Elizabeth A Duke: The future of community banking
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the Federal Reserve
System, at the Southeastern Bank Management and Directors Conference, University of
Georgia, Terry College of Business, Duluth, Georgia, 5 February 2013.
* * *
I would like to thank the Terry College of Business at the University of Georgia for the
opportunity to discuss the future of community banking at this annual conference for bank
officers and directors. Community banks play an important role in our nation's financial
system, and I believe that the future of community banking is bright. But that is not to say that
it will be easy. Success, as always, will require energetic and engaged managers and board
members who are sensitive to the financial needs of their communities, vigilant to economic
conditions, and adaptive to changing regulatory requirements.
I hear from a lot of community bankers who are concerned that the community banking
model might not survive. Many paint a picture so bleak that they see only personal retirement
or sale of the bank as viable strategies. I completely understand how tiring it is to fight a
financial crisis and survive a deep recession followed by a weak recovery only to confront
what seems to be a tsunami of new regulations.
I felt all of those same emotions in 1991. I was a community banker then. We had survived
the savings and loan crisis with some bruises, but we were still standing. The Financial
Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) had been followed by
the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. I had more
new regulations stacked on my desk than I had employees in the bank. My bank had just
reached the $100 million mark in total assets through the purchase of two branches from a
failing thrift. Even more daunting for me personally, was the sudden death of my bank's chief
executive officer (CEO), leaving me as the new CEO. Frankly, I didn't know how I was going
to tackle all that lay in front of us. But those dark days in 1991 were followed by 15 years of
exceptionally strong performance for all banks, including my own. And those experiences -
the good and the bad - give me confidence in predicting a bright future for community
banking today.
Just as the seeds of a crisis are often sown in earlier boom times, strength can be forged
during the tough times that follow a crisis. As we did in the early 1990s, bankers and
regulators today have learned from the lessons of the crisis and are determined not to repeat
the mistakes of the past.
Credit metrics are now improving in most banks as problem loans have been addressed and
resolved and new credit underwriting has been quite restrictive for a number of years.
Deposit growth has outpaced loan demand and reliance on wholesale funding has been
reduced. Capital positions are stronger. The interest margin pressure banks face today is
partly due to low interest rates and partly due to weak loan demand, both of which are
consequences of a sluggish economy. As the economic recovery gains momentum,
however, both of these conditions should reverse and give bankers the opportunity to deploy
the liquidity and capital they have amassed to the benefit of their shareholders and their local
economies.
Community bankers are being heard
Even as they anticipate economic recovery, however, community bankers worry that the
burden of new regulations may inhibit their ability to lend in their communities or prohibitively
increase the costs of such lending. We certainly understand this concern. Federal Reserve
research over the years has confirmed that the burden of regulations falls disproportionately
on smaller banks.
Supervisors at the Federal Reserve Bank of Minneapolis have recently tried to quantify this
effect. To do so, they used survey data to estimate the relative number of new employees
that banks of different sizes might need to hire in response to the same regulatory
requirement. Using Call Report data from 2011, they estimated in their preliminary analysis
that hiring one additional employee would reduce the return on assets by 23 basis points for
the median bank in the group of smallest banks, those with total assets of $50 million or less.
To put this estimate in perspective, such a decline could cause about 13 percent of the
banks of that size to go from profitable to unprofitable. As a comparison, given the same
increase in regulation, they assume banks between $500 million and $1 billion would hire
three employees and experience a decline of about 4 basis points in return on assets for the
median bank. While this is still a significant effect, very few banks in this group would go from
being profitable to unprofitable as a result of the regulatory burden.
Regulatory overreaction to a crisis is always a risk. But this time, I think community bankers
have been more successful than they realize in making the case against "one-size-fits-all"
regulation. I can't remember a time when I have seen more regulatory proposals drafted that
differentiate between banks based on size or complexity. I urge you to continue to identify
the regulatory requirements that are the most onerous to your business model, and continue
to suggest alternatives to achieve those regulatory objectives in a less intrusive way.
