FRBSF Economic Letter

2000-32; October 27, 2000

 Economic Letter Index

Has Bank Performance Peaked?

• Financial market signals
• Balance sheet developments
• Conclusion

After several years of rising to ever greater heights, bank profits took a dive in the second quarter, with return on assets (ROA) falling to 1.0%, the lowest it has been since 1992 (see Table "Banks Headquartered by Region"). The reason: poor performance at large banks, which had an ROA of 0.94%. In contrast, the ROA of small banks remained fairly robust at 1.3%. While the dip in ROA can be attributed in part to some special factors, it also raises the question of whether bank performance has peaked. This Economic Letter examines banks' profit outlook.

Financial market signals

Both stock and bond markets give useful signals on the future profitability of the banking industry. Stock prices give fairly reliable signals about future earnings prospects because they are very forward-looking in discounting future profits. At the same time, equity prices are quite volatile, because equity holders face more risk; their claims on the residual profits of the bank come after those of depositors and bondholders. Figure 1 compares the S&P 500 stock index and the S&P Banks Composite Index from 1997 to the present. While advances in bank stocks tended to keep pace with the broad stock market movement in earlier years, they clearly have diverged since around 1998: the S&P 500 has appreciated 56%, while the Bank Composite Index has declined by 5%. It appears that the market has been reassessing the relative profitability of banks since 1998, well before the recent hit to book earnings.

Another signal comes from the bond market where bank debt is traded. Bond holders differ from equity holders in that they are more concerned about the bank's default risk than they are about the bank's residual earnings. Because bonds are less risky than equities, bond prices are less volatile than equity prices. Figure 2 shows that the spread between the yield on A-rated bank subordinated debt and the yield on default-free Treasuries has risen even above the peak of October 1998 during the bond market turmoil. This spread largely reflects the market's perception of changes in bond's default risk, but recently it somewhat overstates the case because concern about the supply of long-term Treasuries has held down their yields. Hence, a better way to look at the changes in bank debt default risk is to compare their yields to other A-rated corporate bonds. Between 1997 and 1999, yields on bank subordinated debts on average were 55 basis points below similarly rated corporate bonds. This spread has narrowed significantly this year, averaging only 22 basis points year-to-date, although it seems to have widened a bit lately. Thus, relative to other similarly rated non-bank firms, the market's perception of banks' default risk has gone up.

Taken together, these financial market signals clearly indicate the perception that banks' profit growth has deteriorated and that bank risk is rising. These perceptions can be linked to the effects of higher interest rates, in particular a slowing economy and higher loan delinquency rates. To explore these effects on the banking industry, the next section examines some recent balance sheet developments at banks.

Balance sheet developments

The Federal Reserve raised interest rates six times since mid-1999. Rising interest rates could affect bank profitability in two ways. First, it could shrink banks' interest margin if the maturities of their assets and liabilities are mismatched; when longer-term assets are funded by shorter-term liabilities, banks must reprice their liabilities faster than assets, at a higher prevailing interest rate. This was the scenario during the 1980s savings and loan crisis. But banks learned a lesson from that experience and shifted towards floating-rate pricing and toward employing financial derivatives to hedge their interest rate risk exposure. As a result, the narrowing of banks' net interest margin in very recent quarters has been small: it was 3.48% in 2000.Q2 compared to 3.52% in 1999.

Second, rising interest rates can have a negative effect on bank profits through loan delinquencies. Recall that the motivation to tighten monetary policy was to slow the economy. As the economy slows, borrowers with marginal repayment capabilities could easily slip into default. Figure 3 shows the delinquency rates for all loans and for C&I (commercial and industrial) loans, the second largest loan category (behind real estate loans). In the past C&I loans have been the key determinant of bank performance. While the delinquency rate for banks' entire loan portfolio is holding steady and remains low by historical standards, the delinquency rate for banks' C&I lending has risen significantly. To respond to higher delinquencies in C&I loans, banks had to increase their provisions for loan losses, which dragged down bank profits.

Conclusion

Has bank performance peaked? Financial markets have been signaling for quite some time that bank earnings growth may not be able to keep pace with the economy and that bank risk has been on the rise. Judging from these signals, banks' poor financial performance in the second quarter was not just a blip in an otherwise upward trend. This may be the beginning of banks' reckoning with the easy loan standards and terms they extended to commercial borrowers during the mid-1990s. Nevertheless, to the extent that loan losses were expected and properly priced, they would simply even out the supra-normal profits recorded during the boom time, and banks would remain healthy albeit less profitable.

Simon Kwan
Senior Economist

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