Bank profits ; Federal Reserve District, 8th

Lynn M. Barry

English

Research Papers in Economics

FEDERAL RESERVE BANK OF ST. LOUIS APRIL 1987
A Review ofthe Eighth District’s
Banking Economy in 1986
Lynn M. Barry
uring ayear of continuing economic expansion,
banks in the Eighth Federal Reserve District showed
moderate earnings improvement in 1986.1 Reported
earnings rose atmany District banks: profitable invest-
ment decisions and lower interest rates, which re.
duced the cost of deposit liabilities, more than offset
loan losses. Though most institutions are profitable
and in good financial condition, agricultural and other
credit problems continue to trouble some District
banks.
Rank failures, while up sharply nationwide, de-
clined in the Eighth District. Nationally, 138 banks
insured bythe Federal Deposit Insurance Corporation
(FDIC) failed in 1986, the largest number to fail since
theFDIC wasformed in 1933. Fivebanks in theDistrict
failed in 1986 compared with six in 1985 — one na-
tional bank and four state banks not members of the
Federal Reserve System.2 These five banks represent
less than 1 percent of the total number ofbanks in the
District and had combined total assets of$72.7million,
only 0.2 percent ofall District bank assets.3
This article examines the overall condition ofEighth
District banks by assessing several measures of bank
Lynn M. Batty is an economist at the Federal Reserve Bank of St.
Louis. Rosemarie Mueller pmvideciresearch assistance.
‘The Eighth Federal Reserve District consists of the following states
and parts of states:
Arkansas,entirestate; Illinois, southern 44 counties; Indiana, south-
em 24 counties; Kentucky, western 64 counties; Mississippi, north-
ern39 counties; Missouri, eastern and southem 71 counties and the
City ofSt. Louis; Tennessee, western 21 counties.
2(Jf the five District commercial bank failures in 1986, three were
agricultural banks (banks with more than 25 percent of their total
loans to farm borrowers).
‘See Carraro (1986/1987).
performance, including earnings, asset quality and
capital adequacy. An evaluation of these measures
provides useful information on the financial condi-
tion, compliance with banking regulations and stat-
utes, and operating soundness ofthe regional banking
industry.
EARNINGS
The number ofDistrict banks with negative earnings
fell last year from 127 banks in 1985 to 113 (orfrom 92
percent to 8.5 percent of District banksl in 1986. A
notable improvement occurred in the smallest bank
category (less than $25 million in assets), in which the
number of banks with negative net income declined
by seven.
Two key measures of bank earnings and managerial
performance are the return on assets (ROA) ratio and
the return on equity (ROE) ratio. The ROAratio, calcu-
lated by dividing abank’s net income after taxes by its
average assets, gauges how wella bank’s management
is employing its assets. The ROE ratio, obtained by
dividing a bank’s net income by its equity capital,
indicates the return on the shareholders’ investment.4
District banks generally had higher returns on as-
sets and equity in 1986 than in theprevious twoyears.
As table 1 indicates, Eighth District banks earned an
average 0.90 percent ROAand an 11.53 percent ROE in
1986, both up from their 1985 performance. The 1986
figures for District banks compare favorably with the
national average ROA of 0.64 percent and ROE of 9.83
percent.
4Equity capital includes common and perpetual preferredstock, sur-
plus, undivided profits and capital reserves.
16FEDERAL RESERVE BANK OF ST. LOUIS APRIL 1987
Increased profitability at District banks arose pri-
marily from both wider net interest margins and im-
proved asset quality (which resulted in fewer charge-
offs). Net interest margin, roughly similar to a
business’ sales margin, measures the spread between
a bank’s interest income and interest expense. The
decline in interest rates during 1986 reduced debt-
servicing costs and increased the lending spread com-
pared with the previous two years. As table 2 shows,
the average spread between interest income and ex-
pense as apercent of average assets is 4.05 percent in
the District, compared with 3.77 percent inthe nation.
Bank earnings in the District were boosted during
thepast year as thelargest banks continued to expand
their noninterest sources ofincome by pricing more of
