National, Regional Banking Conditions Detailed in Latest “ViewPoint”

September 30, 2020

Asset Quality :: Balance Sheet Growth :: Capital :: Earnings Performance :: Liquidity :: National Banking Trends 

Asset Quality

Consistent with data from the first quarter, asset quality ratios in the second quarter were little changed from the end of 2019. Despite economic conditions, the percentage of loans reported as 30 days or more past due declined year over year at community banks in the Sixth District. The percentage of nonaccrual loans was 50 basis points lower than the prior year (see the chart).

The decline can partly be attributed to forbearance programs that banks instituted to assist borrowers. Banks offered forbearance in a variety of ways, including a standard loan modification under existing accounting guidance and programs under banking agency guidance issued in March 2020 and modifications allowed under the CARES Act. Some programs allowed borrowers to delay payments for a specified period, such as 90 days. A range of methods could address missed payments, including adding the payments to the end of the loan term. For loans modified under the CARES Act, they would maintain the same status as they had when forbearance began. As a result of a variety of mediation programs, problems with asset quality might not completely be reflected in the publicly available call report data. Forbearance on many loans will likely end in the third quarter, except for those loans able to get extensions under stricter guidelines. Community banks in the Sixth District have started building their allowance for loan losses over concerns about their loan portfolio. Analyzing data from the first two quarters, community banks that have adopted CECL—current expected credit losses, the new credit loss methodology—were more aggressive in building a higher allowance balance. With forbearance levels declining at the end of June and asset-quality metrics still manageable, some banks think it is unlikely that allowance levels will continue to rise in the second half of the year.


Balance Sheet Growth

Although community banks have become more cautious, their total asset growth exceeded 16 percent in the second quarter in the Sixth District, the strongest year-over-year growth in more than 15 years. The securities portfolio experienced its strongest growth in roughly 10 years as banks were seeking some shelter from credit and liquidity risks amid a high level of uncertainty. Banks largely sought out U.S. Treasuries along with some agency securities. However, much of the growth was driven by loans, which grew 12 percent on a median basis (see the chart).

Loan growth was firmly centered on the perceived low-risk loans—backed by the Small Business Administration—made through the Paycheck Protection Program (PPP) in the commercial and industrial (C&I) portfolio (see the chart).

Community banks reported working around the clock for weeks to process requests for the loans intended to help businesses retain employees and remain operational. Most banks that participated in the program reported that a large percentage of applications came from businesses with no prior relationship with the bank. Banks have suggested that most loan growth over the next few quarters might come mostly from C&I loans. Beyond PPP loans, loan growth was minimal at most community banks. Demand for most loan types, excluding residential construction and mortgages, has diminished. Existing commercial customers with credit lines have mostly repaid their drawdowns from March. Additionally, banks are exercising greater selectivity in the loans they underwrite. Annualized consumer loan growth declined 3.6 percent, and residential real estate growth was just above 2 percent. Median annualized construction loan growth was up 6 percent, driven by the increased demand for new housing, especially outside large city centers. Commercial real estate (CRE) median annualized growth was 4.5 percent, the slowest growth that portfolio has seen in nearly five years. Although many CRE properties have struggled, the outlook remains most concerning for retail, office, and student housing. Retail properties, which represent a large portion of many community banks’ CRE portfolio, remain a concern, especially for restaurants that have struggled with reduced capacity and limited delivery options. Many restaurants have failed to reopen, negatively affecting rent payments and valuations of restaurant space throughout the Sixth District. Hotels are an additional source of concern as travel and tourism have fallen off dramatically in the pandemic.


Capital

Capital levels at community banks declined slightly year over year, down 50 basis points; however, they remained healthy, with a tier 1 leverage ratio above 10 percent. In the second quarter of 2020, the leverage ratio dropped slightly due to the strong growth from Paycheck Protection Program (PPP) loans and lower earnings. Capital was also aided by the unrealized gains on the securities portfolio recorded in other comprehensive income. Based on results from the second quarter, banks mostly maintained their existing dividend levels. Although not widespread, a few banks issued either equity or subordinated debt to bolster their health, manage any potential asset quality issues, and prepare for a more extended economic downturn. Most public banks have ended or reduced their share buyback plans to maintain current capital levels (see the chart).

To allow banks more flexibility to meet credit needs during the pandemic, the CARES Act directed federal banking agencies to temporarily lower the community bank leverage ratio (CBLR) requirement from 9 percent or above to a minimum of 8 percent. The CBLR will gradually return to 9 percent by 2022.


Earnings Performance

Earnings at community banks in the Sixth District suffered from some of the same problems as banks in other districts: lower net interest margins along with higher provision and noninterest expenses. On a median basis, return on average assets (ROAA) declined by 15 basis points, year over year, in the second quarter. Less than 5 percent of banks reported losses during the quarter, on par with the prior year (see the chart).

