With the distressed economic climate during the last two years, the banking environment has faced many challenges. Increased regulation and the recent mortgage crisis have elevated the overall risk profiles of financial institutions. Many banks in the industry have experienced significant credit losses, particularly those with a concentration in real estate loans. While the overall economy continues its recovery at a slow pace, the banking industry remains in a difficult state.

Past financial results of banks were negatively impacted as a result of reserves and write-downs of problem loans. Recently, a more conservative approach on these loans, coupled with more strict credit approval processes, has resulted in profits for some banks during 2010. The concern has now shifted to the deterioration of collateral values, including real estate and capital equipment. Lenders are requiring more frequent appraisals of property  and collateral audits.

Real estate values have continued to decline during 2010. Historically, banks have earned substantial fees from real estate loan transactions, and some banks hold large portfolios of real estate loans and securities. The concentration of these loans and the overall decline in the real estate market could signal more foreclosures in the future.

Financial institutions are experiencing a movement toward tighter regulatory controls. Many lenders do not have an appetite for certain loan facilities with existing or new customers  because of stricter regulations. This has resulted in a critical challenge to many borrowers  and business owners.

What should borrowers expect in the current environment? It may be more difficult to obtain financing at the levels needed by business owners. Loan covenant requirements are becoming more strict. Therefore, we may see more breaches of financial ratio requirements. Waivers of covenant violations may not be easily obtained and lenders may charge substantial fees for these. Additionally, lenders may consider resetting interest rates with higher spreads and floors at renewal or upon default.

How do borrowers navigate these changes? Communication between borrowers and lenders is the key to a successful banking relationship. Bankers do not like surprises. As a borrower, be proactive and provide financial information that is both timely and accurate. Prepare and deliver on financial forecasts and projected financial covenant ratios. These add to a borrower’s credibility and offer opportunities to negotiate during the loan renewal process. Additionally, business owners should stay focused on their core business and have a solid business plan with contingencies in place. It would not be wise to experiment in different lines of business that could be risky in such a tight credit market. Lastly, borrowers should utilize their key advisors (CPA firm, attorneys, or other financial advisors) throughout the process.

Going forward, the banking environment will continue to experience the impact of increased regulation. During recent months, banks have focused on steadily building capital in preparation for the recovery. This is expected to create capital for borrowers in the short-term and strengthen the banking system in the long-term. However, the loan approval process is more difficult than it has been in the past. As a result, banks are positioning themselves with less risky loan portfolios compared to the recent past.

Given the slow economic recovery that we are experiencing, the banking industry recovery will be slower, as it tends to lag behind the overall economy. There are no signs of interest rate increases in the next several months as
the economy climbs out of the recession. In conclusion, we can expect a tight market during the next 24 months in the banking environment.

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