Outlook
 

SUMMER 2004 

Special Feature This Quarter 

In Person: An Interview with Bank One Chief Economist Diane Swonk 

FDIC Chief Economist Richard Brown interviews Bank One Chief Economist and 

Senior Vice President Diane Swonk about the housing market, consumer credit, the 

role of the U.S. dollar, and the outlook for business in the United States and abroad. 

See page 3. 

Regional Outlook in Charts 

Nationally, solid economic
 

The U.S. Economy Is Expected to Grow at About a growth is expected for the


Four Percent Pace This Year
 rest of 2004, which bodes 

Real Gross Domestic Product well for regional
 

Quarterly percent change at annual rate
 economies. More than two 

10 years after the recession’s 

8 end, job growth finally is 

strengthening. Neverthe­ 6 

less, manufacturing job 4 losses continue to weigh 

2 down overall job growth in 

some of the FDIC Regions. 0 

While the FDIC’s outlook for banks remains positive, the industry faces 

-2 some challenges. Among other things, rising interest rates may affect 

Source: Bureau of Economic Analysis, Macroeconomic Advisers forecast. some consumers in high-risk lending segments and could cause stress in 

certain housing markets where prices have been more volatile than the 

nation’s. Another challenge is high concentrations of commercial real estate—particularly in the San Francisco and Atlanta 

Regions—coupled with poor market fundamentals. Overall, the banking industry is well positioned to meet these challenges, with 

earnings and capital levels at or near record levels. See page 14. 

In Focus This Quarter 

Does Net Interest Margin Matter to Banks? recovery. However, in a rising interest rate environment,
 

Secular forces have contributed to major changes in revenue higher securities yields may not offset declines in bond values.
 

sources for banks, particularly very large institutions. For these See page 20.
 

banks, the significance of net interest margin as a performance
 

metric is not what it used to be. See page 15.
 Implications of Rural Depopulation in the Great Plains for 

Community Banks Bank Investment Portfolios: Strong Gains since 2000— Banks located in depopulating rural counties reported lower

Will They Continue? growth rates than banks in growing rural counties. However, 

Given the inverse relationship between bond values and inter- some banks have employed strategies to remain successful, 

est rates, gains on securities sold supported strong aggregate despite the unfavorable demographic trends unfolding around 

bank profitability throughout the recession and subsequent them. See page 26. 

forecast 

2001 2002 2003 2004 

Bank One Chief Economist Diane Swonk: Finding 

the Stories Behind the Numbers. 

FEDERAL DEPOSIT INSURANCE CORPORATION 
Letter from the Executive Editor 

To the Reader: 

The goal of the FDIC Outlook is to provide useful, risk-focused information to bankers, examiners, financial analysts, policymakers, and the public. At the FDIC, we constantly strive to improve the way we 

communicate information and have changed FDIC Outlook several times to meet the needs of our readers. 

With this issue of FDIC Outlook, we are continuing to refine our presentation of data and analysis. Part of 

this approach involves making FDIC Outlook more visual. For example, we will continue to feature graphical executive summary analyses of economic and banking issues, such as the FDIC Regional Outlook in 

Charts. This graphical analysis first appeared in the Spring 2004 edition. 

Another aspect of our new approach is the selection of more dynamic topics. This means that we will not 

always feature articles from every FDIC region but will focus in each edition on a few key issues facing 

banks. Periodically, we also will publish special features and thematic editions. Our first special feature is 

this edition’s interview with Diane Swonk, Chief Economist and Senior Vice President of Bank One. 

Ongoing dialogue with our readers has been invaluable. On the basis of that feedback, in January 2003 we 

launched FDIC State Profiles, an Internet-based publication that provides an executive summary–style 

analysis of economic and banking trends and financial performance data for each state. These analyses 

have proven to be enormously popular, especially for bankers looking for timely information about their 

marketplace. FDIC State Profiles are available at www.fdic.gov/bank/analytical/stateprofile/index.html. 

As always, we want to hear from you so we can continue to ensure that we are providing useful, accessible, 

timely, and forward-looking risk analysis. After you read this edition, let us know what you think. Please 

provide your comments or suggestions on FDIC Outlook to Rae-Ann Miller, Associate Director, Division 

of Insurance and Research at the FDIC, at 202-898-8523 or rmiller@fdic.gov. 

Sincerely, 

Maureen E. Sweeney 

Executive Editor 
Special Feature 

Bank One Chief Economist Swonk: “Fundamentals always dominate.” FDIC Chief Economist Brown discusses the U.S. economy’s outlook 

and how economics is used in bank risk management. 

In Person: An Interview with Bank One 

Chief Economist Diane Swonk 

On April 6, 2004, FDIC Chief Economist Richard A. 

Brown sat down with Diane Swonk, Chief Economist 

and Senior Vice President, Bank One Corporation, to 

discuss the outlook for the U.S. economy and how 

economics is used in bank risk management. 

Mr. Brown: Thank you for taking the time to talk 

to us for the FDIC Outlook. I’d like to start by 

asking you about the household sector. Consumers 

have carried the economy during and after the 

recession and, in the process, have run up a lot of 

debt, especially mortgage debt. So, the question is, 

are consumers living on borrowed time? 

Ms. Swonk: Not at the moment. What we saw 

during the last mortgage refinancing boom is that 

consumers did something very unusual. Not only 

was it an extraordinarily large refinancing boom in 

2003 and 2002, far swamping anything we’d seen 

before, but consumers paid down but did not close 

out existing credit lines. In the past we’ve told them, 

“Close out.” 

They also were extremely rational, mostly locking into 

low rates rather than adjustable rates, in ways we’d 

never seen before. That means that they’re somewhat 

sheltered as rates rise going forward, for their mortgages 

at least. And that’s a good thing. 

So consumers were extremely rational. Some of them 

refinanced a couple of times, as I did. I’d like to say my 

forecast was perfect on interest rates, but it wasn’t. So I 

refinanced more than once myself, seeing how extraordinarily low rates went. 

But locking into low, fixed rates is a really important 

thing for consumers, because in the next step in the 

cycle, when rates go up and people go back into 

adjustable, that’s when you really start to worry more 

about indebtedness, five years down the road from that. 

The other thing that consumers really have done is to 

clean up their balance sheets. Debt service burdens 

remain relatively low. Consumers have freed up their 

ability to go back into debt in a major way, and they 

have more access to credit than ever before. What that 

FDIC OUTLOOK 3 SUMMER 2004 
Special Feature 

means is that there is liquidity to oil up the machine, 

and consumers have it at their fingertips at the very 

moment that jobs are coming back. And that’s great 

news, of course; we’ll need consistent job growth to 

be able to service that debt. My concern is not that 

consumers will have a problem going forward in 

supporting growth, but that they will continue to 

support too much because they have an ability to spend 

that’s really quite strong. And then they’ll have some 

incentive to spend, because the labor market is finally 

starting to show signs of improving as well. So they’ll 

be confident in taking on more debt again. 

And that could eventually lead us to move to a new 

equilibrium level of defaults, as it did in the early 1990s 

when we saw an extraordinary surge in defaults. That 

can be good for the economy—“creative destruction,” 

as Greenspan puts it. But on the other side of it, as 

banks, we need to be aware of the situation. Consumers 

are going to be a great growth sector and are going to 

be very important for banks, but banks need to 

approach the business wisely. 

Consumer lenders have been on a long learning curve 

where they’ve learned a little bit about subprime lending and making credit more widely available. Credit 

cards used to be a privilege. Membership was a privilege, as one of my competitors once said, and now 

credit is a right. And that’s good. 

The democratization of credit is a great thing, but there 

are consequences to it as well. We have to remember 

going forward that what we’ve done is to open up the 

ability to leverage up as we’ve never seen in this country. That’s not bad in and of itself—it’s only bad if we’re 

not pricing that risk accurately. 

Very true. Let me go further with the topic that you 

just touched on, which is the democratization of 

credit, something that we at the FDIC have written 

about also. You talked about it as having good consequences and bad, but—above all—being intertwined 

with the long-term rise in personal bankruptcy filings 

and higher consumer credit losses. So, as this expansion kicks into gear and we get some job growth, how 

much of a reduction might we see in bankruptcy 

filings and consumer credit losses? 

Well, I think we’ll see that we’re going to get a temporary reprieve, which is good. And some of that is a 

legacy of earlier mortgage restructuring, and some of 

it’s because the economy is improving. 

But remember, bankruptcy filings were going up almost 

the entire 1990s, even as we saw unemployment rates 

plummet. So the good news is we’ve gone through the 

first phase of democratization, and I think we’ve learned 

something from that first phase. I think we’re trying to 

find that new equilibrium level, which is probably a 

little lower than the recent highs, but not a lot lower. 

And that’s in a good economic cycle. 

We have to remember as bank risk managers that the 

downside risk is also much greater. We’ve been in an 

extraordinarily long period of low interest rates or falling 

rates, and at this stage it seems clear that we’re moving 

into a period where there are going to be rising rates 

and even rising real interest rates. Part of this could be a 

normalization of rates by the Federal Reserve, and part 

of it could be an adjustment of risk premiums in the 

financial markets, where there is little or no risk 

premium at all right now. We’re going to be running 

federal budget deficits with the current account deficit. 

And that, in and of itself, over time delivers real rates, 

although not necessarily in the near term. It’s a time 

thing—it takes a long time to unwind. 

So even though consumers are starting from a good 

financial base, the reality is that we’re also going to be 

leveraging up more than ever before. The endgame may 

be a much higher equilibrium level of losses if we’re not 

pricing for that changing environment. 

One of the critical things that we try to do at Bank 

One is look for where the world is going to zig instead 

of zag. And it’s very natural for people to extrapolate 

from the most recent past to forecast the future, especially when it comes to credit risk. 

For consumer credit risk, the recent past sets the stage, 

but not necessarily the trajectory, for where we’re going. 

Although we’ll see near-term improvement, the next 

drop is going to be a much more severe situation, 

because we’re moving into an environment that’s going 

to be very different from how we ended the last expansion, with low interest rates and the ability to refinance 

in a way that was unprecedented. 

Let’s talk about the so-called “housing bubble.” You 

have expressed some concerns about recent increases 

in home prices, which have reached double-digit 

rates in many areas. And clearly a broad decline in 

home prices would be bad not only for consumer 

spending but also for consumer credit quality. Should 

we be concerned about a housing bubble? 

FDIC OUTLOOK 4 SUMMER 2004 
Special Feature 

I think regionally there are always a couple of areas to 

be concerned about. The Midwest is one of them. Nine 

out of 21 metropolitan areas that actually had declines 

in housing prices last year were in the industrial 

Midwest, which was the hardest hit by employment 

losses. Most of these declines were by 2 percent or less. 

(See Table 1.) 

You have to remember that even as interest rates rise in 

response to an improving economic situation, you get 

an offset in terms of employment for housing demand. 

Over the next several years, we’re going to have better 

employment and better income gains to help absorb 

some of the shock from rising interest rates. 

We did get a little additional liquidity to go into asset 

prices in a low inflation environment over the past 

couple years, but most markets are pretty well balanced. 

We don’t have the extreme blocks of regional bubbles 

that we did in the early 1990s. Back then, many 

consumers couldn’t restructure their debt, because their 

homes were still underwater even as the Federal 

Reserve was easing rates. 

You do not see that kind of thing now. So even though, 

in general, we need less money down to get into a home 

and we hold less equity in our homes than we did in the 

past, total housing equity has surged quite a bit to offset 

what we’ve extracted. There is some cushion still there. 

So I’m not overly concerned about a housing market 

bubble. We’d need to see fairly severe employment 

losses to really get a burst in the bubble. And even the 

places where employment was really hit hard—Akron, 

Ohio, for instance—you saw a decline in home prices 

that was mild. 

I think you have to think about it in the context of 

what it really takes to burst the housing market 

bubble. Where the housing market overall saw a 

run-up in appreciation, there were also some markets 

that were already readjusting. Home values in Silicon 

Valley, for example, were falling much of the time 

that home values elsewhere experienced price 

increases. Now there was a market that you really were 

worried about, because it was clearly a bubble funded 

by the dot-com boom. 

And you also have to remember that there is an asymmetry. The key is the kind of equity people hold in 

their home. For the most part, the last thing consumers 

want to lose is their home. They will hold on to their 

Table 1 

What’s Your Home Worth? 

Median home value in selected metropolitan areas as of 

fourth quarter 2003, with percent change in the median 

price during the preceding year. 

Annual 

Metropolitan Median Percent 

Area Price Change 

Akron, OH $111,600 –5.3 

Baltimore, MD $217,800 14.9 

Champaign, IL $112,400 –2.2 

Ft. Myers, FL $156,500 12.8 

Ft. Wayne, IN $90,300 –3.0 

Houston, TX $132,800 –0.8 

Los Angeles, CA $382,200 24.5 

Milwaukee, WI $179,100 –1.2 

Providence, RI $240,700 16.8 

Tulsa, OK $109,000 –2.1 

U.S. Average $174,800 7.6 

Source: Bank One Corporation, One View, March 2004; National Association of Realtors 

(Haver Analytics). 

home for as long as they can. As an investment, it is 

different from other kinds of asset classes, because you 

actually live in it as well as own it. 

