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Economy's recovery poses challenges for district banks.

The past few years have been a wild ride for the U.S. economy--the first recession in a decade, an energy crisis in California, the Sept. 11 terrorist attacks, war in Afghanistan, the largest corporate bankruptcies in history, rising personal bankruptcies, corporate governance scandals and, for the first time since 1941, three consecutive years of stock market declines. Nonetheless, aside from some large corporate defaults and market losses at money center banks, the U.S. banking industry has performed surprisingly well in this turbulent environment.

Many in the banking industry expect 2003 to be another challenging year. In fact, the term most frequently used by bankers in the Sixth Federal Reserve District when discussing their outlook is "uncertainty"--uncertainty about when business investment and related corporate borrowing will return, how long consumers can continue to spend given already-high household debt burdens, and what federal and state banking policy changes will occur. Banks also express uncertainty about whether interest rates will be higher or lower by December 2003.

What is certain for the banking industry is that, for now, business investment and related commercial loan demand remain mostly flat. Consumer borrowing (mainly home equity lines and loans) remains steady, but staying power is a concern. Credit quality is holding up well in light of the weak economy, but some deterioration has occurred in district banks' commercial and consumer portfolios. Some industry analysts point out that there is no assurance that acceptable credit quality will continue since loan defaults typically peak a few quarters after the bottom of the economic cycle. And the current geopolitical uncertainties and the changing legal and regulatory environments only add to the challenges facing banks during this recovery.

Regulatory changes demand bankers' attention

With the changing of the majority political party in Congress, the legislative and regulatory agendas also may change. Despite this shift, the 2003 policy agenda begins with unresolved issues from 2002, such as deposit insurance reform, privacy, regulatory capital reform, corporate governance, bankruptcy reform and accounting issues. In addition, unforeseen issues inevitably arise, as was the case in 2002 with the aggressive legislative and regulatory response to a string of corporate governance failures at companies like Enron and WorldCom.

Regarding deposit insurance reform, the biggest hurdle will be to reach a compromise on insurance coverage levels. As for privacy issues, proponents want states to be able to enact their own legislation, forcing the banking industry to adhere to stricter privacy guidelines and opt-in rules while the industry wants to maintain the current federal guidelines granting more leeway with information sharing.

Regulatory capital reform will remain a hot topic for the next several years because of a massive international effort to overhaul the 1988 Basel Capital Accord. Issued by the Basel Committee on Banking Supervision, the new draft proposal is based on the three mutually reinforcing pillars of bank supervision--minimum regulatory capital requirements, supervisory review and market discipline--to manage the credit, market, operational, legal and reputational risks that banks face today.

Corporate governance reforms will also continue to proliferate. To date, the Securities and Exchange Commission (SEC) has issued nine final rules and four major studies regarding corporate governance practices related to the Sarbanes-Oxley Act (which was created to protect investors by improving the accuracy and reliability of corporate disclosures regarding securities). The SEC continues to work on other rules, studies and requirements as mandated. Some of the requirements for additional disclosures, increased audit committee expertise and increased external audit independence will force changes for many public companies, including financial institutions.

Additional attempts at bankruptcy reform are also possible this year; however, many analysts believe the chances of enacting bankruptcy legislation this year are low.

Finally, the Financial Accounting Standards Board and the American Institute of Certified Public Accountants have announced the imminent release of revised standards for loan-loss reserves and accounting for purchased loans. In the past, banks and their regulators have not been in complete agreement with the accounting groups and the SEC regarding loan-loss reserves standards and methodologies, thus adding to regulatory uncertainty for banks.

