Asset Quality
Overall asset quality at community banks in the Sixth District remains healthy. Nonperforming loans (30–120 days past due) have fluctuated over the last four quarters, but migration to nonaccruals has been limited. Although up slightly year over year, nonaccruals still represent less than half of 1 percent of total loans. The median allowance for loan losses dropped slightly in the fourth quarter of 2019 as provisions did not match charge-offs during the quarter (see the chart).
Despite the lack of significant growth in nonperforming loans, banks remain concerned about both commercial and consumer credit. Changes in consumer preferences continue to put pressure on retail businesses, especially restaurants, as more customers turn to home delivery. A slowdown in the auto industry could also negatively affect credit conditions in the Sixth District, given that a number of manufacturers and suppliers are located in the region. From a consumer viewpoint, consumer credit bureaus such as Transunion are reporting that the level of seriously delinquent auto loans (those past due 60 days and more) has generally trended upward since 2015. Though many of the loans were originated by nonbanks, the increase could be symptomatic of a broader weakness. Additionally, despite receiving additional time to adopt current expected credit losses, or CECL, bankers remain concerned about the effect of the required change on both earnings and the ability to provide credit.
Balance Sheet Growth
Annualized balance sheet growth in the fourth quarter of 2019 was stronger among Sixth District community banks than in the fourth quarter of 2018, increasing by more than 5 percent compared to 3.5 percent in the prior year (see the chart).
Balance sheet growth remains primarily driven by increases in lending. In contrast, securities balances continued to decline. Although exceeding 4 percent in the fourth quarter of 2019, median loan growth has ebbed from a peak of just over 7 percent in the first quarter of 2018. Loan growth was driven by commercial real estate (CRE) and construction and development (C&D) loans. CRE remains the largest concentration on community banks’ balance sheets in the District. Although lending standards remain unchanged, median CRE loan growth for the quarter rebounded slightly to 5.6 percent from the prior quarter, but it remains lower on a year-ago basis. Banks had pulled back in C&D loans in recent years, due partially to competition from nonbanks. A change in the treatment of high volatility commercial real estate (HVCRE), effective in April 2020, might encourage more C&D lending as the final rule clarified some of the requirements for HVCRE. The level of median commercial and industrial loan growth continues to decline, dropping to 4.4 percent as of the fourth quarter of 2019 as banks report a decline in demand. Year-ago median mortgage loan growth remains positive at 3.5, but the level of growth continued to moderate during the second half of 2019. Banks report that mortgage underwriting standards have remained steady, with many markets across the Sixth District having average FICO scores above 700. Issues with housing affordability and the lack of housing inventory appear to be constraining new mortgage origination while refinance activity remained healthy. Consumer loan balances continue to decline as banks report tightening loan standards for consumer credit as a result of concerns about balance growth and delinquencies (see the chart).
Capital
Tier 1 capital growth declined in the fourth quarter primarily because of increased stock dividends and fewer other comprehensive income gains (see the chart).
Growth was just over 1 percent. Median risk-weighted asset growth has also moderated, increasing by less than 1 percent for the quarter. Stock dividends tend to be higher in the fourth quarter than during any other period of the year. Payouts in the fourth quarter of 2019 increased year over year, up to an aggregate of 64 percent from 46 percent in the prior year. Overall, median capital levels have maintained their postcrisis levels above 15 percent for the last six years. More than 96 percent of District community banks are considered well-capitalized based on their capital ratios. The leverage ratio for these banks, on an aggregate basis, reached 10.04 percent, which would qualify as well capitalized under the community bank leverage ratio (CBLR) rule. The final CBLR rule became effective January 1, 2020, and allows qualifying community banks to calculate a leverage ratio to measure capital adequacy. A bank must have less than $10 billion in assets, limited off-balance exposure, and a leverage ratio greater than 9 percent to opt into the new rule.
Earnings Performance
In the Sixth District, the median return on average assets remained unchanged year over year at 1.11 percent in the fourth quarter of 2019 despite the changing interest rate environment in 2019 (see the chart).
Improvements in interest expense and noninterest income offset declines in interest income as well as increases in noninterest expenses and provisions for loan losses. Though still low compared with a decade ago, the percentage of banks reporting losses steadily increased over the course of 2019 to 6.7 percent in the fourth quarter of 2019. During the fourth quarter, a high percentage of banks reported a lower net interest margin as a result of lower rates and interest-sensitive assets repricing faster than interest-sensitive deposits (see the chart).
