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State of Banking, 2016

Cleveland Fed bank examiners and regional bankers say challenges abound for the banking industry, but, overall, bank performance remains solid.

The banking industry remains strong, but the operating environment is extremely challenging, and an uptick in provisions for credit losses suggests that bankers expect asset quality to deteriorate in the near term, say banking supervisors with the Federal Reserve Bank of Cleveland.

“Profitability is high from an absolute dollar standpoint,” says Stephen Ong, a vice president who oversees risk supervision and financial stability. “But return on average assets for banking organizations remains below pre-crisis levels. Capital is strong, liquidity is adequate. There may be a turning of the corner relative to asset quality and lending conditions. We’ve been noticing over the last several months that bankers have been increasing their provisions [for loan and lease losses], a situation which indicates they are expecting higher losses. The bankers may be recognizing losses coming up in the near future, so they’re reserving a little more in their allowance for loan losses.”

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According to Call Report data, the dollar amount for provisions for loan and lease losses (PLL) increased nationwide between December 2014 and December 2015 for the first time since 2008–2009. And in the Fourth Federal Reserve District, which comprises Ohio, western Pennsylvania, the northern panhandle of West Virginia, and eastern Kentucky, while PLL actually dropped, it was the smallest decrease in PLL (-1.27 percent) since 2005 (-0.77 percent). The rest of the past decade, PLL either grew in the Fourth District by double or triple digits or dropped by 9 percent and often much more.

Still, provisions for loan and lease losses remain low comparatively, notes Nadine Wallman, a vice president overseeing the supervision of banking organizations with less than $50 billion in assets.

“Increased provisions don’t mean we’re heading for a credit crisis,” Wallman says. “We’re coming off a timeframe of loan loss reserve releases [when banks withdraw funds they’d set aside for losses]. Provisions for loan and lease losses are nowhere near the levels we saw before the crisis.”

Nadine Wallman

Such provisions are increasing primarily because of concerns related to the energy sector, bank examiners say. That said, banks’ exposure to energy assets relative to overall bank loan portfolios is very small both nationwide and in the Fourth Federal Reserve District, notes Ong.

According to the Federal Reserve Board’s April 2016 Senior Loan Officer Opinion Survey on Bank Lending Practices, of those domestic banks that had made loans to firms in the oil and natural gas drilling or extraction sector, a majority reported that such lending accounted for less than 5 percent of their outstanding commercial and industrial (C&I) loans.

Jenni Frazer

Not only did banks report that they expect delinquency and charge-off rates on loans to firms in the aforementioned sector to deteriorate somewhat over the remainder of 2016, but they also indicated that “the credit quality of loans made to businesses and households located in regions of the United States that are dependent on the energy sector had [also] deteriorated somewhat.”

“In our District and nationwide, it’s the energy sector that’s contributing to the uptick in losses and projections for losses,” explains Jenni Frazer, a Cleveland Fed vice president overseeing the supervision of large banking organizations with more than $50 billion in assets. “Otherwise, there’s not a particular industry or portfolio that we’re concerned about. Even on the real estate side, it’s a longer trend. We’re seeing relaxation of underwriting, but it’s not translating into losses yet.”

That may be, but the easing of commercial real estate (CRE) underwriting standards prompted federal regulators to issue guidance in December, reminding institutions to maintain appropriate risk management practices.

“The agencies [Federal Reserve Board of Governors, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corp.] have observed that many CRE asset and lending markets are experiencing substantial growth,” the statement reads.

The easing of commercial real estate (CRE) underwriting standards prompted federal regulators to issue guidance in December, reminding institutions to maintain appropriate risk management practices.

It also states, “The agencies’ examination and industry outreach activities have revealed an easing of CRE underwriting standards, including less-restrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements. In light of the developments mentioned above, financial institutions should review their policies and practices related to CRE lending and should maintain risk management practices and capital levels commensurate with the level and nature of their CRE concentration risk.”

More often than not, the relaxation of underwriting standards leads to increases in nonperforming assets and net charge-offs over time, the Cleveland Fed’s Ong explains.

Still solid

There’s not a major difference between banking conditions of last year and this year, Frazer says.

“Last year, the banking industry was in sound condition, and that’s the case today. Despite some trends,” she explains, “the fundamentals are still very solid.”

Compressed net interest margins and nonbank competition for what’s been modest loan demand continue to challenge bankers, as do the needs to mitigate cybersecurity risks and to be mindful of geopolitical risks such as the extension of credit to entities doing business in countries experiencing downturns and negative interest rates.

Daryl Patterson

Daryl Patterson, chief credit officer for Fifth Third Bancorp based in Cincinnati, regularly asks his team members if they are seeing anything particularly bad or unusual in the marketplace in terms of underwriting, especially given the pressure that unregulated nonbanks put on terms, covenants, and other structures. So far, the answer’s been no, Patterson says, but the possibility of underwriting deterioration remains.

