In December, President Obama met with bankers from small, community banks and instructed them to start making loans. Ten months later the banks are not making those loans. Why? Is this purposeful defiance of the administration by the grassroots of the financial sector?
The large banks such as Wells Fargo and Bank of America are deemed too large to be allowed to fail. These institutions engage in all manner of exotic transactions including swaps and derivatives that the community banks cannot. The small banks are in business primarily to loan money for mortgages and commercial purposes such as real estate development. But, for the most part they aren’t doing that.
The problem is tied to what are known as bank financial ratios. The following discussion regarding these ratios is somewhat technical, but follow along if you’re seeking financing from your community bank and not making much headway.
Banks are regulated by state and federal agencies created by legislatures, such as Congress, and operate under government-enacted regulations. These agencies also adopt their own rules and regulations as an expansion of power under the enabling legislation. Among these regulations are certain tests known as bank financial ratios. These ratios measure whether a specific bank is adequately capitalized as a means of surviving.
There are 3 main ratio measures that are used by regulators to assess the adequacy of a bank’s capital. The first is the total capital-to-weighted-risk assets ratio.
· Total capital is the sum of Tier 1 and Tier 2 capital.
· Tier 1 capital generally consists of the sum of the current book value of common stock plus surplus and retained earnings.
· Tier 2 capital is loan-loss reserves plus subordinated debt. Subordinated debt is long-term debt that is secondary to the claims of depositors and secured creditors in the event of the bank’s insolvency.
· Risk-weighted assets are the capital a bank must keep to cover its liabilities. They are calculated as follows: Government bonds, cash and equivalents have a risk weight of 0%; interbank loans 20 %; mortgages 50%; and most other assets have a risk weight of 100%. In other words, the total value of each category of assets is multiplied by its appropriate risk factor and the products are summed.
This sum is divided into the total of Tier 1 and Tier 2 capital. The resulting sum has to equal or exceed 8% for the bank to be deemed to have the minimum amount of capital in order to be deemed adequately capitalized.
The second measure of an adequately capitalized bank is the Tier 1 risk-based ratio. The minimum standard is 4% in order for a bank to be deemed to be adequately capitalized.
Third, the adequately capitalized bank also will have a minimum Tier 1 capital-to-average-total-assets ratio (aka leverage ratio) of 4%.
While these ratios originally were designated as guidelines, they now are deemed to be mandatory by banking regulators. Banks that are classified as undercapitalized are restrictively regulated, including replacement of senior executive officers and directors, thus making business efforts difficult at best. Banks labeled significantly or critically undercapitalized are placed in receivership.
There is another rule of thumb that also is used as a measure of a bank’s credit difficulties. It’s known as the Texas ratio, and is calculated by dividing the sum of the value of non-performing assets (including loans more than 90 days delinquent) and REO-Real Estate Owned (properties the bank has acquired by foreclosure or deed in lieu of foreclosure) by the amount the owners of common stock would receive in the event of the bank’s liquidation. History has shown that banks tend to fail when this ratio exceeds 1:1, or 100%.
So, what does all this techno-speak about financial ratios have to do with your community bank not lending to you? Just this: because most banks, large and small, made all the loans they could find and fund in the last decade – many of which now are delinquent, non-performing, underwater, or encumbered properties which the bank now has acquired through foreclosure or deed in lieu – they are experiencing capital adequacy issues when the above described ratios are applied.
Banks in this situation are not in a position to fund any additional loans until the ratios reset to the proper level. This reset can be achieved in a number of ways, but few of them ever are realistic. The larger banks were deemed too large to be allowed to fail, and received TARP funds to assist them. Not so for the community banks.
· The smaller bank could try to raise equity through the sale of stock or subordinated debt. Because the stock in most small banks isn’t publicly traded, this chiefly works only for larger banks. Even if the smaller bank could float a new issue of stock, it has the effect of watering down the stock held by existing shareholders, who naturally oppose this avenue.
· Reduction of assets also has the effect of improving the capital ratio, but also divests the bank of profit producing assets.
· Finally, the troubled bank could allow itself to be merged into a larger bank. This has happened to community banks to a large extent in recent years. In fact, more than 4,000 banks have gone out of existence in the past 15 years.
The bottom line is that this raises the question whether community banks are going the way of the dinosaur. Speaking as a businessman and real estate developer, I believe that would be crippling to our industry. Most developers do not do projects that command the attention of the large banks. We rely on our community banks and the relationships we’ve established with them over the years.
If they disappear, it will make smaller scale development – under $50 million – very difficult to finance. The large banks prefer to put the same amount of time and effort into larger loan transactions, as do most equity funds. Additionally, equity typically coast much more than debt, so the numbers often don’t pencil out on projects heavily funded by equity.
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©2010 by The Falbey Institute for the Development of Real Estate
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