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Economist Til Schuermann concludes that the performance of banks in the 2001 recession was markedly better than in the 1990-1991 recession and in prior recessions due to two factors: banks improved their risk management practices and benefited more broadly from the relative mildness of the 2001 recession. In the 2001 recession, banks’ profits were among the highest in the past thirty years. Capitalization and loan quality were robust, whereas in the early 1990s, banks suffered low profits, poor capitalization and high incidence of non-performing loans.
Schuermann finds that the improved performance in this most recent recession is attributable in large part to bank managers’ skill at managing risk more effectively. The author presents evidence that banks were well served by the adoption of risk-based pricing in several markets, and the use of credit derivatives to shift some of their credit exposure to insurers and asset managers.
The author states that increased use of risk management tools and techniques, in conjunction with revisions to the Basel Accord, has enabled banks to calibrate their pricing to reflect additional risk and thereby also provide credit access to a wider pool of applicants. One such example is consumer lending, specifically in credit cards. In fact, net charge offs as a percentage of average credit card loans were much greater in this past recession: in the third quarter of 1990, the ratio was 3.56 percent; it rose to 4.84 percent in the first quarter of 2001, and hit a high of 8.84 percent in the first quarter of 2002. Despite this trend, banks for the past six to eight quarters have consistently reported positive earnings for retail operations in general and retail lending in particular, suggesting that, even in light of the high net charge-off ratios, banks are being properly compensated for the additional risk they are assuming.
Schuermann notes that bank managers also have adopted the strategic tool of pursuing new markets and new revenue sources. But he finds that risk-adjusted returns for new and diversified business opportunities does not appear to contribute in a meaningful way to current bank performance.
Finally, the author asserts that circumstances played a helpful role. Not only did banks benefit from the relative mildness of the 2001 recession (as measured by its effect on most major components of GDP), but they also benefited from an environment of rapidly declining short-term interest rates. This environment allowed banks to borrow at lower cost, which in turn increased their interest margins.
Til Schuermann is a senior economist in the Bank’s Research and Market Analysis Group.