A combination of low yields and loosening terms may be setting banks up for trouble in the event of an economic downturn, one of the nation's top credit ratings agencies said Monday.

Nearly two-thirds of banks with assets of more than $20 billion say they have lowered pricing on loans to large and middle-market businesses in recent months, while nearly half of lenders reported relaxing loan conditions, up from 30% in January, according to the Federal Reserve's latest survey of senior loan officers.

The combination, which comes amid an uptick in commercial and industrial lending, increases risk for banks, says Moody's Investors Service in a report published Monday.

"Thinner pricing and weaker covenants mean that when loans start to go bad, you have less protection for those loans," Megan Snyder, a Moody's analyst, told American Banker. "To the extent they give away those covenants by not including them in loan documents, they give away their level of protection."

In recent months, banks have expanded C&I lending while de-emphasizing real estate lending. Business borrowers tend to consume a range of financial services and offer banks an opportunity to earn income from fees, notes Moody's.

Business loan books among banks that Moody's rates have increased by roughly 10% annually over the past two years. At the same time, the 15 largest banks experienced a 27-basis-point decline in asset yields in the first quarter of 2013, compared with a year earlier.

As profits on loans narrow and competition for borrowers intensifies, banks tend to underwrite a larger number of loans to companies that carry fewer restrictions. That means lenders face more risk, according to Moody's.

Regulators in March issued guidelines for leverage lending that Moody's says highlights concerns with the loosening of standards in the current credit environment. The guidelines provide a welcome "backstop" according to Alan Tischler, a senior vice president on Moody's banking team, who says the ratings agency still would like to see banks show more discipline. "But the competitive nature of what banks are doing means they have to go along with what's going on in the environment around them," he noted.

Competitiveness within the financial sector also has intensified as both the high-yield corporate bond and structured-finance markets have returned to higher levels of risk taking, Moody's notes. "All those sources of credit compete with banks and that puts pressure on underwriting," Tischler said.

The ratings agency's concerns corroborate the comments of some bankers, who say the combination of low yields and competition is pressuring prices and terms.

"As you think about your alternatives, it makes it easier to continue to drive down pricing on the lending side because you really don't have any other options," Mariner Kemper, the chief executive at UMB Financial (UMB) in Kansas City, Mo., told American Banker recently. "Terms, even, seem to be loosening, which doesn't feel good, doesn't look good."

"We're nervous at the industry level, at the economic activity level, that we might be staring at another bubble at some point," he added.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.