Meet the Author

James B. Thomson |

Author

James B. Thomson

James Thomson is a former vice president and financial economist in the Research Department of the Federal Reserve Bank of Cleveland. He retired in February 2013.

05.30.07

Economic Trends

Fourth District Community Banks

by James B. Thomson and Cara Stepanczuk

Of the 292 banks headquartered in the Fourth Federal Reserve District as of March 31, 2007, 268 are community banks—commercial banks that have less than $1 billion in total assets. The number of community banks headquartered in the Fourth District has declined rapidly in recent years as a result of bank mergers; in 1998, there were 337 such banks in the district. The structure of the market with respect to asset size has also changed. Before 2000, the majority of community banks in the district had less than $100 million in total assets. Since then, banks in the mid-size category ($100 million to $500 million) have constituted the majority.

Mid-size banks also hold the largest amount of assets in the Fourth District (almost 60 percent). The shift in assets from the smallest community banks to the largest community banks in the Fourth District reflects the continued consolidation of the industry.

Total asset growth for Fourth District community banks increased at a 1.2 percent annualized rate in 2007:IQ, but has fluctuated in the last few years. Community banking assets declined sharply in 2000 and 2004. Note that the decline in assets does not necessarily mean that the banks closed shop and 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. For example, the two years in which annual growth rates for assets were the lowest are those in which the greatest number of institutions consolidated or left the population of Fourth District community banks.

The income stream of Fourth District community banks has shown some slight deterioration in recent years. The return on assets (ROA) deteriorated from 1.7 percent in 1998 to 0.8 percent in 2007:IQ. (ROA is measured by income before tax and extraordinary items, because one bank’s extraordinary items can distort the averages in some years.) The decline is in part due to weakening net interest margins (interest income minus interest expense divided by earning assets). Currently at 3.64 percent, the net interest margin is at its lowest level in over 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, this figure remains at its highest level 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 beginning of 2007, 51 percent of their assets were in loans secured by real estate. Including mortgage-backed-securities, the share of real estate-related assets on the balance sheet was 57.6 percent.

Fourth District community banks finance their assets primarily through time deposits (77 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 that are collateralized by the bank’s 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 (6.6 percent of total liabilities) and remain an important source of backup liquidity for most Fourth District community financial institutions.

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. With the exception of a sharp rise in 2001, problem commercial loans have returned to their 1998–2000 levels in recent years, thanks to the strong economy. Currently, 2.47 percent of all commercial loans are problem loans. Problem real estate loans are only 1.25 percent of all outstanding real estate-related loans, but they are at the highest level since 1998. Problem consumer loans continued their decline in 2007:IQ. Currently, 0.40 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 the problem loans, there was a sharp increase in the net charge-offs of commercial loans in 2001 and 2002. Consumer loans followed a similar path but have remained slightly elevated since the recession. Fortunately, the charge-off level for commercial loans has returned to its pre-recession level. Net charge-offs in 2007:IQ were limited to 0.61 percent of outstanding commercial loans, 0.69 percent of outstanding consumer loans, and 0.07 percent of outstanding real estate loans.

Capital is a bank’s cushion against unexpected losses. The recent trends in the 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 beginning of 2007. 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 the bank’s capital and loan loss reserves relative to its problem assets. As of 2007:IQ, Fourth District community banks had almost $15 in capital and reserves for each $1 of problem assets. While the coverage ratio declined considerably following the high charge-off periods of the early 2000s, balance sheets are still strong.