REQUIRED READING: While much of the Federal Reserve's regulatory work recently has involved implementing the requirements of the Dodd-Frank Act, we are also continuing to review the lessons we learned during the crisis and the results of our recent research. In most cases, this work is more likely to result in supervisory guidance than regulation.
Supervisory guidance is commonly viewed as a means to restrict activity but, in fact, during the crisis much of the guidance we issued actually directed bankers and bank examiners to take a balanced approach. For example, we issued guidance urging banks to continue to make loans to all qualified borrowers and, in particular, to continue lending to creditworthy small businesses. We also issued detailed guidance about commercial real estate workouts to encourage prudent modifications of real estate loans.
Lending is the primary source of income for most community banks and also the greatest source of risk. As you develop your business plans, some of the most important decisions you will make relate to lending. In the planning process, banks should define the portion of the lending portfolio they plan to allocate to different loan categories, and investments they are willing to make to develop expertise. Banks should also manage credit and compliance risk, and the levels of credit and interest rate risk they are willing to assume.
I thought it might be helpful to review some recent developments in loan types that are at the core of community bank lending.
Residential mortgage lending
Residential mortgage lending was at the heart of the financial crisis and has been the target of extensive new regulation and supervisory attention, including the rules issued by the Consumer Financial Protection Bureau. I think community banks are in an especially difficult position with respect to residential mortgage lending.
On the one hand, community banks do not appear to have engaged in many of the more problematic practices that led to the crisis. And their rate of seriously delinquent residential mortgage loans is significantly lower than the overall rate of serious delinquencies on such loans made to prime borrowers, indicating that community banks largely have managed their existing portfolios responsibly. On the other hand, residential mortgage loans made by community banks do frequently share some characteristics, such as higher rates and balloon payments, with the subprime lending that proved to be so disastrous.
At the same time, mortgage lending, which averages about one-fourth of community bank loan portfolios, is an important product line for community banks. Further, Federal Reserve research indicates that the residential mortgage loans made by community banks make up a small but vital part of credit availability in the housing market.
The challenge for regulators is to design mortgage regulations to address practices that have proven harmful to consumers or financial stability without inhibiting lending to creditworthy borrowers. The challenge for community bankers is to review the full body of new regulations covering mortgage lending and to develop the expertise and control systems necessary to comply with these regulations while remaining active in this important market.
I think it is unfortunate when I hear some bankers say that they will stop offering mortgages if they cannot make them the same way that they always have. While I certainly understand their frustration, I still believe that community bankers can respond within the new environment by creating products that are profitable and meet the needs of their customers, while still managing their interest rate and funding risks.
Even with some regulatory exceptions, compliance with new mortgage regulations likely will require changes to processing systems and extensive staff training. But it is also possible that the systems and expertise necessary to make qualified mortgages for the bank's books could also be used to originate loans for sale. For many community banks, this could represent a new revenue opportunity and new alternative to offer the bank's customers.
Commercial real estate lending
For community banks, it was commercial real estate lending – in particular, lending for construction and land development – that caused the most problems during the crisis. In 2006, the federal banking agencies issued supervisory guidance that set forth screening criteria based on certain types of commercial real estate concentrations and rapid growth of commercial real estate portfolios.
These guidelines contained specific numerical thresholds for the ratios of construction and total commercial real estate lending to an institution's total capital, as well as for identifying rapid growth of such lending. These criteria were never intended to result in hard caps, but were instead meant to trigger conversations between a bank and its supervisors about the bank's ability to manage the risks arising from these concentrations.
After our experience in the financial crisis, especially considering the severe problems in commercial real estate markets, we were interested in understanding how community banks were affected by the guidance and whether the screening criteria set forth in the guidance were effective indicators of risk. In that regard, the Federal Reserve's staff has worked with our counterparts at the Office of the Comptroller of the Currency to analyze how banks' holdings of commercial real estate loans have evolved since the guidance was issued.
