In April, 2008, I personally needed a change of scenery. I was extremely lucky to be part of arguably the largest banking law practice in the state at that time, and I was equally fortunate to have arguably the state’s best known banking attorney as my mentor. However, the pressures and stresses of balancing the practice of law, billable hours, and my family, which was four months into our second child, was beginning to wear on me. As a result, I made a decision, maybe somewhat hastily, to leave the practice of law and join the bank back home that my family had been involved in for some time. At that point in my life, “Bankers’ Hours” was a dream that was hard to forget and impossible to pass up.
Shortly after I left the firm and joined the bank, an older banker whom I had worked with and have a tremendous amount of respect for called me to chastise me for not telling him that I was leaving the firm. This banker had been around the business for a long time and had seen a lot. He had the charisma of a Marlon Brando with the down home common sense of an Andy Griffith, even though it is safe to say he did not have the Hollywood looks of either. After properly reprimanding me, he turned the conversation to wishing me luck and giving me whatever nuggets of wisdom I could use in my newfound career. He ended the conversation with this statement that has stuck with me since that day: “This business ain’t hard, son, you just can’t make bad loans.” Ironically, five months later, all hell broke loose in banking and within our nation’s economy, and his words remained in the background of my psyche like a continuing subtitle that I used to interpret the chaos that was ensuing all around the banking industry.
In December of 2012, the Federal Deposit Insurance Corporation (“FDIC”) conducted its “Community Banking Study,” which was “a data-driven effort to identify and explore issues and questions about community banks.” It analyzed banking data over the period of time between 1984 and 2011 and tried to analyze trends and circumstances that were altering the banking landscape for community banks and which impacted the performance of community banks as they entered the “Great Recession.” Chapter 5 of that study was a comparative performance of community bank lending specialty groups, and it focused mostly on how community banks had shifted their lending strategies prior to the recession and what affect that strategic change had on their performance during the recession. I found the following points to be particularly interesting:
- In 1984, retail loans represented over 61 percent of all loans at “community banks”, compared with 35 percent of all loans at “noncommunity banks.” By the end of 2011, these ratios had basically flipped so that retail loans made up 36 percent of community bank loans and 54 percent of noncommunity bank loans;
- Between 1984 and 2011, residential real estate loans fell from 47 percent of community bank total loans to 32 percent, while commercial real estate loans rose from 21 percent of loans to 42 percent;
- Commercial Real Estate (“CRE”) specialists experienced the most volatile earnings performance during the examined period, and their pretax ROA trailed the community bank average by more than one-third;
- CRE specialists had a high frequency of failure during the period examined, failing at a rate that was more than two time as frequent as similarly situated community banks;
- Between 1991 and 2007, the number of CRE specialists increased fivefold, going from less than 4 percent of all community banks in 1991 to almost 30 percent of community banks at their peak in 2007;
- For the entire study period, community banks with Commercial and Development (“C&D”) loans, a subset of CRE loans, greater than 10 percent of their assets were 2.8 times more likely to fail than the average community bank, while those with C&D loans below 10 percent were less likely to fail than the average community bank;
- CRE specialists were the worst performers over the entire study period, performing slightly better than the average for all community banks in good economic times, but performing significantly worse during periods of banking crises; and
- CRE specialists were primarily headquartered in metro counties (80 percent), and 74 percent of community banks with at least 10 percent of assets in C&D loans were primarily located in metro areas.
When I was examining the UBPR data for the period of time that mostly followed the FDIC’s study period, my first hypothesis for explaining the earnings discrepancy between metropolitan and non-metropolitan banks was that it had to be related to these “bad” CRE and C&D loans cited in this study that the wise banker warned me about. It seemed quite logical to me that metropolitan banks would have much lower earnings, even during this “recovery” period, because they were still fighting loan provisions and non-accrual loans from CRE and C&D loans that were just more prevalent in their markets.
After testing this assumption, it did appear to hold up, at least partially. From the beginning of 2010 through the end of 2014, banks under $300 million in assets and in a metro area averaged loan provisions that were 0.28% of total assets compared to loan provisions that averaged 0.17% of total assets for similarly sized banks headquartered in non-metro areas. Likewise, the same metro banks had average non-accruals equal to 1.72% of total loans during that period, while their rural counterparts had a non-accrual percentage of 1.04%. There is no doubt that higher balances of “bad” loans are still holding metropolitan banks back. By the way, for what it is worth, banks larger than $300 million averaged provisions and nonaccruals that were higher than each of these averages, even though their average earnings were on par with the smaller, rural banks and much higher than the smaller, metropolitan banks.
However, when I considered that rural banks under $300 million in assets had earnings that basically doubled those of similarly sized metro banks from 2010 through 2014, this answer alone did not seem to be sufficient to answer the question entirely, and it wasn’t. The rest of the story became evident when I dug deeper in the bottom half of the income statement, and that will be the topic of my next article.
 The study developed a new research definition of a community bank that was partially tied to asset size (i.e., an indexed maximum asset value that began at $250 million in 1984 and increased to $1 billion in 2010), but also considered “criteria related to traditional lending and deposit gathering activities and limited geographic scope.”
 In order to be considered a “specialists” for the purposes of this study, a bank had to hold loans of that type greater than 33 percent of total assets.