After a notable uptick following the recession, the percentage of nonperforming assets (red line) has stabilized and is trending lower, though they remain comparatively high. After moving toward pre-recession levels, net charge-offs (blue line) increased in the fourth quarter of last year.

Nonperforming assets are loans that are 90 or more days past due, plus nonaccrual loans (loans on which the bank is not earning income because interest is overdue and full collection of principal is uncertain, usually because of borrower difficulties), plus “other real estate owned” (OREO), which is typically acquired through foreclosure and not generating income. Net charge-offs are the assumed losses from bad loans charged against a bank’s loan portfolio, less any recoveries ultimately collected on those loans.

Banks have a capital buffer to absorb losses. Nonperforming assets are a leading indicator for loan charge-offs, which reduce a bank’s capital buffer and its ability to absorb future losses.

Loans for commercial real estate and construction/land development continue to have abnormally high levels of nonperformance, though both loan sectors saw continued improvement in their asset quality in the fourth quarter of 2011. Nonperformance for commercial and industrial loans also improved, but remains elevated. Nonperformance among agricultural loans is nearing historic lows.

Nonperforming assets are loans that are 90 or more days past due, plus nonaccrual loans (loans on which the bank is not earning income because interest is overdue and full collection of principal is uncertain, usually because of borrower difficulties), plus “other real estate owned” (OREO), which is typically acquired through foreclosure and not generating income.

Nonperforming assets are a leading indicator for loan charge-offs, which consume bank capital and erode the firm’s ability to absorb future losses.

Real estate loans continue to make up almost half of bank lending. In 2011, the average bank continued to reduce nonmortgage consumer lending, while agriculture lending increased.

Commercial real estate loans include those for multifamily residential properties, loans secured by nonfarm nonresidential property, construction and development loans, and unsecured loans to finance commercial real estate. Residential real estate loans include those for 1-unit to 4-unit family residential properties. Consumer loans include credit card loans, other revolving credit plans and other consumer loans. Commercial and industrial loans define their own category. Agriculture loans include loans secured by farmland, loans to finance agricultural productions and other loans to farmers.

All else equal, concentrations of loans in a specific sector, geography or by loan type raise the risk of loss to the bank. An economic or other shock to the sector or within the local economy can create more losses to the bank if its exposure is similarly concentrated. However, banks can take steps to manage concentration risk, and bank supervisors have set up expectations for prudent management of concentrations.

Return on average assets (blue line) improved noticeably in 2011, helped by a lower number of banks reporting negative earnings (red bars).

Return on average assets (ROAA) is a standard measure of bank earnings. It is the ratio of net income to annual average assets. Assets are the cumulative investments, loans and real property owned by a bank. Earnings are a measure of profitability (also referred to as net income or the “bottom line”) and equal a bank’s revenues minus operational costs, depreciation, interest, taxes and other expenses.

Profits (a.k.a. earnings or net income) are ultimately what sustain all businesses, including banks. As profits sag industrywide, it’s likely that a growing number of banks also become unprofitable and are more likely to go out of business.

Coverage ratios have slid steeply since 2006. While still relatively low, reserves as a percentage of nonaccruals (red line) have stabilized, and were mostly unchanged in the fourth quarter of 2011. Provisions (blue line) had been steadily improving since 2009, but worsened slightly last quarter.

Coverage ratio is the ratio of loan-loss reserves to nonaccrual loans. Loan loss reserves are the cumulative provisions, or set-aside capital, used to cover losses from bad loans. Nonaccrual loans, which are a subset of nonperforming loans, are loans on which interest is overdue and collection of full principal is uncertain.

The “proper” size of coverage ratios is different for each bank and dependent on (among other things) specific loans and markets in which the bank operates. Thus, one cannot infer from the median coverage ratio if a bank has too large or too small a reserve. But bank supervisors expect “directionally consistent” behavior between reserves and loan performance, and the current coverage ratio trend suggests that nonaccrual loans have been accelerating faster than loan provisions.

