The banking industry continued to produce healthy profits in 2006, though as the year progressed evidence of weaker fundamentals appeared.
Stiff competition for deposits pushed funding costs higher, and margin compression was a widespread problem.
Some institutions, including Citigroup Inc. and Washington Mutual Inc., took the quest for deposits in a new direction and launched online-only deposit-gathering strategies that wooed customers with higher rates. In Wamu's case, the Seattle company said gathering deposits online justified closing branches in less profitable areas.
Credit quality continued to hold up, despite some blemishes in the auto-lending sector. However, risk officers began raising red flags that competition and looser standards could erode commercial credit quality, and in the third quarter some bankers started boosting reserves.
Consumer credit drew some discussion during the year as investors watched for weakness in the adjustable-rate mortgage and interest-only loan markets following evidence of a softer housing market. However, Kenneth D. Lewis, the chairman, president, and chief executive of Bank of America Corp, said in October that his Charlotte company believes "the consumer is in really good shape."
Options ARMs featured prominently in one of the year's biggest deals: Wachovia Corp.'s purchase of the Oakland, Calif., thrift company Golden West Financial Corp., an option ARM specialist. When the deal was announced in May some investors balked at Wachovia's embrace of what they saw as a risky product. Wachovia also had to deflect criticism of the deal's premium and the company's ability to cross-sell through a monoline institution. Wachovia has worked hard to defend the transaction, but the jury remains out.
Over the summer Sovereign Bancorp Inc. of Philadelphia completed a two-part deal, selling a stake in itself to the Spanish banking giant Banco Santander Central Hispano SA and using some of the proceeds to acquire Independence Community Bank Corp. of Brooklyn, N.Y.
The deal initially irked shareholders, who said then-CEO Jay Sidhu structured it in such a way to avoid putting it to a shareholder vote. Mr. Sidhu managed to appease shareholders before the deal closed, but he could not save his job. He was ousted as the president and CEO in October over broad concerns about the direction he had taken the company. He will remain the nonexecutive chairman until yearend.
Some investors continue to suspect Sovereign will sell itself outright.
Divestitures were popular among Midwestern banking companies seeking to focus on core banking operations.
In September, KeyCorp of Cleveland agreed to sell the retail branches of its wealth advisory unit, McDonald Investments Inc., to the Zurich banking giant UBS AG. A month earlier KeyCorp said it would look for a buyer for its nonprime mortgage business, Champion Mortgage Co. of Parsippany, N.J.
Another Cleveland banking company, National City Corp., made plans to exit the nonprime business, agreeing in September to sell its Franklin Financial Corp. to Merrill Lynch & Co. Inc. In July, Nat City announced plans to enter Florida with a pair of bank deals.
Asset swaps were popular. In October, Merrill merged its Merrill Lynch Investment Managers with BlackRock Inc., the New York investment manager majority owned at the time by PNC Financial Services Group Inc.
That deal halved PNC's stake in BlackRock but gave the Pittsburgh banking company $1.6 billion of capital to play with. PNC didn't wait long to use the proceeds. Less than a week later it announced a $6 billion deal for Mercantile Bankshares Corp. of Baltimore. That deal is expected to close next year.
JPMorgan Chase & Co. and Bank of New York Co. participated in the year's other big asset swap, also in October. JPMorgan Chase traded its $2.8 billion corporate trust business and $150 million in cash for Bank of New York's $3.1 billion retail and middle-market banking business, including 339 branches and $14.5 billion of deposits. The exchange raised JPMorgan Chase's branch total in the New York area to 815.
WASHINGTON
Much of the public policy debate this year felt like a bad television rerun.
For the third consecutive year, lawmakers appeared unlikely to pass a bill reforming the regulation of the government-sponsored enterprises, while the Basel II process was once again beset by regulatory and industry divisions.
Banks continued to sever contact with money-services businesses, despite pleas from regulators to stop, and community bankers struggled to persuade the Federal Deposit Insurance Corp. to reject an application by Wal-Mart Stores Inc. to charter an industrial loan company in Utah.
