Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1998 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

John D. Weier,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael J. Feeney,
 

Financial Analyst
 

In Focus This Quarter 

◆ Gain-on-Sale Accounting Can Result in Unstable Capital Ratios and Volatile Earnings—The accounting for transferring and servicing financial assets causes asset sellers, particularly high-growth lenders, to recognize significant noncash income related to retained economic interests in the sold 

assets. This is true whether a company securitizes its own assets or sells its assets as 

a conduit to another securitizer. Values are often driven by management assumptions about future performance of the sold assets. Major writedowns of gain-on-sale 

assets by some finance and mortgage companies underscore the importance of careful scrutiny of these assumptions by banks and their supervisors. See page 3. 

By Allen Puwalski 

◆ How Will the Expansion End?—Analysts are now focusing on when 

and how the current expansion will end. Although no one can accurately predict 

when a recession will begin, two possible scenarios have emerged. Each scenario has 

important implications for lenders as they prepare for the possibility of slower economic growth or recession. See page 7. 

By Paul C. Bishop 

◆ Trends Affecting the Allowance for Loan and Lease Losses— 

In today’s environment, in which loan availability is abundant, growth is strong, and 

competition is fierce, some industry leaders and regulators have expressed concern 

about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the allowance for loan and lease losses (ALLL) relative to 

total loans at many insured institutions is declining. As the economic expansion 

reaches an advanced age, an important question for insured institutions is whether 

their ALLLs adequately reflect the risks associated with changing industry practices. See page 11. 

By Andrea Bazemore 

Regular Features 

◆ Regional Economy—The Chicago Region’s economy is healthy...however, the aging cyclical expansion and possible repercussions from conditions in Asia 

create the potential for a simultaneous weakening in its manufacturing and agricultural sectors...such a development would expose a number of insured institutions throughout the Region to changing economic conditions in the communities 

they serve. See page 16. 

By the Chicago Region Staff 

◆ Regional Banking—Chicago Region institutions continue to deal with 

significant changes and maintain strong operating performance...this strong performance notwithstanding, analysts have identified a number of emerging risks and 

trends that bank managers, examiners, and auditors likely will have to contend with 

in 1998...while some of these issues are unique, such as Year 2000 concerns, most 

revolve around traditional bank lending, funding, and sales operations. See page 20. 

By the Chicago Region Staff 

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, AS, AZ, CA, 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 Chicago 

Region’s Regional Outlook, please call John Weier at (312) 382-7512 or send an e-mail to 

jweier@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 

Editor George E. French 

Assistant Editors Gary L. Beasley 

Jack M.W. Phelps 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Gain-on-Sale Accounting Can Result in Unstable
 

Capital Ratios and Volatile Earnings 


•	 Gains generated from asset sales under SFAS 125 

rely on management assumptions about the lifetime performance of the assets sold and may not 

materialize in cash if the assumptions prove 

incorrect. 

•	 Gain-on-sale accounting has been most significant to securitizers, but nonsecuritizers can and 

do retain economic interests that give rise to significant gain-on-sale assets. 

•	 Finance companies seeking to shift attention from 

gain-on-sale assumptions may find willing bank 

correspondents. 

•	 The rating services have modified capital and 

earnings analysis in order to lessen what they consider distortions caused by SFAS 125. 

Statement of Financial Accounting Standards No. 125 

(SFAS 125),Accounting for Transfers and Servicing of 

Financial Assets and Extinguishing of Liabilities, 

causes asset sellers, particularly high-growth lenders, to 

recognize significant noncash income. Applying SFAS 

125, which became effective on January 1, 1997, can 

give rise to significant noncash gains and related assets 

if an economic interest is retained in assets sold. The 

value of retained interests in assets sold is quantified on 

the basis of management’s assumptions about future 

charge-off rates, repayment rates, and the rate used to 

discount the expected cash flows from the loans sold. 

Because the value of these assets changes when actual 

performance deviates from the assumptions, the quality 

of earnings, capital, and liquidity for a lender that relies 

significantly on gains on sale must be considered carefully. 

The recent writedowns of interest-only (IO) assets by a 

few major finance companies have led to a higher level 

of scrutiny of companies whose financial statements are 

influenced significantly by gain-on-sale accounting. 

The Securities and Exchange Commission has recently 

increased its scrutiny of publicly traded companies that 

use gain-on-sale accounting, and it may soon require 

assumptions regarding defaults, prepayments, and discount rates to be disclosed in financial statements. The 

same companies that enjoyed soaring stock performance thanks to high earnings growth caused by gainon-sale accounting have seen their stock values tumble 

as they have had to write down their gain-on-salerelated assets. 

Several major credit rating companies have recognized 

the significant effect of gain-on-sale accounting under 

SFAS 125 on interpreting financial statements. These 

companies have issued comments or reports dealing 

with SFAS 125’s effect on the quality of earnings and 

capital of the companies they rate and how they adjust 

their analysis as a result. The consensus of these papers 

is that gain-on-sale accounting for companies that securitize often results in significantly higher reported earnings and equity compared to balance sheet 

lenders—without, in many cases, materially changing 

the underlying economics or credit risk to the originator 

of the assets.1 Generally, the rating services have modified capital and earnings analysis in order to lessen 

what they consider distortions caused by SFAS 125. 

There Are Risks Associated with Gain-on-Sale 

Accounting 

The asset booked in connection with an SFAS 125 loan 

sale is an IO strip that represents the present value of 

future excess spread cash flows generated by the transferred assets. Generally, asset-backed securitizations, 

including some classified as mortgage-backed securities, are structured so that each month the expected cash 

flows from the underlying assets will be sufficient to 

pay the investor coupon, the trust expenses, the servicing fee, and net charge-offs. The cash flow that the 

underlying assets will generate each month cannot be 

known with certainty because the underlying asset may 

allow for variable principal payments (e.g., credit card 

accounts), or the borrowers may default. Securitizations 

are structured so that there is enough cushion between 

the expected cash flows and the required payments and 

1 Duff & Phelps Credit Rating Company, “Securitization and Corporate Credit Risk.” Special Report Financial Services Industry, July 

1997; T. E. Foley and M. R. Foley. “Alternative Financial Ratios for 

the Effects of Securitization Tools for Analysis.” Moody’s Special 

Comment, September 1997; H. L. Moehlman, R. W. Merrit, and N. E. 

Stroker. “Capital Implications of Securitization and Effect of SFAS 

125.” Fitch Research, September 16, 1997. 

Chicago Regional Outlook 3	 Second Quarter 1998 
In Focus This Quarter
 

expected charge-offs to absorb fluctuations in actual 

cash flows and actual charge-offs. This cushion is 

excess spread. As actual cash flows vary from projections, so does the excess spread generated. 

According to SFAS 125, when a company sells assets 

and retains the right to future excess spread cash flows, 

the calculation of the gain on the sale includes the capitalization of this right. In many transactions, the gain 

on sale consists entirely of the fair value of the IO strip 

that represents this right—none of which is necessarily 

received in cash. In addition, with many transactions, 

cash receipt is further delayed while cash flows go to 

fund the spread account, which is analogous to an internal loan loss reserve. 

SFAS 125 states that quoted market prices in active 

markets are the best evidence of fair value and should 

be used whenever available. Although there have been 

some sales of these IO strips, the number of sales is not 

yet sufficient to constitute an active market. When market prices are not available, SFAS 125 states that the 

estimate of fair value should be based on the best information available. In practice, fair value of the excess 

spread is determined by present valuing the expected 

cash flows using a discounted cash flow model. 

The value of the right to future cash flows is determined 

on the basis of management’s assumptions about the 

charge-off rate, the average life of loans, and the rate 

used to discount the cash flows. These input assumptions drive the model results and, therefore, the magnitude of the gain. The stability of the value of the IO will 

depend greatly on the extent to which the input assumptions accurately describe the pool performance over the 

life of the transferred assets. Changes in economic or 

market conditions that were not anticipated in the initial 

cash-flow assumptions will likely cause the pool of 

loans to perform differently than initially projected. 

Gain-on-sale accounting is significant to securitizers. 

To illustrate the significance of the IO account to a 

securitizer’s reported income, consider one major subprime lender. During fiscal year 1997, this company’s 

IO asset grew by over $141 million. Despite a $28 million writedown of the IO asset, the net growth of the 

asset constituted over half of total revenue and over 

eight times net income. The revaluation of the IO was 

necessitated by higher-than-expected prepayment rates. 

Current market conditions were not anticipated by 

many companies that benefited from high earnings 

related to gain-on-sale accounting. Several other major 

securitizers have reduced the carrying value of their IO 

assets in the face of either rising charge-off rates or 

higher prepayment rates. Writing down an IO strip 

largely represents a company’s admission that it will not 

generate on a cash basis income that was booked previously. 

