Tom Heintjes: Hello, and welcome to another episode of the Economy Matters podcast. I'm Tom Heintjes, managing editor of the Atlanta Fed's Economy Matters magazine, and today we're joined by Cynthia Goodwin, a vice president in the Atlanta Fed's Supervision, Regulation, and Credit division. With 2018 behind us, I thought it would be a good time to sit down with Cynthia and talk about the year we saw from a banking perspective. Cynthia, thank you so much for taking the time to sit down with us today.
Cynthia Goodwin: Thank you, Tom—I'm glad to be here.
Photo: David Fine
Heintjes: Cynthia, let's start with a more global view of things, and we'll get more into the nitty-gritty details in a bit. So let me ask you—overall, how would you describe southeastern banking in 2018?
Goodwin: In general, banks in the Sixth District, which encompasses most of the states in the Southeast, are healthy. Earnings have improved, due primarily to an enhanced net interest margin at most firms. Over 60 percent of the banks have seen their return on average assets rise above 1 percent, while fewer than 5 percent are still struggling with losses—that's quite a vast improvement from a decade ago. Credit quality metrics generally remain positive, nonaccruals are at near-record lows, and the coverage ratio for the allowance for loan losses has significantly improved. Nationally, the coverage ratio [loan-loss reserves to noncurrent loan balances] also rose above 120 percent, which is the highest it's been since the first quarter of 2007.
Heintjes: That's very good.
Goodwin: Banks have maintained a coverage ratio above 100 percent actually for the last six consecutive quarters. We've also seen a return to a more traditional balance sheet, with loans forming the majority of earning assets. Portfolios, though, are more diversified, and the level of concentration in commercial real estate loans has declined since the crisis. Also, in terms of liquidity, deposits remain the primary source of funding for balance sheet lending—but we have seen an uptick in the use of borrowed funds in recent quarters as deposit competition intensifies.
Heintjes: Cynthia, you mentioned loans, and I read a report that indicated that banks' loan growth slowed in the third quarter. Is that slowing broad-based? How would you characterize it? Is it a few key loan types, like autos and mortgages?
Goodwin: Well, as you would imagine, broadly, loan growth does continue, but just at a slower pace than we've seen in prior quarters, although loan growth in the Sixth District has been relatively flat over the last four quarters. Right now, the slowdown has occurred primarily in real estate portfolios. That appears to be much more about demand for these products as it is about tighter credit conditions. Residential real estate lending in particular has been impacted by a variety of factors, including rising interest rates, a lack of inventory, and also declining affordability. Both the interest rates and inventory play into affordability issues in many markets, especially markets like Miami. Auto lending is still fluctuating quarter to quarter, so in one quarter growth can slow and then increase in the next.
Heintjes: You mentioned interest rates, and I want to touch on that again. As you noted, after a long period of very low interest rates, we've seen the interest rate environment increasing a bit recently. How has this affected banks' earnings? I guess I could answer my own question by saying it has helped banks, but what impact have you seen?
Goodwin: Banks have definitely benefited from the recent increases in interest rates following the financial crisis and the protracted period of low rates. Short-term interest rates have reached 2.25 percent for the first time in 10 years, as a result of eight increases over the last 12 quarters. At our community banks in the district, the median net interest margin exceeded 4 percent, which is 30 basis points higher than the third quarter of 2008, when the financial downturn started.
Banks' margins have grown through a combination of modest increases in interest-bearing assets and a wider gap between the interest rates charged and what's paid by the banks. We do see that further gains will probably be challenging in the short term as the yield curve flattens, deposit costs rise, and credit normalizes.
Heintjes: Yes, we're all watching the yield curve these days. Cynthia, we've seen household debt reaching pre-financial crisis levels, and we've been hearing a lot about household debt in general. How has the level of household debt affected banks in the region? I would imagine that banks' credit card charge-offs must be feeling some effects, maybe especially at smaller banks?
Goodwin: You've got that right. We're also keeping our eye on the increase in consumer debt, which I think the New York Fed's Quarterly Report on Household Debt and Credit placed at about $14 trillion in the third quarter last year. Of course, that debt is also spread among banks, credit unions, and other nonbanks. You specifically mentioned credit cards, and problems with credit cards do stand out as an anomaly in this current credit environment. In recent months we've observed some loosening of credit standards with credit cards, and as the economy improved over the last two years we've seen continuous growth in credit card balances. With looser underwriting standards, we're also starting to see higher charge-offs and delinquencies in recent months, particularly at smaller commercial banks.