their products explicitly. Major income sources in-
cluded fee income associated with deposit, trust and
mortgage services. Smaller banks, however, have had
much slower gi-owth ofnoninterest income. Astable 3
indicates, noninterest income relative to average as-
sets has remained essentially unchanged at District
banks with assets less than $100 million.
ASSET QUALITY
Asset quality is a primary factor influencing the
banking industry’s earnings pattern. Concern among
regulators about the quality of bank assets has in-
creased in recent years, given its direct effect on bank
profitability.
17FEDERAL RESERVE BANK OF ST. LOUIS APRIL 1987
Table 4
Net Loan Losses as a Percent of
Total Loans1
121986 121985 121984
United States 093°c 08’% 072°c
Eightn D,striu 0 86 0 89 0 60
25 million in assets 1 24 1 51 1 15
2550 116 138 092
50-100 103 1.09 069
100-300 0.95 072 047
300 million-i biSon 088 078 053
billion 0 57 0.59 0 39
Total cans ano ieases charged-off due to ur’collect:budy. -ess
amounts recovered on prev’ouscharge-oHs
SOURCE Feaerai Deposit Insurance Corpo’aiion. Conso-i-
aated Reports of ~oncitior arc lncor”e 1or Insured
Commerciai Barks. ‘984-86
Changes in asset quality typically are monitored by
two indicators. The ratio of net charge-offs to total
loans is atraditional measure of loan quality, showing
the percentage of net loans (adjusted for recoveries)
actually written offas losses.
The second measure of asset quality, the nonper-
forming loan rate, indicates the level of problem loans
as well as the potential forfuture loan losses Problem
assets include the following components: loans
greater than 89 days past due, nonaccrual loans and
renegotiated loans.
Since year-end 1982, all FDIC-insured commercial
banks have reported delinquencies (loans more than
30 days past due(, nonaccrual and renegotiated loans,
and loan charge-offs on aquarterly basis. Nonaccrual
loans are those with scheduled payments due and
unpaid for more than 90 days, forwhich full payment
of interest or principal is unlikely. Nonaccrual loans
may also include loans that the bank decides to clas-
sib’ as nonaccrual (that is, the recent decisions by
majorbanks with respect to Brazilian loans). Renegoti-
ated loans are loans that have been restructured to
provide a reduction of either interest or principal
because ofa deterioration in the borrower’s financial
position. The information now reported permits a
comprehensive analysis ofthe degree and breadth ofa
bank’s loan quality problems.
As table 4 indicates, the ratio of net loan losses to
Table 5
Nonperforming Loans as a Percent of
Total Loans
12-1986 121985 121984
Untec Stales 2 77% 2 83’s 3 05~c
EigI’tn Diswri 2 16 2 50 2 50
25 mi ion in assets 2 oS 326 3.0~
25-50 261 305 295
5000 2d9 267 24~
100300 205 21’ 21i
300 rrillior.- 1 nillion 2 23 2 68 2 08
h,’ioq 18~ 219 262
SOIJROE. Feoera Deposit insurance Gorpc.rauon. ~nnsoi’-
awed Reports of Condition and Vcw~e tor lnsu’ed
~ Banks ~984--86
total loans wa,~litwer a: ~p~ir-end 1986 than one \i’ar
earlier for all size categui vs in the District except for
banks in the siot~ million-Si billion asset range. Small
banks, those with assets less than $25 million, showed
alarge decline during this period, with the charge-off
ratio falling from 1.51 pet-cent to 1.24 percent. For the
largestbanks in the Eighth District, the charge-offratio
fell only slightly. Chart I compares loss rates ofdiffer-
entloan types. As one can see from the chart, the loss
rate was highest for District banks’ agricultural loans,
with commercial loans a close second.
As table 5 shows, the nonperforming loan rate de-
creased in the District during 1986, falling fi-om 2.50
percent in 1985 to 2.16 percent in 1986. This pattern
was mirrored across all size categories of District
banks.
Because of deteriorating asset quality during the
past several years, banks in the Eighth District and the
nation have mci-eased their allowance for loan losses
as a share of theit- total loans outstanding. This action
has been taken as a precautionary measure to absorb
expected future loan losses. Table 6 indicates that
medium-size banks, in particular increased their loan
loss allowance account inresponse to an acceleration
in their level of nonperforming loans. As a percent of
total loans, Eighth District banks’ loan loss allowance
