The Alarming Figure in the FDIC's Otherwise Glowing Earnings Report

WASHINGTON — The banking industry recorded another record profit in the second quarter, but a key number in the Federal Deposit Insurance Corp.'s earnings report is likely to strike fear in some bankers' hearts.

Banks saw a $51 billion drop in the unrealized gains for available-for-sale securities in the second quarter, the biggest such decline on record, as higher rates affected mark-to-market accounting. It was one of the clearest signs yet of the risks to institutions from rising interest rates.

"Unrealized gains and losses on available-for-sale securities do not affect current earnings, but they have implications for future earnings if the securities are sold," FDIC Chairman Martin Gruenberg said Thursday at the release of the Quarterly Banking Profile.

The decline was another warning for regulators and bankers concerned that some institutions have not appropriately matched the price and terms of their assets and liabilities with a continued rise in rates.

"Banks really need to be very attentive to their portfolios to determine the loans that they're making and how they're going to manage those portfolios as the interest rate environment changes," Gruenberg said.

Banks still enjoy income growth despite challenges not limited to interest rate risk, particularly sluggish loan demand. Thanks to a continued slide in loss provisions and a rebound in trading income one year after JPMorgan Chase's trading fiasco, the $42.2 billion earned in the second quarter is the highest income total ever. The quarterly profit — which set a second consecutive record — was 23% higher than quarterly income posted a year earlier and a 4.7% increase from the previous quarter. Meanwhile, total deposits declined for the first time in 12 quarters.

"Asset quality continues to recover, loan balances are trending up, fewer institutions are unprofitable, the number of problem banks is down, and the number of failures is significantly below levels of a year ago," Gruenberg said.

"However, industry revenue growth remains weak, reflecting narrow margins and modest loan growth. And the current interest rate environment creates an incentive for institutions to reach for yield, which is a matter of ongoing supervisory attention. Nonetheless, overall these results show a continuation of the recovery in the banking industry."

Yet the sharp numeric drop in value of available-for-sale securities — the biggest since the FDIC started collecting such data in 1994 — is cause for future concern. Such securities do not affect earnings as long as banks hold them. But certain bonds purchased in a low-rate environment would likely produce losses if sold after interest rates rose.

Gruenberg said the rising rate environment means banks will have to strike "a tricky balance," since higher rates offer the potential for industry growth but also for losses. "It's going to be a challenging environment with opportunities for institutions but also risks as well," he said.

Even industry insiders are concerned that certain institutions took undue risks during the low-rate environment to reach for yield, which may catch up with them.

"The industry is very concerned about it. Many bankers see some deals being put together that shock them because they're too generous and their extended for too long," said James Chessen, the chief economist for the American Bankers Association. "The worry from the banks that are not willing to take the big risk is there may be others out there that are pushing that … out too far."

For now, at least, future risk headwinds are not affecting banks' bottom line.

Nearly 54% of all banks reported higher quarterly income than a year earlier, and just over 8% reported a loss, the FDIC's report said. As noninterest income rose 11% from a year earlier to $66.9 billion, net operating revenue totaled $170.6 billion, a 3% increase from a year earlier. Banks were buoyed by $7.3 billion in gains in their trading books, a 238% turnaround in trading-related revenue from a year earlier when JPMorgan Chase's huge loss from credit derivatives affected the industry overall. Meanwhile, the $8.6 billion set aside in loan loss provisions was nearly 40% lower than the provisions set aside a year earlier.

The industry's average quarterly return on assets was 1.17%, which is well above the 0.99% return of a year earlier, but below the 1.27% average from 2000 through 2006.

But the industry's trading success was not replicated on the lending side as net interest income declined 1.7%, compared with a year earlier, to $103.7 billion, the third such decline in a row. Although loan balances grew overall by 1% to $7.73 trillion — thanks to a 2% rise in commercial and industrial loans to $1.56 trillion — institutions were once again beset by narrow margins. The average net interest margin fell a basis point during the quarter to 3.26%, the lowest level since the third quarter of 2006.

Balances of 1-to-4 family residential mortgages fell 1.3% to $1.85 trillion. Overall industry assets declined 0.1% to $14.41 trillion as assets held in trading accounts fell 9.1%, mostly due to the sharp drop in value for available-for-sale securities.

Credit quality also continued to show signs of improvement. Net loan and lease chargeoffs were $14.2 billion, a 30% decline from a year earlier and the smallest quarterly total in almost six years. Noncurrent loans also fell, dropping by $21.7 billion in the second quarter — the 13th consecutive quarterly decline.

The drop in chargeoffs was led by residential real estate loans, which were almost 42% lower than a year earlier, falling by $1.1 billion. Chargeoffs of other loans secured by one- to four-family homes were 32% lower.

Overall deposits declined during the quarter by 0.4% to $10.78 trillion, which was the first such decline since the second quarter of 2010. But that was in contrast to an 11.6% rise in Federal Home Loan Bank advances, to $368 billion.

The number of banks on the FDIC's "problem" list fell by 59 institutions to 553. The ratio of FDIC insurance reserves to insured deposits increased 4 basis points during the quarter to 0.63%.