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SPRING 2012

CENTRAL

NEWS AND VIEWS FOR EIGHTH DISTRICT BANKERS

FEATURED IN THIS ISSUE: ALLL Best Practices | Bank Performance Continues on Meandering Path

Will Community Bank Returns on
Equity Return to Precrisis Levels?
By Gary Corner

FIGURE 1

I

25%

Historical Pretax Return on Equity
All Banks under $10 Billion
All Banks under $1 Billion

20%
15%
10%
5%
0%

12/31/2011

12/31/2010

12/31/2009

12/31/2008

12/31/2007

12/31/2006

12/31/2005

12/31/2004

12/31/2003

-5%
12/31/2002

n the wake of the financial crisis,
the “value” of a community bank is
generally discussed in the context of the
community: the relationship bankers
have with their customers and community and their understanding of local
economic conditions and opaque credit
opportunities. In many cases, the community bank also stands as an important small business in the community,
albeit as a credit provider and employer.
While these factors are important,
another gauge of the “value” of a community bank is its ability to earn a fair
return for its stakeholders. Without an
adequate return to investors, retaining or even attracting new investment
could become more difficult for community banks. This article examines
the historical trend in community bank
returns on equity (ROE) over the last 10
years and highlights the gap between
current and historical pretax returns.

SOURCE: Reports of Condition and Income for Insured Commercial Banks

Decomposing Return on Equity
Return on equity is more than
simply net income divided by average equity. It can be more completely
expressed as return on assets (ROA)
relative to an equity multiplier or,
more simply, the degree of financial
leverage at a bank. Return on equity
can be further understood by employing a DuPont analysis technique. This

technique dissects ROA into the subcomponents that drive asset utilization, or total revenue/average total
assets.1 From here a bank’s expense
ratio can be segregated into the components that encompass total operating expenses/average total assets.2
continued on Page 10

T H E F E D E R A L R E S E R V E B A N K O F S T. L O U I S : C E N T R A L T O A M E R I C A’ S E C O N O M Y®

|

STLOUISFED.ORG

CENTRAL VIEW
News and Views for Eighth District Bankers

Vol. 22 | No. 1
www.stlouisfed.org/cb

Many Community Banks Must
Make Tough ROE Choices

EDITOR

Scott Kelly
314-444-8593
scott.b.kelly@stls.frb.org
Central Banker is published quarterly by the
Public Affairs department of the Federal
Reserve Bank of St. Louis. Views expressed
are not necessarily official opinions of the
Federal Reserve System or the Federal
Reserve Bank of St. Louis.
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The Eighth Federal Reserve District includes
all of Arkansas, eastern Missouri, southern
Illinois and Indiana, western Kentucky and
Tennessee, and northern Mississippi. The
Eighth District offices are in Little Rock,
Louisville, Memphis and St. Louis.

Useful St. Louis Fed Sites
Dodd-Frank Regulatory Reform Rules
www.stlouisfed.org/rrr
FOMC Speak
www.stlouisfed.org/fomcspeak
FRED (Federal Reserve Economic Data)
www.research.stlouisfed.org/fred2
St. Louis Fed Research
www.research.stlouisfed.org

2 | Central Banker www.stlouisfed.org

By Timothy A. Bosch

A

t year-end 2007, before the reverberations of the global financial crisis
began to be felt across most business
sectors, there were 7,139 community
banks in the U.S. By the end of 2011,
that number had slipped to 6,155. More
than one-third of the decline, or 342
charters, occurred because of institutions that failed. The 642 other banking
Timothy A. Bosch is
organizations found strategic partners
a vice president in
to bolster their financial strength or
Banking Supervision
improve operating efficiencies.
and Regulation at
The 14 percent decline in charters
the Federal Reserve
in just four years is reflective of the
Bank of St. Louis.
challenges facing banks over that time,
especially community banks. And
headwinds prevail: Revenue opportunities continue to be limited, operating costs are climbing
and the uncertainty of added regulation remains a concern.
To be fair, some of the recent data on community bank
performance have been positive. Problem asset ratios have
declined, and earnings performance has improved. Moreover, banks facing asset quality difficulties are working
hard to improve their balance sheets through prudent loan
restructures, asset disposals and the redeployment of funds
into less concentrated market sectors.
I am often asked, “What lies ahead?” No one has a crystal
ball, but one area of the balance sheet that may not recover
to precrisis levels is return on equity (ROE).
Community banks consistently express concerns about
profit opportunities, given current weak loan demand and the
possibility of growing regulation. Community bank managers are going to have to make some tough choices over the
next few years. They will need to identify areas where they
can reduce costs. They might eliminate business lines that
are no longer profitable (even if they are legacy businesses)
and focus on their core areas of expertise and profitability.
All of this uncertainty only underscores the importance of
having a strong management team at the bank.
If the bank cannot make such adjustments, investors in
community banks may need to adjust their expectations for
returns on equity. Depending on the length and depth of
low returns, some investors may turn elsewhere, requiring
some additional consolidation of the industry to scale growing costs.
The community bank model in the U.S. has withstood
numerous challenges throughout its history. Despite some
recent positive signs, bank managers can’t ignore the headwinds they’re facing. The next few years will be crucial
in understanding what it will take for community banks to
return to historic profitability.

