Banking System Conditions
Evolution of the COVID event
As noted in the previous Supervision and Regulation Report, the COVID event caused acute stress in many parts of the financial system beginning in March 2020.2 It induced a sharp decline in economic activity and an accompanying surge in unemployment. Since then, market conditions and investor risk sentiment have improved substantially, though issues continue to exist in various sectors. Some asset prices have largely recovered, in part because of strong and rapid policy responses. However, while recent economic data offer positive signs, output and employment remain far below their levels prior to the COVID event, and the path forward remains uncertain. Recovery hinges in large part on the evolution of public concern about the virus as well as on policy actions taken at all levels of government.
The COVID event differs from previous crises in at least one important way. Because the economic shock emerged outside of a banking system that was significantly more resilient as a result of reforms and measures taken by the banking industry following the 2008 crisis, the role of banking organizations in this crisis has been different—serving as shock absorbers for the real economy, rather than as amplifiers of stress. Programs undertaken by the Federal Reserve have helped to preserve the flow of credit, while policy measures have helped build a bridge from the solid economic foundation on which we entered the crisis to a position of potential economic strength on the other side.
A More Resilient Banking System Has Helped the Economy Weather the Initial Shock
As the crisis broke, the benefits of a more resilient banking system were evident. Despite a great deal of turmoil in financial markets, the solvency of the banking system has not been in question. Banks have increased lending, absorbed a surge of deposits, and worked constructively with borrowers. They have also provided access to substantial lines of credit for corporate borrowers and played a significant role in supporting small businesses via the Paycheck Protection Program (PPP).
Banks also took a number of actions to maintain financial and operational resiliency. As a result, capital levels remain robust—indeed, they have actually increased during the COVID event—aided by timely policy response and capital preservation measures. Despite operational challenges, both banks and examiners have generally transitioned to a largely remote work environment without significant disruption to the provision of financial services. Bank branches have begun to reopen in line with local conditions and relevant guidelines.
Loan growth has moderated in recent months.
Since the beginning of the year, bank loans have grown by slightly more than 4 percent, driven mainly by the PPP. After increasing through May, total loan growth turned negative in June. Growth rates for commercial and industrial (C&I) and consumer loans in particular saw significant declines (figure 1), driven principally by weak loan demand. Despite approximately $500 billion in PPP loans originated by banks between April and August, C&I lending slowed as commitment draws began to be repaid (figure 2). Consumer loan growth declined as consumers reduced spending. Along with lower loan demand, tighter lending standards and greater uncertainty also contributed to declines.
Capital positions remain strong.
The aggregate common equity tier 1 (CET1) capital ratio recovered in the second quarter to around 12 percent, up from the first quarter and similar to the level at the end of 2019 (figure 3). Capital ratios rose slightly in the third quarter, based on preliminary reports from large banks (see figure C, box 2 later in the report). Capital ratios remain well above regulatory requirements at nearly all banks, providing a buffer to support further lending. Recent regulatory changes, such as the transition period for the impact of the current expected credit losses (CECL) accounting standard, have also benefited capital ratios at some banks.3
Liquidity conditions remain strong.
Bank deposits grew at extraordinary rates through June, as investors continued to favor safe assets and consumers increased savings (figure 4). Total deposits for all commercial banks increased by roughly $2.5 trillion between the end of 2019 and September 2020. Liquid assets as a share of total assets for the industry have risen noticeably this year (figure 5), with the majority of the increase occurring in the second quarter. Large banks have consistently remained above their liquidity coverage ratios throughout the COVID event.
Key market indicators reflect improved conditions.
Current market-based indicators of bank health, including credit default swap (CDS) spreads and market leverage ratios, reflect stabilization in financial markets and demonstrate continued resilience of the banking system. Although both CDS spreads and market leverage ratios deteriorated sharply in the first quarter, they have not reached the extremes of the 2008 financial crisis. Both indicators began to recover in April and have generally shown improved or stable trends through the third quarter (figure 6).
