Prior to the financial crisis, many banks, especially in the Southeast, came to depend heavily on real estate lending. In the years following the financial crisis, many banks shifted their growth focus from real estate to commercial and industrial (C&I) lending. C&I is one of two lending portfolios (as defined by regulatory reporting) that has recovered from the financial crisis. It has accounted for the largest increase in loan levels in the last several years (see the chart).
At the national level, C&I loans have increased 63 percent since the first quarter of 2010. In the Sixth District, community banks' C&I loans have increased by over $12 billion, growing more than 50 percent over the last six years. Only 1–4 family loans come close to the increase in C&I loans in the Sixth District, adding a little over $9 billion during the same time period.
Going into the second quarter of 2016, conversations with banks have indicated that they plan to continue to grow their C&I portfolios during the second half of the year. However, there are some key headwinds—including demand, underwriting, and asset quality—that may alter these growth plans. Loan demand is slowing and standards are tightening. Pricing for some loan types is moving higher in the wake of years of highly expansionary conditions and, more recently, the emergence of some economic concerns, including lower energy prices and slower global growth. So a concern now is not just the level of growth, but whether the C&I loans already on the balance sheet can withstand a potential downturn in the credit cycle.
Is demand on the decline?
Although banks are still expecting growth from their C&I portfolios, the demand for new loans appears to be declining. Demand for C&I loans from large and middle-market firms has weakened considerably according to the April 2016 Senior Loan Officer Opinion Survey (SLOOS; see the chart). Banks that participate in the survey reported that weaker demand stemmed from businesses' decreased investment in plants, equipment and inventory. Small businesses continue to lower their credit utilization, even as banks increase their credit lines. Responses to the May 2016 National Federation of Independent Business' (NFIB) small business optimism survey also show that the companies most likely to borrow from banks have little enthusiasm for expanding their existing business, a common reason for borrowing. More than half of the small business owners responding to the survey explicitly stated that they are not interested in obtaining loans.
Part of the reason for weaker demand is that commercial businesses are facing a variety of concerns in 2016. Recent data have shown a significant rise in business inventory holdings relative to sales. Growth in earnings across industries has been slowing for a few quarters, and small businesses appear to be flashing warning signs in earnings. NFIB respondents have expressed little optimism that sales will improve in the near future. Small business surveys from both Wells Fargo and Bank of America from the first quarter of 2016 also indicate that barely half of the owners expect revenue growth in the coming months.
In addition, new technologies are disrupting traditional business models. For example, brick-and-mortar retail businesses are showing weaknesses, especially apparel retailers. Mall retailer Aeropostale recently declared Chapter 11 bankruptcy, and Sports Authority gave up trying to reorganize, deciding instead to liquidate. Commercial bankruptcies have spiked recently: In the first quarter, total commercial bankruptcy filings by corporations of all sizes and other business entities increased 24 percent from a year ago, according to the American Bankruptcy Institute. In fact, year-over-year filings have increased for six straight months. However, despite the recent uptick, the current pace of filings still falls well short of the peak of more than 8,000 experienced during the last recession.
Underwriting standards attract scrutiny
In the second half of 2015, regulators expressed concern about declining underwriting standards across multiple bank portfolios, as this 2015 survey of credit underwriting practices from the Office of the Comptroller of the Currency shows. After the crisis, many banks in the Southeast focused on expanding C&I lending, including some banks that had very limited prior experience with commercial lending. Competitive pressures resulted in rate and term concessions. New nonbank lenders also pushed into business lending, creating more downward pressure on underwriting standards. Now the sharp decline in energy prices is affecting some key commercial borrowers, and there are indications that credit quality concerns extend beyond the energy sector. In January 2016, Deutsche Bank predicted a five-fold increase in loss rates for C&I loans in the United States as a result of the decline in underwriting practices and subsequent increase in economic uncertainty.
Banks are reacting to the changing environment. C&I lending standards have tightened for three consecutive quarters, according to the SLOOS. A majority of banks in the survey that had tightened either standards or terms on C&I loans in the first quarter of 2016 cited a less favorable or more uncertain economic outlook as well as a worsening of industry-specific problems affecting borrowers. Some banks noted in the optional comments that energy-related industries, including oil and gas, were of concern. A significant number of banks also attributed the tightening of loan terms to reduced tolerance for risk; decreased liquidity in the secondary market for these loans; and increased concerns about the effects of legislative changes, supervisory actions, or changes in accounting standards.
Asset quality shows some deterioration
C&I noncurrent loans at institutions insured by the Federal Deposit Insurance Corporation (FDIC) appeared to bottom out in late 2014 and inched upward through the end of 2015 (see the chart). In the first quarter of 2016, the median nonperforming loans-to-total loans ratio is 2.04 percent, on par with precrisis levels. Nationwide, the noncurrent rate on C&I loans increased by 46 basis points to 1.24 percent, the highest level since 2011. According to the FDIC, the $9.3 billion increase in noncurrent C&I loans in the first quarter of 2016 was the largest quarterly increase in noncurrent C&I loans in 30 years (since the first quarter of 1987).
Most of the increase in noncurrent loans occurred at larger banks. Among the largest banks, the average increase in C&I nonaccrual loans (as a percent of total loans) was 18 basis points. An analysis of historical quarter-to-quarter changes in nonaccrual C&I going back over 20 years, to the early 1990s recession, shows the increase in the first quarter of 2016 was arguably worse for large banks as the upper percentile performance equaled historic highs, and at the same time the lowest percentile performers showed positive changes. However, banks under $50 billion in assets also experienced an increase in noncurrent loans. Deterioration among Sixth District community banks, where the aggregate noncurrent rate for C&I loans rose just over 90 basis points from the prior quarter to 2.70 percent in the first quarter of 2016, is a prime example of the impact on smaller banks.
Although deterioration in the energy sector is ostensibly a primary driver of current C&I asset quality problems, the geographical distribution of delinquency increases beyond energy production markets provides an indication that problems could be spreading. In the Sixth District, significant increases in C&I delinquencies were noted around metro Atlanta and in South Florida, along with a few other markets that are not directly tied to energy production (see the figure). On a median basis, nonperforming C&I loans remain low, so there are only a few banks driving the overall increase. In terms of isolating noncurrent loans to a specific industry, data from PayNet shows that delinquencies among every industry segment were up or flat from the prior quarter, including hospitality, retail, and agriculture. The level of delinquencies remains well below levels occurring during the crisis, but the trend is moving upward.
Looking at the near term
The C&I portfolio has been a key source of loan growth at banks since the financial crisis, despite the lack of experience in C&I underwriting at some banks. Going forward, portfolio growth is likely to slow significantly as banks contend with lower demand and tighter underwriting standards. Given current conditions, weaknesses are developing in the portfolio. Delinquencies are increasing rapidly and occurring outside of energy-dependent markets. Bank management and examiners need to monitor portfolios for deterioration and underwriting weaknesses.