As the year comes to a close, we hope it takes with it the distress of the nation’s first downturn since the recession of the early 1990s. We approach 2003 with the University of Michigan index at a nine year low, as the nation’s economic health remains saddled by lingering market malaise, a weak job market and looming foreign policy concerns.

What is impressive to those of us who were once in bank supervision is the fact that, so far, the banking industry has withstood these economic changes without anywhere near the bloodletting of past downturns. On the whole, most institutions have done better than expected, notching respectable progress over 12 challenging months.

For example, the Federal Deposit Insurance Corporation reported that, over the 12 month period ending June 2002, net income for all FDIC insured institutions increased $7.9 billion, or 17.6 percent, and equity capital increased $77.9 billion, an 11.7 percent jump.

Not surprisingly, the blueprint for the successes of 2002 is an adherence to good banking practices: much improved risk management systems, diversification through fee income, and a solid focus on the fundamentals of taking deposits and being selective about what loans get made. Michigan bankers know this well.

Risk Management

Banks continue to succeed in today’s challenging environment because they are using more sophisticated tools to effectively manage their risk exposure. Still, we need to do better. One field of risk that deserves far more attention is reputation risk - a nebulous but critically important risk characteristic that eludes simple quantification.

The long shadow cast by Enron, WorldCom and isolated, though headline-grabbing predatory lending practices of a few misguided financial services providers has tainted, often unfairly, financial services companies and, to some extent, the industry. Whether fair or not, the fact is that the spotlight is often focused on the financial sector, and banks must think carefully about each step they take. Banks have to ask themselves every day whether they are doing everything they can to safeguard their reputations in the decisions they make.

For example, bankers must ask these questions: What’s the nature of the business or transaction I’m funding? How close to the letter of the law am I positioning my bank? What do my customers think of my bank’s service? Will my corporate governance standards hold up to stress? Am I fostering constructive regulatory relations and a responsible work environment?

The answers may be different for each bank, but the questions are the same. And they are critical questions for any financial institution.

Diversification

While dot-coms from a past era litter the landscape and have saddled some financial institutions with significant losses, banks still managed to earn significant revenue in 2002. One way they accomplished this is through fee income, much of which was earned through prudent diversification of products and services.

While not every bank fared well across all sectors, this type of diversification helped more banks do better with less interest income.

We can see the positive impact of increased fee income across the banking industry. FDIC-insured banks and thrifts reported $71.9 billion in non-interest income back in 1992, which reflected17.8 percent of total income. By year-end 2002, insured institutions are projected to report nearly $180 billion in non-interest (fee) based income -- representing nearly 30 percent of total income. This will mark an increase in fee-based income of 150 percent over the past decade.

Fundamentals

In assessing success in 2002 and beyond, it might seem paradoxical to extol as virtues both the reaching out for new opportunities through diversification and the pulling back to fundamentals. Yet, to win in today’s furiously competitive banking climate, banks must have both arrows in their business quiver.

To the great credit of the banking industry, the present economic downturn has brought to the fore an industry that is more focused, more seasoned and in a better leadership position than in the past. As the economy swooned this past year, banks prudently tightened lending standards for C&I loans, while taking advantage of home mortgage refinancing and some consumer and small business lending opportunities.

2003

Looking at 2003, Michigan banks must keep in mind the lessons of 2002. Maintain focus on increasing earnings and reducing the number of bad loans. The higher net interest margins for many institutions in 2002 were offset by an increase in nonperforming loans. Even if we are poised for a further increase in profitability, 2003 is likely to be a challenging year for other reasons.

Even if the economy improves, we still face the lingering anxiety of the possibility of a terrorist attack, a protracted war in Iraq (and oil price shock), additional corporate scandals and an overreaction to these scandals by government. We still have some threatening storm clouds on the horizon.

At the same time, if there is one truism about a market economy, particularly the American free market economy, it is that powerful forces eventually push the pendulum back toward growth. The unpleasant but cleansing medicine of a down cycle is being taken. One of the key reasons to maintain a focus on risk management, diversification and strong fundamentals is that the game will be won by those who are best positioned when the rain clouds move out to sea and the playing field is bathed in sunshine once again.

Eugene A. Ludwig, who served as Comptroller of the Currency from 1993-1998 and Vice-Chairman of Bankers Trust/Deutsche Bank, is currently Managing Partner of Promontory Financial Group in Washington, DC.