Overview of Commercial (Depository) Banking and Industry Conditions
Released: 2016-05-03T00:00:00

Summary:
A commercial bank is an institution that obtains either a federal or state charter that allows it to accept federally insured deposits and pay interest to depositors. In addition, the charter allows banks to make residential and commercial mortgage loans; to provide check cashing and clearing services; to underwrite securities that include U.S. Treasuries, municipal bonds, commercial paper, and Fannie Mae and Freddie Mac issuances; and to conduct other activities as defined by statute, namely the National Banking Act. Commercial banks are limited in what they can do. For example, the Glass-Steagall Act separates commercial banking (i.e., activities that are permissible for depository institutions with a bank charter) from investment banking (i.e., activities that are permissible for brokerage firms, which do not include taking deposits or providing loans).
Congressional interest in the financial conditions of depository banks, or the commercial banking industry, has increased in light of the financial crisis that unfolded in 2007-2009, which resulted in a large increase in the number of distressed institutions. Providing credit during the financial crisis was difficult for the banking system. Thus, an analysis of post-financial crisis trends that pertain to lending activity may provide some useful insights about recovery of the banking system. The financial condition of the banking industry can be examined in terms of profitability, lending activity, and capitalization levels (to buffer against the financial risks). This report focuses primarily on profitability and lending activity levels. Issues related to higher bank capitalization requirements are discussed in CRS Report R42744, U.S. Implementation of the Basel Capital Regulatory Framework, by [author name scrubbed].
The banking system generally has substantially more small banks (i.e., those with $1 billion or less in assets) relative to larger size banks. For several decades, bank assets have increased while the number of banking institutions has decreased. The banking industry continues consolidating, with more of the industry's assets held by a smaller number of institutions.
Generally speaking, by most measures, the health of the banking system has improved since 2009. There are fewer problem banks since the peak in 2011, as well as fewer bank failures in comparison to the peak amount of failures in 2010. The return on assets (RoA) and return on equity (RoE) for the banking industry, expressed as percentages, have rebounded since the financial crisis. Although RoA and RoE have not returned to pre-recessionary levels, the range of percentages that should be associated with optimal performance of the banking system is subjective.
The banking system currently has increased its capital reserves that have been designated to buffer against unforeseen macroeconomic and financial shocks. The banking system also has loan-loss reserves to sufficiently cover losses expected to be uncollectible. For loans that are noncurrent (delinquent) but have not yet gone into default, however, the banking system still needs to rebuild this loan-loss capacity if such loans do become uncollectible. Hence, news of industry profitability should be tempered by the news that aggregate loan-loss provisions still must increase to sufficiently buffer against noncurrent loans.

subsections: section_title: Introduction
paragraphs: A commercial or depository bank is typically a corporation that obtains either a federal or state charter to accept federally insured deposits and pay interest to depositors. Commercial banks also make residential and commercial mortgage loans, consumer loans, provide check cashing and clearing services, and may underwrite securities, including U.S. Treasuries, municipal bonds, Fannie Mae and Freddie Mac issuances, and commercial paper (unsecured short-term loans to cover short-term liquid ity needs). The permissible activities of depository banks are defined by statute, namely the Glass-Steagall Act. By contrast, investment banks (or brokerage firms) are not allowed to accept federally insured deposits, and they do not make loans (i.e., a debt obligation owed to a single lending source). Instead, investment banks receive commissions to facilitate corporate mergers and corporate issuances of securities, such as corporate stocks and bonds (i.e., borrowing from the public). 
Congressional interest in the financial conditions of depository banks, also referred to as the commercial banking system, has increased following challenging economic conditions and changes in the regulatory environment. Specifically, the recession that began in December 2007 and ended in 2009 is frequently referred to as the Great Recession in part due to the financial crisis that unfolded. Both large and small banking institutions experienced losses related to the declining asset values (of mortgage-related assets), resulting in a substantial increase in bank failures. 
Consequently, higher prudential requirements for U.S. banking institutions were implemented. The Basel Committee on Banking Supervision, which provides an international consensus framework to promote internationally consistent bank prudential regulatory standards, adopted the third Basel Accord that was subsequently adopted by U.S. federal banking regulators. In addition, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ( P.L. 111-203 , 124 Stat. 1376), which also contained enhanced prudential regulatory requirements for financial institutions. Hence, the challenge for the banking industry is to determine the sustainable amount of financial (lending) risk-taking while simultaneously facing higher costs associated with greater financial risk-taking (i.e., compliance with prudential regulations designed to minimize the severity of financial distress under deteriorating macroeconomic conditions).
