In Focus This Quarter
Economic Conditions and Emerging Risks
in Banking
The U.S. economy has been growing modestly since early 2002; however,
the Business Cycle Dating Committee of the National Bureau of Economic
Research (NBER) said on April 10, 2003, that it needed additional
time to interpret the movements of the economy last year and this year
before it can officially date the economic recovery, which is believed
to have begun sometime in 2002. Notwithstanding the slow growth of the
economy during 2002, insured commercial banks and savings institutions
registered record earnings performance. This article explains the strong
performance of the banking and thrift industries through the 2001 recession
and during this subsequent period of modest economic growth. It also explores
areas in the banking system that are potentially vulnerable because of
the narrow underpinnings of economic growth.
Industry Summary
The U.S. banking industry’s strong performance in the face of modest
economic growth is remarkable. While real gross domestic product (GDP)
increased only 2.9 percent between fourth quarter 2001 and fourth quarter
2002, insured commercial banks and savings institutions registered record
earnings performance. Together, the banking and thrift industries’
net income reached over $105 billion in 2002, the first time that annual
earnings have topped the $100 billion mark. While the 2001 recession contributed
to higher provision expenses in 2002, low interest rates and strong fee
income helped boost bank earnings to record levels.
Higher provision expenses were far outweighed by a large increase in
net operating revenue. The banking and thrift industries’ net operating
revenue increased by almost $39 billion in 2002 over the previous year.
This surge in operating revenue far outweighed the $5.1 billion increase
in loan loss provisions during the year. Within operating revenue, net
interest income increased by $25.2 billion, while noninterest revenue
increased by $13.7 billion despite a decline in revenues associated with
capital market activities.
A historically steep yield curve helped boost the industry net interest
margin (NIM) to a five-year high of almost 4 percent. On top of the almost
18 percent increase in operating revenue year over year, low interest
rates prompted banks to take record gains of over $12 billion on the sale
of securities.
A Strong Consumer and a Weak Corporate Sector
Economic growth since early 2002 has been based largely on consumer spending,
which has been bolstered by gains in aggregate personal income; a widespread
cashing out of home equity; lower monthly debt service as a result of
mortgage refinancing and the consolidation of high-cost debt into low-cost,
tax-favored mortgage debt; overall growth in consumer credit; and fiscal
stimulus. In contrast, the corporate sector has shown little or no progress
in expanding investment spending (see Chart 1)
or employment, thus limiting its contribution to economic growth.
[D]
To date, the banking and thrift industries have largely been spared the
effects of the broader corporate sector weakness for several reasons.
Commendably, the industry has exercised better risk sharing and developed
more diversified income sources than in previous economic downturns. Also,
falling interest rates and the strength of the consumer sector have resulted
in a windfall for banks and thrifts through strong consumer loan growth,
consumer-related fee income, and improved NIMs and income—gains
that more than offset rising provision expenses. With signs that the consumer
sector may be slowing, and given that deposit rates have reached a floor,
the primary question hanging over financial institutions is whether record
earnings performance can continue.
The outlook for industry performance will depend on resolving a number
of outstanding issues, both economic and operational. The following issues
could challenge continued industry strength and earnings growth:
-
an uncertain or
stalled transition from consumer-dependent economic growth to a broader-based
recovery, including business investment;
-
restructuring
and continued difficulties in the corporate sector;
-
vulnerabilities
in certain business models conceived in a stronger economy;
-
an unprecedented
and challenging interest rate environment;
-
corporate governance
issues and associated reputational risks; and
-
increasing operational
risk that, in some cases, has resulted from cost cutting at the expense
of important loss mitigation functions, such as internal audit.
Two Views of Recent Economic Weakness
Assuming that the recovery began sometime in 2002, its unbalanced nature
is not typical in U.S. economic history. Most analysts agree that for
economic growth to gain momentum, a transition must take place whereby
an expanding corporate business sector takes a growth leadership position,
thus compensating for potentially slower gains in consumer spending. Greater
vigor in business investment and inventory accumulation will be major
factors in determining the vitality of U.S. economic growth—and
the direction of insured institution performance—for the remainder
of 2003.
