Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1997 

FDIC
 

Dallas
 

Region
 

Division of
 

Insurance
 

Alan C. Bush,
 

Regional Manager
 

Adrian R. Sanchez,
 

Regional Economist
 

Jeffrey A. Ayres,
 

Financial Analyst
 

In Focus This Quarter 

◆ Bank Earnings: Competitive Pressures and Cyclical 

Risks—Intense competition to preserve or attract business can lead to relaxed 

underwriting standards and other changes to risk management practices that can 

reduce banks’ ability to weather a downturn. As this economic expansion reaches 

an advanced age, prudent bankers will evaluate their lending standards and reserve 

adequacy with an eye to possible adverse changes in economic conditions. 

See page 3. 

By Ronald Spieker, Steve Linehan, George French 

◆ Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets—Commercial real 

estate markets in many parts of the United States have rebounded, and commercial 

banks are once again actively pursuing lending opportunities. Banks are not alone, 

however, as a broader and more competitive financing market has emerged. 

Securitization vehicles such as commercial mortgage-backed securities and real 

estate investment trusts are changing how real estate is owned and paid for. 

See page 9. 

By Steven Burton, Gary Ternullo 

Regular Features 

◆ Regional Economy—NAFTA and a once-again vibrant Mexican economy are invigorating exports from the Region...the rapid growth in the hightechnology industries of telecommunications and personal computers has 

contributed to employment growing faster in the Region than in the nation as a 

whole...rural economies in the Region, which experienced difficult times during the 

1980s, have added jobs at a rate similar to their metropolitan counterparts during 

the 1990s. See page 15. 

By Adrian R. Sanchez 

◆ Financial Markets—Bank holding companies of all sizes have issued 

trust preferred stock following the Federal Reserve’s decision in October 1996 to 

count these tax-advantaged, capital securities toward Tier 1 capital...rating agencies and investment analysts have argued that trust preferred stock is a weaker 

form of Tier 1 capital. See page 20. 

By Kathy R. Kalser 

◆ Regional Banking—Favorable banking conditions continue... 

Subchapter S tax status institutions are reaping benefits, but earnings analysis 

should focus on pretax operating income...financial modernization is presenting 

risks and opportunities to small and large banks alike...banking consolidation has 

been most pronounced in metropolitan areas. See page 24. 

By Alan C. Bush and Jeffrey A. Ayres 

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, 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. For 

more information or to provide comments or suggestions about the Dallas Region’s Regional 

Outlook, please call Alan Bush at (214) 220-3434 or send an e-mail to abush@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 Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Managing Editor Stephen Linehan 

Associate Editor Maureen E. Sweeney 

Assistant Editors Suzannah L. Susser 

John D. Weier 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Bank Earnings: Competitive Pressures
 

and Cyclical Risks
 

•	 Rapid loan growth, record low credit losses, 

vigorous expansion of income sources, and costcutting continue to propel bank earnings to 

record levels. 

•	 Intense competition to preserve and attract 

business can lead to aggressive loan pricing, 

relaxed loan underwriting standards, increased 

portfolio concentrations, and other changes to 

risk-management practices that can reduce 

banks’ ability to sustain earnings and capital 

through a downturn. 

•	 As this economic expansion approaches an 

advanced age, prudent bankers will allow for the 

possibility of an adverse change in economic 

conditions. 

As the U.S. economic expansion continues through its 

seventh year, the banking industry continues to run at 

full throttle. Earnings climb to ever-higher levels, driven by rapid loan growth, record low credit losses, 

aggressive expansion of income sources, and vigorous 

cost-cutting. Some analysts argue that banking has 

entered a new era in which the development of noninterest income sources and new risk-management techniques will insulate banks from swings in the business 

cycle. 

Yet banks face risks that should not be overlooked. 

Assertions that bank earnings will be less sensitive to 

business cycles remain untested. Meanwhile, competition to attract and maintain business can result in 

relaxed underwriting standards and easing of loan 

terms, or increased focus on business lines whose risks 

are difficult to manage. Policies that boost short-term 

shareholder returns, including high dividends and stock 

repurchase programs, can reduce banks’ capacity to 

weather a future downturn. There is evidence that these 

things are occurring to varying degrees in banking 

today. Accordingly, as this expansion reaches an 

advanced age, prudent bankers will give careful regard 

to the quality and sustainability of the earnings generated by today’s strategic decisions. 

Credit Quality 

Variations in credit quality have been and are likely to 

remain for some time the primary source of large 

swings in bank earnings (see Chart 1). Banks manage 

the risks of large swings in credit quality by adjusting 

underwriting standards and loan terms, by diversifying 

loan portfolio exposures, and by supplying adequate 

amounts to the allowance for loan losses. In large part, 

the degree to which bank earnings can be sustained during a downturn will depend on decisions made about 

these factors during the expansion. 

Some perspective on the cyclical nature of credit quality can be gleaned from Charts 2 and 3 (next page). As 

shown in Chart 2, bank loan growth has exceeded 

growth in gross domestic product (GDP) for ten of the 

past twelve quarters, even without considering the substantial volume of loans originated and sold in securitized pools. Moreover, Chart 3 shows that growth in 

loan losses has tended to follow episodes of rapid loan 

growth. 

Credit standards are important tools for individual 

banks to manage these cyclical fluctuations in credit 

quality. According to the Federal Reserve’s August 1997 

CHART 1 

Earnings Results Are Largely Driven by 

Provision Expenses 

-1.0% 

0.0% 

1.0% 

2.0% 

3.0% 

Return on Avg Assets 

Provision Exp/Avg Assets 

Source: Commercial Bank Call Reports 

-2.0% 

6-’85

12-’86

6-’88

12-’89

6-’91

12-’92

6-’94

6-’97

12-’95 

Dallas Regional Outlook 3	 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 2 CHART 3 

-15% 

-10% 

-5% 

0% 

5% 

10% 

15% 

20% 

1980 

GDP Growth 

Loan Growth 

Average Loan Growth Has Recently 

Outpaced Nominal GDP Growth 

Source: Commercial Bank Call Reports, Haver Analytics 1982 1984 1986 1988 1990

199219941996 

Source: Commercial Bank Call Reports Loan, GDP Growth (%)

Net Loan Loss Growth (%)

Loan Losses and Loan Growth Are Correlated 

-15 

-10 

-5 

0 

5 

10 

15 

-90 

-60 

-30 

0 

30 

60 

90 

Loan Growth 

Net Loan Loss Growth 

198019831986198919921995 

Senior Loan Officer Survey, during the preceding three 

months, a large percentage of banks had eased terms on 

commercial and commercial real estate loans, including 

reducing loan interest rates, increasing credit lines, and 

easing loan covenants and collateralization requirements. A “small but significant” share reported willingness to accept increased levels of risk on commercial 

real estate loans. In a similar vein, the Federal Deposit 

Insurance Corporation’s (FDIC) Report on Underwriting Practices (second quarter 1997) did not note 

any widespread problems with underwriting practices 

but reported that about 24 percent of institutions examined that were actively involved in construction lending 

were “frequently or commonly” funding speculative 

construction projects. About 18 percent of institutions 

examined that were actively involved in business lending “frequently or commonly” made unsecured business 

loans that lack documentation of financial strength. 

Maintaining an adequate allowance for loan losses is 

another important way for banks to sustain earnings and 

capital during downturns. The aggregate allowance held 

by commercial banks has decreased from 2.74 percent 

of total loans in the first quarter of 1992 to 1.90 percent 

in the second quarter of 1997; 166 banks reported negative loan loss provisions in the second quarter. 

Although in the aggregate these reserve numbers 

remain high relative to the early to mid-1980s, when 

reserve levels ranged from 1.20 percent to 1.74 percent, 

the Office of the Comptroller of the Currency (OCC) 

recently issued an advisory letter expressing concern 

about declining reserve levels and the need to maintain 

an adequate allowance. This letter was a response to 

weakness in the credit card sector and to trends in the 

market for syndicated commercial loans, including 

increasing leverage, declining spreads, and a weakening 

in other underwriting terms, all stemming from increasing competitive pressures. 

Diversifying loan portfolios is another way for banks to 

help reduce susceptibility to economic downturns. It 

has often been noted that the trend toward interstate 

banking and branching may improve loan diversification. It should also be noted, however, that many banks 

retain high concentrations of credit exposure to specific 

economic sectors. For example, commercial real estate 

lending and construction lending has been a source of 

volatility in bank earnings since the real estate investment trust (REIT) crisis of the 1970s. As discussed in 

Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets, banks 

are leading a resurgence in commercial real-estate lending. As Table 1 shows, 28 percent of FDIC-insured institutions grew their total commercial real estate and 

construction portfolios more than 30 percent from mid1996 to mid-1997, and 16 percent had total commercial 

real estate and construction exposures1 exceeding 200 

percent of equity and reserves. Concentrations and 

rapid growth do not necessarily portend difficulties, but 

the greater the concentration of credit to a specific sector, the greater the importance of strict adherence to 

sound underwriting policies and standards and the 

maintenance of adequate loss reserves. 

The most immediate concerns about credit quality have 

been expressed regarding credit cards and some other 

1 Includes loans secured by multifamily dwellings and nonfarm nonresidential structures, as well as construction loans. 

Dallas Regional Outlook 4 Fourth Quarter 1997 
In Focus This Quarter
 

consumer debt. Despite seven years of economic expansion, commercial banks’ net credit card charge-offs at 

mid-1997 were running at 5.22 percent of average outstanding balances, matching levels not seen since the 

aftermath of a 56 percent run-up in charge-offs that 

accompanied the recession of 1990 to 1991. Noncurrent 

rates on these loans are at near-historic highs of 1.94 

percent, and some examiners are commenting that these 

rates would be even higher were it not for some of these 

balances being rolled over into home equity debt consolidation loans with loan-to-value ratios as high as 135 

percent. Home equity lines are a rapidly growing business for some banks; 25 percent of banks and thrifts 

grew their home equity lines by more than 30 percent 

during the year ending mid-1997 (see Table 1). 

