In our commentary of the 2020 first quarter key performance indicators (KPIs) of note, we noted that the consequences of the pandemic and the resulting government relief and stimulus programs were not yet evident. However, that is not the case for the second quarter of 2020. Overall, the community banking industry remained relatively stable during the second quarter of 2020 in comparison with the preceding quarter, notwithstanding the dramatic changes to the U.S. and global economies, and the related effects on consumers and small businesses. In addition, the specific allocations to the community banking industry have seen the positive effects of consumer stimulus payments, including increased unemployment benefits, one-time stimulus payments, and the Paycheck Protection Program (PPP), although it cannot be precisely measured. Nonetheless, it is evident that these programs have, at a minimum, delayed the anticipated negative consequences, and may have a longer lasting effect on the overall financial condition and performance of the industry segment.
Community banks provided an increase in its return on average equity from 8.26% in Q1 2020 to 9.54% in Q2 2020. For the most part, this increase is attributable to combination of a measurable reduction in the efficiency ratio and little or a modest reduction in the level of the allowance for loan losses. Efficiency ratios have declined principally to widespread reductions in workforces as banks adjusted their branch and office hours, and made other modifications that resulted in lower labor and benefit costs. In some instances, reductions in the Federal Deposit Insurance Corporation (FDIC) insurance premiums contributed to improved efficiency ratios.
Credit quality, and the corresponding allowance for loan and lease losses (ALLL) levels remained steady or slightly improved as mandated loan deferral programs were executed and the effect of consumer stimulus payments and PPP loans to small businesses enabled borrowers to, at least temporarily, remain current in accordance with applicable loan payments and related terms. Furthermore, a great deal of uncertainty that remains as to the ability of borrowers to continue this method of access to government-sponsored programs subsides.
The decrease of 0.30% (a relative decline of almost 7%) from Q1 2020 (4.4% to 4.1%) reflects the continued challenges of higher liquidity levels, principally from consumer and small business stimulus payments, and muted loan demand, except for PPP loans. This dynamic has required community banks to place an increased portion of their invested assets in short term, low risk investment securities which have correspondingly caused a decrease in net interest margin (3.64% to 3.51%) principally due to lower investment yields, including where applicable, the 1% yield on PPP loans. This dynamic is expected to continue as a second round of consumer stimulus payments is likely, although delayed, and the forgiveness period for PPP loans has been extended to 24 weeks.
As noted above (see yield on average earning assets) with the exception of PPP loans, many community banks have experienced a notable decline in loan demand in response to economic uncertainty, supply chain disruptions and expectations for a sustained COVID-19 environment. Combined with the increases in deposits, as previously discussed, the reduction in loan demand has resulted in a decline in the overall loan-to-deposit ratio of the community banking sector from 81.53% to 79.73% during Q2 2020. We expect this muted loan demand to persist through the end of the year or possibly well into 2021 depending upon the outcome of the November election and progress toward widespread COVID-19 solutions.
Notwithstanding the dramatic negative challenges facing the U.S. and global economies due to the COVID-19 pandemic, credit quality indicators at community banks have remained stable. This otherwise counter-intuitive result arises predominantly from the effect of consumer (one-time payments and increased unemployment benefits) and small business (PPP loans) stimulus payments and government-mandated loan payment deferral programs. As noted above, it is difficult to identify the direct effect of stimulus payments on credit quality. However, it is reasonably clear the borrowers have been able to effectively protect credit relationships through the second quarter of 2020. On the other hand, community banks report that generally between 10% and 20% of the consumer and small business borrowers have taken advantage of loan payment deferral programs. As these payment deferrals reach their conclusions, community bankers are becoming concerned about the ability of the borrowers to resume payments and to effectively accommodate the payment of interest accrued during the deferral period. These concerns will likely be reflected in the credit quality KPIs in the third quarter of 2020.
M&A activity in the community banking sector remains extremely low at this time. Furthermore, the uncertainties reflected in the KPIs discussed above, the outcome of the November election and the depth and duration of the COVID-19 pandemic make bank valuation dynamics cloudy as best. In addition to few, if any, deals being announced during quarter two of 2020, a number of deals were terminated as the changes in bank valuations caused the pre-close valuation floors to be breached. To the extent the uncertainties noted throughout remain, we anticipate community bank M&A activity to remain notably unchanged well into 2021.
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