Some observers argue that 2001 will bring an end to
nearly a decade of strong banking conditions. Assessments of banks
by examiners provide a check on such forecasts because examiners
have access to otherwise private information on banking conditions.
Examiner assessments suggest that conditions remain generally solid.
For example, examiner assessments of loans and bank
management have not weakened to date. However, examiners report
incipient signs of weakening in borrowers' future repayment ability.
Bank supervisors also appear concerned about the management of bank
funding as well as bank exposure to changes in interest rates. Moreover,
history suggests supervisors must remain vigilant because banking
conditions can deteriorate rapidly.
Using examiner assessments to evaluate conditions
The standard approach to evaluating banking conditions
involves reviewing and presenting numerous banking performance statistics,
such as the amount of capital banks hold, the amount of loans in
default and the earnings of banks. These statistics come from the
quarterly data banks submit to regulators. Such ratio analysis certainly
provides insight into the conditions of banks. However, an understanding
of the strategies of banks, their exposure to changes in market
conditions and the quality of bank loans and management would provide
a more timely and accurate assessment of banking conditions. It
is these underlying factors that ultimately determine bank performance.
Bank exams generate the data to gain such a detailed understanding
Examiners have unique access to the internal workings
of banks, particularly smaller banks that rarely issue equity or
debt that trades on public markets. Examiners obtain private information
on these institutions by reviewing the risk management systems of
the bank, interacting with bank staff and management and examining
the quality of loans. Based on this private information, examiners
generate assessments of the condition of the bank.
Federal Reserve examiners, for example, review 40
percent of the commercial/industrial, agricultural and commercial
real estate loans of a bank. Supervisors then classify the loans
based on expected performance, with the level of classification
determining how much of a reserve the bank must set aside against
default. A loan that supervisors deem to be substandard, for example,
would have a reserve equal to 25 percent of the loan.
Supervisors also come to opinions about risk mitigation
strategies and techniques of a bank. These and other assessments
are the inputs for supervisory ratings. Ratings for various attributes
of the bank and for the bank as a whole vary from 1 to 5, with 1
being the strongest rating and 5 the weakest.
We rely on the output from this examination process,
as well as discussions with Federal Reserve examiners, to come to
conclusions as to the conditions of banks in the Ninth District.
In the following discussion, we will focus on quality of bank assets
and management, bank funding and bank exposure to changes in interest
rates for Ninth District banks. Although we would prefer to supplement
the views of examiners with assessments from market participants,
the vast majority of banks in the Ninth District, as noted, do not
issue securities priced in public markets.
To set the stage for the discussion of the Ninth District,
it is worth noting that examiner assessments do not indicate significant
deterioration in banking conditions on the national level. The percent
of bank ratings as of 2001 that remained unchanged has varied little
relative to the preceding years. Compare that to a year like 1989
when almost 70 percent of new ratings were downgrades from the previous
rating (see Chart 1).
Examiner assessments in the Ninth District
Assessments of the Ninth District from bank supervisors
suggest fairly solid conditions in terms of management and asset
quality, although there have been some signs of weakening asset
quality. Examiners have increased their concern about bank funding
and sensitivity of banks to interest rate changes.
Asset Quality. Data from the review of bank
loans suggest that asset quality has not changed appreciably over
the last several years. In particular, the percent of loans that
are classified relative to bank assets in the Ninth District has
remained fairly constant (see Chart 2).
Federal Reserve field examiners attribute the solid
loan quality in part to a reduction in exposure to agricultural
losses, such as through the use of government guarantee programs.
Examiners also believe that bankers in the Ninth District
did not relax underwriting standards as much as the largest banks
located outside the district. In addition, Ninth District banks
have taken steps to actively manage loans that have the greatest
potential for default. Even with this good news, examiners expressed
some concern for the future. For example, banks appear to have been
adding more names to the list of borrowers deserving increased scrutiny.
Funding and market sensitivity. Supervisors
were less sanguine about the funding exposure of banks. Examiners
have seen an increase in banks' use of noninsured deposit funding.
Such funds are more expensive and less stable and, therefore, require
greater facility in their management. For example, bank management
must have plans to address a loss of uninsured funding at a time
when obtaining new sources of money could be more expensive. This
type of activity may require new analysis and skills for bank managers.
Bank managers also face a challenge in measuring and
managing their exposure to a change in interest rates. An increase
in rates can reduce the value of bank assets and increase the cost
of bank funding, thus putting the squeeze on bank solvency. Banks
have access to sophisticated tools to measure such interest rate
risk (IRR). However, examiners are not confident that, on the margin,
bank measurement and management have kept up with spikes in IRR.
(For more details on IRR in the Ninth District, see "Interest
rate risk: What is it, why banks would want it and how to evaluate
it" in the July 2000 fedgazette.)
Examiner ratings of bank funding (more formally called
liquidity) and sensitivity to IRR reflect the increased concern.
The percent of downgrades in the rating of these two areas is one-and-a-half
to two times the percent of rating upgrades (see Chart 3).
Management. Examiners assess Ninth District
bank management as solid. Examiners support their conclusion by
pointing to the proactive steps that managers took in administering
their loans and diversifying revenue sources. Examiners also think
that bankers have implemented lessons learned during the banking
crisis of the late 1980s and 1990s. The current ratings for bank
management reflect this stronger assessment in the current period
relative to the banking crisis period when nearly a third of bank
management ratings fell into the worst three categories (less than
10 percent fall into the worst three categories today).
The current strength of management assessment is at
least somewhat comforting when considering the future because managerial
competence protects banks from failure. The difference between banks
that failed during the last agricultural banking crisis from banks
that survived came from decisions made by bank management, rather
than factors outside their control. Banks that made more loans as
a percent of their assets and grew their loan portfolio faster were
significantly more likely to fail. Further evidence attesting to
the importance of sound management can be inferred from the geographic
location of the agricultural banks that failed, since failed banks
were usually located in a county with other agricultural banks that
did not fail. This implies that the failure was not necessarily
related to a deterioration in the local economy.
Examiner concerns going forward
Federal Reserve examiners believe banks face a number
of challenges not yet mentioned. Some banks in rural areas face
a difficult time attracting and retaining qualified staff. Over
a longer term, bankers in much of the Ninth District must cope with
unfavorable, long-term demographic shifts, leading people and funds
out of these district markets. While the rapid advancement in information
technology can create substantial benefits, it also requires additional
human capital that some bankers may find difficult to acquire in
the short term.
Probably the greatest threat to strong conditions
is a significant downturn in the regional or national economy. Economic
downturns can produce a rapid fall in banking conditions. Indeed,
history shows that a bank that had a strong supervisory rating can
fail in a relatively short period of time (see Chart 4).
Of the banks that failed during the 1980-94 period, 25 percent
had a satisfactory or better rating within 12 months of closing. Clearly,
bank supervisors cannot rest on current conditions and assessments.