Among the major loan categories, credit card balances registered the largest increase in net charge-offs in the third quarter. The net charge-off rate for credit cards increased 14 basis points to 3.6 percent in that quarter, but the net charge-off rate actually remains below the most recent high of 13 percent reported in first quarter 2010. The higher interest rates are causing minimum payments to increase, and it could be that consumers are struggling with the higher minimum payments. Data that we've seen suggest that the problems are occurring mostly with customers with marginal credit scores. So for now, the increase in charge-offs and delinquencies appears to be more like the long-term norms than being elevated beyond the usual expectations. That said, we're seeing some tightening credit for these lines and a shift back toward prime and super prime customers.
Heintjes: Well, let me get you to turn your attention to banks' asset quality. How would you describe, overall, banks' asset quality in 2018? I read that banks have been somewhat more conservative in making loans, with tightened standards, so I assume this has benefited asset quality?
Goodwin: It has. As I mentioned, overall asset quality indicators remain strong. The noncurrent rate declined from the previous quarter, and the net charge-off rate was lower than a year ago. Charge-offs remain below their historical averages, though we've seen them trending back to the norms over the last three quarters.
Banks suffered a lot of losses with home equity products and have not really grown that portfolio during this economic cycle despite the increase in house prices. And other than in the card book, as we just discussed, firms had maintained their credit standards through most of this cycle. However, recently it appears that competition is driving a general easing of credit standards, particularly for commercial and industrial, or C&I, and commercial real estate loans. Examiners are reporting that they see more covenant-light deals, with fewer requirements for guarantors.
Examiners are also seeing less equity being put into new deals. Data reported in the Small Business Lending survey showed that while credit quality for current applicants has remained unchanged in recent months, increased competition, as well as higher tolerance for risk, has had a direct impact on the easing of credit terms. From the consumer side, overall underwriting standards on residential real estate and auto loans remain little changed this year. Median credit scores have remained above 700.
Heintjes: When you say "700," give me a frame of reference. What does that indicate versus other periods we've seen or other recent years?
Goodwin: Well, if you think back to the crisis, we had quite a significant expansion in subprime credit—those would be marginal borrowers that have credit scores probably in the 500–600 range.
Heintjes: So 700 is a considerable improvement.
Goodwin: Yes. We've also seen, though, some weakening in the debt-to-income and loan-to-value ratios, and concessions in residential lending occurring in some of the hot markets like Miami, where affordability has declined rapidly over the past couple of years.
Heintjes: Cynthia, you mentioned your examiners and talking to bankers. I know that you and your staff in Supervision, Regulation, and Credit are constantly talking to bankers. In general, are there any recurring themes to the conversations? Are there concerns you hear them express on a regular basis?
Goodwin: Given the current credit conditions, credit quality has been less of an issue. Most of what we've been talking to banks about over the last couple of years has focused on portfolio diversification, as well as operational issues such as cybersecurity, third-party risk management, and compliance issues. During the crisis, we saw many of our firms rely heavily on commercial real estate, specifically construction and development lending. We issued guidance—clarifying safety and soundness standards—on the importance of strong risk management practices and controls when accepting high levels of concentration to capital.
Also, a recurrent topic is the need for better risk management practices for operations. As the industry experiences digital transformation, it's often executed with multiple service providers, and a strong technology infrastructure is critical because with those benefits and expanded connectivity come increased risks—especially related to cybersecurity, third-party risk management, consumer protection, and data security.
Heintjes: Sure, I know cybersecurity is what keeps a lot of bankers up at night.
Goodwin: And us as well! [laughter]
Heintjes: Well, when we talk about the Southeast in 2018, we cannot ignore the very significant hurricane activity that we saw in this region last year. We all saw the pictures of the utter devastation at Mexico Beach in Florida on the Gulf Coast. How do storms affect banks in those areas? And what steps did the Fed take to make sure the people in the affected areas had access to cash?
Goodwin: The Atlanta Fed—and for that matter, the entire Federal Reserve System—has had extensive experience with natural disasters—and in particular, in our region, hurricanes.
Heintjes: Yes, it was not our first rodeo, for sure.
Goodwin: [laughs] Exactly. In early October, Hurricane Michael significantly damaged local economies in the Florida Panhandle and in southern Alabama and Georgia, especially production on farms. Reports indicate that the short-term impact to banks was minimal, although we do expect to see some problems arising with regard to asset quality in those areas. During the recovery, several banks that operate in those markets impacted offered customers assistance by waiving fees and giving them breaks on loan payments. This is a type of forbearance that is encouraged by the bank regulators, as evidenced by one of our—what we call "supervision and regulation letters," SR 17-14
, "Interagency Supervisory Examiner Guidance for Institutions Affected by a Major Disaster."
