Central Banker - Spring 2012

8/2/2019 Central Banker - Spring 2012

1/12

T H E F E D E R A L R E S E R V E B A N K O F S T . L O U I S : C E N T R A L T O A M E R I C A S E C O N O M Y | S T L O U I S F E D . O R G

CENTRAL

N E W S A N D V I E W S F O R E I G H T H D I S T R I C T B A N K E R S

SPRING

2012

FEATURED IN THIS ISSUE: ALLL Best Practices | Bank Perormance Continues on Meandering Path

By Gary Corner

In the wake o the nancial crisis,the value o a community bank isgenerally discussed in the context o thecommunity: the relationship bankershave with their customers and com-munity and their understanding o local

economic conditions and opaque creditopportunities. In many cases, the com-munity bank also stands as an impor-tant small business in the community,albeit as a credit provider and employer.

While these actors are important,another gauge o the value o a com-munity bank is its ability to earn a airreturn or its stakeholders. Without anadequate return to investors, retain-ing or even attracting new investmentcould become more dicult or com-

munity banks. This article examinesthe historical trend in community bankreturns on equity (ROE) over the last 10

years and highlights the gap betweencurrent and historical pretax returns.

Decomposing Return on Equity

Return on equity is more thansimply net income divided by aver-age equity. It can be more completelyexpressed as return on assets (ROA)

relative to an equity multiplier or,more simply, the degree o nancialleverage at a bank. Return on equity

can be urther understood by employ-ing a DuPont analysis technique. This

Will Community Bank Returns on

Equity Return to Precrisis Levels?

technique dissects ROA into the sub-components that drive asset utiliza-tion, or total revenue/average totalassets.1 From here a banks expense

ratio can be segregated into the com-ponents that encompass total operat-ing expenses/average total assets.2

continued on Page 10

FIGURE 1

Historical Pretax Return on Equity

25%

20%

15%

10%

5%

0%

-5%

12/31/200

2

12/31/200

3

12/31/200

4

12/31/200

5

12/31/200

6

12/31/200

7

12/31/200

8

12/31/200

9

12/31/201

0

12/31/201

1

All Banks under $10 Billion

All Banks under $1 Billion

SOURCE: Reports o Condition and Income or Insured Commercial Banks


2/12

Useful St. Louis Fed Sites

Dodd-Frank Regulatory Reform Ruleswww.stlouised.org/rrr

FOMC Speakwww.stlouised.org/omcspeak

FRED (Federal Reserve Economic Data)www.research.stlouised.org/red

St. Louis Fed Researchwww.research.stlouised.org

News and Views for Eighth District Bankers

Vol. 22 | No. 1

www.stlouisfed.org/cb

E D I T O R

Scott Kelly

314-444-8593

[email protected]

Central Bankeris published quarterly by the

Public Aairs department o the Federal

Reserve Bank o St. Louis. Views expressed

are not necessarily ocial opinions o the

Federal Reserve System or the Federal

Reserve Bank o St. Louis.

Subscribe or ree at www.stlouisfed.orgcb to

receive the online or printed Central Banker. To

subscribe by mail, send your name, address, city,

state and ZIP code to: Central Banker, P.O. Box

44, St. Louis, MO 6366-44. To receive other

St. Louis Fed online or print publications, visit

www.stlouisfed.orgsubscribe

Follow the Fed on Facebook, Twitter and more

at www.stlouisfed.orgfollowthefed

The Eighth Federal Reserve District includes

all o Arkansas, eastern Missouri, southern

Illinois and Indiana, western Kentucky and

Tennessee, and northern Mississippi. The

Eighth District oces are in Little Rock,

Louisville, Memphis and St. Louis.

C E N T R A L V I E W

Many Community Banks MustMake Tough ROE Choices

By Timothy A. Bosch

At year-end 2007, beore the reverber-ations o the global nancial crisisbegan to be elt across most businesssectors, there were 7,139 community

banks in the U.S. By the end o 2011,that number had slipped to 6,155. Morethan one-third o the decline, or 342charters, occurred because o institu-tions that ailed. The 642 other banking

organizations ound strategic partnersto bolster their nancial strength orimprove operating eciencies.

The 14 percent decline in chartersin just our years is refective o thechallenges acing banks over that t ime,especially community banks. Andheadwinds prevail: Revenue opportu-nities continue to be limited, operating costs are climbingand the uncertainty o added regulation remains a concern.

