De novo banks must not be feeling a lot of love lately. Of all bank failures over the past two years, over 20% were institutions no older than seven years old. In banking, as in any line of business, there is risk related to being a start-up firm. Compared to more mature firms, there are fewer long-lasting customer relationships, and reaching optimal operating efficiency takes time.
This picture has led to some generalizations about de novos, and some regulatory response. Let’s explore those, and then, take a closer look at what’s going on in de novo results.
Perils of “youth”
The characteristics leading to potential higher risk seem to have played out in history. During the savings and loan crisis, institutions chartered four to seven years prior were multiple times more likely to fail than their average industry counterparts.
This observation has not been missed by regulators. Last September, FDIC changed its supervisory rules for de novos, stating that “recent experience has demonstrated that newly insured institutions pose an elevated risk to the FDIC Deposit Insurance Fund.” The agency decided to extend the period of closer supervisory review for de novo institutions from three years to seven. (Note that the Federal Reserve, OCC, and OTS did not change their policies to match the FDIC).
This change made the higher capital requirements and stronger scrutiny over business plan modifications that were previously in place for the first three years of an institution’s operation now apply for the first seven years. Applications for charter approvals have also come under closer review and many new banks find themselves competing for starting capital with existing firms looking to build their capital positions.
Beyond the stereotype
However, a view that de novos as a whole are more risky than average is questionable. There is a wide range of performance results, on an institution-by-institution basis. This holds true for banks at large or firms in any industry, for that matter. However, in the case of newly chartered banks, there is even more to the story.
Due to the economic downturn touched off by the rise and fall of residential real estate prices, on average the health of various de novo groups depends heavily on when they were chartered relative to the housing bubble.
The de novos that have generally been hit the hardest are the ones who were chartered in the few years prior to the peak in real estate prices and the following downturn. When the economy began to contract, their portfolios, which were based on higher property values and stronger business conditions, tended to undergo greater stress.
Institutions that were chartered a few years earlier, and which have diversified portfolios across more time of origination, have generally performed better. They tend to exhibit characteristics closer to the industry as a whole, as their age increases. On the other end of the spectrum—though it may still be too early to tell for sure—it appears that institutions chartered in the past two years have been able to avoid most of the bad loans.
Comparing the relative asset quality of banks by charter year sheds light on this dynamic. Banks chartered from 2003-2005 are the ones with the highest rate of nonperforming loans. With each year prior to 2003, the de novo class of that year is generally seeing relatively better loan performance. The same holds true for institutions chartered after 2006.
Chart 1, below, “Non-Performing Assets to Total Assets,” shows the median non-performing asset ratios for banks chartered in each year from 2002 to 2008. This is compared to the median ratio for all banks with assets under $250 million. As can be seen, asset quality worsens, until peaking for the 2005 class. Nonperforming asset ratios for these institutions on a median basis are about twice as high as the industry as a whole. Asset quality then improves for each of the year classes following.
This relationship in turn is then correlated with the de novo bank failures that have occurred in the past two years. As show in Chart 2, below, “Commercial Bank Failures By Charter Class,” not surprisingly failures are concentrated in the same year-classes that have the worst loan performance.
The lesson of all this is that risk is not distributed evenly among all recently chartered banks and is partially affected on average by the charter class year. The importance of timing during the “Great Recession” should not be missed. The rise and fall of real estate asset prices and corresponding economic contraction has affected bank portfolio compositions. Different charter classes are experiencing different situations; therefore de novos should not be brushed with one broad stroke.
A bonus for recent arrivals?
In fact, the newest classes of institutions, those chartered in 2008 and 2009, may even be finding themselves in better situations than they would be otherwise, despite today’s weak economic conditions. Higher rates of nonperforming loans are generally not a factor for these banks. They have a clean slate and have the ability to build portfolios free of loans based on bubble inflated asset valuations.
Mix this with an exceptionally steep yield curve, and these youngest institutions may be in a great place to reach profitability. In some markets, in particular, where nonbank lending has dried up, there may be exceptional opportunity to pursue loans that traditionally would not be available for de novos.
Also, as market risk continues to influence consumer behavior, many investors are turning to the safety of certificates of deposit and money market accounts, and they are willing to do so at yields favorable to banks.
Though market conditions remain difficult, a prudently managed bank with a clean portfolio has a great deal of potential opportunity in this environment. Alan Greenspan commented last year that he would start a bank himself if he were 50 years younger. He said the return on capital would be “impressive.”
In the end, de novos shouldn’t be painted with a broad brushstroke. Being a de novo institution in of itself does not necessitate being a higher risk. Furthermore, due to the nature of this economic cycle, for some classes of institutions, this is perhaps a great opportunity to reach profitably and growth that wouldn’t have otherwise existed.
ABA maintains a special page for de novo banks, which you can find here.
research he prepared for a presentation at ABA’s recent National Conference for Community Bankers.
Topics: Community Banking,