Congressional Research Service Capstone Research Report

Bank Lending Practices After the 2008 Financial Crisis Columbia SIPA Capstone 2013 Workshop

Research Report for Congressional Research Service

SIPA Capstone Team: Jang Hyun Kim

Ada Li Steven Li

Delphine Liu Frank Mamo Paul Tierno

CRS Executive Client: Dr. Darryl Getter Faculty Advisor: George Morriss

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Table of Contents Executive Summary ...................................................................................................................................... 3 Introduction ................................................................................................................................................... 4 Research Methodology ................................................................................................................................. 5 Scope ............................................................................................................................................................. 6 Initial Research ............................................................................................................................................. 6

Initial Research Findings .......................................................................................................................... 7

Loan Supply and Demand ..................................................................................................................... 8

Low Rate Environment ......................................................................................................................... 8

Dodd Frank Wall Street Reform and Consumer Protection Act ......................................................... 10

Basel III Capital Requirements ........................................................................................................... 10

Bank Interviews .......................................................................................................................................... 11 Phone Based-Interviews & Internet-Based Survey ................................................................................. 11

Interview Findings: Data ......................................................................................................................... 12

Interview Findings .................................................................................................................................. 15

Areas for Further Exploration ..................................................................................................................... 17 Conclusion .................................................................................................................................................. 18 Appendix ..................................................................................................................................................... 19

Initial Research: Monetary Policy and Low-Rate Environment ............................................................. 20

Initial Research: Significant Provisions of Dodd Frank ......................................................................... 22

Consumer Financial Protection Bureau .............................................................................................. 22

The Card Act ....................................................................................................................................... 23

Qualified Mortgage and Qualified Residential Mortgage Rules ......................................................... 23

The Durbin Amendment ..................................................................................................................... 25

The Volcker Rule ................................................................................................................................ 26

Phone Based Interviews .......................................................................................................................... 28

Computer Based Survey ......................................................................................................................... 29

Interview Matrix ..................................................................................................................................... 31

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Executive Summary

Since the 2008-2009 financial crisis, U.S. bank lending has been slow to recover and the current loan growth recovery has lagged the recovery experienced in previous recessions. Under the auspices of the Congressional Research Service, our Capstone team was tasked with investigating how domestic lending practices have changed after the 2008-2009 financial crisis and the underlying reasons for such changes. Our mission was to interview banks from across the country and to identify changes in the amount and composition of lending, along with what factors most affected changes in lending practices. Embedded in the project was whether any new legislation was hindering recovery of loan growth.

We conducted interviews, mostly with senior managers at small and mid-sized community and regional banks (18 in total with representation across 12 states) in order to discuss how they have changed their lending strategy and how specific pieces of regulation/legislation might affect their lending in the future. Our main report findings include:

Retail lending declines while wholesale lending increases: While the amount of lending has not declined, the mix of lending has shifted from retail to wholesale. This is owing to the regulations aimed at consumer protection and also to the perceived relative profitability of making loans to corporate/wholesale borrowers.

Regulation and macroeconomic factors together curtails lending: The confluence of macroeconomic environment and anticipated new regulations has hindered the amount that banks are willing to loan. From a macroeconomic perspective, low profitability owing to the low rate environment, conservatism by banks and deleveraging by retail and corporate borrowers are all reasons why banks have curtailed lending. The compression of margins banks make on interest income relative to interest paid on deposits and low consumer confidence both play a role in why bank lending has declined while deposits have grown.

Flat yield curve is shifting duration of lending and investment portfolios: Expectation that rates will remain low has affected lending in two ways: 1) the average maturity of the loan portfolio has generally shortened as banks are unwilling to lend longer maturity products at fixed rates; 2) the excess deposits that banks have are being channeled to investments, and the investment portfolio of a bank has shifted depending on their interest rate risk appetite.

Bank consolidation is likely in the medium term: Banks expect it to be costlier to operate in the near term with compliance costs and higher capital requirements. The stricter capital criteria will also potentially deter banks from offering certain products owing to higher risk weights attached to such lending; as such, smaller banks are considering their continued viability in the near term and are considering strategic consolidation.

Non-banks still have a niche: The non-bank lending sector remains active in the corporate financing space and puts competitive pressures on banks. Also, the risks they bear in the financial system remain an unknown.

Our report has uncovered that the weak economic environment and regulations aimed at the too-big-to-fail institutions, but being broadly applied across the banking industry, may adversely affect the smaller

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banks and the average retail consumer, who may find it more difficult to access financing. This has broader implications for the overall recovery of the U.S. economy.

Introduction Coming out of the 2008-2009 financial crisis, loan growth in the United States considerably lagged that of previous recessions. Due to the combination of uncertainty surrounding new financial regulation, a stubbornly slow economic recovery, deleveraging of balance sheets, and a weak demand for mortgage and commercial real estate loans, the inability to stimulate bank lending has been a problem faced throughout much of the country. As illustrated in Figure 1 below, the current recovery for loan growth quantified as the number of weeks since the recession has significantly lagged behind loan growth in prior recessions. The jump around week 40 indicates the effect of FAS 167 being enacted (FAS 167 was a newly introduced accounting standard that required banks to report their securitized assets on their balance sheets. Thus, this jump is not indicative of loan growth, rather, it is a superficial jump owing to differences in accounting treatments).

Prompted by this slow recovery in lending, our team was asked to investigate how bank lending strategies have changed since the 2008 financial crisis and to the extent possible uncover the primary drivers of such change. Our project endeavored to answer the following questions:

How have banks changed their loan underwriting standards?

Have banks changed their portfolio mix? If so, how? Has the amount changed?

Source: Barclays Research Report

Figure 1. Loan Growth Recovery for the Last Five Recessions

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What are the root causes of these shifts?

What role, if any, has new or impending regulation played in these changes?

What are the implications for lending?

Throughout our research, we paid particular attention to the comparative effects of the new regulatory landscape and the precarious economic environment in which banks have operated over the past five years. As banks play a significant role in the financial health of the economy and changes in lending practices might have broader reaching implications for economic recovery, such an analysis could allow Congress to better understand the extent to which its legislative actions may be curtailing or skewing the growth of bank credit availability in the U.S. economy.

