Tighter Credit: Friend or Foe of Business?

Terrence Wall appeared to be sounding an alarm when he told IB that bank regulators are advising bankers to do the "tighten up" on lending. This approach would appear to place business lenders at cross-purposes with those who are trying to ensure a healthy supply of capital, but Greater Madison bank executives don't believe business borrowers should be overly concerned that credit will be hard to come by in the next 12 months.

The second quarter "Banconomics" report issued by the Community Bankers of Wisconsin indicates that consumers already are tightening up. Total assets and net loans and leases decreased by 0.9% over the first quarter of 2009. With consumers and businesses shedding debt and being more conservative in assuming additional debt, net loans and leases declined by 2.6% and total deposits increased by 4.3% among all banks.

Wisconsin's 270 banks with less than $1 billion in assets fared better than its 12 banks with more than $1 billion in assets, as the smaller banks saw total assets rise by 1.4% (compared to -2.1% for the big banks), total deposits increase by 3.8% (compared to +4.7% for big banks), and net loans and leases increase by 1.2% (compared to -4.6% for big banks).

Daryll Lund, president and CEO of Community Bakers of Wisconsin, a statewide trade association, said the industry has experienced challenges associated with declining property values and other sources of collateral, and regulators are carefully analyzing the banks' loan portfolios and balance sheets. The banks, in turn, have taken a closer look at their underwriting standards. For this look at the environment business borrowers will encounter in 2010, we spoke to several area bankers.

First Business Bank

Corey Chambas, CEO of First Business Financial Services, parent of First Business Bank, doesn't agree that tighter lending is at cross-purposes with attempts to make credit more available. While the Federal Reserve and political power brokers want banks to lend money, Chambas doesn't think anybody wants banks to make bad loans. Thanks to the recession, banks have more bad loans in their portfolios today, so there is more ammunition for regulators. "Are regulators coming into banks and bonking bankers on the head when they don't like a loan? Absolutely. But they are not doing that on the best loans that banks make; they are doing that on the worst loans that the banks have," Chambas stated.

In many cases, evaluating whether a loan is good or bad is highly subjective. According to Chambas, two banking professionals or even two bank examiners could look at the same loan and come to different conclusions.

"We live in a gray world," he said. "Nothing is black and white. It's not like residential lending, in the days when residential lending was done well, where you have to have a credit score, you have to have this loan-to-value data, and boom! Check these boxes and determine that it"s a good loan.

"It's not like that in business lending. It's a matter of degrees of how good or how bad something is. You can have an examiner come in and they may agree with the bank on what's a troubled loan, and sometimes examiners come in and they look at a loan, and there may be a loan that we think is a troubled loan and they pass on it."

Having said that, Chambas noted there are important subjective criteria, such as cash flow and collateral, and those are the things that bank examiners focus on. Meanwhile, bankers concentrate on the borrower's character, which is more of a judgment call, even though factors like credit score come into play.

In terms of what business borrowers have to look forward to in the next six to 12 months, Chambas does not think there will be a difference in approach between working capital and long-term loans. Both types of loans should be available, depending on business performance. If a company is not performing well, it's going to be tough to secure credit because "any silly lending has gone away," Chambas said, and banks will only lend money with cash flow and collateral in mind.

With the economic pie shrinking, Chambas said everybody is deleveraging, or shedding debt. For a business whose sales are down by 20% year over year, their receivables should be down by 20%, their inventory should be down by 20%, and therefore their line of credit borrowing needs should be down by 20%.

"That's a function of the economy," Chambas noted, "and that's the one place where the news is really misleading. I don't think bank lending is down because banks are not lending. There are just not as many quality companies that have lending needs as there were before, and a lot of the quality companies are borrowing less because they have deleveraged."

In terms of the national banking industry, Chambas thinks there will be more than the normal amount of bank closings in the next two or three years. He believes healthier banks will gobble up the assets of weaker ones after they fail because of the capital implications. "If you were to buy a healthy bank, you would pay a premium to make that acquisition," he said. "It takes capital, and that's the one thing that is clearly tight in the whole industry — the amount of capital that banks have. Capital is a cushion, particularly at banks that are continuing to have any kind of losses, so they are reluctant to use that to make acquisitions."