Even the industry's primary legislative victory - a bill to ease regulations on banks and thrifts - was far narrower than originally hoped, after the Senate Banking Committee refused to include several provisions that the House passed, including permission for thrifts to expand commercial lending. Most industry representatives viewed the bill that President Bush signed Oct. 13 as a disappointment.
That "victory" was overshadowed by two other laws that could hurt financial institutions. The Defense Department authorization legislation included a provision that capped at 36% the effective annual percentage rate, including fees, that banks may charge military personnel and their dependents for consumer credit products.
Industry representatives are concerned that the Defense Department - which is required only to "consult" the banking agencies when writing rules to enforce the provision - does not understand established banking law. They have argued that the rules could prevent companies from offering credit cards and other products under traditional terms, because finance charges and late fees could easily push the effective APR over the limit.
A port security law, signed by the president in October, contained an Internet gambling prohibition requiring the Federal Reserve Board and the Treasury Department to write rules mandating the systems banks need to block illegal payments to gambling Web sites. Industry lobbyists have said a last-minute change, requiring banks to block illegal payments but allow legal ones, will be technically difficult to manage.
Meanwhile, the drive to reform GSE regulation generated a lot of noise without much action. Despite a blistering Feb. 23 report from the Office of Federal Housing Enterprise Oversight that criticized Fannie Mae's management and accounting systems, the situation remained much as it did at the end of last year: stalled.
In late summer Treasury Secretary Henry Paulson Jr. began an effort to reach an agreement in the Senate, where Democrats oppose a White House-favored provision that would force Fannie and Freddie Mac to slash their mortgage portfolios. Reps. Barney Frank, D-Mass., is also said to be interested in a compromise. All sides will have one more shot during the lame-duck session following the mid-term elections, but with the Democrats winning the House and possibly the Senate (the Virginia race was not decided at presstime), few expected the legislation to be enacted this year.
The GSEs, meanwhile, continued to grapple with fallout from their respective accounting scandals, including some regulatory restrictions. On May 23, Fannie agreed to cap its portfolio at $727 billion and take other steps to correct problems identified by OFHEO. Freddie followed suit with a similar cap after negotiating the issue with regulators.
The Federal Home Loan banks, meanwhile, had their own turbulent year. In March the Federal Housing Finance Board proposed requiring the banks to slash dividends until they boost retained earnings and limit excess stock.
The proposal garnered universal opposition from the banks and the banking industry, which agued it would hurt the banks' business. As proof, many pointed to efforts by Wamu, the banks' largest shareholder, to reduce its reliance on Home Loan Bank advances. But Finance Board officials signaled that they did not intend to back down, and they appeared likely to finalize the rule by yearend.
The banks also face a dearth of public-interest directors. Finance Board Chairman Ronald Rosenfeld has said he is holding off on appointing the congressionally mandated directors until the GSE reform legislation is resolved. With the prospect of appointments slim, it appears likely that the 12 Home Loan banks will move into 2007 without a single public-interest director - leaving 82 of 200 board seats vacant.
The proposed Basel II capital requirements continued to cause headaches. The latest version, which the Fed unveiled March 30, added provisions to restrict how fast capital can fall once the new system is in place.
The addition immediately drew the ire of banking companies, including Citi, Wamu, JPMorgan Chase, and Wachovia, which argued that the floors counter Basel II's goal of better aligning capital with risk. They also said that the stricter U.S. version would put them at a competitive disadvantage against their European counterparts. The companies asked regulators to give them the option of using the so-called standardized approach, which is simpler than the advanced method favored by the Fed.
Regulators ceded only a little, tacking on a question on the issue when they published the proposal in September. Fed Chairman Ben Bernanke, meanwhile, told lawmakers that the standardized approach would not properly address the risks posed by large banks.
It was unclear when regulators would propose new capital rules for the rest of the banking industry. By press time observers expected Basel IA to be delayed into late in the year or slide into next year.
