Good morning. I very much appreciate the invitation to speak to you today. I am especially glad to be here in person. Looking back to pre-pandemic days, there may have been a tendency to take events like this for granted. At least for me, not having had these opportunities for a few years was a reminder of the value of in-person dialogue. So it truly is a pleasure to be with you.
Economic developments over the past three years have been truly extraordinary. I would like to take the opportunity this morning to share some thoughts on the impact of the pandemic on the economy and banking system, how we got to where we are, the resilience banks have displayed during this period, and what I see as some important risks and challenges ahead.
The Pandemic’s Impact on the Banking System
Three years ago next week, many in-person economic activities across the United States essentially shut down because of the pandemic. The U.S. economy entered a recession that was unprecedented for its suddenness and severity. In a single month, between March and April of 2020, the U.S. unemployment rate increased from 4.4 percent to 14.7 percent.1 GDP during the second quarter of that year was about 30 percent below its first quarter level.2 There was every reason to be concerned about how consumers and businesses, including banks, would navigate the crisis.
The monetary and fiscal policy response to the crisis was equally unprecedented. Through measures to support the liquidity and functioning of financial markets, the Federal Reserve’s balance sheet increased in size from $4.3 trillion to $7 trillion in the five months starting March 11.3 Relief measures enacted by Congress in response to the pandemic have totaled $4.6 trillion through yearend 2022.4
Largely as a result of these policy responses, the 2020 recession was severe, but it was brief.
The immediate effects of the pandemic disruptions on banks included a nearly 37 percent decrease in industry net income during 2020. The main cause of the drop in income was a $77 billion increase in credit loss provisions set aside against the expected effects of the pandemic. The other cause was a 54 basis point drop in net interest margin as the yield curve moved abruptly lower and flatter—again directly attributable to the pandemic.
Since 2020, the banking industry has displayed its resilience. Although net interest margins continued to decline in 2021, the industry reported record net income of $279 billion. This was a result of an improving economy that allowed banks to reduce loan loss provisions by about $163 billion compared to 2020.
As the FDIC reported last week in our Quarterly Banking Profile, 2022 net income of $263 billion was lower than in 2021, but continued to exceed the pre-pandemic average. An important development in 2022, which provided a near-term boost to bank income, was the significant increase in interest rates. Interest earned by banks increased faster in 2022 than the interest rates they paid for deposits, and as a result, their net interest margins increased. The net interest margin in fourth quarter 2022 was 3.37 percent, substantially higher than the 2.56 percent NIM in fourth quarter 2021.
Another important contributor to bank earnings in 2022 was strong loan growth. Total loans and leases grew 8.7 percent in 2022, led by 9.7 percent growth in commercial and industrial (C&I) loans, 9.8 percent growth in 1-4 family residential mortgages, and 15.9 percent growth of credit card loans. The growth in C&I loans was noteworthy because it occurred despite a decline in Paycheck Protection Program (PPP) balances. Excluding PPP loans, C&I loans grew 14 percent during the year. Loan growth in 2022 was accompanied by an $83 billion increase in credit loss provisions that drove the reduction in earnings from the prior year.
The earnings environment for banks continued to be supported by favorable credit quality metrics and the generally strong financial condition of the industry. Measures of loan delinquency remain low by historical standards, as 0.73 percent of loans and leases were noncurrent at yearend.5 Capital and liquidity positions remained strong. These support the industry’s ability to absorb unexpected losses and meet credit needs during periods of adversity.
In short, standard metrics of bank performance have proven resilient during the three year period. As of yearend 2022, only 39 banks were on the FDIC’s problem bank list, a record low. There were no bank failures.
Outstanding Risks to the Banking System
So much for the good news. As I will discuss next, risks facing banks remain and new risks have arisen.
First and foremost is the uncertainty about the macroeconomic outlook. There seem to be important trends at work that push the economy in different directions. Maybe that is why there seems to be even less agreement among economists than usual about when the next recession will occur and how severe it will be.
During the last few years, we saw both supply chain bottlenecks and difficulties of employers in finding qualified workers. These trends tended to constrain the supply of goods and services, and that puts upward pressure on prices. At the same time, significant financial support to the economy, both monetary and fiscal, supported the demand for goods and services by consumers, as well as businesses’ ability to profitably employ workers. Higher demand also puts upward pressure on prices.