Except for credit cards and some other consumer loans, 

loan losses are at historically low levels. Nevertheless, 

lending decisions that assume a continuation of favorable economic conditions should be closely examined 

this far into the expansion. Institutions that maintain 

strong underwriting standards, an adequate allowance 

for losses, and prudent diversification of the loan portfolio will be best positioned to sustain earnings and capital during a downturn in credit quality. 

Net Interest Margin 

Net interest margin (NIM) is another primary driver of 

bank earnings. Indeed, a sharp improvement in NIM 

TABLE 1 

CHART 4 

Rebound in ROA Since 1990 Fueled 

by Improved NIM and Asset Quality 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1984 1986 1988 1990 1992 1994 1996 

2.5% 

3.0% 

3.5% 

4.0% 

4.5% 

5.0% 

ROA 

Net charge-off ratio 

NIM 

Source: Commercial Bank Call Reports ROA, Net Charge-Off Ratio

NIM (%) 

helped lead the banking industry’s dramatic recovery 

from the last recession (see Chart 4). Commercial 

banks’ NIM has declined slightly in recent years, but at 

4.23 percent still remains near the top of the range 

within which it has fluctuated since 1984 (see Table 2, 

next page). 

The banking industry’s rapid loan growth in recent 

years has been one of the factors supporting the current 

high NIM. (Since loans generally yield more than 

securities, a higher proportion of loans generally 

results in a higher yield on the total portfolio of earning assets.) Economic fundamentals cannot sustain 

rapid loan growth indefinitely, however. Accordingly, a 

Rapid Loan Growth Is 

Occurring at a Significant 

Number of Institutions 

(4 qtrs growth ending 6/97) 

TOTAL LOANS AND LEASES 

CONSTRUCTION LOANS 

COMMERCIAL REAL ESTATE LOANS 

TOTAL CRE 

1-4 FAMILY RESIDENTIAL LOANS 

HOME EQUITY LINES 

TOTAL RESIDENTIAL 

CREDIT CARD LOANS AND RELATED PLANS 

OTHER CONSUMER LOANS 

TOTAL CONSUMER LOANS 

COMMERCIAL LOANS 

Source: Bank & Thrift Call Reports 

Dallas Regional Outlook 

Percentage of Institutions with Loan 

Category Growth Approximating 

20% to 30% 30% or Total 

More Over 20% 

11 13 24 

4 36 40 

9 27 37 

10 28 38 

11 17 29 

4 25 29 

12 18 29 

4 17 21 

9 18 27 

9 18 27 

9 26 35 

5 Fourth Quarter 1997 
In Focus This Quarter
 

TABLE 2 

1997 Commercial Bank Performance Compared with Historical Averages 

INDUSTRY AVERAGES 

6/30/97 1984-1996 

ANNUALIZED LOW HIGH 

(%) (%) (%) 

NET INTEREST INCOME/AVERAGE EARNING ASSETS 4.23 3.89 4.36 

X AVERAGE EARNING ASSETS/AVERAGE ASSETS 86.50 86.21 88.42 

= NET INTEREST INCOME/AVERAGE ASSETS 3.66 3.36 3.89 

+ NONINTEREST INCOME/AVERAGE ASSETS 2.13 1.10 2.13 

− NONINTEREST EXPENSE/AVERAGE ASSETS 3.50 3.05 3.90 

− PROVISION EXPENSE/AVERAGE ASSETS 0.40 0.28 1.28 

+ OTHER ITEMS/AVERAGE ASSETS 0.03 − 0.02 0.15 

− TAXES/AVERAGE ASSETS 0.68 0.18 0.64 

= NET INCOME/AVERAGE ASSETS (ROA) 1.25 0.10 1.20 

Source: Bank & Thrift Call Reports 

risk in the current environment is that in the effort to 

support their NIM by generating new lending, banks 

may make compromises in loan underwriting, pricing, 

and portfolio diversification. 

Recent pricing trends have tended to weaken NIM, offsetting to a degree the effects of rapid loan growth. On 

the liability side, over the past six years, commercial 

banks’ average annual deposit growth rate of 3.2 percent 

has been outpaced by the 4.9 percent average annual 

growth rate of earning assets. As a result, nondeposit 

borrowings have increased significantly in importance, 

rising from about 12.6 percent of earning assets in 1991 

to 19.1 percent at mid-1997. Since the average cost of 

nondeposit borrowings has exceeded the average cost of 

deposits over the period by an average of 135 basis 

points, the greater use of relatively higher cost borrowings to fund earning asset growth has been an obstacle 

to wider margins. The slower deposit growth can perhaps be attributed to the increasing array of choices 

available to small savers; its effect is that bank funding 

is becoming more expensive and more interest-rate 

sensitive. 

On the asset side, pricing pressures also are frequently 

cited as contributing to sluggish NIM. For example, in 

the aforementioned syndicated lending market, average 

interest spreads charged to noninvestment-grade large 

customers have dropped more than 63 basis points 

between 1992 and 1996, while spreads on investmentgrade debt are at all-time lows. Reportedly, some deals 

are being done at minimal or no risk-adjusted spreads 

simply to preserve lending relationships. Increased 

securitization of various asset types has also had effects 

on pricing. By increasing the depth and liquidity of the 

market for the underlying loans, securitization has tended to lower spreads on these assets, thereby increasing 

competitive pressures on institutions not able to achieve 

the volumes necessary to efficiently utilize this new 

funding vehicle. 

The thin spreads available from high-quality lending 

may tempt some institutions to finance higher yielding, 

riskier credits in an effort to preserve or boost profit 

margins. For example, recent forays by some banks into 

subprime lending (see Subprime Lending: A Time for 

Caution, Third Quarter 1997) may be one indication of 

how competitive pressures on NIMs are affecting bank 

behavior. Over the long term, institutions that manage 

their NIMs with a prudent regard for how their newly 

booked business may fare during a cyclical downturn 

will have a better chance of sustaining earnings performance through the business cycle. 

Growth in Noninterest Income 

Industry analysts often cite the increasing contribution 

of fees and other sources of noninterest income as 

evidence of the evolution of the banking industry. As 

Chart 5 (next page) illustrates, for commercial banks 

with over $1 billion in assets, noninterest income now 

averages over 40 percent of net revenue (net interest 

income plus noninterest income). In contrast, banks 

Dallas Regional Outlook 6 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 5 Other measures of productivity have shown similar 

Noninterest Revenue to Net Revenue* 

Banks Over $1 Billion 

Banks Under $1 Billion 

Source: Commercial Bank Call Reports 

* Net Revenue = Net interest income plus noninterest income 

10 

20 

30 

40 

50 

6-’85 

Net Revenue (%) 

6-’876-’896-’916-’936-’956-’97 

improvement. For example, commercial banking assets 

per employee doubled, from $1.5 million to $3 million, 

between 1984 and 1997. 

Growth in overhead expense has been contained largely 

through consolidation, technological advances, and low 

levels of problem assets. Mergers have resulted in the 

wringing out of redundant expenses. Information technology (IT) has been deployed to trim underwriting 

expense, manage customer relationships, speed backoffice processing, and facilitate the creation of new 

products and services. Favorable economic conditions 

have reduced costs associated with loan collection and 

asset workouts. 

Whether the downward trend in overhead expenses will 

with under $1 billion show a profile of reliance on more 

traditional banking activities, with only 25 percent of 

revenue from these noninterest sources. 

Noninterest income growth is being driven both by new 

business lines and higher deposit-related fees. 

Examples include fees from sales of mutual funds and 

other nondeposit products, investment banking activities such as securities underwriting and asset management, and increases in traditional fee sources such as 

from automated teller machines. Increasing securitization of assets, in which the accounting conventions convert interest income to noninterest income, has also 

affected the growth in reported noninterest income. 

With the exception of trading revenue, noninterest 

income has historically shown a growth trend that has 

not been especially sensitive to economic cycles. 

However, newer fee-based businesses such as mortgage 

banking, mutual funds, and securities underwriting may 

ultimately share the same cyclical characteristics as traditional bank lines of business, and therefore may not 

reduce banks’ historical exposure to economic cycles. 

The Effect of Expense Control 

on Earnings Performance 

Cost-cutting efforts in banking continue to show their 

effects. Since 1991, commercial banks’ efficiency 

ratio,2 a measure of an institution’s effectiveness in generating revenue, has steadily improved (see Chart 6). 

continue is an open question. Should problem loans 

increase from their cyclical lows, collection and workout costs will increase (evidence of this effect can be 

discerned for the late 1980s in Chart 6). The rapid 

change in information technology may prompt increasing expenditures. The 1996 Atlantic Data Services/ 

Tower Group Survey of Information Technology 

Services in Banking noted that the banking industry is 

“faced with an aging IT infrastructure.” The survey 

suggests that most technology-related expenses could 

increase at a 5.6 percent compounded growth rate until 

the year 2000 and that expenses for outside services 

could increase 11 percent over the same period. The 

ability to generate future revenue gains may depend on 

additional bank investment not only in technology but 

also in the development of new products and services. 

CHART 6 

Commercial Banks’ Efficiency Ratio*
 

Is Steadily Improving
 

70% 

68% 

66% 

64% 

62% 

60% 

58% 

56% 

1984198619881990199219941996 

The efficiency ratio is normally defined as noninterest expense * Noninterest expense/(net interest income + noninterest income) 

Source: Commercial Bank Call Reports divided by the sum of net interest revenue and noninterest revenue.
 

Dallas Regional Outlook 7 Fourth Quarter 1997
 

2 
In Focus This Quarter
 

In any event, cost-cutting is not without its risks. For 

example, reductions in personnel, or excessive reliance 

on automated underwriting procedures (see Will Credit 

Scoring Transform the Market for Small-Business 

Lending? Second Quarter 1997), may raise concerns 

about the effectiveness of internal administration and 

control processes. Cost-cutting that cuts too deeply into 

customer service can erode franchise value. Mergers 

can reduce redundant expense, but at some point there 

may be diseconomies to managing a large organization. 

