Praise for the industry's eighth annual earnings record did not drown out notes of caution sounded by federal regulators, particularly with regard to smaller institutions.

The Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. used last week's announcement of a 15.8% rise in 1999 profits, to $71.7 billion, to remind bankers of the importance of maintaining credit quality and generating noninterest income. The regulators said these are crucial for sustaining upturns and surviving downturns.

Even before the record profits were revealed, Federal Reserve Chairman Alan Greenspan was chastising bankers who view "current strong economic conditions as no longer extraordinary and exceptional, but rather as ordinary and expected."

"Lending granted on that basis," he said, "could have grave consequences for the industry's ability to weather weaker economic conditions."

In her quarterly analysis of the industry's condition, Nancy A. Wentzler, director of the OCC's economic analysis division, emphasized that banks need to keep asset quality high to sustain the good times or weather the bad. "This is particularly true for the smaller banks, where the squeeze on earnings is quite pronounced," she said Friday.

At institutions with less than $100 million of assets, return on assets, a basic measure of profitability, fell 17 basis points over the previous two years, to 1.01%. Returns were 1.18% in 1997 and 1.13% in 1998. This is a reverse of the trend at big banks, where returns grew almost 8 basis points to 1.31% last year, from 1.23% in 1997.

Why are their stories so different?

Ms. Wentzler points to growing reliance on noninterest income, which is generated from fees, trading revenue, and the large category of "other." The large institutions now get 43% of their operating revenue from noninterest income, compared with only 34% in 1994.

Small banks have not been able to keep pace, because they serve local markets and do not make enough money to develop and market specialized, fee-based products. The smaller institutions get 24.7% of their operating revenue from fees, trading, and the like, not much more than the 20.1% share in 1994.

Margin is a much larger contributor to small banks' earnings, making them more dependent on interest income.

Rising rates will have a mixed effect on their future, Ms. Wentzler said, contributing to a rise in interest margins in the short term but a decline in the longer term.

Her advice to the under-$100 million club? "They need an offset to stabilize their earnings."

But she also cautioned that these banks need to recognize the risks of offsets: "They have to keep their credit quality high."

Such offsets can range from new fees and insurance products to what Ms. Wentzler called "synergy-related products" such as data processing and trading.

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.