Developments affecting the profitability of commercial banks.
After peaking early in 1989, short-term interest rates declined from the spring through the end of the year as the Federal Reserve took steps to sustain economic growth (chart 3). Nevertheless, by the end of 1989, short-term market rates were still well above their 1988 averages. Reflecting the higher average level of rates, interest expense as a share of assets rose about 1 percentage point. Increases in delinquent loans restrained the pickup in the rate of return on banks' loan portfolios stemming from higher market rates. As a result, the spread between interest income and interest expense (net interest margin) narrowed slightly, although it remained above the average of recent years (table 1).
On a year-end basis, overall growth of interest-earning assets at U.S. banks picked up to a moderate rate, reflecting mainly stronger expansion of bank holdings of securities (table 2). Bank loan growth was near the pace of 1988 as reduced runoffs in foreign loans and a turnaround in security loans roughly offset a moderation of growth in consumer loans and domestic commercial and industrial (C&I) loans. Much of the slowing in business loans to domestic addressees occurred in lending that was unrelated to mergers. Growth in consumer loans held by banks was reduced by the issuance of securities backed by consumer loan receivables, a transaction that removes loans from bank balance sheets. By contrast, holdings of U.S. government securities, especially of mortgage-backed securities issued by government-sponsored agencies, picked up. This strength was particularly pronounced late in the year, when loan growth slowed and deposit inflows surged as households shifted funds out of thrift institutions and thrift institutions sold off mortgage assets.
Events in the thrift industry enabled commercial banks in 1989 to rely more on retail deposits for funding relative to managed liabilities, such as large time deposits. Banks gained retail deposits directly from thrift institutions by purchasing the deposits in several resolutions of failed institutions. In another and likely more important development, many households shifted or diverted their deposits from savings and loan associations into bank accounts in response to concerns about the viability of thrift institutions or in response to declines in very high deposit rates offered by troubled institutions.
A record 204 federally insured commercial banks failed last year, up slightly from 1988. As in recent years, the majority of the nation's failed banks were located in the Southwest, where banks continued to post high real estate losses. However, the number of banks classified by the Federal Deposit Insurance Corporation as being in danger of becoming insolvent fell sharply last year.
BALANCE SHEET DEVELOPMENTS
Changes in the balance sheet of the banking industry during 1989 largely reflected responses of banks to impending capital requirements, problems in loan quality, and circumstances in the thrift industry.
As measured from year-end 1988 to year-end 1989, the expansion of bank credit strengthened to a moderate pace last year, mainly because of a pickup in the acquisition of U.S. government guaranteed mortgage-backed securities. Real estate loans continued to grow at a fast pace partly because the role of banks in residential mortgage markets increased as the thrift industry contracted.
Commercial and Industrial Loans. C&I loans grew somewhat faster in 1989, as those to foreign addresses declined at a slower rate than in 1988. By contrast, the growth of C&I loans made by U.S. commercial banks to domestic addresses eased to about 5 percent in 1989 from about 7 percent in 1988 (table 2). Domestic C&I loans grew at a moderate pace in the first half of 1989, when stronger expansion in estimated merger-related loans--those associated with acquisitions, mergers, and other corporate restructurings--outweighed declines in loans for other business purposes. However, despite renewed growth in nonmerger-related loans, domestic C&I loan expansion slowed in the second half because of a deceleration in merger-related loans. Merger-related loans had been the primary source of growth in business loans over recent years; indeed, abstracting from such loans, C&I loans were about unchanged last year. The slowdown in business borrowing from banks that was unrelated to mergers apparently owed, in part, to corporations' reliance on commercial paper, which increased sharply last year. Responses to the May 1990 Lending Practices Survey (LPS) of sixty large banks indicated that the major reasons for this deceleration in more traditional C&I lending were, in order of importance, weaker loan demand, tighter credit standards, and greater use of commercial paper by large businesses.
