Daniel Gross

Secrets to Banking Profits Recovery: Free Money, Time, Sustained Growth

Contrary Indicator

As Europe's interconnected banking system struggles with declining asset quality, mini-runs and jogs, and widespread lack of confidence, many people are asking what the solution is to a banking crisis in a developed economy.

Judging by the progress being made by the U.S. banking system in the three years since its near-death experience, the answer is: free money, time and sustained economic growth.

Or at least that's my takeaway from the Federal Deposit Insurance Corporation's most recent quarterly report on the state of America's banking industry, which was issued Thursday. The Institutions insured by the FDIC made a combined $35.3 billion profit in the first quarter of 2012 — I repeat, in one quarter — up 19 percent from the first quarter of 2011. That's 11 straight quarters of year-over-year earnings growth. The whole data-packed report can be seen here. Sure, the free money provided by the Federal Reserve to the financial system helps a great deal. All manufacturers would be profitable if the cost of their most basic input was something close to zero.

But some of the success has nothing to do with policy, and everything to do with more prudent risks, and with businesses and consumers simply being in a better position to handle financial commitments. Banking is a highly procyclical industry. Whenever leverage is involved, failure triggers a chain-reaction of other failures, which is how defaults on subprime mortgages ultimately led to a systemic crisis. But by the same token, success tends to beget success.

And that's what we've seen in the past few years. Since their peaks in 2009, we've seen a serious decline in the rate of financial failure in the U.S. Delinquency rates on credit cards, home mortgages and debt generally have all come down. Chapter 11 filings and bond defaults have also fallen. That's good news for consumers and businesses, but even better news for lenders. And so we have fewer banks failing, and fewer banks in danger of failing. In the first quarter of 2012, just 16 banks failed, the lowest quarterly number since the fourth quarter of 2008, when 12 banks went belly-up. For each of the past four quarters, the number of banks on the FDIC's "problem list" has fallen. In the first quarter, the number of the list's unhappy members fell from 813 to 772, a decline of 41 — the smallest number since the end of 2009. A few dozen banks earned or merged their way out of trouble. Between them, the banks on the "problem list" have assets of $292 billion, down from $403 billion in 2009.

Collectively, banks insured by the FDIC had to write off $21.8 billion in bad loans in the first quarter of 2012 — the seventh straight quarterly decline and the lowest such total in four years. "The amount of loans and leases that were noncurrent — 90 days or more past due or in nonaccrual status — fell for the eighth quarter in a row, declining by $1 billion (0.3 percent)," the FDIC reported. So there are fewer loans failing, and fewer loans in danger of failing.

The results bear witness to a form of deleveraging. Banks now have more capital as a percentage of total assets than they did in recent quarters, in part because they're retaining earnings and in part because they're having to destroy a smaller part of their capital base each quarter to account for bad loans. But there's another factor at work. Due to higher standards and the fact that many consumers aren't exactly in a hurry to pile on new debt, total loan balances of institutions insured by the FDIC actually fell by $56.3 billion, or by .8 percent. Clearly, the continuing rise in retail sales and consumption is not being fueled by bank lending.

One more item worth noting: In Europe, policymakers, bankers and customers are fretting over the lack of a generous, system-wide deposit guarantee scheme. When people doubt their funds will be safe in a bank, the fear can quickly become self-fulfilling prophecy. But in the U.S., deposit insurance works quite well — it works for the banking customers, and it works for the system at large. In fact, that's the whole point of the FDIC. You tax the banking industry so that it can make customers whole in the event of widespread incompetency. Check out Table I-B in the report. The deposit fund built up substantially in the middle years of the past decade, when the U.S. could go for several hundreds days without a bank failure. It was depleted rather swiftly in 2008 and 2009 when lots of large banks failed and the fund had to set lots of cash aside. In the second quarter of 2010, the fund had a net balance of negative $20.8 billion.

But after the crisis, the FDIC imposed special assessments on banks, and continued to collect premiums. And slowly, quarter by quarter, as money came in and less money went out, the fund replenished itself. A year ago, it went into positive balance, and over the first quarter of 2012, as it collected $3.7 billion in premiums and set aside only $12 million to deal with anticipated losses, the fund's balance rose to $15.3 billion — higher than it was three years ago.

Banking still looms large in our consciousness, and the biggest ones are bigger than ever. But the report shows some signs of an industry that is shrinking in some other ways. They've had a very high mortality rate, as is usual after a boom — lots of mergers, acquisitions and failures. Only 7,307 banks are reporting, down from 8,534 in 2007.

Daniel Gross is economics editor at Yahoo! Finance.

Follow him on twitter @grossdm; email him at grossdaniel11@yahoo.com.

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