The business loan market is a tale of two cities. For some “It [is] the best of times,” yet for others “it [is] the worst of times.” Big businesses have lenders offering a broad array of products at ultra-cheap rates, while many healthy and dynamic small and medium-sized businesses can’t get their telephone calls returned.
Successful middle-market and lower-middle-market business owners can’t figure out why they aren’t being invited to the low interest rate party being thrown by the Federal Reserve and are becoming increasingly convinced bank lending is an inside game from which they are being excluded. For these businesses the Fed’s easy money policy means nothing.
Everyone seems to have a favorite scapegoat to blame when explaining why some small businesses are still having trouble getting bank loans. Business owners blame bankers, while bankers blame regulators. In turn, regulators blame Congress. Democrats blame Republicans, and Republicans blame Democrats.
Like most things in life, the real answer is nuanced and complicated. In fact, there are at least five major reasons why good borrowers with plenty of cash-flow, net worth and collateral have a tough time finding bank loans.
Reason #1. Loan Size — It Matters A Lot
Anyone who says size doesn’t matter is lying — at least when it comes to business lending. Size matters a lot and perhaps more than any other factor determines which bank will and won’t provide a credit facility. Borrowers that need loans between $2 million and $10 million are finding that they have the fewest choices and pay the most for their money.
All banks have legal lending limits that they cannot exceed when making loans. A bank legal lending limit is the maximum amount that any particular bank can lend to a single borrower or related group of borrowers. Also, banking regulators want banks to spread their risk by having a diversified portfolio and don’t want them making a lot of loans at or near their legal lending limit. As a result, for most banks the effective in-house lending limit is considerably less than its legal lending limit.
As of December 31, 2012, there were 7,092 banks in the United States. Approximately 80% of the banks had less than $500 million in assets and a resulting small lending limit. To put the size problem in prospective, the vast majority of banks don’t have the financial firepower to be the only lender to even a small McDonalds or Burger King franchisee. They can’t be the only bank providing working capital financing to a mid-size manufacturing company, are too small to finance a successful new car dealer and really shouldn’t take on a mid-sized medical, accounting or law practice.
As a general rule, borrowers that need loans with balances consistently larger than $2 million are too big for about 80% of the banks in the U.S. Surprisingly, only about 6% of the banks in the U.S. are larger than $1 billion in size and have the capital base to concentrate on middle- and lower-middle-market businesses.
Unfortunately, many of the banks larger than $1 billion aren’t active in the commercial lending market because they are savings banks, thrift institutions, non-lending subsidiaries of foreign banks, credit card banks or trust banks. None of these types of specialized institutions has commercial lending as one of its core products. In fact, there are only a few hundred banks in the United States that have both adequate size to service borrowers that need more than $2 million and offer commercial loans as a core product.
The largest commercial banks have very professional lending units and offer a broad array of products and services to borrowers. Not surprisingly, these large banks own and originate most of the commercial loans in the U.S. Unfortunately, despite what they say in their marketing campaigns and in front of the TV cameras, the large national banks don’t want to deal with lower-middle-market businesses and don’t offer their best products to smaller borrowers.
For the most part, a $25 million minimum loan size is needed for an invitation to the big bank club. And, borrowing $50 million is the bare minimum to get accepted into most exclusive lending group — the “syndicated bank loan” society, where the cheapest interest rates are offered.
Even smaller regional lending institutions have minimum loan size requirements. Generally, borrowers need to have a $10 million loan size before they will attract the attention of regional lenders. For borrowers that need more than $2 million but less than $10 million from their bank, there are precious few alternatives.
Reason #2. Geography —
In Love and Lending, Long Distance Relationships Don’t Work
The second most important factor that hurts small business borrowers is geography. Banks want to lend to borrowers in their natural market area. Regulators also take a dim view of out-of-area lending and credit exposure because they have empirical evidence demonstrating that banks that lend to borrowers outside their natural market area have higher loan losses than banks that concentrate on loans in their neighborhood. The regulators want banks to lend in their community, where bankers know the borrower and what their collateral is actually worth.
The geography issue isn’t limited to the location of the borrower’s corporate headquarters, but also includes where all of its operations and collateral are located. Borrowers that operate across regions, but are too small for the large national banks, have a particularly tough time finding a good lender.
For example, a Boston-based manufacturer needing a $6 million credit facility that has its offices in Massachusetts, a manufacturing plant in New York, another plant in Wisconsin and a distribution center in Oregon will have a very tough time getting a bank loan. At $6 million, the loan is too small for a national lender but is not confined to the natural market area of any one region.
