Profits and Balance Sheet Developments at U.S. Commercial Banks in 2007

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William Bassett and Thomas King, of the Board's Division of Monetary Affairs, prepared this article. Thomas C. Allard assisted in developing the database underlying much of the analysis. Adina Goldstein and Oren D. Ziv provided research assistance.

The U.S. commercial banking industry faced significant challenges in 2007, including continued deterioration in the performance of subprime mortgage-related assets and a more general reassessment by investors of structured finance instruments. Those developments contributed to significant strains in financial markets and dislocations in bank funding markets over the second half of the year. Moreover, economic growth slowed late in the year, and the outlook for 2008 worsened. The turmoil in financial markets hampered banks' securitization programs and their ability to syndicate leveraged loans, which put considerable pressure on the balance sheet capacity and liquidity positions of some banks. Profitability--especially in the final quarter of 2007--fell noticeably from the very high levels posted in recent years (figure 1). The drop in profits, reflecting primarily lower trading revenue and significantly higher provisions for loan losses, was more pronounced at large banks, but the net income of smaller banks also declined markedly.

Financial markets came under considerable pressure in 2007. Problems that were mostly contained within the markets for subprime mortgages and related structured products in the first half of the year intensified around midyear. In turn, the deepening troubles in subprime mortgage credit quality caused investors to become increasingly concerned about the likely performance of even highly rated securities backed by subprime mortgages. Furthermore, investors reassessed the soundness of many structured financial products not backed by residential mortgages, including asset-backed commercial paper and collateralized loan obligations. Those developments, along with emerging worries about the economic outlook, contributed to a broad-based reduction in investors' appetite for risk over the second half of the year. As a consequence, the markets for some types of structured investment products virtually dried up by year-end, and the prices of such securities dropped, events that generated large losses at some banks and financial institutions. Yields on both investment-grade and speculative-grade corporate bonds increased, while those on Treasury securities fell because of easier actual and expected monetary policy as well as heightened demand for safer assets (figure 2). Equity prices dropped over the second half of the year, and volatility in many financial markets increased.

Despite the deterioration in housing-related markets and emerging financial strains, the U.S. economy generally performed well through the first three quarters of 2007. However, economic growth weakened considerably in the fourth quarter as pressures in financial markets worsened, the downturn in the housing market intensified, and prices for crude oil and some other commodities rose. Consumer spending and business investment, which had both increased at a healthy pace, on balance, over the first three quarters of the year, slowed, which contributed to reduced demand for credit from households and businesses. Late in the year, consumer sentiment worsened, and forward-looking indicators of business spending also became less favorable. The weakening outlook added to concerns about asset quality at banks. Measures of overall consumer price inflation stepped up in 2007, but core inflation (which excludes the direct effects of movements in energy and food prices) was little changed on balance. With downside risks to economic growth increasing, and with monetary policy makers generally expecting inflation to moderate somewhat in 2008 and 2009, the Federal Open Market Committee substantially eased the stance of monetary policy in late 2007 and early 2008.

The difficulties in financial markets, together with the ongoing weakness of the housing sector, had significant effects on bank balance sheets, especially over the second half of the year. As the residential real estate market contracted and banks tightened their credit standards, the growth of residential mortgages on banks' balance sheets slowed dramatically from the rapid rates posted between 2002 and 2006. At the same time, credit and liquidity concerns reduced institutional investors' willingness to participate in the syndicated loan market. Large commercial banks, which had underwritten a record volume of such loans in the first half of the year, primarily to finance leveraged buyouts, found themselves unable to place these loans in the market. Commercial and industrial lending at those banks expanded rapidly for a time as loans intended for syndication ended up on banks' books. At least partly in response to these unexpected additions to assets, banks sold U.S. Treasury and agency securities and tightened standards and terms on many types of loans.

These balance sheet pressures, coupled with uncertainty about the size and distribution of losses on subprime mortgages and structured financial products, also strained short-term bank funding markets. The Federal Reserve responded to the financial turmoil with a series of actions to support liquidity and functioning in bank funding markets (partly in coordination with foreign central banks).¹ Core deposits continued to grow relatively slowly. As spreads on interbank borrowing widened (figure 3), banks increasingly funded asset expansion with managed liabilities, including Federal Home Loan Bank (FHLB) advances, foreign deposits, and, late in the year, large time deposits.² Some large banks also received substantial cash infusions from their parent holding companies.

Financial and economic developments contributed to the decline in the profitability of the banking industry last year after a long period of very strong performance. As a consequence of the difficult conditions in financial markets, several large banks experienced sharp reductions in trading revenue. Solid revenues from investment banking activities and private asset-management businesses were insufficient to offset those decreases, and total non-interest income declined in 2007. Profitability was also depressed by a stepped-up rate of loss provisioning--which had been at very low levels--in response to an across-the-board worsening of asset quality. In addition, non-interest expense grew briskly last year despite a slight deceleration in employee compensation. Moreover, the declines in market interest rates and higher credit spreads observed in many sectors over the second half of 2007 were inadequate to boost the industrywide net interest margin, which continued its longer-run slide last year.