The Role of Capital in the Management 

of Earnings 

Management, shareholders, and analysts often evaluate 

earnings in relation to the level of capital using measures such as return on equity (ROE) and earnings per 

share (EPS). One result has been pressure on banks to 

continue to grow ROE and EPS; these objectives have 

been made progressively more difficult to attain by the 

significant level of capital that has built up over the past 

five years. 

Finding effective ways to deploy historically high capital levels appears to be one driving force behind the 

recent rash of mergers and acquisitions, high dividend 

payout ratios, increased stock repurchases, and the 

development of alternative types of hybrid capital such 

as trust preferred stock (see Financial Markets). For 

example, during 1995 and 1996, major merger and 

acquisition deals included some $835 billion in bank 

and thrift assets. During 1996, commercial banks with 

over $1 billion in assets had an average dividend payout 

ratio over 89 percent, up significantly from the 67 percent payout rate of 1994. Banks with under $1 billion in 

assets averaged 55 percent for 1996 and 52 percent for 

1994. In addition, banks and bank holding companies 

have issued some $21 billion in trust preferred stock 

during the last nine months, some of which has been 

used to fund the almost $42 billion in share repurchase 

programs announced by large banks during 1996 and 

early 1997.3 

While the book value of equity and other capital ratios 

has increased at the aggregate industry level, a number 

of banks are reporting declines in equity capital and 

leverage capital ratios despite positive earnings (see 

Chart 7). For all institutions, the ability to actively man3 Salomon Brothers. 

CHART 7 

An Increasing Number of Profitable Banks Are
 

Reducing Tier 1 Capital*
 

Number of Banks 

800 

600 

400 

200 

0 

1992 1993 1994 1995 1996 

* Both Tier 1 dollar amount and ratio 

Source: Commercial Bank Call Reports 

age capital accounts going forward will depend largely 

on having earnings available above the levels needed to 

fund dividends and growth, after assuming capital protection adequate for the level of business risk. Bankers 

and examiners will need to carefully review strategies 

that increase bank leverage or increase business risk 

without considering the potential effects of a downturn 

in credit quality or other weakening in the economy. 

Summary 

The most profitable period for U.S. banks in the postWorld War II era is paradoxically occurring during a 

time when banks’ traditional business lines are coming 

under greater competitive pressure than ever. While the 

industry as a whole is adapting well to these competitive 

pressures, there may be a tendency for some insured 

institutions to respond by accepting greater risks to preserve or gain business. 

The nature of banking is to profit by taking calculated 

risks, and naturally more profits will be made during the 

expansionary phase of a cycle than during a downturn. 

Nevertheless, the institutions that are best able to sustain their earnings and capital over the complete cycle 

will be those that allow for the possibility of an adverse 

change in business conditions, and prudently balance 

the levels of risk taken with the expected returns. 

Ronald Spieker, Chief, Depository Institutions Section 

Steve Linehan, Assistant Director, Analysis Branch 

George French, Deputy Director 

Dallas Regional Outlook 8 Fourth Quarter 1997 
In Focus This Quarter
 

Strong Demand and Financial Innovation Fuel
 

Rebounding Commercial Real Estate Markets
 

•	 Commercial banks are leading a resurgence in 

commercial real estate financing; many metropolitan markets are experiencing rapidly rising rents 

and single-digit vacancy rates, suggesting the likelihood of further development. 

•	 New funds directed toward commercial real estate 

are being increasingly supported by commercial 

mortgage-backed securities and real estate investment trusts. 

•	 Some analysts have expressed concern that these 

financing vehicles may serve to heighten competitive pressures that will lead to more aggressive 

loan pricing. 

In the wake of declining values and the large losses of 

the late 1980s and early 1990s, commercial real estate is 

making a comeback. There are two stories here of interest to lenders. The first entails the remarkable resurgence in commercial real estate demand. The second 

involves the major changes taking place in how real 

estate is owned and paid for and—of greater interest to 

banks—who is financing this expanding activity. 

Commercial Banks Show Renewed Interest 

in Commercial Real Estate 

Strong evidence of commercial real estate’s rebound 

can be seen in its renewed attractiveness to lenders. 

TABLE 1 

Federal Reserve figures show that nearly $58 billion of 

new commercial mortgage debt was added to the market in 1995 and 1996 (see Table 1). While this new net 

lending pales in comparison with that of the late 

1980s—when nearly $74 billion in net new debt was 

added in 1987 alone—it positively shines when compared with the $89 billion shrinkage of commercial real 

estate loans from 1991 to 1994. Table 1 shows that commercial banks are leading this resurgence with a $37 

billion net increase in mortgage lending during 1995 

and 1996. 

Perhaps the most convincing evidence of commercial 

real estate’s recovery comes from the market itself. 

Rising prices and tightening supplies of space in most 

major markets and for most property types suggest a 

growing demand for new commercial property stock. 

Numerous indices and market studies support this 

notion: 

•	 As measured by Koll/NREI national composites, 

prices and rents turned up sharply after 1993, with 

rents surpassing their 1988 to 1989 levels by 1995 

(see Chart 1, next page). For office properties in particular, the ten fastest-growing cities in terms of rental 

rates saw increases exceeding 20 percent in 1996.1 

1 Those cities are, in order, Minneapolis, Columbus, Dallas, Portland, 

Salt Lake City, Atlanta, San Jose, Phoenix, San Francisco, and San 

Diego. 

Banks Are Increasing Their Flow of Funds into Commercial Real Estate ($ Billions) 

1991 1992 1993 1994 1995 1996 

NET NEW BORROWING, ALL SOURCES $ − 15.6 $ − 47.1 $ − 21.5 $ − 4.4 $ 22.6 $ 35.1 

COMMERCIAL BANKS 3.1 − 8.4 − 4.3 7.5 18.0 18.7 

CMBSS 1.3 8.7 10.3 11.3 10.6 16.1 

SAVINGS INSTITUTIONS − 22.4 − 18.5 − 7.5 − 6.8 − 1.8 0.8 

LIFE INSURANCE COMPANIES − 5.6 − 15.1 − 13.4 − 10.5 − 3.3 − 2.5 

ALL OTHER SOURCES 8.0 − 13.5 − 6.6 − 5.9 − 0.9 2.3 

EQUITY CAPITAL FLOW, ALL SOURCES $ 4.9 $ 3.1 $ 17.4 $ 21.6 $ 21.5 $ 30.3 

REIT EQUITY OFFERINGS 1.6 2.0 13.2 11.1 8.2 13.0 

PENSION FUNDS − 4.8 − 4.3 − 0.7 9.6 13.8 14.3 

ALL OTHER SOURCES 8.1 5.4 5.0 0.9 − 0.5 3.0 

Sources: Federal Reserve, National Association of Real Estate Investment Trusts (NAREIT), LaSalle Advisors 

Investment Research 

Dallas Regional Outlook 9	 Fourth Quarter 1997 
In Focus This Quarter
 

•	 Property capitalization rates, which measure the 

annual income generated by a property as a percentage of its purchase price, are falling (see Chart 2). 

These falling rates indicate that investors are paying 

higher prices for each dollar of current income generated by the property. Overall, however, prices have 

not yet caught up with rents, which now exceed their 

previous highs in some markets, suggesting that the 

current recovery is not yet peaking. 

•	 Declining vacancy rates reflect strong demand for 

office properties, which Grubb & Ellis cast as the 

hottest sector in its 1997 forecast. Nationwide, office 

vacancies have fallen dramatically, by 5 to 10 percentage points during the last four years (see Chart 

3). Moreover, Torto-Wheaton Research estimates 

that 21 of the 56 metropolitan areas it tracks had 

single-digit vacancy rates at the end of first quarter 

1997. Not surprisingly, many of the tightest markets 

are those with the greatest rent inflation. 

While the unrestrained commercial development of the 

1980s continues to cast a shadow over the industry, that 

shadow is fading as declining vacancy rates and rising 

rental rates for existing properties fuel optimism 

among lenders and investors and strengthen the case 

for new development. Lenders, examiners, and analysts, however, must be diligent in monitoring commercial real estate markets to identify possible imbalances 

between supply and demand. It is particularly important that lending decisions be made on the basis of economic feasibility and realistic property cash flow 

projections rather than solely on the basis of competitive pressures. 

Borrowers’ Financing Options Expanding 

Although banks are clearly the largest source of financing for resurgent commercial real estate markets, a 

broader and more competitive financing market has 

emerged. In this market, financing often bypasses 

banks, being funneled instead through entities that purchase and securitize commercial real-estate-secured 

debt or the properties themselves, parceling them into 

smaller, more standardized, and thus more liquid pieces 

that are attractive to institutional and individual 

investors alike. This trend is illustrated in Table 1, which 

shows the increasing roles commercial mortgagebacked securities (CMBSs) and real estate investment 

trusts (REITs) have played in funding commercial real 

estate over the past five years. This increase in public 

CHART 1 

Prices and Rents on Upswing Nationwide 

Index (1986 = 1.00)
 

1.30
 

1.20
 Rents
 

1.10
 

1.00
 Prices
 

0.90
 

0.80
 

1990 1991 1992 1993 1994 1995 1996 

Source: Koll National Real Estate Index 

CHART 2 

Property Capitalization Rates Dropping 

8.0 

8.5 

9.0 

9.5 

10.0 

10.5 

11.0 

11.5 

1990 1991 1992 1993 1994 1995 1996 1997 

Overall Cap Rates (%)

Office 

Retail 

Apartment 

Source: Donaldson, Lufkin & Jenrette 

CHART 3 

National Downtown and Suburban
 

Class A Vacancy Rates Falling
 

8 

13 

18 

23 

Downtown 

Suburban 

Vacancy Rates (%) 

1988 1989 1990 1991 1992 1993 1994 1995 1996 

Source: CB Commercial / Torto-Wheaton Research 

Dallas Regional Outlook 10	 Fourth Quarter 1997 
In Focus This Quarter
 

financing left financial institutions in 1996 with 

approximately a one-third share of all new net commercial real estate financing, down from well over half just 

a decade before. 