The slowdown in merger-related lending and merger-related activity late last year was in part a result of more caution in providing such financing. In the January 1990 LPS, many respondents indicated that they had tightened their credit standards and credit terms for loans to finance mergers during the last half of 1989, mainly because of a less favorable economic outlook, problems specific to different industries, and problems in asset quality. Respondents to the February 1990 LPS, indicated, on balance, that although the charge-off rate on merger-related loans remained lower than that on other C&I loans, it had risen somewhat from the rate in 1988. With respect to loans unrelated to mergers, very few respondents reported that they had tightened their credit standards on loans to firms that were below investment grade, but about half indicated that loan policies had become more restrictive toward lower-rated businesses, which probably include many smaller firms. Respondents indicated that a deterioration in the general economic outlook and the problems specific to various industries were the two most important factors motivating the tightening of lending policies on C&I loans during the last half of 1989.
Consumer Loans. The growth of consumer loans held by banks was restrained by the securitization of more than $11 billion of consumer receivables last year--mostly credit card debt--up substantially from the pace in 1988. Even so, credit card receivables edged up as a share of bank assets. By reducing loans held on balance sheets, securitization lowers the amount of capital that banks are required to hold. For banks that package enough loans to offset the fixed costs of issuance, securitization is a less-expensive way of funding loans than holding them on the balance sheet, which entails the cost of maintaining or raising expensive capital. Securitization thereby reduces lending costs while enabling banks to continue to earn fee income from originating and servicing the loans backing the securities. Since the announcement in May 1987 that risk-based capital standards would be imposed--effectively raising the capital requirement on most loans--banks have securitized consumer loans at a quickening pace. These factors may promote some consolidation of the credit card market: Several banks and thrift institutions have sold their credit card accounts to larger banks that specialize in securitizing and servicing this type of credit.
Real Estate Loans. In recent years, real estate credit has grown to become the largest type of loan held by banks. In 1989, real estate loans again increased as a share of bank assets as expansion in mortgage credit continued at about the strong pace of 1988. However, the composition of growth shifted away from commercial and toward residential mortgages, likely reflecting a deterioration in commercial real estate markets, the shrinking role of thrifts in residential mortgage markets, regulatory pressures, and the relatively more favorable treatment of residential mortgages under impending risk-based capital guidelines.
The largest category of real estate loans outstanding on commercial bank balance sheets is that secured by one- to four-family residences. Expansion of this component in 1989 continued at about the pace of 1988, as a deceleration in revolving home equity loans was roughly offset by stronger growth in more traditional residential mortgages. Helping to boost the growth rate and portfolio share of residential mortgages, excluding home equity loans, last year was the increased role of banks in the primary mortgage market as the thrift industry contracted.
Home equity credit has expanded rapidly since the passage of the Tax Reform Act of 1986, which phased out the interest deductibility of most nonmortgage debt. Although home equity loans continued growing as a share of bank assets, expansion in this loan category eased last year. This deceleration likely reflected the probable lessening over time in the share of eligible households without home equity lines and a consequent slowing in the number of new lines being put in place. Also, survey data suggest that individuals' use of home equity lines may taper off after initial drawdowns. Responses to the February 1990 LPS indicated that other factors holding down the growth of home equity credit, at least in the second half of 1989, may have been banks' efforts to reduce the size of such lines and the attractiveness of initial teaser rates offered on these loans.
Expansion in longer-term credit secured by nonresidential commercial real estate also slowed in 1989, particularly in the last half when there was heightened concern about high vacancy rates, especially in the commercial office market. Respondents to the November 1989 LPS indicated that they had, on balance, tightened their credit standards for approving commercial real estate loans in the last half of 1989. However, expansion in the commercial mortgage credit category has been increased somewhat in recent years--and may continue to be supported--by a shift from straight C&I lending to C&I lending secured by real estate.
On a year-end basis, the growth of real estate loans for construction and land development also moderated last year. Overbuilding in commercial, and to some extent in condominium, markets has contributed to losses on such loans. These losses have been particularly noteworthy in the Northeast--where problems have recently emerged--and in the Southwest--where charge-offs have cut into the amounts outstanding. Overall, net charge-offs of construction and land development loans noticeably held down growth of this category in the fourth quarter of 1989. Also, poor prospects in real estate, coupled with closer regulatory scrutiny, evidently induced banks to be more cautious in making such loans in the last half of 1989.
