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Lynn M. Barry

Lynn M. Barry is an economist at the Federal Reserve Bank ofSt Lou/a Thomas A. Pollmann provided research assistance.

Eighth District Banks: Back inthe Black

OR COMMERCIAL banks in both the nationand the Eighth Federal Reserve District, 1988was a year of recovery.’ Aggregate bank profitratios in the United States and the EighthDistrict improved as many of the nation’s largerbanks began to recoup from losses associatedwith foreign loans. Further gains were made bysmaller District banks, which posted higher ear-nings as loan loss provisions and loan charge.offs declined. Asset quality also improved atsmall banks as nonperforming loans and actualloan losses decreased.

This article compares the performance of

Eighth District commercial banks with their na-tional counterparts across several asset-sizecategories.’ An analysis of bank earnings, assetquality and capital adequacy provides useful in-formation on the financial condition, regulationcompliance and operating soundness of theDistrict’s banking industry.

EARNINGS

Eighth District banks reported year-end earn-ings of $1.1 billion in 1988, an increase of

$191.6 million from 1987. The U.S. banking in-dustry earned $25.1 billion in 1988, up sharplyfrom $3.2 billion in 1987. Sixty-eight banks, 5.3percent of all District banks, reported negativeearnings in 1988, down from 86 in 1987. Na-tionally, 13.7 percent of commercial banksreported net losses for the year compared with18.2 percent in 1987. Much of the improvementin both District and U.S. bank earnings can betraced to lower’ loan loss provisions, which hada positive effect on earnings.

Return on Assets and Equity

In analyzing bank earnings, there are twostandard measures of bank performance: thereturn on average assets (ROA) and the returnon equity (ROE) ratios.’ The ROA ratio, calcu-lated by dividing a bank’s net income by itsaverage annual assets, shows how well a bank’smanagement is using the company’s assets. TheROE ratio, obtained by dividing a bank’s net in-come by its equity capital, indicates to share-holders how much the institution is earning ontheir investment.~

‘The Eighth Federal Reserve District consists of the follow-ing: Arkansas, entire state; Illinois, southern 44 counties;Indiana, southern 24 counties; Kentucky, western 64 coun-ties; Mississippi, northern 39 counties; Missouri, easternand southern 71 counties and the City of St. Louis; Ten-nessee, western 21 counties.

2For more specific bank performance statistics on eachEighth District state, see the Federal Reserve Bank of St.Louis’ June 1989 issue of Pieces of Eight.

‘A major concern with ROA, ROE and other performancemeasures is that they are calculated using the book valuesof assets, liabilities and equity not the current marketvalue.

4Equity capital includes common and perpetual preferredstock, surplus, undivided profits and capital reserves.

FEDERAL RESERVE BANK OF St LOUIS

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As table 1 reports, the 1988 average ROA andROE for Eighth District banks was 0.93 percentand 11.72 percent, respectively. Nationally,banks reported an average ROA of 0.83 percentand an average ROE of 13.02 percent. For eachof the years presented, District ROA averagesoutperformed national averages. In 1988, ROAsfor both the District and the nation improvedsignificantly over 1987, when they were de-pressed by poor earnings associated with sus-pect foreign loans at the nation’s largest banks.

Table 1 also shows ROAs and ROEs for seven

asset-size categories of commercial banks.Across virtually every category, both District-wide and nationwide, 1988 was a year ofimprovement. Of particular note are the strong

earnings at banks with assets between $1 billionand $10 billion. District banks in this assetrange reported average ROAs of 0.82 percent in1988, up from 0.51 percent in 1987. Nationally,these banks reported a jump in ROA from 0.52percent to 0.79 percent. ROA for banks withassets more than $10 bilion (none of which are

in the Eighth District) was the highest of thesize groupings at 0.96 percent, a substantial im-provement from —0.65 in 1987.

Another bright note in 1988 was the con-tinued earnings improvement at smaller banks.For the periods reported in table 1, 1988 wasthe year in which District banks with assets lessthan $100 million earned their highest ROAsand ROEs. Higher earnings for these bankswere the direct result of lower loan loss provi-sions and a decline in loan charge-offs.

Margin Analysis

The financial success of a bank depends on itsmanagement’s ability to generate sufficientrevenue while controlling costs. Two importantmeasures of management’s success are net in-terest and net noninterest margins.

Net interest margin is the difference betweenwhat a bank earned on loans and investmentsand what it paid its depositors, divided by

MAY/JUNE 1989

16

well interest-earning assets are being employedrelative to interest-bearing liabilities.”