The number of new commercial banks chartered edged down in 2007, and the average size of such banks declined considerably from that of the previous two years. Merger activity also dipped last year but still outpaced bank formation. As a result, the number of banks declined further, to about 7,300 at the end of 2007 from about 7,450 at the end of 2006 (figure 4). The share of assets held by the top 10 banks increased further, reaching 53 percent at the end of 2007, and the share of assets held by the top 100 banks rose to 80 percent. According to the Federal Deposit Insurance Corporation, two banks with assets totaling $100 million failed in 2007.

The formation of new bank holding companies (BHCs) increased for the second consecutive year in 2007 and was the highest in several years. Mergers among BHCs also moved up last year, and the rate of mergers continued to exceed the rate at which new BHCs were formed. The number of BHCs thus edged down to about 5,070 from about 5,100 in 2006 (for multitiered BHCs, only the top-tier organization is counted in these figures). The number of financial holding companies held fairly steady in 2007 at about 640.³ The share of BHC assets that were held by financial holding companies was unchanged in 2007 at 86 percent.

Balance Sheet Developments

Balance sheet developments in 2007 were influenced importantly by the turbulence in financial markets in the second half of the year. The turmoil exerted pressure on both the asset and liability sides of banks' balance sheets, as banks found markets less receptive to sales of loans and securities and faced funding markets that were, at times, illiquid. Together with the softening macroeconomic picture, these disruptions led banks to become more cautious in the extension of credit and to take steps to bolster capital positions.

Total bank assets expanded 10.8 percent in 2007, down somewhat from the previous year but still strong by historical standards (table 1); indeed, the growth rate easily outpaced that of total domestic nonfinancial debt. And, excluding the conversion of one commercial bank to a thrift institution in the first quarter, bank assets grew even faster--11.9 percent. Loans expanded at about the same rate as assets, primarily because of rapid growth in commercial and industrial (C&I) lending. The demand for C&I loans was spurred, in part, by vigorous capital investment and financing for mergers and leveraged buyouts (LBOs) in the first half of the year. In the second half, the deterioration in credit markets caused C&I loans that had been intended for syndication to accumulate on banks' balance sheets. Residential mortgage lending slowed amid the contraction in home sales and the continuing decline in house prices, and lending in the commercial real estate market also decelerated late in the year. In contrast to the rapid pace of overall lending, banks' securities holdings expanded relatively slowly, a development that was likely a result, in part, of efforts to ease the pressures on balance sheets. Other types of bank assets expanded rapidly in 2007, as commercial banks were net providers of liquidity during the financial turbulence; in particular, short-term loans to financial institutions--in the form of federal funds sold, securities purchased under resale agreements, and balances due from depositories--increased 29 percent over the year.

