Asset Quality
Asset quality was unchanged with loan losses and net charge-offs still near historical lows. Even with the decline in stimulus support to individuals and businesses, banks did not experience any notable rise in delinquencies. Median past due loans 30–89 days continued to decline, and loans did not migrate to longer-term delinquencies. As a result, nonperforming assets (made up of loans past due 30 days or more and nonaccrual loans) represent less than 1 percent of total assets. Banks are monitoring commercial real estate (CRE) exposures, particularly to hotels, offices, and some retail affected by the COVID-19 outbreaks during the third quarter. For example, with the delta variant delaying the return to office in the third quarter of 2021, it increased the odds of working from home becoming the standard in many industries. The shift would have a significant impact on a range of CRE types, such as office and retail, that traditionally form a large portion of Sixth District bank balance sheets. The lack of demand for space would affect office properties, while many small retailers would lose the foot traffic that adjacent office buildings generate. The median allowance for the ratio of loan losses to nonaccrual loans has steadily climbed during the last four quarters, reaching a median level of 2.7 in the last two quarters (see the chart).
Net charge-offs also remained below historical norms. Despite reporting low levels of losses since the beginning of the pandemic, and a lack of delinquency migration, a majority of banks maintained their existing allowance levels. Many community banks have yet to adopt the new current expected credit losses (CECL) allowance methodology and continue to rely heavily on historical losses to guide their allowance level. Banks will need to adopt the CECL guidance in 2023, at which time there could be more volatility in the allowance levels on a quarter-to-quarter level. Although banks report the end of forbearance programs, which represented loan modifications for consumers and small businesses made under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the ratio of other real estate owned (OREO) loans to net loans dropped again during the third quarter. So far, many borrowers were able to emerge from those programs ahead of schedule and without a significant increase in problem loans. Concerns linger that asset quality issues could reemerge as stimulus balances decline and the economy experiences new disruptions due to the potential for another COVID spike this winter.
Balance Sheet Growth
Rapid asset growth continued at community banks in the Sixth District in the third quarter of 2021, up 13 percent year over year on a median basis. Asset growth—though lower than banks experienced in 2020, as deposit growth slowed—is still higher than the historical norm during the past 15 years (see the chart).
The securities portfolio continued to experience the highest percentage growth, up nearly 30 percent year over year. Municipal bonds and government agency securities remain the preferred investments in the portfolio. Agency securities represented the fifth-largest on-balance-sheet exposure, 35 percent as a percentage of risk-based capital, exceeding multiple loan categories including consumer, farmland, and agriculture. Although the balance sheet continued to expand, banks reported that loan demand slowed early in the third quarter. On a median basis growth, demand was down 9 percent compared with the prior year. Commercial and industrial (C&I) balances declined primarily as a result of the Paycheck Protection Program (PPP) discontinuation (see the chart).
Outside of PPP, the C&I market has not been as robust as the commercial real estate (CRE) market. C&I loan balances declined during the quarter, with the end of PPP and increased PPP loan forgiveness. Many banks indicated that demand had been picking up until the spread of COVID-19’s delta variant slowed expectations. Banks reported demand was generated by some smaller retail and manufacturing businesses seeking to finance inventory to hedge against future supply disruptions and expected price increases. However, these small businesses lack the financial flexibility to finance large quantities of inventory to store over long periods. Still, banks did experience stronger consumer and residential mortgage loan growth as well as positive CRE growth, signaling an increase in loan demand. From the consumer side, after several slow quarters of growth, demand rebounded for mortgages and auto loans. Home purchases represented the majority of the new mortgage originations, roughly two-thirds of the total originations, although low rates were still drawing refinance customers. Home inventories in some high-demand Sixth District markets briefly showed signs of improvement compared with earlier in the year, spurring additional mortgage demand during the third quarter. Vehicle loan originations also improved but were constrained by available vehicle inventories (see the chart).
