Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 


FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 

Commission file number 001-09718

 


The PNC Financial Services Group, Inc.

(Exact name of registrant as specified in its charter)

 


 

Pennsylvania   25-1435979

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One PNC Plaza, 249 Fifth Avenue, Pittsburgh, Pennsylvania 15222-2707

(Address of principal executive offices)

(Zip Code)

(412) 762-2000

(Registrant’s telephone number, including area code)

 


(Former name, former address and former fiscal year, if changed since last report)

 


Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   x         No   ¨         

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Check one:

Large accelerated filer  x         Accelerated filer  ¨         Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨         No   x

As of October 31, 2006, there were 293,812,255 shares of the registrant’s common stock ($5 par value) outstanding.

 



Table of Contents

The PNC Financial Services Group, Inc.

Cross-Reference Index to 2006 Third Quarter Form 10-Q

 

      Pages

PART I – FINANCIAL INFORMATION

  

Item 1. Financial Statements (Unaudited).

   37-62

Consolidated Income Statement

   37

Consolidated Balance Sheet

   38

Consolidated Statement Of Cash Flows

   39

Notes To Consolidated Financial Statements (Unaudited)

  

Note 1 Accounting Policies

   40

Note 2 Acquisitions

   47

Note 3 Securities

   48

Note 4 Asset Quality

   49

Note 5 Mortgage Loan Portfolio Repositioning

   50

Note 6 Goodwill And Other Intangible Assets

   50

Note 7 Variable Interest Entities

   51

Note 8 Capital Securities Of Subsidiary Trusts

   51

Note 9 Certain Employee Benefit And Stock-Based Compensation Plans

   52

Note 10 Financial Derivatives

   53

Note 11 Earnings Per Share

   55

Note 12 Shareholders’ Equity And Other Comprehensive Income

   56

Note 13 Legal Proceedings

   57

Note 14 Segment Reporting

   58

Note 15 Commitments And Guarantees

   61

Note 16 Subsequent Event

   62

Statistical Information (Unaudited)

  

Average Consolidated Balance Sheet And Net Interest Analysis

   63-64

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

   1-36, 63-64

Consolidated Financial Highlights

   1-2

Financial Review

  

Executive Summary

   3

Consolidated Income Statement Review

   7

Consolidated Balance Sheet Review

   10

Off-Balance Sheet Arrangements And Variable Interest Entities

   14

Business Segments Review

   15

Critical Accounting Policies And Judgments

   23

Status Of Qualified Defined Benefit Pension Plan

   23

Risk Management

   24

Internal Controls And Disclosure Controls And Procedures

   33

Glossary Of Terms

   33

Cautionary Statement Regarding Forward-Looking Information

   35

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

   24-30

Item 4. Controls and Procedures.

   33

PART II – OTHER INFORMATION

  

Item 1. Legal Proceedings.

   65

Item 1A. Risk Factors.

   65

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

   65

Item 6. Exhibits.

   65

Exhibit Index.

   65

Signature

   65

Corporate Information

   66


Table of Contents

CONSOLIDATED FINANCIAL HIGHLIGHTS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Dollars in millions, except per share data    Three months ended September 30     Nine months ended September 30  
Unaudited    2006     2005     2006     2005  

FINANCIAL PERFORMANCE

        

Revenue

        

Net interest income, taxable-equivalent basis (a)

   $574     $566     $1,699     $1,619  

Noninterest income (b)

   2,943     1,116     5,358     3,019  

Total revenue (b)

   $3,517     $1,682     $7,057     $4,638  

Net income (c)

   $1,484     $334     $2,219     $970  

Per common share

        

Diluted earnings (c)

   $5.01     $1.14     $7.46     $3.35  

Cash dividends declared

   $.55     $.50     $1.60     $1.50  

SELECTED RATIOS

        

Net interest margin

   2.89 %   2.96 %   2.92 %   2.99 %

Noninterest income to total revenue (d)

   84     67     76     65  

Efficiency (e)

   34     69     50     69  

Return on

        

Average common shareholders’ equity

   65.94 %   16.13 %   33.87 %   16.49 %

Average assets

   6.17     1.45     3.17     1.48  

See page 33 for a glossary of certain terms used in this Report.

Certain prior period amounts included in these Consolidated Financial Highlights have been reclassified to conform with the current period presentation.

 

(a) The interest income earned on certain earning assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable asset. To provide more meaningful comparisons of yields and margins for all earning assets, we also provide revenue on a taxable-equivalent basis by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income on other taxable assets. This adjustment is not permitted under GAAP in the Consolidated Income Statement.

The following is a reconciliation of net interest income as reported in the Consolidated Income Statement to net interest income on a taxable-equivalent basis (in millions):

 

     Three months ended September 30    Nine months ended September 30
     2006    2005    2006    2005

Net interest income, GAAP basis

   $567    $559    $1,679    $1,599

Taxable-equivalent adjustment

   7    7    20    20
                   

Net interest income, taxable-equivalent basis

   $574    $566    $1,699    $1,619
                   

 

(b) Noninterest income for the three months and nine months ended September 30, 2006 included the pre-tax impact of the net gain on the BlackRock/MLIM transaction of $2.1 billion. This category also included the impact of pre-tax charges from third quarter 2006 balance sheet repositioning activities totaling $244 million. Further information is included in the Executive Summary portion of the Financial Review section of this Report.

 

(c) Net income and earnings per share for the three months and nine months ended September 30, 2006 included the after-tax impact of the items referred to in note (b) above, in addition to the after-tax impact of integration costs related to the BlackRock/MLIM transaction. These integration costs totaled $72 million and $91 million on a pre-tax basis for the three months and nine months ended September 30, 2006, respectively, or $31 million and $39 million on an after-tax basis, net of related minority interest.

 

(d) Calculated as noninterest income divided by the sum of net interest income (GAAP basis) and noninterest income. See note (b) above regarding certain items impacting noninterest income for both 2006 periods.

 

(e) Calculated as noninterest expense divided by the sum of net interest income (GAAP basis) and noninterest income. See notes (b) and (c) above regarding certain items impacting noninterest income and expense for both 2006 periods.

 

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Table of Contents
Unaudited    September 30
2006
    December 31
2005
    September 30
2005
 

BALANCE SHEET DATA (dollars in millions, except per share data)

      

Assets

   $98,436     $91,954     $93,241  

Loans, net of unearned income

   48,900     49,101     50,510  

Allowance for loan and lease losses

   566     596     634  

Securities

   19,512     20,710     20,658  

Loans held for sale

   4,317     2,449     2,377  

Investment in BlackRock (a)

   3,836      

Deposits

   64,572     60,275     60,214  

Borrowed funds

   14,695     16,897     18,374  

Shareholders’ equity

   10,758     8,563     8,317  

Common shareholders’ equity

   10,751     8,555     8,309  

Book value per common share

   36.60     29.21     28.54  

Common shares outstanding (millions)

   294     293     291  

Loans to deposits

   76 %   81 %   84 %

ASSETS ADMINISTERED (billions)

      

Managed (b)

   $52     $494     $469  

Nondiscretionary

   89     84     85  

FUND ASSETS SERVICED (billions)

      

Accounting/administration net assets

   $774     $835     $793  

Custody assets

   399     476     475  

CAPITAL RATIOS

      

Tier 1 risk-based (c)(d)

   10.4 %   8.3 %   8.4 %

Total risk-based (c)(d)

   13.6     12.1     12.5  

Leverage (c)(d)

   9.4     7.2     7.1  

Tangible common equity

   7.5     5.0     4.9  

Common shareholders’ equity to assets

   10.9     9.3     8.9  

ASSET QUALITY RATIOS

      

Nonperforming assets to loans, loans held for sale and foreclosed assets

   .36 %   .42 %   .29 %

Nonperforming loans to loans

   .34     .39     .25  

Net charge-offs to average loans (for the three months ended)

   .37     .33     .12  

Allowance for loan and lease losses to loans

   1.16     1.21     1.26  

Allowance for loan and lease losses to nonperforming loans

   339     314     499  
(a) See “BlackRock/MLIM Transaction” in the Executive Summary portion of the Financial Review section of this Report for additional information.
(b) Assets under management at September 30, 2006 do not include BlackRock’s assets under management as we deconsolidated BlackRock effective September 29, 2006. Excluding the impact of BlackRock, our assets under management (consisting of Retail Banking assets under management) totaled $49 billion at December 31, 2005 and $50 billion at September 30, 2005.
(c) The regulatory minimums are 4.0% for Tier 1, 8.0% for Total, and 3.0% for Leverage ratios. The well-capitalized levels are 6.0% for Tier 1, 10.0% for Total, and 5.0% for Leverage ratios.
(d) The ratios for September 30, 2006 reflect the impact of the deconsolidation of BlackRock effective September 29, 2006.

 

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FINANCIAL REVIEW

THE PNC FINANCIAL SERVICES GROUP, INC.

This Financial Review should be read together with our unaudited Consolidated Financial Statements and unaudited Statistical Information included elsewhere in this Report and with Items 6, 7, 8 and 9A of our 2005 Annual Report on Form 10-K (“2005 Form 10-K”). We have reclassified certain prior period amounts to conform with the current period presentation. For information regarding certain business and regulatory risks, see the Risk Factors and Risk Management sections in this Financial Review and Items 1A and 7 of our 2005 Form 10-K. Also, see the Cautionary Statement Regarding Forward-Looking Information and Critical Accounting Policies And Judgments sections in this Financial Review for certain other factors that could cause actual results or future events to differ, perhaps materially, from those anticipated in the forward-looking statements included in this Report or from historical performance. See Note 14 Segment Reporting in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report for a reconciliation of total business segment earnings to total PNC consolidated net income as reported on a generally accepted accounting principles (“GAAP”) basis.

 

EXECUTIVE SUMMARY

THE PNC FINANCIAL SERVICES GROUP, INC.

PNC is one of the largest diversified financial services companies in the United States based on assets, operating businesses engaged in retail banking, corporate and institutional banking, asset management and global fund processing services. We provide many of our products and services nationally and others in our primary geographic markets located in Pennsylvania; New Jersey; the greater Washington, DC area, including Maryland and Virginia; Ohio; Kentucky; and Delaware. We also provide certain global fund processing services internationally.

KEY STRATEGIC GOALS

Our strategy to enhance shareholder value centers on achieving revenue growth in our various businesses underpinned by prudent management of risk, capital and expenses. In each of our business segments, the primary drivers of growth are the acquisition, expansion and retention of customer relationships. We strive to achieve such growth in our customer base by providing convenient banking options, leading technological systems and a broad range of asset management products and services. We also intend to grow through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.

In recent years, we have managed our interest rate risk to achieve a moderate risk profile with limited exposure to earnings volatility resulting from interest rate fluctuations. Our actions have created a balance sheet characterized by strong asset quality and significant flexibility to take advantage, where appropriate, of changing interest rates and to adjust to changing market conditions.

BLACKROCK/MLIM TRANSACTION

As previously reported, in February 2006, BlackRock, Inc. (“BlackRock”), then a majority-owned subsidiary of PNC, and Merrill Lynch entered into a definitive agreement pursuant to which Merrill Lynch agreed to contribute its investment management business (“MLIM”) to BlackRock in exchange for 65 million shares of newly issued BlackRock common and preferred stock. This transaction closed on September 29, 2006. BlackRock accounted for the MLIM transaction under the purchase method of accounting. The value of the 65 million shares issued to Merrill Lynch was allocated among the MLIM assets acquired, including intangibles, and the MLIM liabilities assumed to the extent of their fair market value, with any excess purchase price being allocated to goodwill. Immediately following the closing, PNC continued to own approximately 44 million shares of BlackRock common stock, representing an ownership interest of approximately 34% of the combined company after the closing (as compared with 69% immediately prior to the closing). Although PNC’s share ownership percentage

declined, BlackRock’s equity increased due to the increase in total net assets recorded by BlackRock as a result of the MLIM transaction.

Upon the closing of the BlackRock/MLIM transaction, the carrying value of our investment in BlackRock increased by approximately $3.1 billion to $3.8 billion, primarily reflecting PNC’s portion of the increase in BlackRock’s equity resulting from the value of shares issued in that transaction. Based on BlackRock’s closing market price of $149 per common share on September 29, 2006, the market value of PNC’s investment in BlackRock was approximately $6.6 billion at that date. As such, an additional $2.8 billion of value is not recognized in PNC’s investment account.

We also recorded a liability at September 30, 2006 for deferred taxes of approximately $.9 billion, related to the excess of the book value over the tax basis of our investment in BlackRock, and a liability of approximately $.6 billion related to our obligation to provide shares of BlackRock common stock to help fund BlackRock long-term incentive plan (“LTIP”) programs. The LTIP liability will be adjusted quarterly based on changes in BlackRock’s common stock price and the number of remaining committed shares.

The overall balance sheet impact was an increase to our shareholders’ equity of approximately $1.6 billion. The increase to equity was comprised of an after-tax gain of approximately $1.3 billion, net of the expense associated with the LTIP liability and the deferred taxes, and an after-tax increase to capital surplus of approximately $.3 billion. The recognition of the gain is consistent with our existing accounting policy for the sale or issuance by subsidiaries of their stock to third parties. The gain represents the difference between our basis in BlackRock stock prior to the BlackRock/MLIM transaction and the new book value per share and resulting increase in value of our investment realized from the transaction. The direct increase to capital surplus rather than inclusion in the gain resulted from the accounting treatment required due to existing BlackRock repurchase commitments or programs.

For the three months and nine months ended September 30, 2006, our Consolidated Income Statement included our former 69% ownership interest in BlackRock’s net income through the closing date. However, our Consolidated Balance Sheet as of September 30, 2006 reflects the deconsolidation of BlackRock’s balance sheet amounts and recognizes our 34% ownership interest in BlackRock as an investment to be accounted for under the equity method. On a prospective basis, this accounting will result in a reduction in certain revenue and noninterest expense categories on PNC’s Consolidated Income Statement as the net pretax earnings impact of our net investment in BlackRock will be reported on a separate line item within noninterest income.

Additional information on the BlackRock/MLIM transaction is included in Current Reports on Form 8-K (“Form 8-K”) dated February 15, 2006 and September 29, 2006 filed by PNC and BlackRock.


 

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MERCANTILE BANKSHARES ACQUISITION

As previously reported, on October 8, 2006 we entered into a definitive agreement with Mercantile Bankshares Corporation (“Mercantile”) for PNC to acquire Mercantile for 52.5 million shares of PNC common stock and $2.13 billion in cash. Based on PNC’s common stock price on October 6, 2006, the consideration represents $6.0 billion in stock and cash or $47.24 per Mercantile share.

Mercantile is a $17 billion asset banking company that provides banking and investment and wealth management services through 240 offices in Maryland, Virginia, the District of Columbia, Delaware and Southeastern Pennsylvania. This transaction will enable us to significantly expand our presence in the mid-Atlantic region, particularly within the attractive Baltimore and Washington, DC markets.

The transaction is subject to customary closing conditions, including regulatory approval and the approval of Mercantile’s shareholders, and is expected to close during the first quarter of 2007. We refer you to our Form 8-K dated October 8, 2006 for additional information on this transaction.

THE ONE PNC INITIATIVE

As further described in our 2005 Form 10-K, the One PNC initiative began in January 2005 and is an ongoing, company-wide initiative with goals of moving closer to the customer, improving our overall efficiency and targeting resources to more value-added activities. PNC expects to realize $400 million of total annual pretax earnings benefit by mid-2007 from this initiative.

PNC plans to achieve approximately $300 million of cost savings through a combination of workforce reduction and other efficiencies. Of the approximately 3,000 positions to be eliminated, approximately 2,700 had been eliminated as of September 30, 2006. We estimate that these changes will result in employee severance and other implementation costs of approximately $74 million, including $54 million recognized during full year 2005 and $9 million recognized during the first nine months of 2006. We expect that the remaining charges of approximately $11 million will be incurred in the remainder of 2006 and early 2007. In addition, PNC intends to achieve at least $100 million in net revenue growth through the implementation of various pricing and business growth enhancements driven by the One PNC initiative. The initiative is progressing according to plan.

We realized a net pretax financial benefit from the One PNC program of approximately $185 million in the first nine months of 2006, including $65 million in the third quarter. We achieved an annualized run rate benefit of $260 million in the third quarter of 2006.

KEY FACTORS AFFECTING FINANCIAL PERFORMANCE

Our financial performance is substantially affected by several external factors outside of our control, including:

  ·   General economic conditions,
  ·   Loan demand and utilization of credit commitments,
  ·   Movement of customer deposits from lower to higher rate accounts or to off-balance sheet accounts,
  ·   The level of interest rates, and the shape of the interest rate yield curve,
  ·   The performance of the capital markets, and
  ·   Customer demand for other products and services.

In addition to changes in general economic conditions, including the direction, timing and magnitude of movement in interest rates and the performance of the capital markets, our

success in the remainder of 2006 will depend, among other things, upon:

  ·   Further success in the acquisition, growth and retention of customers,
  ·   Successful execution of the One PNC initiative,
  ·   Revenue growth,
  ·   A sustained focus on expense management and improved efficiency,
  ·   Maintaining strong overall asset quality, and
  ·   Prudent risk and capital management.

SUMMARY FINANCIAL RESULTS

 

    Three months ended     Nine months ended  
In millions, except per share data   Sept. 30
2006
    Sept. 30
2005
    Sept. 30
2006
    Sept. 30
2005
 

Net income

  $1,484     $334     $2,219     $970  

Diluted earnings per share

  $5.01     $1.14     $7.46     $3.35  

Return on

       

Average common shareholders’ equity

  65.94 %   16.13 %   33.87 %   16.49 %

Average assets

  6.17 %   1.45 %   3.17 %   1.48 %

Results for the third quarter and first nine months of 2006 included the impact of the following items:

  ·   The gain on the third quarter BlackRock/MLIM transaction totaling $1.3 billion after-tax, or $4.36 per diluted share;
  ·   Securities portfolio rebalancing charges recognized in the third quarter totaling $127 million after-tax, or $.43 per diluted share;
  ·   The third quarter mortgage loan portfolio repositioning loss of $31 million after-tax, or $.10 per diluted share; and
  ·   Our share of the after-tax impact of BlackRock/MLIM integration costs, which totaled $31 million, or $.10 per diluted share, for the third quarter of 2006 and $39 million, or $.13 per diluted share, for the first nine months of 2006.

In addition to the closing of the BlackRock/MLIM transaction and our balance sheet repositioning activities, our third quarter 2006 performance included the following accomplishments:

 

  ·   Average loans of $50.3 billion for the third quarter of 2006 increased $888 million, or 2 percent, compared with $49.5 billion for the third quarter 2005, primarily as a result of increased commercial, commercial real estate and residential mortgage loans. Average loans increased $3.0 billion, or 6 percent, compared with the prior year third quarter excluding the $2.1 billion of average loans in the prior year period related to Market Street Funding, PNC’s commercial paper conduit that was deconsolidated in October 2005.

 

  ·   Average deposits for the third quarter increased $5.0 billion, or 8 percent, compared with the same quarter in the prior year, primarily as a result of an increase in money market deposits, retail certificates of deposit, Eurodollar deposits and noninterest-bearing deposits.

