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FRBSF
WEEKLY LETTER
November 16, 1984
Asset Quality and Western Bank Earnings
Historically, business expansions have brought in
their wake an improvement in banks' loan and
asset quality as they improved the economic cond itions of bank customers. Th is process takes time,
but a significant improvement in bank loan quality
usually can be observed by the second year of a
recovery. The current expansion, however, appears likely to prove the exception. Despite a
vigorous economic expansion now nearing the
end of its second year, a significant improvement
in banks' loan and asset quality does not seem
imminent.
Nevertheless, the earni ngs of western (Alaska, Arizona, California, Hawaii, Idaho, Nevada, Oregon,
Utah, Washington) banks have rebounded as improved net interest margins and moderate asset
expansion have offset the deterioration in asset
quality caused by high real.interest rates, a strong
U.S. dollar, and significant changes in the economy. This Letter reviews some of the majorchallenges facing the banking industry and the improvements that have allowed western banks, on
net, to increase their earnings.
Lagging asset quality
As we approach the third year of the expansion in
business activity, there are several indications that
credit quality will continue to act as a drag on
bank earnings. One factor is the high level of real
interest rates during the current recovery (Chart 1),
which has increased the real debt burden of many
firms. With few signs that real rates will decline to
typical post-War average levels, banks can expect
only minor improvement in this determinant of
asset quality in the near-term.
High real interest rates in the U.s. are also complicating the international debt repayment situation.
They, along with the strong
dollar, have increased the repayment burden for dollar-denominated debts, especially among the lesser developed countries (LDCs). Because prospects for a
solution to the economic problems of LDCs seem
unlikely in the near future, large banks probably
will be plagued for some time by their loans outstanding to these nations.
u.s.
High real interest rates and the strong dollar also
have contributed to weakness in several important
segments of the domestic economy. The strong
dollar has curbed the overseas sales of many firms
in the export sector, while stiff competition from
imported products has hurt competing domestic
industries. Furthermore, changes in relative prices
have weakened many so-called "smokestack" industries to the detriment of the regions in which
they are located. The troubled agriculture, steel,
timber, and mining industries have increased
banks' exposure to problem loans, and even a
robust economy is unlikely to improve the prospects of repayment by some firms in these struggling industries. Moreover, persistent weakness in
the markets for petroleum products will continue
to depress the energy industry which has already
accounted for many troubled credits.
No silver lining
The major causes of problem loans are not likely
to be resolved in the nearfutu reo Most analysts are
not expecti ng real interest rates to take a nosed ive;
the dollar also is expected to remain strong; and it
will take time for depressed industries to bounce
back. Still, even if there were significant improvements in these factors, there will be a long lag
before they show up in improved asset quality for
banks.
Indeed, in recent months, bankers have indicated
that they do not expect a sudden improvement in
asset quality. Some of them have taken steps to
boost their loan loss reserves by large increments
wh iIe others have taken sizeable charge-offs wh iIe
still maintaining loss reserve levels. Some banks
have used extraordinary gains (building sales, for
example) to boost their loss reserves rather than
their earnings. These actions reduce current earnings and demonstrate the depth of bankers' concerns about credit quality.
Western performance
Despite the asset quality problems, banks in the
western region have generally reported a significant improvement in earnings for 1984. For example, over the first six months ofthis year, aggregate earnings were up nearly thirty-seven percent
over the level for the first half of 1983. Partial
FRBSF
,
third-quarter-1984 results are likewise encouraging. While there is considerable variation in the
performance ofthe region's 776 commercial
banks, as a group they are expected to post their
first year-over-year increase in net income (excluding extraordinary gains/losses) since 1980.
These institutions, even more than their larger rivals, benefitted from the renewed willingness of
consumers to borrow, even at historically high
real rates, to finance acquisitions of autos, other
consumer durable goods and housing postponed
over the last several years.