1. Change in balance sheet items, all U.S. banks, 1998-2007

Percent
Item	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007	MEMO Dec. 2007 (billions of dollars)
Assets	8.21	5.47	8.78	5.13	7.23	7.25	10.80	7.79	12.36	10.81	11,077
Interest-earning assets	8.19	5.91	8.67	3.97	7.58	7.35	11.31	8.04	12.45	10.12	9,569
Loans and leases (net)	8.73	8.13	9.25	1.83	5.93	6.60	11.23	10.48	11.97	10.58	6,473
Commercial and industrial	12.96	7.90	8.55	-6.72	-7.39	-4.52	4.37	12.54	11.81	20.38	1,362
Real estate	8.03	12.28	10.76	7.95	14.49	9.78	15.44	13.81	14.94	7.03	3,634
Booked in domestic offices	8.01	12.42	11.04	8.03	14.90	9.69	15.11	13.93	15.05	6.77	3,565
One- to four-family residential	6.39	9.73	9.29	5.71	19.92	10.05	15.76	11.95	15.11	5.54	1,995
Other real estate	10.34	16.16	13.34	10.97	8.85	9.22	14.24	16.62	14.96	8.37	1,570
Booked in foreign offices	8.79	6.28	-1.62	3.97	-7.41	15.74	35.59	7.19	8.79	22.76	69
Consumer	.38	-1.47	8.05	4.17	6.60	9.77	10.17	2.80	6.19	11.67	948
Other loans and leases	13.50	7.19	7.01	-2.00	-.02	8.31	3.57	-.17	3.17	12.85	619
Loan-loss reserves and unearned income	3.10	2.40	8.00	13.17	5.82	-2.48	-4.18	-5.56	1.66	27.63	90
Securities	8.45	5.14	6.39	7.26	16.28	9.46	10.59	2.40	11.53	4.57	2,195
Investment account	12.11	6.71	2.89	8.92	13.60	8.73	6.17	1.19	6.94	-4.42	1,562
U.S. Treasury	-25.05	-1.87	-32.71	-40.23	41.93	14.14	-15.87	-17.59	-19.30	-26.90	29
U.S. government agency and corporation obligations	17.03	1.87	3.81	12.90	18.15	9.70	9.48	-1.82	4.71	-12.13	893
Other	27.02	20.93	13.41	12.19	2.81	6.04	3.03	10.12	13.78	10.72	639
Trading account	-13.32	-6.93	37.16	-3.72	36.32	14.01	36.81	7.96	31.32	36.13	633
Other	3.80	-8.35	10.33	13.04	-2.92	6.86	14.29	5.99	19.29	22.34	901
Non-interest-earning assets	8.39	2.66	9.46	12.79	5.14	6.65	7.61	6.21	11.80	15.36	1,509
Liabilities	8.09	5.61	8.60	4.47	7.17	7.31	9.57	7.80	12.10	10.79	9,941
Core deposits	7.08	.27	7.56	10.56	7.62	7.32	8.27	6.41	5.84	5.48	4,721
Transaction deposits	-1.38	-8.93	-1.28	10.22	-5.11	2.84	3.25	-1.19	-4.28	-1.21	695
Savings deposits (including MMDAs)	18.35	6.71	12.53	20.69	18.51	13.71	11.73	6.94	5.53	3.33	2,995
Small time deposits	.59	-.70	7.24	-7.21	-4.85	-6.67	1.61	12.90	16.97	18.00	1,031
Managed liabilities1	9.45	15.55	8.79	-2.71	5.38	7.09	12.07	12.26	19.45	16.58	4,550
Large time deposits	9.14	14.24	19.39	-3.64	5.18	1.84	21.89	23.00	15.95	1.92	1,024
Deposits booked in foreign offices	8.71	14.60	7.84	-10.92	4.49	12.63	16.84	6.32	29.67	25.86	1,502
Subordinated notes and debentures	17.00	5.07	13.98	9.56	-.59	5.08	10.49	11.42	22.60	16.83	174
Gross federal funds purchased and RPs	4.38	1.57	6.49	5.74	12.76	-8.70	8.40	15.62	9.47	7.06	744
Other managed liabilities	15.66	35.29	1.80	-.28	1.00	22.11	1.37	6.15	18.89	28.44	1,106
Revaluation losses held in trading accounts	3.44	-13.20	7.47	-17.06	33.44	14.02	-12.61	-17.86	6.89	42.20	205
Other	12.74	-1.25	20.63	14.92	5.24	5.30	17.19	-.82	22.34	3.35	465
Capital account	9.58	3.92	10.68	12.32	7.87	6.69	23.15	7.73	14.69	10.96	1,136
MEMO
Commercial real estate loans2	11.40	15.52	12.19	13.11	6.86	9.02	13.97	16.87	14.91	9.21	1,578
Mortgage-backed securities	22.14	-3.33	3.30	29.06	15.60	10.14	13.45	2.07	10.22	-1.24	960
Federal Home Loan Bank advances	n.a.	n.a.	n.a.	n.a.	17.30	3.71	3.74	10.00	29.80	30.62	455

Note: Data are from year-end to year-end and are as of April 16, 2008.

1. Measured as the sum of large time deposits in domestic offices, deposits booked in foreign offices, subordinated notes and debentures, federal funds purchased and securities sold under repurchase agreements, Federal Home Loan Bank advances, and other borrowed money.  Return to table

2. Measured as the sum of construction and land development loans secured by real estate; real estate loans secured by nonfarm nonresidential properties or by multifamily residential properties; and loans to finance commercial real estate, construction, and land development activities not secured by real estate.  Return to table

n.a. Not available.

MMDA Money market deposit account.

RP Repurchase agreement.

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On the liability side of the balance sheet, growth of core deposits remained moderate. In the autumn, banks attracted small time deposits by maintaining relatively high rates, on average, on such deposits while other short-term yields were falling, but these inflows were partly offset by the continued sluggish growth of savings deposits (including money market deposit accounts). Given the relatively rapid growth in assets, banks turned to managed liabilities for funding. Moreover, in response to the pressures in funding markets, banks increased their reliance on FHLB advances and subordinated debt late in the year.

Banks' capital expanded at about the same pace as assets. The rise in equity capital was supported by increased goodwill but was hampered by meager retained earnings. Regulatory capital, which excludes goodwill, grew somewhat more slowly than equity capital and assets, and regulatory capital ratios edged lower. A number of large institutions received sizable cash injections from their parent holding companies, which helped maintain capital ratios. As asset quality deteriorated late in the year, many banks significantly boosted loan-loss reserves.

Loans to Businesses

C&I loans grew 20 percent during 2007. For most of the year, this growth was supported by robust fixed investment and merger and acquisition (M&A) activity at nonfinancial corporations. Solid growth of capital expenditures contributed to a large financing gap, especially as corporate profit growth slowed late in the year (figure 5).


d

As conditions in credit markets tightened, the pace of capital accumulation and new borrowing slowed. Meanwhile, with conditions in the syndicated loan market also deteriorating, some large banks were forced to retain on their balance sheets a considerable amount of loans that were originally intended for syndication, many of which were extended to finance LBOs (see box "Market for U.S. Leveraged Syndicated Loans"). As the economic outlook weakened and banks tightened their credit standards, commercial real estate (CRE) lending, particularly for construction and land development, slowed somewhat from the rapid growth of recent years.

