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April 3, 2006

REPORT SUMMARY: The bottom line | Highlights from the Bureau of Financial Institutions' annual report to the Legislature

Maine banks
Interest rates and income

Net income for the first six months of 2005 was flat as higher net interest income was offset by lower non-interest income and higher overhead. The decrease in non-interest income is largely attributed to the slowdown in residential mortgage originations and refinancings, which has generated less fee income and gains on sales of loans.

Net interest income as a percentage of average assets at Maine banks was 3.51%, compared to 3.93% for all federally-insured banks in the United States (see chart below). The comparatively weak net interest income is due to a greater reliance on non-core funding (brokered deposits, certificates of deposits in excess of $100,000 and borrowings), which results in a higher interest expense. The flat yield curve, resulting from long-term interest rates being only narrowly higher than short-term interest rates, has squeezed net interest income. This compression of the interest margin, which is expected to continue over the near term, is one of the biggest challenges facing bankers today.

Assets and loans
Assets at Maine banks increased seven percent for the 12 months ending June 2005, slightly lower than all federally-insured banks. However, loan growth modestly exceeded asset growth as loans increased to a record 76% of assets, well above the national average of 64%. (See table below.)

All major categories of loans increased, except for loans to individuals, which declined a nominal 0.4%. The mix continued to shift slightly towards loans secured by real estate, which now account for 80% of all loans. The national average for loans secured by real estate is 68% and is increasing at about the same pace as that for Maine banks. The strong growth in commercial and industrial loans ("C&I") at the Maine Banks, the highest in five years, is a positive reflection of current economic growth in Maine.

Outlook
Overall, Maine banks remain in sound financial condition with strong capital, adequate earnings and sound asset quality. As such, they are well-positioned to continue to provide a wide variety of financial products and services to Maine consumers and businesses.
However, there are a number of challenges facing Maine banks. These challenges include increasing core deposits, maintaining sound credit underwriting while increasing loans, preventing further erosion of the interest margin, growing non-interest income, and controlling expenses. Management's response to these challenges will continue to be complicated by intense competition ˆ— including increased competition from nonbanks ˆ— the need to keep pace with technological advances and an increased regulatory burden, particularly in the compliance arena. To help prioritize these challenges and their associated risks, increasing importance is placed on each institution's internal risk management practices, especially as the institution grows in asset size and complexity. An effective risk management process will enable management to not only identify the bank's risks, but also to measure, monitor and mitigate those risks. A sound risk management process, though challenging to create in the short-term, will in the long-run assist management to better confront the myriad of issues it will encounter. Management of Maine banks continues to improve and expand their risk practices as they become more familiar with the process and its benefits.

Maine credit unions
Maine credit unions continue to record steady and moderate performance, resulting in an industry that remains in sound financial condition. Key ratios such as net worth-to-total assets, return on average assets, past due loans and net loan losses, while generally not as strong as the national averages, are nevertheless solid. Capital and earnings are more than adequate to support expected future asset growth and the credit quality, based on past due loans and net loan losses, is at or very near historic high points.
Interest rates and income

Maine credit unions' ROA (return on assets) improved slightly in 2004 due to a combination of lower overhead and a lower provision for the allowance for loan losses. The decrease in these two expense categories was greater than the decrease in the two revenue accounts. However, in the first six months of 2005, an increase in overhead and a continued decline in net interest income resulted in a drop in ROA. Despite the ongoing decrease in net interest income, Maine credit unions continue to enjoy a comparatively strong net interest income, due largely to a high loan-to-asset ratio, supplemented by a slightly higher loan yield and a slightly lower cost of funds.

Assets and loans
For the first six months of 2005, Maine credit union asset growth held steady at six percent. Loan growth slowed to an annual rate of five percent. The bulk of the growth has been in real estate loans, which now account for 55% of all loans. Other real estate, which consists primarily of home equity loans, has grown the fastest. Other real estate now accounts for more than one-third of the dollar growth for the first six months of 2005. Unsecured loans, which include credit card loans, continue to decline in both dollars and as a share of total loans.

Over the last ten years, loan and share growth at Maine credit unions has narrowly outpaced that for all financial institutions in Maine. As a result, the percentages of loans and deposits held by Maine credit unions have steadily increased; their percentage of total loans has increased from 11% to 14% and of total deposits from 13% to 16%. Nationally, credit unions hold six percent of total loans and eight percent of total deposits. Over the same ten-year period, the number of Maine credit unions dropped from 94 to 75, but their percentage of all Maine financial institutions has held steady at 66%. The decline in the number of institutions, all attributable to mergers, has contributed to the increase in average asset size from $23 million to $53 million.

Outlook
Maine credit unions, despite their comparatively strong growth, continue to hold a small share of loans and deposits in Maine and are dominated by small, one- or two-office institutions. In addition to facing stiff competition from banks and other financial service providers for loans and deposits, they are confronted with increased regulatory burden and ever-changing technology demands. These challenges generally require added expenditures, but with revenue growth constrained by the increasing pressure on the net interest margin, Maine credit unions must control expenses. These challenges are not unique to Maine credit unions, they are common to all financial institutions regardless of asset size. For Maine credit unions, the difficulties in overcoming the challenges are exacerbated by their relatively small size.




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