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RMA lending outlook for 1995.

Last year is fading into banking memory as the year too many of us bankers chased too few borrowers, and 1995 is materializing as the year more and more of us would like to forget. Squeezed between price competition and the rising cost of funds, we bankers are sacrificing our profit margins as our borrowers push us harder for no-string loans. These kinds of loans are the high-risk deals that made the last recession so painful. If there is no profit reward for taking these risks, the penalty looming ahead is likely to be another round of losses for us bankers.

Just last fall, Fed Chairman Allan Greenspan warned the banking industry that it remained an open question whether current loan standards were adequate. He noted that the riskiest borrowers were not being charged sufficiently high rates to cover their significantly higher risk of default. Moreover, the Options Clearing Corporation's (OCC's) Gene Ludwig has observed signs that some banks have eased underwriting standards over the last several quarters.

The signs that Mr. Ludwig and Mr. Greenspan read include a Federal Reserve quarterly survey that tracks bankers' observations of so-called underwriting standards such as the direction of loan-to-value ratios for collateral, the requirement for guaranties, and the trend in debt service coverage ratios. The latest (January 1995) survey continues to report an easing trend in credit underwriting standards that spans the past several quarters.

According to an analysis of the survey data conducted by RMA's Agency Relations and Research Unit, most of the easing can be found in big corporate loans, and less so in smaller business loans. The RMA analysis, published in its Hot Topics newsletter, points out that the easing begins with just a few institutions in the nation's markets, but that other lenders are usually forced to loosen their standards just to keep their customers.

To the outside world - and especially borrowers - these concerns over loan covenants seem exaggerated. However, these standards underpin loans through economic downturns, and the next one is not all that far away. When top regulators like Chairman Greenspan and Mr. Ludwig express caution over credit standards, bankers know that the Fed and OCC examiners also will be expressing similar concerns.

Bankers Court Small Business

So bankers have been looking for ways to boost the reward for risk; one of the hottest opportunities has been the small business market. Many banks have redesigned their lending processes to accommodate the faster response times and lower documentation requirements that smaller businesses expect. Smaller business borrowers do not have or need all the sophisticated financial reporting of their Fortune 500 corporate big brothers. Tax returns and financial statements are more the rule than audited annual reports and 10-Ks.

So how does a bank lend to a business when its tax returns are on extension and the personal statement omits the spouse's holdings of jointly owned assets? Bank installment lenders have been making loans to smaller businesses for years without much more than a credit bureau report and some limited income information. Somewhere down there in the under $50,000 loan range there are a lot of small business operators who have been looking for credit in all the wrong places (by using 30-day revolving charge cards to buy equipment and substitute for start-up capital, or borrowing from marginal creditors at usurious rates to pay their bills).

By drawing upon the successful credit scoring techniques pioneered in consumer banking, banks have begun to employ credit scoring for business lending. In fact, 1995 will become the year that credit scoring of business loans becomes very hot. You will see more and more banks advertising their fast turnaround times and simple information requirements.

On another front, the SBA's Low Doc program will be eclipsed by its no-doc Loan Express program. Although larger banks will be making more loans to smaller businesses, smaller banks should be able to hold onto their 50 percent share of the under-$1 million loan market, if only because many borrowers will prefer the close attention and more personal service that smaller banks seem able to give their customers.

Regardless of the service in the front office, the bank offices will continue to be centralized. More commercial bankers will be split between a "hunting" sales force and underwriting "skinners." Credit policy "game wardens" will make sure the hunters are duly licensed and the skinners are taking only the game that meet the rules of the hunt. Meanwhile, there will be mounting pressure for research and development into non-financial criteria to measure creditworthiness as the regulatory community, the accounting profession, borrowers, and lenders debate how much information is needed to extend prudent and fair credit to all.

According to Federal Reserve data, commercial loans outstanding have increased about $270 billion since January 1993. This healthy rebound could have been even bigger were it not for the expansion of the capital markets into bank lending markets. Since January 1992, some 1,900 initial public offerings (IPOs) have raised over $120 billion in the stock markets for new public corporations.

The IPO phenomenon is just one of many forms of nonbank competition that bankers are trying to overcome. The 60-year-old Glass-Steagall Act prohibits banks from IPO and related investment banking activities. However, this law is likely to be revised to let banks perform some of the activities that financial institutions everywhere else in the world are permitted to do. Expect to see banks move very steadily toward broader financial services - insurance, stock brokerage, investment banking, mutual funds, annuities, and auto leasing. Today the American household has 4.75 financial services, and banks provide only 1.85 of them. Look for that statistic to change if banks have their way. Bankers know that people need banking, but they don't need banks.

Banks Juggle Risk, Competition

In summary, 1995 has become a year of intense price competition for big business loans, and many banks have turned to small business lending for a better risk-reward return. So 1995 will also be the year that most banks embrace some form of credit scoring for their smaller business loans while they continue to centralize their back-office functions and employ "hunter-skinner-game warden units" to bring in the deals. Finally, banks will continue to move toward more diversified financial service offerings. After all, as Will Rogers once said, "Even if you're on the right track, you'll still get run over if you just sit there." Banks are not sitting still, and neither is the economy. If the banking community is concerned about risk, so should the rest of the business community as the economic train steams into the second half of 1995.

Martin "Dev" Strischek is president and chief spokesperson for Robert Morris Associates (RMA), Philadelphia. He is also executive vice president of Barnett Bank of Palm Beach County, West Palm Beach, Fla.
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Title Annotation:Robert Morris Associates
Author:Strischek, Martin
Publication:Business Credit
Date:Jun 1, 1995
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