WORD ON THE STREET: The economic environment for banks and their borrowers is slowly recovering but remains challenging. As a result of continued high unemployment rates and the cumulative effect of substantial multiyear declines in real estate prices, insured banks face weak loan demand and elevated levels of nonperforming assets. As of March 31, about 12% of insured institutions were on the Federal Deposit Insurance Corp.'s (FDIC) ‘problem bank list.’
Notwithstanding these trends, the FDIC is cautiously optimistic regarding the current condition and trends in the banking industry. Experience suggests that the sooner banks are able to address the lingering credit-quality issues on their books, the faster the pace of recovery will be.
During the first quarter, FDIC-insured institutions recorded annual net income of $29 billion – the highest level since before the recession – but still well below the all-time highs of the mid-2000s. The main driver of earnings improvement has been steadily reduced provisions for loan losses. This reflects general improvement in asset-quality indicators, including declining levels of noncurrent loans and net charge-offs for all major loan types.
However, the ratio of noncurrent loans to total loans, at 4.7%, is still high and remains above the levels seen in the late 1980s and early 1990s. While the reduced provisions for loan losses are encouraging, it is important to note that net operating revenue fell by $5.5 billion in the first quarter, compared to one year ago. Lower revenues, in part, reflect reduced loan balances, which have declined in 10 of the past 11 quarters. Given the lingering effects of the recent recession, loan demand is generally weak.
Despite the economic challenges, community banks, which constitute the vast majority of the banks that we supervise, continue to play a vital role in credit creation across the country, especially for small businesses. As of March 31, community banks, which hold only 10.7% of industry assets, extended some 38.1% of the entire industry's small business loans.
Recent weakness in both residential and commercial property price trends highlight continued concerns. The S&P/Case-Shiller National Housing Index is down 5.1% year-over-year through the first quarter, and the Moody's/REAL Commercial Property Price Index has decreased by 13.4% for the year ending in April. These indexes are down 29.7% and 48.9%, respectively, from their peaks in 2006 and 2007.
These legacy issues have adversely affected the ability of many institutions to grow their lending activity. The primary reasons banks are not lending more is a combination of tightened underwriting standards based on lessons learned from the recent financial crisis and reduced borrower demand. Industry-wide, banks have plenty of capacity to lend, bank balance sheets are more liquid than before the crisis began in 2008 and capital levels continue to increase.
Credit availability
The FDIC recognizes and supports the vital role of community banks in serving the credit needs of their borrowers and helping to restore economic growth in cities, towns, and farming communities across the country. Throughout the real estate and economic downturn, the FDIC has advocated for policies to help community banks and their customers navigate this challenging economy.
The FDIC's examiners operate out of our 85 field offices nationwide. They are well-versed in the business of community banks and their local markets, and have a keen awareness of the challenges many of these banks and their customers are facing. There are creditworthy borrowers that need flexibility in the current environment, and bank regulators have provided financial institutions with that flexibility to help customers through the downturn.
The FDIC strives for a balanced approach to supervision that relies significantly on the validation of banks' own credit risk management processes and their adherence to generally accepted accounting principles (GAAP). The FDIC does not micro-manage banks in how they deal with individual customer relationships or how they manage their loan portfolios. The FDIC does not instruct banks to curtail prudently managed lending activities, restrict lines of credit to strong borrowers, or require appraisals on performing loans unless an advance of new funds is being contemplated.
During economic expansions, problem credit relationships are relatively rare at most institutions and are handled in the normal course of business without jeopardizing earnings performance or the capital base. On the other hand, recessions and real estate downturns often result in an increase in problem loans. This necessitates an increased level of bank management resources devoted to monitoring credit performance, loan workouts, loan grading and review processes, and accurate accounting entries for problem loans.
In carrying out their statutory responsibilities to ensure a safe and sound banking system, banking supervisors also need accurate information about problem assets. Supervisors and investors expect the financial statements prepared by banks to be accurate and to adhere to the standards prescribed by the accounting profession for problem loan accounting, troubled debt restructuring and loss recognition. Adherence to generally accepted accounting principles should render an accurate, transparent depiction of banks' asset quality, earnings and capital – which are all central aspects of the bank supervision process.
Accurate problem loan-reporting that portrays the actual performance and condition of individual loans and groups of credits within a given portfolio is essential. We rely on these loan reporting conventions to determine the condition of financial institutions both during examinations and in interim periods through off-site monitoring. Aggregate past-due and non-accrual data provided by banks in their quarterly Call Reports are critical components of our supervisory evaluation of banks' financial condition and our assessment of necessary corrective actions.
During each on-site examination, examiners exercise a fact-based, informed judgment to evaluate the quality of individual assets and groups of assets held by an insured institution. Loans that present heightened risk of not being repaid, usually already noted by the bank itself, are subject to adverse classification (substandard, doubtful or loss) and warrant increased management attention to limit loss exposure. During the credit review process, examiners also review the accuracy and reliability of internal grading systems used by management, and in the vast majority of cases, the examiners' results validate bank management findings.
The findings of each on-site examination are discussed with bank management and, as warranted, the bank's board of directors. Such communication provides management with an opportunity to discuss the examiner's conclusions and for examiners to consider management's views, as appropriate. The findings of each examination are also subject to a secondary internal review to ensure that our examination policies and procedures were followed, before the Report of Examination is issued to the bank. This internal review process ensures consistency in our supervisory approach to evaluating loans and other aspects of institution risk.
FDIC concerns about H.R.1723
The purpose of the risk management examination is to ascertain the financial condition of an institution. In order to do so, transparent and accurate disclosure and reporting are key requirements.
Under the proposed legislation H.R.1723, the ‘Common Sense Economic Recovery Act of 2011,’ as long as an amortizing loan is current and has performed as agreed in the recent past, institutions could disregard currently available borrower financial information indicating that the borrower lacks the ability to fully repay the principal and interest on the loan going forward. This, in turn, would enable institutions to include accrued but uncollected interest income in regulatory capital when its collection in full is not expected. Prospective information about the borrower's ability to repay the loan would be disregarded for the purposes of placing loans in non-accrual status and measuring capital, including for purposes of Prompt Corrective Action determinations.
This proposed legislation would result in an understatement of problem loans on banks' balance sheets and an overstatement of regulatory capital. This would be contrary to GAAP and the exercise of our supervisory responsibilities. Compromising the quality of information about non-accrual or troubled loans, or preventing supervisors from acting on such information, would detract from supervisors' and investors' ability to properly evaluate the safety and soundness of banks or require corrective action as needed.
Changing the agencies' regulatory capital standards to allow institutions to avoid treating certain loans as non-accrual loans would result in institutions reporting higher regulatory capital than GAAP capital. Such regulatory capital forbearance would detract from investors' confidence in the reliability of all banks' financial statements. Moreover, historical experience has been that policies to systematically delay the recognition of bank losses can ultimately increase losses to the FDIC Deposit Insurance Fund, and thus the cost that healthy banks pay for their deposit insurance premiums.
In our judgment, a safe-and-sound banking system that serves as a foundation for economic growth needs a strong base of high-quality capital. We have been strong supporters of recent efforts to strengthen banking industry capital, and we believe that under-reporting of non-accrual loans for purposes of capital measurement would be inconsistent with the direction regulators should be taking with respect to bank capital.
George French is deputy director of policy in the division of risk management supervision at the Federal Deposit Insurance Corp. This article is adapted and edited from testimony delivered July 8 before the House Subcommittee on Financial Institutions and Consumer Credit. The full testimony is online.