Fred Furlong and Simon Kwan

FRBSF Economic Letter 1999-32 | October 22, 1999

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.

Western Banking is a review of banking developments in the Twelfth Federal Reserve District, and includes FRBSF’s Regional Banking Tables. It is published in the Economic Letter on the fourth Friday of January, April, July, and October.

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

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