A.M. Best Special Report: Loan Demand Helped Banks to Overcome Tighter Margins in Second Quarter.

OLDWICK, N.J. -- Margin compression pressures persisted through the second quarter of 2006 for U.S. banks, although the industry's aggregate net interest margin was unchanged as of the quarter ended June 30, 2006, according to a special report by A.M. Best Co.

The industry generated another quarter of record profits, largely on higher noninterest income. Of note is the lowest percentage of banks reporting earnings gains since September 2004. Banks responded to the persistent flat yield curve with measures ranging from boosting noninterest income to improved operating efficiency.

Although net interest margins showed continued strain from the flat yield curve, overall earnings held up during the second quarter of 2006, with net income reaching a quarterly record of $38.0 billion. The strong earnings were in part due to the continued strength of various sources of noninterest income--notably, improved trading account activity. Noninterest income for the industry as a whole rose to $62.4 billion as of June 30, 2006 from $55.6 billion a year earlier. Service charges from deposit accounts remained the largest component of noninterest income, at $9.3 billion as of June 30, 2006.

Asset-quality measures remained healthy in the second quarter of 2006. The ratio of past-due loans to total loans rose only two basis points to 1.48%, and the ratio of noncurrent loans to total loans improved from 0.72% from 0.70%. Still, the total of noncurrent loans rose from $46.4 billion to $49.3 billion.

On the liability side, the competition for core deposits intensified further, as banks' asset growth surged while core deposits lagged behind. As a percentage of average assets, core deposits continued to decline in the second quarter to 43.90% from 44.76% in the previous quarter.

Net interest expense rose at a slower pace in the second quarter than in the first quarter. For U.S. banks, the average offering rate on interest-bearing deposits rose only by 16 basis points, even though the Federal Reserve raised the federal funds rate from 4.75% to 5.25% during this period.

Banks overall managed their expenses and asset mix more efficiently during the second quarter of 2006, seeking to further boost earnings in the face of margin compression. Earning assets as a percentage of total assets increased during the second quarter of 2006 versus the prior quarter.

For the second half of 2006, A.M. Best expects a larger shift in asset mix toward loan assets; ever-higher dependence on wholesale funding for the asset growth; and further erosion of asset quality.

This special report is available electronically from the A.M. Best Co. Web site at www.ambest.com/banks. Call customer service for more information, [phone], ext. 5742.

A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com.