April 3, 2023

Asset Quality :: Balance Sheet Growth :: Capital :: Earnings Performance :: Liquidity :: National Banking Trends 

Asset Quality

Although secondary indicators, such as missed rent payments, suggest that credit conditions are normalizing, community banks in the Sixth District reported that nonaccrual loans remain at historical lows, representing just 14 basis points of total loans, on a median basis as of the fourth quarter of 2022. As a comparison, nonaccrual loans were 45 basis points of total loans in the fourth quarter of 2019.

However, community banks in the District did report an increase in delinquencies, with commercial and industrial loans and consumer loans increasing the most among loan categories. Though still low by historical standards, banks reported the first measurable movement between past due 30–89 days to past due greater than 90 days for the first time since the third quarter of 2020.

The relatively low level of problem loans has not forestalled banks, both in the District and nationally, from continuing a cycle of tightening lending standards over the fourth quarter of 2022, according to the January 2023 Senior Loan Officer Opinion Survey.

Strong loan growth continues to push the ratio of allowance for credit losses to total loans downward, dropping to 1.25 percent, the lowest level in 12 quarters. Still, the aggregate amount of allowance for credit losses represents nearly three times the amount of nonperforming loans and nearly 3.8 times the amount of nonaccrual loans (see the chart).


Balance Sheet Growth

As interest rates have moved higher, asset growth normalized through 2022 among Sixth District community banks. Annualized asset growth, on a median basis, slowed sharply in 2022, dropping to just 2.55 percent in the fourth quarter of 2022. The slower growth was more in line with the 10-year prepandemic average of 2.64 percent than growth seen in 2021 (see the chart).


Slower year-over-year deposit growth and falling securities portfolio values have weighed on growth rates during the last two quarters. Annualized median deposit growth dropped to 3.60 percent in the fourth quarter as community banks experienced significant deposit outflows. Higher interest rates have enticed some depositor funds into higher-yielding products offered by competitors. At the same time, the fair value of the securities portfolio has declined, pushing unrealized losses higher.

As a result, banks are borrowing more to fund balance sheets, using wholesale funding options like brokered deposits and Federal Home Loan Bank advances. In many cases, banks are using securities and loans as collateral for the borrowings, with higher haircuts on the value of the collateral being required.

The higher unrealized losses don’t have a direct impact on regulatory capital for most community banks, as most of them opted out of the inclusion of accumulated other comprehensive income (AOCI) in 2015. However, one concern has been the impact on tangible equity, which includes AOCI, and the ability to borrow from some wholesale funding sources. After noticeably declining in both the second and third quarters, tangible equity improved in the fourth quarter on the strength of higher earnings and smaller unrealized losses in the securities portfolio.

Loan growth continued to surprise given economic conditions. On a median annualized basis, loan growth was up 12 percent year over year in the fourth quarter of 2022, the strongest quarterly growth since the second quarter of 2020. Unexpectedly, residential real estate loan growth remained healthy through the fourth quarter of 2022, rising 14.5 percent year over year on a median basis. In addition, both commercial and industrial and consumer lending remained strong (see the chart).


Growth in commercial real estate (CRE) exceeded 10 percent on an annualized median basis. Community banks have become among the few lenders willing to finance commercial mortgages as larger banks have reported a desire to reduce their lending on CRE over concerns about valuations. The construction and development portfolio also experienced strong growth, roughly up 25 percent year over year, which may be a concern should the economy slow suddenly. Regulatory guidance on construction suggests that banks should have strong risk management practices around managing the growth of the construction portfolio.



A majority of community banks in the Sixth District remain well capitalized. On an aggregate basis, the total risk-based capital ratio declined slightly while the leverage ratio saw a slight increase thanks to improvement in net interest income.

Losses in the securities portfolio remain a concern. Banks in the Sixth District showed a slight improvement in the unrealized losses reported on their available-for-sale securities, primarily due to a brief dip in mortgage rates at year-end. Equity account accumulated other comprehensive income (AOCI), which captures changes in fair value on available-for-sale securities, continued to reflect higher losses in the fourth quarter. Elevated unrealized losses have yet to affect regulatory capital, as most banks opted out of the inclusion of AOCI in 2015.

From a regulatory capital perspective, banks that sell mortgage-backed securities with elevated losses risk putting downward pressure on their capital ratios. Estimates suggest some banks would fall below minimum ratios for being well capitalized should they recognize existing unrealized loss (see the chart).


Earnings Performance

A majority of Sixth District institutions reported improved earnings in the fourth quarter of 2022, with the median return on average assets (ROAA) increasing to 1.22 percent, up 27 basis points from the fourth quarter of 2021, through higher net interest margins and continued loan growth (see the chart).


