It has been more than five years since the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. When the law first passed, many in the banking industry voiced concerns about the impact it might have on community banks, which are disproportionately affected by the legislation due to their smaller size.

Especially concerning was the higher capital and equity requirements Dodd-Frank placed on community banks. In addition, the law places a greater regulatory burden on community banks via new disclosure and reporting requirements, provisions and obligations. It’s true that all banks are subject to these regulatory requirements; however, their costs will likely have a disproportionate impact on smaller community banks than on large banks with greater economies of scale.

Finally, Dodd-Frank limits how much money banks can charge merchants in interchange fees, which is lowering non-interest fee income. While banks with less than $10 billion in assets are exempted from this provision of the law, the reality is that many community banks are being forced to lower their interchange fees to remain competitive. And it doesn’t help that regulatory guidelines have placed limits on how much banks can charge customers in NSF fees.

Doing the Math

When you do the math, it’s clear that Dodd-Frank is making it harder for community banks to earn the same profits they did in the past. Higher capital and equity requirements, lower fee income and higher compliance costs all add up to lower return on equity (ROE) for community banks.

Given the higher levels of capital required by the law, community banks must earn more money on every dollar of revenue generated in order for ROE to hold steady. In this scenario, the bank has to increase its return on assets (ROA).

Traditionally, community banks have generated interest income and driven revenue by making residential mortgages and construction, commercial real estate, and acquisition and development loans. But regulatory caps on commercial real estate and construction loans as a percentage of capital are reducing the amount of interest income many community banks are earning from these types of loans.

And more stringent mortgage lending rules are forcing some community banks to shy away from this type of lending. In the American Bankers Association 2014 Real Estate Lending Survey Report, more than a third (38 percent) of banks said the new Dodd-Frank mortgage regulations caused them to reconsider their commitments to mortgage lending.

Interest expense, meanwhile, is rising, thanks to new reporting and disclosure requirements, new non-discrimination lending rules and higher compliance costs. And non-interest fee income is falling, as noted above.

Add It All Up

Add all of these factors up and it’s clear that earning a profit is harder for community banks in the post-Dodd-Frank world than it was before financial reform was signed into law. Some industry experts and observers believe that the eventual result will be a consolidation of community banks as they merge with each other or are acquired by larger banks.

The Dodd-Frank Act contains nearly 400 new banking regulations that will eventually be drafted and enacted, but only about half of them have been implemented so far. So it will likely be years before the full impact of the law on community banks is felt.

In the meantime, community banks will continue to await the final drafting and implementation of all the rules contained in Dodd-Frank’s nearly 5,000 pages of regulations. This makes now a good time for community banks to strategize how they can boost profitability in today’s challenging environment — or start thinking about whether a merger or acquisition might eventually make more sense

Once they start ramping up growth, these companies are going to need to replenish working capital to fund additional inventory and receivables and fill orders. Companies that experienced losses in recent years or are already highly leveraged may not be able qualify for traditional bank loans and lines of credit.

Growth Financing via Asset-based Lending

These are the kinds of scenarios where asset-based lending (or ABL) can often help companies get the financing they need to shift back into a growth mode again. For years, startup and fast-growth companies have turned to ABL since it is often difficult for them to meet banks’ underwriting standards for traditional loans and credit lines. With the economic skies finally starting to brighten, more businesses might look to ABL to provide growth financing.

Does this mean your bank should venture into the asset-based lending waters? Offering asset-based loans is certainly one way to grow your loan portfolio. But if your bank is not experienced in asset-based lending, you first need to understand how ABL is different from traditional bank lending. Making asset-based loans requires looking at credit and at a borrower’s financials in a different way.

When considering whether or not to make a traditional loan to a business, you are mainly looking at projected cash flow to see if this will be sufficient to service the debt. This is gauged primarily by scrutinizing the business’ balance sheet and income statement. But when deciding whether or not to make an asset-based loan, your main consideration is how well the collateral — specifically, accounts receivable or inventory — will perform.

Therefore, you will need to carefully analyze collateral eligibility based on the borrower’s debtor base and the level of concentrations. You will also need to carefully monitor and verify collateral on an ongoing basis and receive regular inventory reports from the borrower, as well as reports on the liquidation values of finished goods and raw materials pledged as collateral.

