s&p banking

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December 6, 2007

Industry SurveysBanking

THIS ISSUE REPLACES THE ONE DATED JUNE 7 , 2007 .

THE NEXT UPDATE OF THIS SURVEY IS SCHEDULED FOR JUNE 2008 .

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Erik OjaBanks Analyst

CURRENT ENVIRONMENT..................................................................1Credit quality continues to decline

Review of recent resultsRegulatory and legal issuesBanking industry outlook

INDUSTRY PROFILE...............................................................................6US bank industry consolidation continues

Mergers raise industry concentrationINDUSTRY TRENDS ..................................................................................7

Consolidation likely to resume in long termUS banking system remains healthyConsumer bankruptcies tumble after bankruptcy reform in 2005Customer service and convenience remain a focus for banks

HOW THE INDUSTRY OPERATES ..............................................................13Business typeBank assetsBank liabilitiesInterest rate risksRegulation: the Feds influenceInterest rates: a factor in profitsInfrastructure and operating costsCompetitive strategies: retail and commercial

KEY INDUSTRY RATIOS AND STATISTICS....................................................19HOW TO ANALYZE A BANK....................................................................20

Profitability measures

Measures of financial conditionAnalyzing a hypothetical Bank

GLOSSARY .............................................................................................27

INDUSTRY REFERENCES.....................................................................29

COMPARATIVE COMPANY ANALYSIS ..............................................32


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Executive Editor: Eileen M. Bossong-Martines

Associate Editor: Diane Cappadona

Statistician: Sally Kathryn Nuttall

Production: GraphMedia

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Copyright 2007 by Standard & Poors

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VOLUME 175, NO. 49, SECTION 1

THIS ISSUE OF INDUSTRY SURVEYS INCLUDES 2 SECTIONS.

Standard & Poors Industry Surveys


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rate. Foreclosure filings reached a record of635,000 in the three months of August, Sep-tember, and October 2007 approximatelydouble the level of a year earlier as finan-cially strapped homeowners defaulted ontheir loans.

Review of recent results

Following steep market declines in August2007, and fueled by concerns about the sub-prime mortgage industry, the Federal Reserveannounced on August 17 that it would becutting the discount rate to 5.75%, from6.25%. This 50-basis-point cut was twicethe size that most market observers had ex-pected, and it served as the Feds declarationthat it would provide enough liquidity to

prevent any further worsening of the mid-summer credit crunch that had investors,bank executives, and regulators fearing thatone or more large financial institutionswould fail.

The Feds decision on September 18, 2007,to cut the federal funds rate by 50 basis points(to 4.75%) came as a surprise to many mar-ket observers, who had expected a series of25-basis-point cuts, beginning with the Sep-tember Fed meeting. However, the minutesfrom that meeting indicated that the Fed re-

frained from language that might have height-ened concern that the US economy wouldcontract and that a decline in inflation wouldprobably be sustained, potentially openingthe way for additional rate cuts. In addition,the Feds additional 25-basis-point rate cuton October 31, when analyzed in conjunctionwith the Feds comments on the potentialfor further rate cuts, seemed to precludefurther rate cuts in 2007, a negative forbanking stocks.

While the most immediate liquidity and

funding needs of banks and the securitiesmarkets were addressed by the recent ratecuts, the US banking industry continues toface both high funding costs and soft loangrowth issues that are attributable to theshape of the yield curve and the health of theUS economy, respectively.

Additional Federal Reserve rate cuts maybe costly, in terms of the effect on the ex-change rate of the US dollar with respect tothe currencies of our major trading partners,which in turn may make foreign goods more

expensive. This could lead to a resurgence of

US inflation, which would probably lead tothe suspension of further rate cuts.

The prime rate is currently benchmarkedat a level of 300 basis points above the federalfunds rate target of 4.50%. Since much ofcommercial lending is done at the prime rate,

the Fed rate cuts will also have the effect ofreducing the yields that banks receive onmany of their loans.

Yield curve affects margins and net interestincome

The shape and steepness of the yieldcurve is the major determinant of bankslending margins and net interest income. Inaddition, about 60% of banking industryrevenues typically result from the yieldcurvebased business of borrowing and

lending. The banking industry struggled formost of 2006 and 2007 with a flat to in-verted yield curve, in which the longer-term rates remained stubbornly low. Inmid-June 2007, the market rate on the 10-year Treasury note peaked at 5.32%, lead-ing many investors to celebrate the returnof a normally inclined yield curve. Thesehopes were soon dashed by a rapid declinein the market rate on the 10-year note, asinvestors used it as a flight to qualityinvestment harbor in the midst of the

credit storms of midsummer.According to the FDIC, net interest mar-

gins (NIMs) for the industry, as a whole,bottomed out at 3.31%, at December 31,2006, having fallen from 3.38% at Septem-ber 30, 2006, and 3.46% at June 30, 2006.In 2007, NIMs have stabilized, improvingslightly to 3.32% at March 31, 2007, andimproving yet again to 3.34% at June 30,2007. However, based on a the September30, 2007 earnings reports, we expect a five-to nine-basis-point NIM compression, due to

stubbornly high funding costs.The current industrywide level of the

NIM is relatively low certainly in compar-ison with the period of 2002 to 2004, whenthe federal funds rate target was 1.00%, alevel considered by many market observersto have been artificially low. Even whencompared with a longer historical period, to-days NIMs are low and, together with com-ments from many bank management teams,suggest an industrywide stagnation. Thistrend is lasting long enough to make many

banks eager to combine with each other, and


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thus drive earnings growth by reducing non-interest expenses.

During 2007, many banks have beenforced to write down the mark-to-marketvalues of loans and securities held for sale,resulting in reductions to net income. Some

banks have held back from sales of securitieswhen they estimated they would not be ableto get the prices that they wanted, thus re-sulting in declines in noninterest income.

Year over year, earnings for the group in2007 decreased a median of 1.5% in thefirst quarter, 0.3% in the second quarter,and 2.5% in the third quarter; for the firstthree quarters of 2007 combined, earningswere down 3.0% for the group, versus thecomparable period a year earlier. Net interestincome was flat, and noninterest expenses

and loan loss provisioning expenses werehigher; results were bolstered by strong feeincome.

Banking industry stock performanceThe S&P Regional Banks index fell

24.3% in 2007 through November 19, withmost of the decline having occurred in Julyand November. Although share prices gener-ally held up in the first and second quarters,when the index fell 1.7% and 1.6%, respec-tively, the index fell 8.2% in the third quar-

ter and 14.5% in the fourth quarter throughNovember 19. With the turmoil of 2007, weestimate that the valuation of the industryhas declined to a median of 11.0 times Stan-dard & Poors earnings estimates for 2008 down from more than 14 times a year ago.

Economic outlook as it applies to banksDespite the strong economic results gener-

ated so far this year, we are concerned thatthe US economy may tip into a recession if thedownturn in housing extends to other sec-

tors, if rising energy prices result in a majordecline in consumer spending, or if overseasgrowth stalls and cuts demand for US prod-ucts. A recession would hurt almost all as-pects of banking operations, starting withcredit quality and extending to loan growth,fee income, and lending margins.

The latest economic releases have beenstronger than expected. US gross domesticproduct (GDP) increased 3.9% in the sec-ond quarter of 2007 (at annualized rates),and the unemployment rate held steady in

October at 4.7%. Payrolls increased

166,000 in October, following increases of96,000 in September, and 93,000 in August.

At the same time, measures of inflationhave indicated that prices remain stable. Theconsumer price index increased 0.3% in Sep-tember, and was 2.8% higher than at Sep-

tember 2006. The producer price indexincreased 1.1% in September, following a1.4% decrease in August and a 0.6% increasein July.

Standard & Poors sees housing, consumerspending, and trade as being the three majordeterminants of whether the US economywill slow into a recession (defined as twoconsecutive quarters of negative GDP growth).Furthermore, we see the decline in thehousing market as being mostly offset byincreases in foreign trade, as measured

by improvements in the trade deficit. In ourview, that leaves consumer spending as thedeciding factor of whether or not the USeconomy will experience a recession.

Foreign trade has done well this year. Theyear-long slide in the exchange rate of the USdollar versus major currencies has allowedthe prices of US-made aircraft, autos, and in-formation technology goods to become morecompetitive. At the same time, US consumersare happy to see that in many instances for-eign producers have been unwilling to lose

US market share, and so have held the lineon prices charged in the US. Standard & Poorsthinks that the decline of the US trade deficitto $405 billion in the first half of 2007 helpedthe US economy offset the declines in hous-ing prices.

However, future trends in consumerspending will depend on energy prices andhousing costs, both of which are emittingwarning signs. Even though consumer spend-ing increased at 3.0% in the third quarter of2007, up from a 1.4% gain in the second

quarter, consumers may cut back on retailspending as energy costs continue to in-crease. Standard & Poors thinks that thestrength in payrolls and employment so farhave mitigated the effect of energy costs.Therefore, we think that trends in employ-ment will drive consumer spending.