Whether to let commercial companies such as Wal-Mart own industrial loan companies dominated much of the first half of the year, with the FDIC holding unprecedented public hearings on the Wal-Mart application in April. The situation drew even more attention after Home Depot Inc. applied in May to buy an ILC in Utah.
Wal-Mart insists that it does not have plans to open bank branches in its stores, saying that it would use the ILC charter instead to process debit and credit card transactions. Critics don't buy that, and five states enacted laws this year closing their borders to commercially owned ILC branches.
Reps. Frank and Paul Gillmor, R-Ohio, introduced a bill in July that would bar commercial firms from owning ILCs and effectively undo any decision the FDIC makes on recent applications. But the bill is opposed by Sen. Robert Bennett of Utah, the second-highest Republican on the Banking Committee, who has argued commercial ownership of ILCs is not a problem.
After Sheila Bair joined the FDIC in July as its chairman, the agency imposed a moratorium on approving any ILC applications until Jan. 31. The moratorium prompted two companies to withdraw their applications, but those from Wal-Mart, Home Depot, and 10 others are still pending.
Ms. Bair has said that she hopes to deliver some sort of answer to the applications soon after the moratorium expires.
Wal-Mart was not the only controversy facing the FDIC. The agency passed several rules implementing the deposit insurance reform law enacted in February, including giving banks credit for past premium payments and creating a new risk-based pricing structure.
On Nov. 2 the agency voted to charge most banks premiums equal to 5 to 7 basis points of a bank's total domestic deposits, aiming to restore the fund's ratio of reserves to insured deposits to 1.25% by 2009.
The Office of the Comptroller of the Currency came under fire during the year for letting three banks engage in commercial real estate development projects (Bank of America to develop and own a luxury hotel, PNC Bank to develop and own a mixed-use condominium project, and Union Bank of California to own 70% of a wind-energy farm).
The December 2005 decisions angered the National Association of Realtors, which said such approvals constituted the mixing of banking and commerce. The two sides traded letters and public jabs for much of 2006, with the Realtors demanding that the OCC make no further approvals and the agency insisting that it had done nothing unusual.
The Realtors persuaded the House Government Reform government efficiency and financial management subcommittee to hold a hearing on the issue. The Senate Banking and House Financial Services committees investigated but ultimately took no action.
All four banking and thrift regulators took flak from the industry for guidelines adopted Sept. 29 urging new disclosure and underwriting requirements for alternative mortgage products. Lenders are expected to use fully indexed rates rather than teaser ones when judging a borrower's ability to repay. The guidelines also clarified that interest-only mortgages are included in the definition of exotic products.
Bankers generally reacted by saying the dangers of such products have been overstated, but regulators say they are concerned that defaults may rise as these loans reprice. Bankers and regulators agreed that the guidelines should be enforced on nonbank lenders as well, and the Conference of State Bank Supervisors was expected to release similar guidelines by yearend.
By that time the Financial Crimes Enforcement Network was expected to require banks to report all wire transfers to the government. While the public awaited a report from the agency detailing whether it had the capacity to receive such reports, and their usefulness to law enforcement agencies, news broke June 23 that the government was already analyzing international wire data obtained via subpoenas to Swift, or the Society for Worldwide Interbank Financial Telecommunication.
Bankers argued that a new wire transfer requirement would be redundant, but Treasury officials insisted that the two programs were distinct without really explaining how.
Fincen Director Bob Werner did say Oct. 9 that the Treasury might limit reporting to "gatekeeper" banks that transmit or receive a wire transfer directly to or from a foreign country.
Mr. Werner also said Fincen was still struggling to find a way to stop bankers from severing ties with money-services businesses. In the spring SunTrust Banks Inc. became the most recent of several large banking companies to sever ties with MSBs, citing the expense of added regulatory scrutiny.
Regulators insisted that they have not ordered any sort of crackdown by examiners, and that there was little more they could do. A solution did not seem likely anytime soon.
COMMUNITY BANKING
The year started somewhat ominously for community banks when federal regulators proposed new guidelines in early January for commercial real estate lending.
