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SUMMER 2013 Central N e w s a n d V i e w s f o r E i g h t h D i s t r i ct B a n k e r s Featured in this issue | On the “Too Big To Fail” Debate: Implications of the Dodd-Frank Act | Will the Single-Point-of-Entry Concept End “Too Big To Fail”? Trends in Community Banks’ Net Interest Margins NIM Trends As shown in Figure 1 to the right, the NIM for U.S. banks under $1 billion in assets fell 117 basis points since 1995 (from 4.89 percent to 3.72 percent). Figure 2 on Page 4 shows that in the Eighth District, the NIM experienced a similar decline, falling 74 basis points (from 4.49 percent to 3.75 percent). District margins were historically weaker than national averages because lending levels were generally lower. Based on the numbers above, small community banks in the District reported an average NIM that was 40 basis points below U.S. Banks Under $1 Billion KEY 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 9 8 7 6 5 4 3 2 1 0 1994 N et interest margins are clearly under pressure at community banks, but this trend is not new. It is a product of a highly competitive banking industry and a direct result of today’s lower lending levels and abundant balance sheet liquidity. The net interest margin (NIM) is the difference between interest income and interest expense. (Both are expressed as a percentage of average earning assets.) As shown in Figures 1 to 4, interest income and interest expense fluctuated considerably through the business cycle, but the long-term trend indicates that asset yields are falling faster than deposit and other funding costs. figure 1 Percent By Gary S. Corner and Andrew P. Meyer Interest income / average earning assets Net interest margin Interest expense / average earning assets SOURCE: Reports of Condition and Income for U.S. Commercial Banks their national counterparts in 1995. However, by June 2013, District and national measures of small community bank NIM converged to a difference of only 3 basis points, with small District banks slightly edging out other small U.S. banks. In Figure 3 on Page 4, we see that large community banks (between $1 billion and $10 billion in assets) experienced a similar downward trajectory. It is interesting to note that, generally, smaller banks more effectively reduced funding costs and maintained NIM during the financial crisis than larger banks. As expected, reliance on continued on Page 4 T h e F e d e r a l R e s e r v e B a n k o f St . L o u i s : C e n t r a l t o A m e r i c a ’ s Ec o n o m y ® | stlouisfed.org Central view News and Views for Eighth District Bankers Vol. 23 | No. 2 www.stlouisfed.org/cb E d it o r Kristie Engemann 314-444-8584 firstname.lastname@example.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. Subscribe for free at www.stlouisfed.org/cb to receive the online or printed Central Banker. To subscribe by mail, send your name, address, city, state and ZIP code to: Central Banker, P.O. Box 442, St. Louis, MO 63166-0442. To receive other St. Louis Fed online or print publications, visit www.stlouisfed.org/subscribe. Follow the Fed on Facebook, Twitter and more at www.stlouisfed.org/followthefed. 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. Selected St. Louis Fed Sites Dodd-Frank Regulatory Reform Rules www.stlouisfed.org/rrr FRED® (Federal Reserve Economic Data) www.research.stlouisfed.org/fred2 Center for Household Financial Stability www.stlouisfed.org/HFS FRED is a registered trademark of the Federal Reserve Bank of St. Louis On the “Too Big To Fail” Debate: Implications of the Dodd-Frank Act By Julie Stackhouse I t is common knowledge that the banking industry has become increasingly consolidated over the past 25 years. In 1990, prior to a number of banking law changes, the nation housed around 12,500 charters. Today, there are roughly 6,000 charters, with consolidated assets of the top 10 U.S. banking firms representing approximately Julie Stackhouse 64 percent of U.S. banking assets. The is senior vice nation’s largest banking firm, JPMorgan president of Banking Chase & Co., alone has more than Supervision, $2.3 trillion in consolidated assets and Credit, Community more than 3,300 subsidiaries. Development and Without question, operations of Learning Innovation these large firms magnified the finanfor the Federal cial crisis, emphasizing their systemic Reserve Bank of importance. The resulting landmark St. Louis. legislation—the Dodd-Frank Act—is intended to reduce systemic risk and, ultimately, end “too big to fail.” I am often asked whether the Dodd-Frank Act and its hundreds of pages of supporting regulations “will work.” I think it is fair to say that it is too early to know. What is clear, however, is that the Dodd-Frank Act, the Basel III capital reforms and other planned regulation will go far to eliminate expected bailouts. This will occur in two ways: by significantly reducing the likelihood of systemic firm failures and by greatly limiting the cost to society of such failures.1 The legislative and other requirements to reduce the likelihood of a systemic firm failure are many. They include the Dodd-Frank Act’s multiple “enhanced prudential standards” and requirements for central clearing of derivatives. Capital of large banking firms is now stress-tested on a regular basis—twice a year for the largest firms—under adverse economic scenarios. All financial firms regardless of size are subject to the new Basel III capital standards, but larger firms will also be subject to the liquidity requirements contained in Basel III. (For more on Basel III, see the onlineonly article in this issue of Central Banker.) And the list does not end there. As emphasized by Federal Reserve Gov. Daniel Tarullo in a statement on May 3, four additional rules are planned that will enhance the capital requirements for the eight U.S. financial firms identified as having global systemic importance. These include a regulatory leverage threshold above the Basel III minimum, rules regarding the amount of equity and long-term debt large firms should maintain to facilitate orderly resolution, capital surcharges for banking organizations of global systemic continued on Page 10 2 | Central Banker www.stlouisfed.org Q u a r t e r ly R e p o r t Second-Quarter 2013 Banking Performance1 Earnings Performance Return on Average Assets 2012: 2Q 2013: 1Q 2013: 2Q 1.05% 0.91 1.07 0.73 1.07 1.23 0.90 0.90 0.83 0.94% 0.89 1.26 0.72 1.05 0.94 0.84 0.90 0.80 0.99% 0.93 1.24 0.81 1.09 0.90 0.88 0.93 0.85 3.89% 3.84 4.16 3.64 3.91 4.09 4.04 3.68 3.90 3.74% 3.66 4.07 3.46 3.73 3.79 3.82 3.49 3.82 3.79% 3.66 4.07 3.44 3.73 3.81 3.85 3.48 3.85 0.37% 0.44 0.37 0.57 0.28 0.34 0.24 0.39 0.36 0.22% 0.23 0.19 0.32 0.14 0.23 0.15 0.19 0.24 0.20% 0.21 0.19 0.30 0.13 0.23 0.14 0.15 0.22 2 All U.S. Banks All Eighth District States Arkansas Banks Illinois Banks Indiana Banks Kentucky