 

  ·   Asset quality remained very strong, with the ratio of nonperforming assets to loans, loans held for sale and foreclosed assets declining to .36% from .42% at December 31, 2005.

 

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BALANCE SHEET HIGHLIGHTS

Total assets were $98.4 billion at September 30, 2006. Total average assets were $93.7 billion for the first nine months of 2006 compared with $87.4 billion for the first nine months of 2005. This increase was primarily attributable to a $5.5 billion increase in average interest-earning assets. An increase of $2.9 billion in average loans was the primary factor for the increase in average interest-earning assets. In addition, average total securities increased $2.6 billion in the first nine months of 2006 compared with the prior year period.

Our deconsolidation of BlackRock effective September 29, 2006 and recognition of our investment in BlackRock under the equity method of accounting as of September 30, 2006 did not significantly impact average balances in the nine-month comparison.

Average total loans were $49.8 billion for the first nine months of 2006 and $46.9 billion in the first nine months of 2005. This increase was driven by continued improvements in market loan demand and targeted sales efforts across our banking businesses, as well as our expansion into the greater Washington, DC area that began in May 2005. The increase in average total loans reflected growth in residential mortgages of approximately $1.5 billion, commercial loans of approximately $1.1 billion, and commercial real estate loans of approximately $.6 billion. In addition, average loans for the first nine months of 2005 included $2.1 billion related to Market Street Funding (“Market Street”) which was deconsolidated in October 2005. Loans represented 64% of average interest-earning assets for the first nine months of 2006 and 65% for the first nine months of 2005.

Average securities totaled $21.3 billion for the first nine months of 2006 and $18.8 billion for the first nine months of 2005. Of this increase, $3.0 billion was attributable to increases in mortgage-backed, asset-backed, and other debt securities, partially offset by a $.4 billion decline in US Treasury and government agencies securities. Our third quarter 2006 securities portfolio rebalancing actions are further described in the Consolidated Balance Sheet Review section of this Report. The overall higher average securities balances reflected our desire to continue investing through the interest rate cycle and the impact of the May 2005 Riggs acquisition. Securities comprised 28% of average interest-earning assets for the first nine months of 2006 and 26% for the first nine months of 2005.

Average total deposits were $62.7 billion for the first nine months of 2006, an increase of $6.2 billion over the first nine months of 2005. The increase in average total deposits was primarily driven by the impact of higher retail certificates of deposit, money market account and noninterest-bearing deposit balances, and by higher Eurodollar deposits. Growth in deposits from commercial mortgage loan servicing activities also contributed to the increase. Similar to its impact on average loans and securities described above, our expansion into the greater Washington, DC area also contributed to the increase in average total deposits.

Average total deposits represented 67% of average total assets for the first nine months of 2006 and 65% for the first nine months of 2005. Average transaction deposits were $41.7

billion for the first nine months of 2006 compared with $38.7 billion for the first nine months of 2005.

Average borrowed funds were $15.2 billion for the first nine months of 2006 and $16.2 billion for the first nine months of 2005. This decrease reflected a $2.3 billion decline in commercial paper due to the deconsolidation of Market Street in October 2005, partially offset by net increases in federal funds purchased, subordinated debt and bank notes and senior debt.

Shareholders’ equity totaled $10.8 billion at September 30, 2006, compared with $8.6 billion at December 31, 2005. The increase resulted from the BlackRock/MLIM transaction. See the Consolidated Balance Sheet Review section of this Financial Review for additional information.

BUSINESS SEGMENT HIGHLIGHTS

 

    Three months ended   Nine months ended
In millions   Sept.30
2006
  Sept. 30
2005
  Sept. 30
2006
  Sept. 30
2005

Total segment earnings

  $422   $383   $1,217   $1,101

Total business segment earnings for the first nine months of 2005 included the benefit of a second quarter $53 million loan recovery included in the Corporate & Institutional Banking business segment. A summary of results for both the first nine months and third quarter 2006 comparisons with the prior year periods follows. Further analysis of business segment results for the nine-month periods is found on pages 15 through 24.

We provide a reconciliation of total business segment earnings to total PNC consolidated net income as reported on a GAAP basis in Note 14 Segment Reporting in the Notes To Consolidated Financial Statements in this Report and in the Results of Businesses - Summary table on page 15.

Retail Banking

Retail Banking’s earnings were $581 million for the first nine months of 2006 compared with $487 million for the same period in 2005. Compared with the prior year, revenues increased 10% and noninterest expenses increased 4%, resulting in a 19% earnings improvement. The increase in earnings was driven by improved fee income from customers, higher taxable-equivalent net interest income fueled by continued customer and balance sheet growth, and a sustained focus on expense management.

Earnings from Retail Banking totaled $206 million in the third quarter of 2006 compared with $176 million in the third quarter of 2005. Revenue increased 7% compared with the prior year third quarter, while noninterest expense increased only 2%, driving a 17% increase in earnings and creating positive operating leverage.

Corporate & Institutional Banking

Earnings from Corporate & Institutional Banking for the first nine months of 2006 totaled $334 million compared with $372 million for the first nine months of 2005. This decline was primarily attributable to the benefit of a $53 million loan recovery recognized in the second quarter of 2005 compared with a $36 million provision for credit losses in the first nine


 

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months of 2006. In addition to the negative impact of the $89 million change in the provision for credit losses, total revenue increased $101 million and noninterest expenses grew by $69 million for the first nine months of 2006 compared with the first nine months of 2005.

Corporate & Institutional Banking earned $113 million in the third quarter of 2006 compared with $118 million in the third quarter of 2005. The decrease compared with the prior year quarter was largely the result of an increase in the provision for credit losses. The increase in noninterest revenue and expense was driven by the acquisition of Harris Williams. Revenue increased $10 million compared with the third quarter of 2005, driven by a $22 million increase in noninterest income, partly offset by a $12 million decrease in taxable-equivalent net interest income.

BlackRock

BlackRock reported net income of $153 million for the first nine months of 2006 and $161 million for the first nine months of 2005. BlackRock’s reported net income for the first nine months of 2006 and 2005 included after-tax MLIM and State Street Research and Management (“SSRM”) integration costs of $56 million and $6 million, respectively. The BlackRock business segment earned $209 million in the first nine months of 2006 and $167 million for the first nine months of 2005 excluding the impact of these costs, which we have reported in “Other” for PNC business segment reporting. Adjusted earnings in 2006 reflected higher investment advisory and administration fees due to an increase in assets under management and increased performance fees. These factors more than offset the increase in expense due to increased compensation and benefits, general and administration expense, and a one-time expense of $34 million incurred in the first quarter of 2006 related to the January 2005 acquisition of SSRM.

BlackRock reported net income of $19 million for the third quarter of 2006, compared with $61 million for the third quarter of 2005. BlackRock’s reported net income included after-tax MLIM integration costs of $44 million in the third quarter of 2006. BlackRock earned $63 million in the third quarter of 2006, an increase of $2 million compared with the third quarter of 2005, excluding the impact of MLIM integration costs. The increase compared with the third quarter of 2005 was a result of higher investment and advisory fees due to growth in assets under management, partly offset by lower nonoperating income, due principally to unrealized losses on energy-related investments.

 

We refer you to the BlackRock/MLIM Transaction section of this Executive Summary for further information related to this transaction that closed on September 29, 2006. Information on this transaction is also included in Note 2 Acquisitions in the Notes To Consolidated Financial Statements included in this Report.

PFPC

PFPC’s earnings of $93 million in the first nine months of 2006 increased $18 million, or 24%, compared with the first nine months of 2005. Earnings for the 2006 period included the impact of a $14 million reversal of deferred taxes related to earnings from foreign subsidiaries following management’s determination that the earnings would be indefinitely reinvested outside of the United States. In addition, higher earnings in the first nine months of 2006 reflected servicing revenue contributions from several growth areas of the business and the successful implementation of expense control initiatives which improved the company’s operating margin. Earnings for the first nine months of 2005 included a $3 million tax benefit identified as part of the One PNC initiative.

PFPC earned $40 million in the third quarter of 2006 compared with $28 million in the third quarter of 2005. The earnings increase from the third quarter of 2005 resulted from the $14 million reversal of deferred taxes referred to above.

Other

“Other” earnings for the first nine months of 2006 totaled $1.1 billion, while “Other” for the first nine months of 2005 was a net loss of $80 million. “Other” earnings for the 2006 period included the $1.3 billion after-tax gain on the BlackRock/MLIM transaction recorded in the third quarter of 2006, partially offset by the impact of charges related to the following, all on an after-tax basis:

  ·   Third quarter 2006 balance sheet repositioning activities amounting to $158 million,
  ·   MLIM integration costs of $39 million, and
  ·   Reversal in the third quarter of 2006 of trust preferred securities hedge accounting of $13 million.

The first nine months of 2005 included the impact of third quarter 2005 implementation costs related to the One PNC initiative totaling $29 million after-tax, net securities losses of $24 million after-tax, and Riggs acquisition integration costs totaling $19 million after-tax. These factors were partially offset by the first quarter 2005 benefit recognized from a $45 million deferred tax liability reversal related to the internal transfer of our investment in BlackRock as described above under Summary Financial Results.

We recorded earnings of $1.1 billion in “Other” for the third quarter of 2006 primarily due to the reasons outlined above for the nine-month earnings. “Other” for the third quarter of 2005 was a net loss of $30 million. The net loss for the prior year quarter reflected the One PNC implementation costs referred to above.


 

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CONSOLIDATED INCOME STATEMENT REVIEW

NET INTEREST INCOME AND NET INTEREST MARGIN

 

    Three months ended     Nine months
ended
 
Dollars in millions   Sept. 30
2006
    Sept. 30
2005
    Sept. 30
2006
    Sept. 30
2005
 

Taxable-equivalent net interest income

  $574     $566     $1,699     $1,619  

Net interest margin

  2.89 %   2.96 %   2.92 %   2.99 %

We provide a reconciliation of net interest income as reported under GAAP to net interest income presented on a taxable-equivalent basis in the Consolidated Financial Highlights section on page 1 of this Report.

Changes in net interest income and margin result from the interaction of the volume and composition of interest-earning assets and related yields, interest-bearing liabilities and related rates paid, and noninterest-bearing sources. See Statistical Information-Average Consolidated Balance Sheet And Net Interest Analysis included on pages 63 and 64 of this Report for additional information.

The increase in taxable-equivalent net interest income for the first nine months of 2006 compared with the first nine months of 2005 reflected the impact of a $5.5 billion increase in average interest-earning assets in 2006, driven by organic growth and our expansion into the greater Washington, DC area. The $2.9 billion increase in average interest-earning assets for the third quarter of 2006 compared with the third quarter of 2005 drove the increase in taxable-equivalent net interest income in the third quarter of 2006.

The following factors contributed to the decline in net interest margin for the first nine months of 2006 compared with the first nine months of 2005:

  ·   An increase in the average rate paid on deposits of 106 basis points for the first nine months of 2006 compared with the 2005 period. The average rate paid on money market accounts, the largest single component of interest-bearing deposits, increased 116 basis points. The average rate paid on Retail Banking money market accounts increased only 98 basis points while the average rate paid on Corporate & Institutional Banking money market accounts increased 152 basis points. The average rate paid on money market accounts reported in “Other” increased 190 basis points. These accounts are utilized as an alternative source of short-term liquidity and pay interest at rates that closely approximate short-term market rates.
  ·   An increase in the average rate paid on borrowed funds of 156 basis points for the first nine months of 2006 compared with the first nine months of 2005.
  ·   By comparison, the yield on interest-earning assets increased only 83 basis points. Loans, the single largest component, increased 86 basis points.
  ·   These factors were partially offset by the favorable impact on net interest margin in 2006 of an increase of 21 basis points related to noninterest-bearing sources of funding.

 

During the first nine months of 2006, the average federal funds rate was 4.88% compared with 2.97% for the first nine months of 2005.

The decline in net interest margin for the third quarter of 2006 compared with the third quarter of 2005 reflected the following:

  ·   An increase in the average rate paid on deposits of 110 basis points for the third quarter of 2006 compared with the third quarter of 2005. The average rate paid on money market accounts, the largest single component of interest-bearing deposits, increased 114 basis points. The average rate paid on Retail Banking money market accounts increased only 89 basis points while the average rate paid on Corporate & Institutional Banking money market accounts increased 153 basis points. The average rate paid on money market accounts reported in “Other” increased 173 basis points.
  ·   An increase in the average rate paid on borrowed funds of 161 basis points for the third quarter of 2006 compared with the prior year period.
  ·   By comparison, the yield on interest-earning assets increased only 86 basis points. Loans, the single largest component, increased 84 basis points.
  ·   These factors were partially offset by the favorable impact on net interest margin in 2006 of an increase of 22 basis points related to noninterest-bearing sources of funding.

During the third quarter of 2006, the average federal funds rate was 5.25% compared with 3.46% for the third quarter of 2005.

We believe that net interest margins for our industry will continue to be challenged if the yield curve remains flat or inverted, as competition for loans and deposits remains intense and as customers continue to migrate from lower cost to higher cost deposits. However, we believe that our balance sheet repositioning will have a positive impact on taxable-equivalent net interest income and net interest margin.

PROVISION FOR CREDIT LOSSES

The provision for credit losses increased $85 million, to $82 million, in the first nine months of 2006 compared with the first nine months of 2005. For the third quarter of 2006, the provision for credit losses was unchanged at $16 million compared with the prior year third quarter. The increase in the nine-month comparison reflected the following:

  ·   A $53 million loan recovery in the second quarter of 2005 resulting from a litigation settlement,
  ·   The impact of overall loan growth, as total average loans grew $2.9 billion in the first nine months of 2006 compared with the respective prior year period,
  ·   The effect of a single large overdraft situation that occurred during the second quarter of 2006, and
  ·   Growth in unfunded commitments.

We do not expect to sustain asset quality at its current level. However, based on the assets we currently hold and current business trends and activities, we believe that overall asset quality will remain strong by historical standards for at least the near term. See the Credit Risk Management portion of the Risk Management section of this Financial Review for additional information regarding factors that impact the provision for credit losses.


 

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NONINTEREST INCOME

Summary

Noninterest income was $5.358 billion for the first nine months of 2006 compared with $3.019 billion for the first nine months of 2005. Noninterest income for the third quarter of 2006 totaled $2.943 billion and totaled $1.116 billion in the prior year third quarter. Both the first nine months and third quarter of 2006 included the impact of the gain on the BlackRock transaction, which totaled $2.078 billion, partially offset by the effects of our third quarter balance sheet repositioning activities that resulted in charges totaling $244 million.

Additional Analysis

Asset management fees totaled $1.271 billion in the first nine months of 2006, an increase of $259 million compared with the first nine months of 2005. The increase in the nine-month comparison reflected the impact of higher performance fees, BlackRock’s first quarter 2005 acquisition of SSRM and other growth in assets managed. Asset management fees increased $17 million, to $381 million, for the third quarter of 2006 compared with the third quarter of 2005. An increase in investment advisory base fees at BlackRock, partially offset by lower performance fees, drove the increase in the quarter comparison.

While asset management fees reflected the consolidated impact of BlackRock for all income statement periods presented, assets managed at September 30, 2006 totaled $52 billion compared with $469 billion at September 30, 2005, due to our deconsolidation of BlackRock effective September 29, 2006.

Fund servicing fees of $644 million for the first nine months of 2006 represented a $13 million decline from the prior year period. For the third quarter of 2006, fund servicing fees totaled $213 million, a decline of $5 million from the third quarter of 2005. The decrease in fund servicing fees in both comparisons was primarily due to lower fund accounting and transfer agent fees during 2006 due to loss of clients and price concessions.

PFPC provided fund accounting/administration services for $774 billion of net fund investment assets and provided custody services for $399 billion of fund investment assets at September 30, 2006, compared with $793 billion and $475 billion, respectively, at September 30, 2005. The decreases in domestic accounting/administration net fund assets and custody fund assets at September 30, 2006 resulted primarily from the deconversion of a major client during the first quarter of 2006 which was partially offset by new business, asset inflows from existing customers and equity market appreciation.

Service charges on deposits grew $35 million, to $234 million, in the first nine months of 2006 compared with the prior year nine-month period. Service charges on deposits increased $8 million in the third quarter of 2006, to $81 million, compared with the third quarter of 2005. These increases can be attributed to customer growth, expansion of the branch network, including the expansion into the greater Washington, DC area that began in May 2005, and various pricing actions resulting from the One PNC initiative.

 

Brokerage fees totaled $183 million in the first nine months of 2006 and $168 million in the first nine months of 2005. Brokerage fees increased $5 million, to $61 million, for the third quarter of 2006 compared with the third quarter of 2005. These increases reflected higher annuity income and mutual fund-related revenues in 2006.

Consumer services fees grew $59 million, to $272 million, for the first nine months of 2006 compared with the first nine months of 2005. Consumer services fees increased $13 million, to $89 million, in the third quarter of 2006 compared with the third quarter of 2005. Higher fees reflected the impact of consolidating our merchant services activities in the fourth quarter of 2005 as a result of our increased ownership interest in the merchant services business. The increases in fees were also due to higher debit card revenues resulting from higher transaction volumes, our expansion into the greater Washington, DC area and pricing actions related to the One PNC initiative. These factors were partially offset by lower ATM surcharge revenue in the 2006 periods compared with the respective prior year periods as a result of changing customer behavior and a strategic decision to reduce the out-of-footprint ATM network.

Corporate services revenue totaling $449 million in the first nine months of 2006 represented a $107 million, or 31%, increase over the comparable prior year period. Corporate services revenue increased $36 million, or 30%, in the third quarter of 2006 compared with the third quarter of 2005. Both 2006 periods benefited from the impact of our October 2005 Harris Williams acquisition that resulted in higher revenues.

Equity management (private equity) net gains on portfolio investments totaled $82 million for the first nine months of 2006 compared with $80 million for the first nine months of 2005. For the third quarter of 2006, net gains on portfolio investments totaled $21 million compared with $36 million in the prior year quarter. Based on the nature of private equity activities, net gains or losses may be volatile from period to period.

Net securities losses amounted to $207 million for the first nine months of 2006 compared with net securities losses of $37 million in the first nine months of 2005. Net securities losses totaled $195 million in the third quarter of 2006 and $2 million in the third quarter of 2005. We refer you to the Securities portion of our Consolidated Balance Sheet Review section of this Report for further information regarding the actions we took during the third quarter of 2006 that resulted in the sale of approximately $6 billion of securities available for sale at an aggregate pretax loss of $196 million during that quarter.

Net securities losses for the first nine months of 2005 reflect actions taken during the second quarter of that year regarding our securities portfolio that resulted in realized net securities and other losses of approximately $31 million.

Noninterest revenue from trading activities, which is primarily customer-related, was $150 million for the first nine months of 2006 compared with $108 million for the first nine months of 2005. For the third quarter of 2006, noninterest revenue from trading activities was $38 million, compared with $47 million in the prior year third quarter. We provide additional information on our trading activities under Market Risk


 

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Management – Trading Risk in the Risk Management section of this Financial Review.

