Canada’s banks should fear shrinking U.S. loan spreads

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Shrinking U.S. loan spreads have raised warning flags for Canadian banks looking to lend more south of the border.

The Federal Reserve's newest senior loan officer survey found that two-thirds of big banks – those with more than $20-billion in assets – are seeing the spreads on their large and mid-market commercial and industrial loan portfolios collapse. In other words, the banks are making less per loan.

At a high level, the news of tighter spreads may not seem all that surprising. U.S. net interest margins – the difference between the rates at which banks borrow and lend money – has been shrinking for a few years.

But the new emphasis on commercial lending is particularly worrisome. Until now, the spread concerns have centred on personal lending. Most investors and analysts appreciate that the competition for retail loans is stiff, requiring the banks to cut into their profits.

Canadian banks with U.S. operations have often touted the strength of their commercial lending arms. Just last quarter Bank of Montreal stressed that its U.S. commercial banking team "had another strong year," adding that core C&I loans jumped 19 per cent in fiscal 2013 and noting that its loan growth had been in the mid-to-high double digits all year.

Others, like Royal Bank of Canada, have talked about just how heavily they are pursuing U.S. commercial lending growth. RBC has made it very clear that its U.S. capital markets bottom line is increasingly dependent on lending to big name clients, and in September the bank noted that its U.S. loan book doubled in size since 2008.

The latest survey raises questions about future profits. Although the banks are lending more, the returns may not be as great. "The rate of growth in C&I net interest revenue was appreciably less than the growth rate of C&I loans across the industry," rating agency Moody's Investors Service noted after analyzing the survey.

"In short, banks are being paid less to take on more risk," Moody's added.

However, the agency acknowledged that the data proves a downward trend in commercial spreads since 2010, so the recent survey results for shouldn't be too terrifying. Mark Furlong, BMO's U.S. personal and commercial head has also talked about operating in a tough market, forcing the bank to overcome "headwinds from low rates [and] competition in commercial banking."

But the latest survey only shines a brighter spotlight on the commercial lending arms, forcing the banks to work harder to dispel investor fears.

The Fed survey also contained some interesting data on auto loans, proving that this market's underwriting standards are loosening. The amount of time the banks are giving their borrowers to pay back their loans is growing, rising to an average of 65 months on new auto loans, up from 62 in 2009.

Because loan tenors have risen, even though consumers typically buy a car every 36 months, "vehicle depreciation tends to be greater than the principal reduction of the car loan. This results in banks often rolling the negative equity into the new car loans, resulting in higher loan-to-values and increasing the chances of higher loss severity," Moody's noted.

TD and BMO are two of the eight U.S. banks whose auto lending comprises 10 per cent or more of their total lending portfolio, putting them at higher risks of trouble, should the market deteriorate.