Heintjes: And we'll have a link to that letter on the website.
Goodwin: Excellent. In terms of ensuring the market had sufficient access to cash, the Fed maintains emergency supplies of cash in bank vaults across the United States. The idea is to have a secure location where banks can access cash in the event of a natural disaster, such as a hurricane, when transportation is often disrupted. We saw this played out actually on a larger scale with Hurricane Maria and its impact on Puerto Rico. Typically, the New York Fed supplies the island with cash. However, the lack of flights between New York and Puerto Rico led to the Atlanta Fed stepping in to supply cash to the island—which was critical due to the infrastructure damage, because that market actually has a higher percentage of cash transactions than elsewhere on the mainland. The System learns something from each disaster, and we're already discussing changes that need to be made for ensuring that cash supplies to areas like our territories in the Gulf and South Atlantic Ocean are available.
Heintjes: Yes, these are painful lessons—but they're necessary for us to know, especially in this region with our hurricane activity. Cynthia, you mentioned technology, and I wanted to get you to talk about financial technology—or as we call it, "fintech"—for a second. We hear a lot about fintech's impact on banking and finance, and I know it's very much on the radar of your staff. Can you discuss the role of fintech—again, bearing in mind that we're nonspecialists, not a technical crowd here. Can you discuss the role of fintech as it applies to banks? How do you see the Fed's perspective on fintech evolving over the years?
Goodwin: Taking your last question first, emerging technology has the potential to materially transform banking business models and the delivery of many financial services, so I think the Fed is, and will continue to be, a major stakeholder and influencer in managing the benefits and risks of financial innovation. Financial technology, or fintech, is a catch-all term that encompasses a wide range of technologies—for example, artificial intelligence, mobile payments, cloud computing, distributed ledger technologies, and cryptocurrencies. Given its wide breadth, fintech touches on a number of different regulatory issues, including but not limited to safety and soundness, consumer protection, financial stability, payment systems, as well as mandates of other regulators—for example, securities regulation.
All of the federal and state banking agencies are interested in fintech and the potential impact on the financial industry. The financial services industry is highly regulated due to concerns about financial stability, individual firm safety and soundness, and consumer protection. These concerns haven't traditionally been present in the technology sector, so many of the fintech start-ups don't consider the risk management and control environment needed to comply with banking laws and regulations. Further, most banks' technology infrastructures weren't designed to facilitate the level of connectivity with non-banks.
And as the two sectors blend, new opportunities and risks are likely to emerge and give rise to new policy challenges—and they have. Research conducted by the Federal Reserve has shown that while fintech has brought speed and innovation to the financial services market, it also has increased the level of risk. The Federal Reserve has been evaluating developments with fintech through a multidisciplinary lens, combining information technology and policy analysis to study the potential impact on payments policy, supervision and regulation, financial stability, monetary policy, and the provision of financial services.
The supervision functions—actually from multiple Reserve Banks—collaborated to execute a high-priority initiative to look at fintech's impact. That initiative was organized into four key market segments: credit; digital payments; savings, investment and financial planning; and blockchain. The effort also studied three components of fintech's underlying data and technology ecosystem: looking at big data, application programming interfaces, or APIs, and mobile devices as delivery mechanisms.
Heintjes: Oh, boy—sounds like we might have to have another full episode just on fintech! [laughter] So I'll have to have you back on to talk about just that. You mentioned the speed of fintech companies and the way they're innovating various products. For example, many fintech companies offer consumers a very simple loan application process and a really fast response to requests for financing. Is that something that more conventional banks are responding to, and maybe feeling a need to compete on a similar, level playing field?
Goodwin: Yes. Consumers continue to want faster and easier service, and the banks are responding by developing their own proprietary online applications and by partnering with fintech firms. And yes to the question about a level playing field—the focus of that conversation, though, is typically related to compliance obligations, given the different regulatory oversight structures. Banks and other financial institutions are gaining market share via or through their technical offerings, and to remain competitive financial firms will have to improve their consumers' online experience—consider Rocket Mortgage by Quicken Loans' trajectory in the residential mortgage sector.
Heintjes: Yes, I was thinking about that.
