NorthWesternFinancialReview.com Blog

Although overall industry earnings in banking were much better in the second quarter of 2010 than they were in the second quarter a year ago, there remain challenges in the Upper Midwest. The FDIC notes that the percentage of banks reporting losses declined across the country, but it actually increased in the Upper Midwest.

In the 14-state coverage area of NorthWestern Financial Review magazine, 556 of the 3,274 banks lost money in the second quarter, for 16.9 percent. That’s better than the national average of about 20 percent but it compares with 14.6 percent for Upper Midwest banks at the end of the first quarter. Conditions remain particularly difficult in Colorado and Michigan, where 24.4 percent and 29.1 percent of banks, respectively, lost money in the second quarter.

The strongest states in the region are Nebraska and North Dakota. Nebraska’s 364 banks recorded return on assets in the second quarter of 1.48 percent and return on equity of 14.87. North Dakota’s 124 banks recorded return on assets of 1.00 percent and return on equity of 10.37 percent. Statistics in both states were squewed by particularly strong performance among the largest banks. Statistics for banks in those states with fewer than $100 million in assets were more modest. In Nebraska, average ROA in the quarter among smaller banks was 0.83 percent and ROE was 7.03 percent. In North Dakota, it was 0.80 percent for ROA and 7.99 percent for ROE.

In most Upper Midwest states, however, smaller banks did better than larger banks. Minnesota banks, for example, had ROA of 0.40 percent and ROE of 3.92 percent, but banks with fewer than $100 million in assets had 0.55 percent ROA and 5.16 percent ROA. Iowa banks had ROA of 0.75 percent and ROE of 7.49 percent, but Iowa banks with fewer than $100 million in  assets had ROA of 1.05 percent and ROE of 9.08 percent.

The statistics in Wisconsin look particularly dismal, with aggregate net income through the first six months of the year at negative $111 million, but that is due to M&I Marshall & Ilsley Bank’s $237 million loss through the first half of the year. If you consider only the state’s banks with $100 million in assets or fewer, conditions look much better with average ROA at 0.64 percent and ROE at 5.38 percent.

Fewer banks are losing money. That’s the word from the FDIC this morning as the agency releases second quarter earnings figures for the industry. Here’s the FDIC announcement.

This statement from ABA’s chief economist, Jim Chessen, provides a little more perspective:

Today’s report indicates that the banking industry continues to regain its strength, though the fragile economy still presents significant challenges.  Banks have increased their capital levels and set aside strong reserves to cover problem loans that typically result from high levels of unemployment and business failures.  Problem loans are down, allowing banks to put losses behind them and look for new lending opportunities as the economy improves.

The decrease in loans outstanding is not unexpected given the still weak economy and the regulatory uncertainty that has been hovering over the industry for nearly two years.  Decreased loan levels are in large part due to very low demand from businesses and consumers.  Businesses are still reluctant to take on new debt without having hard evidence that consumers are willing to buy their products.  The economic outlook is still cloudy, which makes a prudent approach to credit a necessity.

Banks added another $27 billion in equity capital in the second quarter and total industry capital is now just short of $1.5 trillion.  When added to the more than $250 billion in reserves banks have set aside to cover losses, this makes for a total buffer of roughly $1.75 trillion against losses.  In addition, the capital-to-assets ratio – a key measure of financial strength – continues to improve and is at the highest level in decades.  In fact, 95.6 percent of banks – holding over 98.8 percent of the industry’s assets – are classified as ‘well capitalized,’ which is the highest regulatory designation possible. 

The increase in the number of banks on the list of troubled institutions is not surprising given some parts of the country are still mired in the recession.  The banking industry is committed to maintaining the strength of the deposit insurance fund and all costs of the FDIC are borne by the industry, not taxpayers.  Each depositor is fully insured up to $250,000, and in the 75-year history of the FDIC no depositor has ever lost a penny of insured deposits.

Navigating the ups and downs of the economy is nothing new to banking.  The vast majority of banks have been in business for more than 50 years, and one of every three banks has served its local community for more than a century.  Through good times and bad, it is this philosophy of building long-term relationships with customers that has made banks successful.

August 15 was the last day a bank could charge an overdraft fee on a debit card or ATM transaction by an existing customer if that customer didn’t opt in to the bank’s overdraft program. New rules are a reaction to cries from consumer groups that the overdraft fees have been excessive.

Currently, the new rules apply only to debit card or ATM withdrawals that exceed the account balances, but the FDIC on August 11 proposed additional rules restricting overdraft practices involving checks.

Many of the financial experts have been encouraging customers not to opt-in. They say that instead, they should work with their bank to set up an automatic sweep of funds from their savings account into their checking account in the event they overdraw their checking account.

