Banking System Conditions
The banking system remains sound and holds high levels of capital and liquidity. However, uncertain economic conditions and rising interest rates are increasing firms' credit, liquidity, and interest rate risks. Declines in the fair value of investment securities have increased significantly, reduced asset liquidity and, for certain banks, weighed on capital. The recent failures of three large U.S. banks have also demonstrated the risks of concentrated funding sources and poor management of interest rate risks (see box 3).
Deposits have also fallen, leading to higher funding costs and increased reliance on wholesale borrowings. Delinquency and net charge-off rates for some consumer loan and commercial real estate (CRE) segments have increased. The strong growth in net interest income in recent quarters is likely to abate as funding costs rise (see the "Supervisory Developments" section).
Loan Growth Continued, but Pace of Growth Has Slowed
Loan balances continued to grow in the fourth quarter of 2022 and the first quarter of 2023 across most major loan categories. However, the pace of growth slowed relative to the second and third quarters of 2022 (figure 1). Tighter lending standards and weaker demand contributed to the slower growth in commercial and industrial (C&I) and CRE lending.2 Robust consumer spending continued to drive growth in credit card loan balances, pushing overall consumer loan balances higher. Residential real estate (RRE) loan balances increased, but mortgage originations slowed with rising interest rates.
Figure 1. Outstanding loans by type
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Note: Data are for all commercial banks.
Source: H.8, "Assets and Liabilities of Commercial Banks in the United States."
Deposits have declined since reaching a high of $18 trillion in April 2022. Between April 2022 and April 2023, deposits fell by $960 billion. Consequently, the ratio of loans to deposits reached 70 percent in April 2023, up from 61 percent a year prior. Despite this recent increase, the ratio of loans to deposits remained below its 10-year average of 72 percent. For additional background, see box 1 on page 6 of the November 2022 Supervision and Regulation Report.3
Net Interest Margins Expanded, but Funding Costs Are Increasing
During the second half of 2022, bank earnings performance, measured as return on average assets and return on equity, improved (figure 2). Strong growth in net interest income more than made up for increasing loan loss provisions and falling noninterest income.
Figure 2. Bank return on average assets (ROAA) and return on equity (ROE)
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Note: ROE is net income divided by average equity capital, and ROAA is net income divided by average assets. 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.
Source: Call Report and FR Y-9C.
Net interest margins measure the difference between interest income and the amount of interest paid for funding, expressed as a share of average earning assets. Between year-end 2021 and year-end 2022, the industry net interest margin increased by nearly 1 percent, boosted by strong year-over-year growth in interest income (figure 3).
Figure 3. Year-over-year change in net interest margin components
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Note: Net interest margin is net interest income divided by average interest-earning assets, annualized. Net interest income is interest income minus interest expense. The key identifies series in order from left to right.
Source: Call Report.
Net interest income is unlikely to experience such strong growth this year. Many firms hold fixed-rate assets that were acquired when interest rates were lower than current market rates. These assets will weigh on future interest income. Funding costs are expected to increase as interest rates on deposits rise with market rates and funding mixes shift toward more use of wholesale sources.
Noninterest income fell as mortgage banking, investment banking, and investment management revenues declined. Provisions increased as firms built up credit loss reserves for loans and leases due to loan growth and a weakening credit outlook (figure 4).4
Figure 4. Loan loss reserves as a share of average loans and leases
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Source: Call Report and FR Y-9C.
Delinquency Rates Are Low but Rising
Overall, problem loan levels remain low. Delinquency rates were little changed across most major loan categories in the second half of 2022. The one exception was consumer loans, as credit card and auto loan delinquency rates continued to rise from low levels (figure 5). The Federal Reserve expects loan delinquency rates to increase as loan interest rates are adjusted higher. CRE loan performance is also being monitored closely given potential deterioration in the office segment stemming from the trend toward working from home. Vacancy rates for office properties in central business districts have increased. Based on data from the Capital Assessments and Stress Testing information collection (FR Y-14Q), the delinquency rate for the office segment was over 1.8 percent in the fourth quarter of 2022, well above its 10-year average of 0.7 percent (figure 6). The office segment represented 22 percent of total income-producing CRE loan commitments as of the fourth quarter of 2022.
Figure 5. Loan delinquency rates
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Note: Delinquent loans are those 90+ days past due or in nonaccrual status.
Source: Call Report and FR Y-9C.
Figure 6. Income-producing CRE loan delinquency rates by property type
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Note: Delinquent loans are those 30+ days past due or in nonaccrual status.
Source: FR Y-14Q.
Net charge-off rates remained near 15-year lows. However, all major loan categories recorded higher net charge-off rates in the second half of 2022. The most notable increase was in consumer loans, as credit card and auto loan charge-offs drove the consumer loan net charge-off rate higher for a fifth quarter in a row (figure 7). In the fourth quarter of 2022, the auto loan net charge-off rate more than doubled from a year prior, albeit from historically low levels. Meanwhile, the credit card net charge-off rate continued to rise, reaching its highest level since the second quarter of 2021.5 Still, the credit card net charge-off rate remains historically low.
