WASHINGTON – Declining credit quality could place serious strains on bank management in coming years, the Office of the Comptroller of the Currency said Friday.

“Credit-quality deterioration as we move forward, if not managed well by the regulators and the banks, will be a drain to earnings and a significant distraction to management,” warned Nancy Wentzler, the agency’s deputy comptroller for global banking and financial analysis.

“In an era of high competition and technological change, we need management to be focused on how to improve product delivery, how to make better products, and how to handle technological change,” she said. “To the extent we have a credit-quality deterioration, that is going to reduce the bank’s ability to meet these new challenges.”

Ms. Wentzler, in her quarterly presentation on the condition of the banking industry, backed up her warning with data showing a dramatic leap in noncurrent commercial loans during the second quarter. She also projected further increases.

The share of commercial loans that are at least 90 days past due is on track to grow more than 50% this year. The loans starting to default now, she added, were probably made in 1997 and 1998. This means that the loans made in 1998 through 2000, when commercial lending grew at an average of 11.4% per year, have not yet begun to go bad.

“They are on the books, and you are going to have to deal with them,” she said. “You’d better look at them real carefully and deal with them effectively and quickly.”

Ms. Wentzler drew a parallel with 1987, when many banks suffered a sharp increase in noncurrent loans. The effect of that event on banks whose noncurrent loan rate grew 200 basis points or more was reflected in decreased earnings for two to three years afterward.

“If you roll this whole story forward,” Ms. Wentzler said, “if banks have a significant spike in their credit quality, they are probably going to have a prolonged problem with their earnings.”

The unavoidable companion of rising delinquency rates, increased provisions for loan losses, will also continue to eat away at bank earnings, she said. Among banks with more than $1 billion of assets (excluding credit card banks, trust companies, and other specialty institutions) the OCC found that provisions had increased to 0.48% of total assets in the second quarter, up from 0.34% of total assets the year earlier.

“To the extent that loss provisioning increases rather dramatically, it is going to be a continual drain on earnings,” Ms. Wentzler said.

But credit quality is not banks’ sole problem, Ms. Wentzler said. Many large banks have boosted revenues in recent years with fees and other noninterest income, but the growth rate of such income is declining sharply.

In 1998, banks’ noninterest income was growing at an annual rate of 18.38%, its best since 1981. This rate fell slightly in 1999, to 16.74%, but by June 30 this year, it was on track to plummet to 6.99%.

Part of the decrease, she said, can be attributed to banks’ increasing reliance on “market-sensitive” noninterest income sources, such as brokerage operations and investments made for their own accounts.

In the year from the first quarter of 1999 to the first quarter of 2000, the growth rate of noninterest income at six of the 12 largest national banks exceeded 50%. Only one of the 12 reported a decline in noninterest income during that time.

Taking a snapshot just a quarter later, by measuring the change from the second quarter of 1999 to the second quarter of 2000, gives a dramatically different picture: Only two of the 12 banks maintained growth rates above 50%, and five of the 12 suffered declines in noninterest income.

“The moral of the story is that this stuff is really quite volatile … and that is going to cause some movement in the return on equity of commercial and national banks,” said Ms. Wentzler.

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