Many community banks are attempting to book more C&I loans. However, for various reasons discussed below, many community banks are finding it a challenge to grow this loan category. There is an interesting technique that we have seen used by smart bankers to drive C&I loan volumes called the “A and B cross-secured structure” (or A/B structure). The A/B structure is useful for almost any bank, as it can have immediate positive effect in generating loans and does not require changes in underwriting, management or personnel. The structure also can increase C&I loan profitability and credit quality. In this article, we will look at the structure and show how we use it.
While many community banks compete for C&I loans, there are some very real challenges in growing this loan category. In the graph below, the C&I loan percentages show as the gray portion of the stacked bar chart. The graph shows all banks in the country that fall into three asset sizes - under $1B, $1-3B, and $3-5B. The data shows that C&I loan portfolios have not gown as a percentage of all loans loan and smaller banks (under $1B) have seen their C&I loan balances decline as a percentage of all loans.
There are some real challenges to community banks growing C&I loans that include the following:
- Many banks find themselves in areas with little C&I loan demand;
- Competition for C&I loans is intense because many banks are targeting this loan category;
- With so much competition, credit structure for C&I loans is now being compromised;
- C&I loans are typically not sticky because of short maturities;
- Smaller banks without the compelling treasury management products find these loans difficult to retain;
- Credit spreads on C&I loans have been narrowing to the point of making these loans unprofitable;
- The loans tend to be both small and under-utilized;
- To win C&I loans banks typically require marketing, industry, underwriting, and monitoring expertise, and this can be an issue for smaller community banks; and
- C&I lenders tend to switch banks in good economic times in an attempt to poach their previous customers making the average life of these loans shorter and thus the loans less profitable.
How A/B Structure Works
The A/B structure involves a bank advancing on two loans simultaneously. The structure requires that some real estate term financing and this often fits owner-occupied real estate collateral, but investor properties can also work. The “A” loan is a term loan secured by real estate, and the “B” loan is a multiple advance evergreen facility with a drawn base that has a second lien on the same real estate. The B loan is a C&I credit used to finance working capital or capital expenditure and has a first lien position on the inventory, accounts receivables or equipment, with an additional junior lien on the real estate. The bank makes sure that loans A & B are cross-collateralized and cross-defaulted. Under this arrangement, the bank is looking primarily to the real estate as collateral, but the bank can strategically increase the B loan and especially increase the base borrowing on the B loan to add outstanding balances.
As an example, assume that a borrower wants to finance the purchase or construction of a building to run their business. If the credit needs are $1mm, and the value of the real estate collateral is $1.3mm the bank can offer the borrower a term loan at 77% LTV. However, under the A/B structure, the bank can offer the borrower the A loan as $750k term loan and the B loan as $300k revolver with a base draw of $250k. Loan A is secured by a first lien on real estate (57.7% LTV), and loan B is secured by a first lien on working capital, equipment or fixtures and furniture, and a second line on the real estate. The LTV on loan B may be 100% of the collateral value, but the total drawn amount of the loan is an acceptable 81% loan to real estate value. Loan B is structured as an evergreen with a starting $250k drawn amount and $50k in additional availability. Pricing on loans A and B can be the same or similarly structured as fixed, floating or adjustable to give the borrower the same economics as a $1mm CRE loan.
Advantages of A/B Structure
The A/B structure has many benefits for community banks looking to increase C&I totals and increase loan outstanding generally. The following is a summary of the advantages of this structure for the bank:
- The A/B structure immediately increases C&I outstanding balances for the bank;
- Both A and B loans are secured by real estate;
- C&I balances can be increased by strategically apportioning balances from the A loan to the B loan;
- The bank has an evergreen provision allowing annual review of the borrower’s performance and ability to call the loan should performance start to deteriorate;
- The expected life of loan B is increased because of the base borrowing, the evergreen provision, and the second lien on the real estate;
- The B loan has a lower chance of being poached because of the prepayment protection on the A loan;
- Bank develops a deeper relationship with the borrower and sells multiple products; and
- The bank is not changing the way that it underwrites credit, C&I expertise is not a requirement, and many borrowers will welcome an opportunity to have the line of credit flexibility at real-estate-secured credit spreads.
We see some smart loan structures in the commercial lending arena. The A/B structure is an interesting way for banks to build C&I loan balances, very quickly, efficiently and without changing their business model. We have also have seen how this structure can be utilized to stave off competition from the national banks with a single close construction through perm A/B structure – but that’s a topic for a future blog.
Submitted by Chris Nichols on November 08, 2017