Other noninterest income of $202 million for the first nine months of 2006 represented a $75 million decrease compared with the prior year first nine months. Other noninterest income totaled $19 million in the third quarter of 2006 compared with $127 million in the third quarter of 2005. Other noninterest income for both 2006 periods included the impact of the following:

  ·   A $48 million pretax loss incurred in the third quarter of 2006 in connection with the rebalancing of our residential mortgage portfolio. Further information on these actions is included in the Loans Held For Sale portion of the Consolidated Balance Sheet Review section of this Report;
  ·   A $20 million charge for an accounting adjustment related to our trust preferred securities hedges recognized during the third quarter of 2006; and
  ·   Lower other equity management income.

Other noninterest income for the first nine months of 2006 included gains totaling $39 million, including $13 million recognized in the third quarter, related to our contributions of BlackRock stock to the PNC Foundation. The comparable 2005 amount was $16 million, recognized in the third quarter. These transactions also impacted noninterest expense in each of those periods.

Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed.

PRODUCT REVENUE

In addition to credit products to commercial customers, Corporate & Institutional Banking offers treasury management and capital markets-related products and services, commercial loan servicing and equipment leasing products that are marketed by several businesses across PNC.

Treasury management revenue, which includes fees as well as net interest income from customer deposit balances, totaled $316 million for first nine months of 2006 and $305 million for first nine months of 2005. For the third quarter of 2006, revenue totaled $108 million compared with $105 million for the third quarter of 2005. The higher revenue in both comparisons reflected continued expansion and client utilization of commercial payment card services, strong revenue growth in various electronic payment and information services, and a steady increase in business-to-business processing volumes.

Revenue from capital markets products and services, including mergers and acquisitions advisory activities, was $204 million for the first nine months of 2006, compared with $113 million in the first nine months of 2005. The acquisition of Harris Williams in October 2005 together with improved customer and proprietary trading activities drove the increase in capital markets revenue in the nine-month comparison. Consolidated revenue from capital markets products and services for the third quarter of 2006 totaled $64 million compared with $42 million for the third quarter of 2005. The increase in capital markets revenue for the third quarter of 2006 compared with the prior year quarter was primarily due to the acquisition of Harris Williams.

Midland Loan Services offers servicing, real estate advisory and technology solutions for the commercial real estate

finance industry. Midland’s revenue, which includes servicing fees and net interest income from servicing portfolio deposit balances, totaled $131 million for first nine months of 2006 and $103 million for first nine months of 2005. Third quarter 2006 revenue totaled $47 million compared with $39 million for the third quarter of 2005. Revenue growth in both comparisons was primarily driven by growth in the commercial mortgage servicing portfolio and related services.

As a component of our advisory services to clients, we provide a select set of insurance products to fulfill specific customer financial needs. Primary insurance offerings include:

  ·   Annuities,
  ·   Life,
  ·   Credit life,
  ·   Health,
  ·   Disability, and
  ·   Commercial lines coverage.

Client segments served by these insurance solutions include those in Retail Banking and Corporate & Institutional Banking. Insurance products are sold by licensed PNC insurance agents and through licensed third-party arrangements. Revenue from these products was $53 million in the first nine months of 2006 and $46 million in first nine months of 2005. Revenue for the third quarter of 2006 totaled $18 million compared with $15 million for the third quarter of 2005. The increases resulted from higher annuity fee revenue.

PNC, through subsidiary companies Alpine Indemnity Limited and PNC Insurance Corp., participates as a direct writer for its general liability, automobile liability, workers’ compensation, property and terrorism programs.

In the normal course of business, Alpine Indemnity Limited and PNC Insurance Corp. maintain insurance reserves for reported claims and for claims incurred but not reported based on actuarial assessments. We believe these reserves were adequate at September 30, 2006.

NONINTEREST EXPENSE

Year-to-date September 30, 2006 and 2005

Total noninterest expense was $3.498 billion for the first nine months of 2006 and $3.199 billion for the first nine months of 2005.

The Consolidated Financial Highlights section of this Report includes our efficiency ratios for the third quarter and first nine months of both 2006 and 2005, along with notes regarding certain items impacting noninterest income and expense for both 2006 periods.

Noninterest expense for the first nine months of 2006 included the following:

  ·   An increase of $270 million in BlackRock operating expenses (including integration costs related to the MLIM transaction of $91 million), reflecting growth in that business,
  ·   Expenses totaling $65 million related to Harris Williams, which we acquired in October 2005, and
  ·   An increase of $40 million related to the consolidation of our merchant services activities in the fourth quarter of 2005.

 

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Apart from the impact of these items, noninterest expense for the first nine months of 2006 decreased $76 million over the prior year period as the benefit of the One PNC initiative more than offset the impact of our expansion into the greater Washington, DC area and contributions of BlackRock stock to the PNC Foundation.

Third quarter 2006 and 2005

Total noninterest expense was $1.178 billion for the third quarter of 2006 and $1.159 billion for the third quarter of 2005.

Noninterest expense for the third quarter of 2006 reflected a $76 million increase in operating expenses at BlackRock (including MLIM integration costs of $72 million), $22 million of expenses related to Harris Williams and an increase of $11 million related to the fourth quarter 2005 consolidation of our merchant services activities. Apart from the impact of these items, noninterest expense for the third quarter of 2006 decreased $90 million compared with the prior year third quarter.

We expect that the percentage increase in total noninterest expense for full year 2006 compared with 2005, excluding the BlackRock business segment and MLIM transaction integration costs, will be in the low single-digit range, with the increase primarily attributable to the acquisition of Harris Williams and the consolidation of merchant services in the fourth quarter of 2005. However, noninterest expense will continue to be impacted by ongoing investments in our businesses.

Period-end employees totaled 23,539 at September 30, 2006 (comprised of 21,374 full-time and 2,165 part-time) compared with 25,348 at December 31, 2005 (comprised of 23,593 full-time and 1,755 part-time) and 25,369 at September 30, 2005 (comprised of 23,811 full-time and 1,558 part-time). The decline in full-time employees at September 30, 2006 reflects the deconsolidation of BlackRock effective September 29, 2006. The increase in part-time employees reflects Retail Banking initiatives to utilize more customer-facing employees during peak business hours versus full-time employees for the entire day.

EFFECTIVE TAX RATE

Our effective tax rate for the first nine months of 2006 was 35.1% compared with 29.7% for the first nine months of 2005. The higher effective rate for first nine months of 2006 was primarily due to a $57 million cumulative adjustment to deferred taxes in connection with the BlackRock/MLIM transaction. The lower effective tax rate in 2005 reflected the impact of the first quarter 2005 reversal of deferred tax liabilities in connection with the transfer of our ownership in BlackRock to our intermediate bank holding company. This transaction reduced our first quarter 2005 tax provision by $45 million.

 

CONSOLIDATED BALANCE SHEET REVIEW

SUMMARIZED BALANCE SHEET DATA

 

In millions   September 30
2006
  December 31
2005

Assets

   

Loans, net of unearned income

  $48,900   $49,101

Securities available for sale and held to maturity

  19,512   20,710

Loans held for sale

  4,317   2,449

Investment in BlackRock

  3,836  

Other

  21,871   19,694

Total assets

  $98,436   $91,954

Liabilities

   

Funding sources

  $79,267   $77,172

Other

  8,003   5,629

Total liabilities

  87,270   82,801

Minority and noncontrolling interests in consolidated entities

  408   590

Total shareholders’ equity

  10,758   8,563

Total liabilities, minority and noncontrolling interests, and shareholders’ equity

  $98,436   $91,954

Our Consolidated Balance Sheet is presented in Part I, Item 1 on page 38 of this Report.

Various seasonal and other factors impact our period-end balances whereas average balances (discussed under the Balance Sheet Highlights section of this Financial Review above and included in the Statistical Information section of this Report on pages 63 and 64) are more indicative of underlying business trends.

The impact of the deconsolidation of BlackRock’s balance sheet amounts and recognition of our approximate 34% ownership interest in BlackRock as an equity investment upon the closing of the BlackRock/MLIM transaction is discussed in the Executive Summary section of this Financial Review and in our Form 8-K dated September 29, 2006.


 

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An analysis of changes in certain balance sheet categories follows.

LOANS, NET OF UNEARNED INCOME

Loans decreased $201 million, to $48.9 billion, at September 30, 2006 compared with the balance at December 31, 2005. A decline in residential mortgage loans in connection with the third quarter 2006 mortgage loan repositioning more than offset increases in several other loan categories. Targeted sales efforts across our banking businesses drove the increase in commercial lending and consumer loans.

Details Of Loans

 

In millions   September 30
2006
    December 31
2005
 

Commercial

   

Retail/wholesale

  $5,245     $4,854  

Manufacturing

  4,318     4,045  

Other service providers

  2,155     1,986  

Real estate related

  3,000     2,577  

Financial services

  1,423     1,438  

Health care

  685     616  

Other

  3,858     3,809  

Total commercial

  20,684     19,325  

Commercial real estate

   

Real estate projects

  2,691     2,244  

Mortgage

  794     918  

Total commercial real estate

  3,485     3,162  

Equipment lease financing

  3,609     3,628  

Total commercial lending

  27,778     26,115  

Consumer

   

Home equity

  13,876     13,790  

Automobile

  1,061     938  

Other

  1,419     1,445  

Total consumer

  16,356     16,173  

Residential mortgage

  5,234     7,307  

Other

  347     341  

Unearned income

  (815 )   (835 )

Total, net of unearned income

  $48,900     $49,101  

As the table above indicates, our total loan portfolio continued to be diversified among types of loan products and numerous industries and businesses. The loans that we hold are also diversified across the geographic areas where we do business.

Commercial Lending Exposure (a)

 

    September 30
2006
    December 31
2005
 

Investment grade or equivalent

  49 %   46 %

Non-investment grade

   

$50 million or greater

  3     2  

All other non-investment grade

  48     52  

Total

  100 %   100 %
(a) Includes total commercial lending in the Retail Banking and Corporate & Institutional Banking business segments.

Commercial loans are the largest category and are the most sensitive to changes in assumptions and judgments underlying the determination of the allowance for loan and lease losses. We have allocated approximately $455 million, or 80%, of the total allowance for loan and lease losses at September 30, 2006 to the commercial loan category. This allocation also considers other relevant factors such as:

  ·   Actual versus estimated losses,
  ·   Regional and national economic conditions,
  ·   Business segment and portfolio concentrations,
  ·   Industry competition and consolidation,
  ·   The impact of government regulations, and
  ·   Risk of potential estimation or judgmental errors, including the accuracy of risk ratings.

Net Unfunded Credit Commitments

 

In millions   September 30
2006
  December 31
2005

Commercial

  $30,018   $27,774

Consumer

  10,164   9,471

Commercial real estate

  2,998   2,337

Other

  624   596

Total

  $43,804   $40,178

Commitments to extend credit represent arrangements to lend funds or provide liquidity subject to specified contractual conditions. Commercial commitments are reported net of participations, assignments and syndications, primarily to financial institutions, totaling $6.8 billion at September 30, 2006 and $6.7 billion at December 31, 2005.

Unfunded liquidity facility commitments and standby bond purchase agreements totaled $6.1 billion at September 30, 2006 and $5.1 billion at December 31, 2005 and are included in the preceding table primarily within the “Commercial” and “Consumer” categories.

In addition to credit commitments, our net outstanding standby letters of credit totaled $4.4 billion at September 30, 2006 and $4.2 billion at December 31, 2005. Standby letters of credit commit us to make payments on behalf of our customers if specified future events occur.

Cross-Border Leases and Related Tax and Accounting Matters

The equipment lease portfolio totaled $3.6 billion at September 30, 2006. Aggregate residual value at risk on the lease portfolio at September 30, 2006 was $1.1 billion. We have taken steps to mitigate $.6 billion of this residual risk, including residual value insurance coverage with third parties, third party guarantees, and other actions. The portfolio included approximately $1.7 billion of cross-border leases at September 30, 2006. Cross-border leases are leveraged leases of equipment located in foreign countries, primarily in western Europe and Australia. We have not entered into cross-border lease transactions since 2003.

Upon completing examination of our 1998-2000 consolidated federal income tax returns, the IRS provided us with an examination report which proposes increases in our tax liability, principally arising from adjustments to several of our cross-border lease transactions.

The IRS has begun an audit of our 2001-2003 consolidated federal income tax returns. We expect them to again make adjustments to the cross-border lease transactions referred to above as well as to new cross-border lease transactions entered into during those years. We believe our reserves for these exposures were adequate at September 30, 2006.

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 13-2, Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction (“FSP 13-2”). FSP 13-2 is


 

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effective January 1, 2007 and will require a recalculation of the timing of income recognition and the reevaluation of lease classification for actual or projected changes in the timing of tax benefits for leveraged leases. Any cumulative adjustment will be recognized through retained earnings upon adoption of FSP 13-2. See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in this Report for additional information. We estimate that the cumulative adjustment that we will record effective January 1, 2007 from the recalculations required by FSP 13-2 will be in the range of approximately $140 million to $160 million, after-tax. Any immediate or future reductions in earnings from our adoption of FSP 13-2 would be recovered in subsequent years.

In addition to these transactions, three lease-to-service contract transactions that we were party to were structured as partnerships for tax purposes. These partnerships are under audit by the IRS. However, we do not believe that our exposure from these transactions is material to our consolidated results of operations or financial position.

Additional information on cross-border lease transactions is included under “Cross-Border Leases and Related Tax and Accounting Matters” in the Consolidated Balance Sheet Review section of Item 7 of our 2005 Form 10-K.

SECURITIES

Details Of Securities (a)

 

In millions   Amortized
Cost
  Fair
Value

September 30, 2006

   

SECURITIES AVAILABLE FOR SALE

   

Debt securities

   

Mortgage-backed

  $14,799   $14,673

US Treasury and government agencies

  556   552

Commercial mortgage-backed

  2,342   2,334

Asset-backed

  1,527   1,519

State and municipal

  141   139

Other debt

  89   87

Corporate stocks and other

  209   208

Total securities available for sale

  $19,663   $19,512

December 31, 2005

   

SECURITIES AVAILABLE FOR SALE

   

Debt securities

   

Mortgage-backed

  $13,794   $13,544

US Treasury and government agencies

  3,816   3,744

Commercial mortgage-backed

  1,955   1,919

Asset-backed

  1,073   1,063

State and municipal

  159   158

Other debt

  87   86

Corporate stocks and other

  196   196

Total securities available for sale

  $21,080   $20,710
(a) Securities held to maturity at September 30, 2006 and December 31, 2005 were less than $.5 million.

Securities represented 20% of total assets at September 30, 2006 and 23% of total assets at December 31, 2005.

We evaluate our portfolio of securities available for sale in light of changing market conditions and other factors and, where appropriate, take steps intended to improve our overall positioning.

At September 30, 2006, securities available for sale included a net unrealized loss of $151 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2005 was a net unrealized loss of $370 million. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income or loss, net of tax.

 

The fair value of securities available for sale decreases when interest rates increase and vice versa. Consequently, increases in interest rates after September 30, 2006, if sustained, will adversely impact the fair value of securities available for sale compared with the balance at September 30, 2006.

During mid-August through early September 2006, we performed a comprehensive review of our securities available for sale portfolio and, by the end of September 2006, completed the process of executing portfolio rebalancing actions in response to the changing economic landscape, recent statements and actions by the Federal Open Market Committee (in particular, the decision not to raise the Fed funds target rate) and our desire to position the securities portfolio to optimize total return performance over the long term.

As a result, we have repositioned our securities portfolio according to our market views. This included reallocating exposure to certain sectors, selling securities holdings we believed would likely underperform on a relative value basis, retaining certain existing securities and purchasing incremental securities all of which we believe will outperform the market going forward.

As part of the rebalancing, we assessed the entire securities available for sale portfolio of which, for the majority of positions, fair value was less than amortized cost. We executed a strategy to reduce our US government agency and mortgage-backed security sector allocations and increase our interest rate swap sector allocation. We sold substantially all of our US government agency securities to reduce our interest rate spread exposure to that asset class. The US government agency securities that we retained are characterized by relatively short terms to maturity and smaller individual security balances. We also sold specific securities in the mortgage-backed portfolio (e.g. all of our holdings of specific coupon US government agency pass-through securities and collateralized mortgage obligations having specific collateral characteristics), and in the commercial mortgage-backed portfolio (e.g. all of our holdings of specific vintage securities) that we believe, given the underlying collateral, will underperform on a relative value basis. We retained the remaining holdings in our mortgage-backed portfolio including all of our holdings of mortgage-backed securities collateralized by hybrid adjustable rate mortgage loans, our commercial mortgage-backed portfolio and our asset-backed portfolio. Our objective was to reduce the portfolio credit spread and interest rate volatility exposures, to position the portfolio for a steeper yield curve and to optimize the relative value performance of the portfolio. We assessed the securities retained relative to the same portfolio objectives, our market view and outlook, our desired sector allocations, our expectation of performance relative to market benchmarks and, given our assessment, we confirmed our intent to hold these remaining securities until either recovery of fair value or maturity. Accordingly, we do not believe that any individual unrealized losses at September 30, 2006 represent an other-than-temporary impairment.

The portfolio rebalancing resulted in the sale during the third quarter of 2006 of $6.0 billion of securities available for sale at an aggregate pretax loss of $196 million, or $127 million after-tax. We repurchased approximately $1.8 billion of securities and added approximately $4.0 billion of interest rate swaps to maintain our interest rate risk position. We also reduced wholesale funding as a result of the actions taken.

The resulting net realized losses on the sale of the securities during the third quarter of 2006 were previously reflected as net unrealized securities losses within accumulated other comprehensive loss in the shareholders’ equity section of PNC’s Consolidated Balance Sheet. Accordingly, total shareholders’ equity did not change as a result of these actions.

The expected weighted-average life of securities available for sale (excluding corporate stocks and other) was 3 years and 11 months at September 30, 2006 and 4 years and 1 month at December 31, 2005.

We estimate that at September 30, 2006 the effective duration of securities available for sale is 2.6 years for an immediate 50 basis points parallel increase in interest rates and 2.2 years for an immediate 50 basis points parallel decrease in interest rates. Comparable amounts at December 31, 2005 were 2.7 years and 2.4 years, respectively.


 

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LOANS HELD FOR SALE

As reported in our Form 8-K dated September 22, we plan to sell or securitize approximately $2.1 billion of loans from our residential mortgage portfolio. We expect these transactions to be substantially consummated during the fourth quarter of 2006. In accordance with GAAP, these loans were transferred to loans held for sale as of September 30, 2006. We recognized a pretax loss in the third quarter of 2006 of $48 million as a reduction of noninterest income, or $31 million after-tax, representing the mark to market valuation of these loans upon transfer to held for sale status. This loss, which is reported in the “Other” business segment, represented the decline in value of the loans almost entirely from the impact of increases in interest rates. We expect to replace these loans with other residential mortgage loans, with the expectation of increasing the overall yield on our total loan portfolio and improving net interest income relative to current estimates.

Education loans held for sale totaled $1.5 billion at September 30, 2006 and $1.9 billion at December 31, 2005. We classify substantially all of our education loans as loans held for sale. Generally, we sell education loans when the loans are placed into repayment status. Gains on sales of education loans are reflected in the Other noninterest income line item in our Consolidated Income Statement and in the results for the Retail Banking business segment.

