Remarks by Chairman Ben S.
Bernanke
At the Independent Community Bankers of
America National Convention and Techworld, Las Vegas,
Nevada
March 8, 2006
Community Banking and Community Bank Supervision in the
Twenty-First Century
Good morning. I am pleased to join you today to discuss matters of
mutual interest to the Federal Reserve and community banks; to learn more
about your business; and, I hope, to meet many of you in person.
Community banks have long played a critical role in the U.S. economy,
and this is no less true in the twenty-first century. Today, I will begin
by making some observations, based in part on research done at the Federal
Reserve and elsewhere, about the health of community banks and their
evolving role in our economy. Community banks are generally doing quite
well, and I expect that good performance to continue. But community banks
also face a changing business environment that presents a number of
important long-run challenges. In the second portion of my remarks, I will
speak a bit about how the Federal Reserve, as the supervisor of many
community banks, is also adjusting to a changing environment, and I will
review some of the key financial risks facing community banks.
Developments in Community Banking
By a wide variety
of indicators, the overall performance of community banks in recent years
has been quite strong. Average return on equity (ROE), for example,
following a decline associated with the 2001 recession, remains solid and
indeed has shown a slight upward trend. Return on assets for community
banks as a whole demonstrates a similar pattern and has stayed well above
traditional benchmarks of strong performance. Net interest margins remain
higher than those of the largest banks, and this gap has even widened
since 2003. Various measures of loan quality for community banks have been
robust, and bank failures have been rare. Equally important, both our
on-site examinations and our off-site surveillance system, which uses
statistical models to attempt to flag emerging weaknesses at community
banks, detect signs of potential problems at very few banks. Consistent
with this view, community bank capital ratios remain impressively high,
and community banks' ability to attract deposits continues to be a source
of strength.
One strong indicator of the continued health of community banks is the
rate at which new banks continue to be created. For example, if we define
a community bank as any bank or thrift organization with total real (2002)
assets of a billion dollars or less, slightly more than 700 community
banks were formed from the beginning of 2000 through 2005, an average of
about 120 per year. Clearly, many people remain willing to invest in the
future of community banking. The Board has long taken the view that
community banks will remain a vigorous and innovative sector of the
economy. I think that forecast remains a good one today.
All of this is good news. But I am sure that many in this audience
would agree that community banks also face serious challenges. Expansion
of the geographic scope of banking activities, rapid technological change
in the production of financial services, the increasing importance of
nonbank providers, and evolving patterns of economic growth are among the
factors that are changing the banking marketplace. And, while many of
these changes have improved the efficiency of our financial system and
lowered costs for consumers, it is only realistic to acknowledge that they
also present new and sometimes daunting tests for community banks.
Indeed, we have seen major shifts in the structure of the U.S. banking
industry in recent decades. Under the same definition of community banks
that I used a moment ago, the share of banking industry assets held in
community banks has fallen from about 20 percent in 1994 to a little more
than 12 percent in 2005. In addition, the number of community banks has
dropped from more than 10,000 in 1994 to about 7,200 in 2005. Other
definitions of community banks and other structural measures, such as the
share of total deposits, also show declines in recent years.
Most of this consolidation is a result of mergers. A recent study by a
member of the Federal Reserve Board staff shows that between 1994 and 2003
there were more than 3,500 bank and thrift mergers (Pilloff, 2004). In
about 92 percent of these mergers, the target institution had one billion
dollars or less in total assets. Although bank merger activity has
generally declined since the late 1990s, at least 200 deals were completed
in each year from 2000 through 2005.
The Evolution of Relationship Finance
These
developments notwithstanding, research by our staff and other economists
supports the view that community banks continue to play an important role
in the provision of financial services, particularly to small businesses,
but also to a wide range of retail customers nationwide. Indeed,
conventional wisdom in the research community is that "the central
principle of community banking is 'relationship finance'" (DeYoung et al.,
2004, p. 81). By relationship finance I mean financial services whose
value-added depends importantly on the ongoing personal interactions of
bankers with their customers, interactions that improve the flow of
information and allow for more customized services. Relationship finance
strengthens the economy by allowing credit and other financial services to
be provided more efficiently.