Mindful of past real estate downturns, regulators suggested that banks with heavy concentrations of CRE and construction loans beef up risk-management systems and perhaps hold more capital.
But CRE and construction lending are community banks' bread and butter, and bankers argued the guidelines could cripple many companies with less than $1 billion of assets, especially those in fast-growing areas of the South and West. (Larger banking companies have much more diverse loan portfolios, so most would be exempt from the proposed guidelines.)
Regulators extended the comment period twice on the proposed guidelines and had not finalized the new rules by early November.
Bankers have urged regulators to discipline individual banks rather than implement "one-size-fits-all" guidelines. As one banker said in March, "If you have a problem, instead of coming after the industry, why not go after the banks that are doing things wrong?"
Still, recent trends hurt community bankers' cause. Demand for new homes and condominiums has slowed significantly, and there is concern that developers in high-cost areas will not be able to repay construction loans. In early October a fast-growing New Jersey home builder filed for bankruptcy protection, and its filing said it was on the hook to a dozen banks for $248 million.
The year was another busy one for mergers, acquisitions, and start-ups.
Dealmaking was particularly brisk in two former unit-banking states, Illinois and Texas, and in two fast-growing Southeastern states, Florida and Georgia.
In Texas and Illinois, many of the buyers were in-state - though there were some notable exceptions. In June the Spanish banking giant Banco Bilbao Vizcaya Argentaria SA announced two deals in Texas worth a combined $2.58 billion.
Florida continues to attract buyers from slower-growing states, particularly in the Midwest. Park National Corp. of Newark, Ohio, Republic Bancorp of Louisville, and Dickinson Financial Corp. of Kansas City, Mo., were among the community banking companies that announced moves into Florida this year.
Mergers and acquisitions often spawn start-ups, but that's not all that is driving such activity. Private-equity firms are "throwing money at de novos," as one banker put it. The result: Start-up banks are coming out of the gates with more capital than ever. They are using that capital to recruit talent from other banks, add branches, acquire deposits, and make larger and larger loans.
Some community bankers say that to keep pace, they have had to raise rates on deposits and lower rates on loans. "Competition is good, but too much competition in a highly regulated environment hurts everyone," one Nashville-area banker said.
MORTGAGES
The big story of 2006 for the mortgage industry was Wall Street's invasion of the primary market.
In July, Deutsche Bank AG agreed to purchase the New York lender MortgageIT Holdings Inc. for $429 million. A month later Morgan Stanley cut a $706 million deal for Saxon Capital Inc., a Glen Allen, Va., real estate investment trust that originates and services mortgages.
A month later Merrill's announced its deal for First Franklin and two other Nat City units for $1.3 billion. And in October, Bear Stearns Cos. Inc. agreed to buy the subprime mortgage origination assets of the Irvine, Calif., real estate investment trust ECC Capital Corp. for $26 million.
Several factors drove the trend. In-house origination gives an investment bank a steady flow of raw material for its securitization business and improves margins, because the trading desk does not have to outbid others for loans. The securitizer also gets a measure of control over loan quality that is not available when buying mortgages in bulk. And there is a fear that lending giants like Wamu and Countrywide Financial Corp., which are building their own securities businesses, will shut out the Wall Street firms.
It didn't hurt that many acquisition targets were struggling in a viciously competitive mortgage market and available at bargain prices. But not everyone on the Street hopped on the bandwagon.
In late October executives at UBS and Credit Suisse Group said that they saw room for prices to fall further, and that they planned to stick to organic origination growth strategies for now. And though Barclays PLC agreed in June to buy HomEq Servicing Corp. from Wachovia for $469 million, so its investment banking arm could rely less on third-party servicers, the British company indicated that it had no immediate plan to start originating loans.
As of late October one major nonprime lender remained unspoken for - Champion Mortgage Co., which KeyCorp put on the block in August.
The other major development in mortgages this year: After years of defying predictions, the housing market finally turned, and credit quality deteriorated.
A rash of early payment defaults - borrowers turning delinquent within months of getting their loans - led to forced loan buybacks at some mortgage companies, which had to resell the loans at sizable discounts.
