Sound Risk Management Practices in Community Bank C&I Lending*
by Cynthia Course, Principal – Policy and Implementation, Federal Reserve Bank of San Francisco
Given weak loan demand, community banks have been challenged to maintain positive net loan growth quarter over quarter. Since the third quarter of 2008, community banks (those with less than $10 billion in assets) have reported positive net loan growth in only two quarters — the second quarters of 2011 and 2012 — although the rate of decline in other quarters has slowed more recently.1 Despite the year-over-year decline in net loans through June 30, 2012, commercial and industrial (C&I) loans outstanding at community banks increased $6.3 billion, or 2.8 percent, during the same period. And, on March 31, 2012, and June 30, 2012, C&I loans represented 16.7 percent and 16.6 percent of community banks’ net loans, the highest levels in three-and-a-half years.
Although the uptick in C&I loans at community banks has been modest, we thought that this was an appropriate time to remind bankers that they should establish controls and sound risk management practices before starting or expanding a C&I lending program.
What Are C&I Loans?
C&I loans generally are loans to sole proprietorships, partnerships, corporations, and other business enterprises to finance accounts receivable or inventory or finance the acquisition of capital assets.2 For some customers, C&I loans may be seasonal working capital loans, bridging uneven cash flows. The broad range of loans included in this category is illustrated in the table below.
Table: Examples of C&I loans
Common examples of C&I loans at community banks by borrower, purpose, or type include the following. The instructions to the Call Report provide a more complete list.
- By borrower for commercial, industrial, or professional purposes
- Mining, oil- and gas-producing, and quarrying companies
- Manufacturing companies
- Construction companies
- Transportation and communications companies
- Wholesale and retail trade enterprises
- Cooperative associations
- Service enterprises, such as hotels, motels, laundries, automotive service stations, and nursing homes and hospitals operated for profit
- Law, medical, accounting, and insurance professionals
- By purpose
- Capital expenditures
- Current operations
- Construction if not meeting the definition of "loan secured by real estate"
- Dealer floor plan
- By type
- Loans guaranteed by the Small Business Administration
- Credit cards and related plans that are readily identifiable as being issued in the name of a commercial or industrial enterprise
Loss Rates on C&I Loans
While a C&I lending program can be a viable business strategy for a community bank, it is not without risk, as shown by the generally higher loss rates on C&I loans than on CRE-secured loans. As illustrated in the figure, while the net charge-off rate on C&I loans at community banks (gold line) was well below that of construction and land development (C&LD) loans (green line) during the crisis, it exceeded the net charge-off rate of nonconstruction CRE loans (blue line). In the early part of the previous decade, the net charge-off rate on C&I loans was over 10 times that of nonconstruction CRE loans. The spread between the net charge-off rates for C&I and CRE loans has generally been wider for the smaller community banks than for those with over $1 billion in total assets.3
Figure: Net charge-off rates by loan type Commercial banks < $10 billion
Source: Data extracted from the Federal Deposit Insurance Corporation (FDIC) Statistics on Depository Institutions database (www2.fdic.gov/sdi/index.asp) for institutions up to $10 billion in assets (as of September 26, 2012). The net charge-off rate is measured as annual net charge-offs divided by prior year-end balances; June 2012 charge-offs annualized.
There are steps banks can take to manage and mitigate risks associated with C&I lending, and the remainder of this article will touch on effective risk management practices for a C&I lending program.
Sound Risk Management Practices
C&I lending often requires a different skill set than that required for real estate-based lending. This doesn’t mean that real estate-based lenders cannot become effective C&I lenders with appropriate training and oversight, but it does mean that management should not merely ask real estate lending and credit administration staff to start making and monitoring C&I loans and expect them to be effective immediately. It may also be increasingly difficult to hire experienced C&I lenders and credit administration staff, as many community banks are seeking to expand into this market.
Community banks seeking to expand their C&I lending may be best served by a combination of targeted training and selective hiring. Experienced commercial lenders and credit administration staff can be trained on sound C&I lending practices and can learn on the job under the mentoring of experienced C&I lenders and staff. Regardless of the approach chosen, management should recognize that even selective hiring and targeted training can be expensive and that personnel costs should be factored into the cost of any new or expanded C&I program.
A bank looking to expand its C&I lending portfolio should ensure that it is appropriately staffed at all levels to manage the risks inherent in this type of lending. This starts at the top of the organization, as chief credit officers should have proficiency in the risks of C&I lending in order to provide appropriate oversight to loan officers. Loan officers should understand the inherent risks and nuances of C&I lending in general. Moreover, institutions lending in niche areas — such as entertainment lending in Los Angeles or oil and gas lending along the Gulf Coast or in the emerging regional shale geographies — should also ensure that their lenders have expertise in the targeted niche. Moreover, small business lending should be considered a niche, with lenders needing deep knowledge about the risk patterns of small businesses and the requirements of guarantors, such as the Small Business Administration.
C&I lending requires a continually open, honest, and transparent business relationship between the lender and the borrower. Depending on the structure of the loan, the lender may have monthly, weekly, or even daily discussions with the borrower about draws, repayment plans, and business issues. While maintaining this close relationship, the lender should be careful not to become an advocate for the borrower’s interests over those of the bank.