Unlike a telecom stock? 

Yes. It is very different; it is not comparable. That is 

why it takes a pretty severe condition for someone to 

have to part with their home. 

Democratization of credit is another issue here that is 

separate from housing market growth. They say mortgage defaults have been at record highs. Well, a record 

number of people have access to housing now, and there 

are more people on the margin than ever. There’s a cost 

to that in the risk-return ratio. They’re not all “A” 

borrowers. But, on the other side of it, there are societal 

benefits that are huge. We have the highest homeownership rates in the world. High home-ownership 

rates are directly tied—once controlled for income—to 

higher rates of high school attainment and lower rates 

of teenage pregnancy. 

What we have to realize is that it’s the banks that bear 

the risk of that democratization of credit, and there are 

huge societal benefits that pay off for everybody down 

the road. But as lenders, we’re the ones who are bearing 

FDIC OUTLOOK 5 SUMMER 2004 
Special Feature 

Chart 1 

Source: The Conference Board (Haver Analytics). 

Corporate CEOs Report Their Highest Level of Confidence in Two Decades 

Business-sentiment index based on survey of 100 CEOs 

80 82 84 86 88 90 92 94 96 98 00 02 04 

20 

30 

40 

50 

60 

70 

80 Index readings above 50 indicate more 

positive than negative responses. 

Recessions 

a new kind of market risk and opportunity. We have 

to be careful in assessing how far we want to go to get 

anybody into a home, because there is a cost as well 

as a reward for that. 

Let’s switch to the business sector. This time last year, 

we were talking to corporate executives about the sluggishness of the economy and their apparent risk aversion. And they told us it wasn’t necessarily because of 

concerns about corporate governance reform, it wasn’t 

even necessarily uncertainty about Iraq, but it was 

related instead to the weakness they saw in global 

demand. Their order books weren’t filling up. 

Now, to what extent do we see evidence that global 

demand has recovered in the intervening year? And 

how has that shaped the outlook for business investment and hiring? 

A key report by the Conference Board just came out 

showing the highest level of corporate CEO confidence 

in two decades. (See Chart 1.) Part of that is just a 

bounceback from the exceedingly low levels of last year. 

But we see firms that have hiring plans today—especially small businesses—that didn’t exist six months 

ago. Top-line revenue growth is beginning to grow 

along with overall demand. 

We saw the turn in domestic demand about the second 

quarter of last year before we saw the tax cuts hit. Tax 

cuts exacerbated the rebound in demand. But there 

was still this hesitancy. The feeling was “Fool me once, 

shame on you; fool me twice, shame on me.” You know, 

it’s a “Show Me” economy. I want to see my order books 

backed up before I’m going to really commit to hiring. 

In the first quarter of this year, somewhere around January, we started to see a dramatic shift among our clientele, particularly in the heavy manufacturing sector that 

had been so hard hit, where all of a sudden they were 

saying, “You know what? Our order books are filling up.” 

And if you look at things like the Institute for Supply 

Managment survey and orders in general, they have 

been trending up for more than a year. (See Chart 2.) 

They were all at such low levels that it took a while to 

feel good about it. Remember, the benchmark was the 

bubble of the late 1990s. 

Now we’re to the point where order books are filling 

up to the degree that they actually have to bring new 

production capacity online. 

Chart 2 

Manufacturing Orders Have Been Trending Up for
 

More than a Year
 

New orders index, manufacturers Index readings 75
 

70
 

65
 

60
 

55
 

50
 

45
 

40
 

35
 

30
 

25
 

Source: Institute for Supply Management (Haver Analytics). 

above 50 indicate 

expansion of orders. Recession 

1999 2000 2001 2002 2003 2004 

FDIC OUTLOOK 6 SUMMER 2004 
Special Feature 

We’ve also got some shortages of raw materials and 

steel bottlenecks and things like that all starting to 

come into play. It’s interesting to me that this year, 

after facing deflation screams by a lot of our industrial 

Midwest clientele a year ago, they’re now saying, “Your 

inflation figures are too low. We’re going to have inflation through the roof.” 

And they have to understand: they’re important, but 

they’re not the only sector in the economy. The reason 

we didn’t have widespread deflation then is the same 

reason why we’re not going to have a sharp, widespread 

acceleration in inflation now just because we’re experiencing raw materials prices going up. But it is an interesting issue, how much the situation has changed. 

Now we’re on the heels of record profits and record cash 

flow. As lenders, we’d like for there to be more interest 

in borrowing, but the bottom line is that we can finance 

a pretty strong recovery and investment in this country 

without much of a pickup in business borrowing. 

Large corporations have restructured their balance 

sheets much like consumers did. They’re cleaned up, 

they’re ready to go, and they’ve got access to easy credit 

in many ways, from equity markets right through to the 

debt markets, which are much deeper than they were 

just a year ago. We’ve been seeing a recovery in business investment since the second quarter of last year, 

but what’s interesting is seeing it broaden in 2004. 

The first phase of it was sort of a high-tech reinvestment boom. We were replacing computers that we had 

bought for 1999 through Y2K. Service on them had 

expired, and even though the computers still ran just 

fine, we had to replace them because the leases had 

expired and things like that. They’ve got a very short 

shelf life. It’s almost impossible to call a computer a 

durable good given how quickly they get replaced 

these days. 

On the other side of it, we’re now seeing the heavy 

truck sector coming back extremely strong, going from 

about a 150,000 run-rate last year to an estimated 

250,000 this year. The heavy truck sector is one of 

those great lead industries in the manufacturing sector, 

because you need trucks to move stuff around. Whether 

it be retail goods or anything else that needs to be 

moved in this economy, you need trucks to do it. 

So, clearly, order backlogs are building. We’re hearing 

from our companies that shipments are picking up in 

the 15 to 20 percent range, but orders are picking up in 

the 30 to 40 percent range. We also have exceedingly 

tight inventories. That provides a little extra momentum—even if you didn’t have demand, you’d have to 

replenish inventories a little bit. But with demand growing, you also are more willing to hold higher inventories. And so we’re set up well on momentum. 

“You know, it’s a ‘Show Me’ 

economy. I want to see my order 

books backed up before I’m going 

to really commit to hiring.” 

D. Swonk 

In terms of global demand, that’s been picking up a 

little bit as well. The export situation has been improving slowly, in part due to the decline in the dollar. The 

situation abroad, although not terrific, is no longer 

deteriorating. And all of that is adding to a much 

brighter outlook for the U.S. economy. 

You always have to be careful that you don’t bite the 

hand that feeds you. People complain about the deficits 

we run with China, but with the rest of the world, 

China doesn’t run very much of a deficit. In fact, with 

much of the world, they run surpluses. Part of the reason 

is that China has supported the economies of the rest of 

Asia that are many of our big buyers. So you want to be 

careful about saying that China is a problem, because if 

you knock China out, all of a sudden you knock out 

many of your developing countries in Asia. One of the 

reasons Japan is coming back is because China has been 

a big buyer of its goods. 

In an election year, you often hear sound-bite solutions 

to complex problems. But I think you have to be very 

cautious not to look for sound-bite answers to complex 

problems. And the issue on trade is rather complex, 

but we’re all better off with free trade than with 

protectionism. 

Before we move to policy issues, I wanted to follow 

up on commercial loans. We’ve seen them decline 

at FDIC-insured institutions for 12 consecutive 

quarters. The decline has been led or dominated by 

large banks that make loans to large corporate 

borrowers. 

FDIC OUTLOOK 7 SUMMER 2004 
Special Feature 

You cited some of the fundamentals that are back, 

and you also cited some of the factors that are 

restraining borrowing, including access to the capital 

markets. Give us, on balance, your outlook for when 

that number will turn positive again. How much of a 

recovery in C&I [commercial and industrial] loan 

volumes do you see later this year? 

I think we still probably have got a very soft first half 

of the year through June or so, but as we get into the 

second half of the year, there are a couple of factors 

that may be pushing up commercial lending. First, the 

underlying fundamentals for investment activity are 

improving, which is the number one thing to look at. 

But cash flow will also remain strong, although 

year-on-year profit gains are going to be tougher to get 

the comparisons on, because we’re already coming off 

an extremely good quarter. 

“I think you have to be very 

cautious not to look for sound-bite 

answers to complex problems.” 

D. Swonk 

So by the end of the year, instead of a 30 percent 

year-over-year gain, we’ll be looking at more like 18 

percent, which is still spectacular. But all of a sudden, 

if you start investing, you’ll be using some of that 

cash flow. 

The other issue is that capital markets have gotten a lot 

deeper. Equity markets have gotten deeper. But I think 

as the fear of rates going up increases, there will be 

some rush to lock in to some kind of borrowing. So 

there will be an opportunity in the second half of the 

year for banks to step up and say, “Here’s your chance, 

guys. This is it on low rates.” 

We have had a Fed that’s been very restrained, very 

willing to be patient, and we have a lot of liquidity. 

There is not a lot of risk out there, and C&I loan 

growth should help strengthen the economy in the 

second half of the year. We expect it to accelerate into 

the fourth quarter. Many people have criticized us for 

having C&I loan growth pegged at around 4 percent in 

the first quarter and saying we’re way too low—and 

now everyone’s revised down to us, so I’d love to be 

surprised now. By the end of the year, I think we are 

looking at 5 percent growth. 

One of the reasons is that the ability to fully expense 

certain types of capital expenditures will expire at 

the end of this year, and many of our capital equipment producers are already saying, “Yeah, we need to 

think about it—we’ll get to that in the second half.” 

So it sets up a second half of the year surge in many 

of the kinds of purchases that require C&I loan 

growth as well. 

In terms of timing, we may end up borrowing a bit of 

investment activity from the beginning of 2005, but 

it could set up for a very nice second half of this 

year. I caution people, though, that if they get a 

really great fourth quarter, to take it with a grain of 

salt—they may want to average it with the first quarter, because it could simply reflect people slipping in 

under the change in the tax law. 

Another experiment that will show that tax policy 

affects behavior. 

That’s right. It does affect behavior. 

You touched on something else also. There is an 

interesting debate that we see developing with 

regard to inflation. Some have said that the 

commodity price increases we’ve seen recently 

are a harbinger of a wider price inflation that 

will be a replay of what we saw in the 1970s. 

Others say no, it’s different this time—we have 

essentially a deflationary global economy, which 

makes inflation a very remote concern at this 

stage. What is your outlook for inflation, and what 

does it imply for Fed policy? 

I guess there is no real black and white to inflation 

this year. I think one of the greatest issues in inflation is that we’ve got some of these temporary 

bottlenecks in raw material price increases and we’ve 

found ourselves in a high-productivity environment, 

so we’ve been very, very able to absorb a lot of that 

shock. Commodity prices are only one piece of a 

very complex inflationary puzzle. 

More important, and maybe more subtle, than that is 

that many of the deflationary factors that people 

were really concerned about have disappeared. And 

FDIC OUTLOOK 8 SUMMER 2004 
 

 

Special Feature 

that could, in turn, lead to some concerns going 

forward about inflation. 

My own view is that we could get some relief on oil 

prices—and that takes a lot of the pressure out of the 

equation. At prices this high you tend to get lots of 

cheating at OPEC, and we may already see that kind 

of activity picking up. And that’s great, because we’d 

like to see oil prices come down a bit. 

In my view, we are in an environment where deflationary pressures are abating, unveiling some of the 

underlying inflationary pressures in this economy, 

which are not overwhelming but certainly are there. 

I believe we have now reached a point of price 

stability. If you look at the underlying core inflation 

numbers, whether it be the Personal Consumption 

Expenditures Core Index or the Consumer Price 

Index, we’ve seen a stabilization. We no longer have 

disinflation, prices are no longer falling, so we’re 

stabilizing. The question is, when is inflation going 

to move up? Well, inflation is inertial, so we should 

expect it to move up slowly, but we should also 

expect it to move up. 

There are two issues there. One is that the Fed 

certainly feels it has a little bit of wiggle room to 

allow inflation to move up. That may be a case of 

“Be careful what you wish for.” If you get price stability, do you really want to be there? The other issue, 

though, is once you start chasing inflation, you have 

to play catch-up, and we’re starting with a Fed funds 

rate that is extremely accommodative. 

Ideally, the Fed would like to have a gradual increase 

in rates that the markets can adjust to. Nobody 

wants disorderly change; they want it all to be very 

orderly. Also ideally, I think, with the stronger 

employment numbers, seeing the Fed move up by the 

end of this year to 1.5 percent in the Fed funds rate 

would be welcome news, because it would set the 

stage for a more gradual pickup in rates over the 

course of the next couple years. Now, “gradual” is a 

relative term. I’ve got the Fed funds rate close to 4 

percent by the end of 2005! 

Four times where it is now. 

Exactly. And that is a lot of heavy lifting for the Fed 

to do in an orderly way. And, you know, the question 

is whether they will be able to do it in an orderly way. 

