THE nation's banks just reported their highest quarterly profits in three years.
The earnings turnaround has not been lost on Wall Street, where stock prices for banks have been outpacing the broader market for 18 months.
But beneath this pretty picture, analysts say, long-term challenges for the industry remain. Banks on the "problem list" of the Federal Deposit Insurance Corporation, the government regulatory agency, have assets totaling $535 billion, up from $319 billion a year before.
Certainly not all these institutions - which number 980 out of the 12,000 commercial banks in the United States - are doomed. One FDIC scenario projects that banks with $200 billion in assets will fail by 1994, and banks with another $300 billion by 2006. The agency also offered scenarios in which failures might be higher or lower.
When regulators shut a bank down, many of its assets (loans and investments) are sound and can be sold to other banks. So the FDIC estimates that its costs in protecting depositors will run around 17 percent of total assets of the failed banks.
The agency is "going to start closing them right after the election," predicts Dan Brumbaugh, an economist and author of the recent book, "The Future of American Banking."
In 1991, the assets of failed banks totaled a record $63 billion.
The industry's problems go far beyond the real estate bust that rolled through Texas in the mid-1980s, New England in the recent recession, and now California.
The basic problem, says Gary Gorton of the University of Pennsylvania's Wharton School, is a long-term decline in industry profitability due to competition from "nonbank" financial companies. Mortgage companies have moved in on banks' home-loan business, automakers run successful car-loan units, and other firms compete with banks to issue short-term commercial debt.
All this has left banks with more risky loans, Mr. Gorton says. In the 1980s, for example, some banks shifted heavily into commercial real estate lending, and many deals went bad.
Meanwhile, federal insurance keeps deposits flowing in, giving banks lots of money to loan. The FDIC projects that the industry will grow from $3.5 trillion in assets today to $5 trillion in 2006.
At present, loan-demand is weak. For the first time on record, banks hold more government securities than business loans.
Economists say banks still have an important role in the economy - particularly as lenders to small businesses that can't turn elsewhere for financing. But the industry is still trying to adapt to the more competitive climate.
"Banks are really caught up in a huge storm, and they don't realize how much has to change," Gorton says.
Mr. Brumbaugh points to three approaches the industry is taking to build profitability:
Cost-cutting. Since 1987, the industry has cut 70,000 jobs, or 4.6 percent of total employment, according to Sheshunoff Information Services Inc. About 10,000 jobs were cut in the first quarter of this year.
Interest-rate spreads. As the Federal Reserve has brought interest rates down, banks have reduced the rates they pay depositors more than the rates at which they lend, increasing the "spread" to an average of 4.34 percent, up 0.25 percentage points from a year ago, according to Sheshunoff. Falling rates also push up the value of US Treasury Securities that banks hold, allowing them to reap capital gains.
Fees from nontraditional activities. Many large banks generate fees by providing so-called "derivative" securities. These futures contracts are designed for companies that want a hedge against changing interest rates or foreign-exchange rates.
Such efforts, combined with the strengthening of real estate markets in many regions, appear to be paying off for many banks.
At the same time, regulators are taking a tougher stand to try to keep banks from failing. Among the steps:
* The FDIC has proposed a system by which the deposit-insurance premiums that banks pay would vary according to risk. Currently the fees are a flat rate for all banks.
* Under international guidelines taking effect at the end of this year, banks must keep a higher ratio of capital to assets, thereby providing a bigger cushion against losses.
* Under the FDIC Improvement Act, passed by Congress last November, regulators are required to intervene early if a bank falters. This could mean forcing a bank to suspend dividend payouts to shareholders or closing a bank before its capital is exhausted.
Congress is hoping to avoid a taxpayer bailout of depositors, as happened with the savings and loan industry. Last year's banking reform requires the FDIC to replenish the Bank Insurance Fund, which is now empty, over a 15-year period. To accomplish this, FDIC chairman William Taylor anticipates boosting the average premium to 28 cents per $100 of deposits, up from 23 cents today. The premiums will be raised or lowered as needed to meet the fund's target level of 1.25 percent of industry assets by 2006.