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FR8SF
teneR'
WEEKLY
Number 95-03, January 20, 1995
Why Banking Isn't Declining
Banking has been described as a declining industry. Banks are not that important anymore, the
story goes; modern capital markets and financial
competitors are displacing them as suppliers of
credit and transaction services. Superficial evidence of a decline is easily found. As Figure 1
shows, bank assets are a steadily smaller proportion of the total assets of the financial sector and
the total number of banks in the United States
has fallen dramatically. During the 1980s, bank
failures hit levels not seen since the Depression.
Is banking dying? This Weekly Letter discusses
evidence from several recent analyses of the
health of banks and the banking industry. These
studies approach the question from various angles, but their results support what may be a surprising conclusion: Banking is surviving, and by
some measures becoming a larger part of the
U.S. financial system.
Assets don't matter as much anymore
Banks' falling share of the total assets of the
financial sector (as in Figure 1) is probably the
most frequently cited evidence of the ill health of
banking. However, the financial sector is growing steadily in importance in the economy. Even
if banks are shrinking relative to their financial
competitors, their slice of the expanding pie may
be bigger. Banking assets are actually growing
faster than the economy as a whole.
But asset trends are misleading, because assets
are not a good signal of the volume of activity
in financial services. An important and widely
noted development in financial markets over the
last decade has been the growth of lines of business that do not create assets in the traditional
accounting balance-sheet sense. For example,
if a bank provides a business customer with a
standby letter of credit instead of a loan, nothing
goes on the balance she~t. Bank involvement in
derivative financial instruments generally adds
little or nothing to booked assets. Yet these and
other relatively new financial activities have
become a major part ofthe business for which
banks and other financial firms compete.
Figure 1
Bank Assets as a Percentage
of All Financial Assets
Number
of Banks
Percent
60
14500
•••• _ •• _ - ••.•••
14000
50
Bank
Assets
40
13500
13000
.
30
:I
1980
~u;:~::
.'. j
12500
12000
11500
11000
1982
1984
1986
1988
1990
In recent research, Boyd and Gertler (1994) try
two different approaches to adjusting bank assets
for the importance of off-balance-sheetactivities.
For one, they use bank regulatory formulas to
calculate "credit equivalents:' the amount of onbalance-sheet assets that would give the same
credit risk exposure as the off~balance-sheet positions. This credit equivalent amount can then be
added to the banks' total reported balance sheet
assets. Their second, alternative adjustment is
based on banks' ratio of noninterest to interest
income. Roughly speaking, balance sheet assets
produce interest income while off-balance-sheet
items produce noninterest income; the mix has
shifted noticeably toward the latter in recent
years. Boyd and Gertler capitalize the noninterest portion, in effect calculating the quantity of
assets that would produce the observed level of
noninterest income. The capitalized value can be
added to the on-balance-sheet total. Using either
type of adjustment, they find that much of the
decline in bank market share disappears. Thus,
at least part of the downward trend in asset share
PRBS':
(as in Figure 1) reflects a change in' how banks
do business, not how much business they do,
Boyd and Gertler also point out thatthe typical
measure of bank assets does not inClude all of
the banking assets active in U.s. financial markets. Specificaiiy, manyioans made by foreign
banks tocustomers in the United States are
booked outside the country. As a result, the official figures understate the amountof business
being done by banks (foreign and domestic combined) in the United States. A shift in favor of offshore bookings causes reported banking assets to
deCline,.even though U.S. banking activity could
be as robust as ever. Total banking assets can be'
corrected for this undercounting using estimates
of loans booked offshore. Boyd and Gertler find
that combining this correction with the earlier
adjustments for off-balance~sheet activities eliminatesthe apparent deCline in banks' share of
financial assets.
Figure 2,
Value Added by Banks
Percent
25
T
I
As a percentage of
Financial Sector GDP
20
15
10
5
As a percentage of
Total GDP
. . - --
-~_
... ---_._ . ..... -_ .. --.-_ •... -
0+---'-0--,----'-0---,----'-0--,----.,.---,---.,.----,
1980
1982
1984
1986
1988
1990
Value added may be a better measure
The various asset adjustments of Boyd and
Gertler are one way to address the problem that
book assets are not a good measure of market
share; However, there are other approaches to
measuring the relative importance of various
kinds of financial firms. One attractive candidate
is "value added;' the difference between the
value of output and the value of intermediate
products used as inputs. Value added is a measure of how much a business has contributed to
the production of valuable goods and services
in theeconomy. If banks are creating relatively
more value nowthan in the pa.st, they are not
deClining in any meariingfulsense.