Figure 7. Loan net charge-off rates
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Source: Call Report and FR Y-9C.
Banks' projections in the second half of 2022 indicated a weakening credit outlook, which led banks to increase loan loss provisions. Firms have been closely monitoring their CRE portfolios, especially office exposures, for signs of stress. The level of credit risk in office exposures has grown amid higher interest rates, tighter lending standards, and a structural change in the office market due to work from home and hybrid work options. In addition, large firms lowered their internal loan risk ratings for most CRE property types and some C&I sectors, such as healthcare and manufacturing, in the fourth quarter of 2022.
Liquid Assets Remain High Overall, but Some Firms Face Increased Funding Risk
Liquid assets, including cash and securities, declined in the second half of 2022. Banks added about $2.4 trillion in cash balances between the onset of the pandemic and the third quarter of 2021. Since then, however, cash balances have declined by almost $1 trillion, as banks have used existing cash holdings to manage a decline in deposits and to fund increased lending. Despite these recent declines, liquid assets' share of total assets remained above its 10-year average (figure 8).
Figure 8. Liquid assets as a share of total assets
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Note: Liquid assets are cash plus estimates of securities that qualify as high-quality liquid assets as defined by the liquidity coverage ratio requirement.
Source: FR Y-9C.
Securities held by firms continued to depreciate in the second half of the year. As of the fourth quarter of 2022, the fair value of available-for-sale securities declined to an estimated $277 billion below their amortized cost, compared to $224 billion as of the second quarter of 2022.6 This level of declines in the fair value of securities limits firms' willingness to sell securities to meet funding needs, as selling securities below their amortized cost would result in realized losses and negatively affect earnings. Significant declines in the fair value of securities, combined with high levels of uninsured deposits, can elevate liquidity risks, as seen with the failure of Silicon Valley Bank. For additional background, see box 3 on page 11 of the November 2022 Supervision and Regulation Report.7 As an alternative to selling securities, firms can access other contingent sources of funding, including the discount window and the new Bank Term Funding Program, by pledging eligible securities.
Capital Levels Remain Well Above Regulatory Minimums
Firms added to capital through the retention of earnings in the second half of 2022. The industry's aggregate common equity tier 1 (CET1) capital ratio, which measures capital that absorbs losses as they occur relative to risk-weighted assets, was slightly below its five-year average at the end of 2022 (figure 9). Despite declines in the fair value of available-for-sale securities weighing on their CET1 capital, the largest and most complex firms improved their aggregate CET1 capital ratio.8
Figure 9. Aggregate common equity tier 1 (CET1) capital ratio
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Note: CET1 capital ratio is the ratio of common equity tier 1 capital to risk-weighted assets. See appendix A for further information. Community banks can opt into the community bank leverage ratio framework. Thirty-seven percent of community banks have done so, and they are excluded from the figure.
Source: Call Report and FR Y-9C.
Many banks, however, have reported declines in tangible common equity capital as interest rates have increased.9 Lower tangible common equity can adversely affect market participants' capital assessments, stock price valuations, and access to certain types of funding.
Bank Market Indicators Have Deteriorated
The market leverage ratio and credit default swap (CDS) spreads reflect the market's assessment of bank health. The market leverage ratio is a market-based measure of a firm's capital position, where a higher ratio indicates more market confidence in the firm's financial strength. CDS spreads are a market-based measure of a firm's risk, where a lower spread indicates more market confidence in the firm. These two indicators provide the Federal Reserve with an independent, forward-looking view of the strength of the banking system.
The average market leverage ratio and average CDS spread for the largest firms showed notable improvement from mid-2022 levels. By mid-October 2022, both indicators had recovered more than two-thirds of the deterioration seen in the first part of 2022. Following the failures of two large firms in March 2023, the average CDS spread for the largest firms spiked from 71 basis points to 112 basis points and the average market leverage ratio for the largest firms fell from 9.2 percent to 8.0 percent (figure 10). Despite the recent deterioration, neither indicator has approached the levels seen during the onset of the pandemic, when the average CDS spread and average market leverage ratio for the largest firms reached 185 basis points and 5.8 percent, respectively.
Figure 10. Average credit default swap (CDS) spread and market leverage ratio (daily)
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Note: The market leverage ratio is the ratio of a firm's market capitalization to the sum of market capitalization and the book value of liabilities. Averages are calculated from available observations for the eight LISCC firms (Bank of America Corporation; The Bank of New York Mellon Corporation; Citigroup Inc.; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; State Street Corporation; and Wells Fargo & Company).
Source: Federal Reserve staff calculations using Bloomberg data.
Box 1 provides a summary of bank financial performance and capital positions through the first quarter of 2023 based on the earnings results of a set of large banks.
