Commercial Lending Trends: A Back-to-Basics Approach to Serve Members, Manage Risk

After experiencing explosive commercial loan growth in 2022, the pace of new loan originations is moderating throughout the industry on a national basis. In aggregate, credit unions funded more than $52 billion in commercial loans in 2022, a 25% increase over the previous year. Commercial loan balances increased by over 19% in 2022.

Whether it is the increasing rate environment, uncertain economic times or tightening liquidity, credit unions and business members face a much tougher lending environment in 2023 than they have seen in quite a while.

In the current environment, credit unions have an opportunity to build brand loyalty for years to come. Now is time to refocus on the basics of commercial lending to make sound decisions without overreacting to the news of the moment.

With free-flowing liquidity and ultra-low rates in past years, some commercial loan decisions may have been made to keep pace with the competition. However, what makes credit unions unique is our not-for-profit cooperative structure. This focus on serving members and communities makes it easier to stay the course and focus on proper loan pricing, credit culture, the economy and the creditworthiness of business owners.

Loan Pricing and Fees

One of the most important factors to consider when making commercial loan decisions is pricing. While many credit unions set rates based on the Prime Rate, I encourage you to consider indexes based on margins above Treasury rates. This will provide a transparent and objective index that credit union decision makers and borrowers can follow to monitor returns on zero risk investments versus the increased risk of commercial loans.

The inverted yield curve has highlighted the flaw in Prime Rate based notes versus Treasury rate based indices. The Prime Rate is designed to be a short-term interest rate, while most commercial loans are fixed for at least five years.

Fees are another factor often overlooked by credit unions. There is borrower value in a federal credit union’s inability to charge a prepayment penalty. A well-priced fee can help offset prepayment risk and compensate the credit union for the extensive work required to book a commercial loan. At MBFS, our average loan origination fee was 0.96% of the loan amount in 2022. Fee income is often the first concession credit unions make in negotiations. However, with limited liquidity in financial markets recently, fee income could be more valuable and necessary than ever.

Credit Policy and Culture

There is a reason why commercial credit books and resources from 30 years ago look eerily like the resource materials you’ll find today. The same sound credit practices outlined in your commercial credit policy from years past were built to last through the ebbs and flows of economic cycles, and are essential to consider when making commercial loan decisions.

Your credit policy sets the general guidelines and rules used to evaluate the creditworthiness of a borrower, but no policy can capture every scenario. Creating a proper credit culture where board members, management and staff are aligned on which loans are desirable and undesirable is a must. Credit unions have several unique advantages compared with other lenders. We can complement the financial analytics of a loan with a grassroots understanding of the community in which our business members operate – for better or worse. Lenders want to make loans and can feel pressure to make high profile loans. However, there is no substitute for creating a strong credit culture to ensure the long-term success of commercial lending operations.

Economic Factors

What are the macro-economic factors credit unions should consider when making commercial loan decisions? More importantly, what are the micro-economic factors to consider in your loan decisions?

What is happening in the world can significantly impact the ability of a business to repay its loans. For example, we have seen the inflation of the past year stress small businesses unable to pass through costs to customers. Local and regional trends can also impact business members’ ability to generate cash flow to repay debts. Good news and bad news happens daily. It’s important to take a broader view and avoid focusing on the daily events at the loan committee table, but rather the long-term economic factors locally and nationally that impact repayment.

Creditworthiness of Business Owners

Good business loans start with quality business owners. The creditworthiness of business owners is a critical factor that credit unions need to consider when making commercial loan decisions. While the traditional factors of credit scores, income and personal financial statements are paramount in determining creditworthiness, there are other factors to consider as well. The experience and expertise of business owners in managing their businesses through various business cycles shows that the owner is committed to success and has developed at least some resilience. There is no substitute for a track record of success, which indicates a strong likelihood of repaying their loans and reduces the risk of default for the credit union.

Focus On the Basics

Economic swings happen and in today’s 24-hour news cycle, it is easy to change or rethink decisions daily. However, well-reasoned loan pricing decisions based on projections over the next few years and strong credit cultures are the foundation of a healthy business lending program. To make informed decisions about commercial loans, credit unions need to have a thorough understanding of the objective and subjective factors impacting the businesses and owners looking to borrow. During the Great Recession, credit unions kept lending by focusing on these well-established credit standards. The same rules and philosophy should continue in 2023 and beyond. Those credit unions that stay the course and continue to lend will find themselves with stronger brand loyalty and financials than those trying to time the market.

Mark Ritter is CEO of the CUSO Member Business Financial Services and its subsidiary, Nu Direction Lending, in Philadelphia, Pa.