Banks as Vital Infrastructure for Rural Communities

On December 5th, Federal Reserve Bank Vice Chairman for Supervision, Randal K. Quarles, gave a speech at the Stanford Institute for Economic Policy Research titled “Banks as Vital Infrastructure for Rural Communities of the West”. While his speech focused on the western states, the fundamental points are relevant to community banks and rural markets across the U.S. The following are some of the key points from his speech:

What was said regarding importance of Community Banks to rural markets:

  • In any community, access to credit is essential for economic growth. In any community, but especially in rural communities, small businesses are key drivers of growth. Small businesses heavily rely on banks for funding, and community banks, those with less than $10 billion in assets, account for a disproportionate share of bank lending to small businesses.

  • But across the country, the number of community banks has fallen by half over the past 20 years, mostly due to consolidation.

  • Faster and more efficient electronic payments hold some promise to bridge these gaps, eventually, and the Federal Reserve is working hard on this and making significant progress.

  • But one thing that technology cannot do is replace the knowledge and perspective of a local banker who is part of the community. Relationship-based lending that is the hallmark of community banking can stem losses during downturns, since community banks may be able to work with borrowers to avoid losses. Research has shown that small business lending at smaller banks declined less severely than at large banks during the last recession.

  • Community banks face considerable competition. One of the reasons that community banks continue to succeed in many places is their understanding of their customers' needs and opportunities to invest in families and businesses. The loss of this relationship, for a community, means that needs will go unmet, and opportunities will be lost.

Smaller, rural markets are predominantly served by Community Banks as shown in this graphic. It is Community Banks that are headquartered in counties with populations of less than 50,000.

But, as the Fed indicates in the speech, there continues to be a decline in the number of banks serving these smaller, rural markets.

What is Federal Reserve and other regulators doing to help Community Banks:

  • Recent regulatory focus has been aimed at streamlining regulations and reducing the regulatory burden on smaller and regional banks.

  • Proposed a community bank leverage ratio that is designed to simplify significantly the standards banks must abide by for holding capital. As a result, qualifying community banks will only need to calculate and meet a single measure of capital adequacy, rather than multiple measures.

  • Proposed a reduction in the burden of reporting requirements for community banks.

  • For a subset of the smallest banks - those with less than $5 billion in total assets - regulators have also lengthened the amount of time between supervisory examinations and expanded eligibility of small bank holding companies that qualify for an exemption to the Federal Reserve's capital rules, a policy that was designed to promote local ownership of small banks and to help maintain banks in rural areas.

This trend - decline in number of community banks - is expected to continue. Actions such as these regulatory relief measures are important steps toward slowing that decline. But it will take a concerted effort by community bankers, their communities, community bank trade groups such as the Independent Community Bankers of America (ICBA) and bank regulators to identify the additional actions necessary to slow this declining trend. Community banks play such a critical role in supporting rural markets and their economies.

For further information and data on trends in community banks, go to tab titled: Community Banks: Number by State and Asset Size.

Proposed Community Bank Leverage Ratio Election

Text Example

Updated to add final Notice of Proposed Rulemaking and final due date - April 9, 2019 - for comments.

The FDIC, OCC and Federal Reserve have issued their proposal for implementing the Community Bank Leverage Ratio under Section 201 of the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCP Act) enacted in May of 2018. This proposal was made public in a November 21, 2018 press release and is expected to appear in the Federal Register soon with comments due by April 9, 2019 (Link to NPR).

Under the proposal, a community banking organization would be eligible to elect the community bank leverage ratio framework if:

  • Less than $10 billion in total consolidated assets

  • Total off-balance sheet exposures < 25% of total assets

  • Total trading assets and liabilities < 5% of total assets

  • Limited amounts of certain assets such as deferred tax assets, and

  • Community Bank Leverage Ratio (CBLR) greater than 9 percent.

A qualifying community banking organization that has chosen the proposed framework would not be required to calculate the existing risk-based and leverage capital requirements - this is the regulatory relief. Such a community banking organization would be considered to have met the capital ratio requirements to be well capitalized for the agencies’ prompt corrective action rules provided it has a CBLR greater than 9 percent.

Calculation of the CBLR:

CBLR = Tangible Equity Capital divided by Average Total Consolidated Assets

Key considerations by federal banking regulators in designing CBLR framework:

  1. CBLR framework is intended to be available to a meaningful number of well capitalized banking organizations with less than $10 billion in total consolidated assets.

