The Banking System: Commercial Banking - Business Lending
ByStephen D. Simpson, CFA
Commercial lending - lending to businesses - is really a two-tier market in the United States. At the level of large corporations, bank lending is not as significant in the United States as in many other countries, as there are a larger number of accessible alternative sources of funds for businesses, like the bond market. For small businesses, though, bank lending is often a crucial source of capital.
Business lending includes commercial mortgages (loans used to purchase buildings), equipment lending, loans secured by accounts receivable and loans intended for expansion and other corporate purposes. Traditionally, the residential construction industry has been a major borrower; using bank loans to acquire land and pay for the construction of houses or apartments, and then repaying the loans when the dwellings are completed or sold. Many banks effectively "double dip" in their lending to the housing market, lending money to homebuyers as residential mortgages, and lending to developers and contractors engaged in building new homes.
Business lending can also take the form of mezzanine financing, project financing or bridge loans. Mezzanine lending is not all that common for most commercial banks, but bridge loans and project financing is often extended on a short-term basis, until the borrower finds a more permanent source of funds.
Banks also frequently use their capital to acquire investment securities. Regulators in all countries require that banks hold back some percentage of capital as reserves. Debt securities issued by the national, state, and local governments are frequently treated as safe as cash, or close to it, by regulators. Therefore, banks will often hold these instruments as a way of earning some income on their reserves.
Many banks will also buy and hold securities as an alternative to lending. In cases where prevailing loan rates are inadequate to satisfy a bank's risk-weighted pricing, certain debt securities may be more attractive as alternate uses of capital. Accordingly, the bank sector is a major buyer of government debt securities. Banks are also frequent buyers of municipal bonds. In the case of so-called "bank qualified bonds," banks can earn interest that is free from Federal taxation.
It is less common for banks to hold common stock. Though many common stocks do pay dividends, U.S. regulators have traditionally punished equity holdings by giving them poor risk weightings.
It is much more common overseas for banks to hold equity. Many banks in Europe and Asia view their relationships with businesses as something akin to partnerships, and will hold equity for a variety of reasons, including both a stake in the upside of the company, as well as the influence that significant ownership can provide.
In the past couple of decades, non-interest income has become a key component of the profits of many commercial banks in North America. As the name suggests, this is income that does not originate as interest on loaned funds. Non-interest income typically requires minimal risk for the bank and minimal capital. It is not fair to say that non-interest income is "free money," employees still have to be paid, for instance, but it is accurate to say that non-interest income often carries very attractive margins and returns on capital, and is a crucial source of income for many banks.
Fees On Deposits and Loans
Customers may revile bank service fees, but they are a large part of how many banks make money. Banks can charge fees for simply allowing a customer to have an account open, typically if, or when, the account balance is below a certain break-point, as well as fees for using ATMs or overdrawing accounts. Banks will also earn income from fees for services like cashier's checks and safe deposit boxes.
Banks also frequently attach a host of fees and charges when they make loans. While banks gamely try to defend these fees as important to defraying the costs of paperwork and so forth, in practice they're a honeypot of profits for the bank. Congress and has moved aggressively, in the wake of the subprime crisis, to restrict some of the fees that banks can charge customers. In many cases these new rules simply mean that customers have to actively select and approve certain account features, like automatic "overdraft insurance," but there are increasing limitations on what services banks can charge for, and how much they can charge.
Business Operations – Insurance and Leasing
nsurance is another surprisingly popular non-banking activity for many banks. Perhaps the popularity of insurance is due to its similarities to banking; both businesses are predicated on adequately evaluating and pricing risk, and supporting a large amount of liability on a thin layer of capital. Both businesses also happen to be highly regulated, though insurance is regulated almost exclusively at the state level.
Likewise, given the similarities between lending and leasing, it is perhaps not surprising that many banks establish leasing operations. Relatively few banks look to take ownership of the underlying assets, but many banks look to form financing relationships with equipment dealers, paying a small fee to the dealer for every leasing agreement signed, and then collecting interest on the lease. In effect, these operations allow banks to expand their business lending, while leveraging the infrastructure of other businesses such as the equipment dealers, for example.
Treasury services are a broad collection of services that banks will offer to corporate/business clients, such as company CFOs or treasurers. In addition to simple services like deposit-gathering and check writing, banks will also help companies manage their accounts receivable and accounts payable. Managing working capital and payroll is a significant headache for many companies, and while banks charge for these services, many customers find that the charges are less than the cost of fully staffing and operating their own treasury functions.
arger banks can also earn non-interest income from payment processing services. Banks will help merchants, frequently small or mid-sized businesses, set up payment systems that will allow them to accept debit and/or credit cards, handle checks electronically, convert currency and automate much of the back-office work, to ensure faster payment and less hassle.
Along similar lines, banks can help businesses set up automated/electronic payment networks that make invoicing and supplier payments faster and less of a hassle. Of course, the banks charge for these services, often earning a small amount on every transaction that they handle or help process. Given that a single network can support large numbers of clients with minimal incremental expenses, these services can be very profitable for a bank, once they have reached a certain scale.
Although making mortgage loans and collecting the interest is certainly part of everyday "interest income" operations at banks, there are aspects of lending that fall into the non-interest income bucket. In some cases, banks are willing and able to lend money, but not especially well-equipped to manage the back office tasks that go into servicing those loans.
In situations like this, a bank can sell the rights to service that loan, collecting and forwarding payments, handling escrow accounts, responding to borrower questions, etc., to another financial institution. While this can be done for almost any kind of loan, it is most common with mortgages and student loans; mortgage servicing rights (MSR) constitutes a multi-billion dollar industry. (For more, check out The New Mortgage Business: More Than Just Loans.)
Other Sources of Income
In their drive for additional sources of income, most commercial banks have expanded into offering various investment and retirement products to banking customers. In many cases, banks will offer an array of products like mutual funds, annuities and portfolio advice. Larger banks may actually operate these funds themselves, through a subsidiary, but others will simply act as a commission-gathering agent.
Although the deposit guarantees that cover bank deposits do not extend to retirement accounts, many investors are under the misconception that they do, and will buy securities from banks under the misconception that they are less risky.
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