Goodwin: Based on a recent study by staff at the Federal Reserve Bank of New York, fintech firms process mortgages on average 20 percent faster than traditional lenders, and the credit quality outcomes have been similar to, or better than, some of the banks. Fintechs have also been able to make headway in other lending portfolios. For example, in 2010, fintech lenders made only 1 percent of personal loan originations in the United States. By mid-2017, fintech firms were responsible for nearly a third of the personal loan market.
Heintjes: Wow. Cynthia, you've mentioned a lot of things that are prompting a lot of questions for me. You mentioned before cybersecurity, and let's talk for just a second about cyber issues. We continue to hear about hacks and breaches at all types of companies, financial and otherwise. How do you see banks dealing with issues like cybercrime, where the bad actors are getting savvier and more sophisticated all the time? How do you stay ahead?
Goodwin: It's tough. Cybersecurity is almost always at the top of the risk list. Cybersecurity threats and attacks continue to arise, they're dynamic, and they're usually not known in advance. Many banks face a variety of ongoing challenges, including the pace of change in the threat landscape, increasing connectivity in operations, complex infrastructures, and fixing more fundamental IT issues. Collaboration among the many stakeholders on cybersecurity is imperative to progress.
The Fed has been working with, and will continue to work with, other financial regulatory agencies on harmonizing cybersecurity management standards and regulatory expectations across the financial services sector. And similarly, depository institutions sponsor associations for the same purpose. FS-ISAC, the Financial Services Information Sharing and Analysis Center, is a global financial industry resource for cyber and physical threat intelligence analysis and sharing.
From a supervisor's perspective, we've seen deficiencies due to weak internal controls and policies and procedures, which have heightened exposure to cybersecurity risk. To be safe and sound, firms should create a strong risk culture around access control and third-party risk management.
Another critical aspect of cybersecurity is the need for banks to adequately invest in safeguarding their systems and platforms by training their employees on how to identify potential cyberattacks, mitigate vulnerabilities, and escalate issues appropriately. Moreover, to address potential insider threats banks must establish and maintain robust protocols and controls in managing employees' access to the firm's systems and databases.
From the banks' perspective, the most frequently cited challenges we hear include attracting and retaining information technology talent, as these skilled individuals are in high demand—of course, we experience that as well—and also implementing sufficiently robust vendor management programs for technology services outsourced to third-party providers.
The Fed is committed to strategies that will enhance the cyber resiliency of the financial sector. The Federal Reserve focuses on sharing threat information, and collaborates with a number of parties toward protective mechanisms. Specifically, we collaborate with government and industry partners to plan and execute cybersecurity tabletop exercises focused on identifying areas where sector resilience and information sharing can be enhanced. We also participate in community and industry outreach forums and actively share threat intelligence with our sector partners.
Heintjes: It's really great and encouraging to hear all those multipronged approaches, because it's certainly a problem that's not going to go away. Cynthia, I know I asked you to come on the podcast to talk about the past year, but I would like to ask you to look ahead for a moment. How do you see 2019, especially as it compares to what we saw in 2018? Do you have your eye on anything in particular in the relatively new year?
Goodwin: In general, the outlook is healthy for banks in the Southeast. The regional economy is doing well. However, as we know, conditions can change. Going forward, we'll continue to enforce safe and sound standards and consumer protection laws, and be open to and conscious of the benefits and risks of financial innovation. Use cases for emerging technologies have the potential to prudently broaden access to credit, reduce fraud, and facilitate effective money management, among other capabilities that can positively impact the economy. As we monitor the technology transition, we'll maintain our focus, though, on bank capital and liquidity, first and foremost.
Heintjes: Well, Cynthia, we're about out of time, so I wanted to thank you again for coming on and speaking with us today—and thanks again for sharing your expertise.
Goodwin: Thanks for the invitation—I appreciate it.
Heintjes: And that brings us to the end of another episode of the Economy Matters podcast. Again, I'm Tom Heintjes, managing editor of Economy Matters magazine, and I've been speaking with Cynthia Goodwin, vice president in Supervision, Regulation, and Credit here at the Atlanta Fed. I encourage you to visit our digital magazine, Economy Matters, at frbatlanta.org. There, you'll find a great deal of banking information, including a brand-new edition of "ViewPoint" from Cynthia's team, which offers a very convenient look at current banking conditions. And I hope you'll return next month when we'll sit down with Nell Campbell-Drake, who will discuss new payments technologies and the Atlanta Fed's role in making the payments system even faster and more efficient. See you next month!