Banks continued to report strong profits in the third quarter, but the Federal Deposit Insurance Corp. on Tuesday highlighted a definite warning sign it sees in bank portfolios: riskier loans.
The FDIC's report on third-quarter earnings pointed to signs of institutions becoming bolder in their risk profiles. The overall loan growth was led by commercial real estate, while loss reserves for commercial loans and overall loss provisions went up. Officials also pointed to loosened credit standards in some categories.
"Credit risk is … a growing concern," FDIC Chairman Martin Gruenberg said at the release of the agency's Quarterly Banking Profile. "As loan growth has picked up, supervisory surveys have noted a relaxation in underwriting standards in some loan portfolios, including auto and multifamily housing portfolios. We also have seen growth in riskier loan categories, such as loans to leveraged commercial borrowers."
Overall, the industry reported net income of $40.4 billion, a 5% increase from a year earlier. The FDIC attributed the gain to lower noninterest expense helped by a "few large banks" recording lower litigation expenses.
Total noninterest expenses fell 2.9%, or $3.2 billion, from a year earlier to $105.6 billion. Litigation expenses contributed to most of the decline, falling $2.7 billion, or 67.3%. Costs associated with employee benefits and salaries fell 0.4%, or $199 million. Goodwill impairments declined 45.4% or $578 million.
Yet in his press conference, Gruenberg flagged credit risk as well as interest rate risk "as the two key issues from a risk management perspective from our institutions."
Gruenberg also said the FDIC will continue to watch institutions that have significant exposure to the oil and gas industry given the significant drop in energy prices. He said banks can generally expect examiners to home in on loan portfolios during upcoming examinations, with particular focus on balance sheet exposure to interest rate and credit risk. "We are very focused on having the institutions address these issues."
But following his remarks, James Chessen, the American Bankers Association's chief economist, told reporters he is less concerned about the credit risk component.
"The credit risk is one that I think is less important now because the economy is improving," Chessen said. On interest rate risk, he added, "They key is how fast the Fed increases interest rates and every signal is it is going to be slow and that allows for a period of adjustment and period of replacing assets that are rolling off with higher priced assets."
Still, while the extent of risk-taking is nowhere near the period before the financial crisis, some indicators in the FDIC report suggest banks feeling more comfortable trying to drive revenue by providing credit.
The ratio of net loans to deposits has slanted upward all year. Meanwhile, even though banks with over $1 billion in assets reported 0.8% reduction in total loss reserves during the quarter, their reserves for non-real estate commercial loans went up by 3.4%. Overall loan loss provisions for the industry increased on a year-over-year basis for the fifth consecutive quarter.
While total loans increased by just over 1%, commercial real estate-related assets grew more. Multifamily residential real estate loans and construction and development loans rose, respectively, 4.4% and 4%. The 334 institutions with construction loan concentrations — meaning construction loans exceeding total capital — was the highest figure since 2012.
Institutions also continued to show interest in longer-term assets. The industry's share of loans and securities with maturities of three years or more rose to 34.6% during the quarter, which is the highest it has ever been for the 18 years that data is available.
Yet despite the industry's efforts to capitalize in a challenging interest-rate environment, banks still struggled to generate much higher operating revenue in the third quarter. Revenue grew by just 0.3% — or $488 million — from a year earlier to $172 billion.
Some of the largest banks saw a decline in servicing and securitization activity as well as lower trading revenue, which dragged the industry's overall noninterest income down 2% in the quarter compared to the third quarter of last year.
The report showed that the banking industry's net interest margin actually rose slightly to 3.08% in the third quarter, up from 3.07% in the second quarter and from the 30-year low of 3.02% seen in the first quarter. Yet the third-quarter margin was still down from the third quarter of last year when it was 3.15%.
Net charge-offs for problem loans also improved, declining by 6.2% from a year earlier. Still, more than one-third of all banks increased their loan-loss provisions, setting aside $8.5 billion for potential losses, which was $1.3 billion or nearly 18% more than in the third quarter of 2014.
"The hope is that you get much stronger loan growth that starts to replace some of the expenses of things related to problem loans," Chessen said. "It is a huge expense to deal with problem loans and charge offs and it is very good that that has diminished significantly."
The number of institutions on the agency's "Problem List" fell by 25 to a total of 203, marking the 18th consecutive quarterly decline.
The report also showed that the Deposit Insurance Fund continues to improve. The fund's balance increased by $2.2 billion to $70.1 billion, bringing the ratio of reserves to insured deposit to 1.09% — 3 basis points higher than in the second quarter.
When the fund reaches a reserve ratio of 1.15%, lower assessments will kick in for the industry overall, but banks with more than $10 billion will soon likely see an additional assessment charge to raise the fund to a new mandatory minimum reserve ratio of 1.35%.