Banking System Conditions
The Banking System's Financial Condition Has Improved, while Some Concerns Persist
Overall, the financial condition of the banking system was strong and improved in the first half of 2021, yet some concerns persist.1 Banks continued to report robust levels of capital and liquidity. Ample capital and liquidity positions make banks more resilient to economic shocks and allow them to continue to support the economic recovery. In the first half of 2021, financial conditions improved: early signs of loan growth emerged, the loan delinquency rate fell, bank profitability increased, and loans in forbearance declined.
Despite these positive developments, there are some concerns. The banking industry's average net interest margin—a bank's yield on its interest-bearing assets after netting out interest expense—remains low. Moreover, while early signs of loan growth are emerging, loan growth has been weak overall. The low net interest margins, combined with weak loan growth, have caused net interest income to decline.
Also, although the aggregate loan delinquency rate fell, financial fallout from the COVID event may continue for some time. Loan delinquency rates may increase in certain sectors, particularly if the COVID event continues and dampens the economic recovery. The path toward full economic recovery is uncertain and contingent on the evolving public health crisis.
Capital and liquidity remain sources of strength.
Banks have reported strong capital levels during the COVID event, and those levels rose in the first half of 2021. The aggregate common equity tier 1 capital (CET1) ratio increased to nearly 13 percent, higher than the ratio reported prior to the COVID event (figure 1). Capital ratios were above regulatory requirements at nearly all banks, providing a buffer against losses and support for lending.
Figure 1. Aggregate common equity tier 1 (CET1) capital ratio
Accessible Version | Return to text
Note: CET1 capital ratio is the ratio of common equity tier 1 capital to risk-weighted assets. See the data appendix for further information. Community bank leverage ratio adopters (currently, about 38 percent of firms) are excluded.
Source: Call Report and FR Y-9C.
The Federal Reserve released the results of its 2021 annual stress test in June, which assessed whether large banks are sufficiently capitalized to absorb losses during a hypothetical recession and continue to lend to households and businesses. The June results showed that large banks had strong capital levels and were well positioned to support the ongoing economic recovery. Consequently, temporary capital distribution restrictions related to the COVID event were lifted, and large banks are now subject to the normal restrictions from the Board's new stress capital buffer framework.2
Bank liquidity positions have also improved this year. Deposits increased by roughly $1 trillion in the first half of 2021. Banks continue to invest these funds in liquid assets, such as cash and securities, providing protection against any instability of the new deposits. Liquid assets now comprise over 27 percent of total assets, well above pre-COVID-event levels (figure 2). Large banks remained above their regulatory liquidity coverage ratio requirements.
Figure 2. Liquid assets as a share of total assets
Accessible Version | Return to text
Note: Liquid assets are cash plus estimates of securities that qualify as high-quality liquid assets as defined by the liquidity coverage ratio requirement.
Source: FR Y-9C.
Firms remain operationally resilient, but concerns persist about cybersecurity threats.
Prior Supervision and Regulation Reports have highlighted the industry's resilience during the COVID event. Banks have continued to provide banking services and to engage with their customers, as each considers when and how to return to the office. The period of the COVID event has also seen an increase in cybersecurity events, which remain a top concern for both firms and supervisors.
Bank profitability recently exceeded pre-COVID-event levels.
Bank profitability, as measured by return on average assets (ROAA) and return on equity (ROE), exceeded pre-COVID-event levels in the first half of 2021, reaching a five-year high in the first quarter (figure 3). Negative provision expense, discussed in detail below, and higher noninterest income drove the first quarter improvement in earnings. Noninterest income benefited from higher investment banking fees and higher trading, mortgage, and wealth-management revenue. Aggregate provision expense remained negative in the second quarter, and noninterest income remained robust. Neither contributed to earnings as much as they did during the first quarter.
Figure 3. Bank profitability
Accessible Version | Return to text
Note: ROE is net income/average equity capital, and ROAA is net income/average assets.
Source: Call Report and FR Y-9C.
In response to the COVID event in early 2020, banks added to reserves to cover an anticipated increase in loan losses. This increase in credit loss expense, or provision expense, drove the sharp decline in earnings reported in early 2020. As the economy improved and loans performed better than expected, banks have reduced reserves. The resulting negative provision expense boosted bank earnings in the first half of 2021 (figure 4).
Figure 4. Provisions as a share of average loans and leases
Accessible Version | Return to text
Source: Call Report and FR Y-9C.
Market indicators of bank health point to financial strength.
The improvement to the banking system's overall financial condition is reflected in key market indicators for large firms, including the market leverage ratio and credit default swap (CDS) spreads. The market leverage ratio is a market-based measure of the strength of capital; a higher ratio generally reflects investor confidence in banks' financial resilience. CDS spreads are a measure of market perceptions of bank risk; a lower spread reflects investor confidence in banks' financial health. These measures deteriorated in early 2020 but have since improved. Recently, they stood near pre-COVID-event levels (figure 5).