Q U A R T E R LY R E P O R T

Bank Performance Continues on
Meandering Path
By Michelle Neely

T

he slight uptick in bank earnings
experienced by District banks and
their U.S. peers in the third quarter did
not carry over into the final quarter of
2011. Asset quality measures did continue to improve, however. Real estate
loans—especially those backed by commercial properties—remain the primary source of nonperforming assets.
Return on average assets (ROA) at
District banks fell 3 basis points in the
fourth quarter to 0.79 percent, but the
ratio was still 29 basis points above
its year-ago level. ROA also declined
at U.S. peer banks—those with average assets of less than $15 billion—but
by a smaller amount, to 0.70 percent.
Although earnings ratios at U.S. peers
still fall below those of District banks,
the gap between the two sets of banks
has narrowed in recent quarters. Two
years ago, District banks outperformed
their U.S. peers by 45 basis points when
measured by ROA; by year-end 2011,
that gap had fallen to 9 basis points.
A more dramatic decline in funds set
aside to cover nonperforming assets by
U.S. peers than those by District banks
explains the closing of this difference.
In the District, the decline in ROA
can be traced to a slight increase in
loan loss provisions that is typical of
the fourth quarter and a slightly larger
increase in noninterest expenses,
primarily personnel expenses. The
net interest margin (NIM) increased
1 basis point in the fourth quarter
to 4.03 percent. The margin is up 17
basis points from a year ago thanks
to a much larger decline in interest
expenses than in interest income.
For U.S. peer banks, ROA declined
a bit because a small increase (2 basis
points) in the average NIM was offset
by a larger increase (4 basis points) in
noninterest expenses. An uptick in
personnel expenses was responsible
for half the increase in overall noninterest expenses. The loan loss provision ratio rose just 1 basis point in the
final quarter to 0.60 percent. The ratio

Earnings Zig, Asset Quality Zags1
2010: Q4

2011: Q3

2011: Q4

District Banks

0.50%

0.82%

0.79%

U.S. Peer Banks

0.22

0.72

0.70

District Banks

3.86

4.02

4.03

U.S. Peer Banks

3.90

3.94

3.96

District Banks

0.88

0.54

0.55

U.S. Peer Banks

1.10

0.59

0.60

District Banks

4.84

4.88

4.66

U.S. Peer Banks

5.27

4.95

4.68

RETURN ON AVERAGE ASSETS 2

NET INTEREST MARGIN

LOAN LOSS PROVISION RATIO

PROBLEM ASSETS RATIO 3

SOURCE: Reports of Condition and Income for Insured Commercial Banks
NOTES:

1

2

3

Because all District banks except one have assets of less than $15 billion, banks
larger than $15 billion have been excluded from the analysis.
All earnings ratios are annualized and use year-to-date average assets or average
earning assets in the denominator.
Problem assets are loans 90 days or more past due or in nonaccrual status plus
other real estate owned (OREO). The ratio is computed by dividing problem assets
by total loans plus OREO.

is about half its year-ago level of 1.10
percent, reflecting in part the steady
improvement in asset quality since
year-end 2010.

Asset Quality Picks Up in
District and Nation
Asset quality improved somewhat
in the final quarter of 2011 at both sets
of banks, with nonperforming loans
and other real estate owned (OREO)
declining from the third quarter. The
problem assets ratio—nonperforming
loans plus OREO divided by total loans
plus OREO—fell 22 basis points to
4.66 percent in the District. The chief
reason for the decline in this ratio
was the sharp drop in nonperforming
construction and land development
(CLD) loans, which make up more than
a quarter of the District’s total nonperforming loans. The nonperforming
CLD loan ratio fell below 10 percent for
continued on Page 4
Central Banker Spring 2012 | 3

Quarterly Report
continued from Page 3

the first time since late 2009, hitting
9.73 percent at year-end 2011. Nonperforming rates also fell in other parts of
the real estate portfolio, as well as in
the consumer loan and the commercial
and industrial (C & I) loan categories.
The asset quality picture is much the
same at U.S. peer banks. Declines in
nonperforming real estate loans, especially CLD loans, brought down the
aggregate problem asset and nonperforming loan ratios. Nonperforming
C & I loans also fell, though nonperforming consumer loans—credit
card and other consumer loans—rose.
Nonperforming ratios for all categories
of loans are higher at U.S. peers than
at District banks, in part reflecting
less volatile real estate markets and a
predominant “lending local” lending
strategy in this region of the country.

Coverage Ratios Are Up and Capital
Ratios Are Steady
Although loan loss reserves declined
at year-end at both sets of banks, loan
loss reserve coverage ratios actually
rose because nonperforming loans fell
more. The coverage ratio at District
banks increased by 310 basis points to
65.01 percent, meaning District banks
had on average 65 cents in reserves for
every dollar of nonperforming loans.
The coverage ratio rose 144 basis
points to 61.63 percent at U.S. peer
banks.
Capital ratios stayed basically flat
in the fourth quarter, and the average
tier 1 leverage ratio was well above the
regulatory minimum at 9.46 percent
for District banks and 9.90 percent for
U.S. peer banks.
Michelle Neely is an economist with the
Federal Reserve Bank of St. Louis.

Statewide Bank Conditions
for Fourth Quarter 20111
Compiled by Daigo Gubo

2010: 4Q

2011: 3Q

2011: 4Q

0.34%
0.77
0.06
0.48
0.80
0.55
0.37
-0.04

0.64%
1.11
0.44
0.89
0.82
0.72
0.70
0.12

0.65%
1.09
0.46
0.90
0.71
0.72
0.66
0.42

3.80
4.13
3.67
3.78
4.00
3.92
3.67
3.80

3.89
4.31
3.73
3.94
4.12
3.98
3.73
3.89

3.91
4.32
3.75
3.97
4.08
4.01
3.78
3.92

1.01
0.88
1.34
0.90
0.60
0.80
0.87
1.02

0.69
0.50
0.93
0.47
0.52
0.56
0.57
0.88

0.67
0.50
0.92
0.44
0.55
0.55
0.58
0.64

3.76
3.48
5.04
3.10
2.38
2.97
3.18
3.64

3.64
3.78
4.78
3.14
2.43
2.70
2.96
3.70

3.50
3.57
4.53
2.94
2.42
2.62
3.06
3.43

5.27
5.46
6.55
3.83
3.55
4.61
4.73
5.60

5.32
5.83
6.56
3.89
3.69
4.50
4.78
5.71

5.14
5.65
6.21
3.64
3.65
4.47
4.85
5.42

RETURN ON AVERAGE ASSETS 2

All Eighth District States
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks
NET INTEREST MARGIN