From a lender’s perspective, CMBSs offer several 

advantages over traditional portfolio lending. Most significantly, lenders can generate fee income from loan 

production and servicing activities while avoiding the 

excessive concentrations of credit risk that plagued 

lenders during the last real estate downturn.2 According 

to Commercial Mortgage Alert, outstanding CMBSs 

reached $125 billion in 1996 on a record $30 billion of 

new issuance. While outstanding volume is still dwarfed 

by the $3 trillion market for residential mortgagebacked securities (MBSs), the growth in CMBS volume 

has been remarkable considering that such securities 

were virtually nonexistent prior to 1991. 

At present, most commercial banks are not active in 

issuing CMBSs, accounting for only $2.6 billion of 

CMBS issuance in 1996, according to E&Y Kenneth 

Leventhal Real Estate Group. Rather, the primary 

source of these securities is investment banks, which 

generate substantial fees by converting existing loans 

into securities. CMBS issues also are being increasingly underwritten by conduits, which are entities created 

to originate mortgage loans for distribution to investors 

in the secondary market. Nomura Securities 

International estimates that such conduits accounted 

for over one-third of CMBS issuance in 1996, nearly 

double the volume of 1995. Only a handful of the 

largest commercial banks have set up conduit programs—the five largest banks accounted for $3.3 billion of the $10.2 billion in conduit issuance during 

1996. Aside from this relatively small number of bank 

competitors, investment banks are among the largest 

and most active conduit issuers. 

There is no fundamental reason why banks cannot take 

greater part in the rapidly growing CMBS market. In 

fact, they possess many distinct advantages over investment banks. Their distribution networks, lending experience, and back-office capabilities are naturally suited 

to facilitating loan demand, evaluating repayment risk, 

servicing loans, and monitoring a project’s development. Obstacles of scale may preclude smaller institu2 While securitization of loans purports to shift credit risk to investors, 

many analysts and rating agencies have recently expressed concern 

over recourse arrangements, both contractual and voluntary, whereby 

the seller/servicer effectively assumes all or most of losses experienced by the security. 

tions from directly issuing CMBSs ($500 million in volume is often cited as a minimum for efficiently assembling a deal). However, if the CMBS market develops 

like that for MBSs, standardized underwriting may 

enable small institutions to remain competitive either by 

cooperatively forming their own conduits or by selling 

their loans to existing conduits. 

Whether or not banks take part, the continuing development of a market for securitized commercial real estate 

assets raises a number of efficiency issues for direct 

lenders. Securitization provides property developers and 

owners access to a much larger pool of potential funding 

sources and a wider array of funding options. Moreover, 

the costs of public financing reflect efficiencies born of 

standardization and liquidity. In short, investors, including banks, can price, enter, and exit their positions in 

securitized debt more easily than could be done with 

whole loans. While improved efficiencies are a positive 

aspect of the growth in securitized investments, these 

efficiencies threaten to dictate bank pricing, thereby 

potentially reducing margins or driving institutions to 

lend on less economically feasible projects in an effort to 

preserve margins and market share. 

REITs: An Alternative to Traditional 

Capital Sources 

Commercial real estate financing is evolving in other 

ways. REITs have become major players in the industry 

since 1993, accounting for fully one-fifth of funds flowing into real estate in 1996. REITs are much like mutual funds in that they allow indirect investment in real 

estate through purchases of equity in the REIT. The 

REIT itself holds title to the underlying properties and, 

provided it meets certain requirements, can directly pass 

through its earnings to investors without any intermediate tax. Although Moody’s estimates place REIT holdings at less than 3 percent of all U.S. commercial real 

estate, outstanding REIT shares have grown considerably, with market capitalization doubling nearly three 

times in just four years (see Chart 4, next page). 

Accompanying this rise in capitalization has been an 

equally dramatic rise in bank lending to REITs. 

According to Loan Pricing Corporation, bank lending 

to REITs surged to $12.8 billion in 1996, a 16 percent 

increase over 1995’s then-record volume and more than 

a tenfold increase over the period 1990 to 1992. 

The rise in REIT capitalization can be attributed in part 

to pent-up institutional demand for real estate. REITs 

Dallas Regional Outlook 11 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 4 

REIT Capitalization Soaring 

0 

10 

20 

30 

40 

50 

60 

70 

80

$ Billions 

0 

400 

1996

50 

100 

150 

200 

250 

300 

350 

Market Capitalization (Left Scale) 

Number of REITs (Right Scale) 

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 

Source: National Association of Real Estate Investment Trusts

have a particular appeal to fund managers since they 

offer the benefits of investment diversification without 

the dual headaches of property management and asset 

illiquidity. Aside from the direct credit risk posed by 

lending to REITs, their rising popularity confronts banks 

with an indirect threat as well—the threat that banks 

could be crowded out of lending opportunities if 

investors find REIT funding structures more attractive 

from a cost and control standpoint. The degree to which 

this crowding out may occur is unclear, for according to 

Nomura Research, REITs historically have borrowed 40 

cents for each dollar of real estate held. However, well 

over half of this borrowing takes place through public 

offerings of secured and unsecured debt, leaving only a 

small portion to be financed by banks and other private 

lenders. Because REITs tend to focus on the highest 

quality projects, their increasing presence also creates 

concerns that banks may be driven to lend to less attractive or more risky properties to preserve market share. 

Many analysts have also expressed unease over the rapid 

rise in the valuations of REITs, some of whose shares 

are priced at a considerable premium to the properties 

themselves. Anecdotal evidence suggests that premiums 

as high as 40 percent over market value have been paid 

for some REIT shares in recent months. Such marketbased valuations create concern over the extent to which 

an REIT’s capital structure allows it to pay more for 

properties than an investor who employs greater financial leverage. Accordingly, while REITs may make up a 

fairly nominal amount of overall real estate holdings, 

they may be quite influential in determining how commercial properties are being valued or appraised. 

Commercial Real Estate Securitization: 

Some Broader Implications 

Maturing CMBS markets could eventually improve the 

overall stability of commercial real estate markets not 

only by improving market liquidity but also by enabling 

investors to diversify and share their credit exposures 

among a greater number of participants. In addition, 

loan performance could become increasingly transparent to the general marketplace, thereby encouraging 

more uniform and prudent underwriting standards. 

However, concern naturally arises because CMBSs are 

a major source of commercial real estate market funding that has not been tested through a serious market 

downturn. This situation leads to questions concerning 

the impact they will have on property values and market 

liquidity and whether today’s underwriting terms, driven 

largely by competitive factors, will stand up to tomorrow’s market downturn. Another question is whether the 

standardized structures underlying these securities offer 

enough flexibility to borrowers to renegotiate loan 

terms—a critical workout tool during times of financial 

stress. The answers to these questions will ultimately 

determine the extent to which lenders and investors suffer as a result of the inevitable cyclical swings in commercial property values. 

There are also questions about how REITs will affect 

commercial real estate markets. One argument is that 

the appetite for REIT investments, combined with the 

premiums that the trusts can pay for properties, will 

push the price of commercial space beyond sustainable 

levels. Those who hold this view see REITs, and other 

Wall Street innovations that increase the supply of funding, as potentially amplifying cyclical swings in real 

estate values. The contrary view holds that REITs will 

improve market efficiency by providing continuous 

pricing benchmarks through daily share price movements and thus enforce discipline upon developers and 

lenders. This discipline, it is argued, will prevent excessive development and dampen the severity of real estate 

cycles. 

As an investment, commercial real estate is quickly 

regaining the broad favor it lost during the last market 

downturn. But the channels through which a lender or 

investor can participate in this market are expanding 

even more dramatically. Investment exposures to real 

estate are no longer effectively limited to private equity 

or debt. The choices are multiplying, with liquid public 

markets for both debt and equity providing the foundation for existing and future commercial real estateDallas Regional Outlook 12 Fourth Quarter 1997 
In Focus This Quarter
 

based instruments—instruments such as swaps, options, 

and property derivatives—that will permit the tailoring, 

hedging, and even creation of synthetic real estate 

investment positions. Although financial institutions are 

participating in this revival, it is clearly a different world 

from the old, and one in which they will have to choose 

how best to compete against—or participate in—these 

new real estate financing strategies. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

Commercial Real Estate Lending
 

Is on the Increase in
 

the Dallas Region
 

Average commercial office property vacancy rates for 

major metropolitan statistical areas (MSAs) in the 

Dallas Region have declined, as a group, from 25.6 

percent as of the first quarter of 1990 to 12.7 percent 

as of the second quarter of 1997. The major MSAs in 

the Dallas Region include Albuquerque, Austin, 

Denver, Dallas, Fort Worth, Houston, and 

Oklahoma City. While all MSAs have shown 

declines in vacancy rates, Austin has shown the most 

dramatic reduction. In the first quarter of 1990 the 

Austin market experienced an average commercial 

vacancy rate of almost 30 percent; by the second quarter of 1997 that number had declined to 8.2 percent. 

CHART 5 

Vacancy Rates Decline while Commercial 

Real Estate Lending Climbs 

Dec-90

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

Jun-97 

Source: CB Commercial Property Information Systems 

0 

5 

10 

15 

20 

25 

Vacancy Rates (%) 

20 

22 

24 

26 

28 

30 

32 

34 

$ Billions 

Commercial RE Loans (right) 

(Banks < $5 billion in assets) 

Avg Vacancy Rates (left) 

Denver is the only other MSA in the Dallas Region to 

report less than a 10 percent commercial vacancy rate. 

Oklahoma City, Dallas, and Houston all reported 

vacancy rates in excess of 15 percent as of the second 

quarter of 1997. 