Many people are saying that we need to be more 

preemptive, but this is a Fed that says no, we need to 

be more reactive. I think we need about three-quarters of a million to a million in employment gains 

before the Fed feels comfortable moving, so we’re not 

there yet. It’ll be volatile in the next couple of 

months, but you can certainly envision the Fed statements beginning to express a balance of risks to 

inflation as they gradually start to take the security 

out of the system. It will start out gradual, but in 

2005 it could be much more aggressive. 

And the Fed will prepare the markets for that. 

They’ve already begun to say, “Rates are going to go 

up, you know they’re going to go up—OK, guys?” 

Just when will depend on how strong the economy is. 

When the rates do go up, we like to see it be nice 

and orderly and gradual. But how many times do we 

really get our wish in that way? Life usually has a lot 

more surprises in it. My concern is that there will be 

a much less orderly rise in rates in 2005. 

The real challenge for the Fed will be to manage the 

bond market so that it doesn’t go too far in the other 

direction. Because clearly, the bond market went too 

far in accommodation in thinking that deflation or 

disinflation was forever in the prices of bond deals, 

which is sort of silly, and the bond markets can 

change pretty quickly—and quick changes are hard. 

Do you get the impression that we are at the end of 

a 20-year cycle of disinflation with short-term 

interest rates at a 45-year low, and that we are 

turning a corner? That’s a very uncertain place to 

be, as evidenced by the bond market’s reaction last 

summer. They weren’t quite sure whether to turn 

that corner. 

There were a number of factors behind the bond 

market reaction, but yes, there is no question there is 

uncertainty. The interesting thing is that, for the 

most part, most traders in the bond market have 

been in a bull market their whole lives, and that lack 

of experience is something that you worry about, 

because we are at a turning point. The Fed is coming 

out and saying, “Eventually we’re going to have to 

raise rates, guys. You know that, right? We’re patient, 

but patient doesn’t mean no rate increases.” 

Inflation is stabilizing, and if the economy improves, 

even if inflation didn’t accelerate, you’d still have to 

FDIC OUTLOOK 9 SUMMER 2004 
Special Feature 

raise rates so you wouldn’t have to worry about it 

later on. 

The Fed is also firing these warning shots, saying that 

if we get into structural federal budget deficits again, 

along with current account deficits, and we get dollar 

depreciation—that may eventually work into prices. 

These are all things we have to worry about. So we 

can’t take it in a vacuum. And the problem is, like I 

said earlier, people’s natural tendency is to take the 

most recent past and forecast the future. The most 

recent past often sets the stage. And the fact that 

we’re at 45-year lows should tell you something—it’s 

not sustainable. So prepare yourself. 

The problem is, it’s very difficult to time. What you 

have to do is be ready to move as soon as the market 

moves, which means you’re not going to get the 

market low, and you won’t be able to fully hedge 

yourself, as a lending institution, against higher 

rates. However, it is probably a good time to go 

ahead and start hedging, because once rates begin to 

move upward, it will probably be part of a long 

process, not a short-term adjustment. 

I’m interested in your views on the current 

account deficit and the dollar. Here again, there 

seem to be opposing views, although the reality is 

probably in the middle. One view is that the 

United States is spending beyond its means, which 

could result in an unstable dollar—a collapse 

scenario for the dollar. Another school of thought 

sees the U.S. current account deficit as structural 

and not unrelated to the fact that many countries 

and firms around the world really depend on 

exports to the United States, so there’s a long-term 

structural global imbalance. Is either view accurate? And how does a half-trillion-dollar current 

account deficit ultimately resolve itself? 

Well, first, we do have a structural trade deficit— 

the rest of the world relies on us because we rely on 

the rest of the world for our goods. We are the most 

efficient economy in the world, and we have the 

highest capacity to consume and invest of anyone in 

the world. So all else being equal, given purchasing 

power parity or anything you want to throw in 

there, we would be running a structural current 

account deficit, importing more than we’re exporting, because we have this insatiable demand that is 

allowed in this country because of the freedom and 

depth of our capital markets. 

“It is probably a good time to go 

ahead and start hedging, because 

once rates begin to move upward, 

it will probably be part of a long 

process, not a short-term 

adjustment.” 

D. Swonk 

The last time we had a merchandise trade surplus was 

right after the recession in the 1990s. At that time, we 

had everything possible going to help the current 

account: weak demand here, strong demand abroad, 

and a weak dollar. 

We had foreign contributions for the war then, too. 

Yes, so that was an extraordinary period of time. And 

to get back to that kind of balance, that’s a heck of a 

lot to ask of the world and us. It would take a recession here to do it, along with an extraordinarily 

weak dollar reminiscent of its plunge in the late 

1980s and early 1990s. 

This time we’ve had a reasonable, orderly decline in 

the dollar. In the near term, I think there is actually 

room for stabilization in the next year or so, and maybe 

even some appreciation, as we start to get into a situation where rates are rising in the U.S. and world 

economies are improving as well. Going forward, we 

should continue to do better than the rest of the world, 

and in a higher rate environment that just tends to 

favor cash flows into the U.S. We’ll also continue to 

see a better return on capital for a while. And that 

should be favorable to the dollar, to at least keep it 

stabilized given the counterpressures or crosscurrents of 

a large current account deficit. 

The other issue is that the dollar alone can’t do the 

heavy lifting. It’s a very crude tool given that many of 

the countries that we have trade deficit problems with 

do not have floating currency. China is only one example. And, frankly, even if the dollar depreciated 40 

percent against China and they moved to a basket of 

currencies, that wouldn’t change—in fact, it’s still 

cheaper to produce in China than it is here. 

FDIC OUTLOOK 10 SUMMER 2004 
Special Feature 

The larger issue over time is going to be very difficult 

for us. I think we’ll get some cyclical improvement in 

federal deficits, which will take some pressure off so we 

can deal with some fundamental problems in the 

federal budget deficit that no one really wants to deal 

with, because they hurt. It’s painful. And you need 

almost a crisis type of situation like we had in the early 

1990s when the balanced budget accord was pushed 

through to actually deal with things like the federal 

budget deficit. 

My fear is that the persistence of the twin deficits 

(federal budget and current account), even with 

momentary improvements, is going to cause an enormous amount of pressure on the dollar over the next 

five to ten years. What we could be talking about is 

dethroning the U.S. dollar over time as the world 

reserve currency. I think no one has really thought 

about what that means, moving to a basket of 

currencies where the euro is one player in that 

basket, the dollar is one player in that basket, and 

perhaps the yen is another player in that basket. 

Having the dollar as the reserve currency has been 

another reason why we have been able to afford the 

luxury of carrying such a large amount of debt as a 

share of GDP, unlike any other economy in the 

world. People say it’s just the depth of our capital 

market. Well, who’s to say other countries that are 

reforming are not going to have depth to their capital markets also? 

I think we’re running a large risk of losing that status as 

the world’s gold reserve, sort of a gold currency. It’s not 

real gold, but it is the reserve currency of the world. In 

fact, gold ore is traded in dollars. Europe has not had to 

pay higher oil prices because it is the dollar that has 

depreciated. 

But on the other side of it, the dollar’s status as a 

reserve currency has afforded us lower interest rates and 

more debt than any other country in the world would 

be allowed to carry—it really is extraordinary. What we 

are doing is walking into a world where I think you 

could see a very substantial collapse in the dollar in 

the next five to ten years if we don’t do some things to 

improve that and, as a result, lose some of our status 

as a world reserve currency. 

That would be a very different world for us to deal 

with. We would have to deal with the same kind of 

consequences as many of our trading partners when 

they go into debt. And we would be expected, like 

firms and individuals and the rest of the world, to make 

an attempt to pay back our debts. That’s something 

we’re not entirely used to in this country. 

So it’s a structural change. And that gets into my role 

at the bank, looking at the world and what could go 

wrong, what could go right—no matter what could 

change. How do you position yourself for that change 

when it comes? Be aware, this is where the potholes are 

and this is where the opportunities are. Every change is 

an opportunity, as long as you anticipate it. 

It’s very difficult to anticipate these regime changes, 

waking up in a different world where the dollar is no 

longer king. 

Right. But it is better to be thinking about them now 

than to let them sneak up on you. 

That leads to the next question, which relates to your 

role at the bank. I would like you to discuss the role of 

point forecasts versus the type of analysis you just 

described, which is a scenario analysis. Which is more 

important in terms of the usefulness in decision 

making, risk management, that sort of thing? Or do 

both have a role? 

The market requires point forecasts. You have to 

remember what economics is at the end of the day— 

it’s the study of collective human behavior. It’s not 

this magic black box of numbers that we spew out for 

markets to move by on a daily basis, and it’s one of 

the main reasons that I don’t work on the trading 

floor. 

I think that fundamentals always dominate, and, over 

time, economics is most powerful over a two- to fiveyear horizon. For planning purposes and risk management, economics is most useful in identifying which 

industries are really going to boom if we’re positioning 

the bank this way and which industries we need to 

worry about. It’s more powerful in all those ways, picking winners and losers, than saying the Fed will move a 

quarter-point on this date. The reality is that we know 

the Fed is going to move within the next 18 months. 

But by how much is it going to move? We can guess 

with a reasonable amount of certainty, but the reality is 

that it is more important to know that we are shifting, 

that we are at a turning point, and to know how to position yourself for that turning point as it comes. 

FDIC OUTLOOK 11 SUMMER 2004 
Special Feature 

“Every change is an opportunity, 

as long as you anticipate it.” 

D. Swonk 

In terms of my role at the bank, I’ve done risk management, I’ve done the equivalent to ALCO [asset-liability 

committee] and those kinds of committees. But more 

often than not, economists get asked the wrong questions. I think the role of an economist is to help define 

the questions so that they can be answered in a meaningful way, rather than let the market determine the 

questions in a less meaningful way. I think we spend 

too much time on point estimates, although they’re 

important, and that’s where the articles are written and 

that’s where brand equity can be generated in answering those questions. 

The reality in terms of adding value to your company is 

to help strategically, and economics is just incredibly 

well suited for that. That’s where, especially for lenders, 

you need to understand where strength in consumer 

borrowing is going to be—which is very, very strong in 

traditional areas—but you need to price the risk, you 

don’t just ride the wave. That’s a really important thing 

to be calling. It’s important to call that heavy manufacturers are going to be coming back, and don’t write off 

and leave behind all these great customers you’ve had a 

relationship with because they’re not coming back at 

that particular moment. Obviously, you want to be 

selective, but you want your institution to be there for 

them, because they are going to make it back. 

“You have to remember what 

economics is at the end of the 

day—it’s the study of collective 

human behavior. It’s not this 

magic black box of numbers...” 

D. Swonk 

So my view is that you add a lot more by identifying 

structural change and using the power of economics in 

terms of what it really tells us about collective human 

behavior, the decisions that are being made out there, 

and the repercussions of the decisions you make, 

rather than just focusing on the point estimates. 

With that said, every point estimate of the economy 

should reflect a story. Far too often, you’ll see forecasts that aren’t consistent. We all have our different 

theories and our own model that points out what is 

consistent and what is not. If we’re not going to be 

consistent at some point, we’re saying that history is 

changing. Are we willing to make that bet, theoretically? Is the world really changing, or is it we’re just 

wrong on our point estimates? You want a consistency 

in your point estimates where someone can read the 

forecast and see a story—for instance, that the 

consumer sector is moving from being the leading 

sector to holding its own, but is no longer the driver 

of the U.S. economy, or that investment is moving 

from being a drag on growth to a booming sector in 

both traditional as well as high-tech equipment. 

Those are consistency issues, and there are stories in 

the numbers. 

I teach MBAs, and their final project is to be a stock 

analyst and value a company. I teach them the 

economics of it, and what I teach them is, “Don’t 

worry so much about what every word of a Fed statement says. Worry about where things are going from 

here, and what the story in the forecast is.” If you are 

going to write about your company in the context of 

the economy, you better have your logic consistent. 

Even if you don’t agree with me about what the 

macro picture says about the individual winners and 

losers—and all are tied, inherently, it goes in both 

directions—you had better understand what you are 

saying. Everybody has their own sound-bite answers, 

and everyone wants to hang onto that, but that’s not 

really a part of strategy, and that does not represent 

long-term understanding. 

At the end of the day, we focus so much on quarterto-quarter movements, day-to-day movements in the 

market, and, frankly, is that where the press comes? 

Absolutely. And that’s where brand equity can be 

generated, and the role that I play as a face for the 

bank. But I always say that’s the icing on the cake— 

I still have to bake the cake. And the baking of the 

cake is to understand what all the inconsistencies are 

in the longer run and the structural changes that are 

emerging. Because you can have someone coming to 

you and saying, “You made an interesting point—you 

didn’t just talk about employment. You made another 

point about that that was something that caught my 

attention.” And that’s what you want to do, to make 

FDIC OUTLOOK 12 SUMMER 2004 
Special Feature 

people get an “Aha,” and give them a toolbox to 

understand the world going forward. 

You impressed people at the FDIC when you spoke to 

our November 2002 economic roundtable.1 A lot of 

people at the FDIC, especially those who are not economists, said, “Diane’s the first economist who I really 

understood. She tied her story to things that were 

tangible to me.” The story behind the numbers is 

something that you really bring across. 

