On June 29, 2010, Sarah Wallace, chair of the board of directors of First Federal Savings and Loan Association in Newark, Ohio, authored a passionate opinion piece in the Wall Street Journal titled “The End of Community Banking.” While I agree with many of Ms. Wallace’s points, I do NOT see the end of community banking in the foreseeable future.
I do think that we are going to see tighter regulations and tighter credit than we saw in the five years before the financial meltdown – 2002 through 2007. Those five years were the culmination of a world wide expansion of credit and leverage that began in the US around 1980, so we really had a great run. Nonetheless, by 2002, a good number of observers would argue that credit availability was running somewhat out of control.
As Mrs. Wallace suggests, we will have tighter rules, but they will by nowhere near as tight as those that prevailed until the late 1980′s or early 1990′s. During my career beginning in the late 1960′s, we have done away with limits on interest paid on deposits, most commercial usury limits, limits on branching and cross state expansion, certain caps on real estate lending, and we have expanded the lending limit in many cases from 10% of capital to 25%. Most of these changes will not be reversed, and credit will continue to be available for borrowers who can demonstrate an ability to repay the loan. However, I do not see banks going to the credit excesses of the 2002-2007 period, and there will be people who might have gotten loans then who will not be able to get loans in 2011… and that is probably not all bad.
We’ve identified a number of stories that or posts that never quite made it into individual BankBryanCave.com posts. Rather than continuing to hold on to them, I’ve assembled them here.
The Simpsons
Short-Term Planning for Recovery and Survival
(This post was authored by Walt Moeling and Dustin Hall. A version of this post originally appeared in the August 2009 issue of the ABA’s Community Banker magazine.)
The grim economic prognoses we continue to hear about have an immediate impact in the bank board room. Boards must think about short-term planning for recovery and survival because virtually no bank is wholly immune from the current recession. Although the problems may have started with residential real estate in the Sunbelt, they have gone much beyond that now, impacting banks throughout the country.
As a director you must plan for both long-term and short-term. Long-term planning is tremendously important, and we hope to make it to the “long-term,” but short-term planning is critical today.
Short-term planning in this context deals with the reality of today’s marketplace. The focus is not on earnings or even stock value, two traditional focal points for planning. Instead, the focus is on capital management, liquidity, and asset quality.
Capital Management
Your short-term capital planning in the face of mounting losses cannot focus on today or yesterday; it must focus on tomorrow. You must ask: Where are we going? What will happen if housing prices drop for another two and a half years, as predicted by some? Can our borrowers sustain a more prolonged recession? If not, where will our capital be three, six, and nine months from now? In essence, you must stress test your bank to see how far it can go.
A real problem for directors is assuming that capital today is as readily available as it has been for the past 15 years, or that they can sell the bank if there is a real problem. Unfortunately, there is no public market, and virtually no private equity, for bank stock. Those sources are presently closed, shall we say, for repair. Instead, short-term capital is likely to be found only within the boardroom and from family and friends.
The front cover of the May 17, 2009 issue of the New York Times Magazine asked “Are Small Banks the Future?“ As noted in the article, lending may have slowed at the largest banks, but at the other end of the financial system, there are 8,500 community banks, and most remain very strong.
In the midst of the worst banking crisis since the Great Depression, community banks have generally fared well. That’s because they typically shunned the lending practices that led to high default rates. They rarely participated in the securitization of loans, credit-default swaps and other overvalued financial products that put the global financial system in crisis. Instead, they stuck to the fundamentals. They considered the character and history of their borrowers. They required collateral. Without community banks, the current financial crisis would be a lot worse.
The focus of the mainstreet press, and the Treasury Department, continues to be on the largest institutions, whether it be the initial nine TARP Capital recipients, or the nineteen that underwent the stress test. There is some rationality for this focus, the majority of assets, deposits and loans are held by these institutions. But just like small businesses generally, community banks play a critical role in the American economy.
Community banks may have weathered the current crisis better than larger banks, but they remain an American oddity. Most other countries have 5 or 10 national banks, and when they get in trouble, as they did in Iceland, it can be devastating. The balance in this country is tipped toward big institutions (the four largest control half the assets held by American banks and 40 percent of all deposits), but community banks still make 43 percent of all small business loans under $1 million. Since January 2008, fewer than 1 percent of all community banks have failed.