Commercial real estate lending trends in the Dallas 

Region have been consistent with the improvement in 

office markets. Since December 1993, commercial 

real estate lending (including commercial real estate, 

construction and land development, and multifamily 

loans) in the Dallas Region has increased almost 50 

percent, to over $33 billion as of June 30, 1997. This 

analysis includes banks with total assets of less than 

$5 billion, which includes more than 99 percent of 

the institutions in the Region. Larger banks were 

excluded because many have headquarters outside 

the Dallas Region and frequently manage balance 

sheet positions by moving loans among subsidiary 

banks or selling loans to third-party investors. It 

should be noted that the above figures are for bank 

financing only. There also is considerable activity by 

real estate investment trusts (REITs) and conduits 

issuing collateralized mortgage obligations (CMOs) 

(see Chart 5). 

Increased commercial estate lending has been accompanied by increased demand for space as reflected in 

higher office rents (see Table 2, next page). 

The Dallas Region’s commercial real estate market, 

like the nation’s, has benefited greatly over the past 

several years from numerous positive factors. These 

factors include increased liquidity (bank lending, 

REITs, and CMOs), reduced vacancy rates, and a 

Dallas Regional Outlook 13 Fourth Quarter 1997 
In Focus This Quarter
 

generally favorable economy (relatively low interest 

rates, inflation, and unemployment). These factors 

have generally resulted in increasing commercial real 

estate prices throughout the Dallas Region as well as 

a resurgence in commercial real estate lending. Wellmanaged institutions will continue to base lending 

decisions on economic feasibility and realistic property cash flow projections rather than solely on competitive pressures. 

Alan C. Bush, Regional Manager 

Jeffrey A. Ayres, Financial Analyst 

TABLE 2 

Average Cost per Square Foot for 

Class A Office Space in Selected 

Dallas Region MSAs 

METROPOLITAN 2Q96 2Q97 % 

AREA INCREASE 

ALBUQUERQUE $17.38 $18.12 4.3 

AUSTIN 20.15 22.00 9.2 

DALLAS– 

FORT WORTH 17.53 18.80 7.2 

DENVER 17.79 18.38 3.3 

HOUSTON 14.34 16.33 13.9 

OKLAHOMA CITY 12.58 12.84 2.1 

Source: CB Commercial National Real Estate Index 

Dallas Regional Outlook 14 Fourth Quarter 1997 
Regular Features	 Regional Economy
 

NAFTA: Three Years Later
 

•	 Three years after the passage of NAFTA, prospects for growth in trade with Mexico appear good. 

•	 Rapid growth in the high-technology industries has been instrumental in the Dallas Region’s outpacing the 

U.S. as a whole during this decade. 

•	 Rural economies, which experienced job losses throughout much of the 1980s, have recovered strongly during the 1990s. 

Three years after NAFTA: An Overview 

This past summer, the Clinton administration released a 

report examining the economic effects of the North 

American Free Trade Agreement (NAFTA) after three 

years in operation. Although the report measured the 

economic effects of NAFTA on all three nations, this 

article will concern itself with the effects of trade with 

Mexico on the Dallas Region, because of the proximity 

and importance of Mexico’s economy to the Region. 

The administration’s report—a compendium of several 

independent studies—found that the economic effects 

of NAFTA on the United States were positive, albeit 

small. 

The goal of NAFTA was to reduce trade 

barriers between the United States, 

Canada, and Mexico. In the year 

before NAFTA, the average 

Mexican tariff rate applied to U.S. 

exports was 10 percent. After NAFTA, 

from 1993 to 1996, Mexico’s average 

tariff rate on U.S. exports dropped to 

2.9 percent. In the same three-year 

period, U.S. exports to Mexico grew nearly 36.3 percent 

($15.1 billion) to a record high of $56.8 billion in 1996. 

By comparison, exports from the Region to Mexico 

grew only 22.1 percent ($3 billion) to $16.8 billion over 

that period. 

Accounting for the Difference. The divergence in 

export performance between the United States and the 

Dallas Region was largely the result of two factors. The 

first was the rapid expansion of Mexico’s maquiladora 

industry during the 1990s. The second was the negative 

effects of Mexico’s peso crisis in December 1994 and 

Mexico’s subsequent recession in 1995. 

A maquiladora plant takes U.S. intermediate goods and 

transforms them into final goods, ready for duty-free reexport back to the United States. Almost half of 

Mexico’s manufactured-goods exports in 1996 were 

produced in maquiladora plants. Nearly three-quarters 

of maquiladora employment is concentrated in three 

sectors: electronics, transportation equipment, and 

apparel/textiles. Furthermore, nearly 85 percent of 

Mexico’s merchandise exports in 1996 were manufactures—up from 45 percent ten years earlier. 

As a result of the long-standing access to duty-free production on the other side of the border enjoyed by manufacturers in the Dallas Region, exports from the 

Region to Mexico after NAFTA did not grow as fast as 

U.S. exports to Mexico. This phenomenon manifested 

itself in a faster rate of growth in the non-maquiladora 

component of Mexican imports relative to the 

maquiladora component, a result of the former’s ability 

to realize the full benefits of lower tariff rates. Given the 

geographic proximity, it is believed that a significant 

portion of U.S. maquiladora activity occurs within the 

Dallas Region. The disparity in export growth rates to 

Mexico between the United States and the Region 

should disappear over time as manufacturers adjust to 

the new realities of NAFTA. 

Another factor that affected export sales from the 

Region was the devaluation of Mexico’s peso in 

December 1994. Devaluation substantially increased 

the cost of U.S. imports to Mexico, plunging the 

Mexican economy into recession. Consequently, 

exports from the United States and the Dallas Region 

fell sharply in 1995 (see Chart 1, next page). 

Winners and Losers. It is still too early to tell definitively which industries in the Region have benefited 

most since NAFTA’s passage. U.S. Census Bureau data 

(Exporter Location Series) by industry sector exist for 

the years 1994 and 1995; however, export data for both 

years were contaminated by the devaluation of the peso 

during that period, making it extremely difficult to 

Dallas Regional Outlook 15	 Fourth Quarter 1997 
Regular Features Regional Economy
 

CHART 1 

Export Sales to Mexico since NAFTA 

Source: U.S. Census Bureau, Exporter Location Series 

United States Dallas Region 

–10 

0 

10 

20 

1994 1995 1996 

30 

–20

Year over Year Export Growth (%) 

discern NAFTA’s true impact on exports from the 

Region. On the basis of dollar volume, the industries 

that stood to gain the most were electrical and electronic equipment, industrial machinery and computers, 

chemical products, and transportation equipment. 

Approximately half of the Region’s export sales to 

Mexico involved one of these four industry sectors. 

The initial effects of NAFTA were not as favorable for 

some industries. The U.S. Department of Labor (DOL) 

found that, as of May 31, 1997, nearly 130,000 U.S. 

workers had lost their jobs as a result of NAFTA. DOL 

estimates that about one out of eight of these workers 

were from the Dallas Region, and nearly 40 percent 

were employed in either the apparel or electronics 

industry. In addition to the effects on employment, there 

remains a great deal of dispute on issues regarding 

environmental and labor concerns, the handling of 

cross-border litigation, and inadequate funding for 

worker/business assistance programs and project development along the border. 

Implications: Although exports from the Region to 

Mexico have not grown as fast as those of the nation as 

a whole, future benefits from U.S.-Mexican trade 

should promote economic prosperity in the Region 

because of large trade flows. This is particularly true 

now that Mexico is once again enjoying healthy economic growth. If export sales to Mexico continue to 

grow at the current double-digit rate, U.S. bankers will 

likely experience increased lending opportunities. 

Cross-border lending may involve risks that are not 

present in domestic lending. An important set of issues 

involves questions of cross-border jurisdiction. 

International lawyers are reporting a rise in the number 

of cross-border lawsuits and arbitration cases. For 

example, one case involved a South Texas cattle rancher and his Mexican lender. The lender originally won a 

judgment against his borrower that was later upheld by 

the Mexican Supreme Court. A U.S. magistrate in 

Houston, however, ruled in favor of the rancher, arguing 

that the contract violated state usury laws, and recommended that U.S. courts disregard the Mexican ruling. 

In another case, a federal judge in Houston ruled that 

foreign debtors living in the United States fell under the 

jurisdiction of U.S. bankruptcy laws. The ruling set a 

precedent that Mexican banks could pursue borrowers 

who have property in the United States, especially when 

those borrowers live and do business in the United 

States. Although these two cases involved lenders and 

debtors from Mexico, U.S. banks and their borrowers 

could some day face comparable circumstances. 

High Technology Propels Region’s 

Growth in the 1990s 

One of the driving forces behind the Dallas Region’s 

strong economic growth in the 1990s has been the 

emergence and rapid growth of its high-technology 

industries. Although there is no single definition of 

what constitutes a “high-technology industry,” for purposes of this article it will include industrial machinery 

and equipment, electronics and other electrical equipment, communications, and business services. While 

this definition is somewhat arbitrary and captures a significant number of non-high-technology industries, 

these four industries include most high-technology 

firms and allow for national and regional comparisons. 

High-technology industries have flourished in Austin, 

Dallas, Denver, Tulsa, and Rio Rancho, New Mexico. 

High-technology firms that are either headquartered in 

the Region or have facilities here include Texas 

Instruments, Motorola, Compaq, Dell, and Intel, to 

name a few. High-technology employment in the Dallas 

Region grew nearly twice as fast as high-technology 

employment in the nation during the 1990s, 46 percent 

versus 25 percent (see Chart 2). Perhaps not coincidentally, total nonfarm employment grew almost twice as 

fast in the Dallas Region as in the nation as a whole over 

that same period (23 percent versus 12 percent). 

According to the American Electronics Association’s 

(AEA) Cyberstates report—a state-by-state overview of 

the high-technology industry—the Dallas Region 

Dallas Regional Outlook 16 Fourth Quarter 1997 
150 

140 

90 

Regular Features	 Regional Economy
 

CHART 2	 growth rate of almost 17 percent. Chart 3 shows business investment in information-technology equipment High-Technology Employment Growth in plotted against real gross domestic product. Clearly, Dallas Region Has Been Twice That of strong investment by businesses has contributed greatly United States during the 1990s to the growth of the high-technology industry. 

