May 22, 2010

A New Paradigm for Community Banks

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 12:08 AM by Robert Barone

The banking landscape is rapidly changing. We had 126 bank failures in 2009, and, through May 7, 2010, there have been 68 additional closures. Sheila Bair, FDIC Chairwoman, has indicated that we can expect a significant number of additional failures for the next few years. The system that America got used to from 1990 through 2007 where credit was easy to get and consumption and investment grew as a result, has disappeared. In its place is emerging a system that is 180 degrees opposed. Those that are “Too Big To Fail” are getting bigger. Meanwhile, the small community bank, the source of working capital for America’s small businesses, is being choked by the regulatory system.

Ask any CEO of a community financial institution who he/she works for – the answer won’t be the Board of Directors or the Shareholders – inevitably, the answer will be the regulator (FDIC, OCC, Fed, OTS). It appears that, having failed to detect the sub-prime, housing, and derivative bubbles (which emanated from Wall Street), the regulatory agencies have decided to get tough on Main Street lenders. Never mind that community institutions didn’t participate in the sub-prime debacle, or didn’t sell synthetic securities to their clients while simultaneously taking short positions. And, ignore the $20 billion of capital that these institutions lost at the flick of the Treasury Secretary’s magic wand (FNMA and FHLMC preferred stock). If you want to figure out why the economy cannot find solid footing, look no further than the way the regulators are treating commercial real estate loans in community bank portfolios.

  • As presently enforced, federal regulations prescribe that all loans in excess of $250,000 that are secured by real estate must be periodically appraised in accordance with mark-to-market rules to determine value. For appraisals that show deteriorating property values, examiners, sometimes using arbitrary criteria, often impose write-off requirements, require additional collateral or demand cash payment for the difference between appraisal and the required loan to value ratio. These actions have set in motion “death spirals” in many communities based on fire-sale prices for assets which results in further market devaluations of other similar assets. Most borrowers in this economic climate cannot provide additional cash or collateral, and financing from an alternative source is simply impossible to get. The loan is classified even if the borrowers have made timely payments. The result is that the community bank has had to utilize its capital to create a reserve for any potential loss the examiner has determined, including loans that are not maturing for a considerable period of time. Under these constraints, most community banks do not have sufficient capital to expand their loan portfolios and finance local economic growth.
  • If a community bank adheres to Congressional pleas to assist borrowers who may have borrowed when interest rates were substantially higher by reducing interest rates to current market levels and bringing the loan in line with the established income of the borrower and/or the property in question, the regulators deem the loan to be “restructured and impaired” and compel the bank to create a reserve and write down the value of the loan. This occurs notwithstanding that the borrower can demonstrate that he and/or the property can sustain the payments at the restructured level. This policy penalizes the bank for assisting a borrower.
  • It is contradictory policy to have the Congress and the Administration urging community banks to lend more to stimulate economic growth and job creation while at the same time the banking regulators increasingly demand that banks build up their capital while substantially increasing their reserves to cover losses generated by the mark to market rules. Increasing capital and increasing lending activity are inconsistent goals in today’s market.

All market participants want “transparency”, i.e., want to know what is on a bank’s balance sheet, the market values of those assets, what other off balance sheet items exist, and how earnings are calculated. Transparency, then, appears both reasonable and necessary for market participants. On the other hand the function of a bank is to turn illiquid assets into liquid ones for its borrowing clients. Marking illiquid assets, which are not easily saleable in the best of times and which are not for sale and aren’t intended to be for sale, to fire sale prices makes little sense. The balance sheet assets of community banks are not there for a quick flip; they are managed over very long periods of time. The current requirement that they be marked to fire sale prices impacts community bank capital and the local economy that those banks serve.

Thus, for community banks, there is a conflict between the desire and the need for “transparency” and the nature of their balance sheets. What could be done? For investors, the market values of assets and liabilities should be disclosed. But, because of the nature of a community bank’s balance sheet, rules for regulatory capital should not require write downs to prices where markets are clearly in turmoil. Regulators should use some measure of tolerance and allow community banks time to work their way through the current negative environment as they have successfully done in countless other economic contractions. Without community banks, who will lend to small business? And without small business expansion, how will we regain the 8.5 million jobs lost in this recession?

Under today’s regulatory regime, here is the new paradigm for community banking:

  • For the foreseeable future, perhaps as long as 3-5 more years, we will continue to see record numbers of community bank failures where the FDIC closes an institution and sells off the assets for pennies on the dollar;
  • For the surviving community bank institutions, credit standards will be quite tight. Loan to value ratios will be very low, and many businesses that got credit (and deserved to get it) in the last 20 years will be excluded. Community banks will shrink in asset size, and when they do start to grow, it will be at single digit rates;
  • The “Too Big To Fail” will get bigger; but, they haven’t been equipped to make loans to small business since they gave up that function in the 1980s.

The new paradigm for American banking is that the big will get bigger and the small will dwindle. But because it is the small institutions that lend to small business, and it is small business that create the majority of new jobs, this new paradigm means much slower economic growth and therefore a continuation of high levels
of unemployment.

Robert Barone, Ph.D.


Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC an SEC Registered Investment Advisor. He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).

Ancora West Advisors LLC is a registered investment adviser with the Securities and ExchangeCommission of the United States. A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II. A copy of this formmay be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

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1 Comment »

  1. […] landscape is rapidly changing. We had 126 bank failures in 2009, and, through May 7, 201 author: san-francisco « WordPress.com Tag Feed VN:F [1.8.9_1076]please wait…Rating: 0.0/10 (0 votes cast)VN:F [1.8.9_1076]Rating: 0 (from 0 […]


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