Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 2000 

FDIC
 

Dallas
 

Region
 

Division of
 

Insurance
 

Alan C. Bush,
 

Regional Manager
 

Adrian R. Sanchez,
 

Regional Economist
 

Jeffrey A. Ayres,
 

Senior Financial
 

Analyst
 

Stephen L. Kiser,
 

Economic Analyst
 

Regional Perspectives 

◆ Dallas Region Average Annual Employment Growth Outpaced Other 

Regions as Decade Ended—However, weak performance in the energy, manufacturing, and agricultural sectors resulted in a 1999 growth rate of 2.5 percent, the 

Region’s slowest since 1992. See page 3. 

◆ Dallas Region Insured Financial Institutions Continued to Report 

Strong Levels of Profitability and Credit Quality—Colorado institutions benefited from the state’s robust construction sector, but rapid increases in real estate 

lending may be cause for concern should the economy slow. See page 6. 

◆ The Region’s Banks and Thrifts Are Experiencing a Lower Cost of 

Funding than Other FDIC Regions and Greater Exposure to Long-Term 

Securities—Funding sources have not changed significantly; however, banks have 

shifted to longer-maturity securities, potentially increasing vulnerability to rising 

interest rates. See page 7. 

By the Dallas Region Staff 

In Focus This Quarter 

◆ Banking Risk in the New Economy—This article summarizes current economic conditions, with a primary focus on potential risks to insured depository 

institutions. It explores the implications of long-term trends that have led to the 

New Economy. Recent high rates of economic growth with low inflation have been 

made possible by increases in productivity arising from new technologies, higher 

investment spending by businesses, and large-scale industrial restructuring. Underlying these trends has been a financial environment that has largely accommodated 

the growing borrowing needs of consumers and businesses. Market-based financing, 

provided in large part through securitizations and mutual funds, has made capital 

readily available to start-up “new economy” firms as well as mature companies that 

seek to merge or restructure. Despite the clear benefits of market-based financing 

in supporting economic activity, there are also concerns. A recurrence of financial 

market turmoil, such as that experienced in fall 1998, has the potential to quickly 

change the currently positive economic outlook to one that is far more challenging. 

Detail is provided on commercial credit quality, market sources of revenue, and 

other risks to watch in banking. See page 11. 

By the Analysis Branch 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 as an information source on banking and economic issues for insured 

financial institutions and financial institution regulators. It is produced for the following eight 

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

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

Outlook, please call Alan Bush at (972) 761-2072 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 Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 The weak performance of the energy, manufacturing, and agricultural sectors is key in explaining why nonfarm employment growth in the Dallas Region slowed substantially in 1999. 

•	 Dallas Region insured financial institutions continued to report strong levels of profitability and credit quality; Colorado institutions benefited from a robust construction sector. 

•	 The Region’s banks and thrifts are experiencing a lower cost of funding and increased exposure to longterm securities in the current rising interest rate environment. 

Dallas Region Average Annual Employment Growth
 

Outpaces Other Regions as Decade Ends
 

The record-breaking U.S. expansion (109 months and 

counting as of April 2000) is entering its tenth year. The 

Dallas Region, however, has experienced 12 years of 

continued economic growth, whether measured in gross 

regional product or nonfarm employment, and is entering its thirteenth year of expansion in 2000. The Dallas 

Region exceeded the nation in employment growth for 

11 consecutive years (see Chart 1). In fact, the Dallas 

Region reported an annual average growth rate of 3 percent during the 1990s, outpacing other FDIC regions in 

the country. 

However, problems in the energy, manufacturing, and 

agricultural sectors resulted in a 1999 growth rate of 2.5 

percent, the Region’s slowest since 1992. The slowing 

of job growth in the goods-producing sectors from 3.5 

percent in 1998 to –0.2 percent in 1999 accounted for 

much of the drag in total nonagricultural employment 

growth in the Dallas Region (see Table 1). At the same 

CHART 1 

time, the services-producing sectors—transportation, 

communications, and public utilities; wholesale and 

retail trade; finance, insurance, and real estate; services; 

and government—continued to experience rapid growth 

in 1999 (3.1 percent). The strength in housing, consumer spending, and investment in information technology buoyed these sectors. 