Figure 5. Average credit default swap (CDS) spread and market leverage ratio (daily)
Accessible Version | Return to text
Note: The market leverage ratio is the ratio of a firm's market capitalization to the sum of market capitalization and the book value of liabilities. Averages are calculated from available observations for the eight LISCC firms (Bank of America Corporation; The Bank of New York Mellon Corporation; Citigroup Inc.; The Goldman Sachs Group; JPMorgan Chase & Co.; Morgan Stanley; State Street Corporation; and Wells Fargo & Company).
Source: Bloomberg.
Loan growth has been weak, but signs of a potential rebound have emerged.
Total loans grew through May 2020, boosted by commercial and industrial (C&I) loan commitment drawdowns and Paycheck Protection Program (PPP) loan originations, but then declined 5 percent in the last half of 2020. However, the decline in loans stabilized in early 2021, and some signs of growth have emerged. Total loan balances were flat in the first quarter of 2021 but have increased slightly since. Consumer loans and residential real estate loans, which were a drag on total loans in 2020, recently turned higher, and commercial real estate (CRE) loans have continued to rise (figure 6).
Figure 6. Loans by type
Accessible Version | Return to text
Note: Data are for all commercial banks.
Source: H.8, "Assets and Liabilities of Commercial Banks in the United States."
All consumer loan categories rose in the second quarter of 2021, leading total consumer loans to increase 3 percent from the prior quarter. Large firms reported more consumer spending on credit cards during the quarter. Strong consumer demand and higher vehicle prices drove growth in auto loans. The Federal Reserve's July 2021 Senior Loan Officer Opinion Survey cited higher demand and eased lending standards for consumer loans during the second quarter, a positive sign for future loan growth.3
Households have taken on more mortgage debt since the COVID event began, but the outstanding balance of residential real estate (RRE) loans at banks declined from the second quarter of 2020 through the second quarter of 2021. Home equity lines of credit (HELOCs) accounted for most of the decline in RRE balances. Some banks pared back or eliminated HELOCs, in response to the uncertainty brought about by the COVID event and consumer preference for other forms of lending. The decline in RRE loans also reflects increased competition from nonbank mortgage lenders, who originate more mortgages than banks. Recent data show RRE loans began to increase in the third quarter of 2021, as growth in mortgage balances has more than offset continued decline in HELOCs.
C&I loans fell in the second quarter of this year, driven by PPP loan forgiveness (figure 7). C&I unused commitments increased in the second quarter, and the combination of C&I loans and unused commitments rose slightly year over year. As with consumer loans, respondents to the Federal Reserve's July 2021 Senior Loan Officer Opinion Survey reported higher demand and eased lending standards for C&I loans.
Figure 7. C&I loans and unused commitments
Accessible Version | Return to text
Note: Assumes all PPP loans are C&I loans. Key identifies bars in order from top to bottom.
Source: Call Report and FR Y-9C.
Net interest margins remain under pressure.
The banking industry's average net interest margin fell to a record low during the first half of 2021, hampering revenue growth. Net interest margins have declined steadily, as interest rates fell and banks invested much of their COVID-event-related deposit inflow into lower yielding assets, such as cash and securities. As discussed earlier in this report, noninterest income has grown this year, compensating for the lack of growth in net interest income (figure 8).
Figure 8. Net interest income and noninterest income
Accessible Version | Return to text
Note: Key identifies bars in order from top to bottom.
Source: Call Report and FR Y-9C.
Loan delinquency rates have declined, but concerns persist in some sectors.
Aggregate loan delinquency rates fell during the first half of 2021. The improvement in delinquency rates was broad-based, with declines across all major loan categories (figure 9). At the same time, loan modification balances declined, as hardship programs continued to wind down. Loans modified in accordance with section 4013 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act decreased to approximately $200 billion in the second quarter of 2021, down 30 percent from year-end 2020 and nearly 70 percent from the second quarter of 2020 (figure 10).
Figure 9. Loan delinquency rates
Accessible Version | Return to text
Note: Delinquent loans are those 90+ days past due or in nonaccrual status.
Source: Call Report and FR Y-9C.
Figure 10. Section 4013 loan balances
Accessible Version | Return to text
Source: Call Report and FR Y-9C.
Although the overall state of credit quality appears favorable, some sectors more negatively affected by the COVID event warrant closer monitoring. As the COVID event emerged and worsened, large banks as a group downgraded their internal risk ratings on loans in COVID-susceptible sectors. For example, large banks reported net downgrades on C&I loans in the entertainment and recreation sector and on CRE loans in the hotel and retail sectors.
Ratings on loans in many COVID-susceptible sectors improved in the second quarter of 2021, but recovery continues to vary by location and sector. For example, while large banks reported quarter-over-quarter net upgrades on loans in most C&I sectors, they reported net downgrades on CRE loans in the office sector. Box 1 focuses on the CRE market, detailing broad learnings from supervisory work, highlighting key risk areas, and discussing ongoing supervisory efforts.
Box 1. CRE Loans Warrant Continued Monitoring
Shutdowns and social-distancing measures related to the COVID event have strained commercial real estate (CRE) properties, especially retail, office, and hotel properties. Despite these areas of weaknesses, few banks have reported problems with CRE loans and delinquencies remain low (figure A). The pandemic's impact on CRE loan performance has been softened by the governmental response. However, concerns remain about the future performance of CRE properties, particularly given uncertainties about where people will work, shop, and live.
