Recent developments affecting the profitability and practices of commercial banks.

Recent Developments Affecting the Profitability and Practices of Commercial Banks

Nineteen-ninety proved to be a difficult year for the U.S. banking industry. U.S.-chartered insured commercial banks experienced a substantial increase in nonperforming loans, and as they attempted to keep pace through a continued high rate of loss provisions, their profitability edged down from the already depressed level of 1989. In contrast to the late 1980s, when heightened loss provisions were made for problem loans to developing countries, loan quality problems last year were concentrated in the commercial real estate sector and, to a lesser extent, in merger-related credits to highly leveraged firms.

Poor loan performance put strong pressure on the banking industry to improve its capital position in 1990. Loan quality problems, however, also lessened investor confidence in the banking industry, particularly in the second half of 1990. This period was marked by sharp declines in bank equity prices, large increases in the risk premiums demanded by investors on bank subordinated debt issues, and difficulties encountered by some large banks in obtaining funds in interbank markets. Confronted with these funding difficulties and weak earnings, and in anticipation of new capital standards, many banks restricted the growth of their assets and sought to preserve their profit margins in 1990, in part by widening margins on loans, aggressively cutting costs, tightening credit standards for approving loans, and stepping up the pace of loan securitizations.

These actions, along with slackening loan demand stemming from a weakening economy, slowed the expansion of loans held on bank balance sheets last year and led to a deceleration in the overall growth of interest-earning assets at U.S. banks (table 1).(1) Each of the three main categories of loans--real estate, business, and consumer loans--weakened; and in a development reminiscent of other economic slowdowns, holdings of U.S. government securities picked up.

Conditions improved somewhat after the turn of the year. The successful conclusion of the Gulf war, accumulating evidence suggesting an improved economic outlook, and monetary policy actions to foster a recovery all dramatically improved the financial market climate for banks in early 1991. Moreover, in recent surveys, the number of banks reporting tighter credit standards has been lower than it was during 1990.

On the liability side of their balance sheets, earnings pressures and difficulties in raising funds in financial markets led commercial banks in 1990 to increase their reliance on retail deposits for funding and to pay down managed liabilities. The continuing shrinkage of the thrift industry, which bolstered banks' share of retail deposits, aided this substitution.

The implementation of interim risk-based capital requirements at year-end 1990 heightened the importance of raising capital at many large banks. The new guidelines attempt to account for differences in the riskiness of various classes of assets in determining the capital adequacy of a bank. Although the composition of most banks' balance sheets is such that the new capital standards generally require more capital than did the previous regulations, especially for loans other than qualifying residential mortgages, the majority of banks already meet the even tougher 1992 standards.

The 1990 developments were manifested in several key aggregate statistics that track the performance of the banking industry. Last year, elevated loan loss provisions, concentrated at banks with substantial exposure to commercial real estate loans, held down the industry's return on assets to 0.50 percent, the second lowest level since the late 1940s (chart 1), and its return on equity to 7.77 percent. Even with depressed profitability, dividends paid as a share of assets continued at high levels for the industry as a whole, and as a result, retained earnings remained low for the second consecutive year. Still, banks managed to increase their risk-weighted capital ratios after the first quarter of 1990, mainly by downsizing and restructuring their balance sheets. Although loss provisions remained high last year, rising losses caused banks to end the year with a slightly lower ratio of loan loss reserves to loans (chart 2).

Banks' net interest margin--the spread between interest income and interest expense--narrowed over 1990 (table 2). Interest expense dipped and loan rates held relatively firm, but interest income fell more than interest expense because of increases in nonperforming loans. (Appendix tables A.1 and A.2 contain detailed information on income, expenses, and portfolio composition, by size of bank, for the years 1985-90.)

In 1990, 158 federally insured commercial banks failed, down from the record of 204 set in 1989. As in recent years, the majority of the nation's failed banks were in the Southwest. Although the number of banks classified by the Federal Deposit Insurance Corporation as being in danger of becoming insolvent dipped last year, assets at troubled institutions rose sharply as those difficulties became more concentrated at larger banks.

