Lessons from Thriving Banks: It’s a Real-World Stress Test

Bank failures during the recent recession led some people to question the ongoing role of community banks in our nation’s financial system. But a 2013 report by the Federal Reserve Bank of St. Louis (the “St. Louis Fed”) suggests that community banks will continue to play a vital role in the U.S. economy by “allocating credit and providing financial services in their communities — particularly to the small businesses in those communities.”

The report, “The Future of Community Banks: Lessons from Banks That Thrived During the Recent Financial Crisis,” analyzes distinguishing features of banks that thrived during the recession. The authors concluded that community banks can prosper in the future by maintaining strong risk management standards in all economic environments and tailoring their business plans to their markets.

More banks thrived than failed

The St. Louis Fed examined the performance of community banks with less than $10 billion in total assets from the beginning of 2006 through 2011. During that period, 417 banks and thrifts failed. (Another 51 banks failed in 2012.) At the same time, 702 community banks “thrived” — defined as maintaining a composite CAMELS rating of 1 during the study period.

To identify the characteristics that distinguished thriving banks from those that merely survived, the report’s authors analyzed balance sheet and income statement ratios. They also conducted detailed interviews with the leaders of 28 thriving banks.

Highlights of the findings

The thriving banks were located in 40 of the 50 states. Compared with surviving banks, thriving banks tended to be:

• Smaller (a higher percentage had less than $100 million in assets, although the authors don’t believe that staying within a certain size range is the “secret” to thriving),
• More rural,
• Less “loaned up” — that is, they had lower ratios of total loans to total assets,
• Less concentrated in commercial real estate loans,
• Significantly less concentrated in construction and land development loans,
• Slightly more concentrated in one- to four-family property mortgages,
• Slightly less concentrated in commercial and industrial loans,
• More concentrated in agricultural and consumer loans, and
• More reliant on core deposits.

In general, thriving banks outperformed surviving banks in several areas, including return on assets, return on equity, loan losses to total loans, and efficiency ratio. They emphasize noninterest income and tend to have lower ratios of loans to assets and higher ratios of core deposits to total deposits. Several key performance indicators identified by the Fed’s findings include:

Attribute	Thriving banks	Surviving banks
Return on assets	1.5%	0.8%
Return on equity	12.7	7.3
Loan losses / total loans	0.1	0.5
Provision expense / average assets	0.1	0.4
Efficiency ratio	61.1	71.8
Net noninterest margin	1.9	2.3
Total loans / total assets	54.4	65.0
Core deposits / total deposits	83.0	80.7

Source: Federal Reserve Bank of St. Louis

The study also indicated that thriving banks tend to adopt relatively conservative growth strategies during good times, enabling them to capitalize on their competitors’ mistakes during bad times. In the period leading up to the recession, for example, surviving banks enjoyed significantly higher asset growth than thriving banks (44.28% vs. 23.58%). But after the financial crisis hit, growth among surviving banks plunged to 26.91% while growth among thriving banks increased to 31.16%.

The authors acknowledge that agricultural loans performed relatively well during the study period, but that could change in the future. To limit the influence of these loans on their analysis, they examined various attributes separately for urban banks and for rural nonagricultural banks. They found that, for these groups, as for community banks as a whole, the same set of factors appears to correlate with long-term financial health.

The authors note that the local economy can have a big impact on performance. At the same time, a number of community banks thrived in states that experienced the greatest decline in real gross domestic product (GDP) during the study period, and a number of banks failed or received CAMELS ratings of 4 or 5 despite being in states that experienced significant GDP growth.

Insights from bank leaders

Interviews with leaders of thriving banks reveal several important themes. They all embrace conservative loan principles, including limiting lending to their own communities, avoiding opportunities outside their expertise and maintaining strong underwriting standards. Many of these banks also maintained high allowances for loan and lease losses.

They also emphasized strong risk management controls, in some cases sacrificing income in exchange for lower risk exposure. That’s why many of the thriving banks prospered despite high concentrations of CRE assets.

One size does not fit all

The St. Louis Fed report provides valuable guidance on the factors that distinguish thriving banks from those that merely survive, but each bank also needs to consider its individual circumstances. One area where there was little uniformity among thriving banks was their business plans. These banks thrived in large part because they designed their business plans to fit their markets.

You can find the full report at http://research.stlouisfed.org/publications/review/article/9833.

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