The dilemma facing community banks They're operating in an "Alice in Wonderland" environment

Community bankers in Georgia and across the country are worried, confused, anxious - some even angry - about the current state of the economy and the mood of the country.

Sound familiar?

Many consumers, small businesses - even your family and mine - have had this range of emotions, often accompanied by a sense that they lack control over economic trends or policy decisions by elected officials that affect their lives, well-being and future financial security.

During the holiday season, a teaser video clip went viral on the Internet advertising the Walt Disney and Tim Burton remake of the classic "Alice in Wonderland" due to be released in early March.

I thought immediately of the memorable scene in which Alice is in a room with the ceiling descending and the walls moving together - threatening to squash our poor heroine. It took place in a world, accessible by falling through a dark hole, where everything was not quite what it appeared to be.

Why the "Alice in Wonderland" reference?

The same situation applies to community banking today. For community banks, the descending ceiling is the economy and the aftermath of the worst recession in two generations. One wall closing in is regulation and regulatory guidelines; the other wall is public opinion and the existing intense anti-bank, anti-stimulus sentiment.

The economy

The recession took its toll on community banks and their customers nationwide during the past two years.

Properly underwritten and well-managed loans went sour as bank borrowers' cash flows shrank because of reductions in consumer spending and sharp decreases in residential and commercial real estate values.

Many of the borrowers were small businesses and local residential and commercial real estate developers - the primary target-market niche of community banks - who bore the brunt of the recession.

Of course, it would be unwise to characterize the banks as either villains or helpless victims. Customer loan defaults and related losses, as well as declining values on investment securities, led to bank failures.

During 2009, 140 banks failed, including 25 in Georgia. Some of those closed banks had high concentrations in real estate development loans or expanded their balance sheets with investment securities financed with an excessive amount of wholesale funds.

Some of the failed banks were just poorly managed.

As in Wonderland, the reality was not always what it appeared to be.

Lost in the headlines of bank failures and loan losses, approximately 86 percent of the 311 banks headquartered in Georgia were well capitalized as of Sept. 30 - with many banks having capital at twice the levels required by existing regulatory guidelines.

Only 40 percent of the banks were profitable, but this was the result of building loss reserves to the highest levels in decades. Georgia community banks between $100 million and $999 million in assets expensed more than $157.1 million to absorb loan defaults and maintain their normal lending and depository activities.

Community banks continue to make good loans to quality customers in a period of weak loan demand. The lack of loan demand is typical at the bottom of the economic cycle and early recovery stages of the economy as evidenced in each of the past five recessions dating back to 1973.

However, community banks are refinancing mortgages at historically low interest rates and modifying loans for distressed borrowers where appropriate and permitted under servicing contractual arrangements.

In addition, community banks are making commercial loans that have created new jobs, as noted by Joe Brannen, President of the Georgia Bankers Association, in an op-ed article in the Savannah Morning News in late December.

Despite the turmoil and volatility in financial markets, community banks continue to provide safe, FDIC-insured deposits to individuals and businesses. No FDIC-insured depositor has ever lost a penny. No taxpayer lost a dime because any losses incurred due to Georgia bank failures have been paid for by banks through insurance premiums paid to the FDIC.

Regulation and regulatory guidelines

During this period of stress, bank regulators have been increasingly proactive in their reviews, raising the bar in terms of classifying loans as substandard, as well as increasing capital and liquidity requirements.

As a result, the Georgia Bankers Association estimated about 100 banks in Georgia - and that number's growing - are under some form of administrative action by their regulators.

Some analysts and bankers believe the local regulators are taking their marching orders from Washington to "thin the herd" under the theory that the large number of small banks in Georgia and excessive competition are key contributors to the banks' problems.

Others believe the market has changed dramatically in the past 18 months and current regulatory reviews and actions reflect the deterioration in banks' loan portfolios.

Whatever the motives or reasons, regulators have taken more aggressive postures with weak banks and otherwise healthy banks with large real estate loan concentrations. While most Georgia bankers understand the increased level of scrutiny, many believe certain regulatory practices need to provide greater flexibility and time for banks to address current issues.

While the government is publicly pressuring banks to make more loans, new or tighter regulatory guidelines are restricting community banks' ability to lend as well as their deposit activities.

