Asset Quality
Asset quality metrics for Sixth District community banks remain strong with low current levels of delinquencies and nonperforming loans as a percentage of net loans. Reserves are at a historic high with coverage at 1.3 times total loans and 3.6 times nonaccruals. Consistent with national trends, slowing conditions in commercial real estate were led by office loans, with Sixth District community banks experiencing a minor uptick in loans 90 or more days past due during the quarter.
Sixth District community banks experienced a year-over-year increase in consumer charge-offs, with an uptick in early card delinquencies over the quarter. With the resumption of federal student loan repayments this fall, many consumers may be under greater financial stress, which could adversely affect other consumer product types, including auto and residential real estate (see the chart).
Balance Sheet Growth
Median asset growth continued to slow during the quarter, reaching a new 10-year low of 1.5 percent. Given concerns about funding and the economic environment, community banks report being more strategic about how they approach growth and are willing to shrink the balance sheet in some cases.
Loan growth across most portfolios slowed during the quarter but remained strong at close to 13 percent year over year on a median basis, driven by growth in commercial real estate (CRE) and residential real estate. CRE growth is expected to slow as a result of tightened underwriting standards and reduced funding commitments. Housing prices and demand throughout the Sixth District remain resilient despite headwinds created by mortgage rates at a 20-year high.
Even with increases in interest rates, community banks reported stability in their securities portfolio, with unrealized losses still elevated compared with prepandemic levels. Normalization of the higher interest rate environment has resulted in a heightened focus on interest rate and liquidity risk management by institutions during the past year, with many having a greater understanding of the effect of the rate environment on their securities portfolio.
Consistent with national trends, Sixth District community banks experienced deposit outflows during the second quarter of 2023 as depositors sought higher-yielding accounts with deposit competitors (see the chart). Median annualized deposit growth dropped to around negative 1 percent. As a result, banks placed increased reliance on wholesale funding sources to boost liquidity and fund the balance sheet.
Capital
A majority of Sixth District community banks remain well-capitalized. Total risk-based capital and tier 1 capital ratios decreased nominally during the quarter as a result of increases in risk-weighted assets. Capital levels declined during the prior quarter, driven by unrealized losses on securities portfolio, indicating that unrealized gains experienced since December 2022 were not a sustained trend.
A limited number of banks in the District use the community bank leverage ratio (CBLR). In aggregate, the CBLR exceeded the 9 percent minimum and increased 9 basis points over the prior quarter.
The dividend payout ratio declined for the third consecutive quarter, indicating that banks might be conserving capital in light of continued uncertainty.
After the end of the second quarter of 2023, the banking agencies released a proposal to modify bank capital requirements for large banks in an effort to better reflect underlying risks and increase the consistency of measuring risks in the capital allocation process (see the chart).
Earnings Performance
Sixth District community banks demonstrated earnings resilience relative to community banks nationwide. Improvement in net interest margin was driven by higher rates on earning assets relative to funding costs, with yields on loans and leases increasing to more than 6 percent during the quarter. Interest expense increased during the quarter as banks offered higher rates to retain deposits (see the chart).
Median return on average assets (ROAA) improved slightly from the first quarter of 2023 and 16 basis points year over year as a result of higher interest rates. The percentage of community banks with ROAA above 1 percent held constant at close to 65 percent (see the chart).
Despite concerns about the economy, provision expense had a positive impact on ROAA as banks continue to adjust to the new current expected credit loss methodology. Efficiency ratios in the District climbed during the quarter, consistent with national banks, though fewer banks report sharp increases in salary to maintain employment levels.
Liquidity
Deposit declines have driven an increase in the median loan-to-core deposits ratio to a two-year high of 78 percent. The composition of short-term deposits remained stable over the quarter with transaction accounts still the primary funding source.
Time deposits—particularly those over $100,000—continued their significant growth since year-end 2022, helping to stem deposit runoffs. Time deposits grew more than 10 percent during the quarter as depositors sought higher yields. Outflows could slow as the gap narrows between deposit rates and higher-yielding alternatives such as treasuries and money market funds.
Sixth District community banks are increasing reliance on noncore funding sources such as Federal Home Loan Bank (FHLB) advances and other borrowings to bolster liquidity. Total FHLB advances grew almost 90 percent year over year driven by an increase in short-term borrowings with new advances in both intermediate and longer-term borrowings (see the chart).
National Banking Trends
Community banks (those with total assets of less than $10 billion) are stable, despite continued earnings pressure during the second quarter and pessimism with respect to the trajectory of the overall economy. Community banks experienced a second consecutive quarter decline in net interest margin (NIM), driven by rising funding costs. Revenue pressures led to an uptick in merger and acquisition activity, with additional transactions anticipated during the year, given expectations of further community bank earnings contraction (see the chart).
Aggregate return on average assets (ROAA) increased approximately 5 basis points at community banks during the quarter, to 1.21 percent, and the banking sector largely reversed the increase in ROAA experienced during the first quarter of 2023. This was largely attributed to stronger community bank loan growth relative to the sector overall. Similarly, provision expense at community banks remained flat while provisions at commercial banks more broadly increased quarter over quarter. This indicated that the decline in provision expense for all commercial banks seen in the first quarter of 2023 was a deviation from an otherwise continuous upward year-over-year trend in anticipation of continued economic uncertainty and deterioration in credit conditions. Community bank efficiency ratios continued to deteriorate, increasing to 60.81 percent as of the second quarter of 2023 (compared to all commercial banks with efficiency ratios of 56.14 percent), as a result of increased expenses relative to revenues (see the chart).
Community bank deposits have gradually declined since the third quarter of 2022. Repeated interest rate hikes since March 2022 led to intense deposit competition, driving many community banks to shift their funding mix toward more expensive wholesale sources, including brokered deposits, borrowings from Federal Home Loan Banks, and certificates of deposits. Deposit pressure is expected to continue in future quarters, which could result in banks continuing to raise rates on interest-bearing accounts, further compressing NIM. In July 2023, The Federal Deposit Insurance Corporation issued regulatory guidance that could result in certain community banks, with assets more than $1 billion, to restate their call reports to correctly account for uninsured deposits. For this reason, reported increases in uninsured deposits in the future could be a result of a reporting adjustment rather than a change in deposits.
Community banks reported strong asset growth over the quarter (see the chart). Asset quality at community banks remains stable with noncurrent loans as a percentage of total loans (those defined as 30–89 days past due) remaining relatively flat at 55 basis points over the quarter. Going forward, lenders might approach new originations with greater caution. Year-over-year growth in community banks’ allowance for credit losses, as well as tightening underwriting standards across all lending categories, indicates that lenders anticipate deterioration in collateral values and asset quality over the remainder of 2023. Commercial real estate (CRE) lending by all commercial banks, and in particular community banks with CRE concentrations, exhibit heightened vulnerability given higher interest rates, lower occupancy rates, and weaker product demand. Asset quality deterioration, coupled with compressed earnings, could result in a focus on capital preservation and earnings retention in lieu of growth (see the chart).
Banks continue to experience unrealized losses on their securities portfolios. Some community banks may choose to sell securities at a realized loss and use cash proceeds to pay down high-cost debt or reinvest in higher-yielding assets. Unrealized losses might remain elevated depending on the trajectory of the economy, inflation, Federal Reserve policy action, and investor reactions.