Mission Not Accomplished: Why 2010 Wasn't a Turnaround Year for Banking

To believe FDIC Chairwoman Sheila Bair last week, 2010 was a “turnaround year” for the US banking industry. Almost two-thirds of all banks reported year on year improvement in quarterly net income in the fourth quarter, and the average return on assets (ROA), which was negative a year ago, ended 2010 at 65 bps.

Unfortunately, Ms. Bair, like so many policymakers around the globe today, likes to focus on the averages; and in the case of the US banking industry, I’d offer that those averages are terribly deceiving when it comes to measuring the industry’s true health.

To me, a more accurate headline for 2010 banking results would be “America’s biggest banks benefit from the reversal of straight-to-equity FAS 166/167 loan loss reserves, while small and mid-size banks approach asphyxiation.”

Why do I offer this? Let me begin with a few statistics from this week’s Quarterly Banking Profile.

During the fourth quarter, our 107 largest banks (those with assets greater than $10 billion, and representing almost 80% of all banking assets) earned $20.561 billion -- an ROA of 79 bps. The other 7,550 banks (those other 98.6% with about 20% of the assets) earned $1.1 billion -- or an ROA of just 15 bps. Even more striking, though, is the fact that the 2,622 banks smaller than $100 million in size, almost 35% of all US banks by number, together earned a total of just $11 million -- an ROA of just 3 bps, or just $4,200 per bank!

Most troublesome, though, is the quarterly earnings progression experienced by smaller banks during 2010. Thanks to rising provision costs and expenses, profitability fell significantly during the year -- from more than 50 bps in ROA at the beginning of 2010 to near breakeven at year end.

Put simply, 35% of our nation’s banks, admittedly which represent just over 1% of system-wide assets, are slowly suffocating to death, with little prospect for recovery.

In contrast, our biggest banks have seen their loan loss reserves come down largely due to improvement in their credit card portfolios. (In fact, reflecting the oligopolistic nature of the US credit card industry, even the FDIC was forced to highlight that more than half of the $31 billion system-wide improvement in provision expense during 2010 came from just seven banks!) Talk about an asymmetric recovery! (See also, Our Increasingly Dangerous Asymmetric Economy.)

But what the FDIC failed to disclose was that the vast majority of the loan loss reserve release, which the biggest banks benefited from during 2010, came out of reserves which were established during the first quarter when the banking industry adopted FAS 166/167 and consolidated their off-balance sheet credit card securitizations. But those FAS 166/167 reserves did not flow through the P&L; rather, they went straight to equity. While not suggesting malfeasance, I struggle when I see large straight-to-equity accruals, like the one we saw for the implementation of FAS 166/167 during the first quarter, followed by straight-into-the-P&L accrual reversals like we saw during the other three quarters of 2010.

To suggest that these earnings somehow represent a turnaround in operating results, when they are in effect out of one pocket and back into another, seems pretty silly.

And then there is the entire question as to how precisely it is that credit card loan losses have come down by some 30% over the past year while consumer bankruptcies continue to mount and unemployment rates remain uncomfortably high. But that is a story for another day.

But even putting the asymmetry of the industry’s 2010 results aside, there are still fundamental weaknesses in our banking system that this quarter’s QBP profile highlights:
 

• “Problem” institutions are now at a record high 884, even with all of the bank closures of the past three years. And with almost $400 billion in assets among the 884 banks, there is a $40-100 billion hit to the still-in-a-deficit Deposit Insurance Fund looming (based on current failed bank loss rates).
  
  
• Twelve states still reported negative ROAs in the fourth quarter. And only seven states had ROAs in excess of 1% -- what I consider the minimum ROA threshold for a “healthy bank."  First mortgage delinquencies remain above 10% and junior mortgage and home equity loan quality continues to deteriorate, albeit at considerably lower levels of delinquency. Non-current construction and development loans still exceed 16%.
  
  
• Notwithstanding the improvement in non-current loans, bank loan loss reserve coverage ratios remain weak, at only 64%. At the end of 2010, there were $6.2 trillion in FDIC insured deposits backed by a Deposit Insurance Fund with a $7.4 billion deficit.
  
  
• And finally, there is the fact that risk-weighted assets comprise just 70% of bank balance sheets. Or put differently, there is the equivalent of $3.3 trillion in assets on bank balance sheets against which banks hold no capital -- none. (And as much of this is sovereign/agency debt, the collective systemic capital call risk is high.)

Later this spring, banking regulators are to consider whether our largest banks should be permitted to increase their dividends. With an average fourth-quarter ROA of just 79 bps, I think any talk of dividend hikes is woefully premature.

Rather than wasting their time on that issue, Washington policymakers need to focus all of their energy on the looming crisis that exists among America’s small community banks, particularly as a small hiccup in our already struggling recovery could more than double the list of problem banks.

With all due respect to policymakers, 2008 was a crisis among a very small universe of too-big-to-fail financial institutions in a mythical place called Wall Street. Yes, the numbers were enormous, but the number of participants could easily fit around a Treasury Department conference table.

The next banking crisis we face is not on Wall Street, but on thousands of Main Streets across America, where no bank is too big to fail. And that is the last thing America’s already strapped mayors need.

With the FDIC’s resources already stretched handling the current pace of bank failures, Washington would be wise to stop celebrating the “Mission Accomplished” turnaround of 2010, and start focusing on the real banking crisis.


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