(FORTUNE Magazine) – AFTER a two-year plunge, the banking industry has finally hit bottom. Bad loans have peaked, and financial statements are looking healthier. Says E. Gerald Corrigan, president of the Federal Reserve Bank of New York: ''A case can be made that we are further along in the healing process than may be widely appreciated.'' That does not mean the patient is out of pain. ''This year could be very, very difficult,'' says Christopher Snyder, president of Loan Pricing Corp., a company that analyzes bank loan quality. ''The year after the economy bottoms out is the time when banks historically have had the most difficulty maintaining earnings.'' The banks still bear the cost of managing all those bad loans, but they are not receiving much income from them. Says John Medlin, chief executive of Wachovia Corp., one of America's best-run banks: ''Each time we've gone through an economic cycle since the mid-1970s, we've accumulated more garbage in the financial system.'' Every lending binge -- to less developed countries in the late 1970s, to highly leveraged corporations and to real estate magnates in the latest case -- has added to the residue of toxic waste on bank balance sheets. The debris of the 1980s is everywhere, represented most prominently by those see-through office towers in major cities around the country. Overbuilding has already clobbered developers and those who lend to them. But it's only beginning to catch up with owners of fully occupied towers. They are suffering as their leases expire and must be renewed at lower rates. John Grundhofer, chief executive of First Bank System in Minneapolis, reports that tenants in his city are getting a year or two of free rent in some buildings. Landlords are desperate, rental rates are tumbling, and occupants are being sucked out of once fully leased buildings into newer, cheaper space. Says Grundhofer: ''That's why it will take a lot longer than most bankers imagine for those real estate loan problems to go away.'' Look for the pain to keep overall bank profits depressed until 1994 at least. Despite the deflated real estate market, bankers are more optimistic today than they were a year ago, mainly because they have already confronted the worst nightmares in their loan portfolios. Last year 18 of the 50 largest banks saw their nonperforming loans jump by more than 15% in a single quarter. Now that the economy is showing signs of life, they don't expect to be surprised. Says John McCoy, CEO of Banc One: ''Banks have their hands around their loan problems.'' One reason banks feel healthier is that the lower short-term interest rates decreed by Federal Reserve Board Chairman Alan Greenspan are a shot of vitamin B to margins. The spread between what lenders pay depositors -- their cost of raw materials -- and the income they receive on loans -- their revenue from the sale of finished goods -- widened nicely in 1991. And banks worked hard to take advantage of the decline. As rates fell, they aggressively lowered their payout to depositors. Within a year Citicorp, for example, dropped the rate it was offering on checking account balances in New York City from 4.95% to 2%, the lowest in ten years. Other lenders followed suit. But rates on mortgages, credit card loans, and business loans did not drop nearly as fast, because long-term interest rates did not decline as sharply as short-term. Result: January and February were terrific months -- at least for margins. The industry has also been exhibiting a salutary and growing concern for its own health. In the late 1980s bankers began dieting to shed excess overhead, bulking up their capital, and, after some flailing around, tightening flabby credit standards. Despite punishing losses over the past three years, the 50 biggest banking companies increased their capital from 5.5% of assets in 1988 to 5.9% at the end of last year while beefing up their reserves against possible loan losses from 2.3% of borrowings to just under 4.8%. The most promising sign is that banks are serious about cost cutting. Hatchet men are the golden lads of this season. During 1991 the top 25 banks $ eliminated 44,000 jobs and they could easily trim up to twice as many this year. The benefits of cost cutting aren't obvious yet because costs rose as fast as the axmen wielded their big blades last year. The expenses of managing bad real estate and laying people off rose steeply industrywide, more than offsetting other cuts. Costly loan problems and layoffs will continue well into 1992, but by mid-decade savings will be fattening bank bottom lines. IN THE SHORT RUN, slow demand will hold down profits. Formerly steely-eyed regulators are now urging banks to shovel out the cash, for example by eliminating the detested loan classification for highly leveraged transactions. Early in the year even Gerald Corrigan was telling the New York State Bankers Association that ''fresh credits ((i.e., loans)) can be a constructive part of workout strategies for some troubled borrowers.'' But except for mortgage holders rushing to refinance at lower rates, scarcely anyone wants to borrow this year. Banks created some of their own problems by slicing credit to businesses last year and discouraging borrowing. Commercial loans dropped by 8% through the end of the third quarter of 1991, a sharper drop than at any time since World War II. Consumer demand also leveled off and is expected to remain sluggish this year. With inflation likely to average 4.5% and GDP growth a real 2.5%, borrowers may not return quickly. J. Richard Fredericks, an analyst at Montgomery Securities, sees a bleak outlook. ''Due to low inflation,'' he says, ''demand will be nothing like what people have lived with in the last 20 years.'' Even banks that are literally knocking on doors looking for new business aren't finding anyone home. John McGillicuddy, chairman and chief executive of Chemical Banking, joined his troops on February 11 for a blitz that saw some 800 lending officers hit the streets in Connecticut and New York to talk with officers of 2,300 middle-size corporations -- those with revenues of $1 million to $250 million. Says McGillicuddy: ''The reactions from customers were good, but there was no landslide of new business. What we thought was true is true: There is not a lot of pent-up