Bank profits ; Federal Reserve District, 12th ; Bank assets ; Banks and banking - West

Gary C. Zimmerman

English

Research Papers in Economics

FRBSF WEEKLY LETTER
November 16, 1984
Asset Quality and Western Bank Earnings
Historically, business expansions have brought in
their wake an improvement in banks' loan and
asset quality as they improved the economic con-
ditionsofbankcustomers. Th is process takes time,
buta significantimprovementin bank loan quality
usually can be observed by the second year ofa
recovery. The current expansion, however, ap-
pears likely to prove the exception. Despite a
vigorous economic expansion now nearingthe
end of its second year, a significantimprovement
in banks' loan and asset qualitydoes notseem
imminent.
Nevertheless, theearnings ofwestern (Alaska, Ari-
zona, California, Hawaii, Idaho, Nevada, Oregon,
Utah, Washington) banks have rebounded as im-
proved net interest margins and moderate asset
expansion have offset the deterioration in asset
quality caused by high real.interest rates, a strong
U.S. dollar, and significant changes in the eco-
nomy. This Letter reviews someofthe majorchal-
lenges facing the banking industry and the im-
provements that have allowed western banks, on
net, to increase theirearnings.
Lagging asset quality
As we approach the thirdyear ofthe expansion in
business activity, there are several indicationsthat
credit qualitywill continue to act as a drag on
bank earnings. One factor is the high level ofreal
interest rates duringthe currentrecovery (Chart 1),
which has increased the real debtburden ofmany
firms. With few signs that real rates will declineto
typical post-Waraverage levels, banks can expect
only minor improvement in this determinantof
asset quality in the near-term.
High real interest rates in the U.s. are also compli-
cating the international debtrepayment situation.
They, along with the strong u.s. dollar, have in-
creased the repayment burden for dollar-denomi-
nated debts, especially among the lesser devel-
oped countries (LDCs). Because prospects for a
solution to the economic problems of LDCs seem
unlikely in the near future, large banks probably
will be plagued for some time by their loans out-
standing to these nations.
High real interest rates and the strong dollar also
havecontributed toweakness in several important
segments ofthe domestic economy. The strong
dollarhas curbed theoverseas salesofmanyfirms
in the export sector, while stiffcompetition from
imported products has hurt competing domestic
industries. Furthermore, changes in relative prices
have weakened many so-called "smokestack" in-
dustries to the detrimentofthe regions in which
they are located. The troubled agriculture, steel,
timber, and mining industries have increased
banks' exposure to problem loans, and even a
robust economy is unlikelyto improve the pros-
pects of repayment by some firms in these strug-
gling industries. Moreover, persistent weakness in
the markets for petroleum products will continue
to depress the energy industry which has already
accounted for many troubled credits.
Nosilver lining
The majorcauses ofproblem loans are not likely
tobe resolved in the nearfutureo Mostanalysts are
notexpecting real interest rates totake anosedive;
the dollaralso is expected to remain strong; and it
will take time for depressed industries to bounce
back. Still, even ifthere were significant improve-
ments in these factors, there will be a long lag
before they show up in improved asset qualityfor
banks.
Indeed, in recent months, bankers have indicated
that they donotexpect a sudden improvement in
asset quality. Some ofthem have taken steps to
boost their loan loss reserves by large increments
whiIe others havetaken sizeablecharge-offswhiIe
still maintaining loss reserve levels. Some banks
have used extraordinary gains (building sales, for
example) to boost their loss reserves rather than
their earnings. These actions reduce currentearn-
ings and demonstrate the depth ofbankers' con-
cerns about credit quality.
Western performance
Despite the asset quality problems, banks in the
western region have generally reported a signifi-
cant improvement in earnings for 1984. For ex-
ample, overthefirstsix monthsofthisyear, aggre-
gate earnings were up nearly thirty-seven percent
overthe level forthe first halfof 1983. PartialFRBSF
third-quarter-1984 results are likewise encour-
aging. While there is considerable variation in the
performance ofthe region's 776 commercial
banks, as a group they are expected to post their
first year-over-year increase in net income (ex-
cluding extraordinary gains/losses) since 1980.
Improved interest margins
Thus far in 1984,banks in the West have been able
to improve their net interest margins in several
importantareas. On the funding side, the deregu-