Because of the likelihood of a slowdownin consumer spending, Standard & Poorsis currently estimating the probability of aUS recession at 40%. As this Survey wasgoing to press in mid-November 2007,

Standard & Poors was projecting US GDP


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growth to slow to 2.1% in 2007, and 1.9%in 2008 (versus 3.1% in 2005 and 2.9% in2006), before picking up to 2.9% in 2009.

Regulatory and legal issues

The banking industrys most significantvictory of the last several years was theBankruptcy Abuse Prevention and ConsumerProtection Act, signed into law by PresidentBush in April 2005 and enacted in October2005. This law made it more difficult forconsumers to entirely discharge their debts,by forcing them to file for Chapter 13 ratherthan Chapter 7, which is a full discharge ofdebts. This law applies a means test, basedon the median income of the state of resi-dence, to determine whether a Chapter 7

bankruptcy filing is allowed.The strict means testing of the bankruptcy

law has already been relaxed by the US De-partment of Justice for victims of natural dis-asters, such as Hurricane Katrina. With theelections in November 2006 leading to atransfer of power in the House and Senate in

January 2007, the bankruptcy law has comeunder increasing attack. Senate BankingCommittee chairman Senator Chris Dodd(D-CT) announced in the summer of 2007that he will introduce legislation to repeal

portions of this law. Other narrower bills areaimed at giving bankruptcy judges morediscretion in deciding who is eligible forChapter 7 and more leeway to change theterms of mortgages.

Related closely to this is the broad issueof subprime mortgage reform. Some Democ-

ratic senators have called for the federalgovernment to offer funding to help troubledborrowers avoid losing their homes, but theyhave not yet introduced legislation. In Sep-tember 2007, House Financial ServicesCommittee chairman Representative Barney

Frank (D-MA) introduced legislation in theHouse of Representatives aimed at toughen-ing standards for mortgage underwriting andlending practices.

Credit card usage is also related to theseissues, with headline stories detailing some ofthe more lurid personal examples of creditcard over-the-limit charges, universal defaultprovisions, and hard-to-understand interestrate hikes. Calls have come from consumeradvocates for an updating of Regulation Z,the Truth in Lending Act, which is imple-

mented by the Federal Reserve. In September2007, the Office of the Comptroller of theCurrency (OCC), a bureau of the US Depart-ment of the Treasury, urged the banking in-dustry to improve business practices warning that otherwise lawmakers will dothis for the OCC.

In addition to the regulatory and legisla-tive issues facing the banking industry, thereare legal challenges. The most recent andprominent case, which was argued in frontof the US Supreme Court in early October

2007, is Stoneridge v. Scientific Atlanta. Ajudgment in favor of plaintiff Stoneridgecould expand legal liability to third parties,such as banks and other financial institu-tions, for aiding and abetting a companyfound to be engaged in fraud. (A decision onthe case is expected in the spring of 2008.)Currently, under the Private Securities Litiga-tion Reform Act of 1995 and the Sarbanes-Oxley Act of 2002, only the US Securitiesand Exchange Commission can initiate law-suits for third-party liability.

Banking industry outlook

We recently lowered our fundamental out-look for the regional banks sub-industry tonegative, from neutral, due to our concernsabout current trends in credit quality, lendingmargins, and fee income growth, and our ex-pectations for 2008. While credit quality andlending margin issues have been well knownfor some time now, we think that the recentdisruptions to the capital markets have been

an additional negative factor affecting the in-

COMMERCIAL AND INDUSTRIAL LOANS(Domestic banks, in billions of dollars, seasonally adjusted)

Source: Federal Reserve Board.

Small banks (left scale)

Small banks as % of total (right scale)36

35

34

33

32

31

302004 2005 2006 2007

Large banks (left scale)

(Billions of dollars) (Percent of total)

1,200

1,000

800

600

400

200

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dustrys cost of capital, trading income, andmortgage banking activities. We think thatregional banks will continue to struggle with

these issues in the remainder of 2007 andinto 2008.

Although US regional banks have, for themost part, reported continuing economic ex-pansion in their service territories, even bankswith the highest credit quality will not be ful-ly immune from indirect effects of housingprice declines in their lending markets, in ourview. Industrywide levels of nonperformingloans have increased from the historical lowsachieved in mid-2006, and we expect furtherincreases through 2008, which may necessi-

tate additional loan loss provisioning.In addition, most regional banks continue

to experience difficulties in funding theirloan portfolios, despite the recent rate cuts.We think that most banks are finding thatthey need to keep deposit rates high in orderto attract funds, and this has resulted in netinterest margin compression in each quarterof 2007. We expect margin compression toease, but we do not foresee expansion untilat least mid-2008. We also are forecastingthat growth of loan loss provisioning will

outstrip any net interest margin expansion in2008. Furthermore, we think that the paceand premiums of takeovers may be slowing,thus neutralizing the best upside catalyst tobank share prices.

MORTGAGE ORIGINATIONS(In billions of dollars)

Source: Mortgage Bankers Association.

Purchasing Originations

Refinancing Originations

Total

1991 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 2007

1,400

1,200

1,000

800

600

400

200

0


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INDUSTRY PROFILE

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Compared with the banking systems of mostdeveloped countries, the US industry is high-ly fragmented. Thousands of smaller playerstry to compete with industry leaders in termsof pricing and service. However, deregulation combined with banks drive to expand mar-ket share, enhance geographic coverage, in-

crease the number of products and servicesoffered, and improve efficiency has led tosignificant consolidation since the early 1980s.

Consolidation activity increased in 1994 and1995, when 518 banks and 514 banks, respec-

tively, announced merger agreements. The peakyear for merger announcements was 1998,when 545 mergers were planned. Subsequently,however, some of the more aggressive acquirersencountered problems with their mergers, whileother firms became less eager to pay premiumprices in order to make a deal. In the more re-

cent period of 2001 to 2006, an average of 277banks per year announced merger agreements.In 2007 to date, 229 banks have announcedmergers an annualized rate of 275, which isin line with recent historical trends.

US bank industry consolidationcontinues

25 LARGEST US BANKING COMPANIES(In millions of dollars, ranked by September 30, 2007, market capitalization)

MARKET CAPITALIZATION 3Q 2007 % CHG. FROM TOTAL ASSETS

12/31/2005 12/31/2006 9/30/2007 12/31/2005 12/31/2006 6/30/2006 6/30/2007 % CHG.

1. Citigroup Inc. 245,512 273,691 232,162 (5.4) (15.2) 1,626,551 2,220,866 36.5

2. Bank of America 185,342 239,758 223,066 20.4 (7.0) 1,445,193 1,534,359 6.2

3. J.P. Morgan Chase & Co. 138,878 167,551 155,050 11.6 (7.5) 1,328,001 1 ,458,042 9.8

4. Wells Fargo 105,067 120,049 119,058 13.3 (0.8) 499,516 539,865 8.1

5. Wachovia Corp 82,116 114,542 95,436 16.2 (16.7) 553,614 719,922 30.0

6. U.S. Bancorp 54,291 63,617 56,161 3.4 (11.7) 213,405 222,530 4.3

7. State Street Corp. 18,179 22,395 26,549 46.0 18.5 102,536 112,268 9.5

8. SunTrust Banks 26,296 29,907 26,431 0.5 (11.6) 181,143 180,314 (0.5)

9. PNC Financial Services Group 18,069 21,754 23,574 30.5 8.4 94,914 125,651 32.4

10. BB&T Corp 22,728 23,763 22,270 (2.0) (6.3) 116,284 127,577 9.7

11. Regions Financial 15,643 27,300 20,752 32.7 (24.0) 86,063 137,622 59.9

12. Fifth Third Bancorp 20,929 22,842 18,134 (13.4) (20.6) 106,111 101,390 (4.4)

13. Natl City Corp 20,789 23,092 16,059 (22.8) (30.5) 141,486 140,636 (0.6)

14. KeyCorp 13,428 15,272 12,621 (6.0) (17.4) 94,794 94,076 (0.8)

15. Marshall & Ilsley 10,131 12,590 11,680 15.3 (7.2) 54,419 58,298 7.1

16. M&T Bank 12,254 13,519 11,088 (9.5) (18.0) 56,507 57,869 2.4

17. Synovus Financial 8,435 10,019 9,353 10.9 (6.6) 30,527 33,221 8.8

18. Comerica Inc 9,381 9,322 7,847 (16.4) (15.8) 57,080 58,570 2.6

19. Commerce Bancorp 5,975 6,614 7,479 25.2 13.1 43,436 48,176 10.9

20. Zions Bancorp 7,893 8,817 7,387 (6.4) (16.2) 45,142 48,691 7.9

21. Huntington Bancshares 5,420 5,586 6,213 14.6 11.2 36,266 36,421 0.4

22. Associated Banc-Corp 4,442 4,545 3,761 (15.3) (17.3) 21,128 20,849 (1.3)

23. City National Corp 3,561 3,388 3,402 (4.5) 0.4 14,477 15,796 9.1

24. First Horizon Natl 4,844 5,200 3,365 (30.5) (35.3) 37,469 38,394 2.5

25. TCF Financial Corp 3,630 3,590 3,324 (8.4) (7.4) 14,198 14,978 5.5

Note: Data has not been restated to reflect mergers.Source: Standard & Poors Compustat.