These developments since the onset of the pandemic contributed strongly to the inflation and interest rate increases that we are now seeing. As the headline inflation rate gradually increased, to a high of 8.9 percent in June 2022,6 the Federal Reserve responded with a tightening of interest rates that is still underway. In less than a year, the interest rate on federal funds has increased from 0.08 percent to 4.58 percent as of February 22, 2023.7
Significant increases in interest rates are expected to reduce business investment demand by increasing the cost of borrowing. This is expected to cool the economy. Historically, episodes of significant tightening of interest rates have often been followed by a recession. And an inverted yield curve, with short-term rates higher than long-term rates, which we now have, also is often followed by a recession. These interest rate trends are an important reason that many economists are forecasting a modest recession sometime in 2023. For example, the February Blue Chip Economic Indicators calls for a 58 percent probability of a recession this year.
Another trend seems to reduce the concern about a possible recession: despite announced layoffs in some industries, many businesses are still hiring workers. The January 2023 unemployment rate of 3.4 percent is the lowest since 1969.8 The shortages of qualified workers in many industries is a major topic of discussion among business leaders.9 These worker shortages seem to represent a structural feature of the landscape that is not going away anytime soon.
So a natural question is: why should we expect a recession when unemployment remains low and many firms continue to search for qualified workers? It is fair to say that the data are presenting mixed signals in a way that is quite unusual.
Uncertainty also exists about the future level and shape of the yield curve. Three years ago this February, just before the pandemic-related shutdowns started, interest rates at all maturities along the Treasury yield curve, from one month to 30 years, ranged between 1 percent and 2 percent. Now (as of February 22), those interest rates range from about 3.9 percent to about 5.1 percent. And as I mentioned, the curve is inverted, with the degree of inversion last exceeded during the period 1978 – 1981.10
Recession uncertainty, inflation, higher and changing interest rates, and structural changes in the economy associated with the increase in remote and hybrid work collectively create a lot of uncertainty for banks. I will discuss a few of the ways these various changes and uncertainties may affect the banking industry.
Interest Rate Risk
The current interest rate environment has had dramatic effects on the profitability and risk profile of banks’ funding and investment strategies. First, as a result of the higher interest rates, longer term maturity assets acquired by banks when interest rates were lower are now worth less than their face values. The result is that most banks have some amount of unrealized losses on securities. The total of these unrealized losses, including securities that are available for sale or held to maturity, was about $620 billion at yearend 2022. Unrealized losses on securities have meaningfully reduced the reported equity capital of the banking industry.
The good news about this issue is that banks are generally in a strong financial condition, and have not been forced to realize losses by selling depreciated securities. On the other hand, unrealized losses weaken a bank’s future ability to meet unexpected liquidity needs. That is because the securities will generate less cash when sold than was originally anticipated, and because the sale often causes a reduction of regulatory capital.11
The increase in interest rates also has had direct effects on banks’ income and expense. In 2022 bank results, we are seeing the typical near-term boost to bank income from higher interest rates as the interest rates banks pay on deposits tend to lag increases in the market interest rates banks receive on loans.
Over time however, as market interest rates increase, banks will likely need to pay more interest to retain their deposits, or accept some deposit outflows. So far, through yearend 2022, we have seen modest decreases in total deposits and modest increases in insured deposits. In aggregate, meaningful deposit outflows have not yet materialized, but banks will need to watch these trends carefully as the interest rate environment evolves.
A complicating factor for banks that hold significant amounts of longer term assets is that increases in market interest rates can cause gradual negative earnings impacts over time. Specifically, assets that were acquired when interest rates were lower are now earning a below-market interest rate. This reduces the net interest margin below what could otherwise be achieved. For that reason, some banks may choose to sell depreciated assets, realize the loss, and replace the sold asset with a new, higher yielding asset.
The bottom line is that planning a bank’s funding and investments in a way that is both prudent and profitable is a complex and challenging task at this time, especially when interest rates change to the extent they have over the past year. The management of interest rate risk is important to all banks and is an area of ongoing supervisory focus at the FDIC.
The various trends and uncertainties regarding the economic outlook, interest rates, inflation and structural changes will likely affect banks’ lending businesses as well. Depending on the business line, effects could range from fairly modest to substantial.
Business lines that could be sensitive to general price inflation could include lending for autos and credit cards. Measures of credit quality in those loan segments turned modestly worse in 2022. Annual auto loan charge-off rates increased 83 basis points to 1.13 percent, and credit card charge-offs increased 87 basis points to 2.50 percent. It would be premature to attribute these trends to the effects of inflation, but it is reasonable to think that cash-strapped consumers could experience greater repayment difficulties as their day-to-day living expenses increase.
Commercial real estate lending, or CRE, and construction and development lending, or C&D, are important business lines for many banks. CRE loans at banks grew 10.7 percent during 2022, and C&D lending grew 16.5 percent. On their face, these may sound like rapid growth rates that could be of concern, especially if we are about to enter a recession. It is important to remember though, that inflation increases the labor and materials costs that banks’ commercial borrowers expect to incur, and therefore increases loan amounts. In real terms, the growth of CRE and C&D lending was slower. The quality of underwriting, and the timing and severity of any future recession, will likely be the key determinants of the performance of these credits. Also, as the increases in interest rates in 2022 make clear, it is important for banks to consider the ability of adjustable-rate borrowers to repay under a variety of interest rate scenarios.