To be air, some o the recent data on community bankperormance have been positive. Problem asset ratios have

declined, and earnings perormance has improved. More-over, banks acing asset quality diculties are workinghard to improve their balance sheets through prudent loanrestructures, asset disposals and the redeployment o undsinto less concentrated market sectors.

I am oten asked, What lies ahead? No one has a crystalball, but one area o the balance sheet that may not recoverto precrisis levels is return on equity (ROE).

Community banks consistently express concerns aboutprot opportunities, given current weak loan demand and thepossibility o growing regulation. Community bank manag-ers are going to have to make some tough choices over the

next ew years. They will need to identiy areas where theycan reduce costs. They might eliminate business lines thatare no longer protable (even i they are legacy businesses)and ocus on their core areas o expertise and protability.All o this uncertainty only underscores the importance ohaving a strong management team at the bank.

I the bank cannot make such adjustments, investors incommunity banks may need to adjust their expectations orreturns on equity. Depending on the length and depth olow returns, some investors may turn elsewhere, requiringsome additional consolidation o the industry to scale grow-

ing costs.The community bank model in the U.S. has withstoodnumerous challenges throughout its history. Despite some

recent positive signs, bank managers cant ignore the head-winds theyre acing. The next ew years will be crucialin understanding what it will take or community banks toreturn to historic protability.

Timothy A. Bosch isa vice president in

Banking Supervision

and Regulation at

the Federal Reserve

Bank of St. Louis.

2 | Central Banker www.stlouised.org


3/12

Earnings Zig, Asset Quality Zags1

2010: Q4 2011: Q3 2011: Q4

RETURN ON AVERAGE ASSETS2

District Banks 0.50% 0.82% 0.79%

U.S. Peer Banks 0.22 0.72 0.70

NET INTEREST MARGIN

District Banks 3.86 4.02 4.03

U.S. Peer Banks 3.90 3.94 3.96

LOAN LOSS PROVISION RATIO


U.S. Peer Banks 1.10 0.59 0.60

PROBLEM ASSETS RATIO3


U.S. Peer Banks 5.27 4.95 4.68


NOTES: 1 Because all District banks except one have assets o less than $15 billion, banks

larger than $15 billion have been excluded rom the analysis.2 All earnings ratios are annualized and use year-to-date average assets or average

earning assets in the denominator.3 Problem assets are loans 90 days or more past due or in nonaccrual status plus

other real estate owned (OREO). The ratio is computed by dividing problem assets

by total loans plus OREO.

Q U A R T E R LY R E P O R T

Bank Perormance Continues onMeandering Path

By Michelle Neely

The slight uptick in bank earningsexperienced by District banks andtheir U.S. peers in the third quarter didnot carry over into the nal quarter o

2011. Asset quality measures did con-tinue to improve, however. Real estateloansespecially those backed by com-mercial propertiesremain the pri-mary source o nonperorming assets.

Return on average assets (ROA) atDistrict banks ell 3 basis points in theourth quarter to 0.79 percent, but theratio was still 29 basis points aboveits year-ago level. ROA also declinedat U.S. peer banksthose with aver-age assets o less than $15 billionbutby a smaller amount, to 0.70 percent.Although earnings ratios at U.S. peersstill all below those o District banks,the gap between the two sets o bankshas narrowed in recent quarters. Two

years ago, District banks outperormedtheir U.S. peers by 45 basis points whenmeasured by ROA; by year-end 2011,that gap had allen to 9 basis points.A more dramatic decline in unds set

aside to cover nonperorming assets byU.S. peers than those by District banksexplains the closing o this dierence.

In the District, the decline in ROAcan be traced to a slight increase inloan loss provisions that is typical othe ourth quarter and a slightly larger

increase in noninterest expenses,primarily personnel expenses. Thenet interest margin (NIM) increased1 basis point in the ourth quarterto 4.03 percent. The margin is up 17basis points rom a year ago thanksto a much larger decline in interestexpenses than in interest income.

For U.S. peer banks, ROA declineda bit because a small increase (2 basispoints) in the average NIM was oset

by a larger increase (4 basis points) innoninterest expenses. An uptick inpersonnel expenses was responsible

or hal the increase in overall nonin-terest expenses. The loan loss provi-sion ratio rose just 1 basis point in thenal quarter to 0.60 percent. The ratio

is about hal its year-ago level o 1.10

percent, refecting in part the steady

improvement in asset quality since

year-end 2010.