This report begins with a general overview of the banking industry. It describes how banks facilitate the financial intermediation process as well as the associated financial risks. It also explains the market structure of the banking industry, referring primarily to the asset distribution. Next, this report summarizes profitability and lending activity levels in the banking industry. Particular attention is paid to metrics related to capitalization levels, asset performance, and earnings of depository banks. 
section_title: The Basics of Commercial (Depository) Banking
paragraphs: Financial intermediation is the process of matching savers, who are willing to lend funds to earn a future rate of return, with borrowers, who are in need of funds to make transactions. It is expensive for savers to locate, underwrite, and monitor repayment behavior of borrowers. Similarly, it is expensive for borrowers to locate a sufficient amount of savers with funds and favorable lending terms. Hence, banks develop expertise in intermediation , or facilitating the transfer of funds from savers to borrowers.
The typical intermediation transaction made by commercial banks provides loans to borrowers at higher rates than the cost to borrow the funds from savers, who provide loanable funds in the form of bank deposits. Generally speaking, banks (as well as numerous lenders or financial institution types) profit from the spread between the rates they receive from borrowers and the rates they pay to depositors. 
Financial intermediation, however, involves risk. Banks face the risk that borrowers will default on their loans, making it more difficult to repay depositors. In addition, banks face funding or liquidity risk stemming from more frequent movements in short-term interest rates. Banks must have access to an uninterrupted source of short-term funding (deposits) until their long-term loans are fully repaid. Consequently, greater variability in short rates may translate into variable profit spreads. Furthermore, depositors could suddenly and simultaneously decide to withdraw their deposits, perhaps due to a sudden change in economic conditions or even speculation about deteriorating economic conditions, resulting in financial distress for one bank or several banks. Hence, bank profitability and financial risk are inextricably linked. 
In addition to default and funding risks, financial intermediation increases borrowers' vulnerability to economic downturns. During business cycle booms, lenders may grow optimistic and increase credit availability as if the ideal economic and financial market conditions will persist. The trade-off (or costs) associated with greater lending is a greater likelihood of severe financial distress if macroeconomic conditions were to deteriorate. In other words, recessions that occur when individuals have more loan repayment obligations (or are more leveraged financially) are likely to be more arduous, in particular if these borrowers suddenly face lower income prospects (via job losses or pay cuts).
subsections: section_title: Commercial Bank Market Structure and Asset Distribution
paragraphs: Assets in the banking industry are not evenly distributed, meaning that banking firms are not identical and, for some metrics, must be analyzed separately to get a more accurate assessment of financial conditions. Using data from the Federal Deposit Insurance Corporation (FDIC), Figure 1 shows the number of U.S. banks since 2000 by size categories of bank asset holdings: less than $100 million, $100 million-$1 billion, $1 billion-$10 billion, and greater than $10 billion. Community banks have traditionally been considered institutions with total assets at or below $1 billion; however, some institutions with $10 billion in total assets may be considered community banks. At the other extreme are the large financial institutions that have $10 billion or more in assets. The number of banks with more than $10 billion in assets has remained relatively constant, ranging from 101 to 107 institutions between year-end 2000 and 2015.
As of 2015, the FDIC reports that total industry assets were $15,967.92 billion. For several decades, bank assets have increased while the number of banking institutions has decreased. The smallest of the community banks, those with less than $100 million in assets, have accounted for most of the industry consolidation even prior to the 2007-2009 recession. 
 Figure 2 shows the same bank asset categories by asset size rather than by number of institutions. Banking institutions with less than $100 million in assets collectively hold approximately 1% of all industry assets. In contrast, banks with more than $10 billion in assets collectively hold approximately 80% of all industry assets. With this in mind, it can be challenging for industry analysts to determine whether the banking industry should be viewed as one competitive industry or as numerous firms with characteristics similar to monopolists. Even though banks generally accept deposits and take loans, it is unclear the extent that small banks compete with large banks and for what types of financial services; small banks compete with each other because of their focus on specialized lending and geographical limitations; or large banks compete with each other or maintain focus on specialized financial services. 
