More business loans are going bad. Should banks be worried?

For all the fretting over office building loans at banks, relatively few observers are worrying about the growing strain among business borrowers.

The stress is nowhere close to Great Recession levels, but it’s nonetheless risen quickly as businesses struggle to keep up with inflation and higher interest rates. Business bankruptcies are up, suggesting that banks may soon need to absorb more losses on loans to shuttered firms.

Unlike commercial real estate — where banks can at least take over a devalued office building — the collateral that supports banks’ business loans is generally weaker. That means it’s more likely that banks will be forced to take a bigger hit when a borrower closes up shop.

Bank analysts aren’t overly concerned about the current deterioration in commercial and industrial loans, since banks’ C&I concentrations generally aren’t large. But they’re cautioning that investors should take a closer look, since losses on business loans will give banks less wiggle room to absorb whatever pain may come on CRE.

“It’s what you’re not expecting, what you’re not looking at, that always surprises you,” said Brandon King, an analyst at Truist Securities. “I think C&I should get more and more attention these days.”

Banks charged off some 0.43% of their C&I loans in the first quarter, according to Federal Reserve data, which is a far cry from the 2% or more seen in the two most recent recessions. But the charge-off rate has jumped from its pandemic low of 0.12% to above pre-pandemic averages. 

Banks are also reporting that more business borrowers are having trouble keeping up with their loan payments, as so-called problem loans start to rise.

“They’re not as bad as they were, thank goodness, in 2009-10, but they are coming off of the bottom,” said Chris Marinac, an analyst at Janney Montgomery Scott. He said the issue is “seemingly overlooked” in comparison with investors’ fears about CRE. 

In recent weeks, bankers have said their commercial loan portfolios remain broadly healthy, even if some weaker borrowers and a couple of sectors are facing a bit more pain. 

The trucking industry stands out, continuing a free fall that started after the COVID-driven goods boom ended. Some borrowers in senior housing and the health care sector are also struggling, which bankers attribute partly to higher interest rates and labor costs.

Despite those weaknesses, there’s “no big pocket” of borrowers at PNC Financial Services Group that’s triggering alarms, Chief Financial Officer Robert Reilly said at a recent conference.

“Things look pretty good,” Reilly said. 

To the extent that bankers are seeing issues, they are describing them as episodic. 

Cincinnati-based Fifth Third Bancorp charged off loans to a couple of clients whose business models had challenges “coming out of COVID,” said Chief Financial Officer Bryan Preston.

At Buffalo, New York-based M&T Bank, charge-offs on C&I loans rose for the second quarter in a row, Barclays analyst Jason Goldberg pointed out at a recent conference, drawing a contrast with the bank’s improved trends in CRE lending.

Daryl Bible, M&T’s CFO, said that loans to a manufacturer and a boat dealer drove the increase last quarter. The latter borrower was hit by a broader slowdown in boats and power sports, a sector that consumers splurged on during COVID as they sought to spend more time outdoors. As purchases slowed in 2022, a lot of dealers were “stuck with that inventory,” Bible said.

M&T’s charge-offs will be “lumpy” in coming quarters as problems pop up at specific clients, Bible said, though he added that the bank may also make recoveries as it liquidates its borrowers’ collateral or finds a way to get repaid.

“It will ebb and flow,” he said.

In recent quarters, banks have put out voluminous disclosures about their CRE portfolios. It’s part of an effort to counter what they see as misperceptions by investors who paint all office buildings with a broad brush of distress. 

Banks have put together slideshows breaking down the types of buildings their borrowers own, what states they’re located in, whether they’re in urban or suburban areas, the level of amenities in the buildings and vacancy trends, as some employers shift to hybrid work.

But that type of disclosure is far more scant for C&I loans, said King, the Truist analyst.

“We don’t want to downplay CRE concerns, but we believe that an overlooked emerging risk such as C&I could surprise investors given the higher volatility of losses historically,” King wrote in a research note this month, adding that “a more severe default cycle remains a risk.”

King and other analysts say smaller businesses appear to be experiencing more stress than larger ones. 

In a report on Main Street businesses, the credit-scoring firm Equifax found that delinquencies on loans, invoices and other payments have risen sharply. But delinquencies are still below their pandemic-era highs and far below their post-2008 levels, according to Sal Hazday, a top executive at Equifax.

“This is a hill of delinquency compared to the mountains of delinquency that happened in the 2009-2010 period,” Hazday said, noting that small businesses remain resilient despite lower consumer spending levels.