Asset Quality Picks Up in

District and Nation

Asset quality improved somewhatin the nal quarter o 2011 at both sets

o banks, with nonperorming loans

and other real estate owned (OREO)

declining rom the third quarter. The

problem assets rationonperorming

loans plus OREO divided by total loans

plus OREOell 22 basis points to

4.66 percent in the District. The chie

reason or the decline in this ratio

was the sharp drop in nonperorming

construction and land development

(CLD) loans, which make up more than

a quarter o the Districts total nonper-

orming loans. The nonperorming

CLD loan ratio ell below 10 percent or

continued on Page 4

Central Banker Spring 2012 | 3


4/12

Statewide Bank Conditionsor Fourth Quarter Compiled by Daigo Gubo

2010: 4Q 2011: 3Q 2011: 4Q

RETURN ON AVERAGE ASSETS2

All Eighth District States 0.34% 0.64% 0.65%

Arkansas Banks 0.77 1.11 1.09

Illinois Banks 0.06 0.44 0.46

Indiana Banks 0.48 0.89 0.90

Kentucky Banks 0.80 0.82 0.71

Mississippi Banks 0.55 0.72 0.72

Missouri Banks 0.37 0.70 0.66

Tennessee Banks -0.04 0.12 0.42

NET INTEREST MARGIN

All Eighth District States 3.80 3.89 3.91







Tennessee Banks 3.80 3.89 3.92

LOAN LOSS PROVISION RATIO






Mississippi Banks 0.80 0.56 0.55Missouri Banks 0.87 0.57 0.58


NONPERFORMING LOAN RATIO3









NONPERFORMING LOAN + OREO RATIO4










NOTES:1

Because all District banks except one have assets o less than $15 billion,banks larger than $15 billion have been excluded rom the analysis.

2 All earnings ratios are annualized and use year-to-date average assets or

average earning assets in the denominator.3 Nonperorming loans are those 90 days or more past due or in nonaccrual status.4 Nonperorming loans plus OREO are those 90 days past due or in nonaccrual

status or other real estate owned.

the rst time since late 2009, hitting9.73 percent at year-end 2011. Nonper-orming rates also ell in other parts othe real estate portolio, as well as inthe consumer loan and the commercial

and industrial (C & I) loan categories.The asset quality picture is much the

same at U.S. peer banks. Declines innonperorming real estate loans, espe-

cially CLD loans, brought down theaggregate problem asset and nonper-orming loan ratios. NonperormingC & I loans also ell, though non-perorming consumer loanscreditcard and other consumer loansrose.Nonperorming ratios or all categorieso loans are higher at U.S. peers thanat District banks, in part refectingless volatile real estate markets and apredominant lending local lendingstrategy in this region o the country.

Coverage Ratios Are Up and Capital

Ratios Are Steady

Although loan loss reserves declinedat year-end at both sets o banks, loanloss reserve coverage ratios actuallyrose because nonperorming loans ell

more. The coverage ratio at Districtbanks increased by 310 basis points to65.01 percent, meaning District bankshad on average 65 cents in reserves orevery dollar o nonperorming loans.The coverage ratio rose 144 basispoints to 61.63 percent at U.S. peerbanks.

Capital ratios stayed basically fatin the ourth quarter, and the averagetier 1 leverage ratio was well above theregulatory minimum at 9.46 percentor District banks and 9.90 percent orU.S. peer banks.

Michelle Neely is an economist with the

Federal Reserve Bank of St. Louis.

Quarterly Reportcontinued from Page 3



5/12

Junior Liens for Certain Residential Properties

Covered in New ALLL Guidance

Federal agencies in January reiterated supervisory guidanceon allowance or loan and lease losses (ALLL) estimation practices associated with loans and lines o credit secured by juniorliens on one to ouramily residential properties.

This ALLL guidance, given in SR 123, applies to all bankingorganizations with junior lien loans, including institutions with

$10 billion or less in consolidated assets.The interagency guidance also reminds institutions to moni

tor all credit quality indicators relevant to credit portolios,including junior liens. Examples o junior liens include second mortgages and home equity lines o credit taken out bymortgage borrowers. For more inormation on SR 123, go toBanking Inormation & Regulation > Supervision and Regulation Letters on the Board o Governors web site(www.ederalreserve.gov).

I N - D E P T H

ALLL Best Practices: Keep the AppropriateAllowance or Loan and Lease Losses Reserve

By Timothy A. Bosch and

Salvatore Ciluffo

During these uncertain economictimes, lenders must continuallyactively assess the quality o their

loans. It seems like a simple statement;

however, a bank can hurt itsel without

such diligence.

