A Fragile Recovery for Banks

Revenue for U.S. commercial banks dropped 3% in the first quarter, as loan portfolios shrank and regulations hammered fee income.

Commercial banks are facing strong headwinds to growing their business, even as they put their underwriting missteps behind them. A lack of lending and negative effects from regulation have put banks in a “revenue drought,” says Lee Kyriacou, a partner at Novantas, a financial services consulting firm.

According to the Federal Deposit Insurance Corp.’s latest quarterly banking report, released on Tuesday, net interest income (the money banks earn primarily from lending) had its first year-over-year drop in 22 years, falling 3% in the first quarter of 2011. The FDIC attributed the downtrend to narrower net interest margins and weak growth in interest-earning assets. Battered by lower revenues from deposit account service charges and reduced trading income, banks also experienced a decline in noninterest income, which fell by $2.2 billion, or 3.7%. In total, banks’ first-quarter net operating revenue was off 3.2%.

For the most part the banks have a balance sheet problem. Total loans and leases dropped by 1.7%, or $126.6 billion, in the quarter, led by declines in one-to-four-family residences, credit cards, and real estate construction and development loans. The last category fell the most — 8%. Credit card and residential mortgage loans actually grew in the fourth quarter of 2010, but the upturn didn’t stick. Commercial and industrial loans were a bright spot, though, rising by $18.1 billion, or 1.5%.

With domestic deposits growing by $116.3 billion in the quarter, banks have no place to put their money, says Kyriacou. “As they write off [bad] loans they are just not able to replace them as fast,” he says. “On the demand side there is some lending, [but areas like] construction and development have been dropping like a rock for two years.”

That dynamic leads to banks putting more money on deposit at the Federal Reserve (such holdings rose by $116.3 billion) and investing in instruments such as mortgage-backed securities (up 2.3%).

Loan income also depends on banks’ net interest margins — the spread between what they pay on deposits and what they earn on loans. In a revitalized economy, the margins should be increasing, but that is not happening yet, says Kyriacou. “We’re awaiting the full recovery, so the loan books will grow and spreads will widen out,” he says.

On the fee-income side, new banking regulations have greatly reduced overdraft-fee revenue, and “there are more hits to come,” says Kyriacou. In particular, the Volcker Rule — which prohibits banks from trading on their own account or investing in hedge funds and private-equity funds — will remove a significant source of revenue from the income statements of large trading banks.

Despite lower revenues, banks earned net income of $29 billion in the first quarter, an $11.6 billion increase from a year ago and “the best quarterly result since the second quarter of 2007,” the FDIC said. Most of the earnings came from a drop in set-asides for loan losses, which fell more than 50% to $20.7 billion. The quality of loan portfolios improved, with noncurrent loan balances falling for the fourth quarter in a row, and net loan charge-offs declining for the third straight quarter.

But loan growth next quarter will be key to banks’ revenue picture and overall health. If the macroeconomic picture improves, “banks will lend more readily and expand their loan books, and that will [drive up] net interest income,” says Kyriacou. “[But] we expect the fee side to drop some more.”

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