Year-over-year deposit growth was 15 percent, down from 17 percent in the third quarter of 2020, in between the stimulus payments made in the second quarter of 2020 and the fourth quarter of 2020. Recent deposit growth combined with slow loan growth has pushed the loan-to-deposit ratio down to 62 percent on an aggregate basis as of the third quarter of 2021. By comparison, the ratio was 92 percent as of the first quarter of 2019.
Capital
Year-over-year capital levels drifted downward in the third quarter of 2021 as asset growth experienced by community banks has placed downward pressure on capital ratios. Recent asset growth—driven by the influx of deposits as well as PPP loans that remain on the balance sheet—has caused the leverage capital ratio to decline, pushing it below 10 percent on an aggregate basis. Despite the increased pressure, a majority of banks in the District remained well capitalized. Retained earnings remained the primary driver of capital levels, but the level of capital growth has not matched the level of asset growth in the current environment. Community banks using the community bank leverage ratio (CBLR) as their primary capital ratio received a grace period during the pandemic that allowed them to fall below the minimum 9 percent level to account for the rapid asset growth. Beginning in 2022, the CBLR requirement will return to 9 percent, and the minimum requirement during the grace period will return to 8 percent. For community banks still using risk-weighted capital ratios, the tier 1 ratio improved slightly as weighted asset growth slowed again in third quarter. Risk-weighted asset levels have been more volatile over the last four quarters as banks have shifted funding between cash, securities, and PPP loans (see the chart).
Earnings Performance
Despite the current low interest rate environment, earnings continued to improve in the third quarter of 2021. Effective expense management primarily drove earnings improvement. The median return on average assets (ROAA) across community banks in the Sixth District exceeded 1 percent for the third consecutive quarter (see the chart).
Nearly 60 percent of banks in the District reported an ROAA above 1 percent compared with 4 percent that reported a loss (see the chart).
Median net interest margin for the quarter was 3.43 percent, down from 3.50 percent reported in the third quarter of 2020. The median net interest margin was unchanged from the prior quarter (see the chart).
Margin pressures remain driven by heightened levels of uncertainty, which has kept deposit levels elevated and impeded loan growth, although loan growth started to rebound toward the end of the quarter. Banks were hoping that an increase in loan demand and a decline in deposits would relieve more margin pressure by the beginning of the third quarter, but the COVID-19 delta variant has raised new concerns for small businesses struggling to attract staff and dealing with supply chain issues slowing new loan demand. Still, more than half of community banks reported higher net interest income for the quarter. At the same time, slower deposit growth helped improve interest expense. Banks have indicated that margin pressures likely will bottom out by year-end and pressure will ease by mid-2022.
As delinquencies and charge-offs remain below historical norms, banks reduced provision expense, which continued to aid with earnings, with very few banks in the District reporting a negative provision. Generating noninterest income remained a challenge for banks despite a push to generate more fee income, though it was a positive contributor to earnings during the quarter. In terms of noninterest expense, banks report increased wage pressure and adjusted starting salaries. The aggregate efficiency ratio declined to 54.97 percent in the third quarter of 2021, down from 60.16 percent in the second quarter of 2020, during the peak of the pandemic when banks were recording extra expense for COVID-related cleaning and for salaries as people worked through the lockdown. To manage expenses, banks continued to focus on reducing the level of lower-skilled staff and increasing automation.
Liquidity
Bank liquidity levels remained healthy through the third quarter. Delayed loan growth, combined with sustained deposit levels, have aided overall liquidity levels at banks. The median on-hand liquidity ratio exceeded 30 percent in the third quarter of 2021 and remained slightly higher than peer banks in other Districts (see the chart).
