Focusing on the Future: Regional Banks and the Financial Marketplace

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The Cleveland Fed is learning more about a small sector of banks called regionals to help clarify regulatory expectations in the wake of the financial crisis.

Of the approximately 6,300 banks across the country, just under 50 are considered regional. Individually, this type of bank doesn’t seem to pose any more of a threat to financial stability than does a local grocery store. But there is strength in numbers, and failure in the aggregate could spell trouble. The financial crisis taught the Federal Reserve and other regulators many things, perhaps the most critical being that they had not focused enough on relationships and dependencies within the broad financial system. The focus had been narrow and concentrated on individual banks, and the cost was a breakdown of financial stability.

So now, even innocuous-appearing institutions like regional banking organizations, or RBOs, get extra scrutiny. On this topic, the Cleveland Federal Reserve hosted a one-of-a-kind conference in October 2013 where regional bank executives and board members from across the country, industry and market specialists, and Federal Reserve officials talked about the role of RBOs in the financial marketplace. In a world where too-big-to-fail banks know they face stepped-up standards, and where community banks know they are excused from the most rigorous new rules, regional banks still face some uncertainty about how they will be supervised. That is why the Cleveland Fed is making the effort to better understand them a priority—so that regional banks can get clarity about their regulatory environment sooner rather than later.

Why regional banks matter

In size, regional banks fall somewhere between the megabank and the bank that still might do business with a handshake. They are like the overlooked middle child, and partly as a consequence their role in the financial marketplace is not yet well understood. The Federal Reserve Bank of Cleveland defines RBOs as those with assets between $10 and $50 billion. Others define it differently, and some define them by what they are not (i.e., they’re not too big to fail or community banks) but suffice it to say that these banks fall somewhere in the middle tier. This is not to say that they are all the same; within the class of banks known as RBOs some are on the large size, some small; some focus on traditional banking products, others provide a much more complex array of products and services.

All banks, however, matter for financial stability, and regional banks are no exception. Following the recent financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted with the overarching goal of addressing the sources of the financial crisis—regulatory gaps and the shadow banking sector. The Cleveland Federal Reserve in particular adopted the practice of filling those regulatory gaps by adjusting the manner in which it supervises financial institutions. In it, banking organizations are assigned to tiers based upon their size, complexity, and riskiness.

The Cleveland Federal Reserve first talked about this approach in 2009, as discussions regarding regulatory reform were taking place. This type of approach is now reflected in the Dodd-Frank Act, under which larger organizations are subject to much stricter regulatory guidelines, supervision, and expectations than smaller organizations.

What the new approach means for RBOs is still being hammered out, but the Federal Reserve is already focusing on "right-sizing" supervision and not pushing down expectations from the larger organizations. At the same time, supervisory expectations for regional banks will continue to evolve. The challenge is to ensure that regulatory expectations and supervisory approaches within the regional banking tier remain reflective of the size, complexity, and riskiness of those organizations.

Knowing what it does about the regulatory environment that RBOs are faced with, the Cleveland Federal Reserve’s approach to understanding this banking sector has focused on answering three questions. First, what impact do RBOs have on the regional economy? Second, what factors affect the health of these banks? Third, and most importantly, what role does this segment of banks play in financial stability?

Regional banks are regional drivers

RBOs are important drivers of growth in their local economies, but have been only recently. In the 1980s, banks rarely had a truly regional reach, in part because they were allowed to open branches only in limited geographic regions, and rarely across state lines. In fact, it wasn’t until 1994 that nationwide branching became feasible, albeit under certain restrictions and regulatory tests. But fast forward several years—think 2003 or so—and regional banks had become a recognized force in the industry. They generally grew by acquiring smaller banks or expanding into wider geographic territories, though exactly how they functioned wasn’t necessarily well understood. Today, regional banks, as defined by the Cleveland Federal Reserve, account for about 8 percent of the nation’s banking assets.