I am very much an applied economist, and, believing 

in that, my job is that of an economic translator. I 

take what really brilliant people say and try to make 

it make sense in the real world. So they make me 

look really smart. That part about being an economic 

translator, you have to take out all that academic 

stuff and say, “This is what it really means for you.” 

That’s part of the job for an economist in any 

company. Everything I have done is useless if I’m not 

helping someone to think, and I have not helped 

them to understand their world in a better way. 

Communication, at the end of the day, is the only 

way to do that. 

I don’t like to invoke my privilege in being a woman, 

but it’s not always been an advantage in my profession to be a woman. I’ve learned to make lemonade 

out of lemons on this issue, and I think I have more 

latitude in making economics real and interweaving, 

talking about my children as an illustration, because 

what we tend to forget is that economics is about the 

thousands of decisions that we make every single day, 

whether we are going to spend time enjoying our 

children, for example, and not make money during 

that period of time. 

That’s a base decision of human behavior. Most of us 

work to live, we don’t live to work. I love what I do 

with a passion, and I understand that everything we 

do is economic, but at the end of the day, it is important to be able to relate that to people so they can 

understand it more in their own world. We all understand economics—we all do it all the time. My challenge is to get people to be aware of how they’re 

In Person Profile: Diane Swonk 

Diane Swonk is Director of Economics, Chief Economist, and Senior Vice President at Bank One Corporation in Chicago, where she manages the bank’s 

Corporate Economics Group, and is a Clinical Professor for DePaul University’s MBA program. She 

recently published her first book, The Passionate Economist: Finding the Power and Humanity Behind the 

Numbers. 

Ms. Swonk began her career with First Chicago Corporation. She is a national economic consultant and 

appears regularly on television and in major financial 

publications. She served on the Board of the National 

Association for Business Economics (NABE) and the 

Finance Committee for the Executive Club of Chicago 

and is a director of the Illinois Economic Education 

Association. She was named “Business Leader of the 

Year” by the YWCA of Metropolitan Chicago and an 

NABE Fellow for her outstanding contributions to business economics. Ms. Swonk was one of the Wall Street 

Journal’s “Star Forecasters,” was named “Top Woman in 

Finance in Chicago” by Today’s Chicago Woman, and 

was just named one of the most influential women in 

business by the Chicago Sun-Times. 

Ms. Swonk earned her master’s in economics with 

honors from the University of Michigan and her MBA 

with honors from the University of Chicago. 

making decisions and how those decisions influence 

the rest of the world. 

You have been very generous with your time and 

your willingness to talk through all these issues with 

us and to bring your own personal experiences to it. 

It’s been my pleasure. It really is. I mean, this is what 

it’s all about, to get people to think a little differently 

than they have. This is what I do. 

Mary Ledwin Bean provided editorial assistance for this 

article. Photographs are also by Ms. Bean. 

1 For a summary of this event, see http://www.fdic.gov/news/ 

conferences/econ_agenda.html. 

FDIC OUTLOOK 13 SUMMER 2004 
Regional Outlook 

Regional Outlook in Charts
 

Job Growth Appears to Be Strengthened, but
 

Manufacturing Job Losses Have Weighed Heavily on
 

Overall Job Growth in Some FDIC Regions
 

Nonfarm Payrolls by FDIC Regions 

Fourth quarter 2003, percent change on year ago 1.5 

Excluding manufacturing 1.0 

0.5 

0.0 

Total 

–0.5 

Nation Atlanta Chicago Dallas Kansas New San –1.0 Region Region Region City York Francisco 

Region Region Region 

Source: Bureau of Labor Statistics. 

With Short-Term Interest Rates at a 45-Year Low, 

a Rate Hike May Be Inevitable, if Not Imminent, 

Which Could Cause Strain in Some Sectors 

12 Effective Federal Funds Rate Percent 

10 Consumer Price Index 

Percent change on year ago 8 

6 

4 

2 

Recessions 

0 

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 

Source: Federal Reserve, Bureau of Labor Statistics. 

The Mortgage Foreclosure Rate Has Escalated in the 

Midwest, Southwest, and Southeast 

0.9 0.7 0.6 0.6 VT 

0.8 1.1 0 . 6 

1.0 1.2 

1.0 1.7 

0.4 

0.8 

0.6 

1.0 

1.7 

0.8 

1.3 

1.9 

1.7 1.4 

2.1 1.6 2.9 3.3 

1.1 1.4 2.2 0.5 

1.6 1.7 1.3 2.6 

2.5 1.3 1.5 

1.3 1.1 ME 

0.4NH

 0.5 MA

 0.6 RI

 0.9 CT

 1.3 NJ

 1.0 DC

 1.2 MD 

1.4 Foreclosure growth rate 1.8 (4Q01 to 4Q03) 

Nation = 24% Note: Numbers represent fourth 1.0 quarter 2003 foreclosures, based on 50% – 115%

end-of-quarter inventory (not 24% – 50%

seasonally adjusted). 0% – 24% 

Source: Mortgage Bankers Association. -38% – 0% 

Home Prices in Some Markets May Be More
 

Vulnerable to Negative Economic Shocks,
 

Such as a Sharp Rise in Interest Rates
 

Seattle 

Minneapolis Portland Milwaukee Detroit Portland 

Chicago Boston 

Denver Indianapolis Providence 

Provo Sacramento New York area KC DC and 

Bay Las Vegas Colorado Baltimore Springs Greensboro 

Charlotte Area 

Riverside Raleigh 

OC LA Dallas Myrtle Beach Ft. Worth San Diego Austin 

Houston Sarasota Economy expanding West Palm Beach 

Economy in recession Ft. Myers Ft. Lauderdale Naples Miami Economy.com’s list of “highly overpriced” cities, 4Q2003 

PMI: top 20 cities most likely to see prices decline 

Source: Economy.com and PMI Economic & Real Estate Trends, Winter 2004. 

Commercial Real Estate (CRE) Exposures Are Elevated,
 

Particularly in the FDIC’s Atlanta and
 

San Francisco Regions
 

Share of Institutions with CRE* to Tier 1 Capital of: 

60% 

25.7% 

18.9% 

50% 

300–399 400–499 500 or greater 40% 

30% 

9.0% 

20% 5.5% 6.5% 6.3% 

4.2% 

10% 

0% San Atlanta NATION Chicago Dallas New York Kansas 

Francisco Region Region Region Region City Region Region 

*CRE includes construction and development, multifamily, and nonresidential loans. 

Source: FDIC, data as of fourth quarter 2003. 

The Banking Industry Is Well Poised to Absorb 

Problems, Given High Earnings and Strong Capital 

Leverage Ratio 

Return on Assets 

1.6 9.0 

1.4 8.5 

1.2 

1.0 8.0 

0.8 7.5 

0.6 7.0 

0.4 6.5 

0.2 

0.0 

-0.2 

6.0 

5.5 

-0.4 5.0 

1989 1991 1993 1995 1997 1999 2001 2003 

Source: FDIC. 

FDIC OUTLOOK 14 SUMMER 2004 
In Focus This Quarter 

Does Net Interest Margin Matter to Banks?
 

On the surface, the answer to this question seems obvious. Net interest margin (NIM) is the difference 

between income generated by earning assets, such as 

loans and securities, and expenses incurred on interestbearing liabilities, such as deposits and borrowings. 

Because banks are in the business of intermediation— 

taking funds from depositors and other sources and 

investing in interest-bearing assets—of course NIM 

matters. But, for some banks, it does not matter as 

much as it used to. 

Over the past 25 years, deregulation, technology, and 

market forces have contributed to increased competition and significant changes in revenue sources for 

insured institutions. These trends have resulted in a 

secular decline in NIM and a concurrent increase in 

other revenue sources, particularly at very large institutions. As a result, the significance of NIM as a performance yardstick is not what it used to be. This article 

will focus on trends in NIMs and analyze institutions of 

similar asset size to identify reasons for differences in 

NIM performance. 

For the purposes of this article, we have divided the 

commercial banking industry into three segments:1 

• Megabanks—commercial banks with assets over 

$100 billion. 

• Large and midsized banks—commercial banks with 

assets of $1 billion to $100 billion. 

• Community banks—commercial banks with assets 

under $1 billion. 

The article also explores whether alternative metrics 

exist that measure earnings performance more effectively than NIM. 

Secular and Cyclical Factors Have Affected NIMs 

The average NIM for the industry had fallen from 4.69 

percent in 1992 to 4.10 percent by year-end 2003 (see 

Chart 1). NIMs for the banking industry have been 

under secular pressure for some time, partly as a result 

of increased price competition within the banking 

industry and from nonbanking firms that offer banklike products. Improvements in technology and other 

marketplace innovations contribute to price competition. For example, in the past, loan and deposit pricing 

were largely set in local markets; they still are in some 

areas, but technology is leading to a convergence in 

pricing. One result is that depositors can now easily use 

the Internet to locate and move money to the offering 

with the highest yield. 

Cyclicity has also played a role in the decline of NIMs, 

particularly in recent years. Yields on loans have fallen 

as a result of nominal interest rates at a level that has 

not been seen since the 1950s. Moreover, despite the 

current steepness of the yield curve, banks have not 

recently reaped much benefit in lower costs, as the 

persistent nature of low interest rates has caused depositors to resist further decreases in deposit rates, thus 

creating an effective “floor” for deposit costs. 

Chart 1 

Commercial Bank Net Interest Margins Fell 

throughout the 1990s 

5.00
 

4.75


Net Interest Margin (%)

1 The article focuses on commercial banks because of the historical 

importance of net interest income as a revenue source. Before 

deregulation and the development of secondary markets, thrifts 

almost exclusively underwrote residential mortgages, with fee 

4.50 

4.25 

4.00 

3.75 Average NIM 

Average Risk-Adjusted NIM1 

income earned in origination and servicing. Funding sources were 

mainly savings and time deposits. The cost structure of thrifts was 

significantly below that of commercial banks because of lower underwriting and deposit-servicing costs. Therefore, NIMs have been 

historically much narrower for thrifts. 

3.50 

90 91 92 93 94 95 96 97 98 99 00 01 02 03 

1 Net interest margin, adjusted for net loan losses. 

Source: FDIC, from Bank Call Reports. 

FDIC OUTLOOK 15 SUMMER 2004 
In Focus This Quarter 

Risk-Adjusted Margin
 

An alternative way to analyze NIM performance is by 

using a risk adjustment process for credit costs. Credit 

costs, namely net loan losses, are inherent in almost 

all forms of lending and should be considered when 

analyzing returns. The adjustment of loan yields and, 

ultimately, the margin for credit costs can facilitate 

comparisons among different types of institutions. For 

example, NIMs of credit card banks are usually much 

higher than those of community banks, because credit 

cards tend to be a riskier business line that yields 

higher revenues than the more traditional business 

mix of a typical community bank. However, adjusting 

for losses, margins between the two become much 

more comparable. 

The NIM charts in this article show the unadjusted 

traditional NIM in a solid line and the risk-adjusted 

NIM Trends for the Three Asset Size Groups 

As a group, megabanks have the lowest reported NIM 

in the industry. The median NIM for megabanks had 

fallen from 4.35 percent in 1994 to 3.84 percent by 

year-end 2003 (see Chart 2, next page). Although 

NIMs for megabanks are lower than those for the other 

groups, megabank NIMs have not shown a greater 

decline over time; that is, historically, these banks have 

reported the lowest NIMs. As we discuss later in this 

article, significant differences in business strategies and 

availability of options between megabanks and other 

groups are major factors in lower megabank NIMs. 

The NIMs of large and midsized banks have fallen 

much more than those of megabanks. The median 

NIM for large and midsized banks fell from 4.55 

percent in 1994 to 3.91 percent by year-end 2003, a 

drop of 64 basis points. This drop was much greater 

than the corresponding 49 basis point decline at 

megabanks. Interestingly, the risk-adjusted NIMs for 

the same period for both groups fell about the same 

amount: For large and midsized banks, the riskadjusted NIM fell 72 basis points; for megabanks, it 

fell 71 basis points. Risk-adjusted NIM at megabanks 

was adversely affected by credit losses on some very 

large corporate borrowers that experienced problems 

during the recent recession. 

The NIM at community banks has experienced 

compression almost identical to that at megabanks. 

margin in a dashed line. In Chart 1, for the entire 

industry, the average risk-adjusted margin has fallen 

52 basis points since 1992, while the average unadjusted NIM has fallen 59 basis points. The two metrics 

have been very close over the measurement period, 

compared with a much greater variance during the 

crises of the late 1980s and early 1990s. This closeness 

is due to improved credit performance over the measurement period. This improved performance has 

resulted from improved risk management and underwriting processes; enhanced regulatory requirements; 

and a shift in portfolio lending from large commercial 

real estate development and business lending to 

consumer-related lending (single-family mortgages 

and residential construction). 

The median NIM for community banks had fallen from 

4.59 percent in 1994 to 4.11 percent by year-end 2003. 

The 48-basis-point decline in the median NIM for 

community banks approximates the 51-basis-point 

decline for megabanks during the same period. 