FUNDING AND CAPITAL SOURCES

Details of Funding Sources

 

In millions   September 30
2006
  December 31
2005

Deposits

   

Money market

  $27,677   $24,462

Demand

  16,105   17,157

Retail certificates of deposit

  14,767   13,010

Savings

  1,924   2,295

Other time

  1,403   1,313

Time deposits in foreign offices

  2,696   2,038

Total deposits

  64,572   60,275

Borrowed funds

   

Federal funds purchased

  3,475   4,128

Repurchase agreements

  2,275   1,691

Bank notes and senior debt

  2,177   3,875

Subordinated debt

  4,436   4,469

Other

  2,332   2,734

Total borrowed funds

  14,695   16,897

Total

  $79,267   $77,172

The decline in total borrowed funds compared with the balance at December 31, 2005 reflects a decrease in federal funds purchased, maturities of $1.95 billion of bank notes and senior debt during the first nine months of 2006, and the deconsolidation of BlackRock’s $250 million of convertible debentures. These factors were partially offset by an issuance of $500 million of bank notes in June 2006 and an increase in repurchase agreements.

 

Capital

We manage our capital position by making adjustments to our balance sheet size and composition, issuing debt and equity instruments, making treasury stock transactions, maintaining dividend policies and retaining earnings.

The increase of $2.2 billion in total shareholders’ equity at September 30, 2006 compared with December 31, 2005 reflected the following:

  ·   Net income to date in 2006,
  ·   An increase in capital surplus in connection with the BlackRock/MLIM transaction, and
  ·   A lower accumulated other comprehensive loss.

The securities repositioning described within the Securities section of the Consolidated Balance Sheet Review section was the primary factor in the reduction in accumulated other comprehensive loss at September 30, 2006 compared with December 31, 2005.

Common shares outstanding at September 30, 2006 were 293.8 million compared with 292.9 million at December 31, 2005. The increase in shares outstanding during the first nine months of 2006 reflected share issuances related to various employee stock-based compensation plans and the exercise of employee stock options.

We purchased 3.7 million common shares under our common stock repurchase program during the first nine months of 2006, with all purchases occurring in the second and third quarters. Our current program, which permits us to purchase up to 20 million shares on the open market or in privately negotiated transactions, will remain in effect until fully utilized or until modified, superseded or terminated. As of September 30, 2006, remaining availability for purchases under this program was 15.8 million shares. The extent and timing of additional share repurchases under this program will depend on a number of factors including, among others, market and general economic conditions, economic and regulatory capital considerations, alternative uses of capital, regulatory limitations resulting from merger activity, and the potential impact on our credit rating. Subject to limitations related to the pending Mercantile acquisition, we expect to continue to be active in share repurchases under favorable market conditions.

See “Mercantile Bankshares Acquisition” in the Executive Summary section of this Report regarding our plans to issue PNC common stock and cash in connection with this planned acquisition.


 

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Risk-Based Capital

 

Dollars in millions   September 30
2006
    December 31
2005
 

Capital components

   

Shareholders’ equity

   

Common

  $10,751     $8,555  

Preferred

  7     8  

Trust preferred capital securities

  1,417     1,417  

Minority interest

  3     291  

Goodwill and other intangibles

  (3,593 )   (4,122 )

Net unrealized securities losses, after-tax

  98     240  

Net unrealized losses on cash flow hedge derivatives, after-tax

  7     26  

Equity investments in nonfinancial companies

  (28 )   (40 )

Other, net

  (8 )   (11 )

Tier 1 risk-based capital

  8,654     6,364  

Subordinated debt

  2,054     2,216  

Eligible allowance for credit losses

  684     697  

Total risk-based capital

  $11,392     $9,277  

Assets

   

Risk-weighted assets, including off-balance sheet instruments and market risk equivalent assets

  $83,513     $76,673  

Adjusted average total assets

  92,235     88,329  

Capital ratios

   

Tier 1 risk-based

  10.4 %   8.3 %

Total risk-based

  13.6     12.1  

Leverage

  9.4     7.2  

Tangible common equity

  7.5     5.0  

The access to, and cost of, funding new business initiatives including acquisitions, the ability to engage in expanded business activities, the ability to pay dividends, the level of deposit insurance costs, and the level and nature of regulatory oversight depend, in part, on a financial institution’s capital strength. At September 30, 2006, each of our banking subsidiaries was considered “well-capitalized” based on regulatory capital ratio requirements, as indicated in the Capital Ratios section of Consolidated Financial Highlights on page 2 of this Report. We believe our bank subsidiaries will continue to meet these requirements during the remainder of 2006.

OFF-BALANCE SHEET ARRANGEMENTS AND VARIABLE INTEREST ENTITIES

We engage in a variety of activities in the normal course of business that involve unconsolidated entities or that are otherwise not reflected in our Consolidated Balance Sheet that are generally referred to as “off-balance sheet arrangements.” Further information on these types of activities is included in Note 15 Commitments And Guarantees included in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report.

Further information on the variable interest entities (“VIEs”) in the following tables is included in our 2005 Form 10-K under this same heading in Part I, Item 7 and in Note 3 Variable Interest Entities in the Notes To Consolidated Financial Statements included in Part II, Item 8 of that report.

We hold significant variable interests in VIEs that have not been consolidated because we are not considered the primary beneficiary. Information on these VIEs follows:

 

Non-Consolidated VIEs - Significant Variable Interests

 

In millions   Aggregate
Assets
  Aggregate
Liabilities
 

PNC Risk

of Loss

 

September 30, 2006

     

Market Street

  $4,049   $4,049   $6,205 (a)

Collateralized debt obligations

  956   727   21  

Partnership interests in low income housing projects

  33   30   7  

Total

  $5,038   $4,806   $6,233  

December 31, 2005

     

Collateralized debt obligations (b)

  $6,290   $5,491   $51 (c)

Private investment funds (b)

  5,186   1,051   13 (c)

Market Street

  3,519   3,519   5,089 (a)

Partnership interests in low income housing projects

  35   29   2  

Total

  $15,030   $10,090   $5,155  
(a) Includes off-balance sheet liquidity commitments to Market Street of $5.7 billion and other credit enhancements of $.5 billion at September 30, 2006. The comparable amounts at December 31, 2005 were $4.6 billion and $.4 billion, respectively. Events whereby PNC may be liable for funding include bankruptcies, delinquencies, or covenant violations.
(b) Primarily held by BlackRock. We deconsolidated BlackRock effective September 29, 2006. See Note 2 Acquisitions in the Notes To Consolidated Financial Statements for additional information.
(c) Includes both PNC’s direct risk of loss and BlackRock’s risk of loss, limited to PNC’s ownership interest in BlackRock.

The aggregate assets and liabilities of VIEs that we have consolidated in our financial statements are as follows:

Consolidated VIEs – PNC Is Primary Beneficiary

 

In millions  

Aggregate

Assets

  Aggregate
Liabilities

September 30, 2006

   

Partnership interests in low income housing projects

  $870   $870

Other

  18   18

Total

  $888   $888

December 31, 2005

   

Partnership interests in low income housing projects

  $680   $680

Other

  12   10

Total

  $692   $690

We also have subsidiaries that invest in and act as the investment manager for private equity funds organized as limited partnerships as part of our equity management activities. The funds invest in private equity investments to generate capital appreciation and profits. As permitted by FASB Interpretation No. 46 (Revised 2003), “Consolidation of Variable Interest Entities,” we have deferred applying the provisions of the interpretation for these entities pending further action by the FASB. Information on these entities follows:

Investment Company Accounting – Deferred Application

 

In millions   Aggregate
Assets
  Aggregate
Equity
 

PNC Risk

of Loss

Private Equity Funds

     

September 30, 2006

  $82   $82   $103

December 31, 2005

  $109   $109   $35

PNC’s risk of loss in the tables above includes both the value of our equity investments and any unfunded commitments to the respective entities.


 

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BUSINESS SEGMENTS REVIEW

We have four major businesses engaged in providing banking, asset management and global fund processing products and services. Business segment results, including inter-segment revenues, and a description of each business are included in Note 14 Segment Reporting included in the Notes To Consolidated Financial Statements under Part I, Item 1 of this Report.

 

Results of individual businesses are presented based on our management accounting practices and our management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to GAAP; therefore, the financial results of individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses and management structure change. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis. As permitted under GAAP, we have aggregated the business results for certain operating segments for financial reporting purposes.

 

Our capital measurement methodology is based on the concept of economic capital for our banking businesses. However, we have increased the capital assigned to Retail Banking to 6% of funds to reflect the capital required for well-capitalized banks and to approximate market comparables for this business. The capital for BlackRock and PFPC currently reflects average legal entity shareholders’ equity, which exceeds required economic capital.

 

BlackRock business segment results for the three months and nine months ended September 30, 2006 and 2005 reflect our majority ownership in BlackRock during each of these periods.

  

Subsequent to the September 29, 2006 BlackRock/MLIM closing, which had the effect of reducing our ownership interest to approximately 34%, our investment in BlackRock is being accounted for under the equity method of accounting but will continue to be a separate reportable business segment of PNC. Our prior period business segment information for BlackRock will not be restated. See Note 2 Acquisitions in the Notes To Consolidated Financial Statements for additional information.

 

We have allocated the allowances for loan and lease losses and unfunded loan commitments and letters of credit based on our assessment of risk inherent in the loan portfolios. Our allocation of the costs incurred by operations and other support areas not directly aligned with the businesses is primarily based on the use of services.

 

Total business segment financial results differ from total consolidated results. The impact of these differences is primarily reflected in minority interest in income of BlackRock up to September 29, 2006, and in the “Other” category in the Results of Businesses – Summary table that follows. “Other” includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as the third quarter 2006 gain on the BlackRock/MLIM transaction, 2006 BlackRock/MLIM integration costs, One PNC implementation costs, asset and liability management activities, related net securities gains or losses, certain trading activities, equity management activities and minority interest in income of BlackRock up to September 29, 2006, differences between business segment performance reporting and financial statement reporting (GAAP), most corporate overhead and intercompany eliminations.

 

The period-end employee statistics disclosed for each business segment in the tables that follow reflect staff directly employed by the respective business segment and may exclude operations, technology and staff services employees not directly managed by the respective business segment.

RESULTS OF BUSINESSES - SUMMARY

(Unaudited)

 

     Earnings     Revenue (a) (b)    Return on
Average Capital (c)
    Average Assets (d)
Nine months ended September 30 - dollars in millions    2006     2005     2006    2005    2006     2005     2006    2005

Retail Banking

   $ 581     $ 487     $ 2,326    $ 2,113    26 %   23 %   $ 29,319    $ 27,138

Corporate & Institutional Banking

     334       372       1,078      977    23     29       26,237      25,303

BlackRock (e)

     209       167       1,103      854    29     28       3,865      1,673

PFPC

     93       75       634      637    31     34       2,053      2,082

Total business segments

     1,217       1,101       5,141      4,581    26     26       61,474      56,196

Minority interest in income of BlackRock

     (64 )     (51 )               

Other (e) (f)

     1,066       (80 )     1,916      57          32,178      31,165

Total consolidated (a)

   $ 2,219     $ 970     $ 7,057    $ 4,638    34 %   16 %   $ 93,652    $ 87,361
(a) Business segment revenue is presented on a taxable-equivalent basis. A reconciliation of total consolidated revenue on a book (GAAP) basis to total consolidated revenue on a taxable-equivalent basis follows:

 

Nine months ended September 30 – (in millions)    2006    2005

Total consolidated revenue, book (GAAP) basis

   $ 7,037    $ 4,618

Taxable-equivalent adjustment

     20      20

Total consolidated revenue, taxable-equivalent basis

   $ 7,057    $ 4,638
(b) Amounts for the BlackRock segment represent the sum of total operating revenue and nonoperating income. Amounts for PFPC represent the sum of servicing revenue and net nonoperating income (expense) less debt financing costs.
(c) Percentages for the BlackRock segment and PFPC reflect return on average equity.
(d) Period-end balances for BlackRock and PFPC.
(e) BlackRock reported GAAP earnings of $153 million and $161 million for the nine months ended September 30, 2006 and September 30, 2005, respectively. For this business segment reporting presentation, pretax integration costs incurred by BlackRock for the MLIM transaction totaling $91 million for the nine months ended September 30, 2006 have been reclassified from BlackRock to “Other.” Similarly, pretax integration costs of $9 million related to BlackRock’s January 2005 acquisition of State Street Research and Management have been reclassified from BlackRock to “Other” for the nine months ended September 30, 2005.
(f) “Other” in the Business Segment Highlights portion of the Executive Summary section of this Report provides further information regarding “Other” results.

 

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Table of Contents

RETAIL BANKING (Unaudited)

 

Nine months ended September 30

Taxable-equivalent basis

Dollars in millions

  2006     2005  

INCOME STATEMENT

   

Net interest income

  $1,259     $1,176  

Noninterest income

   

Asset management

  261     251  

Service charges on deposits

  227     193  

Brokerage

  176     163  

Consumer services

  260     200  

Other

  143     130  

Total noninterest income

  1,067     937  

Total revenue

  2,326     2,113  

Provision for credit losses

  46     43  

Noninterest expense

  1,342     1,292  

Pretax earnings

  938     778  

Minority interest

  14    

Income taxes

  343     291  

Earnings

  $581     $487  

AVERAGE BALANCE SHEET

   

Loans

   

Consumer

   

Home equity

  $13,814     $13,216  

Indirect

  1,025     920  

Other consumer

  1,224     1,174  

Total consumer

  16,063     15,310  

Commercial

  5,658     5,031  

Floor plan

  929     988  

Residential mortgage

  1,578     1,301  

Other

  245     265  

Total loans

  24,473     22,895  

Goodwill and other intangible assets

  1,583     1,338  

Loans held for sale

  1,641     1,468  

Other assets

  1,622     1,437  

Total assets

  $29,319     $27,138  

Deposits

   

Noninterest-bearing demand

  $7,844     $7,543  

Interest-bearing demand

  7,920     7,895  

Money market

  14,725     13,377  

Total transaction deposits

  30,489     28,815  

Savings

  2,089     2,664  

Certificates of deposit

  13,580     11,098  

Total deposits

  46,158     42,577  

Other liabilities

  537     392  

Capital

  2,970     2,814  

Total funds

  $49,665     $45,783  

PERFORMANCE RATIOS

   

Return on average capital

  26 %   23 %

Noninterest income to total revenue

  46     44  

Efficiency

  58     61  

 

At September 30

Dollars in millions except as noted

  2006     2005  

OTHER INFORMATION (a)

   

Credit-related statistics:

   

Total nonperforming assets (b)

  $95     $87  

Net charge-offs

  $64     $41  

Annualized net charge-off ratio

  .35 %   .24 %

Home equity portfolio credit statistics:

   

% of first lien positions

  44 %   47 %

Weighted average loan-to-value ratios

  69 %   70 %

Weighted average FICO scores

  728     721  

Loans 90 days past due

  .22 %   .18 %

 

At September 30

Dollars in millions except as noted

  2006     2005  

OTHER INFORMATION (a)

   

Checking-related statistics:

   

Retail Banking checking relationships

  1,958,000     1,921,000  

Consumer DDA households using online banking

  920,000     830,000  

% of consumer DDA households using online banking

  52 %   48 %

Consumer DDA households using online bill payment

  361,000     188,000  

% of consumer DDA households using online bill payment

  20 %   11 %

Small business managed deposits:

   

On-balance sheet

   

Noninterest-bearing demand

  $4,349     $4,285  

Interest-bearing demand

  $1,464     $1,527  

Money market

  $2,660     $2,818  

Certificates of deposit

  $591     $372  

Off-balance sheet (c)

   

Small business sweep checking

  1,555     1,275  

Total managed deposits

  $10,619     $10,277  

Brokerage statistics:

   

Margin loans

  $170     $223  

Financial consultants (d)

  752     784  

Full service brokerage offices

  99     99  

Brokerage account assets (billions)

  $44     $42  

Other statistics:

   

Gains on sales of education loans (e)

  $22     $15  

Full-time employees

  9,531     9,891  

Part-time employees

  1,660     934  

ATMs

  3,594     3,770  

Branches (f)

  848     830  

ASSETS UNDER ADMINISTRATION
(billions) (g)

   

Assets under management:

   

Personal

  $42     $41  

Institutional

  10     9  

Total

  $52     $50  

Asset Type

   

Equity

  $32     $31  

Fixed income

  12     13  

Liquidity/Other

  8     6  

Total

  $52     $50  

Nondiscretionary assets under administration:

   

Personal

  $27     $27  

Institutional

  62     58  

Total

  $89     $85  

Asset Type

   

Equity

  $32     $32  

Fixed income

  27     25  

Liquidity/Other

  30     28  

Total

  $89     $85  
(a) Presented as of September 30 except for net charge-offs, annualized net charge-off ratio, gains on sales of education loans, and small business deposits, which are for the nine months ended September 30.
(b) Includes nonperforming loans of $85 million at September 30, 2006 and $78 million at September 30, 2005.
(c) Represents small business balances, a portion of which are calculated on a one-month lag. These balances are swept into liquidity products managed by other PNC business segments, the majority of which are off-balance sheet.
(d) Financial consultants provide services in full service brokerage offices and PNC traditional branches.
(e) Included in “Noninterest income-Other.”
(f) Excludes certain satellite branches that provide limited products and service hours.
(g) Excludes brokerage account assets.

 

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Retail Banking’s earnings were $581 million for the first nine months of 2006 compared with $487 million for the same period in 2005. Compared with the prior year, revenues increased 10% and noninterest expenses increased 4%, resulting in a 19% earnings improvement. The increase in earnings was driven by improved fee income from customers, higher taxable-equivalent net interest income fueled by continued customer and balance sheet growth, and a sustained focus on expense management. Retail Banking’s sustained focus on expense management has allowed for additional investments in the business which include branch expansion and renovation, a new checking account line, and a credit card program.

Highlights of Retail Banking’s performance during the first nine months of 2006 include the following:

 

·   A component of our strategy is to be the preferred payments provider for our consumer and small business customers. We are going to market through our “Banking Made Easy” initiative, which was launched during the third quarter of 2006. Two key product changes occurred in the third quarter as a part of this strategy.
  We announced a simplified choice of checking accounts for our customers that offer free access to ATMs worldwide.
  We also launched a new credit card program for our consumer and small business customers.
·   Consumer and small business checking relationships increased by 37,000, or 2%, compared with September 30, 2005. Checking relationship growth has been mitigated by our focus on consolidating low-activity and low-balance accounts, while seeking higher quality deposits.
·   Since September 30, 2005, consumer-related checking households using online banking increased 11% and checking households using online bill payment increased 92%.
·   The small business area continued its positive momentum. Average small business loans increased 14% over the first nine months of 2005 on the strength of increased demand from both existing customers and new relationships. Small business checking relationships increased 4%.
·   Customer assets in brokerage accounts totaled $44 billion at September 30, 2006 compared with $42 billion at September 30, 2005. Brokerage fees increased $13 million or 8% over the first nine months of 2005.
·   Retail Banking’s year-to-date efficiency ratio improved to 58% compared with 61% a year earlier.
·   The branch network increased a net 18 branches to a total of 848 branches at September 30, 2006 compared with 830 at September 30, 2005. This increase was comprised of 30 new branches, offset by 12 branch consolidations. Our strategy is to continue to optimize our network by opening new branches in high growth areas and consolidating branches in areas of declining market opportunity and/or growth.
·   Asset quality remained very strong.

