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A Risky Buildup
It’s tempting for a bank to lend to the vast expanse of private credit, a variety of nonbanks that can include mortgage warehouse intermediaries or even private equity funds. Those loans can help diversify a bank’s assets. Banks also can limit their exposure to such loans by making them a small percentage of the portfolio.
In September, investors began asking questions about such lending following bankruptcy filings for subprime auto lender Tricolor Holdings and the auto parts company First Brands Group, which are likely to lead to significant losses for the banks that lent to them.
Moody’s reported that, through the second quarter, U.S. bank lending to NDFIs, or nondepository financial institutions, had increased more than 300% since 2015. S&P Global Market Intelligence estimates U.S. bank loans to NDFIs have grown rapidly in recent quarters, especially at large U.S. banks, by 9.0% in the second quarter and 5.9% in the third quarter, reaching close to $1.5 trillion.
This building of significant risk in the system may impact smaller banks that don’t engage in this type of lending. During the Great Financial Crisis, in 2007-08, it became all too clear that risky lending inside and outside the banking system could bring down collateral valuations for everyone. In fact, banks in the Southeast failed after seeing good, well collateralized borrowers walk away from their loans because their mortgages were higher than the value of the underlying assets. In those years, that collateral was houses and land for new subdivisions.
Bill Herrell, executive vice president and managing director for Bank Director, was an investment banker during that financial crisis, so he’s well attuned to cycles that tend to repeat themselves. The more distance lenders put between themselves and the borrower, the worse the consequences. “Everyone has the motivation to make the loan. Fewer have the motivation to collect it,” he says. When credit problems begin to surface for NDFIs, they don’t have the funding stability that banks enjoy and would need to liquidate assets quickly, in some cases overnight. That could affect collateral values across the financial system. “When the worm turns, it hurts all lenders due to the impact on collateral values,” he says.
Herrell isn’t saying that’s going to happen. And indeed, he hopes it won’t.
But it’s important for banks to be prepared for the worst.
• Naomi Snyder, editor-in-chief for Bank Director
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