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San Francisco Regional Outlook - First Quarter 1998
Regional Banking Conditions
Supported by a strong economy in most of the San Francisco Region, insured financial institutions reported solid performance in the third quarter of 1997. Return on assets (ROA) at the Region's banks and thrifts continues to trend upward, as shown in Chart 1. During the past 12 months, the asset-weighted Tier 1 capital ratio climbed from 7.44 percent to 7.65 percent. Reported asset quality is characterized by a low and declining ratio of past-due and nonaccrual loans, which now approximates only 2 percent of total loans.
Although overall trends for the Region's insured institutions appear favorable, performance within each of the 11 states varies, particularly among community banks (defined here as non-credit-card banks with total assets of less than $1 billion). In the aggregate, community banks in some of the Region's fastest growing states--Arizona, Nevada, Oregon, Utah, and Washington--report ROAs above 1.30 percent. ROAs at community banks in Alaska, Idaho, and Wyoming also exceed 1 percent, and operating income has improved despite a slowdown in employment growth rates in these states. Conversely, community banks in some states and metropolitan statistical areas (MSAs) whose economies are less diverse or whose major industries have slowed down performed less well during the third quarter of 1997 (see The San Francisco Region's Larger and More Diverse State Economies Tend to Closely Follow the National Economy):
Reserves for Loan Losses Slip at Some InstitutionsWhile profits are generally strong at the Region's banks, their first line of defense against loan losses--the allowance for loan and lease losses (ALLL)--has declined as a percentage of total loans in every year since its 1992 peak. This decline took place during a period of strong postrecession economic growth in much of the Region. Although, as shown in Chart 2, the ALLL decline of 80 basis points for the Region's banks parallels the national decline, the relative adequacy of ALLL levels for some of the Region's banks warrants closer review. In particular, the ALLL levels and trends vary significantly among community banks in different locations around the Region. The differences in ALLL levels are a reflection of differing economic growth patterns, market conditions, and bank portfolios.
Community Banks Exhibit Risky Trends in Certain States and MSAsThe ALLL for community banks in the Region is generally in line with national averages. However, community banks in some states in the Region are raising concerns because of rapid loan growth and an assumption of greater lending risks in recent years. Oregon, Washington, and Nevada, for example, have recorded strong loan growth in recent years and have some of the highest concentrations of construction and commercial real estate lending, measured as a percentage of total assets, in the Region. Despite the increase in risk profiles, the overall level of reserves to loans in all three states has declined below the Region's average of 1.68 percent for similar-size banks with lower risk profiles (see Table 1).
Banks in several MSAs in the fastest growing states in the Region are some of the most heavily exposed to construction and commercial real estate lending, yet have lower loan loss reserves than other community banks in either the nation or the Region. These MSAs are Eugene and Salem in Oregon; Olympia and Seattle in Washington; and Reno in Nevada. In aggregate, banks in each of these MSAs hold about 30 percent of their assets in commercial real estate and construction lending while the reserves to total loans ranged from 0.99 percent to 1.30 percent. These reserve levels are significantly lower than for similar-size banks with lower risk profiles in both the Region and the nation (see Table 1).
Hawaiian community banks also raise concerns because of their very low ratio of reserves to noncurrent loans. This ratio has moved down from 183 percent in 1990 to only 41 percent as of the third quarter of 1997, far below averages for the nation and the Region. The low coverage ratio is noteworthy because, while more than half the noncurrent loans are in one- to four-family residential mortgages, median residential home sale prices in Hawaii continue to decline and have dropped approximately 20 percent from their peak in the third quarter of 1990.
Implications: Community banks in several rapidly growing states have reduced reserve coverage levels to well below averages for both the Region and nation. These lower levels of reserves raise concerns that loss provisions may be inadequate, particularly at rapidly growing banks that appear to be assuming greater lending risks. Hawaii is another area of concern because the reserve coverage of noncurrent loans has been reduced to levels significantly below that of similar-size banks in both the nation and the Region.
Funding Structure Shifts at Region's BanksWith the rebound in the Region's economy, loan growth has accelerated. Historically, insured institutions--especially small community banks--have funded loan growth with core deposits (demand, regular savings, NOW, money market accounts, and certificates of deposit under $100,000) because of the stability and cost-effectiveness of these instruments compared with other funding sources. However, as shown in Chart 3, the Region's loan growth has outpaced core deposit growth since 1993. To fund the increase in loan growth, banks and thrifts have used other, potentially more volatile funding sources.
Weak growth in core deposits appears to be caused by several factors. Banks have faced stiff competition from other types of financial service companies, especially mutual funds that have been generating returns well above the interest rates banks have been paying on deposits. Credit unions also actively compete for consumer deposits and generally offer higher interest rates than banks or thrifts.
As a result of these competitive forces, the Region's institutions appear to have altered their funding strategies. To retain customer relationships, some larger banks have begun offering a wider array of investment products, including annuities and money market mutual funds. For example, Chart 4 shows that bank sales of nondeposit products for the third quarter of 1997 were more than four times those of the fourth quarter of 1994. Often these funds are placed under the bank's own management. In addition, a number of banks are sweeping accounts that shift balances from NOW and other deposit accounts into the bank's own money market accounts. Doing this eliminates the bank's need to hold non-interest-bearing reserves with Federal Reserve Banks.
In addition to their efforts to retain funds, banks and thrifts in the Region have increased their reliance on potentially more volatile funding sources to offset the slow growth of core deposits. They are relying more on noncore funding such as large-denomination time deposits, foreign deposits, and borrowings. These more volatile funding sources had climbed from less than 15 percent of assets in 1992 to almost 25 percent of assets as of September 1997. Large institutions (those with over $1 billion in assets) have augmented their funding primarily through the use of foreign deposits and other borrowed money. However, at community banks, most of the increase in volatile funds has been in time deposits of $100,000 or more. These large time deposits now fund 13.1 percent of total community bank assets for the Region, up from 9.6 percent at year-end 1994 (see Chart 5).
The ongoing funding shift appears to be putting some strain on insured institutions' net interest margins. Large banks in the Region have seen their net interest margins decline from a high of 5.1 percent in 1992 to 4.5 percent as of September 30, 1997. The squeeze on net interest margins at the Region's community banks began in 1991. Net interest margins at these institutions edged down from 5.8 percent in December 1989 to 5.4 percent in the third quarter of 1997.
Implications: The sustained period of low interest rates over the past several years has caused both individuals and corporations to shift balances from core deposits into higher yielding investments and noninsured investment products. This trend is likely to continue as long as a wide differential exists between the yields on these investment alternatives and the rate banks are willing to pay for deposits. Some banks, mostly the larger ones, have been able to retain interest-sensitive funds by offering their own mutual fund and annuity products.
The increased reliance on potentially more volatile funding sources, especially for community banks with limited access to the capital markets, may increase the risk profile of some institutions. In addition, the erosion of a core deposit base underscores the need for sound asset-liability management caused by increased interest rate sensitivity resulting from shorter maturities, increased potential for liquidity problems, and increased pressure on net interest margins.
Catherine I. Phillips-Olsen, Regional Manager
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