Why do Small Community Banks Struggle with ABL?
One unexpected result of COVID-19 is the reexamination of asset-based lending initiatives by community banks. Smaller (sub-$10 billion) community banks have been exiting or evaluating an exit from ABL before they really gave it a shot. It should be noted that most entered during a great economy in preparation for a downturn, yet many decided to reverse course during a downturn, which is the opposite of what should be expected. Why did smaller banks get into ABL in the first place and why would they choose to leave now? There are actually good answers if one digs deeper.
ABL provided an obvious solution to growing pains. Many of the banks that grew via acquisition over the past 10 years formed groups in advance of what they knew would be a pending downturn. Two main enticements made ABL attractive to community banks: higher margins and lower perceived risk. The margins and fees on ABL products were higher than what these banks’ mature portfolios provided. Second, the perception of lower risk was created when community banks compared their own non-performing and charge-off ratios with what most proficient ABL businesses experience.
The ABL product, as it turns out, is a great fit conceptually but difficult fit operationally and organizationally. ABL is a people-intensive, fundamentally different product than traditional C&I community banking. Community banks are mostly real estate-driven and not set up to manage or underwrite tougher credits. Also, most community bankers are not trained as asset-based lenders. Mitigating weaknesses through enhanced monitoring and offsetting poor cash flow with availability blocks or boot collateral are far from a community bank’s appetite. It’s a different business and business model, and when push came to shove, smaller banks were not prepared to transition clients to ABL or on-board them like the bigger banks who have resources in place.
The community banking business model is the definition of relationship banking at its finest and very heavily real estate-oriented. The C&I credits are traditional cash flow loans with light covenants and quarterly reporting. Community banks thrive off deposits, real estate and relationship managers who can play an integral role with each client. ABL is the fundamental opposite — no real estate, no deposits and relationship handed off to a portfolio manager. Said differently, it’s a transactional product that does not come with all the ancillary business of a “good” community banking deal. It makes sense that community banks would think about collateral management during the boom years and even put folks in place, but truly handing off a relationship and changing the dynamic has proven to be difficult.
The relationship between a business owner and their respective community banker is a tried and true bond. Most community bank relationship managers truly manage credits cradle-to-grave, with grave being sale or exit. ABL defines cradle-to-grave very differently because grave in ABL is typically a liquidation vs. exit in a community banking world. ABL is not in the DNA of most C&I trained bankers and it’s a very hard process to transfer a client to hands-on borrowing base management and field audits vs. exiting the client. Moreover, having ABL capabilities means having the infrastructure and for most banks with sub-$10 billion of assets, it is just hard to justify, particularly in the early stages of an ABL business when expenses are high and there’s little or no income. In addition, most community banks that even reach $10 billion in assets are less than 25% C&I, so the math gets further compounded as to whether it is worth it.
True community banks run very lean when a relationship manager provides hands-on client service to their own book of clients. You underwrite the character of the person just as much as the business because community banks simply don’t have the credit monitoring capabilities that asset-based lenders and big banks have. This business model requires a lean approach and reliance on local real estate, treasury and stable credits. It’s relatively scalable given the relationship manager and the chief credit officer review each credit quarterly. Community banks by definition are smaller than the big regional and national banks, so the chief credit officer is often the work-out officer who decides whether to go deeper in the credit or exit.
Realizing it or not, community banks entered a people-intensive, high-touch, low treasury, transactional lending business. It was not surprising that many community banks ventured in toward the end of a cycle, but very surprising to see them rush out at — or in some cases before — the start of a downturn. It is unclear whether the credit culture clash, necessary investment in back-office collateral monitoring or transfer of relationship was the key determinant in many community banks changing course. This article in no way is meant to criticize smaller community banks trying to be innovative, but is meant to point out the economic, organizational and cultural difficulties as it pertains to integrating ABL into a traditional community bank.
What should also be noted is that the community banks who have succeeded have significant scale. Community banks such as Wintrust, Synovus, Western Alliance, Berkshire Bank, First Financial and First Midwest, among others, each invested significant resources and many years to build successful ABL shops. It should be noted that these banks have scale, assets and resources that rival regional banks. They also have such large asset bases that the overhead associated with ABL can be better absorbed. Give credit to these small community banks for being innovative and for sticking to their knitting. Fortune seems to favor the bigger rather than the bolder when it comes to ABL and community banks.
Link to article here.