Types of ABL

There are two main type of asset-based lending:

• Factoring — Your bank will buy the business’ outstanding receivables at a discount and advance the company a percentage of their value (typically between 70 and 90 percent) at this time. The bank will release the balance of the receivable, minus the discount rate or factoring fee, once the invoice has been collected.
• Accounts receivable (A/R) financing — Your bank will establish a borrowing base and lend money based on this amount against eligible collateral. To monitor this borrowing base, you may need to require monthly receivables and payables aging schedules from the business.

If your bank doesn’t have the systems and expertise in house needed for the level of collateral verification and monitoring required for ABL, you have several options. You could build an in-house ABL infrastructure, but this is time-consuming and expensive and might not be practical for your bank. Or you could buy or license an ABL software program that would save you the time and cost of building your own ABL systems from scratch.

Another option is to partner with a commercial finance company or factor that specializes in asset-based lending. Or you could simply refer businesses to a factor or finance company and let them handle the financing. Doing so will position your bank as a true solution provider in the eyes of your customers, who will likely return to your bank for traditional financing if they qualify at some time in the future.

What’s more, two-thirds of U.S. college graduates now leave school with student loan debt averaging $26,600, according to The Institute for College Access and Success.

The Ripple Effect

In this blog, I don’t want to bombard you with more statistics about this crushing level of student loan debt, or debate whether or not a college education is worth taking on debt. Instead, I want to point out how record student loan debt is having a ripple effect that is negatively affecting many different segments of the economy.

Several new studies have demonstrated something that seems fairly obvious: High levels of student loan debt are forcing many young people to make different lifestyle and financial decisions than they might otherwise. When viewed on an aggregate basis, these decisions are having a negative impact on the U.S. economy.

For example, it appears that young people with lots of student loan debt are less likely to start new businesses. This makes sense, because individuals can only borrow so much money. Banks look carefully at an entrepreneur’s personal debt capacity when deciding whether or not to finance a new business start-up, so young entrepreneurs with heavy student loan debt are less likely to qualify for a business loan. Fewer small business start-ups could have a serious impact on the broad economy and employment over the long term, as up to 60 percent of all jobs are created by small businesses.

In addition, heavy student loan debt levels also seem to be discouraging young people from starting families. And when people aren’t getting married and having kids, they are less likely to buy homes, furniture, appliances and all the other purchases that coincide with home ownership. Research indicates that fewer 30-year-olds have bought homes since the recession began, especially 30-year-olds with a history of student loan debt. This is placing a further drag on economic growth, and new home construction, in particular.

Delayed Retirement Savings

Finally, most young people with heavy student loan debt are not getting an early start on saving for retirement. A long-term time horizon and the opportunity to benefit from compound returns over many years is the biggest benefit young people have when it comes to saving for retirement. Putting off opening an IRA or 401(k) account could cost young people tens, if not hundreds, of thousands of retirement dollars over the course of their lifetimes — and lead to a serious retirement crisis several decades down the road.

Of course, all of these trends will have an impact on banks, either directly or indirectly. If the trends continue, they will mean fewer small business loans and home mortgages and a weaker overall economy, which will further depress lending activity. This makes soaring student loan debt something to keep a close eye on going forward, regardless of whether or not you have children going to college.

By buying participation loans, banks with large deposit bases can increase their loan volume by participating in loans made by banks outside of their market area. By selling participation loans, banks can further diversify their loan portfolios by geography and/or industry. In addition, selling participations may enable banks to make loans to customers they might otherwise have to turn down due to lending limits or regulatory rules (i.e., Regulation O) governing loans to board members and other insiders.

What Constitutes a Participation Loan?

In most instances, participation loans are traded between banks that already have an established relationship. These typically include non-competing banks that are located in different geographic areas, as well as correspondent banks and bankers’ banks.

In order to be a considered a participation loan, a loan must meet very specific criteria. For example, the selling bank cannot have any recourse rights, and each participant must possess a pro-rata interest in the financial asset. In addition, neither participant can pledge or exchange the entire asset unless all participant interest holders agree. And all cash flows from the asset must be allocated to participating interest holders proportionally to their ownership.

If a loan doesn’t meet these criteria, the seller must treat it as a secured borrowing. In particular, the loan cannot be removed from the selling bank’s balance sheet, which eliminates one of the main benefits of selling participation loans.