Overall, our research has found that lending activity among the banks we sampled has been moving away from retail-based activities, such as residential mortgages and consumer lending, and into wholesale activities such as commercial and industrial lending as well as commercial real estate. While the slow economic recovery, flat yield curve, and weak demand was often been cited as a significant factor playing into these strategy changes, the new regulatory environment was also cited by a majority of interviewees as a major factor influencing lending strategies. In particular, banks have voiced much concern around the establishment of the Consumer Financial Protection Bureau (CFPB), the limited flexibility afforded under the Qualified Mortgage (QM) and Qualified Residential Mortgage (QRM) rules, and new Basel III capital requirements. Much of the new legislation that aims to protect consumers are also making the lending standards for retail activity at banks much stricter. Additionally, with much of the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd Frank) yet to be implemented, a large majority of the banks we interviewed have started adjusting their strategies based on their own interpretation of how they believe certain provisions of the Act will be carried out. Based on our research, we conclude that it is this regulatory uncertainty, paired with a weak economic environment that has had the most significant impact on lending strategies and has slowed overall loan growth throughout the U.S.

This report aims to synthesize our research, providing a background on the lending environment since 2008, a detailed account of the interviews held with 15 regional and community banks from around the country, and an analysis of how regulatory and economic forces have caused said banks to adjust their lending strategies.

Research Methodology

This report illustrates our findings and divides our research into three stages: initial research, bank interviews, and analysis of interview findings. In the initial research stage, our goal was to examine and fully understand the lending environment in which banks operated during the years following the financial crisis. Such background provided the framework from which we developed our interview scope and relevant questions for banks operating in different areas of the lending market, comprising the second stage of our research.

The second stage involved conducting interviews with 15 community and regional bank from twelve states around the country. As the backbone of our research, these interviews provided us with an on the ground perspective of exactly how lending practices have changed over the past five years and what have been the primary drivers of these changes. Additionally, these interviews revealed that the new regulatory and macro-economic landscape disproportionately affected lending behavior at community and regional banks causing us to revise the scope of our work and focus solely on lending at these institutions.

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Finally, the third part of our research was to analyze our interview findings and cross-check them with our initial research. During this stage, we identified the changes in lending strategies that were primarily attributable to economic factors and those primarily to regulatory factors. Dividing our findings into these categories proved useful as we considered the impact post-2008 financial regulations had on lending.

Scope

Our team was tasked to interview banks in order to uncover the underlying reasons for changes or shifts in their lending strategy. Given that we had roughly four months to complete the project, we decided to narrow the scope of our research to the effect of the macro environment and regulations on small and mid-sized regional and community banks. We did this for several reasons:

General accessibility of smaller banks: Smaller banks were more responsive to our request for an interview. Also, given that they are not as complex in their operations, we were able to more easily perform analysis on their financial reports and do a cross-comparison of their banking activities.

Accessibility to senior-level representatives at smaller banks: For most interviews, we spoke directly to the bank CEOs or to their direct reports. They were able to give us a big-picture view of how lending has changed at their firms.

Small banks may be more adversely affected by regulation: Some of the consumer protection and new rules on mortgage lending that targeted the too-big-to-fail banks will also be pushed down to smaller banks, and may curtail their lending and raise capital and funding costs to the point where they become unviable.

The initial research and the rest of the report outlines our approach to the project and the data findings from our bank interviews with respect to how small and mid-sized community and regional banks might be affected.

Initial Research

To fully understand the lending environment in which banks have operated since 2008, we conducted a series of interviews and background research with industry experts, banking analysts, and a major prudential supervisor. Such research was designed to provide our team with the current state of the banking industry and with multiple perspectives on bank lending. From this research, we were able to better understand how both economic and regulatory forces have influenced lending, and we were able to target specific areas to focus our attention when later conducting bank interviews.

To begin our initial research, we held a series of meetings and interviews with industry experts from throughout the banking sector. To assure that we would gain multiple perspectives on bank lending, we targeted a variety of experts ranging from regulators and banking analysts to ratings agencies and asset managers. Overall, we held six, high level meetings with the following organizations:

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Company Interviewed Company Type Division

Moodys Rating Agency Research: US Banks

Barclays Financial Institution Research: Large- and Mid-Cap Banks

Federal Reserve Bank of New York

Central Bank/Regulator Financial Institution Supervision, Research

Neuberger Berman Asset Management Floating Rate Income

Second Curve Capital Hedge Fund Portfolio Management

Wall Street Journal Business Publication Financial Analysis & Commentary

These meetings revealed several key findings. At a presentation conducted by Second Curve Capital a hedge fund active in the banking sector - we were directed to specific enacted and prospective regulation and how they influenced bank decisions. The fund also addressed salient pressures in retail banking, including the decline in free checking, greater mobility in banking among younger clients, and general deleveraging.

A credit analyst at Moodys Investor Service reiterated the notion of a deleveraging, introducing the concept of weak demand as one of the principal factors behind slow loan growth. This analyst augmented our understanding of macroeconomic pressures on the industry suggesting that low rates put pressure on net interest income negatively affecting profitability.1

A portfolio manager at Neuberger Berman brought to our attention the banking industrys global search for yields. In this quest, even traditionally high yield debt markets were at record lows. All investors, it seemed, were afflicted by the Federal Reserves policy of long-term low rates. We also began to see how the low rates are a double edged sword. In addition to yielding small returns in the present, low rates also introduce duration riskthe concern that taking on loans at low rates could prove costly when rates risethat could harm banks in the future. The rising rates will also affect capital through unrealized marked-to-market losses on their available-for-sale fixed income portfolio.

To supplement these meetings, we also conducted an extensive review of existing research offered by the Federal Reserves Senior Loan Officer Opinion Survey (SLOOS) as well as the Office of the Comptroller of the Currencys Quarterly Perspectives on Credit Risk report. This research offered an initial glimpse into the outlook for loan growth and credit standards for primary loan segments. In particular, we observed that while demand was expected to increase for all loan segments through 2013, actual loan growth was only expected to increase for commercial and industrial as well as commercial real estate loans (with residential mortgages and consumer loans remaining largely flat).

Initial Research Findings

After holding these meetings and reviewing the available research, we were able to identify several factors that have been reported as the key drivers of changes in lending strategies: issues surrounding loan 1 Moodys Investor Service, US Banking Quarterly Credit Update 3Q12, Special Comment, November 29, 2012.

