Board of Governors of the Federal Reserve System

Banking System Conditions

The financial condition of the U.S. banking system is generally strong.

The strong economy has contributed to improvements in the financial condition of banks. Two important measures of profitability--return on equity (ROE) and return on average assets (ROAA)--have seen steady gains over the past several years and attained a 10-year high in the second quarter of 2018 (figure 1).⁵ Earnings for firms of all sizes have been bolstered by rising net interest income. Moderately rising interest rates have been positive for bank earnings and have helped drive increases in net interest income.

Firms have reported growth in loan volume coupled with lower nonperforming loan ratios.

Loan growth remains robust, with total loan volume for the industry growing over 30 percent since 2013 (figure 2). Commercial and industrial (C&I) loans and non-residential real estate loans have experienced the strongest growth. Since 2013, the volume of C&I and non-residential real estate loans has grown by over 40 percent. Residential real estate lending, which continued to experience structural changes over this period, exhibited tepid growth.

Recently, nonbank finance companies are increasing their market share in new mortgage originations, and large banks are shifting their mortgage exposures from loans to securities. As a result, the banking industry's overall loan portfolio is shifting away from residential real estate loans toward C&I loans (figure 3).

The nonperforming loan ratio--one measure of asset quality--is generally improving or stable across the banking system (figure 4).Currently, nonperforming loans as a share of total loans and leases are at or near a 10-year low. However, nonperforming C&I loans increased in 2016 because of a slowdown in the oil and gas industry.

Firms maintain reserves to provide a cushion against losses on loans and leases they are unable to collect. One important financial metric is the ratio of allowance for loan and lease losses (ALLL, which is the amount of reserves banks set aside to absorb losses related to troubled loans) to the volume of nonperforming loans and leases held by a bank, also known as the reserve coverage ratio (figure 5). A higher ratio generally indicates a better ability to absorb future loan losses.

Since 2013, as the volume of nonperforming loans has declined, the industrywide coverage ratio has improved considerably. While the entire industry has seen an improvement in this ratio, the largest firms have seen the greatest improvement. It is important to note that nonperforming loan status is a lagging indicator of loan losses and other factors are considered when estimating the allowance, such as changes in underwriting standards and changes in local or regional economic conditions.

As profitability and asset quality continue to improve, firms still maintain high levels of quality capital.

Capital provides a buffer to absorb losses that may result from unexpected operational, credit, or market events. Since the financial crisis, the Federal Reserve has implemented new rules that have significantly raised the requirements for the quantity and quality of bank capital, particularly at the largest firms. As a result of the new requirements, capital levels have increased across the industry (figure 6).

Firms have also significantly bolstered their liquidity after coming under funding pressure during the financial crisis.

The funding stresses faced by large banks during the financial crisis heavily influenced the subsequent U.S. regulatory framework for addressing funding and liquidity risk. The financial crisis demonstrated the need to ensure that banks hold enough fundamentally sound and reliable liquid assets to survive a stress scenario. Liquidity requirements put in place since the crisis have significantly increased aggregate levels of highly liquid assets (figure 7).

The banking industry remains concentrated, while the market share of the largest banking organizations has declined.

Over the past few decades, as the banking system has grown, there has been a trend of increased bank consolidation. During the height of and immediately after the financial crisis, as the financial system was strained, many banks failed or merged with other institutions. Upon closing, their assets were sold to other, often larger, institutions, and the industry saw a wave of consolidation and growth of the largest institutions. In recent years, however, concentration has slowed by some measures. Even as the total volume of loans and leases has been growing, the distribution of those loans has spread to a broader section of the industry. The market share of loans for the 10 largest banking organizations has declined (figure 8).

Market indicators generally reflect stronger industry performance.

The improvements in overall banking system conditions since the crisis are reflected in market indicators of bank health, such as the market leverage ratio and credit default swap (CDS) spreads. The market leverage ratio is a market-based measure of firm capital, and a higher ratio generally indicates investor confidence in banks' financial strength. Credit default spreads are a measure of market perceptions of bank risk, and a small spread reflects investor confidence in banks' financial health. Both measures are close to pre-crisis levels (figure 9).⁶

 

References

 5. The dip in ROE and ROAA in 2017 was driven by a one-time tax effect. Return to text

 6. Definitions of market leverage and credit default swap spreads are included in Appendix A: Data. Return to text