In the depths of the Great Depression, Solomon A. Smith, the longtime head of Chicago's Northern Trust Co., made a point of carrying an umbrella to work every day, rain or shine. It was his way of conveying an impression of caution and preparedness in an era when bank failures were a common occurrence.
To this day, commercial bankers tend toward pessimism when assessing their business, but given the experience of the past several years, in which double-digit earnings growth has been so common as to be almost unremarkable, even the most wary now leave their umbrellas at home. "It has been a very nice run for banks," says Carl R. Tannenbaum, chief economist for LaSalle Bank/ABN AMRO in Chicago. "Credit losses are still extremely low, and as a result it has been a wonderful period for financial-services companies and their earnings."
Indeed, 2006 began with banks posting average year-over-year earnings growth of 9 percent in the first quarter, jumping to 17 percent in the second quarter. Earnings growth held steady at 15 percent above previous-year levels in the second half of the year. The good times also extended to executive pay. Birmingham, Alabama-based Compass Bancshares reported fourth-quarter earnings up 15 percent from 2005, and a few days later announced an options grant to CEO D. Paul Jones Jr. worth $11.2 million.
While there are some concerns, such as a flat yield curve, upward-creeping mortgage-delinquency rates, and potential instability in the Middle East producing oil-price shocks, the general sense among bankers and analysts is that the industry's strong performance will continue. "We are all wondering what is going to knock us off of this nice Goldilocks path we're on," says Tannenbaum. "But in general it should be another good year for banks."
There is one sticking point, however: increased regulation. Regulatory agencies are currently preparing a number of significant reforms, including new bank-capital requirements, the implementation of a new premium structure for federal deposit insurance, and a new law placing restrictions on lending to members of the U.S. Armed Forces (see "Off Base?" at the end of this article). Bank executives are also concerned about potential regulatory action in other areas, such as rules addressing predatory mortgage lending and new guidance on cash reserves to cover bad loans. In addition, the Democratic takeover of Congress has created some uncertainty about the direction of future legislative efforts, including consumer-protection statutes and personal-bankruptcy rules.
Even taken together, these regulations may not be enough to stop the banking juggernaut. But bankers will undoubtedly spend much of the next year assessing the likelihood and impact of new rules, while at the same time trying to keep earnings growth on its upward trend.
Bracing for Basel
At the top on the list, particularly among larger banks, is the U.S. regulators' expected finalization of rules for implementing the new Basel Accord (Basel II), an internationally negotiated agreement on bank-capital requirements. "Without a doubt the most important regulatory issue this year is going to be what will happen with Basel," says Wayne Abernathy, executive director for financial institutions policy for the American Bankers Association. "We're going from talk to action. The regulators are showing every sign of going forward in earnest."
Simply put, bank capital is the amount of money banks are required to hold in reserve for every dollar of loans they make. Capital requirements differ for various bank assets — they are higher for unsecured credit-card loans, for example, than for loans to a sovereign government. But in every case they have a direct impact on how much it costs a bank to make a particular loan.
Basel II was designed to allow banks to take advantage of modern risk-management techniques to assess their true capital needs, a move that was at first widely expected to result in banks having to hold less capital. To comply, the largest U.S. banks have been required to invest in state-of-the-art technology, and many second-tier banks have made similar moves to stay competitive. However, compared with their counterparts in other countries, U.S. regulators have been slow to implement Basel II, and they have repeatedly said that they do not expect it to result in a net decrease in bank capital.
This has frustrated bankers. "Among the large banks that are in the mandatory-adoption category, there is a good bit of concern," says Malcolm D. Griggs, executive vice president for Fifth Third Bancorp in Cincinnati. "Under the current proposals, banks are required to spend the moneyÂÂ…but if capital can't float down [to the level the new risk-management systems recommend] then bankers have to ask what we're getting for this." What they are getting so far, finance executives say, is a poor return on their investment. "We see some improvement in risk management," says Thomas P. Gibbons, CFO of The Bank of New York, "but certainly not to the level of the expenditure that has been made."
The regulators' conservative approach has also created concern about competitive imbalance. European banks, for instance, have already begun operating under Basel II, and are being allowed to take full advantage of new risk-management methods to lower their capital requirements. "The key issue for our clients is what happens to them now that Basel is final everywhere but here," says Karen Shaw Petrou, managing partner of Federal Financial Analytics Inc., a Washington, D.C.-based consultancy, adding that one concern is that U.S. banks may be undercut in terms of loan pricing.
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