If the latest data on commercial and industrial lending could be translated into sound, it would be a giant hissing noise. Executives at Taylor Capital Group Inc. of Chicago can name that tune.

The company had explosive growth in business credits last year, but demand for them has deflated during the prolonged recession. Its C&I portfolio fell 3.1 percent, to $1.44 billion, in the first quarter, according to regulatory filings. Last year the portfolio grew by about 91 percent.

"With many of our customers experiencing reduction of sales anywhere from 20 percent to 30 percent, their need for working capital lines has diminished," says Bruce Taylor, the company's chairman and chief executive. "They're not borrowing as much because of the slowdown of the economy."

Taylor Capital is not alone. One of 2008's few bright spots, C&I lending has waned across the entire banking industry in the last six months. This has several implications for the banking industry. For one, it indicates that C&I loan losses - which have been relatively modest so far - are sure to accelerate. Yet it also has some banks, particularly smaller ones, picking through the debris for business opportunities.

Anthony Davis, an analyst with Stifel, Nicolaus & Co., says banks ramped up their C&I lending last year to make up for the drop-off in construction, residential and other types of lending. Also, large companies drew their bank lines last fall after a major source of their short-term funding - the commercial paper market - stalled following the collapse of Lehman Brothers. "Last year, the best source of loan growth was the C&I loans," he says. "What's happened more recently - as the recession has broadened and unemployment has risen - the commercial [loan] volume has fallen."

Some of the decline can be attributed to banks' tightened lending standards. But banks for the most part are ready and willing to lend, given the favorable spreads they're generating on business loans. The demand just isn't there. Businesses are paring down, not building up.

Last year the 200 companies with the most commercial loans increased their C&I books by 13 percent, to $1.31 trillion, according to data that SNL Financial collected from the Federal Reserve and Federal Deposit Insurance Corp. Construction and development loans, in turn, grew by just 8.5 percent.

Since then the volume of C&I lending has been trending down in the U.S. commercial banking sector as a whole. C&I loans totaled $1.48 trillion as of June 10, down about 6.4 percent since December, and down 7.5 percent since peaking at $1.6 trillion in October, according to the Fed.

Even at banks that fattened their C&I books by increasing lending to new and established customers, things have cooled down in 2009. For instance, U.S. Bancorp's total commercial loan portfolio fell 3 percent, or $1.7 billion, from December to March, according to regulatory filings. That is after a 16.6 percent year-over-year growth of its C&I book in 2008, according to SNL.

Another big gainer in 2008, Regions Financial Corp., says in its quarterly report that C&I loans shrank 4.2 percent in the first quarter. Its C&I book increased 13.4 percent in 2008.

Industry watchers expect the larger banks to lose C&I business to smaller players. Smaller banks typically have lower C&I loan losses during economic downturns, according to David Rochester, an analyst with FBR Capital Markets. That puts them in a position to take market share.

"For a highly relationship-driven business such as commercial lending, in-depth knowledge of the customer, the market and the product is key," Rochester wrote in a June report. "Smaller community banks likely have better knowledge, versus larger banks, of the local markets in which their average business customers operate and can better foresee problems."

Some smaller companies have already been taking advantage of dislocation in the banking market to ratchet up their C&I lending. Taylor Capital, for instance, attributed much of its C&I growth to the more than 50 commercial bankers it hired from LaSalle Bank Corp. after ABN Amro Holding NV sold the unit in late 2007 to Bank of America Corp. Taylor described that deal as a "the big disruption" in Chicago's commercial lending market, and says it created a "huge opportunity" for his $4.6 billion-asset company.

Cullen/Frost Bankers Inc. of San Antonio stepped up its business lending last year while the national banks with a big presence in Texas, like Bank of America, dealt with various distractions.

Dick Evans, Cullen/Frost's chairman and CEO, says the $15.3 billion-asset company didn't want to repeat the mistakes of the past. "We learned in the 1980s, while we were working through problems, we were not as aggressive as we should have been about going after new business," Evans says.

Cullen/Frost has been putting out about two-thirds more calls to prospective customers. Last year its C&I book rose 17 percent, SNL says. In the first quarter its portfolio shrank by about 1.8 percent.

Larger companies with relatively solid capital bases have benefitted as well. The $31.2 billion-asset First Horizon National Corp. in Memphis, for instance, expanded its C&I book by 7 percent in the first quarter, snatching business in its home market from Regions.

Still, the economic uncertainty could spell trouble for the C&I lending market.

Matthew Anderson, a partner with real estate and economic research firm Foresight Analytics, says C&I loan losses tend to lag the economy by several months. The delinquency rate on C&I loans has climbed from 1.6 percent at mid-2008 to 3.2 percent at the end of the first quarter. After the economic downturn in 2001, the C&I delinquency rate peaked at 3.9 percent in the third quarter of 2002.

"Given the current state of the economy, I think it's safe to assume that the delinquency rate will continue to rise for the next two or three quarters at least," Anderson says.

So far C&I losses have been modest next to the steep chargeoffs banks have booked in their home-building and mortgage books. Rochester says that trend might not hold, as C&I losses tend to be closely correlated with the unemployment rate, which recently hit a 26-year high. "The industry is likely still in the early stages of this recession's C&I loss curve," wrote Rochester. "Based on the recent material increase in unemployment, C&I losses should significantly exceed the prior two recessions' peak levels."

Evans says he realizes that things might get worse. That's why Cullen/Frost, the parent of Frost Bank, makes an effort to work closely with its borrowers, ensuring they take actions to counter slowdowns in sales, he says. Its strategy appears to be working: in the first quarter Cullen/Frost charged off just $2.9 million of its $4.2 billion of C&I loans.

"We believe if you identify problems early and deal with them before they get to serious [that is] the best way to keep chargeoffs down," Evans says. "If you are able to identify a company that is not reducing their inventory and their sales are going down - that's the time to get in and start talking together."


Matthew Monks is a reporter at American Banker.

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