The Federal Reserve Bank of Minneapolis and the Conference of State Bank Supervisors recently sponsored a supervisor-only seminar on banking and banking supervision in shale energy boom locales.1 The goals of the seminar were to (1) share information on how the boom affects communities and the community banks operating in them and (2) discuss how supervisors are responding to these changes now and might respond in the future. I found the discussion from my state supervisory colleagues and presenters of significant value, with broadly applicable lessons learned. Speaking solely for myself, I took the following four related points away from the meeting.
- It may prove tempting in an environment with pressure on bank profits and growth for banks to seek out lending opportunities in areas with very strong growth prospects. Out-of-territory participations originated out of shale boom areas could provide needed returns to a bank. Supervisors expect banks to underwrite such participations as if they were the bank’s originations. That could prove challenging for some banks given the expertise needed to underwrite a loan whose repayment is tightly linked to oil/gas development. To restate this in the affirmative, successful lenders operating within the market manage the risk of a volatile energy sector, in part, by amassing significant information about local conditions and borrowers that is hard for an outsider to replicate.
- Lending in a shale boom area turns virtually all loans into energy-related loans. For example, an auto loan could be dependent on income from oil exploration employment for repayment. But the boom simply highlights a concentration that is almost always present for community banks, particularly those operating in less urban areas. There are some prudent ways that banks can significantly diversify away from their home geography—through the size and composition of their securities portfolios. But those diversification tools have important limits, not the least of which is serving the local community, the mission of all community banks. As a result, community banks must manage the risk of heavy exposure to a limited geography within that local area. They can do so by limiting exposure within a concentrated portfolio, adjusting underwriting standards to meet the specific risk posed by a borrower and point in time, considering government guarantee programs, and amassing private information about borrowers more generally. Put another way, banks create the space to serve their local communities through active risk management and detailed information generation about customers.
- Timing matters, but it is nearly impossible to time your way to effective risk management. It seems likely that financing the first new hotel in an energy boom’s heretofore small locale is less risky than financing the 20th hotel. But timing markets with a fair amount of volatility is challenging to say the least. Banks trying to make the last loan at the peak seem more dependent on luck than may be prudent.
- While it is a cliché, supervisors must find a balanced approach to the potential risks I just noted. Just because times are at their best does not mean the end is near. Moreover, banks exist to provide credit; a boom seems a reasonable time for credit to flow. At the same time, supervisors cannot count on a permanent elimination of volatility to ensure that banks are safe and sound. Finding the right lines is the challenge for banks and supervisors.