  2. CBLR should be calibrated to not reduce the amount of capital currently held by qualifying community banking organizations.

  3. Federal bank regulatory agencies intend for banking organizations with higher risk profiles to remain subject to the generally applicable capital requirements to ensure that such banking organizations hold capital commensurate with the risk of their exposures and activities.

  4. Federal bank regulatory agencies would maintain the supervisory actions applicable under the PCA (Prompt Corrective Action) framework and other statutes and regulations based on the capital ratios and risk profile of a banking organization.

  5. CBLR framework is intended to provide meaningful regulatory compliance burden relief and be relatively simple for banking organizations to implement.

The federal banking regulators chose 9.00% as the initial CBLR - selecting the mid-point in the 8.00% to 10.00% range in the EGRRCP Act. Not an unexpected starting point.

At the 9.00% CBLR, it would appear that approximately 77 percent of Community Banks (total assets < $10 billion) would meet this threshold. And 58 percent of Community Banks would exceed this threshold by at least 100 basis points.

So how does this new CBLR and the 9.00% threshold compare to current bank capital standards?

The CBLR is comparable to the Leverage Ratio under current capital regulations. And, under the Prompt Corrective Action rules, a “well capitalized” bank would need to have a 5.00% Leverage Ratio. So the initial target for CBLR of 9.00% requires Community Banks to hold 400 basis points more in capital than required under PCA. And many Community Banks significantly exceed the PCA Leverage Ratio minimum today

The CBLR can also be roughly converted into a corresponding Total Capital Ratio under the current risk-based capital standards. Depending upon the ratio of risk-weighted assets to total assets, the 9.00% CBLR translates into a range of 11% to 13% Total Capital Ratio. Again, most Community Banks hold Total Capital Ratios within or above this range.

So what should a Community Bank do?

Today many Community Banks hold capital at levels that will meet or exceed the requirements under this proposal while also exceeding the current capital regulations significantly.

However, under the CBLR proposal, a Community Bank will be committing to holding this higher level of capital.

If a Community Bank already exceeds this minimum, why not simply designate that you will operate under this new proposal?

Key questions or issues for consideration before you make this election:

  1. What is the cost burden - and your benefit - of complying with the risk-based capital rules - systems, Call Report schedules, etc.?

  2. Will you need any of the higher levels of capital in the future (balance sheet growth, acquisitions, returning capital to shareholders) - that is, will you utilize some of your “excess” capital?

  3. How difficult will it be and what is the cost to implement operating procedures to opt back out of the CBLR framework at a later date?

While the simplicity of this approach may be beneficial, an important consideration is whether this CBLR proposal becomes a constraint on your capital management flexibility in the future.

Incorporate your assessment of the CBLR in your long range strategic and capital planning activities. And make a disciplined assessment of the trade-offs prior to making your final CBLR election.

 Analytical Comparison: While simplistic, a quick means to assess whether a Community Bank should take advantage of the CBLR election is to compare the cost burden of risk-based capital compliance to returning capital to shareholders (or another alternative is to leverage the additional CBLR capital with earning assets).

If a Community Bank were to dividend excess capital to shareholders, there would be a loss of interest income from the earning assets that are liquidated. Let’s assume that this yield = 3.50%. And let’s assume that the Community Bank can dividend up capital equal to 2% of total assets rather than committing to hold that extra capital under the CBLR proposal. For a $25 million total asset Community Bank, this results in lost income of approximately $18 thousand ($500 thousand in excess capital times opportunity cost of 3.50%). Does a $25 million Community Bank spend over $18 thousand annually in compliance of risk-based capital reporting? As the size of the Community Bank increases, this opportunity cost rises. For a $500 million total asset Community Bank, the opportunity cost increases to $350 thousand. Does a Community Bank of this size spend that much on risk-based capital compliance and reporting?

Update on the Federal Reserve Balance Sheet "Normalization" and the MBS Market in Five Charts

One of the programs put into effect during the mortgage financial crisis was Quantitative Easing(“QE”). There were three QE phases. The objective of this program was to provide liquidity and support to the capital markets, including the agency mortgage-backed securities (MBS) market.

The Federal Reserve used its balance sheet to house MBS and U.S. Treasury securities that were purchased. Since 2008, the Fed has added over $3.5 trillion of securities to its balance sheet - up more than 5X to approximately $4.4 trillion.

Since September 2017, the Fed has implemented a “normalization” program to begin unwinding these holdings in a steady, measured and disciplined manner.

