Profits and Balance Sheet Developments at U.S. Commercial Banks in 2009

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The U.S. commercial banking sector remained under significant pressure in 2009. Bank profitability was damped by the effects of the weak economy on asset quality and lending activity, with loan delinquency and charge-off rates rising to historical highs in many cases and banks' balance sheets contracting. Reflecting the weak portfolios and low profitability that weighed on the sector as a whole, 120 smaller banks failed during the year, and the watch list of the Federal Deposit Insurance Corporation (FDIC) expanded to include about 700 institutions by year-end, the highest levels for both of these measures since the early 1990s. By contrast, the acute strains the largest banks faced in late 2008 abated over the first half of 2009, largely because of unprecedented interventions by the Treasury, the Federal Reserve, and the FDIC.

Asset quality worsened for all major loan classes over 2009, but real estate loans backed by residential and by commercial properties remained at the center of banks' credit quality problems. Conditions in the real estate sector generally stayed weak, especially in commercial markets. House prices continued declining sharply in the first half of the year but were more stable in the second half. The stabilization of prices partly reflects stronger demand for housing that was likely spurred in part by low mortgage rates, which were fostered partly by the Federal Reserve's purchases of agency debt and mortgage-backed securities (MBS). A tax credit for first-time homebuyers also helped support housing demand. Still, with many households' mortgage obligations exceeding the value of their houses, 1.4 million properties entered foreclosure over the year.

Aggregate economic activity picked up in the second half of the year after several quarters of contraction, stimulated by monetary and fiscal expansions, increased foreign growth, and improvements in financial market conditions. However, as is typical in cyclical economic recoveries, the improvement in labor market conditions lagged the trends in economic activity, and the unemployment rate reached 10 percent at year-end before edging lower. The weakness in labor markets contributed to historically elevated delinquency and charge-off rates on consumer credit card loans. The deterioration in credit quality across all loan categories led to a further rise in already elevated rates of loss provisioning. Consequently, the profitability of the commercial banking industry was depressed, and return on assets (ROA) and return on equity (ROE) were both at their lowest annual levels since at least 1985 (figure 1). (1)

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Profitability diverged between the largest banking institutions and the rest of the industry, primarily reflecting the ability of large banks to generate income from specialized activities in which other banks do not generally participate. Indeed, large banks, taken together, posted a small profit last year, as trading revenue rebounded to pre-crisis levels with the improvements in capital markets and income from net servicing fees increased. Those revenues managed to offset the pressures on earnings at these banks caused by the further deterioration in credit quality. In addition, large banks experienced a substantial inflow of core deposits at very low interest rates, which improved their net interest margins. In contrast, profits at small and medium-sized banks declined further, weighed down by higher loan losses that were not offset by other forms of revenue.

The commercial banking sector deleveraged over 2009 as banks raised capital and nominal assets posted an annual decline for the first time since 1948. Loans outstanding declined--across all major loan categories, but especially in loans to businesses--consistent with reports of banks' more stringent lending posture and reduced demand for loans from creditworthy borrowers. Borrowers such as households and small businesses with more limited access to nonbank sources of credit were particularly affected by the tight lending conditions. …