All Eighth District States
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks
LOAN LOSS PROVISION RATIO

All Eighth District States
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks
NONPERFORMING LOAN RATIO 3

All Eighth District States
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks
NONPERFORMING LOAN + OREO RATIO 4

All Eighth District States
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks

SOURCE: Reports of Condition and Income for Insured Commercial Banks
NOTES:

1

2

3
4

4 | Central Banker www.stlouisfed.org

Because all District banks except one have assets of less than $15 billion,
banks larger than $15 billion have been excluded from the analysis.
All earnings ratios are annualized and use year-to-date average assets or
average earning assets in the denominator.
Nonperforming loans are those 90 days or more past due or in nonaccrual status.
Nonperforming loans plus OREO are those 90 days past due or in nonaccrual
status or other real estate owned.

IN-DEPTH

ALLL Best Practices: Keep the Appropriate
Allowance for Loan and Lease Losses Reserve
By Timothy A. Bosch and
Salvatore Ciluffo

D

uring these uncertain economic
times, lenders must continually
actively assess the quality of their
loans. It seems like a simple statement;
however, a bank can hurt itself without
such diligence.
For example, many banks with high
concentrations of commercial real
estate loans have incurred extraordinary losses. Therefore, it is imperative
to document the rationale behind all
quantitative and qualitative factors,
and be vigilant, proactive and realistic.
Examiners will view favorably banks
that are quick to self-identify problem
assets and that apply a solid reserve
against those loans that will likely
result in some loss.
To help your institution explore the
quality of your loans, pay attention
to your allowances for loan and lease
losses (ALLL).

Examiners Expect Higher
ASC Adjustments
For several years, the banking
industry enjoyed low loan loss rates.
Normally, during periods of economic
stability, most ALLL methodologies
use a three- to five-year-average net
loss history to determine the loss factors for the homogeneous loan pools
for the Accounting Standard Codification (ASC) 450 portion of the ALLL.1
However, during periods of significant economic contraction—such as
now—banks should adjust for their
recent loss experience, which they
should expect to more accurately estimate their inherent losses. Accounting
rules require consideration of external and internal factors affecting the
adequacy of the ALLL. Banks should
modify their qualitative and environmental factors to ensure that allowance
estimates place appropriate emphasis
on current market information and
events in a bank’s lending area:

Junior Liens for Certain Residential Properties
Covered in New ALLL Guidance
Federal agencies in January reiterated supervisory guidance
on allowance for loan and lease losses (ALLL) estimation practices associated with loans and lines of credit secured by junior
liens on one- to four-family residential properties.
This ALLL guidance, given in SR 12-3, applies to all banking
organizations with junior lien loans, including institutions with
$10 billion or less in consolidated assets.
The interagency guidance also reminds institutions to monitor all credit quality indicators relevant to credit portfolios,
including junior liens. Examples of junior liens include second mortgages and home equity lines of credit taken out by
mortgage borrowers. For more information on SR 12-3, go to
Banking Information & Regulation > Supervision and Regulation Letters on the Board of Governors’ web site
(www.federalreserve.gov).

• External factors — These include
the direction of national and local
economies, changes in bankruptcy
rates, changes in unemployment
rates, and levels of national and local
foreclosures.
• Internal factors — These include
asset quality trends, trends in nonperforming loans and charge-offs,
portfolio concentrations, refinance
risk, and the strength of the bank’s
credit administration practices.
Simply stated, examiners expect
higher ASC 450 adjustments when the
bank is experiencing larger losses and
the economy is weak.

Requirements under ASC 310
In addition, ASC 310 requires an
individual credit impairment analysis. A loan is impaired if it’s probable
that all principal and interest payments will not be received according
to the contractual terms of the loan
agreement. Banks should define, in
their loan policies, which loans will
continued on Page 11

Central Banker Spring 2012 | 5

ECONOMIC SPOTLIGHT

Where Housing Markets Lead in 2012, Eighth
District Economies Are Likely to Follow
By William Emmons

a peak in late 2005. Eighth District
home prices, adjusted for inflation,
reached peaks as early as the first
quarter of 2005 in Indiana, with all
other district states hitting their high
points between the first quarter of
2006 and the first quarter of 2007.
(See Table 1 below.)
In turn, economic conditions in
states in the District reached their
peaks in the last quarter of 2007 or
the first quarter of 2008, as the middle
column of data in the table indicates.
Across our District and the nation, a
peak in inflation-adjusted house prices
gave between four and 11 quarters
advance warning of the deep recession
that hit in late 2007.3

H

TABLE 1

ousing markets generally have
served as reliable bellwethers
of economic conditions during recent
decades. But while some measures of
Eighth District housing-market activity recently showed signs of life, it’s not
clear yet if it is cause for cautious optimism in the economic outlook.
Historically, home-building activity usually declines a year or two in
advance of a broad economic slowdown or recession, while inflationadjusted house prices often stagnate or
decline during the months preceding
the economic downturn. When the
economy eventually stabilizes and
begins to grow again, home building,
home sales and house prices usually pick up before other economic
vital signs, such as employment, have
shown meaningful improvement. The
2001 recession was a rare exception to
this rule, as Figure 1 on Page 7 shows.
In that instance, home building and
house prices remained strong even as
the overall economy weakened.1,2
Housing markets usually are key
economic indicators in the Eighth
District too. Home-building activity
in most parts of our District reached

2012 Housing Market Indications
If housing markets serve as bellwethers for local economies heading
into as well as out of a downturn, what
do current housing-market indicators
suggest for Eighth District economies
as 2012 gets underway? Figure 2 on
Page 7 shows that an average of Eighth
District inflation-adjusted houseprice indexes appeared to be trending
downward through the first half of
2011, although the last data point, for

Real House-Price and Economic Activity Index Peaks
Peak Quarter for
Inflation-Adjusted (Real) FHFA
House-Price Index

Peak Quarter for the
Philadelphia Fed Coincident
Economic Activity Index

Quarters between Real
House-Price Peak and
Economic Activity Index Peak

2006: Q2

2008: Q1

7

Eighth District States Average

2007: Q1

2008: Q1

4

Arkansas

2006: Q4

2008: Q1

5

Illinois

2007: Q1

2008: Q1

4

Indiana

2005: Q1

2007: Q4

11

Kentucky

2006: Q1

2007: Q4

7

Mississippi

2007: Q1

2008: Q1

4

Missouri

2006: Q1

2007: Q4

7

Tennessee

2007: Q1

2008: Q1

4

U.S.