Prior to the financial crisis, the Fed held no agency MBS.

As the Quantitative Easing programs commenced, the Fed eventually built up a portfolio of approximately $1.78 trillion in agency MBS.

And since commencement of the “normalization” program at the start of Q4 2017, the MBS holdings have fallen by $101 billion, or 5.6%.

As a result of the quantitative easing programs, the Fed owned at its peak approximately 32 percent of outstanding agency MBS.

And since “normalization” commenced, the Fed’s market share of agency MBS has fallen to 28 percent.

While the Fed’s holdings and market share of outstanding agency MBS is significant, its share of purchases of new agency MBS issuance over time is also quite relevant.

When the Quantitative Easing programs started, the Fed was purchasing over 40 percent of the agency MBS issued. Initially moving into the agency MBS market in a big way to quickly bring support and liquidity. Over time, this market share fell to below 30 percent.

And over the past several months, the Fed’s share of agency MBS issuance has fallen to approximately 5 to 10 percent of monthly issuance.

The Fed has been significantly decreasing its presence in the agency MBS market. And, as the Fed moves out, the agency MBS market appears vibrant, resilient and liquid today.

Two other questions of note are:

  1. Can the agency MBS market withstand the pull back of such a major market participant that the Federal Reserve has been since 2008? It would appear that the agency MBS market has the fundamentals necessary - and is doing it.

  2. As the Fed more significantly reduces its 28 percent share of outstanding agency MBS, which investors will step up to purchase these single-family residential mortgage assets? It appears that, in the near term, banks and thrifts have stepped up and added to their holdings. But can banks and thrifts pick up another $0.8 to $1.7 trillion in MBS? If not, what other investors will step up?

The Federal Reserve continues its balance sheet “normalization” program and intends to reduce its holdings of agency MBS materially. Agency MBS held by the Fed are expected to drop by at least 50% - and there is a possibility that this could be reduced to zero (“U.S. Treasury”-only balance sheet).

So far, there has been almost no impact on the market for agency MBS. However, over time, this will remain an important issue to monitor with ramifications for the housing sector, homeownership, housing prices, mortgage financing costs and GSE reform.

For more information on the Fed’s activities, please go to BankingStrategist.

Mid-year update on banking industry consolidation and Community Banks - "Are there too many banks"?

The question still lingers - “Are there too many banks?”

So let’s do a mid-year update on the status of the banking industry consolidation - with a focus on the impact on Community Banks across the United States.

The consolidation trend within the banking industry continues late into another decade. The consolidation across the banking industry has been ongoing for decades. The starts and stops within the consolidation cycle are influenced by economic conditions, regulatory environment and bank performance.

Since 1990 the number of U.S. banks has dropped significantly.

  • 5,542 banks today compared to 15,158 banks in 1990

  • 9,616 banks, or 63% of the industry, have gone away

During these more than three decades, de novo start-up banks totaled over 2,700 offsetting some of the declines due to bank mergers (~11,000) and to bank failures (+1,000).

This pattern of banking industry consolidation has continued into 2018.

  • There was a net loss of 245 banks chartered across the U.S. over the latest 12 months.

  • This was a 4.2% decline - on par with the past 10 years and slightly faster than the 3.5% annual average since 1990.

Bank failures have been nearly non-existent since the Great Recession of 2008 with only 2 failures over the past twelve months - and no failures to date in 2018.

Bank merger activity remains strong with 251 mergers completed. This level is comparable to the past 10 years and the percentage impact consistent with the past several decades.

One missing link has been de novo bank start-ups which have been negligible. There were only 8 new banks started over the latest 12 months compared to an average of over 100 per year over the past several decades. This trend of replenishing the banking industry through de novo banking appears to have all but ended.

 

Most of this banking industry consolidation has occurred within the Community Bank segment. This chart depicts this trend of “larger” acquiring the “smaller”.

The total number of Community Banks declined by 258 over the latest 12 months, or 4.6%.

Of this decline, 211 banks under $250 million in total assets were merged into larger banks, primarily into other Community Banks. Boards and management of Community Banks have developed and successfully executed on acquisition programs under their long term strategic plans.

The recent consolidation activity also reflects some geographic focus. In six states, the number of headquartered banks has fallen by 10 or more institutions.

  • Florida showed the largest decline in number of banks with 17.

  • Missouri had 14 fewer banks.

  • Illinois banks dropped by 13.

  • California and Kansas each had declines of 12 banks.

  • And Minnesota had 11 fewer banks.