increased from 1.31 percent at year-end 1985 to 1.39
percent in 1986, while nationally this iatio tose fiom
1.42 percent to 1.62 percent.
18FEDERAL RESERVE BANK OF ST. LOUIS
Chart 1
Loan Loss Ratios by Category
Eighth District
APRIL 1987
Perunt
—4
Table 6
Allowance for Loan Losses as a Percent
of Total Loans
121986 121985 12-1984
United Slates 1.62% 1 42% 1 24%
Eighth District 1 39 31 1.20
- 25 million in assets 1 56 ~.59 1 41
25-50 142 126 1.’7
50-100 1 39 1 22 1 09
100300 130 119 107
300 m’liion-l billion 1 39 1 35 ‘ 09
1 billion 40 141 1.39
CAPITAL ADEQUACY
Capital — the difference between a bank’s assets
and its liabilities — supports abank’s operations and
provides a cushion for losses that may arise. Bank
capital traditionally has been seen as away to protect
a bank and its creditors from failure. For a given
quality ofassets, the lower the capital base, the greater
therisk ofinsolvency. The level ofcapital also serves to
maintain public confidence in the soundness of indi-
vidual banks and the banking system as awhole.
The amount of capital by itself does not necessarily
provide useful information to regulators; capital must
be measured relative to those balance sheet items
whose fluctuations bank capital is intended to cush-
ion. Regulators generally are concerned with the
amount of ptimary and total capital relative to some
Percent
‘0~~
Agricultural losses! Agricultural loans,-’
•~~4~~_#
4
3
2
1
,
,__~
~
Commercial losses!Commercial loans
3
2
Total losses!Total loans
0 1 0
Dec. 84 Dec. 85 Dec. 86
S0tJR~E:Federal Deposit Insu’ance corporation. - cor.soli~
dated Reports of Condition and Income for Insured
con’mercia~ Banks. 1984.86
19FEDERAL RESERVE BANKOF ST. LOUIS APRIL 1987
measure of the bank’s asset base.’ The regulatory
agencies do not assume that a bank’s capital is ade-
quate simply because it meets the minimum capital
requirements. Banking organizations whose opera-
tions involve higher than normal degrees of risk are
expected to hold additional capital. Areas that merit
particular attention in analyzing risk are the loan and
investment portfolios, the level of liquid assets in rela-
tion to total assets, the volume and nature of off-
balance sheet risk exposure, the level and character of
intangible assets and the extent and nature of all
nonbanking activities 0 Federal banking regulators will
require specific banks to meet higher capital ratios if
their assets are considered to be risky, that is, to have a
relatively high probability of significant decline in
value.’
Improvement in bank capital ratios in recent years
is apparent throughout the range ofinstitutions. One
major reason for the increased levels of capital has
been the adoption of capital adequacy guidelines by
the three federal agencies that regulate U.S. commer-
cial banks: the Federal Deposit Insurance Corpora-
tion, the Federal Reserve System and the Office ofthe
Comptroller ofthe Curren~’,° In November1983, Con-
gress enacted the International Lending Supervision
Act of 1983, which directed the federal banking agen-
cies to establish minimum levels of capital for banks.
As a result, these agencies have set minimum stand-
ards of 5.5 percent primary capital to assets and 6.0
5The componentsof primarycapital asreported in the FDICConsoli-
dated ReportofCondition and Incomeare: common stock, perpetual
preferred stock, surplus, undivided profits, contingency and other
capital reserve, qualifyingmandatory convertible instruments, allow-
ance for loanand lease losses, andminority interestsin consolidated
subsidiaries, less intangible assets excluding purchased mortgage
servicing rights. (For the purposes of this paper, only the goodwill
portion of intangible assets was deducted.) Secondary capital is
limited to 50 percent of primary capital and includes subordinated
notesanddebentures, limited-life preferred stock and that portion of
mandatory convertible securities not included in primary capital.
Each bank’s secondary capital is added to its primary capital to
obtain the total capital level for regulatorypurposes.
eOff.balance sheetactivities arediscussedmost often in termsof loan
commitments, standby and commercial letters of credit, foreign
exchange contracts, financial futures and forward contracts and
interest rate or foreign currency swaps. These transactions all in-
