Economic Letter 2001-30; October 26,
2001
Banking and the Business Cycle
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
The banking industry performed exceptionally well during the strong economic
expansion of the past five years. Strong demand for loans and banking
services and the strong supply of quality customers helped boost bank
earnings. But how will banks fare given the recent weakening of national
economic conditions? Will we see a repeat of their performance in the
last downturn, in 1991, when depressed earnings, high failure rates, and
contracting loan portfolios inflicted significant damage on banks and
the economy in general? So far this year, we have seen signs of a beginning
of a contraction in bank lending. While earnings have held up through
the second quarter, bank stocks have started to dip along with the rest
of the market.
This Economic Letter addresses the question of how banks will
fare during an economic slowing by revisiting bank performance over previous
business cycles. The analysis shows that lending and bank earnings tend
to droop during a downturn, but that the relationship between performance
and macroeconomic variables, such as GDP growth, is not particularly strong
at other points in the cycle. I also point out how the 1991 recession
was a vastly different experience for the banking industry compared to
previous recessions.
Lending, pricing, and performance over the
cycle
In theory, banks can compensate for a riskier environment by tightening
their lending standards—by charging higher interest rates on their loans,
by demanding more collateral, and by simply refusing to lend to marginal
customers. This behavior is fairly well documented over the business cycle
(see Lown and Morgan 2001). The effects of credit tightening (as well
as of lower demand, which, of course, also occurs during downturns) are
shown in Figure 1. The quarterly (annualized) growth rate of commercial
and industrial loans is quite volatile, but tends to dip when the economy
enters into recession (marked with shaded bars). Like loan volumes, loan
prices—proxied here by the prime rate—tend to rise as the economy enters
into recession. These interest rate changes probably understate the price
response by banks, as the spreads over prime charged to the riskiest borrowers
can rise.
While the primary response of banks to a slowing economy is to adjust
credit standards on new loans, the main impact on banks of a slowing economy
is impaired credit quality of existing loans. Figure 2 plots return on
equity (ROE) for the banking sector. This commonly used accounting measure
of performance calculates the percentage of industry earnings to industry
equity capital. Once again, ROE tends to dip during recessions. However,
the contemporaneous correlation between ROE and real GDP growth is low—just
0.03. There are no leads or lags of real GDP growth with which this average
ROE series is significantly correlated. (The relationship between performance
and the economy is slightly stronger when we substitute the percentage
changes in a banking stock index for the performance variable, indicating
that market valuations tend to move more than accounting measures of earnings.)
 Why
is the relationship between bank performance and the economy not as strong
as might be expected? First, although banks are likely to be exposed to
the downside risks associated with economic fluctuations—as the economy
slows and firms fail, the firms will default on their bank loans—the
upside is capped for traditional banks, which depend on earnings from
debt instruments. Once a loan has been made, the best a bank can hope
for is full repayment of interest and principal. Competition, market discipline
from bank funding sources, and regulation all ensure that banks do not
make wildly risky but possibly profitable loans in good states of the
world.
Second, the performance of the banking sector over the 1980s and during
the 1991 recession was vastly different from the performance over the
course of other business cycles. The banking crisis of the 1980s was a
protracted affair that left the sector in an extremely weak position to
weather the recession. For example, the competitive environment for banks
changed dramatically during this period (see Furlong 2001). Interest rates
were deregulated, the prohibition on banking organizations expanding over
state lines began to weaken, thrifts were allowed greater latitude to
compete against banks, and capital markets emerged to draw away many of
the banks' best customers. In addition, in the early 1980s, banking was
buffeted by loan defaults from developing economies and, in the late 1980s,
by the U.S. commercial real estate crisis. These trends culminated in
a stunning number of bank failures, peaking at 280 in 1988 alone. As shown
in Figure 2, the trend in ROE was downward for the entire decade of the
1980s. Not only did earnings drop, but bank capital positions had decayed
to the point where some banks had difficulty making new loans, even after
the economy had emerged from recession.
The current environment
In the current banking environment, there already is some evidence of
a tightening of conditions as reported in the Federal Reserve's senior
loan officer survey (see Federal Reserve Board of Governors 2001). The
percentage of domestic banks reporting a tightening of standards for commercial
loans started to rise in the beginning of 2000 and remains at elevated
levels. Approximately 60% of the large domestic banks surveyed reported
that they were increasing their prices over their cost of funds. So far,
industry earnings seem to be holding up; the ROE for the banking sector
in the second quarter of 2001 was 13.7%. In addition, an important point
to note in Figure 2 is that industry ROE is at
a high level by historical standards. Following the 1991 recession, banks
that survived the crisis emerged as much more productive and profitable
enterprises. The banking sector has rebuilt its capital base and, perhaps
just as important for the outlook, has embraced the push towards implementing
risk management systems. Thus, while an economic slowing could lead to
slower loan and earnings growth, there is no reason to expect the banking
sector as a whole to encounter the same degree of difficulties experienced
during the last downturn.
John Krainer
Economist
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