Classified Assets Stymie Lending, M&A

Bankers are taking a hard-lined approach to classifying commercial loans, even if doing so delays an economic recovery.

Prompted by more regulatory scrutiny, bankers say they are taking a "when in doubt, classify it" approach to businesses that are suffering from limited cash flow. Some bankers admit to playing it safe, skipping over risk categories and sending loans straight to substandard status.

Now, many bankers wonder if such actions are harming the economy, saying an over-abundance of classified loans prevents them from making new loans or pursuing acquisitions. While classified assets have declined since 2010, it often takes at least a year to upgrade existing commercial classified assets.

"Every bank's ability to grow, expand, merge and acquire has largely been driven to a great extent by" classified assets and capital ratios, said John Corbett, the president and chief executive of CenterState Bank of Florida in Davenport. "It has a dampening effect on the entire economy."

Gregory Mitchell, the president and chief executive at First PacTrust Bancorp Inc. in Chula Vista, Calif., said it gives investors "misinformed assumptions when they see a higher level of classified assets" because many are still paying on time.

Typically, a loan is classified when the probability of payment weakens. For commercial loans, an ability to pay is based on a borrower's cash flow.

Regulators do not publicly disclose classified asset ratios at specific banks, but an analysis of enforcement actions indicates they are focused on such loans. Classified assets were cited in more than 60% of the 153 enforcement actions publicly released this year through Aug. 31, based on data from Trepp Bank Navigator.

The Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency raised issues with classified assets in more than 80% of their enforcement actions. The Federal Reserve flagged classified assets in only 20% of the actions. But one observer said that is because the Fed is broader in its language.

Rather, the Fed will tell a bank they "want a plan to improve asset quality," said Chip MacDonald, a partner at Jones Day in Atlanta. "It gives the Fed more flexibility and lot more power."

While bankers must show regulators they are acutely monitoring credit risk, a higher classified ratio can hurt capital and that squeeze can cause banks to pull back on lending.

"We will take whatever actions we can to reduce" the classified asset ratio, "even when we believe the actual loss is relatively low," Harris Simmons, Zions Bancorp's chairman and chief executive, said at the American Banker Regulatory Symposium Sept. 20.

Simmons said Zions planned to close an unused credit line with a large commercial borrower after regulators flagged lower cash flows and leverage compared to pre-crisis performance. He said it was an example among "many hundreds of millions of dollars in classified commitments" where the $51 billion-asset company in Salt Lake City, Utah, had closed credit lines.

With many big commercial borrowers having filed tax return extensions, Corbett said banks are just now getting 2010 tax returns. "You're always looking backwards nine to 12 months and you're looking backwards into some pretty dark times of the recession," he said.

Simmons' remedy calls for regulators to look more at a loan's guarantors and collateral when assessing a borrower's ability to pay and a probable loss. He said 69% of Zions' $2.7 billion in classified assets at June 30 were commercial loans where clients were current on payments.

Still, regulators argue that they look at collateral and guarantors as a secondary source — once default is highly likely.

"Secondary repayment sources, including collateral, can reduce the severity of the classification and may affect the accrual of interest decision," said an OCC spokesperson in an email.

But disagreements often arise when varying appraisals come in for one property, especially after valuations drop significantly.

Such disagreements caused banks such as Dearborn Bancorp Inc. in Michigan to restate second-quarter result after its bank's annual exam with the FDIC. Dearborn was notified by the Nasdaq in August that it was in noncompliance and had until Oct. 17 to submit a plan for refiling its second-quarter results.

There are situations where a borrower "is sending payments every month but we can't convince the regulators how he does it," said Michael Ross, the president and chief executives of the $867 million-asset Dearborn. "The regulator says 'get a sharper pencil on the underlying collateral' … and then you find out you're a couple hundred thousand dollars in the hole."

While Dearborn is working with regulators on revised second-quarter financials, Ross said the classification system does not need changing. Classification "helps you identify and monitor those credits better," he said. "Ignorance is not bliss in the loan portfolio."