Net tightening of lending standards began in third quarter 2022 – even prior to the recent bank failures unfolding – transitioning from a borrower-friendly to a lender-friendly environment in late 2022. The nearby graph shows commercial and industrial (C&I) loans outstanding to U.S. companies overlaid with the net percentage of U.S. banks tightening or loosening credit standards for C&I loans to large and middle-market firms.
Per the Fed’s quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices,” a net 46% of domestic banks continued to tighten standards in the first quarter, up slightly from 45% in fourth quarter 2022, and approaching levels that historically precede a recession – 58% in July 2008 and 42% in April 2020.
In the first quarter, a net 62% of banks increased the cost of credit lines by widening the spreads of loan rates over the costs of funds and increasing premiums for riskier loans, similar to trends seen from 2008 to 2010 and in 2020. A significant portion also tightened loan covenants, maximum facility sizes, maturity, and collateralization requirements. Banks that reported tightening standards on C&I loans cited a lower tolerance of risk, decreased liquidity in the secondary market, and deterioration in their current or expected liquidity position following the deposit migration as motivators.
Brown Brothers Harriman (BBH) Senior Vice President and Fixed Income Product Specialist John Ackler advised that “while the threat of a more widespread banking crisis appears to have abated for now, profitability for small and mid-sized banks will likely remain challenged.”
This will act as a mechanism for further monetary tightening. In the meantime, as elevated interest rates reduce corporate profitability and weaken their ability to service their debt burdens, banks have shifted focus from issuing new credit facilities to maintaining existing loan portfolios and minimizing potential losses with their borrowers.
In instances where banks are making new loans, most are requiring deposits or participation in ancillary services from borrowers to bolster their security position and risk-adjusted returns. Loan interest revenue alone generally is no longer sufficient in the current economic climate.
BBH Senior Vice President Phil Ross said that “we’re seeing banks act with flexibility for their best borrowers, including increasing interest rates on deposits to prevent those from going into money market accounts elsewhere and requiring deposits and ancillary services for qualified new borrowers,” further speaking to banks’ increasing demand for liquidity security. BBH bankers have witnessed an increasing number of peer lenders declining new business altogether, causing syndicated transactions to take longer and requiring greater numbers and a more diverse set of banks to ensure transaction closure. In discussions among our BBH bankers and regional banks around the country, we have heard:
“We are not underwriting loans to new companies without also receiving all their deposit business.”
“Our bank is not making any new loans right now.”
“While we are underwriting new loans to our existing customers, we will not partake in any new syndicated bank loans.”
However, the limited capital outflow to middle-market companies has been partially offset by a decline in demand for new credit facilities and existing line increases. Companies may choose to wait out the current market environment and may have less need for working capital financing, given moderating input prices and M&A activity in the slowing economic environment.
In the near term, private debt may be more attainable to mid-size borrowers (those with a $10 million trailing-12-month EBITDA at minimum), who had historically been too small to access this source of funding – notably for leveraged and M&A transactions.
As a result of the current bank lending mood, institutional investors have rushed to raise new private debt funds to meet lending demand unmet by banks, albeit at disadvantageous pricing for the borrowers. Nonbank lenders typically provide higher cost but more flexible loan terms, including lower annual amortization rates and more lenient covenant structures than banks.
However, borrowers should expect increased equity requirements from both nonbank and bank lenders to offset reduced facility sizes for M&A and dividend recapitalization transactions. Lenders now expect equity contribution of 50%, vs. 20% to 25% on average in 2022, with a preference for new cash equity over rollover equity and seller notes. Asset-backed facilities may be advantageous for both lenders and borrowers in the upcoming period as interest rate ambiguity dilutes cash flow reliability.