By Ray Brastow, Bob Carpenter, Susan Maxey and Mike Riddle
The financial crisis and subsequent economic downturn resulted in a significant number of bank failures. Analysis of failures by the banking industry, regulators and academics has provided insight to help avert future banking crises. However, in the midst of the crisis and ensuing recession, some institutions did more than endure — they maintained strong financial conditions and above average regulatory ratings throughout. How? In what ways do they differ from weak or failed banks? During 2011, the Policy Analysis Group in Supervision, Regulation and Credit’s Risk and Policy unit explored these questions by conducting interviews of bankers at a sample of banks that successfully navigated the crisis.
The study focused on Fifth District state member banks, for which the Federal Reserve shares supervisory responsibility with state banking agencies. Case interviews were conducted through direct discussions with community bankers. The project team chose an interview approach to allow for a complete exchange with bank management.
The primary selection criterion was based on CAMELS ratings. The group focused on institutions rated composite CAMELS 1 or 2 in the second quarter of 2007 (before the crisis) and that maintained a 1 or 2 rating through the recession to the first quarter of 2010. Ratings were chosen over specific financial ratios because the composite rating captures a bank’s overall financial condition plus an assessment of management. Additional criteria were considered to ensure diversity in terms of geographic footprint, size and business model. Ultimately, nine banks were included in the sample. To provide contrast, a control group of banks that became distressed was also identified. This group was composed of institutions with composite ratings of 1 or 2 at the beginning of the sample period that subsequently were downgraded to less than satisfactory.
Description of the Interview Sample
The sample included banks from Virginia, Maryland and West Virginia. Selected banks operate in rural, suburban or urban footprints, providing exposures to different economic environments, local business concentrations and degrees of banking competition. All of the institutions are community banks, but total assets for the third quarter of 2010 ranged from about $150 million to almost $4 billion, with a mean of $1.5 billion.
Financial characteristics before (1Q2000-3Q2007), during (4Q2007-2Q2009) and after (3Q2009-2Q2011) the crisis were used for this case study. Statistics for banks included in the study (“healthy banks”) were compared to those for a sample of eight Fifth District institutions that lost their 1 or 2 rating during the same period (the “control group”).
The study found that, relative to troubled institutions, the healthy banks entered the sample period with less dependence on non-core funding and lower asset concentrations — most notably lower commercial real estate (CRE). While capital ratios were high in 2007, these banks did not enter the crisis with higher capital ratios than control group banks. Unlike the control group banks, however, the healthy banks emerged from the crisis with capital ratios that were only slightly lower than pre-crisis levels.
Interview Format and Findings
Participating banks were asked to respond to questions from the following categories:
An explanatory letter and list of questions were mailed to bank management prior to each interview. Banks were asked to focus on the conditions before, during and after the recession. In each case, the bank’s president or CEO was present, occasionally accompanied by other members of the senior leadership team.
Several common themes emerged. The most common was the presence of veteran senior management, coupled with a supportive and engaged board of directors. Six of the nine institutions discussed this attribute as important for success. Senior management at these institutions are veteran community bankers with long tenures at their current or legacy banks. The interviews highlighted two key features of an effective governance structure. First, the board approves and supports the bank’s strategic plan, including the risk appetite. Second, the board is not involved in daily decision-making, but is committed to carefully monitoring management’s execution of the strategic plan.
In general, successful boards in this sample are composed of individuals knowledgeable about the community and their own businesses and committed to the bank. One of the Board’s main functions is to initiate opportunities for business development. Leading up to and during the crisis, it was important for boards to remain committed to the bank’s business plan and to allow senior management latitude to engage in timely reactions to issues without board approval. In all cases, senior management had implemented the bank’s business model before the real estate cycle began. As local real estate markets began to heat up, each bank resisted the temptation to change focus and dramatically ramp up acquisition, construction and development (ADC) lending.
Sample banks are committed to conservative business models. They emphasize relationship banking, detailed knowledge of their markets and customers, conservative underwriting coupled with detailed loan administration, careful growth plans, diversified balance sheets and business opportunities that fit the bank’s expertise. Several CEOs indicated that they welcomed growth, but only if it could be done responsibly. The study revealed that healthy bank asset growth was slightly slower than the control group during the pre-crisis and crisis periods.
Prior to and throughout the crisis, each bank maintained strong capital levels. Banks held pre-crisis capital for acquisitions, for organic growth, or as part of a relatively conservative overall business model. According to one CEO, “For community banks, capital is king.” He and his board do not manage to ROE. Others mentioned the reputational enhancement that derives from strong capital, noting that their institutions benefitted during the downturn because of the public’s perception of their strength. These banks enjoyed significant deposit inflows and growth opportunities due to the strength of their balance sheets relative to competing community banks.
The healthy banks entered the crisis with strong, but not unusually high, capital ratios. Compared to the control group, there was no statistically significant difference between capital levels. However, capital levels should be assessed relative to an institution’s risk exposures. The healthy banks adopted conservative business models with comparatively low levels of risk on their balance sheets.
