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Introduction | Spotlight: Interest Rate Risk: Deposit Behavior in a Changing Economic Environment | Spotlight: Commercial and Industrial Loans: Analyzing Cash Flow | State of the District| National Banking Trends


By Michael Johnson, Senior Vice President
Supervision & Regulation
Federal Reserve Bank of Atlanta

Mike JohnsonAs we close out the year, I am pleased to report continued improvement in Sixth District bank performance. Only 10.8 percent of the District's commercial banks remained unprofitable in the third quarter of 2013. This performance is in contrast to nearly 20 percent a year ago and more than 40 percent at the height of the crisis. Despite this clear improvement, risk, of course, still exists.

In this edition of Financial Update's "ViewPoint," we take a closer look at two issues: interest rate risk and increased commercial and industrial lending. A note on interest rate risk: this edition represents our third bite at the "interest rate risk apple" this year. This latest article includes an in-depth discussion regarding the modeling of deposit behavior in a changing economic environment. For those who are less inclined to explore technical material, I highly recommend reading at least the introduction and the final paragraphs of the article to appreciate the general conclusions of the analysis. First, as always, we will examine the state of the District.

State of the District
While earnings stagnated in the third quarter at the national level, bank performance in the Sixth District continued to improve. A number of factors contributed to this improvement. In contrast to the national level, the net interest margin in aggregate increased to just above 3 percent during the third quarter. Even though interest rates increased in the previous quarter, funding costs remained low. The improvement in the net interest margin, however, had less to do with loan growth than with improving asset quality, which in the short term is helping to offset long-term compression. Banks have also been extending the duration on assets to boost their yield, although in many cases, any short-term benefit may be lost over the medium to longer term. As asset quality continued to improve, provision expense as a percentage of average assets, declined. As a result, the coverage ratio and the percentage of loan loss reserves to total loans have started to move toward historical averages.

Interest rate risk
As discussed in two previous "ViewPoint" articles on interest rate risk (here and here), as rates have fallen in response to monetary policy efforts to address The Great Recession, banks' net interest margins have trended downward. Initially, the decline was due largely to decreased asset yields; however, more recently, lower incremental benefits from reduced interest-liability costs are also compressing margins. Banks, depending on their degree of operational efficiencies, have reduced liability costs by increasing their use of non-maturity deposits and have increased yields by extending asset maturities.

Commercial and industrial lending
In an effort to expand their portfolios, some firms are stepping up their pursuit of commercial and industrial (C&I) loans. According to the Fed's H.8 report in late November 2013, C&I lending at domestic banks nationwide was up just over 9 percent from a year ago. In the Sixth District, state member bank (SMB) C&I loans have risen by 10.5 percent ($6.9 billion) during the past year ending September 30, 2013. Further analysis of these banks reveals that C&I growth occurred in only 31 percent of the firms. Among these firms, growth ranged from as low as 2.5 percent to more than 40 percent. From a safety and soundness perspective, management must ensure that the appropriate expertise is available to evaluate and handle the increased risks associated with new or expanded business lines.

Regulatory update
Before I close, I wanted to provide our readers with a brief update on progress on the regulatory front. On December 10, 2013, as required by the Dodd-Frank Act, five federal regulators adopted a rule implementing the Volcker rule, which prohibits banks and any affiliated companies from engaging in short-term proprietary trading of certain securities, derivatives, and other financial instruments for the firm's own account, subject to certain exemptions, including market making and risk-mitigating hedging. It also imposes limits on banking entities' investments in, and other relationships with, hedge funds and private equity funds.

Along with the rule, the Federal Reserve's Board of Governors also announced that the conformance period to comply with the rule has been extended. Banking entities covered by the rule will be required to fully conform their activities and investments to the statute and regulations by July 21, 2015.

As always, I look forward to hearing from our readers, so please share any feedback you may have at Best wishes for the New Year and continued improvement in bank performance!

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