The Real Story Behind Banks' $40B Record Earnings

WASHINGTON — On the surface, a regulatory report noting banks' first quarterly profit of $40 billion shows an industry that seems fully recovered from the financial crisis and primed for future growth.

But a closer examination of the Federal Deposit Insurance Corp.'s industry update released Wednesday tells a different, and more dispiriting, story — institutions that are still having trouble making profits from loans. Indeed, much of the record profit appeared due not to a suddenly resurgent industry, but a couple of idiosyncratic balance-sheet items at top-tier banks.

The rest of the report showed a trend that has been constant over the past several quarters, with banks facing flat interest-related revenue and making money mostly from reductions in loan loss provisions, an income booster that will soon run dry.

"We have seen over the last three years a process of improving credit quality for the industry as a whole, and that's allowed for a … reduction in [loss] reserves and that's helped drive the net income improvements that we've seen. Our sense is that process has largely played itself out," FDIC Chairman Martin Gruenberg said at the release of the Quarterly Banking Profile.

Gruenberg reiterated his hope that the situation will soon turn around and that more robust lending will propel higher revenue once provisions stop falling. But he said the industry is "holding its own" in terms of loan growth as it deals with a tough set of circumstances, including limited demand and extremely tight margins resulting from the low interest rate environment. He also echoed concerns voiced by other regulators that the risk banks face from higher liability costs once interest rates rebound should be monitored.

"This is a fairly tricky environment for the industry. It's now in a stronger position to lend" but banks face "an environment with tight interest rate margins and relatively weak loan demand," he said. "There is a temptation for financial institutions to reach for yield in this environment."

The $40.3 billion in net income was nearly 16% higher than a year earlier and eclipsed the previous record of $38.1 billion set in the third quarter of 2006. In addition to banks enjoying yet another decline in loss provisions, which fell more than 23% to a six-year low of $11 billion, total noninterest income rose 8.3% from a year earlier to $66.5 billion and noninterest expense fell 3.9% to $102 billion.

But much of the noninterest boost was isolated to just a couple of institutions. Although the report did not name those institutions, an examination of individual call reports shows Bank of America, for example, registered an increase of $2.5 billion in noninterest income from a year earlier, due in part to intracompany transactions. In another instance, JPMorgan Chase, which saw a reduction in its legal costs, reported a nearly $3.5 billion decline in noninterest expenses.

"Large, nonrecurring income and expense items at some of the industry's largest institutions exerted a significant influence on the quarterly change in net income," said Gruenberg, who also noted that the previous earnings record occurred "when the industry was 20% smaller" as measured by total assets.

Meanwhile, despite the continued reduction in loss provisions, the pace of such declines appears to be slowing.

"As problem loans decline at institutions in all size groups, the year-over-year reduction in the industry's provision expense is becoming progressively smaller," Gruenberg said.

Banks still found other profit centers. Trading revenue rose nearly 18% from the first quarter of 2012 to $7.5 billion and gains on asset sales increased 30%. The average return on assets rose 12 basis points from a year earlier to 1.12%, the highest quarterly ROA since the second quarter of 2007.

"We saw improvement in asset quality indicators over the quarter, a continued increase in the number of profitable institutions and further declines in the number of problem banks and bank failures," Gruenberg said.

But net interest income is still a challenge, falling by 2.2% year-over-year to $104 billion, which was the third such decline in the last four quarters. The average net interest margin, meanwhile, was 3.27%, which was 8 basis points lower than the margin set in the previous quarter and 24 basis points lower than a year earlier. The first-quarter margin was the lowest since the fourth quarter of 2006. The agency said even with nearly 5% more interest-earning assets on their books — compared with a year earlier — banks earned nearly 5% less in total interest income.

"As older, higher-yielding assets mature and are replaced by lower-yielding current assets, average yields continue to fall more rapidly than the average expense of funding these assets," the report said.

Total loans fell by 0.5% from the previous quarter to $7.66 trillion, but the FDIC said the overall decline was "seasonal," since consumers in recent years have tended to pay off a large chunk of their credit card balances in the first quarter. Card balances declined 5.2% during the quarter to $660 billion. Balances for single-family mortgages also fell, dropping 1% during the quarter to $1.88 trillion. The FDIC said mortgage sales topped originations by nearly $24 billion.

Still, loans in other sectors continued to show steady growth. Those included commercial and industrial loans, automobile loans and multifamily residential real estate loans. C&I loans increased 1.6% to $1.53 trillion.

"Revenues have been generally flat, but have been marginally up. The industry has now managed to generate positive loan balances for six out of the last eight quarters," Gruenberg said. "Even in a pretty tough environment, I think the industry is doing reasonably well and continuing that progress. But it's clearly a challenging one that requires them, and we, the regulators, to follow closely."

The agency's list of "problem" institutions shrank by 39 to 612 institutions, and total assets of banks on the list fell from $233 billion to $213 billion. Meanwhile, the ratio of reserves to insured deposits in the Deposit Insurance Fund rose by 15 basis points to 0.59%. The fund's total balance stood at $35.7 billion at the end of the quarter, up from nearly $33 billion in the fourth quarter of 2012.

The FDIC earned $2.6 billion in income from deposit insurance premiums. But much of the increase in the reserve ratio was due to the expiration at the end of 2012 of the Transaction Account Guarantee, a temporary program providing full protection for non-interest-bearing checking deposits. The expiration of TAG significantly reduced the pool of deposits the FDIC is obligated to cover. Moreover, declines in non-interest-bearing deposits above the agency's standard coverage limit of $250,000 per depositor were modest following TAG's departure, declining by less than 5% during the quarter.