Statement required by 12 U.S.C § 250:
The views expressed herein are those of the Office of the Comptroller of the Currency and do not necessarily represent the views of the President.
Mr. Chairman, Senator Gramm, and Members of the Committee, I appreciate this opportunity to discuss the condition of the banking system.
I am pleased to report that the last decade has been a period of economic prosperity and strong growth in the banking sector. Commercial bank credit grew by over 5 percent per annum during the 1990s. During this period of prosperity, most banks strengthened their financial positions and improved their risk management practices.
As a result, the national banking system is in a much better position to bear the stresses of any economic slowdown. National banks are reporting strong earnings with a return on equity (ROE) for the first quarter of this year of 15.2 percent--a level considerably higher than the ROE of 11.5 percent prior to the last economic slowdown in 1990-1991. Fifty five percent of banks reported earnings gains from a year ago. Asset quality for the national banking system is better. The ratio of noncurrent loans (i.e., 90+ days past due and nonaccrual) to total loans is 1.3 percent, compared to 3.3 percent in the first quarter of 1990, the year marking the start of the last slowdown. And capital levels are at historical highs. As of the first quarter of 2001, the ratio of equity capital to assets was 8.9 percent, compared to 6.0 percent in the first quarter of 1990.
As we move into the next decade, banks and bank supervisors face two major challenges. The first is cyclical: how to identify and manage the risks associated with a slowing economy in the U.S. and internationally. Many nonbank companies are experiencing a slowdown in demand for their products and services. This in turn is prompting a scaling back of expansion plans and staff reductions, which invariably will have regional and local economic repercussions for a variety of bank lending and servicing activities.
The second challenge is structural: how to adapt bank operations and supervision to the fundamental long-term changes in the banking industry. The rapid changes in technology, the increased competition in the market for financial services providers, and the globalization of financial markets are all presenting significant strategic and operational challenges for bank management and regulators.
My remarks today will cover four main topics. First, I will discuss the current state of the national banking system. Second, I will describe how the national banking system today compares with 1990, just before the last economic slowdown. I will then highlight the emerging risks and trends, and I will end with a discussion of the steps that the OCC has taken and will continue to take to address those risks.
The Current State of the National Banking System
The 1990s were a period of extraordinary earnings for the banking industry. National banks reported record earnings for eight consecutive years as net income rose from $17.3 billion in 1992 to $42.6 billion in 1999. During this period, the annual return on equity averaged 15.2 percent, peaking in 1993 at 16.4 percent [see Figure 1].
Greater diversification of income sources improved the quality of bank earnings during the 1990s. This diversification trend should improve the capacity of banks to weather difficult economic times and better manage the risks embedded in their operations. For example, the share of banks’ revenues coming from noninterest income sources such as fee income, asset management and trust services, brokerage and trading activities and fiduciary income increased over the last 10 years from 34 percent to over 45 percent [see Figure 2]. The trend away from reliance on traditional interest income is in part an active effort by banks to better manage risk. As a supervisor, we strongly support the efforts of national banks to diversify their revenue streams through financially related activities.
The search for new sources of revenue also reflects an effort to offset the effects of increased competition in traditional lending activities from nonbank competitors. Interest income grew at the modest rate of 5 to 6 percent during this period, largely as a consequence of loan growth. During most of the 1990s, banks’ net interest margins (the spread between what a bank earns on loans and investments and what it pays for funds) declined, a trend that is unlikely to be reversed. Because they expect continuing margin declines and slowing growth, banks have turned to alternative sources of revenue.
Slow revenue growth may become an issue for banks in 2001 if slower economic growth and weakening equity markets continue. Noninterest income is likely to be subdued and bank lending is likely to be sluggish. The most recent Federal Reserve Beige Book published last week reported declining loan demand in many of the Federal Reserve Districts as firms in a variety of industries have cancelled or postponed plans to expand and in some cases are laying off employees.
Another key determinant of the profitability of the banking system is the quality and performance of its loans. One useful measure of asset quality is the level of noncurrent loans--those loans with payments past due at least 90 days or in nonaccrual status, when any payments received by the bank are used first to pay down principal. The ratio of noncurrent loans to total loans, which was 4.1 percent in 1991, fell steadily to less than 1 percent in the late 1990s [see Figure 3]. The low level of noncurrent loans meant that banks were able to divert a relatively small amount of their revenue each year to loan loss reserves, which in turn boosted earnings.