Goods-Producing Sectors Held Down 

Regional Job Growth 

The weak performance of the goods-producing sectors 

of mining, construction, and manufacturing is key in 

explaining why Dallas Region nonfarm employment 

grew substantially slower in 1999. Chart 2 (next page) 

compares job growth in these sectors by state in 1998 

and 1999. 

TABLE 1 

Dallas Region Employment Growth Outpaced 

the Nation in 1999 despite a Significant Slowing Employment Growth (%) (Year-over-Year) 

–2.0 

–1.0 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

Dallas Region 

United States 

Source: U.S. Bureau of Labor Statistics (Haver Analytics) 

Weakness in the Goods-Producing 

Sectors Depressed the Dallas Region 

Employment Growth Rate in 1999 

1999 (%) 1998 (%) 

TOTAL NONFARM 2.5 3.7 

GOODS-PRODUCING 

INDUSTRIES –0.2 3.5 

SERVICES-PRODUCING 

INDUSTRIES 3.1 3.8 

Note: The goods-producing sector includes mining, 

construction, and manufacturing. The servicesproducing sector includes transportation, communications, and public utilities; trade; finance, insurance, 

and real estate; services; and government. 

Source: U.S. Bureau of Labor Statistics (Haver 

Analytics) 

Dallas Regional Outlook 3	 Second Quarter 2000 
Regional Perspectives
 

CHART 2 Net Change in Jobs (in thousands) 

Job Growth in the Dallas Region Goods-Producing 

Sectors Declined Dramatically in 1999 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

70 

New Mexico Oklahoma Colorado Texas 

Note: The goods-producing sectors include mining, construction, and 

manufacturing. 

Source: U.S. Bureau of Labor Statistics (Haver Analytics) 

1998 

1999 

Despite rising oil prices throughout 1999, consolidations and layoffs in the oil and gas industry led to significant employment losses in the Region’s mining 

sector. In 1998, over 205,000 workers were employed in 

the Region’s oil and gas extraction industry. In 1999, 

over 26,000 of these workers—approximately 13 percent of the industry’s employment base—lost their jobs. 

In the wake of these layoffs, rather than rehire workers 

when prices strengthened, many oil companies chose to 

pay off accumulated debts. In addition, companies 

decided to maintain or repair existing wells rather than 

expand exploration and production. 

Oil prices tripled between year-end 1998 and early 

2000. Oil-dependent industries (e.g., those related to 

manufacturing chemical, plastics, and drilling equipment) were particularly hard hit by the significant hike 

in oil prices. 

CHART 3 

Manufacturing employment growth was depressed not 

only by higher energy costs, but also by softness in the 

Region’s exports. Competition from less expensive foreign imports, for example, resulted in continued layoffs 

in the Region’s apparel and textile industries. Furthermore, a plateau in residential construction, coupled with 

shortages in labor and building materials, negatively 

affected construction-related manufacturing industries. 

Finally, weaknesses in the agricultural and oil sectors 

resulted in declining employment in farm and oil 

machinery manufacturing. 

While the Region’s construction industry was quite 

robust, particularly the industrial, retail, and infrastructure sectors, growth slowed from the previous year. 

However, a few metropolitan areas (e.g., Oklahoma 

City and Dallas) reported softening in office and apartment construction. 

Major Risks to the Region’s Economic 

Expansion 

Although the probability of a recession in 2000 remains 

small, approximately one in four economists surveyed 

by the National Association of Business Economics 

indicated that a recession could occur sometime this 

year or next. Scenarios that could result in an end to the 

Region’s current economic expansion include 

•	 Continued Rising Interest Rates. As of May 16, 

2000, the Federal Reserve Board (FRB) has raised 

the Federal Funds rate 175 basis points since June 

1999 in an attempt to slow the U.S. economy and 

dampen inflationary pressures (see Chart 3). Many 

The Federal Reserve Is Applying the Monetary Brakes to Stave Off Incipient Inflationary Pressures 

Federal Funds Rate (%)

Consumer Price Index 

(Year-over-Year Percent Change) 

