Fed says economy stabilized, but uncertainty persists; updates lists of large firms in supervision program

Economic conditions have stabilized, but uncertainty for the financial system persists, a report issued Friday by the Federal Reserve stated, in advance of its top supervisor’s testimony on Capitol Hill.

Also Friday, the Fed said it is updating the list of firms supervised by its Large Institution Supervision Coordinating Committee (LISCC) Program, established in 2010 to supervise the largest and most complex firms. The agency said the update clarifies that that so-called “Category 1” firms will be supervised in the LISCC portfolio and that it will accept input on the update.

“While economic activity has picked up and economic indicators have shown marked improve- ment since the second quarter, a high degree of uncertainty persists,” the Fed’s Supervision and Regulation Report for November 2020 stated. “Loan modifications and other policy measures make it challenging to accurately estimate potential loan losses, and macroeconomic uncertainty further complicates the analysis.”

The report was released in advance of testimony Thursday (Nov. 12) by Fed Board Vice Chair for Supervision Randal Quarles before the House Financial Services Committee. Quarles will be joining other top regulators from federal banking and credit union agencies, including the Federal Deposit Insurance Corp. (FDIC), Office of the Comptroller of the Currency (OCC) and the National Credit Union Administration (NCUA).

Other key aspects of the report noted:

  • Loan growth has moderated in recent months, expanding by 4% since the beginning of the year. That growth, the Fed said, was driven mainly by the Small Business Administration’s (SBA) Paycheck Protection Program (PPP), which made loans to businesses, through banks and credit unions, to keep employees on the payroll. “After increasing through May, total loan growth turned negative in June,” the Fed said. “Growth rates for commercial and industrial (C&I) and consumer loans in particular saw significant declines, driven principally by weak loan demand,” the Fed report states.
  • Nonetheless, liquidity conditions remain strong, according to the report. “Bank deposits grew at extraordinary rates through June, as investors continued to favor safe assets and consumers increased savings,” the report states. “Total deposits for all commercial banks increased by roughly $2.5 trillion between the end of 2019 and September 2020.”
  • Market-based indicators of bank health reflect improved conditions, the Fed stated. “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,” the Fed said.
  • Recent loan modification activity (such as through programs established by last spring’s Coronavirus Aid, Relief, and Economic Security (CARES) Act 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,” the report stated. “Banks will likely see an increase in nonperforming loans once deferral periods expire.”
  • Higher provisions and reserves for loan losses reflect concerns over potential credit losses. The report stated that banks have increased their loan loss reserves and tightened lending standards through the first half of the year as they anticipate in credit losses. The agency said loan loss provisions as a share of average loans and leases rose sharply in the first quarter, as banks aggressively downgraded their eco- nomic forecasts. The agency said in the second quarter, banks continued to increase provisions, albeit at a slower rate, as economic conditions stabilized.
  • Bank profitability fell sharply in the first half of the year, as measured by return on average assets (ROAA) and return on equity (ROE). The Fed said the drop was driven by falling net interest income and elevated provision expenses across both corporate and consumer loans. Although both ROE and ROAA began to recover in the second quarter, the Fed said, both have remained under pressure.

Regarding the definition for its LISCC program, the Fed said it will align its supervisory framework with the new regulatory framework that took effect earlier this year. “As a result, certain foreign banks with U.S. operations that have substantially decreased in size and risk over the past decade will move to the Large and Foreign Banking Organization supervision portfolio, where they will be supervised with other banks of similar size and risk,” the Fed said in a release.

The LISCC has covered eight U.S. global systemically important banks (G-SIBs) and three foreign banking organizations. The Fed said the portfolio move will have no effect on regulatory capital or liquidity requirements of any firm.