Academic journal article
By Carlson, Mark; Perli, Roberto; Allard, Thomas C.; Grimm, Jason; Piraino, Steve
Federal Reserve Bulletin
The U.S. commercial banking industry remained highly profitable in 2003. The return on assets at banks surpassed the previous year's record level, and the return on equity approached the top of its recent range (chart 1). Banks' profits and balance sheets were shaped in part by the financial and economic conditions that prevailed during the year. Perhaps most important, monetary policy remained highly accommodative. The Federal Reserve reduced the intended federal funds rate at midyear from an already low level; and with short-term rates anchored by policy, longer-term interest rates, although volatile, generally remained low (chart 2). Home mortgage interest rates dropped to very low levels in the first half of the year, and yields on many corporate bonds, especially non-investment-grade bonds, fell noticeably as risk spreads contracted to the lowest levels in more than five years.
This supportive interest rate backdrop, coupled with stimulative fiscal policy, helped broaden and strengthen the economic expansion last year. Household spending continued to be strong. Low residential mortgage rates spurred home sales to record levels, and mortgage refinancing swelled. Low interest rates, along with the attractive incentives for automobile purchases, contributed to a pickup in spending on consumer durables. Also, many corporations took advantage of attractive costs of funds to strengthen their balance sheets, often by issuing long-term debt and using the proceeds to pay down commercial paper and bank loans. The pickup in aggregate spending, together with continued favorable productivity trends, boosted corporate profits. And in the second half of the year, brighter business prospects finally began to show through to equipment spending, which had been anemic for several quarters.
These economic developments left an imprint on banks' balance sheets. The strength of the housing market and the record levels of refinancing activity boosted the share of total bank assets accounted for by residential mortgages and mortgage-backed securities to 28.5 percent by the end of 2003. Business loans declined for the third consecutive year as businesses used the proceeds of bond issuance to pay down short-term debt and financed many of their investment outlays with internal funds. But the runoff was slower in 2003 than in 2001 and 2002, and as equipment spending recovered and inventories were built up late in the year, demand for business loans showed signs of turning around. Inflows of core deposits remained strong, as deposit rates fell less than market yields and households responded to the low opportunity cost of holding liquid assets.
Economic developments also significantly affected banks' profitability. The wave of residential mortgage refinancing led to a surge in income from fees associated with the origination, sale, and servicing of these loans. An elevated level of corporate bond issuance supported investment banking income. Debt refinancing led to a reduction in borrowers' debt-service burdens, which in turn lowered delinquency rates. The decline in interest rates, especially during the first half of the year, allowed banks to realize gains by selling some of their investment securities; however, it also likely contributed to a further narrowing of net interest margins.
With increasing business profitability and lower business debt-service burdens, delinquency rates on commercial and industrial loans, which had risen in the previous three years, dropped back notably. Because of lower residential mortgage interest rates and increased house prices, households could extract equity from their homes by taking out cash through either refinancing or home equity loans; the proceeds were used partly to pay down higher-rate debt. With the credit quality of their loan portfolios improving considerably during the year, banks were able to reduce loan-loss provisions; such reduction was a substantial contributor to the increase in bank profitability. …