“We’re in the pretty late innings of an extended cycle,” he says. “We’re very mindful of loosening of terms and stretching too far. It can happen out there. It tends to happen in a tight growth environment.”

From a loan demand perspective, Patterson says, “it’s been slow and steady both on the consumer and commercial sides.”

Still, banks’ C&I lending by dollar volume has increased year over year, albeit slightly. The same is true of banks’ CRE lending. Net income, or profit, is also up year over year in the aggregate in both the region the Cleveland Fed serves and in the nation.

“One current driver to boost earnings is to reduce noninterest expense,” explains Frazer. “That’s reductions in people and systems and delays in infrastructure investments, and that’s something that’s not sustainable. The second area is a focus on fee-generating businesses. We’re seeing a lot more investment in asset management and payment services.”

Fifth Third’s Patterson agrees that keeping down costs is a pressing focus for bankers.

“As far as the economic environment and loan demand, it’s a fairly tough environment in terms of growing the top line,” he says. “All banks will be challenged to show material revenue growth. As a result, expenses will continue to be under strong scrutiny from a control perspective.”

Some large banks are also acquiring fintech, or financial technology, companies, though it’s too early yet to gauge a return on those investments, bank examiners say.

Banks also appear to be acquiring each other with more frequency, as merger and acquisition activity and interest in M&A are higher than they were last year, Wallman says, undoubtedly as bankers seek to grow revenue, expand their business activities, and build efficiencies.

Regulators already are evaluating mergers involving 3 large banking organizations in the Cleveland Fed’s region, Wallman notes. Columbus-based Huntington Bancshares Inc. and Akron-based FirstMerit Corp. have announced an agreement wherein Huntington would acquire the latter, and Cleveland-headquartered KeyCorp has announced its intent to acquire First Niagara Financial Group Inc. of Buffalo, NY.

“Given that regulators consider factors such as an acquiring bank’s financial condition and the soundness of its risk management and compliance programs prior to approving any application, the condition of the industry has to be sound overall to support any type of expansionary activity,” Wallman notes.

All banks will be challenged to show material revenue growth. As a result, expenses will continue to be under strong scrutiny from a control perspective.

Wallman expects such industry consolidation to continue.

Banks in the aggregate hold substantially more liquid assets, namely cash and held-to-maturity securities, on their balance sheets than they did 5 years ago. For example, Fourth Federal Reserve District banks held $69.5 billion in cash as of December 31, 2015, up 117 percent from $32.1 billion in cash as of December 31, 2010. As of the end of last year, those same banks held $79.5 billion in held-to-maturity securities, up 493 percent from $13.4 billion in such securities at the end of 2010.

The spikes in liquid assets are a direct result of regulatory action, bank examiners and bankers say, specifically the liquidity coverage ratio, which requires certain large banking organizations to hold a minimum amount of high-quality liquid assets that can be converted readily into cash in order to meet net cash outflow needs over a 30-day time horizon. Such assets are lower yielding, and “that, too, has affected banks’ earnings performance,” Ong says.

Challenges on the horizon

Sally Cline

Sally Cline classifies the mood among the bankers she knows as “relatively somber,” at least for many of the local independent banks. An executive vice president with the West Virginia Bankers Association, Cline calls regulatory burden the industry’s primary challenge.

“Bankers are just burned out,” she says. “You hear time and time again that banking is not fun anymore. Because of all the laws and regulations, they don’t have discretion to help their customers the way they would like to. There’s fear of enforcement actions and regulation.”

There are also succession-related hurdles to clear.

“A lot of the C-suite bankers are baby boomers entering retirement, and I’m seeing a lot of these banks, particularly in rural communities, having a hard time attracting people to replace them,” Cline explains. “I see that as a significant weakness in West Virginia.”

Further changes are to be expected, particularly the global economy, technology, cyber risk. Consolidation is on the minds of a lot of bankers right now. You have increasing competition from the nonbank financial providers. Those are all areas that will pose a challenge to bankers in the months and years to come.

When asked how banking conditions are likely to change in the second half of 2016 into early 2017, Cline replies, “There’s a lot of uncertainty.

“Further changes are to be expected, particularly the global economy, technology, cyber risk,” she adds. “Consolidation is on the minds of a lot of bankers right now. You have increasing competition from the nonbank financial providers. Those are all areas that will pose a challenge to bankers in the months and years to come.”

Sum and substance: Though net income and commercial lending continued to increase in the aggregate in 2015, the present state of banking is challenging.

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Bad debts and mergers and acquisitions are just 2 topics Cleveland Fed bank examiners tackled in Forefront’s State of Banking, 2015.

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