Jan. 14, 2004

Commercial banks and savings institutions insured by the Federal Deposit Insurance Corp. (FDIC) reported record-high earnings in the third quarter of 2003, the third consecutive quarter that industry earnings have set a record.

Net income totaled $30.4 billion, an increase of $147 million (0.5 percent) from the second quarter, and $3.1 billion (11.3 percent) more than the industry earned in the third quarter of 2002.

The average return on assets was 1.36 percent, compared to 1.38 percent in the second quarter, and 1.34 percent a year earlier. More than half of all institutions (55.3 percent) reported an ROA of 1 percent or higher for the quarter. Slightly more than half reported increased net income compared to the second quarter (50.8 percent), and a similar proportion (50.7 percent) reported higher net income than in the third quarter of 2002.

Nonrecurring gains are sharply lower than in second quarter

Noninterest income growth was a major source of earnings strength and lower expenses for loan-loss provisions also helped lift profits.

The improvement in earnings was held down by reduced gains on sales of securities and other assets, and by lower net interest income.

Net operating income, which does not include gains from securities sales and other nonrecurring items, was $2.0 billion (7.4 percent) higher than in the second quarter, and was $4.5 billion (18.3 percent) more than in the third quarter of 2002.

Consumer business lines continue to exhibit strength

As has been the case in recent quarters, earnings strength was most evident at institutions with concentrations of consumer-related assets.

The average ROA at credit-card lenders rose to 4.18 percent, from 4.04 percent in the second quarter.

At other consumer lenders, the average ROA rose from 1.49 percent to 1.68 percent. An exception was mortgage lenders, whose average ROA fell from 1.50 percent to 1.34 percent, mainly because of sharply lower gains on sales of securities and other assets.

Servicing income rebounds with rise in interest rates

Rising interest rates caused a decline in the market values of fixed-rate securities in the third quarter, and reduced the gains realized on securities sales, which were $2.7 billion (55.8 percent) lower than in the second quarter.

The increase in rates also had a dampening effect on loan demand, especially for mortgage refinancings, and the reduced volume of lending activity contributed to a $390 million (0.6 percent) decline in net interest income.

However, the prospect of reduced refinancing activity had a positive effect on the value of mortgage servicing rights, and servicing income rose by $3.2 billion (281 percent) compared to the second quarter. The industry also registered a $1 billion (20.2 percent) rise in securitization income, and a $2.2 billion (57.0 percent) increase in gains on loan sales.

These improvements helped lift total noninterest income by $2.1 billion (4.3 percent). The industry's bottom line was also helped by lower expenses.

Provisions for loan losses were $1.7 billion (17.1 percent) lower than in the second quarter, and noninterest expenses were only $355 million (0.5 percent) higher.

Small institutions register slight improvement in margins

The increase in medium- and long-term interest rates affected the net interest margins of large and small institutions differently. More than half of all banks and thrifts with less than $100 million in assets -- 52.5 percent -- reported improved net interest margins in the third quarter, whereas only about one-third of institutions with more than $1 billion in assets -- 35.2 percent -- reported margin improvement.

Average asset yields declined more sharply at large institutions than at smaller ones. The reductions in net interest margins at larger institutions caused the industry's margin to fall by 9 basis points, from 3.74 percent to 3.65 percent. This is the lowest level reported by the industry since the first quarter of 1991.

C&I loans remain at forefront of asset quality improvement

The improving trend in asset quality that began late last year continued through the third quarter, as both noncurrent loans and net charge-offs declined.

Net charge-offs were $684 million (6.7 percent) lower than in the second quarter, and were $2.4 billion (20.3 percent) below the level of a year ago.

Charge-offs of commercial and industrial (C&I) loans fell by $423 million (13.4 percent) from the second quarter, accounting for 62 percent of the improvement in total net charge-offs. Compared to the third quarter of 2002, C&I charge-offs were down by $2.2 billion (44.2 percent), representing 88.6 percent of the improvement in all net chargeoffs.