Higher net interest margins were one of thedriving forces behind stronger earnings at thelarger banks in both the District and the UnitedStates in 1988.’ As table 2 shows, District bankswith assets between $1 and $10 billion reportedan average net interest margin of 4.17 percent,a 20 basis-point increase from 1987. Nationally,these banks reported average net interestmargins of 4.45 percent, up from 4.36 percentin 1987. The largest banks in the nation, thosewith assets more than $10 billion, recorded anaverage net interest margin of 3.85 percent, up46 basis points from 1987 averages. At bankswith assets less than $1 billion, net interestmargins declined both Districtwide and nation-wide in 1988. Banks across the nation, however,outperformed banks in the Eighth District foreach of the asset-size categories reported intable 2.

For’ District banks, interest income rose from9.35 percent of average earning assets in 1987

to 9.63 percent in 1988. As figure 1 shows, in-

terest income as a percent of earning assets

was, on average, lower at District banks than atU.S. banks for each year except 1986. Nation-ally, interest income as a percent of earningassets rose from 9.62 percent in 1987 to 10.31percent in 1988. In contrast, interest-related ex-penses, while rising from 5.08 percent of earn-ing assets in 1987 to 5.37 percent in the Districtin 1988, were lower than the 1988 nationalaverage of 6.04 percent.

The net noninterest margin is an indicator’ ofthe efficiency of a bank’s operations and itspricing and marketing decisions. The netnoninterest margin is the difference betweennoninterest income (other) and noninterest ex-pense (overhead) as a percent of average assets.Since noninterest expense generally exceedsnoninterest income, the calculation yields anegative number; it is common practice,however, to report the net noninterest marginas a positive number. Thus, snialler netnoninterest margins indicate better bank perfor-mance, holding all other things constant.

“Earning assets include: loans (net of unearned income) indomestic and foreign offices; lease financing receivables;obligations of U.S. government, states and political sub-divisions and other securities; assets held in trading ac-counts; interest-bearing balances due from depository in-stitutions; federal funds sold and securities purchasedunder agreements to resell.

“On the asset side, this includes both interest income andfees related to interest-earning assets. Examples include:interest on loans; points on loans; income on tax-exempt

municipal loans and bonds and income from holdings ofU.S. government securities. On the liability side, interestexpense includes: the amount paid on all categories ofinterest-bearing deposits; federal funds purchased andcapital notes.

‘Bank management should be concerned not only with thelevel of the net interest margin, but also with its variabilityover time. With volatile interest rates, the stability of thenet interest margin indicates that the interest sensitivity ofassets and liabilities is matched.

average earning assets.’ This ratio indicates how

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Figure 1Interest Income and InterestExpense as a Percent of AverageEarning AssetsPercent Percent11

10

9

8

7

6

51985 1986

Source: EDIC Reports of Condition and Income for InsuredCommercial Banks, 1985-1 988.

To supplement income generated frominterest-earning assets, banks have attempted togenerate more fee-related income. For example,service charges on deposit accounts, leasing in-come, trust activities income, credit card fees,mortgage servicing fees and safe deposit boxrentals.

Noninterest expense includes all the expenseitems involved in overall bank operations, suchas employee salaries and benefits as well as ex-penses of premises and fixed assets. Noninterestexpense also covers such items as directors’fees, insurance premiums, legal fees, advertisingcosts and litigation charges.

For the periods presented in table 3, Districtbanks have lagged national averages in terms ofgenerating noninterest sources of revenue.Noninterest expense, on the other hand, hascontinually been lower at District banks than

for banks across the nation. In 1988, non-interest income continued to average around1 percent of average assets at District banks.Noninterest expense also remained virtually flatat about 3 percent of average assets. Noninter-est expenses generally have been declining, par-ticularly at District banks with assets between$300 million and $1 billion. In recent years,banks have undertaken numerous consolidationand cost-control measures to reduce fixedoverhead costs. For many banks, cost reduc-tions, including staff cuts, could have been amain contributor to profits in 1988.

Loan and Lease Loss Provision

Declining loan and lease loss provision levelshelped boost earnings both in the District andthe nation last year. In 1987, many large banksallocated huge sums to their loan and lease lossprovision account to allow for their deteriora-ting foreign loan portfolio. This was a precau-

Interest Expense-- 6

Eighth District

1987 1988

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Loan and lease loss provision totaled $450.6million at District banks in 1988, down $246.6million from 1987 levels. As reported in table 4,Eighth District banks decreased their provisionfor loan and lease losses to 0.37 percent ofaverage assets, a sharp drop from 0.60 percentin 1987. This decrease can be traced primarilyto the largest District banks. For those banks,provision for loan and lease losses fell from 0.97percent of average assets in 1987 to 0.46 per-cent in 1988.