A full discussion of the appropriate skill set for a seasoned commercial lender is beyond the scope of this article.4 However, at a high level, management should ensure that the commercial lenders have the skills to understand and critically analyze core elements of C&I loans, including:
- The operations and business cycles of the customer base
- Financial statements and financial metrics
- Cash flow analysis and projections, including sources and uses of cash and cash needs to replace depreciable assets
- Global cash flow for a closely held business or groups of related businesses/partnerships
- Liquidity sources for repayment
- Collateral valuation
- Loan structure and covenants that will protect the bank without unnecessarily constraining the borrower
- Appropriate advance rates on eligible receivables and inventory
Policies and Procedures
As noted above, various sources, including the Federal Reserve’s Commercial Bank Examination Manual,5 provide general guidance on community bank lending policies. In addition to establishing growth and concentration parameters to mitigate risk, banks’ boards of directors should set policies, such as those discussed below, that promote a successful C&I lending program. Exceptions to these policies should be reported to the board, and trends in exceptions should be analyzed to determine whether the volume and nature of exceptions are contributing to higher-than-desired C&I credit risk.
Underwriting. An important distinction between C&I lending and construction and land development lending (the focus of many community banks during the pre-crisis expansion) is that in C&I lending, cash flows from business operations are the primary means of debt service. Therefore, the focus of C&I underwriting should be on the ability of the business to generate cash flows through normal operations and maintain sufficient liquidity to service the debt. The loan should also be underwritten to ensure that there are two sources of repayment. The first source, as mentioned, should be from business cash flow that should be sufficient to make the contractual loan payments (which may be interest-only in the case of a line of credit, or principal and interest in the case of term financing). Underwriting the second source of repayment should ensure that the liquidation of the collateral will repay any remaining principal balance if the primary source of repayment is insufficient.
Collateral. The liquidation of collateral — typically accounts receivable, inventory, and property, plant, and equipment — is the primary source of principal repayment if the borrower defaults. Therefore, the institution should develop policies that encourage the proper monitoring and valuation of collateral and should also establish acceptable loan-to-value ratios based on the type of collateral. As many C&I lenders have learned, there can be a high risk of fraud with these types of collateral. For example, inventory and equipment can be easily moved and accounts receivable can become uncollectible. C&I lenders should understand the nuances of accepting this type of collateral and have the experience to appropriately evaluate its worth and secure the bank’s priority lien position in the event of default.
Covenants. Loan covenants can provide an early warning system for emerging problems. A complete discussion of covenants is beyond the scope of this article, but some highlights are worthy of consideration.
A C&I lender should tailor the loan covenants and documentation to appropriately match the borrower’s business and risk profile. While loan covenants should be aligned with the borrower’s financial condition and projections, the loan policies should require certain covenants for all C&I loans and provide optional covenants to be applied at the lender’s discretion, with a mechanism for prior review of exceptions when warranted. Further, because of the protective nature of covenants, community bank C&I lenders are strongly discouraged from making "covenant-lite" loans, as those loans increase the bank’s longer-term risk despite the current creditworthiness of the borrower.
Covenants can take various forms, but most relate to either the operation of the business or the maintenance of financial measures. Some covenants may require a borrower to take certain steps (affirmative covenants), while other covenants may prohibit a borrower from taking particular actions (negative covenants). When the lender drafts the covenants, it is important to ensure each one meets a defined objective. Broadly, financial covenants are generally structured to (i) maintain cash flow, (ii) preserve asset quality, (iii) control growth and leverage, and (iv) maintain the borrower’s net worth. Nonfinancial, or operational, covenants are generally designed to (i) require full and timely disclosure about the borrower’s operations and financial position; (ii) maintain management commitment and quality, which could include personal guarantees by key members of management; and (iii) ensure the continued viability of the borrower’s operations.
However, despite the value of covenants, they are no substitute for a C&I lender’s ongoing monitoring, analysis, and anticipation of emerging problems.
Remediation. Despite a bank’s best efforts, borrowers may experience financial difficulties. Lending policies and individual loan documents should establish a remediation framework that permits certain actions in the event of a covenant violation or any other event of default. A well-structured remediation framework should provide the bank with the flexibility to ensure that its interests are protected. Consequently, one focus of credit administration should be on enforcing covenants through default letters and imposition of default interest rates. While covenant forbearance (which is temporary) or covenant waivers (which are permanent) may be appropriate in certain circumstances to both protect the bank’s interests and ensure the viability of the business, granting forbearance should be considered carefully, and granting covenant waivers should be the exception rather than the norm. The bank’s response to any covenant violation, whether enforcing the covenant or granting forbearance or waiver, should be communicated promptly to the borrower in writing to preserve the bank’s rights under the loan agreements.