Figure 2: Companies Interviewed for Initial Research

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supply and demand; a low rate environment and flat yield curve; several provisions of the Dodd Frank Act; and higher capital requirements under Basel III.2

Loan Supply and Demand

The lag in loan growth recovery was not only due to banks going through a period of de-leveraging and write-down of bad loans. The skittishness to lend and tightening of credit standards that immediately followed the crisis was an overcorrection of the lax credit provision that led to the mortgage crisis. This led as well to a drop in loan demand, as the tightening of credit standards follows with a diminishing of the pool of qualified candidates for a loan. The Federal Reserves SLOOS shows that between 2008 and 2010, tightening credit standards by banks correspond directly to the precipitous drop in demand, especially for commercial real estate and residential mortgage lending. Nonetheless, the overall weak economic conditions and low consumer confidence also hurt the demand for credit.

Low Rate Environment

A slow and prolonged economic recovery coupled with high unemployment has caused the Federal Reserve to aggressively pursue expansionary monetary policy, using conventional and unconventional measures to keep interest rates low.

While such expansionary approach is widely cited as an appropriate stabilization tool in economic downturns, its prolonged use has impacted bank lending strategies in several ways. First, the Federal Reserves forward guidance of near zero interest rates until a target unemployment rate of 6.5 percent is achieved has pushed banks to shorten the maturities of their lending portfolios. Second, such a prolonged low rate environment has contributed to a decline in bank net interest margins.

2 For a more robust analysis of each of these factors, see Initial Research section of the appendix.

Source: Federal Reserve Data

Figure 3: Treasury Yields for 2- and 10-Years

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Such reduction in net interest margins has put pressure on banks to rely more heavily on non-interest income as a primary revenue source; making loans has become less profitable and the flat yield curve means that lending rates will continue to remain pretty low.

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Figure 4: Trend of Declining Net Interest Margins for All US Banks

Figure 5: Summary of Macroeconomic Factors Affecting Bank Lending

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Dodd Frank Wall Street Reform and Consumer Protection Act

While vast in nature and largely unimplemented (only 148 of the 398 new rules have been finalized), Figure 6 identifies four specific pieces of legislation that have caused concern among banks.

While these are the specific provisions of the Dodd Frank Act that were widely cited throughout our initial research as having the most significant impact on lending activity, the uncertainty surrounding the final implementations of the remaining rules has also caused banks to adjust their lending strategies. Some banks with visions of strategic growth may choose to postpone acquisitions or organic growth, ensuring they are below exemption thresholds, until all ramifications are known.

Basel III Capital Requirements

The anticipated implementation of Basel III has several broad implications for banks. Generally, the new capital rules are meant to strengthen banks and a higher minimum is required across the board. The new capital rules will also affect small and mid-size banks in the following way:

Basel 3 has a stricter eligibility criteria for what qualifies as Tier 1 capital-- as such, this means that banks will have to hold more in the form of tangible equity and will have to find a way to transform their existing capital into ones that meet the new criteria.

Basel 3 introduces new liquidity requirements which means that banks will have to adhere to new short- and long-term liquidity ratios. This will likely affect the composition of their investment portfolios and reduce net interest income.

Small banks in particular may curtail lending of certain products because stricter credit criteria are also going to be in force. The risk-weights for select products are going to be much higher translating to banks having to hold more capital if they issue or lend such products (for example, jumbo loans, balloon loans, certain mortgage products). This means that banks may stop lending

Figure 6: Specific Legislations that will Affect Bank Lending for Community/Regional Banks

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certain products altogether or raise interest rates to meet profitability hurdles if they deem it to be too expensive from a capital perspective.

The new capital rules will undoubtedly make it costlier for banks to lend and to operate, and this has implications for their continued viability, which we will discuss in the section on interview findings.

Bank Interviews

The backbone of our research; this stage allowed us to get an on the ground perspective of exactly how lending practices have changed within institutions over the past five years and what have been the primary drivers of these changes.3 Divided into two components, our bank interviews consisted of phone based interviews and computer based surveys.

Phone Based-Interviews & Internet-Based Survey

Arranged by industry contacts of our Capstone Faculty Advisor, we conducted 18 interviews with 15 banks, 1 hedge fund, and 1 non-bank lender from 12 different states (two interviews were conducted with the same bank but different lending divisions, hence we have 18 interviews, but 17 financial firms in total count). We stipulated total anonymity and not-for-attribution citations to bankers in exchange for candid discussions of their banks operations and loan strategies. While most of these interviews were conducted with banks in the Northeast (12), the South (3), Midwest (2), and West (1) regions were also represented. Additionally, a majority of these interviews were held with CEOs (10), while the remaining interviews were conducted with individuals holding the title (or equivalent title) of senior vice president (8).

Furthermore, after conducting our interviews and examining our findings, we decided to narrow our scope to focus on community and regional banks. This scope modification was made for several reasons. First, these smaller banks were more responsive to our requests for an interview. Also, given that they are not as complex in their operations as large banks, we were able to more easily perform analysis of their financial reports and do a cross-comparison of their banking activities. Second, smaller banks provided more

3 For a template of the interview questionnaire, see Phone Based Interviews section of the appendix.

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Figure 7: New Basel III Capital Requirements for Banks

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accessibility to their senior level officials. By being able to interview CEOs and senior vice presidents, we were able to get a big-picture view of how lending strategies have changed at their firms. Lastly, small banks may be more adversely affected by post-2008 financial regulation. This is because many of the regulations designed to target the significantly important financial institutions (SIFIs, also referred to as the too-big to fail banks), are also expected to be pushed down to smaller banks, potentially causing them to curtail their lending and raise capital and funding costs to the point where they could become unviable. The below chart (Figure 8) illustrates the asset size and regional distribution of our interviewees. With the exception of three banks that had loan-to-deposit (LtD) ratios around 95-100%, the rest of the banks had much lower LtD ratios (lowest was at 58%), indicating that banks have an excess of deposits and are not efficiently generating loans.

To supplement our phone-based interviews and to standardize bank responses, we conducted an anonymous follow-up survey amongst the interviewees. This survey consisted of 10 multiple choice questions with some flexibility to qualify answers and provide further explanations. 4 Of our 18 interviewees, 13 responded to the survey.