Megabanks Have Diversified Their Income Streams, 

Resulting in Less Reliance on NIM 

The narrowing NIM at megabanks is part of a gradual 

alteration of the income stream over the past two 

decades, in which these banks have purposefully 

reduced their dependence on spread income. On average, megabanks’ net interest income as a share of total 

revenue fell from 90 percent in 1984 to 65 percent in 

2003 (see Chart 3, page 18). 

Several factors have driven the change in earnings 

composition for megabanks. Traditional key lending 

areas—such as a large corporate loans—have diminished, in both volume and yield, as a result of competition, technology, and other market forces, including 

the expansion of the capital markets. To replace this 

lost revenue, megabanks have expanded into new 

business lines—such as investment banking, asset 

management, and insurance—to generate fee income 

and grow revenue. Megabank managers have sought 

to diversify their revenue streams to lessen their 

dependence on any one source and reduce the volatility in revenue over time. 

FDIC OUTLOOK 16 SUMMER 2004 
In Focus This Quarter 

NIM Has Fallen for All Three Segments of the Banking Industry 

Chart 2a Chart 2b 

Net Interest Margins for Megabanks1 Net Interest Margins for Large and 

Midsized Banks1 

5.00 5.00 

4.50 4.50 ) 

s (%)argin 4.00 4.00 ns (%Margi

3.50 3.50 Net Interest

Net Interest M 3.00 3.00 

Median NIM 2.50 

Median Risk-Adjusted NIM2 

2.00 

90 91 92 93 94 95 96 97 98 99 00 01 02 03 

1 Includes commercial banks with assets over $100 billion at year-end 2003. 

2 Net interest margin, adjusted for net loan losses. 

Source: FDIC, from Bank Call Reports, merger-adjusted data. 

Median NIM 2.50 

Median Risk-Adjusted NIM2 

2.00 

90 91 92 93 94 95 96 97 98 99 00 01 02 03 

1

Includes commercial banks with assets between $1 billion and $100 billion at 

year-end 2003. 

2

Net interest margin, adjusted for net loan losses. 

Source: FDIC, from Bank Call Reports, merger-adjusted data. 

Chart 2c 

Net Interest Margins for Community Banks1 

5.00
 

4.50
 

4.00
 

3.50
 

3.00
 

Median NIM
 2.50 

Median Risk-Adjusted NIM2 

2.00 

90 91 92 93 94 95 96 97 98 99 00 01 02 03 

1 Includes commercial banks with assets less than $1 billion at year-end 2003. 

2 Net interest margin, adjusted for net loan losses.
 

Source: FDIC, from Bank Call Reports, merger-adjusted data.
 Net Interest Margins (%) 

Community banks, on the other hand, still rely heavily on net interest income. For these banks, net interest income as a share of total revenue fell slightly, 

from roughly 95 percent in 1984 to 89 percent in 

2003. Additionally, while there has been an increase 

in fee income at community banks, for the most 

part, this income is closely related to net interest 

income rather than a result of expansion into new 

business lines. These fees are mainly associated with 

deposit accounts: monthly service charges, checkcashing fees, and insufficient funds charges. Price 

increases for these items are the main reason for the 

small increase in the proportion of fee income to 

total revenue. 

The size of the megabanks (over $100 billion) 

suggests institutions with the scale and management 

to operate multiple business lines over multiple geographies and with the largest array of strategic and 

funding options. Conversely, the size of the community banks (under $1 billion) suggests institutions 

that operate a traditional local banking business. 

Income streams at the large and midsized bank 

group—$1 billion to $100 billion—are more complicated to analyze because of the mixed composition of 

this group. Some banks in the group tilt more toward 

the traditional, while the larger banks may emulate 

the megabanks in terms of business lines and strategies. Still others may be niche players. 

FDIC OUTLOOK 17 SUMMER 2004 
In Focus This Quarter 

Chart 3 

Megabanks Have Greatly Reduced Their Reliance 

on Net Interest Income 

100 Community Banks 

95 

90 

85 

80 Large and Midsized Banks 

75 

70 

65 

Megabanks 60
 

55
 

50
 

90 91 92 93 94 95 96 97 98 99 00 01 02 03 

Note: Megabanks are commercial banks with assets of $100 billion or more, large and 

midsized banks are commercial banks with assets between $1 billion and $100 billion, 

and community banks are commercial banks with assets less than $1 billion. 

Source: FDIC, based on Bank Call Reports (merger-adjusted average data). 

Net Interest Income/Total Revenue (%)

(Averages) 

Because of the varied nature of the banks in the large 

and midsized group, the change in revenue stream 

falls at the midway point between that of megabanks 

and that of community banks. Net interest income as 

a share of total revenue fell from 90 percent in 1984 

to 80 percent in 2003. The rate of decline has picked 

up somewhat in the past three years as declines in 

interest rates have prompted these banks to seek 

alternative revenue sources and technology improvements have made it easier to access these sources. 

Diversifying Income Streams Has Been Beneficial 

for Megabanks 

Historically, earnings have deteriorated during 

economic downturns as credit costs generally rise. 

However, record levels of income were generated 

during the recent recession, partly because of 

increased revenue from business lines not tied to net 

interest income. Earnings problems were also muted 

at megabanks by the relatively mild nature of the 

recession and a shift in portfolio lending from 

commercial (where most credit problems were 

concentrated) to consumer lending. In addition, 

advances in active credit portfolio management techniques and the development of secondary markets 

have created new options for managing and transferring credit risk. 

Risk management processes have become more 

sophisticated at megabanks, so that optimization of 

the NIM ratio often is not a primary goal. A principal 

focus among managers in this group is the maximization of revenue and total shareholder return. Business 

lines are scrutinized to determine whether they are 

exceeding a specified hurdle rate of return on a riskadjusted basis. Simply stated, business lines with riskadjusted returns above the hurdle rate are adding 

economic profit while those below are not. 

This hurdle rate methodology is also used to determine the overall profitability of individual customer 

relationships at megabanks. While one product or 

service in a relationship may not exceed the hurdle 

rate of return, other products or services sold to the 

same customer could raise the overall profitability of 

the relationship above the prescribed minimum. For 

example, commercial credit facilities offered by megabanks may be priced below the business line return 

hurdle. This loss-leader strategy is used to cross-sell 

other, higher margin, products that lead to profitable 

relationships in the long run. 

A number of banks in the large to midsized group are 

able to diversify income streams and employ some of 

the same revenue optimization techniques as megabanks. However, among community banks, the lack of 

diversification in the income stream has magnified the 

current cyclical pressures on NIM. Because of the heavy 

reliance on NIM and the prolonged and very low level 

of nominal interest rates, which has created a floor on 

deposit costs, 40 percent of community banks experienced a decline in net interest income in 2003. In 

2002, only 18 percent of community banks saw net 

interest income fall. At many community banks, the 

year-over-year drop in net interest income occurred 

even though earning assets rose as a share of total 

assets. Community banks in the bottom 10th percentile 

had a 2003 NIM of only 3.14 percent, the lowest level 

in 20 years (see Chart 4, next page). 

As NIM’s Usefulness as a Performance Benchmark 

Diminishes for the Largest Banks, Are There 

Alternatives? 

Because several factors have changed the revenue 

stream of the industry over the past two decades, 

NIM may no longer be the most effective tool for 

measuring performance. The change is most evident 

at the megabanks that now control the majority of 

assets in the industry. Because the megabank group 

disproportionately influences the NIM aggregate 

trend, NIM has become less useful as a tool for 

measuring industry performance. 

FDIC OUTLOOK 18 SUMMER 2004 
In Focus This Quarter 

Chart 4 

The Lowest Performing Community Banks Are
 

Adversely Affected by the Lack of Revenue


1 Diversification 

6.5 Top/Bottom 10th Percentiles 

Top/Bottom 25th Percentiles 6.0 

While NIM may be losing some of its relevance, as 

long as banks serve as intermediaries, it provides a 

useful, though not exclusive, measure of earnings 

performance. For the more than 7,300 community 

banks and many of the banks in the large and midsized group, NIM is still a very important performNet Interest Margins (%) 5.5 

5.0 At the FDIC and other bank regulatory agencies, 

examiners are trained to analyze the quality and 4.5 

composition of earnings sources rather than focusing 4.0 solely on ratio analysis and peer group comparisons. 

3.5 This is particularly true at large financial institutions, 

3.0 where the complexity and uniqueness of each institu90 91 92 93 94 95 96 97 98 99 00 01 02 03 tion require a more comprehensive and idiosyncratic 

Average ance measure. 

1 Includes commercial banks with assets less than $1 billion at year-end 2003. 

Source: FDIC, from Bank Call Reports (merger-adjusted data). evaluation. 

Megabanks themselves focus much more on net interest income than NIM in their earnings discussions 

with equity analysts and investors. One metric that 

could be used is risk-adjusting margins for credit 

costs, as described in the text box on page 16. 

Another metric could be the calculation of the ratio 

of pretax net income to gross revenues. In this calculation, gross revenues are defined as interest income 

plus fee income. Essentially, this measure determines 

the percentage of total revenue that flows to the 

bottom line; it allows greater comparability across 

different business models, balance sheet and offbalance sheet structures, and tax status. In Chart 5 

the time-series pro forma graphic for pretax net 

income to gross income shows the very strong earnings performance of the banking industry over the 

past decade—during the past few years in particular. 

Several megabanks are now publicly disclosing their 

internal performance metrics, such as risk-adjusted 

return on capital, economic profit, and shareholder 

value added. These disclosures not only contribute to 

more complete information on earnings performance 

but also indicate the risks that are being taken to 

achieve those earnings. 

Jack Phelps, CFA, Regional Manager, Atlanta 

Scott Hughes, Regional Economist, Atlanta 

Ron Sims, CFA, Senior Financial Analyst, Atlanta 

Robert L. Burns, CFA, CPA, Senior Examiner, Atlanta, 

Division of Supervision and Consumer Protection 

Chart 5 

Commercial Bank Pretax Net Income-to-Gross 

Income Has Increased 

Source: FDIC, from Bank Call Reports. Pretax Net Income/Gross Income (%)

Top/Bottom 10th Percentiles 

Top/Bottom 25th Percentiles 

Average 

-20% 

0% 

20% 

40% 

90 91 92 93 94 95 96 97 98 99 00 01 02 03 

FDIC OUTLOOK 19 SUMMER 2004 
In Focus This Quarter 

Bank Investment Portfolios: Strong Gains since 

2000—Will They Continue? 

Investment portfolios have traditionally served multiple 

purposes at banks. A well-managed securities portfolio 

can reduce a bank’s credit risk profile and the volatility 

of the income stream. Additionally, securities portfolios 

can provide an alternative investment opportunity in 

times of sluggish loan demand and can serve as a source 

of liquidity to fund bank operations. Over time, the 

increased availability of other liquidity options and the 

search for higher yields has led to reductions in the 

relative size of bank securities portfolios. Moreover, 

yield pressures and supply constraints have changed the 

composition of the securities portfolio, resulting in far 

less reliance on U.S. Treasury securities. 

Recently, through a period of historically low interest 

rates, banks benefited from the inverse relationship 

between bond values and interest rates and realized 

significant securities gains. As reported in the FDIC 

Quarterly Banking Profile, gains on securities sold 

supported strong aggregate bank profitability throughout the recession and subsequent recovery.1 However, as 

banks sold securities and rebuilt their portfolios, 

replacement securities often had low yields because of 

changes in prevailing interest rates. 

This article examines the reasons behind the changes 

in the size and composition of bank securities portfolios. It also discusses how the inverse relationship of 

bond prices to interest rates may affect bank earnings 

and capital cushions going forward, particularly in a 

rising interest rate scenario. The implications of rising 

interest rates on debt security yields and valuations will 

be influenced in part by shifts in the composition of 

securities portfolios, the magnitude of interest rate 

changes, and the shape of the yield curve.2 

Funding Alternatives and Yield Pressures Influence 

Banking Investment Strategies 

Securities portfolios have represented a shrinking 

proportion of most bank balance sheets over the past 

1 To view the fourth quarter 2003 and other editions of the 


FDIC Quarterly Banking Profile, go to http://www2.fdic.gov/qbp/
 

qbpSelect.asp?menuItem=QBP. 
 2 Data used for this article came from Call Reports filed by commercial banks. Because of differences in data availability, information
 

from Thrift Financial Report filers was not used.
 

decade. The median securities-to-total-asset ratio 

dropped from 30 percent at year-end 1994 to 23 

percent by year-end 2003. Even the smallest banks now 

have numerous liquidity alternatives, a situation that 

contributes to this decline. In the past, banks maintained securities portfolios to provide a source of liquidity and to help meet deposit outflows or loan demand. 

Now, banks of all sizes commonly have an array of 

liquidity options, such as interbank or Federal Home 

Loan Bank borrowing lines and access to brokered or 

Internet deposits. 

In addition, in the trade-offs among returns, liquidity, 

and credit risk, securities generally pay lower yields 

than loans. Thus, when lending opportunities are abundant, as has been the case over the past decade, the 

incentive is strong to maintain higher loan balances 

and lower security balances. 