Chambas commented on the most recent bankrate.com rating, which gave First Business Bank three stars out of a possible five stars, meaning it's a performing bank, whereas four stars signifies "sound" performance and five stars are given to "superior" banks. Chambas doesn't put much stock in bankrate.com because, in his view, its methodology is not transparent. "I think there is more complexity to looking at a bank and analyzing a bank's strength than to just run the numbers through a model," he said. "There is a lot to look at in terms of the markets that banks are in, what's happening in those markets, and what business lines banks are in."

Chambas believes the bank is well positioned to serve business clients in 2010, in part because "chaos creates opportunity," and there is chaos in the banking world. The bank's sweet spot in terms of clientele is non-retail companies between $5 million and $75 million in annual sales. "When there is turmoil in the banking industry, there are opportunities relative to finding employees who aren't typically there," he said. "It's an opportunity for us to get talent, even more so than in normal times, because of the issues other banks have."

Johnson Bank

Greg Dombrowski, president of Johnson Bank, said bank regulators shouldn't have to tell bankers to restrict credit. Regardless of what regulators say, hindsight should tell banks that credit was too loose until a couple of years ago. "Are the regulators telling us to pull back? They might be, but if bankers are not telling that to themselves, they are not being very introspective," Dombrowski said.

In the next six to 12 months, he expects the contraction of leverage in the economy, with leverage defined as the relative amount of debt that businesses are willing to take on their balance sheets, to continue.

Until the financial crisis hit, the degree of comfort with leverage rose dramatically in this decade, but when leverage rises, so, too, does risk. When banks constrict their leverage, it means there is less money available to lend.

"When you look at traditional economic models, when supply is constricted and demand is constant, what happens is the cost of that capital is going to rise," Dombrowski added, "and that's what I think we're going to see on a relative basis. I think the cost of obtaining capital is going to be higher, and that will play out with higher interest rates, potentially. It's also going to play out with less leverage in a deal. In other words, the bank is going to want to see more money down into a project than it has in the past."

As long as a business isn't over-leveraged, however, credit should be available. The area where Dombrowski thinks credit has been and will continue to be more severely restricted is with investors who borrow money to develop commercial real estate, whether those projects are multi-family apartment buildings, condominiums, or retail strip centers. He said regulators make a distinction between commercial real estate held for investment and real estate that is part of an operating business.

"Because of that, developers and investors who are trying to develop projects where they are not an owner-occupant will face tighter scrutiny because that's where there have been significant losses."

For the purpose of regulating banks, Dombrowski said bank examiners have said a well-capitalized bank is one whose regulatory capital is equal to or greater than 10% of its assets, but that bar might be raised. If regulators were to establish a new definition for well-capitalized banks, and 10% becomes 12%, that would represent a 20% increase in the amount of required capital, and the pricing on loans would have to increase if the bank hopes to deliver the same return to its shareholders.

Dombrowski is not surprised that bank deposits rose and loans decreased in the second quarter Banconomics report because there were still people taking money out of the stock market well into the spring of 2009, when the market had bottomed out. With consumers deleveraging their personal financial statements, and business activity contracting, Dombrowski said the report seems consistent with what he would have expected.

He draws a distinction between failing national banks — he counts 96 bank closings so far this year, and notes the FDIC expects more in 2010 — and more conservative banks in Wisconsin. "I think you have to be careful with how much fear is put out into the marketplace," he said.

"We've got a very strong banking community in Wisconsin. That's not to say that one couldn't fail, but we're in a much better condition here than some parts of the country."

Thanks to an established process in which the FDIC basically nurses troubled banks, it's rare for bank failures to happen suddenly. "The examiners are very concerned about the banks if there are some problems," he explained. "It eventually escalates to a Memorandum of Understanding (MOU) that is a public statement, and that tells you the FDIC expects there will be significant changes made to retain viability on a long-term basis.

"If I was a business owner, I wouldn't get nervous just because a bank has a bad quarter, or there is some minor negative news that comes out," Dombrowski added. "That should not be a cause for panic. The real sign is if there is a public announcement in tracking how severely impacted your bank has been."

