COVER STORY
uring the last economic downturn, in 1990–91, banks were hard hit. Their lines of business were less diverse, they felt the pinch of a slumping and overbuilt real estate market, and their risk-management systems were less stringent than they are today. By comparison, banks across the nation to date have been faring much better in the current recession, which began in March 2001. Bank failures have been minimal during the current cycle of contraction, the ratio of noncurrent loans to total loans has been much healthier, and profits, though reduced, have not fallen precipitously.
As many as 205 banks failed in 1989, representing 1.64 percent of all banks at the time, followed by 160 failures in 1990 and 109 failures in 1991. In contrast, only three banks, 0.04 percent of the much smaller field of banks overall, failed in 2001. At press time, however, the entire number of bank failures for all of 2001 had already been eclipsed by the number of failures in early 2002.
Still, financial institutions have not been as severely shaken by deterioration in credit quality during the current downturn. In 1991 the ratio of noncurrent loans to total loans was 2.45 percent as compared with 0.94 percent in the third quarter of 2001. Despite challenges to banks’ profitability, the average return on assets (ROA) for all U.S. commercial banks was 1.04 percent in 2001, much better than the 0.64 percent posted in 1991.
What accounts for the relative health of the nation’s financial institutions despite continuing economic stresses? One reason appears to be fundamental changes in the structure of banking.
Large banks positioned for stability in downturn
Large banks — those with assets of $10 billion or more — are entirely different operations today than they were during the last downturn because they are far better diversified geographically and across product lines. In addition, risk-management systems have been improved significantly, and bank capital has been strengthened.
Like large banks nationwide, those in the Southeast are better positioned to ride out the current downturn, thanks in part to new flexibility and potential resulting from deregulation in the late 1980s and the 1990s. With the advent of the Riegle-Neal Interstate Banking Act of 1994, which permits branching across state lines and allows banks to diversify geographically, banks have become better able to avoid problems caused by weaknesses in particular industries or areas of the nation.
Diversification across traditional boundaries allows banks to offset shaky holdings in a given region or in a geographically specific industry with stronger holdings in another. “It’s a matter of spreading the pain,” says Larry Wall, senior financial economist and policy adviser for the Atlanta Fed’s research department.
Birmingham’s Compass Bank, for example, has reaped benefits from expansion into markets in Texas, Arizona, Colorado and New Mexico. According to Randy Haines, Compass’ Alabama Corporate Banking Executive and Birmingham City President, “demographics in these regions are better than in the rest of the United States.” He notes that the Southeast overall hasn’t been as severely affected by the economic downturn as heavy manufacturing and high-tech areas, thanks to a more diverse economic base.
The ability to provide new financial products such as brokerage and insurance has also created a source of bank revenue that is less dependent on spreads between lending and saving rates. Banks that offer an array of services in addition to the traditional ones have been better able to maintain profitability despite tightening interest margins.
“Relationship banking is one thing we may do a little better in this part of the country,” states Haines. He says that anticipating the kinds of support services that will augment profitable relationships is an important strategy at Compass and other Southeastern financial institutions.
Richard Hickson, president and CEO of TrustMark Corp., a midsized bank with assets of $7 billion in Jackson, Miss., agrees on the importance of cross-selling financial services. “Traditional banking just doesn’t provide enough growth. And customers are smarter and more demanding. They expect more products and a broader line of services.”
Increasingly sophisticated risk-management tools are another key element in large banks’ ability to hold their own despite the downturn. “After a few near-death experiences in the 1980s and the 1990s, banks are learning to manage risk more effectively,” says Wall.
Haines observes that he is aware of many Birmingham bankers who are controlling individual borrower exposure much more tightly than in the past. “Once we set a limit, we don’t deviate,” he says, pointing out that limits are based on customers’ risk ratings. Computer technology has been an important factor in improving banks’ ability to calculate risk rates. He explains that computers enhance the availability of information and provide banks with the means to get data more frequently, allowing the banks to make more informed decisions.
Advances in computer technology not only play an important role in giving bankers the capacity to assess risk more effectively but also help in determining what financial instruments will be most effective in offsetting risk. Sophisticated new systems for analyzing risk factors allow bankers to see problems developing and to respond more quickly. Then risk can be compensated for through a variety of tools that allow banks more room to maneuver.
Credit derivatives, loan sales markets, and the buying and selling of credit risk provide hedges, and bankers have become much more receptive to using these approaches with the evolution of computer support. The sale of deteriorating syndicated loans also helps institutions manage the level of problem credit on their books.
More stringent capital requirements, which had just begun to take effect in the 1980s, have further positioned banks to maintain stability during the current downturn. Wall adds that an extended period of economic growth has made it possible for banks to rebuild and reinforce their capital holdings.
Despite the prospects for large banks to maintain profitability during this cycle of economic contraction, most bankers acknowledge that 2002 may be a difficult year for financial institutions, and some will experience the pain more than others.
