Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1998 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Gary C. Zimmerman,
 

Regional Economist
 

Millen L. Simpson,
 

Financial Analyst
 

In Focus This Quarter 

◆ Merger and Acquisition Activity in the U.S. Banking Industry: 

Trends and Rationale—The size and value of recent mergers and acquisitions 

(M&A) in the banking industry have received much attention, yet the activity is a 

continuation of a longer-term trend and is one aspect of a broader national and global wave of business mergers. For banks, deregulation, competitive pressures, market 

valuations, synergistic opportunities, technology, globalization, and managerial 

incentives are among important drivers of the trend. By identifying the rationale and 

incentives for bank M&A activity, industry participants can better understand and 

evaluate the risks and challenges facing merged institutions. See page 5. 

By Steven E. Cunningham, John F. Sherman 

◆ Risks and Challenges for Consolidating Institutions—M&A activity 

creates significant challenges for bank managers, including combining management 

teams, integrating technology, realizing the benefits of diversification, and maximizing operating economies. As premiums paid in bank M&A deals have escalated, 

some industry observers have questioned whether the promised benefits of the transactions can be realized. Institutions in the process of integrating an acquired entity 

may be especially vulnerable to a downturn in the economy. See page 11. 

By John F. Sherman 

◆ Industry Consolidation Presents Unique Risks and Challenges for 

Community Banks—Industry consolidation has created competitive challenges 

for small banks and highlights traditional obstacles related to operating scale and 

scope. Aside from merging with or selling to competitors, some small banks are 

addressing consolidation challenges by outsourcing business functions, expanding the 

use of nondeposit funding sources, partnering with other banks and nonbanks, capitalizing on personalized service, and focusing on niche markets. While these adaptive 

strategies may help community banks meet the challenges of industry consolidation, 

they potentially complicate these institutions’ operations and risk profiles. See page 14. 

By Steven E. Cunningham 

Regional Perspectives 

◆ Region’s Economic and Banking Conditions—Economic growth in the 

San Francisco Region continues to outperform the nation...several factors have 

begun to slow growth...including the ongoing effect of the Asian crisis...and a series 

of economic shocks in the summer that have dampened consumer expectations...despite the slower job growth, the Region’s insured financial institutions are 

reporting strong earnings and solid asset quality. See page 19. 

◆ Consumer Credit Portfolios Face Challenges—A recent spurt in household spending was supported partly by the restructuring of existing debt and the 

assumption of additional debt...such actions have had implications for not only 

credit quality but also the composition of loan portfolios in the Region’s institutions...in this environment, lenders may want to continue monitoring not only 

underwriting standards, growth in their consumer portfolios, and gain-on-sale 

assumptions but also pricing and reserve levels for subprime loans. See page 20. 

By Catherine I. Phillips-Olsen, Gary C. Zimmerman, Millen L. Simpson 

A Publication of the Division of Insurance 
The Regional Outlook is published quarterly by the Division of Insurance of the Federal Deposit 

Insurance Corporation for the following eight geographic regions: 

Atlanta Region (AL, FL, GA, NC, SC, VA, WV)
 

Boston Region (CT, MA, ME, NH, RI, VT)
 

Chicago Region (IL, IN, MI, OH, WI)
 

Dallas Region (CO, NM, OK, TX)
 

Kansas City Region (IA, KS, MN, MO, ND, NE, SD)
 

Memphis Region (AR, KY, LA, MS, TN)
 

New York Region (DC, DE, MD, NJ, NY, PA, PR, VI)
 

San Francisco Region (AK, AZ, CA, FJ, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY)
 

Single copy subscriptions of the Regional Outlook can be obtained by sending the subscription 

form found on the back cover to the FDIC Public Information Center. Contact the Public Information Center for current pricing on bulk orders. 

The Regional Outlook is available on-line by visiting the FDIC’s website at www.fdic.gov/ 

publish/regout. For more information or to provide comments or suggestions about the San 

Francisco Region’s Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 974-4247 or 

send an e-mail to cphillips-olsen@fdic.gov. 

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

official positions of the Federal Deposit Insurance Corporation. Some of the information used in 

the preparation of this publication was obtained from publicly available sources that are considered 

reliable. However, the use of this information does not constitute an endorsement of its accuracy by 

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Publications Manager Teresa J. Franks 
To the Reader:
 

The Regional Outlook is intended to enhance readers’ understanding of risks and trends affecting FDIC-insured
 

institutions. The editorial staff welcomes the comments of any reader who is willing to take a few minutes to
 

complete the attached survey. Return the survey in the enclosed envelope or fax to (202) 898-8636.
 

You may also access the survey through the FDIC Internet site at www.fdic.gov. FDIC employees may take the
 

survey via the DOI homepage on the FDICnet.
 

All feedback is confidential. Thank you for your time and thought.
 

Sincerely,
 

George French 

Executive Editor 

The Regional Outlook has three In Focus articles that address national issues and a Regional Perspectives article 

that analyzes the economic and banking conditions in each of the eight FDIC supervisory regions. 

0 

No 

Opinion 

1 

Strongly 

Disagree 

2 

Disagree 

3 

Agree 

4 

Strongly 

Agree 

1 The In Focus articles improve my understanding of risks 

affecting the financial institutions of interest to me. 

2 The Regional Perspectives article improves my understanding 

of risks affecting the financial institutions of interest to me. 

3 The Regional Perspectives article is relevant to my geographic 

area of interest. 

4 How would you prefer the geographic boundaries be delineated? 

by the FDIC’s eight supervisory regions—Atlanta, Boston, Chicago, Dallas, Kansas City, Memphis, 

New York, and San Francisco (current format) 

by a smaller geographic location, such as ______________________________________________________ 

by a larger geographic boundary, such as ______________________________________________________ 

5 The length of the In Focus section is 

just right too long too short 

6 The length of the Regional Perspectives article is 

just right too long too short 

7 What other topics would you like to see in future editions? 

8 Additional comments and suggestions 

9 I am affiliated with: 

FDIC Financial institution 

Federal regulatory agency (non-FDIC) State banking department 

Other __________________________________________________________________________________ 
In Focus This Quarter
 

Merger and Acquisition Activity in the U.S. Banking
 

Industry: Trends and Rationale
 

•	 The size and value of recent mergers and acquisitions in the banking industry have received much 

attention, yet the activity is a continuation of a 

longer-term trend and is one aspect of a broader 

national and global wave of business mergers. 

•	 Deregulation, competitive pressures, market valuations, synergistic opportunities, technology, globalization, and managerial incentives are among 

the important drivers of bank merger and acquisition activity. 

•	 By identifying the rationale and incentives 

for bank merger and acquisition activity, industry participants can better understand and evaluate the risks and challenges facing merged 

institutions. 

Merger and acquisition (M&A) activity among banking 

companies is changing the industry’s structure. The 

number of insured commercial banks in the United 

States, which held relatively steady during the FDIC’s 

first 51 years of existence, has declined by one-third 

since year-end 1984, resulting in just under 9,000 commercial banks at the end of the second quarter of 1998. 

The number of banking organizations (bank holding 

companies, independent banks, and thrifts) also has 

declined precipitously since the mid-1980s. 

The recent flurry in M&A activity by banking companies has attracted significant attention as the magnitude 

of transactions has escalated. As shown in Chart 1, the 

announced values of bank mergers have increased 

sharply in recent years. However, increased consolidation activity is not unique to the banking industry: The 

United States is now experiencing the fifth major wave 

of business M&A in this century, which is in turn part 

of an unprecedented level of worldwide M&A activity. 

According to data from Mergerstat, the value of M&A 

deals announced for all U.S. industries during the first 

half of 1998, measured both absolutely and as a percentage of nominal gross domestic product, exceeded 

the value of announced transactions for any full calendar year on record. 

The factors that have contributed to this activity, including the availability of capital, technological change, and 

CHART 1 

Values of Announced Bank Mergers 

Increased Sharply during 1998 

450 $250 

400 

350 $200 

300 

250 $150 

200 

$100 

150 

100 $50 

50 

0 

Number of Announced

 Deals (left axis) 

Total Announced 

Deal Values (right axis) 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 

($ Billions) 

Year 

Source: SNL Securities 

globalization, are particularly important to the banking 

industry. Indeed, according to data from SNL Securities, the announced values of banking M&A have 

accounted for roughly one-third of all U.S. merger 

activity for the first half of 1998, exceeding any full calendar year percentage since the data have been collected (1989). This article will briefly describe the factors 

that are driving M&A activity in banking. 

Why Are Banks Merging? 

Deregulation 

Historically, state regulations and boundaries dictated 

the structure of commercial banking in the United 

States. Not until the 1980s did most states remove or 

substantially relax intrastate branching restrictions. 

Subsequently, the Riegle-Neal Interstate Banking and 

Branching Act removed most remaining restrictions to 

interstate expansion—restrictions that had been significantly liberalized by a 1985 U.S. Supreme Court decision (Northeast Bancorp v. The Board of Governors of 

the Federal Reserve System) that upheld the ability of 

states to reduce restrictions on entry by out-of-state 

holding companies.1 As recently as January 1994 only 

10 commercial banks owning 30 branches operated 

across state lines. By early 1998, 165 institutions owned 

12,694 interstate branches.2 

1 “Interstate Banking—The Past, Present and Future,” FDIC Banking
 

Review, Fall 1996.
 2 Figures provided by the FDIC’s Division of Research and Statistics.
 

San Francisco Regional Outlook 5	 Fourth Quarter 1998 
In Focus This Quarter
 

There is some evidence that the recent increase in 

expansion and branching opportunities arising from 

deregulation has led to improved efficiencies and profitability, both from M&A activity and from intracompany consolidation of bank subsidiaries by 

multibank holding companies. In addition, the recent 

easing of Federal Reserve Board restrictions governing 

Section 20 securities underwriting subsidiaries of bank 

holding companies and favorable bank operating subCHART 2 

Commercial Bank Profitabilty Has Improved 

While Revenue Growth Rates Are Declining 

14 

12 

10 

Percent 

8 

6 

1940s 1950s 1960s 1970s 1980s 1990s 

sidiary rule interpretations by the Office of the Comptroller of the Currency have made expansions into new 

lines of business and mergers across financial sectors 

more feasible. For example, according to data provided 

by SNL Securities, since the beginning of 1997, 47 

banking companies have purchased investment banking 

units, investment advisors, or broker-dealers. 