Two views prevail as to why corporate sector growth remains restrained
two full years after the beginning of the 2001 recession. The first view
maintains that a postboom structural overhang, characterized by high corporate
debt and excess capacity, will take years to unwind. The second view maintains
that much of the needed corporate reform and restructuring have been completed
and that transient factors—the threat of terrorism, war in Iraq,
unusually severe winter weather, and, most recently, the outbreak of the
severe acute respiratory syndrome (SARS) virus—caused a temporary
break in hiring (see Chart 2) and investment
in early 2003.
Historically, economic data have been particularly mixed around turning
points, with various signals pointing in different directions. Based on
the admittedly mixed evidence, and barring additional significant negative
surprises, it appears likely that business hiring and investment will
pick up, now that many of this year’s drags on growth have passed
or at least moderated. If this scenario plays out, many of the banking
system’s potential vulnerabilities (discussed below) will recede.
The downside risks are of two sorts. First, the corporate structural
overhang may have further to run; if so, modest increases in business
investment and hiring may not adequately replace faltering growth in consumer
spending. Second, certain geopolitical and global economic factors may
continue to weigh on business confidence, including the potential for
a protracted U.S. peacekeeping, nation-building presence in Iraq; additional
terrorist attacks against the United States; and an ongoing global recession—recently
made worse in some parts of Asia by the SARS outbreak.
Banks Have Thrived in the Consumer-Driven Recovery
GDP growth in 2002 reflected the narrow, consumer-driven underpinnings
of economic activity, as modest contributions to growth from housing and
government last year were offset by rising imports and a weakening in
exports late in the year. Despite the corporate bankruptcies, layoffs,
and erosion of equity market wealth associated with the 2001 recession,
consumer spending expanded in every quarter throughout the past two years.
Personal consumption growth has persisted because of monetary and fiscal
policies that helped, in aggregate, to offset job losses and maintain
household disposable income.
Aggressive monetary policy easing by the Federal Reserve, begun in January
2001, contributed to a dramatic shift in the yield curve from inverted
in 2000 to steep and upward sloping by year-end 2001, and brought short-
and long-term rates down to levels not seen for 40 years. Over most of
the Fed’s latest easing, the month-end spread between three-month
and ten-year Treasury rates averaged roughly 230 basis points. As a result,
on a year-over-year basis during much of 2002, net interest margins widened
among institutions of different asset sizes and banking business models
(including commercial, residential, and consumer lenders). Quarterly NIMs
rebounded quickly during 2001 and steadily improved until fourth quarter
2002. Over the same period, gains in net interest income, resulting largely
from Federal Reserve policy, helped offset rising charge-offs at banks
and thrifts.
Federal Reserve policy achieved its desired effect on consumer demand,
and banks benefited from the response. By taking on new debt and refinancing
existing debt at more favorable rates, households were able, for the most
part, to continue to service growing debt and sustain aggregate demand.
Over the past two years, cash-out mortgage refinancing freed up an estimated
$180 billion for consumers to either spend or save (see Chart
3). Over that period, households also took out an additional $169
billion of consumer debt, according to the Federal Reserve’s flow
of funds data. The growth in consumer indebtedness contributed to insured
institutions adding $375 billion to consumer and mortgage lending in 2002,
accounting for two-thirds of total asset growth.
Mortgage applications increased by 28 percent in 2002, from record-high
levels in 2001, while refinancing activity rose by 36 percent. The booming
mortgage market provided a windfall for banks and thrifts through the
inflow of refinancing and mortgage origination fees. Through May 2003,
mortgage rates continued to hold near historic lows, and the refinance
pipeline remained full. However, analysts’ opinions about the strength
of refinancing activity going forward differ widely. Even if mortgage
rates remain low, many of the mortgages that can be refinanced already
have been. Furthermore, stagnation of home appreciation could dampen demand
for cash-out refinancing, which has been both a driver of consumer demand
and a support for consumer credit quality. Ongoing corporate restructuring
may continue to weigh on employment growth, which also would limit gains
in consumer demand.
Subprime Consumer Credit Quality Remains a Concern
The growth in bank consumer lending has not come without credit costs.
Credit card charge-offs exceeded 6 percent of average balances in 2002
as personal bankruptcy filings topped 1.5 million for the first time.
Despite sharply higher loan losses, credit card lenders earned a combined
return on assets of 3.6 percent and a return on managed assets of 2.3
percent in 2002. Return on equity also has risen for this specialty group,
despite higher capital requirements for certain securitization activities.