Nationally, banks decreased their loan andlease loss provision by $20.2 billion and, atyear-end 1988, the account stood at $17.2billion. As a percent of average assets, loan andlease loss provision was 0.51 percent in 1988, asubstantial decline from 1.24 percent in 1987.As with the District, the largest banks wereprimarily responsible for the decrease as theirratio fell from 2.02 percent in 1987 to 0.42 per-cent in 1988.

ASSET QUALITY

As it has for some time, asset quality con-tinues to be a primary factor influencing thebanking industry’s earnings pattern. With loanlosses rising over the past few years at manycommercial banks, investors and regulatorsalike are focusing on asset quality in assessingthe health of the banking industry.

Asset quality typically is measured by two in-dicators. The first measure, the nonperformingloan rate, indicates both the current level ofproblem loans as well as the potential for futureloan losses. The second indicator, the ratio ofnet loan losses to total loans, shows the percen-tage of loans actually written off the bank’sbooks.

Nonpelforming Loans and Leases

The level of nonperforming assets includes allloans and lease financing receivables that are 90days or more past due, are in nonaccrual statusor are restructured because of a deteriorationin the financial position of the obligor. In theDistrict, nonperforming assets decreased $246.5

FEDERAL RESERVE BANK OF St LOUIS

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million from 1987 to 1988. As reported in table5, Eighth District banks’ nonperforming loansand leases as a share of total loans fell from2.11 percent in 1987 to 1.62 percent in 1988.Banks across the nation experienced a similardecline as the nonperforming loan rate droppedfrom 3.49 percent to 2.96 percent.

Across all asset-size categories, District banksreported a decrease in nonperforming loans andleases in 1988. District banks with assets lessthan $25 million saw nonperforming loans andleases fall from 2.13 percent of total loans in1987 to 1.80 percent in 1988. The largestDistrict banks saw their nonperforming loanrate drop from 2.44 percent to 1.65 percent

during the same one-year period. Nationally,this pattern also held true as most asset-size cat-

egories reported a decline in the nonperformingloan rate. The only exception was at banks withassets between $300 million and $1 billionwhere nonperforming loans and leases rose to2.38 percent of total loans, up from 2.29 per-cent in 1987.

Figure 2 shows the distribution of nonperfor-ming loans by loan type for Eighth Districtbanks. At year-end 1988, nonperformingagricultural loans as a percent of total nonper-forming loans was 5.45 percent, down from6.84 percent in 1987. The percentage of nonper-forming commercial loans fell from 45.91 per-cent of the total to 41.14 percent. Consumernonperforming loans, which accounted for 6.88percent of the total in 1987, rose to 8.61 per-cent in 1988. Nonperforming real estate loanshad a fairly substantial increase in 1988, risingfrom 35.81 percent in 1987 to 42.45 percent.

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20

Figure 2District Distribution ofNonperforming Loans by Loan Type

Percent Percent

50

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20

10

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50

40

30

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Loan and Lease Losses

‘I’he most direct measure of a bank’s loan pro-

blems is the percentage of loans and leasescharged-off during the year. Net loan and leaselosses (adjusted for’ recoveries) amounted to$510.8 million at District banks in 1988, an in-crease of $46.7 million from 1987. Nationally,

banks charged-off $17.6 billion in 1988, $1.5billion more than in 1987. As table 6 shows, theaverage charge-off rate at banks in the EighthDistrict rose slightly in 1988, from 0.70 percentof total loans in 1987 to 0.72 percent. Nation-ally, the average charge-off rate rose from 0.89percent of total loans in 1987 to 0.93 percent in1988. Across virtually every asset-size category,charge-off rates at District banks were lowerthan at their national counterparts. The only ex-ception was at the largest District banks wherenet loan losses and leases to total loans jumped

sharply in 1988, from 0.68 percent in 1987 to1.18 percent.