Increasing Competition 

Significant changes in the competitive environment also 

have contributed to the trend in bank M&A activity. 

One way to consider competition in an industry is 

through the “industry life cycle” framework. In this 

framework, an industry is generally categorized into 

one of four stages—start-up, rapid growth, mature, or 

decline. In each stage, firms are likely to take certain 

actions in response to the competitive environment. As 

discussed below, banking best fits the criteria for an 

industry in the mature stage. These criteria include 

declining revenue growth, improving profitability, 

increasing competition, and a shortage of investment 

opportunities relative to the amount of capital being 

generated. 

As shown in Chart 2, over the long term, commercial 

banks have experienced the declining trend in revenue 

growth and the improving trend in profitability that 

characterize a mature industry. The average annual revenue growth rate by decade, adjusted for inflation, has 

declined since the 1960s. Profitability, as measured by 

the average annual return on equity by decade, has 

steadily improved since the 1940s, with the exception of 

the crisis period of the 1980s. 

Competition in a mature industry often intensifies as 

competitors focus on sustaining market share as revenue growth rates slow. In banking, recent changes in 

the operating environment have stimulated a dramatic 

increase in competition. Specifically, barriers to entry 

into the industry have fallen: Capital is plentiful, experienced managerial talent is available (as a result of the 

many mergers), and regulatory restrictions have been 

relaxed. Technological and financial innovations also 

4
 

2
 

0
 

Return on Equity Revenue Growth (Inflation Adjusted) 

Source: FDIC Historical Statistics on Banking 

are influencing how banks compete by enabling them to 

manage disparate operations with broader product 

arrays more efficiently. Moreover, as a result of intensifying nonbank competition and continuing evolution in 

distribution systems, some banking services have come 

to resemble commodities. Consequently, brand loyalty 

appears to be declining and banks are experiencing 

reduced influence over pricing. 

The final criterion for a mature industry, a shortage of 

investment opportunities relative to the level of capital 

being generated (“excess capital”), as discussed below, 

has become an obstacle for banks. Although generating 

and retaining capital increase the level of protection 

from insolvency risk for depositors and the FDIC, rising capital levels without a corresponding increase in 

profitability reduce returns on equity and, thus, returns 

to shareholders. Attempts to increase assets relative to 

equity capital in an industry with excess capital also 

can be undesirable because competition drives the yield 

on available investments to levels that either dilute current earnings or fail to compensate adequately for the 

amount of risk taken. (See “Bank Earnings: Competitive Pressures and Risks,” Regional Outlook, Fourth 

Quarter 1997.) Alternatives for managing capital in 

such an environment include dividends, share repurchases, and M&A transactions; banks have pursued all 

three. 

Commercial bank cash dividend payments have reached 

record levels in the 1990s. In fact, the level of earnings 

retained over the past two years (26 percent in 1996 and 

28 percent in 1997) was the lowest during a noncrisis 

period since the FDIC’s inception (see Chart 3). A large 

percentage of these dividend payments is made to bank 

San Francisco Regional Outlook 6 Fourth Quarter 1998 
In Focus This Quarter
 

CHART 3 

Commercial Banks Are Retaining a Smaller Share 

of Earnings than during Any Other Profitable Period 

35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 

Year 

Note: Negative 285 percent rate in 1987 shown as zero. 

Source: FDIC Historical Statistics on Banking 

$ Billions

Percent 

Percent of Earnings Retained (left axis) 

Cash Dividends Declared (right axis) 

80 

70 

60 

50 

40 

30 

20 

10 

0 

45 

40 

35 

30 

25 

20 

15 

10 

5 

0 

holding companies, which, in turn, use the funds to 

repurchase common stock—another means of reducing 

book capital, increasing financial leverage, and improving return on equity. According to data compiled by 

Keefe, Bruyette & Woods, Inc., share repurchases by the 

top 25 banking organizations increased in each quarter 

during 1995 and 1996 and reached an all-time high of 

$11.5 billion in the first quarter of 1997, but have 

declined steadily since then. There are at least two likely reasons for this trend. First, the continued escalation 

in share prices through the first half of 1998 made 

repurchases more expensive. Second, as share prices 

increase, the “pooling of interests” method of accounting for a merger becomes more attractive; however, it 

carries certain Securities and Exchange Commission 

restrictions on share repurchases both before and after 

the transaction. Therefore, as values rise, institutions 

considering future mergers are less likely to initiate 

repurchase programs. 

The third capital management alternative, M&A, offers 

potential benefits to both parties to the transaction. 

M&A may permit acquirers to deploy excess capital 

while improving earnings through operating and financial economies, diversification of revenues and 

geographic exposures, and greater management 

expertise. M&A also can provide 

access to new products—a common objective of competitors in 

mature industries. For institutions 

acquired through a purchase transaction in which ownership rights 

are relinquished, mergers provide 

a means of returning capital to 

shareholders rather than attempting to remain independent in an increasingly competitive environment. 

Market Valuations 

The increased market values commercial banking companies have experienced through the first half of 1998 

played a major role in recent M&A activity, as common 

stock increasingly has been used as “currency” in transactions, especially the largest mergers. More valuable 

stock allows banks to issue fewer shares to execute 

mergers, which reduces the potential dilutive effects to 

shareholders. Through mid-April 1998, the amount of 

cash used to fund all U.S. business mergers (13.4 percent) had reached the lowest point in ten years.3 Similarly, the aggregate cash amount of announced bank 

deal values through the first half of 1998 was less than 

1 percent and reflects a steady decline since 1994. There 

appears to be a strong relationship between bank stock 

valuations and the level of cash committed in bank 

M&A activity since 1991 (see Chart 4), although this 

relationship is obviously influenced by large, stockbased mergers. 

Record earnings, positive market assessments of earnings quality and stability, and continued consolidation 

expectations sparked the upward trend in bank stocks 

through June 1998. The value of the SNL Bank Index, 

which is composed of publicly traded banking companies, quadrupled between January 1990 and June 1998 

and far outstripped gains in the broader S&P 500 over 

the same period. The result was a rise in bank stock 

prices as a multiple of earnings per share (the price3 As reported by the Wall Street Journal, April 16, 1998, p. C1. 

CHART 4 

5 

10 

15 

20 

25 

30 

’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 

SNL Bank Index 

Price-Earnings Ratio* Percentage of 

Cash Used in 

All Bank M&A 

* Price-Earnings Ratio = stock price of index members to previous 12 months’ 

earnings weighted by market capitalization. 

Source: SNL Securities 

As Market Valuations Have Increased, 

Cash Usage in Bank Mergers Has Declined 

Price-Earnings Ratio,

% Cash 

0 

Year 

San Francisco Regional Outlook 7 Fourth Quarter 1998 
In Focus This Quarter
 

earnings ratio) both absolutely and relative to the S&P 

500. For example, according to the price-earnings ratio 

for the SNL Bank Index, at year-end 1994, investors 

paid $9.76 per dollar of bank earnings; on June 30, 

1998, investors paid $22.88 per dollar of earnings. Over 

the same period, the price-earnings ratio of the SNL 

Bank Index relative to the S&P 500 increased from 65 

percent to 79 percent. 

From a corporate finance perspective, firms create 

wealth for shareholders by generating returns on invested long-term debt and equity capital that exceed their 

combined cost. Since long-term debt is used less in 

banking than in other industries, Credit Suisse/First 

Boston uses return on equity less the cost of equity capital as a proxy for measuring wealth generation by 

banks.4 As shown in Chart 5, over the long term, 

increases in the price-earnings ratio for banks relative to 

that for the S&P 500 tends to track with the banking 

industry’s ability to generate returns on equity in excess 

of the cost of equity capital. Through 1997, high levels 

of industry profitability, low market interest rates, and 

market expectations of more stable long-term industry 

earnings had driven the spread between the return on 

and cost of equity capital to unprecedented levels. 

Following the strong performance through the first half 

of 1998, the SNL Bank Index lost 21 percent of its value 

during the third quarter of 1998 (all during the month of 

August) because of concerns about corporate earnings, 

international exposures, the flat yield curve, and the ability of banking companies to expand market-sensitive 

4 “Value-Based Analysis of Banks,” Credit Suisse/First Boston, Equity Research—Americas, June 4, 1998. 

CHART 5 

revenues. Over the same period, the S&P 500 declined 

only 10 percent. Likely in response to relatively poor 

stock market conditions, only 75 bank mergers were 

announced during the third quarter of 1998— a 30 percent decline from the second quarter—with over half 

announced during July. According to SNL Securities, 

only 32 bank mergers were announced in August and 

September 1998, the lowest number for any two-month 

period since March and April 1997, when 31 mergers 

were announced. The August 1998 decline in the SNL 

Bank Index was the largest monthly decline since a 7 

percent drop in March 1997. In addition, the average 

price-earnings ratio for the index relative to the S&P 500 

during third-quarter 1998 was the lowest in eight quarters. Consistent with the aforementioned relationship 

between bank stock valuations and the level of cash committed to bank M&A activity, the amount of cash committed to mergers in September increased significantly. 

Synergistic Opportunities 

A primary motive for M&A activity is to increase the 

value of the combined company by creating synergies. 

In other words, through some combination of cost cutting and revenue growth, M&A can produce additional 

wealth for shareholders of the combined company 

beyond what the companies operating independently 

could generate. Although each transaction has unique 

characteristics, most bank M&A generate additional 

value from some combination of operating economies, 

diversification of revenues and geographic exposures, 

financial economies, and transfer of management 

expertise. 

Operating economies are achieved by eliminating overlapping administrative functions and infrastructure as 

San Francisco Regional Outlook 8 Fourth Quarter 1998 

Bank Stock Values Relative to the Broader Market 

Reflect Ability to Generate Equity Returns in Excess of Costs 

0 

20 

40 

100 

120 

–14.0 

–12.0 

–10.0 

–8.0 

–6.0 

–4.0 

–2.0 

0.0 

2.0 

4.0 

80 

60 

Year 

’55 ’58 ’61 ’64 ’67 ’70 ’73 ’76 ’79 ’82 ’85 ’88 ’91 ’94 ’97 

Return on Equity Less Estimated Cost of Equity (right axis) 

Bank Price-Earnings Ratio Relative to S&P 500 (left axis) 

Source: Credit Suisse/First Boston Percent

Percent 
In Focus This Quarter
 

well as by using existing distribution networks to crosssell products and services to generate revenue gains. 

