Business Insider

PETER CRABB: State of banking shows we may endure recession, again

Summer was nice while it lasted; a dreary economic winter is upon us.

This past summer, fears of a “double dip” recession subsided. Good corporate profits and increases in consumer confidence suggested the so-called Great Recession was well behind us.

The fear is back as conditions in the banking sector suggest a global recession in 2012.

Banks and financial institutions are early warning indicators for the overall economy. Financial signals from European banks, U.S. banks and even our local Idaho institutions all point to a decline in economic activity.

First, even if the European debt crisis subsides, the economy there is weak and getting weaker. The Organization for Economic Cooperation and Development (OECD) reported in its most recent semi-annual outlook for the world economy that the euro zone is already in a “mild” recession. Given the state of Europe’s banking system, even a mild recession will cause a lot of pain.

Any downturn in economic activity is likely to last longer than usual because banks are in no position to expand credit. European banks are having a hard time as they are getting sovereign debt from Greece and other overburdened countries off their books; there is no room on their balance sheets to offer more credit to business and industry.

Second, while U.S. banks are profitable again, there is substantial uncertainty about their future profits. In the third quarter of 2011, U.S. commercial banks and savings institutions earned more than $35 billion in profits, according to the Federal Deposit Insurance Corporation (FDIC). This was a 48 percent increase from the same period the previous year.

However, U.S bank profits this quarter came from a dramatic drop in provisions for bad loans. The FDIC reports that loss provisions were almost 50 percent less than the previous year.

The resulting lower expenses raised bank profitability as measured by return on assets to more than 1 percent for the first time in four years. Unfortunately, banks are not making money from any new business. Total loans and leases at U.S banks increased only 0.3 percent; and much of this increase came from a rise in holdings of U.S. government debt.

Third, local financial institutions are still struggling to clean up their books. The FDIC reports that even though profitability at Idaho banks and savings institutions improved, loan loss allowances rose to 1.77 percent of assets from 1.68 percent last year. Idaho financial institutions’ profits are up but, unlike the national trend, expected losses are rising.

Idaho banks also are becoming more risk averse than the national average. As a percent of total assets, net loans and leases dropped about 5 percent while holdings of U.S. government debt rose from under 10 percent to more than 15 percent.

Despite improvements in profitability for the U.S. banking industry, financial markets indicate looming trouble. The prices for option contracts on bank stocks imply a level of risk at least twice the level of the stock market as a whole.

The banking industry has taken much blame for the last recession. Banking conditions today, both here and abroad, signal we are headed for another.

PETER CRABB Professor of finance and economics at Northwest Nazarene University in Nampa