CONDITION AND PERFORMANCE OF COMMERCIAL BANKS

US Office of the Comptroller of the Currency: Quarterly Journal, Jun 2003

Summary

Bank income rose again in the first quarter of 2003, as all major income categories-net income, net interest income, and noninterest income-remained near record levels. At national banks, return on assets and return on equity remained just below their all-time highs. In contrast to other recent quarters, however, when strong growth in interest income was the key factor, the biggest contributor this quarter was a decrease in provisions, reflecting improving credit quality at large banks.

Loan growth continued, particularly in the housing sector, which still benefits from record-low interest rates. The income benefit to banks from the expanding housing-related demand for credit was largely offset by a decline in net interest margins. Risks for banks include the following: in the consumer sector, unemployment and high debt burdens; and in the business sector, continued weakness in manufacturing, financial services, airlines, and some other services.

Key Trends

In the first quarter of 2003, all major income categories showed improvement compared to the same quarter of 2002. This time, however, the largest boost to net income came from a decrease in provisions, rather than from an increase in net interest income. Noninterest income continued to rise moderately. Noninterest expense rose, with large banks accounting for nearly all of the increase.

Improvements in credit quality, particularly at large banks, led banks to reduce provisioning expenses. Provisions dropped below charge-offs. Even so, the ratio of reserves against loan losses to noncurrent loans rose, as the nonperforming ratio declined.

Loan quality improved particularly for residential real estate. Business real estate loans showed a slight deterioration. For commercial and industrial (C&I) loans, the noncurrent ratio (noncurrents to total loans in a category) declined from the first quarter of 2002, although the volume of noncurrent loans actually fell. Moreover, the C&I noncurrent ratio improved for loans made to U.S. customers. In contrast, the noncurrent ratio for C&I loans to foreign customers rose again, having more than doubled over the last five quarters. Weakness in foreign economies suggests continuing problems with these loans.

Loan volume continued to rise, driven by the hot market in residential real estate. Over the last five quarters, residential real estate loans have increased at an annual rate of 27 percent at national nonspecialty banks, compared with 5.8 percent for business real estate loans, and minus 1.6 percent for all other loans. Home equity lending has shown particular strength, rising by 23 percent in 2001, 38 percent in 2002, and 37 percent (year-over-year) in the first quarter of 2003. At the same time, credit card lending has slowed to just 2 percent in the first quarter of 2003, suggesting that some homeowners are using home equity loans to pay down credit card debt. The consumer sector, which has kept the economy afloat for the last two years, is showing signs of strain. Persistent unemployment manifests as a rising bankruptcy rate, which now stands at double the level of 10 years ago. This in turn generally leads to an increase in noncurrents and charge-offs for credit cards and other consumer loans.

Net interest margins (NIMs) declined, offsetting the increase in loan volume. NIMs declined at both small and large banks. At large banks (over $1 billion in assets), NIMs had risen dramatically during 2001, coinciding with the sharp drop in short-term interest rates. As large net borrowers in the wholesale funds market, large banks were the big winners from the fall in short-term rates. By 2002, however, competitive pressures were squeezing NIMs, as some borrowers were able to negotiate more favorable terms with their lenders. For large banks, the substantial drop during the first quarter of 2003 returned NIMs to their average level over the last two decades.

In contrast, at small banks (under $1 billion in assets), where NIMs had not risen as far during 2001, the recent decline has pushed NIMs to a 15-year low. NIMs fell for small banks in all regions and in all lines of business. Those small banks with the lowest NIMs have relatively low ratios of core deposits to assets, and the asset side of their balance sheets is skewed toward securities rather than loans.

Deposits continued to flow into banks, as is normal when other investments are not performing well. Deposits grew 10.9 percent year-over-year at large banks, compared with 8.3 percent at small banks. The increase in deposits led to expanded holdings of securities and to healthy loan growth. At large banks, securities on the books grew 19 percent year-over-year, at the same time that loans were growing 6.8 percent.

Large banks continued to displace small banks in the market for residential real estate loans. Until the last two years, the residential real estate portfolios of large and small banks had grown at about the same rate. That changed over the last two years. Large banks expanded their portfolios by 26 percent in 2002 and 29 percent (year-over-year) in the first quarter of 2003; at the same time, small banks have expanded by only about 5 percent annually. Large banks have apparently been able to use their economies of scale, more efficient technologies for the management of smaller transactions, along with their advantages in securitization and hedging to increase their presence in this market.