Air Coming out of Commercial Credit Balloon

(MoneyWatch)  While the shaky commercial real estate sector is a major source of concern for financial institutions, U.S. banks have another problem on their hands: Falling commercial and industrial lending.

Compared with consumer borrowing, C&I loans have held up relatively well during the recession. But that business, until recently a source of strength for banks, is giving way. That also has wider implications, since the availability of commercial credit is a marker for the overall buoyancy of the economy.

By that measure, we're still sinking. Total C&I lending fell to $1.3 trillion in the second quarter, down eight percent from the year-ago period and from a peak of $1.6 trillion in October.

Existing C&I loans also are in bad shape. The rate at which banks are writing off these assets rose 165 percent sequentially, the biggest quarterly hike for any loan category, according to the FDIC. Delinquency rates on C&I loans are also climbing, hitting 3.2 percent at the end of the first quarter.

For banks, that means the air is coming out of the business faster even than in consumer lending. After the dot-com bust, delinquency rates for C&I loans topped out at 3.9 percent in 2002 according to American Banker. That suggests the current downturn has several quarters to run.

Businesses take out C&I loans for a range of uses, such as stocking inventories, making acquisitions, buying equipment and upgrading plants. Not surprisingly, these customers aren't borrowing, focusing instead on cutting costs and paring debt. Banks also have tightened their lending standards.

Of course, the decline in commercial credit had to happen as part of the overall deflation of the bubble. You "glass half full" types will say it's a painful, but necessary, step toward recovery -- no argument there. The retreat by big banks in C&I loans also represents an opportunity for regional and community banks. Smaller institutions usually suffer lower C&I losses during downturns, and they have the local relationships to drive business when economic conditions improve.