Banking System Conditions
This overview of banking system conditions is based on data collected by the Federal Reserve and other federal financial regulatory agencies, as well as market indicators of industry conditions.
The Banking System Has Demonstrated Financial and Operational Resilience
The benefits of a resilient banking system have been evident throughout the COVID event. Banks have been able to take in consumer savings, grant loan modification requests, and fund corporate borrowers via credit lines and bond issuance.
Capital and liquidity positions remain robust.
Financial institutions' strong capital and liquidity positions have enabled the banking system to support the recovery of the U.S. economy.
Banks entered the COVID event with strong capital positions and built further capital last year. For example, the aggregate common equity tier 1 (CET1) capital ratio exceeded its pre-COVID-event level in the second half of 2020 (figure 1). As of year-end 2020, capital ratios remain well above regulatory minimums at nearly all firms, providing a buffer to absorb losses and support lending as the economy recovers.
Bank liquidity also strengthened last year, thanks to strong growth in deposits. Higher deposits helped banks expand liquid assets (figure 2) and reduce wholesale funds. Bank deposit balances increased by over $3 trillion since year-end 2019. Many factors contributed to the rapid growth in deposits. These include higher levels of consumer savings, drawdowns of business loan commitments, Paycheck Protection Program (PPP) loan originations, investor preference for safe assets, record corporate bond issuance, fiscal stimulus payments, and expanded unemployment benefits.
Banks have taken actions to maintain their operational resilience.
Many banks had invested in technology to improve their capacity to process digital transactions prior to the COVID event. This investment enabled banks to continue to provide banking services and work with their customers in a remote environment. As discussed later in this report, cybersecurity risk has been amplified by the COVID event and remains an ongoing supervisory concern. Banks have focused on ensuring their controls are sufficient to mitigate increasing cyber risks.
Bank profitability has mostly rebounded to pre-COVID-event levels.
After falling sharply during the first half of 2020, bank profitability, as measured by return on equity (ROE) and return on average assets (ROAA), improved and reached pre-COVID-event levels by year-end 2020 (figure 3).2 Smaller loan loss provisions accounted for most of the recovery, as discussed below. Improved trading, investment banking, and mortgage banking revenues also contributed to the rebound, offsetting a decline in net interest margins.
Loan loss provisions, which provide banks with a cushion to absorb losses on loans, often are an important driver for bank profitability.3 Provisions rose sharply in the first quarter of 2020 as banks aggressively lowered their economic forecasts and anticipated more problem loans. As the economic outlook improved over the year and loans performed better than expected, banks reduced provisions (figure 4).
Key market indicators reflect improved conditions.
Market indicators of bank health, including market leverage ratios and credit default swap (CDS) spreads, experienced a sharp deterioration in the first quarter of 2020 (figure 5). The market leverage ratio is a market-based measure of a firm's capital level. A higher ratio generally indicates higher confidence in a bank's financial strength. The aggregate market leverage ratio dipped below 6 percent in April 2020. It stabilized through the third quarter of 2020 and improved to over 10 percent in March 2021.
CDS spreads are a measure of the market's perception of bank default risk. Smaller spreads indicate higher investor confidence in a bank's financial strength. After spiking in the first quarter of 2020, CDS spreads recovered in the second quarter of 2020. Since then, they have largely remained stable. Both indicators are currently near their pre-COVID-event levels, reflecting stabilization in the financial markets and increased confidence in the banking system.
Banks are playing a vital role in the PPP.
The Small Business Administration's (SBA) PPP provided small businesses with credit and liquidity support at a time when it was badly needed. Created under the Coronavirus Aid, Relief, and Economic Security (CARES) Act and amended under the Consolidated Appropriations Act, 2021, the PPP provided forgivable loans to support payroll costs at small businesses and nonprofit organizations. PPP loans can be fully forgiven if the funds are used for payroll costs, mortgage interest, rent, or utilities.
The SBA initially processed PPP loans between April and August 2020. During this period, lenders made more than 5.2 million PPP loans, totaling $525 billion. The SBA began processing PPP loans again in January 2021. Between January and mid-April 2021, lenders made another 4.7 million PPP loans, totaling $240 billion.4 Banks made the majority of PPP loans. Bank participation in the program was broad, as roughly 85 percent of banks made PPP loans. Recent legislation provided new borrowers with more flexibility and allowed some borrowers that already received a PPP loan to obtain a second loan. The new legislation also provided priority loan access for underserved borrowers and for community development financial institutions and minority depository institutions.
The Federal Reserve created the Paycheck Protection Program Liquidity Facility (PPPLF) to support PPP lending. The facility allows lenders to borrow funds from the Federal Reserve, using PPP loans as collateral. The Federal Reserve allows banks to exclude PPP loans pledged as collateral to the PPPLF from capital requirements. Additionally, PPP loans held by banks receive a zero percent risk weight under the regulatory capital rule.5
Areas of Focus Given Ongoing Uncertainties
Despite the overall health of the banking sector, some areas have shown signs of potential weakness.