Credit demand is slow, but quality is holding

Consistent with the slow growth in the near-term economic outlook, commercial loan demand remains soft with only a few scattered growth areas. On a positive note, commercial loan runoff appeared to stabilize at district banks during 2002. Some banks throughout the country also continue to see demand for commercial real estate and construction project loans, particularly in Florida and Nevada. In contrast with the 1990-91 recession, commercial real estate loans have continued to perform reasonably well during this soft recovery despite sharply higher vacancy rates. Bankers attribute the stronger loan performance not only to better underwriting and better use of market information but also to low interest rates that have reduced the cost of debt for property owners. Still, commercial real estate market fundamentals have weakened. Several submarkets are particularly soft, including high-end apartments in Dallas and Denver; office space in Atlanta, Dallas, Austin and Denver; and industrial facilities in Austin, Atlanta and Nashville.

Many Sixth District banks have considerable real estate lending exposures--largely a function of strong economic growth in the Sunbelt in recent decades. Thus, district banks are dependent to some degree on the health of real estate markets. This reliance has helped banks in the current downturn as real estate has been viewed by many investors as a safe haven; however, markets where occupancies and rent levels are falling will likely need close monitoring by bankers.

The overall quality of commercial loans in the district appeared to stabilize in mid-2002 and, today, is generally viewed as satisfactory. But pockets of weakness persist. For example, delinquent loans have increased at some smaller banking institutions over the last two years, especially at banks in rural areas hurt by layoffs and plant closings.

Unlike corporate demand, consumer loan demand remains strong. Nearly all institutions in the district are experiencing significant mortgage and home-equity loan growth, spurred by low interest rates. Some lenders have grown more cautious, though, as high household debt levels have raised their concerns about consumers' continued ability to borrow and spend. Some observers also question whether housing prices in some areas are becoming inflated; possible housing price inflation is generally believed to be limited to populous coastal areas. In most of the Sixth District, consumer credit quality, as measured by credit scores and borrower delinquencies, is stable or improving.

Net interest margin pressure continues

The net interest margin, a measure of the spread between interest received on loans and investments and interest paid on deposits and other borrowings, is a key determinant of a bank's profitability. Over the past decade, most banks have diversified revenue streams to include more noninterest income by offering fee-based products and services. The net interest margin, however, still accounts for more than 60 percent of operating revenues at Sixth District banks.

Managing net interest margins is extremely challenging in the current environment. First, although the yield curve is steep, limited loan demand is restricting banks' ability to take advantage of the spread between short-term deposits and longer-term loans. Second, with short-term interest rates at four-decade lows, deposit costs have reached practical minimums at many banks. As a result, any further interest rate declines are likely to hurt rather than help net interest margins. While still tight, margin pressures lessened somewhat in the second half of 2002 as strong deposit inflows and a steep yield curve allowed banks to book new loans at a reasonably good spread.

The combination of low net interest margins and slow revenue growth may tempt banks to extend asset maturities or assume more credit risk to generate higher yields. The shift to longer-term investments already has been shown by the popularity of government-sponsored enterprise debt, particularly mortgage-backed securities. Banks find such investments attractive because they offer a higher yield than Treasury securities with less default risk than loans. These instruments can, however, expose banks to extension risk as well as reinvestment risk. If rates decline, the securities are likely to be called and replaced with lower-yielding investments. If rates move higher, longer-maturity investments could suffer significant price depreciation.

Despite challenges, prospects look positive

Banks face many challenges in 2003, including slack credit demand, net interest margin and asset/liability management issues, forthcoming regulatory changes and the added uncertainty of growing geopolitical risks. Fortunately, banks nationally and in the Sixth District entered into this downturn much stronger than they did going into the last recession, in 1990. The banking sector's performance over the last three years in the face of a weak economy, corporate layoffs and a declining stock market reflects improvements in geographic and product diversification, internal risk management systems and capital levels. While unexpected shocks could have an impact on the U.S. economy, bankers generally believe that they are in a good position to ride out the rough economy and to continue to make credit available once businesses feel confident enough to resume investment spending and hiring.

By Lynn Woosley, senior financial analyst, and Lisa Easterwood and Rick Carlson, financial analysts
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Copyright 2003 Gale, Cengage Learning. All rights reserved.

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Author:Woosley, Lynn; Easterwood, Lisa; Carlson, Rick
Publication:Financial Update
Date:Jan 1, 2003
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