Commercial Banks Appear Resilient despite Pandemic

This post is part of a series titled "Supervising Our Nation’s Financial Institutions."

U.S. commercial banking, like many sectors of the economy, appears to be bouncing back after a challenging 2020. Return on average assets (ROA)—a key benchmark of bank profitability—averaged 1.38% in the first quarter of 2021, up 67 basis points from its year-end 2020 level and 100 basis points from a year earlier. U.S. banks finished 2019 with an average ROA of 1.30%. (See the table below.)

The pattern was much the same in states within the Eighth Federal Reserve District. Banks in Illinois, Mississippi, Missouri and Tennessee recorded average ROAs at or just below the national average in the first quarter of 2021, while banks in Indiana and Kentucky posted averages that exceeded the national average. The average ROA at Arkansas banks hit 1.68%, a level significantly above that of their District and national peers.

An Earnings Roller Coaster

The significant shifts in ROAs over the past 15 months can be traced in large part to pandemic-related set-asides banks made to offset potential loan losses. These set-asides—called loan loss provisions—count as expenses on bank balance sheets and thus reduce earnings. The very low ROA all U.S. banks averaged in the first quarter of 2020 (0.38%) reflects the very large loan loss provisions the nation’s largest banks took at the start of the crisis. Similarly, the big upswing in ROA the past two quarters reflects, in part, the reversal of those provisions as economic conditions improved.Another factor influencing recent provisioning, especially at larger banks, is the introduction of the Current Expected Credit Losses (CECL) accounting methodology. See “The CECL Model: Accounting Changes Coming for Banks.” This pattern is similar, though less pronounced, at banks in Eighth District states.

The pandemic also put further pressure on banks’ main source of income: interest income. Net interest margins—interest income less interest expense as a percentage of earning assets—have been eroding for several years as banks faced increased competition and a very low interest rate environment. Since the pandemic began, banks have benefited from an influx of deposits (which tend to be the least expensive sources of funding). But banks have also faced a substantial decline in loan demand, notwithstanding the popularity of the Small Business Administration’s Paycheck Protection Program. The downward effect on interest income has more than offset the decline in interest expense, reducing net interest margins. The net interest margin for all U.S. banks fell 62 basis points between the first quarter of 2020 and the first quarter of 2021, the largest year-over-year decline since the end of the Great Recession (2007-09). For banks in Eighth District states, net interest margins did not fall as steeply; they declined by 25 to 43 basis points.

Asset Quality, Capital and Liquidity

Loan performance, as measured by the percentage of loans that are 90 days or more past due or in nonaccrual status, exceeded expectations during the pandemic. Nonperforming loans did increase as a percentage of total loans in 2020, but only modestly. As illustrated in the table below, the nonperforming loan ratio for all U.S. banks peaked at 1.19% in the fourth quarter of 2020 before declining somewhat in the first quarter of 2021.

The pattern was similar for banks in Eighth District states, although for four of them (Arkansas, Kentucky, Mississippi and Missouri), the nonperforming loan ratio peaked much earlier in 2020. These results stand in stark contrast to the very high peak delinquency rates commercial banks experienced following the Great Recession when the nonperforming loan ratio hit 5.58% for all U.S. banks and peaked between 2.52% and 4.65% in Eighth District states.

At the national and Eighth District state levels, banks remain well-capitalized. Although the average tier 1 leverage ratio declined at the national level and in all Eighth District states between the first quarter of 2020 and the first quarter of 2021, these averages remain above regulatory minimums.Banks are subject to four regulatory capital requirements. The minimum tier 1 leverage ratio requirement is 5%. Community banks—those with average assets of less than $10 billion—have the option of complying with one standard rather than four. That standard is called the Community Bank Leverage Ratio (CBLR). Provided they meet other requirements, community banks that maintain a CBLR in excess of 9% are considered adequately capitalized for regulatory purposes. During the pandemic, the standard was temporarily reduced to 8%. Some of this decline can be specifically attributed to the previously mentioned influx of deposits, which has led to excess liquidity and larger balance sheets.

Looking Ahead

While banks have weathered the pandemic fairly well, challenges remain. The economic recovery may be uneven, and it may be too soon for problem loans in some sectors to have emerged. A permanent change to more remote work may dampen commercial real estate lending, the bread and butter of many community banks. Longer term, the continued steady erosion in net interest margins places additional pressure on banks to raise noninterest sources of income—by expanding fee-generating business lines, for example—and to reduce expenses, all while making continued investments in new technology to remain competitive.

Notes and References

1. Another factor influencing recent provisioning, especially at larger banks, is the introduction of the Current Expected Credit Losses (CECL) accounting methodology. See “The CECL Model: Accounting Changes Coming for Banks.”
2. Banks are subject to four regulatory capital requirements. The minimum tier 1 leverage ratio requirement is 5%. Community banks—those with average assets of less than $10 billion—have the option of complying with one standard rather than four. That standard is called the Community Bank Leverage Ratio (CBLR). Provided they meet other requirements, community banks that maintain a CBLR in excess of 9% are considered adequately capitalized for regulatory purposes. During the pandemic, the standard was temporarily reduced to 8%.

Additional Resources

• On the Economy: Banks See Challenges from Fintech Disruption
• On the Economy: Small Business Lending Gives a Boost to Banks
• On the Economy: Community Bankers Play a Vital Role in America’s Pandemic Response