The New York Times, March 12, 1995

Basic Business Loans May Undo Banks

by Susan Webber

Once again, worries are growing that banks may be lending themselves into trouble. The danger is not the debt of emerging nations, as it was in the early 1980's, or huge real estate loans, as it was later in the decade.

Instead, bankers and others point to a wide array of bank businesses, from credit card accounts to commercial real estate loans to automobile leasing. All of these may pose risks. But one area traditionally viewed as low risk for banks is where the greatest excesses are occurring—routine lending to large corporations.

The basic problem is an extreme imbalance of power favoring corporate borrowers. This imbalance—unhealthy not just for banks, but for their customers and for taxpayers, too—arises from many factors.

As products, these loans have gradually become less attractive than bonds as a way for companies to raise day-to-day operating funds. For one, bonds are cheaper, especially for companies with good credit ratings. McKinsey & Company, the consulting firm, estimates that the processing cost of a bond is five-tenths of 1 percent of its face amount, compared with 2 percent for a loan.

Bonds can also be a faster way to get financing; companies can prepare much of the documentation required by the Securities and Exchange Commission in advance, and, as a result, gain access to the bond markets in as little as 15 minutes.

And bonds carry fewer restrictions, or covenants, than loans. For the latter, many companies that borrow from banks must agree to maintain certain financial ratios, like total debt to net worth.

These shortcomings of corporate loans have contributed to banks' declining share of the market for corporate finance. In 1970, banks accounted for 65 percent of all short-term corporate borrowing; in 1992, they accounted for 32 percent The erosion has been greatest among borrowers of high credit quality.

Lending to large corporations is not only in a secular decline but under cyclical pricing pressure, too. Banks' loan prices roughly move with the business cycle. They are high early on, when loan demand rises but supply stays thin because banks, remembering the recent recession, proceed with caution. But when the business cycle ages—as it now has—loan prices decline as demand moderates and supply grows.

And the banks also have chronic excess capacity, both in processing ability and in funds available. For example, Arthur Andersen estimates that in 1993, banks would have been able to handle 25 million commercial loans, but the actual number was just 15 million. And while banks had $25 billion more capital in 1993 than they could deploy at attractive returns, that surplus will nearly quadruple by 1996 to $90 billion, according to First Manhattan Consulting, which specializes in the financial services industry.

Low prices are a result of this weak demand and large and growing supply. According to one common measure, the gap between the rates on loans and the London interbank offered rate, which is the interest rate paid on large deposits, loan prices for mainstream corporate borrowers have fallen nearly 40 percent in the last two years.

This drop brings many corporate loans into the danger zone for banks. In many cases, mainstream corporate borrowers are getting five years of revolving credit for less than one-tenth of 1 percent interest, with very skimpy or no up-front fees. Such prices, are hardly enough to cover transaction costs, let alone capital costs and a decent profit margin. Covenants have also deteriorated, becoming fewer in number and shifting from cash-flow calculations to more easily manipulated balance-sheet measures.

If bank loans to big companies are bad business, why don't banks do something else? There is a compelling reason.

As banks struggle to develop new sources of revenue, they confront corporations' common practice of making the extension of credit a requirement for access to their other business. Sometimes the pressure is explicit; sometimes it is subtle. But it is seldom applied to nonbanks. While companies often speak positively of their so-called relationship banks, they do not require their other financial institutions—investment banks, pension fund advisers, insurers—to provide a product at a loss in order to have a shot at other business that the companies can throw their way.

There is nothing wrong with powerful buyers extracting a good deal. But when banks broadly engage in unprofitable activities, the public usually pays. As taxpayers, they pay for the rescue of failed or failing banks; as consumers they pay more for banking services or earn less interest so that banks' money-losing corporate loans can be subsidized.

What can be done? The Federal Reserve prohibits banks from "tying," or requiring customers to buy other banking services in order to get a loan. Logically, we must also prohibit powerful corporate borrowers from "reverse tying," or requiring banks to extend credit to get other, more lucrative business.

If this practice is banned, more banks will exit the corporate-credit business and find other niches of profit. Their departure would reduce the market's excess capacity, giving the remaining banks more power over prices. Of course, higher loan prices might spur companies to seek funds elsewhere, but there is no reason banks cannot provide these new products as well.