However, the degree to which these benefits materialize 

will depend on the specific characteristics of the merger partners and their markets. For example, a review of 

48 banking company mergers from 1995 through the 

first half of 1998, where the seller held more than $1 

billion in assets, revealed estimated cost savings that 

increased with the degree of market overlap (see Chart 

6). Expected cost savings should translate into an 

increase in a firm’s value. This appears to be the case in 

this sample, as the median price paid by acquirers as a 

multiple of the target’s previous 12 months’ earnings 

increased with the level of expected cost savings. 

Although perceived cost savings have contributed to 

bank M&A activity, whether the gains actually materialize hinges on execution, as discussed in “Risks and 

Challenges for Consolidating Institutions” in this 

issue. 

Whereas mergers in overlapping markets provide 

opportunities for cost cutting, value creation from revenue enhancements is more likely to materialize in 

M&A transactions across markets and industries. Such 

mergers can be expected to lead to increased diversification of revenues and geographic exposures. These 

expectations may be driving the recent trend in acquisitions of investment banking units and brokerage houses 

by banking companies. As traditional interest-spread 

income has stagnated, many institutions have focused 

on expanding noninterest sources of revenue. At June 

30, 1998, noninterest income made up 40 percent of net 

operating revenue (net interest income plus noninterest 

income) for all commercial banks, compared with only 

25 percent in 1984. Similarly, geographic expansion can 

CHART 6 

In-Market Overlapping Out-of-Market 

Median Estimated 

Cost Savings (left axis) 

Estimated Cost Savings and Pricing for Bank 

Mergers Are Tied to the Degree of Market Overlap 

Source: SNL Securities 

Multiple of Median Price Paid by 

Acquirer to Seller’s Previous 

12 Months Earnings (right axis) 

0% 

5% 

10% 

15% 

20% 

25% 

30% 

35% 

40% 

16 

17 

18 

19 

20 

21 

22 

reduce a firm’s dependency on local, undiversified 

economies. Supporting this notion, a May 1998 working paper by the Federal Reserve Bank of Philadelphia 

found that economic benefits are strongest for banks 

engaged in interstate expansion, especially for mergers 

that diversify macroeconomic exposures.5 

As an institution’s size increases through M&A activity, 

financial economies may result from greater access to 

nondeposit funding alternatives as well as traded and 

over-the-counter off-balance-sheet financial instruments. As of June 30, 1998, commercial banks with 

assets less than $1 billion funded approximately 80 percent of assets with domestic deposits, compared with 

roughly 50 percent for commercial banks with assets 

greater than $1 billion—reflecting how funding flexibility and accessibility increase with scale. Access to 

money and capital markets is enhanced for larger institutions through potentially lower transaction costs and 

increased coverage by securities analysts and rating 

agencies. For the same reasons, large banks are also the 

primary users of off-balance-sheet financial derivatives. 

Differences in the ability of managers to operate institutions efficiently may also provide impetus for acquisitions. As Federal Reserve Board Chairman Alan 

Greenspan noted in recent testimony, “there are considerable differences in the cost efficiencies of banks 

within all bank classes, implying that there is substantial potential for many banks to improve efficiency of 

their operations, perhaps through mergers.”6 Thus, 

managers of more efficient banks may acquire less 

efficient competitors in an attempt to increase the latters’ value through improved management. As shown in 

Chart 7 (next page), the efficiency ratios7 of bank holding companies improved significantly from 1987 to 

1997. However, continued disparities in efficiency 

among companies, as reflected by the upward slope of 

the lines in Chart 7, may offer additional opportunities 

for M&A activity. 

Technology and Globalization 

The application of technology to nearly every aspect 

of banking offers the potential for more streamlined 

oversight, management, and evaluation of far-flung 

5 The Dollars and Sense of Bank Consolidation, Working Paper No.
 

98-10,The Federal Reserve Bank of Philadelphia.
 

6 Testimony before the Committee on the Judiciary, U.S. Senate, June
 

16, 1998.
 

7 The efficiency ratio is calculated by dividing noninterest expense by
 

the sum of net interest income and noninterest income. The ratio can
 

be interpreted as the cost to generate each dollar of revenue.
 

San Francisco Regional Outlook 9 Fourth Quarter 1998 
In Focus This Quarter
 

CHART 7 

100% 

80% 

60% 

40% 

20% 

Efficiency Ratios* 

Most Efficient 

Institution 

* The efficiency ratio is noninterest expense divided by the sum of net interest 

income and noninterest income. 

Bank Efficiency Has Improved, but Differences 

among Institutions May Provide Merger Incentives 

Bank Holding Companies Continuously Operating from 1987 to 1997 

Least Efficient 

Institution 

Source: Federal Reserve Board Y-9 Reports, adapted from an analysis 

by McKinsey & Company. 

1987 

1997 

operations both domestically and internationally. 

Consequently, technology can facilitate merger activity. 

Moreover, some insured institutions may turn to mergers with compliant partners as a solution to Year 2000 

computer problems. 

In a June 1997 speech to the Institute for International 

Economics, Deputy Treasury Secretary Lawrence Summers credited information and communication technologies as a contributing factor to the trilliondollar-a-day volume of cross-border capital flows.8 

Although the number of insured branches of foreign 

banks and the number of foreign offices of insured 

domestic banks have both declined in recent years, 

increasingly interconnected financial markets, firms, 

and customers have heightened the potential for competition across borders and continents. 

The scale, scope, and structure of many foreign competitors may promote combinations by U.S. institutions 

looking to enhance competitiveness in the global arena. 

Approval of proposed large mergers announced in early 

1998 will elevate several U.S. banking companies to 

banking’s global elite in terms of assets and market capitalization. Mergers among large European financial 

institutions in anticipation of the European economic 

and monetary union may spur U.S. multinational banks 

to consider strategic mergers across financial sectors. 

8 “Promoting Global Financial Stability: The G-7 Agenda,” delivered 

to the Institute for International Economics, June 12, 1997. 

Management Incentives 

Other factors that may drive M&A activity are related to 

managers’ compensation, special reward structures, and 

job security. Industry observers have noted that executive salaries are highly correlated with company size 

and revenues. Some analysts have noted that compensation of bank executives rises as assets expand, regardless of the source of the expansion. Bear, Stearns & 

Company opined in June 1998 that bank mergers would 

continue partly because “executive compensation in 

banking is correlating more with asset size than with 

any other financial performance measure.” 

Special reward structures also may influence acquisition programs. Large salary increases and special merger bonuses have been observed recently for executives 

of large acquiring banking companies. Amassed stock 

holdings and options may offer significant wealth for managers who 

decide to sell. Additionally, managers may take actions to lessen the 

likelihood of takeover and the corresponding probability of job loss. 

Such defensive managers may 

undertake acquisitions to avoid having their own banks targeted for 

purchase. 

Summary and Conclusions 

By identifying the rationale and incentives for bank 

M&A activity, regulators and industry participants can 

better understand and evaluate the risks and challenges 

facing merged institutions. The recent wave of banking 

industry M&A activity has been stimulated by a number 

of factors, including deregulation, increasing competition, market valuations, synergistic opportunities, technology and globalization, and management incentives. 

Although the pace of M&A activity may slow in the 

short term due to such factors as a stock market downturn or concern about Year 2000 implementation issues, 

the presence of multiple drivers will likely extend the 

consolidation trend well into the future. 

Steven E. Cunningham, CFA, Senior Financial Analyst 

scunningham@fdic.gov 

John F. Sherman, CFA, Senior Financial Analyst 

jsherman@fdic.gov 

San Francisco Regional Outlook 10 Fourth Quarter 1998 
In Focus This Quarter
 

Risks and Challenges for Consolidating Institutions
 

•	 Bank merger and acquisition (M&A) activity creates significant challenges for bank managers, 

including combining management teams, integrating technology, realizing the benefits of diversification, and maximizing operating economies. 

•	 As premiums paid in M&A transactions have 

escalated, some industry observers have raised 

concerns over whether the assumptions concerning potential earnings and strategic benefits can 

be realized. 

•	 Institutions in the process of integrating an 

acquired entity are likely to be especially vulnerable to a downturn in the economy. 

Merging institutions are under great pressure to execute 

the combination smoothly and realize its anticipated 

benefits. On the basis of anticipated earnings improvement and other strategic benefits, M&A deals are often 

executed at premiums substantially above recent market 

prices. As a result, financial market participants closely 

scrutinize post-merger results. Senior management of 

the merged entities, who typically are instrumental in 

convincing shareholders to agree to the transaction, are 

responsible for ensuring that expectations are realized. 

Entities that have demonstrated a proficiency at executing mergers have been regarded favorably by the capital 

markets. For some organizations, merging has effectively become a line of business. Alternatively, those that 

struggle after a merger may experience poor financial 

performance and could potentially become targets for 

acquisition themselves. 

Execution Risk 

The term “execution risk” often is applied to potential 

obstacles to integrating merging institutions. According 

to some analysts, execution risks are the primary risk in 

these combinations. These risks stem from a variety of 

uncertainties that arise following a merger: Can the new 

institution combine its management teams, integrate 

technological systems, realize the benefits of diversification, and maximize operating economies, all without 

interrupting services? Each of these uncertainties, summarized below, presents significant challenges to bank 

managers. 

Management 

Combining the management teams of consolidating 

companies is a critical first step in the transition 

process. Lines of reporting and authority must be delineated, and compensation arrangements coordinated and 

aligned with corporate goals. All of this must be accomplished without alienating critical personnel. The most 

difficult aspect may involve intangible cultural differences. A recent poll by Hewitt Associates1 of human 

resource managers of 218 large U.S. companies identified integrating organizational cultures as the “top challenge” in mergers. While some level of turnover must be 

expected, losses of key personnel and interruptions in 

service can result in dissatisfied customers, which in 

turn can lead to poor financial performance. 

