James M. Lyon - Vice President
Published June 1, 1989 | June 1989 issue
Each year the Banking Supervision Department of the Minneapolis Fed prepares a report on the conditions of Ninth District banks. The following summary is from a presentation to the Minneapolis Fed's board of directors by James Lyon, vice president of banking supervision.
The financial performance of district banks continued to rebound during 1988, despite last year's drought and the significant losses of the district's largest bank holding company.
In 1987, bank profitability posted its first annual increase in over five years due to improvements in asset quality. Last year better asset quality and strong loan growth caused continued improvement in Ninth District bank profitability.
Much of the concern during 1988 focused on how last year's dry spell would affect banks in the Ninth District. As it stands, the adverse impact of the drought was lessened by several factors, including relatively high crop prices, crop insurance and drought relief programs.
Another significant development during 1988 was First Bank System's (FBS) loss of $310 million for the year, resulting from securities losses totaling $506 million. Nineteen of FBS's 21 banks in the district reported losses for 1988. In general, however, despite the drought and the problems experienced by FBS, 1988 was a relatively good year for banks.
The mean level of earnings to average assets showed continued improvement in 1988. In 1986 the mean return on average assets (ROAA) for Ninth District banks had fallen 74 basis points from a high of 1.15 percent in 1981 to 0.41 percent. For 1988, an improvement of 16 basis points to 0.74 percent occurred.
Focusing strictly on changes in the mean level of ROAA provides a somewhat misleading picture of what is actually happening to bank earnings in the district. Since the mid-1980s a minority of banks in the district experienced particularly severe earnings problems, and their results depressed the districtwide averages. Further strengthening in the performances of the most troubled banks contributed to the improvement in the 1988 numbers.
One indication of this phenomenon is the change in the number of banks reporting losses. From 120 in 1984, the number of banks showing negative earnings rose to 279 by year-end 1986, or 20 percent of the banks in the district. For 1988, the number of banks reporting losses declined to 126, and 19 of those were FBS banks.
Simply observing trends in mean values can distort the perception of what is really happening to the majority of banks in the district. It is important to review the data to identify particular groups of institutions experiencing significant changes. In an effort to do this, the Minneapolis Fed routinely analyzes bank performance by size, state and dependence on agriculture.
For 1988 the losses by FBS banks, while not affecting the district average numbers significantly, had a large effect on the data for banks in the $50 to $150 million asset category and above, as well as the averages for Minnesota and Montana banks. Five of the 14 banks in the district that exceed $300 million in assets are FBS banks. Accordingly, any following data that compares banks by size or geographic categories do not include FBS banks.
All size groups posted healthy improvements in ROAAs for 1988, but the strongest overall earnings performance was posted by the largest banks in the district. Also, the average ROAAs improved for all of the states in the district, particularly in Montana.
As noted earlier, excluding FBS, 107 district banks reported losses in 1988. While the largest single group of these, 54, was in Minnesota, North Dakota had the highest incidence of banks with losses as a percentage of total banks in the state.
In 1988, banks of all sizes enjoyed improvement in their average ratio of net interest income to average assets. Interestingly, the traditional advantage that smaller banks have enjoyed in net interest income, reflecting largely their lower reliance on purchased funds, has disappeared. The largest banks in the district enjoyed the highest levels of net interest income to average assets. Banks with assets of more than $150 million posted particularly strong improvements in net income to average assets, primarily as a result of strong loan growth.
Banks with total assets of $300 million or more recorded a particularly sharp increase in their average loan to total assets ratio during 1988, from 52 percent at the end of 1987 to 64 percent a year later. For the district as a whole, loan growth during 1988 was considerably stronger than overall asset growth: loan growth was 14 percent and asset growth 3 percent.
The profitability of the largest banks in the district was further enhanced in 1988 by a strong showing in their non-interest income to average assets. In 1988 the level of non-interest expense to average assets was also the highest for the largest banks in the district.
In 1988, better asset quality continued to be one of the principal factors driving the banks' earnings improvement. The extent of the improvement in bank asset quality that occurred in 1988 is illustrated by the decline in the mean level of loan loss provisions as a percentage of average assets for Ninth District banks. This ratio declined 21 basis points to 0.45 percent in 1988, from the high reached in 1986 of 1.11 percent.
Loan loss provisions as a percentage of average assets declined in 1988 for all size categories of banks, except the largest. The data shows declines for all the states in the district when the 1988 levels of loan loss provisions to average assets are compared to 1987.
The close relationship of recent years between the mean ratio of loan loss provisions to average loans and net loan losses to average loans continued in 1988, with provisions occurring at a slightly higher average level than charge-offs. The declining level of net loan charge-offs in 1988 permitted banks to reduce their level of loan loss provisions, thereby contributing to the improvement in their profitability.
