Banks Not out of the Woods

The Bank for International Settlements says the banking industry, particularly in the United States and Europe, is still "fragile."

Has the banking industry recovered from its long, global nightmare? Not by a long shot, says the Bank for International Settlements, “the bank for central banks,” in its annual report published Monday.

Much of the discussion around the health of banks now focuses on the imposition of new regulations, which will be phased in gradually. But the BIS says financial institutions have plenty of other hurdles to overcome in the meantime, all while adapting to a new business model. In particular, the BIS is worried about where future banks will come from; the industry’s large, imminent funding needs; and the continuing deterioration of commercial real estate portfolios.

While bank balance sheets worldwide have improved — aided by $1.24 trillion in new capital raised by mid-April — and tier 1 capital ratios are at their highest levels in 15 years, the sustainability of bank profits is questionable, says the BIS report. Indeed, the BIS goes so far as to call banks “fragile.”

For one, many of the profits from European and U.S. banks in 2009 came from fixed-income and currency-trading markets, which tend to be volatile. In addition, financial markets are still hazy about whether European and U.S. banks have written down all of their crisis-related losses.

Will Harris, a director in the financial services practice of AlixPartners LLP, calls the hidden risks on banks’ books “a financial iceberg.” “Most of it is not visible, and the banks have not been forced to recognize the real value of many assets,” he says. “The values don’t reflect reality.”

Uncertainty in Europe may be reduced by the results of bank stress tests, which will be published next month by eurozone banking supervisors. But commercial real estate lending losses could continue to blow holes in bank balance sheets in Europe and the United States. Worldwide, on average banks had 32% of their loan portfolios in commercial real estate at the end of the first quarter, according to an analysis by CFO of data provided by Capital IQ.

In the United States, more than 100 community and retail banks have a ratio of commercial real estate to total loans of more than 50%. Delinquency rates on these loans rose to more than 8% in the U.S. last year, double the rate of the year before. Congress is even considering inserting a provision in the financial-reform bill that gives 7,800 banks permission to spread their losses on real estate loans over a 6-to-10-year period.

The BIS is doubtful that banks will be able to refinance their huge funding needs, given that funding maturities for banks are at their shortest in 30 years, and banks will be competing against sovereigns in the capital markets. Loan-to-deposit ratios for large international banks have fallen worldwide. And about 60% of banks’ long-term debt flows come due in the next three years, the BIS says. This year and next year alone, $3 trillion of bonds are maturing.

Ending their reliance on government support will also crimp banks’ performance, says the BIS. In the United States, for example, hundreds of small banks have yet to repay Troubled Asset Relief Program funds, and some have also failed to make required dividend payments to the government. Government pullouts may also affect bank credit ratings. Worldwide, according to the BIS, public backstops and liquidity measures were worth three notches of credit-rating upgrades for the 50 largest banks last year. Moreover, central banks still hold bucketfuls of risky assets that they bought to support specific financial markets in the crisis.

Once government measures to inject liquidity into financial markets wind down, there will be incredible pressures on banks’ profit margins, says Harris. Government actions, for example, have kept the London Interbank Offered Rate low for an extended period. “The spread between LIBOR and what banks are actually charging consumers for mortgages represents one of the largest profit margins banks have had for a long time,” says Harris. “They can’t assume that will continue.”

As a means of improving the performance of banks and making them more resilient, the BIS clearly favors stronger capital requirements and less leverage. Proposals by the Basel Committee on Banking Supervision include tighter rules for core tier 1 capital, an increased capital requirement for trading books, and a borrowing ratio that caps bank assets relative to tier 1 capital.

The BIS studies indicate that the resulting lower return on equity would actually be a “desirable outcome” for long-term investors and the entire economy. “In light of recent experience, equity holders will arguably require lower but more stable returns…that are likely to translate into higher profits in risk-adjusted terms,” the report says. “A more stable performance would [also] imply a reduced incidence of financial crisis.”

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