In the January 1990 Lending Practices Survey, nearly four-fifths of respondents reported a reduced willingness, compared with that of six months earlier, to make loans for construction and land development. Of these banks, nearly three-fifths reduced permissible loan-to-value ratios, and substantial proportions reported restricting credit for the building of income-generating properties and of single-family homes that were not sold before construction.
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, reflecting the ongoing retrenchment of international lending by U.S. banks. Large banks, which hold almostall of these loans, continued the process of restructuring and reducing their loans to heavily indebted developing countries. (Table A.2 presents detailed balance sheet ratios by size of bank). This process was most evident at large regional banks, where--owing in part to charge-offs--loans to foreign governments fell nearly one-third and C&I loans to foreign addressees decline 6-1/2 percent. As in 1988, loans to foreign governments declined more slowly at the money center banks. Business loans to foreigners were flat at these very large banks.
Agricultural Loans. The volume of farm lending by banks (including unsecured loans to finance agricultural production and other loans to farmers and loans secured by farmland) rose for the second consecutive year, the increase reflecting in part the continued improvement in the farm economy. Banks also garnered a larger share of the total farm lending market, as total farm debt continued a decline that had begun in 1985.
Positive developments in the farm economy have continued to benefit small banks, the size group that encompasses almost all of the agricultural banks. All small banks reduced their loss provisions relative to assets--in contrast to the industrywide rise--and the decline at agricultural banks was a little faster than at their peers. Nonperforming assets represented a smaller proportion of total loans for agricultural banks than they did for other small banks and for the whole industry (table 3). Partly because of these differences and the relatively lower deposit rates at agricultural banks, the return on assets at agricultural banks was higher than that at other small banks and was almost double that for the industry. This position contrasts sharply with the relative profitability of agricultural banks early in the 1980s.
Securities. In 1989, expansion in security holdings picked up. Strong inflows of retail deposits spurred by thrift industry problems coupled with moderating loan growth encouraged banks to purchase U.S. government securities. Bank holdings of mortgage-backed securities guaranteed by the U.S. government (MBSs) surged. According to respondents in the November 1989 LPS, banks found these securities attractive for two reasons. The first reason was that yields on MBSs rose somewhat relative to those on U.S. Treasury issues, partly because troubled thrifts sold off many MBSs to pare down their balance sheets. The second, but less frequently indicated, factor was that 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 the passage of the Tax Reform Act of 1986, which ended a tax advantage of holding such securities. Indeed, runoffs of tax-exempt securities in 1989 were especially pronounced at banks posting large losses, banks that were not in need of sheltering income from taxation. Also, the less favorable treatment of municipal securities compared with that of U.S. Treasury securities under risk-based capital guidelines may have contributed to the decline in holdings of these securities, from 7-1/2 percent of bank assets in 1986 to about 3 percent in 1989.
Commercial bank deposits grew somewhat faster at 5-1/2 percent in 1989 compared with their rate of growth in 1988; at the same time, several factors worked to change the composition of bank liabilities. Demand deposits were about flat, declining sharply in relation to bank assets. To a large extent, the weakness in demand deposits reflected higher average interest rates, which lowered required deposits under compensating-balance arrangements and encouraged depositors to minimize their non-interest-bearing balances. Also, over the past decade businesses have tended increasingly to compensate their banks for services with fees rather than through holding idle balances.