Banks can no longer cover debit card or ATM withdrawals that exceed account balances if the customer did not opt in or make some other arrangement with the bank. That means some customers could be caught unaware at the checkout counter of a grocery story or other retailer when trying to make a big purchase when they only have little money in their account.

The new federal regulations are particularly discriminatory against smaller banks which typically lack the software for its ATMs to operate on a real-time basis. For example, a bank customer could go to a bank, visit with a teller at the window and withdraw nearly all the funds in his account. An hour or two later, that same customer would likely be able to go to an ATM and use his ATM card to withdraw an equal amount of money, far exceeding his actual balance. This is possible because many banks use ATM software that is updated in “batches” every few hours, or sometimes once a day. That means the balances reported by the ATM can be different from the actual balance of the account. Banks using this older technology are prohibited by law from charging the customer any kind of an overdraft fee if the customer did not opt in.

I have yet to see any good statistics on how many banks operate with this older technology. For many of those banks, the cost to upgrade is prohibitive.

I also haven’t seen any good statistics yet showing how effective banks have been in getting customers to opt-in. Have most customers opted in, or have most ignored the notices from their bank and fallen out of the system? Eventually, this information will come to light.

One of the good things to come out of the Dodd-Frank Act was the permanent increase in deposit insurance protection to $250,000 per account. Typically, Congress increases coverage when the national median household income reaches a level equal to about half of the deposit insurance cap. The current median household income for the nation is about $50,000, which was half the old coverage cap of $100,000 — time to raise the cap.

In 1980, when the cap was raised to $100,000 from $40,000, the median household income across the country was about $17,700. In 1973, when the cap was raised to $40,000 from $20,000, the median household income was about $10,500. In 1968, when the cap was raised to $20,000 from $15,000, the median household income was about $7,700.

Whether it makes sense to tie deposit insurance to median household income is a debatable point. Whatever the cap is, I like to see it tied to real economic data; I really don’t like to see the FDIC and the Deposit Insurance Fund manipulated for political purposes.

The increase to $250,000 may certainly have been the result of political horsetrading. In “On the Brink,” former Secretary of the Treasury Henry Paulson writes about a Sept. 30, 2008 meeting with top Treasury officials. He writes:

“We had a meeting Tuesday morning and then a conference call to discuss raising the FDIC cap on insured deposits from $100,000 to $250,000 per account as part of the TARP sweeteners.”

So the increase in coverage had nothing to do with the economy and appropriate levels of deposit insurance. It was all about getting enough support to pass TARP.

The $250,000 cap is a good thing, even if I don’t really like the way it was achieved.

For a long time industry observers have suggested that the banking industry is poised to move toward the public utilities model. There are enough policy-makers and elected officials who believe the payments system is similar enough to the sewer and electric systems, that banking really should be treated like a utility.

I think you can make an argument that we are headed in that direction. Sheila Bair’s interest in creating a small dollar loan product is a big step. The FDIC, a government agency, is devising a product for the industry to offer. Notwithstanding the merits of the product, why is it appropriate for the government to create financial products?

The creation of a Consumer Financial Protection Bureau as part of the Dodd-Frank Act is another huge step in the direction of “utilitizing” the industry. Some press accounts have referred to CFPB as the most powerful financial regulatory body ever created, with unbelievably little accountability. The truth is, we really don’t know what this agency is going to look like or what it will do, but certainly its potential is ominous. It is not crazy to believe that it will evaluate financial products for the purpose of telling financial services organizations which products they should offer and which they should discontinue. They may also have a thing or two to say about product pricing. All this sounds an awful lot like the way public utilities are regulated.

Since it is the largest institutions which will be hit hardest by the CFPB, I see them as being most vulnerable to being neutered into utilities. Certainly our country can function with a utility-like financial services sector, but we will lose innovation, creativity and fresh ideas. If the people working in financial services have to worry more about pleasing regulators than customers, then it’s all over.

A functioning financial services sector isn’t good enough; we need a thriving financial services sector. If the banks thrive, the economy thrives and the whole country thrives. Sure regulators have a role; they need to stem abuses, but they don’t need to suck the creativity out of the whole system. Because, frankly, I expect more from my bank than I do from my water company.

When should a banker get a new appraisal on collateral? That question came up at the regulator panel hosted by the Minnesota Bankers Association earlier this month in Duluth. James LaPierre, the FDIC Director of the Kansas City Region offered guidance.

“The expectation is that you will have a current appraisal,” LaPierre said. “The most likely need for an appraisal less than annually is if the existing appraisal does not show what is happening in the project.”

LaPierre suggested an example of a condominium project in which the bank loaned the developer money based on a business plan to sell each of the condos. Mid-project, the developer decides to rent the condos. In that situation, “we would expect a new appraisal,” he said.  

