In the late 1960s, Citicorp chairman Walter Wriston stunned the banking community by setting a target for annual growth in earnings. He was quickly criticized by then-Federal Reserve Chairman, the late Arthur Burns, who carried the same prestige as Alan Greenspan does today. Burns argued that a sharp focus on corporate earnings would lead to unhealthy competition among banks, causing them to make ill-advised loans. According to Wriston, years later Burns acknowledged to the Citicorp chief executive, "You know Walt, you were right."

Today, nearly 30 years later, regulators are not that certain. Fretting about a huge increase in problem loans, some regulators are blaming banks for caving into Wall Street's insistant demands for rapid-fire profit growth.

"There is a pressure to make record profits every quarter," David Gibbons, deputy Comptroller of the Currency for credit risk, told U.S. Banker in an interview last month. "Banks are showing a 17% or 18% return on equity and Wall Street asks, 'How about 20%?'" Gibbons said. He suggested, "How about 14%?"

Others also acknowledge that banks are under a lot of pressure to produce high earnings, possibly unsustainable earnings. Michael Mayo, the former bank stock analyst for Credit Suisse First Boston, an early predictor of a steep decline in bank stock prices, says, "Clearly there is external pressure on banks to produce earnings, and some have cut corners to do so."

The bulge in problem loans seems to be upon us. A recent OCC report said problem loans doubled to $100 billion from $50 billion over the past two years. "There are probably not enough good loans to go around," says Gibbons. Yet, he adds, banks are increasing their loan portfolios anyway. And the problems are cropping up while the economy is still booming. If the economy deteriorates, they could get substantially worse. Even if the economy remains strong, banking regulators expect commercial loans 90 days or more overdue will mushroom 50% this year.

One reason Gibbons and other regulators are worried is that loans issued after 1998 have yet to mature, and over the past 24 months, commercial lending has grown at an average of slightly more than 11% per year, a rate greater than they believe to be consistent with prudent lending.

As U.S. Banker was going to press, Atlanta's $100 billion-asset SunTrust Banks Inc. was among the first large regional banks to report third-quarter earnings, and showed a 32% increase in non-performing assets. This was far higher than Wall Street had expected, prompting a sharp decline in banks stocks, although most recovered substantially the following day. SunTrust said four loans were primarily responsible for the $100 million increase in its non-performing assets.

Not all banks' earnings were significantly hurt by loan problems. Although Firstar Corp.'s third-quarter 2000 earnings met analysts' expectations, and were almost 22% higher than in the year-earlier period, it reported a substantial rise in net charge-offs, up 22% to $58.2 million, from $47.7 million in the third quarter of 1999. That doesn't include merger-related charge-offs of $7.5 million. Net charge-offs as a percent of average loans rose to 44 basis points, from 38 basis points in last year's third quarter.

Firstar attributed the rise in charge-offs to a "change in the mix of the loan portfolio from residential real estate loans to commercial and retail loans," and to overall growth in the loan portfolio.

But at BB&T Corp. of Winston-Salem, NC, the provision for loan losses actually declined in this year's third quarter to $24 million, or 1.4%, from $24.352 million in the comparable quarter of 1999. Robert S. Patten, an analyst at UBS Warburg, hailed the results and praised BB&T's "continuing solid asset quality."

He wasn't as sanguine about other banks, however. "BB&T remains one of the few regional names, which in our view, should be positioned to generate sustainable above-average revenue and earnings growth, improving efficiency levels from integration savings, and a risk profile that shouldn't surprise."

In the September-released OCC survey of credit underwriting practices for 2000, the agency said that for the fifth consecutive year, the level of portfolio credit risk continued to increase. Sixteen percent of those surveyed said they had eased underwriting standards over the past year, up from 13% in the 1999 study. At the same time, 25% said they had tightened credit standards, the same percentage as in 1999. The remainder either reported no change (37% versus 36%), or showed no change (22% versus 26%).

The increased risk extended to almost every kind of loan. The 69 banks surveyed by the OCC are responsible for 89% of total loans among national banks. Almost half of those surveyed said they expect risk in commercial portfolios to continue to increase over the next 12 months.

Some regulators said the healthy economy had led some banks to become shortsighted about credit risk. And some said banks have been forced to operate at an uncomfortable speed as they strive to meet robust quarterly earnings expectations. One federal regulator complained that Wall Street demands that bank stocks "perform as if they were Cisco Systems," the highly profitable Internet-oriented company, which sported a 94 price-to-earnings ratio even after its stock was pummeled in October.

But many bankers deny that they have become the slaves of investor demands. "It doesn't make any difference what Wall Street is asking for," stated Dan Springfield, group senior credit officer at First Tennessee National Bank in Memphis. "I don't think that there is any more pressure to produce earnings now than there was three or four years ago. If banks don't stretch too far, they might be better off long-term rather than concentrating on short-term earnings pressure."

Most bankers interviewed said that they resist making less-than-quality loans despite pressure for high returns.

"We have always held credit quality as our first priority," says Steve Schrantz, executive vice president in charge of commercial lending at Cincinnati's $44.7 billion-asset Fifth Third Bancorp. "There's no pressure to produce loans at the expense of credit quality," he says. Of course, Fifth Third is one of the nation's most profitable banking companies, with an unusually high price-to-earnings ratio. "I do think that we are seeing a softening economy," he says, and that slows the growth of commercial loan demand.

Smaller and less known banks had similar responses. Tony Tebeau, president and CEO of the $50 million-asset Washington State Bank in Federal Way, WA, says he feels no pressure to ease underwriting standards. But he describes commercial loan demand as "very flat" and expects it to remain that way into the new year.

And in Charles City, IA, Jo Ann Merfeld, senior vice president for loan and administration at First Citizens National Bank says the bank is focusing on "making sure that we are applying fundamentals to quality" and will not lower its credit standards. Merfeld labels First Citizen's commercial lending portfolio as "strong," adding that its underwriting standards have remained "relatively unchanged" over the past few years.

Randy Howard, commercial banking executive at Hibernia Corp. in New Orleans, which has been penalized by the market for a slew of problem loans last year, agreed with the regulators that there is pressure for banks to perform on a "quarter-to-quarter" basis. Hibernia's stock had been badly damaged last year after reporting large increases in problem loans. Howard says a bank has to "weigh the pressure to perform" at the expense of taking on a credit that could jeopardize a bank's profits.

"We are not going to let earnings pressure pressure us into over-extending ourselves," Howard says. Hibernia has been taking a more conservative lending approach for the past two years and will continue to do so into 2001, he continues. By limiting exposure, "you limit the size of a problem," he adds.

For many banks, though, it may be too late to forestall serious credit problems. John D. Hawke, Comptroller of the Currency said in a letter last September to national bank directors and CEOs that the OCC remains "quite concerned about the high levels of 'embedded' credit risk on the books of some banks." These embedded risks, Hawke said, will not "fully manifest themselves in terms of delinquencies and collection problems until economic conditions deteriorate."

In a recent report, Credit Suisse First Boston banking analysts said "the question is no longer whether problem loans will hurt earnings, but to what degree." Just how badly the banks will be hurt will depend on the rate at which loans turn sour and the depths of the banks' reserves.

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