On the economic scene, it would seem heartening to see a surge in loans that banks are making to corporations of all sizes. The loans help finance business expansion, which may lead to jobs growth. And it shows that banks don’t have to pile back into real estate loans, recently the source of crippling losses, to grow.
But the recent spurt in bank business lending is starting to flash some warning signs.
The concern is that banks are making loans to businesses at rates that are so low that they may end up being unprofitable. A recent survey by the Federal Reserve shows that American banks are charging an average of just 2.83 percent on so-called commercial and industrial loans. That’s down from 3.4 percent a year earlier.
Banks of all sizes are participating in this resurgence, including smaller banks, which managed to avoid many of the excesses of the credit boom of the last decade. In an effort to find alternatives to real estate lending, some banks could be rushing into company loans without due care, says Claude A. Hanley Jr., a partner at the Capital Performance Group, a bank consultancy firm.
“The competition among banks has been fairly pronounced,†Mr. Hanley said. “So there is concern that this will lead to foolish terms to the borrower merely to win business in the short term.â€
Overheated credit markets are a risk that comes with the immense monetary stimulus undertaken by the Federal Reserve to whip up economic growth. Extraordinarily low interest rates have breathed life into several markets where companies go to borrow. Last year, companies issued nearly $360 billion of junk bonds in the United States, according to Dealogic, a large number that has raised eyebrows in some quarters.
Less noticed, but still big, was the increase in commercial and industrial loans at American banks. They added $174 billion of such loans in 2012, a 13 percent increase from the prior year, according to figures from the Fed. Since 1990, the average annual growth for these loans is 4.2 percent.
It’s one thing to make the loans, but another to make money on them over time.
At first blush, the banks’ business loans look very profitable. Take the business loan portfolio at Huntington Bancshares, a regional lender based in Columbus, Ohio.
The bank’s commercial and industrial loans grew by a heady 16 percent last year and the business is a sizable contributor to its revenue. Last year, its business loans had an average interest rate of 4 percent, a nice fat yield for a bank that was able to finance itself for as little as 0.45 percent.
But the 4 percent figure is derived partly from older loans that have higher interest rates. As competition in this sector remains intense, it’s important to understand the profitability of the recent business loans. They may have a significantly thinner profit margin. That can be seen in a theoretical exercise that uses some of Huntington’s numbers.
Unlike some of its peers, Huntington actually discloses the interest rates on newly added commercial and industrial loans. The latest figure it gave was 3.38 percent for the third quarter of 2012.
Estimated costs then need to be subtracted from that figure. First, Huntington’s own financing costs, 0.35 percent in the last quarter of 2012, are taken away, to get net interest income of 3.03 percent on the business loans.
Huntington gets fees and other noninterest revenue from the commercial and industrial banking services it provides. But, as is the case at most banks, it has even higher noninterest expenses.
If this net expense is expressed as a percentage of assets, it comes to 0.59 percent for the division of Huntington that makes commercial and industrial loans. That number is then subtracted from the 3.03 percent net interest income yield on businesses loans. That trims their theoretical annual return to 2.44 percent.
Next, one big potential cost has to be factored in: estimated losses from when loans go bad.
In banking, those can be measured through something called “net charge-offs.†Since 1990, those have averaged 1 percent on commercial and industrial loans to American companies, though they spiked above 3.5 percent at Huntington in 2008 and 2009. To take into account the healthier economy today, it may make sense for this analysis to assume a markedly lower loss rate of 0.8 percent.
Subtracting that from the 2.44 percent, takes the business loan yield down to 1.64 percent.
Finally, the taxman’s take. Huntington expresses that as 35 percent for the division that makes commercial and industrial loans, which would reduce that figure to 1.07 percent.
The analysis does have shortcomings.
In traditional banking right now, earning just over 1 percent on loans after all estimated expenses, is hardly terrible when interest rates are so low.
And it is hard to generalize across the banking sector. Some lenders will prove better than others at commercial and industrial lending during this business cycle.
In theory, banks with strong, long-term relationships with corporate borrowers should be able to generate more business without compromising the quality of their loan books. James E. Dunlap, a Huntington executive who oversees commercial lending, says that if a borrower knows it is getting a valuable range of services from a long-time lender, it will be less tempted to take a cheaper loan from a competitor.
“When you take responsibility for the success of your customers, they will take the responsibility to buy multiple services from you,†said Mr. Dunlap.
Also, the analysis doesn’t take into account the fact that most business loans are structured in such a way that their interest rates would go up if benchmarks, like the London interbank offered rate, increase. In other words, it might be a mistake to assume that today’s low rates on business loans will persist into the foreseeable future.
Still, the Fed shows few signs of wanting to hoist interest rates. And competition between banks could prompt certain lenders to cut interest rates on commercial and industrial loans still further, leaving little room for error if this type of lending hits a rough patch.