 

According to respondents to the Federal Reserve's quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices (BLPS), demand for C&I loans softened steadily throughout the year as the economic outlook deteriorated (figure 6). Banks that experienced weaker C&I loan demand generally pointed to decreased needs by businesses to finance M&A activity and to fund investments in inventories and in plant and equipment. Despite the reported weakening in demand for C&I loans, growth in such loans was evident at commercial banks of all sizes, although it was particularly concentrated among the largest institutions, which are the most active participants in the syndicated loan market.⁴ Meanwhile, some firms drew upon previously arranged backup lines of credit with commercial banks as debt markets tightened, a move that further boosted the volume of C&I loans on banks' balance sheets.

In light of the rapid growth of syndicated lending, and the considerable extent to which such lending was used to finance large LBOs and M&A activity, the July 2007 BLPS queried banks about their participation in the syndicated loan market. About one-half of domestic respondents indicated that syndicated loans accounted for 5 percent to 20 percent of the C&I loans on their books, but a few large institutions noted that syndicated loans accounted for more than 50 percent of their C&I loan portfolios. Most survey participants indicated that only a small fraction of the syndicated loans on their books were originated to finance LBOs. Indeed, nearly two-thirds noted that LBO-related syndicated loans accounted for less than 5 percent of the syndicated loans on their books, which probably reflected the concentration of this activity within a few large banks and the tendency of these banks to place large portions of LBO-related syndications with institutional investors.

The accumulation of previously underwritten C&I loans may have been offset to some degree by a growing reluctance to make new C&I loans in the second half of the year. In the first- and second-quarter BLPS, a majority of banks reported no change in their underwriting standards for C&I loans. However, as concerns about financial market conditions mounted and the allocation of syndicated loans to investors became difficult during the second half of 2007, significant net fractions of respondents tightened their credit standards and terms on C&I loans.

CRE loans expanded 9.2 percent last year, down from the very rapid rates posted over the previous three years. The slowdown was widespread but was somewhat more pronounced at the largest institutions. For 2007 as a whole, CRE lending was supported by growth of construction and land development loans, which accounted for more than one-third of all CRE loans at the end of the year (figure 7). However, the growth in this category of CRE loans, which includes loans to residential real estate developers, slowed in the second half of 2007 along with housing market activity. Real estate loans backed by nonfarm nonresidential structures, the largest category of CRE loans, grew at a pace somewhat below its recent average, and CRE loans secured by multifamily dwellings also expanded somewhat more slowly than in 2006. Smaller banks maintained the relatively high concentrations of CRE lending that they had built over the past two decades (figure 8).⁵

The lower growth rate of CRE loans in 2007 appears to have reflected a moderation in demand and a reduction in supply, trends that began in 2006 but accelerated last year (figure 9).

Banks responding to the BLPS indicated that demand for CRE loans weakened steadily throughout 2007. On the supply side, a notable fraction of survey respondents reported a tightening in their credit standards for CRE loans over the period. Terms on CRE loans were also tightened, with many banks requiring higher loan-to-value and debt-service-coverage ratios. The move toward a more stringent lending posture was likely due, in part, to the effect of the softening economic outlook on the expected credit performance of CRE loans. In addition, banks may have been concerned about deteriorating conditions in the market for commercial mortgage-backed securities (CMBS). Amid the broad reassessment of the risks associated with structured financial products, investors in CMBS retreated from the market, spreads moved significantly higher, and issuance dried up.

Loans to Households

Pressures in the housing market, including outright declines in home prices in some areas, continued to affect bank lending to households last year (figure 10). In response to the easing of monetary policy that started in September, mortgage rates moved down over the remainder of 2007, and refinancing activity increased somewhat (figure 11). Nevertheless, the severe drop in home sales weighed on residential mortgage lending, and turmoil in credit markets during the second half of 2007 impaired securitizations of nonconforming mortgages. Overall, the value of mortgages on banks' books grew just 5.5 percent last year; excluding the aforementioned conversion of a large bank to a thrift charter, the growth rate was 9.3 percent, still the lowest rate of increase since 2001.

The slowdown in residential real estate lending stemmed from both weaker demand and tighter credit standards. In the BLPS survey conducted during the first quarter of 2007, considerable net shares of respondents reported reduced demand for residential mortgages.⁶ Beginning in the second quarter, banks were asked to report separately on changes in demand and credit standards for prime, nontraditional, and subprime mortgages. In the year's remaining surveys, large net percentages of banks reported weaker demand in all three loan categories and indicated that they had tightened their credit standards for all three types of residential mortgages. Not surprisingly, the tightening was especially pronounced for nontraditional and subprime products, although only a small number of banks reported that they originated subprime loans during that period.

In contrast, consumer loans on banks' books expanded 11.7 percent in 2007, almost double the pace in 2006. Credit card loans grew 10 percent overall, but growth was faster at large institutions, where such lending is concentrated. Growth in other consumer lending was even more rapid. The pickup in consumer lending in the past two years might reflect, in part, a substitution away from cash-out refinancing, as softer home prices have made such refinancing a less viable option for some households. Nevertheless, most banks surveyed in the BLPS reported a weakening of demand for consumer credit in 2007. In addition, as the outlook for household credit quality deteriorated, banks significantly tightened their lending standards for non-credit-card consumer loans (figure 12). According to the BLPS, the net percentage of banks reporting tighter standards for such loans reached its highest level on record in the fourth quarter. In contrast, standards and terms for credit card loans changed little, on net, during 2007.

