Rising interest rates should help small banks in West, analyst says.

With interest rates on the rise, community bankers are going to have to dust off their asset-liability management skills, says banking analyst Steve Didion.

The lower rates of recent years had different effects on community banks in different parts of the country. In fact, the lower short-term rates didn't fatten the bottom line at many community banks the way they did at large banks and thrifts.

Some community banks in Texas and California got creamed in 1993 because of the low interest rates. According to Mr. Didion, a bank analyst at Hoefer & Arnett in San Francisco, community banks in the West had relatively more asset-sensitive balance sheets, and they were squeezed when interest rates fell.

Mr. Didion, whose firm closely follows about 80 publicly held community banks from Texas to Washington, says community bankers in the 1990s are becoming more asset-liability savvy.

American Banker talked to Mr. Didion about how community banks are dealing with the potential threat - and windfall - of a rising-rate environment.

Q.: How have rising interest rates affected the margins at small banks?

DIDION: In our universe, which is composed of mostly community banks in the West, falling interest rates hurt bank earnings. The banks here are asset sensitive, meaning their assets reprice faster than their liabilities.

It got to a point six months ago where deposits couldn't reprice any lower without banks' losing them. That's when the squeeze hit. Banc Texas in Dallas is one example of that. Their loan rates kept plummeting but they couldn't lower their deposit rates any more.

Overall, though, the squeeze wasn't that bad. I think it will get better. The banks we follow have taken a lot of measures to benefit from a rise in interest rates.

Q.: What are some examples?

DIDION: A good example in California is Redwood Empire Bancorp in Santa Rosa. They have an interesting asset-liability plan. They have two subsidiaries, a bank and a thrift. Their overall strategic plan is if rates go down, the thrift will make more money by originating mortgages.

When rates are going down, though, the bank makes less money. The upshot is that Redwood Empire's thrift had a record number of originations in 1993, but Redwood Bank's margins did decline.

Their strategy now, as rates rise, is for the thrift to develop fee-based products and more sources of noninterest income. And, now that the bank is making more money from its net interest margin, the S&L is shifting gears to things like construction lending and high-quality owner-occupied commercial real estate loans.

Then there's the most obvious method to take advantage of rising interest rates. The banks with the best asset-liability picture have a high level of non-interest-bearing deposits. Sterling Bankshares down in Houston has about 26% or 27% of their deposits as non-interest- or low-interest-bearing demand deposits. The key to their interest rate management policy is their high level of non-interest-bearing deposits. They just have to wait for their loans to reprice to start making more money.

Q.: So, do you like to see banks make bets on interest rates?

DIDION: I would rather see them not make a big bet. I would say the people we like to see, from an analyst's perspective, is someone who is fairly well matched, but not to the point where you sacrifice profitability in terms of your plan for interest rates.

As long as a bank has capital, it should be able to make a bet on interest rates.

Most of our banks are positively gapped right now. But the key in places like California, which is coming off a recession, is not relying on an interest rate bet, but rather, making loans. What you've had in California is similar in a bigger way to what happened in Texas. Banks have such incredibly low loan-to-deposit levels.

The banks with good lending market shares should be able to grow their portfolios and have highly expanded earnings.

Q.: But than depends on whether loan demand is there.

DIDION: Demand is coming back. From interviews with 50 California independent bankers we just finished, the message was that loan demand is picking up. That's not a blanket statement, because there are some areas where it's not picking up. But the banks that have always had the best niche in middle-market commercial lending will see positive signs.

Q.: The volatile types of mortgage investments have been hard hit. Do community banks have a problem with this? Are they holding more than they admit?

DIDION: I don't think so. I haven't worried about that at the banks we follow at all, really.

Q.: What are you worried about?

DIDION: FAS 115, that's what worries me - the mark-to-market rule.

As we saw it, anywhere from 70% to 80% of the banks we follow had book value losses on securities available for sale. That's a line item in the equity section of the balance sheet.

Those book value losses will go up in the second quarter, in some instances significantly. California independent banks are managing this actively, and they'll get better at it.

But, let's be honest, they've never had to deal with something like this before. They'll have to hire people to do it. I'm not saying there aren't a lot of great CFOs out there at community banks, it's just that they are going to have to go through a learning period.

I'm also not positive how the investment community is going to look at book value adjustments. Book values will swing, and will the community bank investor understand it? Sure, you have institutional investors buying this stock, but a lot of the shares are still held by community people, and a lot of stock in these banks is controlled by local brokers. These types of stockholders in a lot of cases just aren't going to know what to make of these adjustments.

The effects of FAS 115 are not yet calculable.

Q.: Will funding costs be affected? When are community banks going to have to start nudging up their CD rates?

DIDION: They're seeing the beginning signs of deposit demand coming back. Some money has gone back into deposits. But it's not going to be the landslide that you saw going out of them.

More banks in the West are turning to different funding methods, too. A lot of banks - about 10 banks in just the last two weeks - are joining the San Francisco Home Loan Bank. They have good rates, good service, and they're very accessible to banks.

I'm also seeing banks using federal [Home Loan] funds to fund their mortgage operation. It works from a matching standpoint, and you're starting to see their margins go up now, because they are able to put more loans in portfolio as rates rise.

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