Conditions Have Stabilized, but Uncertainty Persists
While economic activity has picked up and economic indicators have shown marked improvement since the second quarter, a high degree of uncertainty persists. Loan modifications and other policy measures make it challenging to accurately estimate potential loan losses, and macroeconomic uncertainty further complicates the analysis.
While measures of asset quality are relatively stable, recent loan modification activity may obscure credit quality issues.
Banks have implemented loan modification programs consistent with section 4013 of the Coronavirus Aid, Relief, and Economic Security Act and have offered other accommodations to borrowers.4 By changing the terms of a loan to make it more affordable, these programs help borrowers deal with temporary economic hardship caused by the COVID event. As discussed in more detail later in this report, the use of these programs by borrowers is lending additional support to the economic recovery.
Historically, bank asset quality rises and falls with the state of the economy. However, current measures of asset quality, such as the ratio of nonperforming loans (NPL) to total loans and leases (the NPL ratio), remain stable, even though unemployment is at a high level. The overall NPL ratio remains near its pre-COVID-event level, rising only slightly to 1.1 percent in the second quarter from 0.9 percent at the end of 2019 (figure 7). The NPL ratio for consumer loans actually decreased by 0.1 percent over this period. NPL ratios for residential real estate, commercial real estate (CRE), and C&I loans each rose slightly in the first half of 2020.
The prevalence of loan modification programs may obscure credit quality issues, as a loan is typically not counted as "nonperforming" while it is covered by a loan modification program. When the deferral period under a loan modification program ends, many borrowers will be able to resume contractual payments; however, other borrowers may be unable to fully meet their obligations.5 Banks will likely see an increase in nonperforming loans once deferral periods expire.
Higher provisions and reserves reflect concerns over potential credit losses.
While the level of nonperforming loans remains low, banks have increased their loan loss reserves and tightened lending standards through the first half of the year in anticipation of a future rise in credit losses. Loan loss provisions as a share of average loans and leases rose sharply in the first quarter, as banks aggressively downgraded their economic forecasts. In the second quarter, as economic conditions stabilized, banks continued to increase provisions, albeit at a slower rate (figure 8). Higher reserves put banks in a stronger position to deal with any future deterioration in asset quality. As discussed in box 2 later in the report, large firms recorded declines in loss provisions in the third quarter, suggesting some confidence that the current levels of reserves can cover future deterioration in asset quality.
Box 1. Reserving Practices and Trends at Firms Adopting CECL
In 2016, the Financial Accounting Standards Board (FASB) issued the current expected credit losses (CECL) methodology, a new standard that significantly revised accounting for credit losses.1 Under CECL, the allowance for credit losses (ACL) measures a bank's lifetime expected credit losses, rather than merely near-term expected losses. To estimate those losses, institutions use a broader range of data than under the previous accounting standard. Data include information about past events, current conditions, and reasonable and supportable forecasts of future conditions. In sum, CECL requires a forward-looking approach to reserving.
Approximately 175 banking organizations adopted the CECL methodology in January 2020. As shown in figure A, those firms generally reported increases in reserves in 2020 because of the adoption of CECL at the beginning of the year and from increased reserves in both the first and second quarters. Increased reserves are not only related to the adoption of CECL, but also to rising expectations of credit risk and uncertainty in economic forecasts related to the COVID event. Increases generally occurred in both consumer and commercial loan portfolios. The most affected commercial loan sectors were oil and gas, auto, travel, and retail.
Banks have reported several challenges in implementing CECL during the COVID event. For example, the impact of government stimulus programs for consumers and businesses on credit risk is uncertain, especially as some stimulus programs are ending. In addition, loan modifications under the CARES Act or other modifications offered by financial institutions are challenging to reflect in CECL reserves. Finally, macroeconomic uncertainty and modeling uncertainty also pose challenges.
Federal Reserve supervisors will continue to conduct examinations of CECL implementation at large state member banks during the second half of 2020. Supervisors have focused on CECL modeling approaches, qualitative adjustments, and documentation of reserving practices. Supervisors will continue to monitor reserve levels, macroeconomic forecast assumptions, qualitative reserves, and reserve treatment for loans in loan modification programs.
In light of the COVID event, the Board, along with the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC), has provided firms with the option to mitigate the impact of CECL on regulatory capital for a transition period of up to five years.