Available data suggests that most commercial property types performed well in 2022. Rents generally increased for industrial, multifamily, and retail properties, and hotel room rates rebounded. The performance for hotel properties was especially encouraging given the difficult conditions for that sector in 2020.12
Structural trends associated with the pandemic are presenting challenges, however, to the office sector. As the economy navigates towards a new normal with respect to remote and hybrid work, the question is whether the need for office space has been permanently and materially reduced.
Since the start of the pandemic, the national average office vacancy rate has trended upwards, from about 9.6 percent at March 31, 2020, to about 12.5 percent as of yearend 2022. As of the fourth quarter of 2022, five major metropolitan areas had office vacancy rates between 15 percent and 20 percent.13
Availability rates are a broader measure of space on the market, as they measure currently vacant space and space tenants are trying to sublet. Availability rates have increased sharply in the past two years and exceeded 20 percent in several major metropolitan areas at yearend 2022.14
Lower occupancy would be expected to reduce the rents and other operating income generated by office properties. At the same time, higher interest rates would be expected to make it more expensive to refinance loans when they come due. Of $152 billion in loans financing office properties that are collateral for commercial mortgage backed securities (CMBS) and that are coming due by 2032, about $56 billion, or 37 percent, are estimated to come due in the next three years. Moreover, in some major metropolitan areas, almost 50 percent of CMBS office loans are set to mature in the next three years.15
The combination of lower operating income generated by office properties and a higher cost of financing, if they persist, would be expected to reduce valuations for these properties over time. Some of the loans financing these properties are whole loans held on the balance sheets of banks, some are syndicated and sold, and many serve as collateral for CMBS. There are early indications that delinquencies on office property in CMBS are starting to tick up.16 The good news is that these default rates remain low at this time. This is an area of ongoing supervisory attention.
Finally, leveraged commercial and industrial loans are another credit category that could be affected by the higher interest rate environment or by a recession, should one occur. The 2022 interagency Shared National Credit Program review found that credit risk associated with leveraged lending remains high. The report noted that many leveraged loans have weak structures that often reflect some combination of high leverage, aggressive assumptions about repayment, or weak covenants.17 While banks hold some leveraged loans, a significant amount of these loans are sold into collateralized loan obligations or CLOs. Most of the securities issued by the CLOs are ultimately held by a variety of nonbank U.S financial firms. Banks do hold some senior securities of the CLO and may have credit exposure to the nonbank entities.
Looking beyond the specifics of CLOs, I think the interconnections between banks and nonbank financial firms, and the risk exposures in times of stress, are a subject that is worthy of urgent attention by U.S. financial regulators.
In conclusion, my purpose today has been to emphasize that, while banks continue to report strong performance and problem banks and failures are few, risks remain on the horizon. Trends stemming from the pandemic have created new challenges for the management of these risks. Banks have benefitted in this respect from strong capital and liquidity positions that allow them to absorb unexpected setbacks while continuing to meet the credit needs of the U.S. economy. Nevertheless, the downside risks are significant and will be a focus of supervisory attention by the FDIC. Thank you for your time.
2 See table 1 at https://www.bea.gov/data/gdp/gross-domestic-product
3 See table 1, page 4 of https://www.federalreserve.gov/publications/files/balance_sheet_developments_report_202008.pdf
5 Noncurrent refers to 90 days or more past due, or in nonaccrual status.
9 See, for example, https://www.uschamber.com/workforce/understanding-americas-labor-shortage-the-most-impacted-industries
10 Specifically, current yields on one- and two-year Treasuries exceed the yield on the ten-year Treasury, with the amount of the excess last being exceeded during 1978-1981. See the Federal Reserve’s H. 15 statistical release cited in footnote 7.
11 For most banks, regulatory capital does not reflect the effect of unrealized losses on available for sale securities. Realizing the loss by selling the depreciated securities therefore causes a decrease in regulatory capital. For the largest banks, the unrealized losses on Available for Sale securities are already reflected in regulatory capital, so selling them and realizing the loss has no effect on regulatory capital.
12 This paragraph is based on data from CoStar
13 The five major metropolitan areas with a vacancy rate between 15 and 20 percent are Chicago, Dallas, Houston, San Francisco, and Washington, D.C.
14 The major metropolitan areas with an availability rate above 20 percent are Dallas, Houston, and San Francisco. This paragraph is based on data from CoStar.
15 This paragraph is based on data from Trepp.