Board of Governors of the Federal Reserve System

Banking System Conditions

The financial performance of the banking industry is generally strong.

The strong performance of the economy over the past five years has contributed to the robust financial performance of the United States banking system. During this period, bank earnings saw an overall upward trend. Return on equity (ROE) and return on average assets (ROAA)—two important measures of profitability—both ended 2018 up, year-over-year. Despite market volatility during the second half of the year and a slight drop in late 2018, both measures of earnings remained above their five-year averages (figure 1). Robust growth in net interest income and the recent cut to the federal corporate income tax rate were two key drivers of bank profitability.

As interest rates trended up over the past several years, banks have managed their balance sheets such that, in the aggregate, yields on loans and securities increased more quickly than liability costs. This in turn has pushed the net interest margin—the difference between interest income and the amount of interest paid out, as a share of average earning assets—along a strong upward trend. The net interest margin ended the year at 2.9 percent, above the low of 2.5 percent from the first quarter of 2015 (figure 2).

Banks have expanded lending throughout the economy.

The last quarter of 2018 saw strong loan growth (figure 3). Over the past five years, the banking system has expanded loans by nearly 30 percent. Commercial and industrial (C&I) and nonresidential real estate loans, in particular, have seen robust growth during this period. Since the beginning of 2014, lending in C&I and nonresidential real estate loans has grown by nearly 40 percent. Growth in consumer loans and residential real estate loans has been slower.

C&I loans, typically used to finance capital business operations and capital expenditures, tend to be more responsive to economic cycles. Growth in this loan category is a key indicator of growth in the broader economy, though often with a lag. C&I loans are currently one of the largest loan categories in the United States. Banking organizations of all sizes have increased C&I lending, with smaller banks seeing stronger growth in recent years than their larger counterparts.

Asset quality of the banking industry continues to improve overall.

As lending expands, the Federal Reserve and other regulatory agencies continue to pay close attention to underwriting standards and the quality of loans that banks are taking onto their books. The nonperforming loan ratio—the ratio of loans 90 days or more past due and those in nonaccrual status, to total loans—is an important measure of asset quality. The lower this ratio, the fewer loans on which banks are unable to collect and the less risk to the overall financial system. This measure has seen marked improvement during the past several years, ending 2018 at roughly 1 percent, below its five-year average of 1.6 percent (figure 4).

Measures like the nonperforming loan ratio typically react to, but do not necessarily predict, economic conditions. Changes in asset quality can highlight areas of potential concern that warrant further supervisory monitoring. One such area is the agricultural loan sector. The nonperforming loan ratios for two types of agricultural loans—farmland and agricultural production loans—saw a year-over-year increase in 2018 (figure 5). Nonperforming loan ratios for credit cards and auto loans also are increasing, partly reflecting expansions of subprime lending.

The Federal Reserve continues to monitor the risks from leveraged lending through the Shared National Credit (SNC) program and annual stress testing. While underwriting and risk-management practices generally have improved in agency-supervised institutions, trends in certain loan characteristics, such as fewer and less-stringent protective covenants, more liberal repayment terms, and incremental debt provisions, suggest vulnerabilities that may lead to increased risk of borrower default or loss.¹

Although capital ratios remain well above regulatory requirements, larger firms have seen a slight decline because of higher payouts and asset growth.

Capital serves as a buffer for the financial industry, enabling financial institutions to absorb losses that may result from unexpected operational, credit, or market events. Maintaining a robust level of capital enables firms to remain resilient in the face of downturns and support economic growth.

All banking portfolios maintained strong capital positions (figure 6), although capital ratios declined slightly in 2018. Capital ratios have been influenced by capital distributions in the form of cash dividends and stock repurchases, and by the growth in total assets held by banks.

Market indicators continue to reflect generally strong industry performance.

Although there have been some fluctuations in market indicators due to uncertainty around certain macroeconomic issues, indicators of bank health such as the market leverage ratio and credit default swap (CDS) spreads continue to reflect strong banking system conditions.

Overall, CDS spreads—a measure of market assessments of bank risk—have been trending downwards over the past several years, reflecting investor confidence in banks' financial health. CDS spreads moved higher in December 2018 and January 2019 but have since settled back down to levels consistent with those from November 2018. Although not directly related to actual capital strength, the market leverage ratio varies depending on changes in the market value of a firm's equity and thus serves as proxy for market assessments of a firm's position. This indicator has decreased somewhat since the beginning of 2018. Although the decline does not rise to a level of concern, the Federal Reserve continues to closely monitor this, as well as other, market indicators (figure 7).

Footnotes