In the US’s multi-layered banking sector, the credit crisis is being felt on all levels. But as the Treasury launches wave after wave of initiatives to protect the larger banks, and the smaller community banks stand firm due to their low exposure to subprime, it is the medium-sized banks that face the greatest threat. Writer Jane Monahan in Washington, DC.

What is the future of small and medium-sized banks in the US? Which banks will survive the credit crisis and recession? The question is moot considering the most recent results of all commercial banks and savings institutions insured by the Federal Deposit Insurance Corporation (FDIC).

These results show that in the third quarter of 2008, the banks had new income of $1.7bn – a 94% decline from the $287bn the industry reported a year earlier – as financial institutions allocated more money for bad loans and sold securities and assets at a loss. One in four banks reported a net loss for the quarter. Furthermore, 22 banks – predominantly smaller ones – failed in the first nine months of 2008; and in the third quarter, the number of ‘problem’ banks – those deemed at risk of failure – grew from 117 to 171. FDIC chairman Sheila Bair warns that more bank failures are likely.

Revival attempts

This bad news from the FDIC preceded an announcement by US president Barack Obama that his plans to revive the financial sector will be accompanied by an aggressive fiscal package – a two-year, $500bn to $700bn government spending programme on roads, bridges, schools and ‘clean’ energy, aimed at creating 2.5 million jobs. This will, according to Mr Obama, put “money into the pockets of the middle class” and “jolt the economy back into shape”.

But whether or not the myriad US Treasury and Federal Reserve initiatives to thaw frozen credit markets, bring down rates on home loans and stimulate the economy succeed, in a banking system as large and as varied as that of the US, where 8643 banks were registered in November 2008, few safe assumptions can be made. Many bankers and analysts do say, however, that medium-sized regional banks – those with assets ranging between $5bn and $100bn – could be the most vulnerable institutions in the crisis.

Middle ground

“[Medium-sized banks] are caught in a no-man’s land,” says Camden Fine, president of the Independent Community Bankers of America (ICBA), which represents the country’s almost 8000 community banks. “They are between community banks [which have assets of $1bn or less] that can fend for themselves, and the biggest banks that are considered too big to fail.”

Banking and monetary policy analyst Bert Ely says: “A bank with assets of between $5bn and $30bn or more will start to lose touch with customers, but also lacks the specialised skills and scale of bigger [national] banks. So what is their future? They are likely to be acquired by larger banks.”

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Edmund Burke, president of the 20-branch Burke and Herbert Bank, a classic community bank with $1.6bn in assets and the state of Virginia’s oldest, maintains that the size of a bank is not the main issue. “Everyone was speculating that the first banks to go would be the small banks. Of course, that’s silly. The first banks to go are the weak banks,” he says.

 

Moreover, both Mr Burke and Mr Fine insist community banks are the banks that have been least affected by the crisis so far.

Smaller banks also tend to do a better job than bigger banks controlling costs and keeping an eye on the bottom line, says Mr Burke. “At a small bank like Burke and Herbert, our efficiency ratio is 44% – it costs us 44 cents to make a dollar – whereas the large banks have 50%, 60% and 70% efficiency ratios,” he explains. Burke and Herbert is also well entrenched in Alexandria, a market just south of Washington, DC, where most of the employment is government-generated and therefore largely immune from recession.

Consolidation threat

But the fact that a majority of community banks are financially sound has not stopped ICBA members from worrying that big banks might be encouraged to buy up rivals too small to fight back, especially as the US Treasury and regulators are using the crisis to engineer a vast – and, many experts say, overdue – consolidation of the US banking system.

So far, however, taxpayers’ money has not been used to consolidate banks in this way.

In December, after about half of a $700bn Congress-approved bank rescue plan had been used up in a capital purchase programme in which the government bought ownership stakes in financial institutions, purchasing preferred shares and warrants, there were no FDIC-brokered mergers involving community banks.

Instead, FDIC arranged a few mergers involving the nation’s biggest banks, such as that between JPMorgan Chase and Seattle-based Washington Mutual, the country’s largest savings and loan institution and the biggest bank failure in US history. However, most FDIC-brokered mergers have involved big, multi-regional or national banks taking over smaller, troubled regional banks.

Treasury criticism

The US Treasury’s implementation of the bank capitalisation scheme has not been without its critics, especially among smaller banks. This is largely because huge sums of public money have been used to bolster the capital of the country’s nine largest banks (Citigroup, JPMorgan Chase, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley, Merrill Lynch, Bank of New York and State Street), considered too big to fail because of their systemic importance, but, according to representatives of small banks, whose excesses caused the financial crisis.