Balance Sheet Developments

Changes in the balance sheet of the banking industry during 1990 largely reflected the effect of the economic slowdown on loan demand and the response of banks to new capital requirements, funding difficulties, and problems in loan quality.

Assets

A sharp slowing in loan growth outweighed a pickup in the net acquisitions of U.S. government securities, resulting in a deceleration in the expansion of bank credit from year-end to year-end. Much of the overall deceleration in loan expansion reflected a moderation in the growth of real estate loans, a decline in commercial and industrial (C&I) loans, and an increased issuance of securities backed by consumer loans (a transaction that removes the loans from bank balance sheets).

Real Estate Loans. Real estate loans, the largest category of bank loans, continued expanding as a share of bank assets, albeit at a reduced rate. The composition of growth shifted last year, as in 1989, away from commercial and toward residential mortgages. This development likely resulted from the response of banks and their regulators to problems with loan quality and overbuilding in commercial real estate markets, the declining role of thrift institutions in providing residential mortgages, and the relatively lower risk weight assigned to qualifying residential mortgages under newly imposed risk-based capital guidelines.

The shrinkage of the thrift industry enabled banks to continue expanding their role in the primary mortgage market. Nonetheless, the growth rate of residential mortgages, excluding home equity loans, slowed last year because of the recession-dampened level of housing demand, the selling of mortgages in the mortgage-backed securities market, and to a lesser extent, more restrictive policies toward mortgage lending. A number of banks that responded to the August and October 1990 Lending Practices Surveys (LPSs) indicated that they had adopted tougher down payment and payments-to-income requirements for approving residential mortgages.

During the past two years, the growth of home equity loans has moderated from the rapid pace that followed the passage of the Tax Reform Act of 1986, which had phased out the interest deductibility of most nonmortgage household debt. This deceleration likely reflects the reduction over time in the number of eligible households without home equity lines as well as the effect of the economic slowdown on the loan demand of those with these lines. More recently, supply factors also may have played a role. Responses to LPSs over 1990 suggested that banks had adopted somewhat more cautious attitudes toward making home equity loans. According to the February 1990 LPS, banks reduced the size of such lines and the attractiveness of teaser rates offered on these loans.

The overbuilding in the market for nonresidential commercial structures helped further slow the expansion of longer-term bank credit in that market in 1990. A large majority of respondents to LPSs indicated that they had tightened their credit standards for approving commercial real estate loans in each quarter of 1990, although the share of respondents indicating further tightening ebbed somewhat near year-end.

Real estate loans for construction and land development fell about 7 1/2 percent last year. This decline reflected, in part, weakening loan demand and the adoption of tougher credit standards by banks. Large majorities of respondents to LPSs conducted last year reported using tougher loan approval standards, likely resulting from accumulating evidence of over-building and mounting loan quality problems in real estate markets, as well as closer regulatory scrutiny. In addition, write-offs of nonperforming loans and foreclosures, concentrated in the Northeast, reduced loans on bank balance sheets.

Commercial and Industrial Loans. After moderate growth in 1989, C&I loans edged down at commercial banks in 1990, mainly because of a dip in such loans made to domestic addressees (table 1). The decline in economic activity held down the demand for loans to finance both working capital and business investment and reduced the demand for merger-related financing. The growth of business loans has also been depressed by banks' tightening of credit terms and standards. Large proportions of banks responding to LPSs throughout 1990 indicated that they had charged somewhat higher rates for C&I loans relative to their funding costs and, on loans to small and medium firms, had tightened nonprice terms of credit such as collateral requirements and loan covenants. In surveys conducted in the gloomy and uncertain environment following Iraq's invasion of Kuwait, sizable proportions of reporting banks indicated that they had tightened credit terms and standards on C&I loans to larger firms as well. A deterioration in the economic outlook was the most frequently cited and highly ranked reason for these loan policy changes, followed by problems specific to the industries of the borrowers.

