The financial crisis that began more than three years ago has changed virtually every aspect of commercial lending – from tighter credit criteria and less risk exposure on the part of banks to greater scrutiny on financial institutions by federal regulators.
For example, regulatory guidance now effectively caps the amount of capital commercial banks can invest in commercial real estate (CRE) and acquisition, development and construction loans as a percentage of total capital. As a result, many banks are now focusing on making more commercial and industrial (or C&I) loans in order to diversify their portfolios.
Back in the Game
Having been out of C&I lending for so long, however, some banks are finding it’s not easy to get back in the game. Many new commercial lenders have very little (if any) experience in C&I lending, and fewer have the kind of formal credit training most lenders received a decade or two ago. And many lenders who are trained in C&I would admit that their skills have grown rusty after having focused heavily on CRE for so long.
Also, the underwriting process for C&I lending is substantially different from how underwriting is performed on other types of commercial loans.
The fact is, most community banks aren’t equipped with the systems or infrastructure required to understand and control the supporting collateral of C&I loans or monitor the borrowing base. Nor do they have staff adequately trained in this level of collateral monitoring. You need lenders who know how to physically inspect and value collateral – there’s more to it than just counting boxes.
If your bank is shifting its focus to C&I lending, your first step should be to make sure you don’t end up making what are essentially unsecured C&I loans without even realizing it. This is what often happens when a community bank takes a blanket lien on receivables and inventory without understanding the nuances involved in monitoring this kind of collateral.
Borrower Collateral Requirements
When presenting receivables and inventory as collateral for a C&I loan, borrowers should be required to provide regular financial statements, a listing of aged receivables and payables, and a detailed summary of inventory, as well as submit to regular site inspections by the lender. Employ a borrowing base that specifies what does and does not qualify as eligible collateral; e.g., foreign receivables and receivables more than 90 days old do not qualify.
Similarly, when it comes to equipment pledged as collateral for C&I loans, you need to have a good understanding of exactly what the equipment is, its potential resale value and how easy or difficult the equipment might be to resell. For example, is the pledged equipment general purpose or special purpose?
There’s an old saying that bankers shouldn’t finance based on equipment that’s bigger than the doors of the building – because you have to physically get the equipment out of there. Also keep in mind, depending on the building’s ownership structure, owners could assert their right as landlord to deny a lender access to the property to repossess the equipment pledged as collateral if rent is delinquent.
When accepting owner-occupied real estate as collateral for C&I loans, remember that it’s the cash flow from the business that should be the source of repayment for the loan. Therefore, the loan should be underwritten with the business as the primary source of re-payment and the real estate as the secondary source, with the real estate valued as investor-owned, not owner-occupied.
True Asset-Based Lending
Finally, you could structure a formal asset-based lending arrangement with borrowers for C&I loans. This would involve formula-based advances on a line of credit, periodic inspections of collateral, and bank control of proceeds from receivables, which would be sent directly to a specially designated post office box or bank account controlled by the bank. Such arrangements, however, are expensive and time-consuming on the part of the bank and require specialized lender expertise.
One alternative for community banks is to hire a CPA firm to provide field reviews for non-attest clients. Another is to partner with a secured lender who specializes in asset-based lending. This way, the bank can maintain the primary relationship with the customer – including retaining customer deposits and fee-based services and perhaps making other types of loans – while allowing the asset-based lender to make the C&I loan or provide assistance in monitoring the collateral.
Forging relationships now with asset-based lenders in your community could pay big dividends down the road. When looking for asset-based lenders to partner with, be sure to investigate them carefully: How long have they been in business? How well capitalized are they? What is the quality of their internal systems for monitoring collateral? How many local banks have used (or are using) them? Professional experience and adequate capitalization are especially crucial.
What’s Your Value Proposition?
Portfolio diversification and regulatory guidance aside, you must offer small businesses a true value proposition if you want to gain or retain them as your customers – regardless of the kinds of loans or services you can provide.
Community banks have traditionally accomplished this by positioning themselves as a trusted advisor small business owners can go to for more than just loans and banking services, but for every aspect of small business financial management. Be sure to keep this in mind as you plan your bank’s strategies for the new year.
Give us a call if you’d like to discuss your bank’s lending strategies in more detail.