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AmericasMay 9 2011

Why did some community banks fail and others thrive in the US crisis?

Some US community banks managed themselves conservatively and stuck to their knitting while others expanded too quickly on the back of the real-estate boom. While the former are prospering, the problems and failures among the latter are adding up.
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Why did some community banks fail and others thrive in the US crisis?Community bank Broadway in Chicago failed

A big bank in trouble naturally attracts the headlines. However, what is little known is that the vast majority of US banks that failed in the crisis were small community banks, and these failures are showing no signs of abating. The impact of this on the US economy is profound.

There are many more small (assets of $1bn or less) and medium-sized (assets of $1bn to $10bn) banks – known collectively as community banks – than any other type of bank in the US (6900 small banks and about 300 medium-sized banks out of a total of 7657 institutions). So the overwhelming majority of the 348 banks that have failed since 2007 have been community banks. Moreover, nearly all of the banks in the Federal Deposit Insurance Corporation's (FDIC) latest list of 884 ‘problem’ banks, about 20% of which are expected to end up failing, are also community banks.

The fate of these banks is considered important because of the crucial niche they have in the US financial industry. “We have an economy where two-thirds of new jobs are created in small businesses. Small businesses like to do business with community banks. Community banks customise products to their needs. Our reliance on community banks makes this an essential segment of the financial industry,” says Richard Brown, the FDIC’s chief economist.

Local business

Christopher Courtney, CEO of Oak Valley Community Bank in Oakdale, California, a bank with assets of $533m and a small 100-kilometre footprint in California's Central Valley, says what distinguishes a community bank from others is local ownership, local decision-making and a local relationship-driven business model. “It can’t be duplicated,” he says.

Unlike the larger banks in the US, community banks also tend to concentrate on commercial loans averaging $2m or less. Small wonder then that community banks, although they hold only about 20% of the US banking system’s assets (total: $13,200bn at December 31), make up more than one-third of the loans to small companies in the US.

Against this background, a common reason among community bank failures is that the banks tended to be in areas that experienced the steepest declines in property values when the real-estate bubble burst in 2007, as well as the biggest job losses from the recession, say regulators, bankers and analysts.

In these areas – comprising 'sun belt' states, such as California in the west and Florida and Georgia in the south east; and 'rust belt' states, such as Ohio and Illinois in the upper midwest – community banks have overextended themselves in real-estate lending, in particular in land acquisition, construction and development (ACD), and commercial real estate (CRE) loans.

Houses of cards

Those concentrations have been a primary reason for the failure of many small and medium-sized institutions, according to both the FDIC’s Mr Brown and Chris Cole, a senior vice-president at the Independent Community Bankers of America, a lobby and advisory group that links 5000 community banks.

The US's south east has been the most affected area. Florida and Georgia accounted for nearly one-third of all the 157 bank failures in the country in 2010. Analysts expect that in 2011 Florida and Georgia will again be the areas with the most problem banks, ie, those with enforcement actions from regulators and bank failures.

A recent example of a failing small bank is Citizens Bank of Effingham, Georgia (with assets of $214m), which in its last FDIC filing on December 31, 2010, before it went into receivership, had a capital adequacy ratio of just 1.02%, too little to continue operating safely, and 59% of its total assets were in real estate.

Leonard Dorminey, CEO of HeritageBank of the South, based in Albany, Georgia (assets: $950m), which acquired Citizens Bank in an FDIC-directed auction in February, alludes to the reasons for the bank’s failure: “It’s pretty much the same story we have seen in many places in the south east. A number of banks in so-called ‘hot‘ markets saw a tremendous amount of growth and expansion, which created a lot of real-estate building, new subdivisions, new homes and a high concentration of ACD and CRE lending. Georgia and Florida had severe problems with that. And Atlanta in Georgia,... really drove a lot of that sort of growth.” 

Inadequate risk management of a heavy concentration in real-estate lending was also the reason for the failure in February of Valley Community Bank (with assets of $124m) based in the St Charles suburb of Chicago, where there was considerable real-estate development before the property crash. Property prices are still falling, and this institution, which the FDIC first listed as a problem bank in May 2009, had a risk-based capital ratio of -0.88% and a 19% non-performing loan ratio, according to its last FDIC filing at the end of last year.

Opportunity from crisis

While too little capital has led to the failure of some community banks, others with a lot of liquidity and capital have found opportunities in the crisis.

For example, HeritageBank of the South had a capital adequacy ratio of 26.4% as of December 31, 2010, and is well placed to expand through acquisitions. “We are in a very favourable position and we are looking at strategic opportunities that fit in with our footprint and with our business model,” says CEO Mr Dorminey, who adds that the preferred course of action for the bank will be participating in FDIC-directed auctions, because the FDIC guarantees 80% of the losses on loans and real estate owned by the failed bank, in FDIC loss-sharing agreements.

Meanwhile competition from larger regional and national banks for commercial and industrial lending relationships, residential mortgage origination and the most profitable segments of consumer lending (credit cards and auto credits) was putting pressure on community banks even before the crisis and contributed to their increased focus on commercial real estate, according to regulators.

