Asset Quality
Asset quality metrics for community banks in the Sixth District are consistent with national trends. On the surface, asset quality remains extremely healthy, with low levels of nonperforming loans and an elevated level of allowance for credit losses to nonaccrual loans.
However, charge-offs rose slightly in the quarter and nationally, and larger banks are reporting increases in consumer delinquencies. Although most community banks in the District have small consumer portfolios, an increase in consumer delinquencies nationally could signal more asset quality issues in the second half of 2023. Additionally, secondary indicators like missed small-business rent payments suggest that credit conditions will deteriorate for banks in the coming quarters. Economic uncertainty, along with shifts in demand, are putting more pressure on banks’ commercial real estate portfolios, particularly office, with banks expecting more scrutiny on those loans.
Currently, the allowance for credit losses represents 3.5 times the amount of nonaccrual loans, driven as much by the limited amount of loans in nonaccrual status as any additions to the allowance. Despite the reportedly low level of problem loans, both Sixth District banks and banks nationally indicated that credit conditions continue tighten based on the April 2023 Senior Loan Officer Opinion Survey (see the chart).
Balance Sheet Growth
Median asset growth slowed dramatically in the first quarter of 2023 among Sixth District community banks, dropping to less than 2 percent, the slowest quarterly growth since the first quarter of 2014. The slower growth was below the 10-year trend of 2.64 percent, perhaps indicating that banks are increasingly concerned about economic conditions and struggling to efficiently fund additional growth (see the chart).
Annualized median growth for the securities portfolio has fallen sharply, dropping below 1 percent for the first time since the beginning of the COVID-19 pandemic. Unrealized losses declined on banks’ balance sheets due to a decline in key rates and increases in bonds maturing. After the banking turmoil began in March 2023, yields on the 10-year Treasury note decreased sharply in response so that at quarter’s end unrealized losses were lower than at the prior quarter’s end for many banks in District. Additionally, some lower-yielding short-term bonds have begun maturing, alleviating some of the pressure from unrealized losses.
Yet, despite concerns about the economy and liquidity, loan growth remains elevated compared with the prepandemic trend. On a median annualized basis, loan growth was up 14 percent year over year in the first quarter of 2023, continuing the strongest quarterly growth since the beginning of the pandemic. Although housing demand is reportedly not as strong as the prior year, residential real estate loan growth remained elevated in the first quarter of 2023, rising 16.6 percent year over year on a median basis. Some of the increase in residential lending might be attributable to refinancing other debts that have higher interest rates, although cash-out refinancing has been slowing in recent months. In addition to residential, banks continued to fund more commercial and development projects. Still, the loan growth outlook is deteriorating because of factors like higher funding costs and credit and liquidity concerns. In addition, banks are considering reducing loan production to avoid relying too heavily on wholesale funding (see the chart).
In line with national trends, median annualized deposit growth dropped to less than 1 percent for community banks in the Sixth District. Year over year, aggregate deposit balances are down 30 basis points as they continue to experience steady deposit outflows. As a result, banks are relying more heavily on borrowings to fund the balance sheet. Banks are primarily using a combination of 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.
Capital
For now, capital has not been significantly affected by shifts in funding sources and turmoil caused by recent bank failures. According to call report data from the first quarter of 2023, roughly 60 percent of community banks in the Sixth District would be considered well capitalized. On an aggregate basis, the total risk-based capital ratio remained basically unchanged from the first quarter of 2022. The aggregate level of the community bank leverage ratio (CBLR) indicates that a majority of the banks using the CBLR met the 9 percent minimum required in the first quarter of 2022 as the aggregate leverage ratio improved by 65 basis points year over year (see the chart).
Though the level of unrealized losses from the securities portfolio remains a concern, banks reported a second consecutive quarter of improvement primarily as a result of a decline in treasury rates associated with bank failures. On a median basis, the change in unrealized losses added to capital during the quarter. Yields on Treasury bills maturing soon have fallen from recent highs, a sign that investors are no longer worried about the possibility of a default on federal debt now that the debt limit deal has passed the House. Furthermore, the impact on unrealized losses for banks is not expected to be detrimental.
The dividend payout ratio declined from the first quarter of 2022 to the first quarter of 2023. Given that banks are experiencing a higher level of uncertainty, more banks may be conserving capital in case they need a higher allowance level going into the latter half of 2023.
Earnings Performance
Margin contraction restrained overall profitability in the first quarter, causing the median return on average assets (ROAA) to decline slightly from the fourth quarter of 2022, but it remains higher than in the first quarter of 2022 due to higher interest rates (see the chart).