borrowing demand.'' A high rate of failures will continue to plague the industry. The ranks of the halt and the comatose are still swollen, and regulators expect them to fold in near record numbers. The Federal Deposit Insurance Corp. may close around 200 institutions this year, up from 127 last year. And it is eyeing another 1,100 nervously. Though the number of problem banks plateaued last year, the assets of those that landed on the FDIC's Problem Bank List grew by 50% to $613 billion -- largely because of those commercial real estate loans. Banks that failed in 1991 had assets of about $64 billion. Those on the chopping block for 1992 have around $100 billion in assets. Will that be a peak? Says FDIC Chairman William Taylor: ''We know we've got a hole in the bow, but we can't be sure when we'll hit bottom.'' The regional real estate depression that plowed through New England and the Middle Atlantic states is now flattening California. Already in trouble are three of the Golden State's largest S&Ls -- HomeFed of San Diego, GlenFed, and CalFed. The assets of this tottering trio add up to about $50 billion. Bankers hope that what they are experiencing is a cathartic purging of the weak so the strong can get stronger -- a financial Darwinism in which the survivors will be efficiently run, shrewd in judging the creditworthiness of borrowers, cautious about taking risks of any kind, and capital-rich. Says John Medlin: ''Bankers are going to make money the old-fashioned way. We're going back to three yards and a cloud of dust banking.'' Among those ready to play that game are some very big banks. Four of America's largest -- Banc One, BankAmerica, Bankers Trust, and J.P. Morgan -- posted biceps-bulging profits of 90 cents per $100 of assets or better last year. Such a level of profitability would have been unthinkable a dozen years ago, when big banks rarely did better than 60 cents per $100 of assets. Other potential winners in this new, more prudent world are banks that can grow through smart combinations. Banc One, BankAmerica, Chemical Banking, Fleet/Norstar Financial, Wachovia, and NationsBank -- a.k.a. that acquisitive regional, NCNB -- are completing or have completed magnum-size mergers. Their capital is at least adequate, their loan controls are tight, and the marriages promise branch closings and job eliminations that will deliver hundreds of millions of dollars a year in cost savings. The new Chemical Banking, for example, is the product of a union between two big New York banks, Manufacturers Hanover and Chemical. As part of its effort to clip $750 million annually out of overhead by 1995, the company is eliminating 6,200 jobs. The bank has already cut 2,000 of these since announcing the merger last July, and in June, when the merger is completed, it will begin erasing redundant operations by lopping whole departments off one bank or the other. ''All the decisions have been made,'' says McGillicuddy. ''Now it's a matter of implementation.'' FLEET/NORSTAR Financial, based in Rhode Island, is riding out the economic disaster in New England lean and mean instead of haggard and laggard. The reason: Fleet, considered the strongest of the region's big banks, bought Bank of New England after it failed. What Fleet got was a clean bank, stripped of bad real estate loans, and a promise from the FDIC that Fleet could hand back to the government within a period of three years any other Bank of New England loans it didn't want. The Rhode Island acquirer was left with a bundle of low- cost deposits and very few asset woes. But Fleet took its lumps along with all New England banks. Says CEO Terrence Murray: ''Over the past 24 months, we've charged off more than $1 billion in bad loans, tripled our reserve to $1 billion, and still managed to make a small profit.'' That last detail, totaling just under $24 million for the two years, was a considerable achievement in a devastated regional economy. Murray did it by squeezing more than $100 million out of his company's overhead. Most of the savings came from making Fleet's back-room operations -- a term that covers such worker-bee activities as data processing, check clearing, and custodial services -- more efficient. As New England's loan problems abate, Fleet's lower breakeven point will put some zip in its earnings. The also-rans in this Darwinian landscape are those with little capital, weak earnings, and flatbeds full of bad loans. They are pinning their hopes on an economic recovery that will boost demand and bail out troubled borrowers. The most prominent is Citicorp, which eliminated its dividend in the third quarter of 1991, took huge loan-loss provisions, and hunkered down for several rugged years. Clearly on the ropes are Midlantic, MNC Financial, Shawmut National, and Bank of Boston. Two other troubled banks, C&S/Sovran and Security Pacific, found rich husbands last year in NationsBank and BankAmerica. On everyone's watch list: Wells Fargo & Co. The San Francisco bank lost money in the third and fourth quarters of last year; a staggering 29% of its loans outstanding are to owners or developers of real estate, mostly in California. As bankers peer fretfully into the future, they worry about the problems that could hang on for years, even in a recovery. The specter of Texas haunts them: Real estate prices there began tumbling in 1982 as a result of declining energy prices and slid ever faster after the 1986 Tax Reform Act eliminated many of the benefits of real estate investing. Every major bank and thrift in the state collapsed. Only now are Texas lenders recovering their stride. Fed Chairman Alan Greenspan is urging Congress to undo some of the 1986 passive loss restrictions on real estate to encourage investment. Without such help, the risk remains that a slow-moving national expansion could stretch out the repair work -- particularly on those real estate-loaded lenders in New England and California -- until the end of the century.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: MONTGOMERY SECURITIES CAPTION: The 50 biggest banks have built their capital and increased reserves over the past year, and the stock market has taken notice. But problem loans are still a dismaying percentage of the total, and those are putting a heavy damper on earnings. THE GOOD THE BAD THE UGLY