Technology 

Technological advances often are 

identified as the single greatest 

enabler of the wave of bank consolidation; however, smoothly 

integrating existing systems and 

maximizing potential benefits of 

technology can be difficult. A 

Federal Reserve Board2 study of 

nine recent mergers concluded that the most frequent 

and serious problem merging institutions encountered 

was unexpected difficulty in integrating data processing 

systems and operations. The faster systems can be consolidated, the sooner cost savings can be realized; however, disruptions in service or breakdowns in control 

mechanisms may be less likely with a more measured 

integration timetable. Rather than attempting to integrate existing, sometimes incompatible systems, many 

merger partners have chosen to maintain parallel operations while integrating data processing systems over 

time. Year 2000 compliance efforts add yet another layer 

of complexity to these endeavors. 

Diversification 

M&A transactions provide an opportunity to diversify 

risk exposures, thereby potentially decreasing earnings 

volatility and moderating the effect of economic down1 “Career Tracks: Personnel Execs: Toughest Job in Mergers Is Blending.” American Banker, August 10, 1998, p. 6. 2 “The Efficiency Effects of Bank Mergers: An Overview of Case 

Studies of Nine Mergers.” Journal of Banking & Finance, March 

1998, vol. 22, no. 3, pp. 273–291. 

San Francisco Regional Outlook 11	 Fourth Quarter 1998 
In Focus This Quarter
 

turns on an institution’s performance. However, diversification creates added complexity for bank managers. 

They may have little practical experience with new 

product lines or new geographic markets and as a result 

they may not fully understand the risks involved in these 

new areas. 

CHART 1 

Many of the Most Acquisitive Banking Companies 

Have Underperformed the Universe of Bank Stocks 

(March 31, 1993–March 31, 1998) 

550 ◆ Total Assets Greater Than $20B 

Total Return (Percent) 

Total Assets between $5B and $20B 

450 Total Assets Less Than $5B 

Operating Economies 

The degree to which anticipated operating economies 

are realized hinges on management’s ability to carry out 

multiple objectives. To achieve anticipated revenue 

enhancements, managers of consolidating institutions 

350 

250 SNL All Bank Index = 249.4% 

150 

have attempted to promote a culture of cross-selling 50 

20 30 40 50 60 70 80 90 

new and existing products to a broader customer base in 

new markets, often through new distribution networks. 

At the same time, they have sought to reduce expenses 

by eliminating redundant administrative functions. 

Underlying these efforts is the need to establish strong 

internal controls and develop appropriate risk management systems. 

Are Expectations Unreasonable? 

As premiums paid to carry out M&A transactions have 

escalated, some industry analysts have viewed the 

assumptions regarding the expected earnings and strategic benefits as aggressive, raising uncertainty as to 

whether these benefits can be realized. Shares of banking organizations that have been active acquirers have 

not necessarily outperformed the universe of bank 

stocks, even before the recent market volatility. According to BankINVESTOR, for the five-year period ending March 31, 1998, most of the returns of the most 

acquisitive banking organizations across three separate 

size categories lagged the SNL Bank Index (Chart 1). 

This lag may be due to investor concerns about whether 

and to what extent the anticipated benefits of merger 

activity will be realized. For example, the assumed benefits related to economies of scale and diversification 

may be overoptimistic. 

Benefits of Scale 

Economies of scale associated with greater size and 

capacity are commonly identified as a potential benefit 

of consolidation. Large banks make substantial capital 

investment in areas such as technology and deliverysystem infrastructures; spreading these costs across a 

larger customer base may lead to greater efficiency. 

However, some observers question whether there is a 

limit to benefits of scale. Federal Reserve Board ChairPercentage of Current Assets Purchased 

over Past Five Years 

Source: BankINVESTOR 

man Alan Greenspan testified before the Senate Judiciary Committee in June 1998 that “there are no clearcut findings that suggest bank mergers uniformly lead 

to efficiency gains. Returns could be muted by large 

company inefficiencies, and their customers may face 

bureaucratic inflexibility.” Perhaps the increased complexity of larger institutions combined with their 

involvement in more nontraditional activities offset the 

advantages of larger scale. 

Benefits of Diversification 

Another common goal of M&A activity is to promote 

diversification of revenue streams. The relaxation of 

regulatory restrictions on geographic expansion and 

permissible activities has made possible new combinations of revenue sources. However, the extent to which 

combining traditional banking with a broader range of 

activities will yield a diversified income stream is not 

yet clear. Industry analysts often point to the declining 

share of total revenues from net interest income as an 

example of improved diversification and potentially less 

volatile earnings. However, others argue that, like 

margin-related income, fee income from activities such 

as mutual fund sales, investment management, and brokerage operations is sensitive to both increasing interest 

rates and deteriorating economic conditions. 

Cost of Capital 

Failure to meet performance expectations following a 

merger can lead to negative market assessments of earnings quality and stability. As creditors and investors 

view an institution’s performance less favorably, they 

San Francisco Regional Outlook 12 Fourth Quarter 1998 
In Focus This Quarter
 

require a higher rate of return on capital markets instruments. While cost of capital always has been important 

for institutions that rely significantly on capital markets 

as a funding source, changes in the competitive environment have made it a critical issue for all banking 

organizations. Technological advances and deregulation 

now permit low-cost competitors to enter previously 

insulated markets. (See “Merger and Acquisition Activity in the U.S. Banking Industry: Trends and Rationale” for a discussion of changes in the competitive 

environment.) Competitors with a lower cost of capital 

often can provide services at a lower price, or they can 

accept similar risks in exchange for a lower expected 

return. Such competition may lead higher-cost competitors to pursue higher-yielding but riskier investment 

alternatives. 

Economic Conditions 

The M&A activity of the past few years has occurred in 

an environment of nearly ideal economic conditions. As 

a result, many of the new business combinations have 

yet to be tested by a downturn in the economy. Until 

these new entities experience a full business (and credit) cycle, the results of the M&A activity cannot be fully 

assessed. 

Regardless of whether the long-term objectives of 

M&A activity are achievable, institutions that are transitioning to a new structure following a merger are likely to be especially vulnerable to deteriorating economic 

conditions. The experience of newly chartered institutions during the 1980s banking crisis is an example of 

deteriorating economic conditions interrupting this 

transition period. According to the FDIC’s recent study, 

History of the Eighties—Lessons for the Future, more 

than 16 percent of institutions chartered during the 

1980s failed by 1994, compared with just 7.6 percent of 

preexisting institutions. The study attributed the high 

failure rate to a combination of “powerful competitive 

pressures to assume greater risk with relative inexperience in a demanding new environment.” The competitive pressures included incentives to “leverage high 

initial capital positions, increase earnings per share, and 

meet stockholder expectations.” Although recently 

merged institutions and newly chartered institutions are 

not identical, today’s merger participants face many of 

the same pressures. 

The percentage of institutions that have recently experienced a structural change is higher today than at any 

other time since the consolidation trend began. Institutions that were chartered or involved in a merger over 

the past three years represent nearly 13 percent of all 

commercial banks and 65 percent of commercial bank 

assets. (See “Industry Consolidation Presents Unique 

Risks and Challenges for Community Banks” for a 

discussion of the trend in newly chartered institutions.) 

As shown in Chart 2, these percentages have increased 

substantially in recent years. Much of the consolidation 

activity is occurring between institutions that have been 

part of the same holding company for extended periods; 

however, even these transactions present integration 

challenges that would be complicated by an economic 

downturn. 

Summary and Conclusions 

While substantial benefits may be derived from bank 

M&A activity, mergers impose heavy demands on bank 

managers and present potential risks to banking organizations, bank investors, and the insurance funds. Bank 

managers face significant challenges associated with 

executing the merger, including combining management teams, integrating technology, realizing the benefits of diversification, and maximizing operating 

economies. Additionally, uncertainty remains as to 

whether merger-related expectations can be fully realized. Finally, the process of integrating two institutions 

is complex and time-consuming. Should this process be 

interrupted by an economic downturn, these institutions 

may be especially vulnerable. 

John F. Sherman, CFA, Senior Financial Analyst 

jsherman@fdic.gov 

CHART 2 

The Share of Institutions That Were Newly
 

Chartered* or Involved in a Merger within the
 

Previous Three Years Is Increasing
 70 14 

60 13 

50 12 

40 

30 

11 

10

 9 

20 8 

10 7 

0 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 6 

Percent of Commercial Banks 

(right axis) 

Percent of Commercial Bank Assets 

(left axis) 

Year * Includes all de novo institutions 

Source: Bank Call Reports 

San Francisco Regional Outlook 13 Fourth Quarter 1998 
In Focus This Quarter
 

Industry Consolidation Presents Unique Risks and
 

Challenges for Community Banks
 

•	 Industry consolidation has created competitive 

challenges for small banks and highlights traditional obstacles related to operating scale and 

scope. 

•	 Some small banks that are not merging with or 

selling to competitors are addressing consolidation challenges by outsourcing business functions, 

expanding the use of nondeposit funding sources, 

partnering with other banks and nonbanks, capitalizing on personalized service, and focusing on 

niche markets. 

•	 While these adaptive strategies may help community banks meet the challenges of industry consolidation, they potentially complicate the 

operations and risk profiles of these institutions. 

Historically, commercial banking has been characterized by a large number of small institutions operating at 

the community level. Although the number of small, or 

community, banks (defined as those with total assets of 

$500 million or less) has declined significantly since 

consolidation began in the 1980s, they continue to dominate the industry’s demographics. At June 30, 1998, 92 

percent (8,306) of FDIC-insured commercial banks 

held assets of $500 million or less. Approximately 73 

percent of these banks had no holding company or were 

subsidiaries of one-bank holding companies, and more 

than one-third operated only one office. The June 30, 

1997, Summary of Deposits data present more evidence 

of the extent of community banking. On that date, twothirds of all commercial banks operated offices exclusively within a one-county area. 

In terms of demographics, the structure of commercial 

banking continues to reflect the time when state and 

interstate banking and branching restrictions tended to 

limit rivalry in many local markets. However, recent 

changes in the structure, regulation, and operating environment of the financial services sector have affected 

commercial banks, especially smaller community 

banks. Specifically, industry consolidation has created 

new challenges for small banks arising from heightened 

competition and accentuates traditional small bank 

obstacles related to size and scope of operations. 

