Hard Lessons in Modern Lending cont’d – post #2

 From 1989 to 1994, the number of small-business loans fell 34 percent, and many economists worried that big banks might stop troubling with them altogether.

Continued from March 7th blog post

To understand how we got to this point, consider how different banking was a mere 30 years ago. Before ATMs sat on every street corner and sports arenas had names like Citi Field and Bank of America Stadium, U.S. banks were far smaller and far more numerous; in fact, there were about 10,000 more of them. They were, on average, a tenth the size of an average bank today. They were prohibited from operating across state lines, and most states capped the number of branches they could have.

big ideaCorporate lending worked differently, too. Companies and banks tended to pair off by size. The community banks that did the bulk of small-business lending tended to make subjective judgments, relying on personal knowledge of the local economy and the character of the local business owners. “You’d go to a loan committee, and there’d be six or eight people who knew the market and probably knew you,” says William Dunkelberg, chief economist at the National Federation of Independent Business, or NFIB, since 1973.

Even by 1993, 55 percent of small-business loans (in dollar terms) were held by banks with less than $1 billion in assets; the largest 25 held less than 9 percent of such loans. The merger wave of the 1980s and ’90s upended this model. As regulations were scaled back, banks joined forces and expanded nationally, and small banks got gobbled up by bigger and bigger ones. This was bad news for entrepreneurs: From 1989 to 1994, the number of small-business loans fell 34 percent, and many economists worried that big banks might stop troubling with them altogether.

Lending eventually came back–thanks to technology. As more data went online, a bank could access a potential borrower’s payment history, compare a company’s financials with industry averages and the finances of competitors, and use economic projections to assess prospects. When companies such as Fair Isaac and Dun & Bradstreet began offering business credit-scoring software online, a large bank’s credit department no longer needed local experts with local expertise; an analyst with a computer and an Internet connection could make decisions from hundreds of miles away, and small businesses could get cheaper rates and approvals without knowing the local bankers. By 2007, the 25 largest banks were nearly six times larger than they had been in 1993 and held 32 percent of all small-business loans.

declined credit application

Then came the financial crisis, which flipped the hard-data model on its head. Banks had used data mainly to identify prospects and turn them into customers. Now Big Data went to work–in a real-life version of the science-fiction film Minority Report–identifying which paying customers were riskiest, so banks could quickly turn them into ex-customers.

On February 26, 2009, Stephen Hester, CEO of Royal Bank of Scotland, told analysts how he planned to defuse what he later termed “the biggest balance-sheet time bomb in history.” The year before, the Edinburgh-based bank had lost $34.2 billion–the biggest loss in British corporate history–leading to a government bailout and the departure of the bank’s then-CEO.

Hester stepped in and within three months identified about $612 billion worth of assets to be sold or dumped altogether. Next, he turned to the assets the bank planned to keep, including its U.S. subsidiaries: Citizens Bank and Charter One. In addition to cutting jobs and closing branches, the bank would look to eliminate individual credit lines, credit cards, and loans. The retreat would begin in the company’s backwaters, where Citizens and Charter One lagged the market leaders, he said.

In the greater Cleveland area, where Joe Bliss and JBC Technologies had Charter One loans, the bank ranked fourth.

Cheryl-Ann Madsen, Bliss’s relationship manager at Charter One, had worked as a banker in Cleveland for decades, starting at Charter One in 2005, shortly after it was acquired by RBS. When the bank moved underwriting to Pittsburgh in 2007, she had adapted; in fact, she planned to retire at the bank. So in July 2009, when the Cleveland relationship managers were told to prepare their loan portfolios for review by a visiting RBS executive from Michigan, she dutifully complied. The review would determine which loans would go into a new noncore group–assets the bank decided were either “high risk or not a strategic fit,” says RBS spokesman Jim Hughes. “In a time in which banks have been forced to make tough choices,” says Hughes, “relationships with some customers have had to change.”

reality check aheadWhen the noncore list was announced to staff, Madsen was stunned. A third of the companies in her portfolio were on it–including nearly every auto-parts supplier she had. “They were all people who worked diligently and lived up to their loan agreements,” Madsen says. She understood that the bank had to shore up its balance sheet. Still, she says, “it was very difficult to justify it to myself. I felt personally responsible.” Madsen asked the head of the Ohio region to reconsider severing the relationship with Joe Bliss. He tried to help but couldn’t. She then wrote an e-mail to the CFO of RBS, pleading for JBC specifically. She got no response.

Then, about a month after Bliss’s loans had been pulled, Madsen was driving back from a client call with an out-of-state colleague toward Charter One’s offices in downtown Cleveland. As they passed by shuttered stores and half-filled parking garages on 12th Street, her co-worker sighed. “Ohio–it’s just a black hole,” he said. The bank wasn’t just writing off her clients now. She felt it was writing off her hometown. That was it, Madsen says. “I knew northeast Ohio would rebound. I have a lot of faith in the Joe Blisses of the world. I didn’t see a black hole. I saw a storm we needed to get through together.” She resigned a month later.

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