FRBSF Economic Letter
2003-37; December 19, 2003
The Current Strength of the U.S. Banking Sector
During the 2001 recession and the recovery, bank performance
has been remarkably strong. To be sure, banks tightened their lending
as the economy softened, lessening their exposures to problem areas such
as the technology and telecommunications sectors. But it is also notable
that banks' lending strategies during the late 1990s boom never resulted
in a buildup of loan losses once the economy weakened, as has happened
so often in the past.
There are a number of possible reasons for the banking sector's resilience.
In fact, we cannot rule out simple good fortune. Perhaps the 2001 recession
was different from previous recessions in that it did not have a great
impact on the sectors the banks had exposure to. Indeed, the technology
firms hardest hit by the recession are relatively less dependent on banks
for external finance than firms in other sectors. It may also be that
banking has changed over time, and that these changes have had an impact
on the cyclicality of banking. Today's large bank has more capital, derives
relatively more of its income from nonlending sources, contains a different
mix of loans in the loan portfolio, and is much better able to hedge
its financial risks than it was in the past. These changes could have
resulted in better performance during this downturn. Finally, the 1990s
were notable for changes in regulation. Much of this change was in reaction
to the banking crisis of the late 1980s. Thus, it could be that the supervision
has changed and that the 2001 recession should be viewed as the first
real test of the efficacy of these changes. In this Economic Letter we
will investigate these possibilities, focusing particularly on the changes
in regulation and supervision.
Bank performance and condition
The clearest indication of the banking sector's resilience in the most
recent downturn can be seen in the aggregate performance measures. Aggregate
return on equity (Figure 1) has remained remarkably stable throughout
the late 1990s following the recovery from the banking crisis. The figure
also shows that it is relatively unusual to see steep contemporaneous
declines in bank performance as the economy enters into recession. In
this regard, bank performance during the 1990-1991 recession was quite
different from that in previous downturns.
Bank conditions, as measured
by the book equity capital ratio and the nonperforming loan ratio, also
illustrate that the banking sector was
well-positioned for the most recent recession (see Figure 2). Simply
put, the banking sector today is better capitalized now than it was in
the early 1990s. This is particularly clear when one looks at the total
The banking sector has changed in distinct ways over our
sample period: the number of banks has shrunk through consolidation and
have substituted commercial and industrial lending for real estate lending,
and banks have gradually expanded their business lines to reduce their
reliance on interest income from lending. Perhaps more importantly, the
improvements in risk management offered by securitization, loan syndication,
and hedging via derivatives instruments have helped banks shed unwanted
These developments in the banking sector all coincide with higher
stock market capitalization rates for banks and lower stock return volatility.
Indeed, bank stocks have outperformed the market since 1995, and particularly
during the 2001 recession (see Figure 3); evidently, investors viewed
banks as better positioned than the overall market to flourish in the
Changes in bank regulation
Certain changes in bank regulation during
the 1990s led to changes in bank behavior, and we highlight three of
the most significant initiatives.
Two regulatory initiatives focused on the amount of capital held by banks.
The first, the Basel Capital Accord of 1988, standardized capital requirements
for internationally active banks at 8% of risk-weighted assets. While
the capital standards in the first Accord did not apply to the vast majority
of U.S. banks, the change in regulatory environment did spill over to
domestic bank regulators, putting new emphasis on risk and the varying
capital needed to support portfolios with different exposures.
regulation took on further prominence with the passage of the FDIC Improvement
Act (FDICIA) of 1991, which laid out a list of privileges,
or eligible operations, for banks deemed to be well-capitalized. If a
bank held at least 8% total equity capital, it could engage in operations
such as merger and acquisition activity and securities underwriting,
and it would be eligible for insurance for its brokered deposits. Linked
to FDICIA was the new mandate of prompt corrective action, which required
regulators to shut down any bank with capital ratio below 2%. The key
features of FDICIA were to reduce the scope for moral hazard at the banks
by requiring them to hold more capital and to provide greater incentives
to protect that capital.
