According to the latest FDIC data, loan credit quality improved in the third quarter with many categories such as construction and multi-family hitting record lows. In general, non-current loans-to-total loans hit 1.20%, the lowest since the second quarter of 2006. Offsetting credit quality, loan growth is slowing which is starting to cause problems for many banks as growth solves many problems. In this article, we look at the current state of commercial credit and look at the how banks might position themselves to take advantage of the changes.
Improving Credit Quality
Credit quality improved in 3Q and continue to improve in the 4Q. The graphic below shows the quarter-over-quarter change in credit quality which details that most categories of loans are improving or are within their normal volatility range. Credit card debt is the only category that showed a marked deterioration in credit quality, but we point out that it is a volatile asset class and the levels remain well below their median levels. In terms of delinquency volume, most issues stem from delinquencies associated with residential real estate followed by C&I and then credit cards.
The allowance for loan losses ticked up just slightly in 3Q for all banks and now stands at 1.26%. For reference, non-current loans and leases to total loans and leases fell six basis points in 3Q or the lowest level since 3Q of 2007. The coverage ratio, or the amount of reserves to non-current loans, rose to 107.9% or the highest level since 2Q of 2007.
Slowing Loan Growth
While loan growth is still positive, the 12-month trailing average again slowed for the 6th straight time and hit the lowest level since 4Q of 2013. Given record low unemployment, strong production, record confidence and strong housing growth, slowing loan volume is puzzling. Looking at this problem from another perspective of all publically traded banks above $1B in asset size, approximately 66% of banks are under their stated loan growth targets on a year to date basis.
Business loans rose at an annual rate of 2.48%, down from 2.79% and materially different than the recent 7.67% rates of last year or the 11.45% average from the five years prior. Of all the asset classes, C&I lending is the hardest to come by. The annual growth rate is 97 basis points with a majority of banks showing not only less demand but loosening credit standards and decreasing loan spreads (below from the latest Federal Reserve Lender's Survey).
The Impact of Competition
Using this data, banks may want to make more of a targeted effort to garner quality loan growth. The reason for slowing loan growth is twofold – 1) Competition and 2) Lower demand. Banks are now feeling competition from non-bank lenders to include marketplace lenders, insurance companies, hedge funds and asset managers, many of which are supported by capital market securitizations. Ten-year fixed rate loans, for example, often never make it to the doorstep of a community bank and go right to an insurance company or to a finance company and then to a securitization. Banks can place themselves in a better competitive position by offering a wider range of structuring options.
Lower Demand and Tax Reform
The other aspect of slowing loan growth is the uncertainty from businesses, one of the main drivers of loan growth for banks. Coming off strong loan demand from 2011 to early 2016, part of what we are seeing is the reversion to the mean. The other dimension is that loan growth has slowed with this new Presidential Administration as many industries waiting to see how potentially looser regulation and tax reform plays out before making major infrastructure investments. The tax rate, the cap on mortgage interest deduction, treatment of passive income, carried interest, small business exemption, amortization of R&D expenses, corporate AMT and other provisions all impact current investment decisions. Given the uncertainty, many businesses reporting holding off. Banks can assist businesses in helping them understand their position and the cost of waiting. While there are legitimate reasons to wait, our experience is that most borrowers are holding off on capital investment for little solid economic reason. While most of the tax law changes alter the return calculations, most do not alter the calculations enough to influence the buy vs. rent decision or to change the capital structure of the investment. Businesses largely benefit from most of the proposed tax changes so likely an investment only gets better. Further, the threat of rising rates could also negate any benefit by waiting.
Putting This Into Action
There is a definitive credit pattern that takes place when the business cycle starts to turn. We are not there yet (as far as history can tell us) and, as such, banks may want to make more of an investment in their sales and marketing effort to drive quality loan growth. Banks that take the time to seek out profitable borrowers, show them multiple loan structuring options and talk them through the outlook for both the economy and the changing business landscape, will find borrowers more likely to accept additional debt.
Submitted by Chris Nichols on November 29, 2017