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The Federal Deposit Insurance Corp.(FDIC) reports a continuous decline in thenumber of commercial banks it has insured:from 14,628 in 1975, to 14,500 in 1984, to10,451 in 1994, to 7,630 in 2004, to 7,527in 2005, to 7,402 in 2006, and to 7,350 at

June 30, 2007.At June 30, 2007, 14 FDIC-insured do-mestic commercial banks in the United Stateshad assets of more than $100 billion each;their aggregate assets totaled $5.90 trillion,or 56.7% of industry assets of $10.411 tril-lion, according to Highline Data, a financialinformation and research firm, and the FDIC.The five largest US bank holding companies,ranked by assets at June 30, were CitigroupInc. ($2.22 trillion), Bank of America Corp.($1.53 trillion), JPMorgan Chase & Co. ($1.46

trillion), Wachovia Corp. ($720 billion), andWells Fargo & Co. ($540 billion).

Ninety-five commercial banks (includingthe 12 banks previously mentioned) had as-sets of more than $10 billion each at June30, 2007; their aggregate assets were $8.19trillion, equal to 78.7% of total industryassets. Furthermore, 557 commercial bankseach had assets of more than $1 billion (to-taling approximately 90.3% of industryassets). By comparison, in 1994, 392 bankseach had assets of more than $1 billion,

representing 75.0% of total 1994 commer-cial banking assets of $4.01 trillion, accord-ing to the FDIC.

Mergers raise industry concentration

As a result of consolidation, a few behe-moth players now dominate some majorbanking segments. For example, in lending,the 10 largest US commercial banks (rankedby total net loans and leases not held forsale) control 37% of the market. In retail

banking, the 10 largest banks (ranked by de-posits) hold about 42% of deposits. Consoli-dation has allowed banks to take advantageof scale opportunities and to earn healthyshareholder returns from larger portfolios.Service levels for customers tend to increaseas banks devote more resources to specialtybusinesses. Marketing costs also can bespread over a large cost base. We believethat, as long as substantial market share doesnot wind up in the hands of only one ortwo players which would limit competi-

tion companies and customers alike will

benefit from the scale advantages that haveresulted from increased concentration.

INDUSTRY TRENDS

Among the important and interrelated bank-ing industry trends covered in this section areconsolidation, credit quality patterns, customerconvenience initiatives, and regulatory change.

Consolidation likely to resume inlong term

Although less favorable industry conditionsand declining stock prices led to a reducedpace of merger activity from 2000 to 2002,consolidation has picked up since 2003 and

remains one of the industrys most notewor-thy trends. In the late 1980s, against a back-drop of concerns about banks credit quality,mergers and acquisitions (M&A) becamecommon, as strong banks took over weak orfailing institutions. M&A activity acceleratedin the 1990s before slowing in recent years.Consolidation may continue over the longterm, as banks move to compete more effi-ciently in a less regulated environment.

Between 1996 and mid-1998, favorablestock prices and excess capital levels gave ac-

quiring banks the means to make purchaseswithout unduly diluting near-term earnings.Sellers found the environment favorable aswell, since they were able to command pre-mium prices. However, from mid-1998through mid-2002, bank stocks witnessed amore difficult deal environment, which re-duced bank merger activity.

US banks have achieved remarkablegrowth in assets since 1989, primarily re-flecting the nearly two decades of economicprosperity since then. Consolidation has fur-

ther boosted asset growth for individualbanks. In 1989, the 12,709 reporting FDIC-insured commercial banks had aggregate as-sets of $3.3 trillion, an average of roughly$260 million per bank. By the end of 2006,the number of reporting commercial bankshad fallen to 7,350 (a 42% decline since1989); total assets, however, had increased to$10.41 trillion, or an average of $1.4 billionper bank (an average annual gain of 10.2%).

The fourth quarter of 2004 marked thefirst time that the number of all FDIC-

insured depository institutions dropped


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below 9,000, to 8,681 at year-end 2006.Structural changes among FDIC-insuredbanks in the first half of 2007 also includedthe issuance of 89 new bank charters, com-pared with 191 in 2006, 179 in 2005, 128 in2004, 119 in 2003, and 91 in 2002.

Standard & Poors believes that long-termconsolidation will continue to improve effi-ciency, boost sustainable profits, and helpbanks to withstand heated competition fromother financial services providers, both do-

mestic and international. If stock marketconditions remain relatively strong, we ex-pect that more small- and medium-sized re-gional banks (those with assets of less than$20 billion) will continue to be absorbed bylarger domestic or foreign banks.

Motives for mergingThe primary factor favoring further con-

solidation is competition, which has inten-sified pressure on banks to expand marketshare, increase geographic presence and di-

versification, improve efficiency, and offera broader range of financial products. Con-solidation can help banks to fend off com-petition from other commercial banks aswell as from nonbank providers of finan-cial services.

Banks contend that they become financiallystronger following a merger because they canreduce the acquired banks noninterest (oper-ating) costs. Savings are especially noticeablein intramarket deals, in which duplication ofbank infrastructure is high. Combining back-

office operations and closing branches in

overlapping service territories can cut thecombined banks costs by 20% or more.

Normally, if the integration process goessmoothly, only a small portion of the ac-quired banks business is lost to competitorswhen branch offices are sold or closed. Of-ten, branches are sold to satisfy antitrust reg-ulators or because a bank does not want tobe in a certain area.

Other benefits of consolidation includeexpanded delivery networks and product

diversification. We believe that, for con-sumers, consolidation stands to bring lowerbanking costs, broader products, andgreater convenience.

The promise of greater efficiency has gen-erated an acquire or be acquired mentalityamong bank managers. For a bank to remainindependent, it must maintain strong earn-ings and an above-average growth rate.

Inducing efficiencyBy reducing operating costs, consolidation

has helped the banking industry becomemore efficient. The relatively low US infla-tion rate has helped banks exercise tight con-trol over expense items, particularly salariesand other personnel-related costs. Restruc-turings that involved workforce reductionsand branch consolidations were commonamong large banks in the mid- to late 1990s.

Efficiency, however, cannot come at theexpense of customer satisfaction. Banks runthe risk of losing customers if their efforts tocut costs lead to perceived reductions in ser-

vice levels. To satisfy both fiscal and quality

MERGER MULTIPLES

AGGREGATE AVERAGE MEDIANDEAL VALUE AVERAGE MEDIAN PRICE/BOOK PRICE/BOOK NUMBER

YEAR (MIL.$) P/E RATIO P/E RATIO RATIO RATIO OF DEALS

2007* 63,762.5 25.8 22.5 2.3 2.1 240

R2006 114,551.2 23.3 20.4 2.6 2.2 293

2005 71,272.4 25.3 21.9 2.2 2.0 274

2004 129,804.0 24.7 21.1 2.1 2.1 286

2003 72,779.2 23.8 20.0 2.0 1.9 286

2002 17,152.7 23.8 18.3 1.8 1.7 234

2001 40,341.6 21.9 17.0 1.7 1.6 291

2000 94,047.5 18.8 16.2 1.8 1.7 336

1999 70,035.1 23.0 20.3 2.1 2.0 410

1998 274,436.7 23.1 20.9 2.4 2.4 545

1997 89,783.8 21.6 18.4 2.0 1.9 498

1996 33,421.9 19.2 16.1 1.8 1.7 482

1995 63,630.2 17.2 15.1 1.7 1.6 514

*Through October. R-Revised.

Source: Highline Data.


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requirements, technological improvementshave helped banks control expenses whileproviding better service. Electronic bankingthrough telephones, automated teller ma-chines (ATMs), and the Internet improve cus-tomer service by offering 24-hour banking

capabilities at convenient locations. Thecosts of completing such transactions remainwell below the more labor-intensive opera-tions at bank branches.

Banks concerted efforts to control theirexpense levels in recent periods have shownup in their efficiency ratios. The efficiencyratio is defined as the ratio of noninterest ex-pense to total revenues; the lower the effi-ciency ratio, the better. In the early 1990s,the banking industry strove for an efficiencyratio of about 60%. By the late 1990s, the

most efficient banks were achieving ratios inthe low- to mid-50% range. The average effi-ciency ratio for all FDIC-insured banks wasslightly more than 57.0%, on an annualizedbasis, in the first six months of 2007.

The efficiency ratio is often related to thesize of a bank. In the first half of 2007, thelargest banks (those with more than $10 bil-lion in assets) maintained an average efficien-cy ratio of 55.5%. Banks with $1 billon to$10 billion in assets had efficiency ratios of58.4% in this same period. Smaller banks

(assets of $100 million to $1 billion) had ef-ficiency ratios of nearly 65.0%, while bankswith less than $100 million in assets had effi-ciency ratios of 74.7%.

The efficiency ratio tracks closely with thelevel of fee incomegenerating businesses that abank has. The banking industry generatedabout 42.5% of revenues from noninterest in-come in the first half of 2007. Banks that gener-ate a lower percentage of their revenues fromfee income, such as those that do not offer bro-kerage services, insurance, or credit cards, often

have efficiency ratios significantly lower thanthe industry average of 57.0% as low as themid-30% range. Likewise, banks with signifi-cant levels of customer services, such as seven-day-per-week branch hours, waivers of ATMand other fees, and free coin counting machines,may have efficiency ratios nearing 75%. In-vestors should examine more closely thosebanks that have a relatively low percentage ofrevenues from fee income, without a corre-sponding reduction in their efficiency ratios.These banks may have inefficiencies in their cost

structures, which may hamper their profitability.