Other Loans and Leases

Other loans and leases grew 13 percent during 2007. Lending to state and local governments grew robustly again in 2007, perhaps because of continued strong growth in construction activity. Agricultural loans expanded at a pace slightly below that of the preceding two years, as originations in this category ticked down for most loan purposes.⁷ The remaining components of other loans, such as lease financing receivables and loans to purchase and carry securities, were about flat last year.

Securities

After growing at an average rate of about 10 percent over the previous five years, overall holdings of securities at commercial banks rose just 4.6 percent last year. Growth in securities was particularly weak in the second half of 2007, an indication that the slowdown likely resulted, in part, from banks' efforts to offset rapid growth elsewhere on their balance sheets. At the same time, banks shifted securities out of investment accounts and into trading accounts; some of that shift is traceable to a few large institutions that adopted new rules on fair value accounting, which led to the reclassification of certain types of securities (see box "New Rules on Fair Value Accounting"). Holdings of investment account securities declined 4.4 percent, as banks of all sizes sold government-backed mortgage pools and collateralized mortgage obligations. In contrast, holdings of private mortgage-backed securities in investment accounts rose during the year. Holdings of Treasury securities declined again in 2007, ending the year at just 2 percent of banks' investment accounts. Banks' holdings of securities issued by state and local governments kept pace with overall asset growth, although such securities ran off late in the year amid concerns that the private guarantors of municipal securities held exposures to subprime mortgage-backed assets that imperiled their AAA ratings.

Liabilities

Bank liabilities increased 10.8 percent in 2007, an advance matching that in bank assets. Core deposits grew only 3.2 percent, the slowest rate since 1999, and transaction deposits contracted for the third consecutive year.⁸ The rate of expansion of savings and money market deposit accounts slowed despite the decline in short-term market interest rates, which lowered the opportunity cost of holding liquid deposits, over the second half of the year (figure 13). Small time deposits grew

somewhat faster than savings accounts; aggressive bidding for them by banks held their yields steady even as other short-term rates declined in the fall. Core deposits are generally a more important funding source for smaller banks than for larger institutions, but core deposit growth was essentially zero for banks below the top 100 in 2007.

To compensate for the lackluster growth of core deposits, banks--especially the largest institutions--continued to ramp up their managed liabilities. Those funding sources accounted for 41 percent of the liabilities of all banks at year-end, up dramatically over the past decade. Given the deterioration in interbank markets late in the year, growth in managed liabilities was due primarily to the expansion of nonbank deposits booked in foreign offices (the largest component of managed liabilities) and to FHLB advances, which grew 42 percent at the 10 largest banks. Although growth in FHLB advances was lower at medium-sized banks, those banks now use advances to fund more than 5 percent of their assets. Large time deposits expanded 13 percent, primarily in the second half of the year.

Capital

Equity capital held by commercial banks expanded 11 percent in 2007, about in line with asset growth. Retained earnings slipped to just 0.2 percent of assets, the lowest level since 1991. However, mergers and acquisitions boosted goodwill, leading to a rise in capital. In addition, parent holding companies injected about $40 billion into their commercial bank subsidiaries in 2007, mostly late in the year, to bolster capital positions in view of the pronounced deterioration in asset quality and the C&I-fueled expansion of loan portfolios. About 60 percent of the volume of transfers from parent holding companies was attributable to one large commercial bank.

Growth of regulatory capital generally slowed last year (figure 14). Tier 1 capital grew 7.1 percent. The gain of 9.7 percent in total regulatory capital reflected a 20 percent increase in tier 2 capital. The rise in tier 2 capital, in turn, was attributable in part to higher loan-loss reserves, as banks boosted provisioning in the second half of the year.⁹ Risk-weighted assets expanded 10.8 percent, a rate in line with that for total assets. As a result, the industry's tier 1 and total capital ratios ended the year a bit lower than they were a year earlier. The regulatory leverage ratio, which is based on tier 1 capital and tangible average assets, also edged down.¹⁰ Nevertheless, the share of assets at well-capitalized banks remained above 99 percent in 2007, although the average margin by which banks remained well capitalized slipped to 1.84 percent, at the lower end of the range over which it has fluctuated during the past decade (figure 15).¹¹

Derivatives and Off-Balance-Sheet Items

The notional principal amount of derivative contracts held by banks rose 26 percent last year, to more than $160 trillion (table 2). Even though the notional value of derivative contracts grew at banks of all sizes, the share of industry contracts at the 10 largest banks has continued to edge higher and stood above 98 percent at the end of the year. The considerable concentration mostly reflects the role that some of the largest banks play as dealers in the derivatives markets. As dealers, these banks often enter into offsetting positions, which significantly boost the notional value of their derivative contracts. The fair market value of derivative contracts held by banks reflects the contracts' replacement cost and is far smaller than the notional principal amount. The fair market values of contracts with positive and negative values in 2007 were both about $1.9 trillion, representing increases of about 60 percent over the year.¹² The growth stemmed primarily from changes in the values of credit derivatives at large institutions.