By contrast, retail deposists became a larger source of funding for banks partly because of the situation in the thrift industry. A portion of the 1989 growth in commercial bank retail deposits reflected funds transferred out of or diverted from savings and loan institutions. Most of the strength in retail-type accounts occurred in small time deposits, which traditionally have been the main source of thrift funding. These inflows helped reduce the need for banks to issue managed liabilities to fund moderate asset growth in the face of flat demand deposits. Because these inflows were not spurred primarily by increased advertising or by the rapid expansion of deposit offices and because spreads between yields on U.S. Treasury securities and rates on retail deposit widened, such retail deposit inflows likely helped bank profitability, as rates paid on managed liabilities, such as term Eurodollars and large time deposits, are typically higher than those on retail deposits. Growth in the more liquid retail bank deposits, such as money market deposit accounts (MMDAs), other checkable deposits, and savings deposits, slowed from the pace of 1988. The deceleration in the growth of liquid retail deposits and the acceleration in the growth of small time deposits at banks reflect, in part, the more sluggish adjustment of rates offered on liquid retail deposits to higher market interest rates than that of yields on small time deposits. Indeed, rates on money market mutual funds (MMMFs), a close substitute for MDDAs, rose more in line with market rates than did MMDA rates. As a result, households shifted or diverted funds into MMMFs last year.
TRENDS IN PROFITABILITY
While small banks continued to post healthy profits in 1989, the money center banks reported a loss, and other large banks recorded a drop in their profits (table 4). Most of this difference reflects sizable additions to loss provisions by large banks for loans to developing countries (chart 4). A saw-tooth pattern in loss provisioning has developed in recent years as large banks have adopted a strategy of periodically declaring huge loss provisions virtually en masse, possibly on the theory that shareholders and others will more likely regard additions to loss provisions as one-time occurrences if one's major peers are also declaring large loss provisions.
When viewed from the perspective of banks' domestic business, net income in 1989, at 0.70 percent of average assets, remained close to that of 1988. The commercial banking industry increased its loss provisions attributable to domestic loans by 30 percent over those of the previous year, less than half the increase in total provisions. This difference reflects the rise of about 350 percent last year in loss provisions on loans to foreign addressees.
In 1987, when all large banks registered large losses, profits on domestic business barely kept the industry's return on assets positive. Seventeen percent of commercial banks ended 1987 in the red. In both 1987 and 1989, loss provisions attributable to business abroad more than accounted for the total negative income actually registered. In 1989, however, fewer large regional banks and only half the money center banks showed negative income, and losses attributable to international operations offset only one-fourth of domestic net income. Also, the share of banks with net losses continued to decline, to 10 percent.
At money center banks, the percentage of loss provisions attributable to international business rose to 88 percent in 1989, near the high reached in 1987. As in 1987, much of the high level reflected provisioning against loans to developing countries. Since the third quarter of 1989, many of the money center banks have made large additions to reserves for such loans. For this reason, somewhat less scope exists for problems with loans to developing countries to affect further the recorded profitability of money center banks.
These very large banks achieved a 0.55 percent return on their domestic business. Operations at home accounted for three-fourths of their net interest margin and 60 percent of their noninterest income, up slightly over results in 1988.
Loss provisions made by other large banks nearly doubled as a share of assets last year, likely reflecting a deterioration in the quality of real estate loans as well as developing country debt (table 5). For all banks with foreign offices, reported income losses from business abroad were somewhat larger than the positive net income reported on a consolidated basis; at money center banks, foreign income losses were almost three times the total net loss reported by this group.
Unlike the experience in 1987, large banks other than the money center banks in 1989 out-performed the industry as a whole in total profitability, and profits on their domestic business were only slightly lower than that of the industry. Those among this group with foreign offices showed virtually the same domestic return on assets in 1989 as that two years earlier; the difference in consolidated net income was attributable entirely to their international operations.
To some extent, after-tax income has been held down in 1988 and 1989 by higher tax liabilities that probably owe, in part, to the phasing in of tax provisions approved in 1986. Before the Tax Reform Act of 1986, banks could deduct from taxable income their additions to the reserve for loan losses. This legislation, however, denies the reserve method and limits banks to deducting their actual net charge-offs. Provisions for loan losses are deducted from net income on their financial reports but must be excluded from the calculation of their taxable income. The result is a higher tax liability.
The regional pattern of loss provisioning was reflected in the profitability of banks by Federal Reserve District (chart 5). The return on assets turned negative in the Boston District--where large provisions were made for real estate loans--and in the New York District--where the money center banks added to reserves for loans to developing countries. On the brighter side, additions to loss provisions at banks in the Dallas District diminished last year, reversing the worsening trend between 1985 and 1988. This development reflected, in part, improved economic conditions inthis area and the declining, albeit still large, backlog of troubled l oans from the mid-1980s. Banks in the Dallas District continued reducing their exposure to commercial real estate loans and increased the share of U.S. government securities in the portfolios.