Merger strategies varyAmong straight banking acquisitions, most

have been intramarket deals rather thanmergers between players operating in differ-ent geographic territories. This reflects thestock markets preference for combinations

that offer clear and realistic cost-saving bene-fits. In addition, many investors are averse toacquisitions that dilute earnings, especially ifany shortfall cannot be recovered in a rea-sonably short time.

As eligible merger partners dwindled inthe late 1990s, acquisition trends changed.Notably, out-of-market deals became morefrequent. In some large acquisitions, such asthe 1998 deals between First Union Corp.(now Wachovia Corp.) and First Fidelity, andbetween BankAmerica and NationsBank

Corp., banks bought into new geographicmarkets. A bank may adopt such a strategyif it cannot find a suitable intramarket merg-er partner, or if a certain geographic serviceterritory is growing faster than its own.

At that time, the industry began to favoracquisitions of nonbank financial institu-tions, which had something to offer otherthan traditional retail branch networks.Banks appeared to be more willing thanbefore to acquire customer bases for high-margin lines (such as credit cards) or for

businesses that give them a national brand-name presence. The trend toward diversifica-tion may have been dampened in 2001 and2002 by tighter regulation, weakness in capi-tal markets, and credit quality concerns. Inrecent years, the industry has seen a numberof spin-offs and divestitures as banks havereturned to a focus on core lending opera-tions. Looking forward, however, we expectthat banks seeking external growth may fo-cus on wealth management companies andconsumer finance companies.

Trends in activity relate to stock pricesThe rising stock prices that boosted ac-

quirers war chests between 1996 and mid-1998 inflated the cost of takeovers. In 1995,the median bank was acquired for 1.6 timesbook value, according to Highline Data. Asbank stocks peaked in 1998, the median pricewas 2.4 times book, and acquisitions beganto look less attractive. Conversely, lowerstock prices in 2001 and 2002 lowered theprice tags of potential acquisitions, but the

trend also reduced acquirers purchasing


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power. In 2001 and 2002, acquisition pricesdropped back to around 1.6 times book value.

According to Highline Data, the total pur-chase price of announced and completedbank acquisitions was $40.3 billion in2001, $17.2 billion in 2002, $72.8 billionin 2003, $129.8 billion in 2004, $71.3 bil-lion in 2005, and $114.7 billion in 2006. Forthe first three quarters of 2007, the total ofall announced purchase prices was $63.5 bil-lion; the largest of these transactions was less

than $10 billion, and only three transactionswere worth more than $2 billion. Median ac-quisition prices increased in 2003, 2004, and2005 to about 1.9, 2.0, and 2.0 times bookvalue, respectively, and to 2.2 times book in2006. (See the Top announced bank merg-ers table for deals in 2006 and 2007.)

In the first three quarters of 2007, 201FDIC-insured institutions were absorbedthrough mergers or other consolidationmoves, compared with 342 mergers or consol-idations in 2006, 315 in 2005, 322 in 2004,

275 in 2003, 297 in 2002, 357 in 2001, 453

in 2000, and 606 in 1995. The number ofbanks involved in deals per year has been rel-atively steady since the start of 2002, with alow of 275 in 2003 and a high of 342 in2006. The dollar volume of merger activity,however, has increased since the end of 2004,due to the large size of several recent deals.

US banking system remains healthy

The banking industry is financially strong.

This is evidenced by several major indicators,such as the number of problem banks, bankfailures, the loan delinquency rate, the levelof charge-offs, and loan loss reserves. Addi-tional measures of industry financial strengthare the percentage of banks that are not prof-itable, industry net income growth, return onequity (ROE), and the equity to capital ratio.

As of June 30, 2007, the FDIC classified61 insured institutions, with combined assetsof $23.1 billion, as problem institutions those having financial, operational, or man-

agerial weaknesses that threaten their viabili-

TOP ANNOUNCED BANK MERGERS 2006-2007(As of October 11, 2007; ranked by deal value)

COMPLETION DEALANNOUNCED DATE/ VALUE

BUYER TARGET DATE STATUS (MIL.$)

1. Mellon Financial Corporation Bank of New York Company Inc. 12/4/2006 7/1/2007 29,054.6

2. Wachovia Corporation Golden West Financial Corp. 5/7/2006 10/2/2006 25,500.8

3. Bank of America Corporation LaSalle Bank Corp. 4/23/2007 10/1/2007 16,000.0

4. Capital One Financial Corp. North Fork Bancorporation 3/12/2006 11/30/2006 15,132.8

5. Regions Financial Corporation AmSouth Bancorporation 5/25/2006 11/4/2006 10,001.2

6. Banco Bilbao Vizcaya Argentaria Compass Bancshares, Inc. 2/16/2007 9/7/2007 9,713.6

7. TD Bank Financial Group Commerce Bancorp, Inc. 10/2/2007 Pending 8,684.5

8. PNC Financial Services Group Mercantile Bankshares Corp. 10/9/2006 3/2/2007 5,990.3

9. State Street Corporation Investors Financial Services 2/5/2007 7/2/2007 4,493.6

10. Huntington Bancshares Inc. Sky Financial Group, Inc. 12/20/2006 7/1/2007 3,578.6

11. J.P. Morgan Chase & Company Bank of New York 4/8/2006 10/2/2006 3,100.0

12. Banco Bilbao Vizcaya Argentaria Texas Regional Bancshares 6/12/2006 11/10/2006 2,159.8

13. National City Corporation MAF Bancorp, Inc. 5/1/2007 9/1/2007 1,911.7

14. Merrill Lynch & Co First Republic Bank 1/29/2007 Pending 1,779.5

15. People's United Financial Inc. Chittenden Corporation 6/27/2007 Pending 1,759.7

16. Royal Bank of Canada Alabama National BanCorporation 9/6/2007 Pending 1,641.6

17. Wells Fargo & Company Greater Bay Bancorp 5/4/2007 10/1/2007 1,474.5

18. National City Corporation Harbor Florida Bancshares, Inc. 7/11/2006 11/30/2006 1,107.9

19. Fifth Third Bancorp First Charter Corporation 8/16/2007 Pending 1,088.6

20. Citizens Banking Corporation Republic Bancorp, Inc. 6/27/2006 12/29/2006 1,053.5

21. National City Corporation Fidelity Bankshares, Inc. 7/27/2006 1/5/2007 1,032.7

22. Washington Mutual, Inc. Commercial Capital Bancorp, Inc. 4/23/2006 10/2/2006 951.4

23. Rabobank Nederland Mid-State Bancshares 11/2/2006 5/1/2007 848.6

24. Susquehanna Bancshares, Inc. Community Banks, Inc. 5/1/2007 Pending 832.2

25. CapitalSource Inc. TierOne Corporation 5/17/2007 Pending 651.9

Source: Highline Data.


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ty. Although this figure is above the low levelof 50 institutions at December 31, 2006, it isdown substantially from 2002, when the figurestood at 136. To place these recent figures ina historical context, at year-end 1991, 1,426banks with $819 billion in assets were classi-

fied as problem institutions.The decline in the total number of USbanks in the late 1980s and early 1990s re-flected not only industry mergers but also arelatively high level of bank failures. The an-nual total of closings and assistance transac-tions, otherwise known as bank failures,peaked at 534 in 1989, according to FDICstatistics. The number of failures rapidly de-clined after 1992, to a level of only one in1997. Only in 2002 did the number of fail-ures exceed 10, and in 2005 and 2006, there

were no failures. So far, in 2007, there hasbeen one failure. There were no bank failuresfrom June 25, 2004, to February 2, 2007 a record-setting length of time, according tothe FDIC.

The percentage of noncurrent loans stoodat 0.90% at June 30, 2007, up from 0.83%at March 31, 2007, 0.78% at December 31,2006, and 0.70% at June 30, 2006 (the all-time low), according to the FDIC. These lev-els are all down significantly from the peaklevels reached in 1991, when the industry-

wide level of noncurrent loans as a percent-age of total loans was above 6.0%.

The level of net charge-offs as a percent-age of loans and leases is another indicationthat lending credit quality remains high byhistorical standards. A net charge-off is thesum of an uncollectible loan, minus any re-coveries of collateral, divided by average

loans and leases. In the first half of 2007, netcharge-offs were 0.34%, down from 0.45%in the year-earlier period.

The level of loan loss reserves is reducedby charge-offs and must be replenished byloan loss provisions, which, in turn, reduce

net income. Some key indicators of bankingindustry health are the level of loan loss re-serves as a percentage of total loans and leas-es, and as a percentage of nonperformingloans. Although total industry reserves of$81.2 billion have increased 4.6% since De-cember 31, 2006, and 4.2% since June 30,2006, we are concerned that reserves arelow, as a percentage of total loans and leases.At June 30, 2007, this figure stood at 1.09%,slightly above the low of 1.07% at December31, 2006, which was a 30-year low, accord-

ing to the FDIC. Reserves as a percentageof nonperforming loans and leases declinedto 121% as of June 30, 2007, down from159% a year earlier; this may require addi-tional loan loss provisioning, which couldaffect industry profitability.

