When the credit markets dry up only a few will understand how it happened.  The few that are in the know – and saw it coming - are bank-ABL industry executives who are pushing credit executives in C&I to properly risk-rate and downgrade marginal credits and transfer to ABL.  Risk-rating models and politics in a bank can be subjective, not forward looking and can be interpreted with the goal of keeping clients in C&I, especially when meaningful P&L income is at risk. 

Banks, like all businesses, need to make money and credit will always be malleable as consumer preferences and economies change so it is only natural that risk standards change.  Furthermore, in today’s economy, banks are focused on doing more with less.  Due to expense-ratio pressure, many are aggressively cutting costs including cuts to special assets, which is their first line of defense.  The fact that we are in the extra innings of a credit cycle surprises very few given the past few years of lax regulations and overheating of the credit markets.  

It’s impossible to time a market cycle and to do so banks would have to take aggressive proactive measures, which could easily result in significant loss of income and market share in any given market as well as reputation risk.  The current cycle has led to intense competition amongst banks and a credit bubble in which every lender is a willing participant.  What will surprise many is why, and it harkens back to the last cycle when, in hindsight, it should have been obvious.

We all know that the last cycle came about partly due to the credit agencies mis-rating risky assets, which enabled a highly complex system of leverage upon leverage to proliferate.  We don’t need to understand the complexities of the financial system to understand the root of the cause – credit was provided to consumers to aggressively finance homes when it should not have been.  Rating agencies signed off on the risk-rating of the aforementioned pools of assets and the rest is history.  The next cycle will be different as the root cause will be different, but what is similar is that there is a canary in the coal mine in today’s market.

The ABL industry is the canary, with a specific focus on bank ABLs.  Bank ABLs are on the front line of monitoring downgraded or watch-list C&I credits in their own banks. The internal bank equivalent of an external rating agency is the risk-rating model that banks use for privately held middle-market clients.  There are a significant amount of bank credits that have borderline ratings, which often makes it a subjective and human decision to keep them within C&I rather than transfer to ABL.  Privately held middle- market businesses are entirely reliant upon their respective banks’ risk-rating systems that dictate whether they stay in C&I, get transferred to the bank’s ABL group or are forced to go the non-bank route.  Right now, there is significant internal friction over borderline C&I credits that should be ABL deals.  Having these deals properly monitored and managed can preventbillions in losses when the credit markets turn and banks face their own liquidity challenges. “Transfer to ABL” is rarely said when P&Ls are kept separate between C&I and bank-ABL.

This is a conundrum for banks, which are generally aware of the risks, but not privy to a crystal ball that indicates exactly when the music will stop.  C&I groups have fought bitterly for credits over the past decade and are loathe to give them up.  This hoarding of credits has been enabled by somewhat arbitrary credit models that differ within each bank, unless dealing with the nation’s largest banks.  To digress, each bank typically has its own system of rating credits.  For a regulator, it is sometimes tantamount to understanding the playbook of each NFL team. The ultimate plays might be similar, but each has a different name.  There is some rhyme and reason to this as big and small banks have very different risk systems and management layers so it makes sense that some will be more complex than others.  For avoidance of doubt, large bank risk-ratings systems are somewhat uniform given OCC risks, but can still vary.

What should not be complex, but has proven to be a challenge, is the relationship between bank C&I groups and bank ABLs.  A good bank ABL group provides strong product coverage and the ability to quickly transition C&I clients that C&I worked hard to obtain.  C&I groups work incredibly hard to win middle-market customers and keep them – this has and always will be the bedrock of banking.  For great credits there is never a problem, but the problem lies within the billions of dollars of credit that are ranked on the lower end of the credit spectrum.  To the bank ABL professionals, these should be ABL deals.

To understand how bank C&I clients typically get transferred to bank ABL, one must understand the credit rating system in a bank.  Banks typically rely on credit models that produce a rating once info is entered into the model.  There is a real basis to these models, however, they are very subjective and rarely take into account or properly risk-rate what could be predictable events.  Said differently, these models work perfectly in a good or moderate  economy, but make it very hard to forecast what will happen. For example, an automotive supplier with customer concentration might be doing great today, but what are the odds it will continue to perform in the next downturn?  The Boeing 737 Max is an example of how cancellation of one model has certainly caused issues in Boeing’s supplier base.  Yet these same suppliers might have a great credit rating in their respective banks.

The list of examples goes on and the key takeaway is that a small change here or there is the difference between staying in C&I and getting transferred to ABL.  Transfer to ABL typically means loss of P&L income and something most C&I groups are very sensitive to.  It also means a very different client experience when they understand the reporting and collateral monitoring they now have to adhere to. One can see why banks have been holding onto assets arguably longer than they should and the ABL industry has been impatiently waiting for the next downturn.

No one thought to initially look to the rating agencies during the last economic downturn and few will think to look to risk-rating models within banks, but bank ABLs are making noise about subjective risk models not properly rating credits that should be ABL.  The potential effect on the financial system is unknown, but for midsized banks, the strain will be real and painful.  No one knows when the music will stop, but rest assured the ABL industry is waiting with plenty of chairs.