The Federal Deposit Insurance Corporation (FDIC) recently released its Risk Review for 2023, detailing a substantial increase in unrealized losses–$617.8 billion in the last quarter of 2022 and $515.5 billion in the first quarter of 2023–driven in large part by “declines in medium- and long-term market interest rates.” If banks face a situation where they need liquidity and therefore have to sell investments at a loss, the depreciation of their portfolios could be a deathblow that renders many financial institutions insolvent.
While several asset quality indicators, such as the delinquency rate and nonconcurrent loan rate, remained favorable, the reality is that the banking sector is not in good shape–and declining macroeconomic conditions have exacerbated risk factors. Rising interest rates, coupled with inflation, have simultaneously affected bank balance sheets and consumer debt and expenditures. However, there is an important silver lining in the report: Community banks have fared much better than their larger counterparts–and helped sustain small business lending.
One important metric for gauging the health of a bank is its net interest margin (NIM), which reflects the interest income generated from credit products, such as loans and mortgages, net of outgoing interest payments to holders of savings accounts and certificates of deposits. Although NIMs increased in the industry as a whole in 2022, the increase was concentrated among community banks at 3.45%–up from roughly 3.25% in 2021. Since 2012, community banks have had roughly 0.5 percentage points higher NIMs than their non-community counterparts.
In addition, community banks have played a major role in supporting small business lending. Even though they only hold 14.7% of total industry loans, they accounted for 23.6% of total small business loans in 2022. Moreover, the increase in lending did not come with additional costs of higher risk: The commercial and industrial early-stage, past-due rate, and nonconcurrent rate for community banks actually declined at the onset of the pandemic and has remained low at around 0.5%, compared with roughly the double among non-community banks.
To better understand the health of the banking sector at a higher frequency, I launched a monthly nationally representative banking survey of 1,500 respondents in June. Consistent with these results from the FDIC Risk Review report, I found that individuals who borrow from smaller banks are much more confident in the safety of their deposits. For example, 34.5% of respondents who work with a small bank report that their bank is “rock solid” with “no concerns,” whereas only 26% of those with a medium-sized bank report similarly (and 33% among large banks). There is a growing recognition that small banks are better positioned to maintain the trust and loyalty of their borrowers because their interactions with customers are more frequent and their investments more prudent, particularly in their local communities.
One potential concern with these results is that differences in perception of risk simply reflect differences in the type of borrower. However, all results are robust to controlling for a wide array of demographic factors (age, race, education, marital status, employment status) and the respondents' overall perception of the banking sector (not their own bank). Furthermore, those who work with a small bank are less optimistic about interest rates and central bank policy overall, so if anything, these results are overly conservative.
As 2023 comes to a close, it is important to remember the important role that small banks play in providing liquidity in the banking system–often with the least amount of risk. Due to their exposure to varying macroeconomic conditions, larger and mid-sized banks will need to pay greater attention to the quality of their assets and the health of their balance sheets.
Christos A. Makridis is the founder and CEO of Dainamic, a financial technology startup that empowers banks with regulatory compliance and forecasting software, in addition to serving as a research affiliate at several leading universities. Christos holds dual doctorates in economics and management science & engineering from Stanford.
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