I firmly believe the fundamentals of both the U.S. banking industry and the economy still support greater valuations for domestic bank equities. I base this view on 17 years in the executive ranks of banking before coming to Wall Street to join Ernst & Co.

During both bull and bear markets for bank stocks over the past five years, the Ernst Bank Equity Fund maintained an incredible record, with average net annual returns of 25%. Two of the past four years, the fund posted net returns greater than 40%. It recorded a 46% net gain for 1995, with an average invested position of only 75% of assets; gross returns were in excess of 53%.

With the economy continuing to grow at a modest rate, inflation is likely to remain under control and interest rates should continue to be lowered. The downward pressure on rates will persist in order to sustain economic growth and avoid the danger of recession.

I believe that this is positive for the banking industry, because it is easier to manage net interest margin with rates declining rather than rising. The banking industry benefits from increasing loan volumes driven by lower borrowing costs.

As a former banker, I can tell you that there is no better incentive than lower borrowing costs to increase loan demand and improve asset quality. Loan volumes have come under some pressure in the past few months as the economy slowed down, but further interest rate declines will provide incentive for solid companies and creditworthy individuals to use leverage for the benefit of their businesses and their personal needs.

But interest rate trends are only part of the story. There is so much more to banking today than just net interest margin. Fee-based revenue lines - particularly in the area of financial services (such as custodial services, securities and insurance brokerage, and capital market services) and asset management products and services - are becoming a greater percentage of the earnings stream for many banking companies.

PNC Bank Corp. is an excellent example of this trend, with more than 40% of its income expected to come from fee-based services on an on-going basis. This is why, as part of our portfolio management process, we study more than just interest rate trends when deciding whether to own a bank stock.

Bank management has also become more shareholder-sensitive, and difficult decisions related to expansion, automation, and staffing are being made with increasing frequency to achieve greater levels of operating efficiency. Most of the major merger deals announced in 1995, for example, were accompanied by tactical plans for system and facility consolidation, business-line divestiture, and staff reduction. The strategic focus of bank management is now clearly on improved profitability.

In New Jersey, UJB Financial Corp. announced its acquisition of Summit Bancorp., with the intention of reducing Summit's expense level by 49% within the first year following the merger.

Mergers within the industry contributed to the rise in bank stock valuations in 1995. I strongly believe that consolidation will continue.

The forces at work are intensifying. The industry is overpopulated with approximately 10,000 commercial banks. Regulatory barriers to geographic and cross-industry expansion have been relaxed and are continuing to lessen. The Interstate Banking and Branching Efficiency Act, which became partially effective in September 1995, will make it even easier to branch across states lines later this year.

Other legislative initiatives and changing regulatory attitudes point to easier paths to consolidation.

Other forces that indicate more industry consolidation will take place are largely related to economy-of-scale issues. These include using more automation and spreading the fixed cost of centralized operations across a broader market area.

It should be noted that from an investor's perspective only about 430 of the industry's 10,000 commercial banks have enough market liquidity to be considered reasonable investment opportunities. Still, these 430 companies have a combined market value of approximately $430 billion, or about 8% of the total U.S. equities market. Therefore, this sector is a market in itself.

Some of the most encouraging facts about the banking industry are technical, and are evident in the industry's fundamental financial structure.

Of all commercial banks reporting to the FDIC as of Sept. 30, asset quality measured by the ratio of noncurrent loans and leases plus foreclosed property to assets had fallen to 0.92. The ratio of net chargeoffs to loans was only 0.45. Both mean that asset quality has improved dramatically. These outstanding results were achieved while asset growth continued at an 8% rate.

Balance sheet statistics for the industry at Sept. 30 were also at historic levels of strength, with the ratio of equity to assets reaching 7.73%. Reduced FDIC premiums have also provided a 5% to 6% annual increase in retained earnings.

This level of capital strength has produced a record number of dividend increases and stock buybacks. I see this trend continuing over the next few years, as bank managements look for ways to reward shareholders and increase on-going returns on equity.

Given a favorable economy and interest rate environment, along with further consolidation and historic fundamental strength, why are some market watchers advising investors to seek other investment opportunities while I remained fixed on the potential for growth in the banking group?

The answer today is the same as it was in January 1993. Then, the banking group had just come off of a 30%-plus increase in stock prices for 1992.

Many market analysts said that the prices had just run up too fast. But 1993 proved to be another good year, with growth of more than 15%. The Ernst Bank Equity Fund produced a 40% net gain in l992, followed by an 18% net gain in 1993.

Now it's January 1996 and we are hearing the same negative remarks. My advice is to look at the valuations of industry, the economy, and the individual stocks: That convinces me that there is the potential for a strong follow-up in 1996, just as there was in 1993.

As always, superior stock selection is the key to strong performance. I like Chemical Banking Corp. because of its earnings profile and potential for sustained earnings growth. PNC is also a favorite because of its restructured balanced sheet and strong fee-based income. Bank of Boston Corp. moves into the spotlight as a result of its announced acquisition of BayBanks Inc., which will produce a well-balanced commercial, retail banking, and financial services leader in New England.

On the consolidation target list, I continue to highlight Provident Bankshares of Baltimore because of its market leadership, geographic concentration, and strong balance sheet. I believe that UJB Financial Corp. is a target because it is one of the best-managed and best-positioned regional banking companies in the Middle Atlantic region. I also believe that Bank of New York Co., with its recent acquisition drive in the area of custodial services, could be one of the more attractive targets, and possibly part of the next mega-deal.

I believe that as 1996 progresses we will see more evidence of sustained earnings growth in the banking industry, more consolidation plays, and increasing valuation of bank equities.

Investors should stay committed to the banking group, and use price weakness as an opportunity to add to positions. I strongly believe the rewards will come in 1996 as they came in 1993. Mr. Bonelli is portfolio manager of Ernst & Co.'s Bank Equity Fund.

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