Interview Findings: Data

Through our interviews, we found that lending activity has generally been moving away from retail-based activities such as residential mortgages and consumer lending and into wholesale activities such as commercial and industrial lending as well as commercial real estate.5

Additionally, the 13 respondents to our computer based survey revealed that this trend is expected to continue over the next five years. 4 See Computer Based Survey Questions in appendix for the full list of survey questions. 5 For a more detailed look at our interviewees changes in lending strategies and the primary factors influencing such changes, please see Interview Matrix in the appendix.

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Figure 8: Bank Profiles by Asset Size and Region

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In order to identify the primary causes of changes in lending, we asked whether uncertainty stemming from new regulation (Dodd Frank), new capital requirements (Basel III), or the economic environment (low interest rates, flat yield curve, and weak demand), played a more significant role. While each of these factors were relatively close in their response rates (between 2 or 3 responses of each other, with a total of 13 responses), uncertainty stemming from new regulation was cited as the main factor.

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Figure 9: Areas of Lending Expected to Change as Percent of Loan Portfolio

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Having repeatedly read and heard that post-2008 financial regulation has introduced uncertainty to the banking industry, we next asked: which aspects of regulation have introduced the most uncertainty to your bank lending activity? This was an open ended where respondendts could list which specific provisions of new regualtion (enacted or pending) have impacted their lending the most.

Our survey revealed that consumer-focused regulation such as the establishment of the CFPB and QM/QRM rules have had the largest impact (with a collective 50 percent of respondents citing these regulations). This is largely in line with our above observations of how banks anticipate moving away from retail lending and into commercial lending.

New Regulation

42%

Economy 33%

Capital 25%

Estab. of CFPB 14%

Volcker Rule 14%

QRM/QM 36%

Basel III 36%

Figure 10: Factors Having the Largest Impact on Lending

Figure 11: Regulations Creating Uncertainty, Affecting Lending

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Interview Findings

Our interviews with banks reinforced our initial research. The key takeaway is that regulations and the macroeconomic environments combined have a crippling effect on the lending and capital of smaller banks. We cannot tease apart entirely which factor has a greater effect.

Banks were able to confirm that for the most part, it was the macroeconomic factors and sluggish economy that was making both the loan demand and supply weak. Many of the banks that we had interviewed maintained that they were already relatively conservative in their lending standards (eg: demanding higher Loan-to-Value ratios post-crisis). The low-rate environment makes lending longer maturity products unattractive to banks (eg: long-term fixed rate loans which banks either do not want to add to their portfolio or they might increase the rate to cover the cost of a hedge), and the duration of their lending portfolio is shifting (eg: borrowers likelier to ask for 10 or 15 year fixed-rate loans). Meanwhile, depending on the interest rate risk-appetite of the banks, the duration of their investment portfolios are also shifting. Some risk averse banks will keep a portfolio of securities with shorter duration, so that they can easily liquidate or roll over debt if rates were to rise. Others, expecting yields to remain flat for several years, take on longer maturity securities for somewhat more yield. Further, the flat yield curve has dampened confidence in the ability to make a recovery through traditional lending products, and banks have shifted their attention toward fee-based income. This comes in the form of pre-purchase card underwriting, treasury services, investment banking activity, trust/fiduciary activity, wealth management and mobile lending, amongst others.

Since 2011, credit standards have started to be eased again, but the pick up in loan demand is still lagging. This is in part because qualified borrowers are being subjected to much stricter underwriting standards than before. Where a bank may have required some form of income verification and stated assets, it may now require full documentation, and many borrowers may now not qualify. The excess deposits are not being efficiently generated into loans, thus some banks have reported that they are channeling the excess cash into securities investments and expanding their investment portfolios. Banks are selling mortgage production to Fannie Mae and Freddie Mac, who are securitizing and selling back to the Federal Reserve through the Quantitative Easing 2 mortgage buy-back program.

Meanwhile, consumer and retail lending has retracted in certain types of loans that are no longer profitable. This is attributable to both the low-rate environment/flat yield curve (compressed NIMs) and also owing to certain tightened standards coming from external sources like regulation. For example, certain mortgage lending on the residential side have been curbed because the government sponsored mortgage investors Fannie Mae and Freddie Mac have a more restrictive criteria as to what they would be willing to insure and the put-back risk to banks of bad loans is now much higher. Additionally, until certain key provisions in regulation are enacted, banks are reticent to lend to borrowers where they think that it might present a legal risk later on, or become exorbitantly costly to hold onto the loan once regulations are enacted and new capital rules apply.

Of the regulatory reform efforts still pending, banks seemed to express most concern for QM/QRM and for the compliance related elements of the CFPB. QM/QRM is perceived to be too blunt an instrument, with prescribed underwriting standards, thus affecting the ability of banks to risk-price their borrowers-- effectively prohibiting banks from taking on certain borrowers who they would perceive as the

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appropriately optimal level of risk, but might be, according to the proposed rules of QM/QRM to be a high-risk borrower. This ultimately affects borrowers ability to secure a mortgage.

Another concern voiced nearly unanimously by banks is the uncertainty created by Basel III capital requirements. For smaller banks, the proposed additional risk weights on credits would mean they have to hold more capital for loans they make. This would also mean that for some banks, they would altogether stop offering certain loans. Additionally, higher minimum capital requirements and a stricter eligibility criteria means that banks will have to fund their capital through more restrictive means. The effect of Basel III is two fold for small banks: 1) they would restrict their lending to less risky products to avoid high capital costs, and 2) less lending means less retained earnings/income, and higher capital requirements compounds the low profitability of banks and they are able to lend less as a result, thus a cycle is created where less lending begets less lending. Meeting higher capital requirements may become so problematic that smaller banks will be more likely to consider consolidation alternatives as the most viable outcome. This was voiced as a near-term concern by some banks that are still struggling coming out of the recession.

In anticipation of greater regulatory compliance standards and also in order to interpret the new rules being issued, banks have increased their compliance costs. Many banks reported hiring more staff or diverting more resources or time to fulfilling documentation standards that might be required by legislation. Though most banks maintained that they were not the cause of the crisis, they feel that they will eventually be held to the same regulatory standards that big banks face, if not by the letter of the law, then by the regulatory push for banks to more prudently manage themselves to the adherence of industry best practices.