Large Southeastern banks faring better
In addition to enjoying new resilience as a result of changes in bank regulations, large banks in the Southeast may have a further advantage over their peers outside the Sixth Federal Reserve District. Reported increases in delinquent loans (loans past due more than 30 days) during this economic downturn have been more modest for large banks in the Sixth District than for large banks outside the region. Specifically, large Sixth District banks posted about 1.9 percent of loans past due in the third quarter of 2001, up from 1.7 percent in the first quarter of 2000. Outside the district, loan quality slipped more as delinquent loans rose from about 1.9 percent in the first quarter of 2000 to 2.8 percent in the third quarter of 2001. The difference can be attributed in part to differences in loan composition.
Sixth District banks are relatively more concentrated in real estate lending and are less focused on commercial and industrial lending than banks outside the district. As a result, losses related to trouble spots like Argentina, or troubled companies like Enron and Kmart, and other syndicated loans have been and are expected to be more moderate at Sixth District banks. While all large banks have experienced varying degrees of credit deterioration since the economy began to slow in 2000, most of the weakness to date has been in loans to businesses and sectors that have suffered the most in the downturn — industrial machinery, chemicals, fabricated metals, textiles, apparel and telecommunications.
Large bank portfolios in the Sixth District include, on average, about 24 percent commercial and industrial holdings as opposed to 32 percent outside the region. On the other hand, Sixth District bank lending is more heavily weighted in real estate, especially commercial real estate and construction loans. Sixth District commercial real estate loans account for about 15 percent of all loans compared with about 8 percent outside the District. Likewise, construction loans make up roughly 10 percent of Sixth District portfolios, versus about 3 percent outside the region.
Favorable credit quality at the large Sixth District banks has also been reflected in earnings performance. Large banks’ earnings in the Sixth District have moved upward since the third quarter of 2000, from about a 1.1 percent ROA to about 1.3 percent in the third quarter of 2001. Large out-of-district banks, in contrast, have experienced ROA declines during the last year — from about 1.1 percent in the third quarter of 2000 to 0.8 percent in the third quarter of 2001 (see chart 1). In addition, Sixth District banks have not been as affected by declines in financial market-related fee income and private equity holdings when compared to large banks outside the district.
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Generally speaking, bankers in the Southeast seem to concur with the interpretation of the ROA data though they also agree that commercial real estate still could pose challenges in some areas of the region.
Community banks not as diversified
Larger banks in the Southeast are strengthened by geographic diversity, but community banks — institutions with assets of less than $1 billion — face a different situation, particularly from a consumer perspective. That’s because many community banks in the Southeast are located in less economically diversified areas that have been more affected by plant closings and layoffs in textiles, apparel, steel, auto parts and trucking.
As a result, many community banks in these areas have experienced more problem loans than their counterparts nationwide. In the third quarter of 2001, community banks in the Sixth District registered past due loans of nearly 2.5 percent of their portfolios whereas community banks outside the district posted about 2.2 percent (see chart 2).
Hickson notes that Mississippi’s community banks have felt the sting of the recession more acutely than banks in urban areas. He explains that the recent decline in interest rates and the absence of loan demand have made it difficult for smaller institutions to compensate for the narrowing spread between the cost of lending and the cost of borrowing. Many banks, he points out, have not been able to reprice their deposits, and, unlike larger banks, smaller banks typically aren’t able to augment their earnings by diversifying the products they offer.
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Mississippi has been hard hit by declines in manufacturing jobs, losing more than 20,000 in the last 24 to 30 months. Most of the manufacturing losses have been in rural areas served by smaller community banks. Hickson says, however, that despite the absence of loan growth, community banks have retained a solid foundation: their loan-loss reserves are for the most part strong, and they have quite a bit of equity relative to their assets — partly due to the absence of lending opportunities.
Hickson believes that Mississippi’s economy as a whole is bearing up well under the stress of the downturn, and this strength will help its banking industry. He says that for Mississippi the loss of jobs in manufacturing has been gradual, and businesses have been able to anticipate the contraction and adjust. Despite a slowdown in government spending for highways and building, for example, there haven’t been new bankruptcies in construction. Homebuilding, he says, has held up better than expected, and the construction of the Nissan plant in central Mississippi has been a source of “euphoria” since it will provide many jobs in the region. However, Hickson is concerned about the duration of the current cycle of contraction and wonders how long it will take for companies to return to profitability.
Many community banks employ time-honored strategies to maintain credit quality and profitability. For Red River Bank in Alexandria, La., a conservative lending policy is the central strategy for negotiating the downturn. Blake Chatelain, the bank’s president, describes Alexandria’s economic climate as “slow and steady.” While the economy is not booming, neither is it suffering excessively during the current contraction. Chatelain attributes his bank’s stability to a strong credit culture. Most of the bank’s customers are small businesses in the area.
