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Federal Deposit Insurance Corporation (FDIC) insured commercial banks and savings institutions reported third-quarter 2013 earnings of $36.0 billion, lagging the year-ago earnings of $37.5 billion by 3.9%. This is the first time since the second quarter of 2009, that earnings have declined on a year-over-year basis.

Though higher litigation expenses recorded by a major bank led to the overall earnings decline, the banking industry is witnessing a gradual improvement. The number of troubled assets and institutions had a marked fall, which is encouraging.

Further, reduction in loan loss provisions was a tailwind. On the flip side, net operating revenue declined due to lower mortgage activity and higher expenses.

Banks with assets worth more than $10 billion contributed a major part of the earnings in the said quarter. Though such banks constitute merely 1.5% of the total number of U.S. banks, these account for approximately 82% of the industry earnings.

Such major banks include Wells Fargo & Company (WFC - Analyst Report), The PNC Financial Services Group, Inc. (PNC - Analyst Report), U.S. Bancorp (USB - Analyst Report) and Bank of America Corporation (BAC - Analyst Report).

Performance in Detail

Banks are striving to reap profits and are consequently bolstering their productivity. Around 50% of all institutions insured by the FDIC reported improvement in their quarterly net income, while the remaining number recorded a decline in comparison to the prior-year quarter. Moreover, the percentage of institutions reporting net losses for the quarter slumped to 8.6% from 10.7% in the last-year quarter.

The measure for profitability or average return on assets (ROA) fell to 0.99% from 1.06% in the prior-year quarter. The average return on equity (ROE) decreased to 8.92% from 9.35%.

Net operating revenue was $163.3 billion, down 3.6% year over year. The decrease was due to a fall in non-interest income as well as net interest income.

Net interest income was recorded at $104.3 billion, down 1.3% year over year. The fall in net interest income was due to interest income from loans and other investments declining faster than interest expense on deposits and other liabilities. The average net interest margin declined to 3.26% from 3.42% in the prior-year quarter.

Non-interest income declined 7.4% year over year to $59 billion for the banks. Notably, income from sale, securitization and servicing of 1-to-4 family mortgage loans at major mortgage lenders suffered a fall. Further, net gains on sales of loans decreased 52.6% year over year.

Total non-interest expenses for the institutions were $106.5 billion in the quarter, 1.9% higher on a year-over-year basis. The rise was primarily due to higher litigation expenses in the quarter.

Credit Quality

Overall, credit quality considerably improved in the reported quarter. Net charge-offs fell to $11.7 billion from $22.2 billion in the third quarter of 2012. Notably, all major loan groups recorded a year-over-year decline in charge-offs.

In the quarter, provisions for loan losses for the institutions came in at $5.8 billion, down 60.4% year over year. The reported figure was the lowest quarterly loss provision since the third quarter of 1999.

The level of non-current loans and leases (those 90 days or more past due or in non-accrual status) declined 7.7% sequentially. Moreover, the percentage of non-current loans and leases fell to 2.83%, which was the lowest since third quarter of 2008.

Balance Sheet

The capital position of the banks was strong. Total deposits continued to rise and were recorded at $11 trillion, up 4.8% year over year. Further, total loans and leases came in at $7.8 trillion, up 2.6% year over year.

As of Sep 30, 2013, the Deposit Insurance Fund (DIF) balance increased to $40.8 billion from $37.9 billion as of Jun 30, 2013. Moreover, assessment revenues and lower estimated losses from expected failures primarily drove growth in fund balance.

Bank Failures and Problem Institutions

During the third quarter of 2013, 6 insured institutions failed, down from 12 failures in the prior-year quarter. Moreover, as of Sep 30, 2013, 23 failures were recorded, as against 50 failures in the comparable prior-year period.

As of Sep 30, 2013, the number of "problem" banks declined from 553 to 515, reflecting the tenth consecutive quarter of decrease. Total assets of the "problem" institutions also fell to $174.2 billion from $192.5 billion.

Our Viewpoint

Though decline in the number of problem institutions is encouraging, higher litigation expenses limited earnings growth in the quarter.  Now that the interest rate environment has been turning around with rising medium- and long-term interest rates, revenues from mortgage fees lessened as the boom in mortgage refinancing fizzled out.

Top-line growth remains uncertain due to continued sluggishness in loan growth and less flexible business models owing to stringent risk-weighted capital requirements (Basel III standards).

Eventually, banks will have to take resort to cost containment through job cuts and reduced size of operations to stay afloat. Already, the industry has witnessed more than half a million layoffs over the last five years.  

Continuous expense control, sound balance sheets and lesser credit loss provisions are considered to be the key growth drivers. Moreover, a favorable equity and asset market backdrop, reduced unemployment, a progressive housing sector and flexible monetary policy are expected to boost earnings.

It is commendable to see U.S. banks taking legal and regulatory pressure in their stride, indicating their ability to overcome challenges. However, with lingering uncertainty in the economy, the sector is not expected to return to its pre-recession peak anytime soon.

Overall, structural changes in the sector will continue to impair business expansion and investor confidence. Several dampening factors – asset-quality troubles, mortgage liabilities and tighter regulations – will decide the fate of the U.S. banks in the quarters ahead. However, entering the new capital regime is expected to ensure long-term stability and security for the industry.

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