Banks across the U.S., including the Eleventh Federal Reserve District, appear to be recovering from the financial crisis that began in mid-2007. The news is welcome because a healthy banking sector spurs economic growth by providing financing for businesses to expand investment spending and for consumers to purchase goods and services. ; Data for 2010 show strong profit growth, with banks across the nation rebounding from a net loss in 2009 and those in the Dallas-based Eleventh District almost doubling their profits. There was also good news regarding asset quality: Problem loans are starting to moderate. And there are indications that the banking industry has grown more efficient, supporting more operations at lower cost. ; However, concerns linger about the sustainability of profits because the recent improvement can be attributed almost entirely to a reduction in what banks set aside to cover future loan losses. Banks refer to this as their provision expense, and it usually falls as asset quality improves. But there is a limit to how far it can decline and contribute to profitability.Business conditions ; Profit

Kelly Klemme

Kenneth J. Robinson

English

Research Papers in Economics

SouthwestEconomy    FEDERAL RESERVE BANK OF DALLAS • SEcOND quARtER 2011 10
Bank Profits Rebound
as Loss Set-Asides Ease
By Kelly Klemme and Kenneth J. Robinson 
Last year, the banking 
 industry both nationally 
 and regionally recorded 
 its highest net income 
 since 2007.
Banks across the U.S., including the Elev-
enth Federal Reserve District, appear to be 
recovering from the financial crisis that began 
in mid-2007.1 The news is welcome because 
a healthy banking sector spurs economic 
growth by providing financing for businesses 
to expand investment spending and for con-
sumers to purchase goods and services.
Data for 2010 show strong profit growth, 
with banks across the nation rebounding from 
a net loss in 2009 and those in the Dallas-
based Eleventh District almost doubling their 
profits. There was also good news regarding 
asset quality: Problem loans are starting to 
moderate. And there are indications that the 
banking industry has grown more efficient, 
supporting more operations at lower cost.
However, concerns linger about the 
sustainability of profits because the recent 
improvement can be attributed almost en-
tirely to a reduction in what banks set aside 
to cover future loan losses. Banks refer to 
this as their provision expense, and it usu-
ally falls as asset quality improves. But there 
is a limit to how far it can decline and con-
tribute to profitability. 
Improved Profitability in 2010
Last year, the banking industry both 
nationally and regionally recorded its highest 
net income since 2007. Return on average as-
sets (ROAA) also reached a three-year peak in 
2010—0.66 percent for banks nationally and 
0.93 percent for those in the Eleventh District. 
The better performance regionally reflects the 
relative strength of the area’s economy and 
general absence of a major housing bubble. 
Asset-quality problems also appeared to 
abate. Nationally, noncurrent loans reached 
a record high of 5.5 percent at the end of 
2009.2 Since then, asset quality has steadily 
improved. A similar picture emerges in the 
district, although the noncurrent loan rate 
peaked at only 2.7 percent in 2010.3
Profits in banking and other industries 
are defined as the difference between rev-
enues and expenses. One major source of 
bank revenue is net interest income, or the 
difference between the interest earned on 
loans and securities and the interest paid 
on deposits and other funding. Another im-
portant revenue source is noninterest in-
come, sometimes referred to as fee income. 
It includes earnings from service charges, 
trading revenue, asset sales and investment 
advice. 
Banks’ major expense categories are 
noninterest expense, which includes items 
such as labor costs and building mainte-
nance, and provision expense, for reserves 
set aside to cover loan defaults. In a dete-
riorating economy, defaults become more 
likely and banks increase their loan-loss 
reserves by increasing their provision ex-
