Fear and flexibility

BY ANNIE JOHNSON | BRBJ

(540) 981-3229 l annie.johnson@bizjournal.com

Rising high above Interstate 581 in Roanoke last year was a large billboard that would foreshadow a bit of success for a portion of the nation's crumbling financial services industry.

Superimposed over a photo of a mountain vista, HomeTown Bank had inscribed the words: "Stable. Safe. Secure."

Community bankers say it was a message that resonated with customers across Southwest Virginia, customers who local bankers say reacted to the financial crisis by transferring their accounts and looking to smaller banks to lend when larger banks could not.

In an industry in tumult, where at-risk loans are dragging down banks' balance sheets and the threat of tighter federal rules hangs heavy, community bank lending outpaced all other banks through September 2009, according to an analysis of Federal Deposit Insurance Corp. data by the Independent Community Bankers of America.

And while other financial institutions certainly offer their share of benefits -- more locations, the ability to take on more risk -- banks with less than $1 billion in total assets posted an average 3 percent loan growth in the first three quarters of 2009, compared with average double-digit losses by larger banks.

Fear and flexibility

Community bankers say that two factors are driving their ability to lend: fear and flexibility.

"Community banks are standing up and saying, 'Hey, we're here. We're safe. We're local. We're secure,' " said Susan Still, president of Roanoke-based HomeTown Bank.

Small banks can be more flexible than larger ones in determining whether to give out loans, Still said. Loan decisions are made in-house, and loan officers might have personal relationships with their clients. While large banks have historically had to rely on strict formulas for lending, smaller banks also can look at alternative measures in addition to classic standards such as the borrower's debt-to-income ratio.

"We're solely dependent on the Roanoke Valley, so as this economy goes, we go," said Ellis Gutshall, president and CEO of Roanoke-based Valley Bank. "So we can't all of a sudden say we don't want to loan money in Roanoke anymore; we're going to go to Richmond or Atlanta. We don't go someplace else where the grass is greener, we just don't have that option.

"So I think we're a little more consistent lender because we hang in there with our customer, because we need them."

Because of their smaller size, community banks also typically didn't have enough capital to offer risky mortgages, which has allowed them to retain their credibility amid public discontent about the roots of the financial crisis, according to Steve Verdier, executive vice president and director of congressional relations for the Independent Community Bankers of America.

And while a majority of small banks accepted funds from the Troubled Asset Relief Program, they have mostly been immune to the fireball of public outrage aimed at larger banks that participated in complex lending practices such as the credit default swap market.

"I did think there was somewhat of a backlash to larger banks in general that the community banks sector is benefiting from," said Greg Feldmann, president and CEO of Christiansburg-based StellarOne.

That public fear played a key role in the increase in Valley Bank's deposits, Gutshall believes.

In its Dec. 31 filing with the Securities and Exchange Commission, Valley Bank reported $552.9 million in total deposits, up more than 19 percent from fourth quarter 2008.

A national campaign has even cropped up, championed by Huffington Post founder Arianna Huffington.

"Move Your Money" urges customers to protest the large bank bailouts by switching their accounts to community banks.

It's a campaign that HomeTown Bank is touting locally through an advertising campaign focused on making it easier than ever to move bank accounts.

Growth and stability

As a group, according to a recent study by A.M. Best Co., community banks have historically shown stable, robust margins, little need for reliance on income from financial markets, higher capital levels and less exposure to exotic investments -- the types of risky investments that are blamed for the financial crisis.

The presumption is that community banks' extensive knowledge of local markets can give them a competitive advantage over other financial institutions.

In fact, small banks' median net interest margin has been consistently higher than that of large banks since at least 2005, according to the study. Net interest margin is the difference between income generated by earning assets, such as loans and securities, and expenses incurred on interest-bearing liabilities, such as deposits and borrowings. It's a common way to measure the health of a bank.

For HomeTown, 2009 was not just a year of growth, but the best on record for the institution, which is in its fifth year.

The bank's net assets increased by about $96 million from the third quarter 2008 to the same period in 2009. Its lending increased by nearly $64 million over the same period.

The company posted a net loss in 2008, compared with $300,000 in year-to-date net income by September 2009, the most recent numbers available.

At Bank of the James in Lynchburg, 2009 was "one of the strongest years we've ever had" in terms of volume, according to Brian Cash, a senior vice president at the bank who is also in charge of the institution's mortgage lending division.

Bank deposits in the third quarter of 2009 were $364 million compared with $268 million in the fourth quarter of 2008, according to the bank's most recent SEC filing. For the same quarters, the bank had $310 million in net loans for 2009, compared with $275 million in 2008.

For StellarOne, deposits and lending remained stable, according to the company's most recent quarterly report filed with the SEC.

In fact, for the period that ended Sept. 30, StellarOne ranked third in the state out of all banks, big and small, in the production of loans to small businesses, according to Feldmann.