In fact, most of the regulations required by the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the Dodd-Frank Act) are directed primarily at larger, systemically
important banks, and many of the Act's provisions specifically exempt community banks. For
example, banks with less than $10 billion in total assets were exempted from a number of the
debit interchange restrictions, and early studies indicate that those exemptions are working.
In addition, formal stress testing was required only for banks with total assets of $10 billion or
more. In implementing these requirements for the larger banks, the bank regulatory agencies
specifically indicated that capital stress testing would not be required for community banks.1
This does not mean that community banks are exempted from prudent risk management, but
rather that smaller banks should think about the negative shocks that could affect their
business in the future and tailor their risk-management procedures to the risks and
complexities of their individual business models.
The Consumer Financial Protection Bureau (CFPB) recently released final rules defining
"qualified mortgages" that include safe harbors for mortgages that meet specific loan term
and pricing criteria, including certain balloon loans made by community banks in rural or
underserved areas.2 At the same time, they issued a new proposal that contains additional
community bank exceptions, as well as a question about the treatment of loans to refinance
balloon payments on mortgages that community banks may already have on their books.3
Noting that smaller institutions have already demonstrated that they generally do a good job
of servicing the loans they originate and that the investments necessary to meet the
requirements would be unduly onerous for institutions that service a small number of loans,
the CFPB also exempted most community banks from many of the provisions of new
servicing requirements.4 I think such exceptions are especially important because, as I
discussed in a recent speech and will touch upon later in my remarks, Federal Reserve
research has shown that (1) community banks are important lenders in the mortgage market,
(2) those mortgage loans represent a significant portion of community bank lending, and
(3) community banks are quite responsible in their practices.5
At the Federal Reserve, we have formalized our process for considering the unique
characteristics of community banks as we craft regulatory and supervisory policies. A few
years ago, we created a subcommittee of the Board, which I chair, that makes
recommendations about matters related to community bank supervision and regulation. This
subcommittee reviews all regulatory proposals and supervisory guidance with an eye toward
the possible effects on community banks. Remembering the days when I had to find time to
read all those new regulations stacked up on my desk, I have insisted that all new proposals
and rules start with a clear statement of their applicability to community banks so that
bankers can spend their time on the rules and guidance that apply to them.
This approach was put into practice in a different way last year, when the banking agencies
issued proposals for capital regulations that incorporated requirements of the Dodd-Frank
Act and the Basel agreement.6 To help community banks identify the provisions that affected
them and submit their comments more easily, the proposal included a short summary of the
provisions that were most likely to affect community banks. We received more than 2,000
comments, many from community banks, and we are reviewing them. It's too early in the
process to know how we and the other agencies are going to address the issues raised, or
when final rules may be released. But what I can promise is that before we issue final capital
rules, we will do everything possible to address the concerns that have been expressed by
community bankers and still achieve the goal of having strong levels of high-quality capital -
built up over a reasonable and realistic transitional period - in banks of all sizes, including
community banks.
Community bank research
To help us better understand community bank issues, our subcommittee established an
informal working group of economists from both the research and supervision functions in the
Federal Reserve System. The group is focused on understanding the factors that influence
the viability and performance of community banks including, importantly, the effect of
regulatory changes and their associated costs and benefits. Members of this working group
are exploring a number of interesting topics that I hope will help us to better understand the
issues that affect community banks and, where appropriate, have a practical impact on how
we supervise these banks.
Determinants of community bank profitability
For example, a recent study undertaken by two Federal Reserve Board economists explores
the determinants of community bank profitability from 1992 through 2010.7 The findings
indicate that a number of bank characteristics are strongly correlated with performance,
including relative bank size, portfolio composition, and management quality. Within the group
of banks with less than $1 billion in total consolidated assets included in this study, larger
bank size is associated with significantly higher profitability. Community banks with higher
portfolio shares of real estate loans earn significantly lower profits, while those with higher
portfolio shares of construction loans earn higher profits through most of the study period.