2. Change in notional value and fair value of derivatives, all U.S. banks, 2002-07

Percent
Item	2002	2003	2004	2005	2006	2007	MEMO Dec. 2007 (billions of dollars)
Total derivatives
Notional amount	24.14	26.54	23.69	15.38	29.75	25.76	166,190
Fair value
Positive	85.41	.36	13.71	-6.46	-4.50	57.78	1,902
Negative	89.18	1.00	13.75	-5.78	-4.27	56.63	1,869
Interest rate derivatives
Notional amount	26.83	27.62	22.07	11.92	27.11	20.63	129,560
Fair value
Positive	108.20	-5.95	13.14	-5.52	-14.55	42.22	1,194
Negative	113.02	-5.07	12.94	-5.15	-15.06	42.12	1,160
Exchange rate derivatives
Notional amount	7.34	18.81	21.03	7.69	29.27	36.69	17,174
Fair value
Positive	8.67	41.81	14.86	-35.84	22.86	44.38	260
Negative	15.73	38.81	12.74	-37.36	21.39	45.02	254
Credit derivatives
Notional amount	52.47	55.98	134.52	148.09	54.93	75.87	15,863
Guarantor	38.57	61.82	139.07	137.87	67.69	73.99	7,823
Beneficiary	66.36	51.13	130.46	157.53	44.03	77.74	8,040
Fair value
Guarantor	n.a.	68.31	69.92	81.43	92.96	295.25	274
Positive	n.a.	378.09	74.56	-5.62	201.40	-38.79	31
Negative	n.a.	-68.87	38.37	827.98	-1.59	1,187.41	243
Beneficiary	n.a.	19.85	51.28	83.50	90.26	301.20	312
Positive	n.a.	-63.13	2.64	505.51	3.98	1,086.95	267
Negative	n.a.	295.74	66.36	2.79	187.44	-18.95	45
Other derivatives1
Notional amount	6.70	3.77	32.66	29.43	75.17	13.60	3,593
Fair value
Positive	20.28	3.16	8.55	58.51	18.99	32.76	150
Negative	24.62	-5.25	19.73	74.29	24.15	30.67	167

Note: Data are from year-end to year-end and are as of April 16, 2008.

1. Other derivatives consist of equity and commodity derivatives and other contracts.  Return to table

n.a. Not available.

One important way for banks to hedge interest rate risk, including that related to interest-sensitive assets such as mortgages and mortgage-backed securities, is through the use of interest rate swaps.¹³ Those swaps are the most common type of derivative used by banks and account for about two-thirds of the notional value of banks' derivative contracts, although most of the swaps are held for trading and market-making purposes rather than for hedging. The notional value of interest rate swaps increased 27 percent in 2007, which is about the average pace over the past decade. Other types of interest rate derivative contracts employed by banks include futures, forwards, and options. The notional value of these other derivative contracts also expanded at a brisk rate last year. Despite the growth in interest rate derivative contracts, their share of total derivative contracts dropped 3 percentage points, to 78 percent.

One of the fastest growing components of banks' derivative portfolios in recent years has been credit derivatives. The notional value of such derivatives at banks jumped 76 percent in 2007, a rate of increase somewhat faster than that in 2006. Increasingly, banks are participating in the credit derivatives market by using credit default swaps written on loan contracts rather than on corporate bonds. Amid the financial turmoil in the second half of the year, the market prices of many credit derivative contracts changed so dramatically that their fair value more than doubled at many large banks. The concentration in this market was even more apparent than in other derivatives markets, as the 10 largest banks held more than 99 percent of the notional value of all the industry's credit derivative contracts at the end of 2007. As dealers, the 10 largest banks are beneficiaries of protection when they buy contracts and providers of protection (guarantors) when they sell. Banks are typically net beneficiaries of protection; as of year-end, contracts in which banks were beneficiaries of protection totaled $8.0 trillion, and contracts in which they were guarantors totaled $7.8 trillion (figure 16).

Banks also use derivatives related to foreign exchange, equities, and commodities. Collectively, however, those instruments account for only 13.6 percent of the notional value of the derivative contracts held by banks. The notional value of banks' foreign-exchange-related contracts grew 37 percent in 2007, considerably faster than in previous years. Bank customers likely increased their hedging activity in light of sharp exchange rate movements last year. Banks' notional holdings of equity and commodity derivatives rose 14 percent in 2007.

Unused commitments at commercial banks grew slightly more slowly than assets in 2007. Lines of credit secured by one- to four-family residential properties grew just 5.8 percent amid the deterioration in the housing market, and commitments to fund CRE loans were flat. Credit card lines increased about 10 percent, and letters of credit rose about 8 percent. The category "other unused commitments," which consists primarily of lines to businesses, grew 11 percent over the year as a whole but contracted in the fourth quarter.

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Trends in Profitability

After many years of high earnings, the commercial banking industry posted significantly lower profits in 2007. Industrywide net income contracted more than 20 percent, primarily because of a sharp drop in trading revenue and much higher provisions for loan losses in response to deterioration in asset quality. Return on equity (ROE) for the full year fell to less than 10 percent from more than 13 percent in recent years. Banks' return on assets (ROA) also declined markedly last year, to less than 1 percent, its lowest level since the early 1990s. The sector's profitability--which had weakened somewhat in the first half of the year--dropped sharply in the second half. In the fourth quarter, ROE tumbled to around 4 percent and ROA to 0.4 percent.

