Imagine a strip mall: Its store fronts were all leased to small businesses when the owner went to the bank and got a loan with a 50% loan-to-value, a seemingly safe bet for the lender. Then the coronavirus pandemic hit, the nation went into lockdown, and suddenly 60% of those stores were vacant.

This is the situation lenders are facing in the post-pandemic world. Bankers must navigate a new economic reality where many borrowers are being propped up by temporary government stimulus and the full impact of COVID-19 remains unclear. That leaves them in a difficult position as they evaluate loan applications and gauge risk in their existing portfolio.

"The loan itself was never a bad loan, but it did depend on those businesses being around, whether it was a restaurant or dry cleaning, whatever it was," said Eric Corrigan, managing director in the financial institutions group at Commerce Street Capital who works with a lender client in a situation similar to the strip-mall scenario.

"We don't know the ultimate borrower behavior coming out of this. It's something you can't model. It's never happened before," Corrigan said. "So people are going to make adjustments, whether that's in the amount of loan-to-value that they'll lend against or the amount of cash flow that's required or guarantees or pandemic insurance clauses. ... It's going to change all of those things."

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'We're happy to sacrifice growth'

In response to the uncertainty, many lenders are hunkering down. Banks are being "as conservative as possible, especially with people that aren't existing customers," said Stephen Scouten, a bank analyst with Piper Sandler & Co.

"Bankers don't really have a clue yet what losses are going to look like. They know they've put a lot of their loans on deferral, they know they're not doing a lot of new loans today, but their existing book is kind of where the big risk factors lie," Scouten said. "In terms of true new business, new customer production, they're going to be extremely cautious."

Respondents to the Federal Reserve's April survey of senior loan officers reported that they tightened their standards on commercial and industrial, commercial real estate, and consumer loans, including credit cards and auto, during the first quarter of 2020.

The federal government has taken steps to bridge borrowers through the economic uncertainty. The CARES Act, the legislation aimed at addressing the effects of the coronavirus crisis, includes relief checks for Americans below a certain income threshold and requires lenders to grant forbearance to borrowers with government-insured mortgages who are experiencing virus-related hardship. The legislation also includes the Paycheck Protection Program, designed to provide billions of dollars in loans to small businesses to maintain their payroll during COVID-19 lockdowns. Many lenders report that they have been consumed by issuing PPP loans in recent weeks.

Outside of PPP, bank loans have been declining since the middle of April.

Independent Bank Corp. is one lender exercising caution. The Grand Rapids, Mich.-based community bank has about $3.6 billion in assets.

"What we're not doing is going down to lesser credits and trying to drum up business or drum up growth. We're happy to sacrifice growth to maintain our credit standards," CFO Stephen Erickson said in an interview.

Rethinking underwriting

In some instances, lenders are adjusting loan terms and their approach to underwriting to address the changing reality.

Leverage is getting "tucked in," required equity contributions are increasing "pretty substantially," pricing has ticked up and there is general tightening in legal terms, said Derek Ladgenski, a partner at law firm Katten who advises banks on debt financing deals. But if a deal is solid, borrowers are still driving good terms.

"Everyone is tucking in a little bit, but in terms of wholesale recalibration on truly competitive deals, a good deal is still a good deal, and lenders are going to make educated, sophisticated decisions," Ladgenski said.

BFS Capital, which provides working capital loans to small businesses, has seen a drop-off in requests for payment deferrals and a recovery in payment rates, as borrowers have accessed government aid and come up with creative ways to adapt to social distancing and other pandemic obstacles, CEO Mark Ruddock said.

The company is moving cautiously, adding capital and "actively managing" its loan books as it overhauls its underwriting approach in the face of the crisis.

"The old way of underwriting working capital loans for small business was increasingly algorithmically assisted" and largely driven by "rearward-looking information," Ruddock said. But data on how a business performed during the crisis is not particularly useful in making conclusions about performance after the pandemic passes.

Ruddock said BFS is shifting to a model that uses real-time bank and cloud accounting data to make ongoing, incremental decisions on credit amounts over the life of a loan. He also said the company is relying on its risk committee to make judgments about the relative prospects of different industries — doctors' offices crushed by shutdown might bounce back quickly, for example.

"In the near term, it's really a hybrid of algorithm and human," Ruddock said.

For now, the banking industry is playing a "waiting game," said Janney Montgomery Scott analyst Christopher Marinac. That can mean making difficult calls.

"Some banks may have to have the hard medicine or the tough love of saying no unless the deal is right and the price is right," Marinac said. "All the forbearance and all the deferrals that we now have in place, that kind of creates a little bit of uncertainty for how to behave on new credit because you're not going to know truly know the status of that customer until the end of September."