Lastly, we heard from several banks that non-bank financing entities are still active in the corporate/wholesale market and these entities have an advantage in that they are still not regulated, nor will they be subject to the same regulation as big banks. Borrowers may have to pay higher rates through these non-bank entities, but the approval standards for financing will tend to be less onerous and take less time because non-banks are not subject to as much regulatory oversight, capital requirements or the same documentation standards of banks.

We see these reported effects pushing the U.S. community/regional banking sector towards greater consolidation (owing to higher and more restrictive capital requirements and low profitability), less lending overall with a trend toward traditional products thus creating greater homogeneity, a growth in fee-based income, and increased competition by the non-banking sector, which continue to force banks to keep rates low in order to attract lending.

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Areas for Further Exploration

In the four months that we explored our research question, several areas came to our attention that we believe merit further review, either because we were only able to learn about them rudimentarily or because the regulations have not yet been enacted and we were unable to investigate their effects. We believe that the following may be of interest to the CRS as future Capstone topics:

1) Non-bank Lending Entities: This was mentioned briefly in our research interviews with banking analysts as well as with some bank interviewees, though no one could give us a sense of the size/scale of such entities. Some initial policy research has been conducted on the existence and potential growth of this sector. We believe this sector has implications for US banks on several levels: i) the US banking sector may be harmed from a competitive perspective if non-bank lending entities are able to provide similar financing options to borrowers who are indifferent to who their lender is; ii) non-bank entities may be taking on greater risks that eventually find their way back to the banking sector in the form of hedges taken on by non-banks to reduce their exposure--since non-banks are not subject to the same capital and underwriting standards, they may take undue risk that goes unseen from regulatory purview unless it becomes problematic for banks.

2) Innovative Banking Products: We are just starting to see that banks are shifting toward fee-based income and expect that if rates remain low, this will form a more substantive part of their revenue stream. As such, we propose an examination of how the fee-based income of banks has

Figure 12: Changes in Lending and Implications for Bank Lending and the Banking Sector

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grown and which sectors appear to be more profitable in their near future. We also propose exploring what risks these products may pose to banks, or whether the shift in revenue stream is sustainable.

3) Effects of Specific Regulations on Banking Industry: We propose diving into one specific regulation, monitoring how banks have been affected by the regulation and whether there are any unintended consequences. QM/QRM will be enacted in 2014, and other pieces of regulation, such as Volcker Rule, have yet to be finalized. When these rules are finalized, doing an analysis of pre- and post- enactment will provide some insight and comparison on the intent of the rule and the actual outcome/effect on the banking industry.

Conclusion

Since the 2008/2009 financial crisis, banks have been sitting on excess cash and increasing their security holdings without being able to generate more loans. After speaking with 18 banks and financial companies and conducting extensive industry research, we conclude that post-2008 financial regulation and the macro environment together have a compounding and crippling effect on the credit provision of smaller banks. Furthermore, it is difficult to fully tease apart entirely which factor has a greater effect as they are mutually reinforcing.

Regulation may not be the only factor that deters banks from lending, but at the margin, it will undoubtedly reduce the amount of lending that banks would otherwise do. While the actual amount of lending may appear unchanged from 2008, the composition of lending mix appears to be less diversified and shifting towards wholesale borrowers. Banks are also looking toward non-interest income as a way to compensate for the decreased interest income.

Given that higher compliance costs and capital costs are anticipated for the medium term (in the next 5 years), we expect smaller banks to consolidate because a number of them may no longer remain viable, especially if they are outcompeted by non-bank lenders who have an advantage in the corporate/wholesale space.

Banks will continue to seek opportunities to be profitable and regulation will not alter that incentive. Nevertheless, one frustration that was voiced unanimously throughout the interviews was that the legislation and rules need to be expediently issued because, until they are finalized and enacted, banks will be reluctant to define their risk appetite and will continue to be conservative in their product offerings.

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Appendix Initial Research: Slow Economic Recovery

While the recession ended in June 2009, economic growth in the United States has been subpar, capital investment stagnant, and unemployment stubbornly high. Economic growth coming out of the recession averaged approximately 2.1 percent, but has decelerated in recent years to 1.9 percent since mid-2010, 1.6 percent since 2012, and a projected 1.4 percent in 2013.6 Such deceleration has largely stemmed from the weakness in the U.S. labor markets, the Eurozone crisis, slowing growth in emerging markets, and uncertainty around the fiscal situation in the U.S. Additionally, both actual and projected growth rates have been lower than the growth in potential output.

This has further depressed the U.S. economy relative to its potential as it has been unable to keep pace with population growth or fully utilize existing industrial capacity. The widening of this potential-actual output gap has prolonged an already slow recovery as well as weaken (even further) the U.S. labor market, keeping unemployment at historically high levels. Such a slow economic recovery has translated into slow growth in spending and loan activity, and limited acceleration in improving credit performance.7

6 http://www.cbo.gov/sites/default/files/cbofiles/attachments/43907-BudgetOutlook.pdf 7 http://www.occ.gov/publications/publications-by-type/other-publications-reports/semiannual-risk-perspective/semiannual-risk-perspective-fall-2012.pdf

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Initial Research: Monetary Policy and Low-Rate Environment

A slow and prolonged recovery coupled with high unemployment, has caused the Federal Reserve to aggressively pursue expansionary monetary policy, using conventional and unconventional measures to keep interest rates low and liquidity high. Theory, history, and current international experience suggest that expansionary monetary policy is most effective at returning the economy to full health when it is complemented by expansionary fiscal policy.8 Current political debate on the fiscal trajectory of the U.S., however, has prevented the Federal Government from implementing the kind expansionary fiscal policy that many economists and policymakers believe is necessary for a rapid recovery.9 Not only is there an absence of expansionary fiscal policy, but fiscal policy has taken a more contractionary swing - with sequestration going into effect on March 1, $2.1 trillion of demand will be pulled out of the economy over the next decade.10 Ultimately, failure to employ adequate policy measures has prolonged the recovery even further, causing the Federal Reserve to keep short term interest rates near zero for a longer period of time than anticipated.11

In addition to the Federal Reserve keeping its short-term interest rates near zero, long-term interest rates have also been declining. According to Federal Reserve Chairman Bernanke, the decline in long-term rates can be attributed to following key drivers: decreased levels of expected inflation, lower expected real interest rates, a lower term premium and the recent quantitative easing measures taken by the Fed. These three components are influenced by a variety of factors. Expected inflation has gradually declined for the past decade. This is largely believed to be the product of the increasing credibility of the Federal Reserves commitment to price stability. The average real short-term interest rate is directly influenced by monetary policy (which, as previously mentioned is currently targeted at near zero levels). The final component, the term premium, Chairman Bernanke defines as, the extra return investors expect to obtain from holding long-term bonds as opposed to holding and rolling over a sequence of short-term bonds. This includes interest rate risk which is suspected to be the primary cause in the decline of the term premium component (largely attributed to lower volatility of Treasury yields).12

The graph below, provided by the OCC illustrates the spread between 2-year and 10-year treasury notes. Additionally, while 2-year and 10-year spreads have declined from their peak, they remain above their historical median.

