Community banks adapt, show improved balance sheets in 2002

The following is excerpted from a speech by Federal Reserve Board Governor Mark W. Olson, delivered at the conference on "Whither the Community Bank," held March 13 at the Federal Reserve Bank of Chicago.

A natural place to begin these remarks about the future of community banking is in the present, with a snapshot of where we are now. The year that just ended was one of record profits for the industry as a whole, and for community banks in particular.

Community banks that is, those with assets of less than $1 billion earned $12.5 billion (11.7 percent) on equity, an increase of 80 basis points over 2001.

This past year was one in which commercial loan demand was very weak, and some of our largest banks stumbled. Community banks were able to adapt successfully to these conditions and made significant changes, in particular to their balance sheets.

Low interest rates, strong home values and weak equity markets all had important roles to play.

Total assets of community banks grew 3.7 percent, about the same as 2001, after several years of declines or minor increases. Nearly all of this year's loan growth came in lending secured by real estate. Construction and other commercial real estate lending represented about two-thirds of that growth and rose more than 10 percent during the year. Loans drawn under home equity lines of credit grew nearly 25 percent.

Outside of the loan portfolio, real estate was an important story as well. Holdings of residential mortgage pass-through securities grew 20 percent in 2002, part of an interesting reversal in community bank balance sheet trends.

Securities holdings increased in 2002 after eight consecutive years of decline, while total loans have declined only once over the same period (in 1998). Over the past two years, community bank holdings of mortgage pass-through securities have risen some 50 percent.

By and large, lending that is not secured in some fashion by real estate declined last year. Consumer loans declined nearly 9 percent, a bit faster than in 2001, while commercial and industrial loans were off very slightly.

Net interest margins rose slightly, to 4.29 percent, but remain about 25 basis points below levels that prevailed in the first half of the 1990s. Partly as a result of low interest rates and uncertainty in the stock market, money market deposit account and savings deposits grew 10 percent in both 2001 and 2002 and, at this point, fund nearly 25 percent of community bank assets.

Noninterest income overall remained at about 1.4 percent of assets, although up slightly (about 4 basis points) from 2001. Deposit growth overall also brought higher deposit account fees.

Mortgage origination revenues were aided by the refinancing boom, although their beneficial effects were moderated by write-downs of servicing rights at those institutions with mortgage-servicing portfolios. Income from fiduciary activities trust fees also declined, attributable in large part to weakness in equity markets.

Problem credits remain elevated but, on the whole, manageable. Nonperforming assets continued to rise moderately, reaching 0.95 percent of loans at year's end. While significant, this figure is less than half the 2.46 percent ratio seen in 1992. Loan losses amounted to 40 basis points of loans, about the same as 2001. Provisions once again exceeded charge-offs, at 0.57 percent of loans, allowing loan-loss reserves to remain at about 1.45 percent of loans and about two times nonaccrual loans.

Although total assets rose during the year, 2002 also brought further consolidation in the number of community banks. At year's end, there were just under 7,500 community banks, down 200 from 2001 and some 3,600 from 10 years earlier.

Protecting community banking

A healthy business franchise does not guarantee financial success, nor does it ensure a safe and sound banking system. From either perspective, it is important that community bankers continue to protect the value of their franchise by avoiding key missteps we have seen in the past.

With market yields at long-term lows and with a relatively steep yield curve, community banks need to keep a watchful eye on interest rate risk issues. Long-term residential mortgage lending comes immediately to mind.

More generally, a critical "franchise" issue for community bankers has been recognizing and managing credit risk concentrations that also tend to be a natural part of the community banking business.

Successful management of concentrations requires adherence to good credit fundamentals.

Strong capital ratios, well in excess of regulatory minimums, have also been a key to managing credit concentrations and, indeed, a striking attribute of the most profitable community banks. The top one-fifth of community banks, in terms of profitability, typically holds 1.6 percentage points more capital relative to assets than other community banks.

With the growth in assets and lending opportunities come potential complications with liquidity management. Assets have grown more rapidly than lower-cost nonmaturity deposits over time among community banks and across the industry, a trend that was only modestly reversed in 2002 by the balloon in money market deposit accounts and savings deposits. Among other factors, this trend has contributed to narrowing margins over the past few years. The relative stability of these nonmaturity deposits has been an important strength to community banks. Conversely, there have been too many instances where rapidly growing banks face unexpected liquidity pressures as they come to rely more heavily on noncore funding sources. Careful planning of growth and funding needs is a key aspect of sound management and requires the appropriate degree of management attention.

Let me also make a brief cautionary note about the importance of good internal controls and the need for management attention to their upkeep. This is simply good business practice, of course, but it's more than that. You may recall that a provision of the FDIC Improvement Act of 1991 required that the management of banks including many community banks report on the quality and integrity of internal controls and that auditors attest to this.

Unfortunately, in several recent examinations, bank examiners were able to identify clear internal control weaknesses that neither the banks' own processes nor outside auditors had noted. Some of these weaknesses raised safety and soundness concerns. Much more progress needs to be made in this area, and we will be following this matter closely in the coming months.