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While conditions solid for community banks, worries about credit quality simmer

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While conditions solid for community banks, worries about credit quality simmer

Higher interest rates and tax cuts could bolster community banks' bottom lines in 2018. But an upward shift on rates poses eventual threats, industry veterans say, and lower government levies do not make the economy impervious to inevitable recession.

As interest rates rise, many banks have been able to lift rates on loans before they have to on deposits, widening the spread between the two and boosting net interest margins — key measures of profitability. But eventually, as rates climb further, depositors tend to demand higher rates and funding costs mount, catching up to loan yields and curbing that margin expansion, said Steve Hovde, a bank investor and the president and CEO of investment bank Hovde Group.

"That worries me," he said this week at Bank Director's annual Acquire or Be Acquired conference in Phoenix. Markets anticipate at least two more Federal Reserve interest rate increases this year.

Tim Johnson, a KPMG partner who works with financial services companies, said many banks already are reporting competition for deposits. In some cases, he said at the conference, it is "pretty fierce."

What's more, Hovde said, after banks lifted rates on variable-rate loans, historically, more customers struggled to make loan payments and many banks' delinquencies ultimately rose. A jump in nonperforming assets and related costs followed, he said.

While the tax cut could delay hits to credit quality — many borrowers will take home more pay because of it — Johnson added that there are already hints of credit quality issues in consumer segments such as credit cards and auto loans. Several banks, including BB&T Corp. and TCF Financial Corp., have backed away from indirect auto lending amid concerns of potential overheating. A majority of major credit card issuers reported modest increases in charge-offs during the last month of 2017, a recent S&P Global Market Intelligence analysis found.

Community banks tend to focus much of their efforts on small businesses, but if those companies' customers are struggling with card payments or auto loans, they may pull back on spending, and that could foreshadow problems for business owners. "I do think there are some concerns on the credit side," Johnson said.

Home BancShares Inc. Chairman John Allison, who is notably optimistic on operating conditions this year, countered that "the cycle is different this time." In the aftermath of the financial crisis, regulators demanded better underwriting and bankers responded, he said. Banks have continued to lend but they have structured safer deals, particularly on real estate loans. That makes the current state of the banking industry difficult to compare to past eras, because today "it's much healthier," said Allison, whose bank catapulted out of the community bank ranks over the past two years via solid organic growth and buyouts of smaller banks.

Hovde, however, said economic downturns are inevitable, and when they strike, most banks' credit quality suffers. He said the economic expansion of the last several years has proven unusually long and its end is all but unavoidable. "There will be a recession at some point," probably within a couple of years, he said.