Banks Mississippi Banks Missouri Banks Tennessee Banks Net Interest Margin All U.S. Banks All Eighth District States Arkansas Banks Illinois Banks Indiana Banks Kentucky Banks Mississippi Banks Missouri Banks Tennessee Banks SOURCE: R eports of Condition and Income for Insured Commercial Banks NOTES: 1 2 3 4 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 earnings assets in the denominator. Nonperforming assets are loans 90 days past due or in nonaccrual status, plus other real estate owned. The loan loss coverage ratio is defined as the loan loss reserve (ALLL) divided by nonperforming loans. Loan Loss Provision Ratio All U.S. Banks All Eighth District States Arkansas Banks Illinois Banks Indiana Banks Kentucky Banks Mississippi Banks Missouri Banks Tennessee Banks Asset Quality Measures 2012: 2Q 2013: 1Q 2013: 2Q 4.26% 4.65 5.09 5.71 2.90 3.72 3.90 4.41 4.89 3.53% 3.98 4.71 4.69 2.48 3.51 3.88 3.37 4.21 3.17% 3.59 4.36 4.06 2.33 3.33 3.55 3.08 3.80 66.94% 65.50 68.89 53.56 83.45 71.79 78.26 77.09 67.36 75.29% 73.69 70.64 64.87 91.72 72.45 69.05 95.25 76.10 80.77% 79.24 72.71 71.96 93.46 74.44 74.11 102.33 82.26 nonperforming Assets Ratio3 All U.S. Banks All Eighth District States Arkansas Banks Illinois Banks Indiana Banks Kentucky Banks Mississippi Banks Missouri Banks Tennessee Banks Loan Loss Coverage Ratio 4 All U.S. Banks All Eighth District States Arkansas Banks Illinois Banks Indiana Banks Kentucky Banks Mississippi Banks Missouri Banks Tennessee Banks Central Banker Summer 2013 | 3 figure 2 Net Interest Margins continued from Page 1 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 9 8 7 6 5 4 3 2 1 0 1994 Percent Eighth District Banks Under $1 Billion figure 3 Loans to Total Assets 2010 2011 2012 2013 2010 2011 2012 2013 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 9 8 7 6 5 4 3 2 1 0 1994 Percent U.S. Banks $1 Billion to $10 Billion figure 4 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 9 8 7 6 5 4 3 2 1 0 1994 Percent Eighth District Banks $1 Billion to $10 Billion KEY institutional or wholesale funding during this period proved less sound than reliance on retail funding. Until recently, bankers have driven down their deposit costs nearly lockstep with the fall of their asset yields, as depicted in Figures 1 to 4. Banks with higher, more stable loan volume are in a generally better earnings position, along with those that have aggressively reduced funding costs. Lending in small community banks (with less than $1 billion in assets) spiked leading up to and into the financial crisis, reaching more than 70 percent of the banks’ total assets by 2008. (See Figure 5 on Page 5.) Since then, lending has retrenched and currently stands at around 62 percent of total assets. Contributing factors are weak loan demand, tightened loan standards and a surge in deposits that loan demand could not absorb. As a result, excess liquidity is held in securities and cash balances. Leading up to the financial crisis, large community banks nationwide (between $1 billion and $10 billion in assets) experienced similar gains in lending, but they have been able to retain a slightly greater amount of that lending, as loans currently represent around 64 percent of total assets. (See Figure 6 on Page 5.) Interest income / average earning assets NIM Risk Factors Net interest margin To maintain margins, banks may need to continue to focus on their deposit costs while waiting for their loan demand to strengthen. Alternatively, chasing asset yields that significantly extend balance sheet duration today may prove painful down the road. As shown in Figures 1 and 3, the average interest expense for banks under $1 billion in assets is 57 basis points; for banks between $1 billion and $10 billion in assets, it is only 48 basis points. Perhaps there is room to further reduce deposit costs, as bank customers today tend to be somewhat indifferent to deposit rates. When the rate environment turns, will bankers have done enough to protect themselves? In addition to higher funding costs, deposits that surged into the banking system may move back Interest expense / average earning assets SOURCE: Reports of Condition and Income for U.S. Commercial Banks TERMINOLOGY Average earning assets – Assets, such as loans and securities, that earn interest income Interest income – Interest earned on the above average earning assets Interest expense – Interest paid on deposits and other liabilities Net interest margin (NIM) – The difference between interest income and interest expense, expressed as a percentage of average earning assets 4 | Central Banker www.stlouisfed.org figure 5 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 Percent Loan-to-Asset Ratio, Banks Under $1 Billion Interest income and interest 75 expense fluctuated 70 65 considerably through the 60 business cycle, but the long55 term trend indicates that asset 50 yields are falling faster than deposit and other funding costs. figure 6 Loan-to-Asset Ratio, Banks $1 Billion to $10 Billion 75 70 Percent 65 60 KEY 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 50 1995 55 1994 out as depositors find more attractive yields elsewhere. Perhaps, just as loan demand improves, a portion of deposit funding may dissipate. Depending on the nimbleness of their balance sheets, many banks are at risk of experiencing further NIM compression for a period of time. Consequently, decisions relative to today’s earnings pressures must be balanced with overall risk-management considerations. U.S. Eighth District Gary S. Corner is a senior examiner and Andrew P. Meyer is a senior economist, both at the Federal Reserve Bank of St. Louis. SOURCE: Reports of Condition and Income for U.S. Commercial Banks IN - D EPT H From Bailouts to Bail-ins: Will the Single-Point-of-Entry Concept End “Too Big To Fail”? By Jim Fuchs I n the wake of the financial crisis, many troubled financial firms were rescued by their sovereign governments. The undesirability of “bailouts” has led global policymakers to shift their focus to new “bail-in” approaches as a means of minimizing the impact of the failure of a large financial institution. Last year, the Federal Deposit Insurance Corp. (FDIC) and the Bank of England (BOE) issued a joint paper outlining the merits of a single-pointof-entry (SPOE) strategy for resolving a large, internationally active financial firm.1 A May 2013 report by the Bipar- tisan Policy Center concluded that the SPOE approach should generally allow a systemically important financial institution to fail “without resorting to taxpayer-funded bailouts or a collapse of the financial system.”2 The SPOE strategy is, in essence, a bail-in strategy because it implements a resolution process that imposes losses on shareholders and unsecured creditors. Resolution powers would be applied at the top-tier level of holding companies by a single-resolution authority, which, in the