For example, many banks with high

concentrations o commercial real

estate loans have incurred extraordi-nary losses. Thereore, it is imperative

to document the rationale behind all

quantitative and qualitative actors,

and be vigilant, proactive and realistic.

Examiners will view avorably banks

that are quick to sel-identiy problem

assets and that apply a solid reserve

against those loans that will likely

result in some loss.

To help your institution explore the

quality o your loans, pay attention

to your allowances or loan and lease

losses (ALLL).

Examiners Expect Higher

ASC Adjustments

For several years, the banking

industry enjoyed low loan loss rates.

Normally, during periods o economic

stability, most ALLL methodologies

use a three- to ve-year-average net

loss history to determine the loss ac-

tors or the homogeneous loan pools

or the Accounting Standard Codica-

tion (ASC) 450 portion o the ALLL.1

However, during periods o signi-

cant economic contractionsuch as

nowbanks should adjust or their

recent loss experience, which they

should expect to more accurately esti-

mate their inherent losses. Accounting

rules require consideration o exter-

nal and internal actors aecting the

adequacy o the ALLL. Banks shouldmodiy their qualitative and environ-

mental actors to ensure that allowance

estimates place appropriate emphasis

on current market inormation and

events in a banks lending area:

Externalfactors These includethe direction o national and localeconomies, changes in bankruptcy

rates, changes in unemploymentrates, and levels o national and localoreclosures.

Internalfactors These includeasset quality trends, trends in non-perorming loans and charge-os,portolio concentrations, renance

risk, and the strength o the banks

credit administration practices.

Simply stated, examiners expecthigher ASC 450 adjustments when thebank is experiencing larger losses andthe economy is weak.

Requirements under ASC 310

In addition, ASC 310 requires anindividual credit impairment analy-sis. A loan is impaired i its probablethat all principal and interest pay-

ments will not be received accordingto the contractual terms o the loanagreement. Banks should dene, intheir loan policies, which loans will




6/12

E C O N O M I C S P O T L I G H T

Where Housing Markets Lead in , Eighth

District Economies Are Likely to Follow

By William Emmons

Housing markets generally haveserved as reliable bellwetherso economic conditions during recentdecades. But while some measures oEighth District housing-market activ-ity recently showed signs o lie, its notclear yet i it is cause or cautious opti-

mism in the economic outlook.Historically, home-building activ-

ity usually declines a year or two inadvance o a broad economic slow-down or recession, while infation-adjusted house prices oten stagnate ordecline during the months precedingthe economic downturn. When theeconomy eventually stabilizes andbegins to grow again, home building,home sales and house prices usu-ally pick up beore other economic

vital signs, such as employment, haveshown meaningul improvement. The2001 recession was a rare exception tothis rule, as Figure 1 on Page 7 shows.In that instance, home building andhouse prices remained strong even asthe overall economy weakened.1,2

Housing markets usually are keyeconomic indicators in the EighthDistrict too. Home-building activityin most parts o our District reached

a peak in late 2005. Eighth District

home prices, adjusted or infation,

reached peaks as early as the rst

quarter o 2005 in Indiana, with all

other district states hitting their high

points between the rst quarter o

2006 and the rst quarter o 2007.

(See Table 1 below.)

In turn, economic conditions in

states in the District reached theirpeaks in the last quarter o 2007 or

the rst quarter o 2008, as the middle

column o data in the table indicates.

Across our District and the nation, a

peak in infation-adjusted house prices

gave between our and 11 quarters

advance warning o the deep recession

that hit in late 2007.3

2012 Housing Market Indications

I housing markets serve as bell-wethers or local economies heading

into as well as out o a downturn, what

do current housing-market indicators

suggest or Eighth District economies

as 2012 gets underway? Figure 2 on

Page 7 shows that an average o Eighth

District infation-adjusted house-

price indexes appeared to be trending

downward through the rst hal o

2011, although the last data point, orTABLE 1

Real House-Price and Economic Activity Index Peaks

Peak Quarter or

Infation-Adjusted (Real) FHFA

House-Price Index

Peak Quarter or the

Philadelphia Fed Coincident

Economic Activity Index

Quarters between Real

House-Price Peak and

Economic Activity Index Peak

U.S. 2006: Q2 2008: Q1 7

Eighth District States Average 2007: Q1 2008: Q1 4

Arkansas 2006: Q4 2008: Q1 5

Illinois 2007: Q1 2008: Q1 4

Indiana 2005: Q1 2007: Q4 11

Kentucky 2006: Q1 2007: Q4 7

Mississippi 2007: Q1 2008: Q1 4

Missouri 2006: Q1 2007: Q4 7

Tennessee 2007: Q1 2008: Q1 4

SOURCES: Federal Housing Finance Agency, Bureau o Economic Analysis, Federal Reserve Bank o Philadelphia



7/12

the third quarter o 2011, showed anuptick.

