Loan spreads for C&I and CRE loans decreased slightly in February of this year from a month earlier, and they contracted further in March. We expect that spreads will continue to contract throughout the remainder of the year. The primary driver of declining loan spreads is the tax changes that passed into law at the end of last year. The vast majority of lending institutions have benefited from an approximately 30% reduction in their tax rate (or a reduction in the tax rate of the pass-through entity). The interesting question is this: will banks pass along the tax savings to customers, or will they retain the benefit for shareholders? Despite argument to the contrary from many bankers, we believe that banks will pass along nearly all of these tax savings in the form of tighter loan spreads. Those banks that can clearly identify this trend and position their pricing strategically to lock in the right customers for an extended period and charge a competitive spread today will win superior credit quality relationships and, we believe, will secure what will become an above-market loan spread within a short period.
Market Clearing Loan Spreads
Loan spreads are set through the equilibrium of: a) supply of credit from thousands of lending institutions (commercial banks, insurance companies, credit unions, central banks, non-traditional lenders and other creditors), and b) the demand for credit from millions of borrowers. The prevailing spreads are simply a function of supply and demand of capital. However, the primary measuring tool that lenders use to decide to lend is the after-tax, risk-adjusted return on assets or equity (“AT RAROC”). With the recent tax law changes, loans for taxpaying lenders just became 30% more profitable (all other things being equal).
Some argue that bankers do not need to tighten spreads, but would prefer to improve their institution’s profitability. We have heard consultants argue that lending institutions will not adjust pricing for tax changes, and bankers have told us that long as other lenders do not adjust pricing, they will not either. We believe that the industry, relatively quickly, will adjust loan spreads to get to the same AT RAROC that prevailed before the tax amendments. We believe this will happen for the following four main reasons:
- While overt collusion is illegal, even tacit understanding on pricing is impossible. With thousands of alternative lenders, borrowers have many choices, and this drives fierce competition among banks. Bankers have historically been willing to undercut pricing to win credit. This will continue to happen, especially late in a credit cycle when winning loans with aggressive pricing is a better formula for survival than winning loans with aggressive credit structure.
- The market clearing loan spread has been rigorously and analytically defined by national and super-regional banks for decades. These larger banks are not concerned with credit spreads on individual loans, but with their loan model output for AT RAROC. As taxes fall, return rises, however, hurdle rates for lenders remain constant. Therefore, loan spreads have room to contract. We have spoken to a number of bankers at larger banks right after their institutions modified the tax rate in the loan pricing model, and the striking comment from lenders is “What happened to our spreads, I can be much more competitive and still make my hurdle ROE.”
- The commercial banking industry is unique in the distribution and concentration of market share. When banking concentration is measured by adding market share of the top 4, 10, or 50 largest competitors, banking appears to be quite concentrated. The top 4 banks control 34% of all loans, the top 10 banks control 44% of all loans, and top 50 banks control almost 70% of all loans. By this definition, the banking industry is concentrated and would be able to exert pricing power and not pass tax benefits to borrowers. Below is a graph showing the cumulative concentration of loans held by the number of banks in the industry. The graph shows that the top few largest banks originate and keep the vast majority of loans in the country. Unfortunately, these top few largest banks are the biggest proponents of AT RAROC models and have already dropped loan spreads to adjust for the tax effect.
4. However, a closer examination concludes that the concentration of the banking industry is skewed to smaller lenders. When measured by the Herfindahl-Hirschman Index (HHI) (which measures concentration across all market participants and has become the standard measure for federal merger guidelines) the banking industry concentration score is only 345 out of a maximum concentration of 10,000. The US Justice Department considers an industry “concentrated” if the HHI exceeds 1,800 and “unconcentrated” if the HHI is below 1,000. Therefore, the banking industry is unconcentrated by definition and banks do not have the pricing power to withhold the benefit of tax changes from borrowers. This is especially the case when the HHI is 345 for banks only, not considering the plethora of all other possible lenders. This means that the vast majority of smaller banks have very little pricing power over credit.
Because of reasons three and four above, we conclude that if you are the top largest 200 bank in the country, you have already re-calibrated your AT RAROC model to take into account the tax change and your credit spreads have been adjusted accordingly. The remaining 5,400 smaller banks (composing only 16% of the loan volume in the banking industry) are waiting to see how much loan volume they can generate without passing along tax change benefits to borrowers.
We believe that the banking industry prices loans uniformly but not perfectly efficient. That means that not every loan is sought by every lender pricing rationally, but over time the industry establishes loan spreads to satisfy the overall AT RAROC hurdle. Stated another way, if you are a small community bank then you may not see Bank of America competing in your market, but you do see a larger community bank that does compete in your market, and that larger community bank does on occasion compete with Bank of America. Therefore, the top 200 banks will, over time, set market pricing through proxy competition.
In our opinion, the vast majority of industry lenders will follow the top largest banks in contracting loan spreads as a result of the recent tax changes. Banks that wait to adjust their pricing will likely attract lesser credit quality borrowers that are not desirable this late in the credit cycle. However, community banks now have an opportunity to take advantage of some competitors that are not willing to adjust their loan spreads and win loan business from this group that is late to adjust to new market conditions. Lower spread to win the right business today will prove smart as credit spreads continue to contract as market laggards catch up to industry trends.
Submitted by Chris Nichols on April 11, 2018