The decrease in profitability was most pronounced among the largest commercial banks, but ROA and ROE decreased considerably for all bank-size groups. In the fourth quarter, some of the largest commercial banks posted substantial losses that reportedly resulted mainly from write-downs of the value of mortgage-related assets and other structured investment products; however, almost all of those banks remained profitable for the year as a whole.¹⁴ Overall, the fraction of banks that incurred losses in 2007 increased notably, to about 10 percent, and those institutions accounted for about 3 percent of industry assets, the highest share since 2000.

Net interest margins of commercial banks slipped further in 2007. Over the first half of the year, spreads reportedly were compressed by price competition in business and mortgage lending. With financial markets and institutions under pressure in the second half of the year, interest rate spreads over market reference rates on many types of bank loans widened. Banks were unable to benefit fully from those developments because spreads on many types of bank funding, especially term funding in wholesale markets, increased well above their levels in recent years. The unexpected growth of their balance sheets in the second half of 2007 also forced banks to rely more heavily on managed liabilities and small time deposits, sources of funds that tend to have higher average interest rates than liquid deposits.

A decline in non-interest income for the year--the first such dip in at least 40 years--contributed importantly to the lower profitability of banks in 2007. Non-interest income was 2.1 percent of average total assets last year, the lowest share since 1995. Large banks experienced a substantial decline in revenue from trading and loan sales, whereas smaller banks registered slower growth in other types of non-interest income. Non-interest expense grew rapidly again in 2007, and the increase was spread across a range of categories.

Profits in 2007 were also significantly reduced by a surge in loss provisions stemming from a slump in asset quality. Amid falling house prices and a slowing economy, the delinquency rate on residential mortgages held by banks climbed to about 3 percent at year-end, its highest rate in more than a decade. The delinquency rate on CRE loans doubled to 2.7 percent at year-end. That jump primarily reflected surging delinquencies on construction and land development loans, particularly those used to finance residential projects. Banks also recorded smaller but still noticeable increases in delinquency rates on consumer and C&I loans. Charge-off rates, which had been very low in each of the past several years, moved up along with delinquencies.

Despite the steep drop in profits, banks still increased dividends in 2007 after having raised them more than 25 percent in 2006. As a result, dividends absorbed much of last year's profits, and retained earnings contributed relatively little to capital. The erosion in profits as well as investors' concerns about banks' exposures to structured investment products, leveraged loans, and subprime mortgages precipitated a sharp decline in bank stock prices, which considerably underperformed the S&P 500 last year (figure 17). Similarly, premiums on credit default swaps on banks' subordinated debt widened sharply (figure 18).

Interest Income and Expense

After increasing throughout 2006, the average interest rates earned on assets and paid on liabilities peaked around the beginning of 2007. Average interest rates on many of banks' assets and liabilities decreased late in the year, in part owing to the decline in market interest rates as the Federal Reserve eased the stance of monetary policy. However, this decline only partly reversed the run-up in 2006, and, as a result, average effective interest rates on banks' assets and liabilities were somewhat higher in 2007 than in 2006. The average interest rate earned increased somewhat less than the average rate paid, and the industrywide net interest margin declined 11 basis points in 2007, to 3.36 percent (figure 19).The decline represented a continuation of the longer-term downward trend in net interest margins evident since the mid-1990s.

Particularly over the second half of the year, banks took steps that could help stem the decline in net interest margins. According to the BLPS for October 2007 and for January 2008, banks charged wider spreads on C&I loans relative to their cost of funds in the second half of last year--the first such increases in several years (figure 20). Similarly, about half the banks responding to a question in the January 2008 survey reported having increased spreads on CRE loans over the course of 2007 after they had reported narrowing spreads on such loans in 2006. Banks also reported that, on net, they widened spreads on consumer loans during 2007.

The average interest rate on bank assets in 2007 increased 13 basis points, to 6.78 percent. The rise mostly reflected higher average rates on trading account securities and on federal funds sold and reverse repurchase agreements. The measured returns for the latter category were boosted by elevated spreads in bank funding markets during the second half of the year. The average interest rate earned on loans and leases was little changed relative to 2006. After increasing throughout 2006, the average interest rate earned by banks on business loans held steady over much of 2007--at about the level that prevailed in the second half of 2006--and then decreased some late in the year. The November 2007 Survey of Terms of Business Lending, which measures the interest rate on new loan originations at a broad sample of banks, indicates that interest rates on new business loans fell significantly relative to earlier in the year. According to the survey, a majority of C&I loans have variable interest rates and are made under the terms of previously negotiated commitments; thus, their interest rates declined along with comparable-maturity market interest rates, and spreads on such loans remained quite low in the November survey. The average interest rate earned on consumer loans rose somewhat in 2007, to 10.2 percent. In contrast, the average effective interest rate on real estate loans declined during 2007 to a little less than 7 percent at year-end, a decrease that partly reflected the effects of lower market interest rates on the portion of banks' real estate portfolios that has variable interest rates.