Numerous studies, including those by Cleveland Fed researchers, have shown that local economic conditions also impact bank health.1 It’s known that smaller regional banks, those closer to $10 billion in assets, tend to be more affected by their local economies. For example, if the unemployment rate is high in a small regional bank’s market, it will be reflected in its bottom line more than for larger regionals. The reason seems to be that smaller regionals are smaller in their geographic footprint, and perhaps narrower in their strategic focus, than larger regionals.

On the flip side, larger regionals are more sensitive to changes in the yield curve , and the wider the spread in yields, the healthier large regional banks tend to be. Larger regionals appear to be managing more activities involving interest-rate risk than their smaller counterparts, probably because of their greater sophistication or access to technology.

As the Cleveland Federal Reserve’s research progresses, RBOs’ impact on the regional economy should become even clearer.

Yield curves track the relationship between interest rates and the maturity of US Treasury securities at a given time. Some look to the slope of the yield curve—the difference between the yields on short- and long-term maturity bonds—as a simple forecaster of economic growth. Generally, a flat curve indicates weak growth, and a steep curve indicates strong growth.

What makes regional banks healthy

Knowing that RBOs affect their local economies on differing scales makes the Cleveland Federal Reserve’s second question—what makes regional banks healthy—even more relevant, as the health of the local economy depends partly on the health of their RBOs and vice versa. Our preliminary research, which was shared at the conference, shows that there may be some features common to both healthy regional banks and struggling ones in the new regulatory/supervisory environment since 2008.

What classifies a bank as healthy, for the purposes of this analysis, comes from using a bank-rating system called CAMELS. Under this system, the following components are assessed:

(C) Capital Adequacy
(A) Asset Quality
(M) Management
(E) Earnings
(L) Liquidity
(S) Sensitivity to Market Risk
These ratings combine financial measures with safety and soundness measures, and include both data and elements of supervisory expertise. CAMELS can deliver a clearer picture than most other individual measures, even though other metrics are undoubtedly useful. For this analysis, a high score on the CAMELS rating system equals a healthy bank.

Hot money refers to investment funds intended for the highest short-term rate of return.

Healthy regional banks shared both a high return on assets and a heavier reliance on "hot" money such as time deposits and brokered deposits. A high return on assets seems a given, but one might assume that large concentrations of hot money wouldn’t describe strong banks. But the preliminary analysis suggests that it can be a sign that banks had such good lending opportunities that the market readily supplied them with hot funds. To be sure, hot money can be risky when it creates a maturity mismatch, and a bank with a lot of mismatched maturities on its balance sheet would probably not be considered healthy.

As for traits shared among not-as-healthy RBOs, the preliminary research showed that these banks' portfolios had high concentrations of commercial real estate. They also tended to be located in states hit hardest by the crisis and recession, particularly where home prices crashed the most, and in states with unemployment rates greater than 10.5 percent.

A particularly noteworthy conclusion of the analysis, however, focused on something else the healthiest banks shared: higher expense ratios. This might seem counterintuitive, but one possible implication of a higher expense ratio may simply be that a bank is spending wisely on quality employees and systems—that’s why they achieved higher safety and soundness ratings. Runaway spending, of course, is probably not a recipe for success.

The preliminary results of this analysis into what has made regional banks successful since 2008 are, of course, just that—preliminary. Other explanations will be explored, other avenues considered. For now, the point is that the Cleveland Fed knows what success looks like; why and how requires more analysis.

Financial stability

The Federal Reserve’s work when it comes to fully understanding regional banks’ role in financial stability is, for all intents and purposes, still in an exploratory stage. Much progress has been made; however, to ensure that financial institutions—regardless of their size—have sufficient capital to absorb losses and support operations during times of adverse economic conditions, a key component in support of financial stability.

Take the Comprehensive Capital Analysis and Review (CCAR) process, for example, now in its fourth year. Throughout the rule-writing process for the Dodd-Frank Act's Stress Test and the work for clarifying examiner expectations, regulators such as the Federal Reserve, Office of the Comptroller of the Currency, and the FDIC have been working together to ensure clear standards are set that are appropriately tailored for the size and complexity of these firms. The burden of compliance with the CCAR falls on companies with more than $50 billion in assets—the largest banking institutions that by size alone can be thought of as systemically important.