“The more likely scenario is we will simply adjust the appraisal. If we see a project where the business plan says we are going to sell eight units a month for 10 months and the sales level is actually four units a month with the sales price $25,000 per unit less than anticipate, that will be an adjustment — assuming you are down to a collateral bases where the loan has become collateral dependent,” LaPierre said.

“If it is not collateral dependent and the borrowers continue to make payments, it is a much more difficult thing because the question becomes ‘does that borrower have both the capacity and the willingness to continue?’ We have seen cases where borrowers had significant other assets, but they get to the point where they realize that it is no longer a good economic decision for them to continue to pay, and if they are paying it is very difficult to look forward and say they are going to get to that point.”

Blake Paulson of the Office of the Comptroller of the Currency, had this to say: ”On appraisals, it is very important that you have done your analysis. And if it is a severe problem loan, I would expect every quarter that you have done you analysis of what that collateral is worth, given recent information. If the examiners see that you have done that analysis and it is reasonable, they are much more likely to accept that than if they open the loan file and there is no appraisal and it looks like the economics have changed. You are much better off doing the analysis yourself and let the examiners validate that, versus forcing the examiners to do their own analysis.”

Look for in-depth coverage of the regulatory panel in the July 15 edition of NorthWestern Financial Review magazine.

As an English major in college who needed a science credit, I took a course in meteorology. I remember the professor telling us that if you simply predict that the weather tomorrow will be the same as it is today, you will be correct about 70 percent of the time.

That statistic came to mind recently while I was listening to a panel of regulators discuss local conditions. The Minnesota Bankers Association hosted the regulators during a session of its annual convention two weeks ago in Duluth.

James LaPierre, the head of the FDIC’s Kansas City Region, commented on CAMELS ratings. He said if you want to predict what composite rating regulators will assign your bank after an examination, you should expect the rating to be the same as the one you had before.

“Across our region, from 1-rated banks to 5, by far the most likely rating if you were rated 1 last time, by far you are most likely to be rated 1 this time. And that is across all five rating bands. If you are examined again, your most likely rating is the same one you had last time,” LaPierre said.

However, if your rating changes, he said, in the current environment you are twice as likely to be downgraded as your are to be upgraded.

Ron Feldman, senior vice president at the Federal Reserve Bank of Minneapolis, also participated in the panel discussion. He noted that every quarter, the Fed runs a predictive model to calculate the likelihood of a CAMELS downgrade at each bank in its district. He said that for Minnesota banks in the first quarter, “It was the first time that I have seen a decrease in the likelihood of downgrades across each of the rating categories. The chance of being downgraded has gone down in virtually all of the categories.”

LaPierre reported that as of June 4, twenty-seven percent of the banks in the country have a CAMELS rating of 3, 4 or 5.

Kevin Murphy, the deputy commissioner of commerce for the state of Minnesota, who also participated in the panel discussion, indicated 200 of Minnesota’s 306 state chartered banks have a rating of 1 or 2.

FDIC Chair Sheila Bear delivered an interesting speech on Monday to a housing non-profit group in Virginia. In the speech, she challenges the notion that home ownership should be a national priority. Here’s what she says:

For 25 years federal policy has been primarily focused on promoting homeownership and promoting the availability of credit to home buyers. While tax deductions for interest on most forms of consumer debt have been curtailed, the home mortgage interest deduction lives on. Local property taxes are also deductible, as are capital gains up to $250,000.

The government-sponsored mortgage enterprises, which flourished during most of the last 25 years, have required large federal subsidies to cover their losses in the crisis — formalizing the implicit guarantee that has long contributed to their success. Meanwhile, the supply of credit to riskier borrowers also expanded during this period — not as a result of CRA, as I have explained, but as a result of private securitization practices that turned out to be seriously flawed.

In the end, these public and private efforts helped to briefly push the homeownership rate as high as 69 percent. That’s a level that ultimately proved unsustainable, and that may not be reached again for many years, if ever.

Even as we emerge from this crisis, it is worth asking whether federal policy is devoting sufficient emphasis to the expansion of quality, affordable rental housing. It is estimated that when you add up the mortgage interest deduction, local property tax deductions, and exclusions on capital gains realized on the sale of owner-occupied housing … the taxpayer subsidies for homeowners are about three times the size of all rental subsidies and tax incentives combined.

In fact, you can argue that this huge subsidy for homeowners has helped push up housing prices over time, making affordability that much more of a problem for the very groups you’re trying to serve. I think we need a better balance. Sustainable home ownership is a worthy national goal. But it should not be pursued to excess when there are other, equally worthy solutions that help meet the needs of people for whom home ownership may NOT be the right answer.

As a nation, we need to take a hard look at the full range of housing policies and programs. And we need to ask: will they improve standards of living for all Americans or just a few? And will our policies lead to sustainable improvements for the long term, or are they just a short term fix?