The continued deceleration in merger-related lending and merger-related activity last year was in part a result of a more cautious approach to providing such financing. Very large proportions of respondents to an early-1990 LPS reported that they had raised their credit standards on merger-related loans. The performance of merger-related loans also deteriorated last year: The percentage of LPS respondents indicating that they had charged off merger-related loans was larger during 1990 than during 1989. In addition, most of the respondents who cited charge-offs of these loans reported an increase in merger-related charge-offs from 1989 to 1990.

Consumer Loans. The growth of consumer loans held by banks was depressed by the securitization of $22 billion of consumer receivables last year--mostly credit card debt. The rapid pace of securitizations, up substantially from an already elevated rate in 1989, was primarily motivated by banks' needs to comply with the new risk-based capital standards, which began to take effect at year-end 1990. By reducing loans held on balance sheets, securitization lowers the amount of capital that banks are required to hold while enabling them to continue earning fee income from originating and servicing the securitized loans. Also, the uncertainty surrounding developments in the Middle East and fears engendered by the recession may have sapped credit demand. Supply factors, too, may have restrained the growth of consumer loans, as the number of banks reporting an increased willingness to lend steadily declined in 1990.

Loans to Foreign Addressees. The sum of loans to foreign governments and C&I loans to foreign addressees, which includes many loans made to developing countries, contracted again last year. As part of their retrenchment in international lending, large banks, which account for almost all holdings of these loans, continued to restructure and reduce their exposure to heavily indebted developing countries. Loans to foreign governments posted another large decline, and business loans to foreigners continued to edge down.

Securities. Despite the deceleration in the growth of assets overall, security holdings grew 8 3/4 percent in 1990, an acceleration reflecting the sharp slowing in the growth of bank loans and the more favorable treatment of U.S. government securities relative to loans under the risk-based capital regulations. The surge in holdings of U.S. government securities more than outweighed continued runoffs in other securities, mainly municipal government securities. As in 1989, banks acquired more government-guaranteed mortgage-backed securities (MBSs). In general, banks find these securities attractive because the yields on MBSs are higher than those on comparable-maturity U.S. Treasury issues and because risk-based capital guidelines require less capital to be maintained for government-guaranteed MBSs than for most other items on a bank's balance sheet. To some extent, increased holdings of MBSs and of one- to four-family mortgages reflect the expansion of banks' role in mortgage markets as the thrift industry contracts.

By contrast, bank holdings of state and local government securities continued to decline, as they have since one of the tax advantages of holding such securities was eliminated by the passage of the Tax Reform Act of 1986. Runoffs of tax-exempt securities in 1990 were more pronounced at those banks that posted large losses and were therefore not in need of sheltering income from taxation. The less-favorable treatment of municipal securities relative to that of U.S. Treasury securities under risk-based capital guidelines may also have contributed to the recent declines in holdings of these securities. In addition, the emergence last year of widespread fiscal problems in many state and local governments likely reduced the attractiveness of purchasing their securities.

Liabilities

Deposits at commercial banks grew 4 percent in 1990 on a year-end basis, a pace comparable to that of the past two years. However, the proportion of bank liabilities represented by demand deposits fell in 1990, as businesses likely continued their shift away from compensating balances and toward fees to pay for bank services.

Retail time and savings deposits, on the other hand, continued to become a larger source of funding, partly because depositors transferred or diverted funds from savings and loan institutions and partly because banks acquired thrift institutions. The strength in retail accounts was concentrated in small-denomination time deposits, a traditional source of funding for thrift institutions. These inflows helped reduce the need for banks to issue more-costly managed liabilities to fund their moderate growth in assets. In addition, the shift away from managed liabilities was also induced by increases late last year in the interest costs of large time and Eurodollar deposits relative to other interest and deposit rates. The higher costs reflected larger risk premiums demanded by investors in bank liabilities not fully covered by deposit insurance.