At lenders like Countrywide and Golden West, noncash income from deferred interest on option ARMs grew rapidly as borrowers made only the minimum payments. By late October lenders were predicting the new federal interagency guidelines for underwriting nontraditional home loans would clip origination volume, particularly in the subprime sector, where borrowers would have a harder time qualifying.
CARDS
The two major events for the credit card industry were MasterCard Inc.'s initial public offering in May and Visa International's announcement in October that it would go public in 12 to 18 months. Together the events made it clear that the association model is a thing of the past, at least in the United States, and both its major proponents now agree that independence is the best path to growth.
MasterCard issued shares at a slightly lower price than its target, but the Purchase, N.Y., company's stock price surged soon afterward and had nearly doubled by October.
Investors viewed the company as a way to bet on consumer spending without the credit risk. They largely discounted the merchant lawsuits that had weighed on the IPO. Instead, they focused on stronger-than-expected financial results and on a string of announcements suggesting that MasterCard was trying to reconcile with retailers.
For example, in July, at its first shareholder meeting as a public company, CEO Robert Selander said MasterCard wanted to put "legacy" suits behind it.
Though merchants were still skeptical that it had become truly independent of its former bank owners, others in the industry reported that as a public company it was behaving differently. Paul Garcia, the president and CEO of Global Payments Inc., said in October that merchant processors now are "more on the inside as opposed to the outside" when dealing with MasterCard. "It's palpable."
As it was for MasterCard, the desire to reduce exposure to antitrust claims was a major factor in Visa's plan to go public. Like MasterCard, Visa said going public would give it the capital it needed to respond to rapid changes in the payments system.
One clear difference: Visa would not include its European operations in the IPO. Visa Europe would remain a bank-owned association, formed by merging Visa International with the other regional associations.
Planning an IPO was not the only way Visa copied MasterCard this year.
In September, MasterCard said it would give in to long-standing retailer demands and publish its interchange rates, the wholesale prices of credit card transactions. Initially, Visa said there was no reason for it to follow suit, because "retailers do know … the price they pay to accept Visa cards." But in October, after it had revealed its plan to go public, the association not only reversed course but also beat MasterCard to the punch by publishing its interchange rates first.
It is not hard to see why both organizations tried to accommodate retailers whose complaints they had long dismissed. Beyond the lawsuits, the Senate Judiciary Committee lambasted MasterCard and Visa in a July hearing on interchange. "It's not likely that nothing is going to come from this," said Senate Judiciary Chairman Arlen Specter, R-Pa.
For issuers, receivables growth remained hard to come by, but credit quality got an artificial boost from the new bankruptcy law. In October 2005 debtors rushed to file for protection from creditors before the law took effect. The stampede included many consumers who probably would have filed this year. As a result, credit card chargeoff rates were unusually low for most of 2006.
INVESTMENT PRODUCTS
Costs associated with compliance and distribution continued to increase, forcing banks to decide whether they wanted to be manufacturers or distributors of such products.
Large deals like the asset swap between Merrill and BlackRock overshadowed divestitures of mutual fund units by regional and community banks; companies such as Federated Investors Inc. and Phoenix Cos. Inc. were active acquirers.
On the insurance side, banking companies such as Citizens Financial Group Inc., a Providence, R.I., unit of Royal Bank of Scotland Group PLC, sold their agencies but continued offering insurance products by partnering with third-party providers.
All of this played into the biggest trend in wealth management in 2006: the adoption of open architecture. Banks slowly moved to a platform that included both proprietary and nonproprietary products.
A survey of wealth management executives from SEI Investments Co., an Oaks, Pa., asset management provider, said 57% of banks offered a mix of proprietary and nonproprietary investment products, and only 8% sold just proprietary ones.
Bankers also looked for ways to offer their customers innovative products that capitalize on an open architecture platform, such as separately managed accounts. Wirehouses have dominated the business, controlling 70% of the market for such accounts; banks control just 8%, according to data from the Money Management Institute.