Chart 1 displays the cumulative charge-off rates by vintage for Moody’s index of home equity loan securitizations. The index consists mostly of prime mortgages, so 

the loss rates are still low. However, the rising trend in 

losses is noteworthy and reflects the growing influence 

of subprime securitizations on the index and the related 

decline in underwriting standards as competition has 

increased in this market. Loans originated in 1995 and 

1996 are causing progressively larger and earlier losses. 

After 21 months of seasoning, the cumulative loss rate 

on loans originated in 1996 is .17 percent—almost six 

times the loss rate experienced by the 1994-originated 

cohort at the same age. Despite the continued low loss 

rates for the home equity market in general, subprime 

lenders are experiencing accelerated loss rates that are 

eroding the value of their interests in excess spreads. 

There may be a tendency for management to base 

assumptions about expected loss rates on loans sold 

solely on past experience with similar loans. Such an 

approach may not capture changes in market conditions 

and trends. For example, the Moody’s data demonstrate 

that loss rates on home equity loans, including first 

liens, have been trending upward rapidly. This trend 

implies that when estimating loss rates, management 

should consider the potential for changes in market conCHART 1 

Vintage Analysis of Home Equity Loan 

Securitizations 

Source: Moody’s Investor Services 

0.00 

0.05 

0.10 

0.15 

0.20 

1 3 5 7 9 11 13 15 17 19 21 

Cumulative 

Loss (%) 

1994 

1995 

1996 

Months 

Chicago Regional Outlook 4 Second Quarter 1998 
In Focus This Quarter
 

ditions over the life of the sold assets as well as the past 

performance of similar assets. 

Like loss rates, prepayment rates have risen substantially in the subprime mortgage market. Several factors 

have contributed to the rise. One factor is the trend 

toward higher loan-to-value (LTV) loans in the mortgage market, which has allowed borrowers to obtain 

additional cash from their homes without waiting to pay 

down principal. Mortgage bankers report the tendency 

of some subprime borrowers, often debt consolidators, 

to maintain outstanding balances at the highest possible 

LTV. With maximum LTV ceilings rising, debt consolidators can refinance home equity loans without having 

to amortize existing debt. 

Another important factor contributing to rising prepayment rates is competition among lenders for volume 

growth. To continue to grow volume, lenders have been 

sacrificing margins on loans to offer a better rate to borrowers. When estimating prepayment rates for subprime 

borrowers, it has been normal to expect that they would 

need to improve their credit rating, or “credit cure,” 

before they would find it economical to refinance. Stiff 

competition for volume has allowed borrowers to find 

better rates without credit curing and has stimulated 

them to refinance prior to the time estimated at origination. Falling interest rates and a relatively flat yield 

curve are likely to increase prepayment rates. 

In standard finance theory, uncertainty about the future 

level of losses and prepayment rates is compensated for 

by discounting the cash flows at a higher rate. Some 

analysts advocate using a discount rate similar to the 

required rate of return for equity investments. Faced 

with changing conditions, one large finance company 

that specializes in high LTV lending announced in 

December 1997 that it was increasing the discount rate 

it uses to value new IO strips from 12.5 percent to 33 

percent. 

The IO Strip Asset Is Growing at Insured 

Depository Institutions 

As of December 31, 1997, only 30 institutions reported 

this IO asset at more than 5 percent of tier 1 capital. 

However, some institutions have booked gains that 

should have given rise to a call-reportable IO strip but 

did not properly report the assets. Therefore, the current 

reporting may understate the prevalence of the asset. 

Furthermore, the recent attention to gain-on-sale 

accounting from the public equity markets has at least a 

few large finance and mortgage companies seeking 

business strategies that shed IO strip-related volatility 

from their financial statements. One such strategy 

already in use is to leave the economic interest in excess 

spread with the correspondents that originate the loans. 

This is done as follows: The correspondent originates 

loans for purchase by a finance company. The finance 

company pays par for the loans, and instead of being 

paid an origination fee or a premium for the loans, the 

seller retains the right to excess spread generated over 

the life of the loan. The seller books a gain and an IO 

asset that capitalizes this right to receive future cash 

flows. The nature of the IO asset is exactly the same 

whether it arises directly from a securitization or from a 

sale of loans to a securitizer. If this strategy is used 

widely by finance and mortgage companies, then IO 

strips are likely to grow among institutions that originate loans for sale to these companies (see Chart 2). 

For insured depository institutions, the capital effects of 

SFAS 125 need to be evaluated carefully. Analysis of the 

financial statements and leverage ratios of insured institutions should consider fully issues related to the quality of earnings and the stability of capital posed by the 

volatility of the IO strip. Insured institutions that engage 

in significant asset sales while retaining economic interests that give rise to SFAS 125–related assets are subject 

to distortions similar to those of nonbank financial 

companies. 

The activity of originating and selling loans and booking associated gains can lead to capital ratios that 

CHART 2 

IO Strip Is Growing at Insured Institutions 

Source: Bank & Thrift Call Reports 

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

3.00 

1Q97 2Q97 3Q97 4Q97 

$Billion 

120 

130 

140 

150 

160 

Number of Institutions 

Number of Institutions 

IO Strip 

Chicago Regional Outlook 5 Second Quarter 1998 
In Focus This Quarter
 

appear high by traditional bank standards. For several 

reasons, the leverage ratio can appear particularly high. 

First, although the asset may be more volatile than 

mortgage serving rights, there is no limit to the amount 

of IO strip that a bank can include in tier 1 capital. Second, the amount of IO strip booked increases capital by 

a gain on the net of the tax effect. The extent to which 

the amount remains in capital depends, of course, on the 

institution’s dividend policy. Third, the denominator of 

the leverage ratio is reduced by the sale because the 

loans are no longer assets of the bank. The cumulative 

result can be a significant boost to the leverage ratio. 

Several insured institutions report an IO strip at greater 

than 25 percent of tier 1 capital. For an institution whose 

primary line of business is originating and selling subprime mortgages, the asset can quickly reach a level 

exceeding tier 1 capital. In a little more than a year of 

originating and selling subprime mortgages to a major 

securitizer, one institution has amassed IO assets that it 

has valued at more than 150 percent of tier 1 capital. 

The institutions that have concentrations of 25 percent 

or more of tier 1 capital in IO assets have a median 

leverage ratio of about 11 percent. In contrast, the median equity capital ratio for nonbank mortgage securitizers tracked by SNL DataSource is about 30 percent. 

Public debt markets or banks that lend to these finance 

companies appear to require significantly higher capital 

levels than regulatory minimums required for banks. 

The potential for growth of the IO 

strip asset at insured institutions 

seems strong. In some circumstances, minimum capital standards for banks may require 

significantly less capital for IO 

asset exposure than the public 

equity markets. Perhaps more 

important, the quick rise of the significance of gain-onsale accounting to the mortgage and consumer credit 

markets exemplifies the speed with which exposure to 

risk can be acquired through the securitization market. 

Strong demand for asset-backed securities coupled with 

changing accounting emphases, which in this case favor 

asset sellers, can lead quickly to substantial exposures. 

Allen Puwalski, Senior Financial Analyst 

Risk-Based Capital (RBC) Treatment of the Gain-on-Sale–Related IO Asset 

If the IO asset derives from excess spread that absorbs tions does not necessarily preclude subprime mortcharge-offs from the sold assets, then the IO strip con- gages in general from receiving the reduced risk 

stitutes recourse from the sold assets for RBC pur- weighting. Although the capital standards require that 

poses. RBC standards require capital to be held mortgages be prudently underwritten to qualify for 

against this exposure. In general, the capital require- the 50 percent risk weighting, it is not entirely clear 

ment for this exposure is the amount of capital that how the term “prudently underwritten” applies to subwould have been required for the assets had they not prime mortgages. A higher expected loss rate alone 

been sold. If the sold assets are one- to four-family may be insufficient cause for presuming that the 

residential mortgages, they may receive a 50 percent mortgages are not prudently underwritten. 

risk weighting. Subprime mortgages are not necessarily precluded from receiving this weighting. The rationale for reducing the capital requirement for 

traditional one- to four-family mortgage lending is 

In order to apply the 50 percent risk weighting, the related to the maturity of the market and consistently 

capital standards require that one- to four-family res- low loss rates. As noted above, the subprime mortgage 

idential mortgages be fully secured and prudently market is changing rapidly, and loss rates can be much 

underwritten. The “fully secured” requirement pre- higher than in traditional mortgage lending. Accordcludes high-LTV loans with LTV ratios of greater ingly, bank managements need to be aware of the 

than 100 percent from receiving reduced capital potential volatility and risks associated with gain-onrequirements, but the language of the RBC regula- sale assets associated with subprime mortgages. 

Chicago Regional Outlook 6 Second Quarter 1998 
In Focus This Quarter
 

How Will the Expansion End?
 

•	 Despite a very low unemployment rate and high 

industry capacity utilization, inflation has been 

unusually subdued during this expansion, with 

price declines in some sectors. 