The CCAR is an annual exercise by the Federal Reserve to ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks and sufficient capital to continue operations throughout times of economic and financial stress.

By comparison, regional banks will be conducting their own reviews annually and reporting the results to their regulator, with the first cycle to begin March 31. These company-run reviews are less burdensome and less complex than the Federal Reserve—run reviews. That reflects the spirit of the Cleveland Federal Reserve’s tailored approach—different tiers mean different expectations. This helps level the competitive playing field both between and within classes of banks while ensuring all companies have sufficient capital to weather an economic storm.

How regional banks can help themselves

In addition to the Federal Reserve’s focus on ensuring that its supervisory approaches evolve with the size and complexity of the firms it supervises, RBOs themselves have realized the need to strengthen their own control and oversight functions. One such area, which has evolved considerably over the past several financial crises, is enterprise risk management (ERM).

A leading topic of discussion at the Cleveland Federal Reserve’s RBO conference, ERM has become a critical component for financial institutions' boards of directors and executive management teams to ensure that risks throughout their organizations are appropriately measured, monitored, and controlled. As testimony to how critical ERM has become to financial institutions, one attendee stressed that their company strives to stay on the leading edge of ERM. Examples of leading practices discussed by conference attendees include board of directors' establishing formal risk appetites, risk management evolving from a control function to becoming something that is owned by all employees within the organization, and the presence of a credible challenge process among all levels of the organization.

In addition, financial institutions are recognizing the need to incorporate more forward-looking parameters in their measurement of risks as a means to better prepare for the uncertainty of the future. As a result, stress testing has become an increasingly important ERM component and therefore an important tool enabling boards of directors to effectively measure, monitor, and report the risks of their institution. Dodd-Frank added the expectation for regional banks to conduct company-run stress tests; however, as one conference attendee stated, such stress tests should be considered a staple risk management tool and not be viewed as a regulatory exercise.

Focusing on the future

While all bankers at the conference seemed to agree that the regulatory compliance environment can be onerous, they also agreed that to succeed they need to be best in class in all areas of regulatory focus. But that’s where agreement became less clear for the regional bankers.

Finding and retaining qualified staff, for example, is always a challenge, but it’s even more so when you’re looking for workers whose skill sets are in high demand, such as quantitative analysts and modeling experts. A common strategy among RBOs has been to outsource model development, which is expensive, and the banks need to continually perform gap analysis to determine if it is better to spend internally or externally. It’s also difficult to determine how much money to spend on risk management functions.

Achieving economies of scale was an underlying theme discussed by conference participants. Some regional banks report trying to be aggressive in their organic growth, but not all bankers think that will be successful in the long term. Others say that over the next few years, as happened in the 1990s, the greatest opportunity for RBO growth will be through acquisitions. Others think more philosophically: It is during the most challenging times that industry leaders pull away from the pack by capitalizing on opportunities.

In the banking world, many community banks focus mainly on service, megabanks on scope, online financial institutions on price. RBOs can offer it all, even under incredible pricing pressures. Because they focus on a particular region, RBOs also have the advantage of knowing their customers more intimately, allowing most to offer a specialized product or a more tailored customer experience. One banker at the Cleveland Federal Reserve’s conference suggested that this hybrid strategy is one way forward-looking RBOs might differentiate themselves.

The next steps in the Federal Reserve Bank of Cleveland’s effort are to extend and refine its preliminary analysis of what makes RBOs healthy. The Bank’s researchers will also be looking to build upon their understanding of the role these financial institutions play in the regional economy and their impact on financial stability.

  • 1. “Do House Prices Impact Business Starts?” Lakshmi Balasubramanyan and Edward Coulson. Journal of Housing Economics, vol. 22, issue 1, pp. 36-44 (2013).

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