WASHINGTON - Though commercial banks, particularly the largest ones, continue to post record earnings, federal regulators said Friday that the trend may not continue because profits are being propped up by one-time gains on asset sales and skimpy provisions for loan losses.
"It would appear that because of the nature of the activities that are feeding the revenues of the larger banks, it will not be continuing as we move forward," said Nancy A. Wentzler, director of economic analysis at the Office of the Comptroller of the Currency. The outlook may be even worse for smaller banks.
Interest income, a key source of small-bank earnings, has been declining as a percentage of operating revenues, reaching 58% on Sept. 30, down from 75% in the mid-1980s.
"The competitive arena is getting tougher, banks are having to pay higher [deposit] rates, and the loan demand is not strong, so they have to keep rates low," said Warren Heller, research director for Veribanc, a Massachusetts-based banking research firm. "Their margins are getting squeezed."
Income from sources other than interest on loans made up 42% of total bank revenue, up from 40% in the second quarter, and is expected to continue increasing. Most of that increase can be found on the balance sheets of larger institutions, according to the OCC's quarterly Condition of the Banking Industry released Friday.
Small banks, hindered by higher costs of funds, lower return on equity, and a lack of access to hedging strategies like swaps, are finding it more difficult to compensate by increasing their noninterest income.
Large banks' noninterest income is derived from trading, fee-based activities, and fiduciary operations, but by far the largest portion falls into the nonspecific category of "other."
"That category captures a lot of activities that we cannot disaggregate," Ms. Wentzler said. She acknowledged that the lack of understanding about where bank income is coming from "gives us all pause - and gastritis."
A large portion of income in the category includes profits from asset sales and fees for special services, she said.
During the third quarter, she said, banks with more than $10 billion of assets benefited from loan-loss provisioning that fell, on average, to less than 0.5% of assets.
Banks with less than $100 million of assets have not performed as well. They have suffered a steady decline in operating income since 1997, and their loan-loss provisions have been climbing since 1994. Both factors have cut into earnings.
Commercial banks' performance - measured by earnings and returns on assets and equity - set records in the third quarter.
Net income was $19.4 billion in the quarter, up from $17 billion in the second quarter and $15 billion a year earlier. Banks' return on equity was 16.6% for the third quarter, up from 14.5% in the previous quarter and 13.3% a year earlier. However, for banks with less than $100 million of assets, ROE has been falling for seven years; it dipped below 10% in the third quarter.
The industry's return on assets was 1.42% in the third quarter, up from 1.15% a year earlier.
But regulators also warned that credit quality - particularly in the areas of commercial and industrial lending and consumer installment loans - is continuing to slip. Noncurrent loans grew to 1.01% of the total at Sept. 30, from 0.91% a year earlier.
The increase was most pronounced in consumer installment loans, where it hit 1.55%, up from 1.17%. Noncurrent commercial and industrial loans rose to 1.06%, from 0.81%.
The OCC predicted that the increase in noncurrent loans would force banks to raise their loan-loss provisions, crimping earnings. But not all industry observers agreed.
"It depends on what the economy does," said Veribanc's Mr. Heller.