Indeed, once the new Congress convenes, ICBA is planning to launch an initiative to break up the nation’s biggest banks and to set a timetable for downsizing them. “It is over-concentration of financial assets that got us into this mess in the first place,” says Mr Fine.

More generally, President Obama’s administration and a Democrat-controlled Congress are expected to tighten the con­ditions and oversight of the Treasury’s bank rescue programme. One source of contention is that in the written preamble of the programme, banks are urged to use the US capital injection to make loans in order to unfreeze credit markets, as well as on modifying residential mortgages, to prevent millions of home foreclosures. However, large, multi-regional banks have been using the money to make acquisitions of smaller bank rivals.

Mr Burke says: “There’s a big argument going on. Is the money supposed to be lent, or are you supposed to go out and buy other banks with it? If you were buying a weak bank, that would be beneficial to the economy because the FDIC wouldn’t have to bail out [the depositors of] the bank.”

Takeover fallout

That type of consideration, however, did not stop congressional and media criticism when the multi-regional, Pennsylvania-based PNC Financial Services reached a $5.2bn all share and warrants deal in October, brokered by the FDIC, to take over National City, a large regional bank, after PNC obtained a Treasury pledge of $7.7bn in new capital.

PNC, which is now the fifth largest US bank in terms of deposits, pursues a banking model that derives 60% of revenue from fees, compared with an industry average of 35% (and whose loans are also a comparatively smaller business component than the average).

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“National City [based in Ohio, adjacent to Pennsylvania] is right next to our footprint. The fit is remarkably good,” says James Rohr, chairman and CEO of PNC.

He adds: “The costs that we saw merging with it, the price we got – $2.35 a share – was very, very financially attractive.” It was also 19% lower than National City’s closing price, and at a time when bank values were already very depressed, reflecting the Ohio bank’s dilemma of finding a partner quickly once regulators said it would not be eligible for government capital funding. Selective help?

National City, with 1563 branches and almost $100bn of deposits, is on the large side for a medium-sized or regional US bank. But like other banks in this category that have fallen into trouble, it was mainly hurt by souring mortgages and home equity loans as well as a deepening recession in its home base of north-east Ohio. However, Ohio politicians, not convinced that National City was in such a bad condition, asked why it was not offered the same kind of US assistance as the much bigger PNC bank.

In a published letter to outgoing Treasury secretary Henry Paulson on October 30 last year, Ohio senator George Voinovich wrote: “It is still unclear what factors, terms and conditions Treasury and various regulators are using to make capital investment decisions.” Lacking a better explanation “people start questioning whether Treasury officials are picking winners and losers”, he added.

“The programme has been done in a very expedited form,” says John Duffy, chief executive of New York investment bank Keefe, Bruyette and Woods. “Banks that request the assistance but do not get it are in a very precarious position. They have a short time to find a merger partner or they wither away.”

Sound help

Treasury officials and bank regulators often re-iterated that the programme would be used to bolster the capital levels of banks that were already sound. “It isn’t a good use of taxpayer money to put taxpayer capital into a financial institution that is going to fail,” Noel Kashkari, head of the Treasury’s bank rescue programme, told Congress in October.

This has led to accusations that banks of any size worried about the recession can use this capital as a cushion. An example of this is Banco Popular, the premier Hispanic bank in the US, which has historically served low and middle-income groups from its base in San Juan, Puerto Rico.

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Richard Carrión, CEO and chairman of the board of Banco Popular, says a $950m capital injection recently approved by the Treasury for the bank “gives us good capital to stabilise things”. But unlike PNC, which found opportunities in the crisis to grow, Popular – which reported a loss of $668.5m in the third quarter of 2008, compared with income of $36m the year before – is retrenching.

Popular took action early in the crisis to stem losses from its US wholesale lending business and drew up a detailed recovery plan – two reasons, some analysts say, that contributed to it being awarded US capital aid. It reduced its subprime mortgage exposure from $6442bn in the third quarter of 2006 to $2376bn in the third quarter 2008. That reduction was achieved principally by shutting down Popular Financial Holdings (PFH), a wholesale subprime mortgage origination unit in the US, and selling off most of PFH’s assets to Goldman Sachs under an agreement reached in September.

