The Federal Deposit Insurance Corporation (FDIC) released yesterday its Second Quarter 2014 Quarterly Banking Profile covering FDIC-insured institutions having $ 15.27 trillion in assets as on June 30, 2014. Deposits held at these institutions aggregated $ 11.54 trillion as on that date.

FDIC coverage

According to this FDIC report,though there are encouraging findings on the state of the banking industry, these are more than offset by challenges that have inhibited its performance.

FDIC Chairman Martin J Gruenberg lauded the industry’s improvement in asset quality, growth in loan portfolios, its higher net income and steady decline in the number of bank failures.

FDIC – Net income trends positive

During Q2 commercial banks and savings institutions insured by the FDIC generated net income of $ 40.2 billion, an increase of 5.3% over the year ago quarter.

Key factors that helped boost net income were falling loan loss provisions and a reduction in non-interest expenses on the one hand, and an increase in interest income due to higher loan making activity on the other.

FDIC net-income

Growing number of profitable versus unprofitable institutions

In the chart below note that loss-making institutions have fallen steadily since 2009, and that over half of insured institutions have reported year-on-year growth in quarterly income.

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Loans activity growing

Q2 is notable for the very significant jump in loan balances as shown by the green arrow in the chart below. “The largest increase since 2007, including first quarter 2010 when there was an accounting change,” said Martin J Gruenberg. “Commercial and industrial loans, which include higher risk loans to leveraged commercial borrowers, continue to have the strongest growth of any loan category at $ 50 billion,” he revealed. Total loans rose by $178.5 billion (+2.3%) in the second quarter to $8.1 trillion.

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Troubled institutions decreasing in number

The chart below shows a steady fall in the number of quarterly failures amongst the insured institutions. It also shows that the number of “problem banks” has been falling every quarter since the last four quarters. “The number of banks on its “Problem List” declined from 411 to 354 during the quarter,” said the FDIC. “The number of ‘problem’ banks now is 60% below the post-crisis high of 888 at the end of the first quarter of 2011.”

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But net operating income remains flat…

On a note of concern, however, quarterly net interest income has been nearly flat for many quarters, as shown in the chart below. Moreover, non-interest income has been lower than what it was a year ago for four straight quarters. This is one of the challenges facing the industry, according to Gruenberg.

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And net interest margins are under severe pressure…

The chart below gives a clue to the problem of flat net operating income. “The average net interest margin (the difference between the average yield banks earn on loans and other investments and the average cost of funding those investments) was 3.15%, the lowest since 3.11% in the third quarter of 1989, as declining asset yields at larger institutions outpaced the decline in the cost of funds” said the FDIC.

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And why non-interest income is down…

According to the FDIC, non-interest income is down primarily due to a decline in the origination, sale, and servicing of new or refinanced mortgages, as shown in the chart below by the red arrow.

Mortgage activity has been adversely affected by the rise in long-term interest rates in the second quarter of 2013. “One- to four-family residential real estate loans originated and intended for sale during the quarter were $290.6 billion (63.9%) lower than in the second quarter of 2013, as higher interest rates reduced the demand for mortgage refinancing, ” observed the FDIC. The FDIC quantified that the fall in mortgage activity lead to a $ 3.6 billion drop in non-interest income for the banks.

(Read ValueWalk’s earlier article “Are Our Mortgage Markets Broken?”)

Banks’ trading activity, another component of non-interest income, declined due to low volatility in the financial markets.

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And banks will soon miss the loan-loss-provision crutch…

The report observed that loan-loss provisions during the quarter were only $ 6.6 billion, down $ 1.9 billion from the level last year of $ 8.5 billion, a fall of 22.4%. “This is the 19th consecutive quarter that the industry has reported a year over year decline in loss provisions,” said the FDIC.

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Gruenberg, however, sounds a cautionary note: “The benefits to earnings from lower provision expenses are diminishing; going forward, earnings growth will be increasingly dependent on sources other than lower loan-loss provisions.”

Challenges to the banking industry therefore arise from lower incomes from core lending activity, reduction in mortgage activity income, and the risks emanating from increasing loans to the leveraged commercial borrowing sector. In addition, the industry has been extending its asset maturities, becoming susceptible, therefore, to interest rate risk.

Deposit Insurance Fund

The net worth of the Deposit Insurance Fund climbed to $ 51.1 billion during Q2 compared to the first quarter, and its reserve ratio climbed to 0.84% from 0.80% as on March 31.

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