pense. Conversely, as economic conditions 
improve, banks are able to set aside less, 
reducing their provision expense.4
Table 1 shows the major components 
of profitability for U.S. and Eleventh District 
banks and their contribution to earnings in 
2009 and 2010. Among banks nationally, the 
76-basis-point improvement in profitability, 
as measured by ROAA, can be traced almost 
entirely to a drop in provision expense. A 
basis point equals one one-hundredth of 
Table 1
Contributions to Bank Profitability
U.S. Eleventh District
Percent of average 
assets
Difference  
(basis points)**
Effect 
on 
ROAA
Percent of average 
assets
Difference  
(basis points)**
Effect 
on  
ROAA 2009 2010 2009 2010
Revenue
Net interest income 3.06 3.26 20 + 3.57 3.49 –8 –
Noninterest income 2.07 1.81 –26 – 1.61 1.21 –40 – 
Expense
Noninterest expense 3.18 2.98 –20 + 3.39 2.89 –50 +
Provision expense 1.96 1.21 –75 + 1.17 0.68 –49 +
Taxes 0.03 0.28 25 –  0.19 0.26 7   –
Other items* –0.05 0.06 11 + 0.09 0.06 –3 –
Net income (ROAA) –0.10 0.66 76 0.52 0.93 41
* "Other items" includes securities gains/losses and extraordinary items.
** A basis point equals one one-hundredth of a percentage point.
SOURCE: Quarterly Reports of Condition and Income, Federal Financial Institutions Examination Council.  FEDERAL RESERVE BANK OF DALLAS • SEcOND quARtER 2011 SouthwestEconomy 11
a percentage point. For the district, profit-
ability increased 41 basis points despite less 
revenue. For these banks, lower revenue was 
more than offset by declines of about 50 basis 
points in both noninterest expense and provi-
sion expense.
Earnings Sustainability
Banks’ improved profitability has been 
characterized as “a drastic reversal from 2009, 
when the prospect of widespread loan de-
faults forced them to set aside billions of dol-
lars to cover losses.”5 Interpreted this way, the 
upturn may seem less resilient. Lower provi-
sion expense means banks are setting aside 
less money for future loan losses. As the over-
all economy improves and asset-quality prob-
lems diminish, such a reduction is expected. 
Given that there is a limit to how much 
provision expense can fall and thus con-
tribute to profitability, and that revenue has 
recently increased little, if any, is bank profit-
ability stagnating? Or will increased revenue, 
or perhaps efficiency gains, help sustain bank 
profitability?
Provision Expense and Return on Assets
Some historical perspective might shed 
light on these questions. While declining pro-
vision expense is a big contributor to recent 
bank profitability, that development is neither 
new nor unusual. Historically, provision ex-
pense changes have been important factors 
affecting movements in bank profitability.
Chart 1
Movements in Profitability Driven by Changes in Provision Expense
A. U.S. Banks
Percent
–.5
0
.5
1
1.5
2
2.5
’10 ’09 ’08 ’07 ’06 ’05 ’04 ’03 ’02 ’01 ’00 ’99 ’98 ’97 ’96 ’95 ’94 ’93 ’92 ’91 ’90 ’89 ’88 ’87 ’86 ’85 ’84
Return on average assets
Provision expense
(percent of average assets)
B. Eleventh District Banks
Percent
’10 ’09 ’08 ’07 ’06 ’05 ’04 ’03 ’02 ’01 ’00 ’99 ’98 ’97 ’96 ’95 ’94 ’93 ’92 ’91 ’90 ’89 ’88 ’87 ’86 ’85 ’84
–2
–1.5
–1
–.5
0
.5
1
1.5
2
2.5
Return on average assets
Provision expense
(percent of average assets)
SOURCE: Quarterly Reports of Condition and Income, Federal Financial Institutions Examination Council.
In periods of relative banking prosper-
ity, such as the 1990s, provision expense and 
profitability are fairly constant. But during 
times of stress, when banks must set aside ad-
ditional funds to cover possible loan defaults, 
the associated provision expense increase 
coincides with declining bank profitability. 
This was true for U.S. banks in the recent fi-
nancial crisis (Chart 1A), and it was also true 
for Eleventh District banks in the late 1980s, 
when the industry experienced severe diffi-
culties (Chart 1B).6
For U.S. banks, provision expense in-
creased 169 basis points from 2006 to 2009 
(Chart 2). This coincided with a decline in 
profitability of 147 basis points. In the district, 
provision expense increased 118 basis points 
in the mid-1980s. During this period, ROAA 