SOURCES: Federal Housing Finance Agency, Bureau of Economic Analysis, Federal Reserve Bank of Philadelphia

6 | Central Banker www.stlouisfed.org

110

100

90

80

70

2012: Q1

2010: Q1

2008: Q1

2006: Q1

FIGURE 2

Eighth District House-Price Index and
Coincident Economic Activity Index
110
Inflation-Adjusted House-Price Index (Peak Level in 2007: Q1)
Coincident Economic Activity Index (Peak Level in 2008: Q1)

100

90

80

70

2012: Q1

2010: Q1

2008: Q1

2006: Q1

2004: Q1

60
2000: Q1

Index Levels Equal 100 at Peak

3 Nationally, the recession began in December 2007
and continued until June 2009, as determined by
the National Bureau of Economic Research. Arkansas and Mississippi experienced somewhat milder
downturns than the nation as a whole, per the
Philadelphia Fed’s Coincident Economic Activity
Indexes. Tennessee tracked the nation very closely
through the recession, while Illinois, Indiana,
Kentucky and Missouri suffered noticeably deeper
recessions than the national average.

2004: Q1

SOURCES: Federal Housing Finance Agency, Bureau of Economic Analysis, Federal
Reserve Bank of Philadelphia. Inflation-adjusted house prices are quarterly through
2011: Q3. The Coincident Economic Activity Index is quarterly through 2011: Q4.

ENDNOTES

2 The Federal Reserve Bank of Philadelphia’s
Coincident Economic Activity Indexes are statistically derived measures of overall economic
strength for the nation and each of the 50 states.
Each index is based on four economic indicators
for a particular state: nonfarm payroll employment, average hours worked in manufacturing,
the unemployment rate, and wage and salary
disbursements deflated by the consumer price
index. See www.philadelphiafed.org/researchand-data/regional-economy/indexes/leading/
for more details and historical data for the
indexes.

2002: Q1

60

William Emmons is an economist at the
Federal Reserve Bank of St. Louis.

1 The surprising strength of housing probably was
due to several unusual factors, including the
brief and mild nature of the recession, strong
demand for housing as a “safe asset” in the
wake of a large stock market decline, and falling
mortgage rates after mid-2000. The 30-year
fixed-rate mortgage fell from 8.5 percent in May
2000 to 5.25 percent by June 2003.

Inflation-Adjusted House-Price Index (Peak Level in 2006: Q2)
Coincident Economic Activity Index (Peak Level in 2008: Q1)

2002: Q1

Housing market indicators suggest
challenges for the 2012 economic outlook for Eighth District states. Moreover, even if housing markets begin
to show strength as 2012 unfolds, the
broader economic vigor they might be
anticipating could take some time to
materialize.

U.S. House-Price Index and
Coincident Economic Activity Index

2000: Q1

In Conclusion

FIGURE 1

Index Levels Equal 100 at Peak

the third quarter of 2011, showed an
uptick.
Likewise, home-building activity showed some signs of life near the
end of 2011, albeit from an historically
depressed level. Based on the weak
housing market data alone, the economic recovery that has been underway
since mid-2009 is surprising. Housing
market problems may well help explain
why the recovery has been weak, both
in our District and nationwide.

SOURCES: Federal Housing Finance Agency, Bureau of Economic Analysis, Federal
Reserve Bank of Philadelphia. Inflation-adjusted house prices are quarterly through
2011: Q3. The Coincident Economic Activity Index is quarterly through 2011: Q4.

Central Banker Spring 2012 | 7

IN-DEPTH

St. Louis Fed President James Bullard
Explores the “Death of a Theory”
M

ore than three years ago, St. Louis
Fed President James Bullard
discussed “Three Funerals and a Wedding”—ideas about how the financial
crisis (up to that point) had changed the
conventional wisdom on some critically
important macroeconomic issues facing
the nation.
Bullard’s “funeral” category had several items, but the “wedding” category
had just one rising idea: fiscal policy
as a business cycle stabilization tool.
Now, in his new research paper titled
“Death of a Theory,” Bullard concludes
that the turn in recent years toward
FIGURE 1

The St. Louis Financial Stress Index
Recession

6
5
4

Index

3
2
1
0
-1

1/2012

1/2011

1/2010

1/2009

1/2008

1/2007

1/2006

-2

SOURCE: Federal Reserve Bank of St. Louis
The St. Louis Financial Stress Index was essentially off the charts during the winter of
2008-2009. A reading of zero would mean normal stress levels and a reading of 2 would
be exceptionally high by historical standards; during the crisis, readings of 5 or higher
were observed. By 2010, however, stress had returned to more normal levels, and so the
case for continued increases in government spending at that point had diminished, says
St. Louis Fed President James Bullard in “Death of a Theory.” See more on the St. Louis
Financial Stress Index at http://research.stlouisfed.org/fred2/series/STLFSI on FRED
(Federal Reserve Economic Data).