U.S., would be the FDIC. continued on Page 6 Central Banker Summer 2013 | 5 From Bailouts to Bail-ins So, Will It Work? continued from Page 5 Critics of SPOE question two underlying assumptions of the approach: that market confidence will be quickly restored, minimizing contagion; and that the underlying business model of the institution is sound. If even one of these conditions is not met, critics believe the overall process could be much more chaotic than the SPOE approach suggests. Ultimately, the credibility of the SPOE approach won’t be known until it is actually tested. The FDIC has made it clear that the first consideration, in any potential resolution, is to assess whether the bankruptcy code provides an appropriate tool for resolving a troubled firm. In fact, the Bipartisan Policy Center, in its May report, makes several recommendations for amending the bankruptcy code to avoid resorting to extraordinary, and untested, measures for resolving global systemically important institutions. Regardless, the approaches discussed under SPOE and under the bankruptcy code suggest that future remedies for handling troubled financial firms will focus on bailing-in the firm by imposing losses on shareholders and unsecured creditors, instead of bailing out firms and putting taxpayers at risk. Bailouts vs. Bail-ins One way to think about the difference between a bailout and a bail-in is to consider the source of funding. In a bailout, the funds essentially come from outside the institution, usually The SPOE strategy is, in essence, a bail-in strategy because it implements a resolution process that imposes losses on shareholders and unsecured creditors. in the form of taxpayer assistance via a direct intervention by the sovereign government. Conversely, in a bail-in, rescue funds come from within the institution as shareholders and unsecured creditors bear the losses. The SPOE Approach Under the FDIC/BOE proposal, a U.S. financial institution for which a determination has been made that it go through resolution under the SPOE approach, instead of bankruptcy, would be subject to the following: 1. The FDIC would be appointed as the receiver of the institution’s toptier holding company. 2. Assets of that holding company would then be transferred to a bridge holding company, enabling domestic and foreign subsidiaries to remain open and operating. 3. Work would then begin to transfer ownership of the bridge holding company to the private sector. 4. The subordinated debt, or even the senior unsecured debt, of the troubled firm would be used as the immediate source of capital for the new private-sector entity. 5. Remaining debt claims would be converted into equity claims that would also serve to capitalize the new private-sector entity. 6. The FDIC would provide assurances, as appropriate, that the ongoing operations of the firm and its attendant liabilities would be supported. 6 | Central Banker www.stlouisfed.org Jim Fuchs is an assistant vice president at the Federal Reserve Bank of St. Louis. ENDNOTES 1 “Resolving Globally Active, Systemically Important Financial Institutions,” a joint paper by the Federal Deposit Insurance Corp. and the Bank of England, Dec. 10, 2012, www.fdic.gov/about/ srac/2012/gsifi.pdf. 2 “Too Big To Fail: The Path to a Solution,” a report of the Failure Resolution Task Force of the Financial Regulatory Reform Initiative of the Bipartisan Policy Center, May 2013, http:// bipartisanpolicy.org/sites/default/files/ TooBigToFail.pdf. IN - D EPT H Can the U.S. Achieve Long-Run Fiscal Sustainability? What Happens When an Irresistible Force Meets an Immovable Object? To visually explain the future fiscal situation of the United States, Emmons used a physics paradox—an irresistible force meeting an immovable object. He characterized nondefense spending growth as the irresistible fiscal force, and tax revenues as a share of GDP as the immovable fiscal object. This collision depicts a looming fiscal disaster, which could include: high inflation, default on government debt, and drastic benefit cuts and tax increases. To best understand the implications, Emmons analyzed trends in federal spending and taxes relative to GDP figure 1 Ratio of Federal Nondefense Spending to GDP 25 20 15 10 5 2030 2025 2020 2015 2010 2005 2000 1995 1990 1985 1980 1975 1970 1965 1960 1955 1950 FORECAST 1945 0 1940 he continual growth of federal nondefense spending in conjunction with the government’s almost flat revenue-to-GDP ratio, which has fluctuated roughly between 15 and 20 percent since 1945, was the topic of the April 8 Dialogue with the Fed. If current trends continue, federal nondefense spending and tax revenues could prompt a fiscal crisis—which the U.S. has so far averted. In his presentation, William Emmons, an assistant vice president and economist at the St. Louis Fed, discussed whether the United States can achieve long-run fiscal sustainability. Emmons explained that the cost drivers of Social Security, Medicare and other federal programs are very difficult to affect and present a challenge when trying to reduce or control spending. Following the presentation, Kevin Kliesen, a research officer and business economist, offered his views on the topic. Kliesen and Emmons then answered questions from the audience in a session moderated by Julie Stackhouse, the senior vice president of Banking Supervision, Credit, Community Development and Learning Innovation. To see Emmons’ presentation slides and videos of the dialogue, visit www.stlouisfed.org/dialogue. Percent T SOURCES: Congressional Budget Office/Haver Analytics NOTE: Annual data through fiscal year 2012; CBO projections for 2013-2023 as of Feb. 2013 and posed two questions: First, how have we avoided a fiscal crisis so far? And, can we achieve long-run fiscal sustainability? Can We Slow Spending Growth? Since 1945, federal nondefense spending relative to GDP has quadrupled. Currently, this spending—on Social Security, Medicare and other programs—is approximately 20 percent of GDP and shows no signs of slowing. (See Figure 1 above.) “This is our irresistible force: Through all sorts of historic periods for all sorts of different reasons, federal nondefense spending has relentlessly grown faster than the overall economy,” Emmons said. Emmons examined the popularity of federal spending programs like Social Security, Medicare and defense, and explained that the major cost drivers are health-care expenditures. He pointed out that health-care costs have risen faster than GDP and are projected to continue to do so. And, while Social Security is presently the largest budget item, it’s projected to remain relatively flat over the next several decades. All other federal spending—including for defense—is declining. Emmons went on to explain that although interest rates on the debt are currently very low, they will return to more historically normal levels. Thus, continued