The advantages of local lending

For a while I have said the US commercial banking industry is on a path to long term contraction and consolidation. The last banks standing are already known – JP Morgan, Wells Fargo, Bank of America, Citi, US Bank, and possibly a dozen or so other corporate banks are all ‘too big to fail’. Case in point – there are fewer banks today than there were in 1934, when the government first started counting.

My concern is on a national basis. We are blessed in Texas to have the economy we currently enjoy. But we are looking at business and lending from the top of the pile. Only seven states are at prerecession employment numbers, and only two states (Texas and California) are really creating jobs and economic strength long term.

Dodd Franks, CFPB, and Basel III have put regulations in place that have changed the economic fabric of our nation. Small businesses will have a much more strict template to borrow from in the future. These standards will affect all levels of our local economy. In the housing industry we can already tell you that entry level home sales have fallen to 7% of all sales; they should be around 30% of the housing market in a healthy economy.

The concern is that bank consolidation and regulation is harming smaller local banks, which takes local knowledge out of the lending equation. Community and regional banks are having harsher and harsher standards for small business lending. 85+/-% of our national GDP is made up of small businesses, and they can’t grow well without access to capital.

While many of the parameters put in place were to prevent another financial meltdown that led to our worldwide recession, the harsher parameters have taken a toll on our community banks. These community banks have been the financial good citizens that many businesses relied on in the past to help them make it through harsh economic times. As many of these regulations continue to hamper the smaller banks, the result is obvious as shown in the charts.

As you look at these charts, realize your view is from the very tip top of the lending environment. This ride will play out over the next decade but Dodd-Frank, the CFPB, public sentiment, and changing demographics have already set the industry on course of concern to those starting new businesses as well as those of us who have watched the industry for years.

Loan growth rate in the US, while better than in the Europe, remains on a downward path. The latest figures suggest that loans are increasing at less than 2%, while deposits continue to grow at 6-7% per year.

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Loan-to-deposit ratio in the banking system hit a 35-year low recently.

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Loans as a percentage of banks’ total assets are at 52.2%, the lowest level on record. Just to put this into perspective, here is the breakdown of bank assets now versus 10 years ago. These two pie charts below are more telling than they may seem at first view. The fundamental economic profitability model of banking relies on three major sources of revenue: (1) interest income from “spread lending” – loan interest minus cost of funds, (2) interest income from bonds and securities (required by regulators to provide readily marketable assets that can generate immediate liquidity when needed) and (3) fee income charged for products and services renders.

Simple supply and demand has been squeezing net interest spreads on loan income for the past decade. Add to this decreasing loan supply and the situation only gets worse.

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Source: FRB (note that derivatives and trading assets were not tracked separately 10 years ago)

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Source: FRB (note that the bulk of “cash” assets are excess reserves held with the Fed).

Again, what is the concern? It is more than a tightening of lending standards platform. The new regulatory standards will force many loans to fit into standards set up by regulators, rather than bankers who understand the business, the individual, the cash flow, etc.

When many of the Baby Boomers got out of school, most bankers looked at a wide open platform for lending based on the “Five C’s”. These are Cash Flow, Collateral, Capital, Character, and Conditions. These were the major elements of a banker’s analysis when considering a request for a loan.

But the main thing that local banks bring to the table is an understanding of local businesses, trends and conditions. Basically the overall environment that the company is operating in. The local banker is going to assess the conditions surrounding your company and its industry to determine the key risks facing your company, and also, whether or not these risks are sufficiently mitigated. Even if the company’s historical financial performance is strong, the bank wants to be sure of the future viability of the company. The bank won’t make a loan to you today if it looks like the viability of your company is threatened by some unmitigated risk that is not sufficiently addressed. If I am looking at your businesses in the national focus, I may not make the loan, because your business is not doing well in 40 other markets.

In this assessment, the banker is going to look to regional needs such as the following.
The local competitive landscape of your company – who is your competition? How do you differentiate yourself from the competition? How does the access to capital of your company compare to the competition and how are any risks posed by this mitigated? Are there technological risks posed by your competition? Are you in a commodity business? If so, what mitigates the risk of your customers going to your competition? I do not need to worry if this business is doing well in Detroit. What is the opportunity and risk locally?