But, perhaps not surprisingly, the latter relationship does not hold for 2008 through 2010,
when greater reliance on construction lending is associated with lower profitability.
Managerial quality, as measured by the management component of the banks' regulatory
ratings, is strongly related to bank profitability. Moreover, the strength of the relationship
increases during and immediately after the financial crisis, confirming that management
quality is particularly important during times of economic stress.
Factors outside the control of bank management, however, are also importantly related to
profitability, particularly over the past several years. For instance, it is not surprising that
community banks operating in markets experiencing high unemployment rates have been
less profitable since the financial crisis. Perhaps less obvious is that in urban markets,
community bank profitability tends to decrease as the size of the market increases. One
might suspect that this relationship derives from a more competitive landscape in larger
urban areas; however, no relationship between market concentration and profits is evident in
urban markets. In contrast, in rural areas, higher market concentration is associated with
higher community bank profitability throughout most of the study period. In addition, the study
finds that community banks operating in rural markets consistently earn higher average rates
of return than do community banks operating in urban markets.
In a separate analysis of deposit market competition that may form the basis for a new
research paper, one researcher has documented the competitive strength of community
banks, especially in rural markets. Although the nationwide share of total deposits held by
banks with assets less than $10 billion has declined over the past decade, in rural markets,
their deposit market share has increased slightly. Moreover, banks with assets less than
$10 billion retained their share of rural market deposits throughout the recent recession and
recovery. At a more micro level, banks with assets less than $10 billion gained market share
in more than two-thirds of rural banking markets and in nearly half of urban markets between
2003 and 2012.
Expansion of deposit insurance during the crisis likely helped all banks retain deposits and
may have changed competition somewhat. Deposit insurance has now been permanently
increased from $100,000 to $250,000 per depositor, but the unlimited deposit insurance for
noninterest-bearing transaction accounts was allowed to expire at the end of 2012. We are
watching deposit movement carefully, but so far have seen little evidence of deposits moving
out of the banking system or, as some had feared, moving from smaller banks to larger
banks perceived as "too big to fail." My own expectation is that, given all of the enhanced
regulatory requirements that apply to larger banks, those larger banks will focus their efforts
on large urban markets and that community banks will be even more competitive and more
vital to the economic well-being of rural, suburban, and small urban markets.
Characteristics of thriving community banks
Researchers at the Federal Reserve Bank of St. Louis took a different approach to
measuring community bank success.8 Studying banks with total assets less than $10 billion,
the researchers attempted to identify the differences between banks that they classified as
"thriving" and those that they classified as "surviving." Banks were identified as "thriving" if
they maintained the highest supervisory rating, a composite CAMELS "1," continuously from
2006 through the end of 2011.9 Approximately 700 banks met this condition. The roughly
4,500 banks in the study that did not qualify as thriving and did not fail or merge out of
existence during the period were classified as "surviving."
After categorizing the banks, the first phase of analysis looked at the location and size of the
thriving banks. Thriving banks were found in 40 of the 50 states but were concentrated in
states with larger economic contributions from agriculture and energy, which held up
relatively well during the downturn. The fewest thriving banks were found on the West Coast
and in the Southeast, where real estate values fell the most. This pattern is consistent with
previous Federal Reserve studies, which found that bank performance is heavily affected by
the local economy, but I think it is important to note that even in states with high
unemployment rates or sharp declines in property values, some community banks were able
to thrive.
The St. Louis study did not find the thriving banks to be concentrated in any particular size
range. Many had total assets less than $50 million as of December 2011, but others had total
assets between $1 billion and $10 billion. And thriving banks did more than just rate well with
supervisors - the thriving banks outperformed the surviving banks on a wide range of
performance indicators, including return on assets, return on equity, loan losses, provision
expense, efficiency ratio, asset growth, net interest margin, and net noninterest margin.
