Vishnu, a partner in Capco's North American finance, risk and compliance practice. Financial institutions should periodically conduct credit portfolio reviews, he adds.
Moody's Analytics has seen increased interest from community banks for some of its products, like RiskFrontier, a tool that analyzes the risk of an entire portfolio rather than reviewing a single loan. It can also help identify if a bank has excessive concentration in a particular area.
Moody's has traditional sold the product to larger financial institutions but smaller banks are "taking on more of the risk management practices that are used at regional or larger banks" as they expand more into C&I lending, says Anna Labowicz, portfolio risk specialist at Moody's Analytics.
"The challenge is you can't just look at your portfolio and intuitively know that you have too much exposure in one area," adds Chris Shayne, head of portfolio and valuation products at Moody's Analytics. "You need granular insight and whether you are being compensated for your risk."
Moody's product uses historical data to examine a client's "underlying sensitivity to various economic factors," Shayne says. How often a bank runs an analysis depends on several factors, including asset size and the number of commercial loans being originated, but many large financial institutions complete reviews monthly or quarterly.
Analytics at community banks are often rudimentary, Vishnu says. For example, a bank may lack contextual data on whether lending to a certain industry would be a smart decision, he says. But the products and services available to smaller banks for commercial lending may change as demand increases.
"In the last several years there has been some renewed emphasis on analytics," Vishnu says. "You are getting more savvy people entering the market that can do the analytics. But you need the underlying data that is typically not in a form that can be easily used" by smaller banks.