section_title: An Overview of Capital (Equity) Regulation
paragraphs: Banking regulators (i.e., the Office of the Comptroller of the Currency, the Federal Reserve, the FDIC, and state banking regulators) require U.S. banking institutions that accept federally insured deposits to comply with safety and soundness regulations, which are designed to monitor and buffer against the types of financial intermediation risks that can result in financial distress for banks and the broader economy. Asset (loan) defaults are less likely to result in the inability of a bank to repay its shorter-term obligations to its creditors (and especially its insured depositors) if sufficient capital is maintained to absorb the losses. If a bank's capital falls below minimum regulatory threshold levels, it would be considered undercapitalized and faces the prospect of being shut down by its regulator, which appoints the FDIC as the receiver of the insolvent institution. Hence, compliance with regulatory capital requirements implies that capital reserves must grow proportionately with bank asset (lending) portfolios.
The abatement of financial risk, however, may curb lending activity. As previously mentioned, recessions are likely to be milder when fewer loan repayment obligations are outstanding; but the trade-off may be fewer loans, translating into fewer transactions that could possibly spur more robust expansions. Consequently, determining the optimal amount of financial intermediation risk for the banking system to take while simultaneously trying not to undermine economically stimulative lending activity is often a regulatory challenge.
section_title: Recovery from the 2007-2009 Recession
paragraphs: After 2007, the banking system saw unusually high numbers of distressed institutions, with failures at rates not seen since the savings and loan crisis that began in the 1980s and lasted through the early 1990s. The number of banks that failed, or fell substantially below their minimum capital reserve requirements, increased as the financial crisis of 2008 unfolded. No banks failed in 2005 and 2006, and three bank failures occurred in 2007. In contrast, the FDIC administered 489 bank failures over the 2008-2013 period. 
The FDIC maintains a problem bank list, which lists banks at risk of failure because their capital reserves have fallen below regulatory minimum levels (but perhaps not yet far enough below to be shut down). The number of depository institutions on the FDIC's problem list spiked beginning in 2008 and peaked at 888 in the first quarter of 2011. Figure 3 shows the number of problem banks and the total assets of those banks relative to the total assets of the entire banking system. The chart suggests that problem banks were primarily small institutions because of the small share of total banking assets they held. 
The industry has returned to profitability since the recession. Return on assets (RoA) and return on equity (RoE) are commonly used metrics to gauge bank profitability. RoA is computed with net revenue (i.e., total revenue minus total expenses) in the numerator and average total assets in the denominator. The RoA measures the financial return of a bank's average assets or lending activities. Because the banking industry relies heavily upon borrowed liabilities to fund assets, the ratio's numerator would be significantly smaller than the denominator; therefore, a RoA of approximately 1% is considered profitable. RoE is computed with net income in the numerator and the total amount of common shareholder equity in the denominator. The RoE is a measure of financial return for shareholders. Unlike RoA, RoE does not have a barometer of "acceptable" performance because it can increase due to either asset profitability or depleting capital positions, making it difficult to establish a benchmark standard. Nonetheless, double-digit RoE returns such as those prior to the recession tend to be more acceptable for shareholders.
The FDIC reported industry declines in both RoA and RoE during the 2007-2009 recession as the numerators of both ratios fell even faster than their denominators. The negative returns coincided with the wave of loan defaults that also occurred during the recession, which led to the deterioration of capital, increases in the number of banks on the FDIC's problem list, and increases in bank failures. The RoA and RoE measures, which are illustrated in Figure 4 , have exhibited a reversal in course since the recession. 
 Figure 5 shows the increase in noncurrent assets (i.e., loans or bonds) and charge-offs after 2007. Non-current assets are loans or bonds that borrowers do not repay as scheduled. The allowance for loan and lease losses (ALLL) is a component of regulatory bank capital set aside for anticipated (or estimated) loan losses. Loan loss provisioning refers to increasing the amount of ALLL when loan default risks increase; decreases are referred to as charge-offs or deductions from ALLL when lenders determine that noncurrent assets will not be repaid. RoA and RoE movements are essentially related to loan and bond repayment problems.
Bank regulators require banking organizations to hold capital for both anticipated and unanticipated default risks. Capital requirements pertaining to the maintenance of equity shareholder levels are designed to buffer against unanticipated losses and generally do not vary. In contrast, ALLL requirements change more frequently (quarterly) or when expected credit losses may have increased. Hence, a bank may have sufficient capital to meet unanticipated defaults, which may be associated with unforeseen events (such as a sudden increase in the unemployment rate), but it may still need to increase ALLL provisions should a borrower begin showing signs of repayment difficulties that may result in default. If banks can absorb anticipated loan losses using current income earnings, their capital will be left intact for unanticipated losses.