Likewise, home-building activ-ity showed some signs o lie near theend o 2011, albeit rom an historicallydepressed level. Based on the weakhousing market data alone, the eco-nomic recovery that has been underway

since mid-2009 is surprising. Housingmarket problems may well help explainwhy the recovery has been weak, bothin our District and nationwide.

In Conclusion

Housing market indicators suggestchallenges or the 2012 economic out-look or Eighth District states. More-over, even i housing markets beginto show strength as 2012 unolds, thebroader economic vigor they might beanticipating could take some time tomaterialize.

William Emmons is an economist at the

Federal Reserve Bank of St. Louis.

ENDNOTES

The surprising strength o housing probably was

due to several unusual actors, including the

brie and mild nature o the recession, strong

demand or housing as a sae asset in the

wake o a large stock market decline, and alling

mortgage rates ater mid-. The 3-year

xed-rate mortgage ell rom 8.5 percent in May

to 5. 5 percent by June 3.

The Federal Reserve Bank o Philadelphias

Coincident Economic Activity Indexes are sta-

tistically derived measures o overall economic

strength or the nation and each o the 5 states.

Each index is based on our economic indicators

or a particular state: nonarm payroll employ-

ment, average hours worked in manuacturing,

the unemployment rate, and wage and salary

disbursements defated by the consumer price

index. See www.philadelphiaed.org/research-

and-data/regional-economy/indexes/leading/

or more details and historical data or the

indexes.

3 Nationally, the recession began in December 7

and continued until June 9, as determined by

the National Bureau o Economic Research. Arkan-

sas and Mississippi experienced somewhat milder

downturns than the nation as a whole, per the

Philadelphia Feds Coincident Economic Activity

Indexes. Tennessee tracked the nation very closely

through the recession, while Illinois, Indiana,

Kentucky and Missouri suered noticeably deeper

recessions than the national average.

FIGURE 2

Eighth District House-Price Index andCoincident Economic Activity Index

110

100

90

80

70

60

Index

Levels

Equal100

atPeak

2000:

Q1

2002:

Q1

2004:

Q1

2006:

Q1

2008:

Q1

2010:

Q1

2012:

Q1

Ination-Adjusted House-Price Index (Peak Level in 2006: Q2)

Coincident Economic Activity Index (Peak Level in 2008: Q1)

110

100

90

80

70

60

Index

LevelsE

qual100

atPeak

2000:

Q1

2002:

Q1

2004:

Q1

2006:

Q1

2008:

Q1

2010:

Q1

2012:

Q1

Ination-Adjusted House-Price Index (Peak Level in 2007: Q1)

Coincident Economic Activity Index (Peak Level in 2008: Q1)

FIGURE 1

U.S. House-Price Index andCoincident Economic Activity Index

SOURCES: Federal Housing Finance Agency, Bureau o Economic Analysis, Federal

Reserve Bank o Philadelphia. Infation-adjusted house prices are quarterly through

2011: Q3. The Coincident Economic Activit y Index is quarterly through 2011: Q4.

SOURCES: Federal Housing Finance Agency, Bureau o Economic Analysis, FederalReserve Bank o Philadelphia. Infation-adjusted house prices are quarterly through

2011: Q3. The Coincident Economic Activit y Index is quarterly through 2011: Q4.



8/12

I N - D E P T H

St. Louis Fed President James BullardExplores the Death o a Theory

scal approaches to stabilization policyhas run its course and that the con-

ventional wisdom o the past severaldecades is reasserting itsel. (See the

brie description on Page 9 o scal vs.monetary stabilization policy.)

Over the two decades leading up tothe nancial crisis, the conventional

wisdom was that scal policy was not

a good tool or macroeconomic sta-bilizationthat is, not a good way toattempt to react to shocks that buet theeconomy, says Bullard. Conventional

wisdom suggested that shorter-run sta-bilization issues should be handled bythe monetary authority (e.g., the FederalReserve) and that scal authorities (e.g.,the president and the Congress) shouldocus on a stable taxing and spendingregime to achieve economic and politi-cal goals over the medium and longer

run. This state o aairs lasted, broadlyspeaking, until the all o 2008.