With the lion's share of banks, examiners are not only reviewing loans, they are evaluating the processes that banks use to run their business, and they are assessing the management that is implementing the processes. "When they do that, it avoids the circumstance of just going along and all of the sudden a huge problem comes up, the bank goes under an MOU, and 60 days later the FDIC is closing the bank because it's failing miserably," Dombrowski said. "You generally don't see that. There are very rare cases where you have this accelerated deterioration taking place."

Dombrowski considers FDIC monitoring a better sign of bank trouble than the bankrate.com rating, which gave Johnson Bank two stars out of a possible five, given to a bank that bankrate.com believes is performing below its peer group. He said bankrate.com won't disclose how it does its calculations. "We don't understand their methodology," Dombrowski said. "We've asked, but they won't share their methodology, and so I can't comment on how valid their assessment tool is."

Regarding Johnson Bank, Dombrowski said the institution is well-positioned, well-capitalized and still profitable to serve clients whose annual revenues range from $5 million to $100 million. Those clients face challenges in this economy, which puts more pressure on the bank. "Two years ago, there was high optimism when things were going great," Dombrowski noted, "and now we have some clients that are having some challenges. We really have to work for our salary right now."

The real difficulty, he said, is when you have a longstanding client that begins to experience financial losses and doesn't have the wherewithal to fund them. Do you put more money into that company to help save it, or do you conclude that the company can't make it?

"As bankers, we're having to make those decisions a lot more often today," Dombrowski said. "They are not easy discussions, and there are some sleepless nights."

State Bank of Cross Plains

Jan Patrick Hogan, senior executive vice president and chief operating officer for State Bank of Cross Plains, said the bank enjoys a variety of different-sized business relationships. It has clients that gross between $50,000 and $25 million in sales.

Hogan, too, does not believe that bank regulators are intentionally trying to prevent banks from lending. "Our economy in southern Wisconsin has been so strong for so long that I believe the banks and the regulators softened on their underwriting criteria," he observed. "This recession and times of deflation have been a wake-up call to the business owners, the banks, and the regulators.

"Our bank continues to be aggressive regarding commercial lending, and we have plenty of money available for business loans, lines of credit, and long-term capital loans."

Regarding the recent Banconomics report, Hogan is not surprised that smaller banks are performing better than the big boys. Regarding Wisconsin banks with over $1 billion in assets, Hogan noted that three or four very large banks make up a large percentage of the assets, and several of those banks are working through difficult times. In some cases, they have explored out-of- state markets where the economy is much weaker than in Wisconsin.

The report also indicates a slight decline in total assets and loans from 2008 to 2009, which Hogan attributed to a substantial decline in start-up business opportunities. "I think that a number of new business projects have been put on hold to see how the economy shakes out in 2010," he noted.

Over the next 12 months, Hogan expects a combination of additional bank closings and bank sales, as 2010 brings more economic pain. "The combination of increased regulatory pressure and cost, such as FDIC insurance, over the next few years will cause additional banks to fail or sell," he predicted.

As for bankrate.com rating, which gave State Bank of Cross Plains three stars out of a possible five stars, Hogan noted that every bank rating service uses different criteria to establish subjective ratings. He said the criteria and ratings that are important to State Bank of Cross Plains, especially regarding safety and soundness, are regulatory ratings. Recently and historically, he said the bank has received favorable regulatory ratings.

Hogan said the FDIC defines an adequately capitalized bank as one that has 5% tier-one capital; at 7.63%, State Bank of Cross Plains' capital level is substantially higher. "We feel we have managed our capital very well over the last 10 years while acquiring two local community banks and opening two additional offices," he noted. "We have continued to pay over $1 million in dividends to our shareholders in 2009, and we anticipate a very respectable return on equity to the shareholder."

McFarland State Bank

David Locke, president and CEO of McFarland State Bank, said Wisconsin banks generally are in better shape than most. He noted that the average bank in Wisconsin has a loan-to-deposit ratio, which is an indication of bank liquidity, of about 100%. The purpose of liquidity is to meet the daily needs of consumers when it comes to drawing upon their deposits.

"The economic meltdown we found ourselves in a year ago was principally the result of a lack of liquidity within the financial system," Locke said. "So bank liquidity has been strained in the past 12 months, and I think regulators have rightly taken note of that and put some pressure on banks to rebalance their portfolios and realign their balance sheet for a lack of liquidity. That's the crux of regulatory pressure that affects a banks' ability to lend."

