ViewPoint: State of the District

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

Asset Quality :: Balance Sheet Growth :: Capital :: Earnings Performance :: Liquidity

Asset Quality

Banks are finally able to shift their focus from asset quality to improving their earnings and looking at ways to grow. Asset quality problems are slowly fading and are not nearly as severe as they were during the financial crisis. A number of different metrics show that in general, banks are getting back to the level of problem assets they had prior to the crisis. For example, repossessed assets have fallen to their lowest levels since 2006. Although net charge-offs ticked up slightly in the second quarter, the four-quarter moving average continued to decline, dropping to its lowest level in nearly five years (see the chart).

In aggregate, noncurrent loans have declined to $5.7 billion in Sixth District community banks, representing just over 3 percent of total loans (see the chart).

The decline in noncurrent loans is occurring across every loan type, with noncurrent C&I loans declining even as underwriting standards have loosened over the past four quarters. In addition to lower noncurrent loans, the improvement in the real estate market is helping banks more quickly dispose of other real estate owned (OREO) properties. Better real estate market conditions have also helped drive down the amount of in-process foreclosures. Although there is a lot of positive news regarding asset quality, there are still a few banks and a few markets that are struggling to recover. OREO losses continue to be a problem for banks. Improvement in real estate prices in more rural areas would help with some of the remaining problem assets. Also, consumers’ ability to pay, given economic conditions, remains a concern.


Balance Sheet Growth

For three consecutive quarters, banks have experienced modest balance sheet growth, as loan demand slowly returns (see the chart).

The growth in the securities portfolio has stabilized at nearly a quarter of the banks' assets. The focus on loan growth continues to be on commercial and industrial (C&I) loans (see the chart).

Part of the reason for the growth is that banks appear to be easing credit standards for C&I loans, according to the latest Senior Loan Officer Opinion Survey. From a customer standpoint, C&I demand has strengthened, specifically for revolvers rather than term loans (see the chart).

Looking ahead to the next quarter, a number of new C&I loans are in the pipeline, so growth is expected to continue for the foreseeable future. Demand by commercial customers has extended into commercial real estate (CRE) as well. While multifamily has been one of the strongest growth components in CRE (see the chart),

there are two concerns that may have an impact on future demand over the next few quarters. First, rising construction costs could render new apartment projects uneconomical and slow the demand for new multifamily loans. Second, the amount of new space being constructed is a concern because of the negative impact on rents and the ability to service the mortgage. In the Sixth District, nonresidential loans have been slowly growing. Loan growth has been constrained by the lack of demand for office and retail space, both of which have plenty of vacancies. Residential real estate loan growth has remained positive, even as long-term rates begin to increase (see the table).

Single-family property prices have appreciated in many of the Sixth Districts markets, though there are still pockets of no growth. Home sales are no longer being dominated by cash transactions, as more existing homebuyers have entered the market and seek to take advantage of lower rates than the historic norm. Still, the increase in rates has affected the level of refinance activity, which slowed in the middle of the second quarter. At the same time, underwriting standards for mortgages remain much tighter than standards for commercial loans, and tighter than they were prior to the financial crisis. Those standards may ease, though, as the level of refinance activity continues to fall and banks seek to replace the mortgage income with new originations (or layoffs, in the cases of Wells Fargo and JP Morgan Chase). Consumer loans in the Sixth District have shown slow but steady growth over the past year. The trend reflects consumer trends on a national level. In the Sixth District, consumer loans grew by 3 percent over the prior quarter, while growth was negative in aggregate among out-of-district banks. Like mortgages, underwriting standards for consumer loans remain tight. Growth from consumer lending is primarily attributable to nonrevolving debt (e.g., automobile loans and student loans).


In early July, the Federal Reserve approved a final rule to implement the Basel III accord. The rule is effective for community banks beginning in January 2015. The Federal Reserve estimates that 95 percent of banks will be able to meet the new capital requirements without raising additional capital. As part of its release on the new capital rule, a community bank guide was produced to provide a quick snapshot on the impact of the new rule. On the heels of the introduction of new capital standards required under Basel III, banks in the Sixth District reported a median tier 1 leverage ratio of 10.01 percent, the highest the ratio has been in nearly six years (see the chart).

At the same time, the median tier 1 leverage ratio for banks outside the district also reported an improvement in its leverage ratio (see the chart).

Earnings Performance

After a couple of weak quarters, second-quarter earnings for Sixth District community banks (assets less than $10 billion) rebounded again as the aggregate ROAA increased to nearly 1 percent. The increase in interest rates that occurred during the middle of the quarter helped boost the net interest margin (NIM) as interest rates on loans increased, but deposit rates remained unchanged. Also, rate-sensitive assets have declined relative to rate-sensitive liabilities, suggesting that some Sixth District institutions have taken on additional interest rate risk to improve their NIM. While the sudden increase in interest rates provided a boost this quarter, the rising rates could pose a risk to earnings over the next couple of quarters as deposits could re-price higher while floating loan yields that are currently below their floors will not, producing NIM compression. After declining for most of the last eight quarters, provision expense remained on par with the percentage of average assets as in the second quarter of 2013, perhaps signaling the end of releasing of reserves (see the chart).

The coverage ratio and the percentage of loan loss reserves to total loans are starting to move toward an historical average, though the coverage ratio remains low. Little has changed for noninterest income since the inception of the Dodd-Frank Act. While many banks have sought a way to increase this revenue line item, few have been able to generate significant new fee income in the current banking environment. In addition, even though housing prices are appreciating in many markets, banks are still suffering losses on the sale of other real estate owned (OREO) properties (see the chart).

Many banks have reached the end of the holding period in which they can retain properties on the balance sheet and must now sell the properties. On a positive note, banks are again making headway in reducing their noninterest expense. Community banks have focused on reducing expenses for the past five years. Although many banks have specific plans to reduce expenses, overhead expenses had remained stubbornly high. Still, banks have to be careful in expense cutting, so that the reduction in expenses occurs without significantly damaging the bank itself.



At this point in the economic cycle, funding is considered stable for most banks in the district. Noncore funding dependence continues to decline while balance sheet liquidity remains at its highest level in years (see the chart).

Banks have been flush with deposits since the financial crisis started. The volume of deposits and low interest rates have helped banks maintain profitability and high liquidity levels. That trend has continued through the second quarter of 2013, as core funding as a percentage of assets remained at a six-year peak of 67.4 percent. Many of the deposits are in noninterest-bearing accounts. As conditions improve, customers may look to put their deposits in higher-yielding accounts, which could impact banks'margins, or shift the deposits to other institutions, which could affect liquidity.

For more detailed information on banking trends in the Sixth District, see the Federal Reserve Bank of Atlanta's Regional Economy web page. The Federal Reserve Bank of Atlanta also produces a variety of publications dealing with other economic and financial topics. These materials appeal to a wide range of readers, including bankers, businesspeople, economists, students, and economics teachers.