But recent research also confirms what many community bankers tell
us--that traditional notions of relationship finance are changing, along
with the nature of community bank-customer relationships.
The conventional research paradigm included the idea that small
businesses and households tend to be informationally "opaque"; that is,
information about these potential borrowers can be costly to obtain and
hard to quantify. According to this view, the efficient supply of credit
to such parties required close interactions to elicit "soft," or
qualitative, information, such as the personal characteristics of the
borrower or relevant aspects of local markets and opportunities. This
paradigm holds that large banks have a comparative advantage lending to
those relatively transparent customers from which they can obtain "hard,"
or quantitative, information, such as standardized accounting data, and
community banks have a comparative advantage lending to relatively opaque
small businesses and households.
However, this division of labor between large and small institutions
has begun to blur. Today, practitioners and researchers understand that
low-cost information processing, improved credit-scoring, and more
sophisticated management techniques are rapidly reducing the effective
opacity of many small businesses and households. Credit card lending
provides an example of this phenomenon. Technological and financial
innovation, including credit scoring, securitization, and economies of
scale in data processing, have combined to make credit card lending a
hard-information, transactions-driven business, quite different from
traditional unsecured personal lending, which relies heavily on personal
knowledge and relationships.
Some recent data from the Board's forthcoming Survey of Small Business
Finances sheds some light on how the marketplace, and the role of
community banks, is changing. The Board conducts this survey every five
years. Our most recent data, which are still preliminary and will be
released later this year, are for year-end 2003; they are the result of
interviews with more than 4,200 small businesses that represent an
estimated 6.3 million small businesses in the United States. The surveys
show that small businesses are heavy users of financial services. For
example, the proportion of these businesses using some type of financial
service at a bank or thrift rose from 92 percent in 1998 to 96 percent in
2003. Increases occurred across a broad range of financial services and
were especially strong in the area of "financial management services,"
which includes activities such as check clearing, cash management, letters
of credit, and credit card processing.
According to the surveys, community banks remain an important provider
of these services, albeit in an increasingly competitive marketplace.
Among small businesses that reported using a bank or thrift in 2003, about
37 percent used a community bank, down from about 42 percent in 1998. Over
the same period, the share of small businesses using a financial service
supplied by a nondepository institution rose from 40 percent to 54
percent.
Although these surveys show that community banks face increasing
competition, including from nondepository providers, they also highlight
the importance of one of the traditional strengths of community banks:
local presence. For example, in 2003 the median distance between a small
business's headquarters and its bank or thrift was three miles, about the
same as in 1998. Indeed, part of the success of nondepository institutions
may have been due to the fact that the median distance between a
small-business customer and its nondepository service provider fell from
83 miles in 1998 to 37 miles in 2003, with most of the change resulting
from greater proximity of customers to nondepository loan providers. Being
close and convenient is important.
Data collected as part of the banking agencies' Community Reinvestment
Act (CRA) activities also demonstrate the importance of proximity. As you
know, the CRA focuses on banks' lending and services provided within their
local communities. From CRA and other data, we can estimate the share of
loans to small businesses made by depository institutions located
physically within the local market area. These data show that between 1996
(the year we began collecting such data) and 2004, the competition from
out-of-market lenders has increased, a result that will not surprise you.
However, in value terms, the share of small-business loans made by
out-of-market firms did not exceed 18 percent in any year. Small-business
owners look overwhelmingly to local lenders for credit.
We see that, for community banks, the overall picture is complex. In
financial terms, community banks remain quite strong, and there is
considerable entry into the business. New technologies and management
methods have eroded some of the traditional informational benefits of
relationship finance, however, and community banks have lost market share
to larger banks and to nondepository institutions. But the data also show
that many customers want to be served locally; they value proximity and
convenience. In my view, the strong relationships and personalized
services provided by community banks remain an important reason for their
continuing success.
