The Economist, 9 March 2006
Banks in America have had a rich few years. Now the going will be harder
LIFE has been good for American banks. Low interest rates, a roaring mortgage market and borrowing by the spendthrift American consumer have sent money washing into their coffers. According to the Federal Deposit Insurance Corporation (FDIC), one of America's many financial regulators, banks chalked up $135 billion in profits last year, their fifth consecutive year of record earnings—even though the Federal Reserve has raised interest rates 14 times since mid-2004.
But there are signs that the best days are gone. Despite the profits, last year also saw banks' return on equity drop to 12.5% from a peak of 15% in 2003, according to FDIC figures (see chart 1). Are rising interest rates finally taking a toll?
Certainly, they are making lending less lucrative. Banks make money by taking short-term deposits and lending them for longer periods, and at higher rates, to companies, governments and households. In recent years, the yield curve (the difference between short- and long-term interest rates) has been steep—and the lending business an easy one.
But with short-term interest rates rising, the yield curve has flattened—and even inverted. The FDIC reckons that big banks saw their net interest margin squeezed from 4.06% in the first quarter of 2002 to 3.48% in the second quarter of 2005, where it has since stabilised. Commerce Bancorp, a recent high-flyer, saw its net interest margin fall to 3.77% last year from 4.28% in 2004, owing to what Vernon Hill, its chairman, called “the worst interest-rate environment in recent years.”
How much this “margin squeeze” matters varies greatly across the industry. Although banks both large and small rely more on fees and less on lending (and hence interest income) than they did ten years ago, smaller institutions tend to be more dependent on lending than larger ones and so are more at risk from a flatter yield curve (see chart 2). According to Morningstar, a research firm, Hudson City Bancorp, a small savings bank in New Jersey, derives 99% of its revenues from interest income. Fee income makes up 64% of the revenues of JPMorgan Chase, for example, and 47% of Citigroup's.
For bankers, a more worrying consequence of rising interest rates is that they have dampened demand for the mortgages and refinancing that have underpinned their profits in recent years. According to the Mortgage Bankers Association, originations for both housebuying and refinancing cooled in the fourth quarter.
A housing slowdown could, in turn, hit construction lending, which has been another growth area. According to the FDIC, in the last quarter of 2005 such lending was 33.2% higher than a year earlier, the fastest increase since 1986. Most of these loans have been for residential projects but, as Richard Brown, chief economist at the FDIC, notes, “The best days are past for anything related to real estate, at least in this cycle.”
To make matters worse, the pace of deposit-gathering by banks is slowing. Banks had seen deposits grow at annual rates of up to 13% in the early part of the decade, as consumers withdrew cash from their homes and stashed it at the bank, for lack of more attractive investment options.
But an analysis of monthly deposit-growth rates at large commercial banks by Fox-Pitt, Kelton, an investment bank, shows a slowing that started in August 2003 and became more marked in 2004 and 2005. Competition for deposits “has intensified”, says Jon Balkind, a Fox-Pitt analyst, since the Fed started raising rates.
Perhaps the biggest worry of all is, for the moment at least, the hardest to quantify: a drop in credit quality. The FDIC puts the share of non-current loans (those at least 90 days late) in total debts outstanding at 0.74% in the third and fourth quarters of 2005, just above the second quarter's record low. By way of comparison, in 1990 the rate was 3.5%. “Credit has rarely if ever been so good,” says Mr Brown.
Too good to last, perhaps. Rising interest rates or an economic slowdown could make it hard for companies and, especially, consumers to pay off their debts. In the past two years households' mortgage debt has grown by almost a third, to an eye-watering $1.8 trillion, says the FDIC.
Worryingly, part of this new borrowing has been at variable interest rates, which makes it susceptible to tighter credit conditions. Other fancy lending schemes, such as sub-prime and interest-only mortgages, have been introduced to encourage poorer Americans onto the housing ladder. Although this has fostered the “democratisation” of the mortgage market, a lofty aim, some of these borrowers may be unable to pay when the market tightens.
Indeed, both bankers and regulators are paying close attention to loose lending standards and thin, even foolish, pricing of some mortgages and commercial loans. Competition for commercial lending, they note, has been fierce not just among banks but also from the capital markets. This week Ben Bernanke, the Fed's new chairman, warned community banks about their commercial-property lending.
Then again, banks have become adept at passing on risk through derivatives and the securitisation of loans. Indeed, the capital markets—and ultimately insurance funds, and investors in hedge funds and pension funds—increasingly take on risks, from non-traditional mortgages to commercial loans, that once remained on banks' balance sheets. The good news is that banks would not bear the brunt of a credit meltdown. The bad news is that your pension fund might.