Growth in the more liquid retail bank deposits, such as money market deposit accounts (MMDAs), other checkable deposits, and savings deposits, strengthened considerably last year. This pickup primarily reflected the fact that rates on liquid retail deposits reacted more slowly to declines in short-term market rates than did yields on small time deposits.

Trends in Profitability

While small banks continued to post healthy profits in 1990, larger banks reported weak earnings (table 3). Most of this difference reflects substantial additions to loss provisions by medium and large banks for commercial real estate and domestic business loans (table 4). During the late 1980s, loss provisioning against loans to developing countries, which lowered income attributable to foreign operations, had accounted for most of the variation both in industry-wide profits across time and in profits across the different size categories of banks. Indeed, for several years up to 1990, the return on assets for all banks, excluding net income attributable to foreign operations, had moved in a narrow range (chart 3). Last year, however, net income attributable to domestic operations fell, accounting for the weakness in bank profits.

The 47 percent increase in loss provisions for domestic loans in 1990 more than accounted for the 5 1/2 percent increase in total provisions. By contrast, loss provisions attributable to foreign operations fell 84 percent last year, following an increase of 350 percent in 1989. Most of the decline in domestic earnings was likely attributable to the deterioration in the performance of commercial real estate loans. For about one-fourth of all U.S. banks, commercial mortgages plus construction and land development loans at each of them amounted to at least one-eighth of their total assets. At these "commercial real estate banks," net income attributable to domestic activities declined from 0.60 percent of assets in 1989 to 0.28 percent in 1990. This decline was greater than at other banks, where domestic income fell from 0.75 percent of assets in 1989 to 0.53 percent in 1990 (chart 4).

As a result of much-reduced provisioning for losses against loans to developing countries last year, net income attributable to foreign operations swung from a large loss in 1989 to a moderate gain last year. This turnaround aided the partial recovery in the profitability of money center banks, which hold the bulk of U.S. bank loans to developing countries.

The regional pattern of loss provisioning in 1990 is reflected in the profitability of banks grouped by Federal Reserve District (chart 5). In general, the return on assets fell in most of the eastern Districts because of large provisions made against commercial real estate loans. The one exception was the New York District, where the slight recovery in profitability mainly reflected reduced provisioning against foreign loans by the money center banks. Profitability fell sharply in the Richmond District, while losses mounted in the Boston District. On the brighter side, the declining (albeit still large) backlog of troubled loans in the Dallas District allowed additions to loss provisions to diminish for the second straight year, and the return on assets of banks in the District rose markedly during 1990.

For the banking system as a whole, the net rate of loss (charge-off rate) on all loans rose from 1.09 percent in 1989 to 1.37 percent last year. Detailed data on charge-offs net of recoveries by type of loan are available for banks with assets of more than $300 million or with foreign offices (table 5). At this large subset of the banking industry, which accounts for nearly 80 percent of bank assets, the net charge-off rate on all loans rose from 1.21 percent in 1989 to 1.58 percent last year, paced by steep increases in charge-offs against real estate, consumer, and domestic business loans. On a seasonally adjusted basis, the charge-off and delinquency rates on these loans generally rose throughout last year (chart 6).

Noninterest Income and Expense and Gains on Securities

Noninterest income in 1990 increased about as much as noninterest expense (excluding loss provisions), leaving the negative spread between these two components unchanged. On the expense side, cost-cutting efforts and bank mergers contributed to a 1 percent decline in bank employment from year-end 1989 to year-end 1990. Nevertheless, salaries and employee benefits grew somewhat faster than total industry assets last year, in part because the growth of assets slowed. Noninterest income was supported by moderate increases in fees received for deposit services and additional fees for servicing newly issued securities backed by consumer loans. However, to some extent, increases in noninterest income were restrained by the slowdown in merger-related lending, which generates fee income.