"We are seeing a lot of customers that typically we might not have seen because there are some folks casting about for a different financial institution," he said.

Big-bank advantages

Still, larger banks retain plenty of advantages over their smaller counterparts.

Banks with $5 billion or more in assets have a more extensive network of branches as well as the ability to take on more risk than smaller operations, according to the A.M. Best study.

Specifically, the study found an important measure of profitability that favors large banks is their access to more varied sources of funding, including public and wholesale funding.

Good news also has begun cropping up for big institutions. Two of the nation's largest banks, Bank of America and Wells Fargo, announced Jan. 27 that their loan losses have stopped increasing, although customers aren't asking for new loans, a point also made by Feldmann at StellarOne.

But those two firms' annual reports painted two very different pictures of the banking recovery. Bank of America said it lost $2.2 billion during 2009, while Wells Fargo reported an $8 billion profit.

Jon Greenlee, the Federal Reserve's associate director of banking and supervision, told Congress in mid-January that, generally, banks have recently reported a loosening of lending.

Meanwhile, larger banks have had to defend themselves amid public rage over lending practices and accusations of being too big.

Bank of America CEO Brian Moynihan told CNBC on Jan. 29 that his bank wasn't too big and that any political pressure to strip banks of their trading activities wouldn't prevent a financial crisis.

Still, President Obama has continued to place political pressure on all financial institutions by proposing to limit the size of banks as well as pushing financial institutions to lend more money, and soon.

The latter of those proposals could add to some of the lending success for smaller banks, as Obama proposed in his State of the Union address to take $30 billion in TARP money and channel it to community banks.

Increasing scrutiny

Not all the news is good for small banks. While growth has exceeded expectations and bank deposits have increased, earnings are down in some cases, an indication that community banks aren't immune to the hardships facing other industries.

Valley Bank reported a net loss of $4.8 million for 2009, compared with a $1.6 million profit in 2008.

At HomeTown Bank, nonperforming assets, such as mortgages in default, accounted for $5.3 million, or 1.7 percent of total assets, as of Sept. 30. That's up from $2.8 million, or 0.3 percent of total assets, during the same period in 2008.

Part of the problem is that bank examiners have become stricter when determining the real-time value of outstanding loans.

"The current situation is that banks are being examined extremely strictly as far as their commercial real estate loans are concerned -- that's the major bugaboo today," Verdier said. Those examinations have come amid increased federal scrutiny of the value at which banks can carry loans on their books.

Another challenging metric for small banks is what is called the Allowance for Loan and Lease Losses, a general reserve account maintained by a bank to absorb loan losses.

As speculation foresees tougher times, banks have to put aside more money to cover potential losses -- an amount that is subtracted from earnings, according to Gutshall.

Take, for example, the increase in the amount set aside for loan losses by StellarOne in 2009 compared with 2008, as outlined in the bank's most recent SEC filing.

The amount set aside for the year ending 2008 was roughly $21 million, compared with nearly $38 million in 2009.

Feldmann said that he also foresees problems in 2010 with supply outpacing demand for loans.

"I think the main governor on our lending is probably the economy and how well businesses are able to do in this environment," he said. "Because with the economy being off, you have a lot of businesses contracting, and when they're contracting they are not buying new equipment" or buildings.

That fact also was illustrated in the fourth quarter numbers posted by Valley Bank, where average loans were down 2 percent compared with the third quarter. Gutshall attributed that decrease to a "decline in loan demand as a result of the depressed economic environment."

In other words, the money is there, but clients aren't out looking for new loans.

A mixed forecast

While Congress has yet to pass a comprehensive financial services overhaul, a slew of pending regulations could have a significant impact on all financial institutions.

One such regulation is the Real Estate Settlement Procedures Act. The rules, which took effect Jan. 1, require that loan officers give their borrowers a "good faith estimate" that discloses key loan terms and closing costs.

Local community bankers said that the regulation is cumbersome and should only be imposed on the banks that handed out the risky mortgages that are blamed for the financial crisis.

Smaller banks also have decried draft legislation that would set up a new Consumer Financial Protection Agency, arguing that they should be exempt from any sort of new rules or regulations for similar reasons they opposed the RESPA rules.

A bright spot for community banks could be the potential chairmanship of South Dakota Democrat Tim Johnson on the Senate Banking Committee.

With his rural base, Johnson could fight to exempt community banks from strict regulations, Verdier said.

"If you're a congressman from New York City, you're not going to worry so much about small rural banks in South Dakota," he said.

Johnson, who has the support of Senate Majority Leader Harry Reid, D-Nev., has taken that fact seriously, expressing at a Nov. 19 banking committee hearing his desire for Congress to "strike the right balance that strengthens regulation where needed, but doesn't unnecessarily harm community banks and credit unions that were not the cause of the financial crisis."