Looking at balance sheet structure, when the researchers compared the characteristics of
thriving banks with surviving banks, they found that the thriving banks had lower levels of
loans-to-total-assets and were more reliant on core deposits. Thriving banks also had lower
concentrations in commercial real estate (CRE) lending and much lower concentrations in
construction and land development loans. Instead, thriving banks were slightly more
concentrated in one- to four-family mortgage loans held in portfolio, as well as consumer
loans. Despite these overall balance sheet findings, the researchers also noted the wide
diversity of business models that they found among the thriving banks.
Recognizing that a large part of good performance comes from factors that are more difficult
to measure statistically, the researchers examined a sample of comments in examination
reports and found that thriving banks benefited from a strong and localized customer service
focus with high visibility in the community, conservative underwriting, and products that were
profitable and met customer needs. They supplemented their review of examination reports
by interviewing management at some of the thriving banks. The bankers they interviewed
attributed their success to strong ties to the community, relationship banking, conservative
underwriting, and a focus on products and markets they understood. These results were
strikingly similar to the results of interviews in separate studies at the Federal Reserve Bank
of Kansas City10 and the Federal Reserve Bank of Richmond.11
9
CAMELS is the supervisory rating system for banks and other depository institutions, used by federal and
state banking agencies to communicate to financial institutions their assessment of the institution and to
identify institutions that raise concern or require special attention. CAMELS is an acronym for the six
components of the rating system that examiners evaluate and take into account when assigning an overall
composite rating: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market
risk. See Board of Governors of the Federal Reserve System (1996), Supervision and
Regulation Letter 96-38, "Uniform Financial Institutions Rating System," December 27.
10
See Forest Myers and Kenneth Spong (2003), "Community Bank Performance in Slower Growing Markets:
Finding Sound Strategies for Success (PDF)," Federal Reserve Bank of Kansas City, Financial Industry
Perspectives.
11
See Ray Brastow, Bob Carpenter, Susan Maxey, and Mike Riddle (2012), "Weathering the Storm: A Case
Study of Healthy Fifth District State Member Banks Over the Recent Downturn," Federal Reserve Bank of
Richmond, S&R Perspectives, Summer. See also Community Banking Connections (2012), Federal Reserve
System, Fourth Quarter.
These studies confirm what experience has already taught me: Community banks that have
deep ties to the community, engaged managers and directors, conservative underwriting,
and strong risk management can not only survive, but thrive, even in adverse conditions.
Using research to shape supervisory guidance on lending
While much of our regulatory work recently has involved implementing the requirements of
the Dodd-Frank Act, we are also continuing to review the lessons we learned during the
crisis and the results of our recent research. In most cases, this work is more likely to result
in supervisory guidance than regulation. Supervisory guidance is commonly viewed as a
means to restrict activity but, in fact, during the crisis much of the guidance we issued
actually directed bankers and bank examiners to take a balanced approach. For example, we
issued guidance urging banks to continue to make loans to all qualified borrowers and, in
particular, to continue lending to creditworthy small businesses.12
We also issued detailed
guidance about commercial real estate workouts to encourage prudent modifications of real
estate loans.13
Lending is the primary source of income for most community banks and also the greatest
source of risk. As you develop your business plans, some of the most important decisions
you will make relate to lending. In the planning process, banks should define the portion of
the lending portfolio they plan to allocate to different loan categories, the investments they
are willing to make to develop expertise and to manage credit and compliance risk, and the
levels of credit and interest rate risk they are willing to assume. So I thought it might be
helpful to review some recent developments in loan types that are at the core of community
bank lending.