Bank lending activity has been slow, with little growth beyond PPP loans.
After peaking in May 2020, total loan balances at commercial banks declined throughout the rest of the year. Respondents to the Federal Reserve's Senior Loan Officer Opinion Survey reported that both reduced demand and tighter lending standards, particularly at smaller banks, contributed to the decline in lending.6
Among the four major loan categories displayed in figure 6, the commercial and industrial (C&I) loan category observed the strongest growth. PPP loans accounted for most of the C&I loan growth over the first half of 2020. Leaving out PPP loans, C&I loans would have declined in 2020. The new second round of PPP loans also drove C&I loan growth between late-January and mid-March. Consumer lending has shown notable weakness during the COVID event. Consumer loan balances at commercial banks dropped 4 percent in 2020. Credit card loan balances, in particular, fell sharply in 2020. The reduction in credit card debt is likely the result of several factors, including tighter lending standards, lower spending, and the financial benefits of fiscal stimulus.
Decline in net interest margin accelerated in 2020.
Net interest margin, which represents a bank's yield on its financial assets after netting out interest expense, has declined over the past two years. It declined sharply in the first three quarters of 2020 and recovered slightly in the fourth quarter (figure 7).
Net interest margin compression in 2020 was due to slow loan growth relative to deposit growth. As discussed earlier in the report, banks reported strong deposit growth in 2020 and invested much of the deposit inflow in lower yielding assets, such as cash and securities. Lower interest rates also contributed to the decline in net interest margin last year.
Delinquency rates slightly increased, and loan modification activity continues.
Although loan forbearance and loan modification programs have eased the burden on borrowers, delinquency rates for most loan types increased in 2020, though they remain low by historical standards.7 Residential real estate (RRE) and commercial real estate (CRE) saw the largest increases (figure 8). Some mortgage loans that did not enter forbearance may become delinquent due to COVID-event-related economic conditions. Supervisory data collected on large firms suggest the increase in CRE loan delinquency is driven by the retail and hospitality CRE loan sectors.
Banks increased loan loss reserves significantly in the first half of 2020 in anticipation of rising credit losses. While banks maintained high reserve levels in the second half of 2020, they lowered provisions. This indicates that banks considered loan loss reserves to be adequate. However, some banks are still reporting a high level of loan modifications and forbearance activity for borrowers affected by the COVID event. As discussed in box 1, loans under modification or forbearance programs might not be reported as delinquent loans even if interest payments are not received. Therefore, loan delinquency statistics may be understated.
Box 1: Loan Modifications Have Declined
Since the COVID event began, the Federal Reserve has encouraged banks to work prudently with their borrowers.1 Banks can modify loan terms by deferring payments or reducing the interest rate. They can also extend the maturity date or adjust covenants and collateral requirements. These actions reduce financial pressure on borrowers and can help banks reduce loan losses. So far, banks appear to have been successful in helping many consumers and businesses weather the COVID event.
Section 4013 of the CARES Act eases certain accounting requirements when banks work with borrowers affected by the COVID event.2 Banks began modifying loans, consistent with Section 4013, during the first quarter of 2020.3 These loan modifications peaked in the second quarter of 2020 and have declined each quarter thereafter. At the end of 2020, banks held around $286 billion in Section 4013 modified loans (figure A).
Based on information gathered from banks, consumer loan modification balances peaked in the second quarter of 2020, while commercial loan modification balances peaked in the third quarter of 2020. Mortgages account for the largest share of consumer loan modifications, and loans to the finance and insurance, manufacturing, retail, and hospitality sectors account for the largest share of commercial loan modifications.
1. See SR letter 20-15, "Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions," at https://www.federalreserve.gov/supervisionreg/srletters/sr2015.htm and SR letter 20-18, "Joint Statement on Additional Loan Accommodations Related to COVID-19," at https://www.federalreserve.gov/supervisionreg/srletters/SR2018.htm. Return to text
2. Section 4013 suspended the accounting requirement that a bank classify a loan as a troubled debt restructuring if the bank modified the loan because of the COVID event. Return to text
3. Section 4013 loans are a subset of banks' modified loans. They do not include troubled debt restructurings or loans modified not meeting other Section 4013 requirements (such as a loan more than 30 days past due prior to December 31, 2019). Return to text
2. The dip in ROE and ROAA in the fourth quarter of 2017 was driven by a one-time tax effect associated with the Tax Cuts and Jobs Act of 2017. Return to text
4. See the SBA's "Paycheck Protection Program (PPP) Report" at https://www.sba.gov/sites/default/files/2021-04/PPP_Report_Public_210418-508.pdf. Return to text
5. See the Federal Reserve Board announcement at https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200409a.htm. Return to text
7. Total loan delinquency rates approached 6 percent during the 2008 financial crisis. See the November 2018 Supervision and Regulation Reportat https://www.federalreserve.gov/publications/2018-november-supervision-and-regulation-report-preface.htm. Return to text