In the third quarter, the loans-to-deposits ratio dropped below 70 percent, a significant decline during the last six quarters. Banks continued to manage elevated levels of deposits. However, the level of deposit growth declined between the second quarter of 2021 and the third quarter of 2021, dropping to 2.6 percent annualized, as stimulus deposits and other extended benefit programs began to end. The new monthly child tax credit payments that began in July 2021 and which are deposited directly for most recipients appear to have slowed deposit runoff and not built deposit levels, as previous stimulus payments did at most banks. Though transaction account balances declined, growth occurred primarily in savings and money market accounts as CD accounts also continued to run off. Larger banks are closely managing commercial deposit levels and making difficult decisions about how much more in deposits they’re willing to accept while loan growth remains tepid. Elevated deposit levels and securities portfolio investments in the current environment have kept the dependence on noncore funding—such as brokered deposits and other borrowings—well below historical levels.
National Banking Trends
Asset quality drove earnings in the third quarter, which limited provision expense. Additionally, interest income improved as loan demand started to pick up toward the end of the quarter. On an aggregate basis, ROAA among all banks was up 25 basis points (bps), year over year, to 1.21 percent (see the chart).
ROAA at community banks increased 16 bps year over year. The aggregate net interest margin at community banks improved slightly, up 7 bps year over year, but is down 50 bps from the third quarter of 2019. In contrast, year-over-year net interest margin declined 10 bps on an aggregate basis across all banks (see the chart).
Community banks remain concerned about earnings drivers during the next few quarters. Pressure on net interest margins is a long-term trend that is unlikely to be reversed quickly as effects from the pandemic fade and short-term interest rates rise once again. The return to more robust loan growth is crucial—especially for community banks—to generate more interest income and improve margins. Larger banks have more diverse revenue streams and are not as reliant on the net interest margin to drive earnings. Meanwhile, strong asset quality metrics have pushed the level of provision expense down, which aided earnings in recent quarters. In aggregate, across all banks, the provision expense as a percentage of loans remained negative for the third consecutive quarter (see the chart).
Larger banks continued to release reserves built during early 2020, as those banks adopted CECL methodology and made assessments about the potential impact of the pandemic. Bank balance sheets continued to expand in the third quarter of 2021, with annualized asset growth rebounding from the prior quarter and reaching nearly 8 percent. Asset growth has been slower in 2021 compared with 2020. Generally, organic loan growth was mixed in the third quarter of 2021, with some banks reporting improved growth based on a variety of factors. Growth hinged primarily on the strength of a bank’s local market.
All banks reported annualized loan growth in the third quarter of 2021 of 1.9 percent, up nearly 5 percent year over year. Among banks with assets less than $10 billion, a majority reported a net year-over-year decline in annualized loan growth, down 6 percent as the PPP ended and balances began to roll off due to loan forgiveness. Expectations are that loan growth will likely return late in the fourth quarter of 2021 or early in 2022. Banks have plenty of low-cost deposits but are struggling to deploy them in a still-recovering economy and in markets with increased competition from nonbank lenders. Increased competition has led some larger community banks to reduce their focus on small business commercial and industrial lending to pursue other opportunities now that PPP has ended. Still, excluding PPP loans, some community banks reported positive loan growth, particularly for consumer, residential, and commercial real estate.
Asset quality remains stable. The percentage of nonperforming loans (those past due 30 days or more) declined 20 bps year over year in the third quarter of 2021 and remained less than 1 percent (see the chart).
The aggregate amount of nonaccrual loans was down sharply compared with a year ago. In general, borrowers are in a better condition financially than they were before the pandemic, keeping delinquency rates from climbing. As a result, larger banks continue to lower their allowance levels, both as a result of lower delinquency rates and a more positive economic outlook. In aggregate, community banks did not release reserves but are maintaining existing allowance levels. Although a few banks have reported some asset quality issues, primarily in commercial and industrial and some commercial real estate, the issues appear isolated. Most asset-quality metrics, such as net charge-off ratios, remain near historical lows. Still, some banks expect that modest asset quality deterioration might occur in 2022 with the end of loan forbearance and other support.