At that point, the short-term nomi-nal interest rate targeted by the FOMC

(Federal Open Market Committee) waspushed nearly to zero, where it remainsto this day. This led many to concludethat the burden or short-term macro-economic stabilization had, as a result,shited to scal policy. Indeed, over thepast three years, we have seen numer-ous attempts at stabilization policy by

scal authorities in the U.S. and aroundthe globe, Bullard says.

However, Bullard argues that the neteect o these attempts has been to con-rm much o the conventional wisdomregarding scal stabilization policy thatexisted prior to the nancial crisis.

Addressing the Case for the

Fiscal Approach

Much research has been published

on when the scal approach to busi-ness cycle stabilization would beuseul and eective. In Death oa Theory, Bullard cites a paper byeconomist Michael Woodord in whichWoodord notes that while a case or

More than three years ago, St. LouisFed President James Bullarddiscussed Three Funerals and a Wed-dingideas about how the nancial

crisis (up to that point) had changed theconventional wisdom on some criticallyimportant macroeconomic issues acingthe nation.

Bullards uneral category had sev-

eral items, but the wedding categoryhad just one rising idea: scal policyas a business cycle stabilization tool.Now, in his new research paper titledDeath o a Theory, Bullard concludesthat the turn in recent years toward

6

5

4

3

2

1

0

-1

-2

Index

1/2006

1/2007

1/2008

1/2009

1/2010

1/2011

1/2012

Recession

SOURCE: Federal Reserve Bank o St. Louis

The St. Louis Financial Stress Index was essentially o the charts during the winter o

2008-2009. A reading o zero would mean normal stress levels and a reading o 2 would

be exceptionally high by historical standards; during the crisis, readings o 5 or higher

were observed. By 2010, however, stress had returned to more normal levels, and so the

case or continued increases in government spending at that point had diminished, says

St. Louis Fed President James Bullard in Death o a Theory. See more on the St. Louis

Financial Stress Index at http://research.stlouised.org/red2/series/STLFSI on FRED

(Federal Reserve Economic Data).

FIGURE 1

The St. Louis Financial Stress Index



9/12

Stabilization Policy: Fiscal vs. Monetary

Macroeconomic stabilization policy means reacting in a

timely manner to aggregate shocks that hit the economy and

in a way that smoothes out an otherwise rocky ride or the

economys businesses and households:

Fiscal policy, which is controlled by the president and the

Congress, attempts to do this through changes in taxes and

government spending.

Monetary policy, which is the charge o the Federal Reserve,

attempts to do this by targeting the nominal interest rate or,

when the interest rate is near zero, by inuencing ination and

ination expectations primarily through quantitative easing.

aggressive scal stimulus can be madeunder certain circumstances, suchpolicy must be designed with care i itis to have the desired eect.1

This line o research assumes thatmonetary business cycle stabiliza-tion policy is ineective and unable toinfuence real interest rates once the

policy rate is near zero. In addition,the types o policy experiments con-sidered in this research involve extragovernment spending and taxationonly during the period when the policyrate is near zero and nancial marketsare in considerable turmoil, and notany longer than that. (See Figure 1 onPage 8 or a measure o nancial stressduring the crisis.)

Three key issues related to theassumptions in Woodords paper lead

Bullard to doubt the merits o possiblescal stabilization programs or thepresent circumstances:First, the types o scal policy

interventions recommended in theresearch are airly intricate and mustbe designed careully i they are tohave the desired eect. However, theconventional wisdom on scal stabili-zation policy emphasizes that politicalprocesses in the U.S. and elsewhereare not well-suited to make timely and

subtle decisions like these.Second, monetary stabilization

policy has been quite eective, evenwhile the policy rate has been nearzero, Bullard emphasizes. This isbecause the monetary policy authoritycan use many other tools to infuence

infation and infation expectations.Thus, a turn toward scal stabilizationpolicy is not necessary.Third, although the research says

that taxes should be collected simul-taneously with the increase in gov-ernment spending, the actual scalstabilization policy or many countrieshas involved heavy reliance on gov-ernment borrowing. This increaseddebt would be interpreted as promiseduture taxes. However, shiting thetaxes into the uture can undo most orall o the benets that might otherwisecome rom the scal stabilization pro-gram, Bullard explains.

In Summary

Bullard concludes that the conven-tional wisdom on stabilization policyis being re-established in the U.S.Stabilization policy should be let to

the monetary authority, which canoperate eectively even with a near-zero policy rate. Fiscal authoritiesshould set the tax and spending pro-grams in a way that makes economicand political sense or the medium tolonger term. In particular, a stable taxcode that is aligned with a stable plano government spending would allowbusinesses and households to plan orthe uture in the most eective way,Bullard says.

