Academic journal article Chicago Fed Letter

Exploring Risks and Opportunities for Community Banks in an Improving Environment

Academic journal article Chicago Fed Letter

Exploring Risks and Opportunities for Community Banks in an Improving Environment

Article excerpt

Key presentations at the Community Bankers Symposium were delivered by Charles Evans, president and CEO, Federal Reserve Bank of Chicago; Thomas Curry, comptroller, Office of the Comptroller of the Currency; Daniel Tarullo, member, Board of Governors of the Federal Reserve System; Richard Brown, chief economist and associate director of regional operations, FDIC; and John Ryan, president, Conference of State Bank Supervisors. Nearly 200 participants, mostly executive officers and directors of community banking organizations in the Seventh Federal Reserve District,1 gathered to discuss both the opportunities and key emerging risks that lie ahead for community banks. The major themes of the symposium were the critical role that community banks play in the communities they serve; the importance of managing "strategic risk" (i.e., the risk that earnings and capital will be negatively impacted by improperly executed or poor business decisions) ; the need to tailor supervisory oversight to the size and complexity of the financial institution; and the increasing risks related to cyberthreats.

Economic implications for banking

Remarks by both Evans and Brown indicated a favorable outlook for the U.S. economy, boding well for the banking sector in the upcoming year. Some of the reasons for their optimism included economic growth that is expected to be above its long-term trend; well-controlled inflation; firming labor markets, with the actual unemployment rate approaching its natural rate;2 and rising levels of consumer and business confidence and spending. While the U.S. economy's pace of expansion is clearly improving, challenges remain. Most notably, the weak global economy continues to present considerable downside risks to the U.S. economic outlook. A stronger U.S. dollar could hurt net exports and dampen inflation, which has already been tracking well below the Federal Reserve's long-term goal of 2% for an extended period. Evans offered the view that the Federal Open Market Committee needs to be patient on the timing (and pace) of raising the federal funds rate (i.e., the traditional short-term interest rate policy tool) until economic growth is more assured. Tightening monetary policy too soon (or too quickly) could halt the recovery and potentially require a return to accommodative monetary policy support. According to Evans, at the time of the conference, the downside risk of prematurely raising short-term interest rates continues to outweigh the risk of inflation rising somewhat above the Fed's 2% target while accommodative monetary policy remains in place.

In regard to the economy and the banking sector, Brown made several notable comments, including the following:

* Residential properties are experiencing a remarkable turnaround in price appreciation; this positive development should reduce losses due to defaults on these properties and should translate into less risk for the banking system.

* The positive traction in declining vacancy rates in the U.S. office market is generally reflective of the slow pace of new commercial construction during this expansion. Multifamily and warehouse units are experiencing relatively higher demand, prompting new construction projects.

* Commercial real estate capitalization rates remain near decade lows in part due to low long-term interest rates, although existing property values are vulnerable to declines if investors continue to demand higher rates of return when rates begin to rise.

* The growth in construction and real estate development varies widely across the nation, although the collective size of this business line is down by about 66% from its 2006 peak.

* The economy is becoming less entrepreneurial as the rate of newly created businesses lags the number of firms exiting the market. This is problematic for smaller banks, as they devote a far larger portion of their lending to small business loans.

Other relevant economic topics at the symposium included the booms in the agricultural and energy sectors during the recovery. …

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