By sticking with their traditional “plain vanilla” practices, Kentucky banks have remained on a solid financial footing while the nation weathers its worst economic crisis since the Great Depression. Collectively, Bluegrass state banks are sound and have ample cash to lend – if only qualified borrowers will step forward.
National financial news reports continue to focus on bank bailouts, toxic assets, zombie banks, nationalization and potential catastrophe. Kentucky is feeling the effects of the current recession. While commonwealth bank assets and deposits increased, net income dropped for the past two years according to FDIC figures.
Nonetheless, banking conditions are far more positive here than in the nation’s financial and political capitals.
Collectively, the state’s system ranks seventh in the nation, according to the Kentucky Bankers Association. And one of the state’s largest institutions was just recognized as among the 10 best-performing banks in the nation.
“From my viewpoint, it is because we are a very plain vanilla, conservative state when it comes to banking,” said Ballard Cassady, executive director of the Kentucky Bankers Association.
Like their brethren around the nation, some Kentucky banks had to write down the value of investment stock they held in the Federal National Mortgage Association and Federal Home Loan Mortgage Corp., better known as Fannie Mae and Freddie Mac.
Overall, however, state banks remain among the most sound in the nation because in managing their risk they stuck to conservative banking practices while other supposedly more sophisticated players placed big bets on what University of Kentucky banking professor Donald Mullineaux recently described as “failed innovations.”
Commonwealth bankers wrote few subprime loans, and they largely passed on buying the mortgage-backed securities into which those now-soured loans were repackaged.
“Right now, plain vanilla tastes good,” Cassady said.
Washington decision makers remain busy contemplating policies for damaged banks at the upper end of the financial spectrum: banks that expect losses far beyond their assets; banks whose market capitalization is far less than the big cash infusions they’ve received from taxpayers; institutions holding mortgage-based securities for which there now is no market, rendering them worthless though backed by hundreds or thousands of U.S. homes as collateral.
Through February, the Federal Deposit Insurance Corporation had already closed 16 banks – none in Kentucky – and at the end of the month imposed a surcharge on its members after having already more than doubled premiums this year.
“When you hear ‘banks’ aren’t lending, they aren’t talking about commercial banks. They are talking about Wall Street,” said Cassady. “Every (Kentucky) bank I talk to is begging for loans.”
No failures in decades
Most Kentucky banks are on the smaller end of the scale; more than three-fourths of the state’s 201 banks have assets of less than $250 million, according to the FDIC. The commonwealth has 40 banks in the $250 million to $1 billion asset range and eight in the $1-10 billion category. None reach the FDIC’s $10 billion and up asset category.
The FDIC last fall raised its protection level from $100,000 to $250,000 per bank customer, but it hasn’t paid off a Kentucky account in recent memory.
“It’s been at least 20 years since a Kentucky bank has failed, and we’re working very hard to make sure it stays that way,” said Kelly May, spokesperson for the state Department of Financial Institutions, which regulates the 158 banks with state charters.
FDIC officials have been busy elsewhere. They closed 25 banks in 2008, compared to three in 2007 and none in 2005 or 2006. As of Feb. 28, the FDIC had closed 16 banks in 2009.
That does affect Kentucky bankers, even if they’ve been diligent about maintaining prudent performance ratios, capital, return on assets, return on investments, low rates of non-performing losses and adequate loan loss reserves. FDIC premiums for commonwealth banks more than doubled along with everyone else’s.
“It gives all of us a black eye,” said Ronald Rousey, president of Lexington-based Whitaker Bank, which operates 37 offices in 13 communities from Hazard to Frankfort.
Rousey has been in banking 38 years and now oversees just more than $1 billion in deposits. He said the present environment is unlike anything he’s experienced previously.
“We’ve got a serious problem,” he said, referring to the national scene. “It really is a shame what has happened in this country.” He attributes basic greed as the major cause of the difficulties afflicting the financial system presently.
However, as bad as the reality is, Rousey and other Kentucky bankers also believe the media is sensationalizing the news in a way that is worsening the marketplace. The drumbeat of negative reports, which focus almost solely on the woes of the big banks, delivers a blow to the entire banking sector and the business community in general.
It affects attitudes, which in turn dampens customers’ confidence and willingness to do business – with anyone.
Clients are being cautious, said Chuck Denny, regional president for Kentucky with National City, now part of PNC, the biggest banking entity in the state with more than $8 billion in deposits.
