Bank capital, liquidity ‘robust’ following pandemic – but challenges remain in lending, net interest margin, Fed reports

Capital and liquidity positions of the nation’s banking system remain “robust,” with bank profitability mostly rebounding to pre-pandemic levels, the Federal Reserve said Friday in its semiannual report on safety and soundness.

However, the report notes, challenges remain: Lending activity has been slow, with little growth beyond that provided through Payroll Protection Program (PPP) loans, and the decline in banks’ net interest margin – which began in fourth quarter of 2019 – accelerated last year.

The Fed report stresses that banks entered the coronavirus crisis last spring with strong capital positions and built on that throughout the year. “For example, the aggregate common equity tier 1 (CET1) capital ratio exceeded its pre- COVID-event level in the second half of 2020,” the report states. “As of year-end 2020, capital ratios remain well above regulatory minimums at nearly all firms, providing a buffer to absorb losses and support lending as the economy recovers.”

Liquidity strengthened too, the report asserts, with strong growth in deposits. “Bank deposit balances increased by over $3 trillion since year-end 2019,” the report states. “Many factors contributed to the rapid growth in deposits. These include higher levels of consumer savings, drawdowns of business loan commitments, Paycheck Protection Program (PPP) loan originations, investor preference for safe assets, record corporate bond issuance, fiscal stimulus payments, and expanded unemployment benefits.”

Profitability – measured by return on equity (ROE) and return on average assets (ROAA) – reached pre-pandemic levels by year-end 2020, the Fed reported. The agency said smaller loan loss provisions accounted for most of the recovery. “Improved trading, investment banking, and mortgage banking revenues also contributed to the rebound, offsetting a decline in net interest margins,” the Fed said

Nonetheless, the report indicated banks do face challenges. Lending activity, except for the PPP loans, was slow with loan balances declining at commercial banks after peaking in May. The Fed noted, for example, that commercial and industry (C&I) loans grew with the help of PPP. Without that program, however, the Fed noted C&I loans would have declined in 2020.

Consumer lending has shown notable weakness during the pandemic, the Fed said, with loan balances at commercial banks dropping 4% last year. “Credit card loan balances, in particular, fell sharply in 2020,” the Fed said. “The reduction in credit card debt is likely the result of several factors, including tighter lending standards, lower spending, and the financial benefits of fiscal stimulus.”

The decline in net interest margin, the Fed report stated, was sharp in first three quarters of 2020 and recovered slightly in the last. “Net interest margin compression in 2020 was due to slow loan growth relative to deposit growth,” the Fed said. “As discussed earlier in the report, banks reported strong deposit growth in 2020 and invested much of the deposit inflow in lower yielding assets, such as cash and securities. Lower interest rates also contributed to the decline in net interest margin last year.”

The report also notes that the Fed continues to focus on high-risk community banking organizations (CBOs) and regional banking organizations (RBOs), which the agency resumed examining in June 2020. The Fed said it the is placing a priority on the examination of high-risk CBOs and RBOs, assessing their financial resiliency. Since resuming examinations, state member bank ratings have remained relatively stable, the Fed added.

The agency said it is also monitoring asset-quality measures of the CBOs and RBOs, including their processes for credit loss recognition. Other supervisory priorities include: capital and liquidity resiliency; risk identification and management practices; credit risk (including loan modifications, high-risk loan portfolios – such as commercial real estate loan portfolios and loans to borrowers in industries affected by the pandemic; underwriting practices and asset growth; reserve practices (and levels); capital (including planning, actions and earning assessments); and operational risk (including continuity of operations and information technology and cybersecurity).

In the back of the report, the Fed lists the total number of institutions, and their assets, that it supervises. The grand total (including everything from the eight global systemically important banks [G-SIBs] to the 3,696 banks with assets less than $10 billion each) is 4,876 institutions, which hold $39.9 trillion in assets as of year-end 2020.

Of the total assets, the eight G-SIBs account for more than one-third (33.8%), with $13.5 trillion, the table shows. The banks with less than $10 billion in assets, which count three out of every four banks (75.8%) the Fed supervises, hold only 6.8% of the total assets under Fed supervision.

Federal Reserve Supervision and Regulation Report; April, 2021

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