The upshot is that community banks had been branching out by making loans in property development and construction, and commercial real estate, which tend to be long-term and involve large sums of money. Because of this increased competition, they have also increasingly wanted, when making loans to small businesses, to take real estate as collateral with the aim, in theory, of protecting themselves.

“This has tended to make the sector vulnerable to trends in the real-estate market. And that’s what has hit them in this cycle,” says FDIC’s Mr Brown.

Indeed, banks with assets of $10bn or less in the US not only accounted for half of all the system’s commercial real-estate loans at the end of 2009. Seventy-five per cent of these banks' total loans were also secured by real estate at June 2010, district federal reserve bank reports claim.

Property evaluations

The real-estate problems of community banks are also far from over. From 2010 to 2012, for instance, tens of billions of dollars in commercial mortgages come up for renewal by banks and in many areas these properties (offices, warehouses, shopping centres, hotels, apartment blocks) are worth less than they were when the loans were made, bringing new challenges to already stressed smaller banks.

In contrast with their failed peers, community banks that survived the crisis have tended to be based in areas where property prices and local economies have held up, such as in Virginia and Maryland in the mid-Atlantic states, and New England and New York in the north east.

This fact is backed up by Hunt Burke, CEO of Burke & Herbert Bank (assets: $2.2bn), when he talks about the city of Alexandria in northern Virginia, where his bank has been operating since 1852: “This is a great area, [just outside] of Washington, DC, because the government continues working regardless of good and bad economies. There are not just government workers, but all the subsidiary contractors and industries that support the government and service businesses, such as restaurants, doctors, lawyers and engineers. Some say the area is recession-proof. That’s not true. But it is resilient.”

Similar to California’s Oak Valley Community Bank, Burke & Herbert Bank is also doing better than its peers. It had a 10.16% core capital ratio, a lower-than-the-US-average 0.66% non-performing loan rate and a higher-than-the-US-average 1.59% return on assets on December 31 last year. At the same time, Oak Valley Community Bank had a capital-asset ratio of 14%, a non-performing loan rate of 2.2% and a return on assets of 0.89%.

“Successful community banks also maintained diverse revenue streams,” says Mr Cole at Independent Community Bankers of America. Consider Oak Valley Community Bank’s list of personal and business customers, which reads like the proverbial butcher, baker and candle-stick maker. Chris Courtney, the bank’s CEO, says: “It includes a hauler and grower of walnuts, a medical supply company, a concrete contractor, a cold storage facility, a chiropractor, a hotel, a tree nursery, a church, an ice cream and pizza company and a garbage disposal company.”

Growing too fast

Another contrast is that before the crisis, community banks that failed were often the fastest growing, while those that are thriving now were treading a more steady path.

“Before the recession we weren’t the star bank locally," says Mr Burke of Burke & Herbert. "There were banks making much higher returns. But we didn’t want to take risks. We didn’t want to invest large amounts of our capital in mainly home construction. So one reason we were successful is because when the crisis hit we didn’t have to plough a lot of our money into loan loss reserves, which other banks did.” 

Additionally, failed banks often gained market share at the expense of competitors, not only by over-concentrating loans in a particular segment, but also by relaxing standards.

For instance, according to the Federal Reserve Bank of Atlanta, 93% of construction and development loans made by community banks in the south east in 2009 were extended to builders to construct homes that were not pre-sold, making these loans highly speculative. And this was done when the banks’ own internal policies limited such loans to 60% of their residential construction loan portfolio, the federal district bank noted.

Aggressive underwriting

In contrast, Mr Dorminey, CEO of HeritageBank of the South, says that during the 2002-06 property boom “we never changed our underwriting to reflect some of the aggressive underwriting standards that were adopted by other banks”.

Mr Courtney at Oak Valley Community Bank adds: “The key factor, the reason we survived the crisis, is that we stuck to some basic tenets of credit.”

Successful community banks also tend to maintain relationships with local customers and businesses, and stick to the markets where their name and reputations are known.

For example, First Community Bank, New Mexico’s biggest community bank ($2.3bn in assets and 38 branches), was successful when it stayed in its home state, but when it embarked on a buying spree, expanding into Colorado and Utah in 2002 and Arizona in 2006, it met its demise.

“While it made some mistakes in New Mexico, my observation would be that the expansion into markets that it was not familiar with, and a heavy shift towards land loans and real-estate development loans in those markets, is what ended up being the final blow for the organisation financially,” says John Elmore, an executive vice-president at US Bank, the holding company of US Bancorp, the fifth biggest bank in the country, which acquired First Community Bank when it failed in February in an FDIC-directed auction (but without any FDIC loss-sharing agreement).

Cost controls

A further characteristic of successful community banks is that they control costs, such as the cost of deposits. “There are methods you can follow so you are not just looking up the street and some other bank is paying a higher rate on deposits so you raise all your rates. We do it more selectively,” says Mr Burke. 

Conversely, Mr Elmore says: “There were community banks which failed that were opening loan production offices in different parts of the country, and to fund those loans they increased their dependence on wholesale funds and were taking brokered deposits (which are more costly than core deposits). That certainly has been a practice that has caused a number of banks to have difficulties and a number of them have failed.” 

Summing up small banks' failures and successes, Mr Burke remarks with modesty and a degree of irony: "We look smarter than we really are at Burke & Herbert, but this is because everyone else did such dumb things."

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