The Participation Agreement

Before buying or selling participation loans, it’s important to draft a participation agreement between the two banks. Such an agreement will detail all of the particular details of the loan (such as who will handle loan servicing, for example) and both the buying and selling bank’s specific rights and responsibilities as they relate to the participation loan.

A participation agreement should also require the selling bank to keep the buying bank regularly informed about all aspects of the loan, including the credit risk rating. In particular, the selling bank should provide financial information to the buying bank on a regular basis with regard to the loan’s credit risk rating.

Perhaps most important, the participation agreement should address each bank’s rights and responsibilities if the participation loan runs into trouble. For example, what rights (if any) does the buying bank have when it comes to demanding payment from the borrower, renewing the loan or moving into foreclosure? Or does the selling bank make all of these decisions?

Underwriting Guidelines for Participation Loans

Finally, you need to make sure participation loans are underwritten no differently than other loans when buying participations. Perform your own due diligence on borrowers instead of counting on the selling bank to perform due diligence for you, and review any outstanding environmental or appraisal issues with the borrower. Also insist that the selling bank provide you with a complete underwriting package on the loan.

Participation loans could be a path to portfolio growth and diversification in an improving economic environment. But proceed with caution, as they present unique risks as well as opportunities.

This agency — the Consumer Financial Protection Bureau, or CFPB as it’s usually referred to by lenders — was officially born on July 21, 2011. Since then, many in the lending industry have been watching carefully to see what kind of impact, if any, the creation of such a watchdog consumer financial protection agency would have on the credit and lending markets in general.

A Hint of the Impact

One hint of this impact was revealed earlier this month when the Federal Reserve Board released a report detailing the results of its most recent senior loan officer opinion survey. Most large banks that responded to the survey (78%) said that new mortgage lending rules enacted this year by the CFPB have not impacted their mortgage approval rates. But 50% of non-large banks in the survey said that these new CFPB mortgage rules are lowering their mortgage approval rates, resulting in fewer new mortgage loans.

About one-third (36%) of all banks in the survey said that new CFPB mortgage rules are lowering their mortgage approval rates.

New CFPB mortgage rules went into effect this past January that require mortgages to meet certain underwriting criteria in order to be considered as qualified mortgages. (An exception is made for mortgages purchased by Fannie Mae and Freddie Mac, which are automatically qualified.) Banks receive greater legal protections on qualified mortgages than they do on non-qualified mortgages,

Specifically, there is now a 43% cap on a borrower’s debt-to-income ratio in order for the loan to be considered a qualified mortgage. Also, a provision of the new CFPB ability-to-repay rule requires banks to evaluate borrowers’ income and assess their credit history, assets and debt payments as part of the mortgage approval process.

The Survey Says…

Digging deeper into the survey results, about one-third (31%) of all the banks that responded said the new CFPB rules have reduced their approval rates on prime jumbo mortgage applications. More than half of all banks (52%) said that their mortgage approval rate was lower on prime jumbo mortgage applications if the loan principal balance is greater than the conforming loan limit.

Interestingly, about half of the large banks that said the new CFPB rules have not impacted mortgage lending indicated that mortgage lending would have been impacted if not for the safe harbor for Fannie Mae and Freddie Mac loans.

A look at the total volume of mortgage loans being made in the U.S. provides a more revealing picture of the state of the mortgage lending market. During the first quarter of this year, U.S. banks made $226 billion in mortgage loans, which is the smallest quarterly volume of mortgage loans since 1997.

Whether this is due to the new CFPB regulations, slightly higher interest rates, a jump in all-cash purchases, or a combination of these and other factors isn’t entirely clear. But this drastic drop in mortgage loan volume should serve as a wake-up call to banks and mortgage lenders planning strategies for the rest of this year and 2015.

Fortunately, the OCC has provided some regulatory guidance to try to help clear up the confusion. The OCC published Community Bank Stress Testing: Supervisory Guidance (Bulletin OCC 2012-33) to help community banks determine the best way to use stress testing to spot and quantify portfolio risk.

What the Bulletin Says

In a nutshell, the bulletin states that some form of annual portfolio stress testing or sensitivity analysis is critical to sound risk management for any bank, including community banks smaller than $10 billion. And stress testing should be performed on the entire portfolio, not just on individual loans, according to the bulletin.

The regulators expect all banks, regardless of size, to have a plan in place for how they will maintain adequate capital levels, in addition to effective internal processes for assessing capital adequacy as it relates to overall risk. They believe that stress testing is the best way for community banks to find out where they’re vulnerable to market forces and determine how they will manage these risks.