ENDNOTE

Michael Woodord, Simple Analytics o the

Government Expenditure Multiplier,American

Economic Journal: Macroeconomics 3: -35, .

Death o a Theory and Other James Bullard ResourcesThis article was based on the paper, presentation and summary

o Death o a Theory, which was originally released in January2012. President Bullard presented the paper to members o vari

ous nancial institutions and business leaders on Jan. 13, 2012, at

the Edward Jones Annual Meeting in St. Louis.

Visit www.stlouised.org/theory to read the presentation and sum

mary or read the paper in the March/April 2012 issue o the St. Louis

Feds Review(http://research.stlouised.org/publications/review).

Other key policy papers by President Bullard are also available on

his web page, http://research.stlouised.org/econ/bullard, including:

Measuring Ination: The Core Is Rotten

Seven Faces o The Peril Three Funerals and a Wedding



10/12

Community Bank Returnscontinued from Page 1

More succinctly, this analysis breaksdown bank or industry perormanceinto revenue management and costmanagement.

Given the complication posed by the

U.S. tax code, which drives many small,closely held banks to elect Subchapter Sstatus, it may be preerable to considerROE on a pretax basis. While pretax

results do not eliminate all biases, theymay help improve the comparability ocommunity bank results.3

Historically, a well-run communitybank oered a predictable pretax ROE.As shown in Figure 1 on Page 1, aver-age pretax ROE or banks $10 billion

and under rom 2002 through 2006 wasan attractive 17.9 percent (and within apredictable range o 16.9 percent to 19.2percent). A balance o revenue-collect-ing opportunities, a modest cost struc-ture and appropriate leverage were thehallmarks o this perormance.

The next ve years proved moreturbulent. From 2007 through 2011,the average pretax return on equity orcommunity banks nationwide deterio-rated to 13.3 percent at year-end 2007,

turned negative in 2009 at -2.8 percent,and rebounded to a low but positive8.4 percent by year-end 2011. This

precipitous decline in pretax ROE isunderstandable given that the ve-year

average or provision expenses morethan tripled to 0.91 percent o average

assets, up rom 0.29 percent during the

previous ve years. O course, thisadjustment was necessary to replenish

loan loss reserves as commercial real

estate and residential real estate loanlosses skyrocketed.

An important but somewhat dis-guised trend, interrupted by the nan-cial crisis, was that community bank

returns on equity (excluding securities

gains) were in a decadelong periodo decline. The trend is illustrated in

Figure 2. The decline was driven by a

narrowing in the spread between assetutilization and operating expenses.

In Conclusion

As bank health nationwide contin-

ues to recover ater the nancial crisis,

it is possible ROE will settle in at alower-than-precrisis historical rate,

leading to a resetting o perormance

expectations by community bankstakeholders. This could be a transi-

tional adjustment or may represent a

structural change or the industry.In either scenario, there may be

important repercussions. For example,

a lower return expectation might

encourage consolidation betweenhealthy institutions in order to gain

greater scale and spread out operating

FIGURE 2

Asset Utilization Rate and Expense Ratio

6

5.5

5

4.5

4

3.5

3

Percentage

ofTotalAverage

Ass

ets

AU for Banks $10 Billion and under

AU for Banks $1 Billion and under

Expense Ratio for Banks $10 Billion and under

Expense Ratio for Banks $1 Billion and under

12/31/2002

12/31/2003

12/31/2004

12/31/2005

12/31/2006

12/31/2007

12/31/2008

12/31/2009

12/31/2010

12/31/2011





11/12

Community Bank Returnscontinued from Page 10

ALLL Best Practicescontinued from Page 5

costs. Alternatively, changing expecta-tions may reshape the thinking o bank

management on xed investments,such as acilities, and urther shit theemphasis to electronic delivery mecha-nisms. Only time will tell whethercommunity banks will be able to returnto precrisis levels o protability.

Gary Corner is a senior examiner at the Fed-

eral Reserve Bank of St. Louis. The author

thanks Daigo Gubo, policy analyst in the

Supervisory Policy and Risk Analysis Unit,

for contributing to this article.

ENDNOTES

Total revenue or purposes o this analysis is net

interest income and noninterest income combined.

The author chose to exclude ad hoc securities gains

rom the revenue total, believing most investors

do not consider community bank securities gains a

valuable ongoing revenue source.