Banks in America have had a rich few years. Now the going will be harder
LIFE has been good for American banks. Low interest rates, a roaring mortgage market and borrowing by the spendthrift American consumer have sent money washing into their coffers. According to the Federal Deposit Insurance Corporation (FDIC), one of America's many financial regulators, banks chalked up $135 billion in profits last year, their fifth consecutive year of record earnings—even though the Federal Reserve has raised interest rates 14 times since mid-2004.
But there are signs that the best days are gone. Despite the profits, last year also saw banks' return on equity drop to 12.5% from a peak of 15% in 2003, according to FDIC figures (see chart 1). Are rising interest rates finally taking a toll?
Certainly, they are making lending less lucrative. Banks make money by taking short-term deposits and lending them for longer periods, and at higher rates, to companies, governments and households. In recent years, the yield curve (the difference between short- and long-term interest rates) has been steep—and the lending business an easy one.
But with short-term interest rates rising, the yield curve has flattened—and even inverted. The FDIC reckons that big banks saw their net interest margin squeezed from 4.06% in the first quarter of 2002 to 3.48% in the second quarter of 2005, where it has since stabilised. Commerce Bancorp, a recent high-flyer, saw its net interest margin fall to 3.77% last year from 4.28% in 2004, owing to what Vernon Hill, its chairman, called “the worst interest-rate environment in recent years.”
How much this “margin squeeze” matters varies greatly across the industry. Although banks both large and small rely more on fees and less on lending (and hence interest income) than they did ten years ago, smaller institutions tend to be more dependent on lending than larger ones and so are more at risk from a flatter yield curve (see chart 2). According to Morningstar, a research firm, Hudson City Bancorp, a small savings bank in New Jersey, derives 99% of its revenues from interest income. Fee income makes up 64% of the revenues of JPMorgan Chase, for example, and 47% of Citigroup's.
For bankers, a more worrying consequence of rising interest rates is that they have dampened demand for the mortgages and refinancing that have underpinned their profits in recent years. According to the Mortgage Bankers Association, originations for both housebuying and refinancing cooled in the fourth quarter.
A housing slowdown could, in turn, hit construction lending, which has been another growth area. According to the FDIC, in the last quarter of 2005 such lending was 33.2% higher than a year earlier, the fastest increase since 1986. Most of these loans have been for residential projects but, as Richard Brown, chief economist at the FDIC, notes, “The best days are past for anything related to real estate, at least in this cycle.”
To make matters worse, the pace of deposit-gathering by banks is slowing. Banks had seen deposits grow at annual rates of up to 13% in the early part of the decade, as consumers withdrew cash from their homes and stashed it at the bank, for lack of more attractive investment options.
But an analysis of monthly deposit-growth rates at large commercial banks by Fox-Pitt, Kelton, an investment bank, shows a slowing that started in August 2003 and became more marked in 2004 and 2005. Competition for deposits “has intensified”, says Jon Balkind, a Fox-Pitt analyst, since the Fed started raising rates.
Perhaps the biggest worry of all is, for the moment at least, the hardest to quantify: a drop in credit quality. The FDIC puts the share of non-current loans (those at least 90 days late) in total debts outstanding at 0.74% in the third and fourth quarters of 2005, just above the second quarter's record low. By way of comparison, in 1990 the rate was 3.5%. “Credit has rarely if ever been so good,” says Mr Brown.
Too good to last, perhaps. Rising interest rates or an economic slowdown could make it hard for companies and, especially, consumers to pay off their debts. In the past two years households' mortgage debt has grown by almost a third, to an eye-watering $1.8 trillion, says the FDIC.
Worryingly, part of this new borrowing has been at variable interest rates, which makes it susceptible to tighter credit conditions. Other fancy lending schemes, such as sub-prime and interest-only mortgages, have been introduced to encourage poorer Americans onto the housing ladder. Although this has fostered the “democratisation” of the mortgage market, a lofty aim, some of these borrowers may be unable to pay when the market tightens.
Indeed, both bankers and regulators are paying close attention to loose lending standards and thin, even foolish, pricing of some mortgages and commercial loans. Competition for commercial lending, they note, has been fierce not just among banks but also from the capital markets. This week Ben Bernanke, the Fed's new chairman, warned community banks about their commercial-property lending.
Then again, banks have become adept at passing on risk through derivatives and the securitisation of loans. Indeed, the capital markets—and ultimately insurance funds, and investors in hedge funds and pension funds—increasingly take on risks, from non-traditional mortgages to commercial loans, that once remained on banks' balance sheets. The good news is that banks would not bear the brunt of a credit meltdown. The bad news is that your pension fund might.