Locke does not view regulatory pressure as a worrisome development, especially during a broad-based recession. He said tighter lending probably is necessary right now because the economy is under stress. "Consumers are not spending like they used to, and that all trickles down through the business sector," he explained. "When a business is under stress, and if they are highly leveraged, they are going to have some problems. To have a more conservative time right now is not necessarily a bad thing, and the process is going to be fraught with some pain because you don't turn around the Queen Mary in a short period of time."

McFarland State Bank targets businesses with sales in the $1 million to $50 million range. In the next six to 12 months, Locke predicted that credit will be available to businesses, but on different terms. The bank's lending was up June-to-June over the previous 12-month period, but there is a difference in the requirements for credit. "Cash-flow requirements are higher, and leveraged loan-to-value limits are lower, so credit has just tightened up," Locke said. "That's all there is to it."

The second quarter Banconomics report struck Locke as a "flight to quality." He thinks small businesses and consumers like the ability to touch things within their own marketplace; whereas they once might have done business with somebody that provides something over the Internet, through an 800 number, or a bank in a remote location, those days are over. There is much higher degree of comfort when they can walk into their financial institution and sit down and engage someone face to face, Locke explained.

McFarland State Bank has been in business for 105 years, surviving the Great Depression, and Locke said it will outlast the current situation by sticking to fundamental banking practices. "We know our customers, we stick to loans in our market, and we don't go out of state," he noted. "We don't do derivatives. We don't do subprime lending. We don't buy securities that we don't understand. A few years ago, that was pretty boring. You know what? Boring is back in vogue."

Another factor in that boredom is how the bank has stuck to underwriting its loans. Many times, Locke said bankers are not doing a borrower a favor if they actually make the loan.

He said underwriting a loan that truly benefits the borrower, as well as the bank, is critical and that has been born out by the financial meltdown. "There were a lot of mortgage brokers and investment banks that were more than happy to crank out loans like crazy to people who had no business borrowing the money and being put in those positions," he stated. "Ultimately, of course, that melted down and that's what brought Freddie Mac and Fannie Mae down. Who would have ever thought a few years ago that those two agencies would go into conservatorship and the government would take them over?"

With five stars, McFarland State Bank is highly regarded on the most recent bankrate.com rating. Locke defended bankrate.com, saying it provides a pretty good overview of the five areas that regulators review as part of the CAMELS rating system: capital adequacy; asset quality (as measured in low loan delinquency); management capability; earnings; liquidity; and sensitivity, which pertains to interest rate sensitivity.

According to Locke, small businesses and consumers who want bank information are hard pressed find it. The FDIC Web site has information, but it's hard to navigate and bankrate.com does a good job of providing an easy-to-understand analysis.

Monona State Bank

Paul Hoffmann, president and CEO of Monona State Bank, said business borrowers must be prepared to provide more information to their banker than they have in the past, especially with more competition for loans.

"Some of the banks are just looking a little bit deeper into the numbers," Hoffmann said. "I still think banks are lending. I know we are. I think there is money to lend out there. It's just got to make sense, which would seem to be smart advice in any business cycle."

Hoffmann thinks there is alignment between the Banconomics report and market realities, adding that increased savings comes as no surprise, nor does a desire to bank closer to home. How soon might some might abandon the safety of bank deposits for the volatility of the stock market? "I think there will always be people who are comfortable with the market," he said. "As for the people on the sidelines, you have to wonder about people in their later years of retirement. Will they still invest in the stock market to the degree they were?"

He agreed that Wisconsin banks are in a much better position than banks nationally, and cited [three-stars on bankrate.com] Monona State Bank's regulatory capital-to-assets ratio of nearly 14% as proof of the bank's sound condition.

Final Deposit

While established businesses that have positive cash flow and strong balance sheets are still able to obtain credit, the requirements are much different for start ups. According to Lund (Wisconsin Community Bankers), it's going to depend on the quality of the management team and how much of their own capital they bring to the table — not only to get the business started, but also to withstand any initial shortfalls in getting the enterprise up and running.

"It's really on an individual basis," Lund said, "but I think it's about the business plan, the quality of the management team, and the sources of equity capital that they are able to bring to the deal."

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