“We still see clients expanding their business, but being very careful. We applaud them,” Denny said. “If that means (bank) business is down a little, that’s the way it’s going to be, and this will pass.”
National City and PNC see many plans being deferred but not cancelled, he said.
It is all about trust, said Frank Wilson, president of 143-year-old Wilson & Muir Bank and Trust Co. based in Bardstown. Wilson cited a January piece in The Wall Street Journal about the “animal spirits” notion John Maynard Keynes popularized in his 1936 book “The General Theory of Employment, Interest and Money.” Trust, at an almost subconscious level, creates confidence and instinctively drives activity. Conversely, its absence has the opposite effect, and animal spirits are ebbing in the business world today.
Wilson, Rousey and other Kentucky bankers interviewed for this article all spoke about the importance of the level of trust that their operations have established through their relationships with their communities and customers. It is part of the base of knowledge from which they make individual business decisions.
“We have the flexibility that we can work with our clients if they do have problems,” Wilson said, speaking of the state’s community commercial banks. “We don’t have a collection department two states away. Most community banks, if they make the loan they collect the loan.”
They also adhere to banking basics. Kentucky community commercial banks’ books have few “subprime” mortgages or other loans – so designated because the borrower does not meet traditional, “prime” creditworthiness guidelines. Subprime borrowers have a heightened perceived risk of default: a history of loan delinquency or default, a recorded bankruptcy or limited debt experience.
Banks in Kentucky are “prudent lenders,” said Cassady. They remain so, but they’ve had to resist pressure to change. He said commonwealth banks continue to get pressure from Washington to make loans they consider unsafe. Explaining the state’s banking philosophy, Cassady referenced his own experience growing up in eastern Kentucky.
“Owning a house was a privilege, and government has been turning it into a birthright,” he said. “Credit is a privilege; you don’t get it just because you were born.”
Kentucky banking officials say they get conflicting messages from Washington. Politicians urge more lending currently to turn the tide in the “credit crisis.” Meanwhile, regulators reacting to the view that too-easy credit – especially subprime mortgages – was a cause of the financial crisis are telling lending officers to raise the bar, impose tougher credit score requirements for borrowers, etc.
Bank managers say they are in the middle of the political-regulatory squeeze, which makes their jobs of managing risk and making money a little more difficult. They’ve done so rather successfully, however.
ROAs are double the nation average
Kentucky-chartered banks had a 0.88 percent return on assets, a key metric for the industry, in the most recent figures from the state Department of Financial Institutions, according spokesperson May. That’s within the banking industry’s traditional target range, and it is exactly double the figure for all nationally chartered banks across the United States.
“The benchmark is you want to be around 1 percent, plus or minus 0.2 percent,” May said.
The average return on assets for all banks in the nation was 0.44 percent, she said. However, within Kentucky only, nationally chartered banks did nearly as well as state-chartered institutions, earning a 0.86 percent return on assets.
“Kentucky banks are doing very well, especially compared to other states,” May said.
“A lot of what you’re hearing on the news (about the national banking scene) has to do with the subprime bubble and securities. Kentucky banks typically didn’t get involved.”
In Kentucky, bankers earned money the old-fashioned way.
“We didn’t do subprime loans; our credit quality is good,” said Steve Trager, president of Louisville-based Republic Bank, a 27-year-old institution that has grown to just more than $3 billion in assets.
Bank Director magazine last month ranked Republic the 10th best in the nation. The publication’s list of the Top 150 Performers was based on profitability, capital adequacy and asset quality. Republic Bancorp operates 45 locations: 36 in Kentucky, three in Indiana, one in Ohio and five in the Tampa, Fla., area.
“We stuck to what we know,” Trager said, “and that’s taking care of customers in and around Kentucky and our other markets. And I think our customers take comfort in the fact that they do business with a very safe bank, and a bank that they can hold accountable for treating them right.”
Despite the difficult economy, Republic had its best year ever in 2008, said Trager. “We’ve done a pretty good job of guiding our customers into products that are appropriate for their situation. It’s all about making less mistakes – doing some good things and making less mistakes.”
Wilson describes banking as managing risk – something all businesses have to do.
“Banking,” he explained, “is all about managing your margins: the difference between what we have to pay for our product, which is money, and what we get for our product, which is money. We’re trading money. So stable interest rates are the key to banking. If rates were to really shoot up it would create problems.”