Prior to the decline in interest rates, banks were trying to lock in funding costs by offering longer-termed deposits at existing rates in late 2018. As rates started to fall, banks were unable to take advantage of cheaper funding as quickly as customers did with loan rates. Fourth-quarter earnings are also typically affected by annual recognition of certain noninterest expenses that ding earnings slightly from the prior quarter. Year-end accruals for employee benefits, as well as other expenses for legal and service vendors, tend to drive the increase in noninterest expense. However, noninterest expenses had a larger impact on earnings in the fourth quarter of 2019 than a year earlier. Going forward, interest rates are expected to hold steady, but some of the larger community banks will implement the new accounting guidance (Current Expected Credit Losses, or CECL) in early 2020, which is expected to increase their provision for loan losses.
Liquidity
Median on-hand liquidity ratio for District community banks was 19.76 percent as of the fourth quarter of 2019 even though banks continue to shrink their securities portfolio (see the chart).
However, the ratio has increased nearly 300 basis points from the prior year. Weaker loan growth, combined with sustained deposit growth over the last four quarters, has improved overall liquidity levels at banks. Median deposits increased nearly 5 percent in the fourth quarter, slightly higher than the 3 percent to 4 percent quarterly growth rate since 2015. Deposit growth has primarily occurred in core deposits as noncore funding dependence remains at historic lows. (Typically, loan growth has outstripped deposit growth.) For the fourth quarter, the loans-to-deposits ratio remained around 80 percent, an improvement from precrisis levels. Deposit data through the end of the fourth quarter show the recent rate cuts have not yet harmed bank deposit levels. Rather, deposits are still growing. The percentage of transaction accounts, compared with total deposits, remains nearly 10 percentage points higher than precrisis levels. A higher percentage of transaction accounts has helped push interest expense lower and maintain banks’ net interest margin in a period of falling interest rates.
National Banking Trends
At a national level, return on average assets remains above 1 percent across banks of all sizes but declined 13 basis points (bps) year over year primarily because of the decline in interest rates (see the chart).
During 2019, the Federal Reserve reduced the targeted fed funds rate three times, lowering the target rate to between 1.50 percent and 1.75 percent. The lower interest rate environment started compressing banks’ net interest margin (NIM) and profitability (see the chart).
The aggregate NIM fell 18 bps, dropping from 3.37 percent in the fourth quarter of 2018 to 3.19 percent in the fourth quarter of 2019. Despite differences in asset composition, funding sources, and growth, the decline in margins was nearly the same for both large and small banks. Interest rates are expected to remain stable through the first half of 2020. Some banks have concerns that if the interest rate environment further deteriorates, loan growth and asset quality could be adversely affected.
Annualized asset growth slowed in fourth quarter, dropping to 4.1 percent from 5.9 percent in the fourth quarter of 2018 (see the chart).
Moderating year-ago loan growth drove the decline in asset growth. Data from the call report suggests that lending trends are diverging between large and small banks. Loan growth improved primarily at banks with assets greater than $1 billion, and smaller banks experienced almost no increase. According to the January 2020 Senior Loan Officer Opinion Survey, banks reported little change in underwriting standards from the prior quarter for both commercial and industrial and most commercial real estate lending.
After nearly a decade since the recovery began, nonperforming assets remain near record lows. Noncurrent loans, as a percentage of total loans, declined 10 bps from a year earlier to 0.85 percent in the fourth quarter of 2019 (see the chart).
The percentage of nonperforming loans has steadily declined during the last 10 quarters, even with the continued predictions that credit conditions would begin to deteriorate with changes in the interest rate environment. However, community banks have started noting potential issues with asset quality. Problems with agricultural credit could signal potential problems with other types of loans in rural areas where community banks often serve as the primary source of credit. Additionally, other key lending sectors such as health care and energy are struggling and not expected to fare well during a recession, according to a recent report by Moody’s.
Both capital and liquidity levels remain stable. Deposit data through the end of the fourth quarter show that the recent rate cuts have not harmed bank deposit levels. Rather, deposits are still growing. Although deposits may not have run off yet, the impact of rate cuts usually takes a couple of quarters to materialize. For now, there doesn’t appear to be a spike in borrowed funds. At the same time, loan growth is slowing, helping banks keep a reasonable level of loans to deposits and maintain higher capital levels.