Residential mortgage lending
Residential mortgage lending was at the heart of the financial crisis and has been the target
of extensive new regulation and supervisory attention, including the rules issued by the
CFPB that I discussed earlier. I think community banks are in an especially difficult position
with respect to residential mortgage lending. On the one hand, community banks do not
appear to have engaged in many of the more problematic practices that led to the crisis. And
their rate of seriously delinquent residential mortgage loans is significantly lower than the
overall rate of serious delinquencies on such loans made to prime borrowers, indicating that
community banks largely have managed their existing portfolios responsibly. On the other
hand, residential mortgage loans made by community banks do frequently share some
characteristics, such as higher rates and balloon payments, with the subprime lending that
proved to be so disastrous. At the same time, mortgage lending, which averages about
one-fourth of community bank loan portfolios, is an important product line for community
banks. Further, Federal Reserve research indicates that the residential mortgage loans made
by community banks make up a small but vital part of credit availability in the housing
market.
The challenge for regulators is to design mortgage regulations to address practices that have
proved harmful to consumers or financial stability without inhibiting lending to creditworthy
borrowers. The challenge for community bankers is to review the full body of new regulations
covering mortgage lending and to develop the expertise and control systems necessary to
comply with these regulations while remaining active in this important market.
I think it is unfortunate when I hear some bankers say that they will stop offering mortgages if
they can't make them the same way that they always have. While I certainly understand their
frustration, I still believe that community bankers can respond within the new environment by
creating products that are profitable and meet the needs of their customers, while still
managing their interest rate and funding risks.
Even with some regulatory exceptions, compliance with new mortgage regulations likely will
require changes to processing systems and extensive staff training. But it is also possible
that the systems and expertise necessary to make qualified mortgages for the bank's books
could also be used to originate loans for sale. For many community banks, this could
represent a new revenue opportunity and a new alternative to offer the bank's customers.
Commercial real estate lending
For community banks, it was CRE lending - in particular, lending for construction and land
development - that caused the most problems during the crisis. As you may know, in 2006
the federal banking agencies issued supervisory guidance that set forth screening criteria
based on certain types of CRE concentrations and rapid growth of CRE portfolios.14 These
guidelines contained specific numerical thresholds for the ratios of construction and total
CRE lending to an institution's total capital, as well as for identifying rapid growth of such
lending.15 These criteria were never intended to result in hard caps, but were instead meant
to trigger conversations between a bank and its supervisors about the bank's ability to
manage the risks arising from these concentrations.
After our experience in the financial crisis, especially considering the severe problems in
commercial real estate markets, we were interested in understanding how community banks
were affected by the guidance and whether the screening criteria set forth in the guidance
were effective indicators of risk. In that regard, Federal Reserve staff has worked with our
counterparts at the Office of the Comptroller of the Currency to analyze how banks' holdings
of CRE loans have evolved since the guidance was issued.16
We have learned a few interesting things based on the findings of this research. For
example, the number of institutions that exceed at least one of the two screening criteria has
declined substantially from 2006 to the present. While much of this decline seems to have
resulted from the contraction of construction portfolios in the wake of the crisis, banks that
exceeded the criteria when the guidance was issued appear to have experienced a bigger
decline in total CRE loans than can be explained by the adverse economic environment
alone. This finding could indicate that the thresholds are indeed being interpreted as hard
14
See Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, and
Federal Deposit Insurance Corporation (2006), "Concentrations in Commercial Real Estate Lending, Sound
Risk Management Practices," final guidance, Federal Register, vol. 71 (December 12), pp. 74580-88. See also
Board of Governors of the Federal Reserve System (2007), Supervision and Regulation Letter 07-1,
"Interagency Guidance on Concentrations in Commercial Real Estate," January 4.
15
Specifically, the guidance indicated that examiners would give heightened supervisory scrutiny to banks where
(1) total construction and land development loans represented 100 percent or more of the institution's total
capital, or (2) total CRE loans represented 300 percent or more of the institution's total capital and the
institution's CRE loan portfolio had increased by 50 percent or more during the prior 36 months. This second
criteria is calculated excluding holdings of owner-occupied CRE loans.