Until the early 1990s, insured institutions traditionally 

invested heavily in federal, state, and local government 

bonds, with some exposure to U.S. Agency (agency) 

debt and mortgage-backed securities (MBS).3 However, 

banks have increasingly shifted securities investments 

away from default-free U.S. Treasury (UST) instruments and toward agency-issued notes, MBS, and various other debt issues.4 For instance, between 1994 and 

2003, the share of institutions with at least 25 percent 

of securities invested in UST instruments plummeted, 

while banks investing above this threshold in agency, 

pass-through MBS, municipal securities, and other debt 

classes increased (see Chart 1, next page).5 

Yield considerations as well as developments in the 

capital markets contributed to the shift in investment 

portfolio mix. In general, MBS, agency, and other debt 

securities offer more attractive yields than UST instru3 U.S. Agency securities include direct debt issued by governmentsponsored enterprises (GSEs) such as Fannie Mae, Freddie Mac, and 

Ginnie Mae; MBS include bonds backed by single-family mortgages 

issued through private parties or GSEs. 

4 Other debt instruments include asset-backed securities, trust 

preferred securities, and foreign government bonds. 

5 In a pass-through MBS structure, principal, interest, and prepayments made on the underlying pool of mortgages are passed through 

to the ultimate certificate holders. In contrast, investors in non-passthrough MBS such as collateralized mortgage obligations and real 

estate mortgage investment conduits receive cash flows structured 

differently from the payments on the underlying mortgages. 

FDIC OUTLOOK 20 SUMMER 2004 
In Focus This Quarter 

Chart 1 Chart 2 Share of Banks with Holdings Exceeding

Bank Exposures to U.S. Treasury Instruments Have 25 Percent of Total Securities (%) 

Dwindled, Unlike Other Classes of Debt Securities 

80 

70 

1994 1997 2000 2003 

60 

50 

40 

30 

20 

10 

0 

U.S. U.S. Municipal Pass- Other Other 

Treasury Agency Through MBS Debt 

MBS 

Note: MBS = mortgage-backed securities. 

Source: Bank Call Reports (December of each year). 

U.S. Agency, Mortgage-Related, and Asset-Backed 

Securities Increased Dramatically over the 

Past Decade 

6,000 

5,000 Mortgage-Related 

U.S. Treasury 4,000 

3,000 

U.S. Agency 

2,000 Municipal 

1,000 

Asset-Backed 

0 

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 

Note: 2003 data through third quarter. 

Source: Bond Market Association. Volume Outstanding ($ Billions) 

ments, reflecting in part the potentially higher credit 

and interest rate risk of these investments. In addition, 

secondary market developments throughout the 1990s 

and considerable mortgage refinancing activity over the 

past three years accelerated both MBS and agency debt 

issuance. According to the Bond Market Association, 

agency and MBS debt issuance outpaced UST issuance 

over the past several years.6 By 1999, the volume of 

outstanding MBS instruments exceeded outstanding 

UST obligations (see Chart 2). 

The Shift Away from USTs May Have Increased 

the Risk Profile of Bank Securities Portfolios 

MBS and agency bonds pose unique interest rate risks 

compared with UST securities, because most MBS and 

many agency securities contain embedded options. MBS 

have option risk, as mortgage borrowers have the right 

to prepay their loans. During periods of refinancing 

activity induced by low interest rates, MBS holders tend 

to receive cash flows earlier than originally expected, 

forcing them to reinvest proceeds at the prevailing 

lower interest rates. Conversely, MBS holders may face 

extension risk when prepayments fall because of rising 

rates and the expected life of the investment increases. 

In other words, with many MBS investments, the 

investor receives money faster when reinvestment 

options are less desirable and more slowly when similar 

but higher yielding securities are available. 

6 Data on the composition of bond markets are from the Bond Market 

Association website at http://www.bondmarkets.com/Research/ 

osdebt.shtml. 

Similarly, agency bonds can have option risk, because 

they often are callable or “structured.” For Call Report 

purposes, structured notes include “debt securities 

whose cash flow characteristics (coupon rate, redemption amount, or stated maturity) depend upon one or 

more indices and/or that have embedded forwards or 

options.”7 Structured notes have never been a large 

portion of community bank securities portfolios; 

however, they have come in and out of favor as investment options as interest rates and yield-curve steepness 

have changed (see Chart 3, next page).8 

Structured notes can be appropriate investment vehicles, and not all structured notes carry the same 

degree of risk. Many banks were drawn to structured 

notes in the early 1990s, because they were issued by 

government-sponsored enterprises and had attractive 

yields compared with those of other agency bonds or 

notes. Typically, initial yields were high, but the 

embedded options were very difficult to price. Some 

institutions found themselves with highly depreciated, low-paying investments when interest rates 

moved higher. In fact, on a median basis, banks that 

held structured notes reported net unrealized losses 

on these instruments between 1995 and 2000 and 

7 For additional information, see the instructions for the preparation 

of schedule RC-B of the Consolidated Reports of Condition and 

Income (http://www.ffiec.gov/ffiec_report_forms.htm), which define 

structured notes to include step-up bonds, index amortizing notes, 

dual index notes, deleveraged bonds, range bonds, and inverse 

floaters. 

8 Generally, the federal agencies that issue most structured notes 

(Federal Home Loan Bank, Fannie Mae, and Freddie Mac) do so when 

interest rates are low and the yield curve is steep. 

FDIC OUTLOOK 21 SUMMER 2004 
In Focus This Quarter 

Chart 3 Chart 4 

The Share of Banks Holding Large Amounts of 

Structured Notes in 2003 Approached 1995 Levels 

(%) 

8 

7 Structured Notes to Tier 1 Capital 

Banks with Structured Notes to Tier 1 Capital > 100% 6 

Average Ten

U.S. T

Asset Yields Have Plummeted over the Past 

Three Years 

10 10 

All Earning Assets

9 (left axis) 9 

8 8

Median %)

5 

reas

-Yea

7 7

Year-to-Date Yield (

4 

ury

r Co

6 6 

3 

2 

1 

0 

Rate (%)

nstant Maturity

5 Securities 5 

(left axis) Average Ten-Year U.S. 4 4 Treasury Rate (right axis) 

3 3 

1Q95

3Q95

1Q96

3Q96

1Q97

3Q97

1Q98

3Q98

1Q99

3Q99

1Q00

3Q00

1Q01

3Q01

1Q02

3Q02

1Q03

3Q03

91 92 93 94 95 96 97 98 99 00 01 02 03 

Note: Bank asset and securities yields not shown on a tax-equivalent basis. 

Source: FDIC from Bank Call Reports. Sources: FDIC from Bank Call Reports; Federal Reserve Board via Haver Analytics. 

registered only mild appreciation throughout 2001, 

2002, and 2003.9 

While some structured notes have very little credit risk, 

virtually all have characteristics that require prepurchase scrutiny and ongoing assessment of their sensitivity to interest rate movements. Data on structured note 

issuance as well as anecdotal reports suggest that these 

instruments currently tend to be relatively straightforward step-up bonds; in the early 1990s, they were more 

likely to feature exotic derivative aspects.10 Managers of 

insured institutions should understand the unique characteristics of these instruments and how they might fit 

into the bank’s overall strategies for investment and 

interest rate risk management. Because of the embedded options, structured notes need to be monitored 

closely during the holding period.11 

Low Interest Rates Hampered Bond Yields and 

Boosted Market Values 

Declining interest rates pushed the median 2003 

year-end yield on securities among insured commercial banks to 3.73 percent, down steadily from 6.13 

percent in 2000 (see Chart 4). Given their positive 

9 Because Call Report information on structured notes was not
 

collected until 1995, data are not available for 1994 and earlier.
 

10 Mauro, Martin J., and Michele Chesnicka, Merrill Lynch Fixed
 

Income Digest, January 8, 2004, p. 9.
 11 For additional information on risks posed by structured notes, refer
 

to the 1998 Interagency Supervisory Policy Statement on Investment
 

Securities and End-User Derivatives Activities, http://www.fdic.gov/
 

regulations/laws/rules/5000-4400.html#5000supervisoryps.
 

correlation with changes in interest rates, investment 

portfolio yields likely will improve should rates rise 

prospectively, as cash flows are invested at progressively higher rates. This correlation was demonstrated 

when rising interest rates in the 1994 to 1995 and 

1999 to 2000 periods provided a temporary lift to 

bond yields. 

During a period of increasing interest rates, however, 

rising securities yields may not offset declines in bond 

values, especially as there is typically a lag in the repricing dates for securities. For instance, indices compiled 

by Merrill Lynch on total bond returns, which include 

recurring yield income as well as price changes, suggest 

that interest rate increases during 1994 to 1995 and 

1999 to 2000 created negative year-over-year total 

returns in many bond classes, because declines in bond 

values outweighed yield increases. 

In addition to boosting earnings, securities appreciation can serve as a cushion to capital and liquidity in 

the form of unrealized gains. Financial statements 

prepared in accordance with generally accepted 

accounting principles (GAAP) adjust asset and 

capital balances for unrealized gains and losses on 

available-for-sale debt securities.12 Although regulatory capital standards do not include such adjustments, the agencies recognize that large unrealized 

losses may impair earnings in the event securities 

12 For additional details on GAAP treatment of held-to-maturity, 

available-for-sale, and trading securities, refer to Financial Accounting Standard Number 115. As of December 31, 2003, banks classified 

most securities as available-for-sale and reported associated unrealized gains in GAAP capital accounts. 

FDIC OUTLOOK 22 SUMMER 2004 
In Focus This Quarter 

Chart 5 Chart 6 Share of Insured Commercial Banks (%)

Banks Realized Gains when Rates Declined but 

Recognized Losses when Rates Increased 

Share with 80 Average Ten-Year U.S. 8.0 Realized Gains Treasury Rate (right axis) (left axis) 7.5 60 

7.0 

40 6.5 

20 6.0 

5.5 0 

5.0 

–20 4.5 Share with 

–40 Realized Losses 4.0 

91 92 93 94 95 96 97 98 99 00 01 02 03 

Average Ten-Year Constant Maturity 

U.S. Treasury Rate (%) 

Maturities for Pass-Through MBS Increased, while 

Average Lives of Other MBS Exposures Shortened 

100 

1997 1999 2001 2003 90 

80 

70 

60 

50 

40 

30 

20 

10 

0 

Pass-Through Other MBS Non-MBS Total Debt 

MBS Securities

Share of Securities Next Repricing or

Maturing in Over Three Years* (Median %) 

*Other mortgage-backed securities (MBS) shown according to expected average life. 

Sources: FDIC from Bank Call Reports; Federal Reserve Board via Haver Analytics. Source: FDIC from Bank Call Reports (December of each year). 

have to be sold to meet liquidity needs. Similarly, 

unrealized losses may limit liquidity options, as bank 

management may decide not to sell investments 

because of the potential effect on earnings and capital. 

Unrealized gains and losses on bank balance sheets 

have fluctuated over time, depending on the level 

and direction of interest rates. Rising interest rates 

during periods in the early and late 1990s drove down 

bond values and caused net portfolio depreciation. 

After periods of rising interest rates at the end of 

1994 and 1999, the median net unrealized loss-toamortized-cost ratios among insured banks were negative 3.14 percent and negative 1.90 percent, 

respectively. However, declining interest rates over 

the past few years enabled many insured banks to 

augment earnings by selling higher yielding securities 

for gains. Whereas only 17 percent of insured banks 

reported gains on the sale of securities during 2000 (a 

period of rising interest rates—see Chart 5), nearly 

half of insured banks realized securities gains during 

2001, 2002, and 2003. 

How Will Increasing Interest Rates Affect 

Securities Portfolios? 

Changes in portfolio mix have contributed to a general 

lengthening of investment maturities, which implies 

that investment portfolios may have greater price risk. 

As of year-end 2003, debt securities with a next-earliest 

repricing, maturity, or estimated average life of more 

than three years typically accounted for 59 percent of 

securities held by insured banks, up from 41 percent in 

1997.13 Most of the lengthening occurred in the passthrough MBS segment, which often accounts for a large 

share of total securities (see Chart 6). 

While Chart 6 suggests that the estimated average life 

of non-pass-through MBS declined over a six-year 

period, this may not indicate declining interest rate risk 

in this category. For instance, estimated average lives 

among non-pass-through MBS appear to have lengthened during 1999— a period of rising interest rates— 

but shortened as interest rates declined during 

subsequent years. Although the specific types of MBS 

held in this category cannot be known with certainty 

on the basis of Call Report data alone, this alternating 

pattern of extension and contraction in estimated average life may be symptomatic of heightened interest rate 

and prepayment risk.14 Thus, the estimated lives of 

these instruments could lengthen quickly should interest rates rise sharply. Understanding the maturity or 

duration profile of an investment product is important, 

because—given an equal change in short-term and 

long-term interest rates (that is, a parallel yield curve 

13 Per Call Report instructions, banks report non-pass-through MBS 

according to estimated average life. For other categories of debt 

securities, banks report by earliest repricing or maturity date. The 

estimated average life calculation considers expected prepayments 

and is dollar- and time-weighted. As a result, it is not equivalent to 

contractual maturity or expected final maturity. 