To establish a separately managed account platform for its customers, Boston Private Financial Holdings Inc. bought the Boston asset manager Anchor Holdings LLC in February.
Many banks are turning to outsourcers such as FundQuest Inc. of Boston to deliver separately managed accounts to their customers without making a deal or building a platform.
Though banks continue to lag behind wirehouses and registered investment advisers in the business, many are skipping right to the next generation: unified managed accounts.
A unified managed account is a platform on which customers can manage all their investments, including separately managed accounts, mutual funds, and exchange-traded funds, in one well-allocated portfolio.
Dover Financial Research, a Boston consulting firm, said that 11% of the banks it surveyed were offering unified managed accounts, and 67% planned to develop one within 12 months. B of A unveiled its account on Nov. 1.
Other investment products, such as health savings accounts and 529 college savings plans, continued to evolve. As management contracts in some states came up for renewal, former leaders such as TIAA-CREF were supplanted by new competitors such as Upromise Inc., a Needham, Mass., provider acquired in June by SLM Corp., the student loan giant commonly known as Sallie Mae.
Large banking companies such as Mellon Financial Corp., Wells Fargo & Co., and JPMorgan Chase are looking to compete for assets in the HSA market, which had been dominated by smaller banks such as HSA Bank, a unit of Webster Financial Corp. in Waterbury, Conn., and Exante Financial Services, a unit of United Health Group in Minneapolis.
On the brokerage side, the largest deal of the year was Ameritrade Holding Corp.'s January acquisition of TD Waterhouse Group. (Ameritrade renamed itself TD Ameritrade Holding Corp.)
E-Trade Financial Corp. acquired smaller advice providers to cross-sell additional services to its wealthy customers.
Rumors swirled in September and October about the potential sale of Putnam Investments LLC, and Mellon and Wachovia were said to be bidding for MFS Investment Management, a Boston unit of the Canadian insurer Sun Life Financial Inc.
TECHNOLOGY
Though thousands of banks are settling checks across image exchange networks, some of the largest have discovered that processing costs have not declined as quickly as expected. That's because so many financial companies still cannot receive image files.
Those trends prompted Wells, JPMorgan Chase, B of A, and Zions Bancorp. to call for a merged payments system that would use elements of both image exchange and the automated clearing house network.
The controversial idea has drawn cheers from those who want to deliver image files to any bank across the ACH network, as well as jeers from those who say the concept is both unnecessary and too complex.
When the plan was announced at Nacha's Payments 2006 conference in May, one executive optimistically said the system could be undergoing early tests by November, but that goal later was pushed out to next year.
Fraud remains a top concern, and the looming regulatory deadline for banks to improve their online security proved a boon for software vendors.
In August regulators made it clear that the username/password combination that has been the standard authentication mechanism for years is no longer considered adequate. Banks must have additional systems in place to spot and stop fraud, the agencies said.
Con artists, also trying to beat the yearend deadline, have ramped up their attempts to access online banking accounts before the new measures, which are designed to make their scams harder to pull off. The Anti-Phishing Working Group said that the number of phishing e-mails reached an all-time high this summer. Though a smaller percentage of the e-mails used banks' names, financial companies are still bearing the lion's share of fraud losses.
This was also a year of restructuring for some major companies. Ending months of speculation that it would sell its lagging card processing unit, First Data Corp. announced instead that it would focus exclusively on the card industry and spin off its cash cow, Western Union Financial Services Inc. After months of planning, that transaction was completed in October.
Fidelity National Financial Inc. spent much of 2005 completing a complex transaction to establish itself as a holding company with three interrelated public companies; only two months after that deal closed in February, the holding company announced a new plan, to separate its banking technology and title insurance units into two separate companies.
Its technology unit, Fidelity National Information Services, also made news in February by merging with the transaction processor Certegy Inc. Core processing and transaction processing historically have been very different beasts, but Fidelity National Information Services already has announced several deals, including a big processing contract with a consortium of Brazilian banks. The vendor said the contract demonstrates the cross-selling potential of having multiple processing capabilities.
