For Community Banks, the Worst May Not Be Over

By Jeff Voss, CPA, Managing Partner, Artisan Advisors

There’s a lot of talk lately about getting back to normal. People are getting vaccinated. Mask restrictions are easing. Towns and cities across America are opening up again. Businesses are beginning to call people back into the office and many industries are seeing signs of real recovery.

Banking is something of a different story. Given the data that is disclosed by the larger publicly traded banks, you might believe that the worst is over. For smaller privately held banks, that may not be the case. Frankly, we see three significant issues that community banks must still contend with.

First, lending in certain commercial sectors such as hotels, restaurants, office buildings, and retail strip centers are common in community bank loan portfolios. While these sectors may rebound, with the added time and aid provided by various government programs, it is clear that COVID continues to negatively impact many of these businesses. At some point, the impact of these issues will be fully disclosed. Unfortunately, the disclosure of this information for non-publicly traded banks is still not available to the general public. Only the banking regulators and the banks with these portfolios truly know the potential impact at this point.

Second, two rounds of PPP lending created strong growth in bank commercial loan portfolios and related origination fees in 2020 and 2021. Unfortunately, these loans and related fees are one-time events by their nature. Most of this growth will likely go away by the end of 2022. Additionally, banks took proactive steps toward increasing loan loss reserves in 2020. Many of these banks are now beginning to reverse these reserves to levels deemed to be more realistic. Last, residential mortgage origination fees increased at many community banks to record levels, as customers took advantage of historically low mortgage rates.

The real question to be asked is: what do the core earnings of most banks look like after removing the positive impact of PPP fees, the reversal of excess 2020 loan loss provisions, and normalizing mortgage fees? We would contend that most community bank core earnings are flat to down in 2021, as loan growth in non-PPP sectors has been slow. At the same time, customer bank deposits are growing as they wait for market interest rates to move upward. As liquidity grows, banks have no place to invest these funds as falling market rates have resulted in near record lows for yields on investments. When rates do rise, what will happen to mortgage fees and the growth in deposits? Third, as we become more assured that COVID is under control, our economy will likely grow rapidly. Unfortunately, our economy is linked to what happens in the rest of the world. While the COVID cases are dropping each week across the country, other parts of the world are still being ravaged by the virus. It is a race to vaccinate the United States and world populations amid speculation about the risks and benefits of taking these vaccines. While the United States economy has started to pick up quickly, as more of our population becomes fully vaccinated, we believe that this rapid growth will be tempered by year-end, as the vaccination rate slows.