The deterioration in credit quality, particularly in the commercial and Industrial (C&I) loan portfolio, began three years ago and picked up steam in 2000. The noncurrent ratio for C&I loans for large banks increased by 56 basis points last year. While overall credit quality deterioration was more modest for smaller banks, rising only 3 basis points in 2000, these nationwide aggregate ratios understate the impact that the slowdown in economic growth is having on small bank credit quality in some geographic areas.
Spurred by the slippage in asset quality in 2000, particularly for C&I loans at large banks, the dollar value of loss provisions (the additions to loan loss reserves) rose 32 percent over the previous year. The ratio of provisions to loans rose to 0.95 percent, its highest rate since 1993. The rise in provisioning was most pronounced at the large banks and credit card banks, but provisioning at smaller banks also increased to its highest rate since 1993. Nonetheless, provisioning remains below the rates experienced during the banking turmoil of the 1980s and early 1990s.
The weakening in credit quality indicators and slowing of the economy increases the likelihood that banks will increase the level of provisioning in coming quarters to cover inherent loan losses. Prior to the 1990-1991 recession, loan loss reserves, as a percentage of total loans at national banks, were 2.5 percent, rising to a peak of 2.8 percent in 1992. During the current expansion, by contrast, the industry-wide loss reserve ratio for national banks declined to 1.8 percent. While loan loss reserves as a percentage of loans have remained fairly stable at 1.8 percent for the last two years, the coverage ratio of reserves to noncurrent loans has fallen from 184 percent to 138 percent. If the economy continues to slow, causing a further deterioration in credit quality, banks will be expected to increase their level of reserves.
The record earnings of the 1990s and good asset quality enabled national banks to build their capital. The ratio of equity capital to assets for all national banks rose to 8.9 percent at the end of the first quarter of 2001, the highest level in nearly four decades [see Figure 4]. Nearly 98 percent of all national banks met the regulatory definition of well capitalized by maintaining a ratio of equity capital to assets above 5% and a total capital to risk-based assets above 10 percent.
Comparison with Prior Economic Slowdown
With the slowing of economic activity in the U.S. and the potential for increased financial stress on banking institutions, it is worthwhile comparing the current condition of national banks to conditions that existed just prior to the recession of the early 1990s. Indeed, mindful of the stresses that many commercial banks experienced in the late 1980s, that point is a constant frame of reference for us as we approach today's supervisory challenges.
For the national banking system as a whole, profitability, asset quality and capitalization are significantly stronger today than in 1990 [figure 5]. For example, median income as a percentage of assets (return on assets, or ROA) was 14 basis points higher in the first quarter of 2001 than in the same period in 1990. The median ratio of noncurrent loans to total loans was 92 basis points lower and the median capital ratio was 160 basis points higher.
The proportion of the banking industry facing the economic slowdown from a position of weak performance is substantially less than in 1990 just prior to the last recession. For example, less than 1.5 percent of the banks currently have an equity capital ratio under 6 percent. In 1990, 17 percent of banks had an equity capital ratio under 6 percent.
Banks have also made gains during these years in diversifying risks. Loan securitization has become a significant funding tool, enabling banks to generate revenues from loan origination while shifting credit and interest rate risk off of their balance sheets. Banks have also broadened the geographic scope of their operations and increased the range of financial services they offer, providing them with a greater capacity to weather adverse economic developments. Advances in information technology along with more sophisticated risk measurement tools now provide bank managers with advanced risk management tools that were unavailable a decade ago.
While the national banking system is in a stronger position relative to the last economic slowdown, banks cannot be complacent about the risks that will continue to surface in the current economic environment, particularly in the areas of credit and liquidity.
While the level of loan losses is still relatively low, since 1997 the OCC has been concerned about a lowering of underwriting standards at many banks. This relaxation of standards stems from the competitive pressure to maintain earnings in the face of greater competition for high-quality credits, particularly from nonbank lenders. In some cases, banks' credit risk management practices did not keep pace with changes in standards. We now are beginning to see the consequences of those market and operational strategies in the rising number of problem loans.
The deterioration in credit quality indicators that began three years ago has to date been largely concentrated in the C&I loan portfolios of the larger banks [see Figure 6]. The Asian financial crisis and the turmoil in the capital markets in the fall of 1998 also put pressure on large banks’ loan portfolios. As capital markets contracted and the cost of debt became more expensive, corporations turned to the banking sector for an increasing share of their financing needs. This shift accounts, in part, for the substantial growth rates that banks have experienced in C&I lending, leveraged financing, and commercial real estate and construction financing. While such lending resulted in strong growth in the banking sector, competition to book these loans also put pressure on banks’ underwriting and risk management controls.
