Community Bankers Face Regulatory Inequalities

Maryann F. Hunter, Deputy Director, Division of Banking Supervision and Regulation, Federal Reserve Bank told the U.S. Senate Subcommittee on Financial Institutions and Consumer Protection, Committee on Banking, Housing, and Urban Affairs that the banks that weathered the recent financial crisis most effectively were those that adhered to the traditional community banking model.

None-the-less, she said, the economic downturn significantly impacted community banks and many continue to struggle. The banks recorded an aggregate profit last year but one in five reported a loss. While the need to bolster reserves remains a critical task, the pace of deterioration in their loan portfolios continued to slow during the fourth quarter of 2010 and nonperforming assets fell for the third straight quarter.  Loans secured by real estate continue to be the main contributors behind poor asset quality, particularly loans for construction and land development.

Although community banks have cut their exposure to commercial real estate lending, she said, community banks are particularly vulnerable to deterioration in real estate markets because of their emphasis on local lending. Because of reduced revenue in that sector many banks are seeking alternative sources of revenue.

Community banks have actively worked to restructure their problem loans though. During the past year, loans restructured and in compliance with modified terms have increased more than 30 percent to $15.1 billion including $3.5 billion in restructured residential mortgages. Although banks have been aggressive in charging off losses and restructuring, reserves may require further strengthening and loan loss provisions will likely continue to weigh on earnings in future quarters at many banks.

Outstanding loan balances have declined for nine consecutive quarters for all banks including community banks but Hunter said many healthy community banks continue to lend to creditworthy borrowers.  A significantly higher proportion of banks with assets under $1 billion actually increased their lending during this period than larger banks. 

Community banks have reported a number of possible causes for reduced levels of lending including reduced demand, tighter underwriting standards, fewer creditworthy borrowers, declining collateral values, and high levels of problem loans.  They also cite increased supervisory expectations of capital, liquidity, and oversight of commercial real estate loans.  The Fed is working, she said, to ensure that its examiners are well-trained and employ a balanced approach to bank supervision.

Community bankers and their supervisors have also been increasing their attention to other areas where lending concentrations may exist such as monitoring agricultural lending to ensure that underwriting standards are consistent with potential exposures to fluctuations in commodity prices and land values.

Hunter said that community bankers are concerned about the changing regulatory environment.  While recent reforms are aimed at the largest and most complex financial institutions, there is a fear that they will ultimately affect smaller community-based institutions as well.  Of particular concern are some provisions of the Dodd-Frank Act such as the limit on debit card interchange fees and a rule to prohibit network exclusivity arrangements and merchant routing restrictions.  Bankers are also concerned about the ultimate impact of new prudential standards that the Federal Reserve is required to develop as well as the Basel III framework, both of which are aimed are large and/or globally active banks, and the new Consumer Financial Protection Bureau (CFPB).  They feel that the cost of compliance with new regulations may fall disproportionately on smaller banks that do not benefit from the economies of scale of larger institutions and that this may increase consolidation of the banking sector.  All federal regulators will be publishing proposed rulemaking under Dodd-Frank for public comment and the Federal Reserve encourages comments from community banks and others on this and all proposals.

Hunter said the Federal Reserve has been working closing with the Offices of Thrift Supervision, Comptroller of the Currency, and the Federal Deposit Insurance Corporation to prepare for the transfer of supervisory authority of savings and loan holding companies to the Fed.  "Our intent--to the maximum extent possible and consistent with the Home Owners' Loan Act and other laws--is to create an oversight regime for savings and loan holding companies that is consistent with our comprehensive consolidated supervision regime for bank holding companies." The Fed appreciates, she said, that savings and loan and bank holding companies differ in important ways and will remain governed by different statutes.

These regulatory changes will provide a new set of challenges for community banks.  However, Hunter said they have faced similar challenges in the past and have performed effectively and continued to meet the needs of their communities. The banks that entered the financial crisis with moderate exposures to commercial real estate, moderate loan-to-deposit ratios, and ample investment securities tended to operate safely, soundly, and profitably despite the most challenging financial climate since the Great Depression.