Tuesday, May 18, 2010

The Small Bank Wish: Ease Up!

Greg M. Ohlendorf
President & CEO, First Community Bank and Trust

On behalf of the Independent Community Bankers of America & The Community Bankers Association of Illinois

Before the Congress of the United States House of Representatives Committee on Financial Services Subcommittee on Oversight and Investigations Field Hearing on

"Commercial Real Estate: A Chicago Perspective on Current Market Challenges and Possible Responses"

May 17, 2010
Chicago, IL

“As you know, community banks serve a vital role in small business lending and local economic activity not supported by Wall Street. Even during these challenging times, our nation's nearly 8,000 community banks remain committed to serving their local small business and commercial real estate customers, who are pivotal to our country's economic recovery.

The overwhelming majority of community banks are well capitalized and have good liquidity. But, many community banks face serious challenges that can hinder their ability to make loans. First, community banks confront the toughest regulatory environment in more than two decades.

While Washington policymakers exhort community banks to lend to businesses and consumers, banking regulators, particularly field examiners and their field offices, place restrictions on banks well beyond what is required to protect bank safety and soundness. The banking agencies have moved the regulatory pendulum too far in the direction of overregulation at the expense of lending. We need to return to a more balanced approach that promotes lending and economic recovery in addition to bank safety and soundness.

While the tough regulatory environment is inhibiting new loans in many instances, community banks have also witnessed a decrease in demand for loans from qualified borrowers. Many of our best small business and real estate customers cite their uncertainty about the recovery as their key reason for not seeking additional credit.

Commercial real estate lending presents special challenges for the community banking sector. Many community banks rely on CRE loans as the “bread and butter” of their local banking market. Community bank CRE portfolios are under stress. The downturn in the economy affects the ability of CRE borrowers to service their loans. Regulatory overreaction adds further stress to community bank CRE portfolios. For example, field examiners continue to require community banks to classify and reserve capital for performing CRE loans solely because collateral is impaired, despite guidance from Washington to look beyond collateral values. Community banks all over the country, even those located in areas that have relatively healthy economies, are under regulatory pressure to decrease CRE concentrations.

Aggressive Writedowns of Loans; High Loan Loss Reserves

While the banking regulators in Washington have been very willing to discuss their safety and soundness examination policies with the ICBA and have reassured us that they are taking measures to ensure their examiners are being reasonable and consistent with recent guidance, ICBA continues to hear from community bankers that their examinations are unreasonably tough.

For example, despite the guidance on CRE loan workouts, community banks continue to report that they are forced to write down performing CRE loans based solely on appraisals and absorption rates (lots sold). In those cases, examiners are ignoring the borrower’s ability to repay its loan, the borrower’s history of repaying other loans with the lender, favorable loan-to-value ratios and guarantors. When a recent appraisal is unavailable, examiners often substitute their own judgment to determine collateral value.

Further, commercial credits that show adequate cash flow to support loan payments are being downgraded because of collateral values, or because the examiner believes the cash flow will diminish in the future. Other bankers complain that otherwise solid loans are being downgraded simply because they are located in a state with a high mortgage foreclosure rate. This form of stereotyping is tantamount to statewide redlining that ignores any differences among markets within a state.

Many community banks report that examiners are not only requiring an aggressive write down of commercial assets, they are also requiring banks to establish reserves at historically high levels.

Banks, which were rated CAMELS 1 or 2 on prior examinations and had loan loss reserves of 1 to 1.5 percent of total loans, report that they are being required to more than double their loan loss reserves. Aggressive write-downs of commercial assets and large loan loss reserves have a serious negative impact on bank earnings and capital and the ability of community banks to meet the credit needs of small businesses.

Banks May Avoid Good Loans to Satisfy Regulators

Examiner practices not only undermine the fundamental goal of the interagency policies, they are costing community banks money, leading to a contraction of credit, and forcing many of them to rethink their credit policies. Under this climate, community bankers may avoid making good loans for fear of examiner criticism, write-downs, and the resulting loss of income and capital.

Moreover, the examination environment is driving down the amount banks are willing to lend on a project, when they do decide to provide financing. Two years ago, a bank such as mine would have been willing to finance 75 to 80 percent of the cost of a project, but under today’s circumstances, my bank could only finance about 60 to 70 percent of a project, at most, out of concern about future downgrades of the loan.

Commercial Real Estate

One issue of increasing concern in the community banking sector is that of commercial real estate and the potential for overexposure. Many community banks rely on commercial real estate (CRE) as the “bread and butter” of their local markets. The degree of borrowers’ ability to service their CRE loans is closely tied to the performance of the overall economy, employment and income. Notably, retail sales declined 0.3% in the important December 2009 figure and unemployment remains near a 26-year high. So the sales at stores and businesses occupying commercial space is under stress and rents are suffering, putting increased pressure on paying loan and lease commitments. Until individual spending (which makes up 70% of GDP) and employment numbers improve, CRE loans set for renewal are likely to see continuing rising defaults.

This adds stress to the community banking sector as they rely on commercial real estate as a significant portion of their overall portfolio. However, bank regulators have much more aggressively examined community banks for CRE concentration dating back to 2006. For example, an institution whose total amount of reported construction, land development, and other land loans represents, approaches, or exceeds 100% or more of the institution's total capital will be subject to greater regulatory pressure and oversight. An institution whose total CRE loans represent, approach, or exceed 300% or more of the institution's total capital and whose outstanding balance of CRE loans has increased by 50% or more during the prior 36 months will also come under even greater regulatory scrutiny.

It is not uncommon to have community banks exceed the 100/300% of regulatory capital threshold, but few have seen very rapid growth in CRE exceeding 50% in the past 3 years. Many community banks survived the CRE stress in the 1980s and 1990s, and have much better controls over their CRE concentration. Community bankers report today’s CRE troubles are nowhere near the magnitude of the late 1980s and 1990s. CRE credit in the economy has already shrunk by about $45 billion from its 2007 peak. However, CRE exposure will be a significant reason banks will remain under stress in 2010 and is a key reason 702 banks are on the FDIC problem bank list.

That said, community banks report they underwrite and manage these commercial real estate loans in a conservative manner, requiring higher down payments or other steps that offset credit risks and concentrations. Community banks believe they do a better job monitoring CRE loans than do large nationwide lenders because they are more likely to work one-on-one with the customer, and they have a better understanding of the economic conditions in their communities. The vast majority of community banks have the capital to ride out the depressed CRE market.

However, community banks all over the country, even those located in areas with relatively healthy economies, are under regulatory pressure to decrease CRE concentrations. Should real estate prices stabilize with economic growth, the CRE concerns will abate. Many community banks report that CRE loan payments are regularly being made (so the loans are performing) but their underlying collateral value has declined. Therefore, as CRE loans are due for renewal; borrowers as well as banks are often forced to put up increased capital to be able to renew the loan and prevent default.”