1. The CECL methodology is codified in FASB Accounting Standards Codification (ASC) Topic 326, Financial Instruments—Credit Losses. Return to text
Profitability fell sharply in the first two quarters of 2020.
Bank profitability, as measured by return on equity (ROE) and return on average assets (ROAA), fell sharply in the first quarter of 2020, driven by falling net interest income and elevated provision expenses across both corporate and consumer loans. ROE and ROAA both began to recover in the second quarter (figure 9) but have remained under pressure. Net interest margins also experienced large declines in the first half of 2020 because of lower interest rates and higher holdings of low-yield assets. Growth in trading and investment banking revenues and mortgage origination fees helped offset some of these declines. Banks participating in the PPP have reported interest and noninterest income attributable to PPP loans, which will continue to influence banks' earnings in coming quarters, particularly for community and regional banks.
Box 2. Third-Quarter Earnings at a Sample of Large Banks
This box provides a preliminary update on third-quarter banking sector conditions, based on early reporting by a sample of large banks that reported third-quarter earnings on or before October 16 (reporting banks).1 While such trends are indicative, it should be noted that early reporters are not necessarily representative of the banking sector as a whole.
Third-Quarter Earnings Improved Because of Lower Provisions
Preliminary third-quarter earnings data suggest large banks improved earnings relative to the first two quarters of 2020, predominantly because of lower loan loss provisions. Bank profitability, as measured by return on equity (ROE), increased from 5 percent in the first half of 2020 to 10 percent in the third quarter for the sample, nearing levels earned in the prior year period (figure A).
In the third quarter, the level of nonperforming loans rose modestly, and reporting banks limited additional increases in their loan loss reserves (figure B). Reporting banks generally expressed confidence that current reserve levels would be sufficient to deal with future deterioration in asset quality given the current economic outlook, but acknowledged that the path of the economic recovery and ultimate magnitude and timing of loan losses remain uncertain.
Pressure on Net Revenue
Net interest income declined 4 percent quarter-over-quarter. Declines in net interest income were due to lower interest rates and slowed loan growth, which turned negative quarter-over-quarter for the reporting banks. Noninterest income also declined on aggregate quarter-over-quarter (−10 percent), as sales and trading and investment banking earnings were strong but declined relative to the record-setting previous quarter.
Improved Capital Ratios
During the quarter, reporting banks accreted common equity tier 1 (CET1) capital and improved their capital ratios (figure C). This continues the trend seen in the second quarter, as earnings offset dividends paid, and as banks continued suspensions of share repurchases. Declines in risk-weighted assets, driven in part by slower loan demand and tighter lending standards, also contributed to the rise in CET1 capital ratios. The aggregate CET1 ratio for the reporting banks ended the third quarter near 12 percent, above its level at the start of 2020.
1. Ally Financial Inc., Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., Citizens Financial Group, Inc., The Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley, The PNC Financial Services Group, Inc., State Street Corporation, Truist Financial Corporation, U.S. Bancorp, and Wells Fargo & Company. Return to text
2. See Board of Governors of the Federal Reserve System, Supervision and Regulation Report, May 2020, (Washington: Board of Governors, May), https://www.federalreserve.gov/publications/2020-may-supervision-and-regulation-report.htm. Return to text
3. The CECL transition provisions allowed firms to add back 40 basis points to the aggregate CET1 ratio through second quarter 2020. Return to text
4. Section 4013 of the CARES Act encourages financial institutions to work with borrowers whose ability to repay has been adversely impacted by COVID-19. Under section 4013, there is no limitation on the length of deferral periods or number of loan modifications that can be made during the applicable period. The Federal Reserve and the other federal banking agencies have also encouraged banks to work prudently with borrowers affected by COVID event containment measures. See "Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (Revised)," news release, April 7, 2020, https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200407a1.pdf. Return to text
5. See SR Letter 20-18/CA 20-13 "Joint Statement on Additional Loan Accommodations Related to COVID-19" at https://www.federalreserve.gov/supervisionreg/srletters/SR2018.htm. Return to text