Emerging credit risk is not just an issue for large banks. As corporate earnings have weakened, the spillover effects on credit portfolios are beginning to show up in the smaller institutions. Community banks (defined as banks with assets under $1 billion) in 33 states and the District of Columbia have experienced an increase in their non-current loans over the last year [see Figure 7]. Particularly vulnerable to a downturn are banks in manufacturing areas that are highly dependent on energy production and distribution systems. Areas that are heavily reliant on manufacturing are experiencing falling earnings and slowing or negative employment trends.
We expect credit quality to be an issue for banks throughout 2001, as the financial positions of some businesses and households weaken due to slow economic growth. This deterioration in credit quality will be an additional drag on bank earnings.
Funding (or liquidity) risk at banks is also increasing as households and small businesses reduce their holdings of commercial bank deposits. Banks have traditionally relied on consumers and small businesses in their communities as a major source of funding. These so-called core deposits, most of which are covered by federal deposit insurance, have provided a stable and generally non-rate sensitive source of funding. With the rapid run up in the stock market in the 1990s, however, and the widespread popularity of money market mutual funds, households and small businesses have increasingly shifted their savings and transaction accounts into pension funds, equities, and mutual funds. Deposits in banks and thrifts accounted for 10.5 percent of household financial assets in 2000, down substantially from 19 percent in 1990 and 22 percent in 1980.
Between 1993 and 2000, while annual asset growth in the banking system averaged 7 percent, core deposits at banks grew at a rate of less than 4 percent per year. This lagging growth in core deposits relative to asset growth is likely to continue.
In response to the long-run, secular trend of slower deposit growth, banks have turned increasingly to higher interest rate wholesale funding. Both large and small banks have increased their reliance on wholesale (non-core deposit) funding sources to finance their incremental loan and asset growth. While large banks are accustomed to accessing the capital markets for funding, this is a new activity for many smaller banks. Because of costs and information constraints, small banks find it more difficult than large banks to raise funds through public debt offerings, securitizations, and other capital market instruments. Thus, we see that small banks are increasingly relying on wholesale providers such as the Federal Home Loan Banks as well as deposits obtained through the Internet or CD listing services. Although these sources can provide community banks with cost-effective funding, their use requires banks to have more rigorous management systems to monitor and control funding concentrations and maturity concentrations.
Consequently, traditional measures of bank liquidity, such as the ratio of core deposits to assets, reflect increased liquidity risk for both small and large banks. For example, core deposits as a percentage of assets for small banks (those with less than $1 billion in assets) declined from 79.8 percent in 1992, the first year of recovery from the last recession, to 69.6 percent in 2000. For the larger banks, the core deposits to assets ratio declined from 56.6 percent in 1992 to 43.9 percent in 2000.
How a bank funds itself is important because when a bank experiences deteriorating credit quality, it faces the risk of pressure on its funding and liquidity. Wholesale funds are far more risk- and price-sensitive than federally insured core deposits. Prudent management of this type of funding, therefore, is increasingly important. In particular, community banks that engage in business lending and have high levels of wholesale funding need to have effective internal controls and realistic contingency funding plans.
OCC Approach to Growing Risk in the Banking System
A dynamic and healthy banking system is vital to the functioning of the overall economy. Our job as bank supervisors is to maintain a sound banking system by encouraging banks to address problems early so that they can better weather economic downturns and are in a position to contribute to economic recovery. As we have seen in the past, banks whose financial condition is seriously weakened by credit quality problems are less capable of extending credit because their attention is necessarily devoted to problem resolution and capital preservation.
By acting early, in a measured and intelligent way, bank supervisors can moderate the severity of problems in the banking system that will inevitably arise when the economy weakens. By responding when we first detect weak banking practices, supervisors can avoid the need to take more stringent actions during times of economic weakness. Supervisors are most effective when they take early and carefully calibrated steps that target potential industry excesses and failures in risk management. This approach will help us maintain a healthy banking system that can continue to extend needed credit to sound borrowers during difficult economic times.
Since 1997 the OCC has implemented a series of increasingly firm regulatory responses to rising credit risk and weak lending and risk management practices. These efforts, which started with industry reminders and advisories about the dangers of weakening lending standards and poor credit risk management, grew into more focused examination and policy responses as risks increased.
