CONDITION AND PERFORMANCE OF COMMERCIAL BANKS

Summary

Banks reported favorable results once again in the second quarter of 2003. At national banks, all major income categories remained at or near record levels, as did both return on assets and return on equity. As in the first quarter, however, the biggest contributor to the increase in net income was a decrease in provisions. This is in contrast to earlier periods when rising net interest income had been the most significant factor boosting income.

Continued strength in real estate offset weakness in several other sectors, including commercial and industrial (C&I). Net interest margins drifted lower, depressing growth in net interest income. Credit quality improved modestly at large banks. As in recent quarters, the risks for banks continue to be unemployment and high debt burdens in the consumer sector, plus continued weakness in manufacturing, financial services, and some other services.

Key Trends

As in the first quarter of 2003, all major income categories showed improvement over the same quarter of 2002, as shown in Figure 1. Net interest income rose by 1.3 percent, as declining net interest margins nearly offset an increase in loan volume. This is a change from 2002, when a surge in net interest income accounted for most of the growth in net income.

Realized gains and losses on securities rose strongly year-over-year, but gains here are strongly related to interest rates and are not expected to continue in an environment of rising interest rates. Noninterest income rose again, helped by gains in fee income from the boom in mortgages and refinancing, and the rise in market-sensitive income that accompanied favorable conditions in the stock and bond markets this spring.

Return on equity reached 16.1 percent for the first half of 2003, slightly short of the all-time record reached in 1993. Return on assets remained just below its all-time peak, set in the third quarter of 2003.

Decreasing provisions accounted for the largest contribution to the change in net income. Most of this effect came from large banks, reflecting the expectation of improved credit quality. In contrast, in 2001 and 2002, provisions were generally increasing, reflecting the deterioration in credit quality during the recession. Noninterest expense rose, with the increase concentrated at large banks.

Net interest margins (NlMs) continued to decline at both small and large banks during the second quarter. Small-bank NIMs now stand at a 15-year low.

Loan growth, which never turned negative during the recent recession, continued apace during the second quarter. In contrast, around the time of the last recession shown in Figure 2 as the shaded area, total loans on the books of national banks fell for 10 consecutive quarters. The difference is that the earlier recession affected all sectors of the economy. This followed the normal pattern of post-war recessions, in which rising interest rates choke off home and auto sales, causing spending on housing and consumer durables to fall by 15 to 20 percent. The recession of 2001 was different: it began in the manufacturing sector, but never spread to the consumer sector. The demand for business loans fell sharply, but the mortgage and consumer sectors remained strong.

As Figure 3 shows, residential real estate lending continued to drive the aggregate numbers for loan growth. Total loans and leases rose 7.5 percent year-over-year, with residential real estate growing at over 28 percent, compared with 5.3 percent for commercial real estate loans, minus 8.1 percent for C&I loans.

Home equity lending showed particular strength, finishing the second quarter up 30 percent yearover-year. This compares with 23 percent in 2001, and 38 percent in 2002. On the other hand, credit card lending rose only 2 percent year-over-year, strengthening the impression that some homeowners are using home equity loans and cash-out refinancing to pay down credit card debt.

Several factors suggest that loan growth will be hard to sustain. First, higher interest rates have already taken the steam out of the boom in mortgage refinancing, with refinancing falling by half over the summer. second, high vacancy rates are depressing new commercial real estate development. Third, corporate loan demand will likely lag the recovery. Capacity utilization rates remain at 20-year lows, discouraging investment and expansion. Further, firms have now reliquified their balance sheets, as is normal during a recession; with relatively high ratios of internally generated funds to capital needs, firms will be able to fund the first stage of new business spending by themselves. Fourth, the soft job market is expected to hold down growth in consumer loans.

Loan quality improved at large banks, with the C&I sector accounting for most of the gain (Figure 4). The noncurrent ratio for large-bank C&I loans improved for the fourth quarter in a row. C&I loans to foreign customers, however, are still deteriorating, as the noncurrent ratio has more than doubled over the last six quarters, and now stands 70 percent higher than the ratio for loans to U.S. customers.

Credit quality deteriorated slightly at community banks, with most of the slide concentrated in business real estate and residential real estate. C&I loan quality improved slightly, as it has at large banks, reflecting the modest upturn in the manufacturing sector.

Glossary

Data Sources

Data are from the Federal Financial Institutions Examination Council (FFIEC) Reports of Condition and Income (call reports) submitted by all FDIC-insured, national-chartered and state-chartered commercial banks and trust companies in the United States and its territories. Uninsured banks, savings banks, savings associations, and U.S. branches and agencies of foreign banks are excluded from these tables. all data are collected and presented based on the location of each reporting institution's main office. Reported data may include assets and liabilities located outside of the reporting institution's home state.

The data are stored on and retrieved from the OCC's Integrated Banking Information System (IBIS), which is obtained from the FDIC's Research Information System (RIS) database.

