In the depths of the Great Depression, Solomon A. Smith, the longtime head of Chicago’s Northern Trust Co., made a point of carrying an umbrella to work every day, rain or shine. It was his way of conveying an impression of caution and preparedness in an era when bank failures were a common occurrence.
To this day, commercial bankers tend toward pessimism when assessing their business, but given the experience of the past several years, in which double-digit earnings growth has been so common as to be almost unremarkable, even the most wary now leave their umbrellas at home. “It has been a very nice run for banks,” says Carl R. Tannenbaum, chief economist for LaSalle Bank/ABN AMRO in Chicago. “Credit losses are still extremely low, and as a result it has been a wonderful period for financial-services companies and their earnings.”
Indeed, 2006 began with banks posting average year-over-year earnings growth of 9 percent in the first quarter, jumping to 17 percent in the second quarter. Earnings growth held steady at 15 percent above previous-year levels in the second half of the year. The good times also extended to executive pay. Birmingham, Alabama-based Compass Bancshares reported fourth-quarter earnings up 15 percent from 2005, and a few days later announced an options grant to CEO D. Paul Jones Jr. worth $11.2 million.
While there are some concerns, such as a flat yield curve, upward-creeping mortgage-delinquency rates, and potential instability in the Middle East producing oil-price shocks, the general sense among bankers and analysts is that the industry’s strong performance will continue. “We are all wondering what is going to knock us off of this nice Goldilocks path we’re on,” says Tannenbaum. “But in general it should be another good year for banks.”
There is one sticking point, however: increased regulation. Regulatory agencies are currently preparing a number of significant reforms, including new bank-capital requirements, the implementation of a new premium structure for federal deposit insurance, and a new law placing restrictions on lending to members of the U.S. Armed Forces (see “Off Base?” at the end of this article). Bank executives are also concerned about potential regulatory action in other areas, such as rules addressing predatory mortgage lending and new guidance on cash reserves to cover bad loans. In addition, the Democratic takeover of Congress has created some uncertainty about the direction of future legislative efforts, including consumer-protection statutes and personal-bankruptcy rules.
Even taken together, these regulations may not be enough to stop the banking juggernaut. But bankers will undoubtedly spend much of the next year assessing the likelihood and impact of new rules, while at the same time trying to keep earnings growth on its upward trend.
Bracing for Basel
At the top on the list, particularly among larger banks, is the U.S. regulators’ expected finalization of rules for implementing the new Basel Accord (Basel II), an internationally negotiated agreement on bank-capital requirements. “Without a doubt the most important regulatory issue this year is going to be what will happen with Basel,” says Wayne Abernathy, executive director for financial institutions policy for the American Bankers Association. “We’re going from talk to action. The regulators are showing every sign of going forward in earnest.”