Are Corporate Loans Risky for Banks?

Lax underwriting and low profit could make corporate loans risky, especially for defaults.
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Earlier this week, Moody’s, whose CEO is Ray McDaniel, warned banks to be cautious about handing out riskier loans to stay competitive. Over the past twelve months, the number of corporate loans given out rose about 7.4%, as compared to the 0.2% growth of other loan types.

Regional banks have increased corporate lending in an effort to recover from the financial crisis and resulting flattening of profits. Now that the market is beginning to recover, though, banks are making corporate loans with lower rates in order to stay competitive and keep potential customers that might otherwise raise money elsewhere.

In this Financial Times article, Tracy Alloway explains that the average loan loss rate for corporate lending is unusually low—33 basis points in the second quarter versus the average 93 basis points over the past 25 years. That’s good news for lenders, but experts at Fitch say that those loss rates are unsustainable. Should the loan default rate rise once more, banks that had looser underwriting would suffer.

Underwriting is the process by which banks and other financial institutions assess the eligibility of customers. By nature, lending requires banks to take on some risk for the customer, and when a loan is approved, the bank, or underwriter, is responsible for raising the necessary capital. Profit is made when there is a positive price difference between what banks loaned out and what they were able to bring in from investors or broker-dealers. When underwriting is looser, or weaker, things get riskier.

“Commercial loan growth has led to heightened competition, resulting in weaker underwriting standards and narrower pricing,” said Megan Snyder, a Moody’s analyst. “This growth has occurred while corporate borrowers have become more levered as their debt has increased more than their profits.”

So, are banks really at risk with these loans? Currently, they're not in bad water, but if loans begin defaulting at higher rates, big lenders with small profits will be in trouble.