Return on average equity (ROAE)
In comparison to the fourth quarter of 2017, community banks realized a significant increase in the return on average equity. The largest component of this increase reflects the effect of tax reform, specifically the reduced tax rate applicable to deferred taxes, on many institutions during the fourth quarter of 2017. We estimate this accounted for about one-half of the increase in this key performance indicator (KPI) from quarter-to-quarter. Similarly, the current period returns reflect the lower corporate income tax rate, which went into effect at the beginning of 2018.
Also reflected in this improvement is the continued strong performance in most credit sectors, enabling community banks to maintain an adequate allowance for loan losses (ALLL) while experiencing level or reduced provisions for losses. Finally, community banks continue to demonstrate improved operating efficiency, principally from the expanded use of technology and a modestly reduced regulatory burden arising from changes in the tone of certain regulatory agencies.
Cost of funds
This KPI, demonstrating the price of maintaining sufficient liquidity to fund operations and growth, remained essentially flat in comparison with the preceding quarter. The stability of this metric reflects the strength of loyalty of key community bank depositors and the absence of market leaders choosing to get out ahead of anticipated rate increases as signaled by the Federal Reserve. Community banks continue to be the beneficiary of low cost, core deposits and the flatness of the short-term yield curve. We anticipate some upward movement in this KPI concurrent with rate increases expected to be announced this summer and fall.
As noted above, community banks continue to improve operating efficiency. Most notably, community banks are realizing the benefits of developed and emerging technologies in addressing historically labor-intensive activities, including branch operations and data management. Although community banks continue to dedicate significant funding to managing regulatory compliance, mostly related to Bank Secrecy Act (BSA) / Anti-money Laundering (AML) and Home Mortgage Disclosure Act (HMDA), the overall cost of regulation appears to be subsiding, principally due to what appears to be a more efficient and relaxed bank regulatory framework. Based on the recently passed legislation rolling back key provisions we expect community bank efficiency ratios to continue to improve. Much of this improvement will be realized by community banks with residential mortgage operations that will benefit from relaxed requirements for the collection of data under HMDA and the application of the Qualifying Mortgage (QM) standard for banks will lower mortgage origination volumes.
ALLL to total loans and leases
Community banks continue to experience positive performance across all segments of their credit portfolios. The strong economy, historically low levels of unemployment and reduced tax burdens have all contributed to sustained strong credit performance. In addition, community banks appear to have broadly embraced enhanced credit discipline, both in terms of pricing and credit quality. Although the competition for loans has been relatively intense for the past two to three years, most community banks have stayed within their risk appetites and have avoided serious credit problems. As noted above, the ALLL levels have been maintained without incurring measurable increases in provisions for losses. As the implementation of the new current expected credit loss standard (CECL) draws nearer, many community banks are likely to remain well within their risk frameworks until they have a clearer picture of the effect of the transformative accounting pronouncement.
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