For the banking system as a whole, the net charge-off rate on all loans rose from 0.96 percent of loans in 1988 to 1.09 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 (table 6). 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 1.03 percent in 1988 to 1.21 percent last year. This development reflected not only a steep rise in charge-offs of loans to developing countries but also increased charge-offs against real estate and consumer loans, as well as loans to depository institutions.
Noninterest Income and Expense and
The increase in noninterest income in 1989 was twice as large as the increase in noninterest expense (excluding loss provisions). As a consequence, the negative spread between these two components continued to contract. On the expense side, layoffs and consolidations at several large banks prevented employment in the banking industry from growing much last year. Partly as a result, salaries and employee benefits grew no faster than total industry assets last year.
One source of increased noninterest income was fee income from merger-related financing activities, particularly at money center banks, which originate most of these loans. The ratio of noninterest income to assets was bolstered further by the pickup in issuance of consumer-loan-backed securities last year as banks recorded income from originating and servicing the underlying loans. Noninterest income also was supported by a small rise in fees received for deposit services. To some extent, such fee income reflects the ongoing shift by businesses away from compensating balances and toward fees as a means of paying banks for services.
Capital gains on the sale of investment account securities edged up last year but were still low relative to the high levels earned between 1985 and 1987. As in recent years, money center banks have outperformed other banks in realizing gains on holdings of securities.
Net Interest Margins
The banking industry's net interest margin edged down, as declines at money center banks outweighed slight increases at small- and medium-sized banks. As a result of higher average market interest rates during 1989, interest expense and income rose. However, interest expense increased somewhat more, particularly for money center and large banks, which, as a group, rely more on managed liabilities for funding than do smaller banks. The interest costs of managed liabilities, such as large time deposits and foreign deposits (for example, Eurodollar deposits), adjust more quickly to changes in market interest rates than do yields on retail deposits. Net interest margins were depressed at very large banks by a sharp rise in interest paid on Treasury tax and loan note balances and other borrowed funds.
The ongoing resolution of problems in the thrift industry, however, is helping reduce upward pressured on retail deposit rates. In recent years, troubled thrift institutions had attracted small time deposits by offering unusually high rate sand thereby put upward pressures on deposit rates at sound thrift institutions and banks. Regulatory intervention over several quarters before the passage of thrift legislation in the summer of 1989 had curtailed such practices. Since August 1989, when regulators obtained funds to resolve some insolvent thrift institutions, such deposit pricing practices have abated further. Partly as a result, spreads of short-term market interest rates over small time deposit rates at banks have recently widened.
Dividends and Retained Earnings
Despite the drop in profitability (table A.1), commercial banks paid dividends of 0.44 percent of assets in 1989, equaling the record performance of 1988. Smaller institutions continued paying out about two-thirds of profits in dividends. But dividends as a share of profits in dividends. But dividends as a share of profits surged at large banks other than money centers, reflecting mainly the maintenance of dividend payouts in the face of a substantial decline in profitability. Money center banks, as a group, dipped into capital to pay dividends, as they had in 1987 when they also boosted loss provisions against loans to developing countries. Reflecting differences in dividend policy as well as changes in relative profitability, retained earnings as a share of assets at small and medium-sized banks continued at levels near those of 1988 but fell for large banks and turned negative for money center banks (table 7).
Stock price indexes for money center and regional banks generally had increased somewhat faster than the Standard and Poor's 500 index through the third quarter (chart 6). However, in the fourth quarter both bank indexes fell, partly on information suggesting 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. Concerns over economic problems in several heavily indebted developing countries further depressed the stock prices of money center banks with large loan exposures to these nations.
As a whole, the banking industry added less equity last year than it did in 1988, reflecting the very low level of retained earnings and the damping effect of the fall in bank stock prices in late 1989 on the incentive to issue new equity. However, some banks that are less well capitalized continued raising equity, securitizing loans, and paring down low-earning assets last year in advance of the initial phase-in of risk-based capital standards at the end of 1990.