With long-term interest rates relatively stable in recent years, capital gains on the sale of investment-account securities continued to be low relative to the high levels that were seen in the mid-1980s.

Net Interest Margins

The net interest margin of the banking industry fell in 1990, with sharp drops at money center banks and small changes at other banks (chart 7, top panel). Rates on sources of funds followed market rates downward last year and, somewhat more sluggishly, so did rates on interest-earning assets, but increases in nonperforming loans caused the narrowing of the interest margin.

In the second half of 1990 (and into 1991), short-term interest rates declined substantially as the Federal Reserve took steps to cushion the emerging economic slowdown. Interest expense as a proportion of assets, moving in line with short-term rates, dipped about 1/4 percentage point in 1990. The interest costs of managed liabilities, such as large time deposits and foreign deposits (for example, Eurodollar deposits), typically are more responsive to changes in market rates than are yields on retail deposits; hence, the drop in interest expense was larger at money center banks, which rely on managed liabilities for funding more than other banks do (chart 7, middle panel). But the drop in interest income, which overall was sharper than the fall in interest expense (about 1/3 percentage point), was also deeper at money center banks (chart 7, bottom panel) and other large banks largely because of increases in nonperforming loans (table 6). This negative effect of worsening loan quality was softened, however, by the lag in the adjustment of loan rates to the decline in short-term market rates.

Dividends and Retained Earnings

Despite low levels of profitability, commercial banks paid dividends of 0.42 percent of assets in 1990, near the record rates posted in 1988 and 1989. Cuts in dividends, along with reduced provisioning for loans to developing countries, enabled money center banks to bolster their capital positions with retained earnings. But dividends as a share of profits surged at medium and large non-money-center banks, which maintained dividend payouts in the face of a substantial decline in profitability. As a result, medium banks retained virtually no earnings, and large banks other than money center banks dipped into capital to pay dividends. By contrast, small institutions continued paying out about two-thirds of profits in dividends, and their retained earnings as a share of assets stayed at levels near the average of the past five years.

Stock price indexes for money center and regional banks generally fell faster than the broad market through October (chart 8), likely reflecting the growing perception that the performance of merger-related and real estate loans was deteriorating. Such problems particularly affected stock prices of several New England bank holding companies, while concerns over economic problems in several heavily indebted developing countries depressed the stock prices of vulnerable money center banks. In the fourth quarter, however, a reduction in reserve requirements and other Federal Reserve actions to foster an economic recovery created a market climate in which bank stock price indexes recovered some of these losses.

Capital

As a whole, the banking industry added more equity last year than it did in 1989, despite the very low level of retained earnings and increased costs of issuing new bank equity and subordinated debt (table 7). Most of the net changes in equity capital occurred at smaller banks, where retained earnings remained at healthy levels. Large banks as a group raised only a bit more equity capital last year than in 1989, partly because their dividend payouts in 1990 exceeded earnings. Issuance of subordinated debt weakened last year as its cost rose sharply against a backdrop of market concerns about the health of large banks (chart 9). Nevertheless, the ratio of total capital to risk-adjusted assets actually rose for the industry as a whole between the first and fourth quarters of last year. The industry owed much of this increase to successful efforts by some large, less-well-capitalized banks to meet or exceed the initial phase-in of risk-based capital standards at the end of 1990 by securitizing loans, shifting the composition of their portfolios toward assets with lower risk weights, and paring down low-earning assets.

