New regulations, heightened supervisory expectations and challenging economic conditions continue to weigh on community banks as they work to help their communities rebuild in the wake of the economic crisis. However, recent research from the Federal Reserve shows community banks can thrive even under adverse circumstances. Fed Governor and former community banker Elizabeth Duke outlined the characteristics that are strongly linked to banks’ success during a speech at the University of Georgia’s Terry College of Business in Duluth, Ga., on Feb. 5.
Duke said one unpublished Federal Reserve study of community bank profitability from 1992 through 2010 found that a number of characteristics are strongly correlated with bank performance. These characteristics include relative bank size, portfolio composition and management quality.
This study found that within the group of banks with less than $1 billion in total consolidated assets, larger bank size is associated with significantly higher profitability. Community banks with higher portfolio shares of real estate loans earned significantly lower profits, while those with higher portfolio shares of construction loans earned higher profits through most of the study period.
“Perhaps not surprisingly, the latter relationship does not hold for 2008 through 2010, when greater reliance on construction lending is associated with lower profitability,” Duke noted.
Managerial quality, as measured by the management component of the banks’ regulatory ratings, was also strongly related to bank profitability.
“The strength of the relationship increases during and immediately after the financial crisis, confirming that management quality is particularly important during times of economic stress,” Duke said.
A separate recent study of banks with total assets less than $10 billion conducted by the Federal Reserve Bank of St. Louis attempted to identify differences between thriving and surviving banks. Banks were identified as “thriving” if they maintained the highest supervisory rating, a composite CAMELS “1,” continuously from 2006 through the end of 2011. Duke said approximately 700 banks met this condition. The roughly 4,500 banks in the study that did not qualify as thriving and did not fail or merge out of existence during the period were classified as “surviving.”
Duke said thriving banks were found in most states but were concentrated in states with larger economic contributions from agriculture and energy. She noted these states “held up relatively well” during the economic downturn. The fewest thriving banks were found on the West Coast and in the Southeast, regions plagued by falling real estate values.
Thriving banks were not concentrated in any particular size range. The St. Louis Fed’s review of thriving banks’ balance sheet structures, however, revealed thriving banks had lower levels of loans-to-total-assets and were more reliant on core deposits. Thriving banks also had lower concentrations in commercial real estate lending and much lower concentrations in construction and land development loans. Instead, thriving banks were slightly more concentrated in one- to four-family mortgage loans held in portfolio, as well as consumer loans.
“Despite these overall balance sheet findings, the researchers also noted the wide diversity of business models that they found among the thriving banks,” Duke said.
Researchers examined a sample of comments in examination reports and found that thriving banks benefited from a strong and localized customer service focus with high visibility in the community, conservative underwriting and products that were profitable and met customer needs.
Researchers also interviewed bankers at thriving institutions.
“The bankers they interviewed attributed their success to strong ties to the community, relationship banking, conservative underwriting, and a focus on products and markets they understood,” Duke said.
“These studies confirm what experience has already taught me: Community banks that have deep ties to the community, engaged managers and directors, conservative underwriting, and strong risk management can not only survive, but thrive, even in adverse conditions,” she concluded.
In addition to sharing these findings, Duke discussed regulators’ efforts to be cognizant of community bankers’ concerns as they craft new regulations under the Dodd-Frank Act and Basel III.
[To find out what Duke had to say about this issue, see “Community bankers ‘more successful than they realize’ in fighting one-size-fits-all regulations”]
View Duke’s full remarks