fell 206 basis points. Provision expense in 
both downturns was the single-biggest con-
tributor to profitability movement, far outpac-
ing other components.
During periods of recovery, though, this 
trend is reversed. As Chart 1 reveals, we are 
beginning to see a decline in provision ex-
pense at banks nationwide as the recovery 
takes hold. Similarly, provision expense fell 
sharply in the district in the late 1980s after 
banking difficulties subsided. 
Weakness in Revenue
If banks are showing weakness in rev-
enue measures, as seen in Table 1, how 
durable can the recent profitability upturn 
be? Again, historical perspective is useful. Rev-
enue measures at both U.S. and district banks 
rose fairly steadily until peaking in the mid-to-
late 1990s (Chart 3).
Since then, overall revenue has trended 
lower. Revenue sources differ somewhat, 
with banks in the district deriving a greater 
proportion of revenue from net interest 
income than banks nationally, and banks 
nationwide deriving a relatively larger 
proportion of revenue from noninterest 
income. However, despite this revenue de-
cline, banks were able to earn a healthy re-
turn on assets of 1 percent or more, at least 
until the onset of the financial crisis. So a 
lack of recent revenue growth is not neces-
sarily cause for concern. An increasingly 
competitive marketplace tends to pressure 
revenue and overall profitability.7 Yet, banks 
have earned robust profits even in the face 
of a sustained revenue decline. 
Maintaining Profitability
The banking industry has confronted 
significant competitive issues over the past   FEDERAL RESERVE BANK OF DALLAS • SEcOND quARtER 2011 SouthwestEconomy 12
two decades. Interstate branching restric-
tions were eliminated with the Riegle–Neal 
Interstate Banking and Branching Efficiency 
Act of 1994, increasing industry consolida-
tion. And entities such as hedge funds and 
money market funds lured customers away 
from banks. 
Despite the pressures on revenue, 
banks were able to maintain profitability. 
One possible explanation may be that in-
creased efficiency offset declining revenue, 
thus mitigating the pressure on profitability. 
Noninterest expense, as a percent of aver-
age assets, can be used as a rough measure 
of bank efficiency. 
Noninterest expense is a broad cat-
egory that includes employee salaries and 
benefits, facility and equipment expenses, 
advertising and marketing costs and other 
types of overhead. If bank efficiency is im-
proving, it is expected that noninterest ex-
pense would decline relative to assets. That 
ratio, after increasing fairly steadily, peaked 
in the mid-to-late 1990s at U.S. and Elev-
Lower provision expense 
means banks are setting aside 
less money for future loan 
losses. As the overall economy 
improves and asset-quality 
problems diminish, such a 
reduction is expected.
Chart 2
Higher Provision Expense Biggest Contributor to Declining Profitability
Change in basis points
–250
–200
–150
–100
–50
0
50
100
150
200
250
118
169
–206
Net interest income
Noninterest income
Noninterest expense
Provision expense
Taxes
Other items
ROAA
118
–147
U.S. 2006–09 Eleventh District, 1984–87
NOTE: Components of return on average assets (ROAA) are calculated as a percent of average assets.
SOURCE: Quarterly Reports of Condition and Income, Federal Financial Institutions Examination Council.
Chart 3
Bank Revenue Trending Downward
Percent of average assets
0
1
2
3
4
5
6
7
8
’10 ’08 ’06 ’04 ’02 ’00 ’98 ’96 ’94 ’92 ’90 ’88 ’86 ’84 ’10 ’08 ’06 ’04 ’02 ’00 ’98 ’96 ’94 ’92 ’90 ’88 ’86 ’84
Net interest income
Noninterest income
U.S. Eleventh District
SOURCE: Quarterly Reports of Condition and Income, Federal Financial Institutions Examination Council.  FEDERAL RESERVE BANK OF DALLAS • SEcOND quARtER 2011 SouthwestEconomy 13
enth District banks and has since trended 
downward (Chart 4).
For banks in the U.S. and the district, 
falling salary and premises expense relative 
to assets accounted for roughly half of the 
overall decline. In other words, banks are 
now able to support more assets at a lower 
cost. That may reflect recent advances in 
information technology.8 
Rebuilding Balance Sheets
