ByGary S. Corner , Emily Dai , Daigo Gubo
Community banks in the U.S. have significantly increased their municipal securities holdings since the onset of the financial crisis. Increased holdings of municipal bonds mean possible increases in interest rate risk, credit risk and liquidity risk. Without a well-considered asset/liability management strategy, these risks may manifest themselves at just the wrong time.
An analysis of call report data reveals that U.S. commercial banks’ municipal securities as a percentage of total assets have elevated significantly since the financial crisis, especially for community banks (Figure 1). The trend also holds in the Eighth District as shown in Figure 2.
Several factors may have contributed to community banks’ increased municipal exposure. A provision of the American Recovery and Reinvestment Act of 2009 (ARRA) increased the tax efficiency of municipal bonds issued in 2009 and 2010. This tax treatment change provided a strong incentive for banks to deploy funds into municipal bonds holdings. This trend continued in 2011, 2012 and 2013, even though banks no longer benefited from the favorable tax treatment. Thus, seeking yield may be another factor behind the increase in municipal securities holdings. In a low interest rate environment, banks are under pressure to find sources of additional earnings. With ample funds to deploy and reduced lending opportunities, municipal bonds remained attractive compared to other lower-yielding assets.
Significant municipal bond holdings bring increased risk in several areas. One is interest rate risk, a major threat to all fixed income securities holders. At the end of the first quarter, for banks with total assets under $10 billion, the unrealized gain from their municipal securities portfolios was $4.7 billion. By the end of the second quarter, the gain slid to less than $0.4 billion. The $4.3 billion decline in value of the municipal securities was equivalent to 1.9 percent of these banks’ tier 1 capital.
Community banks with significant municipal bond holdings also face potential credit risk and liquidity risk. Financial stress on state and local governments has increased since 2008. Local governments continue to face significant challenges: a slow economic recovery, mounting pension and health care liabilities, and continued decreases in funding from federal and state governments. However, extremely distressed state and local governments are outliers and are not reflective of the overall credit profile of the municipal bond market, especially the general obligation debt market. On the other hand, community banks’ holdings include a significant amount of smaller, infrequently traded municipal issuances for which liquidity risk cannot be ignored.
Municipal bond holders also face potential structural changes in the municipal bond market. The city of Detroit’s recent bankruptcy filing created significant anxiety in the municipal bond market. Detroit’s appointed emergency manager has proposed classifying some general obligation unlimited tax (GOULT) bonds as “unsecured” debt. Rating agencies usually give GOULT bonds high ratings because municipal governments generally attach these bonds with unlimited property taxing authority to fulfill the obligations of these bonds. An unfavorable court ruling for bond holders in this case may have a far reaching effect on the credit ratings and ultimately the prices of municipal bonds. Although banks are now required to assess the credit quality of municipal bonds independently, many other municipal bond market participants rely on the ratings.
Since the onset of the financial crisis, community banks’ balance sheets have seen greater investment in municipal bond holdings. While favorable tax treatment and yield opportunity nudged community banks in this direction, the potential risk buildup should not be ignored. The municipal bond market also might have structural changes in the near future as long-held assumptions on the credit strength of general obligation bonds are being tested. These factors increase the need to monitor municipal bond portfolios closely.