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Evidence early signs of pandemic

Although the financial condition and operating results of the community banking industry remained relatively stable as of and through the quarter ended March 31, 2020, certain key performance indicators (KPIs) began to reflect the consequence of the early stages of the global COVID-19 pandemic. As the economy began to respond to broad-based shutdowns across the country community bank balance sheets began to expand modestly resulting in changes to capital levels and the efficient use of deposits to support lending activities. We expect second quarter results to be more impacted by the economic consequences of the pandemic as well as the emergence of government stimulus, including the Small Business Administration’s Paycheck Protection Program (PPP). Also, by the end of the first quarter we observed the dramatic curtailment of community bank mergers and acquisitions activity. We do not expect this to recover at time during the remainder of 2020.

Notable observation from the first quarter KPIs, in comparison to the fourth quarter of 2019 are:

Tier 1 capital

As businesses and consumers initially responded to the emergence of the pandemic, deposit balances at community banks increased, resulting in a modest increase in the size of bank balance sheets. Because of the continuing challenges to generation higher net interest margins, as discussed below, bank earnings, to some degree as expected, were not sufficient to maintain the tier 1 capital levels that existed at the end of the most previous quarter. Notwithstanding, this modest decline in the average tier 1 capital ratio from 15.37% as of Dec. 31, 2019 to 14.47% as of March 31, 2020, the community banking industry as a whole remains well-capitalized and is expected to be able to sustain this position through the end of the year, dependent upon the depth of expected increases in loan loss provisions.

Return on average equity (ROAE)

As anticipated as we entered 2020, the collective ROAE of the community banking industry declined, in most part due to continuing downward pressure on yields on earning assets and net interest margins. The ongoing challenges of attracting and retaining deposits, prior to the emergence of the pandemic, resulted in only a slight decline in the cost of funds, from 0.86% to 0.80% in comparison with the previous quarter, notwithstanding the Federal Reserve’s decision to move their benchmark interest rate to near zero. Although asset quality remained stable through the end of the quarter, some community banks began to accommodate higher credit reserves as government-mandated payment deferrals and modifications began to emerge. Yields on earning assets were modestly lower at 4.41% in comparison with 4.56%, due principally to the effect of declining rates on investment portfolios and variable rate loans.

Loans to deposits

As deposits grew near the end of the first quarter of 2020 banks generally found limited loan demand (preceding the introduction of the PPP). Accordingly, loan to deposit ratios declined, on average, from 82.09% at Dec. 31, 2019 to 81.53% as of March 31, 2020. Because of the significantly lower interest rate environment resulting from Federal Reserve strategies, community banks have limited asset alternatives that will enable them to increase returns while maintaining sufficient liquidity. One benefit the lower loan to deposit ratio is the corresponding capacity to actively engage in the PPP, which we expect will result in a notably higher loan to deposit ratio at the end of the second quarter (prior to the anticipated forgiveness of a sizable amount of these loans).

Credit quality

Both the allowance for loan and lease losses (ALLL) to total loans and the level of non-performing assets remained relatively stable during the first quarter of 2020. This reflects the strength of the economy up until the dramatic consequences of the COVID-19 crisis. Although most parties expect the credit quality indicators to deteriorate measurably, it is not expected they will be fully reflective of the depth of the decline of the credit markets until after the PPP and certain mandated payment deferral programs have been completed. Other than for larger publicly traded banks, the delay in the required implementation of the current expected credit loss (CECL) accounting standard will likely result in a more measured and steady increase in the ALLL levels and non-performing loans.

Mergers and acquisitions (M&A) insights

Consistent with historical patterns, the first quarter was expected quite with regard to announced and complete community bank M&A transactions. In response to the beginning of the COVID-19 pandemic and the resulting declines in bank valuations, at or near the end of the first quarter and into the second quarter of 2020 community bank deals have essentially evaporated. In fact, pursuant to the terms of the related agreements, a number of deals were cancelled as the valuation of the acquirers’ equity declined to levels below the state floor. We expect the absence of community bank M&As to remain for the foreseeable future. The return of these deals will be dependent in large part on the depth and duration of the pandemic, as well as the extent of credit deterioration that occurs within the community banking sector.

For more information on this topic, or to learn how Baker Tilly’s Value Architects™ can help, contact our team.

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