Both regulatory changes had a clear impact on
the capital U.S. banks held. For example, Furlong (1992) shows that the
average target capital
ratios for all banks rose from about 7% during the 1985-1989 period to
almost 9% during the 1990-1991 period. This increase was observed for
both large banks, which were more likely to be affected by these regulatory
changes, and for small banks. All of the reported increases were found
to be statistically significant.
The third regulatory initiative was the
passage of the Riegle-Neal Act of 1994, which paved the way for interstate
banking. By 1998, most states
had implemented its provisions. The overall effect of Riegle-Neal was
to provide for the potential of cross-state diversification, which, in
theory, could reduce the variance of bank condition variables, such as
nonperforming loans. The wave of ensuing cross-state mergers in the banking
industry certainly suggest that banks believed there was diversification
Changes in bank supervision
The prudential oversight of the banking system
includes both regulations and ongoing supervision. The major regulatory
changes discussed above
had a major impact on the banking industry and changed important tenets
of banking in the U.S. It is reasonable to assume that such changes also
led to modifications in the supervisory process and in supervisory concerns.
We can gain an insight into some of these potential changes by looking
at supervisory bank ratings. These ratings, like the agency ratings,
are based on an absolute scale and are intended to be comparable over
time. Interestingly, research has shown that both agency and supervisory
rating standards may actually change over time. Blume, Lim, and MacKinlay
(1998) were among the first to report this for the case of the ratings
agencies. They observed that the apparent worsening of U.S. credit quality
in the 1990s was not so much a deterioration in corporate balance sheets
as it was a change in behavior by the ratings agencies. In essence, the
authors estimated a simple model of ratings using data from a given year,
extracted a set of ratings agency standards from the model, and then
applied those estimated standards to data generated in a later year.
They concluded that lower debt ratings in later years were driven in
part by tougher standards.
Studies of this sort have been conducted on
the bank supervisory ratings as well. Berger, Kyle, and Scalise (2001)
suggest that commercial bank
rating standards were "tougher" during the credit crunch of
the early 1990s, and then eased in the expansion. In our own empirical
research, we model supervisory ratings for bank holding companies (BHCs)
during the 1990s. We relate a BHC's supervisory rating to variables such
as the BHC's lagged nonperforming loan ratio, its loan loss reserve ratio,
the capital ratio, return on assets, and its lagged rating. Our results
for the early 1990s match those of Berger, Kyle, and Scalise; moreover,
we find that standards changed again in the late 1990s and early 2000.
Specifically, the actual ratings assigned in the latter period were more
strict than predicted by a model based on empirical ratings standards
from the mid-1990s.
It is important to note that all of these studies
are model-based approaches, so they cannot include the complete list
of variables that supervisors
use to rate banks. However, empirical results suggesting that supervisory
standards can change imply that specific banking outcomes—such as
finding that a bank's nonperforming loan ratio is, say, 2%—have differing
on supervisory ratings at different points in time. This is consistent
with the notion that supervisors adjusted to the new economic and regulatory
environment during the 1990s.
Banking has been thought to be a cyclical business, yet banks
have actually enjoyed excellent performance and health throughout the
last cycle. In
this Economic Letter we have investigated some of the reasons for
this good performance. While we cannot rule out the explanation
1990s and the 2001 recession were relatively tranquil economic
times with no
shocks large enough to destabilize the banking sector, we argue
that the good performance is at least in part due to changes in regulation
and changes in approach by supervisory staff.
|Jose A. Lopez
Berger, A., M. Kyle, and J. Scalise. 2001. "Did U.S. Bank Supervisors
Get Tougher during the Credit Crunch? Did They Get Easier during the
Banking Boom? Did It Matter to Bank Lending?" In Prudential
Supervision: What Works and What Doesn't, ed. Frederic S. Mishkin. Chicago: University
of Chicago Press.
Blume, M., F. Lim, and A. MacKinlay. 1998. "The Declining Credit
Quality of U.S. Corporate Debt: Myth or Reality." Journal of
Finance 53, pp. 1,389-1,413.
Furlong, F. 1992. "Capital
Regulation and Bank Lending." FRBSF
Economic Review 3, pp. 23-33.