Profits and Balance Sheet Developments at U.S. Commercial Banks in 2006

By Carlson, Mark; Weinbach, Gretchen C. | Federal Reserve Bulletin, July 12, 2007 | Go to article overview

Profits and Balance Sheet Developments at U.S. Commercial Banks in 2006


Carlson, Mark, Weinbach, Gretchen C., Federal Reserve Bulletin


The U.S. commercial banking industry continued to be quite profitable in 2006, and industry assets grew considerably. The strength in profitability and growth of bank balance sheets last year reflected favorable U.S. financial market conditions and the generally solid economic expansion. Industry return on equity advanced from its 2005 level, and the return on assets edged up to match its highest annual level in recent decades (figure 1). Profitability was supported by brisk growth in non-interest income and generally strong asset quality; the flattening of the yield curve and competitive pressures, however, further weighed on net interest margins.

In U.S. financial markets during 2006, short-term interest rates generally moved higher with the target federal funds rate, which increased 1 percentage point over the first half of the year as monetary policy was tightened and then held steady thereafter (figure 2). Intermediate- and longer-term interest rates also rose significantly over the first half of the year, but much of those increases were later reversed. The Treasury yield curve flattened further and at times was inverted. Interest rates on fixed-rate home mortgages rose somewhat on average and, like Treasury yields, peaked around midyear. Corporate risk spreads generally remained quite narrow, and spreads on high-yield corporate bonds fell to levels seldom seen since 1997.

[FIGURE 1 OMITTED]

The U.S. economy expanded at a brisk pace over the first quarter of 2006 and then grew moderately, on average, over the rest of the year. In the corporate sector, spending picked up relative to 2005 as businesses increased their investment in fixed assets and inventories. Although hefty corporate profits and substantial cash balances helped fund business spending, firms' demand for external financing still rose notably. Demand was also supported by heavy merger and acquisition activity and record levels of share repurchases. Availability of bank-intermediated business credit also increased during the year as banks reportedly eased terms on their commercial and industrial (C&I) loans, particularly spreads of loan rates over their costs of funds. Strong fundamentals in the commercial real estate sector, including rising property values and declining vacancy rates, bolstered the demand for commercial mortgages.

[FIGURE 2 OMITTED]

In the household sector, higher mortgage rates and a cooling of the pace of house-price appreciation combined to damp residential housing activity. By the end of 2006, home sales had ebbed markedly, and home construction activity had slowed significantly. In addition, mortgage refinancing activity declined, on average, last year. Moderate growth in consumer spending was supported by continued strength in the labor market and gains in household wealth from significant increases in equity prices and advances in home prices during the first half of the year.

These financial and economic conditions shaped balance sheet developments at commercial banks. On the asset side, borrowing by businesses to finance capital expenditures and merger and acquisition activity contributed to the rapid growth in C&I lending for the second consecutive year. The financing of residential home construction likely helped fuel the construction and land development component of commercial real estate loans in recent years, but the pace of such lending moved lower in 2006 as home construction activity slowed. Apart from the consolidation of a sizable amount of thrift assets onto banks' books in the fourth quarter that resulted from a reorganization within a large bank holding company, residential real estate lending also decelerated. Growth in consumer loans--which had been particularly lackluster in 2005, when households apparently substituted mortgage debt for consumer debt--picked back up to a moderate pace. (1) The attractiveness of mortgage financing relative to consumer loans probably diminished last year as mortgage rates rose and appreciation in house prices slowed. …

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