In terms of earnings, prime consumer lending specialists, in particular,
generally outperformed the rest of the industry.
A weak job market and a slowing in receivables growth have contributed
to rising charge-offs. Rapid growth of accounts can mask deteriorating
credit quality trends, because new accounts tend to have lower loss rates
than seasoned accounts. A continued slowdown in the growth of credit card
receivables will likely result in higher loss rates. In addition to cyclical
pressures, the wider availability of consumer credit over the past decade
may affect aggregate credit quality adversely.
At the FDIC consumer debt roundtable on February 28, 2003, the extension
of credit to higher-risk borrowers and growth of the subprime lending
industry were discussed as part of a long-term “consumer lending
revolution” that is likely to result in permanently higher loss
rates for many consumer lenders. While higher loss rates, in and of themselves,
are not necessarily an impediment to profitability, the extent to which
some lenders’ credit scoring technology underpredicted losses during
the recession is a concern. For subprime lenders in particular, loss rates
rose more than predicted during the recession, and some lenders were not
prepared for the volatility of loss rates demonstrated by the higher-risk
loan pools. Even rating agencies were taken aback by the extent and velocity
of portfolio deterioration at some credit card lenders.
As of year-end 2002, the FDIC identified 125 institutions as subprime
lenders (with 25 percent or more of Tier 1 capital in subprime loans).
These institutions held $62.8 billion in subprime assets. This level had
declined from two years earlier, when 156 institutions holding $70.3 billion
in subprime assets were identified. The decline, by and large, is the
result of a retrenchment of activity by former subprime lenders, and this
retrenchment has led to an overall decline in the number of problem banks
(defined as institutions rated a 4 or 5). However, some institutions have
remained committed to this business line and have replaced those that
have withdrawn.
Some subprime lenders followed the consumer lending revolution to troubled
bank status (defined as institutions rated a 3, 4, or 5). Although the
number and assets of subprime lenders rated 3, 4, and 5 have declined
since 2000, the volume of subprime assets held by troubled institutions
is higher. Of the 125 institutions identified as subprime lenders, 48
are rated 3, 4, or 5, and the dollar volume of subprime assets held by
these 48 troubled institutions is $26.1 billion. Two years ago, 54 subprime
lenders were rated 3, 4, or 5, and they held $19.9 billion in subprime
assets. The majority of the institutions currently identified as most
susceptible to failure are subprime lenders.
Ongoing Risks in Consumer Lending
Several additional factors could lead to a continued rise in subprime
and prime consumer charge-offs. A continued weak employment picture, unfavorable
bankruptcy reform, and any decline in the “take-out financing”
provided by cashed-out home equity could result in higher consumer loan
charge-offs.
Credit losses aside, some consumer lending business models have been
found inadequate for other reasons in staving off the market and economic
challenges of the recession. Among these business models are those, such
as certain home equity and credit card lenders, that relied heavily on
the securitization market for funding and were, therefore, highly sensitive
to pricing in this market. These institutions were unable to meet liquidity
demands when access to the securitization market became more selective.1
1 Capital market conditions recently resulted in securitization
pricing for one credit card lender that some analysts estimate will cost
as much as an additional $10 million over the life of the transaction
because of current market selectivity.
Other business models relied on the generation of fees from programs
such as the sale of “club” memberships, such as frequent flier
programs, or credit-life insurance. Demand for these products has proved
tenuous, and credit losses at these lenders are cutting more deeply into
total revenue as this source of fee income fades. Finally, some business
strategies have relied on third-party relationships that have given rise
to significant operational risks. In some instances, these relationships
have resulted in reputational and legal risks for the contracting banks;
in extreme cases, they have caused significant fraud-related losses.
Credit card lenders face several challenges in the future that are not
yet reflected in their performance results. Securitization costs are rising,
not only because of market conditions but also as a result of increased
subordination levels. The latter condition resulted from rating agencies’
diminished view of the value of early amortization as a credit enhancement.
Credit card lenders also face generally higher capital requirements for
retained interests in securitizations because of recently enacted regulations
and may face higher requirements under the proposed Basel II capital requirements.
Home equity lending is emerging as another risk area in consumer lending.