The ratio of aggregate ALLL provisioning to total bank assets, also shown in Figure 5 , is an ALLL proxy. Loan loss provisioning matched and often exceeded the anticipated percentage of problem assets prior to 2007, which are composed of net charge-offs and noncurrent assets. The ALLL indicator suggests that the amount of loan loss provisioning since the recession covers net charge-offs. The percentage of noncurrent loans, however, must decline even more relative to the current level of ALLL provisioning (or ALLL provisioning must increase more) before the industry can fully cover its anticipated default risks.
Although the ALLL indicator was constructed for illustrative purposes, the amount of loan loss allowance of noncurrent loans and leases, also referred to as the coverage ratio , is a more commonly used metric to assess the ability to absorb losses from nonperforming assets (as shown in Figure 5 ). A coverage ratio below 100% indicates that there is insufficient provisioning to cover weak loans that could go into further distress. Since the recession, regulators have required banks to increase loan-loss provisioning (as well as other components of regulatory capital) levels to better match the levels of problem loans. 
section_title: Post-Recession Lending Activity
paragraphs: The asset (lending) growth rate of the banking industry is computed using two methodologies (illustrated in Figure 6 ). For both methodologies, the total assets per quarter were initially averaged for each year, arguably adjusting for seasonal movements in lending activity over the year. The asset growth rate (represented by the more volatile striped bars) is computed by simply calculating the percentage change of the average total assets from year to year. The asset growth rate (represented by the solid bars) is computed using a moving average smoothing technique that reduces short-term volatility in data. Some economists prefer analyzing smoothed data series to curtail overstating observed activity or directional change. Hence, the asset growth rate using the moving average or smoothing methodology fell below negative 2% beginning in the first quarter of 2009, which had not occurred since the 1990-1991 recession; the second and fourth quarters of 2009 also saw negative asset growth. Given the magnitude of loan repayment problems, banks grew more cautious about lending (or allowing their asset portfolios to grow) to avoid the risk of further weakening their ALLL and capital reserve positions. The bank lending rate has increased since the 2007-2009 recession. Except for the 2001 recession, the more recent growth rates are below the pre-recessionary levels.
 Figure 7 illustrates some of the more common types of asset holdings in the aggregate banking portfolio. Since the 2007-2009 recession, the banking system holds larger shares of cash and smaller shares of residential mortgages, which is computed in Figure 7 using 1-4 family residential mortgages and home equity lines of credit. The share of cash holdings has more than doubled since 2000 to approximately 12% of aggregate portfolio holdings. The increase in cash holdings would be consistent with the increase in regulatory capital requirements for banks as shareholders purchase bank stocks with cash. Conversely, the share of residential mortgage credit, which peaked to almost 24% in 2005, has since steadily declined (by more than 33%) to approximately 15%. The share of commercial and industrial (C&I) lending has seen a decrease of approximately 24% since 2000, but it appears to be rising since the 2007-2009 recession. As of 2015, the total asset shares represented by commercial real estate lending, consumer loans (e.g., credit cards, installment loans), and securities (e.g., state and municipal bonds, U.S. Treasury securities) approximate pre-recession levels. Lastly, a trading account holds assets that the bank would like to sell or trade. Although banks wanted to sell more assets during the recession, the share of assets for sale has returned to and has fallen below pre-recessionary levels. 
section_title: Revenue Composition by Bank Size
paragraphs: As previously stated, banks typically borrow funds from depositors for shorter periods of time relative to their originated loans. Banks must continuously renew their short-term borrowings until longer-term loans have been fully repaid. For example, suppose a bank originates a consumer loan that is expected to be repaid in full over two years. Over the two years that the loan is being repaid, the bank will simultaneously "fund the loan," meaning that it will treat its depositors' funds as a sequence of quarterly (for a total of eight quarters) or monthly (for a total of 24 months) short-term loans and make periodic interest payments to depositors. The spread or difference between lending long and borrowing short is known as the net interest margin . 
Typically, smaller banks engage in "relationship banking," meaning that they develop close familiarity with their respective customer bases and provide financial services within a circumscribed geographical area. Relationship banking allows these institutions to capture lending risks that are unique, infrequent, and localized. These institutions, which rely heavily on commercial (real estate and retail) lending and funding with deposits, typically have higher net interest margins than large banks. Funding loans with deposits is cheaper than accessing the short-term financial markets, particularly for small institutions that do not have the transaction volume or size to justify the higher costs.