Recent data suggest that the banking 
industry, with improved profitability and 
fewer problem assets, is in the early stages 
of recovery from the worst financial crisis 
since the Great Depression. Adjustments 
continue as banks strive to rebuild their 
balance sheets and position themselves for 
the future. These changes, coupled with 
declining revenue, could be contributing 
to a spate of mergers and acquisitions. In 
2010, for example, 172 bank mergers were 
announced. Of this total, more than three-
fourths involved sellers with fewer than 
$1 billion in assets. So far this year, 44 deals 
have been announced, and almost all in-
volve sellers with assets below $1 billion.9
Concerns remain about the source of 
the industry’s profits, but these may be mis-
placed. Put in historical context, the recent 
rebound in profitability that has been driv-
en almost entirely by a drop in provision 
expense is both welcome and expected. As 
the economic recovery advances and asset 
quality improves, the upturn in profitability 
should continue.
Klemme is a financial industry analyst and Rob-
inson is a research officer in the Financial In-
dustry Studies Department at the Federal Reserve 
Bank of Dallas.
Notes
1 The Eleventh Federal Reserve District consists of Texas, 
northern Louisiana and southern New Mexico.
2 Noncurrent loans are those 90 days or more past due or 
those with nonaccrual status (the stated interest rate was not 
being paid).
3 Data were obtained from the Federal Financial Institutions 
Examination Council’s Reports of Condition and Income. Data 
for the Eleventh District banking industry have been adjusted 
for structural changes involving recent relocations of banks 
into the district.
4 Technically, the loan-loss reserve is known as the Allowance 
for Loan and Lease Losses (ALLL). There are no formal 
numerical requirements for banks’ ALLL. However, banks are 
responsible for “developing, maintaining, and documenting a 
comprehensive, systematic, and consistently applied process 
for determining the amounts of the ALLL.” See Board of 
Governors of the Federal Reserve System, SR 06-17, Dec. 
13, 2006, www.federalreserve.gov/boarddocs/srletters/2006/
SR0617.htm. 
5 See “Banks’ Underlying Problem is Revenue,” by Eric Dash, 
New York Times, Jan. 18, 2011.
6 For more on the 1980s banking difficulties in the Eleventh 
District and how district banks have fared relatively better 
in the current crisis, see “Eleventh District Banking Industry 
Weathers Financial Storms,” by Kenneth J. Robinson, 
Southwest Economy, Second Quarter 2010.
7 See “The Competitive Dynamics of Geographic Deregulation 
in Banking: Implications for Productive Efficiency,” by 
Douglas D. Evanoff and Evren Ors, Journal of Money, Credit 
and Banking, vol. 40, no. 5, August 2008, pp. 897–928. 
Product restrictions were also relaxed. See “The Impact of the 
Gramm–Leach–Bliley Act on the Financial Services Industry,” 
by Abdullah Al Mamun, M. Kabir Hassan and Van Son Lai, 
Journal of Economics and Finance, vol. 28, no. 3, Fall 2004, 
pp. 333–47. 
8 See “The Economic Effects of Technological Progress: 
Evidence from the Banking Industry,” by Allen N. Berger, 
Journal of Money, Credit and Banking, vol. 35, no. 2, April 
2003, pp. 141–76.
9 See “Merged Banks Could Become Future Bait for Bigger 
Banks,” by Rachel Witkowski, American Banker, March 29, 
2011. Data on mergers are from SNL Securities as of April 
28, 2011. 
Chart 4
Lower Noninterest Expense Points to Improved Efficiency
Percent of average assets
’10 ’09 ’08 ’07 ’06 ’05 ’04 ’03 ’02 ’01 ’00 ’99 ’98 ’97 ’96 ’95 ’94 ’93 ’92 ’91 ’90 ’89 ’88 ’87 ’86 ’85 ’84
Net interest income
Noninterest income
2.5
3.0
3.5
4.0
4.5
Eleventh District
U.S.
SOURCE: Quarterly Reports of Condition and Income, Federal Financial Institutions Examination Council.
Recent data suggest that the 
banking industry, with  
improved profitability and 
fewer problem assets, is in the 
early stages of recovery.

Bank profits rebound as loss set-asides ease

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Bank profits rebound as loss set-asides ease

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