on Page 8 Central Banker Summer 2013 | 7 Long-Run Fiscal Sustainability continued from Page 7 given unchanged circumstances, the interest payments will eventually become the largest budget item. Elaborating on why it won’t be easy to slow spending growth, Emmons explained that the first obstacle is the popularity of major federal programs. He cited a March 24 CBS News poll that indicated strong majorities opposed spending cuts to Medicare, Social Security and, to a lesser extent, defense to reduce the deficit.1 The immense popularity of the health-care programs, plus the program cost drivers that are very difficult to influence— including the aging population and the fact that health-care costs are rising faster than GDP—make it difficult to find a way to control or slow spending. Can the U.S. Stabilize the Debt? Emmons pointed out that the federal revenue-to-GDP ratio has been essentially flat since 1945. (See Figure 2 below.) Even with the current fiscal tightening, it is projected to return to its historic level (around 18 to 20 percent of GDP). So, when the federal spending-to-GDP ratio is figure 2 Ratio of Federal Revenue to GDP Why Haven’t We Had a Fiscal Crisis Already? 25 Percent 20 15 10 5 2030 2025 2020 2015 2010 2005 2000 1995 1990 1985 1980 1975 1970 1965 1960 1955 1950 FORECAST 1945 1940 0 SOURCES: Congressional Budget Office/Haver Analytics NOTE: Annual data through fiscal year 2012; CBO projections for 2013-2023 as of Feb. 2013 figure 3 Ratio of all federal spending to GDP Ratio of all federal revenues to GDP Annual federal budget deficit relative to GDP SOURCES: Congressional Budget Office/Haver Analytics NOTE: Projections as of June 2012 8 | Central Banker www.stlouisfed.org 2042 2040 2038 2036 2034 2032 2030 2028 2026 2024 2022 2020 2018 2016 FORECAST (under the CBO’s alternative fiscal scenario) 2014 2012 Percent Budget Deficits 40 35 30 25 20 15 10 5 0 combined with the federal revenueto-GDP ratio, a fiscal crisis seems probable, Emmons suggested. (See Figure 3 at the bottom.) According to Congressional Budget Office (CBO) projections, the budget deficit will be at approximately 20 percentage points (or $3 trillion) by the end of the projection period. “The result of these exploding budget deficits is that accumulated debt would also explode,” said Emmons. Figure 4 (opposite page) depicts the CBO’s baseline scenario and its alternative fiscal scenario. The latter is the CBO’s more plausible projection; however, both of these scenarios are unsustainable, as the ratio of debt-toGDP goes up indefinitely. “That is the simplest and most pertinent measure of fiscal sustainability. Can we get the debt stabilized relative to the size of GDP? It’s not the case that we have to pay off the debt, and it’s not the case that the debt can’t grow; it’s just that it can’t grow faster than the economy forever. That’s the situation of fiscal unsustainability,” Emmons explained. So, can the U.S. stabilize the debt? Historical evidence suggests that when other countries have hit these levels of debt-to-GDP, the ratios have been difficult to stabilize—but is the United States different? Given that nondefense spending has continued to rise, while revenues have stayed flat, how has the United States gone so long without a crisis? Emmons proposed a few explanations. First, we have had an extended peace dividend, which refers to declining military spending. However, he pointed out that due to the defense cuts previously enacted, there isn’t much left to cut; certainly not enough to absorb the soaring health-care costs expected over the next few decades. The second reason we’ve been able to avoid a fiscal crisis is the demographic dividend. “We’ve had the Baby Boomers—often defined as people born between 1946 and 1964—moving through their most productive years, swelling the labor force, increasing GDP growth, paying taxes—and at the same time, not collecting as many benefits as, say, a very young population or a very old population,” said Emmons. As we are figure 4 Ratio of Federal Debt Held by the Public to GDP 100 90 80 70 60 50 40 30 20 10 0 CBO’s baseline scenario (current law) CBO’s alternative fiscal scenario 2030 2025 2020 2015 2010 2005 2000 1995 1990 1985 1980 1975 1970 FORECAST SOURCES: Congressional Budget Office/Haver Analytics NOTE: Annual data through fiscal year 2012; CBO projections for 2013-2023 as of Feb. 2013 figure 5 CBO Estimate of Real Potential GDP Growth (5-year trailing average) 5 4 3 2 1 2025 2020 2015 2010 2005 2000 1995 1990 1985 1980 1975 1970 FORECAST 1965 0 1960 “The U.S. government will not default on its debt in the foreseeable future,” Emmons said, suggesting no pressing need to worry. “Also, the Federal Reserve will not allow inflation to surge in the foreseeable future. With these two options off the table, the only Since 1945, federal nondefense spending relative to GDP has quadrupled. Currently, this spending—on Social Security, Medicare and other programs—is approximately 20 percent of GDP and shows no signs of slowing. 1955 To Worry or Not To Worry about a Fiscal Crisis? continued on Page 11 1950 The issue, Emmons said, is that in general neither political faction nor the public seems to be willing to address the reality of what lies ahead in terms of the U.S. fiscal situation. Overall, it seems that one faction will not admit to the popularity of the major federal programs, such as Social Security and Medicare, whereas the other faction will not admit that the tax revenues needed to pay for these programs are not politically or economically feasible. Given these circumstances, will the United States have a fiscal crisis? Emmons referenced This Time Is Different: Eight Centuries of Financial Folly, by Carmen M. Reinhart and Kenneth S. Rogoff.2 Reinhart and Rogoff found that default on sovereign debt is more common than one might think. History is full of countries that lost control of their fiscal situations, ending in crisis. For example, Spain has defaulted 15 times during the last 450 years. Implicit defaults through inflation or currency devaluation, though less obvious, are just as common, Emmons noted. For example, the United States implicitly defaulted on its debt by effectively reducing the value of its financial promises when it devalued the dollar against gold in 1933 and when it broke the link between the dollar and other currencies in 1971. Percent In Light of These Obstacles, Can We Achieve Long-Run Fiscal Sustainability? way to achieve fiscal sustainability is through political action.” Unfortunately, our political system seems gridlocked, and most members of the public seem hesitant to make sacrifices, as illustrated by the aforementioned poll. However, Emmons urged that “our political leaders must help the public understand spending and taxing realities.” The public perception needs to change; the public must agree to make sacrifices—not all