By year-end 1992, banks must meet three basic required capital ratios. First, tier 1 capital--mainly common equity and perpetual preferred stock--must amount to at least 4 percent of risk-weighted assets. Second, tier 1 capital must equal at least 3 percent of unweighted assets. Third, total capital--tier 1 plus tier 2--must equal at least 8 percent of risk-weighted assets. The corresponding interim ratios (1991-92) are 3.625 percent, 3 percent, and 7.25 percent. Tier 2 capital includes other types of preferred stock, subordinated debt, loan loss reserves (up to 1.25 percent of risk-based capital), and mandatory convertible debt. In the calculation of the risk-based capital ratio, a weight of 0 percent is applied to U.S. Treasury securities, mortgages backed by the Federal Housing and Veterans administrations, and MBSs guaranteed by the Government National Mortgage Association (GNMA). The risk weights are 20 percent for most other MBSs and federal agency securities, 50 percent for qualifying one- to four-family conventional mortgages, and 100 percent for most other loans, including C&I, consumer, and commercial real estate. To varying degrees, capital also must be maintained on most off-balance-sheet exposures to risk.

Currently, the vast majority of banks meet the interim standards, and partly in response to market pressures, many already meet the final 1992 capital standards. Across banks of different size categories, the ratio of total capital to risk-weighted assets was somewhat lower for large banks. Moreover, the ratio of tier 1 capital to risk-adjusted assets was much lower at large banks, mainly because of the greater reliance by these banks on subordinated debt (chart 10).

In general, asset growth was faster at banks that began 1990 with high ratios of equity capital to assets. For example, interest-earning assets expanded 7 1/4 percent at large banks (those with at least $5 billion in assets) whose ratios of equity capital to assets were in the highest quartile, but such assets declined at a similar pace at large banks in the lowest quartile. Interest-bearing assets at smaller banks with capital to asset ratios in the highest quartile grew nearly 11 percent last year but expanded only 3 1/2 percent at smaller banks with ratios in the lowest quartile.

Developments in Early 1991

Loan quality has continued to trouble the commercial banking industry into 1991. The deterioration in the performance of real estate loans, mainly commercial mortgages, has spread from the Northeast down the eastern seaboard, requiring additions to loss provisions. Moreover, signs of further weakening in the performance of merger-related lending have become more visible. After suffering large loan losses, particularly on commercial mortgages, the Bank of New England failed in January. In the face of mounting estimates of the costs of bank failures, the Federal Deposit Insurance Corporation has raised deposit insurance premiums and has asked the Congress for additional borrowing authority to close capital-deficient banks more quickly, thereby holding down the costs of resolutions.

First-quarter profit results were mixed. The profitability of several large banks was depressed, mainly by mounting real estate loss provisions and declining performance of loans to highly leveraged firms. Weak earnings and a need to preserve capital led several large banks to cut their dividend payments late last year and in early 1991. On the brighter side, the weakness in earnings of regional and money center banks did not hamper a rally in their equity prices, which rose sharply during the first quarter to outperform broader stock price indexes. A more favorable market assessment of the banking industry spurred banks to issue large volumes of subordinated debt and equity shortly after the Gulf war. Indeed, banks issued more subordinated debt and equity in the first quarter of 1991 than during all of 1990.

Survey responses to the May 1991 LPS indicated that banks continued to tighten their credit standards for riskier types of loans in early 1991, but to a much lesser extent than before the conclusion of the Gulf war. On the liability side of their balance sheets, deposit outflows from the thrift industry and acquisitions of thrift institutions have enabled banks to continue substituting retail deposits for more expensive, managed liabilities in an environment of slow asset expansion. [Tabular Data 1 to 7 Omitted] [Charts 1 to 10 Omitted & A.1 to A.2 Omitted] (1)Except where otherwise noted, data reported in this article are from the quarterly Reports of Condition and Income for all insured commercial banks. Asset values are fully consolidated averages (foreign and domestic offices) net of loss reserves. Net income is net of all taxes estimated to be due on income, extraordinary gains, and gains on securities. Size categories of banks, based on year-end fully consolidated assets, are as follows: small--less than $300 million; medium--$300 million to $5 billion; large--$5 billion or more.

Allan D. Brunner, John V. Duca, and Mary M. McLaughlin, of the Board's Division of Monetary Affairs, prepared this article. Thomas C. Allard and Charles R. Fendig provided research assistance.