Like most industries, banks are facing significant financial challenges in the current crisis. In this post, we’ll review five charts that highlight some of the most important factors affecting community bank performance and their potential impacts on community bank portfolios.
Contributors to net income: Year-over-year change from 2019 Q2 to 2020 Q2
Chart 1 reflects Federal Deposit Insurance Corporation (FDIC) data on community banks, specifically, as of the end of the second quarter.
Net income for the 12 months ending June 30, 2020, was down 21% vs. net income for the period ending June 30, 2019.
Three factors drove the negative shift:
- A rise in loan loss provisions
- A rise in noninterest expenses
- Realized losses on securities.
Net interest margin
In Chart 2, the green line reflects the net interest margin trend for community banks. The blue line shows data for the industry overall.
Banks have asset-sensitive balance sheets, which negatively affects earnings when interest rates decline and remain low. Office of the Comptroller of the Currency (OCC) data on bank interest rate risk exposures show that 75% of banks expect to lose net interest income if interest rates decline.
Most banks expected to lose less than 5% of net interest income if rates decline by 1%, which occurred in the first quarter of 2020.
Sound bank risk management practices include reviewing potential exposure to declining interest rates and managing exposures to established risk limits to provide opportunities in this challenging environment.
The cost of mitigating heightened interest rate exposure typically rises as the adverse interest rate scenario becomes more likely. Operating with properly structured risk management systems and controls commensurate with risk taking are necessary for addressing earnings and interest rate risk changes in times of low and volatile market yields.
Noncurrent loan rate and quarterly net charge-off rate
Although Chart 3 is for all FDIC-insured information, the trends hold true for community banks as well.
Looking back to the 2008 financial crisis, we see dramatic increases in noncurrent loan and quarterly net charge-off rates, followed by a gradual fall over the next decade. Those low rates coming into the current crisis are a positive sign.
In 2006, the tier 1 risk-based capital ratio for the system was 10.1%, compared to 13.3% at year-end 2019. For banks with less than $1 billion in assets, there was a similar improvement from 14.8% to 17.7% over this same time period.
Reserve coverage ratios
Like the one prior, Chart 4 shows trendlines from the prior crisis to today.
Coverage ratio and loan-loss reserves have spiked upward faster in 2020 than in the 2008 financial crisis. The fact that coverage ratios have been trending upward in recent years—while noncurrent loans continued to fall—puts banks in a better position to weather the current crisis.
Bankruptcies spiking higher
The position of strength reflected in the prior two charts is important as we see a spike in bankruptcies in Chart 5.
Leverage is elevated in nonfinancial companies across many industries including travel, entertainment, energy, hospitality, retail, transportation, residential home building, electronics, restaurants, small businesses, and nursing homes.
Credit agency rating downgrades of public companies included many energy sector borrowers and leveraged loans that exhibit weaker underwriting and fewer covenant protections, increasing the risk of payment stress. Additionally, corporate borrowers drew down credit lines or requested new facilities to preserve liquidity and pay expenses.
The pandemic will further slow economic growth, placing stress on borrowers and significantly affecting commercial and consumer credit exposures over the next several quarters.
Impacts to the energy sector are significant because of lower crude oil and refined petroleum product prices caused by a simultaneous steep reduction in demand and a slow supply reduction arising in part from disagreements among major oil producing countries. Oil and gas ancillary services are also negatively affected.
Banks should consider updating their portfolio management practices regarding stress tests to incorporate both the direct and indirect impacts of changing economic and market conditions.
Impacts of the pandemic on community bank investment portfolios
UMB tracks the makeup of community bank investment portfolios across both C-Corp and S-Corp peer groups. The below provides a snapshot of those portfolios prior to the current crisis (January 2020) and in the midst of it (June 2020).
UMB community bank peer group—C-Corp: Investment portfolio snapshot
For the C-Corp peer group, the investment portfolio was largely unchanged from an allocation perspective from the end January 2020 to the end of June 2020. The only category that showed a difference of more than 1% was an increase in pools. CMOs also saw a small increase and there was a slight pull back in agencies. There was a little bit of an extension from an average life perspective. However, duration declined from January-June 2020. Yields pulled back with the lower rate environment, yet, total returns saw a jump with the unrealized gains banks are seeing in their investment portfolios.
UMB community bank peer group—S-Corp: Investment portfolio snapshot
The S-Corp peer group, on the other hand, shows larger changes. Portfolios favored CMOs, pools and treasuries in June. Yields are also down for this peer group with the lower rate environment, while average life extended.
These tables do not represent the amount of overnight investments being held on bank balance sheets. Liquidity has risen substantially—overall, bank balance sheets have not extended, even with the extension of some assets on the balance sheet as they’re being balanced out with that excess cash.
Bank bond portfolios
At the end of the first quarter of 2020, bank bond portfolios were showing considerable gains as rates declined. Those gains were even higher in the second quarter which in turn is increasing book values on bank balance sheets.
U.S. banks de-emphasizing held-to-maturity (HTM) securities
In past years, many banks had been making a shift to categorizing investments as HTM as a way to protect their investment portfolios from fluctuations in market valuations as HTM portfolios do not have to be marked to market quarterly. Recently, we have been seeing this trend reverse. The move to HTM was happening most likely in response to capital and liquidity guidelines passed after the Great Recession.
HTM portfolios hit their peak in the third quarter of 2018 at 30.5% but have declined since then. We can attribute some of the decline to regulatory relief measures. While HTM portfolios are off their peak balances, they still are being maintained at levels higher than those before the adoption of the Basel III capital rules and the liquidity coverage ratio.
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