U.S. Banking Industry Executes Quick Turnaround Lower Costs, Cautious Lending Practices Lead To Record Profits

Unlike banks in so many other nations, U.S. commercial banks are making money like mad a scant five years after many were brought to their knees by a vast wave of loan losses.

Despite competition from an array of other financial-services firms, such as mutual funds, thrifts, business lenders and brokerage firms, the banks collectively earned a record $52.4 billion last year, a 7.5 percent increase over 1995, which itself was a record-setting year.

As recently as 1991, 1,016 banks with combined assets of more than half a trillion dollars were regarded as “problem” institutions by the Federal Deposit Insurance Corp., which provides insurance on most of the deposits held by the banks. That year more than 100 failed.

The troubled industry’s turnaround was incredibly swift. For decades, the goal of many bankers was to do well enough to earn an amount each year equal to 1 percent of their bank’s assets - their cash on hand, the loans they have made, the securities they own and other shortterm investments. But the industry as a whole was never that profitable in any year from 1935 through 1991, hitting highs of 0.91 percent in 1936 and 1958.

Then it all came together:

The economy steadied.

The Federal Reserve kept short-term interest rates low in 1992 and 1993, which widened the spread between what banks paid to get funds from depositors and other sources and the interest rates they charged borrowers. Importantly, many banks have managed to keep their spreads high except on loans to larger businesses where cutthroat competition has driven them to extremely low levels.

Banks became far more cautious in making new loans while finding the money to cover losses on the bad ones they had made earlier - though recently many institutions have been relaxing the stringent standards they adopted several years ago.

Regulatory changes, such as the increased availability of interstate branching, reduced overheads and encouraged mergers and acquisitions that also cut costs.

Increased use of technology allowed more explicit pricing of many services for which fees were raised and permitted many cost-cutting changes that allowed operation with fewer employees.

In 1992, the return on assets, or ROA as it’s known, jumped to 0.93 percent and since then has ranged from 1.15 percent to 1.20 percent.

Among the banks, the highest average ROA is for those with $1 billion to $10 billion in assets. Geographically, the highest is among banks in the Midwest, where the ROA was 1.43 percent last year, according to the FDIC.

“Sometimes I am amazed at how they manage to outdo themselves every year,” said James Chessen, chief economist of the American Bankers Association, who attributes most of the stellar performances to the huge improvement of the banks’ loan portfolios and cost cutting.

Last year, for example, only 0.75 percent of all loans and “other real estate owned” - a type of asset that is largely foreclosed real estate - were regarded as non-current. Non-current loans are those on which payments are 90 days or more past due or those with repayment prospects so doubtful that a bank counts payments as a reduction in the outstanding loan amount rather than interest income. The comparable figure in 1991 was 3.02 percent.

Meanwhile, banks have set aside reserves of almost $54 billion to cover potential losses. Those reserves are roundly 80 percent greater than the total of non-current assets.

Rob Dugger, Chessen’s predecessor at the ABA who now is with a Washington money-management firm, cited the same two factors as being behind the soaring profitability.

“Banks have been enormously successful in reducing the costs of their operations,” said Dugger.

In addition, “you are seeing an earnings level that is entirely free from the problems of real estate, energy, commercial and emerging market lending” that plagued the industry through the 1980s, he said.

The loan losses raised bank costs in another way as well. Deposit-insurance premiums rose because so many banks failed that the FDIC insurance fund was dangerously depleted. But the losses and the failures stopped so abruptly that the higher premiums - which reached 23 cents for every $1,000 of insured deposits - quickly rebuilt the Bank Insurance Fund’s reserves.

Now, the vast majority of institutions are regarded as so well capitalized and so well run, from the standpoint of safety and soundness, that 96.8 percent of all commercial banks pay no deposit-insurance premiums at all.

At the end of last year, only 82 of the nation’s 9,528 banks, all relatively small, were still in the problem category. Only five failed last year.

Banking fees of all types have been going up, including those associated with various types of deposits such as checking accounts. These have not been an important element in the surge in bank profitability, Chessen said, because such charges account for only a little more than 4 percent of bank revenue.

That compares with more than the 78 percent that comes from interest income on loans. The remaining revenue is from trust activities, trading gains on securities owned by banks, providing lines of credit and other types of services.