Community Bank Commercial Loan Default Rates – Current and Projections

Quantified Lending Risk

We analyzed default rates through 2015 for banks between $300mm and $3B in asset size.  Historical default rates were measured and analyzed for various loan categories for this bank set.  We also reviewed Moody’s Investor Services corporate default and recovery rates through 2015 and considered which industries may present opportunities for community banks from a yield/risk perspective and as a way to diversify from real estate concentrations. 

 

Default Rates for Loan Categories and Industries

Bank Loan Default Rates

The above graph shows annual default rates for various loan categories for community banks (asset size $300mm to $3B from 2005 to 2015).  The graph also shows default rates for non-community bank C&I loans (Syndicated National Credits) and default experience for credits booked through CenterState Bank’s C&I National-to-Local loan program.

A few observations on the data shown in graph above:

 

  1. Construction and land development loans represent the highest default rates for community banks.  Default rates for this loan category were especially high during the last downturn (reaching 14.5% in 2010).  This loan category’s default rate is an outlier and currently represents just over 6% of the average community bank’s loan portfolio.
  2. Community bank C&I loans have demonstrated consistently lower default rates than community bank real estate loans.  This difference for community banks was largest in 2009 and 2010.  At that point real estate loan default rates were 4.77% per annum, while C&I loan default rates were only 2.40%.
  3. During the last recession, owner occupied CRE exhibited lower default rates than non-owner occupied CRE.  However, this differential has recently reversed and for the last three years, NOOCRE default rates have outperformed OOCRE default rates.
  4. Historically non-community bank Syndicated National Credits (SNCs) have shown favorable default rates to community bank real estate and C&I loans.  However, these SNC credit default rates increased in 2008 and 2009 to match and then slightly exceed average community bank loan default rates.
  5. In 2015 SNCs default rates increased to 1.60% primarily because of higher default rates in metals and energy sectors.   Backing out those two sectors, default rates for this loan group drops to 0.71% and compares favorably to other community bank loan categories.

 

Preferred Industries for Community Banks

We analyzed default rates by industry for all loans tracked by Moody’s from 1970 to 2015.  We wanted to determine which industries demonstrated lower credit risk and a better form of diversification for community banks. 

Of the 35 industries tracked by Moody’s, the lowest average default rates were found in utilities (0.18% per annum), followed by public finance (0.34% pa), and then by banking (0.40% pa).  The last category may be surprising to some.  The highest default rates were in the media industry (3.89% pa), followed by hotel, gaming and leisure (3.44% pa), and then by consumer transportation (3.31% pa). 

We then performed a regression analysis for community bank loan default rates versus various industry default rates.  For banks looking for diversification for their loan portfolio, the best source of diversification is in the following industries: public finance (negative 0.23 r-squared (R2)), energy (negative 0.015 R2), and utilities (zero R2).  The highest correlation between industry default rates and community bank average loan default rates (lowest diversification benefit) is as follows: retail (0.87 R2), media (0.73 R2), hotel, gaming and leisure (0.73 R2) and then capital equipment (0.71 R2). 

The superior industries for community banks to consider from both historical default rates and effectiveness in diversification are as follows: utilities, followed by public finance, followed by aerospace and defense (0.62% pa historical default rate, and a 0.30 R2 correlation to community bank loan defaults).

Forecast Default Rates

For C&I loans across all industries, default rates have averaged just over 3% over the last 20 years.  Last year’s default rate of 0.71% (this number excludes energy and metals/mining sectors) is below historical average.  A number of broker dealers forecast industry-wide loan default rates.  The average forecast is for loans in energy and metals/mining to maintain currently high default rates (those two sectors represented 35% of all dollar defaults in 2015).  For the remaining industries default rates are expected to drift higher through 2016 and 2017 approaching a 2.0% default rate (still below historical average, but approximating industry average when excluding the much higher default rates witnessed during the Great Recession).     

Recovery Rates For Bank Loans

 Default rates only capture one dimension of the potential expected loss and credit impact for banks.  The second important variable driving capital reserve is loss given default (LGD) (the inverse of recovery rate).  Historically senior bank debt across all industries has exhibited 33.4% LGD, and this is broadly similar to historical LGD experiences for senior secured real estate loans.  Surprisingly, junior debt (bond and loan structure) has shown relatively high recovery rates (considering priority of lien in the capital structure).

Conclusion

Assuming availability and access, banks should consider credit exposure to certain C&I industries.  Generally, C&I loans have demonstrated superior default rates compared to real estate loans.  Loans in certain C&I industries also demonstrate meaningful diversification benefits for community banks.  Finally, expected losses on C&I credits when considering both default rates and recoveries are comparable to community bank real estate secured loans.  The issue for most banks is the ability to source, underwrite and maintain these C&I credits.  We have observed that many community banks have the desire to book these credits but little opportunity in their local markets – however, wholesale sources exist that allow banks to purchase C&I credits without the need to establish a relationship with the borrower.