A.M. Best Special Report: U.S. Banks' Earnings Reach Quarterly High on a Variety of Operating Tactics.

OLDWICK, N.J. -- U.S. banks ended the first quarter of 2006 with record earnings of $37.3 billion in aggregate (from an average of $33.9 billion in 2005), benefiting from higher fee income and lower loss provisions, which offset a continuing trend of lower net interest margins. However, the industry's profitability is distributed less evenly, according to a special report issued by A.M. Best Co., as a lower percentage of banks saw higher profits. Higher aggregate earnings contributed to a corresponding increase in the industry's aggregate capital base as of the first quarter of 2006. Both return on assets (ROA) and return on equity (ROE) increased slightly from their fourth-quarter 2005 levels, with ROA rising from 1.34% to 1.35% and ROE rising from 13.01% to 13.07%.

Regional and large banks (of asset size exceeding $1 billion) were better able to increase noninterest income, while community banks fared best in combating margin compression. The industry also saw a jump in insured deposits, aided by higher rates. The evolving asset mix of U.S. banks toward higher-yielding assets, combined with significantly higher trading activities in derivatives, was the primary driver of the industry's response during the first quarter of 2006, with the former seen more among the community banks while the latter was more prevalent among larger banks. Highlights of the primary issues for U.S. banks are discussed further below.

The effects of a rising rate environment on the industry are being felt on dual fronts: margin compression, on one hand, and slower growth in demand for consumer credit, historically the highest-margin asset class for banks, on the other. Most segments of consumer-credit assets grew at a flat or lower rate in the first quarter of 2006.

As a result, U.S. banks were challenged to enhance yields elsewhere besides consumer credit. Data for the first quarter of 2006 showed that banks were seeking higher yields in construction and land development loans (C&LD), commercial and industrial loans (C&I), trading activities and mortgage-backed securities (MBS).

Yields on earning assets increased significantly to 6.3% during the first quarter of 2006, from 5.8% in the fourth quarter of 2005 and 5.4% for the same period last year. However, with the cost of funds rising even faster, U.S. banks were only able to limit the decline in net interest margin to 6 basis points, with a resulting margin of 3.46% for the first quarter of 2006.

U.S. banks further boosted earnings during the first quarter of 2006 with fee income generated from derivative trading (service charges on deposit accounts were flat as a percentage of assets) and by lower loss provisions.

Taken together, the changing asset mix, with greater concentration in C&LD and C&I loans; expanding non-interest income--especially trading activity; and the drawing down of loss reserves point to an incrementally higher risk profile for U.S. banks, albeit one that is mitigated by higher capital levels in the industry.

U.S. banks faced largely the same set of factors as late last year: a benign credit environment, continuing margin compression and a slowdown in consumer credit, offset by higher activity in C&I loans, C&LD loans and in fee-income-generating trading accounts.

Best's Banking Center provides online access to data, special reports, analytical methodologies and news on the U.S. banking industry. For a complete overview, please visit www.ambest.com/banks.

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.