Authors: Uri Dadush, Bennett Stanson
Originally published by the Carnegie Endowment for International Peace
Eighteen months after the failure of Lehman Brothers, a smaller and more concentrated banking system is emerging from the crisis. Capital has been rebuilt, market confidence in the banks has been reestablished, and profits are recovering. But continuing loan losses and rising financing requirements mean that banks have remained cautious and loan volume is still declining. The sector remains dependent on government support and is vulnerable to a number of possible shocks, including financial reforms that impose immediate and significant new costs on banks. Though markets are shifting their attention from risks in the banks to those posed by surging sovereign debts, U.S. policy makers need to still exercise great caution when withdrawing support from the banking system.
A smaller banking system
After nearly collapsing in 2008, the financial sector has rallied impressively over the past year. Since falling to their nadirs in March 2009, financial equities have risen by 150 percent, compared to the S&P 500’s increase of 77 percent. Compared to their average levels in 2007, financials are down over 50 percent, while the S&P is only down 20 percent.
The banking system that stepped back from the abyss, however, is smaller and more concentrated than the one that nearly fell in. The weakest financial institutions failed outright, were absorbed by larger firms, or survived on direct government cash injections, reducing the number of FDIC-insured institutions by 7.6 percent—from 7401 to 6839—over the last three years. The banking industry also become more concentrated, as the number of institutions with less than $100 million in assets fell by 22 percent, while those with more than $100 million in assets grew by 3.7 percent. Additionally, total assets of the banking system have declined considerably, falling by 5.3 percent from the fourth quarter of 2008 to the fourth quarter of 2009, the largest one year decline since the FDIC began keeping records.
This smaller banking system remains dependent on extraordinary government measures. The Fed balance sheet expanded from an average of $856 billion in 2007 to $2.3 trillion currently, reflecting asset purchases. The FDIC is also guaranteeing $305 billion in debt issued by banks and other financial institutions. The federal funds rate, the primary determinant of the cost of borrowing, is at its lowest level in history, and the yield curve remains very steep (a steeper yield curve indicates greater market expectation of rate increases), with the difference between 3-month and 10-year yields Treasury securities around 360 basis points, one of the widest spreads since 1990.
Confidence in the banks returns
Government support and aggressive bank restructuring, as well as the stabilization of the economy, allowed a gradual return of market confidence in the financial system. Indicators of financial sector risk and volatility, including the TED spread, corporate bond spreads, and the VIX Index, are back to near pre-crisis levels. Furthermore, according to Bloomberg’s Financial Conditions Index, financial market conditions are currently better than their long run average.
The banking industry has also seen a gradual return to profitability. Banking institutions made a small profit in 2009, with net-income increasing to $12.5 billion, a fraction of the $100 billion reported in 2007. This upward trend consolidated further in the first quarter of 2010, though most major banks’ substantial gains came from investment banking and trading operations, not improvements in loan and real estate markets.
Reflecting these improvements, as well as stronger growth prospects for the economy as a whole, the IMF recently revised its projection for total U.S. write-downs to $885 billion, from $1025 billion in October. As banks have repaid emergency loans and their stock prices surged, taxpayer losses from the public bailouts have also been revised downward from a year ago. The estimated cost of the Troubled Asset Relief Program (TARP) was lowered from $356 billion to $89 billion, a small amount relative to the size of the U.S. banking system and to previous financial crises.
Bank lending: still cautious
Despite these improvements and the government’s unprecedented support, the banking system continues to play a diminished role in financial intermediation. Total loan and lease balances fell by 1.7 percent in the fourth quarter of 2009, the sixth consecutive quarterly decline, as banks have continued to use cheap credit from the Fed to shore up balance sheets. The ratio of reserves to total lending increased to 3.1 percent in the fourth quarter, reaching the highest level since 1933, and the ratio of capital to risk-weighted assets rose from 12.8 percent in 2008 to 14.3 percent in 2009.
Depressed demand partly accounts for the continued lending contraction, but bank resistance appears to be the most important factor. The IMF projects that the credit shortfall (the difference between credit supply and credit demand as a percentage of credit demand) will be 14 percent in 2010, even with significant government support adding to supply.
Rising loan losses and an approaching hump in the banks’ own financing requirements appear to justify the banks’ cautious approach. Loan write-offs were 37 percent higher in the fourth quarter of 2009 than in the same period in 2008. The quality of outstanding loans is also deteriorating; overdue loans rose by 68 percent over the same period. Furthermore, of the $1.4 trillion in commercial real estate loans coming due from 2010 to 2014, nearly half are estimated to have an outstanding value of more than the value of the asset used to secure them. With unemployment expected to remain high, banks will likely see more losses on the $1 trillion worth of securities backed by auto loans, credit card debt, home equity, and student loans.
The turmoil in Europe is an additional worry, though U.S. banks’ direct exposure, at $176 billion, to the most threatened European countries—Greece, Portugal, Ireland, and Spain—is modest compared to that of European banks and represents less than 5 percent of all foreign exposure.
With $1 trillion of their own debt maturing over the next three years, banks will require dependable capital. Raising capital to cover maturing debt and possible domestic losses, however, could become increasingly difficult. Though the IMF predicts the credit shortfall in the United States will narrow to 2 percent in 2011, banks’ own financing needs will imply higher borrowing costs. Additionally, U.S. government borrowing needs are predicted to rise from 3.3 percent of GDP in 2003-2008 to 8.3 percent in 2009-2011, potentially crowding out private sector borrowing, including by banks.
Policy support remains crucial
Though market confidence in the banks has returned, they remain cautious, and correctly so. The combination of uncertainty about future loan losses, rising capital needs, and increased borrowing costs could snowball. Banks are rebuilding their balance sheets, and will remain reluctant to lend until their own recovery, as well as the U.S. economy’s recovery, is fully entrenched. And to meet credit demand predicted to grow by an average of 6.3 percent over the next two years, banking institutions need to be prepared to open the spigots—but are unlikely to do so without continued policy support.
Though the Fed has already taken modest steps to tighten its policy, increasing the discount rate by 25 basis points in February and ending its mortgage-backed security purchasing program in March, these steps have had a minimal effect on the market: 30-year mortgage rates rose by less than 15 basis points in the week following each change. Larger policy shifts, however—such as an increase in the federal funds rate or a substantial reduction of the Fed’s balance sheet—should wait until bank finances are stronger and more robust. Higher policy interest rates and withdrawal of other stimulus measures, which markets are speculating will come later this year, would increase borrowing costs for a banking system that is still being nursed back to health.
Badly needed reforms of bank regulation and the imposition of new fees now being debated in Congress should also proceed with some caution. New regulations are essential to ensure the long-term stability of the banking system, but steps that impose immediate and significant new costs on banks could delay the recovery of the still fragile and crucial financial sector.
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