8 http://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf ( 9 http://www.epi.org/files/2013/bp355-five-years-after-start-of-great-recession.pdf 10 http://taxvox.taxpolicycenter.org/2013/02/15/five-reasons-why-the-sequesters-automatic-spending-cuts-are-bad-policy/ 11 http://www.federalreserve.gov/faqs/money_12849.htm 12 http://www.occ.gov/publications/publications-by-type/other-publications-reports/semiannual-risk-perspective/semiannual-risk-perspective-fall-2012.pdf

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Such a low interest rate environment, coupled with weak demand caused by a slow economic recovery, has put pressure on banks net interest margins.

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Initial Research: Significant Provisions of Dodd Frank

Consumer Financial Protection Bureau

Dodd Franks Title X created a new agency called the Consumer Financial Protection Bureau (CFPB), as an independent bureau within the Federal Reserve System. The title effectively consolidates federal consumer protection responsibilities, giving the agency rulemaking, enforcement and supervisory authority over various consumer financial products and services. The agencys responsibility is determined by the type of financial institution, and the broad categories include large (assets >$10billion), small (assets

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The Card Act

Credit Card Accountability Responsibility and Disclosure Act (Credit CARD Act) introduced by B. Maloney on January 22, 2009 and went into effect on February 2010. The bill aimed that . to establish fair and transparent practices relating to the extension of credit under an open end consumer credit plan, and for other purposes13 The bill intend to protect consumer and market from credit card companies through various methods. The contents of bill could be categorized into 12 goals such as Prevents Unfair Increases in Interest Rates and Changes in Terms, Prohibits Exorbitant and Unnecessary Fees, Requires Fairness in Application and Timing of Card Payments, Protects the Rights of Financially Responsible Credit Card Users, Provides Enhanced Disclosures of Card Terms and Conditions, and Strengthens Oversight of Credit Card Industry Practices 14 The bill contains harsher conditions in changing interest rate, more openness in disclosure, and stronger restriction on discretion of fee determination. When the bill was signed by President Obama on May 22 2009, the banking industry showed uneasiness about the bill. The banking industry warned higher interest rate, shutting out bad credit consumers from the market, and falling credit. They argued that the firms would make up for losing margin from downward pressure of the restrictions.15 Now, it is considered as many parts of warnings are not seemed to be realized. Based on research Center for Responsible Lending, actual rate has not been increase and there was no falling in credit. Instead, the transparency in pricing is considered as improved.16 In other hand, there are many opinions that the effect of Credit CARD Act should be looking into in longer term to find out its consequence.

Qualified Mortgage and Qualified Residential Mortgage Rules The final rule that CFPB sets forth with specific income verification requirements, product features, and underwriting criteriaincluding a 43% debt-to-income ratio capthat creditors must follow for residential mortgage loans to be treated as qualified mortgages and, therefore, subject to certain protections from liability. Steep liability for failure to appropriately establish repayment ability will encourage lenders to adhere to the rules conservative standard for qualified mortgages. Moreover, defining the standard for a qualified mortgage was a necessary first step to defining what constitutes a qualified residential mortgage (QRM), which will be exempt from the 5% risk retention requirement for asset-backed securities. As the preamble states, the final rule will set the outer boundary of a QRM. Together, the qualified mortgage standard and the QRM standard will dictate the types of residential mortgage loans that are made and sold in secondary markets and, ultimately, the size of the overall residential mortgage loan market. Qualified Mortgage - Ability to Repay: Mortgage lenders must verify financial documents to ensure borrowers have a reasonable ability to repay the obligation

13 Text of H.R. 627 (111th)". Govtrack.us. Retrieved 28 March 2012. 14 Summary, The Credit Card Accountability Responsibility and Disclosure Act. United States Senate Committee on Banking, Housing and Urban Affairs, May 19, 2009 15 Connie Prater, Winners and Losers 3 Years After Credit CARD Act, CreditCards.com, May 24, 2012 16 Joshua M. Frank, Credit Card Clarity: CARD Act Reform Works, Center for Responsible Lending, February 16, 2011

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New federal regulations require mortgage lenders to verify that prospective borrowers can pay. Required under the Dodd-Frank Act, the rule prohibits the no-doc loans common during the bubble. Before making a loan, lenders must document the borrowers job status, income and assets, debt, and credit history. Lenders must also calculate a borrowers ability to pay the principal and interest over the length of the loan. They may not base their calculation solely on the payment due when an introductory teaser rate is in effect. To meet the definition of a QM, a loan must not contain certain features, including:

1. Excessive upfront points and fees (those exceeding 3% of the total loan amount, less bona fide discount points for prime loans),