Supervisory Perspectives
Like community banks, bank
supervisors must also adapt to a changing financial and economic
environment. I would like to discuss some of the ways in which the Federal
Reserve's supervision of community banks has evolved in recent years and
also briefly review some of the key financial risks that we see in our
examinations.
In the 1990s, bank supervisors began to take a more proactive,
risk-focused approach. Under this approach, examiners focus their on-site
reviews on those activities that appear to pose the greatest risks to each
individual banking organization, with particular attention to the bank's
procedures for evaluating, monitoring, and managing those risks. The
objective is to address weaknesses in management and internal controls
before, rather than after, financial performance suffers.
In adapting to change, the Federal Reserve and the other banking
agencies have also consistently kept in view the competitive pressures
that community banks face, pressures that make the costs of regulation an
important concern. Whenever possible, we have streamlined procedures and
worked to eliminate unnecessary burden. For example, based on industry
feedback and supervisory experience, the Federal Reserve recently modified
its Small Bank Holding Company Policy Statement to raise the asset size
used to define eligible companies from $150 million to $500 million. These
revisions address changes in the industry and in the economy since the
initial issuance of the policy statement in 1980. While the bank holding
companies (BHCs) affected hold only 6 percent of total BHC assets, this
change increases the exempt group to roughly 85 percent of all BHCs,
thereby providing some burden relief to many smaller companies. These
companies will be exempt from consolidated risk-based capital guidelines
and will be allowed to file abbreviated semiannual reports in place of
consolidated quarterly financial statements. Under the policy statement,
the exemption would not be extended to holding companies with significant
nonbank or off-balance-sheet activities or that have material amounts of
public debt or equity securities outstanding. Of course, we and the other
banking agencies will vigorously enforce prudential capital standards for
all deposit-taking institutions, including those owned by the exempt BHCs.
Supervisors have sought to adjust regulatory procedures to account for
the needs of community banking organizations in other ways. As you are no
doubt aware, in tandem with the review of capital standards for the
largest banks, known as Basel II, the federal banking agencies are taking
a comprehensive look at additional possible changes to existing regulatory
capital guidelines for banks that would not adopt the proposed Basel II
revisions. These possible changes to Basel I would seek to increase the
risk sensitivity of the framework and to help mitigate any competitive
inequities that could result from the implementation of Basel II.
The recent update to the CRA regulations provides another example in
which regulators have taken into account the special features of community
banks. Last year, the Federal Reserve and other federal agencies issued
final CRA rules that reduced compliance burden by creating a new category
of intermediate small banks with assets between $250 million and $1
billion. Banks in this new category now face reduced requirements for data
collection and reporting, and they have become eligible for a two-pronged
set of CRA tests--a streamlined lending test and a community development
test--rather than the three-part CRA criteria that larger banks must meet.
These changes are intended to reduce the costs borne by smaller banks and
to increase flexibility while still achieving the community development
objectives of CRA.
To target examination resources and to limit the burden of on-site
reviews, the Federal Reserve also has increasingly relied on automated
off-site monitoring tools. For example, since the late 1990s, the Federal
Reserve has supervised many small bank holding companies using an off-site
review program. We support this program with a targeted monitoring system
that seeks to identify parent company and nonbank issues that may
adversely affect affiliated insured depository institutions. This program
enables us to limit on-site reviews to those bank holding companies with
characteristics that could pose risks to insured depositories. We also use
statistical models to monitor the condition of state member banks and
quickly address any issues that emerge between regularly scheduled on-site
examinations. This year, we substantially updated these models to improve
their performance. Thanks in large part to such efforts, examiners today
conduct more of their supervisory activities offsite, helping to reduce
the burden that is associated with on-site examinations at institutions
like yours.
