Meet the Author

O. Emre Ergungor |

Assistant Vice President and Economist

O. Emre Ergungor

Emre Ergungor is an assistant vice president and economist in the Research Department at the Federal Reserve Bank of Cleveland. He is responsible for the household finance section of the Banking Policy and Analysis Group, which conducts research on regulatory policy and banking issues and provides advice on financial policy formulation. He also oversees the Federal Reserve System’s Muni Financial Monitoring Team (FMT), which monitors municipal bond markets, state and local funding, and public pension funds. Dr. Ergungor specializes in research related to financial intermediation, information economics, housing policy, and credit access in low- to moderate-income households.

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Economic Trends

Fourth District Community Banks

O. Emre Ergungor and Patrick Higgins

Of the 290 banks headquartered in the Fourth Federal Reserve District as of June 30, 2007, 265 are community banks—commercial banks that have less than $1 billion in total assets.

The assets of community banks in the Fourth District have risen in five of the past eight years and declined in three. A decline in the community banking assets within the district does not necessarily mean that any banks closed shop or left the district. A community bank might disappear from our radar because it is acquired by bank holding company that is headquartered in another district (which would change the district the bank and branch offices belong to) or because it is acquired by another Fourth District holding company and the combined assets of the banks after the acquisition exceed the $1 billion cutoff. The latter phenomenon occurred twice in May 2007. The Lorain National Bank, a Fourth District bank with assets of $853 million in the first quarter of 2007, acquired Morgan Bank, National Association—another Fourth District bank whose assets were $125 million in the first quarter of 2007. By the second quarter of 2007, the assets of the acquirer totaled $1.003 billion, just over the threshold that defines a community bank. This acquisition explains most of the second-quarter 2007 decline in year-to-date community bank asset growth. Including the Lorain National Bank’s second-quarter 2007 assets with the Fourth District’s second-quarter 2007 community bank assets pushes up year-to-date asset growth in that quarter from −3.4 percent to 0.7 percent.

Another acquisition of a Fourth District community bank occurred in May 2007 when the Bank of Kentucky, whose assets have exceeded $1 billion since 2006, acquired the First Bank of Northern Kentucky. These two acquisitions account for the decline in the number of community banks headquartered in the Fourth District, from 268 in the first quarter of 2007 to 265 in the second quarter. Since the end of 1998, the number of Fourth District community banks has declined by 72 (from 337) as a result of other bank mergers and acquisitions.

The structure of the market with respect to asset size has also changed since 1998. Back then, most Fourth District community banks had less than $100 million in total assets. Now banks in the $100 million to $500 million category constitute the majority.

The income stream of Fourth District community banks has shown some slight deterioration since 1998. The return on assets (ROA) deteriorated from 1.7 percent in 1998 to 1.3 percent in the second quarter of 2007. (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 due in part to weakening net interest margins (interest income minus interest expense divided by earning assets). The net interest margin has trended down, from 3.97 percent in 1998 to 3.69 percent in the second quarter of 2007.

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 the second quarter of 2007, 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. In the second quarter of 2007, 51.4 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 58 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, 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 (6.9 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, returned to 1998–2000 levels by the end of 2006 thanks to the strong economy, and have since crept up some to their current level of 2.58 percent. Problem real estate loans were only 1.25 percent of all outstanding real-estate-related loans in the first quarter of 2007 and 1.21 percent of all such loans in the second quarter. These are still the highest figures since 1998. Problem consumer loans have continued their decline in 2007. Currently, 0.38 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 the second quarter of 2007 were limited to 0.61 percent of outstanding commercial loans, 0.73 percent of outstanding consumer loans, and 0.11 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. In the second quarter of 2007 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 nearly 11 percent. 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 the second quarter of 2007, 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.