FRBSF Economic Letter

1996-22 | July 26, 1996

Rising Economic Tide

Fred Furlong

A rising tide raises all ships. That is good news for community banks in California, where the economic tide continues to flow in after the pronounced ebb of the past recession. With strong economic growth in the state this year, earnings have edged up further at community banks (banks with assets of $300 million or less). However, profitability among California community banks still lags noticeably, due in part to the effects of relatively poor asset quality. Looking ahead, poor asset quality likely will remain a drag on performance for some community banks. However, the outlook for continued economic growth in California, along with signs of improvement in the real estate sector, should work to buoy the overall performance of community banks in the state.

California economy

California is adding jobs at a faster pace than the U.S. as a whole. Official data, which likely understate actual growth, show nonfarm payroll jobs in the state increased 2.3 percent over the 12 months ending in May, compared with 2.1 percent for the nation. Figure 1 shows that, with three years of job gains, the level of employment in the state has moved above the pre-recession level. The 7.2 percent unemployment rate in the state, however, suggests that the economy has not fully recovered from the effects of the past recession. This rate is about 2 percentage points higher than the pre-recession rate.

Most regions within California also are experiencing healthy employment gains. For example, the rate of employment gains for Northern California (nine county San Francisco Bay Area) was about the same as that for the state over the past 12 months, while in Southern California growth was only a bit less.

Still, since the past recession hit harder in the southern part of the state, the level of activity there is lagging more than would be suggested by the recent growth. Figure 1 indicates that payroll employment in Southern California has yet to reach its pre-recession level. The high unemployment rate in the region is also consistent with its having further to go in recovering from the recession. The unemployment rate is 7 percent in Southern California, close to 2 percentage points above the prerecession level. In contrast, the rate in Northern California is only 4.6 percent, closer to levels prevailing prior to the recession.

Bank performance

The performance of community banks in California reflects the economic performance of the state and its subregions. In keeping with the strong economic growth rate in the state, community bank earnings for the four quarters ending in the first quarter of this year edged up, with a return on assets (ROA) of 0.74 percent. While this is a positive for community banks in California, the profitability figure is well off that for other banks. For example, large banks in the state posted an average ROA of 1.36 percent, while the figure for community banks in the District outside of California was 1.65 percent.

The lower profitability of community banks in California is related in large part to the relatively poor asset quality at some banks. Lower quality assets can affect profitability through the need to make provisions to loan loss reserves as well as through the drag on earnings from holding loans not accruing interest and real estate acquired through foreclosures. For example, community banks in California continue to add to loan loss reserves, while the state’s large banks have reduced their reserves. Also, net interest margins (interest income less interest expenses divided by assets) have been lower at California community banks than at community banks in the rest of the District as a group.

Figure 2 shows that ROA for community banks in the hard-hit southern part of the state are coming back from the losses experienced during the recession. However, average profitability of the community banks in Southern California continues to fall short of that of their Northern California counterparts. Figure 3 indicates that problem loan ratios have improved compared to the cyclical high; still, in Southern California, the problem loan ratio showed little improvement in the first quarter of this year and remains high.

Outlook

The patterns during the current cycle suggest that the future performance of community banks in California will be tied in part to the continued health of the economy. Particularly important for community banks in the state is the outlook for the real estate sector. The portfolios of California community banks tend to have relatively high concentrations in real estate loans–67 percent of total loans, compared with 55 percent for community banks in the rest of the District and 46 percent for the large banks in California. In addition, problem real estate loans have been important contributors to the lowering of asset quality among community banks.

So far in the recovery, the California real estate sector has lagged the rest of the economy. This is reflected in unusual weakness in new home and nonresidential construction. There are indications of improvement, however. One is the pickup in the volume of existing home sales in the state. California residential real estate values also are increasing. For example, the CPI index of owner’s equivalent rent for the Los Angeles and San Francisco areas accelerated this year, with a larger increase for San Francisco.

Nonresidential real estate conditions also have tightened. In the San Francisco area, for example, office vacancy rates have dropped from 12.5 percent to a tight 7 percent over the past three years. Parts of Southern California, like Orange County and San Diego, show declines in office vacancy rates, while reports for Los Angeles show a drop in industrial vacancy rates.

The prospects for some improvement in real estate markets along with the strength in indicators like employment growth, point to overall economic conditions that should work to buoy the performance of California community banks, though the level of performance is likely to continue to lag for those banks with relatively poor asset quality.

Fred Furlong
Vice President, Banking, Finance and Regional Studies


References

Western Economic Developments. 1996. Federal Reserve Bank of San Francisco (July).

Zimmerman, Gary C. 1996. “Factors Influencing Community Bank Performance in California.” Federal Reserve Bank of San Francisco Economic Review, 1, pp.26-42.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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