State of the State Mid-Year 2023: Banks reacting to the Fed

Editor’s note: The State of the State series provides reports twice a year on Arkansas’ key economic sectors. The series publishes stories to begin a year and stories in July/August to provide a broad mid-year update on the state’s economy. Link here for the State of the State page and previous stories.

Three high-profile bank failures earlier this year have not spread to the state. Meanwhile, banks are having to respond to rapidly rising interest rates. Overall, the state of banks in Arkansas is “stable but reacting.”

The U.S. banking system got a scare earlier this year when Silicon Valley Bank in Santa Clara, Signature Bank in New York, and First Republic Bank in San Francisco failed. So far, the fallout has not spread.

“We just did not see any of that turmoil that happened with those large institutions,” said State Bank Commissioner Susannah Marshall. “We did not see that here in Arkansas.”

RATE PRESSURE
Marshall said Arkansas banks’ asset quality and capital levels are strong. However, they are contending with an interest rate environment where the Federal Reserve on March 17, 2022, started raising its benchmark rate from 0% to the current 5.25% to 5.5% in an effort to tame inflation.

That environment is starting to have an impact on earnings and profitability, and some institutions have had smaller margins. In Arkansas, the return on average assets, a common measure of profitability, declined from 1.3% at the end of December to 1.22% March 31. Considering 1% is the benchmark, they’re still doing well, and the retraction was anticipated following a period of record earnings.

Marshall said the speed with which the Federal Reserve has deployed its interest rate hikes has been the issue – not the increases themselves.

“Rate movements are not bad things,” she said. “That’s not a problem, but the pace and the steepness of which they made those rate increases – you know, we’ve had 11 since March of 2022 – the pace of those is what has really impacted the industry, the banking sector, because you’re not able to react to those changes as quickly as they’re coming.”

Lorrie Trogden, president and CEO of the Arkansas Bankers Association, said Arkansas’ financial institutions are well capitalized and have good liquidity. They also are based on a community bank model with longstanding relationships with customers.

“Silicon Valley Bank – the name itself tells you it’s got a different model,” she said. “So our banks here, they don’t operate like those banks did, so that is not indicative of a systemic crisis what happened there.”

‘MORE AGGRESSIVE’
Sam Sicard, president and CEO of the First National Bank of Fort Smith, said banks are stable economically because there hasn’t been a lot of market disruption, problem assets or foreclosures. His bank’s past-dues are low because the economy is enjoying full employment and because small businesses are doing OK.

However, the rising rate environment forces banks to pay more for deposits and charge more for loans. It is slowing loan projects because it’s harder to make the cash flow cover the debt service. The 0% interest rate environment squeezed banks’ margins, Sicard said. They had to pay CD holders something. He was glad to see rates reach 2%-3% because it helped the bank, was good for depositors and didn’t hurt borrowers. Now, he’d like to see the Fed stop raising rates.

Sicard said banks became flush with deposits in the early days of the COVID-19 pandemic when the federal government was sending stimulus payments to consumers to prop up the economy. Deposits increased 20% to 30% or between $300 and $500 million between First National’s branches in the Fort Smith area, Northwest Arkansas and Oklahoma, along with Citizens Bank and Trust in Van Buren, which the holding company also owns.

Deposits have been declining over the last year as consumers have been spending down their savings because of inflation and also putting their money elsewhere, Sicard said. Higher interest rates have made bonds and treasury notes more attractive, and investors also are investing in the stock market.

“Banks are now being more more aggressive with the Fed raising rates and now with deposits declining, and needing those deposits to fund loans, banks are being more aggressive on rates, and we are too,” Sicard said.

As of late July, his bank was offering 7-month and 11-month CDs with interest rates of 4.5% with a 4.59% annual percentage rate. Sicard said the effects of the Fed’s higher rates have been limited because monetary policy has a lagging effect. New construction projects had their rates locked in at the end of last year when rates were lower, demand was strong and supply was limited. The economic data may not reflect the slowdown in future projects yet.

“But we see it on the front end because we’re seeing less requests for loans for future projects that would normally start later this year and really … get going into ’24,” Sicard said.

BANK DEALS
Marshall said there haven’t been many major banking moves or acquisitions lately, which she expects to continue for the remainder of this year. Banks are interested in merger and acquisition activity, but it may be next year before there’s an uptick as they try to figure out what will happen with interest rates.

Sicard said acquisitions have been limited for several reasons. Bank stocks generally have been trading low because of recession fears and because of those three bank failures. However, neither a recession nor additional bank failures have materialized, and bank valuations have started to increase this quarter. The lower valuations have made it harder for banks to engage in stock-for-stock acquisitions. The higher interest rates have made it more expensive to buy a bank. Moreover, with the economy doing fairly well, banks are less motivated to sell because they are not as concerned about the future.

Among the challenges facing the banking industry is section 1071, a regulation by the Consumer Financial Protection Bureau. The provision of the Dodd-Frank Act is intended to ensure fair lending to minorities and women-owned business, but the 880-page rule is forcing banks to work to comply with it, and there are privacy concerns.

“You’re seeing a lot of banks have to scramble very quickly to stand up new processes, new procedures, new actual technology to try and comply with these things, so they’re having to put a lot of focus, a lot of employee time, a lot of money behind all these efforts, and it’s stymying them quite a bit,” Trogden said.