FRBSF Economic Letter

1996-04 | January 26, 1996

California’s Community Banks in the 1990s

California’s Community Banks in the 1990s

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.

Regional conditions

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 lending.

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.

Portfolio adjustments

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 loans.

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 California banks.

Impact on asset quality

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 significant.

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 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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