I think this is really interesting. Since the economy peaked five years ago, home ownership across the country has actually declined. In 2005, the home ownership rate was 69.1 percent; first quarter 2010, it was 67.1 percent. This information from the U.S. Census Bureau provides a pretty clear picture. Note in particular the data on page 5. For a look at home ownership by state, have a look at this graphic.

When it comes to a home, renting is the right approach for a lot of people, and we should not downplay this option.

FDIC Chair Sheila Bair made a very interesting point in her speech to bankers in Orlando earlier this month when she noted that extensive consumer protection laws applied to the banking industry spawned the shadow banking sector. She noted that the buttoned-down practices of traditional banks allowed no room for questionable practices, so those questionable practices emerged outside the ranks of traditional banking.

“The regulatory reforms put in place after the last crisis actually helped push risk-taking outside of traditional banking and into the shadow banking system,” she said. “This created gaps between regulatory jurisdictions; weakened consumer protection; and led to the problems with subprime and nontraditional mortgages, and risky securitization structures.”

Bair then goes on to make the case that increased consumer protections should not be focused on the traditional banking sector, but on the shadow sector. Here is what she said:

But it’s time we leveled the playing field for all market players. We need strong rules that apply — and that are enforced — across the board for banks and nonbanks. And it is just as important to ensure that the burden of this regulation does not fall on the mainstream lenders who were not the cause of the problem.

The bankers welcomed this message. But I think it is worth considering whether this problem can ever be solved. When lawmakers passed tougher consumer protection laws and applied them to banks, they thought they were applying the law to all the relevant parties. They didn’t think they were leaving anyone out. Well, since the laws were passed, new industry sectors emerged to get around the laws. Is this cycle breakable? If new, broader laws are passed this time around, what is to stop the emergence of still more niche sectors?

It will be a daunting task to come up with an examination and enforcement regime for non-banks sufficient to match the level of supervision currently applied to banks. Keep in mind that the non-bank sector is much larger than the bank sector. My point is, even if you accomplish this herculean task, new kinds of businesses that skirt the rules are likely to emerge. It is a vicious cycle.

I am not saying government shouldn’t try to protect consumers, but I suspect there will always be weak spots. Universal oversight that prevents all companies from offering any products that could be deemed questionable simply seems impossible to me.

A decade or more ago, community bankers would argue that they need their own regulator. They said that the existing regulators were focused on large banks, which had an entirely different business model. They said they wanted their own regulator, an agency that understood the economic dynamics of a small town, who understood agricultural banking, and an agency that understand what “character” means in a loan decision.

But the community bankers seemed to drop their call for a dedicated regulator. With so many other issues to resolve, the groups that advocate for community banks turned their attention to other, more pressing, issues.

But now, an advocate emerges who is calling for a community bank regulator. John Bowman, acting director of the Office of Thrift Supervision, said that Congress should terminate the existing scheme of regulatory agencies and start over. “Our proposal is simple: instead of four federal banking regulators, there should be two: one for community-based banks and thrifts and one for complex commercial banks.”

Speaking in Orlando 10 days ago, Bowman made the case for a dedicated regulatory agency that would focus solely on community banks.

Whether a community bank holds a state charter, a national charter or a federal thrift charter, that institution should not be supervised by the same agency that oversees complex commercial banks. The one-size-fits-all regulator, by necessity, will pay the greatest attention to the complex commercial banks, because they pose the greatest potential risks to the financial system. As a result, the community banks and thrifts that by far make up the largest number of institutions will receive “afterthought” supervision, rather than a regulatory approach tailored to their unique business model.

Bowman said he finds it “ironic” that none of the regulatory reform proposals being considered in Congress include a stand-alone agency for community banks.

You could argue that the FDIC serves as a regulator for community banks, but Bowman dismissed that idea, saying the agency has an inherent conflict of interest. Minimizing losses to the deposit insurance fund is a different mission than assuring the safety and soundness of banks, he said. Bowman also said the Federal Reserve should not be involved in the supervision of community banks, but instead should focus on monetary policy. He said the Fed could rely on other agencies for information about community banks.

I believe community bank supervision would best be managed by a new independent agency that would have the sole mission of supervising community banks and thrifts, supervising their holding companies and protecting consumers. For the first time, the health and welfare of this nation’s community banking sector and its consumers would be the top priority of a federal agency.

Read Bowman’s entire speech here.

Of course, the way things are going, OTS is likely to be merged out of existence. Such a pending fate likely emboldens Bowman to propose this radical idea. But it is unlikely anyone in Congress will pick up Bowman’s idea and run with it. And that’s too bad. It is really not a bad idea and at one time, most of the industry was advocating for something along these lines.