•	 After seven years of expansion, most analysts 

expect the economy’s growth to slow in the coming 

months. 

•	 The last seven expansions have ended with an 

inflation-driven increase in short-term interest 

rates; in contrast, some analysts believe that the 

next recession will be caused by a period of falling 

prices for commodities, finished goods, and perhaps wages. 

•	 Insured institutions that base lending and strategic decisions on assumptions of continued robust 

economic growth should scrutinize and test those 

decisions against possible adverse change in economic conditions. 

The current economic expansion is the third longest on 

record since World War II. Since mid-1991, when the 

expansion began, more than 15 million new jobs have 

been created and inflation-adjusted gross domestic 

product (GDP) has increased by nearly 20 percent. In 

fact, the unemployment rate reached a 24-year low 

when it fell to 4.6 percent in November 1997 and again 

in February 1998. At the same time, inflation has 

remained unusually low, at only 2.3 percent during 

1997. 

Analysts are now focusing on when and under what circumstances the current expansion will end. While no 

one can accurately predict when the expansion will end, 

two related but competing theories about how it will end 

have emerged in recent months. The first and more 

familiar scenario occurs when the Federal Reserve 

increases short-term interest rates to prevent a rapid 

increase in inflation caused by an overheating economy. 

The second scenario, a deflation-induced contraction, is 

less familiar in the context of recent recessions. This 

scenario posits a period of falling prices for commodities, finished goods, and, under the most severe circumstances, even wages. 

Whatever the cause of the next downturn, its effects are 

likely to be important for the performance of lenders. 

During the 1990–91 recession, for example, the widespread deterioration of economic conditions was 

reflected in a number of indicators: Inflation-adjusted 

GDP fell by 2 percent; the number of business failures 

rose by nearly 40 percent; unemployment increased by 

more than 40 percent to 9.8 million; the unemployment 

rate peaked at more than 7 percent; single-family housing starts fell by almost 22 percent; and the bank card 

delinquency rate increased from 2.4 percent to 3.3 percent. This experience suggests that no matter what triggers the next downturn, dramatic adverse changes in the 

drivers of bank performance will likely result. 

How Have Economic Expansions 

Usually Ended? 

Although to some extent each business cycle is unique, 

virtually all of the post–World War II expansions have 

shown a similar characteristic: Toward the end of the 

expansion, inflation has accelerated. As the economy 

expands, the prices of inputs, including the wages of 

workers, are bid up as firms compete for resources to 

meet demand. The overall inflation rate will rise if 

prices increase across a large number of industries. Left 

unchecked, an increase in the overall price level may 

itself feed back into the labor market through demands 

for higher wages. 

By raising short-term interest rates, the Federal Reserve 

can limit what might otherwise lead to a rapid increase 

in both wages and prices. Higher interest rates will 

reduce sales of capital goods, housing, and consumer 

durables, the demand for which is very sensitive to the 

level of interest rates. One reflection of this sensitivity 

is the changing pattern of loan growth over the business 

cycle. During periods of expansion, the demand for 

loans grows rapidly as businesses and households borrow to finance purchases of capital goods and consumer 

durables. If short-term interest rates are increased in 

response to inflationary pressures, loan growth will 

slow as businesses and consumers reduce their demand 

for loans. If interest rates continue to increase, loan 

growth may decline as it has done before and during 

each recession. The cyclical movement of loan growth 

(with vertical bars indicating periods of recession) is 

shown in Chart 1 (next page). 

Looking more closely at short-term interest rates, Chart 

2 (next page) illustrates the federal funds rate during the 

Chicago Regional Outlook 7	 Second Quarter 1998 
In Focus This Quarter
 

CHART 1	 expansion began. During the expansion between 1975 

and 1980, for example, the inflation rate was nearly 12 Commercial Bank Loan Growth percent at the start of the expansion but fell to just over during the Business Cycle 6 percent after four quarters. Inflation remained at 

approximately 6 percent until the twelfth quarter of the 

–5 

0 

5 

10 

15 

20 

25 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 

Percent Change—Year Ago 

expansion, after which it accelerated to more than 12 

percent by the end of the 20-quarter expansion. 

The current inflation trend differs from previous expansions in two ways. First, by the later stages of previous 

expansions, inflation was accelerating (see Chart 3). In 

contrast, there are few signs of accelerating consumer 

price inflation during the current expansion. In fact, it 

appears that the rate of inflation is declining; the United 

States has experienced disinflation.1 Second, among 

Source: Federal Reserve 

last seven business cycles. While an increase in shortterm interest rates has preceded each recession, it 

should be noted that an increase in rates is not sufficient 

to induce a recession. An increase in rates in 1984 was 

followed by a period of rapid growth that lasted until 

1990. More recently, the increase in rates during 1994 

was accompanied by a slowdown in the economy, but 

not a recession. 

What Is Different about Inflation 

during This Expansion? 

With history as a guide, one would expect inflation to 

rise as the current expansion matures. Chart 3 illustrates 

consumer price inflation during the four longest postwar expansions, including the current one. The chart 

shows the inflation rate at various points after the 

CHART 2 

expansions that have lasted more than 20 quarters, the 

current rate of inflation is one of the lowest since World 

War II. Consumer inflation is both decreasing and low 

by historical standards. 

What Are the Two Views about 

Future Inflation? 

Two views have developed about how the current 

expansion will end. The debate, couched in terms of the 

expected rate of future inflation, is of more than academic concern. The Federal Reserve’s decision about 

1 In popular discussions of inflation rates and the price level, terminology is sometimes used loosely. To clarify, a declining rate of inflation, properly described as disinflation, means that prices are 

increasing at a progressively slower rate over time. Deflation is 

defined as a generally falling price level or, equivalently, a negative 

inflation rate. 

CHART 3 

Federal Funds Rate and Recent 

Recessions 

0 

5 

10 

15 

20 

1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 

Federal Funds Rate (percent) 

Source: Federal Reserve 

Consumer Price Inflation during Four Longest 

Postwar Expansions 

0 

2 

4 

6 

8 

10 

12 

14 

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 

Quarters after Start of Expansion 

Percent 

1975–1980 

1982–1990 

1961–1969 

1991–present 

Note: Prices exclude food and energy 

Source: Bureau of Labor Statistics 

Chicago Regional Outlook 8	 Second Quarter 1998 
In Focus This Quarter
 

whether to change short-term interest rates may be 

influenced by arguments on either side of the debate. 

The Traditional View 

Although inflation has been tame during this expansion, 

adherents of the traditional view believe that impending 

inflation still poses a danger to the longevity of the 

expansion. Evidence cited to support this view includes 

a very low unemployment rate and rising inflationadjusted wages. The reasons for the low inflation rate 

include low energy prices, inexpensive imports, and 

brisk domestic and international competition. These 

factors have delayed the onset of inflationary pressures, 

but they will not remain favorable indefinitely. The 

underlying dynamics have not changed significantly 

from those that led to rising inflation during every other 

recent economic expansion. This is also the view of the 

Federal Reserve Open Market Committee, as stated in 

the minutes of its November 12, 1997, meeting: 

The reasons for the relative quiescence of inflation 

were not fully understood, but they undoubtedly 

included a number of special factors...the risks 

remained in the direction of rising price inflation 

though the extent and timing of that outcome were 

subject to considerable debate. 

—Federal Reserve Bulletin, February 1998, p. 104 

The Deflation View 

Alternatively, some analysts suggest that a recession 

may be brought about by a period of deflation. Advocates of this scenario base their view on the unusually 

low and falling inflation rate in the United States, even 

after seven years of economic expansion. They also suggest that the national economy of the 1990s is markedly different from that of the 1970s and 1980s. Intense 

global competition is now the norm and not the exception. Worker productivity growth is believed to be higher than the official data show, meaning that wage 

growth will not translate as readily as before into price 

increases. The U.S. economy is more prone to a period 

of falling prices than at any time in the recent past, especially in view of decreasing rates of inflation and deflationary forces originating from the ongoing Asian 

financial crisis. 

What Does the Evidence Show? 

Because determining economic policy is necessarily a 

forward-looking process, policymakers look at many 

indicators to determine the likely future course of inflation. A brief review of some of the more popular indicators reveals contradictory readings that can support 

either the inflation or deflation scenario. 

Wage Growth 

The national unemployment rate is currently very low, 

signaling that labor markets are near capacity in terms 

of their ability to create new jobs. The nation’s unemployment rate was below 5 percent for nine months during 1997. This rate has been well below what many 

analysts thought possible without a sharp rise in inflation. As labor market conditions have tightened, wage 

growth has increased. Since 1993 the rate of growth has 

been on a steady upward trend, from a low of just over 

2 percent to about 4 percent in the first quarter of 1998. 

Capacity Utilization 

Capacity utilization, the percentage of industrial capacity that is currently in use, has risen since early 1997. 

