A Close Look at Fourth District Community Banks
Most of the 293 banks headquartered in the Fourth District as of December 31, 2006, are community banks—commercial banks with less than $1 billion in total assets. There are 269 such banks headquartered in the District today, a number that, as a result of bank mergers, has declined since 1998, when there were 337.
Community banking assets declined most severely in 2000 and 2004, which does not necessarily mean that any banks closed shop or left the district. A bank may disappear from our radar because it is acquired by an out-of-state bank holding company (which could change which Federal Reserve district the bank and branch offices belong to) or because it merges with another Fourth District bank and the total assets of the merged institution push it above the $1 billion cutoff.
The structure of the market with respect to asset size has also changed since 2000. Before then, most Fourth District community banks had less than $100 million in total assets, but since then, banks in the $100 million to $500 million category have constituted the majority.
The income streams of Fourth District community banks have shown some slight deterioration in recent years. Return on assets (ROA) deteriorated from 1.7 percent in 1998 to 1.3 percent in 2006. (ROA is measured by income before tax and extraordinary items, because one bank’s extraordinary items distort the averages in some years.) The decline in ROA is due in part to weakening net interest margins (interest income minus interest expense divided by earning assets). Currently at 3.68 percent, the net interest margin is at its lowest level in eight years.
One issue which may become a cause for concern in the future is the elevated level of income earned but not received; at 0.63 percent in 2006, this measure was at its highest since 2001. If a loan agreement allows a borrower to pay an amount that does not cover the interest accrued on the loan, the uncollected interest is booked as income even though there is no cash inflow. The assumption is that the unpaid interest will eventually be paid before the loan matures. However, if an economic slowdown forces an unusually large number of borrowers to default on their loans, the bank’s capital may be impaired unexpectedly.
Fourth District community banks are heavily engaged in real-estate-related lending. At the end of 2006, 51 percent of their assets were in loans secured by real estate. Including mortgage-backed-securities, the share of real-estate-related assets on their balance sheets was 57.6 percent.
Fourth District community banks finance their assets primarily through time deposits (76 percent of total liabilities). Brokered deposits—a riskier type of deposit for banks because it chases higher yields and is not a dependable source of funding—are seldom used. Federal Home Loan Bank (FHLB) advances are loans from the FHLBs, which are collateralized by banks’ small business loans and home mortgages. Although they have gained some popularity in recent years, FHLB advances are still a small fraction of community banks’ liabilities (7.1 percent of total liabilities).
Problem loans include loans that are past due for more than 90 days but are still receiving interest payments as well as loans that are no longer accruing interest. Problem commercial loans rose sharply in 2001 but returned to 1998-2000 levels in recent years, thanks to the strong economy. Currently, 2.15 percent of all commercial loans are problem loans. Problem real estate loans are only 1.16 percent of all outstanding real-estate-related loans but are at their highest level since 1998. Problem consumer loans continued their decline in 2006. Currently, 0.45 percent of all outstanding consumer loans (credit cards, installment loans, etc.) are problem loans.
Net charge-offs are loans that are removed from the balance sheet because they are deemed unrecoverable minus the loans that were deemed unrecoverable in the past but are recovered in the current year. As with problem loans, net charge-offs of commercial loans increased sharply in 2001 and 2002. A similar but less pronounced trend is visible in consumer loans. Fortunately, charge-off levels have returned to their prerecession levels in recent years. Net charge-offs in 2006:IVQ were limited to 0.78 percent of outstanding commercial loans, 0.63 percent of outstanding consumer loans, and 0.08 percent of outstanding real estate loans.
Capital is a bank’s cushion against unexpected losses. Recent trends in capital ratios indicate that Fourth District community banks are protected by a large cushion. The leverage ratio (balance sheet capital over total assets) was above 10 percent, and the risk-based capital ratio (a ratio determined by assigning a larger capital charge on riskier assets) was above 10.5 percent at the end of 2006. The growing ratios are signs of strength for community banks.
An alternative measure of balance sheet strength is the coverage ratio. The coverage ratio measures the size of a bank’s capital and loan loss reserves relative to its problem assets. As of 2006:IVQ, Fourth District community banks had $15 in capital and reserves for each dollar of problem assets. While the coverage ratio declined considerably following the high charge-off periods of the early 2000s, balance sheets are still strong.