 

Total revenue for the first nine months of 2006 was $2.326 billion compared with $2.113 billion for the same period last year. Taxable-equivalent net interest income of $1.259 billion increased $83 million, or 7%, compared with 2005 due to an 8% increase in average deposits and a 7% increase in average loan balances. The net interest income growth has been somewhat mitigated by declining spreads on the loan portfolio. In the current rate environment, we expect the spread on both loans and deposits to be under pressure.

Noninterest income increased $130 million, or 14%, compared with the first nine months of 2005 primarily driven by increased consumer services fees and service charges on deposits. This growth can be attributed primarily to the following:

 

  ·   Customer growth,
  ·   Expansion of the branch network, including a new market,
  ·   Consolidation of our merchant services activities,
  ·   Increased brokerage account assets and activities,
  ·   Improved asset management fees,
  ·   Increased third party loan servicing activities, and
  ·   Various pricing actions resulting from the One PNC initiative.

The provision for credit losses increased $3 million in the first nine months of 2006 compared with 2005. Excluding the impact of a single large overdraft situation, net charge-offs are consistent with the prior year and with corresponding loan growth.

Noninterest expense in the first nine months of 2006 totaled $1.342 billion, an increase of $50 million, or 4%, compared with the first nine months of 2005. Operating costs increased $43 million compared with the prior year period as a result of our expansion into the greater Washington, DC area. Other expense increases were primarily attributable to continued growth of the company’s branch network, the consolidation of the company’s merchant services activities, investments in various initiatives such as the new checking account product line and credit card, and an increase in volume-related expenses tied to revenue, partially offset by lower staff-related expense as a result of One PNC initiatives.

The new simplified checking product line is expected to increase checking account households and average balances per account. Two features of the new product line, free access to ATMs worldwide and a first time overdraft waiver, will negatively impact service charges on deposits fee income and noninterest expenses.

Full-time employees at September 30, 2006 totaled 9,531, a decline of 360 from September 30, 2005. Part-time employees have increased by 726 since September 30, 2005. The decline in full-time employees and increase in part-time employees is a direct result of various cost-saving initiatives. These initiatives include utilizing more part-time customer-facing employees during peak business hours versus full-time employees for the entire day.


 

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We have adopted a relationship-based lending strategy to target specific customer sectors (homeowners, small businesses and auto dealerships) while seeking to maintain a moderate risk profile in the loan portfolio.

 

·   Average commercial loans grew $627 million, or 12%, on the strength of increased loan demand from existing small business customers and the acquisition of new relationships through our sales efforts.
·   Average home equity loans grew by $598 million, or 5%, compared with the first nine months of 2005. Consumer loan demand has slowed as a result of the current rate environment.
·   Average indirect loans grew $105 million, or 11%, compared with the first nine months of 2005. The indirect auto business benefited from increased sales and marketing efforts.
·   Average residential mortgage loans increased $277 million, or 21%, primarily due to the addition of loans from the greater Washington, DC area acquisition. Payoffs in our existing portfolio, which will continue throughout 2006, reduced the impact of the additional loans acquired. Additionally, the transfer of residential mortgages to held for sale at the end of September will reduce the size of this loan portfolio moving forward.

Growing core checking deposits as a lower cost-funding source and as the cornerstone product to build customer relationships is the primary objective of our deposit strategy. Average total deposits increased $3.6 billion, or 8%, compared with the first nine months of 2005. The deposit growth was driven by increases in the number of checking relationships and the recapture of consumer certificate of deposit balances as interest rates have risen.

During this current rate environment, we expect the rate of growth in demand deposit balances to be equal to or less than the rate of growth for customer checking relationships. Additionally, we expect to see customers shift their funds from lower yielding interest-bearing deposits to higher yielding deposits or investment

products, and to pay off loans. The shift has been evident during the past year and has impacted the level of average demand deposits in that period.

 

·   Certificates of deposits increased $2.5 billion and money market deposits increased $1.3 billion. These increases were attributable to the current interest rate environment attracting customers back into these products.
·   Average demand deposit growth of $.3 billion, or 2%, was driven by a $.5 billion increase from the expansion into the greater Washington, DC area and a decline of $.2 billion in the core business due to customers shifting funds into higher yielding deposits, small business sweep checking products, and investment products.
·   Small business and consumer-related checking relationships retention remains strong and stable. Consumer-related checking relationship retention has benefited from improved penetration rates of debit cards, online banking and online bill payment.

Assets under management of $52 billion at September 30, 2006 increased $2 billion compared with the balance at September 30, 2005. The effect of comparatively higher equity markets more than offset client net asset outflows. Client net asset outflows are the result of ordinary course distributions from trust and investment management accounts and account closures exceeding investment additions from new and existing clients.

Nondiscretionary assets under administration of $89 billion at September 30, 2006 increased $4 billion compared with the balance at September 30, 2005. The effect of comparatively higher equity markets combined with client net positive asset inflows accounted for the increase.


 

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CORPORATE & INSTITUTIONAL BANKING

(Unaudited)

 

Nine months ended September 30

Taxable-equivalent basis

Dollars in millions except as noted

  2006   2005  

INCOME STATEMENT

   

Net interest income

  $530   $555  

Noninterest income

   

Corporate service fees

  377   280  

Other

  171   142  

Noninterest income

  548   422  

Total revenue

  1,078   977  

Provision for (recoveries of) credit losses

  36   (53 )

Noninterest expense

  550   481  

Pretax earnings

  492   549  

Income taxes

  158   177  

Earnings

  $334   $372  

AVERAGE BALANCE SHEET

   

Loans

   

Corporate (a)

  $9,835   $10,934  

Commercial real estate

  2,786   2,178  

Commercial – real estate related

  2,515   2,021  

Asset-based lending

  4,424   4,195  

Total loans (a)

  19,560   19,328  

Loans held for sale

  869   694  

Goodwill and other intangible assets

  1,336   997  

Other assets

  4,472   4,284  

Total assets

  $26,237   $25,303  

Deposits

   

Noninterest-bearing demand

  $6,623   $5,856  

Money market

  2,321   2,597  

Other

  902   678  

Total deposits

  9,846   9,131  

Commercial paper (b)

    2,284  

Other liabilities

  3,683   3,330  

Capital

  1,950   1,702  

Total funds

  $15,479   $16,447  

Earnings from Corporate & Institutional Banking for the first nine months of 2006 totaled $334 million compared with $372 million for the first nine months of 2005. This decline was primarily attributable to the benefit of a $53 million loan recovery recognized in the second quarter of 2005 compared with a $36 million provision for credit losses in the first nine months of 2006. In addition to the negative impact of the $89 million change in the provision for credit losses, total revenue increased $101 million and noninterest expenses grew by $69 million for the first nine months of 2006 compared with the first nine months of 2005.

 

Nine months ended September 30

Taxable-equivalent basis

Dollars in millions except as noted

  2006     2005  

PERFORMANCE RATIOS

   

Return on average capital

  23 %   29 %

Noninterest income to total revenue

  51     43  

Efficiency

  51     49  
COMMERCIAL MORTGAGE SERVICING PORTFOLIO (in billions)    

Beginning of period

  $136     $98  

Acquisitions/additions

  69     53  

Repayments/transfers

  (25 )   (25 )

End of period

  $180     $126  

OTHER INFORMATION

   

Consolidated revenue from: (c)

   

Treasury Management

  $316     $305  

Capital Markets

  $204     $113  

Midland Loan Services

  $131     $103  

Total loans (a) (d)

  $20,405     $21,084  

Nonperforming assets (d) (e)

  $94     $67  

Net charge-offs (recoveries)

  $30     $(51 )

Full-time employees (d)

  1,925     1,740  

Net gains on commercial mortgage loan sales

  $37     $48  

Net carrying amount of commercial mortgage servicing rights (d)

  $414     $297  
(a) Includes lease financing and Market Street. Effective October 17, 2005, Market Street was deconsolidated from our Consolidated Balance Sheet.
(b) Amount for 2005 includes Market Street.
(c) Represents consolidated PNC amounts.
(d) At September 30.
(e) Includes nonperforming loans of $81 million at September 30, 2006 and $48 million at September 30, 2005.

Highlights of the first nine months of 2006 for Corporate & Institutional Banking included:

 

·   Average loan balances increased $232 million, or 1%, over 2005. The prior year average included $2.1 billion in loans from the Market Street Funding commercial paper conduit that was deconsolidated in October 2005. Excluding the impact of deconsolidating the conduit, average loan balances increased 13%. The growth in loans was driven by continuing customer demand, increasing utilization and our expansion into the greater Washington, DC area in May 2005. Based upon the impact of increasing competitive pressures and shrinking loan spreads on PNC’s risk reward criteria, the rate of loan growth has slowed from that experienced in the first half of 2006 and we expect this trend to continue during the remainder of the year.
·   Average deposits increased $715 million, or 8%, over the comparable prior year period driven by growth in our commercial mortgage servicing portfolio and related deposits and the sale of treasury management products. Corporate & Institutional Banking has experienced a modest decline in interest-bearing deposits as more clients improve the management of their overall liquidity given the higher rate environment. This trend in interest-bearing deposits is anticipated to reverse during the remainder of 2006 due to new business activities.
·   Total revenue increased 10% compared with 2005 as strong growth in fee income offset a decline in taxable-equivalent net interest income. Fee income growth was driven by increases in merger and acquisition advisory activity, capital market-related activities, treasury management products and services, and commercial mortgage servicing.

 

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Commercial mortgage servicing revenue, which includes fees and net interest income, totaled $131 million for the first nine months of 2006. The 27% revenue growth over the first nine months of 2005 was driven by growth in the commercial mortgage servicing portfolio, which increased to $180 billion, and other commercial real estate related services.

Taxable-equivalent net interest income declined $25 million, to $530 million, for the first nine months of 2006 compared with the first nine months of 2005. This decline was attributable to narrowing loan and interest-bearing deposits spreads, an increase in goodwill and other intangible assets, the deconsolidation of Market Street Funding, and lower average interest-bearing deposit volumes partially offset by an increase in average loans outstanding and average noninterest-bearing demand deposits.

Noninterest income totaled $548 million in the first nine months of 2006, an increase of $126 million, or 30%, compared with the prior year first nine months. The increase in corporate service fees reflects fee income attributable to the Harris Williams acquisition completed in October 2005 and growth in net commercial mortgage servicing and treasury management, partially offset by lower loan syndications income. Improved trading results modestly offset by a decline in net gains on commercial mortgage loan sales drove the increase in other noninterest income.

 

The provision for credit losses was $36 million for the first nine months of 2006 compared with a credit of $53 million for the first nine months of 2005. The prior year provision reflected the impact of a $53 million loan recovery recognized in the second quarter of 2005. The higher provision for credit losses in the first nine months of 2006 reflected $30 million of net chargeoffs during this period. Nonperforming assets at September 30, 2006 increased $27 million compared with September 30, 2005, and are below levels at December 31, 2005. Based on the assets we currently hold and current business trends and activities, we believe that overall asset quality will remain strong at least for the near term.

Noninterest expense increased 14%, compared with the first nine months of 2005. The increases in noninterest expense and full-time employees were primarily due to acquisition activity, customer growth and the increase in the commercial mortgage servicing portfolio.

See the additional revenue discussion regarding treasury management and capital markets-related products and services and commercial loan servicing on page 9.


 

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BLACKROCK (Unaudited)

 

Nine months ended September 30

Taxable-equivalent basis

Dollars in millions except as noted

  2006     2005  

INCOME STATEMENT

   

Investment advisory and administrative fees

  $938     $698  

Other income

  141     124  

Total operating revenue

  1,079     822  

Operating expense (a)

  732     553  

Fund administration and servicing costs

  32     32  

Total expense (a)

  764     585  

Operating income

  315     237  

Nonoperating income

  24     32  

Pretax earnings

  339     269  

Minority interest

  2     2  

Income taxes

  128     100  

Earnings (a)

  $209     $167  

PERIOD-END BALANCE SHEET (b)

   

Investment in BlackRock

  $3,836    

Goodwill and other intangible assets

  29     $492  

Other assets

        1,181  

Total assets

  $3,865     $1,673  

Liabilities and minority interest

  $1,541     $806  

Stockholders’ equity

  2,324     867  

Total liabilities and stockholders’ equity

  $3,865     $1,673  

Return on average equity

  29 %   28 %

 

(a) BlackRock reported GAAP earnings of $153 million and $161 million for the nine months ended September 30, 2006 and September 30, 2005, respectively. For this PNC business segment reporting presentation, pretax integration costs incurred by BlackRock for the MLIM transaction totaling $91 million for the nine months ended September 30, 2006 have been reclassified from BlackRock to “Other.” Similarly, pretax integration costs of $9 million related to BlackRock’s January 2005 acquisition of State Street Research and Management (“SSRM”) have been reclassified from BlackRock to “Other” for the nine months ended September 30, 2005. The following is a reconciliation of BlackRock’s earnings as reported in this PNC business segment reporting presentation to BlackRock’s reported GAAP earnings (in millions):

 

Nine months ended September 30   2006   2005

BlackRock earnings, as reported in PNC’s business reporting presentation

  $209   $167

Less: BlackRock/MLIM transaction integration costs, after-tax

  56  

Less: SSRM acquisition integration costs, after-tax

      6

BlackRock reported GAAP earnings

  $153   $161

 

(b) We deconsolidated BlackRock effective September 29, 2006. As of September 30, 2006, we recorded our 34% ownership interest in BlackRock under the equity method of accounting. Goodwill and other intangible assets of $29 million at September 30, 2006 consist of goodwill recognized as a result of changes in our ownership interest in BlackRock. See Note 6 Goodwill And Other Intangible Assets in the Notes To Consolidated Financial Statements in this Report for additional information.

 

BlackRock reported GAAP net income of $153 million for the first nine months of 2006 and $161 million for the first nine months of 2005. BlackRock’s reported net income for the first nine months of 2006 and 2005 included after-tax MLIM and SSRM integration costs of $56 million and $6 million, respectively. The BlackRock business segment earned $209 million in the first nine months of 2006 and $167 million for the first nine months of 2005 excluding the impact of these costs, which we have reported in “Other” for PNC business segment reporting. The remainder of this discussion of BlackRock business segment results for these periods excludes the impact of MLIM and SSRM integration costs.

Higher earnings in 2006 reflected higher investment advisory and administrative fees due to an increase in assets under management and increased performance fees. These factors more than offset increased compensation and benefits expense, general and administration expense, and a one-time expense of $34 million incurred in the first quarter of 2006 related to the January 2005 acquisition of SSRM.

Total operating revenue increased $257 million, or 31%, in the first nine months of 2006 compared with the prior year period. The impact of higher assets under management and increased investment advisory and administrative fees in 2006 was reflected in the significantly higher revenue. The increase in investment advisory and administrative fees was the result of increases in fees earned across all asset classes as well as increased performance fees principally related to a large institutional real estate equity client account and an energy equity hedge fund acquired in the 2005 SSRM transaction.

Total expense for the first nine months of 2006 increased $179 million, or 31%, compared with the first nine months of 2005, primarily due to an increase in compensation and benefits. This increase reflected higher incentive compensation associated with higher performance fees and increased operating income growth, and higher salaries and benefits primarily attributable to higher staffing levels associated with business growth. Higher general and administration expense and the SSRM one-time expense of $34 million recognized in 2006 were also evident in the increase over the first nine months of 2005.

We refer you to the BlackRock/MLIM Transaction section of the Executive Summary section of this Financial Review for further information related to this transaction that closed on September 29, 2006. Information on this transaction is also included in Note 2 Acquisitions in the Notes To Consolidated Financial Statements included in this Report.

BlackRock is listed on the New York Stock Exchange under the symbol BLK. Additional information about BlackRock is available in its SEC filings, which can be found at www.sec.gov and on BlackRock’s website, www.blackrock.com.


 

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PFPC (Unaudited)

 

Nine months ended September 30

Dollars in millions except as noted

  2006     2005  

INCOME STATEMENT

   

Servicing revenue

  $663     $662  

Other revenue

        10  

Total operating revenue

  663     672  

Operating expense

  496     510  

Amortization of other intangibles, net

  10     10  

Total expense

  506     520  

Operating income

  157     152  

Debt financing

  32     28  

Nonoperating income (expense) (a)

  3     (7 )

Pretax earnings

  128     117  

Income taxes

  35     42  

Earnings

  $93     $75  

PERIOD-END BALANCE SHEET

   

Goodwill and other intangible assets

  $1,015     $1,029  

Other assets

  1,038     1,053  

Total assets

  $2,053     $2,082  

Debt financing

  $813     $939  

Other liabilities

  772     799  

Shareholder’s equity

  468     344  

Total funds

  $2,053     $2,082  

PERFORMANCE RATIOS

   

Return on average equity

  31 %   34 %

Operating margin (b)

  24     23  

SERVICING STATISTICS (at September 30)

   

Accounting/administration net fund assets (in billions) (c)

   

Domestic

  $695     $726  

Offshore

  79     67  

Total

  $774     $793  

Asset type (in billions)

   

Money market

  $260     $333  

Equity

  331     284  

Fixed income

  111     114  

Other

  72     62  

Total

  $774     $793  

Custody fund assets (in billions)

  $399     $475  

Shareholder accounts (in millions)

   

Transfer agency

  18     19  

Subaccounting

  48     40  

Total

  66     59  

OTHER INFORMATION

   

Full-time employees (at September 30)

  4,317     4,457  
(a) Net of nonoperating expense.
(b) Operating income divided by total operating revenue.
(c) Includes alternative investment net assets serviced.

PFPC’s earnings of $93 million in the first nine months of 2006 increased $18 million, or 24%, compared with the first nine months of 2005. Earnings for the 2006 period included the impact of a $14 million reversal of deferred taxes related to earnings from a foreign subsidiary following management’s determination that the earnings would be indefinitely reinvested outside of the United States. In addition, higher earnings in the first nine months of 2006 reflected servicing revenue contributions from several growth areas of the business and the successful implementation of expense control initiatives which improved the company’s operating margin. Earnings for the first nine months of 2005 included a $3 million tax benefit identified as part of the One PNC initiative.

 

Highlights of PFPC’s performance in the first nine months of 2006 included:

 

  ·   Offshore revenues increased 30% compared with the first nine months of 2005 fueled by new business in the alternative arena.

 

  ·   Managed account service revenue increased 30% as assets serviced increased by 70%.

 

  ·   Subaccounting revenues were up 13% as shareholder accounts grew by 20%.

Servicing revenue for the first nine months of 2006 increased slightly over the first nine months of 2005, to $663 million. Excluding the $9 million comparative decline in revenue related to out-of-pocket and pass-through items that had no impact on earnings, servicing revenue increased $10 million compared with the first nine months of 2005. Revenue increases related to offshore activities, custody, managed account services, subaccounting and securities lending drove the higher servicing revenue in 2006, partially offset by a decline in fund accounting and transfer agency revenue due to loss of clients and price concessions.