Utilization has been around 83 percent since mid-1997, 

a threshold rate that has traditionally signaled impending inflationary pressures at factories, mines, and utilities. 

Commodity Prices 

Many commodities, such as metals, crude oil, and 

unprocessed food products, have exhibited weak prices 

during the past several months. Between mid-1996 and 

early 1998, the Knight-Ridder Commodity Research 

Board Price Index fell by more than 15 percent. Key to 

the decline was a 35 percent decrease in crude oil 

prices. 

Finished Goods Prices 

Since the data show that both labor and physical capital 

are at high rates of utilization, the traditional inflation 

scenario suggests that there will be increasing price 

pressures. In the manufacturing sector, such price pressures would likely show up first in the prices of goods 

as they leave the factory. The price of finished goods 

rose by only 0.4 percent during 1997, however. On a 

monthly basis, prices declined during eight months in 

1997. 

Service Sector Prices 

The service sector accounts for a growing portion of all 

output and employment in the U.S. economy. Labor 

costs generally account for a much higher percentage of 

input costs in the service sector than in the manufacturChicago Regional Outlook 9 Second Quarter 1998 
In Focus This Quarter
 

ing industries. Additionally, many service industries 

operate in local markets and are insulated from national or global competition. Consequently, inflation rates 

in the service sector are generally higher than in the 

goods sector. Service sector inflation has, however, 

been on a downward trend, falling from 5.5 percent in 

1990 to 3.1 percent in 1997. 

Import Prices 

Since early 1996, import prices have fallen precipitously. The decline is due in part to the rising value of the 

dollar, which has reduced the cost of imports. Nonpetroleum import prices have fallen by 5 percent since 

early 1996. Within that group, capital goods prices have 

decreased by 12 percent over the same period. 

One factor that will continue to put downward pressure 

on prices is the turmoil in Asian markets. Asian 

exporters are now much more competitive with the rest 

of the world, following the drop in the value of their currencies. Consequently, U.S. firms that compete with 

Asian producers will be under greater pressure to cut 

prices. At the same time, reduced Asian demand for 

U.S. exports could lead to a ballooning trade deficit and 

a softening of export prices. In January 1998, for example, the United States reported a record-breaking trade 

deficit of $12 billion, caused in part by slower export 

growth. 

From this brief review, it is apparent that signs of 

impending inflation are at best mixed. Clearly, U.S. 

labor markets are at or near full effective capacity, and 

the utilization of factories and physical capital is also 

very high. There is little evidence that these factors are 

causing an increase in prices at either the producer or 

consumer levels. 

How Will the Expansion End? 

Although no one can accurately determine when the 

expansion will end, most analysts are predicting slower 

economic growth in the second half of 1998. Indicators 

such as the unemployment rate suggest that growth will 

be limited by the availability of labor needed to produce 

an increasing supply of goods and services. Weak or 

declining output prices in some sectors could act as a 

further constraint on economic growth. 

Among economists, the traditional view that the expansion will end following a rise in inflation and an 

increase in short-term interest rates appears to be the 

more prevalent view. Nevertheless, the possibility that 

the next economic downturn might be triggered by the 

ripple effects of declining output prices should not be 

dismissed, especially in light of the potentially adverse 

and less familiar risks associated with deflation. What is 

clear for insured institutions is that at this stage of the 

economic expansion, lending and strategic decisions 

predicated on an assumption of continued robust economic growth should be carefully scrutinized and considered in light of a possible deterioration of economic 

conditions. 

Paul C. Bishop, Economist 

Why Might Deflation 


Be a Concern?
 

The most significant difference between the inflation and deflation scenarios is reflected in the 

response of financial markets. One of the consequences of inflation is that a dollar in the future is 

of less value than today’s dollar. In a deflationary 

environment, the opposite is true—a dollar in the 

future will buy more goods and services than a dollar today. 

In a deflation scenario, debtors would see the real 

value of their financial obligations rise and might 

therefore be hesitant to borrow. A fixed monthly 

mortgage payment, for example, would be paid 

back with increasingly valuable dollars over time. 

Asset values could fall, especially since the purchase of an asset, such as a house, would require 

inflation-adjusted debt repayments that increase 

through time. Likewise, consumer credit debt obligations, such as payments on outstanding credit 

card balances, would become increasingly onerous. 

For households already experiencing credit problems, the prospect of a period of sustained deflation 

would worsen their financial position. At the very 

least, deterioration in credit quality would be 

expected, along with an increase in the number of 

business and personal bankruptcies. 

Chicago Regional Outlook 10 Second Quarter 1998 
In Focus This Quarter
 

Trends Affecting the Allowance for
 

Loan and Lease Losses
 

•	 Allowance for loan and lease loss (ALLL) levels 

are declining relative to total loans. 

•	 Some industry leaders and regulators have 

expressed concern about the loosening of underwriting standards and greater risk in bank loan 

portfolios. 

•	 Significant growth in riskier loan types calls 

attention to the need to scrutinize closely the adequacy of the allowance. 

Weakening underwriting standards and significant 

growth in riskier loan types have increased the risk 

exposures of some insured institutions to an economic 

downturn. Meanwhile, the ALLL relative to total loans 

has declined in recent years. This article provides information on trends in the ALLL over time and by loan 

type and discusses the factors analysts consider when 

evaluating the adequacy of the ALLL. Special attention 

is given to issues related to the volatility of loan losses 

and the composition of the loan portfolio. 

Historical Perspective on the Allowance 

for Loan and Lease Losses 

The nation is currently witnessing one of the longest 

economic expansions since World War II. It is to be 

expected that some institutions will reduce their ALLL 

CHART 1 

coverage during periods of improved economic conditions. However, in the current environment—in which 

loan availability is abundant, growth is strong, and competition is fierce—some industry leaders and regulators 

have expressed concern about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the ALLL relative to total loans 

for commercial banks has declined to the lowest point in 

a decade (see Chart 1). This allowance ratio has diminished because commercial banks’ loan loss provisions 

have not kept pace with new loan growth. In some 

cases, banks have determined that their allowances are 

higher than necessary and have taken negative loan loss 

provisions, which are credited back to income. 

This decline in reserve coverage has been broad based, 

with the exception of credit card specialists. Commercial banks with concentrations in commercial lending 

and large multinational banks have significantly 

reduced the level of reserves to total loans in recent 

years. Table 1 (next page) shows that since 1993, ALLL 

ratios at both commercial lending banks and multinational banks have declined 31 percent. Moreover, commercial lending banks with assets exceeding $10 billion 

have reduced ALLL ratios by slightly over 37 percent, 

or 98 basis points, over the same period. 

The low level of nonperforming and charged-off loans, 

coupled with prevailing favorable economic conditions, 

is doubtless a significant factor in the reduction of 

Chicago Regional Outlook 11 Second Quarter 1998 

Commercial Bank Reserves at Lowest Point in a Decade 

Source: FDIC Historical Statistics on Banking, National Bureau of Economic Research, Inc. 

1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

% of Loans

Current 

Expansion 

Recessionary 

periods 
In Focus This Quarter
 

TABLE 1 

Commercial Bank Allowance for Loan and Lease Losses to 

Total Loans by Lender Type 

TYPE OF LENDER 

NUMBER OF 

BANKS 

ASSETS 

($BILLIONS) 1997 1996 1995 1994 1993 

MULTINATIONAL 

COMMERCIAL 

CREDIT CARD 

MORTGAGE 

AGRICULTURAL 

11 

3,207 

67 

286 

2,373 

$1,383 

$1,915 

$202 

$120 

$120 

2.14 

1.63 

4.21 

1.26 

1.53 

2.25 

1.71 

3.48 

1.45 

1.66 

2.55 

1.90 

3.21 

1.45 

1.69 

2.83 

2.16 

2.89 

1.69 

1.75 

3.10 

2.37 

3.35 

1.87 

1.83 

Definitions for lender types by order of priority: Multinational—assets >$10 billion and foreign assets >25% of 

assets; Commercial—C&I plus CRE loans >50% of assets; Credit Card—credit card loans >50% of assets; Mortgage— 

1- to 4-family mortgages and mortgage-backed securities >50% of assets; Agricultural—agricultural production and 

agricultural real-estate loans >25% of total loans. 

Source: Bank Call Reports 

ALLL levels. Asset quality indicators such as nonperforming loans and loan loss rates are at historically 

favorable levels. At year-end 1997, the banking industry’s nonperforming loans were just under 1 percent of 

total loans, the lowest in 13 years. The industry’s loan 

charge-off rates (with the exception of consumer loans) 

are also at historical lows. (See the Regional Outlook, 

first quarter 1997, for a detailed discussion of consumer 

loan losses.) However, even with the problems in consumer lending, the banking industry’s aggregate loan 

loss rate is down significantly from levels in the early 

1990s (see Chart 2). 

