Tough Times Still Ahead for Banks, Fed’s Kohn Tells Senators

Testifying before the Senate Committee of Banking, Housing and Urban Affairs yesterday, Federal Reserve Bank vice chairman Donald Kohn offered some indications of improvement in the U.S. banking sector, but on the whole painted a somber picture of the short- to mid-term outlook for the industry. Banks have been responding to the economic turmoil touched off by the subprime meltdown last year, he said, but not enough yet. “Over the coming months, we expect banking institutions to continue to face deteriorating loan quality,” Kohn told members of the committee. “House prices are still declining sharply in many localities and losses related to residential real estate–including loans to builders and developers–are bound to increase further.” Not only that, he explained, but weak U.S. economic conditions could well extend problems to other kinds of lending portfolios, such as credit card loans, as well as corporate loan portfolios. “Banking organizations must be prepared for the possibility that liquidity conditions [will] become tighter, if uncertainties in the capital markets fail to subside or if credit conditions deteriorate significantly,” Kohn added. “Accordingly, we anticipate that the number of banks with less-than-satisfactory supervisory ratings [i.e., banks in trouble] will continue to increase.” The banking sector isn’t completely on the rocks, he noted, though it hasn’t really bounced back from a very tough fourth quarter 2007, when the 50 largest bank holding companies, which represent more than three-fourths of all bank holding company assets, reported losses totaling more than $9 billion. In the first quarter of 2008, by contrast, the same 50 largest bank holding companies reported profits of $5.2 billion and reduced trading losses. “Consequently, bank holding companies overall reported net income of nearly $10 billion for the quarter, down substantially from the $36.5 billion in income they reported for the first quarter of 2007 but a considerable improvement over the prior quarter’s losses,” Kohn said. But that’s only an aggregate figure. At the bottom of the top 50, there’s still some serious trouble. “Seven of the 50 largest bank holding companies still recorded net losses for the [first quarter of 2008],” Kohl said. “As economic conditions have softened, these large companies have reported increasing problems in mortgage loan portfolios, particularly home equity lines of credit, and in loans to residential real estate developers… [and] nonperforming assets more than doubled over the past year from $37 billion to $81 billion and, as of March 31, 2008, nonperforming assets as a share of overall assets reached the highest level since 2002.” The Fed has been pushing banks to bolster their liquidity, and they’ve been doing so, he added. But not by enough. “Despite higher provisioning during the past several quarters, coverage of nonperforming loans by loan loss reserves has not kept pace with growth in problem assets,” Kohl said. “In view of this uncertain outlook, additional capital injections and the consideration of dividend cuts are still warranted for some of these companies, and we have strongly encouraged supervised bank holding companies to enhance their capital positions.” Kohl, in reflecting on the origins of the current malaise, stressed overconfidence and complacency among the financial institutions themselves, and threw in a note of “we told you so.” “Before the recent market turbulence, the Federal Reserve–in many cases along with the other U.S. banking agencies–acted on a number of fronts to alert financial institutions about emerging risks, for example by issuing supervisory guidance on nontraditional mortgages, home equity lending, commercial real estate, and subprime lending,” he said. As for the future role of the Fed in preventing another such risk-spawned financial crisis, Kohl said that “we are also considering new or augmented supervisory guidance [i.e., new rules] on other aspects of risk management, including further emphasis on the need for an enterprise-wide perspective when assessing and managing risk.” In other words, the Fed wants the left hand to know what the right hand is doing, in terms of banks taking on lending risk. “We are developing supervisory guidance to clarify expectations surrounding compliance risk, focusing particularly on firm-wide compliance risk management for large, complex organizations,” Kohl said.