Kaufman and Mote (1994) estirnate value added
for the banking industry, using information in
corporateincome tax returns. Specifically, they
note that the difference between total receipts
(which inCludes both interest and noninterest reve·
nues) and interest paid should be a good approximationofvalue added in banking. The solid line
in Figure 2 shows that this measure of banking
value added has been increasing slightly relative
to the financial sector as a whole. In addition,
over this period the firiancialsector increased
from 15.4 percent to 17.7 percent of gross domestic product (GDP). As a result, banking grew relatiVEjtothei.test6fthe·.econom~.atc:oliritlrigfor···,
the slight but noticeable upward slope of the
dashed line in Figllre 2, which compared bankingto totaIQPP.Suc,h growth invalue added is
not consistent with terminal decay.
Evidence from the stock market
Stock prices are another place to look for signs
of banking's health. In particular, investors in the
shares of banks and other financial firms have
strong incentives to make correctjudgments
about the health of banking firms, since they
stand to lose real money if they are wrong. Because of the high stakes, sophisticated investors
carefully analyze bank health and try to forecast
the future profits of banks in which they invest.
Their consensus beliefs are reflected in the prices
of bank stocks; lookingat those stock prices is
like taking a surveybf a group of experts. If those
experts think banking is a deClining industry,
bank stock prices will be low to reflect the meager profits expected in the future.
I recently created a model linking the level,
growth, and riskiness of a firm's profits to its
stock price, and evaluated a group of large, publiCly traded banks that comprise the bulk of the
industry (Levonian J994). Investors' consensus
beliefsabout these banks!. long-run profitability
can be inferred from the stock-price model.
There was no evidence that investors expect future bank profits to be subpar. On the contrary,
the.prices.of tlie'bankstocksseernla(eflett'(l
belief thatcompetition in the industry will gradually drive profitrates to alevel .that is perfectly
nqrmaUor the leve.1 of riskihherentjn the. bank,.
ing business.
Why people think banking is declining
The research described above suggests that banking is viable. Yet a public perception of decline
persists. Graphic evidence as in Figure 1 is compelling, showing the seemingly clear decline in
"market share" and the disappearance of thousands of banks; failures of ban.k-typeinstitutions
were prominent during the 1980s. Adding to this
evidence from another direction were the low
industry profits during the late 1980s and early
1990s, when many banks lost money. Recent
earnings have improved greatly/but the suspicion
remains that the good times are not sustainable.
It is tempting to view the earlier poor financial
performance as a sign of decline, part of a larger
trend, in much the same way that hot summers
bring discussions of global warming and cold
winters of the next ice age. If banks are so
healthy, why have profits been so uneven?
Research on bank stock prices sheds light on the
poor industry profitability of the recent past. The
prices that investors are willing to pay for shares
of stock incorporate estimates of core economic
profitability, which may differ from the profits
reported in any period. Estimates of core profitability are buried in stock prices, but can be unearthed with the help of the right model; if this
fundamental underlying economic profitability is
high, banks are basicaIIYhe<llthY.Th~st()ck-price
model in Levonian (1994) produces an estimate
of the rate of return on bankequitythiltis.. most
consistent with the prices investors are willing to
pay for bank stocks. The solid line in Figure 3
shows these estimates of the underlying,ot core,
economic rate ofreturn for large, publicly traded
banks for the last few years; the dashed line
shows the return on equity actually reported by
those banks>Repotted ptofits obviously sagged
during much of the late 1980s,butthe market
viewed those low profits as aberrant and shortlived. True profitability, revealed by bank stock
prices, remained consistently high. The market
does not see the industry's poor recent profits as
signs of longer-term decay.
Conclusion
Banks are not dinosaurs. Bank assets are growing
faster than the rest of the economy, and after adjusting for off-balance-sheet activities and other
accounting issues banks have lost little ifany
ground to other types offinancial firms. Value
added by banks has been growing fairly steadily.
