Small Bank Commercial Loan Problems making Market Anxious

In an age of connectedness, it almost seems unfathomable that distance could be a cause for concern amongst the commercial lending landscape. However, what economists call “friction of distance” can cause trouble. If this economic theory applies to lenders financing commercial real estate loans outside their geographical areas of expertise, there is an obvious necessity to investigate further.

This problem has been brought to the surface by the quick beat-down lowered upon The Bank of the Ozarks, now renamed Bank OZK. The renaming alone might signal the raising of a warning flag. Bank OZK revealed that it was taking a $45 million write-down on two commercial real estate (CRE) loans, sending its shares down by more than a quarter in Friday trading.

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As big banks have pulled back from CRE and regulators have warned about high valuations, small banks have turned to the asset class as opportunities to expand in other areas have declined. If a bank is successfully able to manage whatever element of risk may be involved in expanding its lending to more distant markets, that can be a good way to enlarge and diversify its loan portfolio as well as drive overall institutional growth.

Commercial Property Prices Have Topped Out

As counter-intuitive as it may sound, the distance between a community bank and its debt, the “friction of distance,” does seem to matter. According to the Federal Reserve Bank of St. Louis, the friction translates directly to the bottom line through its impact on information costs, managerial costs, competition, risk diversification, and growth opportunities,”  adding that “information asymmetries increase along with managerial costs” as distance grows. As a result of regulatory capital rules, CRE’s are perhaps the best way for small banks to grow their balance sheets. “Over the last 20 years or so, the avenues for loan growth for small banks have shrunk,” said David Ellison, a portfolio manager specializing in financials at Hennessey funds.

Even with commercial property values peaking, it is unlikely that banks, big and small, will be the cause of the next asset bubble. Commercial lending makes up a relatively small portion of the trillions of dollars in total loans extended by the big banks. For Bank OZK, its $40 million lending loss means that just 0.23 percent of its core loans (those it originated itself) are now nonperforming. Not nearly enough to sink the bank.

The potential draconian result could be the investment risks being taken by another group. The majority of holders of commercial debt are savings institutions like pension funds and insurance firms. Herein lies the real crux of this problem. When a mall or similar asset starts to falter, the end result is usually big losses for lenders.

While some see long-distance lending as posing risks for regional lenders, there are clearly banks that don’t seem to be afraid to invest across the country. The question is whether each of those lenders will find the grass to be greener on the other side.

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