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Central Banker | Spring 2013

Community Bank Lending during the Financial Crisis

The total volume of loans held by community banks peaked in 2008 and dropped during the financial crisis and Great Recession. Total loans bottomed out in 2011 and, as of December 2012, have only recovered to a level roughly 10 percent below their 2008 peak.

During this period, both demand and supply factors undoubtedly played roles in the change in bank lending. In the years before the crisis, the perception of ever-rising residential and commercial real estate prices caused loan demand to soar. On the supply side, some (though certainly not all) banks relaxed assorted underwriting standards, accepting applicants with little equity or with overly optimistic property appraisals and income forecasts. During the financial crisis, Great Recession and sluggish economic recovery, business and household loan demand weakened considerably as firms and households cut spending, increased savings and increased balance sheet liquidity. On the supply side, banks that had relaxed some standards naturally raised them to more sustainable levels in an effort to reduce their risk and to limit further losses. Thus, both demand and supply factors contributed to the drop-off in lending, and the relative contribution of each factor is difficult to distinguish.

Community Bank Lending Trends

Quality loans and local deposit-taking are the foundation of community bank profits and growth. Despite the financial crisis, healthy community banks still had an incentive to maximize profits by lending, as long as risk factors were balanced. As illustrated in Figure 1 below, small community banks across the Eighth Federal Reserve District did increase the size of their total loan portfolios compared to their 2007 levels.1

KEY



Figure 1

Total Loans

The story is different for the other groups of community banks, however, as their total loans experienced a notable decline relative to their 2007 levels. In fact, across the loan categories we reviewed—commercial real estate, 1- to 4-family first-lien loans, and commercial and industrial loans—the data suggest that small Eighth District community banks collectively experienced more stability in lending volume than large Eighth District community banks and community banks nationwide.

One example is in commercial real estate lending. From 2008 onward, commercial real estate lending dropped in all four groups of banks, as seen in Figure 2 below. A major factor in this decrease was the fall in commercial real estate prices across the nation. Lending has increased somewhat in small Eighth District community banks and appears to have leveled off in the other bank categories.

Figure 2

Commercial Real Estate Loans

In reviewing 1- to 4-family loan volumes, more stability is shown across community banks both nationally and District-wide, as seen in Figure 3 below. For all four groups, total loan volume was higher in 2012 than in 2007. It is important to note that these mortgages are the ones that community banks have kept in their own portfolios, as opposed to the ones that they have sold in secondary markets. During this period, the default rate on loans in banks’ own portfolios was lower than those in the securitized secondary market.

Figure 3

1- to 4-Family First Mortgages

Next we turn to commercial and industrial lending. Across all groups, commercial and industrial lending volume largely declined relative to 2007 levels, as seen in Figure 4 below. But again, the lending pattern for small Eighth District banks was the most consistent. In a push to diversify away from the hard-hit commercial real estate sector, many lenders are emphasizing commercial and industrial lending. Anecdotally, community bank lenders report that they increasingly find themselves competing with regional-sized institutions for the same customers.

Figure 4

Commercial and Industrial Loans

Loans as a Percentage of Community Bank Balance Sheets

The data suggest that growth in community bank total assets has outpaced the growth in community bank total loans, as seen in Table 1 below. As the returns on other personal investment vehicles fell dramatically, customers flooded banks with deposits, causing a huge increase in liquidity. Loan demand could not absorb all of the funds; so, the banks funneled many of them into investment securities and cash balances. Of course, this surge in deposits may quickly dissipate as depositors’ economic opportunities change.

TABLE 1

Growth in Community Bank Total Assets

YearNumber of Community BanksAverage Assets of Community BanksTotal Loans/Total Assets
2007 – District 717 $267.2 million 69.7%
2012 – District 645 $332.6 million 60.3%
2007 – U.S. 7,139 $319.9 million 68.9%
2012 – U.S. 5,949 $384.4 million 60.7%

NOTE: Community banks are those that averaged less than $10 billion in total assets over the six-year period.

In terms of earnings, the opportunity cost of holding excess liquidity is significant. Consequently, community banks’ profitability is unlikely to reach historical norms with their current balance sheet mix. Of course, community bankers are cognizant of their high levels of liquidity and are generally poised and eager to lend.

Conclusion

Community bank lending has apparently turned a corner and is rising again after a prolonged decrease during the financial crisis. Although demand and supply factors play difficult-to-measure roles, one factor that stands firm is that community banks have a strong profit motive to pursue quality lending relationships and are not presently constrained by balance sheet liquidity needs.

Endnotes

  1. Small community banks are defined in this article as institutions with less than $1 billion in assets, while large community banks have between $1 billion and $10 billion in assets.  In all of the figures, banks are assigned to a size class based on their average assets over the full six-year period; so, no banks move between size classes.  To facilitate comparisons across size classes and geographic regions, each time series is indexed to 100 at the beginning of the period (December 2007). [back to text]

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