Table 7 shows the distribution of loan lossesby type of loan. For’ both the nation and theDistrict, commercial loan losses contributed thegreatest percentage to overall loan loss. The

percent of District commercial loan charge-offsfell in 1988, from more than 50 percent of totalloan losses in 1987 to approximately 44 percent.Farm-related charge-offs declined further in1988 and now account for slightly more than 2percent of total District loan losses. <l’he percen-tage of District consumer loan charge-offs alsodeclined in 1988, falling from 23.24 percent in1987 to 17.88 percent of total loan losses. Onlyone category, loans held in foreign offices, in-creased in 1988. Loan losses for this categoryincreased to 17.51 percent of overall loan loss,up substantially from 1.79 percent in 1987.

1985 1986 1987 1988Source: FDIC Reports of Condition and Income for Insured

Commercial Banks, 1985-1988.Note: Percentages may sum to greater than 100 because

agricultural loans are included in other categories as well.

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“The components of primary capital as defined in the FDICConsolidated Report of Condition and Income are: com-mon stock; perpetual preferred stock; surplus; undividedprofits; contingency and other capital reserve; qualifyingmandatory convertible instruments; allowance for loan andlease losses and minority interests in consolidated sub-sidiaries, less intangible assets excluding purchased mor-tgage servicing rights. (For the purposes of this paper, on-ly the goodwill portion of intangible assets was deducted.)Secondary capital is limited to 50 percent of primarycapital and includes subordinated notes and debentures,limited-life preferred stock and that portion of mandatoryconvertible securities not included in primary capital. Each

Bank regulators have a strong interest in en-

suring that banks maintain adequate financial

capital. Bank capital is intended to absorblosses, cushion against risk, provide for asset ex-pansion and protect uninsured depositors. Givenits importance, the regulatory agencies have setminimum standards of 5.5 percent primary capi-tal to assets and 6 percent total capital toassets.” These standards have been revised re-cently and, on December 16, 1988, the FederalReserve Board approved new risk-based capitalguidelines intended to encourage banks to makesafer investments.”

The improved performance of District bankshad a favorable effect on their capital levels. Astable 8 indicates, improvement in bank primarycapital ratios is apparent throughout most asset-size ranges. Average primary capital ratios forbanks both in the District and nationwide arewell above the current minimum standardsestablished by the regulatory agencies. Nation-ally. an average primary capital ratio of 7.92

bank’s secondary capital is added to its primary capital toobtain the total capital level for regulatory purposes.

‘The guidelines establish a systematic framework wherebyregulatory capital requirements are more sensitive to dif-ferences in risk profiles among banking organizations. Inaddition. off-balance sheet activity is evaluated for risk ex-posure. The guidelines provide for a phase-in periodthrough the end of 1992 at which time the standardsbecome fully effective, Starting December 31, 1990, thelevel of capital that banks are required to hold will in-crease to 7.25 percent of qualifying total capital toweighted risk assets and, finally, to 8 percent in 1g92.

CAPITAL ADEQUACY

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percent was reported, up slightly from 1987.While District aggregate primary capital ratiosremained the same in 1988, some asset-sizegroups showed notable improvement. In par-ticular, the smallest District banks reported anaverage primary capital ratio of 10.44 percentin 1988, up from 10.14 percent in 1987. In con-trast, the largest District banks reported adecline in their average primary capital ratio,falling from 7.89 percent in 1987 to 7.66 per-cent in 1988.

As of December 1988, six banks or 0.5 per-

cent of all District banks fell short of theminimum regulatory primary capital standards.This number was down from 15 banks in 1987.Nationally, 465 banks had deficient primarycapital ratios at year-end 1988, compared with474 in 1987.

CONCLUSION

1988 marked a year of recovery fm’om theoverall poor earnings reported by banks acrossthe nation in 1987. Bank performance in theEighth Federal Reserve District improved in

1988, propelled by lower loan loss provisions.Aggregate bank profit ratios improved as manyof the District’s largest banks began to reboundfrom the negative earnings associated with in-creased loan loss provisions tied to foreignloans. Profits recouped across virtually every as-set size category of Eighth District commercialbanks. The smaller District banks employedhigher earnings as both loan losses and loanloss provisions levels declined.

As with most of the banking industry, betterasset quality helped to improve earnings atDistrict banks last year. Finally, a majority ofEighth District banks impm’oved their primarycapital ratios in 1988 and are positioned wellabove the minimum standards set by bankregulators.

The banking industry in the Eighth Districthas returned to profitability, and, barring anyshocks, should continue to improve in the com-ing quarters. With a continued positive eco-nomic environment, loan problems that haveplagued District banks should abate and as thelevel of nonperforming loans declines, futureloan problems should be less severe.

FEDERAL RESERVE BANK OF St LOUIS