Improved interest margins
Assets at most of the West's largest banks, and
especially those in California, showed little
growth during the first half, with a few banks even
reporting small declines. This is not surprising
however, since growth at many of the largest
banks was constrained by the need to build up
capital and to reduce their leverage in accordance
with new capital guidelines proposed by the regulatory agencies. Yet, while total assets stagnated,
loans grew at a moderate. pace as institutions restructured their asset portfolios by liquidating securities and converting other assets into loans.
Thus far in 1984, banks in the West have been able
to improve their net interest margins in several
important areas. On the funding side, the deregulation of interest rates on consumer time and savings deposits, and particularly the market pricing
of money market deposit accounts (MMDAs),
have had less of an impact on interest expenses
than might have been expected. Throughout
much of the year, the interest rates paid on money
market deposit accounts, which total over twenty
percent of western banks' total domestic deposits,
were well below those paid by competing money
market mutual funds or by banks on large-denomination time certificates of deposit (CDs)-an alternative source of funds (Chart 2). While this
MMDA pricing strategy resulted in some erosion
of MMDA balances, it represented a significant
cost savings, especially as the difference between
MMDA and the other rates widened over much of
the year.
Banks also boosted net interest margins (with
some added risk of potential loan losses as well) by
shifting from lower to higher return assets. For
example, the twenty-nine largest banks in the
West ran off over $1.5 billion in securities during
the first half of 1984 as commercial lending took
off. In addition, institutions continued to increase
the flexibility of the return on various assets by
pricing a larger portion of new real estate and
consumer loans on a variable rate basis. Thus,
when interest rates rose earlier in the year, banks
were able to maintain more favorable interest rate
spreads than if these loans had been made on a
fixed rate basis.
Business loan demand at large banks in the West
picked up sharply during the first two quarters as
the improved financial health of the corporate
sector increased itsappetite for bank financing for
mergers and acqu isitions, investment in new plant
and equipment, and inventory accumulation.
Commercial loans at these banks increased by
$3.5 billion (a 15-percent annual rate) during the
first six months.
Large western banks were also successful in their
efforts to expand lending to individuals. Consumer loans, paced by new automobile purchases,
increased nearly $2 billion (a 12-percent annual
rate) over the first six months. Real estate loan
growth was less robust, climbing by $1.5 billion
(less than a 5-percent annual rate), despite a relatively high level of new lending activity. Many
larger institutions with sizeable mortgage portfolios sell most of the new loans they originate to
generate fee and service income and to avoid the
risk of holding these assets should rates move
adversely.
Uneven growth
Asset quality's impact on profits
Not only were banks able to imPfove their net
interest margins in the first half but, in the aggregate, western banks were also able to expand their
assets moderately. Such growth was considerably
uneven across banks, however, with most of the
expansion reported by smaller institutions.
Growth at small community banks and regional
institutions in the western states resulted from rapid increases in mortgage and consumer lending.
The improvement in western bank earnings does
not mean that they escaped the lagging recovery
in asset quality that afflicts the banking industry
elsewhere. As did banks across the nation, western banks increased their loan loss provisions in
1984 in response to continued high levels of nonperforming loans and defaults which were heaviest in agricultural, energy, and construction portfolios. Even though the economic climate has im-
Chart 1
Real Treasury Bill Rate"
Chart 2
Improved Interest Margins
?erc&nt
8
6 -
Blllians
Perclmt
2.25
12
2.00
30·Day CD Rate
,.-
.;
11
;' Money Market
/
Fund Rate
2
10 '
o
9
. . . , ... .1/ ..'-.. l
"
.......... _~-.-._~"
$1.75
1.75
: ....
1.50
1.25
;'
.;
Chart 3
Aggregate Net Income
Twelfth District Banks
MMDA Rate
.'
./."~,,,.