equally—but everyone should be involved. A step in this direction, Emmons suggested, would be to separate the insurance function of government Percent now moving to a permanently older population though, one consequence is that economic growth is likely to be slower (see Figure 5 at the bottom), and another is that government spending on health and retirement programs will be higher. Finally, some good luck and good policy in the 1980s and 1990s helped prevent a fiscal crisis. For instance, economic growth and the stock market were strong, reducing deficits. SOURCES: Congressional Budget Office/Haver Analytics NOTE: Annual data through 2012; CBO projections for 2013-2024 as of Feb. 2013 Central Banker Summer 2013 | 9 Final Basel III Capital Rule—Less Impact on Community Banks >> online extr a The U.S. federal banking agencies approved the final Basel III riskbased capital rule this summer. Our online-only Central Banker article examines three key provisions that provide some relief to community banks under the final rule relative to the proposed rule and discusses how many banks will be affected by the new capital requirements. To read the article, visit www.stlouisfed.org/cb. Why Do Family Balance Sheets Matter? The financial crisis and Great Recession had profound effects not only on the U.S. economy as a whole, but on individual households. In our new annual report, find out more about the link between households’ balance sheets (their savings, assets, debts and net worth, as distinct from wages and income) and the overall performance of the U.S. economy. In addition, learn why it’s important not just for individual families but the economy as a whole for those balance sheets to get back on track. This essay, “After the Fall: Rebuilding Family Balance Sheets, Rebuilding the Economy,” is also the subject of a short video. To read the report, visit www.stlouisfed.org/ar. Central View continued from Page 2 importance, and additional measures that will directly address risks related to short-term wholesale funding. Beyond efforts to reduce the likelihood of failure, the Dodd-Frank Act also contains provisions to address the cost to society should a failure occur. In this regard, large banking firms are required to submit resolution plans, or “living wills,” for their orderly resolution under the Bankruptcy Code. Beyond efforts to reduce the likelihood of failure, the Dodd-Frank Act also contains provisions to address the cost to society should a failure occur. The Dodd-Frank Act also contains an Orderly Liquidation Authority, giving the Federal Deposit Insurance Corp. backup resolution authority. The associated single-point-of-entry concept is discussed separately in this issue of Central Banker (see Page 5). Finally, the Dodd-Frank Act forbids acquisitions by any financial firm that controls more than 10 percent of the total liabilities of financial firms in the U.S., and requires banking regulators to consider “risk to the stability of the U.S. banking or financial system” in evaluating any proposed merger or acquisition. It would be unrealistic to conclude that the Dodd-Frank Act will end “too big to fail.” Many of the supporting rules are not yet implemented, and importantly, the provisions of the DoddFrank Act have not been tested during a period of financial stress. Although, having said that, the safeguards in the Dodd-Frank Act have already influenced a safer banking system. ENDNOTE 1 See also the speech by Federal Reserve Gov. Jerome Powell on March 4. 10 | Central Banker www.stlouisfed.org The St. Louis Fed Financial Stress Index The St. Louis Fed Financial Stress Index (STLFSI) measures the degree of financial stress in U.S. markets. The index is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each series captures some facet of financial stress. As the level of financial stress in the economy changes, the data series are likely to move together. The average value of the index, which begins in late 1993, is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress. The St. Louis Fed is now issuing a weekly news release of the STLFSI. To view past news releases, visit www.stlouisfed.org/ newsroom/financial-stress-index/. For an > > F RED Long-Run Fiscal Sustainability key. We must convince our political leaders to help the public better understand these realities and to emphasize that we are all in this together. Going forward, he suggested, we must initiate a more straightforward discussion about health-care costs, the role of the aging population and taxes. continued from Page 9 from redistribution. “Make the actual cost of government insurance programs transparent, so that everyone knows how much it costs to provide services—especially health care and retirement annuities,” said Emmons. Changing the Discussion: Be Transparent about the Cost of Benefits Under current circumstances, federal nondefense spending and tax revenues are, respectively, an irresistible force meeting an immovable object, according to Emmons. “A series of temporary fixes has prevented a fiscal crisis so far, but those fixes are gone. The only plausible route to long-run fiscal sustainability is through political courage and leadership. Since we are not going to default on our debt or inflate away our debt, the only solution is political. We have to get the taxes and the spending to add up, and that’s going to require shared sacrifice.” However, to accept this sacrifice, the public must be informed—Emmons reinforced that transparency is the St. Louis Fed Financial Stress Index www.research.stlouisfed.org/fred2/series/STLFSI explanation of the data series used to construct the STLFSI, refer to www.stlouisfed. org/newsroom/financial-stress-index/key. ENDNOTES 1 “Americans’ Views on Washington, the President & the Budget Deficit,” CBS News poll, March 20-24, 2013, www.cbsnews.com/8301-250_16257576433/poll-80-of-americans-unhappy-withwashington/?pageNum=2. 