Net charge-offs on credit-card loans declined by $363 million (9.0 percent) from the second quarter, and were $306 million (7.7 percent) lower than a year earlier. The only loan category that had a significant increase in charge-offs was loans to foreign governments, where net charge-offs rose by $133 million.

Noncurrent rate falls to two-year low

Noncurrent loans declined for the fourth quarter in a row, falling by $2.6 billion (4.0 percent). Compared to the level of a year ago, noncurrent loans are down by $6.7 billion (9.7 percent). Noncurrent C&I loans fell by $1.4 billion (5.7 percent) during the quarter, and have fallen by $5.3 billion (18.5 percent) in the past 12 months. As with net charge-offs, improvements in C&I loans have accounted for the majority of the improvement in total noncurrent loans. At the end of September, the percent of total loans that were noncurrent stood at 1.17 percent, the lowest level since midyear 2001.

Coverage ratio improves despite decline in loss reserves

Total loan-loss provisions fell short of total net charge-offs for the third quarter in a row, contributing to a $991-million (1.2-percent) decline in the industry's loss reserves. The ratio of reserves to total loans declined from 1.64 percent to 1.59 percent during the quarter. This is the lowest level for this ratio in more than 2 years (it was 1.55 percent at the end of the second quarter of 2001). In contrast, the industry's "coverage ratio" increased to $1.36 in reserves for every $1.00 of noncurrent loans, from $1.33 at midyear, thanks to the decline in noncurrent loans.

Regulatory capital ratios hit new highs

Total equity capital increased by only $5.0 billion (0.6 percent) during the quarter, the smallest quarterly increase since the third quarter of 1999.

The main reason that equity growth slowed was depreciation in the market values of institutions' available-for-sale securities, caused by rising interest rates. Under Generally Accepted Accounting Principles (GAAP), changes in the values of these securities are reflected in equity capital.

At midyear, commercial banks' available-for-sale securities contained about $26 billion in unrealized gains; at the end of the third quarter, this figure had declined to $14 billion. Even with the small increase in equity capital, the industry's equity-to-assets ratio registered a modest improvement, from 9.10 percent to 9.13 percent.

Because regulatory capital definitions do not include adjustments for unrealized gains in securities portfolios, two of the industry's three regulatory capital ratios -- tier 1 risk-based capital and total risk-based capital -- rose to record-high levels during the quarter.

Shrinkage in mortgage-backed securities limits asset growth

Assets of insured banks and thrifts increased by only $22.2 billion (0.2 percent) in the third quarter, the smallest increase in the last six quarters.

The industry's portfolio of loans grew by $87 billion (1.7 percent), but securities holdings fell by $59.6 billion (3.4 percent). Residential mortgage loans increased by $40.6 billion (2.5 percent), and home equity loans grew by $19.5 billion (6.6 percent), but both increases were below the levels of the previous quarter.

Mortgage-backed securities declined by $86.2 billion (8.3 percent). C&I loans declined for an 11th consecutive quarter, but the $2.7-billion decline was the smallest quarterly drop during this period of shrinkage.

Savings deposits continue to grow

Domestic deposits declined for the first time since the first quarter of 1999, falling by $7.7 billion (0.1 percent). Most of the decrease occurred in demand deposits, which declined by $46.2 billion (7.5 percent).

At banks filing Call Reports, savings deposits increased by $52.8 billion (2.3 percent). Deposits in foreign offices increased by $14.1 billion (2.1 percent), and nondeposit liabilities rose by $10.8 billion (0.5 percent). Most of the growth in nondeposit liabilities consisted of short-term borrowings.

Industry contraction is smallest in 17 years

The number of insured banks and thrifts filing quarterly financial reports declined by 31 in the third quarter. This is the smallest quarterly reduction in reporting institutions since 1986.

There were no failures during the third quarter. Mergers absorbed 57 institutions and 31 new institutions were chartered during the quarter. Two mutual savings banks, with total assets of $494 million, converted to stock ownership.

The number of institutions on the FDIC's "Problem List" declined from 129 to 116 during the quarter, and total assets of "problem" institutions fell from $32.2 billion to $30.3 billion.