FRBSF Economic Letter
99-32; October 22, 1999
 Economic
Letter Index
Rising Bank Risk?
The banking industry is in its eighth year of strong earnings. As a result,
banks have rebuilt their capital positions, and conditions in the industry
appear to be quite good by historical standards. Against the backdrop
of strong profits, it is useful to remember that banks, as financial intermediaries,
are in the business of taking risk. Hence, it is important to monitor
banks for indications of adverse effects from risk-taking.
This Letter examines several measures that may provide early
signs of increases in bank risk. We look at bank financial statements,
indicators of bank lending practices, and market-based information related
to subordinated debt. Reflecting the strong economic expansion, the accounting
data and lending practices show only weak signs of a general rise in risk
at banks, though risk in commercial lending apparently has turned up some.
The more forward-looking market data do show widening yield spreads on
banks' subordinated debt securities. While the spreads probably are signaling
some concerns about greater bank risk, they also reflect higher liquidity
premiums and perhaps a shift in investors' risk preferences.
Loan performance and loss reserves
A common place to look for evidence of changes in risk is bank financial
statements; however, they tend to provide a picture of realized rather
than potential problems. One measure of current portfolio quality is non-performing
loans, defined as loans with interest past due 90 or more days or loans
not accruing interest. In the aggregate, changes in the share of non-performing
loans are heavily influenced by underlying economic conditions. As Figure
1 shows, the ratio of non-performing loans to total loans for large
bank holding companies declined steadily following the early 1990s recession
and hit a low in the third quarter of last year. Since then, the ratio
has risen a bit, with non-performing commercial loans and farm loans in
particular contributing to the rise. Upticks in non-performing loans during
economic expansion are noteworthy, and the non-performing loan ratio is
more likely to move up more should the economy finally slow.
Furthermore, rather than building up loan loss reserves for a rainy day,
the ratio of loss reserves to total loans remains relatively low (see
Figure 1). Thus, as non-performing
loans started to creep up in recent quarters, banks increased their provisions
for loan losses by charging against current earnings. This suggests more
downside than upside risk in bank earnings, as any future increase in
problem loans would require additional provisioning, which would drag
down earnings.
Credit standards and terms
Banks' own standards for extending new loans and terms on new loans may
provide more of a forward-looking view on risk. The Federal Reserve Senior
Loan Officer Opinion Survey on Bank Lending Practices asks more than 50
of the largest U.S. banks whether they had tightened or eased loan terms
and credit standards for loan approval for a variety of loan types over
the preceding three months, and the results suggest that they see some
added credit risk.
Though recent surveys found little change, on net, in bank lending practices
relating to households, they do suggest that banks are more cautious in
commercial lending (see Figure
2). While it is not uncommon to see banks tightening credit standards
and loan terms during economic contractions, such as the 1990-91 recession,
it is noteworthy that banks, on net, tightened both standards and terms
for their business lending during the past four quarters in a row, even
while the economy has expanded at a rather rapid pace. Banks most commonly
cited a worsening of industry-specific problems, a less favorable or more
uncertain economic outlook, and a reduced tolerance for risk as reasons
for tightening. A number of respondents also indicated that over the past
year the performance of their business loan portfolios had become more
sensitive to a period of economic weakness, primarily because of weaker
financial conditions of borrowers, but also because of earlier eased lending
standards and terms.
Widening yield spreads on bank debt
The market's assessment of risk in banks should be the most forward-looking.
One source of information on this assessment is the subordinated debt
market. A number of bank holding companies and banks issue subordinated
notes and debentures as a source of funds. Empirical research suggests
that the yield spread between bank subordinated debt and a default-free
Treasury bond of similar maturity reflects the market's view about default
risk in banking.
Figure 3 shows that these
yield spreads have risen substantially in recent periods. The heavy solid
line shows some rise in risk spreads on bank debt in late 1997 and into
1998, when the Asian financial crisis was unfolding. The large jump in
spreads in the later part of 1998 corresponds with Russia's default on
its sovereign debt in August 1998, which ultimately led to the seizing
up of the credit markets in October. The average yield spread on bank
subordinated debt settled at around 110 basis points in the spring of
this year before moving back up again.
Although the credit market has been demanding a higher premium for holding
bank subordinated debt securities, it is not clear how much of the higher
premium reflects the market's perception of higher default risk. For example,
the rise in yield spreads has not been limited to bank debt. As shown
in the figure, the rise in the risk spread on bank debt tracks the movement
in spreads for corporate bonds. Indeed, spreads on almost all private
debt instruments have increased since the latter part of 1998. Among the
explanations for this general rise in spreads is an increased demand for
liquidity in financial markets, with the increased spreads on longer-term
private debt representing higher liquidity, rather than default, premiums.
Another explanation is a general shift in investors' risk preferences;
that is, investors now demand higher premiums for the same degree of default
risk, so the rise in the spread may or may not reflect higher default
risk. Only a third explanation, that economic developments have raised
some concerns about the pace of economic activity posing risks for banks
as well as other firms, points to higher default risk.
Fred Furlong
Vice President |
Simon Kwan
Senior Economist |
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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Research Department
Federal Reserve Bank of San Francisco
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