2 See chapters 4-9 and chapter 12 in This Time Is Different: Eight Centuries of Financial Folly, by Carmen M. Reinhart and Kenneth S. Rogoff. Princeton University Press, 2009. Central Banker Summer 2013 | 11 FIRST-CLASS US POSTAGE PAID PERMIT NO 444 ST LOUIS, MO Central Banker Online S ee the online version of the S ummer 2013 C ent r a l B a n k e r at www. s tlo u i s f e d. o r g/C b for regulatory spotlights , recent S t. Louis F ed research and additional content . NEW BANKING AND E C O N O M I C RESEAR C H RU L ES A N D RE G U L AT I O N S • Farm Income, Land Values Rise in Eighth District • CFPB, SEC/CFTC Release Final Rules Related to Mortgage Markets, Identity Theft Prevention Programs • Mind the Regional Output Gap • The Mechanics Behind Manufacturing Job Losses • Big Banks in Small Places: Are Community Banks Being Driven Out of Rural Markets? B a s e l I I I Up d at e • Final Basel III Capital Rule—Less Impact on Community Banks • Average Household Has Yet To Recover from Crisis • Why Are Student Loan Debt and Delinquency Rates Growing? printed on recycled paper using 10% post-consumer waste Community Banking Research Conference To Be Webcast Community bankers, academics, policymakers and bank supervisors from across the country will meet at the Federal Reserve Bank of St. Louis for “Community Banking in the 21st Century,” an inaugural community banking research and policy conference Oct. 2-3. A live webcast of the conference, which will be hosted by the Federal Reserve System and the Conference of State Bank Supervisors (CSBS), can be viewed when the conference begins Oct. 2 at 2 p.m. CT at www.stlouisfed.org/live. Scheduled speakers include Fed Chairman Ben Bernanke, St. Louis Fed President James Bullard and CSBS President and CEO John Ryan. View the full schedule at www.stlouisfed.org/CBRC2013/agenda. CENTRAL BANKER | SUMMER 2013 https://www.stlouisfed.org/publications/central-banker/summer-2013/the-st-louis-fed-financial-stress-index The St. Louis Fed Financial Stress Index The St. Louis Fed Financial Stress Index (STLFSI) measures the degree of financial stress in U.S. markets. The index is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each series captures some facet of financial stress. As the level of financial stress in the economy changes, the data series are likely to move together. The average value of the index, which begins in late 1993, is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress. The St. Louis Fed is now issuing a weekly news release of the STLFSI. To view past news releases, visit www.stlouisfed.org/news-releases. For an explanation of the data series used to construct the STLFSI, refer to www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key. CENTRAL BANKER | SUMMER 2013 https://www.stlouisfed.org/publications/central-banker/summer-2013/final-basel-iii-capital-ruleless-impact-on-community-banks Final Basel III Capital Rule—Less Impact on Community Banks In early July, the Federal Reserve Board of Governors, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. approved the final Basel III risk-based capital rule. This rule aims to improve the quality and quantity of capital for all banking organizations. The agencies, in response to comments on their June 2012 proposed capital rule, sought to minimize the potential burden on community organizations where consistent with applicable law and the establishment of a robust and comprehensive capital framework. For community banking organizations, the rule in final form provides some relief from the initial proposal in three important areas: residential mortgage exposure, accumulated other comprehensive income (AOCI) and grandfathered capital instruments. Community banking organizations first become subject to the final Basel III rule on Jan. 1, 2015. Thereafter begins a phase-in period through Jan. 1, 2019. While Basel III increases minimum capital requirements, the vast majority of Eighth District bank holding companies (BHCs)—as well as BHCs across the country—already comply with the new minimums. The final rule also looks to minimize the potential burden on community banks—in response to comments received by the agencies on the June 2012 proposed rule—while remaining consistent with applicable law and the establishment of a robust and comprehensive capital framework. Key Changes from the Proposed Capital Rule that Affect Community Banks Comments from community banks resulted in three major changes from the proposed rule. These changes include: Residential Mortgage Exposure: The proposed rule called for higher risk weights applied to certain residential mortgage exposures. None of the proposed changes are found in the final rule. Thus, remaining unchanged is the 50 percent risk weight for prudently underwritten first-lien mortgage loans that are not past due, reported as nonaccrual or restructured, and a 100 percent risk weight for all other residential mortgages. Similarly, the new rule does not change the current exclusions from the definition of credit-enhancing representations and warranties. Accumulated Other Comprehensive Income (AOCI) Filter: The initial proposal would have included most AOCI components in regulatory capital. In the new rule, community banking organizations are given a one-time option to filter certain AOCI components, similar to current treatment. The AOCI opt-out election must be made on the institution’s first regulatory report filed after Jan. 1, 2015. Grandfathered Capital Instruments and Tier 1 Capital: The initial proposal would have required trust preferred securities and cumulative perpetual preferred stock to be phased out of tier 1 capital. The new rule exempts depository institution holding companies with less than $15 billion in total consolidated assets as of Dec. 31, 2009, or organized in mutual form as of May 19, 2010, from this requirement. Grandfathered capital instruments, consistent with current treatment, are limited to 25 percent of adjusted tier 1 capital elements. Major Changes from the Existing Basel I Capital Rule The new rule implements higher minimum capital requirements and emphasizes the use of common equity through the introduction of a new capital ratio: common equity tier 1 (CET1). In addition, the new rule establishes stricter eligibility for capital instruments included in CET1, additional tier 1 capital or tier 2 capital. In addition, the rule introduces the requirement of a capital conservation buffer, beginning on Jan. 1, 2016, and ending on Jan. 1, 2019. Banking organizations without other supervisory issues that wish to distribute capital freely must maintain the buffer. Tables 1 and 2 compare current treatments versus final capital rule treatments. TABLE 1 Minimum Capital Standards Current Minimums Final Rule Minimum Buffer Total Common equity tier 1 capital (CET1) ratio N/A 4.5%* 2.5% 7.0% Tier 1 capital ratio 4% 6.0%* 2.5% 8.5% Total capital ratio 8% 8.0%* 2.5% 10.5% Leverage ratio 4% 4.0%* N/A N/A * Please note when the new capital rule is fully phased in, the minimum capital requirements plus the conservation buffer will exceed the prompt corrective action well-capitalized thresholds below. This 0.5-percentage-point cushion allows institutions to dip into a portion of their capital conservation buffer before reaching a status that is considered less than well capitalized for prompt corrective action purposes. TABLE 2 Prompt Corrective Action Well-Capitalized Thresholds Current Treatment Treatment in Final Rule* N/A ≥6.5% Tier 1 capital ratio ≥6.0% ≥8.0% Total capital ratio ≥10.0% ≥10.0% Leverage ratio ≥5.0% ≥5.0% Common equity tier 1 capital (CET1) ratio * Conservation buffer is included in the above standards reflective of the final transition date of Jan. 1, 2019. The new rule emphasizes common equity as the preferred capital instrument. It also limits the inclusion of intangible assets, including