Competitive Pressures 

In addition to intensifying competitive pressures from 

nonbanks, industry consolidation has heightened competition among commercial banks. According to the 

Federal Reserve Board’s Flow of Funds data, for the 

seven-year period ending on March 31, 1998, commercial banks’ share of total financial assets in the U.S. 

economy declined nearly 6 percentage points to just 

over 20 percent. At the same time that banks are capturing a smaller slice of the financial services pie, mergers, 

acquisitions, and consolidation have set the stage for 

increased competition within the industry. Larger banks 

operating across state lines and in multiple markets via 

branches, mailings, or technology now vie for community bank customers. Moreover, the rebound in new 

bank charters over the past four years, an outgrowth of 

the consolidation trend, has increased the number of 

small bank competitors in many markets. The inaugural 

ABA Community Bank Competitiveness Survey1 in 

1997 reported that small bankers considered other community banks their chief competitors for deposit gathering and all types of lending, and considered large banks 

formidable competitors in commercial and consumer 

lending and deposit gathering. While competition 

among small banks in common markets has existed for 

some time, the emergence of larger institutions as challengers results largely from many of the merger motivators and drivers discussed in “Merger and Acquisition 

Activity in the U.S. Banking Industry: Trends and 

Rationale” in this issue. 

New Chartering Activity 

A secondary effect of industry consolidation, and a 

potential source of increased competition for preexisting community banks, is the recent trend in new bank 

charters. From June 1994 to June 1998, more than 500 

commercial banks were established in 48 states. 

Although rebounding, the annual level of new chartering activity remains well below the peaks of the previous three decades. Industry observers attribute the 

recent increase in new charters to many factors, including the availability of displaced banking talent, strong 

economic growth, potential niche opportunities in mar1 As presented in the ABA Banking Journal, April 1997, p. 55. 

San Francisco Regional Outlook 14	 Fourth Quarter 1998 
Small Banks in Business 4 Years or Less

18%

21%

29%

40%

24%

38% 20%

27%

In Focus This Quarter
 

ket segments underserved by larger banks, and the loss CHART 1 

of local decision making and perceived service gaps as New Chartering Activity Appears to Be Related local banks are acquired by larger banks or are consoli­ to the Number of Banks Sold or Consolidated dated into far-flung multibank companies. in Merger Transactions 

New bank activity is not concentrated in one region of 

the country. However, at the state level there appears to 

be a relationship between new chartering activity and 

the number of institutions sold or consolidated in merger and acquisition transactions (see Chart 1). Forty percent of all banks sold or consolidated and 27 percent of 

new charters from June 1994 to June 1998 were in 

Texas, California, Florida, Illinois, and Georgia. 

Number of New Commercial Banks 

TX 

IL 

GA 

FL CA 

(June 1994–June 1998) 40 

35 

30 

25 

20 

15 

10 

5 

0 

As shown in Map 1, ten states currently host a high per0 50 100 150 200 250 

Number of Banks Sold or Consolidated 

Sources: Bank Call Reports, FDIC Division of Research and Statistics centage of recently established community banks. Many 

of these states have experienced strong economic MAP 1

growth during this expansion and have a large number 

of banking offices owned by out-of-state institutions. 

These concentrations are especially noteworthy since 

newly chartered institutions often pursue aggressive 

growth to improve profitability, which may influence 

pricing and terms for competitors within their markets. 

Reflecting the recent surge in new banks, 57 percent of 

the 402 unprofitable commercial banks through the first 

half of 1998 had been in business less than four years, 

up from 17 percent at year-end 1994 (see Chart 2). As 

would be expected, the ten states highlighted in Map 1 

rank among the top in terms of the percentage of small 

banks that were unprofitable during the first half of 

1998. 

Challenges of Scale and Scope 

A by-product of industry consolidation is the emerSome States Host a High Percentage of Banks 

Established in the Past Four Years 

Greater than 15% (10) 

5% to 15% (19) 

Less than 5% (22) 

New Banks as a Percentage of Total 

June 30, 1998 

24% 

16% 

gence of larger institutions. By definition, community CHART 2 

banks operate with relatively less scale than their 

regional, super-regional, and money-center counter- Recently Chartered Small Banks Comprise a 

Higher Proportion of Unprofitable Institutions parts. As a result, small banks have limited ability to 

spread the costs of new investments or operating 

expenses across a broad asset base. This characteristic 

has traditionally forced community banks to spend 

more to generate each dollar of revenue than the rest of 

the industry, as measured by efficiency ratios.2 The 

inability of many community banks to fund large expenditures, such as investments in technology, alternative 

delivery systems, or new business lines, may cause 

Percentage of All Unprofitable Banks 100 

80 

60 

40 

20 

0 

Small Banks in Business More Than 4 Years 

Small Banks in Business 4 Years or Less 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 2 The efficiency ratio is calculated by dividing noninterest expense by Year the sum of net interest income and noninterest income. The ratio can 

Source: Bank Call Reports be interpreted as the cost to generate each dollar of revenue.
 

San Francisco Regional Outlook 15 Fourth Quarter 1998
 
In Focus This Quarter
 

CHART 3 

Small Banks Remain Highly Dependent 

on Spread Income 

55% 

60% 

65% 

70% 

75% 

80% 

85%

Net Interest Income to Net Operating Revenue 

Total Assets Greater 

Than $500M 

Total Assets Less 

Than $500M 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 

Year 

Source: Bank Call Reports 

long-term competitive disadvantages. For example, The 

Tower Group estimates that 70 percent of 1997 information technology (IT) spending by banks was by the 

top 15 institutions.3 Smaller institutions competing with 

larger banks that are investing in technology to improve 

operational efficiency, increase customer convenience, 

or to better identify customer profitability, pricing 

strategies, or cross-selling opportunities may find a 

diminished presence in the marketplace. Consequently, 

small banks may face increasing competition for customers who are attracted to sophisticated pricing, wider 

product arrays, and multiple delivery channels offered 

by competitors. 

Closely related to scale is the issue of scope of operations, both business line and geographic. Community 

banks’ scale may limit their ability to expand into new 

business lines or activities, thereby reducing the degree 

of revenue diversification and resulting in dependence 

on spread income. Since many noninterest sources of 

revenue require scale to economically justify investment, small banks tend to derive a greater percentage 

of net operating revenue from spread income, as shown 

in Chart 3. Also, the limited geographic scope of many 

community banks may result in less loan portfolio 

diversification and greater exposures to local economic downturns. From a portfolio management perspective, lenders with more diverse loan portfolios that can 

spread risks over a broader customer and economic 

base may gain pricing advantages over less diversified 

competitors. 

3 “How Much Do US Banks Spend On Information Technology?,” 

The Tower Group Research Notes, www.towergroup.com. 

How Are Community Banks Addressing 

Consolidation Challenges? 

In response to competitive pressures arising from industry consolidation, community banks, new and old, 

appear to be adapting to meet strategic challenges to 

their long-term viability. Indeed, this summer, Federal 

Reserve Board Chairman Alan Greenspan told the 

Charlotte, North Carolina, Chamber of Commerce that 

“well-managed smaller banks have little to fear from 

technology, deregulation, or consolidation.” Recent surveys and anecdotes reveal that small banks that are not 

selling to or merging with competitors are adjusting 

business practices to cope with the aforementioned 

pressures and challenges. Their strategies include outsourcing business functions, expanding the use of nondeposit funding sources, partnering with other banks 

and nonbanks, emphasizing personalized service, and 

developing niches or specialties. However, as described 

below, while these approaches may help small banks 

meet the challenges of consolidation, they potentially 

complicate the operations and risk profiles of these 

institutions. 

Outsourcing 

A recent survey by Electronic Data Systems Corporation and Bank Earnings International LLP4 found that 

community bankers are more concerned with controlling operating expenses than any other issue. This finding is not surprising given the cost savings expected 

from many recent mergers. The study also revealed that 

banks view IT as the most valuable tool for improving 

day-to-day performance—from controlling expenses to 

increasing fee income. Yet, according to The Tower 

Group, IT budgets as a percentage of total noninterest 

expenses for small banks are typically half of those for 

larger banks.5 As a result, some small banks are turning 

to outside parties to maximize the utility of expenditures, IT and others. 

American Banker recently reported on a trend among 

small banks to outsource the origination of consumer 

loans. The Tower Group noted that third parties handled 

2.7 million noncard, nonmortgage loan applications 

(mostly from small institutions) in 1997, and annual 

outsourced volume growth is projected to average 40 

percent through 2002.6 Vendor networks designed to 

4 American Banker, July 22, 1998, p. 16.
 5 Computerworld, May 25, 1998, p. 20.
 6 “More Banks Handing Off Nitty-Gritty of Consumer Lending,”
 

American Banker, June 12, 1998, p. 1.
 

San Francisco Regional Outlook 16 Fourth Quarter 1998 
In Focus This Quarter
 

enable small banks to reduce hardware and personnel CHART 4 

needs also have emerged and allow for more cost- Small Bank FHLB Membership and efficient processing and cheaper access to customer Borrowing Are Rising information. Many small banks planning Internet-based 

or home banking also are turning to outside experts. 60 Nonborrowing members 

Outsourcing certain business functions may allow for 

greater focus on profitable business lines, less risky 

access to state-of-the-art technology, cost savings, and 

more options for customers. However, these arrangements are not without risk. Indeed, FDIC-insured institutions have experienced difficulties in the past with 

indirect consumer lending, such as auto lending. Moreover, banks that outsource business functions may have 

Percentage of Small Banks


Belonging to the FHLBs


Borrowing members 50 

’93 ’94 ’95 ’96 ’97 2Q98 

40 

30 

20 

10 

less control over those functions and may become overreliant on third-party providers. 