Pricing. Setting an appropriate interest rate and appropriate fees for C&I loans is both an art and a science. It is an art, since the pricing is expected to reflect the lender’s judgment about a myriad of risk factors unique to the borrower’s business and the purpose and terms of the credit. Yet, it must also be a science to ensure that the institution receives an appropriate risk-adjusted return for its shareholders. Without consistently applied interest rate and fee pricing parameters and centralized monitoring of all C&I loan proposals, individual lenders could make inconsistent pricing decisions, often to the detriment of the borrower and the bank.
Pricing C&I loans based on competitors’ pricing may generate volume, but at the potentially steep cost of insufficient compensation for higher risk. In fact, the comparative advantage of a community bank C&I lending program may not be price, but instead the personal service that a community bank credit team can provide.
Exit Strategy. Acknowledging that defaults will occur, management should identify a strategy to exit nonperforming C&I loans. In the recent financial crisis, community banks often found it difficult to quickly and profitably dispose of CRE acquired when a real estate borrower defaulted. However, it can be even more difficult to secure and then dispose of accounts receivable, inventory, or property and equipment acquired when a C&I borrower defaults. Often, a community bank may find that an effective exit strategy for C&I collateral involves third-party vendors, such as factoring companies that specialize in this area.
Monitoring and Reporting
Bank management should develop reporting to track specific elements of C&I lending, such as accounts receivable and inventory valuation at the individual loan or line level, over-credit-line reporting, as well as C&I sub-category reporting. C&I sub-category reporting is particularly helpful in assessing concentrations in C&I lending. Given the variety of industries, business cycles, and collateral in a community bank’s C&I portfolio, measuring concentrations at the sub-category level will provide management with better indicators of concentration risk.
Internal and external loan review, as well as internal audit, should provide assurance that C&I loans are underwritten in accordance with policy, that credit administration activities are timely and comprehensive, and that emerging portfolio issues are identified promptly. A bank may choose to focus its review efforts on C&I loans originated in the previous 12 months, those with larger-dollar credit exposures, borrowers with a history of frequent delinquencies, and borrowers with a history of covenant violations. Bank management may also need to consider outsourcing some aspects of internal audit if current audit staff does not have sufficient experience to audit C&I lending activities.
Information gleaned from monitoring and reporting will also be helpful in establishing appropriate provisions for losses on C&I loans. Management should review the Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL) for guidance on establishing appropriate ALLL levels when entering into new lending areas for which historical loss information may not be available.6
Finally, management should consider performance expectations for the C&I sub-categories and for the portfolio as a whole under more adverse conditions.7 For example, if management determines that a large proportion of its borrowers provide products and services to one large business, a scenario analysis may assess the impact on the portfolio if the large business were to experience financial difficulties.
While this article touched on some of the risk management factors that bank management should consider when entering or expanding a C&I lending program, it is not a comprehensive list. Each community bank will likely identify different gaps in its staffing, policies and procedures, or monitoring and reporting that need to be addressed. However, if a community bank’s management and board of directors determine that C&I lending is an appropriate and viable business strategy, management should implement a plan to mitigate the identified gaps and establish appropriate controls before making the first loan.
The Federal Reserve has been very clear that bank lending to creditworthy borrowers plays an important role in the ongoing economic recovery. To avoid a repeat of the factors that contributed to the financial crisis, however, both bank supervisors and banking organizations should ensure that prudent underwriting practices are maintained throughout the credit cycle and that underwriting standards are not compromised by competitive pressures, investor demands, or the desire for rapid growth or increased market share.
- * The author would like to thank Kevin Cragholm, Tim Marder, Adrienne Thompson,and Dante Tosetti of the Federal Reserve Bank of San Francisco for their thoughtful contributions to earlier drafts of this article and Carmen Holly and Jinai Holmes of the Board of Governors for their thorough review of and contributions to the final article.
- 1 Based on data extracted from the Federal Deposit Insurance Corporation (FDIC) Statistics on Depository Institutions database (www2.fdic.gov/sdi/index.asp ) for institutions up to $10 billion in assets (accessed September 26, 2012)
- 2 For the purposes of this article, the term C&I loans has the meaning set forth in the instructions to the interagency Consolidated Reports of Condition and Income (Call Report), available at www.ffiec.gov/PDF/FFIEC_forms/FFIEC031_FFIEC041_201209_i.pdf, p. 158.
- 3 The Federal Reserve Bank of San Francisco maintains a historical data set of net charge-off rates for its District and national populations at http://www.frbsf.org/banking-supervision/banking-economic-data/aggregate-data/.
- 4 National and local bankers associations offer or provide information on programs to build or validate a C&I lender’s skill set. Other organizations provide analytical information that could help lenders better understand the risks inherent in specific industries.
- 5 For example, see section 2040, Loan Portfolio Management, and section 2080, Commercial and Industrial Loans, in the Federal Reserve’s Commercial Bank Examination Manual at www.federalreserve.gov/boarddocs/supmanual/cbem/cbem.pdf.
- 6 See SR Letter 06-17, "Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL)," at www.federalreserve.gov/boarddocs/srletters/2006/SR0617.htm.
- 7 See the interagency Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks, press release, May 14, 2012, at www.federalreserve.gov/newsevents/press/bcreg/20120514b.htm.