That managing of margins is why banks don’t hold onto long-term loans such as mortgages. Even if borrowers make every payment on time, a bank could lose money unless it had an offsetting stable, long-term source of money. Bank deposits aren’t locked into 30-year commitments. A certificate of deposit might be three years long; beyond that, the bank can’t depend on having that money.
Community commercial banks prefer loans in the three- to five-year range as a result. Some of the new financial securities that crashed and burned in the past two years were actually designed to protect banks and offer longer term stability for the cost of money. Unfortunately, many of these products were based on packages containing subprime mortgages whose risk was inadequately assessed.
Wired magazine’s March cover story details how bond rating agencies and Wall Street institutions put too much faith in a model for assessing complex default-correlation risks that a Chinese math whiz developed while working for JPMorgan Chase. Thinking that David X. Li, in a paper published in 2000, had solved the problem of how to price risk for complex instruments that insured pooled mortgage bonds, the “credit default swap” market sprang to life and trillions of dollars worth of instruments were issued.
As the magazine’s headline for the article explains, Li’s discovery actually was “The Secret Formula That Destroyed Wall Street.” The reality is that there wasn’t enough history to reliably price the risk of instruments that insured securities based on the long-term performance of subprime mortgages. Doubters warned that this was the case, and even Li himself said his formula was being misused, Wired’s article reports.
When the inflated real-estate?price bubble inevitably burst, it took with it not only home prices and mortgages, but the pooled mortgage securities and the instruments that insured them as well as the balance sheets of companies that held them.
It turns out that no one can properly price the risk of those complex derivative financial instruments. Unknown risk equals no price for that product, as any Kentucky banker will explain.
“You can’t evaluate or assess what you don’t understand,” said Rousey.
Mark-to-market accounting rules render unfathomable products worthless. Kentucky bankers dodged trouble because of the mark-to-market thinking they’ve always applied to their dealings. A subprime mortgage just didn’t look like it had true value. Most shied away from the complex securities that had arisen this decade because they simply could not understand the mechanism by which they were supposed to create a return.
“If you don’t understand it, you shouldn’t do it,” Rousey said flatly, whether it’s an investment or a loan.
What Kentucky bankers do seem to understand well is financing Main Street.
“The fundamentals of lending,” Wilson calls it. “Just stick to the three Cs. There’re three Cs to credit: which is character, capacity and collateral. Character is probably the most important of those three Cs.”
PNC and National City Merger Creates Biggest Bank in State
Two of Kentucky’s biggest banking entities became one in November 2008 when Pittsburgh-based PNC took over Cleveland-based National City, forming the largest single player in commonwealth banking.
National City had the largest market share in Kentucky with 8.95 percent of deposits in the commonwealth, totaling $5.76 billion in the most recent FDIC report. PNC was sixth in Kentucky with 3.54 percent of deposits, totaling $2.28 billion. Combined, their numbers become $8.046 billion in deposits, which is 12.49 percent of the market in Kentucky.
The combined bank will have $180 billion in deposits and more than 2,700 branches, most in the Mid-Atlantic, the Midwest and Florida. It will have the largest deposit bases in Kentucky, Ohio and Pennsylvania. PNC obtained money from the federal government’s $700 billion bailout program to acquire National City for $5.6 billion.
It will take into the second half of 2009 for the banks to meld their branch systems and adopt a single bank name, which will be PNC, said a spokesperson. National City operations are known as “National City, now a part of PNC.”
Chuck Denny, regional president, National City, now part of PNC, describes the deal as a merger of two Kentucky banking powerhouses.
Considering the $8 billion in Kentucky deposits the bank now works with, Denny said, “To have that much of our state’s resources entrusted to us, we take it very seriously.” He also views it as a reflection of the level of trust and confidence the institution enjoys.
Others consider the merger an opportunity, such as Steve Trager, president of Louis-ville-based Republic Bancorp, which since its beginning in 1982 has grown to the eighth largest in Kentucky with 35 locations and $3 billion in deposits. Republic considers large mergers inherently difficult to pull off effectively and thinks it can lure customers away.
Denny says PNC-National City has no problem with the aspirations of Republic and others.
“Competition has long made our country a good place to do business,” Denny said. “Kentucky benefits. … It’s a great competitive environment. It only makes us better.”