Box 1. 1Q23 Earnings at Large Firms
This box provides a recap of banking sector conditions through March 31, 2023, based on earnings results for the 22 large U.S. bank holding companies and one savings and loan holding company subject to stress testing on an annual or biennial basis.1 While such trends are indicative, it should be noted that the sample may not necessarily be representative of the banking sector.
Earnings Increased Both Quarter-over-Quarter and Year-over-Year
Large banks' earnings in the first quarter of 2023 surpassed 2022 levels. Aggregate bank profitability, as measured by return on equity, approximated 13 percent in the first quarter of 2023, compared with 11 percent in the fourth quarter of 2022 and 12 percent earned in the first quarter of 2022.
Higher noninterest income, in part due to seasonally higher trading revenue, drove the quarter-over-quarter improvement in return on equity. Higher net interest income, reflecting the effect of rising interest rates on asset yields and robust loan growth, drove the year-over-year improvement in return on equity.
Deposits Continued to Decline though Trends Mixed Across Large Bank Sample
In the first quarter of 2023, aggregate deposits for the sample declined quarter-over-quarter for the third time in the past four quarters.
Outflows of commercial, wealth management, and noninterest-bearing deposits continued to drive deposit declines in the first quarter of 2023. Across the large bank sample, deposit flows were comparatively better for online consumer-focused banks, which tend to pay higher deposit rates. On earnings calls, management teams indicated that the recent bank failures had minimal impacts on their forecasts for deposit levels and costs.
Banks Modestly Built Loan Loss Reserves
In the first quarter of 2023, banks modestly built loan loss reserves for a third consecutive quarter. As expected, loan losses continued to rise slowly in the first quarter of 2023 and remain below pre-pandemic levels. On earnings calls, bank management teams cited commercial real estate as a sector that they are watching closely, particularly the office category.
Capital Ratios Increased Modestly
Common equity tier 1 (CET1) capital ratios increased modestly since the end of 2022. The aggregate CET1 capital ratio for the sample approximated 12 percent on March 31, 2023, which was slightly higher than last quarter's level and pre-pandemic levels.
Increased CET1 capital drove the quarter-over-quarter increase in the aggregate CET1 capital ratio. During the first quarter of 2023, many Large Banking Organizations reduced or halted share repurchases in part due to heightened macroeconomic uncertainty. Although Large Institution Supervision Coordinating Committee (LISCC) firms had previously slowed or suspended share repurchase in prior quarters, several LISCC firms have increased share repurchases in the first quarter of 2023.
1. The sample includes Ally Financial Inc.; American Express Company; Bank of America Corporation; The Bank of New York Mellon Corporation; Capital One Financial Corporation; The Charles Schwab Corporation; Citigroup Inc.; Citizens Financial Group, Inc.; Discover Financial Services; Fifth Third Bancorp; The Goldman Sachs Group, Inc.; Huntington Bancshares Incorporated; JPMorgan Chase & Co.; KeyCorp; M&T Bank Corporation; Morgan Stanley; Northern Trust Corporation; The PNC Financial Services Group, Inc.; Regions Financial Corporation; State Street Corporation; Truist Financial Corporation; U.S. Bancorp; and Wells Fargo & Company. Data is unadjusted for mergers and acquisitions. Return to text
References
2. Board of Governors of the Federal Reserve System, "The January 2023 Senior Loan Office Opinion Survey on Bank Lending Practices," Senior Loan Office Opinion Survey on Bank Lending Practices (2023), https://www.federalreserve.gov/data/sloos/sloos-202301.htm. Return to text
3. Board of Governors of the Federal Reserve System, Supervision and Regulation Report (Washington: Board of Governors, November 2022), https://www.federalreserve.gov/publications/files/202211-supervision-and-regulation-report.pdf. Return to text
4. As of the fourth quarter of 2022, more than one-third of the industry's credit loss reserves for loans and leases were allocated to credit cards. Return to text
5. The recent rise in credit card delinquency and net charge-off rates were driven by the nonprime segment. Return to text
6. Held-to-maturity securities are reported at amortized cost. As such, changes in their fair value are not reflected on firms' balance sheet and do not affect firms' tangible book value of capital. As of the fourth quarter of 2022, the fair value of held-to-maturity securities was an estimated $341 billion below their amortized cost. Estimates do not reflect losses related to available-for-sale securities that were transferred to held-to-maturity and do not reflect hedging impacts or tax consequences. Return to text
7. November 2022 Supervision and Regulation Report. Return to text
8. While most firms can opt out of including changes in the fair value of available-for-sale securities in regulatory capital, LISCC firms must include these fair value changes in CET1 capital. Return to text
9. Tangible common equity is calculated by subtracting preferred equity and intangible assets (including goodwill) from a bank's book value of capital. Changes in the fair value of available-for-sale securities are included in the book value of capital. Return to text