Nondeposit Funding Sources 

As noted above, increasing competition for deposits has 

left some small banks searching for alternative funding 

sources to meet loan demand. On average each year 

from 1993 to 1997, 64 percent of small commercial 

banks experienced loan growth in excess of deposit 

growth. Similarly, six in ten banks responding to the 

1998 ABA Community Bank Competitiveness Survey7 

reported that deposit levels were not keeping pace with 

loan demand. In response, small banks are increasingly 

turning to nondeposit funding sources. From 1993 

through the second quarter of 1998, the percentage of 

small banks using borrowings of any type increased 

from 48 to 56 percent. Over the same period, the percentage of small banks funding with borrowings other 

than overnight funds (Federal funds and repurchase 

agreements) increased from 20 percent to 35 percent, 

and the percentage reporting brokered deposits rose 

from 7 percent to 12 percent. 

The rising number of commercial banks joining the 

Federal Home Loan Bank (FHLB) System in recent 

years, as reflected in Chart 4, is likely a symptom of the 

aforementioned funding trend. At June 30, 1998, nearly 

half of all small banks were FHLB members, compared 

with 21 percent at year-end 1993. On the same date, 90 

percent of FHLB commercial bank members and 87 

percent of FHLB commercial bank borrowers were 

small banks. In addition to providing a backup source of 

liquidity, the FHLB is essentially acting as an intermediary to the capital markets for banks with limited 

access. The relatively limited nondeposit funding 

options available to many small banks may explain their 

7 ABA Banking Journal, February 1998, p. 47. 

0 

Year 

Sources: Bank Call Reports, Federal Housing Finance Board 

increasing reliance on FHLB advances. At June 30, 

1998, approximately 80 percent of small banks’ 

nonovernight borrowings were FHLB advances. 

The increasing liquidity of loan portfolios is becoming 

another funding alternative. Many small banks have 

used participation arrangements to sell off portions of 

loans to correspondent banks or have turned to Fannie 

Mae or Freddie Mac to sell mortgages. The securitization of other loan types also may become increasingly 

appealing as funding shortages persist and market 

opportunities for small banks increase. For example, in 

July 1998, American Banker highlighted the creation 

of a new commercial mortgage conduit established 

specifically to buy loans originated by community 

banks.8 The secondary market for the guaranteed portion of Small Business Administration loans also has 

been cited as a potential source of liquidity. 

Although identifying and expanding the use of 

nondeposit funds may increase the flexibility of small 

banks, their use complicates asset-liability management. While net interest margins for small banks have 

yet to reveal significant compression, recent evidence 

suggests future declines. For example, a recent survey 

conducted by the Federal Reserve Bank of Minneapolis found that 57 percent of small bankers in the upper 

Midwest expect a shift away from deposit funding to 

decrease profitability.9 

8 “Commercial Real Estate: New Conduit Plans to Help Small Banks
 

Enter,” American Banker, July 21, 1998, p. 29.
 9 “Location Influences Community Bank Challenges,” Fedgazzette,
 

Federal Reserve Bank of Minneapolis, July 1998, p. 2.
 

San Francisco Regional Outlook 17 Fourth Quarter 1998 
In Focus This Quarter
 

Partnering 

In an effort to expand revenue sources and attract and 

retain customers, smaller banks are expanding their 

spectrum of products and services through partnerships 

with other entities. The 1998 ABA Community Bank 

Competitiveness Survey found that 10 percent of community banks partnered with other banks in 1997, while 

nearly twice as many have teamed up with nonbanks. 

Over two-thirds of the survey’s respondents considered 

their partnering approach profitable. The leading types 

of arrangements with other banks include loan participations, title insurance, data processing, credit card programs, and mortgage lending. Nonbank partnering has 

been used to expand offerings to customers such as brokerage, insurance, and travel agency services. However, 

like outsourcing, partnering could result in less control 

and overreliance on third parties. 

Service Orientation 

Small banks have long touted personalized service and 

local decision making as a competitive advantage. 

Influenced by the recent wave of merger and acquisition 

activity in the industry, community bankers cited service as an area 

with great opportunity in the 1998 

ABA Community Bank Competitiveness Survey. Indeed, many 

community bankers have publicly 

welcomed consolidation as a 

chance to establish new relationships and attract customers affected by integration problems and personnel shifting at larger acquiring or 

merging banks. 

Establishing prudent relationships with smaller, underserved customers may present opportunities and profits 

for small banks. This may be especially true for small 

business customers, which may not fit more standardized lending models of larger banks yet remain acceptable credit risks. According to the Federal Reserve 

Board’s second-quarter 1998 Survey of Terms of Business Lending, rates on small commercial and industrial 

loans earn the greatest spread of any size business 

loans. Further, a recent survey by PSI Global of small 

business owners in south Florida, which has seen a great 

deal of merger and acquisition activity in recent years, 

found that nearly one-quarter of respondents would 

move their business if their bank was purchased, exemplifying the extent to which small banks may be able to 

use service to capitalize on consolidation activity.10 

Developing Niches or Specialties 

Anecdotal evidence suggests that some small banks are 

specializing in narrow markets and niches. Some analysts and consultants have emphasized that community 

banks should not try to be what they are not, but should 

instead focus on a particular market segment or niche. 

By default, many small banks depend on their customers’ local businesses and, through local expertise, 

may be better at serving specific industries than their 

larger competitors. However, a narrow focus may 

reduce portfolio diversification and could lead to 

greater exposures during an economic downturn. 

Summary and Conclusions 

Small banks are facing heightened competitive pressures from larger, merged institutions and from new 

banks. Their ability to respond to these pressures is 

restricted by traditional scale and scope limitations. 

Community banks are addressing these challenges by 

outsourcing business functions, utilizing nondeposit 

funding sources, partnering with other banks and nonbanks to diversify revenues and widen customer 

options, capitalizing on personalized service, and developing niches or specialties. While these strategies may 

help community banks meet the challenges of industry 

consolidation, they potentially complicate the operations and risk profiles of these institutions. 

Steven E. Cunningham, CFA, Senior Financial Analyst 

scunningham@fdic.gov 

10 South Florida Business Journal, May 22, 1998, p. 6. 

San Francisco Regional Outlook 18 Fourth Quarter 1998 
Regular Feature
 

Regional Perspectives
 

•	 After years of strong economic and job growth, consumers in the San Francisco Region face increasing 

uncertainty and are reporting a moderation in confidence. 

•	 A significant downturn in consumer confidence could weaken consumer spending, a key factor in the 

Region’s strong growth. 

•	 Although growth in personal bankruptcy filings is moderating, credit card banks in the Region continue to 

report accelerating credit card charge-off rates. 

•	 The profitability and asset quality of the Region’s subprime lending specialists should be evaluated over the 

entire business cycle, not just during the current economic expansion. 

Region’s Economic and Banking Conditions 

The Region’s Economy Is Still Generally 

Healthy; However, the Effects of the 

Asian Crisis Are Evident 

High-Tech Slowdown—Asia’s crisis has diminished the 

earnings of a number of leading Silicon Valley hightech firms; simultaneously, a number of manufacturers 

are reporting layoffs and plant closings. The slowdown 

is also affecting high-tech firms with operations in Arizona, California, Idaho, Oregon, Utah, and Washington. Some analysts are already reporting a softening in 

San Jose’s hot housing and commercial real estate markets, as high-tech employers curtail plant expansions 

and lay off workers. 

Aerospace Concerns Mount—Slowing sales, cancellations of aircraft orders, and severe problems among 

Asian air carriers, including the September bankruptcy 

of Philippine Airlines, are expected to slow the 

Region’s key aerospace sector in the year ahead. Washington and California account for most of the Region’s 

aerospace jobs. 

Agricultural Exports Are Lagging—Many of the 

Region’s states export a significant volume of agricultural products to Asia. The Asian crisis has particularly 

hurt the Pacific Northwest’s wheat farmers, California’s 

fruit and vegetable producers, and Washington’s apple 

growers. The farm sector in Montana and Wyoming 

has been hurt by falling prices for wheat and livestock. 

Falling Energy Prices—Falling oil prices, mostly driven by the events in Asia, have hit the Region’s major 

energy-producing states. State government oil revenues 

are expected to decline in Alaska and Wyoming in 

particular. 

Across the Region, Economic Conditions 

Vary Widely 

One indication of the impact the Asian crisis is having 

on the Region’s economy is the breadth of the gradual 

slowing. Ten of the Region’s 11 states reported slower 

job growth in the 12-month period ending August 1998 

than in the same period in 1997. The Region’s growth 

rate for the 12-month period ending August 1998 was 

3.1 percent, below the 3.5 percent growth rate for the 

previous year but still higher than that of the nation, 

which added jobs at a 2.7 percent rate. 

Top Performers—Arizona, Nevada, and Washington 

remained among the nation’s five fastest growing states, 

adding jobs at rates of 3.7 percent or better over the past 

12 months. Arizona recorded strong growth across the 

board. The Asian effect seems to be more important in 

Nevada and Washington. Nevada reported slower 

growth in tourism and gaming, the state’s major industry. In Washington, manufacturing job growth slowed 

dramatically, although most other sectors remained 

strong. 

San Francisco Regional Outlook 19	 Fourth Quarter 1998 
Regular Feature	 Regional Perspectives
 

Strong Growth—California, Utah, and Oregon added 

jobs moderately faster than the nation as a whole, but all 

three grew more slowly in the 12-month period ending 

August 1998 than in the previous 12-month period. 

Over the past year, each of these states has recorded a 

sharp decline in the growth rate of manufacturing jobs, 

probably because of the Asian crisis. 

Trailing the Nation—Alaska and Idaho continued to 

trail the nation in job growth—Alaska and Idaho added 

jobs at 2.0 percent and 1.8 percent annual rates, respectively, over the 12 months ending August 1998. Alaska’s 

job growth rate has remained relatively stable despite 

mixed performance across sectors. Energy, construction, and transportation jobs are up, while job conditions are weak in manufacturing and the government 

sector. Idaho’s job growth has dropped sharply over the 

past 12 months as the service job growth rate has fallen 

by more than half, to 2.0 percent. 

Weakness Continues—Wyoming, Montana, and 

Hawaii continue to lag far behind the rest of the 

Region in job growth. Over the 12-month period ending August 1998, Wyoming and Montana added jobs at 

less than a 1 percent annual rate, about half their rate in 

the previous 12 months. Hawaii, which continues to 

suffer from a protracted recession, lost 1.2 percent of 

its jobs during the 12-month period ending August 

1998. The state has ranked last in the nation in job 

growth over the past two years. 