The FDIC has previously addressed this issue in its more egregious form—high
loan-to-value lending—but the risks of other forms of home equity
lending may be subtler. Lenders have a tendency to price this product
very thinly because of stiff competition and the perception that home
equity lending will perform similarly to other residential lending; however,
they may find that borrowers behave differently when there is not as much
equity at stake, even if they face a nominal threat of foreclosure. Stagnant
or declining home values in certain markets may exacerbate this effect.
Continued consumer sector strength will depend on the resilience of real
disposable income growth. An active mortgage refinancing market through
May 2003 also bodes well for consumer liquidity, though the extent to
which consumers choose to spend cashed-out equity or reductions in monthly
mortgage payments remains uncertain—they may choose to retire other
debt or increase saving instead. Although new tax rebates, an additional
extension of unemployment benefits, and tax cuts were approved in May,
monetary and fiscal stimuli may not boost consumption growth significantly
during the next six months, especially if households elect to save more
or retire debt, rather than increase spending. Any slowdown in consumption
growth may impede the overall economy’s pace, unless it is offset
by another source of expanding aggregate demand.
Business Spending and Hiring Necessary to the Recovery
In contrast to the robust consumer and banking sectors, contracting corporate
business investment dragged on overall U.S. economic growth throughout
2001 and most of 2002. After nearly a decade of uninterrupted sequential
quarterly growth, aggregate real nonresidential investment has contracted
more than 10 percent over the past two years. In this sense, the 2001
recession can be viewed primarily as a nonfinancial corporate sector recession,
as opposed to the “traditional” recessions that affect consumers,
financial companies, and other businesses more evenly.
Currently, business investment appears to be the most likely replacement
for any slowdown in consumer spending. Residential investment and government
spending are expected to continue growing, but probably not at the higher
rates necessary to compensate for an easing in consumption growth. No
improvement is foreseen in net exports; in fact, the U.S. current account
deficit is likely to continue deteriorating over the near term despite
the dollar’s recent depreciation, as weak final demand abroad may
more than offset lower dollar-denominated prices.
Although the importance of stronger growth in business investment (and
hiring) is clear, there is substantial debate about when the pace of these
activities will pick up. As seen in Chart 4,
equipment and software investment had been recovering modestly last year
but slowed in first quarter 2003. The slowdown, though, was mostly due
to a drop in transportation equipment outlays; technology investment continued
to grow. Meanwhile, the overall decline in business plant and structure
investment seemed to stabilize by early 2003. While the recession-induced
decline in capital equipment spending may be over, a return to strong
growth remains elusive. Much of the needed corporate restructuring may
have occurred already, but the problems of high debt loads, excess capacity,
and slow revenue growth may be slow to abate.
Business Recession Has Hurt Commercial Credit Quality
In contrast to the strong growth of consumer lending, commercial credit
provided by banks and thrifts increased by only $13.8 billion in 2002.
During the corporate sector shakeout that accompanied the recession, more
than 78,000 businesses failed in two years. These bankruptcies contributed
to 229 defaults on almost $197 billion in publicly rated bonds over the
same period.
Banks, particularly large banks, have not been immune to these corporate
credit trends as commercial and industrial (C&I) loss rates increased
during the past few years. Loan losses have been disproportionately borne
by large banks because of poor risk-selection practices during the rapid
syndicated loan growth years of 1996–2000 and high-profile financial
woes brought on by accounting irregularities exposed at a number of formerly
investment-grade companies (“fallen angels”). Recently, the
segment of the industry experiencing worsening credit quality trends has
narrowed. In fact, three large banks accounted for all of the $2.1 billion
increase in losses on C&I loans at FDIC-insured institutions in 2002.
Commercial Credit Problems Likely to Abate
Two trends look promising for commercial credit quality in the near term.
First, C&I charge-offs declined in fourth quarter 2002 by almost 30
percent from a year ago. Second, noncurrent C&I loans (those 90 days
or more past due or in nonaccrual status) fell by $1.2 billion during
the quarter—the first quarterly decline in three years. A continued
improvement in noncurrent C&I loans will help the industry’s
coverage ratio, which has been declining since 1998. C&I losses seem
to follow default rates on noninvestment-grade corporate bonds, suggesting
continued improvement in C&I loan quality this year (see Chart
5). The extent of the improvement in commercial credit quality will
be evaluated during the 2003 Shared National Credits (SNC) Review by the
three federal bank regulatory agencies. Results for the 2003 review should
be available by September.