The local and regional nature of your customer relationships – are there any significant customer concentrations (do any of your customers represent more than 10% of the company’s revenues)? If so, how does the company protect these customer relationships? What is the company doing to diversify its revenue base? What is the longevity of customer relationships? Are any major customers subject to financial duress? Is the company sufficiently capitalized to withstand a sizable write-down if they can’t collect their receivable to a bankrupt customer? Again the concern is to look at these needs in a community context, rather than a regional or national. What is happening nationally is a great teacher, but needs should be weighed on local risks and needs.

Supply risks – this is where someone like me comes in. Where are we in developed lots, housing, etc? Locally, regionally we don’t have enough and haven’t for the last 4+ years, but we’re hampered by the national housing picture. Presently Austin and other metros will not have enough housing and office for awhile due to looking at the real estate lending economy from a national level.

Industry issues – what are the macro-economic or political factors affecting, or potentially affecting the company and their local growth? National concerns should not necessarily affect a local lending decision. The national concerns need to be weighed against local needs and opportunity. Again could the passage of pending legislation impair the industry or company’s economics locally? Are there any trends emerging among customers or suppliers that in the future will negatively impact operations?

Character – While we have left “Character” for last, it is by no means the least important of the 5 C’s of Credit or Banking. Arguably it is the most important. Character gets to the issue of people – are the owner and management of the company honorable people when it comes to meeting their obligations? Without scoring high marks for character, the banker will not approve your loan. National guidelines will not help measure the intent or heart of the business.

How does a banker assess character? After all, it is an intangible. It is partly fact-based and partly “gut feeling”. The fact-based assessment involves a review of credit reports on the company, and in the case of smaller companies, the personal credit report of the owner as well. The bank will also communicate with your current and former bankers to determine how you have handled your banking arrangements in the past. The bank may also communicate with your customers and vendors and the local industry to assess how you have dealt with these business partners in the past. The soft side of character assessment will be determined by how you deal with the banker during the application process and their resultant “gut feeling”. You cannot legislate or measure this.

In the end, the community bankers want to deal only with people that they can trust to act in good faith at all times – in good times and in bad. Banks want to know that if things go wrong, that you will be there and do your best to ensure that the company honors its commitments to the bank. Even if the company’s financial profile is strong and the company has scored well in all of the other “Five C’s of Credit”, the banker will turn down the loan if the character test is failed. To be clear – it is not necessarily an issue if your company has gone through troubled times in the past. What is more important is how you dealt with the situation. Were you forthright and proactive with the bank in communicating problems? Or did you wait until a default situation was already in effect before reaching out to the bank? Were you cooperative with the bank while getting through the distressed period? The importance of character cannot be stressed enough. How can this be measured by legislation?

The good news is that for 2014, irrespective of the Fed, the long range forecast for interest rates is low and steady. What you never hear any more is the time proven fact that interest rates are fundamentally a function of both the actual and projected rate of inflation, plus a spread. With US inflation consistently running 1+/-%, and the historical spread over inflation of 1.75% – 2.25% to arrive at the 30 year bond rate, you can see why treasury rates keep retreating. Simple US demographics are enough to keep US inflation low for awhile. So the formerly positive economics of banks holding income producing securities as part of their asset base has essentially going away.

Lastly, if you are having a harder time making loans, where do you look for profits? Fees! Everyone hates fees. The double whammy of the CFPB and consumer hate for banks will be a strong headwind to fees. And remember, in the 70’s thru the 90’s non-sufficient fund fee income typically comprised 75% to 125% of a bank’s net income. The CFPB wants to effectively eliminate NSF fees and the FDIC is actively helping them by criticizing banks with large NSF fee income (like IBC) for not employing “best practices” of not charging NSF fees. This will make it hard for banks to make their needed capital.

Larger multi-state banks are great, but on a local and regional level they are subject to the national lending issues which prevents them from taking advantage of local and regional opportunities. The strength of our national banking system has been small community banks and businesses. It would be a shame to see them go away.

What can you do? Try to do more business with your local banks. And know that you are blessed to be doing business in Texas.