8 | Central Banker www.stlouisfed.org

fiscal approaches to stabilization policy
has run its course and that the conventional wisdom of the past several
decades is reasserting itself. (See the
brief description on Page 9 of fiscal vs.
monetary stabilization policy.)
Over the two decades leading up to
the financial crisis, the conventional
wisdom was that fiscal policy was not
a good tool for macroeconomic stabilization—that is, not a good way to
attempt to react to shocks that buffet the
economy, says Bullard. Conventional
wisdom suggested that shorter-run stabilization issues should be handled by
the monetary authority (e.g., the Federal
Reserve) and that fiscal authorities (e.g.,
the president and the Congress) should
focus on a stable taxing and spending
regime to achieve economic and political goals over the medium and longer
run. This state of affairs lasted, broadly
speaking, until the fall of 2008.
At that point, the short-term nominal interest rate targeted by the FOMC
(Federal Open Market Committee) was
pushed nearly to zero, where it remains
to this day. This led many to conclude
that the burden for short-term macroeconomic stabilization had, as a result,
shifted to fiscal policy. Indeed, over the
past three years, we have seen numerous attempts at stabilization policy by
fiscal authorities in the U.S. and around
the globe, Bullard says.
However, Bullard argues that the net
effect of these attempts has been to confirm much of the conventional wisdom
regarding fiscal stabilization policy that
existed prior to the financial crisis.

Addressing the Case for the
Fiscal Approach
Much research has been published
on when the fiscal approach to business cycle stabilization would be
useful and effective. In “Death of
a Theory,” Bullard cites a paper by
economist Michael Woodford in which
Woodford notes that “while a case for

aggressive fiscal stimulus can be made
under certain circumstances, such
policy must be designed with care if it
is to have the desired effect.”1
This line of research assumes that
monetary business cycle stabilization policy is ineffective and unable to
influence real interest rates once the
policy rate is near zero. In addition,
the types of policy experiments considered in this research involve extra
government spending and taxation
only during the period when the policy
rate is near zero and financial markets
are in considerable turmoil, and not
any longer than that. (See Figure 1 on
Page 8 for a measure of financial stress
during the crisis.)
Three key issues related to the
assumptions in Woodford’s paper lead
Bullard to doubt the merits of possible
fiscal stabilization programs for the
present circumstances:
First, the types of fiscal policy
interventions recommended in the
research are fairly intricate and must
be designed carefully if they are to
have the desired effect. However, the
conventional wisdom on fiscal stabilization policy emphasizes that political
processes in the U.S. and elsewhere
are not well-suited to make timely and
subtle decisions like these.
Second, monetary stabilization
policy has been quite effective, even
while the policy rate has been near
zero, Bullard emphasizes. This is
because the monetary policy authority
can use many other tools to influence
inflation and inflation expectations.
Thus, a turn toward fiscal stabilization
policy is not necessary.
Third, although the research says
that taxes should be collected simultaneously with the increase in government spending, the actual fiscal
stabilization policy for many countries
has involved heavy reliance on government borrowing. This increased
debt would be interpreted as promised
future taxes. However, shifting the
taxes into the future can undo most or
all of the benefits that might otherwise
come from the fiscal stabilization program, Bullard explains.

Stabilization Policy: Fiscal vs. Monetary
Macroeconomic stabilization policy means reacting in a
timely manner to aggregate shocks that hit the economy and
in a way that smoothes out an otherwise rocky ride for the
economy’s businesses and households:
Fiscal policy, which is controlled by the president and the
Congress, attempts to do this through changes in taxes and
government spending.
Monetary policy, which is the charge of the Federal Reserve,
attempts to do this by targeting the nominal interest rate or,
when the interest rate is near zero, by influencing inflation and
inflation expectations primarily through quantitative easing.

“Death of a Theory” and Other James Bullard Resources
This article was based on the paper, presentation and summary
of “Death of a Theory,” which was originally released in January
2012. President Bullard presented the paper to members of various financial institutions and business leaders on Jan. 13, 2012, at
the Edward Jones Annual Meeting in St. Louis.
Visit www.stlouisfed.org/theory to read the presentation and summary or read the paper in the March/April 2012 issue of the St. Louis
Fed’s Review (http://research.stlouisfed.org/publications/review).
Other key policy papers by President Bullard are also available on
his web page, http://research.stlouisfed.org/econ/bullard, including:
• “Measuring Inflation: The Core Is Rotten”
• “Seven Faces of ‘The Peril’”
• “Three Funerals and a Wedding”

the monetary authority, which can
operate effectively even with a nearzero policy rate. Fiscal authorities
should set the tax and spending programs in a way that makes economic
and political sense for the medium to
longer term. In particular, a stable tax
code that is aligned with a stable plan
of government spending would allow
businesses and households to plan for
the future in the most effective way,
Bullard says.
ENDNOTE
1 Michael Woodford, “Simple Analytics of the
Government Expenditure Multiplier,” American
Economic Journal: Macroeconomics 3: 1-35, 2011.

In Summary
Bullard concludes that the conventional wisdom on stabilization policy
is being re-established in the U.S.
Stabilization policy should be left to

Central Banker Spring 2012 | 9

Community Bank Returns
continued from Page 1

More succinctly, this analysis breaks
down bank or industry performance
into revenue management and cost
management.
Given the complication posed by the
U.S. tax code, which drives many small,
closely held banks to elect Subchapter S
status, it may be preferable to consider
ROE on a pretax basis. While pretax
results do not eliminate all biases, they
may help improve the comparability of
community bank results.3
Historically, a well-run community
bank offered a predictable pretax ROE.
As shown in Figure 1 on Page 1, average pretax ROE for banks $10 billion
and under from 2002 through 2006 was
an attractive 17.9 percent (and within a
predictable range of 16.9 percent to 19.2
percent). A balance of revenue-collecting opportunities, a modest cost structure and appropriate leverage were the
hallmarks of this performance.
The next five years proved more
turbulent. From 2007 through 2011,
the average pretax return on equity for
community banks nationwide deteriorated to 13.3 percent at year-end 2007,
turned negative in 2009 at -2.8 percent,
and rebounded to a low but positive
8.4 percent by year-end 2011. This
precipitous decline in pretax ROE is
understandable given that the five-year

average for provision expenses more
than tripled to 0.91 percent of average
assets, up from 0.29 percent during the
previous five years. Of course, this
adjustment was necessary to replenish
loan loss reserves as commercial real
estate and residential real estate loan
losses skyrocketed.
An important but somewhat disguised trend, interrupted by the financial crisis, was that community bank
returns on equity (excluding securities
gains) were in a decadelong period
of decline. The trend is illustrated in
Figure 2. The decline was driven by a
narrowing in the spread between asset
utilization and operating expenses.

