Board of Governors of the Federal Reserve System

Banking System Conditions

Evolution of the COVID event

As noted in the previous Supervision and Regulation Report, the COVID event caused acute stress in many parts of the financial system beginning in March 2020.² It induced a sharp decline in economic activity and an accompanying surge in unemployment. Since then, market conditions and investor risk sentiment have improved substantially, though issues continue to exist in various sectors. Some asset prices have largely recovered, in part because of strong and rapid policy responses. However, while recent economic data offer positive signs, output and employment remain far below their levels prior to the COVID event, and the path forward remains uncertain. Recovery hinges in large part on the evolution of public concern about the virus as well as on policy actions taken at all levels of government.

The COVID event differs from previous crises in at least one important way. Because the economic shock emerged outside of a banking system that was significantly more resilient as a result of reforms and measures taken by the banking industry following the 2008 crisis, the role of banking organizations in this crisis has been different—serving as shock absorbers for the real economy, rather than as amplifiers of stress. Programs undertaken by the Federal Reserve have helped to preserve the flow of credit, while policy measures have helped build a bridge from the solid economic foundation on which we entered the crisis to a position of potential economic strength on the other side.

A More Resilient Banking System Has Helped the Economy Weather the Initial Shock

As the crisis broke, the benefits of a more resilient banking system were evident. Despite a great deal of turmoil in financial markets, the solvency of the banking system has not been in question. Banks have increased lending, absorbed a surge of deposits, and worked constructively with borrowers. They have also provided access to substantial lines of credit for corporate borrowers and played a significant role in supporting small businesses via the Paycheck Protection Program (PPP).

Banks also took a number of actions to maintain financial and operational resiliency. As a result, capital levels remain robust—indeed, they have actually increased during the COVID event—aided by timely policy response and capital preservation measures. Despite operational challenges, both banks and examiners have generally transitioned to a largely remote work environment without significant disruption to the provision of financial services. Bank branches have begun to reopen in line with local conditions and relevant guidelines.

Loan growth has moderated in recent months.

Since the beginning of the year, bank loans have grown by slightly more than 4 percent, driven mainly by the PPP. After increasing through May, total loan growth turned negative in June. Growth rates for commercial and industrial (C&I) and consumer loans in particular saw significant declines (figure 1), driven principally by weak loan demand. Despite approximately $500 billion in PPP loans originated by banks between April and August, C&I lending slowed as commitment draws began to be repaid (figure 2). Consumer loan growth declined as consumers reduced spending. Along with lower loan demand, tighter lending standards and greater uncertainty also contributed to declines.

Capital positions remain strong.

The aggregate common equity tier 1 (CET1) capital ratio recovered in the second quarter to around 12 percent, up from the first quarter and similar to the level at the end of 2019 (figure 3). Capital ratios rose slightly in the third quarter, based on preliminary reports from large banks (see figure C, box 2 later in the report). Capital ratios remain well above regulatory requirements at nearly all banks, providing a buffer to support further lending. Recent regulatory changes, such as the transition period for the impact of the current expected credit losses (CECL) accounting standard, have also benefited capital ratios at some banks.³

Liquidity conditions remain strong.

Bank deposits grew at extraordinary rates through June, as investors continued to favor safe assets and consumers increased savings (figure 4). Total deposits for all commercial banks increased by roughly $2.5 trillion between the end of 2019 and September 2020. Liquid assets as a share of total assets for the industry have risen noticeably this year (figure 5), with the majority of the increase occurring in the second quarter. Large banks have consistently remained above their liquidity coverage ratios throughout the COVID event.

Key market indicators reflect improved conditions.

Current market-based indicators of bank health, including credit default swap (CDS) spreads and market leverage ratios, reflect stabilization in financial markets and demonstrate continued resilience of the banking system. Although both CDS spreads and market leverage ratios deteriorated sharply in the first quarter, they have not reached the extremes of the 2008 financial crisis. Both indicators began to recover in April and have generally shown improved or stable trends through the third quarter (figure 6).

Conditions Have Stabilized, but Uncertainty Persists

While economic activity has picked up and economic indicators have shown marked improvement since the second quarter, a high degree of uncertainty persists. Loan modifications and other policy measures make it challenging to accurately estimate potential loan losses, and macroeconomic uncertainty further complicates the analysis.

While measures of asset quality are relatively stable, recent loan modification activity may obscure credit quality issues.

Banks have implemented loan modification programs consistent with section 4013 of the Coronavirus Aid, Relief, and Economic Security Act and have offered other accommodations to borrowers.⁴ By changing the terms of a loan to make it more affordable, these programs help borrowers deal with temporary economic hardship caused by the COVID event. As discussed in more detail later in this report, the use of these programs by borrowers is lending additional support to the economic recovery.

Historically, bank asset quality rises and falls with the state of the economy. However, current measures of asset quality, such as the ratio of nonperforming loans (NPL) to total loans and leases (the NPL ratio), remain stable, even though unemployment is at a high level. The overall NPL ratio remains near its pre-COVID-event level, rising only slightly to 1.1 percent in the second quarter from 0.9 percent at the end of 2019 (figure 7). The NPL ratio for consumer loans actually decreased by 0.1 percent over this period. NPL ratios for residential real estate, commercial real estate (CRE), and C&I loans each rose slightly in the first half of 2020.

The prevalence of loan modification programs may obscure credit quality issues, as a loan is typically not counted as "nonperforming" while it is covered by a loan modification program. When the deferral period under a loan modification program ends, many borrowers will be able to resume contractual payments; however, other borrowers may be unable to fully meet their obligations.⁵ Banks will likely see an increase in nonperforming loans once deferral periods expire.

Higher provisions and reserves reflect concerns over potential credit losses.

While the level of nonperforming loans remains low, banks have increased their loan loss reserves and tightened lending standards through the first half of the year in anticipation of a future rise in credit losses. Loan loss provisions as a share of average loans and leases rose sharply in the first quarter, as banks aggressively downgraded their economic forecasts. In the second quarter, as economic conditions stabilized, banks continued to increase provisions, albeit at a slower rate (figure 8). Higher reserves put banks in a stronger position to deal with any future deterioration in asset quality. As discussed in box 2 later in the report, large firms recorded declines in loss provisions in the third quarter, suggesting some confidence that the current levels of reserves can cover future deterioration in asset quality.

Profitability fell sharply in the first two quarters of 2020.

Bank profitability, as measured by return on equity (ROE) and return on average assets (ROAA), fell sharply in the first quarter of 2020, driven by falling net interest income and elevated provision expenses across both corporate and consumer loans. ROE and ROAA both began to recover in the second quarter (figure 9) but have remained under pressure. Net interest margins also experienced large declines in the first half of 2020 because of lower interest rates and higher holdings of low-yield assets. Growth in trading and investment banking revenues and mortgage origination fees helped offset some of these declines. Banks participating in the PPP have reported interest and noninterest income attributable to PPP loans, which will continue to influence banks' earnings in coming quarters, particularly for community and regional banks.

Footnotes