Banks are scrubbing their commercial loan books, ditching high-risk borrowers before the industry's nearly pristine credit quality takes a turn for the worse.
During the fourth quarter, regional banks such as Fifth Third Bancorp and Regions Financial cut back on some riskier commercial lending, including energy-related credits and leveraged loans to heavily indebted companies.
Fifth Third said it unloaded $3.5 billion in commercial loans in 2016, including about $1.2 billion in the fourth quarter. Executives cited concerns about the quality of the borrowers and whether the company was being adequately compensated for the risk it was taking.
Analysts describe the moves as prudent. Credit quality across the industry remains strong, providing an opportune time to jettison the borrowers who could wreak havoc on balance sheets later on.
But the strategy nonetheless carried a short-term cost and curbed loan growth at a time when new revenue is hard to come by.
"We're trying to become the bank that we've communicated we want to be," Greg Carmichael, chief executive of the $142 billion-asset Fifth Third, said in an interview. High-risk loans "tend to be falling trees in your backyard, so to speak, and create anomalies in your earnings."
Total loans at Fifth Third shrunk 1% from a year earlier to $92.9 billion as the company pulled back on business lending. In the coming year the Cincinnati company plans to remove another $1.5 billion in commercial loans from its books.
"It's the smart thing to do, in anticipation of whenever the next credit cycle comes," said Gerard Cassidy, an analyst with RBC Capital Markets.
Regions Financial in Birmingham, Ala., also reported a decline in total loans as it continues to scale back on its participation in shared national credits in cases where it does not already have a relationship with the borrowers.
Total loans at the $126 billion-asset Regions fell 0.2% from the previous year to $80.6 billion.
A few other big regionals, such as PNC Financial Services Group and BB&T, reported modest fourth-quarter loan growth.
During earnings conference calls, bank CEOs have said that optimism among business clients has increased following the Republican sweep in the elections and the rising momentum for tax cuts and deregulation. It remains to be seen if borrowing will ramp up in the months ahead and meet the bullish expectations for business loans.
Fifth Third and Regions have gone against the grain, making a concerted effort to shrink their commercial loan books.
Fifth Third began scaling back on risky commercial credits a year ago, ending relationships in a range of industries, including those that are dependent on commodities, according to Carmichael. The company also has scaled back on auto loans.
Carmichael, who became CEO in November 2015, said he means to position the company for the credit cycle in the years ahead and to increase profits.
In the past year, the company's average yield on interest-earning commercial and industrial assets increased 21 basis points to 3.33%.
"The big thing is that you have a new management team that is much more focused on improved profitability and lower risk throughout a credit cycle," said Peter Winter, an analyst with Wedbush Securities.
Winter noted that a spike in the benchmark London interbank offered rate helped Fifth Third exit high-risk relationships more quickly than expected. Higher rates on commercial loans during the fourth quarter encouraged some borrowers to pay down or refinance their loans too.
"The new management team is looking to smooth out earnings" after running into a slew of commercial credit problems after the financial crisis, Winter said.
In the year ahead, Fifth Third plans to expand its commercial loan book by 2% even as it pulls back from major credits. Total commercial loans were $57.3 billion as of Dec. 31.
The company predicts strong growth in its specialty loan divisions, including for health care, telecommunications and leisure. Loans for manufacturing and automotive companies are also expected to grow, Carmichael said.
Fifth Third will continue to "take a pause" on commercial real estate loans, citing concerns that the market is overheating.
Analysts noted that now is an ideal time for Fifth Third to reposition its balance sheet given that credit quality remains strong. Net chargeoffs, for instance, declined 8% from a year earlier to $73 million.
"There's nothing that destroys shareholder value more than bad credit," Cassidy said.
This article was licensed through Dow Jones Direct.
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