In contrast, large institutions typically engage in "transactional banking" or high-volume lending that employs automated underwriting methodologies that often cannot capture atypical lending risks. Large banks are not as dependent upon deposits to fund their lending activities because of their greater ability to access short-term money markets. Large banks typically have lower spreads because their large-scale activities generate large amounts of fee income from a wide range of activities, which can be used to cover the costs of borrowing in the short-term money markets. Revenues are earned by originating and selling large amounts of loans to nonbank institutions, such as government-sponsored enterprises (Fannie Mae and Freddie Mac) and non-depository institutions that hold financial assets (e.g., insurance companies, hedge funds). A large share of fees are still generated from traditional banking activities (e.g., safe deposit, payroll processing, trust services, payment services) and from facilitating daily purchase and payment transactions, in which service fees may be collected from checking, money orders, and electronic payment card (debit and credit) transactions. Hence, transactional or high-volume banking activities allow large banks to generate fee income and engage in financial transactions characterized by minimum deal size or institutional size requirements, which simultaneously act as a participation barrier for community banks.
Because of the differences in the composition of bank revenue streams, the net interest margins and fee income streams are illustrated by asset size categories. Figure 8 presents the net interest margins (or spreads) by bank size. By 2009, the net interest margins had declined for small banks, but they still remained higher over time than the margins for larger banks. The net interest margins for large banks increased over the recession period as they experienced a large influx of deposits during the recession, perhaps due to uncertainty in the money market; this "flight to safety" influx resulted in a substantial drop in their funding costs. In other words, large banks were able to rely relatively less on short-term financial markets and could, instead, take advantage of cheaper funding from deposits. Although net interest margins may appear to be returning to pre-recession trends, the future performance of this spread would still be affected by a shift in the composition of asset holdings. For example, the spread may be affected by an increase in liquid asset holdings (e.g., securities backed by the U.S. federal government), perhaps due to weaker demand for more illiquid loans (e.g., mortgages, commercial loans) or lower capital requirements associated with holding more liquid loans. Banks may alter the composition of their asset portfolios, attempting to seek higher yielding lending opportunities (e.g., holding less mortgages and more credit card loans) to help maintain spreads above 3%. Bank spreads may also be affected by the amount of deposits that remain or flow out of the banking system as the economy strengthens. Hence, it has become more challenging to predict future profitability arising from more traditional lending activities.
 Figure 9 presents noninterest income as a percentage of assets by bank size. The overall trend of fee-generating activities has rebounded since the recession, but there appears to be more volatility in fee-income revenues of smaller institutions. Although greater reliance upon fee income as a percentage of (large) bank income suggests a reduction in exposure to credit and funding risks, it may not necessarily translate into greater stability of earnings streams. For example, banks no longer generate as much fee income by selling (mortgage) loans to private-label securitization markets, particularly those largely abandoned by investors at the beginning of the financial crisis. In other words, high-volume fee-generating transactions are still dependent upon fluctuations in investor demand for securities created from securitized (structured finance) deals, which adds variability to income. In addition, regulatory costs may reduce fee income. Recent regulation of fees that large institutions may collect from debit transactions would affect the earnings streams. Banks might respond by seeking new opportunities to provide financial services to generate new fee revenues. Hence, future fee-generating activities are still affected by financial market uncertainty.
section_title: Conclusion
paragraphs: Since the 2007-2009 financial crisis, the banking industry has exhibited profitability. Net interest margins and fee income as a percentage of assets are less volatile now than when the U.S. economy was in recession, but they are still lower in comparison to 2000. The industry is still accumulating sufficient reserves to cover noncurrent assets. These factors may be influencing the asset growth rate, which has been positive since 2011, but remains below the average rate of growth observed over the past two decades. 
Profitability in the banking industry should not be interpreted as evidence of a return to previous lending patterns. The industry is adapting its business models to the post-recession regulatory environment in which higher overall capital requirements would be expected to increase funding costs and the choice of financial assets held in portfolios. Because large banks may be less dependent upon traditional lending activities than smaller banks, large institutions might be able to generate sufficient fee income from a wide range of other financial activities to remain profitable even if lending activity does not resemble pre-recessionary levels. Hence, profitability trends may differ for banks by size.