The financial crisis and the persistent regulatory uncertainty on Capitol Hill continue to roil the correspondent banking market, making it difficult for community banks to find crucial support needed to regain their financial footing and start making loans again.

Community banks have relied ontheir correspondent relationships for loan syndications, Fed Funds lines and loans directly to the bank holding company backed by its stock. But many banks offering correspondent services-banker's banks and some commercial banks-have grown leery of doing business withcommunity banks whose health can be difficult to gauge.

As of Dec. 31, more than 700 banks were classified as problem institutions by the Federal Deposit Insurance Corp., and hundreds more were under formal or informal enforcement actions. Meanwhile, the bankers' banks themselves have come under increased regulatory scrutiny for the so-called "concentration risk" posed by extending loans to community banks within their geographic footprint.

The result, says Walter Moeling, a partner at the law firm Bryan Cave, is that "there are virtually no sources for community banks to turn to for loan support."

Though the issue has become critical lately, commercial banks exiting or scaling back their correspondent business has been the trend for decades. At one time, large banks liked to offercorrespondent services as away toutilize excess capacity. They would do check processing,along with cash management, international payments, lending, capital markets and consulting.

Since then, several factors have pushed commercial banks out of the business, explains Steve Brown, the president and chief executive at the $616 million-asset Pacific Coast Bankers' Bank in San Francisco. Check processing has gone electronic, so excess capacity is less of an issue. Also, over the last 10 years there's been a renewed focus on the branch network and a growing attitude that community banks are competitors. These large banks also see greater growth potential in overseas markets and have built international correspondent relationships.

The financial crisis has only accelerated this long-term trend. According to Foresight Analytics in Oakland, Calif., banks had $85.7 billion of loans to other depository institutions in the U.S. at the end of 2009; that figure was almost unchanged from2008 and 2007, but down significantly from the pre-crisis level of $123.6 billion in 2006.

A few commercial bankshave cut back drastically in the past year. Bank of America slashed its loans to other banks from $16.4 billion in 2008 to $274 million in 2009. Volumealso dropped at Fifth Third Bank, from $509 million to $20 million, and at U.S. Bank,from $132 million to $85 million, Foresightdata showed. Industry observers say even for small banks that manage to get a loan or already have one, it is common for lenders to drastically shorten repayment periods, demand more collateral and increase rates.

Bankers' banks would appear to be in position to pick up the slack, but they are facing challenges of their own. By their nature these institutions are less diversified than larger commercial banks for which correspondent lending is just one line of business. Now the Federal Reserve Board has instructed several bankers' banks, including the Independent Bankers' Bank of Florida, to develop a plan for reducing concentrations of loan participations and loans to other banks and bank holding companies.

"Concentration risk can't be avoided with bankers' banks," says James McKillop, the CEO of the $474 million-asset bank in Lake Mary. "Sure it's a concentration, but is it a risk? For years it's been a good business model. If the community banks are not at risk, I would contend the bankers' bank is not at risk."

Jimmy Thomason, president and CEO of the $164 million-asset Arkansas Bankers' Bank in Little Rock, adds that if the bank operates in an agricultural area, then of course there are going to be lots of agriculturalloans. "Sure there's a concentration, but what am I going to do?"

In response to the challenges the industry faces, the American Bankers Association helped form a correspondent banking working group in January to help influence policy decisions.

Many bankers point to the failure of the $4.1 billion-asset Silverton Bank in Atlanta last year as the source of the intense scrutiny. "The Silverton failure really changed the environment," says Chris Cole, the senior regulatory counsel at the Independent Community Bankers of America. "But I think Silverton is an exception."

Besides making loans to banks, officers and directors, Silverton bought trust securities and subordinated debentures, assets bankers' banks don't routinely hold on their balance sheets. What's more, Silverton operated across the country, very unlike the typical bankers' bank, which is focused locally."Silverton had not really been operating as a bankers' bank for some time, but we were all painted with that model," says Thomason.

Thomason and others believethe market's recovery depends on two elements: one is simply time for the financial crisis to unwind; the other is regulatory clarity, which is now muddled by political pressureand proposed rule changes. Randy Cameron, a senior vice president at Zions Bank, says that possible amendments to the Federal Reserve's Regulation F (limitation on interbank liabilities) are particularly worrying. Last fall, the four federal banking regulators issued proposed guidance on correspondent concentration risks for public comment. The proposed guidance requires financial institutions to implement policies and procedures for identifying, monitoring, and managing correspondent concentration risk exposures and perform appropriate due diligence on all interbank credit exposures and funding transactions. But many smaller correspondent banks fret this will create another level of competitive inequality with too-big-to-fail banks, as well as the Federal Reserve Board and Federal Home Loan banks.

Yet among the tumult there is opportunity. Several executives say that once the industry stabilizes there will be far fewer banks offering correspondent services and still many small banks in need of loans. Already some, such as JPMorgan Chase, Citizens Financial Group, and Bank of New York Mellon, are ramping up, according to Foresight Analytics.

And correspondent bankscontinue to serve small banks in other ways. Zions has seen a 250 percent customer increase over the past three years as it has rolled out newservices, such as credit risk management and core processing. Zions offers seven times more products than it did four years ago, Cameron estimates. Pacific Coast's Brown estimates his roster of clients grew20 percent last yearalone.

Thomason says that when market conditions improve, community banks will remember the correspondent banks that stuck around. "We're going to pull through these issues, and the banks that remain will have a lot of opportunity in front of them."

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