Operating expense declined $14 million, to $496 million, in the first nine months of 2006 compared with the first nine months of 2005. Out-of-pocket and pass-through items declined by $9 million. The remainder of the decline is attributable to expense control and efficiencies implemented during the past year that resulted in a lower head count and associated lower compensation costs.

The decreases in domestic accounting/administration net fund assets and custody fund assets at September 30, 2006 compared with September 30, 2005 resulted primarily from the deconversion of a major client during the first quarter of 2006, which was partially offset by new business, asset inflows from existing customers, and equity market appreciation. Subaccounting shareholder accounts serviced by PFPC increased over the year-earlier period due to net new business and growth in existing client accounts. Total assets serviced by PFPC amounted to $2.0 trillion at September 30, 2006 and $1.8 trillion at September 30, 2005.

PFPC’s performance is partially dependent on the underlying performance of its fund clients and, in particular, their ability to attract and retain customers. As a result, to the extent that PFPC clients’ businesses are adversely affected by ongoing governmental investigations into the practices of the mutual and hedge fund industries, PFPC’s results also could be adversely impacted. In addition, this regulatory and business environment is likely to continue to result in operating margin pressure for our various services.


 

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CRITICAL ACCOUNTING POLICIES AND JUDGMENTS

Note 1 Accounting Policies in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report and in Part II, Item 8 of our 2005 Form 10-K describe the most significant accounting policies that we use. Certain of these policies require us to make estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations that may significantly affect our reported results and financial position for the period or in future periods.

We must use estimates, assumptions, and judgments when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such third-party information is not available, we estimate fair value primarily by using cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could materially impact our future financial condition and results of operations.

We discuss the following critical accounting policies and judgments under this same heading in Item 7 of our 2005 Form 10-K:

  ·   Allowances for loan and lease losses and unfunded loan commitments and letters of credit
  ·   Private equity asset valuation
  ·   Lease residuals
  ·   Goodwill
  ·   Revenue recognition
  ·   Income taxes
  ·   Legal contingencies

Additional discussion and information on the application of these policies is found in other portions of this Financial Review and in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report.

 

STATUS OF QUALIFIED DEFINED BENEFIT PENSION PLAN

We have a noncontributory, qualified defined benefit pension plan (“plan” or “pension plan”) covering eligible employees. Retirement benefits are derived from a cash balance formula based on compensation levels, age and length of service. Pension contributions are based on an actuarially determined amount necessary to fund total benefits payable to plan participants. Plan assets are currently approximately 60% invested in equity investments with most of the remainder invested in fixed income instruments. Plan fiduciaries determine and review the plan’s investment policy.

We calculate the expense associated with the pension plan in accordance with Statement of Financial Accounting Standards No. (“SFAS”) 87, “Employers’ Accounting for Pensions,” and we use assumptions and methods that are compatible with the requirements of SFAS 87, including a policy of reflecting trust assets at their fair market value. On an annual basis, we review the actuarial assumptions related to the pension plan, including the discount rate, rate of compensation increase and the expected return on plan assets. Neither the discount rate nor the compensation increase assumptions significantly affect pension expense.

The expected long-term return on assets assumption does significantly affect pension expense. We decreased the expected long-term return on plan assets assumption from the 8.5% used for 2005 to 8.25% for determining net periodic cost for 2006. This change will increase pension expense in 2006 by approximately $4 million. Also, under current accounting rules, the differences between expected long-term returns and actual returns are accumulated and amortized to pension expense over future periods. Each one percentage point difference between our actual return and the expected return causes our expense in the following year to change by approximately $3 million.

The table below reflects the estimated effects on current year pension expense of certain changes in assumptions, using 2006 estimated expense as a baseline.

 

Change in Assumption  

Estimated
Increase to 2006
Pension Expense

(in millions)

.5% decrease in discount rate

  $2

.5% decrease in expected long-term return on assets

  8

.5% increase in compensation rate

  1

We currently estimate a pretax pension benefit of $12 million in 2006 compared with a pretax benefit of $8 million in 2005. Actual pension benefit recognized for the first nine months of 2006 totaled $9 million.


 

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Plan asset investment performance has the most impact on contribution requirements. However, contribution requirements are not particularly sensitive to actuarial assumptions. Investment performance will drive the amount of permitted contributions in future years. Also, current law sets limits as to both minimum and maximum contributions to the plan. In any event, any large near-term contributions to the plan will be at our discretion, as we currently expect that the minimum required contributions under the law will be minimal or zero for several years.

In September 2006, the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R).” This statement affects the accounting and reporting for our qualified pension plan, our nonqualified retirement plans, and our postretirement welfare benefit plans. SFAS 158 requires recognition on the balance sheet of the over- or underfunded position of these plans as the difference between the fair value of plan assets and the related benefit obligations. To the extent that a plan’s net funded status differs from the amounts currently recognized on the balance sheet, the difference, net of tax, will be recorded as part of accumulated other comprehensive income or loss (“AOCI”) within the shareholders’ equity section of the balance sheet. This guidance also requires the reclassification of any unrecognized actuarial gains and losses and unrecognized prior service costs to AOCI, net of tax. Post-adoption changes in unrecognized actuarial gains and losses as well as unrecognized prior service costs will be recognized in other comprehensive income, net of tax. The current year-end after-tax estimate of adjusting our plans’ funded status for any unamortized net actuarial losses and prior service costs is approximately $200 million. Additionally, each 1% change in pension trust investment returns between now and year-end 2006 will affect this estimate by approximately $10 million after-tax, and each 10 basis point change in discount rates will affect the current estimate by approximately $7 million after-tax. SFAS 158 will be effective for PNC as of December 31, 2006, with no restatement permitted for prior year-end reporting periods.

 

RISK MANAGEMENT

We encounter risk as part of the normal course of our business and we design risk management processes to help manage these risks. The Risk Management section included in Item 7 of our 2005 Form 10-K provides a general overview of the risk measurement, control strategies and monitoring aspects of our corporate-level risk management processes. Additionally, our 2005 Form 10-K provides an analysis of the risk management processes for what we view as our primary areas of risk: credit, operational, market and liquidity, as well as a discussion of our use of financial derivatives as part of our overall asset and liability risk management process. In appropriate places within that section, historical performance is also addressed. The following information in this Risk Management section updates our 2005 Form 10-K disclosures in these areas.

CREDIT RISK MANAGEMENT

Credit risk represents the possibility that a customer, counterparty or issuer may not perform in accordance with contractual terms. Credit risk is inherent in the financial services business and results from extending credit to customers, purchasing securities, and entering into financial derivative transactions. Credit risk is one of the most common risks in banking and is one of our most significant risks.

Nonperforming, Past Due And Potential Problem Assets

See Note 4 Asset Quality in the Notes To Consolidated Financial Statements of this Report and included here by reference for details of the types of nonperforming assets that we held at September 30, 2006 and December 31, 2005. In addition, certain performing assets have interest payments that are past due or have the potential for future repayment problems.

Total nonperforming assets at September 30, 2006 decreased $25 million, to $191 million, compared with December 31, 2005 driven by a $23 million decrease in nonperforming loans.

Foreclosed lease assets of $12 million at September 30, 2006 and $13 million at December 31, 2005 primarily represent our repossession of collateral related to a single airline industry credit. This repossessed collateral is currently being leased.

The amount of nonperforming loans that was current as to principal and interest was $93 million at September 30, 2006 and $115 million at December 31, 2005. While we believe that overall asset quality will remain strong for the near term, we anticipate an increase in nonperforming loans going forward. The current level of asset quality is not sustainable for the foreseeable future.


 

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Nonperforming Assets By Business

 

In millions   Sept. 30
2006
  Dec. 31
2005

Retail Banking

  $95   $90

Corporate & Institutional Banking

  94   124

Other

  2   2

Total nonperforming assets

  $191   $216

Change In Nonperforming Assets

 

In millions   2006     2005  

January 1

  $216     $175  

Transferred from accrual

  182     182  

Returned to performing

  (15 )   (11 )

Principal activity including payoffs

  (93 )   (128 )

Asset sales

  (14 )   (11 )

Charge-offs and valuation adjustments

  (85 )   (51 )

September 30

  $191     $156  

Accruing Loans And Loans Held For Sale Past Due 90 Days Or More

 

    Amount   Percent of Total
Outstandings
 
Dollars in millions  

Sept. 30

2006

 

Dec. 31

2005

 

Sept. 30

2006

   

Dec. 31

2005

 

Commercial

  $12   $12   .06 %   .06 %

Commercial real estate

  2   2   .06     .06  

Consumer

  23   22   .14     .14  

Residential mortgage

  8   10   .15     .14  

Other

  2        .58    

Total loans

  47   46   .10     .09  

Loans held for sale

  8   47   .19     1.92  

Total loans and loans held for sale

  $55   $93   .10 %   .18 %

Loans that are not included in nonperforming or past due categories but cause us to be uncertain about the borrower’s ability to comply with existing repayment terms over the next six months totaled $23 million at September 30, 2006 compared with $67 million at December 31, 2005. Approximately 45% of these loans are in the Corporate & Institutional Banking portfolio.

Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit

We maintain an allowance for loan and lease losses to absorb losses from the loan portfolio. We determine the allowance based on quarterly assessments of the probable estimated losses inherent in the loan portfolio. While we make allocations to specific loans and pools of loans, the total reserve is available for all loan and lease losses.

We refer you to Note 4 Asset Quality in the Notes To Consolidated Financial Statements in this Report regarding changes in the allowance for loan and lease losses and changes in the allowance for unfunded loan commitments and letters of credit for additional information which is included herein by reference.

 

Allocation Of Allowance For Loan And Lease Losses

 

    September 30, 2006     December 31, 2005  
Dollars in millions   Allowance  

Loans to

Total

Loans

    Allowance  

Loans to

Total

Loans

 

Commercial

  $455   42.1 %   $489   39.2 %

Commercial real estate

  31   7.1     32   6.4  

Consumer

  25   33.6     24   33.1  

Residential mortgage

  6   10.7     7   14.9  

Lease financing

  45   5.8     41   5.7  

Other

  4   .7     3   .7  

Total

  $566   100.0 %   $596   100.0 %

In addition to the allowance for loan and lease losses, we maintain an allowance for unfunded loan commitments and letters of credit. We report this allowance as a liability on our Consolidated Balance Sheet. We determine this amount using estimates of the probability of the ultimate funding and losses related to those credit exposures. This methodology is similar to the one we use for determining the adequacy of our allowance for loan and lease losses.

The provision for credit losses for the first nine months of 2006 and the evaluation of the allowances for loan and lease losses and unfunded loan commitments and letters of credit as of September 30, 2006 reflected loan growth, changes in loan portfolio composition, the impact of refinements to our reserve methodology, and changes in asset quality. The provision includes amounts for probable losses on loans and credit exposure related to unfunded loan commitments and letters of credit.

We do not expect to sustain asset quality at its current level. However, based on the assets we currently hold and current business trends and activities, we believe that overall asset quality will remain strong by historical standards for at least the near term. This outlook, combined with expected loan growth, may result in an increase in the allowance for loan and lease losses in future periods.

The allowance as a percent of nonperforming loans was 339% and as a percent of total loans was 1.16% at September 30, 2006. The comparable percentages at December 31, 2005 were 314% and 1.21%.


 

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Table of Contents

Charge-Offs And Recoveries

 

Nine months ended

September 30 Dollars

in millions

  Charge-offs   Recoveries   Net
Charge-offs
    Percent of
Average
Loans
 

2006

       

Commercial

  $85   $16   $69     .46 %

Commercial real estate

  2     2     .09  

Consumer

  37   11   26     .22  

Residential mortgage

  2     2     .04  

Lease financing

       4   (4 )   (.19 )

Total

  $126   $31   $95     .26  

2005

       

Commercial (a)

  $44   $76   $(32 )   (.23 )%

Commercial real estate

    1   (1 )   (.05 )

Consumer

  33   11   22     .18  

Residential mortgage

  1     1     .02  

Lease financing

       1   (1 )   (.04 )

Total

  $78   $89   $(11 )   (.03 )
(a) Includes a $53 million loan recovery.

We establish reserves to provide coverage for probable losses not considered in the specific, pool and consumer reserve methodologies, such as, but not limited to, industry concentrations and conditions; credit quality trends; recent loss experience in particular sectors of the portfolio; ability and depth of lending management; changes in risk selection and underwriting standards; and the timing of available information. The amount of reserves for these qualitative factors is assigned to loan categories and to business segments based on the relative specific and pool allocation amounts. The amount of reserve allocated for qualitative factors represented 10.6% of the total allowance and .12% of total loans at September 30, 2006.

CREDIT DEFAULT SWAPS

Credit default swaps provide, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying financial instruments. We use the contracts to mitigate credit risk associated with commercial lending activities as well as proprietary derivative and convertible bond trading. Credit default swaps are included in the Free-Standing Derivatives table in the Financial Derivatives section of this Risk Management discussion. We realized a net loss of $10.5 million during the first nine months of 2006 and a minimal net loss during the same period of 2005 in connection with credit default swaps.

MARKET RISK MANAGEMENT OVERVIEW

Market risk is the possibility of a loss in earnings or economic value due to adverse movements in market factors such as interest rates, credit spreads, foreign exchange rates, and equity prices.

MARKET RISK MANAGEMENT – INTEREST RATE RISK

Interest rate risk results primarily from our traditional banking activities of gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates, and consumer preferences, affect the difference between the interest that we earn on assets and the interest that

we pay on liabilities. Because of repricing term mismatches and embedded options inherent in certain of these products, changes in market interest rates not only affect expected near-term earnings, but the economic values of these assets and liabilities as well.

PNC’s Asset and Liability Management group centrally manages interest rate risk subject to interest rate risk limits and certain policies approved by the Asset and Liability Committee and the Risk Committee of the Board.

Sensitivity estimates and market interest rate benchmarks for the third quarter of 2006 and 2005 follow:

Interest Sensitivity Analysis

 

     Third
Quarter
2006
    Third
Quarter
2005
 

Net Interest Income Sensitivity Simulation

     

Effect on net interest income in first year from gradual interest rate change over following 12 months of:

     

100 basis point increase

  (2.2 )%   .7 %

100 basis point decrease

  2.0 %   (1.1 )%

Effect on net interest income in second year from gradual interest rate change over the preceding 12 months of:

     

100 basis point increase

  (5.1 )%   1.2 %

100 basis point decrease

  4.0 %   (4.7 )%

Duration of Equity Model

     

Base case duration of equity (in years):

  .8     (1.5 )

Key Period-End Interest Rates

     

One-month LIBOR

  5.32 %   3.86 %

Three-year swap

  5.05 %   4.60 %

In addition to measuring the effect on net interest income assuming parallel changes in current interest rates, we routinely simulate the effects of a number of nonparallel interest rate environments. The following Net Interest Income Sensitivity To Alternate Rate Scenarios table reflects the estimated percentage change in net interest income over the next two 12-month periods assuming (i) the PNC Economist’s most likely rate forecast, (ii) implied forward rates, which result in an essentially flat rate scenario, and (iii) a Two-Ten Inversion (a 200 basis point inversion between two-year and ten-year rates superimposed on current base rates) scenario. We are inherently sensitive to a flatter or inverted yield curve.

Net Interest Income Sensitivity To Alternate Rate Scenarios (for third quarter 2006)

 

     PNC
Economist
    Market
Forward
    Two-Ten
Inversion
 

First year sensitivity

  1.4 %   0.8 %   (5.1 )%

Second year sensitivity

  8.2 %   3.3 %   (5.1 )%

 

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Table of Contents

All changes in forecasted net interest income are relative to results in a base rate scenario where current market rates are assumed to remain unchanged over the forecast horizon.

When forecasting net interest income, we make assumptions about interest rates and the shape of the yield curve, the volume and characteristics of new business, and the behavior of existing positions. These assumptions determine the future level of simulated net interest income in the base interest rate scenario and the other interest rate scenarios presented in the table above. These simulations assume that as assets and liabilities mature, they are replaced or repriced at market rates.

The graph below presents the yield curves for the base rate scenario and each of the alternative scenarios one year forward.

LOGO

Our risk position has become increasingly liability sensitive in part due to the increase in market interest rates and in part due to our balance sheet management strategy. We believe that we have the deposit funding base and balance sheet flexibility to take advantage, where appropriate, of changing interest rates and to adjust to changing market conditions.

MARKET RISK MANAGEMENT – TRADING RISK

Our trading activities primarily include customer-driven trading in fixed income securities, equities, derivatives, and foreign exchange contracts. They also include the underwriting of fixed income and equity securities and proprietary trading.

 

We use value-at-risk (“VaR”) as the primary means to measure and monitor market risk in trading activities. The Risk Committee of the Board establishes an enterprise-wide VaR limit on our trading activities.

During the first nine months of 2006, our VaR ranged between $3.8 million and $6.8 million, averaging $5.2 million.

To help ensure the integrity of the models used to calculate VaR for each portfolio and enterprise-wide, we use a process known as backtesting. The backtesting process consists of comparing actual observations of trading-related gains or losses against the VaR levels that were calculated at the close of the prior day. We would expect a maximum of two to three instances a year in which actual losses exceeded the prior day VaR measure. During the first nine months of 2006, there were no such instances at the enterprise-wide level.

The following graph shows a comparison of enterprise-wide trading-related gains and losses against prior day VaR for the period.

LOGO


 

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Table of Contents

Total trading revenue for the first nine months and third quarter of 2006 and 2005 was as follows:

 

Nine months ended September 30 – in millions   2006     2005

Net interest income (loss)

  $(4 )   $7

Noninterest income

  150     108

Total trading revenue

  $146     $115

Securities underwriting and trading (a)

  $14     $12

Foreign exchange

  42     27

Financial derivatives

  90     76

Total trading revenue

  $146     $115
Three months ended September 30 – in millions   2006     2005

Net interest income (loss)

  $(1 )   $1

Noninterest income

  38     47

Total trading revenue

  $37     $48

Securities underwriting and trading (a)

  $8     $2

Foreign exchange

  11     10

Financial derivatives

  18     36

Total trading revenue

  $37     $48
(a) Includes changes in fair value for certain loans accounted for at fair value.

Average trading assets and liabilities consisted of the following:

 

Nine months ended September 30 - in millions   2006   2005

Assets

   

Securities (a)

  $1,577   $1,849

Resale agreements (b)

  413   687

Financial derivatives (c)

  1,127   746

Loans at fair value (c)

  113    

Total assets

  $3,230   $3,282

Liabilities

   

Securities sold short (d)

  $767   $1,004

Repurchase agreements and other borrowings (e)

  744   1,064

Financial derivatives (f)

  1,085   797

Borrowings at fair value (f)

  29    

Total liabilities

  $2,625   $2,865
Three months ended September 30 - in millions   2006   2005

Assets

   

Securities (a)

  $1,460   $1,734

Resale agreements (b)

  537   411

Financial derivatives (c)

  1,220   695

Loans at fair value (c)

  168    

Total assets

  $3,385   $2,840

Liabilities

   

Securities sold short (d)

  $867   $806

Repurchase agreements and other borrowings (e)

  708   933

Financial derivatives (f)

  1,151   814

Borrowings at fair value (f)

  40    

Total liabilities

  $2,766   $2,553
(a) Included in Interest-earning assets-Other on the Average Consolidated Balance Sheet and Net Interest Analysis.
(b) Included in Federal funds sold and resale agreements.
(c) Included in Noninterest-earning assets-Other.
(d) Included in Other borrowed funds.
(e) Included in Repurchase agreements and Other borrowed funds.
(f) Included in Accrued expenses and other liabilities.

