In a recent nationwide survey of small businesses, nearly two-thirds said it has become significantly harder to get loans today than just a few years ago. Similarly, a National Federation of Independent Business survey found a nearly 10% increase in the number of small businesses trying to borrow but no change in the number of small businesses actually obtaining credit.
As a result small businesses across the country are turning to credit unions for loans as banks continue to tighten credit standards. And credit unions have answered the call, experiencing a 45% increase in business lending nationally since the financial crisis began in December 2007. During that same period, large national banks reduced small business lending by 15% due to the tough economy, new government regulations and the decision to limit small business lending.
While this represents an area of potential growth for many credit unions, business lending is still relatively unfamiliar territory for most credit unions and many smaller credit unions just don’t have the expertise in house to support a significant business loan portfolio. For those credit unions with little to no experience in member business lending, a good way to get started is through loan participations. A loan participation occurs when an originating credit union sells off a portion of a loan to one or more participating credit unions. Loan participations are also a good way for any credit union coming up against the current MBL cap (12.25% of total assets) to continuing serving members while remaining compliant with regulatory limitations.
For credit unions looking to grow their business lending programs, partnering with larger, more experienced credit unions is a good way to gain experience in member business lending while minimizing risk. Some larger credit unions are now even creating formalized programs. For example, in July, a large, Washington, D.C.-based credit union launched a new commercial participation loan program, which will create partnerships with other credit unions nationwide.
Loan participations can be beneficial for both institutions. The lead (experienced) credit union is able to reduce its risk by participating out a portion, which also allows them the ability to continue to fund new loans if it is too close to the current lending cap. For the participating credit union, it can create a mentoring relationship, allowing them to gain valuable experience in underwriting and servicing business loans while also limiting its risk exposure.
Credit unions considering loan participations should be aware of a few important items. First and foremost is risk appetite. Risk appetite and management are an integral part of any credit union’s plan, but risk management becomes even more important when entering into member business lending or a loan participation agreement. Business loans are typically much larger in dollar value than consumer loans and inherently are more risky due to the different underwriting standards.
And while it is imperative the credit union’s board determine its risk appetite in advance, that may be a challenge as the board may not have the experience in business lending to fully understand all the associated risks. Consider having thorough training for the board and management prior to engaging in business lending or loan participations so that an appropriate risk appetite and guidelines can be established.
In addition, several key areas of risk should be considered before entering into business lending and loan participation agreements.
Concentration risk. The types of loans that the credit union is willing to enter into including dollar exposure. Don’t forget the lessons learned from banks that were too concentrated in real estate. Inadequate diversification of the loan portfolio in terms of different industries, loan products, terms of loan products or the number of borrowers may result in significant losses.
Collateral risk. As with any loan ensuring the security interest is perfected and that adequate loan to value ratios are maintained are instrumental in protecting the credit union from potential losses.
Interest rate risk. Maturity and re-pricing characteristics of loans can have a significant impact on the credit union’s interest rate risk profile. The terms of the participations as well as the interest rates that credit union is willing to accept are vital to controlling interest rate risk.
Management and operational risk. As stated earlier, it’s key to enter into participation agreements with credit unions who are experienced in business lending. Failure of the institution to properly evaluate and monitor business loans could expose both institutions to significant financial and reputational losses if the loan becomes troubled or uncollectible.
Legal/compliance risk. Have an attorney with experience in credit unions and loan participations review the agreement before execution. A well-drafted participation agreement that spells out each institution’s rights and obligations can help both institutions avoid–and resolve–any conflicts that may arise down the road
By providing available credit to businesses in need, credit unions can be a vital resource to small businesses. Loan participations can be a great way for credit unions to be a major contributor in helping our ailing economy while mitigating their risk exposure.
Harvey L. Johnson, CPA, is a senior manager at Witt Mares, PLC.
Contact 757-627-4644 or hjohnson@ wittmares.com