Banks are being pressured to reduce the amount of real estate loans, which typically represent 50 percent to 70 percent of a community bank's loan portfolio. In some cases, new real estate loans with quality borrowers are being denied as banks seek to comply with regulatory requirements.

Good customers often are unable to refinance their loans with local banks due to collateral deficiencies related to depressed real estate prices or when the loan balance exceeds the lending limit of a bank whose capital has shrunk due to operating losses.

New guidelines on higher-priced loans on a consumer's primary residence have had the unintended consequence of potentially limiting banks from offering three to five year "balloon" loans - loans structured to have partial periodic payments and a larger payment at maturity.

These have been traditional loans made by community banks to prime quality customers who, for one reason or another, do not qualify for loans eligible to be sold in the secondary market. They are conservatively underwritten, offered at competitive rates and have substantially lower delinquency rates.

Similar situations exist with deposits.

Banks that are not "well-capitalized" or under some form of regulatory administrative action have deposit rate caps or restrictions based on an index to the national average interest rate for specific bank deposits - a rate that appears to be significantly lower than local rates in highly competitive Georgia banking markets.

In addition, regulators are requiring banks to reduce the amount of brokered deposits as a source of funding. Requirements to repay and not renew brokered deposits upon maturity may create a liquidity crisis for some banks.

For many banks, this is a cheap source of funds and replacing them with customer deposits may result in a 1.5 percent to 1.75 percent increase in interest costs just as banks are being required to develop profit-improvement plans.

Most banks have increased loss reserves as a prudent measure to accommodate increased non-performing and defaulted loans. However, banks can include only 1.25 percent of risk-weighted assets under existing calculations for regulatory capital guidelines.

In effect, about $2.3 billion in capital for 240 banks is not being included in equity ratios for regulatory purposes.

New federal reserve guidelines effective later this year will limit overdraft programs for community banks - a primary source of fee income. At the same time, regulators are conducting mini-audits between normal safety and soundness examination dates and often downgrading the bank's rating.

In doing so, some banks face substantially higher premium costs for FDIC insurance. One bank in the coastal Georgia region indicated the combination of reduced overdraft fee income and higher FDIC insurance premiums will reduce its pre-tax income by 38 percent in 2010.

Public relations

The public does not have a favorable opinion of banks.

A majority did not view the bank-bailout program favorably. Plus, politicians as well as political pundits have fueled rising anti-bank sentiment. Then, no sooner than the wounds began to heal, the recent excessive bonus announcements by the largest banks have been a public relations fiasco.

Most community banks in Georgia did not receive capital investments from taxpayers, nor, in any stretch of imagination, engage in excessive compensation practices. Yet for the average taxpayer, all banks are lumped together.

The average person does not differentiate between community banks, the mega-banks, mortgage brokers, investment bankers or hedge funds.

New regulatory guidelines restricting overdraft programs will also cause a black eye for community banks.

Banks will be blamed when a customer's debit card or ATM transaction is rejected because of insufficient funds after a meal at a restaurant or when stranded late at night at a gas station. Banks also will be criticized when new fees are imposed on checking accounts to replace the income lost on overdraft programs.

The community banker's dilemma

Community bankers are facing pressures from all directions. The ceiling is descending, and the walls are closing in. There is no single Mad Hatter in this story - it's a "perfect storm" of economic conditions, regulatory restrictions and a negative public.

Banks are faced with contradictory pressures from different government agencies, accounting rules that artificially magnify losses and regulatory guidelines that limit the recognition of capital and may restrict normal prudent lending and deposit activities.

It is a Wonderland world where right is wrong and wrong is right.

Many people are clamoring for financial regulatory reform and almost everyone wants to eliminate the concept of "too-big-to-fail" for the largest banks.

Community bankers, however, are more concerned the Queen of Hearts and her knaves will appear and scream "off with their heads," and a new policy of "too-small-to-survive" will become the operating principle in government and regulatory policy.

Edward H. Sibbald is the BB&T executive in residence in banking, College of Business Administration, Georgia Southern University and director of the college's Center for Excellence in Financial Services. Contact him at ehsibbald@georgiasouthern.edu.