Two different capital ratios show that capital adequacy for banks remains stable and risk-adjusted capital continues to improve, suggesting that the banking sector in the Ninth District appears financially sound overall.

Capital ratios are a key measure of a bank’s financial stability. There are a variety of capital ratios, but they generally measure certain types of bank capital against certain types of assets. As a rule of thumb, the higher the ratio, the more sound the bank. Equity capital to total assets (blue line) simply compares the two main elements of a bank’s balance sheet. The total risk-based ratio (red line) adjusts the assets for their underlying risk, which allows lower capital charges for less risky assets.

Capital ratios represent a bank’s buffer against losses. The closer that buffer gets to zero, the higher the chance of failure, all else equal. Bank supervisors group banks based on risk-based capital ratios. If this ratio is 10 percent or more (along with meeting certain targets on other select capital ratios), banks fall into the highest (safest) capital category and are considered “well capitalized,” which means they do not necessarily face prespecified supervisory restrictions on their activities.

Liquid asset ratios have steadily improved since their low point in 2008.

Liquid assets are cash and other assets that can be converted easily into cash, including fed funds (which are reserve funds of commercial banks held at Federal Reserve banks) and securities (which are any negotiated instrument that has underlying financial value). Pledged securities are collateral and other financial instruments that have been negotiated but not transferred or delivered, and as such are not available as liquid assets. Examples include loan collateral pledged to secure discount window borrowing or a security purchased to guarantee the safety of a large deposit above the government-insured amount.

When banks face funding challenges, they need assets that convert easily and quickly to cash. A steady decline suggests that more bank assets are invested in higher yielding assets that are not easily convertible to cash to cushion a funding crisis.

Noncore funds (red line) and brokered deposits (blue line) can be relatively less stable sources of bank funding. While their overall share has increased considerably over the past two decades, both noncore funds and brokered deposits have been moving lower in recent quarters.

Core funding is the deposits made by customers in the bank’s general market area, who are generally considered to be the most consistent and loyal. Noncore funding is the deposits from outside the bank’s general market area and include sources such as federal funds purchased, Federal Home Loan Bank advances, subordinated notes and debentures, and jumbo CDs (more than $100,000). A brokered deposit is a large-denomination deposit (similar to a certificate of deposit) that has been facilitated by a third-party broker who has pooled smaller deposits.

Because noncore funds and some brokered deposits (those over $250,000 currently, but previously $100,000) are not insured by the federal government, the owners of these funds have reason to move such funds out of weak banks, which can further weaken a bank. As the funding share of noncore and brokered deposits increases, banks face potentially higher volatility in the shifting of these more mobile funds.

Despite higher than average levels of low-rated (or problem) banks, a large majority of banks are still considered healthy.

Ratings are evaluations of a bank’s safety and soundness by the appropriate bank regulator. The rating is a composite measure, ranging from 1 (best) to 5 (worst, and considered a significant risk for failure). Bank regulators include the following: The Federal Reserve supervises bank holding companies and state-chartered banks that are members of the Federal Reserve System; the Federal Deposit Insurance Corp. regulates state-chartered banks that are not part of the Federal Reserve System; the Office of the Comptroller of the Currency supervises nationally chartered banks; state regulatory agencies also supervise banks chartered in their state. Still other federal and state agencies regulate national and state-chartered thrifts (savings banks, savings and loan associations) and credit unions.

Ratings are the best single measure available on bank health and safety—individually and as a sector—because they embody a summary analysis of the many measures of bank health and risk. At the same time, however, ratings are a lagging indicator because banks are typically examined every 12 to 18 months. This means ratings might decline further as examiners update ratings in the current environment.

After a significant increase in the number of failed banks in 2009 and 2010, the Ninth District had two banks fail in 2011, both in Minnesota.

A failure occurs when a bank is forced to close.

Bank failures are rare events; indeed, even many problem banks do not fail. As such, they represent more of a lagging indicator, reflecting the fruition of previous problems among banks rather than the current health of the sector.