About a year ago in these pages I described a scenario under which employment in the banking industry would fall from 1.5 million to 1.3 million by 1995 and remain there for five years.

That was the optimistic scenario. Under the pessimistic one, employment would fall to 1.2 million by 1995 and remain near that figure.

If employment did not fall by about 17% to 23%, I wrote, the industry could not achieve competitive returns.

Favorable Figures

Recently I compared the banking system's recent performance with the 1992 projections. The current analysis considers the 11,983 commercial banks open on Dec. 31 and tracks their performance since 1989.

Total assets, which had been projected to reach $3.7 trillion by yearend 1992, were right on target. System earnings were somewhat below projections during 1991 but rose sharply in 1992 to exceed projections considerably. Return on equity, 13.1% for the full year, reached a level we did not expect until about 1995.

On a cursory level, it might appear that the banking system is nearly on track with the improvements called for in my projections, as well as those of other analysts made at about the same time.

But employment, rather than declining, has been on the rise.

Aggregate industry employment statistics - stable at about 1.5 million since 1989 - mask the reality seen by focusing on the banks in existence at yearend 1992.

Their work forces increased by 171,000 since 1989.

Sales per employee (with sales defined as the sum of net interest income and noninterest income) have risen to $137,000, or slightly above the projected level of $135,000 under the pessimistic scenario.

Because of rising employment, assets per employee rose only modestly, from $2.2 million in 1990 to $2.3 million in 1992, or considerably less than the projected range of $2.6 million to $2.7 million.

Worrisome Trend

The ratio of personnel expense to average assets has been rising modestly, rather than declining as projected.

Given that employment is also rising in absolute terms, it is clear that the system has not focused on personnel expense and productivity as closely as we had expected.

While the rate of growth of personnel expense relative to asset growth has been declining since 1989, only in 1992 did bankers slow expense growth to the approximate growth rate of assets.

A more detailed analysis suggests that the worst culprit is the "other operating expense" category, and that the problem is more pronounced in larger banks.

These have higher levels of nonperforming assets than smaller banks and have shown less progress in reducing asset quality problems since 1989.

The projections anticipated lower levels of loan-loss provisions beginning in 1991, falling from 1990's historic high of 0.95% of average assets to 0.88% and 0.80% in 1991 and 1992.

The pessimistic view held loss provisions at 0.80% of assets for the duration of the decade, while the optimistic version allowed the loss provision to fall to 0.60% over the remainder of the forecast period.

The industry recorded a very high loss provision of 0.96% of assets in 1991, and improved to 0.75% of average assets in 1992, providing an indication of lingering problems with nonperforming assets.

Net chargeoffs as a percentage of loans have totaled 1% or more since 1989, requiring annual provisions exceeding 1.3% of loans every year since 1989.

Illusory Progress

During this time, the loan loss reserve rose modestly, from 2.40% of loans at yearend 1989 to 2.60% of loans at yearend 1992, implying that the banking system has absorbed massive chargeoffs during the last four years while enjoying rising earnings.

That sounds almost favorable, but nonperforming assets escalated from $68 million in 1989 to $110 million as of September 1992.

Nonperforming assets as a percentage of equity have risen from 34% to 48%, and the equity base has been dramatically expanded.

Finally, bank capital ratios improved substantially between 1990 and 1992. The aggregate equity to asset ratio rose from 6.45% at yearend 1990 to 7.56% at Dec. 31, 1992, far exceeding the improvement anticipated in our projections.

A Case for Caution

I hate to be negative about bank equity values at a time when bankers and shareholders are enjoying premium pricing in the marketplace, but the current analysis suggests that caution should be the watchword for investors in bank stocks.

The fundamentals of banking are weaker today than most people seem to think.

Credit quality problems are rife. The yearend 1992 level of $110 billion in nonperforming assets represented a 7% decline from peak nonperforming asset levels reached in June 1992.

While some improvement is noticeable, the implication of continuing high levels of nonperforming assets places ongoing pressure for banks to maintain provisions at higher than historic levels, and the nonearning and reduced-earning assets place additional pressure on the system.

Meanwhile, binkers have not been swinging the layoff ax. While "reengineering" has become a management buzzword, bankers as a whole have not reengineered jobs and reduced employment.

The massive merger economies anticipated by the public stock markets have not yet been forthcoming. As noted earlier, bankers have been increasing employment at a time when there is a clear expectation and real pressure for reductions.

While pressure remains on the credit side of banking, most of the easy gains in fee income have already been obtained.

With the exception of many rural banks, which, we believe, have more capacity to increase fees than apparent willingness to do so, future fee-income increases will have to come the hard way. That means selling more of current products and services to existing and new customers and creating new products to sell to both.

Two Risks

With interest rates at their current low levels and with spreads wider than in recent memory, banking system net interest income is faced with two risks.

If interest rates rise or the yield curve flattens, or if both occur, banks will experience fairly immediate spread pressure.

Less obvious is the lagged margin squeeze that will occur after interest rates stabilize, and asset yields fall as assets reprice in the months following the halted interest rate decline.

In other words, the cash cow of net interest income is subject to more risk than many observers believe.

The recent surge in bank capital ratios is the result of massive net sales of equity. In 1991 and 1992, the system raised more than $44 billion in equity. More capital and higher capital ratios imply much greater pressure on banks to maintain an adequate return on equity when there are few places to turn for earnings.

These observations suggest that today's high bank equity valuations are at considerable risk.

Investors in publicly traded bank stocks should not be misled about the fundamental strength of the banking system by those who have a vested interest in taking the optimistic view.

Mr. Mercer is president of Mercer Capital Management, a national bank and business appraisal firm based in Memphis.

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