mortgage servicing assets, deferred tax assets and significant investments in unconsolidated capital of financial institutions. Each will be subject to a 10 percent individual limit and 15 percent aggregate limit of CET1. The new capital rule addresses the Dodd-Frank Act prohibition on reliance on external credit ratings specified in the regulations of the federal banking agencies. Consequently, the new capital rule replaces the previous credit-rating-based risk-weighting approach of certain assets with the simplified supervisory formula approach. As an alternative, banking organizations may use a gross-up approach or otherwise default to the seemly prohibitive 1,250 percent asset risk weight. Impact on Banking Organizations We estimate that approximately 96 percent of U.S. BHCs and 90 percent of Eighth District BHCs immediately meet the 4.5 percent CET1 to risk-weighted assets ratio required under the final capital rule. Thus, the immediate effect is small, while in addition, community banking organizations have a lengthy period to meet the final phased-in requirements. Summary The new Basel III capital rule introduces a comprehensive new regulatory framework for U.S. banking organizations which is consistent with international standards. For the most part, community banking organizations have been insulated from a capital rule that results from a severe knee-jerk reaction to the financial crisis. Based on our estimates, for the majority of community banking organizations, the final rule will have little impact on their capital level and structure. However, for a minority, some capital will need to accrue prior to final phase-in of the new rule. Endnotes 1. See the Federal Register Notice on Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, and Standardized Approach for Risk-Weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule and Market Risk Capital Rule at www.federalreserve.gov/newsevents/press/bcreg/20130702a.htm. [back to text] 2. Altogether exempt from the final rule are bank holding companies with less than $500 million in assets, as they remain subject to the Board’s Small Bank Holding Company Policy Statement. [back to text] 3. CET1 is broadly defined as the sum of common stock, surplus and retained earnings, adjusted by AOCI, other equity capital and qualifying noncontrolling minorities; with goodwill, net deferred assets (DTA), mortgage servicing assets (MSA) and unconsolidated subsidiaries deductions. [back to text] CENTRAL BANKER | SUMMER 2013 https://www.stlouisfed.org/publications/central-banker/summer-2013/recent-st-louis-fed-banking-and-economic-research Recent St. Louis Fed Banking and Economic Research Farm Income, Land Values Rise in Eighth District Our latest survey of agricultural banks in the Eighth District shows that farm income, along with capital and household spending, rose modestly in the second quarter compared with a year earlier. Farmland values in the second quarter were 11 percent higher than in the first quarter, rising to a District average of $5,672 per acre. Cash rents for quality farmland rose 6.7 percent from the first quarter to the second, averaging $183 per acre. To find out more about agricultural credit conditions, read the latest issue of Agricultural Finance Monitor. Mind the Regional Output Gap When looking at the performance of the economy on a national scale, the recovery has been slow. However, progress varies significantly from state to state. For example, poorer/smaller states have experienced a more rapid recovery than have wealthier/larger states since the Great Recession. Find out more in this recent installment in our Economic Synopses series. The Mechanics Behind Manufacturing Job Losses Manufacturing jobs as a percentage of private employment have fallen by half since the late 1980s—from about 21 percent in 1987 to less than 11 percent today. Yet, manufacturing output as a percentage of private output has remained steady over this same period. Despite some economic distress associated with change in this sector, producing the same share of output with a declining share of the workforce reflects rising productivity and higher standards of living for the average American. For more, read this recent essay in our Economic Synopses series. Unemployment Benefits: How Much Money Goes Unclaimed? Even in challenging times, not everyone who is eligible to receive unemployment benefits actually collects them. For example, during the recent recession (2007-09), only about 50 percent of those eligible collected their benefits. A recent installment in our Economic Synopses series details these percentages, examines how they are impacted by unemployment benefit extensions and evaluates the savings generated due to unclaimed benefits. For 2009 alone, those savings are estimated at $100 billion. Big Banks in Small Places: Are Community Banks Being Driven Out of Rural Markets? Well-managed community banks can continue to remain competitive, at least in rural markets where their niche is most likely stronger than in urban markets. In this article from the May/June 2013 issue of Review, the authors explore the viability of the community bank business model in rural markets. The two main advantages are that the cost of relationship lending may be lower in rural areas than in urban areas and rural markets likely have higher percentages of borrowers for whom there is limited quantitative information. Average Household Has Yet To Recover from Crisis The average household has recovered about 63 percent of the net worth that it lost during the financial crisis. In dollars, average household net worth, adjusted for inflation and population growth, has grown by $95,335 from its low point at the end of the first quarter of 2009. At least an additional $56,000 would be needed to return that figure to its precrisis peak. Read more about the state of household balance sheets in a recent issue of In the Balance, a publication from the St. Louis Fed’s Center for Household Financial Stability. What Flattened the Earnings Profile of Recent College Graduates? The average life-cycle earnings profile for college graduates of more-recent birth cohorts increased at a slower rate than that of cohorts who entered the workforce many decades ago. Continue reading this essay in our Economic Synopses series to find out why and to discover the theoretical link between a measure of ability and the life-cycle earnings profile. Winners and Losers in the Great Recession A significant number of industries—representing roughly a quarter of the U.S. economy—conducted business as usual during the most recent recession when judged by pre-recession trends. For a slightly larger group of industries—mostly related to construction, manufacturing and trade—the contractions have been severe, reinforcing a preexisting process of steady relative decline. Read more in this recent essay from