14 Because non-pass-through MBS are issued in tranches that differ 

in terms of priority for receiving principal and interest payments on 

the underlying pool of mortgages, some classes may have relatively 

more or less exposure to prepayment risk. Continuous declines in 

mortgage interest rates during 2001, 2002, and parts of 2003 triggered 

so much refinancing activity that some tranches that were contractually last in line to receive principal cash flows ended up receiving 

payments earlier than expected. 

FDIC OUTLOOK 23 SUMMER 2004 
Jun-94

Dec-94 Jun-95

Dec-95 Jun-96

Dec-96 Jun-97

Dec-97 Jun-98

Dec-98 Jun-99

Dec-99 Jun-00

Dec-00 Jun-01

Dec-01 Jun-02

Dec-02 Jun-03

Dec-03 

In Focus This Quarter 

Chart 7 Chart 8 

Bond Values Declined More Severely during Rising
 

Rate Periods of 1994–95 than 1999–2000
 

Realized and Unrealized Securities Gains 

Subsided in Late 2003 

Unrealized Securities Gains/Amortized Cost

(Aggregate %) 

Source: FDIC from Bank Call Reports. 

Quarterly Securities Gains to 

Net Income (right axis) 

Realized Gains / Net Income

(Aggregate %) 

4Q00

1Q01

2Q01

3Q01

4Q01

1Q02

2Q02

3Q02

4Q02

1Q03

2Q03

3Q03

4Q03 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

0 

2 

4 

6 

8 

10 

12 

Securities Portfolio Appreciation (left axis) 

Unrealized Gains (Losses)/

Amortized Cost (Median %)

U.S. Agency 

U.S. Treasury 

Pass-Through MBS 

Non-Pass-Through MBS 

–6 

–5 

–4 

–3 

–2 

–1 

0 

1 

2 

3 

shift)—bonds with longer maturities may exhibit larger 

percentage-point price swings. 

Not surprisingly, as long-term rates rose in the second 

half of 2003, aggregate securities gains and portfolio 

appreciation decelerated among the nation’s banks (see 

Chart 7).15 In the future, the effects of rising interest 

rates on bond valuations will ultimately depend on how 

quickly rates increase and the shape of a post-shift yield 

curve (for example, flat versus steep). 

If both short- and long-term rates change by equal 

amounts, prices for longer duration bonds likely would 

decline by a greater magnitude than prices for shorter 

duration investments. However, if the yield curve flattens because short-term rates rise faster than long-term 

rates, prices for bonds with shorter durations could 

suffer disproportionately. 

For instance, interest rates increased sharply and in a 

parallel fashion during 1994, maintaining a very steep 

yield curve. These conditions triggered relatively large 

amounts of unrealized losses in bank bond portfolios, in 

particular for agency and MBS securities (see Chart 8). 

However, when both long- and short-term rates 

increased during 1999, the rate rise was less severe and 

the yield curve was flatter than that in 1994. As a 

result, although the bonds depreciated in value, the 

correction was less pronounced. 

15 For a discussion of the elements that contributed to interest rate 

volatility during 2003, see “Causes and Implications of Recent Interest 

Rate Volatility,” FDIC Outlook, Winter 2003 (http://www.fdic.gov/bank/ 

analytical/regional/ro20034q/na/infocus.html). 

Medians calculated on banks holding that type of investment. MBS = mortgage-backed
 

securities.
 

Source: FDIC from Bank Call Reports.
 

Should interest rates move up sharply, institutions with 

portfolios of longer-term assets might be faced with the 

prospect of holding many securities to maturity at 

below-market interest rates or realizing losses to reinvest in new assets with higher yields. Most institutions 

may be able to hold depressed securities until maturity 

and technically never realize a loss, but the trade-off is 

lower yields over time. 

Banks Are in the Business of Managing Risk 

Banks have been investing in securities for many years, 

and individual bank managements adopt policies and 

strategies to manage their portfolios under various 

scenarios, balancing loan demand, liquidity needs, and 

the effects of interest rates on yields and values. Some 

banks use the securities portfolio as a hedge to reduce 

credit risk or interest rate risk elsewhere on their 

balance sheets. Bank investment policies and strategies 

are typically dynamic and unique to individual institutions and, as a result, are a key area of review for bank 

directors, auditors, and examiners. 

Innovation in the capital markets results in the introduction of new types of investment vehicles, which can 

make investment selection more difficult and challenge 

efforts to model the potential effects of changing interest rates on investment holdings. In this environment, it 

is incumbent upon bank managers and directors to 

understand fully the unique characteristics of each 

investment they own. As noted in the Interagency Supervisory Policy Statement on Investment Securities and EndUser Derivatives Activities, risk limits associated with 

FDIC OUTLOOK 24 SUMMER 2004 
In Focus This Quarter 

capital market activities should be consistent with a 

bank’s strategic plans and overall asset/liability management objectives. Policies should seek to manage market, 

credit, liquidity, and interest rate risks. In addition, 

insured institutions that have increased their holdings of 

interest-sensitive investments and have purchased 

investments with extended maturities or repricing intervals must ensure that these holdings fit into their overall 

asset and liability management strategies. 

Judy Plock, Senior Financial Analyst, 

San Francisco Region 

Mike Anas, Senior Financial Analyst, Chicago Region 

David Van Vickle, Regional Manager, Chicago Region 

FDIC OUTLOOK 25 SUMMER 2004 
In Focus This Quarter 

Implications of Rural Depopulation in the Great 

Plains for Community Banks 

The United States is currently undergoing a major 

demographic event: the depopulation of a significant 

number of rural counties. This subject has been under 

review by the FDIC for a number of years. For example, an FDIC report examined rural depopulation 

trends in the Kansas City Region and concluded that 

while depopulation is a slow-moving event, it does 

have an effect on the economic viability of counties 

experiencing out-migration and on the banks operating in those counties.1 In particular, that report found 

that lack of growth was the most prominent negative 

factor affecting community banks in counties with 

declining populations. These banks reported lower 

growth rates for assets, loans, deposits, and core 

deposits than banks in growing rural counties. 

This article again examines performance trends of 

community banks located in depopulating counties.2 

However, it also attempts to identify strategies that 

some banks have employed to remain successful, 

despite the unfavorable demographic trends unfolding 

around them. The article is an excerpt of an expansive analysis of rural depopulation trends in the 

United States and rural bank performance that was 

released on May 18, 2004, as part of the FDIC’s 

Future of Banking in America 

(www.fdic.gov/bank/analytical/future). 

Depopulation Trends Are Most Pronounced in the 

Great Plains 

The analysis in this report employs a method developed by the FDIC in which counties are divided into 

categories depending on their rurality and on population trends between 1970 and 2000 (see Map 1). 

Rural counties that added population over the 30­

year span are called “growing counties”; rural counties 

that lost population at a relatively constant rate are 

called “declining counties”; and rural counties that 

not only lost population but saw the rate of loss 

increase in the 1990s are called “accelerated declining counties.” Metropolitan counties, which almost 

universally added population, were not analyzed in 

this report. 

Map 1 

Rural Depopulation Is Most Prevalent in the Great Plains 

Number of Counties 

Growing—Rural 1,390 

Declining—Rural 452 

Accelerated Declining 210 

Metropolitan 1,089 

Note: 2000 census data as compared to 1970 census data. 

The Great Plains is outlined above. 

Source: Bureau of the Census. 

1 Anderlik, John M., Jeffrey W. Walser, Christopher J. Sesler, and 2 Community banks are defined as FDIC-insured banks and thrifts with 

Troy D. Osborne, Kansas City Regional Outlook, first quarter 2000, assets of less than $250 million at year-end 2002. 

http://www.fdic.gov/bank/analytical/regional/ro20001q/kc/index.html. 

FDIC OUTLOOK 26 SUMMER 2004 
In Focus This Quarter 

As Map 1 shows, rural depopulation is most prevalent 

in the middle of the country but can also be seen in the 

South and Northeast. Our analysis in this article 

focuses on the Great Plains region (outlined in the map 

on page 26), because the problem of rural depopulation 

is far more advanced there than anywhere else in the 

country. In fact, of the 424 rural counties in the Great 

Plains region, 304 (72 percent) are either declining or 

accelerated declining counties. 

The Great Plains region is also striking from a banking 

perspective. As of year-end 2003, either declining or 

accelerated declining counties were home to more than 

500 community banks—more than half of all community banks in the Great Plains. In addition, banks in the 

Great Plains tend to be much smaller than banks located 

elsewhere. The median size of a bank in the Great Plains 

is just $56 million, and only about $39 million in rural 

counties with declining populations. Institutions in other 

depopulating areas are significantly larger—even the 

Corn Belt’s median bank has $89 million in assets— 

reflecting the fact that although other regions may also 

be experiencing depopulation, their financial institutions 

have much larger beginning customer bases. 

Table 1 

Rurality Affects Growth Rates, but Not 

Performance Measures 

Despite the demographic challenges that face the Great 

Plains, rural community banks headquartered there 

report performance measures that are in line with 

community banks located elsewhere. As Table 1 indicates, measures related to earnings and asset quality are 

very similar, and Great Plains community banks have 

considerably higher levels of equity capital. The most 

significant difference between the groups of institutions 

is the level of farm loans. Not surprisingly, community 

banks in the rural Great Plains have a far higher 

concentration of farm loans than do community banks 

in other rural areas. This leaves Great Plains’ financial 

institutions much more dependent on federal farm 

policy and vulnerable to swings in net farm income 

caused by commodity price fluctuations, persistent 

drought conditions, and unexpected impacts, such as 

the “mad cow” discovery that led to a steep drop in 

cattle prices in early 2004. A challenge rural bank 

managers continuously confront is that many rural farm 

banks have few local options with which to diversify 

their loan portfolios. 

Great Plains Rural Community Banks Perform Similarly to Those in the Rest of the Nation (%) 

2003 2002 2001 2000 1999 

GP—Pretax ROA 1.44 1.49 1.42 1.59 1.55 

Nation—Pretax ROA 1.44 1.51 1.39 1.50 1.54 

GP—Net Interest Margin 4.12 4.25 4.17 4.34 4.24 

Nation—Net Interest Margin 4.05 4.24 4.08 4.24 4.23 

GP—Loans-to-Assets Ratio 58.51 59.59 58.92 59.25 57.45 

Nation—Loans-to-Assets Ratio 61.94 62.39 63.02 64.52 63.04 

GP—Total PD Loan Ratio 2.59 2.89 2.86 2.53 2.50 

Nation—Total PD Loan Ratio 2.59 2.82 2.92 2.62 2.29 

GP—Net Charged-Off Loans 0.31 0.34 0.46 0.30 0.30 

Nation—Net Charged-Off Loans 0.30 0.33 0.31 0.23 0.22 

GP—Equity Capital 10.97 11.19 10.95 10.81 10.16 

Nation—Equity Capital 10.52 10.59 10.25 10.34 10.05 

GP—Ag Loans/Total Loans 40.33 40.68 40.84 40.35 40.81 

Nation—Ag Loans/Total Loans 13.76 13.68 13.27 13.22 13.42 

GP—Ag Inst./Total Inst. 79.97 80.08 80.44 81.22 82.21 

Nation—Ag Inst./Total Inst. 28.46 28.55 28.07 28.62 29.03 

Notes: "GP" refers to banks and thrifts with less than $250 million in assets in rural counties in the Great Plains. "Nation" refers to banks and thrifts with less than $250 million in assets in rural 

counties in the United States, excluding the Great Plains. 

Source: Bank and Thrift Call Reports. 

FDIC OUTLOOK 27 SUMMER 2004 
In Focus This Quarter 

Table 2 

Great Plains Metro Community Banks Have Grown Balance Sheets Far More 

Quickly than Rural Banks 

Annualized Growth Rate (%) between Year-End 1993 and Year-End 2003 

Great Plains County Type Total Assets Total Loans Total Deposits Core Deposits 

Metropolitan 8.87 11.16 8.61 7.87 

Rural 4.37 6.77 3.84 3.04 

Rural County Breakdown: 

Growing 4.78 6.96 4.28 3.47 

Declining 4.04 6.32 3.45 2.64 

Accelerated Declining 4.10 7.16 3.61 2.84 

Note: All growth rates are merger-adjusted. "Community banks" are as defined in this article. 

Source: Bank and Thrift Call Reports. 

In comparing community bank performance in the 

rural Great Plains, it is interesting to note that institutions in growing, declining, and accelerated declining 

counties perform similarly. Earnings measures are generally satisfactory regardless of the institution’s location, 

although institutions in growing counties have earned a 

bit more pretax revenue, largely through higher sources 

of noninterest income. Net interest margins (NIMs) are 

similar, as declining and accelerated declining county 

banks have offset lower loan yields with lower funding 

costs. Loan quality measures tend to favor growing 

county institutions moderately, but institutions in 

declining and accelerated declining counties offset this 

difference with higher levels of equity capital. 

Similarly to national comparisons, differences in farm 

loan levels exist within the Great Plains region. Growing county community banks have about 30 percent of 

all loans invested in farm loans, while community 

banks in depopulating areas average just under 50 

percent. Growing counties, which likely are adding to 

their populations through nonagricultural job growth, 

tend to offer community banks more diversified lending 

opportunities. 