lation ofinterest rates on consumer time and sav-
ings deposits, and particularly the market pricing
ofmoney market deposit accounts (MMDAs),
have had less ofan impact on interestexpenses
than might have been expected. Throughout
muchofthe year, the interestrates paid on money
marketdeposit accounts, which total overtwenty
percentofwestern banks' total domestic deposits,
were well below those paid by competing money
marketmutual funds orby banks on large-denom-
ination time certificates ofdeposit (CDs)-an al-
ternative source offunds (Chart 2). While this
MMDA pricing strategy resulted in some erosion
ofMMDA balances, it represented a significant
cost savings, especially as the difference between
MMDA and the otherrates widened over much of
the year.
Banks also boosted net interest margins (with
some added risk ofpotential loan losses as well) by
shifting from lowerto higher return assets. For
example, the twenty-nine largest banks in the
West ran offover $1.5 billion in securities during
the first halfof 1984 as commercial lendingtook
off. In addition, institutions continued to increase
the flexibility ofthe return on various assets by
pricing a larger portion ofnew real estate and
consumer loans on a variable rate basis. Thus,
when interest rates rose earlier in the year, banks
were able to maintain more favorable interest rate
spreads than ifthese loans had been made on a
fixed rate basis.
Uneven growth
Notonly were banks able to imPfove their net
interest margins in the first halfbut, in the aggre-
gate, western banks werealso abletoexpand their
assets moderately. Such growth was considerably
uneven across banks, however, with most ofthe
expansion reported by smaller institutions.
Growth at small community banks and regional
institutions in thewestern states resulted from rap-
id increases in mortgage and consumer lending.
,
These institutions, even more than their larger ri-
vals, benefitted from the renewed willingness of
consumers to borrow, even at historically high
real rates, to finance acquisitions ofautos, other
consumer durable goods and housing postponed
over the last several years.
Assets at most ofthe West's largest banks, and
especially those in California, showed little
growth duringthe first half, with a few banks even
reporting small declines. This is not surprising
however, since growth at manyofthe largest
banks was constrained by the need to build up
capital and to reducetheir leverage in accordance
withnewcapital guidelinesproposed bythe regu-
latory agencies. Yet, while total assets stagnated,
loans grew at a moderate. pace as institutions re-
structured their asset portfolios by liquidating se-
curities and converting other assets into loans.
Business loan demand at large banks in the West
picked up sharply duringthe first two quarters as
the improved financial health ofthe corporate
sector increased itsappetite for bank financing for
mergers and acquisitions, investment in newplant
and equipment, and inventory accumulation.
Commercial loans at these banks increased by
$3.5 billion (a 15-percentannual rate) duringthe
first six months.
Large western banks were also successful in their
efforts to expand lending to individuals. Consum-
er loans, paced by newautomobile purchases,
increased nearly $2 billion (a 12-percentannual
rate) over the first six months. Real estate loan
growth was less robust, climbingby $1.5 billion
(less than a 5-percent annual rate), despite a rela-
tively high level ofnew lending activity. Many
larger institutions with sizeable mortgage port-
folios sell most ofthe new loans they originate to
generate fee and service income and to avoid the
risk ofholdingthese assets should rates move
adversely.
Asset quality's impact on profits
The improvement in western bank earnings does
not mean that they escaped the lagging recovery
in asset quality that afflicts the banking industry
elsewhere. As did banks across the nation, west-
ern banks increased their loan loss provisions in
1984 in response to continued high levels ofnon-
performing loans and defaults which were heavi-
est in agricultural, energy, and construction port-
folios. Even though the economic climate has im-Perclmt
$1.75
:....
/'
Chart 3
Aggregate Net Income
Twelfth District Banks
Blllians
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0.00 1...-.l-....I-.....1--...!---'---'----'---"---'
1975 19761971 1978 1979 1980 1981 1982198~ 1984
30·Day CD Rate ,.- .;
;' Money Market
/ FundRate
"
;'
......, / ..'- ...l
.; ....1 MMDA Rate
.'
./."~,,,.
.......... _~-.-._~"
Chart 2
Improved Interest Margins
7I..W..I.-I..~I..WJ-LLLl,...L.J...I.-I...L.LJ
DJFMAMJJASONDJFMAMJJAS
1982 1984
9
11
12
10 '
·1964 is an ilJlght.mOrilh. <)VGrage
?erc&nt
8
2
Chart 1
Real Treasury Bill Rate"
o
6 -
.4 ~-J.--l.-J--l--L-J--.L-J-""'-JLL-L-J--.L_