Although earnings declined compared to the previous year, earnings were slightly higher than the prior quarter as many regional economies throughout the Sixth District started reopening in late April or early May. Margin compression, or costs rising faster than income, continued to be the primary reason for lower earnings. Although many banks reported an increase in net interest income—a result of the volume of Paycheck Protection Program (PPP) loans added to the balance sheet—a majority of banks reported lower net interest margins (NIM) for the quarter (see the chart).

On a median basis, the NIM for community banks in the District fell below 4 percent for the third consecutive quarter. NIM continued to fall as banks added more assets at lower rates, such as PPP loans at 1 percent (see the chart).

Banks added more securities like U.S. treasuries and moved away from higher-yielding loans due to lack of demand and tighter underwriting. In addition to margin compression, provision expenses were also higher as banks continue to assess potential delinquencies as a result of COVID-19. So far, community banks that have adopted the current expected credit losses, or CECL, accounting standard had higher provision levels, though it’s unclear if the switch to CECL was driving the higher levels. Noninterest income growth, probably the strongest in years, was driven by fees that the PPP generated. Although fees on these loans were supposed to be amortized over the life of the loan, some banks recognized all of the income at once in the second quarter, due to the size of the fees on individual loans.


Liquidity

Liquidity remains healthy at community banks within the District. The median on-hand liquidity ratio among community banks in the District rose to 22 percent, the highest level since the third quarter of 2013. On-hand liquidity at Sixth District community banks is higher than their peers across the country (see the chart).

Banks have become more liquid both on the liability and asset sides of the balance sheet. On the liability side, banks’ deposit levels continued to build. Median deposit growth has exceeded 7 percent despite the low-interest-rate environment, double the growth rate from the second quarter of 2019. Banks have received an influx of deposits due to lower spending from customers and loans from the Paycheck Protection Program (PPP) being deposited back into the bank. The sudden increase in deposits means that banks faced more challenges in managing their liquidity positions. As a result of the rise in deposits, banks have paid down existing debt levels, and senior debt issuances at larger community banks have virtually ceased. Given the uncertainty of how long proceeds from PPP loans would remain, cash and securities balances have increased on the asset side of the balance sheet. The longer the deposits remain, the more likely banks’ profitability might suffer as finding more revenue-earning assets becomes more difficult in the absence of higher loan demand.


National Banking Trends

The economic uncertainty caused by the ongoing COVID-19 outbreak has put downward pressure on bank earnings, as reported in quarterly call report data. On an aggregate basis, the return on average assets dropped for a second straight quarter to 0.33 percent (see the chart).

Most of the earnings pressure came from a decline in the net interest margin and an increase in the provision for loan loss expense. With the drop in both long- and short-term interest rates—due in part to the fact that the Federal Reserve lowered its benchmark rate to near zero in March—the net interest margin reported in the second quarter, at 2.70 basis points (bp), was 67 bp below the margin reported in the prior year (see the chart).

In addition to rates declining, banks were changing the composition of their balance sheet to lower-yielding assets to help limit credit risk. Provision for loan losses increased during the quarter again, reaching 2.18 percent of average loans, more than four times higher than in the second quarter of 2019. Noninterest income increased as Paycheck Protection Program (PPP) loans generated significant fees for banks in the second quarter. Noninterest expenses declined from the first quarter but remain elevated compared with the prior year due to costs associated with coping with COVID-19, such as janitorial cleaning.

Despite the current economic uncertainty, total assets increased 16 percent in the second quarter. On an annualized basis, second-quarter asset growth saw the second-highest growth of the last 10 quarters, next to only the first quarter of 2020. Banks with assets between $1 billion and $10 billion recorded especially strong quarterly growth, building on the higher asset growth from the first quarter. However, reflecting the uncertainty driven by the COVID-19 outbreak, most of the asset growth was in either cash or securities as loan growth fell during the quarter. The portfolio of U.S. treasuries has expanded rapidly as most other interest-earning assets have declined. Annualized loan growth was less than 1 percent on an aggregate basis in the second quarter. Commercial loans continued to drive loan growth across banks of all sizes, as lenders funded thousands more federally backed small business loans under the PPP. Outside of new PPP loans, loan growth has stalled (see the chart).

In the latest Senior Loan Officer Opinion Survey, banks reported tightening underwriting across nearly every loan category.

Aggregate asset quality ratios deteriorated slightly during the quarter. In the second quarter of 2020, the percentage of loans past due 90 days or more remained basically unchanged from the prior quarter and prior year. Noncurrent loans now represent 1 percent of total loans, the highest ratio since the second quarter of 2018 (see the chart).

The number of loans reported as past due was basically at a standstill as many loans were still in forbearance at the end of June. The effects of the COVID-19 pandemic have led to historic increases in forbearance levels and rising nonpayment statuses for major loan segments, creating the potential for large loan losses in the second half of 2020. Many of the forbearance programs, which allowed customers to defer payments, are ending as of either late August or early September. Some banks have already indicated that another deferral may be extended, if borrowers qualify, although conditions will likely be stricter.

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