Although the industry is healthy, accord-ing to the measures of bank failures andnoncurrent loans, we are concerned about arecent increase in the percentage of banksthat are not profitable, which could possiblyforeshadow an increase in future bank fail-

ures. Through June 30, 2007, the percentageof banks that were not profitable rose to9.39%, up from 7.88% at December 31,2006, and 6.81% a year earlier.

Net income for all FDIC-insured commer-cial banks totaled $72.7 billion in the firsthalf of 2007, down 2.9% from $74.8 billionin the year-earlier period, as net interestincome growth of 3.7% and noninterest in-come growth of 5.5% were more than offsetby a 5.2% increase in noninterest expense. In2006, net income totaled $128.6 billion, up

12.5% from $114.3 in 2005. Net income hasgrown 11.6% annually since 1989.

Another measure of industry profitabilitythat bears watching is the recent decline inreturn on equity (ROE). In the six monthsended June 30, 2007, ROE for the industrydropped to 11.49%, on an annualized basis,down from 12.34% in the full year 2006,which in turn was slightly down from 12.46%in 2005. Up from a mid-single-digits level inthe late 1980s, ROE fluctuated between12.0% and 15.0% from 1992 to 2006. The

decline in ROE seen in 2007 is related to

LOAN QUALITY ALL COMMERCIAL BANKS(All items as a percentage of total loans and leases)

*Through June.Source: Federal Deposit Insurance Corporation.

Nonperforming assets

Loss reserves

Net charge-offs

Provision for loan losses

1989 91 93 95 97 99 01 03 05 2007*

6

5

4

3

2

1

0


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higher noninterest expenses and loan lossprovisioning reported by many banks in thefirst half of 2007.

The equity to capital ratio is another indi-cator of bank balance sheet strength. This ra-tio has steadily increased since 1987, when it

was approximately 6.0% for the industry, toa level of 10.5% at the end of 2006. Mostrecently, at June 30, 2007, the equity to capi-tal ratio stood at 10.27%.

Consumer bankruptcies tumble afterbankruptcy reform in 2005

Consumer bankruptcies had risen fromthe late 1990s through 2005 and that trendhad concerned us. There was a surge inbankruptcies in 2005 that resulted from

consumers rushing to file before the Bank-ruptcy Abuse Prevention and ConsumerProtection Act of 2005 that took effect inmid-October 2005.

A major provision of the 2005 bankrupt-cy law a provision that affects the bank-ing industry is the needs-based bankruptcytest. For all filers with incomes above thestate median, the test determines if a filerwill file Chapter 7 bankruptcy or Chapter13. Under Chapter 7, debts are dischargedby liquidation of assets; under Chapter 13,

the filer repays the lesser of either $10,000or 25% (but no less than $6,000) of unse-cured nonpriority debt (e.g., credit card debt)over a five-year period.

The bankruptcy law limits the amount ofreal estate assets that a borrower can shelterfrom creditors, bars the discharge of certaineducational loans and credit incurred to paystate or local taxes, and broadens the cate-gories of retirement funds sheltered fromcreditors. We believe that the 2005 bank-ruptcy law will be beneficial to the banking

industry in the long term by reducing thenumber of Chapter 7 filings and by increas-ing the likelihood of recovery and theamount of funds recovered.

According to the Administrative Officeof the US Courts, which provides support tothe federal judiciary branch, consumerbankruptcy filings reached 2.04 million dur-ing 2005, up 30% from 2004 and up 25%from the previous record of 1.625 million in2003. In 2006, consumer bankruptcy filingssank to 597,965, well below the average

prior to the enactment of the 2005 bank-

ruptcy law. Consumer bankruptcy filingscontinue to represent a growing percentageof total bankruptcy filings they accountedfor 96.8% of total filings in 2006. By con-trast, consumers made 86.8% of total filingsin 1980.

Whatever its cause, the recent bankruptcybooms cost to creditors and to financiallyresponsible debtors was significant. Al-though bankruptcy laws are designed to helpconsumers, the tidal wave of filings also hurtthem in a number of ways. For instance,lenders often pass much of the cost of bank-ruptcies on to consumers in the form of higherfees and interest charges. In essence, borrowersend up footing the bill for those bankruptcies.Second, the higher rates of bankruptcy maydiscourage lenders from making loans to

marginal borrowers: individuals who bare-ly qualify for credit based on income. Thus,many low-income families may find it moredifficult and costly to obtain credit.

Customer service and convenienceremain a focus for banks

Customer service and convenience havetaken on a new importance in the bankingindustry. Many banks now offer extendedhours, prime locations, customer-friendly

products, Internet banking, reduced fees,and faster, more personalized customer ser-vice. In the highly competitive environmentof major metropolitan areas, it is increas-ingly important for banks to differentiatethemselves. There has been a growing trendtoward extending branch hours and offer-ing good customer service. Several banksnow waive ATM fees and offer more inter-action between customers and associates.Several banks use the customer-associate in-teraction to offer cross-selling opportunities

for additional products and services (e.g.,insurance).

Much of this competition has beenbrought on by several key players offeringabove-average service and establishing them-selves in new markets at a rapid rate, mainlythrough de novo branch building. (De novobranches are built from scratch, rather thanacquired through mergers and acquisitions.)These branches tend to have prime locations,with several additional offices within reason-able proximity. Several banks have also start-

ed determining their expansion plans based


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on the existing customer base. For example,several banks with locations in New Englandhave expanded into Florida; they know thatmany past customers have retired to Florida,and some current customers have vacationhomes there. In addition, Florida has a

rapidly growing population, making it evenmore attractive.

New regulations raising costsFor the past several years, the US banking

industry has focused on regulatory issues,such as the corporate governance provisionsof the Sarbanes-Oxley Act (enacted in 2002)and the banking-related parts of the USA Pa-triot Act (enacted in 2001). These provisionsare now beginning to have an impact. Small-er community banks have contended that it

is difficult for them to comply with certainSarbanes-Oxley provisions, such as the re-quirement that audit committees be com-posed entirely of independent directors andthat companies have a financial expert onthe board of directors. The provisions of theUSA Patriot Act require increased invest-ments in technology, though many in the in-dustry have questioned the effectiveness ofthese investments in preventing the fundingof terrorist groups or activities.

New regulations are driving banks to a

new level of accuracy and disclosure in anumber of other reporting areas. The BaselCommittee on Banking Supervision, anagency of the Bank for International Settle-ments, released its framework for new inter-national capital standards known as theBasel II Capital Accord in June 2004. Therules will govern how much capital bankswill be required to hold.

US regulators were expected to issue com-pliance requirements for US banks in 2007,with implementation expected by year-end

2007, but there have been several delays; it isnow uncertain when this will happen. Whenthe Basel II Capital Accord goes into effect,all top US banks must be in compliance,with risk management systems in place toalign their risk measurement and risk capi-tal with their regulatory capital. Under BaselII, banking companies will be required to ac-curately report transaction positions, markedto the market, almost daily. Achieving com-pliance appears to be a complicated processthat will demand significant technical and

organizational changes.

HOW THE INDUSTRY OPERATES

Commercial banks serve as intermediariesbetween customers who save money andcustomers who borrow it. Their principalactivities are collecting deposits and disburs-

ing loans.Individual commercial banks may di-verge widely in terms of markets servedand earnings sources, as we discuss in thissection. Other industry concerns that weconsider are: costs related to obtaining andmaintaining adequate funding sources; theinherent risks in financing at a given inter-est rate; Federal Reserve policies and theireffect on interest rates; and competitive in-fluences on the retail (consumer) and com-mercial strategies of regional and money

center banks.

Business type

Although mergers and the consolidationof business activities have blurred the lines ofdistinction in recent years, there are twomain categories of banks: money centersand regionals. Money center banks tend tobe located in major US financial centersand are typically involved in internationallending and foreign currency operations.

Regional banks tend to be located in oneor a few geographic areas or states, wheretheir lending and deposit activities are gen-erally focused.

The merger of several large regional banksin the late 1980s spurred the creation of anew type of regional bank, the so-calledsuper-regional. Such banks operate acrossmany states or geographic areas and can benational in scope.

The Federal Deposit Insurance Corpora-tion (FDIC) classifies all banks according to

the geographic regions in which they operate.The six regions, identified by their majorbanking centers, are New York, Atlanta,Chicago, San Francisco, Dallas, and KansasCity. As of June 30, 2007, 7,350 commercialbanks operated in the United States, with to-tal assets of $10.41 trillion. New York had564 banks (with $1.61 trillion in assets); At-lanta, 1,070 banks ($2.73 trillion); Chicago,1,490 banks ($2.68 trillion); San Francisco,703 banks ($1.957 trillion); Dallas, 1,628banks ($565 billion); and Kansas City,

1,895 banks ($872 billion).