16
Keith Friend, Harry Glenos, and Joseph B. Nichols (2013), "An Analysis of the Impact of the Commercial Real
Estate Concentration Guidance," unpublished paper, Board of Governors of the Federal Reserve System,
Division of Banking Supervision and Regulation, and Office of the Comptroller of the Currency, January; and
William Bassett and W. Blake Marsh (2012), "Cause or Effect: Supervisory Guidance and the Collapse of
Commercial Real Estate," unpublished paper, Board of Governors of the Federal Reserve System Division of
Monetary Affairs, October.
caps. Moreover, it was apparent that banks that exceeded the criterion for construction and
land development were far more likely to have failed over the period from 2007 to 2011 than
were those banks that exceeded the criterion for overall CRE exposures and portfolio growth.
We now recognize the importance of the rapid growth criterion, which may have received
less attention than the criteria for construction and overall CRE lending concentrations. We
intend to use the findings of this research to help clarify our communication and training for
examiners and bankers around CRE lending concentrations.
Small business lending
There is probably no loan category in which community bankers' local knowledge and deep
ties to the community are more important than small business lending. The Federal Reserve
System has a project under way to try to improve our understanding of small business credit
markets, which would of course include community banks. One challenge we have faced is
that it is difficult to measure lending to small businesses precisely. For one thing, small
business owners frequently tap their personal home equity, credit cards, or loans secured by
commercial real estate that they own to finance their business operations,17 which means
such borrowing is not reported as small business lending. But there is also no definition of
small business borrowers for the reporting of small business lending as a loan category.
However, small loans to businesses - commercial and industrial loans and CRE loans with
original principal amounts of less than $1 million - are reported separately and can be used
as a proxy for small business lending. Using this measure, we can estimate the importance
of small business lending to community banks and the importance of community banks to
small businesses. As of September 2012, banks with $10 billion or less in assets accounted
for more than 98 percent of all commercial banking institutions, but they held less than
20 percent of banking industry assets. However, they held more than half of outstanding
small loans to businesses. For such institutions, these small loans to businesses represent
nearly 20 percent of their total domestic lending and slightly more than 40 percent of their
total commercial lending. Small business lending is likely even more important to smaller
banks than these statistics show because these loans are identified by the size of the loan
rather than the size of the borrower. I believe it is probable that many of the larger business
loans made by these smaller banks were also made to small business borrowers.
At the other end of the spectrum, banking organizations with more than $50 billion in assets
accounted for less than one percent of institutions, but held 75 percent of the assets. Holding
almost 40 percent of outstanding small loans to businesses, these large banks are important
small business lenders, but small loans to businesses were not a significant segment of large
bank loan portfolios. They represented less than five percent of these banks' total domestic
lending.
These statistics demonstrate the importance of community banks to small business and the
corresponding importance of small business lending to the community banking business
model. In developing policies for small business lending, I think it is critically important for
bank boards of directors to insist on appropriate risk management that retains the flexibility to
use the bankers' knowledge of their customers' business to their best advantage. And it is
equally critical that supervisors develop tools to measure the overall effectiveness of risk
management in small business lending without being overly prescriptive for individual loans.
Conclusion
I would like to end where I began. I think the future for community banking is bright. I
recognize that the regulatory changes underway are not without cost to community banks.
But I also know that we at the Federal Reserve are doing our best to avoid adding to
regulatory burden wherever possible as we respond to the worst excesses of the financial
crisis and make the U.S. financial system more resilient. Research is helpful in this effort but
it is also important to maintain an ongoing dialogue with community bankers and to actively
solicit comment on regulatory proposals. So I urge you to continue to communicate about the
challenges that regulations pose for community banks.
More importantly, I know that the natural advantages found in community banks - deep
community ties, daily interaction between senior managers of banks and their customers,
and the dexterity to customize financial solutions - have not been diminished in any way.
Yes, the regulatory environment is challenging and the economy remains weak in many
areas. But all our research shows that with creative, engaged bankers and strong
risk-management processes, community banks can continue to not only survive but to thrive.
Thank you very much for your attention, and I would be interested in hearing your thoughts.