We have learned a few interesting things based on the findings of this research. For example, the number of institutions that exceed at least one of the two screening criteria has declined substantially from 2006 to the present. While much of this decline seems to have resulted from the contraction of construction portfolios in the wake of the crisis, banks that exceeded the criteria when the guidance was issued appear to have experienced a bigger decline in total commercial real estate loans than can be explained by the adverse economic environment alone. This finding could indicate that the thresholds are indeed being interpreted as hard caps.
Moreover, it was apparent that banks that exceeded the criterion for construction and land development were far more likely to have failed over the period from 2007 to 2011 than were banks that exceeded the criterion for overall commercial real estate exposures and portfolio growth.
We now recognize the importance of the rapid growth criterion, which may have received less attention than the criteria for construction and overall commercial real estate lending concentrations. We intend to use the findings of this research to help clarify our communication and training for examiners and bankers around commercial real estate lending concentrations.
Small business lending
There is probably no loan category in which community bankers' local knowledge and deep ties to the community are more important than small business lending. The Federal Reserve System has a project under way to try to improve our understanding of small business credit markets, which would of course include community banks.
One challenge we have faced is that it is difficult to measure lending to small businesses precisely. For one thing, small business owners frequently tap their personal home equity, credit cards or loans secured by commercial real estate that they own to finance their business operations, which means such borrowing is not reported as small business lending. But there is also no definition of small business borrowers for the reporting of small business lending as a loan category.
However, small loans to businesses – commercial and industrial loans and commercial real estate loans with original principal amounts of less than $1 million – are reported separately and can be used as a proxy for small business lending. Using this measure, we can estimate the importance of small business lending to community banks and the importance of community banks to small businesses.
As of September 2012, banks with $10 billion or less in assets accounted for more than 98% of all commercial banking institutions, but they held less than 20% of banking industry assets. However, they held more than half of outstanding small loans to businesses. For such institutions, these small loans to businesses represent nearly 20% of their total domestic lending and slightly more than 40% of their total commercial lending.
Small business lending is likely even more important to smaller banks than these statistics show because these loans are identified by the size of the loan rather than the size of the borrower. I believe it is probable that many of the larger business loans made by these smaller banks were also made to small business borrowers.
At the other end of the spectrum, banking organizations with more than $50 billion in assets accounted for less than 1% of institutions, but held 75% of the assets. Holding almost 40% of outstanding small loans to businesses, these large banks are important small business lenders, but small loans to businesses were not a significant segment of large bank loan portfolios. They represented less than 5% of these banks' total domestic lending.
These statistics demonstrate the importance of community banks to small business and the corresponding importance of small business lending to the community banking business model. In developing policies for small business lending, I think it is critically important for bank boards of directors to insist on appropriate risk management that retains the flexibility to use the bankers' knowledge of their customers' business to their best advantage. And it is equally critical that supervisors develop tools to measure the overall effectiveness of risk management in small business lending without being overly prescriptive for individual loans.
I think the future for community banking is bright. I recognize that the regulatory changes underway are not without cost to community banks. But I also know that we at the Federal Reserve are doing our best to avoid adding to regulatory burden wherever possible as we respond to the worst excesses of the financial crisis and make the U.S. financial system more resilient. Research is helpful in this effort, but it is also important to maintain an ongoing dialogue with community bankers and to actively solicit comment on regulatory proposals. So I urge you to continue to communicate about the challenges that regulations pose for community banks.
More importantly, I know that the natural advantages found in community banks – deep community ties, daily interaction between senior managers of banks and their customers and the dexterity to customize financial solutions – have not been diminished in any way.
Yes, the regulatory environment is challenging and the economy remains weak in many areas. But our research shows that with creative, engaged bankers and strong risk-management processes, community banks can continue to not only survive, but to thrive.
Elizabeth A. Duke is a governor of the Federal Reserve System. This article is adapted and edited from a speech delivered on Feb. 5 at the Southeastern Bank Management and Directors Conference, held at the University of Georgia's Terry College of Business in Duluth, Ga. The original text is available online.