In support of this "market~share" evidence, bank
stock price data also show that investors expect
banking to remain profitabie. Banks may be
evolvi ng away from thei r trad itional role as lenders, but they remain central to other, equally vital
forms of financial activity. Despite gloomy predictions and eye-catching headlines, banking is
al ive and well.
Figure 3
Return on Equity for Banks
(in percentage points)
Mark E. Levonian
Research Officer
References
25
Boyd, John H., and Mark Gertler (1994), "Is banking
dead? Or, are the reports greatly exaggerated?" in
Implicit "Core"
ROE
20
15
10
,
....
.
, , ...
The (Declining?) Role of Banking: Proceedings of
the 30th Annual Conference .on BankStructure and
Competition, Federal Reserve Bank of Chicago,
-.-
pp.85-117.
Kaufman, George G., and tarry R. Mote (1994), "Is
banking a declining industry? A historical perspective;' EconomicPerspectives,Federal Reserve Bank
ofChicago; May/June, pp. 2-21.
.'
'.
Reported ROE
"..
"'.'.'
5
Levonian, Mark E\ (1994), Will. banking be profitable
in the long~run?" in The (Declining?) Role of BankIf
O+--+--'-t-+--+--'--+-+---'-+--+~I--+--+---l
86:11
.
87:11
88:11
89:11
90:11
91:11
92:11
i'1g: Proceedings of the 30th Annual Conference
on Bank Structure and Competition, Federal
Reserve Bank ofChic:ago, pp. 118-129.
.
Opinions expressed in this newsletter do not ne<:essarily refled the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Govemorsofthe Federal Reserve System.
.... .
'.
.
Editorial comments may be addressed to the editor or to the author••.. Freecopieso~FederalRe~.erve 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, Fax (415) 974-3341.
.
.
AeSeOf<3A,@eportment .
Feder~I'Reserve{
_ _~_,-:_:,;r ,',:>:';'}
,;-/
(;"";":,:G';.,',·
Bank' of
San Francisco
P.O. Box 7702
San Francisco, CA 94120
Printed on recycled paper
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lC.lI .6.
\%I ~
Index to Recent Issues of FRBSF Weekly Letter
DATE
711
7115
7/22
8/5
8119
9/2
9/9
9116
9/23
9/30
10/7
10114
10/21
10/28
11/4
11111
11118
11/25
12/9
12/23
12/30
1/6
1/13
NUMBER
94-24
94-25
94-26
94-27
94-28
94-29
94-30
94-31
94-32
94~33
94-34
94~35
94-36
94-37
94-38
94-39
94-40
94-41
94-42
94-43
94-44
95-01
95-02
TItlE
AUTHOR
Trade and Growth: Some Recent Evidence
Should the Central Bank Be Responsible for Regional Stabilization?
Interstate Banking and Risk
A Primer on Monetary Policy Part I: Goals and Instruments
A Primer On Monetary Policy Part II: Targets and Indicators
Linkages of National Interest Rates
Regional Income Divergence in the 1980s
Exchange Rate Arrangements in the Pacific Basin
How Bad is the "Bad Loan Problem" in Japan?
Measuring the Cost of "Financial Repression"
The Recent Behavior of Interest Rates
Risk-Based Capital Requirements and Loan Growth
Growth and Government Policy: Lessons from Hong Kong and Singapore
Bank Business Lending Bounces Back
Explaining Asia's Low Inflation
Crises in the Thrift Industry and the Cost of Mortgage Credit
International Trade and US. Labor Market Trends
EU + Austria + Finland + Sweden + ?
The Development of Stock Markets in China
Effects of California Migration
Gradualism and Chinese Financial Reforms
TheCredibility of Inflation Targets
A Look Back at Monetary Policy in 1994
Trehan
Cogley/Schaan
Levonian
Walsh
Walsh
Throop
Sherwood-Call
Glick
Huh/Kim
Huh/Kim
Trehan
Laderman
Kasa
Zimmerman
Moreno
Gabriel
Kasa
Zimmerman
Booth/Chua
Mattey
Spiegel
Trehan
Parry
The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.
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