Computation Methodology

For performance ratios constructed by dividing an income statement (flow) item by a balance sheet (stock) item, the income item for the period was annualized (multiplied by the number of periods in a year) and divided by the average balance sheet item for the period (beginning-ofperiod amount plus end-of-period amount plus any interim periods, divided by the total number of periods). For "pooling-of-interest" mergers, prior period(s) balance sheet items of "acquired" institution(s) are included in balance sheet averages because the year-to-date income reported by the "acquirer" includes the year-to-date results of "acquired" institutions. No adjustments are made for "purchase accounting" mergers because the year-to-date income reported by the "acquirer" does not include the prior-to-merger results of "acquired" institutions.

Definitions

Commercial real estate loans-loans secured by nonfarm nonresidential properties.

Construction real estate loans-includes loans for all property types under construction, as well as loans for land acquisition and development.

Core deposits-the sum of transaction deposits plus savings deposits plus small time deposits (under $100,000).

IBIS-the OCC's Integrated Banking Information System.

Leverage ratio-Tier 1 capital divided by adjusted tangible total assets.

Loans to individuals-includes outstanding credit card balances and other secured and unsecured installment loans.

Net charge-offs to loan and lease reserve-total loans and leases charged off (removed from balance sheet because of uncollectibility), less amounts recovered on loans and leases previously charged off.

Net loans and leases to assets-total loans and leases net of the reserve for losses.

Net operating income-income excluding discretionary transactions such as gains (or losses) on the sale of investment securities and extraordinary items. Income taxes subtracted from operating income have been adjusted to exclude the portion applicable to securities gains (or losses).

Net operating revenue-the sum of net interest income plus noninterest income.

Noncurrent loans and leases-the sum of loans and leases 90 days or more past due plus loans and leases in nonaccrual status.

Nonperforming assets-the sum of noncurrent loans and leases plus noncurrent debt securities and other assets plus other real estate owned.

Number of institutions reporting-the number of institutions that actually filed a financial report.

Off-balance-sheet derivatives-the notional value of futures and forwards, swaps, and options contracts; beginning March 31, 1995, new reporting detail permits the exclusion of spot foreign exchange contracts. For March 31, 1984 through December 31, 1985, only foreign exchange futures and forwards contracts were reported; beginning March 31, 1986, interest rate swaps contracts were reported; beginning March 31, 1990, banks began to report interest rate and other futures and forwards contracts, foreign exchange and other swaps contracts, and all types of option contracts.

Other real estate owned-primarily foreclosed property. Direct and indirect investments in real estate ventures are excluded. The amount is reflected net of valuation allowances.

Percent of institutions unprofitable-the percent of institutions with negative net income for the respective period.

Percent of institutions with earnings gains-the percent of institutions that increased their net income (or decreased their losses) compared to the same period a year earlier.

Reserve for losses-the sum of the allowance for loan and lease losses plus the allocated transfer risk reserve.

Residential mortgage assets-the sum of 1- to 4-family residential mortgages plus mortgage-backed securities.

Return on assets (ROA)-net income (including gains or losses on securities and extraordinary items) as a percentage of average total assets.

Return on equity (ROE)-net income (including gains or losses on securities and extraordinary items) as a percentage of average total equity capital.

Risk-based capital ratio-total capital divided by risk-weighted assets.

Risk-weighted assets-assets adjusted for risk-based capital definitions, which include on-balance-sheet as well as off-balance-sheet items multiplied by risk weights that range from zero to 100 percent.

Securities-excludes securities held in trading accounts. Effective March 31, 1994 with the full implementation of Financial Accounting Standard (FAS) 115, securities classified by banks as "held -to-maturity" are reported at their amortized cost, and securities classified a "available-for-sale" are reported at their current fair (market) values.

Securities gains (losses)-net pre-tax realized gains (losses) on hcld-to-maturity and available-for-sale securities.

Total capital-the sum of Tier 1 and Tier 2 capital. Tier 1 capital consists of common equity capital plus noncumulative perpetual preferred stock plus minority interest in consolidated subsidiaries less goodwill and other ineligible intangible assets. Tier 2 capital consists of subordinated debt plus intermediate-term preferred stock plus cumulative long-term preferred stock plus a portion of a bank's allowance for loan and lease losses. The amount of eligible intangibles (including mortgage servicing rights) included in Tier 1 capital and the amount of the allowance included in Tier 2 capital are limited in accordance with supervisory capital regulations.

Volatile liabilities-the sum of large-denomination time deposits plus foreign-office deposits plus federal funds purchased plus securities sold under agreements to repurchase plus other borrowings. Beginning March 31, 1994, new reporting detail permits the exclusion of other borrowed money with original maturity of more than one year; previously, all other borrowed money was included. Also beginning March 31, 1994, the newly reported "trading liabilities less revaluation losses on assets held in trading accounts" is included.

Copyright Comptroller of the Currency Sep 2003
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