Relationship lending has its own risks

Different strategies dictated for different lenders: relationship lending has its own risks

Phillip J. Britt

More than one strategy can lead to successful business-loan portfolios, lenders of several institutions and a banking regulator told attendees at the Federal Reserve Bank of Chicago’s 41st Annual Bank Structure and Competition Conference. Among the panelists represented in this article are Jeff Plagge, president and CEO, First National Bank of Waverly, Iowa; Michael D. Sharkey, president of LaSalle Business Credit, LLC, Chicago (a subsidiary of ABN AMRO NV); Tom Okel, head of debt capital markets for Banc of America Securities; and John Bovenzi, FDIC chief operating officer.

Lenders employ different but equally effective strategies to control risk and build their business-lending portfolios. Factors in creating the strategy may include size of the institution, culture, expertise, and demographics of the markets they serve.

The First National Bank of Waverly, Iowa ($150 million), has found that relationship lending helps keep risk in check while also helping the bank compete with much larger banks and nonbank lenders, said Jeff Plagge, president and CEO. One of three privately held banks in Waverly (there are also two credit unions), First National has a $100 million loan portfolio, including $35 million in small business/commercial and manufacturing, $35 million in agricultural, and $30 million in consumer and residential real estate.

The bank has a $2 million lending limit. That figure increases to $2.7 million when combined with First National’s sister bank, First National Bank of Cedar Falls. The First National Bank of Waverly maintains an 80% loan-to-deposit ratio.

To finance business start-ups or expansions, First National relies largely on the Small Business Administration (SBA) and the U.S. Department of Agriculture’s Farm Service Agency guarantees, which limit the bank’s risk to the nonguaranteed portion. These loans couldn’t be sold in the secondary market without the guarantees, Plagge added.

Many of the bank’s customers operate businesses that have been in the family for generations. First National has financed many of these companies since their inception. The bank conducts much of the business at the owner’s site and plays a dual role as a financial advisor until companies get large enough to hire outside accounting assistance or internal chief financial officers.

“We really know the customers, and, in most cases, we know their families,” Plagge said. “All of the relationships are one-on-one. These businesses are local, and we can see what is going on with them and talk to our customers. Although we risk-rate the credits, we don’t credit-score for decisions.”

That’s not to say the bank doesn’t use technology in its relationship lending, but the analysis information also is provided to the customers so that they can use the information to aid their own businesses. The bank helps retail, commercial, and manufacturing customers with year-end summaries of their results based on the analysis that the bank provides.

However, relationship lending has its own risks, Plagge explained. “Lenders may potentially lose some of their objectivity over time due to the close relationships that are formed. Customers can become very reliant on the lender for business and advice and not seek additional opinions from other third parties.”

Additionally, the bank sometimes doesn’t have enough timely or comprehensive information from customers regarding marketing, business, and long-term plans–all of which are important for the company’s long-term health and for the bank’s early recognition of any trouble signs.

Another risk in working with these types of businesses is that the owners try to do everything themselves and can easily burn out on the “office” side of the business, another important factor in the long-term success of the company and in its relationship with the bank.

“Community bank lending operations continue to change due to regulatory pressures to provide more analysis, risk assessments, and documentation,” said Plagge, who also pointed to the need for an ongoing effort to remind loan officers of good credit quality as they work to get new loans and keep the existing ones.

Middle-Market Differences

Middle-market companies can rely more on asset-based lending, said LaSalle Bank’s Michael D. Sharkey. (1) Nonbank lenders dominated asset-based lending until 1980, when more banks, leveraged buyout firms, and others entered the market. Asset-based lending began to gain acceptance among upper-tier, middle-market borrowers in 2000.

Asset-based lending uses collateral as the primary source of repayment, Sharkey said. This type of lending includes too much risk for some banks due to high leverage or refinancing of balance sheet assets. LaSalle Business Credit takes a security interest in the customer’s collateral and lends on a formula basis. LaSalle regularly monitors the collateral to ensure that it stays within the guidelines of the formula.

LaSalle controls risk in what can be a tricky lending market through a combination of in-house auditors, daily collateral monitoring, documentation, asset appraisals, and monthly financial reporting, Sharkey said.

“Cash flow is nice, but collateral is king” for asset-based lenders, Sharkey added.

Syndicated Loans Dominate Market

Credit for large businesses, by contrast, consists largely of syndicated loans. The syndicated loan market is the largest capital market in the U.S., according to Tom Okel, Banc of America Securities. Syndicated loans accounted for 60% of the U.S. debt capital market in 2004.

Institutional investors have largely replaced banks in this segment of the market, Okel added. A “lead arranger” syndicates the loans to a group of banks, investment banks, or institutional investors. These loans are attractive to lenders because they represent senior, secured debt and have liquidity through the secondary market.

Multiple tools help Banc of America Securities assess and control risk, including in-house statistical models, public credit ratings, and the Sharpe ratio, which compares risks and rewards of investments, including credit.

Regulatory Concerns

Regulators are carefully watching the evolution of the lending market, said John Bovenzi, FDIC chief operating officer. In December 2004, the FDIC and other banking agencies released for comment a proposal to revise Shared National Credit (SNC) data collection practices. The proposal seeks to improve the efficiency of the SNC loan-review process and help support Basel II implementation efforts of supervisors and banks. The key benefit for banks is that they will be able to receive timely feedback about their internal risk assessments relative to other banks with common exposures.

New risk management practices also bring new concerns, Bovenzi says:

* Do banks possess sufficient data to support all risk estimates required by Basel II and other internal risk-management models?

* Will banks’ risk estimates and risk-modeling assumptions hold through an economic downturn?

* Do risk transference mechanisms contain certain inherent systematic risks (e.g., concentrations among dealers)?


(1) To learn more about Michael Sharkey and LaSalle Business Credit, see the cover story on Sharkey in the July-August 2004 issue of The RMA Journal.

Contact Phillip J. Britt by e-mail at

[c] 2005 by RMA. Phillip Britt is a freelance writer from South Holland, Illinois, who has spent the past 12 years focusing on the financial services industry. His company, S&P Enterprises, Inc., provides features and news articles for various magazines, newsletters, and online e-zines.

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