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Bank assets

A commercial banks earnings are derivedfrom a variety of sources. These sources, orearning assets, include loans (commercial,consumer, and real estate) and securities (in-

vestment and trading account).

LoansAccording to FDIC statistics, aggregate

loans outstanding were valued at $7.47 tril-lion on June 30, 2007. Loans secured by realestate accounted for 62% of that sum, fol-lowed by commercial and industrial (C&I)loans (17%), consumer loans (13%), andother loans (8%).

Commercial and residential real estateloans, secured by customers property, are

generally long-term installment mortgages.Prime residential mortgages generate a pre-dictable cash flow and are usually the leastrisky type of loan. Commercial real estateand interim construction loans are medium-term loans that generate high yields but alsocan carry high risks.

C&I loans come in many variations, rang-ing from variable rate lines of credit, up to15-year fixed-rate loans, and may be eithersecured or unsecured. Often the lowest yield-ing of a banks loans, C&I loans usually in-

clude compensating balance requirements,commitment fees, or both, although these re-quirements are becoming less common in to-days intensely competitive environment.Processing costs are relatively low for C&Iloans, and pricing (i.e., interest rates andfees) is flexible.

Consumer loans, comprising installmentand credit card lending, are usually medium-term in maturity, with predictable principaland interest payments that reliably generatecash flow. Credit risk and processing costs

are generally higher than for business loans,and yields are subject to usury ceilings insome states.

SecuritiesBanks purchase securities as investments,

with some 95% of their securities portfoliostypically invested in fixed-income securities.A fixed-income securitys value depends onthe interest rate it carries, and the securitysvalue fluctuates with the market level of in-terest rates. Securities may be taxable (such

as US government bonds and other securi-

ties) or tax-exempt (such as state and localgovernment securities). The maturities ofthese financial instruments vary widely.

Banks purchase securities as a means ofearning interest on assets while maintainingthe liquidity they need to meet deposit with-

drawals or to satisfy sudden increases in loandemand. In addition, securities diversify abanks risk, improve the overall quality of itsearning assets portfolio, and help the bankmanage interest rate risk.

Investment securities are an importantsource of a banks earnings, particularlywhen lending is weak but funds for investingare plentiful. US banks are major partici-pants in the bond market. Municipal bondsgenerally have longer terms and less liquiditythan US government and Treasury bonds,

but their tax-exempt feature is attractive inthat it reduces taxable income.

Trading account securities are interest-bearing securities held primarily for realizingcapital gains. Because their trading perfor-mance is strongly affected by interest ratetrends, they carry a high risk. According tothe FDIC, banks had aggregate securities of$1.977 trillion at June 30, 2007, and $1.980trillion at December 31, 2006, up from$1.893 trillion at year-end 2005.

Bank liabilitiesA banks principal liabilities consist of de-

posits, debt, and shareholders equity. Depositsinclude consumer demand and time deposits,corporate demand and time deposits, foreigndeposits and borrowings, and negotiable cer-tificates of deposit (jumbo CDs, usually soldin denominations of $100,000 or more).Debt includes federal funds and other short-term borrowings (such as commercial paper),as well as long-term debt.

Consumer savings plans with commercialbanks consist of demand deposits (such aschecking accounts) and time deposits (nego-tiable order of withdrawal accounts and six-month money market certificates). Thesesources of funds, which usually account forabout 70% of bank liabilities, have histori-cally proven to be stable and important forbanks. The interest rates that they commandvary with overall money market interest ratesor the duration of the time deposit, and theymust be competitive in order to attract and

keep depositors.


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Low deposit interest rates (in the range of2% to 4%) resulted in minimal deposit growthat a low-single-digit annual pace in the late1990s, as consumers sought investments withhigher rates of return, such as mutual funds.The stock markets malaise in 2001 and

2002 led to a flight to safety, with moreinvestment dollars going into bank accounts.Although equity markets have regainedstrength since then, deposits have continuedto grow at a high-single-digits pace, mostlikely attracted by increasing rates. Accord-ing to the FDIC, deposits held in domesticoffices (US offices of all banks, whetherforeign or domestic) grew 7.9% in 2001,7.6% in 2002, 6.2% in 2003, 10.6% in2004, 8.8% in 2005, 9.6% in 2006, and2.7% in the six months ended June 30, 2007.

Interest rate risks

Assets and liabilities can mature or berepriced in periods ranging from overnight to30 years. Most of them, however, mature inless than one year, and few extend beyondfive years. Interest rate risk occurs when a li-ability matures or is repriced at a time that isnot synchronized with the asset that it isfunding.

As a rule, banks do not match assets and

liabilities on a one-to-one basis. Instead, as-sets and liabilities are grouped together intospecific time frames, such as overnight, 30days, 90 days, one year, and the like. Thus,within a given period, banks can determinetheir interest rate sensitivity.

If more of its liabilities than assets reachmaturity or are repriced, a bank is said to beliability-sensitive or to have a negative gap. Ifmore assets mature than liabilities, the bankis said to be asset-sensitive, or to have a posi-tive gap. If a banks assets and liabilities are

evenly matched, it is said to be balanced. In aperiod of falling interest rates, a bank witha negative gap (liability-sensitive) will see netinterest margins widen. Conversely, a bankwith a positive gap (asset-sensitive) will bene-fit during a period of rising rates.

The banking industrys concern with limit-ing its interest rate risk has grown since1979, when bank policy changes by the Fed-eral Reserve resulted in high and extremelyvolatile interest rates. As a result, most bankloans now come with variable rates. Conse-

quently, much of the interest rate risk has

been shifted from the lender to the borrower.On the funding side, many of the debts, de-posits, and preferred stock dividends alsocarry variable rates, which shifts some riskback to the bank.

Because techniques for managing assets

and liabilities have become highly sophisti-cated, banks are generally well hedgedagainst interest rate risks. For example, inter-est rate hedging (with futures, options, andswaps) and the use of Macaulay durationmatching (which involves balancing liabilitiesand assets) have been widely adopted.

Regulation: the Feds influence

Unlike the capital market, which deals inlong-term investments, such as stocks and

bonds, the money market is the arena inwhich banks, corporations, and US govern-ment securities dealers can lend or borrowfunds for short periods (one day to oneyear). As a major player in this arena, theFederal Reserve has a great deal of influenceover the amount of funds available in thebanking system on a day-to-day basis.

The Fed has three methods of adjustingthe money supply. One is by conductingopen-market operations, such as buying andselling Treasury bills. By virtue of the laws of

supply and demand, this method has a directimpact on the rate charged for federal funds(reserves loaned by one bank to another, typ-ically overnight, to cover a shortfall in reserverequirements or to profit from excess reserves).Open-market operations also influence theinterest rate structure of the economy as awhole, albeit indirectly.

By reducing the amount of Treasury billsit sells and thus decreasing supply, the Fedcan cause the federal funds rate to rise. Risinginterest rates curtail demand for borrowing

by increasing the cost of funds. In addition,when the money supply is restricted, banksmust rely more heavily on expensive pur-chased funds. Banks must then become moreselective in their lending and perhaps evenraise their prime rate (the interest rate onloans to large creditworthy corporations).

A second way for the Fed to control themoney supply is by raising or lowering thediscount rate, which is the interest rate thatthe Fed charges member banks for loans us-ing government securities as collateral. Small

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to the bond markets regarding Federal Re-serve monetary policy, thus influencing mar-ket interest rates.

The Feds third means of controlling themoney supply is to raise or lower banksreserve requirements on deposits. Far more

powerful than open-market operations, thismethod is rarely used. Raising reserve re-quirements reduces banks ability to extendloans, thus tightening money supply.

The Fed most recently changed reserve re-quirements in February 1992, when it triedto stimulate bank lending by lowering the re-serve requirement on checking, negotiableorder of withdrawal (NOW), and othertransaction accounts from 12% to 10%.The Feds action in 1992 marked the firstchange in reserve requirements on these

kinds of accounts since 1980.Since the Volcker era began in 1979, the

Fed has been lauded for controlling priceinflation. It is important to note, however,that the Feds control over the market is notabsolute, and that monetary policy does notalways achieve the desired effect. For exam-ple, a tightening in monetary policy is gen-erally intended to reduce demand for bankcredit. However, it can initially increase de-mand for two reasons. Many creditworthycustomers substitute short-term borrowings

for long-term debt in the hope of obtainingbetter terms on permanent financing later.In addition, because customers tend to bor-row in advance of actual needs (to ensurethat they have adequate funds at their dis-posal), they may actually increase their bor-rowing when rates initially rise to avoideven higher costs later.

Glass-Steagall repeal opens doorsIn November 1999, the US Congress

passed the Gramm-Leach-Bliley (GLB) Act,

also known as the Gramm-Leach-Bliley Fi-nancial Services Modernization Act, whicheffectively repealed the Glass-Steagall Act.Approved in 1933 at the height of the GreatDepression, Glass-Steagall authorized depositinsurance and restricted banks ability to en-gage in debt and securities underwriting inan effort to protect bank depositors.

A 1987 revision to the Glass-Steagall Actallowed commercial banks to engage in spe-cific securities activities, subject to limita-tions. Specifically, the provision authorized

banks to earn up to 5% of their revenues

(raised to 10% in 1989 and 25% in 1996)from securities underwriting by letting bankholding companies establish separate unitsfor that purpose. Concurrent with the 1987revision, investment banks were permitted toenter commercial banks traditional turf by

offering such services as check writing.GLB created a new kind of financial hold-ing company that is permitted to expand intoa variety of business activities related to fi-nancial services. These activities include theunderwriting and selling of insurance and se-curities, commercial and merchant banking,investing in and development of real estate,and other complementary activities. (As be-fore, however, holding companies are re-stricted from having interests in enterprisesthat are nonfinancial in nature.) GLB also al-

lows affiliations between banks and insur-ance underwriters and prohibits state actionsthat prevent bank-affiliated firms from sell-ing insurance on an equal basis with otherinsurance agents.

An existing bank holding company canbecome a financial holding company, provid-ed that its depository institutions are wellcapitalized (as described in this SurveysHow to Analyze a Bank section) and wellmanaged, and that those institutions have re-ceived a rating of at least satisfactory from

the most recent Community ReinvestmentAct examination.

As a result of the repeal of Glass-Steagall,commercial banks have pushed their wayinto the fields of investment management,mutual funds, insurance, municipal finance,and corporate investment banking. Such ac-tivities provide diversified sources of nonin-terest income for commercial banks. Therepeal also opened traditional banking ac-tivities to competition from other financialinstitutions.

The Community Reinvestment ActCongress enacted the Community Rein-

vestment Act (CRA) in 1977 to encouragefederally insured banks and thrifts to helpmeet the credit needs of their entire commu-nity, including low- and moderate-incomeneighborhoods, consistent with safe and soundoperations. The CRA requires each federalbank regulatory agency to assess each feder-ally insured institutions record of compliance.The four federal bank regulatory agencies

responsible for enforcing the CRA include


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the FDIC, the Federal Reserve System, theOffice of the Comptroller of the Currency,and the Office of Thrift Supervision.

In 1995, CRA regulations were substan-tially revised to put greater emphasis on per-formance as opposed to process, and to

establish different evaluation tests for differ-ent kinds of institutions: large institutions,small institutions, and wholesale and limited-purpose institutions. Streamlined procedureswith an emphasis on lending were adoptedfor small institutions, while large banks areevaluated under a three-part lending, service,and investment test. Wholesale and limited-purpose banks are evaluated under a com-munity development test.

Assessing new opportunities

As noted earlier, many restrictions onbanks imposed by the original Glass-SteagallAct had already been whittled away, so GLBsimply brought an old law up to date witheconomic reality. The reform has not led to arash of mergers between companies in thethree major businesses concerned (commercialbanking, insurance, and investment banking),though many banks have diversified into newbusiness areas.

Some of the new businesses in whichbanks are now permitted to invest, most no-

tably insurance, are not viewed as particular-ly enticing. For example, Citigroup Inc. wasformed in October 1998 through the mergerof a bank (Citicorp) and an insurance com-pany (Travelers Group), which would nothave been permitted under the old law.However, Travelers was involved in severalbusinesses other than insurance most im-portantly, investment banking, through its

Salomon Smith Barney subsidiary. Indeed, inAugust 2002, Citigroup spun off Travelersproperty-casualty business.

Banks may be tempted to purchase an in-surance operation to become more verticallyintegrated, or to add an insurance companys

sizable investment portfolio to its own. How-ever, many insurance lines, such as property-casualty, are actually quite volatile andpotentially high in risk, and their investmentreturns can be lower than those of tradition-al banking businesses.

Compared with property-casualty, life in-surance would seem to be a better fit withbanks appetite for risk and return. Further-more, banks do have some potential synergieswith insurance companies: notably, bankslarge distribution networks and broad cus-

tomer lists create opportunities for the cross-selling of products and services. Many bankshave become active agents of insurance com-panies by selling annuities and other insur-ance products.

The industry has seen some melding ofcorporate banking and investment bankingand brokerage operations, including themerger of the retail brokerage forces of Wa-chovia and Prudential Financial Inc. in July2003. However, issues surrounding the inde-pendence of stock research, allocation of ini-

tial public offerings, and unique financingarrangements got a number of larger diversi-fied banks into some trouble and caused awidespread loss of investor confidence. Fol-lowing Senate hearings in 2002 and actionsby the Securities and Exchange Commissionand other regulators, these incidents have ledto greater regulatory oversight and may havedeterred commercial banks forays into invest-ment banking activities, at least temporarily.

Interest rates: a factor in profits

The outlook for interest rates has impor-tant implications for bank profits. Becausebanks derive most of their profits from netinterest income (the interest income receivedon loans minus the interest expense for bor-rowed funds), interest rates influence howmuch money a bank can make.

Net interest margin (a banks net interestincome divided by its average earning assets)is a common measure of a banks profitabili-ty. Net interest margins widen or narrow de-

pending on the direction of interest rates, the

MONEY RATES VS. LOAN RATES(In percent)


Prime loan rate

Certificates of deposit

12

10

8

6

4

2

01989 91 93 95 97 99 01 03 05 2007


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mix of funding sources underlying the loans,and the duration (or time period until expi-ration) of the investment portfolio.

Falling interest rates have a positive effecton banks for several reasons. They can makenet interest margins expand, at least in theshort term; while banks are still earning ahigher-than-market yield on loans, the costof funds goes down more quickly in responseto the lower rates. Second, declining rates en-hance the value of a banks fixed-rate invest-ment portfolio, since fixed rate bondsbecome more valuable as prevailing ratesdrop. Furthermore, falling rates lower thecost of credit, which often stimulates loan

demand and reduces delinquency rates.Of course, rate decreases do not affect all

banks equally. Liability-sensitive banks those that rely more heavily on borrowedfunds than on customer deposits to fund loangrowth typically reap greater benefits.

In the broadest sense, banks are inherentlyasset-sensitive because they derive a signifi-cant portion of their funding from essentiallyfree sources, such as equity issues or demanddeposits. This is especially true of the smallerregional banks that focus on garnering retail

(consumer) deposits and that have limitedaccess to the purchased money markets. Un-less they work to reduce their asset sensitivity,they tend to do better in periods of risinginterest rates.

Money center banks, however, rely heavilyon borrowed funds, and have a small retaildeposit base relative to their asset size. Thus,they tend to be liability-sensitive and theirlending operations benefit most during peri-ods of falling rates.

Fluctuations in interest rates, while impor-

tant, do not have an absolute influence over

the net interest margins of commercialbanks, primarily because banks are able toadjust to such fluctuations. In theory, bankscan match the maturities of their assets(loans and investments) and liabilities (de-posits and borrowings) so that rates earned

and rates paid move more or less in tandem,while net interest margins remain relativelystable. In addition, banks can make use ofhedging techniques to reduce their sensitivityto interest rates. In practice, however, banksgenerally deviate from a perfectly balancedposition.

Infrastructure and operating costs

Banks physical capital requirementsmainly include constructing and maintaining

branch offices (which are either owned orleased), and buying and maintaining comput-ers and other machines used in the course ofproviding services. Banks try to economizetheir infrastructure costs by having branchlocations within similar geographic regions.

As in most industries, other large costcomponents consist of salary and benefits,supplies, and insurance. Most expense lineitems tend to rise over time with inflation.In recent years, the low inflationary envi-ronment has allowed banks to restrain

cost increases. In addition, technologicalimprovements including the introductionof online banking and automated teller ma-chines (ATMs) have provided for the re-placement of certain labor-intensive functionswith computers or other forms of automa-tion, allowing increased productivity and arelated improvement in the salary and bene-fits cost structure. Separately, mergers andinternal consolidation measures have led tosubstantial gains in overall efficiency.

Competitive strategies: retail andcommercial

Most banks in the United States are smallentities competing in limited markets for localbusiness. Often, these banks which haveretail as well as commercial operations must compete for retail business againstmoney center banks and large regional banksoperating in their territories.

Retail banking, because it seeks to attractindividual consumers, remains a service-

oriented business. Todays banks are increas-

SPREAD BETWEEN SHORT-TERM/ LONG-TERM YIELDS(In percent)


10-year Treasury bond

3-month Treasury bill

Yield spread

8

7

6

5

4

3

2

1

0

(1)1997 98 99 00 01 02 03 04 05 06 2007


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ingly investing in new technology to makebanking more pleasant and convenient forcustomers. ATMs, drive-through windows,and home banking services via phone orpersonal computer are all ways in whichbanks have attempted to improve the cus-

tomer experience.Competition has heated up in the retailmarket as some banks have expanded andachieved economies of scale through acqui-sitions. Interstate banks have the servicingadvantages of larger ATM networks andmore product offerings, such as mutualfunds, insurance, and a variety of loanproducts.

Industry competition has intensified as theconsolidation wave has swept into every cor-ner of the financial services industry. Consol-

idation has forced banks to rethink theircorporate strategies in many areas, includinggeographic expansion, pricing of productsand services, and efficiency optimization.Merged companies often set lofty perfor-mance goals for themselves to attain im-proved earnings growth, better returns onassets and equity, and enhanced efficiencylevels. Such improvements also raise the levelof competition.

Increasingly, commercial banks must com-pete for retail business against other types of

financial institutions, such as credit cardcompanies and other specialized consumerlending organizations. Some banks have eventurned to buying these institutions to acquiretheir large customer bases, strong marketingskills, and efficiency levels.

KEY INDUSTRYRATIOS AND STATISTICS

Interest rates. Interest rates are the key

macroeconomic indicators affecting banks.For this reason, the banking world is highlyconcerned with Federal Reserve policy andits influence on interest rates. Bank analystswatch both short- and long-term rates, aswell as the relationship between the shortand long markets, which can be graphed asthe yield curve.

Short-term rates, generally represented bythe discount rate (the rate charged by FederalReserve banks when they extend credit to de-pository institutions) or by the federal funds

rate (the rate charged among commercial

banks for overnight lending), are subject toFederal Reserve Board policy targets. Strongeconomic conditions and/or employment ac-tivity which can generate shortages inboth labor and goods, and fuel inflation may lead the Fed to raise interest rates.

Although long-term rates (as representedby the yield on 10-year bonds) are subject tothe same economic factors that influenceshort-term rates, they are controlled by mar-ket forces rather than by the Federal ReserveBoard. Because market forces make them re-act more swiftly to daily economic develop-ments, changes in long-term rates oftenprecede those in short-term rates, and thuscan be viewed as a leading indicator.

When long-term rates decline but short-term rates do not, it may mean that econom-

ic growth is falling or that unemployment isrising. In these circumstances, the Fed maydecide to lower interest rates to stimulate theeconomy. Conversely, when long-term rateshave risen but short-term rates have not, theFed may raise interest rates.

Interest rates can be followed in variousfinancial publications, including the businesssections of many newspapers. The FederalReserve reduced the federal funds rate 13times from 2001 to 2003. After the seven-teenth straight 25-basis-point increase in

June 2006, the federal funds rate was 5.25%.Following rate cuts on September 18 andOctober 31, 2007, the federal funds ratestood at 4.50%. The yield on the 10-yearnote was 4.27% on November 8, 2007,down from a high of 5.22% in July andfrom 4.71% on December 31, 2006 andstill low on an historical basis. Previous year-end yields were 4.24% in 2004, 4.27% in2003, 5.12% in 2000, and 6.43% in 1996.

Gross domestic product (GDP). Re-

ported quarterly by the US Department ofCommerce, GDP is the market value of allgoods and services produced by labor andcapital in the United States. As the broad-est measure of aggregate economic activity,it is an important macroeconomic indicatorfor banks. Growth in the economy is mea-sured by changes in inflation-adjusted (orreal) GDP.

When the economy is strong, businesseswant to borrow to fund expansion. Simi-larly, when job markets are favorable and

consumer confidence is up, demand for


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consumer credit increases. Conversely, eco-nomic slowdowns tend to reduce credit de-mand. In addition, shortfalls in corporateprofits and personal income can hurt creditquality.

In the early phases of an economic cycle,

increased business activity tends to stimulatethe financial markets, providing opportunitiesfor banks to increase their earnings. Theequation is not simple, however. Rapidgrowth in the economy can eventually driveup interest rates, as credit demand pushes upthe cost of credit. In addition, if the FederalReserve, which watches GDP closely, per-ceives that the economy is overheating, itwill raise interest rates to restrain inflation.Conversely, it will consider reducing rates ifinflation is slowing.

As the US economy rebounded from a re-cession in 2001, real GDP growth was 3.1%in 2003, 4.2% in 2004, and 3.2% in 2005.As of mid-November 2007, Standard &Poors was projecting real GDP growth of2.1% in 2007 and 1.9% in 2008.

HOW TO ANALYZE A BANK

When evaluating a bank, an analystshould consider both its profitability and

its financial condition. Taken alone, short-term profit trends can be misleading. Forexample, if a bank achieves loan growth byengaging in excessively risky lending, itmay be vulnerable to developments thatwould hurt its earnings or even threaten itssurvival over time.

It is important to note that the accountingsystems of financial institutions are differentfrom those of most other corporations. Tojudge a particular institutions earnings andfinancial security, an analyst must use several

measures. Such measures are most usefulwhen trends are examined over various peri-ods and compared with data from similarbanks.

Every bank makes trade-offs between theprofitability level it is striving to achieve andthe risks it is willing to take. When banks ofsimilar size and business profile are com-pared, a wide deviation from the norm onany one indicator can signal possible prob-lems or advantages. Before drawing conclu-sions, however, it is important to pinpoint

the reasons for the deviation.

Profitability measures

Return on assets (ROA). A comprehen-sive measure of bank profitability is ROA a banks net income divided by its averagetotal assets during a given period. A trend of

rising ROA is generally positive, provided itis not the result of excessive risk-taking.Because banks are highly leveraged, they

tend to have low ROAs, relative to other in-dustries. Historically, most banks have hadROAs within a range of 0.60% to 1.50%.Regional banks often have a higher-yieldingloan portfolio; because of this, over the longterm, they are more apt to have ROAs in theupper part of the range.

In the three months ended June 30, 2007,the industrys average ROA, annualized, was

1.21%, down from 1.34% in the secondquarter of 2006, according to the FederalDeposit Insurance Corp. (FDIC). For 2006,the average ROA was 1.28%, down slightlyfrom 1.30% in 2005. In the second quarterof 2007, average ROA was 1.33% for com-mercial lenders, down from 1.39% in thequarter a year earlier, and 1.79% for con-sumer lenders, up from 1.40%.

Return on equity (ROE). Another mea-sure of profitability, usually considered in

conjunction with ROA, is return on equity. Abanks ROE is calculated by dividing net in-come by average shareholders equity.

Because shareholders equity normally backsonly a small fraction (usually 5% to 10%)of a banks assets, ROE is much larger thanROA typically, ranging from 10% to 25%.In the second quarter of 2007, the industrysaverage ROE was 11.49%, compared with12.97% a year earlier.

Banks that rely heavily on deposits andborrowings to support assets, rather than on

stockholders equity, tend to have higherROEs. An unusually high ROE versus ROAcan indicate that the banks equity base istoo small compared with its debt; this highleverage may limit its ability to borrow further.

Yield on earning assets (YEA). Becausebanks can achieve a given profit level in avariety of ways, the components affecting netincome must be considered when evaluatingthe quality of earnings. Interest-earningassets loans, short-term money market

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and nontaxable investment securities are

the principal source of most banks interestincome.

The YEA is calculated by dividing interestincome on earning assets by the averagevalue of these assets during the same peri-od. Because some investment securities aretax-exempt, the interest income side of theratio usually is calculated on a tax-equivalentbasis to account for the added value of non-taxable income. (This is done by subtractingthe tax rate from 1.0, then dividing nontax-able income by that figure.)

Because it reflects general interest-rate lev-els, the YEA can fluctuate considerably overtime. If a banks YEA is high relative to thoseof other banks, it may indicate a high-riskportfolio of earning assets, particularly high-risk loans. If it is substantially lower thanthose of other banks, it may indicate that thebanks portfolio has several problem loansthat are yielding less than they should. Alter-natively, it may simply show that the bankhas overly conservative lending policies.

According to the FDIC, the average US

commercial bank had a YEA of 6.85% in thesecond quarter of 2007, up from 6.57% ayear earlier, reflecting an overall increase ininterest rates. For full-year 2006, the averageYEA was 6.45%, compared with 5.73% in2005 a 72-basis-point increase. Consumerlenders earned the highest YEA (8.84%) in2006, followed by commercial lenders (6.73%)and mortgage lenders (5.82%).

Cost of funding earning assets (COF).

The raw material that banks use to pro-

duce income is earning assets, and the cost of

obtaining such deposits and other borrowedmoney significantly affects bank profits. COFis calculated by dividing the total interestexpense on the funds a bank uses to supportearning assets by the total average level offunds employed in that way.

COF varies with the general level of inter-est rates and is affected by the make-up ofthe banks liabilities. The greater the propor-tion of a banks noninterest-bearing demandaccounts, low interest-rate savings accounts,and equity, the lower its COF will be. Conse-quently, retail-oriented banks that derive ahigher proportion of their funds from con-sumer deposit accounts tend to have lowerCOFs than wholesale banks that purchasemost of their funds in the form of federalfund borrowings, certificates of deposit that

have higher interest rates, and debt issuances.According to the FDIC, the average US

commercial bank had a COF of 3.51% inthe second quarter of 2007, compared with3.12% in the second quarter of 2006, re-flecting an overall increase in interest rates.For full-year 2006, the average COF was3.14%, compared with 2.24% in 2005 a90-basis-point increase, which was largerthan the 72-basis-point increase of the aver-age YEA. This led to a general narrowingof the average net interest spread and net

interest margin.

Net interest margin (NIM). The NIM iscalculated by dividing the tax-equivalent netinterest income by average earning assets.(Tax-equivalent net interest income is calcu-lated by subtracting interest expense fromtax-equivalent interest income.)

A NIM of less than 3% is generally con-sidered low; more than 5% is very high. Thisrange is only a rough guideline, however, be-cause NIM can vary with the particula

s&p banking

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