More than 65 percent of community banks in the District reported ROAA above 1 percent, compared with 45 percent in the prior year, with 5 percent of institutions in the District reporting a net loss. Net interest margins at community banks in the Sixth District have improved dramatically from recent troughs, driven almost entirely by the increases in interest rates during 2022. Nearly 70 percent of banks reported a higher net interest margin, the second-highest percentage in more than 10 years (see the chart).


Banks continued to benefit from strong loan production, at higher interest rates, in the fourth quarter. However, expectations are that deposit costs will continue to accelerate in 2023. In addition, community banks in the District are also increasingly relying on Federal Home Loan Bank advances and other noncore funding options that will push costs higher in the next few quarters.

Concerns about the direction of the economy pushed the provision for credit losses higher during the quarter. As a percentage of average loans, provision expense has jumped from 7 basis points in the fourth quarter of 2021 to 25 basis points in the fourth quarter of 2022 at community banks. Continued economic uncertainty and the transition to current expected credit losses will likely lift provision expense even higher during 2023.

Efficiency ratios also climbed as noninterest income declined during the quarter as a result of fewer deposit fees and slower loan sales.



The median on-hand liquidity ratio continued to decline from its cyclical high of 34.1 percent, as of the first quarter of 2022, to 23.6 percent as of the fourth quarter of 2022, reflecting an increasing outflow of deposits (see the chart).


Liquidity pressures noticeably increased in the fourth quarter of 2022 at community banks as they struggled to match higher rates offered by either treasuries or money-market funds. Community banks in the District are increasing deposit rates over the concern that customers will transfer balances to other institutions offering higher rates. As deposits have declined, the median loans-to-core deposits ratio has increased. Banks are also increasingly using noncore funding options, such as Federal Home Loan Bank advances and other borrowings, to improve their liquidity and satisfy regulatory requirements.

At the same time, community banks lack access to liquidity from their securities portfolios due to the level of unrealized losses in the portfolio. In 2020 and 2021, institutions used a rapid influx of deposits to purchase securities with higher yields but longer durations because loan demand at the time was insufficient to effectively deploy all the additional deposits.

Banks have historically held securities on balance sheet to meet liquidity needs. However, in 2022, deposit balances started to decline when the fed funds rates suddenly shifted, increasing 425 basis points in 12 months, leaving banks exposed to rapidly declining valuations in the securities portfolios.


National Banking Trends

Earnings at community banks (assets less than $10 billion) improved in the fourth quarter compared with the prior year but were flat compared with the prior quarter. Aggregate return on average assets was 1.31 percent at community banks, up from 1.18 percent reported in the fourth quarter of 2021. Limitations on loan sales, as well as lower fees and higher provision costs, started to drag on earnings during the quarter for the first time since the second quarter of 2020 (see the chart).


Healthy loan growth, higher interest rates, and manageable increases in deposit rates boosted community banks’ net interest margin by 50 basis points in the fourth quarter of 2022 over the fourth quarter of 2021 to 3.77 in aggregate. Improvement was largely driven by higher rates, with the fed funds rate up 425 basis points from the beginning of 2022. Still, margin growth at community banks has lagged growth at larger institutions. In addition, rising funding costs at community banks are expected to limit further margin improvement in 2023. Competitors, including other financial companies like fintechs, are becoming increasingly aggressive with raising their rates on deposit products (see the chart).


Asset growth rebounded in the fourth quarter of 2022 as surprisingly strong loan growth lifted balance sheets while unrealized losses continued to climb—but at a slower pace—in the securities portfolio. Loan growth has been spread across the majority of loan types, including residential loans, despite higher mortgage rates and slower home sales. Banks have shown a willingness to expand their exposure to commercial real estate as well, despite concerns about valuations and future office use (see the chart).


Deposit growth continued slowing as some depositors switched to other financial products in search of higher yields. Among community banks, deposits increased more than 1 percent year over year. Increasingly expensive certificates of deposit and other borrowings replacing the rapidly outflowing core deposits on the balance sheet at most institutions, as they look to noncore funding for liquidity requirements.

Higher interest rates have pushed the value of securities portfolios downward, since the existing securities held by community banks generally have lower yields than newer issuances. Rather than selling the securities and taking the loss, institutions are pledging securities as collateral for other borrowings to increase their liquidity.

Asset quality remains favorable. As of the fourth quarter of 2022, the percentage of nonperforming loans at community banks was still near historic lows at 59 basis points. Allowance for credit losses represented more than two times the level of noncurrent loans at the fourth quarter of 2022. Additionally, many community banks will adopt the current expected credit losses methodology at the beginning of 2023, which will push allowance balances even higher based on the experience with larger banks (see the chart).