FRBSF Economic Letter
2000-32; October 27, 2000
Has Bank Performance Peaked?
Western Banking Quarterly is a review of banking developments in the
Twelfth Federal Reserve District, and includes FRBSF's Regional Banking Tables.
It is normally published in the Economic Letter on the fourth Friday
of January, April, July, and October.
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.
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.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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