 

MARKET RISK MANAGEMENT – EQUITY AND OTHER

INVESTMENT RISK

Equity investment risk is the risk of potential losses associated with investing in both private and public equity markets.

Private Equity

The private equity portfolio is comprised of investments that vary by industry, stage and type of investment.

At September 30, 2006, private equity investments carried at estimated fair value totaled $411 million compared with $449 million at December 31, 2005. As of September 30, 2006, approximately 36% of the amount was invested directly in a variety of companies and approximately 64% was invested in various limited partnerships. Private equity unfunded commitments totaled $131 million at September 30, 2006 compared with $78 million at December 31, 2005. The increase resulted from our $75 million commitment to a new equity fund, PNC Equity Partners II, LP, which has $226 million of total commitments. Future closings are anticipated into the first half of 2007. Our commitment is expected to be funded over a five-year period. This fund is not consolidated as we have less than a 50% ownership interest. See Note 15 Commitments And Guarantees in the Notes To Consolidated Financial Statements regarding our commitment to PNC Mezzanine Partners III, LP, which is consolidated for financial reporting purposes as PNC has a 57% ownership interest.

Other Investments

We also make investments in affiliated and non-affiliated funds with both traditional and alternative investment strategies. The economic values could be driven by either the fixed-income market or the equity markets, or both.

In July 2006, we committed to invest an aggregate of $100 million in FIM Holdings, LLC (“FIM”) as a non-managing member with a 1.25% ownership interest. FIM was formed to acquire a 51% ownership position in GMAC LLC from General Motors Corporation (“GM”) and to make a purchase of redeemable preferred stock from GMAC LLC. Our commitment, presently unfunded, is subject to satisfaction of certain conditions to the obligations of FIM contained in an agreement between FIM and GM. The current timetable for the closing and funding of this investment is the fourth quarter of 2006. However, delays in satisfying pre-closing conditions included in the agreements, including regulatory approval, may delay this investment until 2007.

LIQUIDITY RISK MANAGEMENT

Liquidity risk is the risk of potential loss if we were unable to meet our funding requirements at a reasonable cost. We manage liquidity risk to help ensure that we can obtain cost-effective funding to meet current and future obligations under both normal “business as usual” and stressful circumstances.

Our largest source of funding on a consolidated basis is the deposit base that comes from our retail and wholesale banking activities. Other borrowed funds come from a diverse mix of long and short-term funding sources. Liquid assets and unused borrowing capacity from a number of sources are also available to maintain our liquidity position.


 

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Table of Contents

Liquid assets consist of short-term investments (federal funds sold, resale agreements and other short-term investments) and securities available for sale. At September 30, 2006, our liquid assets totaled $25 billion, with $10.8 billion pledged as collateral for borrowings, trust, and other commitments.

PNC Bank, N.A. is a member of the Federal Home Loan Bank of Pittsburgh (“FHLB-Pittsburgh”) and as such has access to advances from FHLB-Pittsburgh secured generally by residential mortgages, other real estate related loans, and mortgage-backed securities. At September 30, 2006, our total unused borrowing capacity from FHLB-Pittsburgh under current collateral requirements was $23.8 billion.

We can also obtain funding through alternative forms of borrowing, including federal funds purchased, repurchase agreements, and short-term and long-term debt issuances. In July 2004, PNC Bank, N.A. established a program to offer up to $20 billion in senior and subordinated unsecured debt obligations with maturities of more than nine months. Through September 30, 2006, PNC Bank, N.A. had issued $2.9 billion of debt under this program.

PNC Bank, N.A. established a program in December 2004 to offer up to $3.0 billion of its commercial paper. As of September 30, 2006, $110 million of commercial paper was outstanding under this program.

Our parent company’s routine funding needs consist primarily of dividends to PNC shareholders, share repurchases, debt service, the funding of non-bank affiliates, and acquisitions.

Parent company liquidity guidelines are designed to help ensure that sufficient liquidity is available to meet these requirements over the succeeding 12-month period. In managing parent company liquidity we consider funding sources, such as expected dividends to be received from PNC Bank, N.A. and potential debt issuance, and discretionary funding uses, the most significant of which is the external dividend to be paid on PNC’s stock.

 

The principal source of parent company cash flow is the dividends it receives from PNC Bank, N.A., which may be impacted by the following:

  ·   Capital needs,
  ·   Laws and regulations,
  ·   Corporate policies,
  ·   Contractual restrictions, and
  ·   Other factors.

Also, there are statutory and regulatory limitations on the ability of national banks to pay dividends or make other capital distributions or to extend credit to the parent company or its non-bank subsidiaries. The amount available for dividend payments to the parent company by PNC Bank, N.A. without prior regulatory approval was approximately $464 million at September 30, 2006.

In addition to dividends from PNC Bank, N.A., other sources of parent company liquidity include cash and short-term investments, as well as dividends and loan repayments from other subsidiaries. As of September 30, 2006, the parent company had approximately $348 million in funds available from its cash and short-term investments.

We can also generate liquidity for the parent company and PNC’s non-bank subsidiaries through the issuance of securities in public or private markets. At September 30, 2006, we had unused capacity under effective shelf registration statements of approximately $1.6 billion of debt or equity securities. In October 2006, we issued $450 million of floating rate senior notes that mature on October 3, 2008. Interest will be reset monthly to 1-month LIBOR plus 2 basis points and will be paid monthly. During the third quarter 2006, $1.1 billion of parent company senior debt matured.

In July 2006, PNC Funding Corp established a program to offer up to $3.0 billion of commercial paper to provide the parent company with additional liquidity. As of September 30, 2006, there were no issuances outstanding under this program.

As of September 30, 2006, there were $350 million of parent company contractual obligations with maturities of less than one year.

In connection with our planned acquisition of Mercantile, we expect to issue approximately $2.0 billion of parent company debt securities and hybrid capital instruments during the fourth quarter of 2006 and the first quarter of 2007 to fund the cash portion of this transaction.


 

29


Table of Contents

Commitments

The following tables set forth contractual obligations and various other commitments representing required and potential cash outflows as of September 30, 2006.

Contractual Obligations

September 30, 2006 - in millions   Total

Remaining contractual maturities of time deposits

  $18,866

Borrowed funds

  14,695

Minimum annual rentals on noncancellable leases

  925

Nonqualified pension and postretirement benefits

  299

Purchase obligations (a)

  270

Total contractual cash obligations

  $35,055
(a) Includes purchase obligations for goods and services covered by noncancellable contracts and contracts including cancellation fees.

Other Commitments (a)

September 30, 2006 - in millions   Total
Amounts
Committed

Credit commitments

  $43,804

Standby letters of credit

  4,416

Other commitments (b)

  173

Total commitments

  $48,393
(a) Other commitments are funding commitments that could potentially require performance in the event of demands by third parties or contingent events. Loan commitments are reported net of participations, assignments and syndications.
(b) Includes equity funding commitments related to equity management and affordable housing.

 

FINANCIAL DERIVATIVES

We use a variety of financial derivatives as part of the overall asset and liability risk management process to help manage interest rate, market and credit risk inherent in our business activities. Substantially all such instruments are used to manage risk related to changes in interest rates. Interest rate and total return swaps, interest rate caps and floors and futures contracts are the primary instruments used by us for interest rate risk management.

Financial derivatives involve, to varying degrees, interest rate, market and credit risk. For interest rate swaps and total return swaps, options and futures contracts, only periodic cash payments and, with respect to options, premiums, are exchanged. Therefore, cash requirements and exposure to credit risk are significantly less than the notional amount on these instruments. Further information on our financial derivatives, including the credit risk amounts of these derivatives as of September 30, 2006 and December 31, 2005, is presented in Note 1 Accounting Policies and Note 10 Financial Derivatives in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report.

Not all elements of interest rate, market and credit risk are addressed through the use of financial or other derivatives, and such instruments may be ineffective for their intended purposes due to unanticipated market characteristics, among other reasons.


 

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Table of Contents

The following tables provide the notional amount and fair value of financial derivatives used for risk management and designated as accounting hedges as well as free-standing derivatives at September 30, 2006 and December 31, 2005. Weighted-average interest rates presented are based on contractual terms, if fixed, or the implied forward yield curve at each respective date, if floating.

Financial Derivatives - 2006

 

     Notional/
Contract
Amount
   Net
Fair Value
   

Weighted
Average

Maturity

  

Weighted-Average

Interest Rates

 
September 30, 2006 - dollars in millions            Paid     Received  

Accounting Hedges

                                    

Interest rate risk management

              

Asset rate conversion

              

Interest rate swaps (a)

              

Receive fixed

   $7,218    $22     3 yrs. 11 mos.    4.96 %   5.09 %

Pay fixed

              

Interest rate floors (b)

   7      4 yrs. 6 mos.    NM     NM  

Forward purchase commitments

              

Futures contracts

   67            9 mos.    NM     NM  

Total asset rate conversion

   7,292    22           

Liability rate conversion

              

Interest rate swaps (a)

              

Receive fixed

   4,245    4     7 yrs. 2 mos.    5.11     5.43  

Total liability rate conversion

   4,245    4           

Total interest rate risk management

   11,537    26           

Commercial mortgage banking risk management

              

Pay fixed interest rate swaps (a)

   274    (8 )   8 yrs. 10 mos.    5.44     5.05  

Pay total return swaps designated to loans held for sale (a)

   150    (1 )   1 mo.    NM     4.99  

Total commercial mortgage banking risk management

   424    (9 )         

Total accounting hedges (c)

   $11,961    $17                   

Free-Standing Derivatives

              

Customer-related

              

Interest rate

              

Swaps

   $47,041    $10     4 yrs. 8 mos.    4.95 %   4.98 %

Caps/floors

              

Sold

   1,814    (4 )   6 yrs. 1 mos.    NM     NM  

Purchased

   893    3     7 yrs. 4 mos.    NM     NM  

Futures

   3,485      6 mos.    NM     NM  

Foreign exchange

   4,868    3     7 mos.    NM     NM  

Equity

   3,029    (35 )   1 yr. 3 mos.    NM     NM  

Swaptions

   7,409    15     7 yrs. 2 mos.    NM     NM  

Other

   20            10 yrs. 9 mos.    NM     NM  

Total customer-related

   68,559    (8 )         

Other risk management and proprietary

              

Interest rate

              

Swaps

   19,037    (26 )   6 yrs. 11 mos.    4.80 %   4.94 %

Caps/floors

              

Sold

   6,000    (54 )   3 yrs. 3 mos.    NM     NM  

Purchased

   6,510    64     3 yrs. 4 mos.    NM     NM  

Futures

   13,451    (6 )   1 yr. 4 mos.    NM     NM  

Foreign exchange

              

Credit derivatives

   3,230    (8 )   7 yrs. 5 mos.    NM     NM  

Risk participation agreements

   685      5 yrs. 10 mos.    NM     NM  

Commitments related to mortgage-related assets

   1,574    36     3 mos.    NM     NM  

Options

              

Futures

   30,827    (5 )   8 mos.    NM     NM  

Swaptions

   15,635    59     8 yrs. 7 mos.    NM     NM  

Total other risk management and proprietary

   96,949    60           

Total free-standing derivatives

   $165,508    $52                   
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional amount, 68% were based on 1-month LIBOR, 32% on 3-month LIBOR.
(b) Interest rate floors have a weighted-average strike of 3.21%.
(c) Fair value amounts include accrued interest of $43 million.
NM Not meaningful

 

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Table of Contents

Financial Derivatives - 2005

 

    

Notional/
Contract
Amount

   Net
Fair Value
    Weighted
Average
Maturity
  

Weighted-Average

Interest Rates

 
December 31, 2005 - dollars in millions           

Paid

    Received  

Accounting Hedges

                                    

Interest rate risk management

              

Asset rate conversion

              

Interest rate swaps (a)

              

Receive fixed

   $2,926    $(9 )   2 yrs. 10 mos.    4.75 %   4.42 %

Pay fixed

   12      2 yrs. 1 mo.    3.68     4.77  

Futures contracts

   42            1 yr. 1 mo.    NM     NM  

Total asset rate conversion

   2,980    (9 )         

Liability rate conversion

              

Interest rate swaps (a)

              

Receive fixed

   5,345    84     6 yrs. 5 mos.    4.87     5.37  

Total liability rate conversion

   5,345    84           

Total interest rate risk management

   8,325    75           

Commercial mortgage banking risk management

              

Pay fixed interest rate swaps (a)

   251    (4 )   10 yrs. 9 mos.    5.05     4.88  

Pay total return swaps designated to loans held for sale (a)

   250    (2 )   1 mo.    NM     4.37  

Total commercial mortgage banking risk management

   501    (6 )         

Total accounting hedges (b)

   $8,826    $69                   

Free-Standing Derivatives

              

Customer-related

              

Interest rate

              

Swaps

   $43,868    $34     4 yrs. 2 mos.    4.69 %   4.69 %

Caps/floors

              

Sold

   1,710    (4 )   1 yr. 11 mos.    NM     NM  

Purchased

   1,446    3     11 mos.    NM     NM  

Futures

   2,570      10 mos.    NM     NM  

Foreign exchange

   4,687    4     5 mos.    NM     NM  

Equity

   2,744    (79 )   1 yr. 6 mos.    NM     NM  

Swaptions

   2,559    (1 )   8 yrs. 11 mos.    NM     NM  

Other

   230    1     10 yrs. 8 mos.    NM     NM  

Total customer-related

   59,814    (42 )         

Other risk management and proprietary

              

Interest rate

              

Swaps

   2,369    1     4 yrs. 11 mos.    4.56 %   4.65 %

Basis swaps

   756    1     6 yrs. 10 mos.    4.14     4.85  

Pay fixed swaps

   2,474    (2 )   7 yrs. 7 mos.    4.37     4.57  

Caps/floors

              

Sold

   2,000    (10 )   2 yrs. 7 mos.    NM     NM  

Purchased

   2,310    14     2 yrs. 10 mos.    NM     NM  

Futures

   10,901    2     1 yr. 2 mos.    NM     NM  

Credit derivatives

   1,353      4 yrs. 7 mos.    NM     NM  

Risk participation agreements

   461      3 yrs. 11 mos.    NM     NM  

Commitments related to mortgage-related assets

   1,695    1     2 mos.    NM     NM  

Options

              

Futures

   33,384    3     5 mos.    NM     NM  

Swaptions

   15,440    30     7 yrs. 7 mos.    NM     NM  

Other

   24    4     4 mos.    NM     NM  

Total other risk management and proprietary

   73,167    44           

Total free-standing derivatives

   $132,981    $2                   
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional amount, 67% were based on 1-month LIBOR, 33% on 3-month LIBOR.
(b) Fair value amounts include accrued interest of $81 million.
NM Not meaningful

 

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Table of Contents

INTERNAL CONTROLS AND DISCLOSURE CONTROLS AND PROCEDURES

As of September 30, 2006, we performed an evaluation under the supervision and with the participation of our management, including the Chairman and Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures and of changes in our internal control over financial reporting.

Based on that evaluation, our management, including the Chairman and Chief Executive Officer and the Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of September 30, 2006, and that there has been no change in internal control over financial reporting that occurred during the third quarter of 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

GLOSSARY OF TERMS

Accounting/administration net fund assets - Net domestic and foreign fund investment assets for which we provide accounting and administration services. We do not include these assets on our Consolidated Balance Sheet.

Adjusted average total assets - Primarily comprised of total average quarterly (or annual) assets plus (less) unrealized losses (gains) on available-for-sale debt securities, less goodwill and certain other intangible assets.

Annualized - Adjusted to reflect a full year of activity.

Assets under management - Assets over which we have sole or shared investment authority for our customers/clients. We do not include these assets on our Consolidated Balance Sheet.

Basis point - One hundredth of a percentage point.

Charge-off - Process of removing a loan or portion of a loan from our balance sheet because it is considered uncollectible. We also record a charge-off when a loan is transferred to held for sale and the loan’s market value is less than its carrying amount.

Common shareholders’ equity to total assets - Common shareholders’ equity divided by total assets. Common shareholders’ equity equals total shareholders’ equity less the liquidation value of preferred stock.

Credit derivatives - Contractual agreements that provide protection against a credit event of one or more referenced credits. The nature of a credit event is established by the protection buyer and protection seller at the inception of a transaction, and such events include bankruptcy, insolvency and failure to meet payment obligations when due. The buyer of the credit derivative pays a periodic fee in return for a payment by the protection seller upon the occurrence, if any, of a credit event.

 

Custody assets - Investment assets held on behalf of clients under safekeeping arrangements. We do not include these assets on our Consolidated Balance Sheet. Investment assets held in custody at other institutions on our behalf are included in the appropriate asset categories on the Consolidated Balance Sheet as if physically held by us.

Derivatives - Financial contracts whose value is derived from publicly traded securities, interest rates, currency exchange rates or market indices. Derivatives cover a wide assortment of financial contracts, including forward contracts, futures, options and swaps.

Duration of equity - An estimate of the rate sensitivity of our economic value of equity. A negative duration of equity is associated with asset sensitivity (i.e., positioned for rising interest rates), while a positive value implies liability sensitivity (i.e., vulnerable to rising rates). For example, if the duration of equity is +1.5 years, the economic value of equity declines by 1.5% for each 100 basis point increase in interest rates.

Earning assets - Assets that generate income, which include: federal funds sold; resale agreements; other short-term investments, including trading securities; loans held for sale; loans, net of unearned income; securities; and certain other assets.

Economic capital - Represents the amount of resources that our business segments should hold to guard against potentially large losses that could cause insolvency. It is based on a measurement of economic risk, as opposed to risk as defined by regulatory bodies. The economic capital measurement process involves converting a risk distribution to the capital that is required to support the risk, consistent with our target credit rating. As such, economic risk serves as a “common currency” of risk that allows us to compare different risks on a similar basis.

Economic value of equity (“EVE”) - The present value of the expected cash flows of our existing assets less the present value of the expected cash flows of our existing liabilities, plus the present value of the net cash flows of our existing off-balance sheet positions.

Effective duration - A measurement, expressed in years, that, when multiplied by a change in interest rates, would approximate the percentage change in value of on- and off- balance sheet positions.

Efficiency - Noninterest expense divided by the sum of net interest income and noninterest income.

Foreign exchange contracts - Contracts that provide for the future receipt and delivery of foreign currency at previously agreed-upon terms.

Funds transfer pricing - A management accounting methodology designed to recognize the net interest income effects of sources and uses of funds provided by the assets and liabilities of our business segments. We assign these balances LIBOR-based funding rates at origination that represent the interest cost for us to raise/invest funds with similar maturity and repricing structures.


 

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Futures and forward contracts - Contracts in which the buyer agrees to purchase and the seller agrees to deliver a specific financial instrument at a predetermined price or yield. May be settled either in cash or by delivery of the underlying financial instrument.

GAAP - Accounting principles generally accepted in the United States of America.

