The captains of the banking industry are bracing for rough sailing next year, expecting an even bumpier ride than in 1991.

The nation's top bank executives say their industry can expect these challenges:

* A weak economy through most of 1992.

* Ongoing slack demand for loans, with some hope for a modest revival late in the year.

* Continued high rates of loan defaults, particularly for real estate credits.

* A heightened focus on fee-based services as loan revenues decline.

* Stepped up cost-cutting, sparking additional mergers and shrinkage.

* Problems as some completed acquisitions are dragged down by the weight of bad assets and entrenched bureaucracies.

* Further encroachment by nonbank competitors.

* No relief from Congress, which is unlikely to expand bank powers.

"1992 will be an especially tough year for the banking industry," says John Medlin, chairman and chief executive of Wachovia Corp., Winston-Salem, N.C.

No Rebound in Sight

Topping the list of bankers' concerns is the $847 billion of realty loans on their books. This huge concentration is the product of a 64% realty loan expansion over the past five years.

A daunting 7.5% of total reality credits are either delinquent or foreclosed. No one predicts a rebound anytime soon.

"We are seriously overbuilt in most of the nation's major metropolitan areas, and I don't see demand catching up with supply for a number of years," says Richard Thomas, chairman and chief executive of First Chicago Corp.

Overall, 5.65% of bank loans are delinquent or foreclosed. This burdensome concentration will sap bank earnings again next year, says David Cates, the Washington-based chairman of the consulting firm W.C. Ferguson & Co.

Loan Shrinkage Momentum

In the meantime, bankers will be contending with a loan market shrinking at an accelerating pace. A big turning point for the industry came early this year, when total loans peaked at about $2.1 trillion and began a mild descent.

Some prominent bankers believe this is but the start of a trend that may well persist when the economy revives. Even as worthy borrowers develop an aversion for credit, bankers are cutting off risky borrowers, contracting credit even more.

"We may well be witnessing a structural change in our economy," says Edward M. Carson, chairman and chief executive of First Interstate Bancorp in Lost Angeles. "There will be no return to the euphoria of the 1980s."

The executive says bankers no longer can afford to issue speculative credit on higher-risk loans, such as for commercial realty and leveraged buyouts. Part of the ough job next year, he adds, is educating previously pampered borrowers about the tigter underwriting realities of this decade.

Time for Scaling Down

And with commercial lending business destined to contract, Mr. Carson says, the banking industry in turn will have to pare operations to a size that can be supported.

In the process, banks will be exiting weak lines of business and redeploying capital into many areas other than commercial lending, says Thomas H. O'Brien, chairman and chief executive of Pittsburgh-based PNC Financial Corp.

PNC, for example, has sold foreign loan production offices, a collection of Ohio banks deemed too far away to permit cost-effective integration, and most of its merchant processing business.

In turn, the company has poured capital into corporate cash management, a mortgage banking unit, and the purchase of home town banks that could easily be absorbed.

'Driven by Profit Margins'

"This industry will not be driven by loan volume, as it was in the 1980s," says Mr. O'Brien. "It will be driven by profit margins, and that means bankers will be getting out of narrow-margin businesses."

At the same time, banks in all size categories will merge next year, sustaining an industry trend of cutting costs by eliminating redundant operations. "The logic of eliminating over-capacity is pretty compelling," says Richard J. Lehmann, chairman and chief executive of Valley National Corp. in Phoenix.

For most acquirers in these transactions, "it very much will be a story of the strong getting stronger," says Lowell Bryan, a Washington-based bank consultant with McKinsey & Co.

The healthy aspect of these mergers, he says, is that a few top banking companies with "real skill and real capital" are absorbing weaker competitors and strengthening the industry in the process.

Question Mark on Mergers

But a growing group of bankers and regulators say it is an open question whether all the mergers will work.

One big concern is credit quality. In a recessionary environment where borrowers are having trouble with their loans, "putting together two banks with mediocre credit quality just gives you a bigger bank with mediocre credit quality," says Wachovia's Mr. Medlin.

A second concern is whether equally sized operations and work forces can be melded with the dispatch and rigor needed to make deals work. A number of such "mergers of equals" are pending and others are believed to be on the drawing board.

"My guess is that one of these deals is not going to work," says John B. McCoy, chairman and chief executive of Banc One Corp. in Columbus, Ohio.

'Postmortem' on Cost Cuts

Finally, some contrarians are questioning the common wisdom about merger benefits.

"When you do a postmortem on most bank mergers, the combined institution doesn't seem to run more cheaply or profitably than the two [predecessors] did separately," Robert T. Parry, president of the Federal Reserve Bank of San Francisco, said at a recent conference.

What will help keep the banking industry focused on consolidation next year is the legislative defeat the industry suffered in 1991, officers of large banking companies say.

Barred from entering the inssurance and securities industries, banks have little choice but to putll back as their lesser-regulated rivals - and a host of others - make further inroads into traditional bank markets.

"Nonbank competitors have a major advantage, in that they don't have to bear the increasingly burdensome cost of federal regulation," says Stuart Greenbaum, a banking professor at Northwestern University, Evanston.

Next year will also foster a continuation of what happened during the first nine months of 1991, when banks suffered a $30 billion drop in total commercial and industrial loans while finance companies enjoyed a $15 billion increase.

"Congress ended up doing nothing at a time when Rome was burning," says Mr. Thomas of First Chicago. "We've got to find a way of offsetting the encroachment of nonbank competitors into our business."

Mr. Thomas believes an expansion of permitted bank activities would expand the flow of capital into the banking industry, better enabling it to provide the credit the Bush administration says is necessary to revive the economy.

Chorus of Contradictions

But the cacophony of contradicting voices arising from the banking industry looms as a continuing impediment to reform legislation.

"The industry's splinter groups have this myopic view that 'if it ain't good for us, then we don't care about it,' and that's why we can't get anything done in Congress," says Mr. Lehmann of Valley National.

"We simply can't afford the luxury of carrying out the agenda of a small sector of the industry," agrees Alan Tubbs, president of the American Bankers Association.

One divisive debate is how to rein in the 10% of the industry that is troubled so that the other 90% can be entrusted with broader powers, says Mr. Bryan of McKinsey & Co.

"We've got to curtail the ability of weakly managed and -capitalized institutions to place the insurance fund at risk by bidding up for deposits and deploying up for deposits and deploying the funds into high-risk ventures," Mr. Bryan says. "Until the, legislators will use blunt force to reduce risks."

Indeed, tightened regulatory oversight is what the banking industry will get next year. Ranging from oversight of executive salaries to the beginnings of mark-to-market accounting on bank securities portfolios, the fall banking bill "provided the regulators with more than enough authority," says Mr. Carson of First Interstate.

Given lawmakers' performance in 1991, "the country probably would be better off if Congress just took next year off," says Mr. Melin of Wachoivia.

But given the outlook, 1992 is a year the banking industry itself might prefer to skip.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.