Total operating expense is noninterest expense

plus provision or loan and lease losses.

3 Banks that elect Subchapter S tax status are not

subject to ederal corporate taxes. Rather, the

shareholders are subject to personal income

taxes on their pro rata share o the banks entire

earnings. Gilbert, R. Alton and Wheelock, David

C., Measuring Commercial Bank Protability:

Proceed with Caution, November/December

7 Federal Reserve Bank o St. Louis Review.

be tested or impairment, such as allloans over a certain size, all classied

loans or all nonaccrual loans.Once the loan is determined to be

impaired, the amount o the impair-ment needs to be measured using oneo the three methods, the most com-mon o which is air value o collateralless selling and carrying costs. Thechallenge in todays economic environ-ment is obtaining a realistic appraisal.Bank management is encouraged tomaintain an ASC 310 analysis indicat-ing the amount o impairment or eachloan tested.

Dont hesitate to contact your exam-iners i you have questions on ALLLmethodology.

Timothy A. Bosch is a vice president in Bank-

ing Supervision and Regulation and Salvatore

Ciluffo is a senior examiner at the Federal

Reserve Bank of St. Louis.

ENDNOTE

A version o this article rst appeared in the

summer 9 Central Banker. Since that time,

the Financial Accounting Standards Board

restructured accounting and reporting standards

as Accounting Standard Codications (ASC).

FAS 5 is ound under ASC 45 and FAS 4 is

ound under ASC 3.

The Dialogue Resumes this Springwith the European Sovereign Debt Crisis

Go beyond the headlines again this year

with the St. Louis Feds public discussion

series, Dialogue with the Fed. The series,which began last all, ocuses on critical

issues acing the economy and nancial mar

kets. Each session

eatured presenta

tions by St. Louis Fed

ocials ollowed by

an open discussion.

The rst session or

2012 will be held on May 8 at the St. Louis

Fed in downtown St. Louis. ChristopherWaller, senior vice president and director

o Research, will lead the presentation and

discussion on the European sovereign debt

crisis. The discussion, which will be held

rom 78:30 p.m. CT, will also be webcast liveon the St. Louis Feds web site.

Registration or the onsite event and

other inormation will be

available in April at www.

stlouisfed.orgdialogue.

Watch or Dialogue

announcements on Twitter,

Facebook, RSS eeds and

email (visit www.stlouised.org/ollowtheed

or more). Also visit the Dialogue web pageor video and presentations rom the all

sessions.



12/12

N E W B A N K I N G A N D

E C O N O M I C R E S E A R C H Wanted: A New Engine

or Economic Growth

EconomicSynopses: BrieEssays Explore Structural

and Cyclical Shocks,Employment Dynamics,

and Speculation in theOil Market

How Home Loan Modi

cation through the 60/40Plan Can Save the Hous

ing Sector

Federal Reserve Lending

to Troubled Banks Duringthe Financial Crisis

C D I A C U P D A T E

The St. Louis Feds 2012

Community DepositoryInstitution AdvisoryCouncil Meets

R U L E S A N D

R E G U L A T I O N S What the Changes to

the Home Afordability

Renance Program Meanor Lenders

New Fed GuidanceAddresses Rating

Upgrades Standards

Comment by April 30 onDoddFrank Enhanced

Prudential Standardsand Early Remediation

Requirements

Consumers Can Sub

mit Foreclosure ReviewRequests by July 31

Central Banker Online

S EE THE ONLINE VERS ION OF THE S PRING 2012

CENT RAL BANKER FOR REGU LA TORY S POTLIGHTS

A ND RECENT S T . LOU IS FED RES EA RCH

AT WWW.STLOUISFED.ORG/CB

FRED is a registered trademark o theFederal Reserve Bank o St. Louis.

MORE DISTRICT DATA

The District in FRED

Our signature database, Federal

Reserve Economic Data (or FRED),

includes nearly charts on

District-specic data that are

updated regularly. Want to knowthe net interest margin or banks in

the Eighth District? Weve got the

numbers on that. Need to see the

trend in personal income in the seven

states in our District? We have that

and much more. See http://research.

stlouised.org/red/categories/33

FIRST-CLASS

US POSTAGE

PAID

PERMIT NO 444

ST LOUIS, MO

Date post:	05-Apr-2018
Category:	Documents
Upload:	federal-reserve-bank-of-st-louis
View:	214 times
Download:	0 times

Central Banker - Spring 2012

Documents