The Great Lending Shift

FDIC study tracks dramatic changes in profitable community bank mainline and specialty lending

By Kelly Pike

A community bank’s lending strategy is critical to its success—but the most common strategy isn’t necessarily the most profitable one. As community banks have adjusted their lending strategies to keep pace in a highly competitive market—many embracing commercial lending over retail for the past 27 years—a new FDIC study finds that just as in the old fable, the tortoise ultimately beats the hare.

In the early 1980s, the community bank lending landscape looked different than it does today. Then, just 2 percent of community banks specialized in commercial real estate lending, which the FDIC defines as banks holding construction and development loans greater than 10 percent of assets or total commercial real estate loans greater than 30 percent of total assets. Back then, 9 percent of community banks specialized in consumer lending, 11 percent specialized in commercial and industrial lending, 8 percent were multi-specialists focusing on more than one loan category, and a huge number, 38 percent, had no specialty at all, according to the 2012 FDIC Community Banking Study.

But as interstate branching, cost-reducing technologies and access to capital markets enabled noncommunity banks to push into consumer lending and residential mortgages, community banks responded by seeking out areas in which their local expertise gave them a sharper edge, especially commercial real estate loans. Between 2000 and 2005, more than 900 community banks (about 11 percent of community banks at the time) that had specialized in agricultural or mortgage lending, or had no-specialty lending focus, began specializing in commercial real estate lending—including commercial and development lending—as did 60 percent of newly chartered banks. At the peak in 2007, almost 30 percent of community banks specialized in commercial real estate lending—up from 11 percent in 2000.

Yet the lost story, according to Rich Brown, chief economist at the FDIC, involves the bottom-line results of the shift. Since 1984, the most profitable community banks pursued agricultural or consumer lending, or did not specialize in any particular lending area. The FDIC classifies banks with no specializations as lenders that focus on loan administration and underwriting, have experience in their local market and avoid lending in areas that aren’t familiar.

From 1986 to 2011, the FDIC found community banks with no specialty saw an average return on average assets of 1.28 percent compared with 0.64 percent for those focused on commercial real estate lending. Meanwhile, community banks focused on agricultural or consumer lending came out on top with average return on average assets of 1.4 percent and 1.27 percent, respectively. Mortgage banks, commercial and industrial lenders, and multi-specialists returned close to 1 percent return on average assets.

“Those lines of business are hares and tortoises,” says Brown. “They [ag, consumer and no specialty] are not spectacularly profitable lines of business, but are very steady. It’s a diversified business strategy—meeting a broad spectrum of credit needs.”

Boom and bust

While many may assume that the extra return during the boom years offsets the losses of the down years for commercial real estate lending, the FDIC’s study finds that is not the case. Commercial real estate specialists performed slightly better than the average in good economic times but much worse during difficult times.

When real estate prices increase, we “have seen that perhaps too many players are entering these markets all at once, engendering volatility,” suggests Brown.

Consider the 1980s real estate boom and subsequent bust in the late 1980s and early 1990s: From 1986 to 1990, return on average assets at commercial real estate specialized community banks averaged -1.57 percent compared with 0.88 percent at community banks with no specialization.

“Empirical research shows that sticking to your knitting makes more profitability on average over a long time,” Brown notes. “There’s systemic volatility in real estate. Cycles are so strong, they undermine what is otherwise a natural line of business for community banks.”

That doesn’t mean that commercial real estate lending isn’t a good business model—it just means that not all the benefits can be easily measured by the balance sheet, a subject the FDIC is interested in studying in the future, Brown says. “These are very important industries to local economies,” he says. “Community banks are an important source of credit. Going forward, we’d like to have a better idea of the social costs and social benefits of that type of lending.”

Community banks across all lending specializations increased their commercial real estate lending over the study period, yet many of those particular loans have important and distinctive differences, the FDIC notes. About half of the commercial real estate loans during the study period were secured by owner-occupied properties, which tend to resemble and perform like commercial and industrial loans, a possible explanation for the decline in commercial and industrial loan specialists among community banks from 11 percent in 1984 to just 2 percent in 2011.

Interestingly, community banks that were commercial and industrial lending specialists had a 25-year average return on assets of 1.03 percent. Farm properties performed best of all, while banks specializing in construction and development lending were hit the hardest by downturns.

The most consistently profitable niche over the last 25 years—agricultural lending—held steady with 13 percent of community banks specializing in it in 1984 and 14 percent in 2011. Residential mortgage lending specialization declined somewhat, reaching a peak of 22 percent from 1995 to 2000, when many banks picked up new mortgage volume after many savings and loan institutions failed during that period’s real estate finance crisis.

Brown describes residential mortgage lending as a resilient niche, especially in the Midwest and Northeast. The good news is that although providing home mortgages is a scalable business, the biggest players have needed to increase their budgets and expenses after previous cost cutting to clean up inefficiencies.

The future of lending

While consumer spending and residential real estate lending have fueled the economy in recent years, that trend may not continue, notes Brown. But other industry sectors, particularly energy and manufacturing, could create demand for small-business lending where community banks have an advantage. “Will the economy be as dependent on consumer spending and real estate, or will it be agriculture, energy and manufacturing—things that community banks are more involved with on a credit-providing basis?” he wonders.

Regardless, it’s likely that more community banks will embrace the basic blocking and tackling of community banking and become non-specialist lenders. Already the number of no-specialty lending community banks is increasing, up five percentage points over the past five years, in part due to the failure of many banks heavily concentrated in commercial real estate lending. This prototypical definition of a community bank is poised for success.

“I think this overlooked business strategy—broad spectrum service—will come more back into vogue,” predicts Brown. “It’s more stable and viable.” endmark


Kelly Pike is a freelance writer in Annandale, Va.

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