In Conclusion
As bank health nationwide continues to recover after the financial crisis,
it is possible ROE will settle in at a
lower-than-precrisis historical rate,
leading to a resetting of performance
expectations by community bank
stakeholders. This could be a transitional adjustment or may represent a
structural change for the industry.
In either scenario, there may be
important repercussions. For example,
a lower return expectation might
encourage consolidation between
healthy institutions in order to gain
greater scale and spread out operating
continued on Page 11

FIGURE 2

Asset Utilization Rate and Expense Ratio

Percentage of Total Average Assets

6

AU for Banks $10 Billion and under
AU for Banks $1 Billion and under

5.5

Expense Ratio for Banks $10 Billion and under
5

Expense Ratio for Banks $1 Billion and under

4.5
4
3.5

SOURCE: Reports of Condition and Income for Insured Commercial Banks

10 | Central Banker www.stlouisfed.org

12/31/2011

12/31/2010

12/31/2009

12/31/2008

12/31/2007

12/31/2006

12/31/2005

12/31/2004

12/31/2003

12/31/2002

3

The “Dialogue” Resumes this Spring
with the European Sovereign Debt Crisis
Go beyond the headlines again this year
with the St. Louis Fed’s public discussion
series, “Dialogue with the Fed.” The series,
which began last fall, focuses on critical
issues facing the economy and financial markets. Each session
featured presentations by St. Louis Fed
officials followed by
an open discussion.
The first session for
2012 will be held on May 8 at the St. Louis
Fed in downtown St. Louis. Christopher
Waller, senior vice president and director
of Research, will lead the presentation and

discussion on the European sovereign debt
crisis. The discussion, which will be held
from 7-8:30 p.m. CT, will also be webcast live
on the St. Louis Fed’s web site.
Registration for the on-site event and
other information will be
available in April at www.
stlouisfed.org/dialogue.
Watch for Dialogue
announcements on Twitter,
Facebook, RSS feeds and
e-mail (visit www.stlouisfed.org/followthefed
for more). Also visit the Dialogue web page
for video and presentations from the fall
sessions.

Community Bank Returns

ALLL Best Practices

continued from Page 10

continued from Page 5

costs. Alternatively, changing expectations may reshape the thinking of bank
management on fixed investments,
such as facilities, and further shift the
emphasis to electronic delivery mechanisms. Only time will tell whether
community banks will be able to return
to precrisis levels of profitability.

be tested for impairment, such as all
loans over a certain size, all classified
loans or all nonaccrual loans.
Once the loan is determined to be
impaired, the amount of the impairment needs to be measured using one
of the three methods, the most common of which is fair value of collateral
less selling and carrying costs. The
challenge in today’s economic environment is obtaining a realistic appraisal.
Bank management is encouraged to
maintain an ASC 310 analysis indicating the amount of impairment for each
loan tested.
Don’t hesitate to contact your examiners if you have questions on ALLL
methodology.

Gary Corner is a senior examiner at the Federal Reserve Bank of St. Louis. The author
thanks Daigo Gubo, policy analyst in the
Supervisory Policy and Risk Analysis Unit,
for contributing to this article.
ENDNOTES
1 Total revenue for purposes of this analysis is net
interest income and noninterest income combined.
The author chose to exclude ad hoc securities gains
from the revenue total, believing most investors
do not consider community bank securities gains a
valuable ongoing revenue source.
2 Total operating expense is noninterest expense
plus provision for loan and lease losses.
3 Banks that elect Subchapter S tax status are not
subject to federal corporate taxes. Rather, the
shareholders are subject to personal income
taxes on their pro rata share of the bank’s entire
earnings. Gilbert, R. Alton and Wheelock, David
C., “Measuring Commercial Bank Profitability:
Proceed with Caution,” November/December
2007 Federal Reserve Bank of St. Louis Review.

Timothy A. Bosch is a vice president in Banking Supervision and Regulation and Salvatore
Ciluffo is a senior examiner at the Federal
Reserve Bank of St. Louis.
ENDNOTE
1 A version of this article first appeared in the
summer 2009 Central Banker. Since that time,
the Financial Accounting Standards Board
restructured accounting and reporting standards
as Accounting Standard Codifications (ASC).
FAS 5 is found under ASC 450 and FAS 114 is
found under ASC 310.
Central Banker Spring 2012 | 11

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NEW BANKING AND
ECONOMIC RESEARCH

RULES AND
R E G U L AT I O N S

• Wanted: A New Engine
for Economic Growth

• What the Changes to
the Home Affordability
Refinance Program Mean
for Lenders

• Economic Synopses: Brief
Essays Explore Structural
and Cyclical Shocks,
Employment Dynamics,
and Speculation in the
Oil Market

• New Fed Guidance
Addresses Rating
Upgrades Standards

• How Home Loan Modification through the 60/40
Plan Can Save the Housing Sector

• Comment by April 30 on
Dodd-Frank Enhanced
Prudential Standards
and Early Remediation
Requirements

