By Joseph Lowe, Sageworks
According to the most recent Federal Reserve Senior Loan Officer Opinion Survey, bank loan officers are easing lending standards for commercial and industrial (C&I) lending due to increased competition and a more favorable economic outlook.
As banks and credit unions look to close out 2018 strong and drive growth into 2019, a C&I lending focus could present the strategy they’re seeking.
A C&I loan is a loan that is extended to a business as opposed to an individual person. These types of loans, such as small business loans, are typically short-term and serve to aid in the financing of capital expenditures or providing working capital. According to the Federal Reserve survey, small and mid-sized businesses increased demand for C&I loans in Q2 of 2018, despite weaker demand for other lending segments such as commercial real estate (CRE) loans.
Small business lending constitutes a $700 billion market, serving over 58 million employees and 29 million small businesses. The small business lending market is a sizable one and represents some untapped opportunity for many community financial institutions who have passed on market share to focus on more profitable loan concentrations.
Focusing on a C&I lending concentration is often viewed as a strategy best suited for large financial institutions due to tighter supervision and amplified bank regulations. Forty percent of total loans from the five largest U.S. banks – Wells Fargo, Citigroup, Bank of America, JPMorgan Chase, Citigroup, U.S. Bancorp – consist of C&I loans.
However, the top 100 commercial banks by asset size only account for $1.8 billion of the $2.4 trillion C&I lending market, and C&I lending has continued to prosper for all commercial banks since Q4 of 2010, after the impact of the Great Recession began to recede.
According to the EY Q1 2018 Market Report, “[C&I lending] Delinquencies have tapered since the 2016 bump upward driven by the oil and gas sector.” Excluding the slight increase in delinquencies in 2016, C&I lending delinquencies and asset quality stress has remained close to historic lows. Furthermore, the corporate income tax was cut in December 2017 in an effort to boost demand for C&I loans, and those effects have slowly been seen across the market. For small or mid-sized financial institutions with the right projection strategy in place, investing in C&I lending can be a wise strategy for many reasons, according to Rick Dailey, senior credit risk consultant at Sageworks.
Dailey says institutions looking to concentrate their loan growth strategy on C&I lending must create projections that properly evaluate the borrowing company’s cash flow to better understand fixed expenses, variable expenses and projected expenses over a time span of 1-3 years. Banks and credit unions can choose whether to do monthly, quarterly or annual projections based on the needs of the unique financial institution or based on trends within the borrower’s industry.
“Working with projections will give you the ability to look to the future and see what’s the strength of the company to repay,” Dailey says. “Also we can look at different assumptions. What happens if [the businesses] grow 17%? What happens if [the businesses] lose a primary customer and they lose 20% in revenue. What happens if [the businesses] split the difference?”
Projections also allow credit analysts to compare the borrower’s projected cash flow and other metrics with the industry standard, which proves the customer is knowledgeable of their business and their industry, according to Dailey. “If you had a coffee shop, and the coffee shop projections you provide were showing 30% gross profit, that’s a little unrealistic considering that a coffee shop industry-wide would have a gross profit of about three percent,” Dailey says. “Does the customer have a grasp of what their industry is and what their business can perform?” Despite the many benefits, some financial institutions are not performing projections within their C&I lending strategy, according to Dailey.
“Most of the banks I’ve been working with have not been using projections [outside of SBA]. Most banks are primarily not running them because of the time that it takes to build out the projections and trying to reference what they will be using for the assumptions that they’ll make as far as accounts receivable days, accounts payable days, gross profit margin and the industry trends.”
Lenders and credit analysts remain hopeful that the uptick in C&I lending will continue to grow through the end of this year and into 2019. However, for smaller banks and credit unions to capitalize on C&I lending growth early, and ensure a strategic approach to the concentration, it’s critical to perform projections and gain a holistic view of a company’s potential cash flow.