Dallas Region 

United States 

Implications: The Region’s high-technology industry 

1990:1Q = 100.0

has contributed to its strong economic growth; however, 130 

business cycles may be more pronounced in this area 120 

precisely because of its large high-technology base. 110 Although the dominant firms in the industry tend to 100 raise their funds through capital markets, many small 

suppliers, support industries, and the workers they 90:1Q 91:1Q 92:1Q 93:1Q 94:1Q 95:1Q 96:1Q 97:1Q employ depend on depository institutions for their borrowing needs. Thus, lending opportunities may be plenSource: U.S. Department of Labor, Bureau of Labor Statistics 

employed approximately 475,000 high-technology 

workers in 14,200 establishments as of 1995, with an 

estimated payroll of almost $22 billion. The average 

high-technology worker received an annual salary of 

$46,000. In 1995, high-technology exports from the 

Region totaled almost $35 billion, or 45 percent of total 

exports from the Region that year. 

What are the industry’s growth prospects? Two major 

factors driving the high-technology industry will be the 

growth of the personal computer (PC) market and the 

continued investment boom for new information-technology equipment by businesses. Analysts expect PC 

shipments to grow at annual rates of 15 percent to 20 

percent through the year 2000. The current penetration 

rate for computers (the percentage of U.S. households 

that already own a computer) is 40 percent, far below 

the penetration rates for other household electronics 

such as television sets or telephones. Analysts expect 

household demand for PCs to be spurred by 

tiful for these rapidly growing industries. Lenders 

should be cognizant, however, of the boom-bust nature 

of the industry and apply appropriate risk-management 

measures. 

Rural Economies Recovered Strongly in the 

1990s, after Suffering Job Losses in the 1980s 

Job growth in metropolitan and rural areas in the Dallas 

Region during the past 15 years has been a study in contrasts. Total employment in the Region’s metropolitan 

areas grew, albeit slowly, during the 1980s. Rural 

employment, on the other hand, declined over the same 

period. In the 1990s, however, both rural and metropolitan areas were experiencing employment growth faster 

than the nation. 

Table 1 (next page) shows annual average growth rates 

in nonfarm employment for two different time periods 

CHART 3 

Investment in Information Technology Equipment 

Has Helped Drive This Expansion 

U.S. GDP Information technology equipment 

Source: U.S. Department of Commerce. Bureau of Economic Analysis % Change from Year Ago 

1992 1993 1994 1995 1996 1997 

0 

5 

10 

15 

20 

25 

30 

35 

40 

U.S. GDP 

7 Info Tech Equip 

% Change from Year Ago 

6 

5 

4 

3 

2 

1 

0 

•	 a strong U.S. economy and rising incomes; 

•	 a continued increase in Internet usage; and 

•	 the introduction of high-quality low-end ($1,000 or 

less) computers. 

According to U.S. Department of Commerce data, U.S. 

businesses invested nearly $800 billion in informationtechnology equipment during the five-year period that 

ended in 1996, and slightly more than one-third of this 

total was in computers and peripheral equipment. 

Adjusted for inflation, that was an average annual 

Dallas Regional Outlook 17	 Fourth Quarter 1997 
Regular Features Regional Economy
 

for New Mexico, Oklahoma, and Texas (Colorado was 

omitted because of data gaps). From 1982 to 1989 

(Period I), rural areas experienced employment losses in 

all three states totaling 210,100, with Texas rural areas 

alone losing 152,000 jobs. Economic downturns in agriculture and the oil and gas industry were largely responsible for the decline in jobs in many of these 

resource-dependent communities. 

Metropolitan areas, meanwhile, did not altogether 

escape the economic fallout from agriculture and oil. 

These two depressed industries, combined with weaknesses in banking and real estate, held metropolitan 

average job growth in Texas (1.9 percent) and 

Oklahoma (–0.1 percent) far below the national average 

growth rate (2.7 percent) during this period. 

Metropolitan average job growth in New Mexico (4.6 

percent) was the exception, stimulated by large defense 

expenditures as a result of the Reagan defense buildup. 

By the 1990s, the three states’ rural areas were once 

again adding jobs. Rural economies generated 250,200 

jobs from 1989 to 1996. Table 1 shows rural areas in all 

three states growing at virtually the same rates as their 

metropolitan counterparts in Period II. Both metropolitan and rural economies in the Region grew faster than 

the nation’s economy. 

TABLE 1 

Rural economies are growing again in the 1990s, partly 

as a result of agriculture’s improved financial and economic health. Net farm annual income in the Dallas 

Region has averaged $5.3 billion this decade, twice as 

much as the $2.6 billion averaged during the 1980s. 

According to the U.S. Department of Agriculture’s 

Economic Research Service (ERS), U.S. net farm 

annual income in 1997 should be close to its 1990 to 

1995 average of $43 billion. Although the ERS does not 

make a separate forecast for individual states, the Dallas 

Region is expected to record solid gains in net farm 

income this year as well. Higher beef cattle prices 

caused by reductions in the beef herd and strong export 

demand are expected to contribute to this projected 

gain. Cattle and calves account for about half of state 

farm receipts in Colorado, Oklahoma, and Texas, and 

slightly more than one-third in New Mexico. Together, 

these four states account for 30 percent of the nation’s 

farm receipts in cattle and calves. Rising agricultural 

exports have been another major contributor to a 

healthy farm sector. U.S. agricultural production has 

outstripped domestic consumption, so strong export 

demand is important for farmers. Agricultural exports 

from the Dallas Region in 1995 totaled $4.8 billion, or 

8.8 percent of total U.S. agricultural exports. Leading 

exports from the Region were cotton, live animals, feed 

grains, wheat, and hides and skins. 

Metropolitan and Rural Employment Growth Converge in the 1990s 

PERIOD I II 

1982–1989 1989–1996 

AAGR JOBS AAGR JOBS 

GAINED (LOST) GAINED (LOST) 

NEW MEXICO 2.5% 88,600 3.1% 131,800 

METROPOLITAN AREAS 4.6% 97,700 3.1% 86,300 

RURAL AREAS − 0.6% (9,100) 2.9% 45,500 

OKLAHOMA − 0.6% (53,100) 2.2% 190,800 

METROPOLITAN AREAS − 0.1% (4,100) 2.2% 144,800 

RURAL AREAS − 2.1% (49,000) 2.1% 46,000 

TEXAS 1.3% 577,400 2.7% 2,130,700 

METROPOLITAN AREAS 1.9% 729,400 2.7% 1,972,000 

RURAL AREAS − 2.4% (152,000) 2.6% 158,700 

UNITED STATES 2.7% 18,340,000 1.5% 11,639,000 

AAGR = Annual Average Growth Rate 

Source: U.S. Department of Labor, Bureau of Labor Statistics 

Dallas Regional Outlook 18 Fourth Quarter 1997 
Regular Features Regional Economy
 

The resurgence of the oil and gas industry in recent 

years has also contributed to growth in certain rural 

areas. Although oil prices are below their early 1980s 

peak, industry restructuring and the development of new 

technologies have enabled producers to cut costs, 

improve productivity, and open up new areas of exploration. The cost of finding and developing a barrel of oil 

today is 40 percent lower than five years ago. The result 

is that producers can now earn profits with oil at $16 per 

barrel or natural gas at $1.60 per thousand cubic feet. 

Agriculture nevertheless remains a major factor driving 

economic and employment growth in many rural communities. ERS data show agriculture-related employment as a share of total rural employment in the Dallas 

Region—from production to wholesale and retail— 

ranging from 19 percent to 28 percent. By contrast, 

agriculture-related employment in the Region’s metropolitan areas accounted for only 13 percent to 14 percent of total employment, the overwhelming majority of 

which is in wholesale and retail trade. 

Implications: The resurgence of rural economies is just 

one reason why employment growth in the Dallas 

Region has outpaced U.S. employment growth in the 1990s. Behind 

this improved performance has been 

the recovery of two of the Region’s 

basic industries—agriculture and 

oil—and the expansion of hightechnology industries. Loan growth 

and credit quality of banks and 

thrifts in this Region will continue 

to be influenced substantially by 

development in these industries. 

Adrian R. Sanchez, Regional Economist 

Dallas Regional Outlook 19 Fourth Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

• Bank holding companies of all sizes have issued trust preferred stock following the Federal Reserve’s decision in October 1996 to count these tax-advantaged capital securities toward Tier 1 capital. 

•	 Although the tax-advantaged status of trust preferred stock was not eliminated in the federal budget this 

year, there still exists the possibility that the Internal Revenue Service may alter the tax treatment of trust 

preferred dividends. 

• Institutions contemplating issuing trust preferred stock should be aware of the concerns expressed by rating agencies and of the potential risks associated with excessive reliance on debt-like capital instruments. 

Bank holding company capital requirements were effectively relaxed in October 1996 when the Federal 

Reserve ruled that trust preferred stock may be included in the portion of cumulative preferred stock that can 

compose up to 25 percent of a bank holding company’s 

Tier 1 capital. In the wake of this decision, financial 

institutions moved quickly to issue trust preferred stock. 

Trust preferred stock can be a less expensive form of 

Tier 1 capital for bank holding companies because of 

the tax deductibility of the dividend payments paid on 

this type of preferred stock. 

Approximately 90 banking organizations issued an estimated $21 billion of trust preferred shares from October 

1996 through June 1997.1 The dollar amount of trust 

preferred stock issued represented almost 95 percent of 

the incremental amount of Tier 1 capital added by those 

institutions during the period. A number of these institutions used the proceeds of trust preferred stock issues 

to fund stock buyback programs. As an example of the 

relative importance of these stock buyback programs, 

one large bank holding company’s Tier 1 capital ratio 

would be 7.25 percent excluding the trust preferred 

shares, and 8.34 percent including the shares. 

Rating agencies and investment analysts have argued 

that trust preferred stock is a weaker form of Tier 1 capital because of its limited life and debt-like characteristics. These characteristics include the tax treatment of 

trust preferred dividends,2 the limited life of the shares, 

and the ability of investors to accelerate their claims 

against the bank holding company. Institutions contem1 The amount of trust preferred stock outstanding is not delineated in 

Call Reports. 