Beyond these changes, the Federal Reserve is participating in an
ongoing interagency review of banking regulations pursuant to the Economic
Growth and Regulatory Paperwork Reduction Act, known as EGRPRA. This
review seeks to identify opportunities to streamline regulatory procedures
and requirements when such changes would be consistent with maintaining
bank safety and soundness. The Board has also supported various
legislative changes that would ease regulatory burden. These include a
recently proposed change that would permit supervisors to extend the time
between on-site examinations to eighteen months for well-managed and
well-capitalized banks with up to $500 million in assets. This change
would double the current size threshold and has the potential to allow
roughly 1,200 more community institutions to qualify for the extended
examination cycle.
In my remaining time, I would like to discuss some of the key financial
and risk-management challenges that we have identified through our
supervisory activities.
Banking has always been a business of taking and managing risks, but
evolving market and economic conditions affect the types of opportunities
available. In recent years, community banks have become more focused on
commercial real estate lending, leading to a significant shift in the
balance sheet and risk profiles of growing numbers of banks.
In most local markets, commercial real estate loans have performed
well. Our examiners tell us that lending standards are generally sound and
are not comparable to the standards that contributed to broad problems in
the banking industry two decades ago. In particular, real estate appraisal
practices have improved. However, more recently, there have been signs of
some easing of underwriting standards. The rapid growth in commercial real
estate exposures relative to capital and assets raises the possibility
that risk-management practices in community banks may not have kept pace
with growing concentrations and may be due for upgrades in oversight,
policies, information systems, and stress testing.
In response to these developments, the federal banking agencies have
recently proposed guidance that would focus examiners' attention on those
loans that are particularly vulnerable to adverse market conditions--that
is, loans dependent primarily on the sale, lease, or refinancing of
commercial property as the source of repayment.
I emphasize that, in proposing this guidance, supervisors are not
aiming to discourage banks from making sound loans in commercial real
estate or in any other loan category. Rather, we are affirming the need
for each bank to recognize the risks arising from concentration and to
have in place appropriate risk-management practices and capital
levels.
Adjusting to changes in the level of short-term interest rates can also
pose challenges to community banks. Thus far, the relative stability of
community bank net interest margins suggests that they have done a good
job of managing their interest rate risk exposure throughout the recent
increase in market rates. Importantly, most community banks have
effectively controlled the maturity distributions of their assets and made
significant improvements over the past decade to their management and
measurement of interest rate risk. Certainly, the procedures employed by
community banks today are significantly more effective than those
typically used as recently as a decade ago. However, we continue to see a
small number of institutions with concentrations in longer-term assets. In
these cases, our examiners encourage banks to gauge the risks of new
yield-enhancing strategies over the intermediate and longer terms.
The unique funding structure of community banks supports their strong
recent performance. For the most part, community banks continue to fund
themselves primarily with relatively low cost and stable "core" deposits.
However, a limited segment of community banks is increasing its reliance
on wholesale sources of funding. Greater reliance on these sources places
a premium on appropriate measurement and management of liquidity risk.
Most community banks manage their liquidity risk positions well, but
supervisory reviews suggest that some institutions have room for
improvement. With the banking system enjoying a period of relatively high
liquidity, now is a good time for all companies to assess the adequacy of
their processes for managing liquidity risk.
I emphasize that, on the whole, we do not have broad supervisory
concerns with community banks. But it is only prudent to reiterate the
importance of sound risk management to the continued success of community
banks.
Conclusion
In closing, I want to return to where I
began. In my judgment, well-managed and innovative community banks will
continue to play a critical role in the U.S. economy. Community banks
provide vital services for their customers and are key contributors to
sustained economic growth, both locally and nationally. Indeed, the
performance of community banks over the past decade has been very
impressive. But neither bankers nor their supervisors should become
complacent. Doubtless the future will continue to require both of us to
evaluate and respond to changes that are often complex and difficult to
understand, much less to predict. It has been my pleasure to be here
today, and I look forward to working with you in the coming years to
ensure the continued vitality of the U.S. banking and financial
system.
Thank you. |
