Economy: A Brighter Banking Picture

Market conditions will improve for Georgia’s financial institutions, but regulatory changes will create some new challenges. The Wall Street Reform and Consumer Protection Act creates new regulators, extends regulations into new areas, provides new protections and gives regulators new abilities to define firms that create systemic risk.

Nonetheless, it is clear that these new regulations do not address several primary causes of the financial crisis – financial institutions’ tendency to use pro-cyclical loan-to-value ratios, the moral hazard of deposit insurance and the FDIC, and the pro-cyclical policies of Fannie Mae and Freddie Mac. Hence, the new regulations probably will do very little to prevent future financial crises.

In 2011, net interest margins will remain reasonably wide. The entire yield curve is very depressed, but deposit growth will remain strong, with deposits growing faster at small banks and credit unions than at large banks.

Loan growth, which has been sorely lacking, will improve, but the gains in loans to both businesses and consumers will come slowly. Financial institutions will benefit from several trends: slightly lower mortgage default rates, slightly more active housing markets, the end of home price depreciation, higher spending for consumer durable goods, higher corporate profits, and more opportunities to boost earnings.

Recovering foreign economies and expanding export markets are additional areas of opportunity that favor banks operating globally.

Gradual improvement in housing markets and more new mortgage origination will have the greatest beneficial impact on community banks. Due to more rigorous lending standards and depreciated real estate values, these new loans will generally be very good loans. The best loans are typically made during economic recoveries and the worst during the boom years.

Georgia’s financial institutions will continue to benefit from positive demographic trends – including population growth – because the in-flow of new residents increases the demand for banking services, props up asset prices and encourages new business formation.

The recent rapid growth of customers’ deposits favors financial institutions’ bottom lines. Deposit growth provides banks with their cheapest funds. The lingering effects of the housing recession and the stock market’s poor performance over the last decade make it very likely that households will continue to look for safe places, such as short-term CDs, to park their increasing savings. But due to new regulations, the bank fees earned on these burgeoning deposit accounts will decline.

Banks will become slightly less dependent on more expensive sources of funds, such as wholesale markets or sales of equities. Relatively slow growth in loans will reduce the need for these costly funds, but competition among banks for the lowest-risk loans will be keen, which could trim margins on loans with the least amount of risk.

When the Federal Reserve begins to raise rates in late 2011 or early 2012, rates on CDs will rise. This will reinforce growth of the deposit base, but will cause net interest margins to narrow. The long-term prospects for deposit growth are very good, as aging baby boomers gravitate towards safer and more liquid assets.

The quality of corporate and business loans outstanding will improve. Although capacity utilization will be at levels that do not typically provide much stimulus to investment in plants and equipment, such spending has been so de-pressed that it has failed to maintain the capital stock. Thus, businesses’ confidence in the economic situation will improve and should boost demand for loans.

Corporate profits will continue to grow, en-couraging companies to dust off plans to expand or otherwise invest. Meanwhile, growing export markets should boost commercial lending.

Although the increase in profits will hold down delinquency rates for corporate and business loans, banks’ willingness to make new loans – and the quality of their old loans – will continue to be adversely affected by the downcycle in nonresidential real estate. So financial institutions will remain reluctant to make new commercial loans secured by real estate, even though the commercial real estate price bubble will have pretty much deflated.

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