As the economic expansion reaches an advanced age, 

an important question for insured institutions is 

whether their ALLLs adequately reflect the risks assoCHART 2 

Source: Bank Call Reports 

Asset Quality Indicators Are at Historically 

Favorable Levels 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1985 1987 1989 1991 1993 1995 1997

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

Charge-off 

Rates 

Nonperforming 

Loan Rates 

% of Total Loans 

ciated with changing industry practices. Insured institutions could experience strains on profitability and capital if allowance levels are inadequate. Given changing 

underwriting trends and loan delinquency patterns, a 

related question is whether reliance on past loss experience in setting the allowance will be an adequate measure for current losses. 

Trends in Underwriting Prompt 

Regulatory Cautions 

Over the past year, various underwriting and lending 

practices surveys by the FDIC, the Office of the Comptroller of the Currency (OCC), and the Federal Reserve 

have noted easing of terms and weakening underwriting 

standards on loans, especially in commercial loan portfolios. It is important to note that, in 1997, nearly twothirds of the commercial banking industry’s loan growth 

was centered in the commercial real estate (CRE) and 

commercial and industrial (C&I) loan categories 

(Chart 3). 

In the FDIC’s Report on Underwriting Practices for 

April 1997 through September 1997, examiners noted 

“above-average” risk in current underwriting practices 

for new loans at almost 10 percent of the 1,233 FDICsupervised institutions examined. Of the institutions 

with above-average risk, 12 percent did not adjust pricing for loan risk. Examiners noted that several of the 

852 institutions examined that were making business 

loans had poor underwriting standards, including lack 

of documentation of the borrower’s financial strength 

Chicago Regional Outlook 12 Second Quarter 1998 
In Focus This Quarter
 

(21 percent) and poor and unpredictable loan repayment 

sources (14 percent). Also, of the 571 institutions 

specifically involved in asset-based business lending, 

20 percent often failed to monitor collateral. Furthermore, 20 percent of the 398 institutions examined that 

were actively engaged in construction lending repeatedly failed to consider alternative repayment sources, and 

29 percent often funded speculative projects. In contrast, just one year earlier, in the Report on Underwriting Practices for April 1996 through September 1996, 

examiners reported that only 11 percent of the institutions examined that were actively engaged in construction lending often funded speculative projects. 

The Federal Reserve’s Senior Loan Officer Opinion 

Survey for November 1997 and February 1998 both 

indicated some easing of commercial business lending 

terms and standards. Also, the OCC’s 1997 Survey of 

Credit Underwriting Practices stated that the level of 

inherent credit risk continues to increase for components of both commercial and consumer loan portfolios. 

These underwriting trends have resulted in increased 

risk profiles for some insured institutions, while ALLL 

ratios at some institutions continue to decline. 

In August 1997, the OCC issued an Advisory Letter 

voicing its concern about declining allowance levels in 

commercial banks. The OCC cited as primary concerns 

the apparent increases in credit risk reported by examiners, such as weakening underwriting trends in the syndicated loan market, easing of other commercial 

underwriting standards, and consumer lending delinquency and charge-off trends. Moreover, the OCC 

found that some banks were using flawed reserve 

CHART 3 

Loan Growth in 1997 Centered in
 

Commercial Loans
 

% of Total Loan Growth 

–30 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

70 

80 

Commercial

Consumer

Residential

Mortgages

CRE 

C&I 

Other 

Note: Percent of all loan growth for commercial banks in 1997 

Source: Bank Call Reports 

methodologies for estimating loan loss rates, including 

an overreliance on historical loss rates. 

Factors Affecting Adequacy 

of the ALLL 

In using offsite data to assess allowance adequacy, analysts consider financial ratios such as the allowance to 

total loans, reserve coverage (allowance to nonperforming loans), loan loss provisions to charge-offs, and loan 

delinquency levels. These ratios are evaluated against 

historical benchmarks. At the same time, however, analysts supplement the analysis with consideration of the 

potential effects of current industry trends. For example, the banking industry is currently witnessing higher 

than normal losses in consumer lending spurred by 

increased bankruptcy filings and the migration of loans 

from current to charged off without intervening delinquencies. An institution that has a sizable consumer 

loan portfolio may therefore need to attach more weight 

to recent loan loss data in setting the allowance, since 

historical trends may not adequately reflect reserving 

needs. 

Insured institutions exhibit different management and 

portfolio characteristics that significantly influence the 

level of the allowance. These characteristics include the 

diversification of a loan portfolio (diversification by 

borrower, loan type, geography, or industry), the history and recent trends of credit losses, management’s 

practices in the recognition of losses, trends in past-due 

and nonperforming loans, underwriting practices, and 

economic conditions. 

New techniques continue to be developed to improve 

the reliability of allowance estimates. Management 

information systems, which enable the collection of 

more refined historical data, coupled with the application of statistical techniques, are helping some institutions formulate more statistically reasoned allowance 

estimates. Loan management tools such as credit scoring systems, risk rating systems, and consideration of 

economic cycles in the review of historical loss and 

delinquency data all are aiding bankers in the reserving 

process. While these new techniques provide more analytically defensible estimates, they do not diminish the 

role of judgment in assessing ALLL adequacy. 

The role of judgment in setting the ALLL is underscored by the volatility of loan losses over time. 

Chicago Regional Outlook 13 Second Quarter 1998 
In Focus This Quarter
 

CHART 4 

Historically, Commercial Loan Loss Rates Have Been Higher and More Volatile 

than Mortgage Loss Rates 

Source: Bank Call Reports 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1991 1992 1993 1994 1995 1996 1997 

Loan Loss Rates (%)

Commercial Real Estate Loans 

Commercial & Industrial Loans 

Residential Mortgages 

“Volatility” in this context refers to the degree to which 

loan losses have diverged or might diverge from the 

long-run averages. Volatility in loan losses can result 

from changes in the business cycle, local economic 

events, and major one-time events. For example, a bank 

relying on a historic average loan loss calculation to 

derive its reserve level could find itself underreserved if 

it does not adjust its historical loss rates for deteriorating economic conditions and suddenly incurs greater 

loan losses than it had anticipated simply on the basis of 

past performance. 

Generally, different types of loans experience varying 

loan loss rates because of the inherently different risks 

and varying levels of volatility within each type. Chart 

4 shows that commercial loans, such as commercial and 

industrial loans and commercial real estate, historically 

have had greater losses than residential loans. Furthermore, the loss rates on commercial loans have not only 

been higher, they have been more volatile over the 

years, while average losses on mortgage loans have varied little. 

Volatility in loan losses is determined not only by economic events but also by banks’ willingness to take risk. 

Banks that adopt more liberal underwriting policies and 

high loan growth objectives may experience greater 

loan default risk and greater volatility in loan loss rates 

than suggested by their own past experience. For example, Chart 4 shows that mortgage lending has had low 

and stable loss rates on average. The recent growth in 

subprime and high loan-to-value mortgage lending, 

however, may result in increased volatility and losses 

for some lenders going forward. 

All of these factors suggest that ALLLs would be 

expected to vary considerably both over time and across 

loan types. Table 2 shows that this has been the case. 

The ALLL is reported as a single line item on the Call 

Report. This makes it difficult to estimate how much of 

the ALLL is attributable to a particular loan type or to 

compare allowance levels for banks with significantly 

different loan portfolios. Table 2 shows the results of a 

statistical regression estimation of commercial bank 

allowance allocations across the various loan types for 

TABLE 2 

ALLL Allocations Have Varied over Time and by Loan Type 

(Commercial Banks under $1 Billion)* 

LOAN TYPE 1997 (%) 1996 (%) 1995 (%) 1994 (%) 1993 (%) 1992 (%) 1991 (%) 

C&I 

CRE 

MORTGAGES 

CREDIT CARDS 

1.71 

1.44 

0.92 

4.47 

1.85 

1.54 

1.00 

4.42 

1.87 

1.77 

1.05 

3.32 

2.06 

1.83 

1.19 

3.11 

2.14 

1.97 

1.22 

3.20 

2.29 

2.02 

1.07 

3.29 

2.45 

1.99 

0.91 

3.59 

* Estimated regression results 

Source: Bank Call Reports 

Chicago Regional Outlook 14 Second Quarter 1998 
In Focus This Quarter
 

1991 through 1997 for commercial banks with under $1 

billion in assets. Not surprisingly, CRE and C&I loans 

received relatively higher allowance allocations than 

residential mortgage loans, indicating that banks saw 

greater risk in these loan types. Also, credit card loans 

consistently received higher allocations than the other 

loan categories, and the allocations have increased in 

recent years owing to the increased delinquencies and 

charge-offs in this area. 

Conclusions 

The adequacy of the ALLL is measured not only relative to historical loan loss experience but also relative to 

current conditions that may cause losses to differ from 

past experience. Increased losses could result from 

adverse economic developments, from changes in 

banks’ appetite for taking risk, or 

both. In this regard, reported weakening in underwriting standards is 

increasing some banks’ risk exposure to an economic downturn. 