Credit Implications of Corporate
Sector Restructuring
In addition to the
rash of corporate defaults and bankruptcies during this period of restructuring,
other businesses have been downsizing, reducing their workforces in response
to strong domestic and foreign competition and lackluster sales growth.
Reducing workforces has raised productivity levels and helped to maintain
profits, but it has also idled large amounts of plants and equipment.
Industrial capacity utilization tumbled precipitously from May 2000 through
December 2001, falling from 83.6 percent to 74.6 percent, mostly as a
result of weakness in manufacturing. Although capacity use rose somewhat
in early 2002, that gain was short-lived. As a result, April 2003 overall
capacity utilization of 74.4 percent was little changed from the December
2001 rate. Reduced
workforces and lower capacity utilization (as well as historically lean
inventories) have implications for commercial real estate (CRE) and potential
C&I loan growth. Because the recession caused demand for working capital
to diminish, commercial loan demand declined also. As a result, although
total loans at commercial banks have grown steadily for the past few years,
the percentage of C&I loans to total loans has been declining. Historical
precedent suggests that C&I loan demand will remain lackluster so
long as capacity utilization remains low and corporate profit growth lacks
traction.
In addition, the effects
of corporate restructuring have been reverberating through the CRE markets,
resulting in continued upward pressure on office vacancy rates and unprecedented
negative net absorption. Throughout this period of corporate restructuring,
many property owners have been confronted by tenants demanding lower rents
and who are scrambling to pare back holdings of office, industrial, apartment,
retail, and other space. But in spite of the weaknesses in CRE market
fundamentals, CRE credit quality at insured institutions has remained
sound. Past-due loans and charge-offs remained at near-record lows through
year-end 2002 for each of the three commercial real estate loan categories:
construction and development, multifamily, and nonfarm-nonresidential
(see Chart 6).
A number of factors
may explain the disconnect between market fundamentals and banks’
CRE credit performance. In contrast to the CRE downturn of the late 1980s
and early 1990s, the current situation is due mostly to rapidly diminished
demand rather than to oversupply. While many landlords have had to accept
static or lower rents to remain competitive in attracting and retaining
tenants, few have found this situation to be a major hindrance to net
cash flow, largely because the low interest rate environment has enabled
property owners to refinance existing CRE loans at lower rates.
The stronger performance
of CRE loans at banks and thrifts in this cycle is due also to the fact
that risk has been spread more widely through the tremendous growth in
commercial mortgage-backed securities (CMBS) and real estate investment
trust (REIT) activity since the last cycle. Growth in these aspects of
public real estate markets has enhanced transparency and public scrutiny
of CRE fundamentals. In addition, increased regulator oversight and tighter
CRE lending requirements may have improved the underlying credit quality
since the last cycle.
Several issues regarding
commercial real estate warrant continued monitoring, however. Many properties
that had been under construction are now coming on line, and for those
that had leases executed during the boom period of two years ago, the
full effect of the decline in market rents has yet to be felt. The cash
flows generated by these newly completed properties could be considerably
less than was anticipated when the original construction, or takeout,
financing was arranged. Similarly, as existing leases on occupied properties
come up for renewal, landlords face the prospect of tenants returning
unused space or requesting rent concessions. In addition, sublease space
exerts downward pressure on market rents as overextended tenants seek
to exit properties by finding substitute tenants to assume their leases
at less than market rents.
The extent to which
low rates have kept weak CRE market fundamentals from affecting banks’
credit quality will be tested if rates rise before the demand for space
improves, and some analysts envision a corporate restructuring process
that could result in just such a scenario. Corporate restructuring may
continue to push the work of some firms offshore, especially labor-intensive
businesses and those with minimal product shipping costs, such as software
companies. This scenario could be accompanied by rising interest rates
without a recovery in the demand for industrial space.
An additional concern
that affects both CRE and non-real estate-related commercial lending is
larger companies’ lack of pricing power. The recent slow economic
growth has limited the ability of larger companies, especially those that
face international competition, to raise prices. A global recession and
slack capacity worldwide in many industries has engendered significant
disinflationary (and outright deflationary) trends in recent years. In
the absence of strong revenue growth, income growth has become dependent
on cost control. As a result, large companies have been seeking price
reductions from other businesses down the supply chain. For example, the
major auto manufacturers have recently pressed their parts and assembly
suppliers for price concessions. It is likely that pricing pressures will
continue to be passed down, affecting revenue at mid- and small-sized
businesses. This could, in turn, affect the credit quality of the smaller
financial institutions that lend to these companies.