Simply based upon geography and size, the above Boston-based manufacturer doesn’t have a lot of financing alternatives. Among the 7,092 U.S., there are no more than a handful of institutions that will even answer a telephone call from this prospective borrower.
Reason #3. Loan Syndication — Sharing Isn’t the Answer
Helen Keller’s adage that “Alone we can do so little. Together we can do so much,” doesn’t apply to middle-market commercial lending. Just like out-of-area lending results in higher loan losses, strategies that rely upon combining small banks across geographic areas don’t work. These loan participation pools generally performed poorly during the 2008 credit crisis, and the FDIC doesn’t like them.
Moreover, regulators don’t want banks using loan participations to take on credit risks they don’t understand and can’t control or indirectly do what would otherwise be prohibited on a standalone basis. As a result, it isn’t really practical to bootstrap together a bank syndicate by combining two, three or four small lenders into a single facility.
Reason #4. Lending Standards — There Are Rules That Need to be Followed
Bankers who say that the rules changed after the 2008/2009 banking crisis are wrong. The rules for small business and lower-middle-market lending are essentially unchanged. What is different is that regulators recently decided to start enforcing their rules rather than trusting bank executives to self-regulate.
As an example, the rules for providing business loans secured by accounts receivable and inventory have been around since March 2000. And, the rules concerning floor plan lending to retailers haven’t materially changed since May 1998. These rules are set forth in easy to understand and very detailed “how to” manuals published by the Office of the Comptroller of the Currency and can be easily found on the Internet.
Unfortunately, only a few banks under $1 billion in size comply with the lending rules, and as result only a few banks can participate in the collateral-dependent secured commercial loan market without being criticized by their regulator.
That doesn’t mean that banks that don’t make an effort to comply with the rules and therefore don’t lend are bad banks or are turning their back on the business community. The problem that small banks have is that it is expensive to comply with the lending rules. Unless banks are going to make a large number of accounts receivable and inventory-secured loans or inventory-dependent floor plan loans, it just doesn’t make economic sense to spend the money required to comply with the rules.
Small banks in all but the most densely populated and largest metropolitan markets can’t make money providing collateral-dependent loans and still comply with decades-old regulations. Since regulators are now enforcing these regulations, many small banks have pulled out of collateral-dependent business lending and business borrowers are finding that their financing options have been restricted.
Reason #5. Product Mix Counts —
21st Century Businesses Need 21st Century Loan Products
The most dynamic businesses have the most diverse borrowing needs and require the broadest array loan products. While large companies get these products from large banks at very low cost, middle- and lower-middle-market companies have almost no access to similar products and pricing.
Some very 20th century businesses are finding that the 21st century banking sector isn’t supporting their needs. For example, smallish industrial manufacturers are finding it difficult to compete with larger foreign competitors because of a lack of banking support.
There is, for example, a growing group of automobile parts companies that import raw materials from outside the United States, own and operate multiple manufacturing plants that are close to their domestic customers, distribute finished goods through consumer direct channels, selling most of their products upstream for inclusion in final assembly and use excess manufacturing capacity to produce specialty export parts for foreign customers.
These distinctly 20th century metal bending and fabrication businesses need their banks to provide accounts receivable and inventory working capital financing, floor plan financing, equipment term financing, real estate secured mortgage lending and import/export trade facilitation and credit.
While these products are delivered “off the shelf” by large national banks to big customers, there is literally no small bank alternative for such lower-middle-market commercial loan customers.
The Hollowed-Out U.S. Banking System
After a generation of bank consolidation, the U.S. banking industry has been hollowed out from the middle. While big banks deliver diversified, professional and cost-effective products and services, they just don’t do it for middle- and lower-middle-market businesses.
On the other hand, small banks lack balance sheet size, geographic reach, back office infrastructure and product mix to satisfy the needs of most middle- and lower-middle-market businesses. Regulators that are rightfully concerned about future loan losses and credit quality are further restricting small bank credit in an effort to prevent today’s new loans from becoming tomorrow’s mistakes.
If small and community banks are to regain their relevance to Main Street, the blame game needs to end and a new community banking business model needs to begin. In the meantime, dynamic middle- and lower-middle-market businesses will continue to get their credit needs filled by non-bank lenders and through private equity and mezzanine financing.
Mark Sunshine is chairman and CEO of Veritas Financial Partners. Previously, he was president of First Capital/Siemens First Capital.