Monday, July 10, 2006

US Regional Banks in a Rate Whirl

The Wall Street Journal, Robin Sidel & Clint Riley, 10 June 2006

After watching interest rates rise for two years, a growing number of Americans are transferring their money into high-yielding bank accounts, a trend that is taking its toll on the nation's regional banks.

As financial institutions gear up for quarterly earnings reports this month, a number of them have warned investors and Wall Street analysts that results will be hurt by rising rates. And part of the blame is being placed on consumers and businesses who are moving funds from traditional low-interest-bearing accounts to online savings accounts, certificates of deposit and other bank products that are sporting annual rates of more than 5%.

While this may be good news for consumers who are earning less than 1% on a plain-vanilla savings account, it is putting the banks in a pickle because they must either raise rates to stay competitive or watch their customers flee to rivals.

Although interest rates have been rising steadily since mid-2004, there is typically a lag time before banking customers take action, say industry analysts. Last month, the Federal Reserve raised interest rates for the 17th consecutive time, boosting its short-term target a quarter-point to 5.25%.

"We seem to have passed some threshold between 4.75% and 5% where the depositors' attention is focused on the costs associated with not moving their accounts," says Gary Townsend, an analyst at Friedman, Billings, Ramsey & Co. in Arlington, Va.

That is the case at City National Corp., a Beverly Hills, Calif., bank that has about $15 billion in assets. The bank, which has a market value of $3.2 billion, last month lowered its forecast for 2006 earnings growth to between 1% and 4% from its previous expectation of 8% to 10%.

"Responding to a steady rise in short-term interest rates over the past two years, some of City National's business clients have shifted funds from core deposit accounts into higher-yielding accounts and instruments," the bank said in a Securities and Exchange Commission filing. The company's stock tumbled 11% on the news and pressured shares of other California banks. City National, which fell to a 52-week low of $60.02, was trading at $65.84 on Friday as of 4 p.m. composite trading on the New York Stock Exchange.

The trend is contributing to a tricky time for regional banks, which often don't have a steady stream of fee-based products that can help offset the impact of rising rates. The recent deposit trends are adding more pressure to net interest margins -- the key measure of profitability that represents the difference between the amount that banks earn in interest from loans and what they pay out in interest for deposits.

Net-interest margins have been squeezed for much of the year by the flat yield curve, or the difference between long- and short-term interest rates. Banks, which borrow at lower-cost short-term rates and lend money at higher long-term rates, typically profit on the gap between the two. When the curve flattens or inverts -- as it did briefly earlier this year -- banks earn lower profits.

"With the curve remaining flat, we expect managements' tone to be cautious as the rate cycle could extend past most expectations," wrote John McDonald, an analyst at Banc of America Securities, in a June 30 report.

In recent weeks, other regional banks also have warned that the financial results are being squeezed. Among them: National City Corp. of Cleveland; Fifth Third Bancorp, which is based in Cincinnati; and New Jersey's Commerce Bancorp Inc. The warnings have prompted analysts to reduce their expectations for other regional banks that haven't yet sounded the alarm.

"As we get closer to second-quarter earnings season, it seems clear that the current operating environment is continuing to take a toll on bank earnings," wrote Robert Hughes, an analyst at Keefe, Bruyette & Woods Inc., in a 526-page earnings outlook issued late last month. The New York boutique firm specializes in providing investment banking and research in the financial-services sector.

Even as people move their money into higher-yielding accounts, banks are competing fiercely to retain those customers and attract new ones. Citigroup Inc.'s online savings account, for example, now boasts a 5% yield, up from 4.5% when the global bank introduced the account in March. A traditional Citibank savings account, meanwhile, is yielding 0.7%. And New York-based Emigrant Bank has raised the interest rate on its online savings account twice in the past two weeks. It now yields 5%.

The continued squeeze on net-interest margins is expected to accelerate a round of consolidation that already is taking place in the banking sector. Citizens Banking Corp. recently agreed to buy Republic Bancorp Inc. for $1.05 billion in a deal combining two Michigan banks that "will be better positioned to compete with super-regional as well as community banks," according to a statement announcing the transaction.

"We believe the challenges will force the hands of banks to strike low-premium, defensive consolidation deals, further limiting upside for investors," wrote Meredith Whitney, an analyst at CIBC World Markets in a report issued last month.