Insured Financial Institutions 

Post Record Earnings 

Despite the slower job growth in 

most states, insured financial institutions throughout the Region 

(except in Hawaii and Montana) 

report excellent performance as of June 30, 1998. They 

posted a collective return on assets (ROA) of 1.34 percent and a return on equity of 14.72 percent through the 

second quarter of 1998, well above the national returns 

of 1.22 percent and 14.34 percent, respectively. These 

excellent earnings are the result of noninterest income 

growth and low provisions for loan losses. The ratio of 

loans 30 or more days past due and loans on nonaccrual fell to 1.79 percent of total loans—the lowest ratio in 

over a decade and well below the nation’s 2.07 percent 

ratio. Reported capital ratios for the Region remain 

strong: At 7.71 percent, they are on par with the average 

industry ratio of 7.72 percent. The strong performance 

reported by insured institutions is in part attributable to 

the strong national and regional economies. 

Consumer Credit Portfolios Face Challenges
 

Can Consumer Spending Keep the Region’s 

Economy and Consumer Lending 

Going Strong? 

Robust consumer spending was a major factor in the 

continued expansion of the economies of the Region 

and the nation, particularly during the first half of 1998. 

However, during summer 1998, both economies were 

exposed to a series of shocks that lowered consumer 

confidence levels and dampened consumer expectations. Many analysts fear that as a result of these events, 

consumers may alter their spending plans. Potential 

weakness in consumer spending in the months ahead 

could have important implications for the economy and 

for lenders. 

The following national economic conditions, which 

helped bolster consumer confidence during the first 

half of 1998, may be adversely affected by the summer 

shocks: 

•	 The economy recorded strong growth. 

•	 The unemployment rate dipped as low as 4.3 percent 

in May. 

•	 The inflation rate fell below 2 percent as inflation 

expectations subsided. 

•	 The bellwether 30-year Treasury bond yield was at or 

near decade lows. 

•	 The stock market appreciated considerably. 

Low unemployment, healthy income growth, favorable 

financing terms, and asset appreciation buoyed consumer confidence and prompted consumers throughout 

the nation to spend freely. During this period, the gap 

between consumer spending and income growth 

widened (see Chart 1). To finance this gap, consumers 

San Francisco Regional Outlook 20	 Fourth Quarter 1998 
Regular Feature	 Regional Perspectives
 

CHART 1	 CHART 2 

The Gap between Consumer Spending
 

Growth and Income Gains Is Growing
 

Real Consumption

Percent Change from Four Quarters Ago

6 

4 

2 

0 

–2 

Spending 

Real After-Tax Income 

Q2 ’90

Q2 ’92Q2 ’94Q2 ’96Q2 ’98 

Debt Servicing Burden Has Been Stable Recently 

despite Rising Amount of Debt Relative to Income 

Sources: Bureau of Economic Analysis and Federal Reserve, via Haver Analytics Ratio of Liabilities to Income 

1.15 

1.20 

1.25 

1.30 

14 

15 

16 

17 

18 

Payments for Consumer Debt 

and Mortgages (right axis) 

Household Liabilities to Disposable Income (left axis) 

Payments as % of Disposable Income 

Q2-88

Q2-89

Q2-90

Q2-91

Q2-92

Q2-93Q2-94Q2-95Q2-96Q2-97Q2-98 

Source: Bureau of Economic Analysis, via Haver Analytics 

have relied on debt restructuring, the assumption of 

more debt, and appreciating asset values. 

Households have been able to assume more debt relative 

to income in the past few years without boosting their 

monthly payments (see Chart 2). They have stabilized 

debt payment burdens in a variety of ways. Low and 

falling interest rates have allowed consumers to refinance existing debt at lower interest rates or take on 

additional debt. Innovative loan products have allowed 

them to restructure and consolidate high-interest-rate 

debt into one loan secured by the household’s residence 

or to take cash out to pay other bills or debts. 

A Summer of Shocks 

The strong economic performances of the nation and 

the Region during the first half of 1998 were followed 

by a series of economic shocks after midyear. 

•	 Since the Dow Jones Industrial average reached a 

record high in July 1998, a series of events has 

caused a sharp drop in world equity values. The outlook for corporate earnings has slipped as earnings 

failed to match expectations. In the U.S. manufacturing sector, the outlook has been clouded by a 

worsening Asian situation that has led to falling 

exports and soaring imports. This situation presents 

a major challenge in the San Francisco Region 

because the Region is much more dependent than 

the nation on manufactured exports, especially hightechnology and commercial aerospace products sold 

in Asia. 

•	 In August, Russia’s faltering economy was hit by a 

massive devaluation that caused financial market jitters worldwide and raised new concerns about the 

condition of Asian, Eastern European, and Latin 

American economies. 

•	 By September, U.S. equity markets had lost close to 

20 percent of their value in a matter of weeks, wiping out hundreds of billions of dollars in investors’ 

potential profits on equity and mutual fund holdings 

as well as stock options. Equity markets also 

appeared to have entered a period of increased 

volatility in both price swings and trading activity. 

Will Consumer Expectations Reflect the 

Tranquil Spring or the Turbulent Summer? 

Analysts fear that this unusual series of shocks may 

affect the attitudes and spending of U.S. consumers. 

“Tumultuous financial markets here and abroad and 

unsettling political developments in the U.S. have been 

major factors in curbing consumer confidence,” noted 

Conference Board economist Lynn Franco when the 

Conference Board’s consumer confidence index tumbled for the third consecutive month in September.1 The 

recent declines can be observed in the two measures of 

consumer confidence shown in Chart 3 (next page). The 

first is the consumer confidence indicator, a broad 

measure that takes into account both consumers’ evaluation of their present economic situation and their 

1 Christian Duff, “U.S. Consumer Confidence Drops Again,” Wall 

Street Journal, September 30, 1998, page A2. 

San Francisco Regional Outlook 21	 Fourth Quarter 1998 
Regular Feature Regional Perspectives 

CHART 3 both the Pacific index (which includes Alaska, CaliNational Consumer Confidence and Consumer 

Expectations Slip in the Third Quarter of 1998 

fornia, Hawaii, Oregon, and Washington) and the 

Mountain index (which includes six San Francisco 

Region states, Arizona, Idaho, Montana, Nevada, 

Index Value 

150 

140 

130 

120 

110 

100 

90 

80 

70 

60 

Consumer 

Confidence 

Consumer 

Expectations 

Annual Average Monthly Data Utah, and Wyoming, as well as two other states, Colorado and New Mexico) have declined in recent 

months. Chart 4 shows that the Pacific consumer 

expectations index fell by nearly 21 points in August, 

the largest monthly decline in more than ten years, but 

fell only slightly in September. The Mountain index has 

fallen in five of the past seven months for a cumulative 

decline of nearly 24 points. 

Deteriorating expectations may lead consumers to ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94’95 ’96 ’97 01 02 03 04 05 06 07 08 09 

’98 ’98 ’98 ’98 ’98 ’98 ’98 ’98 ’98 change their savings and spending patterns. For examSource: The Conference Board 

expectations for the future. After reaching a high for the 

year in July 1998, this index has fallen noticeably. The 

second, the consumer expectations index, is a forwardlooking measure that tracks consumers’ expectations of 

future economic conditions. It fell even more dramatically between July and September. 

Falling consumer confidence and expectations may 

influence consumer spending, which makes up about 

two-thirds of the country’s gross domestic product.2 For 

example, national consumer confidence, as measured 

by the Conference Board’s monthly survey, began to fall 

before the 1990-91 recession and then dropped sharply 

with the onset of the recession. Much of that decline 

took place as consumers revised their expectations 

about the economy’s performance and cut back on their 

spending. 

The 1998 decline in consumer expectations is important 

because, according to the Conference Board, the expecple, consumers may: 

•	 Alter their savings behavior, which already is at historically low rates; 

•	 Postpone buying homes and other big-ticket items; 

•	 Limit discretionary travel and leisure expenditures; 

and 

•	 Reduce spending on nondurable goods and services. 

Analysts already are monitoring retail sales and consumer spending for signs of weakness as the critical 

1998 holiday shopping season approaches. Weakerthan-expected retail sales in August and September have 

heightened concerns about consumer spending for the 

rest of 1998. 

CHART 4 

tations measure “has a strong track record in predicting 

future activity.” Moreover, the declines in August and 

September are large, and there is now a danger of the 

index value falling below the strong expectations range. 

If consumers begin to act on those expectations, then 

consumer spending, a recent mainstay of the economy, 

is likely to soften. 

Like the nation, the San Francisco Region is reporting 

a sharp downturn in consumer expectations as measured by the Conference Board. As shown in Chart 4, 

2 Jonathan McCarthy, “Debt, Delinquencies, and Consumer Spending,” Current Issues in Economics and Finance, Federal Reserve 

Bank of New York, (3): 3, page 1. 

Consumer Expectations Declined after Summer Shocks 

Hit the San Francisco Region 

Source: The Conference Board Index Value 

150 

140 

130 

120 

110 

100 

90 

80 

70 

60 

Annual Average Monthly Data 

’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94’95 ’96 ’97 01 

’98 

02 

’98 

03 

’98 

04 

’98 

05 

’98 

06 

’98 

07 

’98 

08 

’98 

09 

’98 

Mountain 

Region 

Pacific 

Region 

San Francisco Regional Outlook 22	 Fourth Quarter 1998 
Regular Feature Regional Perspectives
 

Effects on the San Francisco Region’s 

Economy: Still Too Early to Tell? 

Although job growth slowed somewhat for the Region 

in the 12-month period ending in August 1998 compared with the prior year, the overall deterioration in 

employment growth was not dramatic (see Chart 5). 

However, the impact may become more dramatic as 

time passes. The initial negative effects of the Asian crisis that began around mid-1997 have only recently 

begun to be felt across much of the Region. 

Credit Card Portfolios Continue to Deteriorate 

The overall strength in consumer spending and the 

health of the economy are important because, although 

the Region’s insured financial institutions are reporting 

excellent asset quality in most loan categories, credit 

card portfolios are exhibiting some negative trends. The 

past-due credit card loan ratio3 declined from 4.32 percent in June 1997 to 4.07 percent in June 1998, but a 

larger percentage (almost 45 percent) of credit card 

loans are now in the 90 days and over past due or nonaccrual categories. This shift to the more severe delinquency status suggests that additional losses are likely. 