• Federal Reserve Lending
to Troubled Banks During
the Financial Crisis

• Consumers Can Submit Foreclosure Review
Requests by July 31

67139015466619598160568597935734676519715493177565742479898797737
045828453367245669262457873204611387091483378545776285166374094
6935327539637171293327675625836167676119030934024222013646208160
50426627033953052329732206658737683734934912632238645835349945
31511991404965999716336125971558314872504990100479719287507361272
56053214053998748763026662710529351563191251348536533138100283317
5469818733295707683481224333378484882058320301322767566411961612
4224369910446854974811896223794832236357698603846076367315366114
892580796475589478571255283905025673052879081658893682379353612
581860275170234157111191324508047617662985770173813615793652483386
575628874350100448657847281442226254100269930649582676510702623
90113245907238743917102824466833234495967124567307726711646717683
5550148416995256739167342647456554283919648388312474936145848443
1791949410247396421947773925597820494960881727628526918864471350
2059527753641195252630144314576650859627725127776960999852510423
4582123965830466012839543464838788143957436738762885931985508941
5785422120440537367081421236438841167225803354931689361176404293
8735100658225276534758158275966425845158386214471497948349358570
2754382578917499994910613255991125242282047523697318489360269917
8114463343772226572766216897488996847267877881004437383780854826
721806491233914747840547840633744268723652064933795452489685323
4583798919443544760473016634179551480157163236733446488175540718
4156026554123708386657568494499030595248779112653032172778681974
24748333715839764837558911675676112814355839029642727184685537654
923293811621968436203888486665648553248792215328646031404869195
6225642398494771986764118746100521659998837971005365495213579752
8998463637160836971931637982163259543798729096338891807091993606
1696418636910080917686757217724755879256715949202097635884353922
2811472853713672894358266756983420493486368806468899159708713558
3 4 3 3 5 4 4 2 0 4 0 3 4 9 8 4 0 1 0 5 8 1 7 3 6 2

MORE DISTRICT DATA

The District in FRED®
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Reserve Economic Data (or FRED),
includes nearly 200 charts on
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the Eighth District? We’ve got the
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trend in personal income in the seven
states in our District? We have that—
and much more. See http://research.
stlouisfed.org/fred2/categories/133

C D I A C U P D AT E

• The St. Louis Fed’s 2012
Community Depository
Institution Advisory
Council Meets
FRED® is a registered trademark of the
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CENTRAL BANKER | SPRING 2012
https://www.stlouisfed.org/publications/central-banker/spring-2012/st-louis-feds-2012-community-depository-institutionsadvisory-council-meets

St. Louis Fed's 2012 Community Depository
Institutions Advisory Council Meets
The St. Louis Fed’s Community Depository Institutions Advisory Council (CDIAC) met March 5 and 6, 2012, for
the first of its bi-annual meetings at the Bank with President James Bullard. The St. Louis council, comprised of
12 executives of smaller financial institutions from communities across the Eighth District, was established in
2011 to advise Bullard on local credit, banking and economic conditions. The chairman of the council then
reports twice a year, along with counterparts from the Federal Reserve System’s 11 other districts, to the
Federal Reserve Board of Governors’ Community Depository Institutions Advisory Council.
Four of the members whose original one-year terms expired in 2011 were re-appointed to three-year terms
beginning in 2012. For more information, see the St. Louis Fed’s CDIAC page, or for more information about all
of the Federal Reserve System CDIAC councils, see the Federal Reserve Board of Governors’ site.
The St. Louis council next meets Sept. 17 and 18, 2012.

2012 St. Louis Fed Community Depository Institutions
Advisory Council
Dennis M. Terry (Chairman)
President and CEO, First Clover Leaf Bank FSB, Edwardsville, Ill.
Term expiration: 2012
Kirk P. Bailey
CEO, Magna Bank, Memphis, Tenn.
Term expiration: 2014
Glenn D. Barks
President and CEO, First Community Credit Union, Chesterfield, Mo.
Term expiration: 2013
H. David Hale
Chairman, President and CEO, First Capital Bank of Kentucky, Louisville, Ky.
Term expiration: 2014
D. Keith Hefner
President and CEO, Citizens Bank & Trust Company, Van Buren, Ark.
Term expiration: 2012
Gary E. Metzger
President, Liberty Bank, Springfield, Mo.

Term expiration: 2013
William J. Rissel
President and CEO, Fort Knox Federal Credit Union, Radcliff, Ky.
Term expiration: 2012
Mark A. Schroeder
Chairman and CEO, German American Bancorp, Jasper, Ind.
Term expiration: 2014
Gordon Waller
President and CEO, First State Bank & Trust, Caruthersville, Mo.
Term expiration: 2013
Larry T. Wilson
President and CEO, First Arkansas Bank & Trust, Jacksonville, Ark.
Term expiration: 2014
Vance Witt
CEO & Chairman, BNA Bank, New Albany, Miss.
Term expiration: 2013
Larry Ziglar
President, First National Bank in Staunton, Staunton, Ill.
Term expiration: 2012

CENTRAL BANKER | SPRING 2012
https://www.stlouisfed.org/publications/central-banker/spring-2012/recent-st-louis-fed-banking-and-economic-research

Recent St. Louis Fed Banking and Economic
Research
Wanted: A New Engine for Economic Growth
Don’t expect consumer spending to be the engine of economic growth it once was, argues St. Louis Fed
economist William Emmons. “Can American consumers continue to serve as the engine of U.S. and global
economic growth as they did during recent decades? Several powerful trends suggest not, at least for a while,”
Emmons writes.
“Instead, new sources of demand, both domestic and foreign, are needed if we are to maintain healthy rates of
growth. Unfortunately, this won't be easy because consumer spending constitutes the largest part of our
economy, and replacements for it—more investment, more government spending or more exports—either can't
be increased rapidly or might create unwanted consequences of their own,” Emmons writes. Read the full
article in the January Regional Economist.