Institutions with high concentrations in riskier loans, significant 

growth in riskier loans, or weaknesses in underwriting may be most at risk. Especially 

for such institutions, the adequacy of the ALLL and its 

methodologies merits close scrutiny. 

Andrea Bazemore, Banking Analyst 

Chicago Regional Outlook 15 Second Quarter 1998 
Regular Features	 Regional Economy
 

Asian Situation Adds to Region’s
 

Vulnerabilities and Challenges
 

•	 The Chicago Region’s economy is currently quite healthy. However, cyclical conditions and the potential 

effects of the Asian situation suggest that manufacturers’ near-term ability to grow rapidly and maintain 

their profit margins may face increasing challenges. 

•	 The agricultural sector also may face stiff winds on a number of fronts, including expectations of lower crop 

prices, reduced export demand from Asia, and structural change. 

•	 Thus, the potential exists for both the Region’s manufacturing and agriculture sectors to weaken simultaneously. Such a development would expose a large number of insured institutions throughout the Region to 

changing economic conditions in the communities they serve. 

Overview: Current Conditions and 

Vulnerabilities 

The Chicago Region’s economy is quite healthy, but, as 

we have stated before, it continues to show some conditions and vulnerabilities typically experienced in the 

later stages of cyclical expansions. Recent developments in Asia add to the downside risks facing the 

Region’s important manufacturing and agricultural sectors. At best, the Region’s economy could continue 

operating at its currently high level—but moderate 

growth pace—for some time. Or, on the downside, both 

these sectors could falter simultaneously. Should this 

occur, the combined deterioration in two major but geographically dispersed parts of the Region’s economy 

might create widespread challenges and difficulties for 

growth; government hiring remained modest; and job 

losses in the mining sector continued. 

Commercial Real Estate Markets 

Both new construction and investment remain active. 

Even so, new construction starts in the Region fell by 9 

percent in 1997, with mixed behavior among the states, 

according to the FDIC’s Real Estate Report of April 

1998. Most dramatic were declines of 17 to 18 percent 

in Wisconsin and Illinois. Starts in Ohio were 11 percent lower than in 1996, while new construction in 

Indiana fell only 5 percent. By contrast, commercial 

construction starts in Michigan rebounded by 7 percent, almost offsetting the prior year’s decline. Although 

TABLE 1 

its banks. 

Labor Markets 

The unemployment rate of 4.0 percent in early 1998 was 

1.5 percentage points below its lowest point of the past 

two decades. Overall employment growth remained 

moderate, with varying strength among individual sectors (see Table 1). Construction posted the fastest 

growth (4.8 percent), although it slowed from the 1996 

pace. The services sector (e.g., health care, business, 

personal, legal, and other services) added jobs at the 

same, fairly rapid, 3.5 percent rate of the prior two 

years. New hiring in the finance-insurance-real estate 

(FIRE) sector was less rapid but held about steady relative to 1996. A revival in manufacturing job growth offset the prior years’ weakness and contributed to 

sustained hiring in the wholesale trade sector. Meanwhile, the retail trade and transportation-public utility 

sectors extended their recent trends of moderating 

Job Growth Strength Varies among 

Sectors in the Chicago Region (%) 

Q1:96 Q1:97 Q1:98* 

TOTAL PAYROLL 

EMPLOYMENT 1.5 1.7 1.9 

MINING − 7.3 − 0.8 − 1.4 

CONSTRUCTION 2.3 6.2 4.8 

MANUFACTURING − 0.3 − 0.2 1.0 

TRANSPORTATION, 

PUBLIC UTILITIES 1.5 1.8 1.1 

WHOLESALE TRADE 0.7 2.0 2.1 

RETAIL TRADE 2.1 1.0 0.8 

FIRE 1.3 2.7 2.4 

SERVICES 3.4 3.5 3.5 

GOVERNMENT 0.7 0.4 0.6 

Note: Growth calculated as percent change from the 

same period a year earlier 

* Q1:98 reflects January–February average. 

Source: Bureau of Labor Statistics via Haver 

Analytics, Inc. 

Chicago Regional Outlook 16	 Second Quarter 1998 
Regular Features Regional Economy
 

the estimated 88.8 million square feet of starts in 1997 

represent continuation of a slowing trend from 1995’s 

peak of 98.2 million square feet, recent activity still represents a considerable amount of space either just completed or yet to become available. 

Plans for future construction of commercial space in the 

Region are mixed. Millions of square feet of new office 

space are reportedly in the early planning stage for 

Chicago, Grand Rapids, and Indianapolis, while 

plans for retail space picked up in Cleveland and 

Youngstown.1 By contrast, according to the same 

source, late 1997 saw plans for significant amounts of 

new commercial space canceled in Columbus and 

Detroit. To date, absorption rates remain fairly high and 

vacancy rates are low or trending down in most of the 

Region’s metropolitan areas. Even so, clusters of speculative projects in some submarkets and the traditional 

slowing of economic growth late in a cyclical expansion 

suggest the need for caution ahead. 

Residential Construction 

Residential construction remains fairly high, although 

last year’s 9 percent drop in permits for single-family 

homes and 7.5 percent decline in multifamily building 

permits suggest that the peak in residential construction 

for this expansion may have passed. The Region’s resale 

1 FDIC, The Real Estate Report, January 1998. 

TABLE 2 

market (sales of existing single-family homes, condos, 

and co-ops) posted a lackluster advance, expanding by 

only 2 percent despite favorable employment conditions 

and mortgage rates. 

Ahead: Mixed growth outlooks for the Region’s manufacturers, potentially lower agricultural incomes, and 

the impact of the past year’s developments in Asia are 

expected to influence the Region’s economic health as 

the year unfolds. Because the Region’s composition and 

cyclical sensitivity have been discussed in previous 

Chicago Region editions of Regional Outlook, the rest 

of this article highlights the possible drag on the 

Region’s manufacturing and agricultural sectors that 

could arise from the past year’s financial and economic 

turmoil in a number of Asian countries. 

“Asian Contagion” May Affect the 

Manufacturing Sector 

The Region’s manufacturers are unlikely to escape 

repercussions from developments in Asia. Since mid1997, eight Asian countries have experienced moderate 

to significant currency depreciations (see Table 2). Consequently, the U.S. dollar prices of goods produced 

there have the potential to fall sharply, while slumping 

economic growth in many Asian nations has curtailed 

their demand for goods imported from the United States 

and elsewhere. Almost 16 percent of this Region’s 

Some Asian Countries Experienced Moderate to Significant 

Currency Depreciations 

UNITS OF FOREIGN CURRENCY PERCENT CHANGE: 

PER U.S. DOLLAR JUNE 97 

THROUGH 

JUNE 97 MARCH 98 MARCH 98 

INDONESIA (RUPIAH) 2427.83 9722.05 300 

THAILAND (BAHT) 24.91 41.58 67 

SOUTH KOREA (WON) 892.50 1472.16 65 

MALAYSIA (RINGGIT) 2.52 3.74 49 

PHILIPPINES (PESO) 26.37 39.08 48 

TAIWAN (TAIWAN $) 27.88 32.72 17 

SINGAPORE (SINGAPORE $) 1.43 1.62 13 

JAPAN (YEN) 114.30 129.09 13 

HONG KONG (HONG KONG $) 7.74 7.75 0 

PEOPLE’S REPUBLIC OF CHINA (YUAN) 8.30 8.28 0 

Source: Générale de Banque, New York, via Haver Analytics, Inc. 

Chicago Regional Outlook 17 Second Quarter 1998 
Regular Features 

exports last year went to the ten Asian countries shown 

in Table 2 (previous page). 

Regional firms that either purchase inputs from the affected 

countries or have production 

facilities there are expected to 

benefit from both the realigned 

exchange rates and the drop in 

labor and production costs 

abroad. Other firms, whose sales 

depend on the vigor of Asian economies or that compete 

with Asian producers in both domestic and overseas 

markets, are expected to fare less well. 

While the net impact of the Asian situation on Chicago 

Region manufacturers is expected to be negative, its 

magnitude is hard to gauge. Consensus forecasts suggest that 1998 real gross domestic product growth for 

the nation will be reduced by 0.5 to 1.0 percentage 

points from what it would have been in the absence of 

the Asian crisis. That is, forecasts of 3.5 percent growth 

were revised to the 2.5 to 3.0 percent range. It is reasonable to assume that the reduction in this Region’s 

growth because of Asian developments will be about the 

same magnitude. 

Specific industries and even individual companies may 

be affected quite differently, depending on their mix of 

products, input sources, and customer bases. Even 

though we cannot pinpoint specific firms or communities likely to experience significant negative repercussions from the Asian situation, we can highlight 

counties in this Region heavily exposed to the manufacturing sectors thought to be most vulnerable. Especially 

susceptible may be producers of: 

• motor vehicles and parts; 

• steel; 

• capital equipment; 

• heavy machinery; 

• electronic communications equipment; 

• chemicals; and 

• pharmaceuticals. 

