May 28, 2013
Authored by: Robert Klingler
Notwithstanding the headlines in the press, more community banks thrived during the Great Recession than failed. A new study from the Federal Reserve Bank of St. Louis looks at The Future of Community Banks: Lessons from Banks That Thrived During the Recent Financial Crisis. While 417 banks and thrifts failed from the beginning of 2006 through the end of 2011 (and another 51 banks failed during 2012), the Federal Reserve Bank of St. Louis found that 702 community banks (total assets of less than $10 billion) retained a composite CAMELS 1 rating throughout the financial downturn.
The report confirms that community banks can continue to play a vital role in the U.S. economy by allocating credit and providing financial services in their communities – particularly to the small businesses in those communities. In general, the thriving banks were found to have strong commitments to maintaining standards for risk control in all economic environments and business plans that work for their individual markets. At a macro level, the thriving banks had lower total loans-to-total asset ratios (54% vs. 65%), lower concentrations in commercial real estate and construction and development lending, higher concentrations in consumer and agricultural loans, and were slightly more reliant on core deposits.
It is clear that at least some of the thriving banks elected to forgo income in exchange for lowering the risk exposure experienced by the bank. The low loan-to-total asset ratio resulted in lower returns.; almost 36% of the thriving banks were in the lowest quartile of their peers for interest income (although 42% were in the lowest quartile for interest expense). Similarly, the thriving banks grew at a rate that was half that of non-thriving banks from 2004 through 2007. That said, thriving banks provided an average return on assets of 1.5% and an average return on equity of 12.7% during the period from 2006 though 2011. (The report also acknowledged the risks present in an aggressive investment portfolio, including a note that the thriving banks “either intentionally or serendipitously” avoided purchasing the preferred shares of Fannie Mae and Freddie Mac.) This aspect of the research may be the most important from understanding expected regulatory pressures, with continued regulatory scrutiny on above average growth. A community bank can only outgrow the growth of its market by (a) increasing market share by stealing customers from competitors, (b) expanding outside of its market, or (c) expanding its lending practice into new categories of loans. Each of these practices potentially moves the community bank up and out the risk curve.
However, the report also noted a great degree of variability amongst the community banks that thrived during the downturn; there was no one dominant business plan that was necessary to thrive. Non-interest income was certainly in a number of thriving community banks, but overall almost 20% of the thriving banks were in the lowest quartile of their peers for non-interest income. Similarly, maintaining a low efficiency ratio was important to many thriving banks, but over 10% of the thriving banks experienced non-interest expenses that placed them in the highest quartile of their peers. Thriving banks tended to have higher capital ratios than their peers, but there was substantial diversity among the thriving banks with regard to capital ratios; 39 percent had a leverage ratio in the highest quartile, but 18 percent were in the lowest quartile.
While CRE concentrations were, on average, lower in the thriving group, the report also found that 16% of the thriving banks exceed the federal supervisory guidelines for commercial real estate at some during the 2006 through 2011 period, indicating that it is possible for community banks to successfully manage the risks inherent in CRE lending, particularly so long as management had a deep knowledge of these “concentrated” lines of business and had robust risk management controls in place in case their niche business line underperformed.
While generally a strong study, I believe the report suffers from two weaknesses, only one of which is expressly acknowledged in the report. First, as noted in the report, the results of the analysis were shaped by the economic environment of the Great Recession, namely a collapse of the real estate market. While the report found that a concentration in agricultural lending had a statistically significant impact on whether a bank was a thriving bank, it did so in the context of an economic environment in which agricultural land and product prices increased. As acknowledged by the study, if the same analysis were conducted with data from the 1980’s, they would ten to observe the opposite case; concentrations in agricultural lending would be a source of weakness.
The study also fails to fully address the importance that geography played in whether a community bank was able to thrive during the Great Recession. The report notes that the West Coast and Southeast had the fewest thriving banks, and suffered some of the biggest declines in property values in the nation. While the report acknowledges that the geographic concentration found in the study appears to be related to the relative prosperity of the agricultural and energy sectors of the economy, by aggregating the thriving banks in successful geographical areas and comparing with the aggregated non-thriving banks in other areas, the report fails to explore either the relative importance of geography or how the relatively few community banks in economically depressed areas nonetheless managed to avoid CAMELS downgrades. In our experience, community banks can rarely significantly over perform the communities they serve, no matter what risk controls are in place. While community banks could attempt to diversify outside of the communities they serve, this out-of-market lending is equally (if not more) risky. Similarly, particularly in states with significant economic distress, potentially thriving community banks (and community banks that may have otherwise qualified for the study if the CAMELS ratings were purely objective) may have been downgraded one or more CAMELS ratings merely because of the economic uncertainties of the region and regulator pressures on the individual examiner in charge to have justified why a particular community bank should not have been downgraded. Two identical banks in different markets (or difference FDIC districts) can easily get different ratings. The Report also did not analyze whether the “thriving” banks were able to play a dominant role in the local market they serve. While dominance can be a difficult feature to quantify for study purposes, we believe that whether a community bank is the dominant bank in its local market plays a significant role in the bank’s ability to weather economic downturns.
We suspect that a survey of 2-rated banks may have been even more meaningful for many community bankers. 1-rated banks can be considered too conservative, and unwilling to move slightly out the risk curve in exchange for better expected returns (and may be operating below the efficient frontier of maximizing expected returns for any given level of risk). The low loan-to-total asset ratios experienced by the “thriving” banks is a good example of the overall risk tolerances of these banks. The Fed study briefly analyzes other potential definitions for “thriving” banks, and notes that 2-rated banks had an average total loan-to-total assets ratio of approximately 63%. At least during the Great Recession, however, the conservativeness of the 1-rated banks vis-a-vis the 2-rated banks also led to higher average returns on assets (1.5% vs. 1.1%).
Notwithstanding its weaknesses, the St. Louis Fed study is worth a review by community bank management and directors. While there is a strong future for well-run community banks, each bank must develop a business plan that works in its market… and that can be explained to regulators.