2. Interest only 3. Negative amortization, and 4. Terms of longer than 30 years.

The rule does include some accommodations for lenders that serve low- to moderate-income households, in order to encourage such households continued access to credit. For example, loans that dont meet the 43 percent debt-to-income cut-off but do meet affordability standards set by Fannie Mae and Freddie Mac will still be considered qualified mortgages. In return for their compliance, lenders of qualified mortgages will in the event of a foreclosure be granted a safe harbour from litigation challenging a loans legality. Although the QM definition includes a broad spectrum of loans, there will likely be a significant preference among lenders and loan purchasers for QM loans which qualify for the safe harbour. Lenders may be reluctant to make QMs that will only provide a rebuttable presumption or non-QM loans. As a result, there could be contraction and realignment in the mortgage market for nonprime borrowers. This may disproportionately affect low-income populations and certain geographic areas, raising questions as to whether government regulations are incentivizing lending standards that have a disparate impact, which, in turn, may generate fair lending challenges by the government and private parties and performance evaluation issues under the Community Reinvestment Act. Mortgage bankers generally applauded the new regulations, saying that they clear up uncertainty that has hung over the home lending business since the financial crisis. In fact, most of the types of loans now being restricted, which were rampant during the inflation of the housing bubble, have been relatively rare in the last couple of years because many banks have tightened lending since the financial crisis. Qualified Residential Mortgage -Risk-retention rules: Mortgage loans that meet certain guidelines are exempt from risk-retention rules. Lenders can sell them off without restriction. A qualified residential mortgage is a home loan with a statistically lower risk of default, based on the underwriting guidelines and product features built into the loan. The Consumer Financial Protection Bureau (CFPB), along with other federal agencies, is currently developing these guidelines. QRM loans are also exempt from the risk-retention rules created with the passing of the "Dodd-Frank Act". The QRM is intended to provide stability within the housing market in general, and the residential mortgage market in particular. Title XIV of the Dodd-Frank act calls on federal banking agencies, the SEC, the Department of Housing and Urban Development, and the Federal Housing Finance Agency (FHFA) to jointly define the criteria of the qualified residential mortgage.

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Title XIV, Section 1401 of the Dodd-Frank Act explains that these agencies must "take into consideration underwriting and product features that historical loan performance data indicate result in a lower risk of default." When regulators first proposed this rule, for what would be a Qualified Residential Mortgage, there was a 20% down-payment requirement. Following opposition from banks and borrowers, regulators look likely to waive any such requirement. During a recent Senate hearing, Federal Reserve Governor Daniel Tarullo said regulators would consider aligning requirements for this kind of mortgage with rules recently passed by the CFPB. Those didnt include any down-payment criteria. Down payment size is the major credit-risk driver in mortgages that was untouched by the QM rule, Karen Shaw Petrou, managing partner of Federal Financial Analytics in Washington. Defining safe loans as those with a 10 percent down payment, instead of 20 percent, is the politically expedient course to take, Petrou said. Others, including Republican Senator Johnny Isakson of Georgia, are calling for a down payment requirement as low as 5 percent and a continued role for private mortgage insurance to hold a share of the risk on loans with less than a 20 percent down payment. Bankers say they worry that the QM rule could prevent borrowers from obtaining so-called jumbo mortgages, which are larger than the $729,750 ceiling on FHA-eligible loans or the $625,000 ceiling on loans backed by Fannie Mae and Freddie Mac. An article on Bloomberg March 21st titled FDIC Said to Plan First Sale of Home Loan Bonds since July 2011stated that the FDIC plans to sell $221.1mn of securities backed by residential mortgages held by failed banks. The agency is selling guaranteed notes backed by $276.4mn of loans, it said. More than 70% of the mortgages are from Home Savings of America, and at least 6 other banks contributed 2.5% or more, the person said. The underlying mortgages are 54 months old on average and carry CLTV ratios of 106%, it added.

The Durbin Amendment The Durbin Amendment is a law introduced by the Dodd-Frank Wall Street Reform and Consumer Protection Act and enacted in October 2011 that limits fees banks generate on debit transactions, called interchange fees. When a consumer makes a purchase using a debit card, only a portion of the purchase price goes to the merchant. The remainder is split among the issuer (which issues the card used in the transaction), acquirer (which process the payment on behalf of the merchant) and the networks used to clear the transactions.17

17 Chorazak, Mark and McGinn, Stacie E. Debit Interchange Regulation: Another Battle or the End of the War. Harvard Business Law Review Online. Volume 2. Online 18 (2011), http://www.hblr.org/?p=1536.

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Originally established to help combat potential fraud in transactions, as debit use grew, these fees became a drag on merchant sales (because more of their sales were performed using debit cards) and a boon to banks on the card processing side of the transactions. (According to a Harvard Business Law Review article, the number of debit and prepaid transactions in 2009 was approximately 37.7 billion.) The Durbin Amendment caps the amount of an interchange fee at $0.24.18 Prior to the Durbin Amendment, the fee was approximately 1.14% of the purchase (or about $0.44 on the average debit purchase). This cap allows for a one-cent addition in cases where the issuer implements fraud protection measures also introduced in the Act. The Durbin Amendment also removes the effective monopoly on card network systems, removing restrictions on the number of networks on which a transaction may be processed and prohibiting networks for precluding a merchant from processing a transaction over a network capable of performing the transaction.19 S&P, the ratings agency, estimates that the Durbin Amendment cost the banking industry between $6.5 to $7 billion (about 1.5% of 2011 total bank revenue). It believes large banks, with a hefty debit business, absorbed the brunt of costs. However, it will have the most lasting effects on regional banks where interchange fees comprise between 10%-25% of their non-interest income. Most pertinent to this paper, many large banks have found ways to recoup the lost revenue by reintroducing fees on bank accounts and removing rewards programs.20 While small banks might not be as affected, market forces will cause them to reduce their interchange fees, and non-interest income may decline at smaller banks due to the pressures of the Durbin Amendment.

The Volcker Rule The Volcker rule refers to section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act that prohibits banksdefined as financial institutions that accept deposits, enjoy federal deposit insurance and have access to Federal funds from proprietary trading and from entering into specific relationships with hedge funds and private equity funds.21 Some interpret the Volcker Rule as a limited reinstatement of the Glass Steagall Act of 1933, which separated investment banks that could buy and sell securities for its own gain from commercial banks, which took deposits.22 The rule prohibits banks from engaging in the short-term trading of securities, derivatives or commodities, the general purpose of which is to generate a profit. The rule exempts government treasuries from the ban as well as securities held for its client underwriting and market making activities. Trading activity intended to mitigate risk would be also permitted.

18 Ibid. 19 Ibid. 20 Bartko, John K. U.S. Banks Are Changing Their Strategies To Mitigate The Financial Impact Of The Durbin Amendment, Standard and Poors Financial Services LLC, New York , April 30, 2012. 21 Financial Institutions: The Volcker Rule Skadden, Arps, Slate, Meagher & Flom LLP & Affliates. 22 Patterson, Scott. Q&A: The Volcker Rule, The Wall Street Journal, June 13, 2012. Accessed on March 29, 2013.

