Most community banks are interested in booking local C&I loans but are unable to generate meaningful outstanding balances. There are a number of reasons for this lack of C&I loan generation: first, most banks simply do not see much C&I demand in their local market; second, the C&I loan market is very competitive (both in pricing and structure); third, much of the C&I loan demand is unfunded lines of credit, so those facilities do not create outstanding balances; and fourth, the average stickiness of these loans is very low and borrowers easily move the loan from one bank to the next in search of better pricing or more advantageous structure.
However, there is one often overlooked area where community banks can generate meaningful and profitable C&I loans: an A/B structure for owner-occupied credits. Here, the A facility is a term loan used to finance the real estate and the B facility is a revolver or asset-based loan used to finance receivables, inventory or equipment.
The graph below shows C&I loans as a percentage of the total loan portfolio for all banks in the country between $100mm to $10B in assets, from 1990 to 2015. Two observations are noteworthy: first, C&I loans are a relatively small portion of these banks’ loan portfolio, and two, the C&I loan portfolios are declining as a percentage of the entire loan book. Neither facts are positive for our industry where many community banks are looking to diversify their loans away from investor CRE.
Community Bank’s Response
In an effort to generate more C&I loan business, some community banks have hired seasoned C&I loan specialist. We meet with many bankers every week, and our observation is that this strategy has produced relatively meager results for many community banks for the following reasons:
- While any bank can hire a C&I loan “rainmaker”, most banks cannot change their credit culture that easily. We often hear these C&I loan specialists lament that they were hired to bring strong C&I borrowers to the bank, but when they submit their loans for approval the credit officer continues to look for the real estate collateral to accompany the request. Worst still, even the CEO who hired the C&I loan specialist will insist on “real collateral” (meaning real estate) to secure the loan.
- Many community banks lack the treasury and commercial management services that serve as the mortar that keeps the borrower at the bank. Without the back-end cash management services that bind the borrower’s business to the bank, the customer will move from one bank to another frequently. This results in high overhead costs, decreasing margins and low profitability – a frustrating experience for executives and lenders alike.
- As with most loans, the smaller C&I credits are least profitable. The real C&I plum business is the larger and more complicated credits. These larger borrower relationships have more borrowing needs, larger loan outstandings and substantial transactional fee business. Unfortunately, many community banks are unable to accommodate credits that require single borrower exposures approaching $10, $20 or in some cases $30mm.
A real opportunity for community banks is to seek out owner-occupied CRE credits that can be structured as an A/B split. Facility A is a CRE term loan with a first lien position on the real estate collateral. Facility B is a revolving like or asset-backed loan with a first lien on working capital and a second line on the real estate. The smart banker understands the flexibility in apportioning exposure between the A/B split if properly secured and with cross-default/acceleration. The advantages of this A/B structure are as follows:
- The bank is taking real estate collateral for both facilities.
- The stickiness of the credit is improved because of multiple facilities and the prepayment provision typical for a term CRE credit, thereby, increasing the profitability of the relationship.
- The total size of the credit is increased and both facilities act as a good form of diversification for banks heavy in investor CRE portfolio.
- Where a borrower does not own the real estate where they operate, the opportunity is just as compelling to the astute lender. A banker should be able to make a compelling argument that with interest rates at historical lows, it makes ample sense to buy rather than rent. After tax, after depreciation and after inflation the ROI for ownership is highly positive and much more profitable for borrowers than to rent real estate. Bankers that partner with real estate brokers can develop good customer relationships and secure loans without lender competition – and, therefore, better pricing.
The A/B split allows community banks to turn small, unprofitable and disloyal customers into larger, profitable and stickier clients. All the while, allowing real estate to form some basis of collateral for the credit. When it comes to pricing, while C&I risk tends to run higher in some economic environments (below), including a lien on real estate reduces the loss given default and hence the expected loss. As a result, banks can be more aggressive in pricing C&I helping them when business from banks that don’t pay attention to credit performance when pricing.
Community banks have historically been challenged to develop meaningful and profitable C&I loan portfolios. Between the small loan size, high cost of loan monitoring, unfunded commitments that earn no fees and frequent relationship changes, standalone revolving lines credit and ABL facilities can be a challenging business for community banks.
However, an A/B split can be a good fit for many community banks. While the yield on owner-occupied credits can be thin (1.75 to 2.25% over LIBOR), given all the attendant positives of the structure, the relationships can still be priced with a risk-adjusted ROE of between 10 to 20%.
Submitted by Chris Nichols on August 31, 2016