Counties with a high share of earnings generated 

by manufacturing industries sensitive to cyclical and 

Asian developments are highlighted by dark shading in 

Chart 1. Although data underlying the map may not be 

Regional Economy 

all-inclusive for some counties (because of disclosure 

restrictions with respect to individual firms), the map 

shows that communities in northern and western Ohio, 

south and central Michigan, northern and eastern Indiana, northern Illinois, and southeastern Wisconsin are 

particularly vulnerable. 

Implications: About 23 percent of this Region’s 1,954 

banks and thrifts with assets of $500 million or less are 

headquartered in the counties with the darkest shading 

in the map. These banks service communities where 20 

percent or more of household earnings comes from 

manufacturing industries sensitive to both the aging 

expansion and repercussions from Asia. Another 36 

percent of the Region’s small and midsized banks are 

headquartered in counties where between 10 and 20 

percent of earnings come from the sensitive industries. 

Anecdotal reports indicate that some community 

bankers are already taking steps to identify potential 

exposure and to monitor their loan portfolios for possible ripple effects from Asia on their customer bases and 

communities. 

CHART 1 

Sensitive Manufacturing Industries Are Clustered 

in the Chicago Region 

Percent of 1995 County Earnings Generated 

by Sensitive Manufacturing Industries 

0 to 10% (211 counties) 

10% to 20% (110 counties) 

20% or more (116 counties) 

Note: The specific industries reflected in the map are motor vehicles and parts, 

machinery and other industrial equipment, fabricated and primary metals, electronic 

and other electrical equipment, rubber and plastic products, and chemicals and 

allied products. Individually, each of these industries accounts for more than 5 

percent of manufacturing jobs in the Region. 

Source: Bureau of Economic Analysis 

Chicago Regional Outlook 18 Second Quarter 1998 
Regular Features	 Regional Economy
 

Agricultural Communities Are Also Vulnerable 

Asia’s woes probably will have a more clear-cut negative influence on parts of the Region’s agricultural sector than on manufacturing. Corn and soybean farmers 

likely will feel the biggest impact, although hog and 

other agricultural sectors also may be affected. 

Corn and Soybeans 

Because Asia is a major purchaser of U.S. corn and soybeans, the net impact from recent events there is expected to be clearly negative for this Region’s crop farmers. 

About 60 percent of U.S. corn exports and 42 percent of 

soybean exports went to Asia last year. This is significant because this Region produces about 32 percent of 

the nation’s corn and 35 percent of its soybeans. Moreover, corn and soybeans (combined) account for almost 

46 percent of this Region’s agricultural cash receipts. 

In addition to the impacts from realigned exchange rates 

and economic weakness, U.S. corn exports to Asia are 

being trimmed by aggressive corn sales by the People’s 

Republic of China and by plummeting demand for feed 

corn from Taiwan, whose hog stock was decimated by 

disease last season. 

Late-spring estimates from the U.S. Department of 

Agriculture call for soybean prices this crop year to be 

around $6.50 a bushel, about 11.5 percent below last 

year’s average price. Corn prices are estimated to fall by 

roughly 8 percent, but such a decline would follow a 16 

percent decrease last year. 

While the direct effect of slumping demand for agricultural products will be felt in the farm sector, indirect 

effects may be felt by manufacturers of farm equipment 

and supplies if lower farm income cuts into such businesses as sales of tractors and farm equipment. 

Implications: The potential for reduced near-term vigor 

in the agricultural sector could affect over one-third of 

the Region’s counties. Because of crop farmers’ significant role, counties with large harvests of corn, soybeans, 

or both are highlighted in Chart 2. Most of these counties are relatively immune to shifts in manufacturing 

activity, but a few have measurable participation in both 

the manufacturing and crop farming sectors. 

Other Concerns 

The potential drag on farm incomes from the Asian situation unfortunately comes at a time when other challenges and uncertainties face the Region’s farmers. 

These include: 

•	 whether the continuing phaseout of subsidies and 

industry restructuring will prompt some small and 

marginal producers to leave the industry. This conCHART 2 

Corn and Soybean Production Is Concentrated 

in the Chicago Region 

Millions of Bushels 

(1997 Crop Year) 

0 to 10 (271 counties) 

11 to 20 (124 counties) 

21 to 30 (27 counties) 

31 or more (15 counties) 

Source: U.S. Department of Agriculture 

cern is especially relevant to the hog and dairy sectors; the number of hog farms in the Region fell by 

11 percent last year and the number of dairy operations fell by 8 percent. 

•	 whether more freedom in planting decisions leads to 

lower prices or greater price volatility than crop 

farmers and their lenders have dealt with in recent 

years. 

•	 whether effects from El Niño will contribute more 

uncertainty to planting decisions and heighten the 

risks associated with future price levels and volatility. 

In turn, these uncertainties raise issues for banks and 

lenders to the agricultural sector, including: 

•	 whether crop farmers’ income projections and balance sheets have sufficient flexibility to handle lower 

prices, potentially increased volatility, or both; 

•	 how banks will handle the loss of some long-standing hog and dairy customers as structural change 

affects their operations; and 

•	 how potentially greater seasonal price fluctuations, 

loss of some export markets, and longer term structural changes should be considered when valuing 

farmland as collateral for loans. 

More than 500 banks in the Region with direct agricultural loan exposure exceeding 100 percent of tier 1 capital are at risk from these conditions. 

Chicago Region Staff 

Chicago Regional Outlook 19	 Second Quarter 1998 
Regular Features	 Regional Banking
 

Risks and Trends to Watch in the Chicago Region 

•	 Institutions in the Chicago Region continue to deal with significant changes in the competitive landscape 

and maintain strong operating performance, with many institutions posting earnings gains in 1997. 

•	 Despite this strong performance, analysts have identified a number of emerging risks and trends over the 

past several quarters that bank managers, examiners, and auditors likely will have to contend with in 1998. 

•	 While some of these issues are unique, such as Year 2000 concerns, most revolve around traditional bank 

lending, funding, and sales operations. 

Overview 

Institutions in the Chicago Region continue to see significant changes in the competitive landscape. For 

example, 1997 saw: 

•	 an increase in nonbank lending competition, especially in subprime consumer markets; 

•	 ongoing banking company consolidations that have 

resulted in a net reduction of over 140 independently chartered banks and thrifts in the five-state Chicago Region, while at the same time increasing assets 

by about $88 billion; and 

•	 increased reliance on technology to perform traditional banking functions, such as the use of smallbusiness credit scoring to underwrite commercial 

loans. 

The vast majority of banks and thrifts in the Chicago 

Region appear to have adjusted successfully to this 

changing environment. As Chart 1 shows, over threequarters had earning gains in 1997 over 1996. This performance is due, at least in part, to favorable economic 

conditions (see Regional Economy: Asian Situation 

Adds to Region’s Vulnerabilities and Challenges, in 

this issue). Performance on an aggregate basis was just 

as impressive, with the Region’s institutions: 

•	 maintaining aggregate leverage capital at 7.9 percent 

of average assets despite a dividend payout ratio of 

almost 80 percent; 

•	 improving their aggregate return on assets by 11 

basis points to 1.22 percent; and 

•	 maintaining good overall asset quality, although 

many individual institutions are seeing growth in 

past-due loans. 

Good conditions notwithstanding, various banking analysts have identified emerging risks and trends that bank 

managers, examiners, and auditors likely will need to 

contend with in 1998. Many of these issues have been 

discussed in this publication in previous quarters. This 

quarter, we look back on some of these issues with the 

goal of summarizing and updating the more significant 

ones. 

Technology-Related Risks and Trends to Watch 

Year 2000 Conversions 

The issue with the highest profile continues to be the 

potential effect of the Year 2000 on the computer systems of banks and thrifts, their customers, and service 

providers. The effect on financial institutions is expectCHART 1 

Three-Quarters of Chicago Region Institutions 

Reported Higher Net Income in 1997 over 1996 

Percentage of

Insured Institutions 

Source: Bank and Thrift Call Reports 

0 

20 

40 

60 

80 

100 

1990 1991 1992 1993 1994 1995 1996 1997 

Chicago Regional Outlook 20	 Second Quarter 1998 
Regular Features	 Regional Banking
 

ed to be especially significant because they make heavy 

use of computer technology. In addition, bank customers may experience similar problems that could 

potentially disrupt their ability to conduct business or 

repay their debt. 

Last quarter’s Regional Outlook indicated that addressing Year 2000 (Y2K) issues is becoming ever more costly as the time and resources left to do so disappear. It 

also indicated that a failure to address Y2K exposures 

successfully may amount to a gamble backed by the 

bank franchise itself. 

