Profits and Balance Sheet Developments at U.S. Commercial Banks in 2004
Klee, Elizabeth C., Natalucci, Fabio M., Federal Reserve Bulletin
U.S. commercial banks continued to be highly profitable in 2004. Return on assets and return on equity declined moderately from the previous year's levels, but they remained in the elevated range that has prevailed since the mid-1990s (chart 1). Banks' profitability and balance sheets benefited from a brisk expansion of the economy and supportive financial conditions during 2004. Although the Federal Reserve gradually raised its target for the federal funds rate over the second half of the year, the stance of policy remained accommodative (chart 2). Short-and intermediate-term interest rates rose over the course of the year, but yields on longer-term Treasury securities were little changed on net, and the Treasury yield curve flattened noticeably. Interest rates on residential mortgages ended the year a touch lower, on balance, and continued to support robust housing activity. Risk spreads on corporate bonds--particularly high-yield bonds--narrowed substantially.
Favorable financial market conditions, accompanied by a stimulative fiscal policy and continued rapid growth in productivity, supported economic activity. Buoyant consumer spending on durable and nondurable goods reflected solid income growth, improvements in labor market conditions, and greater household wealth; the greater wealth, in turn, arose from gains in the stock market and continued sharp increases in house prices. Healthy profits and cash flows encouraged business investment in equipment and software, which rose smartly throughout the year. Businesses also added considerably to inventories for the first time since 2001. With the financial obligations ratio of households stabilizing below the peak reached at the end of 2002 and the debt burden for nonfinancial corporations continuing to fall, households and businesses had relatively strong financial positions overall during 2004.
These economic and financial conditions were reflected in the changes in bank balance sheets over the year. The robust activity in the housing sector and generally low mortgage interest rates buoyed residential mortgage lending at banks despite the ebbing of the 2003 refinancing wave. Even though consumer spending was strong, consumer loans advanced at only a moderate pace and likely were restrained by the substitution of mortgage debt for higher-rate consumer credit. Strong cash flows and profits allowed many nonfinancial corporations to finance capital spending with internal funds and thus reduce their borrowing needs. Nonetheless, after three years of retrenchment, short-term business debt--consisting of commercial and industrial (C&I) loans from banks and commercial paper--rose last year to meet firms' greater need to fund accounts receivable, inventories, capital expenditures, and merger and acquisition activity. C&I loans also received a boost from the supply side, as banks reported easing their lending standards and terms throughout the year. Banks also reported easing their standards and terms on commercial real estate loans, and such loans increased despite soft conditions overall in that sector. Still-low interest rates fueled the growth of core deposits, but the rise was insufficient to fund the increase in bank assets. (1) As a result, banks relied more heavily on managed liabilities, which rose strongly last year.
Economic and financial developments also strongly influenced banks' profitability in 2004. As the yield curve flattened markedly, the net interest margin narrowed a bit further. The net interest margin may also have been eroded by increased competition in the C&I loan market, which contributed to a narrowing of loan spreads over reference rates. Gains in non-interest income were less pronounced than in 2003. Despite contributions from fiduciary activities, loan-servicing fees, and securitization activities, the growth of non-interest income was restrained by weakness in investment banking revenue, a marked contraction in trading income, and a decline in gains from loan sales. …