Other Emerging Risks in Banking
Market-Sensitive Revenues
Diversification of
revenue streams has been noteworthy industrywide, with noninterest income
continuing to grow as a percentage of net operating revenue. While such
strategies have produced lower earnings volatility for many institutions,
this has not been the case for some of the largest financial companies
because of heavy reliance on market-sensitive revenues. Some institutions
have experienced highly volatile earnings over the past two years, largely
because of investment banking, merchant banking, and proprietary trading
activities. For example, weak and volatile financial markets led to losses
in private equity funds and venture capital activities totaling $1.2 billion
for commercial banks during 2002. Significant declines in trading revenues
were also seen last year, particularly at the seven largest banking organizations.
Even trust management revenue—a former stalwart—has declined
as a result of the prolonged bear market. In total, market-sensitive revenue
for commercial banks declined by almost $1.7 billion from 2001 to 2002.
Interest Rate Risk
In 2002, the historically
steep yield curve helped boost the industry’s net interest margin
to a five-year high of almost 4 percent. The significant decline in short-term
rates, prompted by a series of cuts in the federal funds rate starting
in January 2001, contributed to a dramatic shift in the yield curve from
inverted in 2000 to steep and upward sloping by year-end 2001. A steeply
upward sloping yield curve has persisted since then, although the spread
between ten-year note and three-month Treasury bill yields narrowed from
nearly 350 basis points in early 2002 to 234 basis points by May 20, 2003.
This easing of longer maturity yields was the result of emerging concerns
over the U.S. economy’s near-term economic growth prospects, as
well as expectations of further rate reductions by the Federal Reserve.
In addition to the
generally favorable aggregate industry NIM through 2002, NIMs widened
among institutions of different asset sizes and banking business models
(including commercial, residential, and consumer lenders). Nevertheless,
one area of concern arises in an examination of the recent trend in the
industry’s median NIM (that of a typical institution). This measure
of NIM contracted in fourth quarter 2002 (see Chart
7).
The fourth quarter
2002 narrowing in median NIM suggests that the benefit derived from low
short-term rates may have run its course and that many banks are finding
significant resistance to lowering funding costs any further. The historically
low level of short-term rates has led to a complex interest rate risk
environment in which various banks are exposed to potentially adverse
interest rate scenarios. Recent FDIC analysis has found that relationships
between NIM performance and rates appeared to be stronger in past higher-rate
environments, but recently that link has started to break down as rates
have fallen below a certain point.
At this stage of the
rate cycle, banks with the highest percentage of very low cost funding
appear to be most at risk, from a net interest income perspective, to
a falling or even stable rate environment. This is because funding that
is already not rate-sensitive will not get cheaper, no matter how long
low rates persist. In fact, the longer low rates persist, the more likely
it is that the yield on assets of these banks will fall without an offsetting
decline in funding costs. The risk of lower asset pricing was highlighted
by the renewed flattening of the yield during May 2003.
Even larger banks
(which, because of a higher percentage of market-based funding, reaped
the benefit of low short-term rates sooner than smaller institutions)
have not been immune to the magnitude of the rate decline. Large-bank
assets are currently repricing downward more quickly than funding costs
(see Chart 8).
As
shown in Chart 8, the effective federal funds rate has declined steeply
since 2001, almost to the average level of retail certificates of deposit
(CDs) and bank money market rates by early 2003. (The retail CD and bank
money market average rate provides a proxy for deposit costs.) As a result,
new money that flows into some banks may be invested at a loss, at least
initially, because the narrow spread between estimated deposit costs and
the effective federal funds rate (interest paid on bank-invested overnight
funds) may not cover operating expenses. Therefore, some banks face margin
compression in the current low interest rate environment as higher-yielding
loans and securities reprice at lower rates, while funding costs seemingly
have reached a trough.
In addition, more
positively sloped yield curves have historically induced some banks to
take on additional risks. Banks took a record $12 billion in securities
gains in 2002. If these securities were not sold to meet loan demand,
replacing them with lower-yielding assets may dampen future profitability.
Moreover, flush with deposits and challenged for loan growth, banks tend
to reach for yield in their securities portfolios by extending maturities
and, in some cases, increasing the complexity of their securities portfolio
and, more recently, their liability structure.