2 Trust preferred dividends, unlike dividends on traditional preferred 

stock, are treated as a tax-deductible expense at the bank holding 

company level and as taxable income by investors of the trust preferred shares. 

plating issuing trust preferred stock should be aware of 

the concerns expressed by rating agencies and of the 

possibility that excessive reliance on debt-like capital 

instruments could increase their financial fragility during times of economic stress. 

Trust Preferred Structure 

Provides a Tax-Advantaged 

Capital Funding Alternative 

Trust preferred shares, also 

known as capital securities, are 

traded under different names 

depending on the underwriter, payment terms, and 

maturity. Some of the more common acronyms include 

TOPRS (Trust Originated Preferred Shares), QUIPS 

(Quarterly Income Preferred Shares), and MIPS 

(Monthly Income Preferred Shares). 

Although trust preferreds are issued under different 

names, they share the same basic structure (see Chart 1). 

A non-taxpaying subsidiary, or “trust,” of the bank 

holding company is formed. The trust issues two classes of stock: common and preferred shares. The common 

stock of the trust subsidiary is owned by the bank holding company, and the trust preferred stock is sold to 

investors. The trust upstreams the proceeds from the 

sale of the preferred shares to the bank holding company in exchange for a long-term, deeply subordinated 

note with terms identical to the trust preferred shares. 

(The subordinated note must be the sole asset of the 

trust and subordinated to all other debt of the bank holding company.) 

On a consolidated basis, the trust preferred stock is 

treated as a minority interest of the bank holding company, and the subordinated note is eliminated as interDallas Regional Outlook 20	 Fourth Quarter 1997 
Regular Features Financial Markets
 

CHART 1
 

How Is Trust Preferred Stock Structured 

to Count as Tier 1 Capital? 

Trust Preferred 

Proceeds 

Trust Preferred Shares 

Dividend Payments—funded by interest 

received on subordinated note 

Investors in Trust 

Preferred Shares 

Trust Subsidiary 

Issues trust preferred shares 

(structured as a non-taxpaying entity) 

Trust Preferred Proceeds 

(Trust preferred shares treated as 

minority interest by BHC and 

counted toward Tier 1 capital) 

Subordinated Note—same coupon 

and payment terms as trust preferred 

shares, booked as intercompany debt 

and eliminated upon consolidation 

Interest Payments—paid with 

before-tax dollars by the BHC 

Bank Holding Company 

(BHC) 

(BHC owns common stock of 

trust subsidiary) 

Dallas Regional Outlook 21 Fourth Quarter 1997
 
Regular Features Financial Markets
 

company debt. The interest paid by the bank holding 

company on the subordinated note, which is taxdeductible at the bank holding company level, is used to 

fund the dividends on the trust preferred shares. In 

short, the issuing trust serves as a conduit for exchanging cash flows between the bank holding company and 

the investors in the trust preferred shares. 

To be eligible for Tier 1 capital treatment, trust preferred dividends may be cumulative, but dividends must 

be deferrable for a minimum of five years. If the dividends are not paid for more than five years, the trust 

preferred shares could be exchanged for junior subordinated debt of the trust. After the exchange, the trust preferred holder could declare an event of default and 

accelerate the claim against the bank holding company. 

Trust preferred shareholders would then be treated similarly to deeply subordinated debt holders or preferred 

stockholders of the bank holding company. 

Trust preferred shares typically have maturities of 30 

years or more and contain call options and redemption 

provisions. The redemption provisions, which are subject to Federal Reserve approval, permit the issuer to 

redeem or buy back the preferred shares prior to maturity upon an adverse event such as the loss of Tier 1 capital treatment or the tax deductible status. 

Banks are not permitted to count trust preferred stock 

toward Tier 1 capital because of the cumulative feature 

of trust preferred dividends. While bank holding companies are permitted to include up to 25 percent of Tier 

1 capital as cumulative preferred stock, including trust 

preferred shares, banks must exclude cumulative preferred stock from Tier 1 capital ratios pursuant to the 

Risk-Based Capital Standards set by the Basle Accord. 

Bank Holding Companies of All Sizes 

Have Issued Trust Preferred Stock 

The flood of trust preferred stock issuance was prompted in part by the threat of extinction under the 1997 

federal budget. Bank holding companies rushed to take 

advantage of a potentially short-lived tax loophole, 

while investors were attracted by the opportunity to 

earn higher rates than on similarly rated bank debt. 

Bank holding companies have used proceeds from trust 

preferred stock to retire or call more expensive outstanding preferred issues, to provide capital to bank 

subsidiaries, to finance acquisitions, and to buy back 

common stock. 

As the tax advantage of the trust preferred stock 

remained intact through the budget negotiations, the 

pace of trust preferred issuance subsided from an estimated $4.3 billion in the first quarter of 1997 to just 

under $2.5 billion in the second quarter. Trust preferred 

issuance by larger banks declined as some approached 

their limit on Tier 1 trust preferred, while more smaller 

banks took advantage of the market for trust preferred 

stock. (See Chart 2 for a distribution of the number of 

banks in various size categories that have issued trust 

preferred stock in recent quarters.) Investment bankers 

are reportedly working on new structures that may make 

it easier and more cost effective for smaller institutions 

to issue these capital securities, perhaps through some 

pooling arrangement. 

REIT Preferred Stock—Another Type 

of Tax-Advantaged Tier 1 Capital 

Prior to the Federal Reserve’s announcement last 

October, the REIT (real estate investment trust) preferred stock structure was the chosen way for financial 

institutions to issue tax-advantaged preferred shares. 

Bank-issued REIT preferreds lost favor once trust preferreds debuted, because the trust structure is less costly and easier to administer than REIT preferreds. 

In an REIT preferred structure, the issuer establishes a 

corporation that elects REIT tax status. Proceeds from 

the preferred shares that are sold to investors are used to 

purchase qualifying real estate assets such as mortgagebacked securities or equity interests in real property. 

Cash flow from the real estate assets funds the REIT’s 

CHART 2 

More Small Institutions Issue Trust
 

Preferred Stock
 

Bank Size 

Number of < $10 billion Banks 

$10-100 billion 30 

$100+ billion 25 

20 

15 

10 

5 

0 4Q96 1Q97 2Q97 

Source: Keefe, Bruyette & Woods 

Dallas Regional Outlook 22 Fourth Quarter 1997 
Regular Features Financial Markets
 

operating costs and preferred dividends. As long as the 

subsidiary continues to qualify for REIT tax status,3 dividend payments on the common and preferred shares 

are tax deductible by the holding company. 

Will the Tax-Advantaged Status of Trust 

Preferred Stock Continue? 

Although the tax-advantaged status of trust preferred 

stock was not eliminated in the federal budget, the possibility still exists that the Internal Revenue Service 

(IRS) may alter the tax treatment of trust preferred dividends. (In the first half of 1997, the IRS issued a ruling 

that eliminated the tax-advantaged status of a specific 

type of preferred stock known as Step-Down preferred 

stock.) If the tax advantage is eliminated, REIT preferred shares might again become a more popular 

means of raising tax advantaged Tier 1 capital. 

Issues and Concerns 

A number of bank holding companies have embarked 

on stock buyback programs financed by trust preferred 

stock issuance, thereby boosting earnings per share by 

reducing the number of common shares outstanding, 

while maintaining Tier 1 regulatory capital ratios. 

Rating agencies and investment analysts, however, 

generally view trust preferreds as analogous to preferred stock or deeply subordinated debt of the issuer. 

In fact, Standard & Poor’s has announced that bank 

holding companies with trust preferred stock in excess 

of 10 percent of Tier 1 capital may be subject to a ratings review. This announcement reflects the view of 

some analysts that trust preferred stock is a weaker 

form of Tier 1 capital than other forms of capital such 

as common and perpetual preferred stock, because of 

its limited life and treatment upon a liquidation of the 

trust. 

A recent regulatory interpretation has underscored the 

debt-like nature of trust preferred stock. The Office of 

the Comptroller of the Currency (OCC) has determined 

that investments by banks in trust preferred stock 

should be treated as investments in debt securities.4 The 

OCC cited a number of similarities between trust preferred stock and debt securities, including the fact that 

an investment in trust preferred securities is functionally equivalent to an investment in the underlying subordinated debt issued by the bank holding company, and 

that the trading characteristics of trust preferred securities are similar to traditional debt securities. 

Banking organizations should be aware of the views of 

rating agencies and bank analysts toward trust preferred 

stock. In times of economic stress, excessive reliance on 

debt-like capital instruments could result in increased 

financial fragility of the overall organization, a higher 

cost of raising new capital, and potential ratings downgrades. In extreme scenarios, pressures on the bank to 

service the obligations (explicit or implicit) of the 

holding company could attract the attention of bank 

regulators. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

3 To qualify as an REIT, the subsidiary must comply with Section 856 

of the U.S. Federal Income Tax Code, which requires that 75 percent 

of the REIT’s income come from real property rents, interest income 

from mortgage debt on real property, and other related sources. In 

addition, the REIT must distribute at least 95 percent of its net income 

to shareholders. 

4 In a letter dated April 8, 1997, the OCC stated that subject to applicable rating and marketability requirements, bank investments in trust 

preferred stock would be treated as Type III investments under 12 

CFR Section 2 1.2 (k). 

Dallas Regional Outlook 23 Fourth Quarter 1997 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

•	 Banks and thrifts in the Dallas Region continued to report strong financial performance in the second 

quarter. 

•	 Banks that elected Subchapter S corporation tax status report higher earnings, but institutions considering 

this election should be aware of both the benefits and the drawbacks of this tax status. 

•	 Insurance and securities sales are changing the landscape of the financial services industry. 

•	 Banking consolidation in the Dallas Region is most prevalent among metropolitan banks. 