/'
1.00
0.75
0.50
0.25
.4
~-J.--l.-J--l--L-J--.L-J-""'-JLL-L-J--.L_
1989 1971 1973 1975 1977 1979 1981 1983
·1964
is an
ilJlght.mOrilh. <)VGrage
7I..W..I.-I..~I..WJ-LLLl,...L.J...I.-I...L.LJ
DJFMAMJJASONDJFMAMJJAS
1982
proved since 1982, nonperforming loans rose in
1984 to new highs at many banks and dampened
earnings growth. Moreover, actual loan chargeoffs at western banks were up during the first half,
reaching $1 bi Ilion, and exceeding even the record 1983 pace.
Even without any large defaults, major multinational banks continue to face considerable earnings risk if LDC credits were to be renegotiated on
unfavorable terms. At mid-year the foreign assets
ofthe twenty multinational banks in the nine western states accounted for about sixteen percent of
these banks' $375 billion in assets. While most of
these banks' foreign loans are not LDC-related, the
combined loans to Mexico, Brazil, Argentina, and
Venezuela exceed primary capital at four of the
fjve largest west coast banks. Thus, LDC loans
renegotiated at lower than market rates could
have a considerable negative impact on banks'
interest margins.
1984 results
Western banks in the aggregate have lagged well
behind the industry in earnings performance over
the last three years primarily because of large loan
losses suffered by a few banks. In 1984, they are
likely to show a stronger improvement in net income and returns on equity and assets than banks
nationally. Furthermore, in the absence of major
interest rate changes or defaults during the last
quarter, western banks will record higher net in-
0.00
1...-.l-....I-.....1--...!---'---'----'---"---'
1975 19761971 1978 1979 1980 1981
1982198~
1984
1984
terest margins for the year and report moderate
asset expansion.
Interest margins shou ld remain large as banks take
advantage of their ability to price MMDA interest
rates below alternative rates and to take advantage
of the tendency when rates decline (as they have
recently) for loan rates to lag temporarily behind
the decline in funding costs. While loan demand
from the corporate sector has weakened during
the second half of 1984, western banks should
continue to be able to increase their lending to the
household sector. The result is that this region's
banks will record a moderate expansion in domestic assets even though foreign assets wi II probably
decline slightly.
Together I the posit ive factors will offset the continued need for large provisions for loss reserves
and allow annual earnings for western banks in
1984 to reach $1.75 billion (net of extraordinary
gains or losses). This figure is well up from last
year's depressed $1.1 billion profit, but below the
record $2 billion earnings for 1980 (Chart 3). Still,
the turnaround following successive decl ines in
earnings since 1980 is important, especially in
light of continued credit quality problems. Strong
earnings will allow western banks to generate a
substantial increase in much needed capital, and
will give concerned institutions the opportunity to
continue to build their cushion against potential
Gary C. Zimmerman
loan losses.
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.
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(';SL 'ON l1WH:Jd
(]IVd :JDVlS0d"S"n
llVW SSVl:> ISHI:I
aUHOS:JHd
(Dollar amounts in millions)
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities2
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Change from 12/28/83
Dollar
Percent!
Amount
Outstanding
10/31/84
Change
from
10/24/84
185,720
167,020
50,558
61,163
30,593
5,074
11,573
7,127
191,652
45,530
29,300
12,279
133,843
1,734
1,699
664
44
186
23
25
10
2,186
2,191
19
223
229
-
38,552
66
-
1,045
-
3.1
263
2,197
-
3,006
491
-
09.3
2.5
41,171
22,516
Period ended
10/22/84
-
-
-
9,695
11,665
4,595
2,264
3,942
11
934
1,036
655
3,707
2,031
496
4,858
Period ended
10/08/84
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+)/Net borrowed( -)
13
102
89
102
67
35
Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
3 Excludes U.s. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB,IT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change
1
2
IOJapaj
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
Selected Assets and Liabilities
large Commercial Banks
~U08
-
-
-
6.5
8.8
11.8
4.5
17.4
0.2
8.8
14.9
0.4
8.8
7.6
4.5
4.4
@FedFRASER