Regional Banking Conditions Discussed in "ViewPoint"

January 3, 2023

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

Asset Quality

Despite concerns about higher interest rates and inflation, the percentage of nonperforming loans to total loans held steady from the prior quarter, at 56 basis points on aggregate, and below the percentage from the fourth quarter of 2021, which was 69 basis points among community banks in the Sixth District.

Unlike banks at the national level, banks in the District saw no discernable shift in the level of loans reported past due 90 days or more, on aggregate.

A few banks reported new troubled debt restructuring of loans (TDRs), indicating some problems with borrowers. The TDR designation had been placed on hold by the CARES Act through 2021. Recently, those who set accounting standards decided to eliminate TDR designation once a bank adopts the new current expected credit losses (CECL) model, which most banks will adopt in the first quarter of 2023.

Although banks' problem assets remain low, the Senior Loan Officer Opinion Survey indicates that banks, both in the District and nationally, have been tightening lending standards during the third quarter of 2022 to forestall potential problems in the current economic environment.

Loan loss reserves as a percentage of total loans declined in the third quarter of 2022 because of stronger loan growth. Although the ratio declined, the allowance level still represents more than twice the amount of nonperforming loans and nearly 3.5 times the amount of nonaccrual loans. By comparison, the ratio was less than one in the second quarter of 2008, ahead of the start of the great financial crisis (see the chart).


Balance Sheet Growth

Annualized asset growth, on a median basis, dropped to 5 percent in the third quarter of 2022, the slowest growth for a quarter since the beginning of the pandemic though twice as fast as the 10-year prepandemic average of 2.64 percent (see the chart).

A variety of factors affected growth, including slower deposit growth, which affected the securities portfolio. Deposit growth slowed to 7 percent, annualized, as inflationary costs have eroded personal savings and higher interest rates have enticed some depositor funds into higher-yielding products outside the banking industry. Banks are borrowing more to fund the balance sheet, using wholesale funding options like brokered deposits and Federal Home Loan Bank advances.

Additionally, the fair value of the securities portfolio also declined as interest rates rose. Higher unrealized losses have yet to affect regulatory capital, as most banks opted out of the inclusion of accumulated other comprehensive income (AOCI) in 2015. However, declining tangible equity (which includes AOCI) could affect banks' ability to borrow from some wholesale funding sources.

Loan growth remained a bright spot, up 9 percent year over year on a median basis. The level of growth has been surprising given the sharp rise in interest rates. Many banks in the District continued to experience steady residential mortgage production through late into the third quarter of 2022. Commercial and industrial lending was also still strong despite the obstacles facing many small businesses. Yet, as the quarter closed, banks were seeing neither the usage of credit lines nor the levels of prepayment increasing as customers decided to keep their existing interest rates. The lack of early repayments has helped contribute to showing overall positive loan growth (see the chart).

Consumer vehicle financing and commercial real estate lending are also slowing as concerns about collateral valuations increase in the current interest rate environment.


Capital

On an aggregate basis, both the total risk-based capital and tier 1 leverage ratios declined in the third quarter of 2022 as increased loan growth put pressure on capital levels. Banks have discussed slowing loan growth as a means of protecting capital ahead of fears of a possible economic downturn.

Equity account accumulated other comprehensive income (AOCI), which captures changes in fair value on securities that are available for sale, continued to reflect higher losses in the third quarter. Higher losses caused a sharp decline in reported tangible equity at some banks. Community banks had the ability to opt out of AOCI inclusion in risk-based capital in 2015, and most of the Sixth District's banks elected this option. The rules do not allow them to opt back in and include AOCI in equity capital, except in limited circumstances (see the chart).


Earnings Performance

Earnings at community banks in the Sixth District strengthened in the third quarter of 2022, with the median return on average assets (ROAA) jumping to 1.23 percent, its highest level in more than 15 years (see the chart).

More than 70 percent of community banks in the District report an ROAA above 1 percent, with only 3 percent reporting a loss.

