Rapid growth in commercial and industrial loan balances and a corresponding decline in interest rate spreads have given rise to concerns that competition has become overheated. The fear is that banks either will be burned when interest rates rise or become more vulnerable to problem loans extended to marginal borrowers.
At this stage such concerns are overblown. Even so, trends in C&I loan growth and pricing do warrant a careful consideration of how to leverage the dynamics of the business to increase overall line-of-business profitability.
C&I loans have grown markedly over the last few years in absolute dollars and as a percentage of total loans. Between the fourth quarter of 2009 to and the first quarter of 2013, C&I loan outstanding held by FDIC-insured depositories increased by $330 billion. That equated to a compound annual growth of 7.7% and was well above average annual GDP growth during the same period. The growth rate has moderated in 2013, but the imperatives that led banks to focus on this business remain in place. Therefore, competition for C&I loans will intensify.
In light of these competitive trends, it is especially important for community banks to be clear-eyed regarding the profit dynamics for C&I lending. Spreads on C&I loans have narrowed since the economic recovery began. Spreads over the fed funds rate declined 48 basis points from 3.33% to 2.85% between the fourth quarter 2009 and second quarter 2013, according to the Board of Governors of Federal Reserve Board's Survey of Terms of Business Lending.
In fact, the Fed's survey likely overstates prevailing spreads because it does not reflect costs of matched funding. An examination of historical data shows that spreads today are above their long-term average and that in the past they have fallen below 2% for extended periods. So, it seems prudent to assume that they will fall further, perhaps by an additional 50 basis points.
With current spreads, a loan by itself may not generate sufficient revenue to meet a bank's target rate of return. One way to illustrate this is to calculate the estimated average net revenue per loan. As defined here, net revenue is interest income and fees, less interest expenses and credit losses. Net revenue is what's left to cover expenses for marketing and business development, underwriting, servicing activities and the cost of capital.
For example, an assumed C&I loan with a balance of $500,000 that earns an interest spread of 2.85% and incurs a provision expense of 1% (the long-term average net charge-off rate on C&I loans) would generate net revenue of approximately $9,200 in its first year. Net revenue would increase slightly in the second year without the provision; however, that benefit would be offset by amortization/attrition of the outstanding balance (assuming it's a term loan).
That doesn't leave very much to cover the costs associated with sales, underwriting, servicing and any indirect expense allocations. Net revenue per loan is even more modest for smaller loans.
Consequently, it's important to avoid overlooking other contributors to the profitability of a customer relationship. For instance, cross-sales of other products, especially cash management services, are important contributors to C&I profitability. That means managers should make sure with relationship managers to emphasize the importance of payment services both in the customer's deciding which bank to use and in the profitability of C&I lending relationships. Banks should consistently feature commercial payments capabilities in proposals for new business customers and make it a priority to address weaknesses in their commercial cash management capabilities.
Finally, with spreads falling, back-office efficiency becomes increasingly important. Managers should establish benchmarks for measuring back-office productivity and efficiency at each step of the process, from business development through problem loan management. It's also critical to streamline the underwriting and approval process for smaller loans. This can be accomplished without sacrificing credit standards and, when done properly, can also improve the customer experience.
Competitive pressures will ensure that interest spreads will continue to fall on C&I loans. To ensure that the business remains as profitable as possible, community bankers need to improve other elements of the C&I formula.
Claude A. Hanley, Jr. is a partner at Capital Performance Group LLC.