The current lending environment is showing signs of recovery but remains challenging. When the economy is soft, it shows up in bank earnings and balance sheets, just as it shows up on your company’s balance sheets. Banks are a reflection of the economy. Many banks continue to lose money, the regulatory environment continues to change and the banking industry is adjusting to this new environment.
Banking is a tightly regulated industry, and these regulations affect the ability of banks to make loans. Banks are being asked to have their foot on the gas, increasing lending to help small business and the economic recovery, and also to have their foot on the brake pedal, keeping up with regulatory requirements and safeguards to prevent further disruption of our economic system.
Banks are in business to lend
Loan demand is increasing but remains below historic levels. The federal government is calling for higher capital requirements for banks to ensure they might be prepared to handle a long, deep recession. Banks can respond to this requirement in a number of ways. They can raise additional capital by retaining earnings, which is difficult when many aren’t making money; by selling stock or ownership, which also is challenging in this cautious environment; or by reducing the number of loans they’re carrying to shrink balance sheets.
Regulatory pressure also has led banks to reduce the concentration of loans made in certain industries, primarily real estate. Some small banks have carried significant portfolios in real estate. Many have been forced to halt this practice and even shed some of their existing real estate loans. This affects businesses connected to the real estate industry as well; contractors, landscapers, architects and others also are having a difficult time securing loans. Banks are in business to make loans, and so regulation around loan concentration has compromised their business.
Loan grading also is a key factor in the lending environment. Each time a bank makes a loan, it must set aside money for potential loss. For well-performing companies with low risk, the lender must set aside approximately 1 percent of the loan amount. A much higher loan loss reserve is required for loans that don’t perform as they were originally underwritten.
For example, if a business has been hurt by the recession, its revenues might be down 30 percent to 40 percent. That company now must cut expenses or lose money, and its loan is categorized as problem credit. Even if the loan is well collateralized, there’s greater pressure from regulators to bump the reserve on such a customer to 10 percent or 15 percent.
On a $10 million loan, the 1 percent reserve amounts to $100,000. When this amount is boosted to 15 percent, the bank is required to set aside $1.5 million to cover the loan – often shifting this money from its earnings and creating a situation where the bank risks losing money. Until the businesses and individuals to which they lend money are healthy, banks simply can’t be.
How can businesses increase their probability of securing a loan? Although the lending environment might never return to its pre-recession state, there are a few things business owners can do to improve their chances. Before applying, make sure you can provide complete, accurate and current financial information on your business. Potential borrowers also should prepare a forward-looking business plan with projections.
Include all possible situations: What happens if the recession continues for 12 to 18 months, or if the economy stabilizes and your organization experiences a surge in sales? Plan for best, worst and probable scenarios. Businesses seeking a loan also might explore SBA guarantees or consider bringing in additional investors to spread out risk and make the loan proposition more attractive to your bank.
Most traditional banks didn’t contribute to the recent economic meltdown, which was precipitated by risky practices employed mostly by securities firms, insurance companies and mortgage lenders. However, banks can be part of the solution and are advocating for responsible bank regulation that fosters credit availability. Sensible measures can help ensure the stability of the system and also facilitate the return to healthy lending levels.
By carefully listening to customers and working hard to understand their needs, banks can help those businesses grow responsibly as we gradually come out of the recession.
This article was written by Kelly Anderson, region president of Zions Bank.