The Perils of Fixed-Rate Lending

The road to hell is paved with good intention.

As I travel across the country talking to bankers, I am hearing two messages. First, loan demand, though better than a year ago, remains sluggish. Second, some banks are beginning to cut corners on loan terms in an attempt to book earning assets, improve net interest margins and pump up profits.

Here's the good news. Anecdotal evidence does not suggest the loan push is driving a wholesale reduction in prudent credit underwriting. Though there may be a few banks beginning to compromise lending standards, the bigger risk to banks may be the rising tide of fixed-rate lending that is beginning to creep across the nation.

While on the road two weeks ago, I heard from a banker who complained that he lost a good borrower to a commercial bank competitor offering a 4% fixed-rate, 20-year farmland loan. Here's the kicker: No balloon.

A few days later I talked to another commercial banker with over 30 years of experience in the industry. He told me that for the first time in his career, his bank has an endless appetite for long-term, fixed-rate loans for good borrowers.

Banking problems in this country don't happen overnight. Every crisis has its roots in risky behaviors that started off in small pockets around the country. Over time, in an effort to protect market share, other banks start picking up on these risky behaviors. Over the course of several years, the risk builds up until it is obvious to everyone that there is a problem. Too often the end result is financial losses and regionwide bank failures.

Some big-picture background data may be helpful to illuminate the motivation banks may have to book long-term fixed-rate loans. Net loans and leases in the nation's commercial and savings banks are up 3.4% year over year (as of September 30, 2013), but down 2.2% from five years ago. On the bright side, annual growth over 3% is actually not bad given GDP growth for the past year is closer to 2%.

Taking a wider lens to understanding the pressure banks feel to grow loans, it's necessary to examine two key industry metrics: the loan-to-deposit ratio and return on equity.

As of the third quarter of 2013, the industry had a 69.5% loan-to-deposit ratio. How does that number compare to history? For the past two years, the ratio is 70.5%. Go back to the 80s and the ratio was 78.0%. It reached 82.9% in the 90s, and then from 2000 to 2009, it went all the way up to 90.5%.

Against this backdrop, commercial bank profitability is a concern. Through September 2013, the Federal Deposit Insurance Corp. reports the industry's return on equity is 9.44%, a number only slightly better than the industry's 30-year average of 9.12%.

Neither number is much to brag about when the top 15 utility companies in the U.S. have a 10-year average ROE of more than 12% and Canadian big banks average 17%. There should be no surprise that this superior performance enables the utilities and big Canadian banks to reward their shareholders with dividend payouts (4%) and long-term stock price appreciation substantially better than U.S. banks.

However, as ho-hum as the current and 30-year average ROE is for commercial banks in the U.S., the true story is arguably a lot worse than what is reported. You see, when the FDIC reports bank profits, it weights returns based on asset size of the reporting banks.

If the FDIC reported industry return on equity in 2013 based on the average bank, then the ROE drops to 7.84%. This steep decline reveals the unmistakable challenge thousands of community banks face in creating shareholder returns close to the bigger banks. Double-digit industrywide ROEs that banks of all sizes saw from the mid-'90s to 2006 proved to be short-lived. Don't expect to see such industry returns anytime soon.

Some bankers may be beginning to feel a bit desperate to improve profits which may explain the motivation to book long-term, fixed-rate loans without balloons. But such loans do not come without risk.

First, to state the obvious, locking in long-term assets – be it bonds or loans – opens banks to the same risks the savings and loans faced in the 1970s when inflation and interest rates escalated to a point where assets and liabilities were woefully mismatched. Banks that bet on long-term fixed-rate assets are betting that the 30-year downward trend in interest rates does not reverse. We'll see. It's been a good bet for the past 30 years, but cautious bankers and boards recognize that rates will rise eventually.

Second, for investors in bank stocks, they need to be wary of banks where loan growth rates impressively eclipse GDP growth. At a minimum, investors in faster growing banks need to press management to be transparent about the duration of loans and bonds. Fatter margins and better-than-industry loan growth may be the result of the bank's lean to higher-yielding, longer-term bonds and loans.

The highway to higher bank profits is littered with dead banks and S&Ls. Don't be surprised to discover a few more casualties along the highway if and when long-term fixed-rate lending really takes off.

Richard J. Parsons is the author of "Broke: America's Banking System – Common Sense Ideas to Fix Banking in America," published in 2013 by the Risk Management Association. He worked for 31 years at Bank of America.