Internet/Electronic Banking 

Y2K is not the only technological issue that will have a 

high profile in the coming quarters. Many insured institutions are expanding their operational capabilities 

related to electronic/Internet banking. More transaction 

volume is being handled by telephone and personal 

computer. Lower transaction costs, expanded geographic reach, and the need to remain competitive with other 

bank and nonbank delivery systems are cited as reasons 

for growth in this area. 

As the volume of electronic transactions grows, financial institutions will likely expand their geographic markets and encounter more competitors for loan and 

deposit products. In addition, as banks and thrifts 

increase electronic commerce capabilities, they will 

need to ensure that their control systems address 

increased risks of: 

•	 theft or misappropriation of internal data or external 

transmissions; 

•	 errors in underwriting of virtual transactions; 

Credit Card and Other Consumer Lending 

Aggressive underwriting and solicitations, generally 

high levels of consumer debt, and continuing high rates 

of consumer bankruptcy have negatively affected consumer loan portfolios in the Region. 

Chart 2 shows that most losses to date have been centered in credit card portfolios, which reflected net 

charge-offs of 6.12 percent of credit card loans outstanding during 1997 and past-due rates at year-end of 

5.3 percent. Overall, credit card loans now account for 

over 50 percent of all charge-offs in this Region. 

Reportedly, many institutions have taken steps to tighten underwriting standards in this area, but these steps 

have not yet resulted in a decline in charge-off or pastdue rates. 

Home equity portfolios also have become an area of 

interest. These traditionally smaller portfolios increased 

at a rate of more than 20 percent at about 780 institutions in the Region during 1997. It is believed that some 

of the recent growth is a result of credit card problems, 

as bankers attempt to improve their positions by collateralizing some unsecured credits. It also may be caused 

by some institutions’ aggressive attempts to increase or 

maintain market share by lowering underwriting standards, increasing advance ratios (loan-to-value ratios of 

100 percent are not uncommon), or both. 

Deserving attention as well are indirect auto loan and 

lease portfolios. Anecdotal reports indicate that pricing 

and underwriting terms are becoming more aggressive, 

and recent surveys indicate that the percentage of pastdue indirect loans (by number) have been on the rise. 

CHART 2 

•	 changing technical standards; and 

•	 inadequate or geographically inconsistent regulatory 

and legal infrastructure. 

Traditional Risks and Trends 

While technological issues will take a considerable 

amount of bank management’s attention, traditional 

banking concerns, such as loan quality and funding 

availability, will also remain important. Several of these 

issues are discussed below. 

Consumer Credits Now Dominate Chicago Region 

Net Charge-Offs 

Source: Bank and Thrift Call Reports * Not secured real estate 

0 

20 

40 

60 

80 

100 

Dec-90 Dec-91Dec-92Dec-93Dec-94Dec-95Dec-96Dec-97

Percentage of Net Charge-Offs 

Credit 

Cards 

All Other 

Credits 

Other 

Consumer* 

Chicago Regional Outlook 21	 Second Quarter 1998 
Regular Features Regional Banking
 

Growth and Concentration of Commercial 

Real Estate (CRE) Loans 

Declining vacancy rates, increasing rental rates, and 

improving perceptions are combining to increase construction and commercial real estate lending activity 

throughout the Region. However, loan pricing is reportedly getting thin, as banks, thrifts, insurance companies, real estate investment trusts, and others vie for this 

business. 

It is reported that speculative development is starting in 

some metropolitan areas. For example, FDIC examiner 

surveys indicate that a small but significant amount of 

lending for speculative projects is occurring in Chicago 

Region institutions. 

CRE lending activity as displayed in Chart 3 is especially important in the Chicago Region, as over 1,060 (out 

of a total of 2,147) institutions have exposures that 

exceed 100 percent of tier 1 capital, and over 750 had 

growth rates that exceeded 20 percent over the past year. 

Ongoing monitoring of the repayment capacity of CRE 

loans at these banks will be extremely important in 1998. 

Control systems need to ensure that exposure to loans 

with marginal debt service ability or overly optimistic 

cash flow assumptions does not become excessive. 

CHART 3 

CRE Loans Are Growing at Many Institutions 

Percentage of Institutions Headquartered in County 

with CRE Loan Growth of 20% or Higher 

0.1 to 33% 

33% to 50% 

50% or more 

None/NA 

Note: Growth rates not adjusted for mergers 

Source: Bank and Thrift Call Reports 

Easing of Commercial Loan Lending Terms 

The three federal banking regulators have released surveys that indicate an easing of loan terms and, in some 

cases, standards. The Federal Reserve recently released 

the results of its national Senior Loan Officer Opinion 

Survey on Bank Lending Practices. The survey did not 

note a significant easing of lending standards but did 

note continued easing of terms—primarily interest 

rates. It also disclosed that, to a much lesser degree, 

increased competition apparently has led some banks to 

increase the maximum size of credit lines and adjust 

loan covenants on commercial and industrial loans during the previous three months. 

The Office of the Comptroller of the Currency’s national 1997 Survey of Credit Underwriting Practices 

indicates that there has been a discernable shift in 

underwriting standards since 1996, and most of the surveyed banks now have moderate or liberal underwriting 

standards. The survey notes that the trend toward eased 

standards was most pronounced in middle market loans, 

syndicated and national credits, and commercial real 

estate. 

The Chicago Region’s FDIC Examiner Credit Underwriting Survey for the fourth quarter of 1997 disclosed 

that about 17 percent of institutions examined “frequently or commonly” had made business loans that 

lacked documentation of financial strength. 

Eased underwriting terms and poor documentation of 

commercial loans are always important, but even more 

so when they occur at this stage of an economic expansion and growth rates for such credits are high. Over 32 

percent of all insured institutions in the Chicago Region 

had growth rates exceeding 20 percent in the commercial lending category during the past year. 

Exposure to Recent Changes in the Agricultural 

Operating Environment 

This sector is generally prospering but faces challenges 

ahead. Plunging Asian demand is one (see Regional 

Economy: Asian Situation Adds to Region’s Vulnerabilities and Challenges, in this issue). Other challenges 

arise from large harvests, competition by foreign producers, and legislative changes that have altered the 

subsidies some farmers will receive. Analysts expect 

that corn and soybean farmers will see prices lower than 

last year. At the same time, the recent problems of small 

dairy and hog operators may continue in the face of 

Chicago Regional Outlook 22 Second Quarter 1998 
Regular Features Regional Banking
 

competition from larger and technologically more 

sophisticated producers. 

These factors could lead to increased complexity for the 

more than 500 banks in the Region that have direct agricultural loan exposures exceeding 100 percent of tier 1 

capital. 

Changing Funding Strategies 

Loan growth and changing funding strategies have 

resulted in an aggregate loan-to-deposit ratio of over 90 

percent for Chicago Region institutions as of December 31, 1997—an all-time high for the decade (see 

Chart 4). Over half the institutions in the Region 

reported loan-to-deposit ratios exceeding 75 percent. 

Loan-to-deposit ratios normally have increased during 

periods of economic growth because lending tends to 

pick up. What is unusual is that banks now are relying 

more on noncore sources to fund this growth. Some of 

these alternative funding sources are foreign deposits, 

brokered deposits, short-term debt, and Federal Home 

Loan Bank borrowings. 

CHART 4 

Loan-to-Deposit Ratios Have Been 

Rising in the Chicago Region since 1992 

Source: Bank and Thrift Call Reports 

60 

70 

80 

90 

100 

Dec-90 Dec-91Dec-92Dec-93Dec-94Dec-95Dec-96Dec-97

Aggregate Loan-to-Deposit

Ratio (%) 

It is important that managers recognize changes to funding structures and ensure that procedures are in place to 

assess and manage liquidity risk adequately, especially 

if an institution obtains a large portion of funding from 

limited sources. 

Prepayment Increases 

Large numbers of Chicago Region institutions have 

heavy investments in mortgaged-backed securities and 

mortgage loans. Prepayment rates on mortgage loans 

have been rising steadily over the past few months. This 

additional cash flow may result in increased interest rate 

risk or credit risk, as some institutions may reinvest prepayments in either long-term fixed-rate mortgage products or, possibly, higher credit risk loan types in order to 

maintain an acceptable spread over their funding costs. 

In addition, substantial investments in callable agency 

securities may exacerbate potential risks. 

Prudent planning for significant cash inflow from 

callable loans and securities likely will be important in 

1998. 

Trend Toward Fee-Related Businesses 

In an attempt to mitigate the effect of interest rate risk 

on total revenues, as well as to diversify revenue 

streams, insured institutions have focused on increasing 

noninterest income. 

Some of the resulting new business lines, such as insurance sales, mutual funds, and annuities, have unique 

risks. Increased revenues from these sources must be 

balanced against potential contingent liability and reputation risks arising from the sale of these products. 

Chicago Region Staff 

Chicago Regional Outlook 23 Second Quarter 1998 
✁
 

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