Banks are a critical funding source of CRE debt and held approximately half of the $5 trillion total loans outstanding to the U.S. CRE market at the end of the second quarter of 2021 (figure B). Supervisors have observed that banks have been actively monitoring CRE loans and downgrading them appropriately. Banks worked with their CRE borrowers and granted loan modifications. Many CRE borrowers who requested accommodations have returned to normal payment terms.
Figure A. CRE delinquencies and net charge-off rates
Accessible Version | Return to text
Note: Delinquent loans are those 90+ days past due or in nonaccrual status.
Source: Call Report and FR Y-9C.
Figure B. Holders of U.S. CRE mortgage loans, 2021:Q2
Accessible Version | Return to text
Source: Financial Accounts of the United States, Call Report, and FR Y-9C.
As the economy and the CRE market continue to recover, the Federal Reserve encourages banks to maintain sound underwriting standards. The Federal Reserve will closely monitor CRE loans and will remain focused on higher risk properties, such as hotels, office, and retail. The Federal Reserve will also monitor banks that hold higher concentrations of loans secured by CRE.
Return to textBox 2. Third-Quarter 2021 Earnings at a Sample of Large Banks
This box provides a recap of third-quarter 2021 banking sector conditions, based on third-quarter 2021 earnings results for a sample of large U.S. bank holding companies.1 While such trends are indicative, it should be noted that the sample may not necessarily be representative of the banking sector as a whole.
Third-Quarter Earnings Remain above Pre-COVID-Event Levels
Preliminary third-quarter earnings data suggest large banks' earnings remained above pre-COVID-event levels but declined relative to levels earned in the first half of 2021. Aggregate bank profitability, as measured by ROE, approximated 14 percent in the third quarter for the sample, compared with 12 percent earned in full-year 2019 and 16 percent earned in the first half of 2021.
Figure A. Return on equity
Source: S&P Global Market Intelligence and earnings releases.
Banks continued to release credit loss reserves but at a slower pace than previous quarters. Reserve releases coincided with continued improvement in net-charge-off rates and other asset quality indicators, which remained near or fell to new historic lows during the quarter.
Net interest income and net interest margin improved quarter-over-quarter, in part reflecting growth in loans and securities as deposit growth persisted. Loan growth was strongest in the consumer sector. On earnings calls, bank management teams forecast continued net interest income growth, based on expectations for increased loan demand and higher interest rates.
Figure B. Loan loss reserves as a percent of average loans
Note: See the data appendix for additional information.
Source: S&P Global Market Intelligence and earnings releases.
Noninterest income trends were mixed across firms but declined in the aggregate from levels earned in the first half of 2021. This is despite elevated capital markets 2 revenues, which remained near a post-global financial crisis high. Operating expense trends were mixed across banks, though several management teams on earnings calls acknowledged increased compensation pressure.
Capital Ratios Declined but Remain above Pre-COVID-event Levels for Most Firms
Common equity tier 1 (CET1) ratios declined on a quarter-over-quarter basis for the majority of reporting banks. Ratio declines were driven by risk-weighted asset growth and higher capital distributions during the quarter, which for some firms exceeded earnings. Despite declines, the aggregate CET1 ratio for the reporting banks ended the third quarter near 12 percent, remaining above its level at the end of 2019.3
Figure C. CET1 ratio
Source: S&P Global Market Intelligence and earnings releases.
1. This sample includes top-tier U.S. bank holding companies with total consolidated assets of $100 billion or more as of 9/30/2020. These firms include: Ally Financial Inc., American Express Company, Bank of America Corporation, The Bank of New York Mellon Corporation, Capital One Financial Corporation, Citigroup Inc., Citizens Financial Group, Inc., Discover Financial Services, Fifth Third Bancorp, The Goldman Sachs Group, Inc., Huntington Bancshares Incorporated, JPMorgan Chase & Co., KeyCorp, M&T Bank Corporation, Morgan Stanley, Northern Trust Corporation, The PNC Financial Services Group, Inc., Regions Financial Corporation, State Street Corporation, Truist Financial Corporation, U.S. Bancorp, and Wells Fargo & Company. Return to text
2. Comprises revenue generated from debt underwriting, equity underwriting, mergers and acquisitions, equity trading and fixed income, and currency and commodity trading. Return to text
3. M&T Bank Corporation and Northern Trust Corporation are excluded from the aggregate CET1 ratio due to reporting differences. Return to text
References
1. This overview of banking system conditions is based on data collected by the Federal Reserve and other federal financial regulatory agencies, as well as market indicators of bank health. For more information, please see appendix A. Return to text
2. See Board of Governors of the Federal Reserve System, news release, "Federal Reserve Board releases results of annual bank stress tests, which show that large banks continue to have strong capital levels and could continue lending to households and businesses during a severe recession," June 24, 2021, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20210624a.htm. Return to text
3. See the July 2021 "Senior Loan Officer Opinion Survey on Bank Lending Practices" at https://www.federalreserve.gov/data/sloos/sloos-202107.htm. Return to text