1989 1971 1973 1975 1977 1979 1981 1983
proved since 1982, nonperforming loans rose in
1984 to new highs at many banks and dampened
earnings growth. Moreover, actual loan charge-
offs at western banks were upduringthe first half,
reaching $1 biIlion, and exceeding even the rec-
ord 1983 pace.
Even without any large defaults, major multina-
tional banks continue to face considerable earn-
ings risk if LDC credits were to be renegotiated on
unfavorable terms. At mid-year the foreign assets
ofthetwenty multinational banks in theninewest-
ern states accounted for about sixteen percent of
these banks' $375 billion in assets. While most of
these banks' foreign loans are notLDC-related, the
combined loanstoMexico, Brazil, Argentina, and
Venezuela exceed primarycapital at four ofthe
fjve largest west coast banks. Thus, LDC loans
renegotiated at lowerthan market rates could
have a considerable negative impacton banks'
interest margins.
1984 results
Western banks in the aggregate have lagged well
behind the industry in earnings performance over
the last three years primarilybecauseoflarge loan
losses suffered by a few banks. In 1984, they are
likelyto show a stronger improvement in net in-
come and returns on equity and assets than banks
nationally. Furthermore, in the absence ofmajor
interest rate changes ordefaults during the last
quarter, western banks will record higher net in-
terest margins for the year andreportmoderate
asset expansion.
Interest margins shou ld remain large as banks take
advantage oftheir ability to price MMDA interest
rates belowalternative rates and totakeadvantage
ofthe tendency when rates decline (as they have
recently) for loan rates to lag temporarily behind
the decline in funding costs. While loan demand
from the corporate sector has weakened during
the second halfof 1984, western banks should
continuetobe ableto increase theirlendingtothe
household sector. The result is that this region's
bankswill record amoderateexpansion in domes-
tic assets even though foreign assets wiII probably
decline slightly.
TogetherI the positive factors will offset the con-
tinued need for large provisions for loss reserves
and allowannual earnings for western banks in
1984 to reach $1.75 billion (net ofextraordinary
gains or losses). This figure is well up from last
year's depressed $1.1 billion profit, butbelow the
record $2 billion earnings for 1980 (Chart 3). Still,
the turnaround following successive declines in
earnings since 1980 is important, especially in
lightofcontinued creditquality problems. Strong
earnings will allowwestern banks to generate a
substantial increase in much needed capital, and
will giveconcerned institutionsthe opportunityto
continue to build theircushion against potential
loan losses. GaryC. Zimmerman
Opinionsexpressed in this newsletterdonotnecessarily reflect theviews ofthe management ofthe Federal Reserve Bank of San
Francisco,orofthe Board ofGovernors ofthe Federal Reserve System.
Editorial commentsmaybeaddressedtotheeditor(GregoryTong)ortotheauthor....Freecopiesof Federal Reserve publications
can be obtainedfrom the Public Information Department, Federal Reserve BankofSan Francisco, P.O. Box 7702,San Francisco
94120. Phone(415) 974-2246."l!Il?:) io:JSpUl?J:J Ul?S
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
uo~6U!4S0m 4o~n U060JO OpOA0U
040PI !!omoH O!UJOj!l0) ouoz!Jl:J o~soll:J
O)SI)UOJj UOS
JO ~U08
aAJaSa~ IOJapaj
~uaw~Jodaa 4)Joasa~
Selected Assets and Liabilities
large Commercial Banks
Amount
Outstanding
10/31/84
Change
from
10/24/84
Change from 12/28/83
Dollar Percent!
Loans, Leases and Investments1 2 185,720 1,734 9,695 6.5
Loans and Leases1 6 167,020 1,699 11,665 8.8
Commercial and Industrial 50,558 664 4,595 11.8
Real estate 61,163 44 2,264 4.5
Loans to Individuals 30,593 186 3,942 17.4
Leases 5,074 23 11 0.2
U.S. Treasury and Agency Securities2 11,573 25 - 934 - 8.8
Other Securities2 7,127 10 - 1,036 - 14.9
Total Deposits 191,652 2,186 655 0.4
Demand Deposits 45,530 2,191 - 3,707 - 8.8
Demand Deposits Adjusted3 29,300 19 - 2,031 - 7.6
OtherTransaction Balances4 12,279 223 - 496 - 4.5
Total Non-Transaction Balances6 133,843 - 229 4,858 4.4
MoneyMarket Deposit
Accounts-Total 38,552 66 - 1,045 - 3.1
Time Deposits in Amounts of
$100,000 or more 41,171 - 263 3,006 09.3
Other Liabilities for Borrowed MoneyS 22,516 2,197 - 491 - 2.5
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
10/22/84
13
102
89
Period ended
10/08/84
102
67
35
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.s. government and depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB,IT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

Asset quality and western bank earnings

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Asset quality and western bank earnings

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