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The complexity of modern finance creates distances between the rules intentions and prospective results. In particular, determining whether a bank entered a trade to hedge risk may be hard to prove and may create loopholes. Similarly, S&P, the rating agency, believes that distinguishing between banks engaging in proprietary trading or on behalf of a client may also difficult. As such, it believes that the overall impact of the Volcker rule will not be felt until final implementation, which it believes can take two forms. A less stringent rule would keep the ambiguity and ensure the perpetuation of current bank trading practices. A stricter rule would essentially reduce bank trading activity to matching buyers and sellers with equities in inventory.23 The Volcker Rule exempts non-bank financial institutions from these trading bans. However, non-bank financial companies may face additional capital requirements for, and additional quantitative limits with respect to, the foregoing activities.24 The affect of the rule on banks bottom lines are similarly uncertain. According to another S&P analysis, the final outcome will be a function of the severity of enforcement. A lax implementation of the Volcker Rule could result in $2 to $3 billion losses in pre-tax earnings, while a stricter interpretation would cost between $8 and $10 billion per year25 with the eight largest American banks bearing the brunt of the costs.26 While the implementation of the Volcker Rule is stalled amid debate, current legal understanding is that, while a bank can continue proprietary trading, it should make good-faith efforts to evaluate and fully conform its proprietary trading activities to the Volcker Rule and its implementing regulations by the end of the conformance period, currently set at July 21, 2014.27

23 Frey, Jr. Kenneth J., For U.S. Bank Ratings, The Volcker Rule's Impact Depends On The Final Details, Standard and Poors Financial Services LLC NY October 22, 2012. 24 Skadden 25 [5] Albrecht, Matthew B. Two Years On, Reassessing The Cost Of Dodd-Frank For The Largest U.S. Banks Standard and Poors Financial Services LLC NY August 9, 2012. 26 Frey, Jr. Kenneth J., For U.S. Bank Ratings, The Volcker Rule's Impact Depends On The Final Details, Standard and Poors Financial Services LLC NY October 22, 2012. 27 Client Memorandum: Conformance Period Guidelines, April 20, 2012, Davis Polk & Wardwell LLP.

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Phone Based Interviews Questionnaire Template Our Capstone project for Congressional Research Service is to examine banking trends following the 2008-2009 financial crisis. We have seen, in aggregate, US banking sector grow its excess deposits to loans, while also observing a gradual loosening of credit standards and decline of lending. We would like to understand the underlying reasons for the relatively small amount of lending we see compared to the growth in deposits. In general, our team would like to understand how the demand and supply of credit has evolved since the crisis. We appreciate any insights you would have to offer. We have assembled some questions below as a general guide to the discussion.

1. How have your lending practices changed since the 2008 financial crisis? Can you point to specific areas where lending has been curtailed, grown? Have you changed duration of loans?

2. What are the reasons for these shifts?

3. What is your risk appetite in the current environment and in which areas have you focused your revenue-generating activity?

4. What is the current outlook on lending and growth in loans? Which new non-core activities do you see upcoming in the banking sector? Have banks retained certain credit risks when securitizing and selling loans? Why/why not? How long will the current outlook/practices persist?

5. In the past quarter or so, how have your banks credit standards changed with respect to: 1. commercial/industrial loans? 2. mortgage loans? 3. consumer loans? 4. Are these the result of funding risk, liquidity risk, competition or general economic

expectations?

6. What have been your observations on the state of the non-banking financial sector?

7. Has regulatory oversight changed since 2008: how has regulator visits changed (duration, requests for information)?

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Computer Based Survey Survey on Post-2008 Lending Strategies

Thank you for offering your expertise and perspective as we continue to research trends in post-2008 lending practices on behalf of Congressional Research Service.

As previously mentioned, it would be greatly appreciated if you could complete this brief follow-up survey on post-2008 lending strategies. Responses are completely anonymous. Further, an abstract of our final report can be provided to those who participate.

Thank you for your time.

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1. What best describes your firm? a. National Bank b. Regional Bank c. Community Bank d. Other (Specify)

2. Which of the following do you expect to decrease as a percent of your total loan portfolio over

the next five years? a. Residential Mortgages b. Consumer Loans c. Commercial Loans d. Commercial Real Estate e. Other

3. Which of the following do you expect to increase as a percent of your total loan portfolio over the

next five years? a. Residential Mortgages b. Consumer Loans c. Commercial Loans d. Commercial Real Estate e. Other

4. Please specify if you answered other in one of the questions above.

5. Which of the following will have the largest negative impact on your lending activity?

a. Implementation of New Regulation b. Macro-economic Environment c. Capital Requirements d. Other (Specify)

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6. Which aspects of regulation introduce the most uncertainty for your banks lending activity?

7. How do you expect compliance costs to change as a percent of pre-tax operating income in response to the current financial regulatory environment?

a. No Change b. 1-2% c. 2-5% d. +5% e. n/a

8. What have been your observations on the role of the largely unregulated, non-banking financial

sector since the 2008 crisis? a. Growing b. No Change c. Declining

9. What is your current outlook for overall loan growth in the next five years?

a. Very Positive (>10%) b. Positive (5 to 10%) c. Neutral (0 to 5%) d. Negative (-5 to 0%) e. Very Negative (

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Interview Matrix The below matrix illustrates our phone interview findings. Breaking down interviews into community and regional banks, it illustrates the number

of respondents that expect to increase () or decrease () a certain segment of their loan portfolio. Additionally, it provides the number of interviewees who listed regulation or the economy as the primary driver of this change in lending. Furthermore, it shows the specific factors cited for increasing/decreasing a particular loan segment.

Executive SummaryIntroductionResearch MethodologyScopeInitial ResearchInitial Research FindingsInterview Findings: DataInterview Findings

Areas for Further ExplorationConclusionInitial Research: Monetary Policy and Low-Rate EnvironmentInitial Research: Significant Provisions of Dodd FrankConsumer Financial Protection BureauThe Card ActQualified Mortgage and Qualified Residential Mortgage RulesThe Durbin AmendmentThe Volcker Rule

Phone Based InterviewsComputer Based SurveyInterview Matrix

Congressional Research Service Capstone Research Report

Documents

Transcript of Congressional Research Service Capstone Research Report