Higher interest rates could affect asset quality, say community bankers

RMA Journal, The, April, 2005 by Kathleen M. Beans

Portfolios are performing well today; but rising interest rates are like clouds forming on the horizon. Community bank executives worry that higher rates could affect asset quality and cause a decline in the general economic environment during the next 12 to 18 months. During a recent RMA audioconference, four community bank executives discussed how they are working to protect their institutions' portfolios.

"I'm concerned about the ability of our borrowers to deal with higher interest rates, and the impact those rates will ultimately have on overall economic activity, particularly in real estate," said Mark T. Garrigus, EVP and CCO, Cole Taylor Bank, Chicago. "If liquidity problems develop in real estate markets, it will create challenges."

His fellow panelists, Edward Summers, SVP and credit risk manager, Affinity Bank, Ventura, California, and Frank R. Krepp, vice president, credit administration, NorthSide Bank, Pittsburgh, Pennsylvania, said the rates would test the sustainability of borrowers. They stressed the importance of maintaining discipline in the underwriting process.

Commercial Real Estate

The panelists attributed the strong performances in their real estate portfolios to the availability of capital and to better management, thanks to the lessons learned in the 1980s. But as Garrigus pointed out, the cycle has not been repealed.

"Low rates have had a propping effect in the commercial real estate market," said Daniel J. Sullivan, SVP and CCO, Eastern Bank, Boston. "If the rates rise while we're experiencing significant vacancies in the Northeast, risk will rise in that portfolio."

Although Eastern Bank has not experienced a change in delinquencies or nonperforming loans, Sullivan expects to see a little more stress on its debt service coverage ratios, eventually leading to a normalization of the bank's asset quality. "Eastern has not experienced a loss related to commercial real estate in several years," said Sullivan.

Summers reported seeing an increase in commercial real estate lending. "We track 40 peer banks with assets of $500 million to about $2 billion," he said. "Over the past three years, the bank with the lowest concentration of real estate in its portfolio had about 21%. Today, it is almost 57%. A lot of banks have moved into the commercial real estate market."

Summers noted that in California the multi-family real estate market is experiencing very low capitalization rates, much competition, and very strong prices. "The prices in the market are beginning to take a toll on the ability of the lender to meet the borrowing needs of our clients," he said and noted that the regulators are now questioning how much of a shock the real estate portfolio can absrob as interest rates rise. "They want us to analyze our portfolio not only at today's rates, but also at two and three percent above current lending rates."

Krepp noted his institution is pushing its analysis down further in terms of size and transaction.

Single-Family Home Construction

Krepp also noted that the single-family home market is not experiencing a fall-off in demand, although that portfolio at NorthSide Bank is in good shape. "As a small, local bank, we can follow what's happening in our local market easily," he said. "We also align ourselves with certain builders and track what they are doing; they're closest to the market. They are a good source of business as well as a good support function for our bank."

Affinity Bank's lending philosophy is to get in on the first and second phase of a construction subdivision project. "We want to ensure that the demand continues, so we monitor the sales," said Summers. "So if we're lending to a 120-home project, we want to see a phase start of 10 or 20 units at a time. As the developer sells the units, we will see more stakes in the ground."

Consumer Portfolio

Consumer portfolios have been performing well, reported the panelists. Eastern Bank's consumer portfolio is about $1.3 billion, with 75% to 80% of it in indirect auto loans, and over the past several years its loss experience has been fewer than 30 basis points.

Similarly, NorthSide Bank has a long history of strong credit quality in its consumer portfolio, which represents about $150 million or one-third of the bank's assets. "We're seeing a little bit of weakness in the number of bankruptcies on the collection side, but so far, the numbers haven't moved very much. Our buying is disciplined."

The Regulatory Focus

The Bank Secrecy Act and the Patriot Act are the focus of the regulators today, but the panelists believe that the focus will migrate down to Basel rules, even for community banks. The challenge is to comply with the regulations in the absence of hard rules and standards.

"The regulators are asking what we're doing and what we plan to do," said Garrigus, referring to BSA and Patriot Act compliance. "Then they say if it's acceptable or not. That can be frustrating."

Garrigus also expressed concerns about the statistical significance of the small data pools used by small banks as they apply Basel methodology. "We want to do work that is justified and that enables us to make better decisions, but we've been resisting efforts to do things that don't yield that result."