Date: Friday, July 22, 2011

It has been nearly three years since Leh­man Brothers Holdings Inc., the fourth-largest U.S. investment bank, filed for the nation’s biggest bankruptcy in history and sent shock waves through the financial services industry. But new data released this month show many community and regional banks in Arizona still could be facing trouble.

More than half of Arizona’s local and regional banks will become undercapitalized if exposed to continued economic stress, according to a report from New York-based Invictus Consulting Group LLC.

Arizona’s results were far worse than the national average. According to the study, released last week, Arizona has the highest rate of potentially undercapitalized banks in the nation: 19 of its 36 regional and community banks, or 53 percent, were shown to be undercapitalized after a stress test.

The study excluded banks with more than $20 billion in assets.

Of the 7,695 community and regional banks across the U.S., 25.8 percent would be undercapitalized with prolonged economic stress if they received no capital infusions.

The test, which replicates how a bank’s loan portfolio would fare under tough economic conditions, shows commercial, residential and construction lending has taken a great toll on Arizona’s institutions.

“Arizona banks were very heavily involved in real estate lending, and the recession has hit that sector very badly,” said Invictus CEO Kamal Mustafa, a former head of Citibank’s mergers and acquisitions practice. “The rest of its economy is still in trouble as well.”

Mustafa said his firm has worked with regulators since the beginning of the recession to develop accurate stress tests for banks.

A major problem with loan classification and financial reporting is that the actual performance of the loans on a bank’s balance sheet lags the actual performance of the loan, he said.

For example, a construction loan in which the company never misses an interest payment may be classified as a good loan until the balance comes due, Mustafa said. If the company can’t pay, the bank has recorded income on a loan that actually was nonperforming.

“Many companies are severely hemorrhaging,” Mustafa said. “But you have this combination of lags in the data, especially in real estate.”

Mike Thorell, president and CEO of Pinnacle Bank in Scottsdale, said many banks
have been able to raise a finite amount of capital in the current economic climate.

“A number of things have to be right to raise capital,” he said, citing factors including loan-loss provisions, a clean loan portfolio, a future revenue model and pricing the stock correctly.

“You have to price it right,” said Thorell. “The days of big premiums are gone. That fact is still lost on a lot of people right now.”

Big banks enjoy a competitive advantage over community banks, in both raising capital and the interest paid on deposits and other borrowed money.

In the fourth quarter of 2010, banks with more than $100 billion in assets generally had to pay only about half the interest rates paid by community banks — those with less than $1 billion in assets — because of their size and buying power, Sheila Bair, former chairwoman of the Federal Deposit Insurance Corp., said in May.

Industry experts predict a wave of consolidations as well-capitalized banks acquire others that are weaker, but still have assets worth saving.

Banks will need more assets and adequate capital — partly because of increased regulatory requirements and costs, and partly because of a changed competitive landscape, Mustafa said.

He said companies that wait too long to raise capital can go into a death spiral. Many acquiring companies will wait for an FDIC decision rather than take the risk on their balance sheets.

Even if a bank’s loan portfolio is performing well now, it will need to find new operating revenue streams when those loans come due, according to Mustafa. That’s going to be a problem for small banks in Phoenix, he said.

Operating revenue as a percentage of average assets at banks with less than

$1 billion in assets was about 4.5 percent at the end of 2010, compared with almost 6 percent in 1999, according to American Banker.

While consolidation and declining revenue streams aren’t exactly headline news, the new regulatory burdens and down economy add to the challenges for community banks.

In 1990, banks with less than $100 billion in assets made up 70 percent of the industry by number, but held only 9.1 percent of the total assets. In 2010, they represented 34 percent of all banks and about 1 percent of the industry’s assets, according to American Banker.

“Banks that manage to survive bad loans will be limping along while the strong banks grab market share,” Mustafa said.