volve contractsfor the future purchase orsaleof assets and include
relativelynew activitiesfor banks.
‘TheFederal Reserve Board has developedaproposal fortheadop-
tion of risk-based capital standards. The proposed guideline would
assign weights based on relative risk to assets and certain off-
balance sheetitems. The sum ofthese weighted asset values is the
weighted risk asset total against which actual primary capital would
be compared.
°See Gilbert, Stone and Trebing (1985).
As indicated in table 7, total capital ratios are well
above the minimum standards established by the
bank regulatory agencies both for banks in the Eighth
District and the banking industry as a whole. ‘Fhe
average total capital ratio (the sum of the individual
banks’ total capital divided by the sum of the individ-
ual banks’ total adjusted assets) was 8.56 percent for
Eighth District banks compared with 8.18 percent for
all 11.5. commercial banks-In 1986, total capital ratios
rose across all asset size ranges except those District
banks in the $300 million to Si billion range. Forbanks
with assets greater than $1 billion, the average total
capital ratio rose from 7.21 percent in 1985 to 7.62
percent in 1986. As of December 1986, approximately
1.6 percent of all District banks did not meet the
minimum regulatory total capital standards, while for
the nation, slightly more than 3.8 percent of the com-
mercial banks had deficient total capital ratios.
SUMMARY
Overall, District commercial banks showed im-
proved profitability in 1986, outperforming their peers
across the nation. District banks, in general, earned
higher returns on assets and equity than in the pre-
vious two years. Net interest margins also improved at
banks in the region.
Asset quality continues to be a major factor in-
fluencing the banking industry’s level of earnings.
percent total capital to assets. The minimum capital
ratios are the same forall federally supervised banking
organizations regardless of size, type of charter or
membership in the Federal Reserve System.
20FEDERAL RESERVE BANK OF ST. LOUIS APRIL 1987
While the ratios of loan charge-offs and nonperform-
ing loans to total loans declined in the District, banks
did, however, increase their allowance for loan losses
in order to absorb additional loan losses in the future.
A majority of Eighth District banks improved their
capital ratios during 1986 and are positioned well
above the minimum standards established by bank
regulators. On thewhole, District banks outperformed
the nation in terms of their capital adequacy position.
REFERENCES
Barry, Lynn M. “1985— Eighth District BankPerformance,” Bank-
ing and Finance — AnEighth DistrictPerspective (Spring 1986).
Board of Govenors of the Federal Reserve System. Press Release,
Capital Adequacy Guidelines, April 18, 1985.
Carraro, Kenneth C. “Uneven Trends in Eighth District Bank Profit-
ability,” Banking and Finance — An Eighth District Perspective
(Spring 1985).
________ - “Bank Failures in the 1 980s — Another Perspective,”
Banking and Finance — An Eighth District Perspective (Winter
1986/1987).
Gilbert, R. Alton, Courtenay C.Stone, and Michael E.Trebing. “The
NewBank Capital Adequacy Standards,” this Review (May 1985).
Waldrop, Ross. “Commercial BankPerformance in 1985,” Banking
and Economic Review, Federal Deposit Insurance Corporation.
Vol.4, No.3, April1986, pp. 19—24.
________ - “Commercial Banking Performance, Mid-Year 1986,”
BankingandEconomic Review, Federal Deposit Insurance Corpo-
ration, Vol.4, No.8, November/December 1986, pp. 13—19.
21

Bank Failures in the 1 980s — Another Perspective,” Banking and Finance — An Eighth District Perspective

Commercial Banking Performance, Mid-Year

Commercial BankPerformance in 1985,” Banking and Economic Review, Federal Deposit Insurance Corporation.

Courtenay C.Stone, and Michael E.Trebing. “The NewBank Capital Adequacy Standards,” this Review

Govenors of the Federal Reserve System. Press Release, Capital Adequacy Guidelines,

Uneven Trends in Eighth District Bank Profitability,” Banking and Finance — An Eighth District Perspective (Spring

A review of the Eighth District's banking economy in 1986

http://research.stlouisfed.org/publications/review/87/04/Banking_Apr1987.pdf

A review of the Eighth District's banking economy in 1986

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics