Bank Profits Are Up: Quality Of Bank Earnings Is Down

Includes: IYF, PFI, VFH, XLF
by: John M. Mason

Gretchen Morgenson wrote on the FDIC quarterly report on Sunday in the New York Times.

The summary of the report: bank earnings were up; and the return on bank assets was up. But the net interest margin earned by the banks was the lowest since 2006; allocations to the loan-loss reserve dropped by 23 percent from a year ago, helping to improve profit results; and loan delinquencies are still quite high. Furthermore, the banks are earning more from fees and other charges, which helped to offset the low net interest margin earned.

Two further pieces of good news: the number of problem banks dropped from 651 at the end of December 2012 to 612 at the end of March 2013; and there were only four banks that failed during the first quarter of the year.

The bad news is that there were 64 fewer banks in the banking system at the end of the first quarter of 2013 than there were at the end of 2012. This is an annual rate of 256 fewer banks at the end of the year than existed at the beginning. Of the 64 total, 48 of these were commercial banks, showing a potential annual rate of decline of commercial banks of almost 200.

Morgenson finally goes into the issue of loan quality. She reported "Loans that are delinquent more than 90 days accounted for 3.41 percent of total loans in the first quarter… Although this is down from more than 5 percent, a few years ago, it is still high. In 2007, for example, it was 0.83 percent."

Where should we be the most concerned? It looks like we should be concerned about the commercial banks that are less than $1.0 billion in asset size. In the smallest banks as of March 31, 2013, loans that were delinquent by more than 90 days totaled 2.36 percent of the amount of loans outstanding. On March 31, 2007, to be consistent with Morgenson's report, the comparable number was 0.96 percent.

Note that the amount of loans in this category of bank size were only 57 percent of the amount these banks held on March 31, 2007. That is, loan balances at this size of bank dropped by 43 percent over the last six years.

For commercial banks in the $100 million to $1.0 billion asset size, the loans that were delinquent by more than 90 days totaled 2.42 percent of the amount of loans outstanding.

Furthermore, the amount of loans in this category of bank size was only 89 percent of the amount these banks held on March 31, 2007. That is, loan balances at this size of bank dropped by more than 11 percent over the past six years.

Morgenson quotes Scott A. Anderson, chief economist at Bank of the West: "the FDIC report showed that scars from the financial crisis remained in the banking system." A result of this, Mr. Anderson continued, was that banks were still reluctant to lend… "even six years after credit started to seize up around the world…" I would add to this that the banks less than $1.0 billion in asset size are the most reluctant to lend.

The conclusion one can draw from this analysis is that there are still plenty of problems in the banking sector, and the greatest problems seem to be those being faced by the "less than large" banks in the system.

As I recently wrote:

Of the 216 commercial banks that left the banking system in the last 12 months "the number of smaller banks, those with assets less than $100 million in asset size produced 187 of the 216. The medium-sized banks (according to FDIC definitions), those with asset sizes between $100 million and $1.0 billion, declined by 41 units. That's right, commercial banks with an asset size in excess of $1.0 billion rose by 12 units, all of them coming from the FDIC's medium sized classification.

How about this? The commercial banking industry grew by almost $600 billion over the 12-month period ending March 31, 2013, an increase of about 4.5 percent.

Guess who grew? And, note, this, the commercial banks with more than $1.0 billion in assets accounted for 90.7 percent of the assets in the banking system on March 31, 2012, but accounted for 91.2 percent of the assets in the banking system on March 31, 2013!

And, if one looks at the Federal Reserve statistics, the largest 25 domestically chartered banks in the United States control about 56 percent of the banking assets in the country. Are commercial banks lending again?

The answer to this is yes, net loans and leases at commercial banks rose by 4.8 percent in the year ending March 31, 2013. And, guess who did the lending?

The loans of the smallest commercial banks in the country actually declined by $10.0 billion. The loans in the banks in the medium-sized category remained roughly constant, which means that all the lending taking place in the United States over the past 12 months, in aggregate, was at the largest banks in the country."

The banking system has a problem. And, it looks as if the problem seems to be centered in the smaller, less than $1.0 billion in asset size, banks.

The current bond buying programs of the Federal Reserve System are not going to rescue these "smaller" banks. These banks have asset problems and they just do not have the management skills to operate in the banking world of the 21st century.

Over the past six years, the number of banks in the less than $100 million asset size dropped by almost 1,300 banks. In the $100 million to $1.0 billion classification, there were 76 fewer banks.

This is the future. And in the meantime, these commercial banks are just not going to lend much. This is the heart of Main Street.

Will Main Street get loans? My answer to this is yes. Main Street will get loans from credit unions and alternative finance organizations. Just as we saw the massive decline in the thrift industry from its pinnacle in the 1960s and 1970s, we are going to see a restructuring of the financial system away from the smaller commercial banks to institutions that can better serve the Main Street community. It's just that a lot of this lending will take place in different institutions than we have experienced in the past.

Again, I recommend you to keep a special watch on what is going to happen in alternative finance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.