Just under 65 percent of community banks in the District reported an ROAA above 1 percent, down slightly from the prior two quarters. However, the percentage of institutions in the District reporting a net loss also declined to under 4 percent.
Call report data for the first quarter of 2023 show more banks in the Sixth District with assets under $10 billion reported a shift downward in net interest income and net interest margin on a median basis. Banks had primarily benefited from rising rates in 2022, but declining deposits and concerns over recent bank failures have pushed funding costs upward.
Interest expense is increasingly driving changes in ROAA. Given the length of time in which Sixth District community banks reported elevated deposit levels, increases in deposit costs at those banks were generally lower and slower relative to larger national banks throughout 2022. But many banks in the District expect price increases will be more in line with competitor institutions throughout 2023 to prevent customers from shifting deposits out of noninterest-bearing accounts into higher-yielding accounts such as certificates of deposit, at other banks (see the chart).
Liquidity
On an aggregate basis, banks in the Sixth District are experiencing a decline in their deposit base. Sharp interest rate increases and customers moving deposits into higher-yielding alternatives put ongoing pressure on liquidity despite relative calmness following the failure of Silicon Valley Bank (SVB) and other bank failures. Spillover from bank failures has increased concerns about depositors shifting balances to other entities.
As deposits have declined, the median loans-to-core deposits ratio has increased, reaching 73.7 percent in the first quarter of 2023 compared with 64.1 percent in the first quarter of 2022.
To date, banks are not reporting a significant shift in the composition of short-term deposits. Transaction accounts still make up a higher percentage of short-term deposits than in 2007, before interest rates were lowered in response to the financial crisis. Yet, Sixth District banks have reported an increase in longer-term time deposits, which are helping stem demand deposit runoff. Time deposit balances are up 60 percent year over year (see the chart).
Banks are heavily relying on noncore funding options, such as Federal Home Loan Bank advances and other borrowings, to improve their liquidity and satisfy regulatory requirements. Growth in borrowings now exceeds over 80 percent year over year at small banks through the first quarter of 2023, showing the sharp shifts in the deposit base as well as ongoing loan growth. Borrowing growth among Sixth District banks has receded from the highs seen in mid-March, as turmoil over bank failures has cooled but the level of growth remained elevated at quarter’s end.
National Banking Trends
In aggregate, community banks (assets less than $10 billion) reported lower first-quarter earnings as a result of lower loan demand and higher funding costs. Aggregate return on average assets (ROAA) was 1.17 percent at community banks, down from 1.30 percent reported in the fourth quarter of 2022. By comparison, ROAA for banks of all sizes was up 16 basis points from the prior quarter. Expense management was a key driver as banks continued contending with rising interest rates, shrinking loan demand, and concerns about liquidity (see the chart).
As interest rates have risen, banks are facing higher deposit costs, which has put more pressure on net interest margins. Community banks were able to limit the level of deposit pricing increases in the prior year. However, stress over funding that emerged in March 2023 due to bank failures have clearly accelerated changes in deposit pricing as community banks are aggressively trying to retain existing deposits and attract new funding. The effort to stabilize the deposit base will likely lead to higher deposit prices and downward pressure on community banks’ net interest margins for the remainder of 2023 (see the chart).
Given the need for funding and concerns about rising interest rates, banks continued to reduce their securities portfolio exposures through a combination of sales and maturities. Total securities declined nearly 5 percent on an aggregate basis compared with the prior quarter. At the same time, loan balances declined by nearly 1 percent, continuing an ongoing trend of slower growth from the last two quarters of 2022. Loan growth slowed across all loan types, with aggregate consumer loan balances driving the declining balances during the quarter (see the chart).
Reported asset quality remains healthy in the first quarter of 2023, but recession concerns remain. In the first quarter of 2023, many community banks adopted the current expected credit loss (CECL) methodology of estimating losses. As expected, the aggregate allowance for credit losses as a percentage of nonperforming loans rose. Aggregate noncurrent loans, classified as 30–89 days past due, as a percentage of total loans dropped to 54 basis points at community banks, returning to a cycle low.
Deposits continued to decline, down 1 percent year over year, as concerns about recent bank failures drove some depositors to switch to other financial institutions. Additionally, more customers are seeking higher-yielding products, which is also increasing funding costs for community banks at a time the banks are relying more on higher-cost funding sources like Federal Home Loan Bank advances (see the chart).