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The Risks of De-Leveraging by Parliment Consulting Services, Inc.
The economic impact of de-leveraging is real for community financial institutions and the local economies they support.
Federal regulators’ reasons for requiring increased capital ratios are also real. Asset quality erosion has generated pressure for increased reserves to counteract weaknesses across all types of loan categories. More institutions are finding themselves with composite CAMELS ratings of 3 or worse. In the words of one banker, “3 is the new 2.” Consent orders and memoranda of understanding are commonplace and frequently require institutions to maintain 8% leverage capital ratios and 12% total risk-based capital ratios. Regulators are determined to stem the tide of failures by requiring enhanced capital and loan loss allowance positions.
The macro-economic cost of this risk-constrained mindset must be acknowledged. Many well-capitalized institutions are reacting cautiously to the increased regulatory vigilance regarding capital, economic, and compliance issues. On the other hand, many institutions were able to address these same issues while growing their loan portfolios.
The exhibit provided shows data on community financial institutions within the HLB’s District (both members and non-members). Institutions were divided into two groups: institutions that increased their capital ratios from the fourth quarter of 2007 to the fourth quarter of 2010 (during the second worst recession in the past century) and institutions that decreased capital ratios over the same period.*
The exhibit makes a clear statement. The 118 institutions that increased capital ratios (median capital ratios increased from 8.17% to 9.44%) grew their equity by $2.9 billion, but only grew net loans by $ 4.7 billion — a ratio of $1.65 in loans for every $1.00 increase in capital. This group clearly shows the effects of de-leveraging.
On the other hand, those 263 institutions that decreased their capital ratios (median capital ratios decreased from 12.25% to 10.28%) were on average less than half the asset size of the group of institutions that increased their capital ratios. These institutions increased their total leverage capital by $1.4 billion, yet originated net loans of $13.9 billion — a ratio of $9.58 in loans for every $1.00 of increased capital. Confronted with an identical set of environmental factors, the institutions with increased capital ratios generated capital but provided far less economic stimulus for loan originations than the institutions that decreased capital ratios.
This is not an indictment of any institution, nor is it a critique of how they reacted to unprecedented regulatory pressure and economic and regulatory uncertainty. However, the clear distinction between these two groups should be noted and analyzed. Parliment Consulting has performed the same analysis for community financial institutions nationwide, as well as regionally, across the total asset spectrum — and the story is the same. Perhaps we need to pay attention to the institutions that found a way to grow through the recession.
The HLB of New York’s member-lenders do not have to ignore the inevitable demand by borrowers for fixed-rate loans in an economy where rates are more likely to rise than fall. Several HLB advance products can be used to help manage the potential interest-rate risk of such loans, namely laddered fixed-rate and amortizing advances, as well as the Callable Advance.
Regardless of the economic environment, there is one thing we can say with certainty: the target asset growth rate for any institution should never (except for regulatory mandated shrinkage) be less than its equity growth rate. But this is a story for another article, which can be found online here.
To discuss funding opportunities with the HLB, contact a Calling Officer at (212) 441-6700. For questions or more information regarding this article, you may contact Thomas J. Parliment, Ph.D., Chairman and CEO, or Janet Frankl-Lockwood, President of Parliment Consulting Services, Inc. at (508) 881-7002, or visit www.parlimentconsulting.com.
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