“We act as advisers to our customers,” says Chatelain. “We help them structure their transactions, and we really become a business partner to the extent they will let us. Knowing our customers is absolutely the most critical thing we have to do.” He points out that Red River Bank underwrites every loan, avoiding computer models of creditworthiness and pre-approved credit. He believes that the personal relationship community banks maintain with customers not only helps customers make better decisions about borrowing but also encourages them to be more conscientious about paying down debts.
Community banks in metropolitan markets in the Sixth District have not been as affected by the layoffs in the manufacturing sector as the rural community banks have, but the metropolitan community banks do have a greater construction lending concentration, especially in residential construction. Therefore, if the housing market weakens, banks with heavy concentrations in this type of lending could see some deterioration in their portfolios. But to date, the housing sector has remained quite strong.
Community banks in Florida face a different set of challenges. For instance, some community banks in south Florida have extensive ties to Latin America. Thus Argentina’s current economic crisis could exacerbate the problems that confront this area’s financial institutions, though bank analysts say direct lending exposure to Argentina by banks in the Sixth District is not substantial. The crimp in trade and tourism created by contraction in Latin American economies as well as fallout from Sept. 11 will also affect banks in both south and central Florida. While there is some indication that Latin American tourists are returning to Florida, European travel to the region remains limited.
Banker William Smith Jr. of Capital City Bank in Tallahassee, Fla., remains optimistic about the overall condition of Florida’s banking industry and economy in general. Although he acknowledges that Florida has suffered from declines in tourism in the wake of Sept. 11, he believes Florida’s economy is resilient.
“We have warm weather — and we can rely on people to keep moving here. And they will buy houses, automobiles and groceries. All that keeps the economy healthy,” says Smith. He notes that, overall, problem loans for banks in the state are at low levels and that capital reserves are generally good.
Exposure to commercial real estate
While the current recession has not been a commercial real estate recession, commercial real estate exposure may still pose problems for some highly exposed Southeastern banks. But analysts believe the situation should be less severe than in the 1990s. Hotels and office and industrial properties are nevertheless of some concern.
“Unfortunately, the travel-related impact of the recession and the Sept. 11 attacks come at a time when there is a large pipeline of hotels under construction in markets like Orlando, Miami and New Orleans. It’s uncertain how these markets will absorb the amount of new rooms that will be delivered over the next 12 to 18 months,” says John Robertson, who leads the Federal Reserve Bank of Atlanta’s regional research section.
Smith believes Florida bankers are in a better position to cope with commercial real estate problems than they were in the past. “We have a group of bankers in Florida who have been through a cycle of downturn, and we’re better prepared than we were last time. We also have a much better understanding of risk and how to control risk exposure,” he says, referring specifically to the potential problem of commercial loans to hotels. “We have much better internal controls. Technology alone has made us a much more sophisticated group of lenders.”
Office and industrial properties also show signs of weakening because of a fall in demand, but the extent of overbuilding seems to be less than in past cycles. Part of the excess space has been created by vacating dot-com firms in Atlanta and south Florida, but these markets have not been affected nearly as seriously as the technology-intensive areas of California, Boston or Washington, D.C.
“The real news of this cycle so far seems to be the health of bank portfolios in the face of weakened commercial real estate markets,” Robertson notes. He says that discipline imposed by the capital markets, tax policies that don’t reward unnecessary development and less willingness by banks to compete for commercial real estate loans through lax underwriting have all served to limit the impact of soft commercial real estate markets.
According to Haines, the Birmingham area hasn’t seen the kind of speculative commercial real estate development that was widespread in the 1970s and ’80s. “Banks are conservative,” he says, “but so are developers. They just aren’t pursuing speculative deals, though they are still fairly active in retail and multifamily development.”
“We do not think we’re looking at a repeat of the early 1990s in real estate lending,” Robertson reassures.
Not like last time
The banking system headed into the current downturn in better shape than during the earlier economic crunch. The systemic weaknesses that afflicted the banking industry in the early 1990s are absent. Larger banks in particular are more diversified geographically and across product lines. They have developed better risk-management systems and been subjected to more stringent market discipline. In addition, most banks are maintaining higher capital levels, higher levels of coverage for problem loans and lower percentages of nonperforming loans.
The economic climate is nonetheless challenging. Credit quality has weakened somewhat, loan growth has slowed and earnings are under pressure. Community banks, banks with international exposure and those banks with high exposure to commercial real estate, especially projects begun late in the business cycle, are likely to suffer more acutely than others.
“The silver lining so far,” says Robertson, “is that, despite all the bad news on the economy, the problems in the banking sector remain isolated.” Banks are not entirely out of the woods, however, as credit cycles typically lag economic cycles. Because of this lag, most banking analysts expect 2002 to be a challenging year for banks even as the nation’s economy improves.
Supporting data and commentary for this article were provided by the Atlanta Fed’s Supervision and Regulation Department’s Policy and Supervisory Studies Group.