Overview 

The Region’s insured institutions are reaping the benefits of a strong economy, stable interest rates, and 

increasing fee income. Banks and thrifts in the Dallas 

Region continue to display solid financial condition 

(see Chart 1). During the second quarter of 1997, they 

saw 

•	 the aggregate Tier 1 capital ratio climb six basis 

points to 8.06 percent of average assets; 

• total past-due loans decrease by 19 basis points to 

2.28 percent of total loans and leases; and 

•	 net interest income and noninterest income increase 

as a percentage of assets. 

In past Regional Outlook publications, concern was 

expressed over farm banks in Oklahoma and the Texas 

CHART 1 

Dallas Region Institutions Show
 

Financial Strength
 

6/97 

9 United States 6/96 6/97 

Percent of Assets 

8 

7 

6 6/95 

5 

4 

3 

2 

1 

0 

Noninterest Net Interest 

Income Margin 

Source: Bank and Thrift Call Reports 

Past Due & Leverage 

Noncurrent Ratio 

Loans 

panhandle as a consequence of low cattle prices and 

poor wheat harvests. Cattle prices have since rebounded 

and the strength of this year’s wheat harvest surprised 

many. These factors helped Oklahoma farm banks 

(institutions with agricultural loans greater than 25 percent of total loans) increase their quarterly return on 

assets (ROA) from 0.74 percent in the second quarter of 

1996 to 1.42 percent in the second quarter of 1997. 

Despite this recent improvement, income volatility of 

this magnitude merits the continued attention of banks 

in these areas. 

Subchapter S Banks 

This section revisits the Subchapter S tax status issue 

originally discussed in the first quarter 1997 Regional 

Outlook In Focus article “New Tax Benefits for Owners 

of Community Banks.” (Back issues of the Regional 

Outlook for each region are available on the FDIC’s 

website at http://www.fdic.gov/publish/regout/index. 

html.) By the end of the second quarter, 144 of the 

Region’s 1,554 institutions, with assets of $11.3 billion, 

had elected the Subchapter S corporation tax status. 

This corporate tax structure, which passes the federal 

income tax liability through the corporation directly to 

shareholders, is a benefit directed at closely held institutions, usually smaller banks. The median-size 

Subchapter S bank in the Dallas Region has assets of 

$51.5 million. Eighty (55 percent) of the banks are 

located in nonmetropolitan areas. Nine out of ten of 

these nonmetropolitan Subchapter S banks are located 

in counties with populations of less than 20,000. 

Banks in the Region that have taken advantage of the 

Subchapter S corporation tax status are realizing anticipated benefits. From 1994 through 1996, the average 

ROA for Subchapter S banks was 1.36 percent, comDallas Regional Outlook 24	 Fourth Quarter 1997 
Regular Features Regional Banking
 

pared with 1.17 percent for all institutions in the 

Region. Aided by the new tax status, these banks 

increased their ROA to 2.29 percent for the second 

quarter of 1997, which compares very favorably with 

1.27 percent for all institutions in the Region. (The ROA 

data for Subchapter S banks in this discussion excludes 

the largest Subchapter S bank in the Region because its 

performance indicators skew the averages.) Table 1 

shows the significant effect of eliminating income tax at 

the corporate level. 

Election of Subchapter S status may affect a bank’s 

financial results in several ways. Because Subchapter S 

banks no longer pay federal income tax, net income or 

financial ratios that use net income may be misleading 

if they are compared with earlier performance as a Class 

C entity or with other Class C status banks. One solution to that problem is to analyze profit measures at the 

pretax level. Also, shifts in securities portfolios—possibly at the behest of shareholders—may occur to take 

advantage of the benefits of tax-free securities that will 

now pass through directly to shareholders. While the 

new tax status adds pressure to pay dividends to provide 

shareholders with funds for tax payments, the dividend 

payout ratio is not out of line with that of other banks in 

the Region. As the year draws to an end and the income 

picture for these banks and other investments held by 

Subchapter S shareholders crystallizes, the dividend 

payout could become more pronounced. 

TABLE 1 

Subchapter S Banks—Before and 

After Tax Status Election 

Quarterly Income Stream Components as a 

Percent of Average Assets—Annualized 

JUN-97 JUN-96 

+ NET INTEREST INCOME 4.69 4.73 

+ NONINTEREST INCOME 1.49 1.64 

− PROVISION EXPENSE 0.17 0.27 

− OVERHEAD EXPENSE 3.74 3.74 

= PRETAX NET 

OPERATING INCOME 2.28 2.35 

+ SECURITIES GAINS/LOSSES 0.00 0.01 

− APPLICABLE INCOME TAXES − 0.01 0.78 

+ EXTRAORDINARY ITEMS, 

NET 0.00 0.00 

= RETURN ON AVERAGE 

ASSETS 2.29 1.57 

Source: Bank and Thrift Call Reports 

In addition to potential pressure for dividend payment—possibly motivated by investors’ needs—this tax 

structure could mean less flexibility for an institution 

that may want or need to increase capital resources. 

Subchapter S institutions remain under the same capital 

adequacy standards and dividend restrictions as other 

institutions. Consequently, should a bank operating with 

a Subchapter S structure need to raise capital, difficulties could arise because the total number of shareholders must remain at 75 or fewer to preserve the S status. 

Furthermore, no new classes of stock may be issued. 

This restriction may limit the potential sources of new 

capital to existing shareholders. Growth or acquisition 

opportunities requiring additional capital may also be 

hindered with capital resources being confined to a limited number of shareholders. 

Update on Insurance and Securities Activities 

Insurance. The Supreme Court determined in March 

1996 that state laws cannot prevent or significantly 

interfere with national bank powers under Section 92 of 

the National Banking Act, which allows national banks 

to sell insurance from small towns with fewer than 

5,000 residents. Since then, 19 states have enacted or 

revised their laws governing how banks may enter the 

business. Measures enacted thus far take many different 

approaches. In the Dallas Region, Colorado allows 

banks to sell insurance statewide with few restrictions. 

In Oklahoma and Texas, insurance sales offices may 

only be in towns of 5,000 or fewer residents, and banks 

must build strong firewalls and follow tough consumer 

protection requirements. In New Mexico, banks are forbidden to offer borrowers a discount on insurance and 

may not solicit a loan customer until the credit has been 

approved. Many bankers and analysts see insurance 

sales as a way to expand the revenue that can be generated from their customer base. Consequently, many 

banks argue that they should be allowed to sell insurance in larger towns. In this regard, it should be noted 

that current rules provide an incentive to larger banks to 

establish branch locations in small towns. 

Securities. The Federal Reserve Board first allowed 

banks to set up securities underwriting units in 1987, 

under a loophole in Section 20 of the 1933 GlassSteagall Act. Since then, 44 banking companies have 

created securities units, usually gaining Tier 1 powers 

first, which include municipal securities underwriting 

and dealing and asset securitization. After gaining expeDallas Regional Outlook 25 Fourth Quarter 1997 
Regular Features Regional Banking
 

rience, banks apply for Tier 2 powers, which permit corporate debt and equity underwriting and dealing. 

Initially, the Federal Reserve allowed banks to earn only 

5 percent of the revenue in their securities affiliates 

from the new powers. In 1989 the income limit was 

hiked to 10 percent. Late last year the Federal Reserve 

raised it again, this time to 25 percent. Prompted by the 

Federal Reserve Board’s relaxation of rules governing 

bank securities operations, five of the nation’s largest 

banks are acquiring securities firms. The higher limit, 

which took effect on March 6, 1997, has made it practical for regional banks to actively use their Section 20 

units and made it possible for the industry’s biggest 

players to buy investment banks. 

The Federal Reserve Board began work on August 21 to 

abolish nearly two dozen firewalls between banks and 

their Section 20 affiliates. The firewalls will be replaced 

by a set of operating standards. The changes are expected by many to allow banks to extend credit to customers 

of their underwriting affiliates, offer letters of credit and 

credit enhancements in conjunction with underwriting, 

buy stocks from related securities firms, and count 

investments in Section 20 subsidiaries toward the holding company’s capital requirements. (A summary of 

these changes as well as the actual modification to 12 

CFR Part 225—Regulation Y—is available at the 

Federal Reserve website: http://www.bog.fed.us.) 

Banking Consolidation Is Most Prevalent 

in Metropolitan Areas 

The pace of banking industry consolidation over the 

past ten years has been significantly more pronounced 

for metropolitan banks than for nonmetropolitan banks 

(see Chart 2). The number of metropolitan banks and 

thrifts in the Region declined by 65 percent over the tenyear period ending June 1997, compared with 36 percent for nonmetropolitan entities. In 1994 the number of 

nonmetropolitan banks and thrifts in the Region surCHART 2 

Source: Bank & Thrift Call Reports 

0 

500 

1,000 

1,500 

2,000 

2,500 

Jun-87 

Nonmetro 

Institutions 

Metro Institutions 

Metropolitan Banks Are Consolidating More 

Rapidly than Nonmetropolitan Banks 

# of Banks 

Jun-89 Jun-91 Jun-93 Jun-95 Jun-97 

passed the number of metropolitan banks and thrifts. 

The reasons for the differing speeds of consolidation 

include the following: (1) demographic growth expectations are higher in metropolitan areas; (2) metropolitan 

banks tend to be larger, which may provide economies 

of scale that allow them to offer a broader array of services; (3) concentrated markets may offer the greatest 

potential for cost savings, through the elimination of 

redundant branch sites and the capture of large local 

market share; and (4) due diligence and other related 

merger and acquisition costs per dollar of acquired 

assets are greater for smaller acquisitions. 

Implications: Consolidation may significantly alter the 

competitive environment. Banks may feel pressure to 

alter pricing strategies or credit standards to preserve 

individual customer relationships or market share in 

general. In addition, competition may lead banks to 

venture into unfamiliar product lines. An important 

challenge for banks will be to remain focused on maintaining sound lending standards and other operating 

policies despite these competitive pressures. 

Alan C. Bush, Regional Manager 

Jeffrey A. Ayres, Financial Analyst 

Dallas Regional Outlook 26 Fourth Quarter 1997 
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