Banking Industry Gains Currency

Is the world of finance finally shaking off the blues? There are signs of hope – if you can ignore the regulations heaped on banks, not to mention occasional political raids on their cash flow, and if you are unfazed by surging gas prices and concern about the accuracy of recent government jobs data.

Most major banks, 18 of 19, passed the latest round of federal stress tests designed to evaluate them under an economic nightmare scenario, a sign the financial industry is healing. Federal Reserve Chairman Ben Bernanke has promised to clarify to community banks whether new federal banking rules apply to them, or just the big guys.

By mid-March, the stock market had rallied impressively, with the Apple-propelled Nasdaq hitting a 12-year high and the Dow rising above 13,000, its highest level since late 2007 – about the time the economy caught its first recessionary cold. Corporate balance sheets remain healthy, and the fact that interest rates have started creeping up is actually a sign of economic strength, not weakness.

Yet banks are facing IRS audits related to the bad debt they are trying to shed from their books – ironically, at the insistence of federal bank regulators. Some fear this could lead to another period of tight credit, but local banking industry officials view the impact as negligible.



The IRS treatment

Since the recession began, federal bank regulators have directed banks to get bad debt off the books, and to watch the size of their loan portfolios in certain industries. The IRS now is auditing banks, suspicious they are overdoing the loan charge-offs to gain tax advantages.

There certainly is nothing new about the IRS getting into the bank audit act, but one of our financial sources sees a peculiar twist to these audits. Melaine Brandt, tax partner with Wipfli CPAs and Consultants, said about two dozen of the accounting firm's Upper Midwest bank clients were selected for audits by the IRS during the past two years, and she said the IRS is challenging bad debts that have been claimed by banks that are struggling. Most of the audited banks reported large bad debt expense, but also have excess loss carried forward.

"It seems like a strange use of resources for the IRS to go in there and audit them because they would have to find a lot of adjustments to come up with any revenue that they are actually raising for the government," she said.

So on one hand, federal bank regulators are forcing banks to take these charge-offs; on the other hand, the IRS is second-guessing the regulators and the banks. "They (the IRS auditors) are coming along a year or two later and saying, 'No, we don't think that's a bad debt in 2010. Maybe it should not have been written off until 2011,'" Brandt said.

Brandt does not think this is inhibiting credit, but cited other factors that could be. Banks that are struggling are under regulatory orders to raise capital and have been ordered to get their capital up to 10% of their assets, and in this climate it's hard to find new investors. The alternative is to shrink the balance sheet because if assets and liabilities go down, that 8% might get up to 10% without new investment.

The other lending inhibitor, Brandt said, comes when banks are under orders to reduce their concentrations in certain types of loans – commercial real estate being the most common one.

Mark Meloy, CEO of First Business Bank, also does not see a correlation between the IRS's recent audit thrust and lending activity. "One thing I've learned about being in banking and running a bank is that when it comes to regulators, everyone's experience is a little bit different," Meloy said. "There are some common pieces to it, but banks can be impacted by perceptions, and sometimes they are impacted by reality.

Sometimes they are impacted by where the regulators are in the discovery related to the hot topic of the time, whether it's appraisals or global cash flow.

"The regulators go through their training, they get their internal directives and sometimes it's a hot-off-the-press, big issue and they overemphasize it. Sometimes it is intense at the first few banks, and then it moderates. Like any other big organization, it's learn as they go, so you try to let level heads and common sense prevail. Most of the time, eventually, they do."

While access to capital is gradually improving, the appetite for borrowing is still suppressed. Small businesses in particular remain in a deleveraging phase. Meloy acknowledged the caution, noting that in addition to paying down debt, they still are hoarding cash.

"What that is doing is creating a lack of demand," he said. "It's creating a situation where banks in general are very liquid, and what you are starting to see is banks being at least modestly more aggressive in pricing, but still careful and cautious with sound underwriting principles."

What has to happen before all that cash is unleashed? For Meloy, the key metric is the unemployment rate, which is directly linked to consumer confidence. "That will be a sign, as people get back to work, that will create more confidence," he said. "From the standpoint of an employer that's going to do the hiring, there are so many questions about everything from budget deficits to the cost of health care, to taxes. Have we artificially supported a recovery or is there really fundamental momentum occurring that is slowly but surely getting us back on track? It's certainly not at a speed that we're used to. In other economic downturns, we've come back stronger and faster."

In January, the WBA surveyed banks to forecast the next six to 12 months of demand for business loans, and the result was mixed. Some anticipate an increase in demand for loans; others forecast no change. "Nobody really said it would go down," said Rose Oswald Poels, president and CEO of the Wisconsin Bankers Association. "There is certainly still a problem of consumer confidence, and when I say consumer, I also mean business owners' confidence in the economy and in a rebound.

"They are just continuing to build up their own cash reserves as they wait for more positive signs in the national economy before they borrow money to put in new equipment or expand an existing business."

Rolling in dough

Adding credence to the belief that Wisconsin banks are stronger than their national counterparts is their $532 million increase in net income in 2011, according to fourth quarter data released by the Federal Deposit Insurance Corp.

In addition, 87% of Wisconsin banks currently are profitable, which is higher than the national average, and they saw their net income grow by 27.8% from the third quarter to the fourth quarter of 2011. Wisconsin banks also report an average capital ratio, which is the industry's buffer against loan losses, of 10.3%, which tops a steadily improving national average of 9.17%. Wisconsin banks maintain an 86.3% loan-to-deposit ratio, which is more than 10% higher than the national average of 73.3% and ranks as the third highest among the 50 states.

Oswald Poels called these clear signs that industry stability is gaining strength. "There is room for continued improvement, but the fact that the industry continues to make progress is a good sign that we are that much more stable," she said. "More and more banks are able to return to what they normally do, which is taking in deposits and giving out loans in our communities."

Considering the banking regulations enacted since 1999, when a financial modernization law known as the Gramm-Leach-Bliley Act was signed into law, banks are increasingly concerned about the cost of regulatory compliance. From Sarbanes-Oxley of 2002 to the Dodd-Frank Act of 2010, each regulatory thrust has come with its own government-mandated costs.

Dodd-Frank is a huge concern for community banks, notes Oswald Poels, because they don't have as much scale to absorb the costs. One example is in mortgage lending, where disclosure rules have been in place since the 1970s. Dodd-Frank, whose banking rules alone consume more than 1,000 pages of the Federal Register, attempted to streamline that disclosure process, but probably will do the opposite.

"In theory, that's a nice idea, and bankers would be supportive of that," Oswald Poels said. "In reality, the streamlining process with the new Consumer Financial Protection Bureau is probably going to add more paper to that process rather than take it away."

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