Growth rates clearly show that depopulation trends 

have adversely affected community banks. Because 

declining populations translate into dwindling bases of 

potential borrowers and depositors, growth rates for 

total assets, loans, and deposits for community banks in 

declining and accelerated declining counties have been 

lower than the corresponding growth rates in growing 

counties’ financial institutions. Table 2 shows a tenyear trend of annualized growth rates for balance sheet 

accounts. The most striking point in the table is the 

politan community banks and those in rural areas. 

Across the board, the economic vibrancy of metropolitan areas has translated into higher growth rates. In 

rural areas, community banks in growing counties were 

able to increase assets, loans, and deposit accounts at a 

significantly higher rate than declining or accelerated 

declining institutions. 

Demographic Problems Have Not Yet Accelerated 

Consolidation Trends 

The number of insured banks and thrifts has been 

declining in the United States for more than two 

decades.3 Because of the large number of depopulating 

rural counties in the Great Plains region, one might 

expect that bank consolidation would have been more 

severe in that region. However, reductions in the 

number of banks in the Great Plains are similar to 

those in rural areas in the rest of the nation (see Chart 

1, next page). Perhaps surprisingly, the reduction in 

insured institutions is consistent among all three types 

(growing, declining, and accelerated declining) of 

Great Plains rural counties. 

Although consolidation trends in Great Plains rural 

community banks have been consistent with national 

figures, two trends suggest that consolidation in the 

Great Plains may increase in the future. First, the 

elderly population in depopulating counties is very 

large. At some point in the relatively near future, these 

3 For more information on bank charter declines see “The Declining 

Number of Banking Organizations: Will the Trend Continue.” FDIC 

Future of Banking Series at 

difference in the Great Plains region between metro- www.fdic.gov/bank/analytical/future/index.html. 

FDIC OUTLOOK 28 SUMMER 2004 
In Focus This Quarter 

Chart 1 

Rural Counties in the Great Plains
 

Have Shown Similar Bank Consolidation Trends
 

as the Nation
 

100
 

90
 

80
 

70
 

60
 

50
 

Source: Bank and Thrift Call Reports. Total Insured Institutions (1984 = 100)

Great Plains 

Rural Counties 

Rural Counties 

Outside the 

Great Plains 

84 86 88 90 92 94 96 98 00 02 

people are going to begin to pass away, taking a disproportionate amount of banking business with them. 

Second, many rural community banks in the Great 

Plains may lack adequate succession plans. In many 

cases, when the owner/operators of these institutions 

retire, no family members are ready to take their 

places, because the younger relatives have long since 

migrated to counties with more economic opportunities. And because of the shortage of young professionals in rural areas, no qualified nonfamily members may 

be available to take over the operations. In such cases, 

owner/operators may simply continue working well 

into their retirement-age years. When these bankers 

finally do retire, their institutions may be sold, which 

could increase the pace of rural bank consolidation. 

What Strategies Can Help Rural Community Banks 

Remain Successful? 

often used as an indicator of success, although some 

banks can achieve success in other metrics (such as 

profitability) without significant growth. For this 

analysis, growth is measured by the five-year annualized asset growth rate, adjusted to negate the effects 

of mergers. 

Among the 483 banks studied, profitability and 

growth performance differed significantly from bank 

to bank. Annualized profitability ranged from a low 

of –1.07 percent to a high of 3.53 percent, with the 

middle 80 percent of banks in the range of 0.62 

percent to 2.10 percent. Annualized asset growth 

ranged from –11.71 percent to 79.65 percent, with 

the middle 80 percent of banks falling between –0.51 

percent and 9.04 percent. 

To analyze relatively high- and low-performing institutions, each of the two metrics was divided into 

thirds, creating a nine-cell matrix (see Table 3, next 

page). The corner cells contain summary analyses for 

the 203 banks at the upper and lower levels of both 

performance metrics. The other 280 institutions, 

which fall into the middle range, are lumped into a 

single unit, the Middle Cross, and used as a control 

group for the analysis. 

In looking at the data for the corner banks, one 

might ask, for example, about the successful business 

strategies of the 49 community banks in the upper 

right-hand corner (those that reported high asset 

growth and high profitability). By contrast, why do 

the 61 institutions in the lower left-hand corner 

report both low growth and low profitability? The 

other corners indicate institutions that were able to 

achieve high profits despite low growth and those 

that reported high growth but low profits. 

While many counties in the Great Plains face similar 

economic issues, community banks in the region have 

responded differently and reported disparate operating results. Two metrics— profitability and growth— 

were used to try to identify common strategies 

employed by the more successful rural banks. Most 

analysts would agree that profitability is an appropriate measure of success. For the purposes of this analysis, profitability is measured by the five-year pretax 

return-on-assets (ROA) ratio.4 Asset growth is also 

4 Pretax ROA is used in lieu of after-tax ROA, because some institutions have adopted Subchapter S status, in which they do not pay 

income taxes and thus have a much higher after-tax ROA than nonSubchapter S institutions. 

Briefly, here are the reasons for the widely disparate 

performances of community banks in the corners of 

the matrix: 

Low-growth/high-earnings banks. These institutions 

have maintained a high level of profitability in the 

absence of asset growth by controlling operating costs 

extremely well. Seventy percent of these banks operate 

a single (albeit likely large) banking office, which helps 

keep costs down. Lending activity and capital levels 

also suggest effective management strategies. 

High-growth/high-earnings banks. These banks tend 

to be larger (as Table 3 shows, the median bank in 

FDIC OUTLOOK 29 SUMMER 2004 
In Focus This Quarter 

Table 3 

Have Some Great Plains Community Banks Found a Recipe for Success? 

Low Asset Growth/High Pretax ROA 

Number of Institutions 44 

Median Total Assets $41.2MM 

Asset Growth Rate 0.56% 

Pretax ROA 1.90% 

High Asset Growth/High Pretax ROA 

Number of Institutions: 49 

Median Total Assets $54.8MM 

Asset Growth Rate 7.47% 

Pretax ROA 1.96% 

Low Asset Growth/Low Pretax ROA 

Number of Institutions 61 

Median Total Assets $21.5MM 

Asset Growth Rate –0.80% 

Pretax ROA 0.64% 

High Asset Growth/Low Pretax ROA 

Number of Institutions 49 

Median Total Assets $37.5MM 

Asset Growth Rate 9.10% 

Pretax ROA 0.76% 

(11.71)% to 1.91% 1.91% to 4.88% 4.88% to 79.65% 

Five-Year Annualized Growth Rate Range 

Middle Cross 

Number of Institutions: 280 

Median Total Assets $40.4MM 

Asset Growth Rate 3.99% 

Pretax ROA 1.44%

Five-Year Annualized Pretax ROA Range

(1.07)% to 1.05% 1.05% to 1.57% 1.57% to 3.53% 

Notes: 1. Asset growth figures are merger-adjusted, asset-weighted, annualized five-year growth rates. 

2. Pretax ROA figures are for merger-adjusted, asset-weighted, annualized five-year pretax return-on-asset performance. 

3. A total of 483 institutions analyzed above met the following descriptives: 

a. as of December 31, 2003, had total assets of $250 million or less; 

b. were established on December 31, 1993, or earlier; 

c. were headquartered in rural counties within the Great Plains region with either a declining population or an accelerated declining population. 

Source: Bank and Thrift Call Reports. 

this group is the largest in the matrix), allowing them 

to control operating costs through scale efficiencies. 

They achieved the highest NIMs by maintaining 

reasonable funding costs and maximizing loan 

volumes in relation to total assets. Many banks in 

this group have branches in metropolitan areas or 

growing rural counties, which helps explain why 

they have been able to achieve higher than average 

asset growth. 

Low-growth/low-earnings banks. These institutions 

are the smallest, with a median asset size of just $21.5 

million. They report by far the lowest NIMs of any 

group, have not controlled costs well, and have significantly higher levels of past-due loans than the other 

groups. Nearly two-thirds of these institutions operate a 

single banking office. 

High-growth/low-earnings banks. Like highgrowth/high-earnings banks, these institutions have 

aggressively pursued growth through branching activities but without the earnings success. These banks 

report lower than average NIMs coupled with the highest operating costs of any group. 

One strategy bankers are pursuing is branching activity. 

Because community banks in depopulating counties 

have declining customer bases, many institutions have 

turned to branching in more economically vibrant areas 

to attract new loan and deposit customers. Many institutions that have achieved high asset growth have 

adopted this strategy (see Table 4, next page). 

However, banks have had varied success in pursuing 

their branching strategies. A case can be made that 

FDIC OUTLOOK 30 SUMMER 2004 
In Focus This Quarter 

Table 4 

Community Banks with High Growth Are More Likely to Have Branched into Metropolitan 


Areas or Counties with Growing Populations
 

Multibranch with 

Multibranch with Multibranch No Metro County 

Multibranch— Only Depop­ with but with 

Matrix Total Unit All Branches ulating County Metro County Growing County 

Category Institutions Bank % in HQ County % Branch(es) % Branch(es) % Branch(es) % 

High Growth/
 

High Earnings 49
 19 39 7 14 11 22 3 6 9 18 

Low Growth/ 

High Earnings 44 31 70 9 20 3 7 1 2 0 0 

High Growth/ 

Low Earnings 49 17 35 8 16 11 22 8 16 5 10 

Low Growth/ 

Low Earnings 61 40 66 12 20 3 5 3 5 3 5 

Middle Cross 280 150 54 39 14 43 15 25 9 23 8 

Totals 483 257 53 75 16 71 15 40 8 40 8 

Sources: Bank and Thrift Call Reports (dated December 31, 2003); FDIC Summary of Deposits (dated June 30, 2003, for branch data). 

branching into metropolitan and growing rural counties was a primary factor in high-growth/highearnings banks’ success, as nearly one-quarter of those 

banks have done so. By contrast, just 10 percent of 

low-growth/low-earnings banks have branched into 

more economically vibrant counties. 

On the other hand, branching can be somewhat of a 

risky proposition, depending on management’s knowledge of new markets, expertise in new types of lending activities, and ability to control expenses. Nearly 

half of the high-growth/low-earnings banks operate 

branches outside their home county, which may 

suggest that these banks’ strategies may not have 

been as successful as those of the high-growth/highearnings banks. However, about 22 percent of the 

high-growth/low-earnings banks that branched did so 

into other depopulating rural counties, which may 

have adversely affected their earnings prospects. 

What Does the Future Hold for Great Plains Rural 

Community Banks? 

Continuing depopulation in many rural areas of the 

Great Plains will pose challenges for community banks. 

Community bank consolidation in the Great Plains has 

yet to outpace that in other rural areas in the nation, but 

the aging of the customer base and of bank managers and 

owners could result in increased consolidation. 

In the meantime, strategic options available to 

community banks in depopulating counties are somewhat limited. In the short term, community bank 

success in rural areas could depend on management’s 

willingness to take well-conceived risks, such as 

branching into more economically vibrant areas. 

However, management teams should ensure that they 

have the expertise to branch without unduly increasing their institutions’ risk profiles. Another viable 

strategy may be to streamline their institutions, 

cutting costs wherever possible to compensate for the 

absence of local growth opportunities. 

Technology, such as the Internet, coupled with the 

spread of broadband access into rural areas, potentially 

holds some promise for depopulating counties and their 

banks. In theory, the Internet could enhance the ability 

of farmers, rural customers, and rural businesses to access 

information, goods, and services, possibly increasing the 

economic viability of rural areas. Companies could 

locate their businesses in rural areas, taking advantage of 

lower labor and land costs, while marketing their products to geographically dispersed end users, creating a 

“bridge from” rural communities to other areas. 

However, technology and the Internet may be a 

double-edged sword, allowing larger banks and financial companies to create a “bridge to” rural communities by offering their products in areas where it is not 

feasible to locate a physical branch. Because larger 

financial organizations typically have a wider array of 

FDIC OUTLOOK 31 SUMMER 2004 
In Focus This Quarter 

products than rural banks, and their size allows them 

some scale benefits in the cost of providing banking 

services, they may become very formidable competitors of rural institutions as the Internet becomes 

increasingly diffused in rural areas.5 

On a positive note, rural depopulation has been occurring over a long period, which has given bank manage5 Walser, Jeffrey, The Information Superhighway: Panacea or Threat 

for Rural America? Kansas City Regional Outlook, third quarter 2002, 

http://www.fdic.gov/bank/analytical/regional/ro20023q/kc/index.html. 

ment and owners time to react to and manage the 

issue. Rural bank managers should continue to monitor 

the situation and develop business plans accordingly. 

The FDIC will also continue to monitor and analyze 

rural depopulation trends and their effects on banking. 

John M. Anderlik, CFA, Regional Manager 

Richard D. Cofer, Senior Financial Analyst 

FDIC OUTLOOK 32 SUMMER 2004 
In Focus This Quarter 

The FDIC Outlook is published quarterly by the Division of Insurance and Research of the Federal Deposit 

Insurance Corporation as an information source on banking and economic issues for insured financial 

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The views expressed in the FDIC Outlook are those of the authors and do not necessarily reflect official 

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of this publication was obtained from publicly available sources that are considered reliable. However, the 

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Corporation. 

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and Research 

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FDIC OUTLOOK 35 SUMMER 2004

In Focus This Quarter

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