Interest rate floors and caps - Interest rate protection instruments that involve payment from the seller to the buyer of an interest differential, which represents the difference between a short-term rate (e.g., three-month LIBOR) and an agreed-upon rate (the strike rate) applied to a notional principal amount.

Interest rate swap contracts - Contracts that are entered into primarily as an asset/liability management strategy to reduce interest rate risk. Interest rate swap contracts are exchanges of interest rate payments, such as fixed-rate payments for floating-rate payments, based on notional principal amounts.

Intrinsic value - The amount by which the fair value of an underlying stock exceeds the exercise price of an option on that stock.

Leverage ratio - Tier 1 risk-based capital divided by adjusted average total assets.

Net interest margin - Annualized taxable-equivalent net interest income divided by average earning assets.

Nondiscretionary assets under administration - Assets we hold for our customers/clients in a non-discretionary, custodial capacity. We do not include these assets on our Consolidated Balance Sheet.

Noninterest income to total revenue - Noninterest income divided by the sum of net interest income and noninterest income.

Nonperforming assets - Nonperforming assets include nonaccrual loans, troubled debt restructured loans, nonaccrual loans held for sale, foreclosed assets and other assets. We do not accrue interest income on assets classified as nonperforming.

Nonperforming loans - Nonperforming loans include loans to commercial, commercial real estate, equipment lease financing, consumer, and residential mortgage customers as well as troubled debt restructured loans. Nonperforming loans do not include nonaccrual loans held for sale or foreclosed and other assets. We do not accrue interest income on loans classified as nonperforming.

Notional amount - A number of currency units, shares, or other units specified in a derivatives contract.

Operating leverage - The period to period percentage change in total revenue less the percentage change in noninterest expense. A positive percentage indicates that revenue growth exceeded expense growth (i.e., positive operating leverage) while a negative percentage implies expense growth exceeded revenue growth (i.e., negative operating leverage).

 

Options - Contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to either purchase or sell the associated financial instrument at a set price during a period or at a specified date in the future.

Recovery - Cash proceeds received on a loan that we had previously charged off. We credit the amount received to the allowance for loan and lease losses.

Return on average capital - Annualized net income divided by average capital.

Return on average assets - Annualized net income divided by average assets.

Return on average common equity - Annualized net income divided by average common shareholders’ equity.

Risk-weighted assets - Primarily computed by the assignment of specific risk-weights (as defined by The Board of Governors of the Federal Reserve System) to assets and off-balance sheet instruments.

Securitization - The process of legally transforming financial assets into securities.

Swaptions - Contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to enter into an interest rate swap agreement during a period or at a specified date in the future.

Tangible common equity ratio - Period-end common shareholders’ equity less goodwill and other intangible assets (excluding mortgage servicing rights) divided by period-end assets less goodwill and other intangible assets (excluding mortgage servicing rights).

Taxable-equivalent interest - The interest income earned on certain assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable asset. To provide more meaningful comparisons of yields and margins for all interest-earning assets, we also provide revenue on a taxable-equivalent basis by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income on other taxable assets. This adjustment is not permitted under GAAP on the Consolidated Income Statement.

Tier 1 risk-based capital - Tier 1 risk-based capital equals: total shareholders’ equity, plus trust preferred capital securities, plus certain minority interests that are held by others; less goodwill and certain other intangible assets, less equity investments in nonfinancial companies and less net unrealized holding losses on available-for-sale equity securities. Net unrealized holding gains on available-for-sale equity securities, net unrealized holding gains (losses) on available-for-sale debt securities and net unrealized holding gains (losses) on cash flow hedge derivatives are excluded from total shareholders’ equity for tier 1 risk-based capital purposes.


 

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Tier 1 risk-based capital ratio - Tier 1 risk-based capital divided by period-end risk-weighted assets.

Total fund assets serviced - Total domestic and offshore fund investment assets for which we provide related processing services. We do not include these assets on our Consolidated Balance Sheet.

Total return swap - A non-traditional swap where one party agrees to pay the other the “total return” of a defined underlying asset (e.g., a loan), usually in return for receiving a stream of LIBOR-based cash flows. The total returns of the asset, including interest and any default shortfall, are passed through to the counterparty. The counterparty is therefore assuming the credit and economic risk of the underlying asset.

Total risk-based capital - Tier 1 risk-based capital plus qualifying senior and subordinated debt, other minority interest not qualified as tier 1, and the allowance for loan and lease losses, subject to certain limitations.

Total risk-based capital ratio - Total risk-based capital divided by period-end risk-weighted assets.

Transaction deposits - The sum of money market and interest-bearing demand deposits and demand and other noninterest-bearing deposits.

Value-at-risk (“VaR”) - A statistically-based measure of risk which describes the amount of potential loss which may be incurred due to severe and adverse market movements. The measure is of the maximum loss which should not be exceeded on 99 out of 100 days.

Yield curve - A graph showing the relationship between the yields on financial instruments or market indices of the same credit quality with different maturities. For example, a “normal” or “positive” yield curve exists when long-term bonds have higher yields than short-term bonds. A “flat” yield curve exists when yields are the same for short-term and long-term bonds. A “steep” yield curve exists when yields on long-term bonds are significantly higher than on short-term bonds. An “inverted” or “negative” yield curve exists when short-term bonds have higher yields than long-term bonds.

 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

We make statements in this Report, and we may from time to time make other statements, regarding our outlook or expectations for earnings, revenues, expenses and/or other matters regarding or affecting PNC that are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Forward-looking statements are typically identified by words such as “believe,” “expect,” “anticipate,” “intend,” “outlook,” “estimate,” “forecast,” “project” and other similar words and expressions.

Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Forward-looking statements speak only as of the date they are made. We do not assume any duty and do not undertake to update our forward-looking statements. Actual results or future events could differ, possibly materially, from those that we anticipated in our forward-looking statements, and future results could differ materially from our historical performance.

Our forward-looking statements are subject to the following principal risks and uncertainties. We provide greater detail regarding some of these factors in our 2005 Form 10-K and in our current year Form 10-Qs, including in the Risk Factors and Risk Management sections of those reports. Our forward-looking statements may also be subject to other risks and uncertainties, including those discussed elsewhere in this Report or in our other filings with the SEC.

 

  ·   Our business and operating results are affected by business and economic conditions generally or specifically in the principal markets in which we do business. We are affected by changes in our customers’ financial performance, as well as changes in customer preferences and behavior, including as a result of changing economic conditions.

 

  ·   The value of our assets and liabilities as well as our overall financial performance are affected by changes in interest rates or in valuations in the debt and equity markets. Actions by the Federal Reserve and other government agencies, including those that impact money supply and market interest rates, can affect our activities and financial results.

 

  ·   Competition can have an impact on customer acquisition, growth and retention, as well as on our credit spreads and product pricing, which can affect market share, deposits and revenues.

 

  ·   Our ability to implement our One PNC initiative, as well as other business initiatives and strategies we may pursue, could affect our financial performance over the next several years.

 

  ·   Our ability to grow successfully through acquisitions is impacted by a number of risks and uncertainties related both to the acquisition transactions themselves and to the integration of the acquired businesses into PNC after closing. These uncertainties are present in transactions such as our pending acquisition of Mercantile Bankshares Corporation.

 

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  ·   Legal and regulatory developments could have an impact on our ability to operate our businesses or our financial condition or results of operations or our competitive position or reputation. Reputational impacts, in turn, could affect matters such as business generation and retention, our ability to attract and retain management, liquidity and funding. These legal and regulatory developments could include: (a) the unfavorable resolution of legal proceedings or regulatory and other governmental inquiries; (b) increased litigation risk from recent regulatory and other governmental developments; (c) the results of the regulatory examination process, our failure to satisfy the requirements of agreements with governmental agencies, and regulators’ future use of supervisory and enforcement tools; (d) legislative and regulatory reforms, including changes to laws and regulations involving tax, pension, and the protection of confidential customer information; and (e) changes in accounting policies and principles.

 

  ·   Our business and operating results are affected by our ability to identify and effectively manage risks inherent in our businesses, including, where appropriate, through the effective use of third-party insurance and capital management techniques.

 

  ·   Our ability to anticipate and respond to technological changes can have an impact on our ability to respond to customer needs and to meet competitive demands.

 

  ·   The adequacy of our intellectual property protection, and the extent of any costs associated with obtaining rights in intellectual property claimed by others, can impact our business and operating results.

 

  ·   Our business and operating results can be affected by widespread natural disasters, terrorist activities or international hostilities, either as a result of the impact on the economy and financial and capital markets generally or on us or on our customers, suppliers or other counterparties specifically.

 

  ·   Also, risks and uncertainties that could affect the results anticipated in forward-looking statements or from historical performance relating to our interest in BlackRock, Inc. are discussed in more detail in BlackRock’s 2005 Form 10-K, including in the Risk Factors section, and in BlackRock’s other filings with the SEC, accessible on the SEC’s website at www.sec.gov and on or through BlackRock’s website at www.blackrock.com.

 

In addition, our pending acquisition of Mercantile Bankshares presents us with a number of risks and uncertainties related both to the acquisition transaction itself and to the integration of the acquired businesses into PNC after closing. These risks and uncertainties include the following:

 

  ·   Completion of the transaction is dependent on, among other things, receipt of regulatory and Mercantile shareholder approvals, the timing of which cannot be predicted with precision at this point and which may not be received at all. The impact of the completion of the transaction on PNC’s financial statements will be affected by the timing of the transaction.

 

  ·   The transaction may be substantially more expensive to complete (including the integration of Mercantile’s businesses) and the anticipated benefits, including anticipated cost savings and strategic gains, may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety as a result of unexpected factors or events.

 

  ·   The integration of Mercantile’s business and operations into PNC, which will include conversion of Mercantile’s different systems and procedures, may take longer than anticipated or be more costly than anticipated or have unanticipated adverse results relating to Mercantile’s or PNC’s existing businesses.

 

  ·   The anticipated benefits to PNC are dependent in part on Mercantile’s business performance in the future, and there can be no assurance as to actual future results, which could be impacted by various factors, including the risks and uncertainties generally related to PNC’s and Mercantile’s performance (with respect to Mercantile, see Mercantile’s SEC reports, accessible on the SEC’s website) or due to factors related to the acquisition of Mercantile and the process of integrating it into PNC.

In addition to the pending Mercantile Bankshares transaction, we grow our business from time to time by acquiring other financial services companies. Acquisitions in general present us with risks other than those presented by the nature of the business acquired. In particular, acquisitions may be substantially more expensive to complete (including as a result of costs incurred in connection with the integration of the acquired company) and the anticipated benefits (including anticipated cost savings and strategic gains) may be significantly harder or take longer to achieve than expected. In some cases, acquisitions involve our entry into new businesses or new geographic or other markets, and these situations also present risks resulting from our inexperience in these new areas. As a regulated financial institution, our pursuit of attractive acquisition opportunities could be negatively impacted due to regulatory delays or other regulatory issues. Regulatory and/or legal issues related to the pre-acquisition operations of an acquired business may cause reputational harm to PNC following the acquisition and integration of the acquired business into ours and may result in additional future costs and expenses arising as a result of those issues.


 

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CONSOLIDATED INCOME STATEMENT

THE PNC FINANCIAL SERVICES GROUP, INC.

 

In millions, except per share data

Unaudited

  

Three months ended

September 30

        

Nine months ended

September 30

 
       2006         2005               2006         2005  

Interest Income

           

Loans

   $ 838     $ 718        $ 2,382     $ 1,942  

Securities available for sale and held to maturity

     271       219          769       589  

Other

     94       58            244       169  

Total interest income

     1,203       995            3,395       2,700  

Interest Expense

           

Deposits

     434       270          1,140       676  

Borrowed funds

     202       166            576       425  

Total interest expense

     636       436            1,716       1,101  

Net interest income

     567       559          1,679       1,599  

Provision for (recoveries of) credit losses

     16       16            82       (3 )

Net interest income less provision for (recoveries of) credit losses

     551       543            1,597       1,602  

Noninterest Income

           

Asset management

     381       364          1,271       1,012  

Fund servicing

     213       218          644       657  

Service charges on deposits

     81       73          234       199  

Brokerage

     61       56          183       168  

Consumer services

     89       76          272       213  

Corporate services

     157       121          449       342  

Equity management gains

     21       36          82       80  

Net securities losses

     (195 )     (2 )        (207 )     (37 )

Trading

     38       47          150       108  

Gain on BlackRock transaction

     2,078            2,078    

Other

     19       127            202       277  

Total noninterest income

     2,943       1,116            5,358       3,019  

Noninterest Expense

           

Compensation

     573       545          1,686       1,505  

Employee benefits

     86       86          249       255  

Net occupancy

     79       86          241       231  

Equipment

     77       73          234       221  

Marketing

     39       30          81       75  

Other

     324       339            1,007       912  

Total noninterest expense

     1,178       1,159            3,498       3,199  

Income before minority and noncontrolling interests and income taxes

     2,316       500          3,457       1,422  

Minority and noncontrolling interests in income (loss) of consolidated entities

     (5 )     14          23       29  

Income taxes

     837       152            1,215       423  

Net income

   $ 1,484     $ 334          $ 2,219     $ 970  

Earnings Per Common Share

           

Basic

   $ 5.09     $ 1.16        $ 7.60     $ 3.40  

Diluted

   $ 5.01     $ 1.14          $ 7.46     $ 3.35  

Average Common Shares Outstanding

           

Basic

     291       289          292       285  

Diluted

     296       292            297       288  

See accompanying Notes To Consolidated Financial Statements.

 

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CONSOLIDATED BALANCE SHEET

THE PNC FINANCIAL SERVICES GROUP, INC.

 

In millions, except par value

Unaudited

  

September 30

2006

   

December 31

2005

 

Assets

    

Cash and due from banks

   $ 3,018     $ 3,518  

Federal funds sold and resale agreements

     2,818       350  

Other short-term investments, including trading securities

     2,718       2,543  

Loans held for sale

     4,317       2,449  

Securities available for sale and held to maturity

     19,512       20,710  

Loans, net of unearned income of $815 and $835

     48,900       49,101  

Allowance for loan and lease losses

     (566 )     (596 )

Net loans

     48,334       48,505  

Goodwill

     3,418       3,619  

Other intangible assets

     590       847  

Investment in BlackRock

     3,836    

Other

     9,875       9,413  

Total assets

   $ 98,436     $ 91,954  

Liabilities

    

Deposits

    

Noninterest-bearing

   $ 14,840     $ 14,988  

Interest-bearing

     49,732       45,287  

Total deposits

     64,572       60,275  

Borrowed funds

    

Federal funds purchased

     3,475       4,128  

Repurchase agreements

     2,275       1,691  

Bank notes and senior debt

     2,177       3,875  

Subordinated debt

     4,436       4,469  

Other

     2,332       2,734  

Total borrowed funds

     14,695       16,897  

Allowance for unfunded loan commitments and letters of credit

     117       100  

Accrued expenses

     3,855       2,770  

Other

     4,031       2,759  

Total liabilities

     87,270       82,801  

Minority and noncontrolling interests in consolidated entities

     408       590  

Shareholders’ Equity

    

Preferred stock (a)

    

Common stock - $5 par value

    

Authorized 800 shares, issued 353 shares

     1,764       1,764  

Capital surplus

     1,679       1,358  

Retained earnings

     10,771       9,023  

Deferred compensation expense

     (51 )     (59 )

Accumulated other comprehensive loss

     (109 )     (267 )

Common stock held in treasury at cost: 59 and 60 shares

     (3,296 )     (3,256 )

Total shareholders’ equity

     10,758       8,563  

Total liabilities, minority and noncontrolling interests, and shareholders’ equity

   $ 98,436     $ 91,954  

(a)   Less than $.5 million at each date.

See accompanying Notes To Consolidated Financial Statements.

 

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CONSOLIDATED STATEMENT OF CASH FLOWS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Nine months ended September 30 - in millions

Unaudited

   2006     2005  

Operating Activities

    

Net income

   $ 2,219     $ 970  

Adjustments to reconcile net income to net cash provided by operating activities

    

Provision for (recoveries of) credit losses

     82       (3 )

Depreciation, amortization and accretion

     268       277  

Deferred income taxes

     855       (20 )

Net securities losses

     207       37  

Valuation adjustments

     45       (5 )

Gain on BlackRock transaction

     (2,078 )  

Excess tax benefits from share-based payment arrangements

     (21 )  

Net change in

    

Loans held for sale

     244       (692 )

Other short-term investments

     140       (561 )

Accrued expenses and other liabilities

     (70 )     (1,203 )

Other

     (371 )     228  

Net cash provided (used) by operating activities

     1,520       (972 )

Investing Activities

    

Repayment of securities

     2,663       3,121  

Sales

    

Securities

     10,619       11,627  

Loans

     27       31  

Foreclosed and other nonperforming assets

     11       13  

Purchases

    

Securities

     (11,567 )     (18,136 )

Loans

     (875 )     (2,273 )

Net change in

    

Loans

     (1,208 )     (1,971 )

Federal funds sold and resale agreements

     (2,468 )     1,218  

Cash received from divestitures

       26  

Net cash paid for acquisitions

     (55 )     (372 )

Purchase of corporate and bank-owned life insurance

     (300 )  

Other

     (83 )     (217 )

Net cash used by investing activities

     (3,236 )     (6,933 )

Financing Activities

    

Net change in

    

Noninterest-bearing deposits

     (148 )     (1,169 )

Interest-bearing deposits

     4,442       4,366  

Federal funds purchased

     (653 )     1,257  

Repurchase agreements

     583       368  

Commercial paper

     100       1,196  

Other short-term borrowed funds

     5       198  

Sales/issuances

    

Bank notes and senior debt

     509       1,873  

Subordinated debt

       494  

Other long-term borrowed funds

     274       1,551  

Common stock

     292       138  

Repayments/maturities

    

Bank notes and senior debt

     (2,200 )     (750 )

Subordinated debt

       (351 )

Other long-term borrowed funds

     (1,142 )     (466 )

Excess tax benefits from share-based payment arrangements

     21    

Acquisition of treasury stock

     (396 )     (127 )

Cash dividends paid

     (471 )     (429 )

Net cash provided by financing activities

     1,216       8,149  

Net Increase (Decrease) In Cash And Due From Banks

     (500 )     244  

Cash and due from banks at beginning of period

     3,518       3,230  

Cash and due from banks at end of period

   $ 3,018     $ 3,474  

Cash Paid For

    

Interest

   $ 1,693     $ 1,040  

Income taxes

     473       363  

Non-cash Items

    

Investment in BlackRock, net

     3,126    

Transfer from loans to loans held for sale, net

     2,157       10  

Transfer from loans to other assets

     9       12  

See accompanying Notes To Consolidated Financial Statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

THE PNC FINANCIAL SERVICES GROUP, INC.

 

BUSINESS

We are one of the largest diversified financial services companies in the United States based on assets, with businesses engaged in:

  ·   Retail banking,
  ·   Corporate and institutional banking,
  ·   Asset management, and
  ·   Global fund processing services.

We provide many of our products and services nationally and others in our primary geographic markets located in Pennsylvania; New Jersey; the greater Washington, DC area, including Maryland and Virginia; Ohio; Kentucky; and Delaware. We also provide certain global fund processing services internationally. We are subject to intense competition from other financial services companies and are subject to regulation by various domestic and internation