For Banks, Business Must Pick Up

Corporate borrowers remain chary as doubts mount about consumer stamina.
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With consumer spending

possibly faltering, the future of bank stocks could rest with business borrowers. That isn't necessarily good news for a sector that has struggled all year for catalysts and whose ballooning size relative to other segments makes it the No. 1 determinant of overall stock market return.

Since Jan. 1 through the end of the third quarter, the dollar value of outstanding commercial and industrial loans at the nation's banks is essentially unchanged from a year ago at $890 billion, according to the

Federal Reserve

. Over the same period, the volume of commercial loans is down 3% from the same time a year ago.

Judging by those numbers, it's hard to tell that an economic recovery is even under way. It's a big reason investors shouldn't expect anything but mediocre earnings growth at the nation's banks when they report their quarters.

"Growth won't be as great ... but we take what we can get," says Lehman Brothers bank analyst Jason Goldberg. "It will be a good, but not a great, quarter."

On average, analysts are expecting a 7% rise in earnings at the nation's banks, which begin reporting third-quarter numbers next week. The diminished expectations for the nation's banks may explain why the Philadelphia KBW Bank Index has barely budged in the past month.

The most vulnerable in the banking sector may be regional lenders such as


(STI) - Get Report


Fifth Third

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Regions Financial

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(KEY) - Get Report

, which rely on commercial lending to complement their consumer and retail lending operations.

While banks are likely to benefit from tighter controls on expenses and a continued decline in the number of bad loans on their books, they'll struggle to find revenue to fill the void. Clouding the revenue picture is a decline in home refinancings and mortgage originations, a combination that had fueled double-digit earnings growth at many banks earlier this year.

"We believe the main challenge for banks is to show revenue growth, which is more important now that the recovery story of the past few years is about done," says Michael Mayo, a bank analyst with Prudential Equity Group, in a recent research note.

But without a revival in commercial borrowing, banks may struggle to post even modest revenue gains. Banks can do little to spark such business. Right now, businesses simply don't want the money.

"You've only seen this kind of downturn one other time, in the early 1990s, and then it was the banks that wouldn't lend," says Goldberg. "But this time it's a lack of demand."

Some of the reticence in the business community about taking out new lines of credit stems from the continuing uncertainty about the strength of the economic recovery. A recent survey by PNC Bank found U.S. businesses "moderately optimistic" about the economy but concerned about the impact of rising oil prices and health insurance costs.

But it's more than economic jitters that is causing businesses to refrain from bank borrowing. With interest rates at historically low levels before the Fed started to tighten the money supply, the bond market presented an attractive alternative to bank loans for many companies. Banks are hoping that will change, now that interest rates are on the rise.

"With rates starting to rise, that may move people more to traditional loans than the bond market," says Meredith Coffey, director of analytics with Loan Pricing Corp.

Coffey also says the commercial lending statistics are a bit misleading. Earlier this year, she says, companies were taking out new bank loans, but those credit lines were being used to refinance existing bank debt. With corporate balance sheets in better shape, Coffey says it's only a matter of time before commercial borrowing picks up.

Ironically, the banks least hurt by the dearth of commercial borrowing are the nation's three biggest lenders,


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J.P Morgan Chase

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Bank of America

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, all of which have big investment banking operations that had feasted earlier this year on the corporate demand for debt offerings. The three banks also are the dominant players in the market for syndicated loans -- the big multimillion-dollar credit lines companies use to finance corporate mergers.

It's not all dreary news on the commercial loan front. Wall Street is expecting corporate borrowing to rise in the fourth quarter and keep rising into next year. Lehman's Goldberg is predicting that next year will be the best year for commercial lending since 2000.

Of course, many analysts had made similar predictions for 2004 back in January.