Banks' increased reliance on managed liabilities, which generally pay higher interest rates than other funding instruments, contributed to a 23 basis point increase in the average interest rate paid on liabilities in 2007, to 3.82 percent. For 2007 as a whole, the interest rate on managed liabilities averaged 4.8 percent, a little higher than in 2006. Realized interest rates on the category called "other borrowed money," which includes FHLB advances, declined appreciably in 2007. In contrast, interest rates on large time deposits and on federal funds and repurchase agreements rose significantly between 2006 and 2007. Although the average effective interest rates paid by banks on those instruments moved down some late in the year as the Federal Open Market Committee eased policy, the spreads of those rates over various short-term market interest rates jumped in the third and fourth quarters of 2007 to fairly high levels.

After a large advance in 2006, average effective interest rates paid on core deposits increased somewhat further in 2007, to 2.81 percent. The increase reflected both higher rates paid on each type of deposit as well as the rapid growth of small time deposits, which, as noted earlier, generally pay higher interest rates than liquid deposits. The rate on savings deposits (including money market deposit accounts) averaged 2.22 percent last year, somewhat higher than in 2006. The average interest rate on small time deposits increased significantly to 4.72 percent in 2007, and it remained elevated at the end of the year even though interest rates on other money market instruments declined. Banks, particularly those experiencing unplanned expansions of their balance sheets or those leery of volatility in interbank funding markets, likely kept rates on small time deposits relatively high--and, as noted earlier, boosted spreads on large time deposits--to attract depositors.¹⁵

The downward pressure on banks' net interest margins last year was exacerbated by a decline in the share of bank assets funded by non-interest-bearing liabilities and capital.¹⁶ Because these instruments, by definition, have no explicit interest expense, the returns on the interest-earning assets that they fund help support banks' net interest margins.

Non-interest Income and Expense

Total non-interest income dipped in 2007, marking the first time in at least 40 years that non-interest income contracted on an annual basis. As a result, total revenue of commercial banks, defined as net interest income plus non-interest income, edged up only 3.4 percent. The share of total revenue from non-interest income dropped to 42 percent, its lowest level since 1998 (figure 21). Non-interest expense grew at a faster clip in 2007 than it had in 2006, and it increased as a share of revenue to the upper end of its recent range.

In recent years, the growth of non-interest income has been concentrated among the largest banks, while smaller banks have seen this revenue source stagnate or decline. In 2007, non-interest income dropped at the largest banks and was flat to lower in most other bank-size categories. The softness in non-interest income at the largest banks last year primarily reflected steep declines in trading revenue at a few of those institutions. Banks reported almost $10 billion in net losses on the trading of credit exposures last year, which likely included some of the substantial write-downs of mortgage-related structured products as well as losses on collateralized debt obligations and credit derivatives associated with syndicated leveraged loans. Income from the trading of equity exposures also dropped considerably in the second half of the year, and trading revenue generated by other products--interest rate, foreign exchange, and commodities--weakened as well. In addition, several of the largest banks experienced losses or a steep drop in income from the sale of loans that were not held in their trading accounts, particularly in the second half of the year.

However, the difficulties were partly offset by strong growth in other categories of non-interest income at large banks. Revenue from investment banking services increased as banks profited from their role in financing robust M&A activity over much of 2007 and also benefited from high trading volumes, spurred by market volatility, in their wealth-management businesses. In a related area, several large institutions experienced jumps in income from fiduciary activities. Fees collected on deposit accounts also advanced briskly, outstripping the muted growth in deposits (figure 22).

The weakness in non-interest income at smaller banks was widespread across many business lines. Revenue from securitization activities and from loan-servicing operations declined, a development probably related, in part, to the problems in the residential mortgage markets. Income from subsidiaries and other affiliates also dropped considerably at some smaller banks; the decrease may have stemmed to some degree from reduced contributions from mortgage banking arms.

Non-interest expense rose 9 percent in 2007, somewhat faster than in 2006. That increase, combined with the sluggish growth in revenue, pushed non-interest expense to about 61 percent of total revenue, the top end of the range over the past 10 years (figure 23). Growth of employee compensation, which accounts for about 45 percent of non-interest expense, slowed in 2007. The easing in that category reflected both a reduced pace of net hiring as well as a slowdown in the growth of compensation per employee. The cost of premises and fixed assets rose modestly in 2007, about in line with recent annual increases. Other non-interest expense, which accounts for more than 40 percent of total non-interest expense, increased more than 10 percent last year. The category includes various intercompany transactions, such as payments to affiliates and to parent holding companies, which appear to have increased notably in 2007; it also includes expenses related to restructuring or mergers and the cost of amortization of goodwill and other intangible assets. The total of restructuring costs and amortization of intangible assets accounted for about 15 percent of the increase in non-interest expense.

Loan Performance and Loss Provisioning

Credit quality declined across all types of loans in 2007, and the overall delinquency rate at commercial banks rose to about 2.5 percent of total loans and leases at year-end, its highest level since early 2003. The aggregate charge-off rate also moved up, reaching an annual rate