ViewPoint: Spotlight: Non-CRE Lending

C&I, Other Forms of Non-CRE Lending Present Opportunities, Challenges

Financial institutions in today's increasingly competitive marketplace continue to look for new business opportunities and additional loan growth by entering new lines of business or, in certain cases, reentering lines of business they had previously exited. A major focus of this new area of targeted growth is in the commercial and industrial (C&I) space. A number of firms are squarely focused on C&I lending as a way to offset existing commercial real estate (CRE) concentrations and provide increased loan diversification to existing portfolios.

In the second quarter of 2011, total loans outstanding at U.S. banks increased for the first time since the second quarter of 2008. C&I lending accounts for the majority of new loan growth, as C&I lending by U.S. banks has increased 6 percent since hitting its trough in June 2010. New areas of credit growth being explored include indirect automobile lending, asset-based lending, credit cards, student loans, and even hybrid forms of payday lending in certain cases. This movement into new areas by market participants not only presents new opportunities for growth but also raises credit risk management challenges for all firms involved.

Traditional CRE lenders face a number of challenges as they enter new lines of business and make the transition into new lending areas. Several key differences exist between the CRE and C&I business segments that lenders should take into account when making the transition.

C&I lending normally requires a more complex credit administration and credit risk management infrastructure to properly monitor credit exposures, as certain segments of C&I lending—such as asset-based lending and leverage finance—normally require more in-depth monitoring and reporting. In addition, C&I lending is generally more focused on cash flow and places a greater emphasis on balance sheet management with regard to inventories and receivables in a number of C&I segments.

C&I lending also presents additional risks. Certain segments of C&I loans are made on an unsecured basis, whereas CRE lending normally includes tangible collateral that is included as part of the loan structure. Finally, C&I lending requires highly specialized skill sets for the various product segments offered, such as small business lending, leverage finance, asset-based lending, and other specialized product types.

To help ensure a successful transition into new business segments, lenders making the transition into new lending areas should receive appropriate training and support to fully understand and manage the inherent risks associated with the new products they are offering to their customers.

Pricing pressure and underwriting standards
Trends are emerging to which all market participants should pay close attention. Concerns with the high level of competition and the direct impact on market pricing and underwriting standards are shared concerns that arise regarding current credit market conditions. Several bankers have observed that the more conservative market discipline that was reestablished in the marketplace as a result of the 2007â??8 financial crisis has started to erode slowly over the last 12 to 18 months.

Evidence has started to emerge that this relaxed discipline is evident in reviews of recently originated C&I deals. Such reviews have generally indicated weakening underwriting standards as a result of an increase in concessions and a general decline in loan covenant requirements related to key financial covenant measurement ratios.

Certain institutions have recently decided to waive sponsor guarantees as standard practice and granted other underwriting concessions that, in most cases, would not be considered prudent practices in a highly disciplined market environment. Fierce competition and pricing pressures are at the center of current underwriting trends in the marketplace. Additionally, more financial institutions are experiencing an increase in hold level exceptions as a result of a lack of loan growth.

The desire to hold more direct exposure on the balance sheet given the overall weakness in loan demand creates credit risk management challenges as financial institutions increase their overall credit-risk profile through less credit diversification. Moreover, some institutions are trying to counter this weak demand by working with borrowers who have lower credit quality to counter the intense pricing pressures that exist in more traditional segments.

Sound credit risk management practices remain a priority
As a number of financial institutions have discovered as a result of the financial crisis, it is more important than ever to ensure that their boards of directors and management implement a robust credit risk management program to effectively identify, measure, monitor, and control credit risk.

As financial institutions enter new areas of lending, it is imperative that firms ensure that appropriate due diligence and planning have taken place before new lending is originated. A safe and sound operating environment is a key factor for financial institutions to be successful and profitable in the long run. Supervisors continue to identify instances where financial institutions have entered new areas of lending without implementing an appropriate credit risk management infrastructure to effectively manage and control new lending opportunities. Sound management information systems that have the ability to appropriately segment and analyze various credit exposures are vital in today's complex and ever-changing banking environment.

Balancing loan growth with risk management
Banking supervisors understand that sound credit granting by institutions is instrumental to the return of economic prosperity and the improved soundness of the banking industry. They are also conscious of the pressure to improve earnings in an environment where competition for sound credit is intense.

As financial institutions target new lines of business seeking additional revenues and loan growth, institutions must factor in the inherent risk of these lines of business as part of their strategy. Firms are being challenged on a number of fronts as the banking environment is becoming increasingly competitive and the economic outlook remains unclear. Financial institutions must be reasonable in their growth estimates and fully appreciate the risks involved as they explore new business opportunities. A disciplined approach with a focus on ensuring credit risks are managed appropriately is the best way forward.

By Trey Wheeler, credit risk director in the supervision and regulation department at the Atlanta Fed