Perhaps the most widely reported characteristic of the healthy bank sample was the significant time and resources devoted to monitoring credit quality. The CEOs generally attributed their low levels of delinquencies to detailed and careful underwriting and credit administration. One CEO described his bank’s credit policy as “just blocking and tackling, fundamental community banking.” Several described their institutions as relationship banks. Another CEO described in detail the customer service that makes them a “high-touch bank.” His customers expect frequent contact from the bank, and one advantage of that model is on the credit side.
The healthy banks appear to understand the behavior of their customers, their customers’ businesses and their local markets well. In contrast, they are reluctant to participate in markets or offer products that they do not understand. They lend aggressively in markets where they have expertise and relationships, but generally resist opportunities in other business lines or markets where they lack detailed knowledge.
These banks also maintain a culture where problems are acknowledged immediately and dealt with aggressively. These institutions were not immune to credit issues in the downturn. The key was how they dealt with problems. One bank formed a special assets group to deal with its impaired loans, implemented new and enhanced risk management practices, and adopted an aggressive loan modification policy. This same bank successfully managed to quickly repair asset quality and cover losses through earnings without depleting capital.
Healthy banks reported a commitment to diversification across the balance sheet. In several cases, banks insisted on tying business relationship lending to receiving the clients’ transaction accounts. In addition to providing sources of low cost and stable funding, one banker acknowledged this arrangement allows better monitoring of client cash flows. In all but one case, healthy banks’ local markets exhibited relatively low degrees of economic cyclicality and provided a relatively strong base for business opportunities. While for some banks, the surrounding communities did experience rapid real estate growth, the healthy banks adopted business models that allowed them to have limited exposure to the ensuing downturn.
A final common characteristic is an emphasis on a strong management team and staff. CEOs described training efforts to create both a culture and the specific expertise required to successfully implement the bank’s strategies. Many of these banks work hard to recognize when staff limitations make it necessary to hire experience from outside. During the downturn, two banks hired staff with real estate finance backgrounds to manage losses and improve credit administration. Several CEOs reported hiring loan officers from larger competitors to bring both expertise and business relationships.
While these institutions have been relatively successful, CEOs also described several concerns about the future of community banking. Among those most commonly expressed were severe earnings pressures, difficulty in achieving or maintaining asset diversification, regulatory overload relative to staff size and expertise, growth challenges, and management or director fatigue. Most CEOs also anticipate future community bank consolidation, speculating that community banks will need to merge to become attractive acquisition targets or to achieve competitive scale.
Several implications emerge from the interview responses. Most importantly, the healthy banks have strong management and effective boards that support and monitor management’s strategies. Although these banks have conservative business models, they were not immune to losses during the crisis and downturn. However, effective governance structures enabled these institutions to quickly address supervisory findings and emerging credit issues.
Banks in the interview sample are committed to controlled growth strategies, while maintaining diversification on both sides of the balance sheet as well as across markets and customers. Strategies which made these institutions successful are very different from the control group. Those institutions had rapid growth strategies and significant CRE concentrations. Risk management at control group banks was inadequate, given the increased risk profile.
Institutions shouldn’t wait to implement risk management processes appropriate to their exposures. The time to act is in good economic times when a bank’s financial results are sound. Additionally, credit culture is central to the organization. Not all of the healthy banks completely avoided CRE and ADC, but they mitigated risk through detailed underwriting and credit administration.
Finally, capital adequacy must be considered relative to a bank’s risk profile. Healthy banks had strong regulatory capital ratios, but not substantially higher than peers. However, relative to risk exposures, these banks were truly well capitalized. Concentrations are inherently risky, even in asset classes that appear to be safe or offer attractive earnings. Supervisors expect to see some combination of enhanced risk management practices, explicit risk mitigants, or higher capital levels at institutions with large asset concentrations or otherwise risky profiles. Again, the time for these to be in place is prior to a downturn.
Bob Carpenter is a supervision and regulation lead financial economist for the Federal Reserve Bank of Richmond. He can be reached at firstname.lastname@example.org.
Ray Brastow is a supervision and regulation financial economist for the Federal Reserve Bank of Richmond. He can be reached at email@example.com.
Susan Maxey is a quantitative research analyst for the Federal Reserve Bank of Richmond. She can be reached at firstname.lastname@example.org.
Mike Riddle is a Risk and Policy team leader for the Federal Reserve Bank of Richmond. He can be reached at email@example.com.
The analyses and conclusions set forth in this publication are those of the authors and do not necessarily indicate concurrence by the Board of Governors, the Federal Reserve Banks, or the members of their staffs. Although we strive to make the information in this publication as accurate as possible, it is made available for educational and informational purposes only. Accordingly, for purposes of determining compliance with any legal requirement, the statements and views expressed in this publication do not constitute an interpretation of any laws, rule or regulation by the Board or by the officials or employees of the Federal Reserve System.
Supervision, Regulation & Credit