New Economic Synopses Essays from St. Louis Fed Economists
Identifying Structural and Cyclical Shocks Across U.S. Regions
The statistical relationship between vacancies and unemployment is not always a stable one, as
unemployment remains high even while job vacancy rates are returning to pre-financial crisis levels. A
February Economic Synopsis briefly explores why it is not clear how monetary policy might be used to reduce
local unemployment rates where recruiting intensity is high but the right kind of worker is hard to find.

Unemployment Dynamics During Economic Recoveries
Employment turnover was significantly lower following the Great Recession than it was after the previous two
recessions. A January Economic Synopsis briefly explores slow employment growth and low turnover, and
speculates that a decrease in labor reallocation may be caused by higher rigidity and regulations in the labor
market as well as more generous unemployment welfare.

Speculation in the Oil Market
When oil prices jump, is speculation in the oil markets truly to blame? A March Economic Synopsis identifies
and assesses four components that contribute to the price of oil—which is a critical first step for allocating
resources efficiently and designing good policy.
This Economic Synopsis is based on the working paper of the same name co-authored by St. Louis Fed
economist Luciana Juvenal.

How Home Loan Modification through the 60/40 Plan Can Save the
Housing Sector
Many well-respected economists have suggested plans for mortgage restructuring built on the idea of share
appreciation mortgages, which generate rather complex transactions with conflicting interests between the
lender and the homeowner. The 60/40 Plan, however, combines several economic principles adapted to the
nature of home loans and appears to provide all the benefits but fewer of the drawbacks of many of these
programs, including current government programs such as the Home Affordable Refinance (HARP) and Home
Affordable Modification (HAMP) programs. Read the full article in the St. Louis Fed’s March/April 2012 Review.

Federal Reserve Lending to Troubled Banks During the Financial
Crisis, 2007-2010
Numerous commentaries have questioned both the legality and appropriateness of Federal Reserve lending to
banks during the recent financial crisis. This working paper by St. Louis Fed economists addresses two
questions motivated by such commentary: Did the Federal Reserve violate either the letter or spirit of the law
by lending to undercapitalized banks, and 2) did Federal Reserve credit constitute a large fraction of the
deposit liabilities of failed banks during their last year prior to failure. The authors found no evidence that the
Federal Reserve ever exceeded statutory limits during the recent financial crisis, recession and recovery
periods, and conclude that Federal Reserve lending to depository institutions during the recent episode was
consistent with the intentions of the U.S. Congress.

CENTRAL BANKER | SPRING 2012
https://www.stlouisfed.org/publications/central-banker/spring-2012/rules-and-regulations

Rules and Regulations
What the Changes to the Home Affordability Refinance Program
Mean for Lenders
Among the most significant of the recent changes to the Home Affordable Refinance Program (HARP) are the
elimination of risk-based fees for borrowers who finance into shorter-term mortgages; removal of the loan-tovalue ceiling for some fixed-rate mortgages backed by GSEs (government-sponsored enterprises); and a
program extension. Read more in the latest issue of Bridges.

New Fed Guidance Addresses Rating Upgrades Standards
The Federal Reserve Board issued guidance in March to ensure that supervisors apply consistent standards
as they evaluate whether banking organizations with $10 billion or less in assets are eligible for upgrades of
supervisory ratings.
The guidance is being issued to ensure that upgrades occur in a timely manner when the banking
organizations have made the requisite progress in addressing any supervisory concerns that had prompted
lower ratings. To be eligible for an upgrade, banks are expected to demonstrate, among other things,
improvement in financial condition and risk management, as well as show that such improvement is likely to
continue.

Comment by April 30 on Enhanced Prudential Standards, Early
Remediation Requirements
Interested persons now have until April 30 to comment on a proposed rule to implement the enhanced
prudential standards and early remediation requirements in the Dodd-Frank Act for bank holding companies
with consolidated assets of $50 billion or more and nonbank financial companies supervised by the Federal
Reserve Board.
The proposal includes a wide range of measures addressing issues such as capital, liquidity, single
counterparty credit limits, stress testing, risk management, and early remediation requirements. They are
designed to reduce the probability of failure of systemically important companies and minimize damage in the
event that such a company fails. The Board extended the comment period (originally ending March 21) to allow
interested persons more time to analyze the issues and prepare their comments.

Certain Consumers Can Submit Foreclosure Review Requests by
July 31
People seeking a review of their mortgage foreclosures under the Federal banking agencies’ Independent
Foreclosure Review now have until July 31, 2012, to submit their requests.

The new deadline provides an additional three months for borrowers to request a review if they believe they
suffered financial injury as a result of errors in foreclosure actions on their homes in 2009 or 2010 by one of the
servicers covered by enforcement actions issued in April 2011.
The actions required 14 large mortgage servicers to retain independent consultants to conduct a
comprehensive review of foreclosure activity in 2009 and 2010 to identify borrowers who may have been
financially injured due to errors, misrepresentations, or other deficiencies in the foreclosure process. If the
review finds that financial injury occurred, the borrower may receive compensation or other remedy.
Borrowers are eligible for an Independent Foreclosure Review if they meet the following basic criteria:
1. The mortgage loan was active in the foreclosure process between Jan. 1, 2009, and Dec. 31, 2010.
2. The property securing the mortgage loan was the borrower's primary residence.
3. The mortgage loan was serviced by one of the participating mortgage servicers. Those include:
America’s Servicing Company, Aurora Loan Services, BAC Home Loans Servicing, Bank of America,
Beneficial, Chase, Citibank, CitiFinancial, CitiMortgage, Countrywide, EMC, Everbank/Everhome
Mortgage Company, Financial Freedom, GMAC Mortgage, HFC, HSBC, IndyMac Mortgage Services,
MetLife Bank, National City Mortgage, PNC Mortgage, Sovereign Bank, U.S. Bank, Wachovia
Mortgage, Washington Mutual, Wells Fargo, and Wilshire Credit Corporation.