Potential risks for institutions new to C&I
Since more banks and credit unions have started to expand their C&I portfolios, the subtleties that come with C&I lending could expose banks to several, specific risks if they lack experience and resources.
Different data sources. For financial institutions accustomed to consumer or development loans, C&I loans require a different type of financial data than the bank may be used to collecting or analyzing. To understand borrower risk, the bank must collect and properly analyze business and personal tax returns including K-1s and financial statements for all the entities. Knowing how to accurately spread or review these documents might be a challenge to institutions that are inexperienced with commercial lending; it could be an even bigger challenge if the institution had not been diligent in collecting all these items as needed throughout the year.
Improper global cash flow analysis. Financial institutions that previously had a large CRE or consumer portfolio might be unaccustomed to performing an adequate global cash flow analysis, which involves assesses and combining income and debt for complex borrower relationships. Lubansky pointed out, “Doing a global cash flow in the way needed for C&I loans may not have been in place for much of their CRE lending.”
With C&I, a bank could have, in one borrowing entity, several different operating companies and owners, each of which comes with its own financial story and potentially overlapping commitments. To properly assess the credit risk of that entity, the bank has to do a global analysis, which Lubansky notes is one of the most difficult or complex tasks in credit analysis. The documentation required for commercial loan analysis could also pose a problem.
Inadequate strategic planning. Expanding the C&I portfolio is a strategic decision that will impact other critical areas of the bank including capital requirements, stress tests, risk thresholds, hiring needs, etc. If the bank utilizes personnel who lack experience in C&I lending and loan administration, they put themselves at risk. They need to understand the risks associated with these loans just as they would with CRE loans, as well as the impact on risk weightings with regards to capital ratios. Additionally, if they need to stress test these loans, it is different, unfamiliar territory for banks that already struggle with knowing what to do to stress CRE loans.
Inexperience with business entities. An experienced analyst knows when to make a loan, even if the spreads are unconventional or otherwise hard to spread. Familiarity with this type loan empowers experienced analysts to ask the right questions for a comprehensive credit analysis. Without a seasoned commercial lender (or several), a financial institution could be ill equipped to handle C&I loans that require special attention.
Given these potential risks, not at all financial institutions are equally prepared to expand their C&I portfolios. Community banks, institutions that have customarily relied on relationship-based lending or that have scarce resources, should ensure that they have the necessary people and technologies in place prior to expanding.
Similarly, credit unions should expand their member business loan portfolio conservatively. While some banks might have insufficient experience, “some credit unions have next to none” and could be apt to encounter problems, Lubansky points out. Unlike banks, credit unions have traditionally had a cap on the amount of business loans they could have in the portfolio. Currently, that cap limits member business loans to 12.25 percent of assets. If pending credit union legislation passes, however, that cap could increase to 27.5 percent, which would allow credit unions to more than double their business relationships. Credit unions argue that they can provide a new source of additional commercial lending if banks are not able to fulfill the demand for business lending while they clean up their balance sheet; however, if these credit unions don’t appropriately measure their risk while they expand this portfolio, they could find themselves in a similar situation to their banking counterparts during the next downturn.
To continue reading, download the whitepaper, “Shifting Credit Concentrations: 6 Ways to Prepare.”