This regulatory guidance goes beyond stress testing for interest rates to include stress testing for other adverse market factors that can affect commercial real estate (CRE) loans and acquisition, development and construction (ADC) loans. These factors could include falling rents, slowing absorption rates, rising cap rates, and higher operating expenses for property owners.

The OCC bulletin gives community banks some leeway in terms of deciding which of these and other market factors they should test for. “A community bank’s approach to stress testing should fit its unique loan portfolio strategy, size, loan types, composition, operations, and management,” it states.

Types of Stress Testing

While the bulletin doesn’t endorse any specific stress testing method, it does point out that the stress testing methods used by community banks can be less complex than those used by large banks.

Here are four stress testing methods noted by the bulletin that are commonly used by community banks:

1. Transaction — Gauges the potential impact of changing economic conditions on the ability of individual borrowers to service debt, and uses this to estimate potential loan losses.
2. Portfolio — Gauges the potential impact of changing economic conditions on the financial performance of borrowers, and uses this to help spot portfolio risks (both current and future).
3. Enterprise-level — Gauges how different types of risk and their interrelated effects might impact the bank assuming different economic scenarios.
4. Reverse — Postulates what types of events and scenarios could lead to possible adverse outcomes.

Regardless of which method is used, the OCC bulletin includes several things that are common to all effective stress tests. These include the use of “what if” questions as they relate to specific bank vulnerabilities and making reasonable determinations of the impact a market factor could have on capital and earnings. Also, the test’s results should be incorporated into the bank’s overall risk management process, the bulletin states.

A new type of consumer and small business lending has popped up over the past couple of years that many lenders are just now becoming aware of. Internet-based lending platforms are connecting lenders and borrowers virtually, thus enabling borrowers to bypass traditional banks for many types of consumer and small business loans.

These Internet-based loans are usually referred to as peer-to-peer loans, cloud funding or crowdfunding. While Internet loans represent just a tiny fraction of overall lending volume in the U.S. now, it’s worth keeping an eye on as its popularity as an alternative to traditional lending continues to rise.

The Lowdown on Internet Lending

Peer-to-peer lenders are mostly individual investors looking to earn healthy returns on their money. LendingClub.com and Prosper.com are two of the biggest peer-to-peer lending websites right now. Crowdfunding investors are often the family members and friends of entrepreneurs looking to raise money for new startup ventures. IndieGoGo.com, Kickstarter.com and Kiva.com are among the most popular crowd-funding websites today.

Cloud lenders focus primarily on making small business loans up to $100,000. OnDeck and Kabbage are two of the biggest sources of cloud funding. In just seven years, OnDeck has become one of the largest small business lenders in the U.S., lending over $1 billion to more than 20,000 small businesses in every state. The lender has developed a proprietary credit scoring model that it uses to make decisions on small business loan applications in a matter of minutes, based on the information borrowers provide in a simple online loan application that takes less than 10 minutes to complete.

Kabbage specializes in lending to online merchants and e-commerce businesses — their loan review process looks at the merchant’s online transaction history, user feedback ratings and even social media activity, along with its business credit score. Once approved, borrowers can access their funds immediately via PayPal.

Advantages and Drawbacks

The biggest benefits of Internet lending to borrowers are the ease of application and relatively high loan approval rates compared to bank consumer and small business loans. Specific loan approval rates vary among different Internet lending platforms, but in general, it’s easier to get a loan from a peer-to-peer or cloud lender or via crowdfunding than it is from a traditional bank.

But this ease of application and approval does come at a cost. The interest rate on small business cloud loans is generally higher than on bank small business loans. Interest rates on consumer peer-to-peer loans vary widely — they can be higher or lower than bank consumer loans, depending on many different factors.

Crowdfunding, meanwhile, is a little bit different from peer-to-peer lending and cloud funding. Most crowdfunding lenders aren’t looking to earn high rates of return on their money; rather, they just want to help entrepreneurs raise money to start a new business venture or launch a new product or service. Also, borrowers raising money via crowdfunding typically must raise 100 percent of their requested amount in order to receive funding — if they fall short, they don’t get any money.

If you are involved in the lending industry, it’s probably smart to keep Internet lending on your radar. It will be interesting to see how it fares in the coming years as traditional bank lending continues to search for its footing.