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Is the banking system healthy?

By Danielle Douglas,February 19, 2013

Thomas Curry, comptroller of the U.S. currency, right, speaks during a… (Andrew Harrer/BLOOMBERG )

On paper, the nation’s banks are making a comeback: More money is being set aside in case of trouble, there are fewer losses on loans and there is less reliance on volatile funding.

Too bad the markets don’t seem to care.

Despite the strides banks have made to repair their balance sheets since the financial crisis, their stocks are trading below book value. Wall Street remains skeptical about the overall health of these institutions, even as profits have soared in the past year.

But why?

“Investors expect more losses ahead,” said Mark Williams, a former bank examiner who teaches finance at Boston University. “Many of these banks still have loans that could go bad if the economy goes south.”

Bank stocks, he noted, have increased in recent months but remain 50 percent below their 2007 pre-crisis peak. Investors appear weary of the regulatory risks still facing banks, wondering how aggressively Dodd-Frank financial reform will be enforced and what impact it will have on profit margins. And a growing chorus from Congress and regulators that large banks should be broken into smaller institutions is adding to the uncertainty.

The largest banks have also been engulfed in a sea of litigation with no clear end in sight, Williams said. Dozens of cases brought by investors who claim they were misled about securities deals are still winding through the courts.

Meanwhile, prosecutors have yet to reach agreements with many of the banks, including JPMorgan Chase, Bank of America and Citigroup, being investigated for manipulating the global interest rate known as Libor. Resolution of these investigations could take another year at least, placing an ominous cloud over some of the nation’s largest institutions.

Regulators, nonetheless, are encouraged by gains in the banking system that point to continued improvement of a once beleaguered industry.

Testifying before the Senate Banking Committee last week, Thomas Curry, the comptroller of the currency, said conditions at the more than 1,800 banks his agency supervises continue to improve.

Charge-off rates, or percentage of loans deemed uncollectable, have dipped below their pre-crisis levels, except for residential mortgages, he said. Common equity, a basic reserve against losses, is at 12.5 percent of risk-weighted assets, up from its low of just over 9 percent in the fall of 2008. And the number of problem national banks and federal savings associations fell from 192 in March 2011 to 146 last month.

“The banking system is arguably as strong as it has ever been,” Mark Zandi, Moody’s Analytics chief economist, said. “Capital is at record levels, and there is ample liquidity. Credit quality is good and improving rapidly.”

He pointed out that banks are no longer as profitable as they were before the recession, but they may never be given the higher capital requirements and greater regulatory oversight. All the trend lines, Zandi said, are moving in the right direction on credit quality, but as long as interest rates remain low banks will endure pressure on their profit margins.

The comptroller also noted that banks are making more loans, but it is still only at about half the historical average pace. Curry stressed that “in this environment, institutions should be especially vigilant about monitoring the risks they are taking on. This is certainly not the time to let up on risk management.”

Mark Calabria, director of financial-regulation studies at the Cato Institute, suspects there is an unwillingness among some bankers to expand small-business lending, for instance, because of the economics involved.

“Trying to make sure you can cover your credit costs in this interest rate environment is difficult on small-business loans,” he said. “You get to a point where if you start charging a whole lot more, you get adverse selection and you only get bad loans.”

Nevertheless, there are a number of banks of all sizes that are slowly growing their commercial loan portfolios, mainly with very conservative loans.

Banks are also still working through substantial portfolios of foreclosed real estate, totaling $38.5 billion at the end of the fourth quarter, according to research firm SNL Financial. While that figure represents a 9.7 percent decline from the previous year, it is more than twice the amount recorded pre-crisis.