FRBSF Weekly Letter
96-04; January 26, 1996
In 1995, California's community banks (assets under $300 million) improved
their earnings and asset quality, although their overall performance remained
lackluster. The total problem loan ratio for the state's 333 community
banks still is above the pre-recession level, and their return on assets
in 1995 was less than half that for all banks in the state and the nation.
The sub-par performance of many community banks in California is a continuation
of the difficulties many small banks have struggled with since the 1990-1991
recession. Two of the most important factors for their performance have
been the severity of regional economic conditions in the state and their
earlier decisions to move away from a more diversified loan portfolio
and into more commercial real estate financing. This Weekly Letter examines
the effects of these factors on asset quality among community banks in
California, focusing on the period between 1990 and 1994.
The performance of banks generally depends on underlying economic conditions.
For a community bank, the local economy is what matters. Because most
small banks have a more limited geographic scope than do larger statewide
and multi-state institutions, they also have fewer opportunities to diversify
This link to local markets has meant that community banks in different
parts of California have faced considerably different economic conditions
during the recent recession. For example, Southern California has about
60 percent of the nonagricultural jobs, but it accounted for more than
85 percent of the job losses during the recession. In Northern California,
job losses were about proportional to the region's share of jobs in the
state, while the Central Valley and remaining parts of the state were
affected considerably less during the recession. Southern California also
took the worst hit in terms of the deterioration of the commercial real
estate market. For example, the vacancy rate for downtown Los Angeles
was over 26 percent in December 1994; at its worst during this recession
in San Francisco (June 1991), the rate was under 14 percent.
Figure 1 (this file requires
Adobe Acrobat) shows the relationship between local economic conditions
and aggregate measures of asset quality for community banks in California.
The total problem loan ratio for the community banks increased the most
and remains the highest in Southern California, the hardest hit region.
In contrast, banks in the Central Valley as a group registered the lowest
ratio and the smallest increase.
While a bank has little control over local economic conditions, it can
control its portfolio decisions. However, in this case many banks' portfolio
choices ended up accentuating the negative impacts of the recession on
asset quality. Consistent with their relatively poor asset quality, community
banks in California registered the largest shares of relatively higher
risk commercial real estate loans in their portfolios, more than doubling
their ratios of commercial real estate loans to total loans since 1984.
Commercial real estate loans include construction and land development
loans secured by real estate and loans secured by nonfarm nonresidential
properties. Figure 2 (this file requires Adobe
Acrobat) shows that the 45 percent ratio for California community
banks was far above the ratios for all banks in the state and in the nation
at the end of 1994. Moreover, this shift was most evident at community
banks in Southern California (this shift is not displayed in the Figure).
Between 1984 and 1994, those banks increased their concentration in commercial
real estate loans by 30.8 percentage points, to almost 47 percent of total
As part of the shift to commercial real estate, California community
banks also moved heavily into construction lending. This was the highest
risk loan category in the 1990s, as measured by net charge-offs over the
period, and it grew to a peak in 1990 of nearly 18 percent of total loans
at community banks, far above the comparable ratio for either U.S. or
Aggregated data, as in the accompanying figures, are useful, but the
relationship of asset quality to economic conditions and portfolio decisions
can be examined somewhat more precisely by using data for individual banks.
Zimmerman (1996) takes this approach, using a sample of 327 California
community banks for the period 1990 to 1994.
The results of that study confirm that local economic conditions had
a significant impact on asset quality among community banks. First, the
statistical analysis shows that asset quality at community banks was affected
by local employment growth. The relationship between employment growth
and asset quality was negative, as expected, and typically highly statistically
While employment growth may be a reasonable proxy for economic conditions,
one indicator alone may not capture fully the range of differences from
region to region. In fact, the results from the statistical analysis show
community banks in Southern California and Northern California tended
to have lower asset quality compared to other banks, even when controlling
for employment growth as well as bank portfolio composition and other
factors. This suggests that there are additional regional factors that
influenced community bank asset quality during this period.
The evidence also supports the view that a bank's portfolio decisions
had an important impact on asset quality. The analysis shows statistically
significant relationships between California community banks' concentration
in various types of real estate loans and their asset quality, even while
controlling for regional location and economic conditions. In particular,
greater commercial real estate financing, which accounted for the bulk
of the increase in real estate lending over the period, was associated
with lower asset quality. This was true for commercial real estate lending
and construction lending. Interestingly, financing residential real estate
had the opposite effect: Higher concentrations in residential real estate
loans were associated with lower problem real estate loans ratio over
the 1990-1994 period.
The results of this study provide evidence that both factors regional
economic conditions and banks' portfolio decisions to shift to commercial
real estate lending had a significant impact on California's community
banks' asset quality between 1990 and 1994.
Gary C. Zimmerman
Zimmerman, Gary C. 1996. "Factors Influencing Community Bank Performance
in California." FRBSF Economic Review, No. 1, forthcoming.
Opinions expressed in this newsletter 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. Editorial
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