our Economic Synopses series. Why Are Student Loan Debt and Delinquency Rates Growing? Student loan debt increased significantly over the past few years, almost doubling from half a trillion dollars in 2007 to nearly $1 trillion today. And in the third quarter of 2012, the share of delinquent student loan balances exceeded the share of delinquent credit card balances. Explore the reasons why in a recent issue of Inside the Vault. CENTRAL BANKER | SUMMER 2013 https://www.stlouisfed.org/publications/central-banker/summer-2013/stress-tests-mortgage-markets-among-latest-doddfrankact-proposed-and-final-rules Rules and Regulations: Stress Tests, Mortgage Markets among Latest Dodd-Frank Act Proposed and Final Rules Agencies Request Comments on the Following Proposed Rules NCUA proposes a Minority Depository Institution Preservation Program The National Credit Union Administration (NCUA) is requesting comment on a proposed program designed to encourage the preservation of Minority Depository Institutions (MDIs). The NCUA envisions a program of proactive steps and outreach efforts to promote and preserve minority ownership in the credit union industry and its role in minority communities. Comments are due by Sept. 30, 2013. OCC, FRS and FDIC jointly propose guidance for certain company-run stress tests The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRS) and the Federal Deposit Insurance Corp. (FDIC) are requesting comment on jointly proposed supervisory guidance for company-run stress test requirements for banking organizations with total consolidated assets of more than $10 billion but less than $50 billion. The stress test requirements were published in October 2012. This proposed supervisory guidance serves to assist the banking companies in meeting stress test rule requirements. Comments are due to the OCC and the FDIC by Sept. 25, 2013, and to the FRS by Sept. 30, 2013. OCC, FRS and FDIC jointly propose new leverage ratio standards for BHCs and subsidiary insured banks The OCC, FRS and FDIC are requesting comment on a jointly proposed rule to amend leverage ratio standards for certain U.S. banking organizations. The proposed rule would apply to any U.S. top-tier bank holding company (BHC) with at least $700 billion in total combined assets or $10 trillion in assets under custody (covered BHC) and any subsidiary insured depository institution (IDI) of the BHCs or covered BHCs. Comments are due by Oct. 21, 2013. CFPB, SEC/CFTC Release Final Rules Related to Mortgage Markets, Identity Theft Prevention Programs CFPB adopts rules related to mortgage servicing, higher-priced mortgages and qualified mortgages The Consumer Financial Protection Bureau (CFPB) previously issued several final rules concerning mortgage markets, including the Ability-to-Repay rule under the Truth in Lending Act (TILA), the Mortgage Servicing Rule under the Real Estate Settlement Procedures Act (RESPA), the Mortgage Servicing Rule under TILA and an amended Escrow Rule under TILA. This rule implements several amendments and clarifications, including: amending the pre-emption commentary in RESPA; clarifying the adjustable-rate mortgage provisions of TILA; providing clarifications regarding repayment and prepayment requirements for higher-priced mortgage loans (HPMLs) under TILA; clarifying the exemption for small servicers under TILA; revising and adopting an interpretation regarding the ability-to-pay compliance under TILA; clarifying loan meeting eligibility requirements under TILA; and amending appendix Q of TILA. The rule is effective on Jan. 10, 2014, except for the amendment to Section 1026.35(e)—regarding repayment and prepayment requirements for HPMLs—which was effective as of July 24, 2013. CFPB rules for supervision of nonbank covered persons This CFPB final rule establishes the procedures by which a nonbank covered person may be subject to CFPB supervision pursuant to reasonable cause that a person is or has engaged in conduct that poses risks to consumers with regard to the consumer financial products or services offered. The procedures outline notice requirements, available rebuttal options for the noncovered person, CFPB determination procedures and available relief. The rule was effective as of Aug. 2, 2013. CFPB exempts certain creditors from ability-to-pay determinations, definition of qualified mortgages Regulation Z generally prohibits a creditor from making a mortgage loan unless the creditor determines that the consumer will have the ability to repay the loan. This CFPB final rule provides an exemption to these requirements for creditors with certain designations, loans pursuant to certain programs, certain nonprofit creditors and mortgage loans made in connection with certain federal emergency economic stabilization programs. The final rule also provides additional definitions for qualified mortgages and modifies the fee calculation requirements. The rule is effective on Jan. 10, 2014. CFPB delays effective date for prohibition on creditors and insurance premiums On Feb. 15, 2013, the CFPB issued a final rule adopting loan originator compensation requirements under Regulation Z. The rule included an effective date of June 1, 2013, for Section 1026.36(i), which dealt with financing single-premium credit insurance. On May 10, 2013, the CFPB published a rule proposing to delay the June 1, 2013, effective date. This rule delays the effective date to Jan. 10, 2014. CFPB amends escrow rules, definitions for rural and underserved counties; posts list of rural and underserved counties This CFPB final rule clarifies the method for making “rural” and “underserved” designations and retains certain existing protections for higher priced mortgage loans (HPMLs). This rule amends the final rule published in the Federal Register on Jan. 22, 2013. Additionally, the CFPB is posting a final list of rural and underserved counties on its public web site for use with mortgages consummated from June 1, 2013, to Dec. 31, 2013. This rule was effective as of June 1, 2013, except for the addition of Section 1026.35(e)—regarding repayment and prepayment requirements for HPMLs—which will be effective from June 1, 2013, through Jan. 9, 2014. SEC, CFTC set final rules regarding identity theft prevention programs and procedures These joint final rules and guidelines from the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) require certain financial institutions and creditors to establish written identity theft prevention programs designed to detect, prevent and mitigate identity theft. The joint rules also require credit and debit card issuers to implement identity verification procedures where a change of address notification and a subsequent request for an additional or replacement card are received within a short period of time. These rules and guidelines were effective as of May 20, 2013, with a compliance date of Nov. 20, 2013.