Throughout this process we have maintained an open and candid dialogue with the banking industry and our examiners about rising credit risk in the system and the need for improved risk management by bankers. Through regular meetings with individual bank CEOs and periodic meetings with groups of CEOs and Chief Credit Officers, we have discussed the risks involved with some of the weaker credit-granting practices that seeped back into the system during the mid-to-late 1990s. We have worked with bankers to identify and mitigate their higher-risk, more vulnerable credits at a time when their capital accounts and income statements are most capable of absorbing the risk. We have also insisted on accurate risk identification and disclosure so that market forces are capable of influencing change where appropriate.
National banks have responded positively to these initiatives. Bankers are adjusting both their risk selection and underwriting practices. Credit spreads are wider, recent credit transactions are better underwritten than they were as little as twelve months ago, and speculative grade and highly leveraged financing activity has slowed in both the bank and public credit markets.
The widening of credit spreads and tightening of risk selection and underwriting standards reflect a reassessment of risk tolerance by all credit providers, not just banks. Bankers are working diligently to shore up previously weak risk selection and underwriting practices, improve deficiencies in credit risk identification and risk management, and strengthen reserves as appropriate. Our recent examining activities are confirming these positive responses.
We recognize that we need to ensure a balanced approach as economic and credit conditions weaken. We have implemented, and will continue to follow, a careful but firm approach to addressing weak credit practices and conditions. In this regard, we are constantly mindful that the alternative approach of silent forbearance can allow problems to fester and deepen to the point where sound remedial action is no longer possible--a lesson that all bank supervisors learned painfully in the late 1980s and early 1990s.
The OCC has also taken a number of steps to address our concerns about increasing liquidity and funding risk.
The growing complexity of the banking industry requires us to develop new and modern tools to help detect emerging weaknesses more quickly. The OCC has been strengthening our early warning systems, which now include a set of tools--we call it "Project Canary"--designed to enhance our identification of and supervisory responses to banks that may be more vulnerable to emerging risks. We have created financial measures based on Call Report data, and we look at changes in those measures in assessing movement to higher risk position levels, particularly in the area of credit, interest rate, and liquidity risks. For each measure, we have established benchmarks to assist in the identification of those banks with the highest financial risk positions. While risk taking is necessary in the normal course of banking, the key issue is whether high levels of risk taking are balanced with commensurate levels of risk management. Bank managers, bank directors, and OCC examiners can use this information to look for high levels of risk and determine if risk management and mitigants are appropriate for the given level of risk.
Our early warning system also provides assessments of a bank’s vulnerability to changes in economic conditions. We have developed several internal models, which we combine with existing external models, to better define those banks that may be at higher risk of adverse macroeconomic or regional economic developments. For example, we can review the potential earnings impact of layoffs in a particular industry or community for banks in that area.
This early warning system is providing us with information to better calibrate our supervisory efforts and target the application of examination resources to the area of highest potential risk. Our supervisory managers use this information in planning examinations, allocating resources, and targeting key risks. These early warning tools also provide a useful, consistent method for identifying potential risk areas and performing comparative analysis. As such, they enable examiners and managers to better allocate resources through more focused examinations and offsite reviews. Supervisory offices use these measures as an oversight tool, by comparing the early warning reports to current risk assessments and supervisory plans, so that inconsistencies can be identified and resolved. And these tools also help us in assessing and tracking systemic risk.
In conclusion, we believe the condition of the banking industry today is strong. The vast majority of banks have strong capital and earnings, improved risk management processes, and more diversified revenue streams. As a result, we believe the banking industry today is better able to withstand adverse economic developments than it was going into the recession of the early 1990s.
We are, however, in a period of heightened uncertainty concerning the domestic and global economic outlook. Credit problems are rising in our banks and we project continued pressure on bank earnings, at least over the near term. If the U.S. slowdown becomes deeper and persists, the effects on the banking industry will be much more serious. Declining earnings would heighten concerns about the safety and soundness of certain banks.
As supervisors, we have the important responsibility to neither discourage nor encourage lending but to ensure the soundness of the banking system. In good times, this is easy. It is more difficult to do when economic conditions are deteriorating and we are challenged to ensure that our standards for safety and soundness are neither too harsh nor too lax. We have experience with the difficult long-term problems created when bank supervisors failed to act in a timely and measured fashion and they tried to play catch up after the damage is done.
If we have learned anything from past economic crises both in the U.S. and overseas, we know that a sound banking system is essential to continued economic growth. I can assure you that the OCC will remain vigilant in our efforts to continually improve the risk management of national banks and thereby maintain a viable, healthy industry to support our economy.
Home | Menu | Links | Info | Chairman's Page