Vulnerable Banks Impeding Economic Recovery

by: Research Recap

Over the past 18 months, there has been a gradual healing in the banking sector. This improvement has been most pronounced in the largest US banks, according to the Federal Deposit Insurance Corporation (FDIC):

  • The banking industry recorded earnings of 21.6 billion dollars in the second quarter of 2010, the highest quarterly profit since 2007, reversing a 4 billion dollar loss in the corresponding quarter of 2009.
  • Over the past two years, the 19 largest US banks raised approximately 205 billion dollars of private capital, and redeemed 220 billion dollars of preferred shares issued under the Treasury’s Capital Assistance Program.

Despite this solid performance, the US banking system has not yet fully recovered from the crisis. Both Standard & Poor’s (S&P) and Moody’s have cautioned against overestimating the recovery of the banking system’s profitability, since a significant part of that improved performance has derived from a slowing in loan-loss provisioning that could prove premature. S&P estimates that US banks have recognized approximately 475 billion dollars in loan losses but still have approximately 365 billion to write down.

There are three particularly striking indications of continued US banking-system weakness:

  1. Decreased lending. Despite the record liquidity that the Federal Reserve has injected into the banking system, banks are tending to hoard these funds rather than lend to households with a view to repairing eroded balance sheets.
  2. ‘Troubled banks’. The number of banks on the FDIC ‘problem institutions’ list continues to rise, currently standing at around 825 of the nation’s approximate 7,800 banks.
  3. Massive official support. The enormous official support for the system must at some point be removed. This includes the Fed’s ultra-loose monetary policy, the 780 billion dollars Troubled Asset Relief Program and FDIC guarantees of new debt issued by banks and holding companies.

IMF stress test. The continued vulnerability of the US banking system is highlighted by a recent stress test exercise undertaken by the IMF that covered 53 bank holding companies. The scenario used assumed the following macroeconomic variables:

  • US GDP growth slowing to a little less than 1% in 2011, and only picking up gradually thereafter;
  • unemployment rising to approximately 10% in 2011, before declining slowly; and
  • US home prices declining by approximately 5% from present levels.

Despite the relative mildness of the IMF’s adverse scenario, its stress test suggests that the banking system faces significant downside risks:

  • Approximately one-third of US banks would experience a capital shortfall, even assuming a not particularly stringent capital threshold.
  • An adverse economic scenario would hit smaller banks the hardest — they would require 22 billion dollars additional capital.

Outlook As long as growth remains mired below trend, bank loan losses will continue to rise as profitability declines at small and medium-sized institutions — which could require additional capital. This is likely to prolong the period in which banks are reluctant to lend, serving as another drag on the anaemic economic recovery.