Regulators Fret as Banks Pile into Commercial Lending

Business borrowing has become a rare zone of vitality for loan portfolios at large banks, a new horizon for some small banks—and a source of anxiety for regulators worried that lenders’ ambitions exceed their expertise.

The collapse in construction and development loans has left a void in small bank balance sheets. For institutions with less than $10 billion in assets, such loans decreased to $111 billion in the first quarter, which represents a decline of $213 billion, or about two-thirds, since peaking in the fourth quarter of 2007. That explains most of the $265 billion decline in gross loans at small banks during the same time. No other loan category has emerged as a substitute — C&I loans were down about 12% over the same period to $262 billion (see the first chart).

Dozens of small banks have broken from the pack, however, substantially increasing their C&I portfolios from next to nothing a few years ago.

Such moves have raised flags at the Office of the Comptroller of the Currency, which warned against stretching for profits during lean times in its semiannual overview of risks facing the industry released this month. The OCC observed that small banks had extended the maturity profiles of their securities portfolios in a quest for yield, for instance, exposing themselves to greater interest rate risk. (Large banks were given a pass on this count.)

Also, the OCC said that some banks “are seeking asset growth by expanding or starting new product lines for which they may lack the appropriate control processes and expertise,” including C&I lending.

The second set of charts shows banks that have posted the largest increases in C&I lending as a percentage of their portfolios among institutions where C&I accounted for less than 3% of loans in the first quarter of 2007. (The data covers top-tier entities that report consolidated financials to regulators.)

The growth exhibited among this group — from 12 to 42 percentage points — is not necessarily reckless. Much could be explained by mergers where established controls and experienced loan officers may have been part of the package, or new management teams.

At the $8.4 billion-asset Apple Financial in New York, total loans were only about half of assets at March 31, despite a rapid rise in business lending that made C&I the largest component of the portfolio. (C&I displaced single-family mortgages, which had accounted for about 60% of Apple Financial’s loans in the first quarter of 2007.) The firm had few nonperforming assets through this year’s first quarter and a Tier 1 common capital ratio of 28%.

Rapid entry into business lending may not hurt all banks, but it seems inevitable that where rapid shifts occur, mistakes will be made.