A further flattening
of the yield curve could result in a greater narrowing of NIMs for banks
with high concentrations of long-term assets. While measures of such concentrations
have stabilized during the past few years, residential mortgage lenders
continue to report higher levels of long-term assets as a result of the
recent refinancing wave.
The interest rate
risk positions of banks with high concentrations of long-term assets likely
will result in NIM compression if short-term interest rates rise. Following
the 1998 refinancing wave, some banks were left with high concentrations
of long-term assets, which typically expose institutions to a rise in
short-term interest rates. From mid-1999 through 2000, short-term interest
rates rose relative to long-term rates (the yield curve flattened), and
banks with higher concentrations of long-term assets reported weaker NIM
performance than those with lower concentrations of long-term assets (see
Chart 9).
From first quarter
1999 through 2000, banks with high concentrations of long-term assets
reported a decline in the median NIM of 15 basis points, compared with
an increase of 23 basis points for banks with low levels of long-term
assets. This situation reversed in 2001, as banks with high levels of
long-term assets began to benefit from steepening in the yield curve.
However, if short-term interest rates rise following the current refinancing
wave, as they did after the 1998 wave, this group of banks again could
experience greater compression in NIMs than other banks. The banks with
the highest levels of long-term assets are centered in the Northeast and
on the West Coast.
Reputational and Legal Risks
Certain institutions
have received heightened scrutiny over their dealings with companies such
as Enron and Worldcom, as well as over their past investment banking activities.
The reputational damage caused by negative media coverage of these issues
is difficult to measure.
However, lapses in
corporate governance could result in direct losses in the form of increased
legal costs, damages from investor lawsuits, and regulatory fines. According
to Donald Langevoort of the Georgetown Law Center, a likely estimate of
eight banks’ scandal-related exposure to investor lawsuits alone
is close to $20–$25 billion.2 Any investor litigation
is likely to be a protracted affair—taking years, not months—and
this cost may be spread over a long period. However, according to one
large-capitalization banking analyst group, noninterest expenses as a
percentage of net operating revenue for the largest financial institutions
was as much as 780 basis points higher in the fourth quarter of 2002 as
a result of legal expenses.3 The ultimate result could be legal costs
amounting to four times more than what the largest financial companies
have reserved for so far. According to some analysts, some banks may be
reluctant to reserve for potential damages because they believe that a
provision for lawsuits could be viewed as an invitation to sue.
2 Prudential Financial
Research, Lawsuits Against Banks, January 14, 2003, p. 12.
3 FBR Financial Services
Research, Bank & Finance Weekly, January 15, 2003, p. 5.
In addition to legal
expenses, banks may find that reputational and legal risk, and the associated
uncertainty surrounding ultimate payouts, results in higher market funding
costs. As news of progress or regress in lawsuits is released or even
speculated about, bond spreads for the companies involved will likely
become more volatile, and they may find it difficult to raise additional
equity should they need it.
Internal Controls
The cost to generate
each dollar of revenue at insured institutions (the efficiency ratio)
declined substantially in the past decade, from almost 76 cents at year-end
1990 to almost 56 cents at the end of 2002. Some of this decline reflects
benign or even positive factors, such as consolidation benefits and lower
loan workout costs. However, bank supervisors are concerned that some
of this improved efficiency may have come at the expense of internal controls
or other important loss mitigation functions, such as internal audit.
For this reason, bank supervisors have intensified review of efforts to
detect and reduce suspicious activities at banks.
Increased reporting
of suspicious activities, anecdotal evidence from recent Reports of Examination,
and the nature of enforcement actions brought against banks in the last
year suggest that bank supervisors have brought significant resources
to bear on these issues. From the perspective of the deposit insurer,
these are resources well-spent. Since 1997, fraudulent activity and accounting
irregularities have resulted in the greatest losses to the FDIC. Of the
35 failures since 1997, 22 involved fraudulent activity or accounting
irregularities. The weighted average loss rates where fraud or irregular
accounting has been indicated as a significant contributing factor to
the failure is 37 percent-more than twice the average loss rate for similar
size institutions since 1986. These failures cost the insurance funds
almost $2 billion, or 86 percent of the total cost to the funds since
1997.
Richard Austin, Senior Financial Economist
Alan Puwalski, Senior Policy Analyst
Regional Outlook Information
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