One issue that seems to be gaining traction is the need for banks to show how they are using TARP Capital, with a strong preference for the banks to be using TARP Capital to make loans. While the fungibility of bank capital makes it virtually impossible to directly tie any particular dollar of capital with any particular dollar lent, that fungibility also gives great leeway to community banks to demonstrate the lending impact of TARP Capital. Despite the political hot potato, we expect very few, if any, community banks to be criticized for their use of TARP Capital funds.
We do not believe that TARP Capital should fundamentally change the way in which bankers run their banks. Solely because they have TARP Capital, banks should not approve loans that they otherwise would turn down. However, any bank with additional capital, which TARP Capital provides, is in a better position to make or renew loans than that same bank would have been without TARP Capital.
A bank should be able to show that TARP Capital is “working” so long as its total loans are higher than they would have been without the TARP Capital infusion. In recognition of the current economic environment and capital restraints, we believe many banks would be actively attempting to shrink the size of the bank were they not to receive TARP Capital infusions. As a result, merely maintaining the current levels of loans could, in reality, be the result of TARP Capital increasing bank lending activity. Even Barney Frank’s proposed reform legislation acknowledges that TARP Capital may simply minimize the decline in lending that normally accompanies economic recessions. While this metric may be difficult for the Congressional Oversight Committee to accept, anytime the question is asked whether a new program is working, you have to make assumptions about what the situation would look like without the program.
Whether to apply for or accept TARP Capital is a decision that each bank needs to make individually depending on its own markets and circumstances. However, as explained below, we believe each bank needs to prepare a realistic, worst-case scenario for the next three years. Unless your bank’s capital will remain strong, we think you should apply for TARP Capital.
In three years, your bank will likely be in position to redeem the TARP Capital. If that’s true, then the TARP Capital will have served as an inexpensive insurance policy that went unused, and you won’t be subject to any further government restrictions.
On the other hand, it is possible that, in three years, the financial condition of your bank makes you unable to redeem the TARP Capital. In that event, it is very clear that you needed the TARP Capital.
With only these two scenarios, we believe almost every bank is better off applying for TARP Capital.
Where is the Economy Headed?
As the residential real estate market declined, all the contractors and subcontractors associated with that market began to suffer. These contractors and subcontractors include our drywall installers, plumbers, painters, flooring specialists, lighting specialists, landscapers, pavers, pool installers, and numerous others – a vast group of construction and service-industry workers. With new residential starts drying up, and with in-progress projects shutting down, many of the employees in those contracting and subcontracting fields began to lose their jobs.
The ABA has noted that some banks are concerned with the reputational risk of participating in a bail-out. While some customers may have this concern, it does not change our belief that all eligible banks should strongly consider participating. Having said that, we also think banks should be prepared to deal with this issue and should be proactive with their customers. The emphasis should be on supporting the Government’s program to strengthen the entire banking system in order to enable banks to continue supporting their local community through this economic downturn. The program is designed to earn a return for the Government (and thus the taxpayer), and is thus not a “bail-out” at all. The program is for healthy banks, not to save problem banks. Customers should be comforted by the facts.
We have heard a number of bankers state that they are concerned with accepting the TARP Capital, fearing potential future regulation imposed on those that accept government money. While each bank’s situation is unique, we generally consider this concern to be overstated for the following reasons:
- Once the TARP Capital is in place and the preferred stock and warrants are issued, the terms of those instruments are defined by contract. The government should not be able to modify the terms to give itself a better deal. For example, the government cannot require that the institution pay the 9% dividend before the expiration of five years.
- We believe that if the government decides to impose additional regulatory restrictions (which in this economic environment seems likely), it is more likely to do so with regard to the whole industry rather than distinguish between banks that accepted the TARP Capital and those that did not. From a policy perspective, Congress and the regulators may view “the whole industry” as having been helped and therefore that “the whole industry” should bear the burden of any additional regulations.
- The government already has broad powers to regulate financial institutions; it seems unlikely that the government would use its relatively weak power as a preferred shareholder to impose change when it has stronger regulatory powers to impose change.
- The government may impose one or more of the restrictions that are currently associated with the TARP Capital program on all companies – for example, it is possible that the executive compensation changes may be expanded to all companies, whether or not they have accepted (or were even eligible for) TARP Capital.
That’s our belief. We’d love to hear yours in the comments.