Consistent with national trends, the improvement in earnings was driven by the net interest margin, which was up 30 basis points year over year, to 3.73 percent on a median basis. Changes in the fed funds rates drove the change in net interest margin, which represented one of the largest increases in the margin in more than 15 years. Nearly every community bank in the District reported a higher margin from the prior quarter (see the chart).

Banks benefited through the third quarter from strong loan production at higher rates, while deposit rates were stable even as deposit balances declined. The net interest margin is expected to weaken over the next few quarters as deposit rates rise. Higher margins also helped offset lower fees reported by banks as residential loan demand started to slide late in the third quarter. Going forward, changes in funding costs are expected to weigh on further margin increases, while reduced loan demand will continue to restrict noninterest fee growth. Additionally, lingering concerns about the direction of the economy will encourage banks to add to the provision for credit losses during the next couple of quarters.


Liquidity

The median on-hand liquidity ratio continued to decline from its cyclical high of 34.1 percent as of the first quarter of 2022, to 27 percent as of the third quarter of 2022, reflecting slower deposit growth (see the chart).

Competition for deposits is building among Sixth District banks, with pricing moving up in reaction to fed funds rate increases. Still, many banks in the District have strong liquidity because of the pandemic-era surge in deposits.

Though deposit levels remain elevated at some banks, they have begun to express concerns about liquidity levels amid improving loan growth and slowing deposit growth. The aggregate loan-to-deposit ratio was 76.2 percent, up from 69.4 percent in the fourth quarter of 2021.

Increasing unrealized losses on debt securities limit the use of the securities portfolio as a source of liquidity, as banks seek to avoid a negative effect on earnings and capital from recognizing losses through the income statement.

Although noncore funding dependence remains relatively low, for the first time since the beginning of the pandemic banks are borrowing wholesale funds, particularly Federal Home Loan Bank advances, to keep pace with loan growth.


National Banking Trends

Earnings in the third quarter at community banks were consistent with the prior year on the strength of higher net interest margins. Aggregate return on average assets (ROAA) was 1.37 percent at community banks, nearly identical to the 1.36 percent reported in the third quarter of 2021 (see the chart).

Aggregate net interest margin reached 3.67 percent, returning to its prepandemic level. During the last three quarters, most banks have experienced one of the most rapid increases in margins since the financial crisis because of several large fed funds rate increases. The fed funds rate has increased more than 350 basis points since the beginning of the year. Although bank margins still were strong in the third quarter, the expectation is they will compress because of raising deposit rates and the need to borrow more funding to support loan growth. Already, bank competitors are getting aggressive with raising their deposit rates, which will put downward pressure on the margin in the fourth quarter of 2022 (see the chart).

Asset growth continued to cool in the third quarter of 2022, as unrealized losses climbed in the securities portfolio, and deposit growth slowed significantly compared with the prior year. Among all banks, deposits increased just over 1 percent year over year but are down almost 1 percent from the prior quarter. Deposit growth at community banks was stronger, 2.8 percent year over year.

As interest rates have increased, banks' bond portfolios have declined in value, since the existing bonds have lower yields than newly issued bonds. Banks are considering a variety of ways of dealing with the declining value, including selling bonds at a loss or reclassifying the bonds to held-to-maturity, which will eliminate recognizing losses on balance sheet but reduce the ability to sell the bonds for liquidity purposes.

Community banks continued to experience strong loan growth in the third quarter of 2022, fueled by the last wave of residential mortgage originations before higher mortgage rates began to cool housing demand. Yet, beyond the third quarter of 2022, there is evidence that loan growth is slowing rapidly, both because of lower demand and concerns over erosion of bank capital (see the chart).

Asset quality on banks' balance sheets remained healthy in the third quarter of 2022, though data suggest some weakening through the middle of the fourth quarter. As of the third quarter of 2022, problem loans at community banks still were at historically low percentages (just 45 basis points). As of the third quarter of 2022, nonaccrual loans were down roughly 24 percent. However, the percentage of loans past due 90 days or more rose for the first time in eight quarters, to 15 basis points year over year—still low, but a sign of building stress. Banks have responded by increasing their allowance for credit losses. The allowance now represents more than two times the level of noncurrent loans, a much stronger position for banks than during the last significant economic downturn (see the chart).

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