Over the latest 12 months, 40 states showed a drop in the number of banks headquartered in these states.

 

Even as this consolidation trend continues, banks of all sizes remain chartered (or headquartered) and serve markets across population areas of all sizes. For this discussion, we use counties.

The “blue” shaded bars represent Community Banks, or banks with total assets of less than $10 billion. The “red” shaded bars represent larger regional and national banks, or banks with total assets of more than $10 billion.

The regional and national banks (in “red”) are primarily headquartered or chartered in larger population centers. Community Banks (in “blue”) are chartered across all county sizes, but are primarily headquartered in counties with populations of 100,000 or less - and predominantly in counties with populations of less than 50,000.

There are several key take-aways from this data.

There are many more Community Banks across the U.S. than larger banks.

  • Community Banks hold approximately 98% of all banking charters.

Community Banks are predominantly located and serve smaller, more rural counties across the U.S. compared to the larger banks.

  • 61% of Community Banks, or 3,275, are headquartered in U.S. counties with populations of less than 100,000.

Community Banks are the key to providing financing and capital to these local markets.

And as the banking industry continues its ongoing consolidation, these smaller counties / population centers are seeing much of this impact. While counties of all population levels saw net reductions in number of banks:

  • Counties with populations of less than 50,000 lost 96 banks

  • Another 39 bank charters were eliminated in counties with populations of less than 100,000

The nature of the industry merger dynamics - “larger” acquiring “smaller” banks - continues across markets of all population sizes but primarily is impacting Community Banks. In and of itself, this dynamic is not necessarily negative. It depends upon how the acquiring bank manages the employees and serve the customers in these new markets that they have accessed through the merger.

 

Community Banks continue to serve customers locally across the U.S.. Community Banks remain a critical component of our local markets and economies. Here are some important statistics on the impact of Community Banks:

  • # of States with Community Bank Headquarters 50

  • # of Employees 531 thousand

  • Total Banking Assets $2.9 trillion

  • Total Banking Capital $337 billion

  • Total Loans $2.0 trillion

  • Total Deposits $2.4 trillion

Community Bank contributions in various markets are highlighted in the table below.

For example, there are 2,650 Community Banks headquartered in counties with populations of less than 50,000. Here is how Community Banks impact these markets:

  • serve markets with total population exceeding 28 million people

  • employ over 147 thousand staff

  • hold total assets exceeding $664 billion, and

  • have capital strength supported by over $73 billion in shareholder equity capital.

Community Banks continue to prosper and bring a competitive presence across all states. They remain highly profitable with strong capital positions and superior asset quality. They continue to be important partners for local families, businesses and governments. Sometimes a Community Bank is the only bank headquartered in a county.

The banking industry consolidation trend will continue - and will so for mostly sound, strategic reasons: population declines, slow or no growth local economies and estate or succession planning.

Community Banks show that the question should not be “Are there too many banks?”. The better question would be “Is your local bank contributing to your community and its economy?”. Community Banks continue to be successful at this and remain important contributors to the communities that they serve.

For more on the banking industry trends, visit our website: BankingStrategist.com.

Bank Planning 2019 - Interest Rate Scenario Alternative

Labor Day has come and gone. And our summer is nearly over. It is time for banks to begin developing their operating plans for 2019.

If you have followed our recommended approach over the past year, then you have reviewed your thoughts on M&A strategy. You have assessed your outlook for upgrades in technology (software, hardware, security, third-party vendors). You evaluated required capital expenditures over the next five years and set priorities. You determined your human resource requirements. And you have re-visited and either confirmed or modified your long term strategic plan.

Now is the time to leverage those longer term planning activities into an operating plan and budget for 2019. 

As you begin your 2019 operating plan, one of the key starting points is an interest rate scenario. For discussion purposes as you establish a viewpoint on the direction of interest rates, we offer up two scenarios. First scenario, the Federal Reserve implements three (3) hikes to the fed funds rate. And a second scenario, the Federal Reserve executes only two (2) hikes to the fed funds rate. Both scenarios are reasonable possibilities. These scenarios also assume that, as the economic growth slows slightly from the strong growth in 2018, the yield curve flattens further.

Here are the two scenarios (click on image for PDF):

Your 2019 Operating Plan should be the culmination of the various planning activities that you carried out throughout the past year. We hope that the above interest rate scenarios are helpful as you layout your own assumptions or incorporate from elsewhere.

Much continued success as your move into 2019! And visit our planning and banking data and information at BankingStrategist.com.