By year-end 1992, banks must meet three basic required capital ratios. First, they must maintain tier 1 capital, mainly common equity and perpetual preferred stock, equal to at least 4 percent of their risk-based assets. Second, tier 1 capital must equal at least 3 percent of their unweighted total assets. Third, total capital must equal at least 8 percent of risk-adjusted assets. Currently, many banks already meet the interim 1990 and the final 1992 capital standards with respect to tier 1 capital. Besides tier 1 capital, total 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, 0 percent weights are applied to U.S. Treasury securities, FHA and VA mortgages, and MBSs guaranteed by GNMA. The risk-based weights are 20 percent for most other MBSs and 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 off-balance-sheet exposures to risk.
Across banks of different size categories, the ratio of total capital to assets was about the same. However, as illustrated in chart 7, equity capital composed a greater share of total capital at smaller banks, whereas subordinated debt, mandatory convertible debt, and loan loss reserves constituted a greater share at large banks. Indeed, at money center banks, that loan loss reserves were almost as large as equity capital reflected in part that money center banks account for most loans made to developing countries.
DEVELOPMENTS IN EARLY 1990
Concerns about credit quality continued to trouble the commercial banking industry into 1990. In the Northeast and some other areas of the country, real estate loan problems mounted further, and banks set aside additional loss provisions. In response to problems of loan quality, some New England banks have sold off a large volume of assets to meet capital requirements. Concerns about the quality of real estate loans appear strongest in areas in which land prices had risen sharply in previous years. For example, a number of banks in the Southeast reported a decline in profitability in the first quarter of 1990 because of increased provisioning for nonperforming commercial real estate loans. In addition, signs of a possible deterioration in the performance of merger-related lending have grown stronger.
The profitability of money center banks suffered in the first quarter of 1990 mainly because of mounting real estate loss provisions, declining performance of loans to highly leveraged firms, a drop in fee income from arranging merger financing, and the failure of Brazil to make interest payments. These developments likely induced much of the additional decline in the stock indexes for regional and money center banks.
Thus far in 1990, banks and a number of countries, including Mexico, have started implementing debt-restructuring packages. The package with Mexico has resulted mainly in debt and debt-service reduction and, to a lesser extent, some provision of new credits.
Survey responses to the May 1990 LPS indicated that banks had continued to tighten selectively their credit standards and nonprice terms of credit for riskier types of loans in early 1990. Such tightening was particularly pronounced for commercial real estate loans. Somewhat fewer banks, about half, indicated that loan policies became more restrictive for nonmerger-related C&I loans to small- and medium-sized businesses, but few reported that they had tightened their credit standards on such loans to large firms. Respondents indicated that a decline in the general economic outlook and a deterioration in loan quality were the most important reasons for tighter lending policies toward small- and medium-sized firms. Other factors frequently mentioned included regulatory pressures and industry-specific problems. Although large numbers of banks reported tightening credit standards for certain types of loans, the extent of the tightening is not clear, and the impact of more restrictive lending policies on firms is even less quantifiable, especially amid signs of weakening bank loan demand. Other surveys conducted by Federal Reserve Banks generally confirmed that credit standards were tightened for loans to real estate developers but suggested that business loan demands from banks continued to be met for most of the firms that were contacted.
Issuance of securities backed by consumer loans surged in the first quarter and enabled banks to reduce consumer loans on their balance sheets around $6 billion, about twice the quarterly rate of 1989. As a result, consumer loans held on the balance sheets at large banks actually declined in the first quarter.
On the liability side of their balance sheets, deposit outflows from the thrift industry enabled banks to continue substituting retail deposits for more expensive, managed liabilities while funding a more moderate expansion in assets. Indeed, large time deposits issued by banks have run off since the new year. This development will help support net interest margins in 1990.
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|Author:||McLaughlin, Mary M.|
|Publication:||Federal Reserve Bulletin|
|Date:||Jul 1, 1990|
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