In fact, annualized credit card charge-offs increased 

from 5.32 percent of total credit card loans at June 30, 

1997 to 6.79 percent at June 30, 1998. Although credit 

card loans represent less than 8 percent of total loans in 

3 The past-due credit card loan ratio is all credit card loans 30 days or 

more past due plus nonaccrual credit card loans divided by total credit card loans outstanding. 

CHART 5 

the Region, they account for almost 57 percent of all 

gross charge-offs. 

Chart 6 shows that credit card charge-offs in the San 

Francisco Region continue to accelerate, despite a slowdown in the rate of growth of bankruptcy filings. This 

trend is especially relevant to the Region’s 24 specialty 

credit card banks,4 which hold almost 82 percent of the 

Region’s total credit card loans. These institutions, 

located primarily in Nevada, Utah, and Arizona, are 

generally subsidiaries of large holding companies that 

do business in several regional markets, as well as 

nationally. The increasing charge-off levels, however, 

affect all the Region’s institutions, since over 75 percent 

of the Region’s 866 insured institutions report some 

credit card activity. 

The fact that net credit card charge-offs in the Region 

are increasing faster than personal bankruptcies in both 

the Region and nation means that other factors likely 

are causing these banks’ charge-offs to increase. Chart 

7 (next page) highlights two other possible explanations 

for the increase. First, the Region’s institutions rapidly 

increased their credit card loans from year-end 1992 

through year-end 1996. Second, according to the Federal Reserve Bank Senior Lending Officer Survey, banks 

generally loosened their underwriting standards from 

1994 to 1996. While bank lenders have recently tightened underwriting standards and slowed credit card loan 

growth, the high current charge-off levels probably 

4 A specialty credit card bank has total loans of 50 percent or more of 

total assets and credit card loans of 50 percent or more of total loans. 

CHART 6 

Job Growth Rates for the San Francisco Region 

Have Slowed over the Past Year 

Source: Bureau of Labor Statistics, via Haver Analytics Percentage Growth in Payroll Employment

1997 

1998 

6 

5 

4 

3 

2 

1 

0 

–1 

–2 

The Region’s Credit Card Charge-Offs 

Outpace Personal Bankruptcies 

Sources: Call Reports, U.S. Census Bureau, and Administrative Office of U.S. 

Courts 

Nation’s bankruptcy filings/1000 population 

Region’s bankruptcy filings/1000 population 

Bankruptcy 

Filings/1,000 

0 

2 

4 

6 

8 

0 

2 

4 

6 

8 

Charge-Offs 

(%) 

Nation’s 

Charge-Offs 

Region’s 

Charge-Offs 

’91 ’92 ’93 ’94 ’95 ’96 ’97 Jun-’98 

San Francisco Regional Outlook 23 Fourth Quarter 1998 
Regular Feature Regional Perspectives
 

CHART 7 CHART 8 

Region’s Credit Card Growth Rate Declines 

as Lenders Tighten Underwriting Standards 

Sources: Bank Call Reports and Federal Reserve senior lending officer 

’92 

30 

25 

20 

15 

10 

5 

0 

–5 

–10 ’90 ’91 ’93 ’94 ’95 ’96 ’97 Jun­

’98 

Banks with Tighter 

Underwriting 

Credit Card Loan 

and Securitized 

Receivable Growth 

Percent Growth and Percent of Banks

Tightening Consumer Credit 

Securitization and Profitability
 

Increase at Region’s
 

Credit Card Banks
 Securitized 

Percent of Receivables 

Assets ($ millions) Securitized 

Receivables 40,000 

30,000 

15 

10 Noninterest 

ROA Income 

20,000 

5 

10,000 

0 0 

’96 ’97 Jun-’96 

Source: Bank Call Reports 

relate to loans booked during earlier periods of high 

loan growth. 

Despite high credit card losses, earnings at the Region’s 

specialty credit card banks have not suffered, likely 

because of increased securitization profits. As Chart 8 

shows, the Region’s credit card banks have produced 

more noninterest income and higher ROAs as securitized receivables outstanding have increased. Many 

financial institutions have used securitization to manage 

interest rate and liquidity risks, as well as to reduce the 

cost of funding; however, new gain-on-sale accounting 

standards can increase earnings volatility from securitization if the original assumptions at the time of sale 

must be revised. In particular, the value of interest-only 

strips and retained subordinated interests in securitizations can fluctuate greatly depending on the related 

charge-off and prepayment rate assumptions made at 

the time of sale (see “Gain-on-Sale Accounting Can 

Result in Unstable Capital Ratios and Volatile Earnings,” Regional Outlook, second quarter 1998). 

Subprime Lenders Expand Their Activities 

Although credit card lending in the Region has slowed 

recently, consumers have found other alternatives for 

consumer loan financing at insured institutions, in particular those that specialize in so-called subprime lending. As Chart 9 shows, subprime lenders in the Region 

have generally recorded much higher asset growth than 

the Region’s insured institutions as a whole. While these 

30 institutions do not have significant on-balance-sheet 

exposure as measured by total assets, many originate 

and service loans at several times their on-balance-sheet 

asset base. Most of these institutions specialize in 

lower-credit-quality auto paper, but a growing number 

are involved in residential lending to borrowers with tarnished credit records or at high loan-to-value ratios. 

High loan-to-value residential loans have allowed consumers to consolidate existing mortgage debt, credit 

card debt, and other consumer debt into one loan with 

potentially lower overall debt service. 

In addition to faster asset growth, the Region’s subprime 

lenders have recorded higher profitability ratios than 

similarly sized institutions; however, as with specialty 

credit card banks, analysts and bank examiners must 

consider the profitability of these institutions over the 

entire business and credit cycle. As Table 1 shows, the 

CHART 9 

’92 

Subprime Lender Asset Growth 

Exceeds That of the Region’s Other 

Institutions 

Sources: Call Report Data and Division of Supervision Survey of Subprime 

Lenders Asset Growth (%) 

20 

15 

10 

5 

0 

–5 

–10 

Subprime Lender 

Asset Growth 

Region’s 

Asset Growth 

’91 ’93 ’94 ’95 ’96 ’97 Jun­

’98 

San Francisco Regional Outlook 24 Fourth Quarter 1998 
Regular Feature Regional Perspectives
 

TABLE 1 

Subprime Lenders on Average Have Been More Profitable than 

Similarly Sized Banks over the Past Five Years 

5-YEAR AVERAGE 

SUBPRIME LENDERS 

(%) 

5-YEAR AVERAGE 

COMMUNITY BANKS 

(%) 

DIFFERENCE 

(%) 

ROA 

ROE 

ASSET YIELD 

NET INTEREST MARGIN 

PROVISION EXPENSE/TA* 

NONINTEREST INCOME/TA 

LOAN SALE GAINS/TA 

PAST-DUE RATIO 

CHARGE-OFF RATIO 

1.38 

13.90 

12.46 

8.03 

1.62 

2.34 

1.05 

8.36 

1.89 

0.99 

10.04 

8.59 

5.48 

0.44 

1.45 

0.17 

3.26 

0.64 

0.39 

3.87 

3.87 

2.55 

1.17 

0.90 

0.88 

5.10 

1.24 

* TA = Total Assets 

Sources: Call Report Data and the Division of Supervision, Survey of Field Office Personnel and Case Managers 

Region’s subprime lenders with assets under $1 billion5 

have used higher-yielding assets and loan sale gains to 

outperform similarly sized community banks in the 

Region.6 However, Table 1 also shows that the subprime 

lenders have poorer asset quality than their counterparts. 

Acting Comptroller of the Currency Julie L. Williams 

recently criticized high loan-to-value residential lenders, 

stating that the pricing of these loans does not “cover the 

additional risks these loans entail.” Pricing for subprime 

credit should be considered over the entire credit cycle 

and not just the recent economic recovery. 

The financial market shocks that have disrupted consumer confidence also have affected the asset-backed 

securities markets, a major source of capital for many 

subprime mortgage securitizers. According to Henry 

Willmore, senior economist for Barclays Capital in 

New York, spreads in the asset-backed market have 

widened already owing to the uncertain outlook. This 

uncertainty, which has forced down pricing, has made 

securitizers more reluctant to securitize, hurting the 

market’s liquidity. While most of the Region’s smaller 

subprime lenders do not securitize themselves, they do 

often sell their product to entities that use securitization 

as a major source of capital. Therefore, banks relying on 

loan sale gains for profitability and liquidity should be 

aware of the potential ramifications of increasing 

5 The group of banks and thrifts under $1 billion engaged in subprime 

lending was derived from a Division of Supervision survey of Field 

Office personnel and Case Managers in the San Francisco region. 6 Community banks have less than $1 billion in total assets and 

exclude specialty credit card banks. 

spreads and declining liquidity in the asset-backed securities market. 

Implications: This summer’s economic shocks, while 

perhaps too recent to affect the real economy, have 

reduced consumer expectations and could reduce consumer spending in the future. Some of these shocks, 

particularly the developments in Asia, will have a more 

severe effect on the San Francisco Region than on the 

rest of the nation. A reduction in consumer spending at 

this point in the economic cycle could signal both a 

slowdown in the economy and a deterioration in loan 

quality. 

Both the Region’s credit card and subprime lenders have 

benefited from the surge in consumer spending. While 

growth in the credit card market appears to be slowing, 

the decline in this sector has been offset to some degree 

by growth in the subprime and high loan-to-value residential market. Given the potential for an economic 

slowdown, credit card lenders and subprime lenders 

should evaluate their portfolios and business products 

closely to ensure that their products remain appropriately priced. Further, because of their reliance on securitization and loan sales to securitizers for profits, these 

lenders must continually monitor liquidity and investor 

preferences in the asset-backed security market. 

Catherine I. Phillips-Olsen, Regional Manager 

Gary C. Zimmerman, Regional Economist 

Millen L. Simpson, Financial Analyst 

San Francisco Regional Outlook 25 Fourth Quarter 1998 
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