A.M. Best Special Report: U.S. Banks' Non-Interest Income Enjoyed Healthy Growth in the First Quarter of 2006.

OLDWICK, N.J. -- Despite multiple increases in short-term interest rates over the past two years, the U.S. banking industry reported record earnings in the quarter ended March 31, 2006, in part due to the strength of various sources of non-interest income. Although the Federal Reserve has boosted short-term rates by 425 basis points since June 30, 2004, the yield curve remains relatively flat.

This situation has resulted in margin compression and increased pressure on banks to develop alternative sources of income. However, non-interest income as a percentage of net operating income (defined as net interest income plus non-interest income) has been declining steadily for all but the largest U.S. banks. In recent years, smaller banks have focused their business strategies largely on real estate lending, leading to the drop in non-interest income as a percentage of net operating income. In contrast, the largest banks have been able to expand their revenue sources to better insulate themselves from shrinking margins.

From the year-ended December 31, 2003 to December 31, 2005, non-interest income rose by some 9.5% from $202.7 billion to $222.0 billion, in part due to increases in loan-servicing fees ($3.3 billion), trading account gains ($2.3 billion) and charges on deposit accounts ($1.9 billion).

Although trading account gains are generally a non-recurring source of income, the steady increase in overall non-interest income for banks stems from loan-servicing fees generated by the solid growth in real estate mortgage activity prevalent during this time period. Non-interest income growth remained healthy in the quarter ended March 31, 2006, as it rose by $5.7 billion, or 10.3%, over the quarter ended March 31, 2005. Some of the most significant increases consisted of trading-account gains ($1.5 billion) and higher securitization income ($1.1 billion).

The ratio of non-interest income to net operating revenue for the industry reached 39.9% in 2002 and rose to 41.8% in 2003; however, for both 2004 and 2005, this figure did not surpass 41.1%. In the first quarter of 2006, the ratio of non-interest income to net operating income for the industry rebounded and reached 42.3%, compared with 41.4% in the first quarter of 2005, in part due to higher fee income from deposit accounts, increased securitization income, trading account gains, and fiduciary and capital market fees.

If the flat yield curve continues to persist, banks likely will remain focused on developing other sources of non-interest income in the short run, while also searching for higher-yielding lending opportunities. A.M. Best Co. will continue to monitor the situation and will comment on the credit risk implications and other significant issues presented by these changes.

This study is available electronically from the A.M. Best Co. Web site at www.ambest.com/banks.

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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.