Loan Growth Returns, But Could Be Short-Lived

WASHINGTON — On the surface, the industry turned a corner last quarter. Loans actually grew, the Federal Deposit Insurance Corp. returned to black and the official watch list for failure-prone banks shrank for the first time in five years.

But a closer look at the FDIC's Quarterly Banking Profile reveals a familiar theme: banks are still tiptoeing to recovery. Loans rose for the first time since 2008, but lower loss provisions yet again drove earnings, and lower revenue was a sign that institutions remain risk-averse as the economy continues to struggle.

"We are mindful that earnings growth cannot be sustained indefinitely only by reducing loss provisions," Martin Gruenberg, the FDIC's acting chairman, said at the release of the second-quarter report.

Overall, banks and thrifts reported earnings of $28.8 billion for the quarter, down 0.3% from the first quarter but up by nearly 38% from a year earlier. It was the eighth straight quarter with year-over-year earnings growth.

Once again, profits were attributable mostly to the fact banks stored away fewer reserves for loan losses. Loss provisions have dropped for six straight quarters. Compared with the second quarter of 2010, provisions fell 53%, to $19 billion, the seventh consecutive such decline.

Nearly 60% of all institutions had better quarterly earnings than a year earlier, and the 15% of unprofitable institutions was the lowest level since the first quarter of 2008.

After three whole years of declining loan balances, the industry finally reversed the trend in the second quarter, increasing loans by 0.9% during the quarter, to $7.3 trillion. (Loans had technically risen in early 2010, but that was a result of new accounting rules.)

But further detail shows the growth was modest. While commercial and industrial loans increased for the fourth straight quarter, by 2.8%, to $1.24 trillion, other indicators were less encouraging.

Real estate construction loans fell for the 13th straight quarter, by 7%, to $275 billion. Also declining were one-to-four-family mortgages, by 0.3%, to $1.83 trillion.

In fact, the FDIC said a sizable portion of the higher balances reflected an increase in loans between banks. Loans to depository institutions rose by 22.6%, to $147 billion, and, the agency said, "the increase in reported balances consisted of growth in intracompany loans between related institutions."

Meanwhile, operating revenue, $164.3 billion, was lower than a year earlier (by 1.7%) for the second straight quarter.

Net interest income fell 1.7%, to $105.9 billion, as some of the largest banks, driving up balances at the Federal Reserve banks, reported lower asset yields. Total balances at the Fed banks increased by more than 22% in the quarter.

The push for ultrasafe assets caused net interest margins to go down. The average margin in the second quarter was 3.61%, versus 3.76% a year earlier. Noninterest income fell 1.9% from a year earlier, to $58.4 billion. The decline in noninterest income stemmed from lower income on loan servicing fees. Service charges on deposit accounts also declined. Fee income has likely fallen, officials said, in part because of stricter regulation of overdraft protection.

Gruenberg says that the "lack of revenue growth limits the pace of earnings improvement," and that more robust loan growth is crucial.

"As the levels of loss provisions approach their historic norms, the prospects of earnings improvement from further reductions in provisions diminish," he says. "The traditional banking business of taking deposits and making loans accounts for almost two-thirds of the industry's revenues. Increased lending is essential for future revenue growth."

Officials say that despite an increase in commercial lending, the housing market continues to be an obstacle to the expansion of credit.

"This cycle is characterized by sort of a divergence between commercial and industrial lending, which has come back … in recent quarters, and real estate lending," says Richard Brown, the FDIC's chief economist. The real estate sector, Brown says, "is really holding back growth."

"There is still shrinkage in that part of the loan book," he says.

Nonetheless, the report showed further signs the industry is recovering from the crisis.

Perhaps the most favorable indicators were in the area of failed-bank costs and projections. The agency's list of institutions at risk of failure fell for the first time since the third quarter of 2006. The list contained 23 fewer institutions than it did in the first quarter, totaling 865.

Assets of institutions on the list fell by 6%, to $372 billion. And as the FDIC has received assessment income and lowered its projections for future failures, the Deposit Insurance Fund registered its first positive balance since June 30, 2009. The balance was $3.9 billion at the end of the second quarter, and the ratio of insurance reserves to insured deposits was 0.06%.

The reserve ratio hit positive territory even as domestic deposits grew by almost 3% during the quarter, to $8.2 trillion. Deposits in accounts with more than $250,000, the FDIC's insurance limit, grew by almost 9%.

"Assessment income and fewer expected bank failures are behind the growth in the fund balance," Gruenberg says.

Just over half of the industry reported having a lower loan-loss provision in the second quarter than a year earlier. Nearly 70% of institutions with assets of more than $1 billion reported lower provisions, compared with 48.6% of community banks.

Yet in the wake of the government's recent credit downgrade, and continued unease in financial markets, Gruenberg sounded a note of caution.

"Recent events have reminded us that the U.S. economy and U.S. banks still face serious challenges ahead," he said. "The FDIC will remain alert to these challenges going forward."

Responding to questions about the battered stock prices of some of the largest institutions, and whether the FDIC was prepared should it have to exercise new powers to resolve large firms, Gruenberg said the agency was ready. The Dodd-Frank Act enacted in July 2010 gave the agency new authority to seize failing behemoths.

"We've had … this authority for over a year now," he said. "We've had sufficient time to engage in necessary planning."