The decline in the level of net loan losses as a percentage of average loans in 1988 holds across all size categories of banks except the largest, and it is most pronounced for the smallest banks in the district.
On a state-by-state basis, net loan losses significantly declined in all states during 1988, with the improvement recorded over the last two years being even more striking.
Since the average level of loan loss provisions continued in 1988 at a higher level than the average level of charge-offs, there has been the resulting increase in the mean ratio of loan loss reserves to total loans that one would expect. However, the increase in the level of loan loss reserves to total loans does not hold across all size categories of banks. Rather, levels of loan loss reserves increased only for the smaller banks in the district and declined as a percentage of total loans for larger banks.
The best barometer for future asset quality problems is the ratio of non-performing loans to total loans. For 1988 the mean value of this ratio continued the downward movement that we first observed in 1986. From a high of 4.6 percent at year-end 1985, this ratio has now declined to 2.4 percent. The frequency distribution of non-performing loans to total loans shows that the number of banks with levels of non-performing assets equal to 2.5 percent of their total loans or less increased by 80 institutions.
The level of non-performing loans declined for all size categories of banks in the district. Likewise, the average level of non-performing loans to total loans improved in all of the states, with Montana again reporting the highest ratio of non-performing loans to total loans.
As would be expected with the decline in the average level of non- performing loans and the increase in loan loss reserves, the coverage of non- performing loans by loan loss reserves continued to improve in 1988. The improvement in coverage holds across all size categories of banks and for all states in the district.
A broader measure of banks' ability to weather adversity is the ratio of primary capitalwhich includes loan loss reservesto non-performing loans. Here again, on a district-wide level, 1988 brought considerable improvement in this ratio. Equally encouraging is the fact that the number of banks in the district reporting non-performing loans in excess of their capital fell to 11 in 1988, after having increased from 1984 to 1986.
The average primary capital ratio of Ninth District banks improved 37 basis points to 9.38 percent. For 1988 the average primary capital ratios of banks in all size categories, except the largest, improved from the levels of a year earlier.
The smallest banks continue to maintain the highest average level of primary capital. The size of the actual gap in capitalization is somewhat understated by these figures since they only measure banks' capital in relation to their balance sheet assets.
The largest banks report much higher levels of off-balance sheet items than do smaller banks, thereby increasing the actual gap in capital ratios. The magnitude of off-balance sheet items reported, particularly by larger banks, is one of the principal reasons that the Federal Reserve, along with the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, has implemented new risk-based capital guidelines. Those guidelines explicitly take such off-balance sheet exposure into account in assessing the adequacy of a bank's capitalization.
Average retained earnings were positive for the smaller banks in the district and slightly negative for the larger banks. When compared by state, positive levels of retained earnings are present in all of the states, with the strongest levels in Michigan and Minnesota.
Finally, regarding capital ratios of Ninth District banks, at year-end there were 37 banks with primary capital ratios below the 5.5 percent minimuman increase from 31 a year earlier.
In summary, regarding the capitalization of banks in the Ninth District, average primary capital ratios of all size categories of banks, except the largest, improved during 1988. Improved earnings allowed banks to sustain their dividend levels while at the same time increasing the level of retained earnings.
In addition to analyzing the performance of Ninth District banks by size and location, the Minneapolis Fed has also found it useful in recent years to analyze differences in performance between small ag and non-ag banks. For this purpose we define small banks as those with assets of less than $50 million, and ag banks as those with farm production and farm real estate loans equal to 25 percent or more of their total loans. Focusing on just banks under $50 million for this analysis makes sense because the importance of ag loans declines rapidly for the typical large Ninth District bank.
Comparing the performance of these two categories reveals that the gap in the average performance that opened in 1985 and widened in 1986, was eliminated in 1987 and 1988.
As expected from the earlier analysis of factors influencing bank earnings, the elimination of the gap in earnings between ag and non-ag banks is due to a narrowing of the difference in the level of loan loss provisions. Loan loss provisions declined for both ag and non-ag banks in 1988.
As was the case for the districtwide numbers, the improvements in loan loss provision expense for ag and non-ag banks parallel the improvements in the level of net loan charge-offs to average loans. The improvements for both categories of banks in their levels of non-performing loans continued in 1988.
To conclude, with respect to the performance of small ag and non-ag banks in the district, the trend of the mid-1980s, in which ag banks underperformed their non-ag counterparts, has disappeared.
There are 1,320 commercial banks in the Ninth District, ranging in size from less than $1 million to $17.8 billion in assets.
The majority of the banks, 694, are located in Minnesota, as are the bulk of the district's banking assets67 percent.
Most of the banks are small: almost half are under $25 million in assets and roughly two-thirds are under $50 million.
Banks with assets in excess of $150 million make up only 4 percent of the total number of banks in the district, yet these larger banks account for 50 percent of the total banking assets.