The agreement resulted in Popular losing $457m on its assets but it is also expected to provide $900m in additional liquidity that will help repay debt and shore up capital. At the same time, Popular is consolidating 41 of its 139 US branches, “turning lower volume branches into higher volume branches”, says Mr Carrión. He adds that in the six US states where Popular has operations “there are problems. Nobody alive has seen anything like it.”

Varied conditions

In contrast, Harris Simmons, CEO at Utah-based Zions Bancorporation, the 30th largest bank in the US, says that economic conditions in states that most affect his bank’s performance vary. “The housing market in Nevada and southern California is worse than the average but the Texas economy has remained better. The inter-mountain western states of Utah, Idaho and Colorado have performed better than the national economy.”

But like many other large banks in the third quarter of 2008, Zions significantly increased its loan loss provisions, adding roughly $60m in excess of the amount it had to write down on bad loans, and took measures to strengthen its capital ratios.

“It is possible to [strengthen capital ratios] when [credit] markets are closing down, either by increasing equity or by decreasing total assets, most of which are loans,” says Mr Simmons. The alternative chosen by most banks was “a managed contraction in lending. A lot of banks were doing this,” he adds. For instance, Zions’ loan growth of $1.2bn in the second quarter of 2008 was cut back to just $40m in the third quarter, a decline of more than 30%.

Mr Simmons believes that the basic aim of the US Treasury’s capital purchase programme is to eliminate capital ratios as a constraint in banks lending. In the case of Zions, which was approved for $1.4bn in Treasury capital, the government’s efforts appear to have paid off. The bank, which specialises in lending to small businesses, planned to put several hundred million dollars into circulation in a small business loan campaign in 10 western US states by the end of 2008, and is expecting to make loans of about $750m per quarter in 2009.

However, banking analyst Mr Ely believes it will take time for many banks to deploy government capital into loans. Constraints in bank lending, he says, include: the collapse of securitisation and other “shadow banking” markets, which have reduced liquidity; a tightening of lending standards after several years of lending conditions that “became way too lax”; a “necessary and unavoidable process of de-leveraging in the economy” after many banks, businesses and individuals became over-leveraged; and less demand for loans as the recession bites.

Commercial survival

Many bankers and analysts say banks that are surviving better in the crisis are those that follow a commercial bank model, based on increasing core deposits and using these, and the bank’s own balance sheet, to make loans, and holding these loans until they mature.

On the other hand, “the Merrill Lynch-type of investment banking model, which relies on capital markets, taking a bundle of loans and creating a security and selling them on to someone else, that’s finished”, says Mr Simmons.

“Deposits are king again,” says Mr Rohr, as a race begins among US banks to increase core deposits, which are generally considered a much more stable source of funding for banks during the crisis than capital markets.

The upshot is that in spite of being weak because of bad credit portfolios, many smaller and medium-sized banks are still appealing to buyers because they have strengths such as a good deposit base.

“There will be a lot of predatory activity, as many as 200 mergers a year, over the next two years,” predicts Mr Ely, as newcomers such as Goldman Sachs, Morgan Stanley and dozens of insurance and brokerage firms, which are transforming themselves into bank holding companies, have plenty of capital but no deposits.

“Everything is focused on deposits. We are clearly heading into an environment where the customer relationship is going to mean a lot,” says Mr Carrión.

Small comfort

The situation bodes well, it would seem, for small community banks, especially as there are many Americans who do not want to do business with big, monolithic banks and prefer a localised service. Bearing this out, the deposit base of some 6500 community banks, about two-thirds of all community banks, grew between 9% and12%, double their average growth, in the first half of 2008. At the same time the deposits of large and multi-regional banks declined, and at some of the biggest banks they did not grow at all, according to ICBA surveys.

An example of the shift in deposits is provided by North Carolina-based Wachovia, a large multi-regional bank that started to fail last autumn, which led to banking giants Citigroup and Wells Fargo competing to take it over. Wachovia’s offices bled deposits and in Virginia many of them ended up at Burke and Herbert. “At the height of the crisis, when Wachovia was in the news every day, we had an influx of new deposits of $66m over a four-week period. That’s a year’s growth in deposits for us normally,” says Mr Burke.

Meanwhile, unlike PNC, Banco Popular and Zions Bancorporation, Burke and Herbert did not apply for a US capital injection. “We can get funds cheaper than the government’s 5% [rate], and that goes up to 9% after five years. You also get the government participating in the running of the bank, which we don’t really need,” says Mr Burke.

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