Sources: The Federal Reserve Board; U.S. Bureau of Labor Statistics (Haver Analytics) 

4.50 

5.00 

5.50 

6.00 

6.50 

7.00 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

Jan ’97

Mar ’97 

Federal Funds Rate (left scale) Consumer Price Index (right scale) 

Jul ’97

Sep ’97

Nov ’97

Jan ’98

Mar ’98

May ’98

Jul ’98

Sep ’98

Nov ’98

Jan ’99

Mar ’99

May ’99

Jul ’99

Sep ’99

Nov ’99

Jan ’00

Mar ’00

May ’00 

Dallas Regional Outlook 4	 Second Quarter 2000 
Regional Perspectives
 

economists and financial analysts view the FRB’s 

growing concern about an overheating economy as 

an indication that it may continue to raise interest 

rates. In addition to the broader economic implications, rising rates erode the value of fixed-rate securities, particularly those with longer maturities. As 

we will discuss later in this article, rising interest 

rates have implications for the Region’s community 

banks. 

•	 Stock Market Correction. The recent volatility in 

equity markets underscores the nervousness 

investors are feeling about the economy, inflation, 

rising interest rates, and technology stocks. Major 

metropolitan areas in the Dallas Region, including 

Austin, Dallas, Houston, Denver, and Albuquerque, are home to many high-tech companies 

and have particularly benefited from the extended 

bull market. These areas could be extremely vulnerable to a significant decline in income and spending 

in the event of an extended bear market because of 

the highly cyclical nature of high-tech manufacturing and services.1 

•	 Contagion Effects from Abroad. External shocks, 

such as the Asian currency and the Russian bond 

crises, or Mexico’s 1994–95 peso devaluation, have 

affected U.S. capital markets and the U.S. economy, 

particularly in states with large export sectors. Mexico and several other Latin American countries will 

be holding midyear elections in 2000. Over the past 

CHART 4 

quarter century, currency devaluation has occurred 

in Mexico every time an election was held, with 

repercussions felt in the United States. While the 

Mexican government is trying to avoid a similar situation, economic disruptions there (or in other parts 

of the world) could negatively affect trade and investment flows in the Dallas Region. In 1999 Mexico 

alone imported $41.4 billion from Texas, or 45 percent of the state’s exports. Asian nations also are 

major trading partners with Colorado, Texas, and 

New Mexico. 

•	 Growing Pains. Average annual employment growth 

in the Dallas Region outpaced the other FDIC 

Regions during the 1990s (see Chart 4). However, 

this growth, driven in large part by lower business 

costs and living costs than elsewhere in the country, 

did not come without costs. The flip side of this rapid 

growth has been the significant migration of people 

and corporations into the Region, straining the existing infrastructure by increasing congestion and pollution levels and pushing up housing prices and 

wages. To the extent that these costs continue to 

climb, businesses may relocate or expand operations 

elsewhere. These factors alone will not cause a recession but may certainly exacerbate any future downturn; consider the out-migration of people and 

businesses from the Northeast in the late 1980s and 

from California in the early 1990s after years of 

rapid growth and subsequent to their economic 

downturns. 

The Dallas Region Employment and Population Growth Rates 

Exceeded Those in Other FDIC Regions during the 1990s 

Annual Average Growth Rates,

1989–99 (%) 

Source: U.S. Bureau of Labor Statistics (Haver Analytics) 

Dallas 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

Atlanta Memphis San Francisco Kansas City Chicago New York Boston 

Employment 

Population 

1 Devol, Ross. July 13, 1999. America’s High-Tech Economy: Growth, 

Development, and Risks for Metropolitan Areas. The Milken Institute. 

Dallas Regional Outlook 5	 Second Quarter 2000 
Regional Perspectives
 

Regional Banking Conditions
 

Insured financial institutions in the Dallas Region continued to report strong levels of profitability and credit 

quality during 1999 (see Table 2). The Region’s insured 

institutions tracked the national return on assets (ROA), 

leverage, and past-due ratios. The Region’s banks tend 

to have a slightly higher net interest margin (NIM) but 

lower noninterest income, reflecting the Region’s high 

proportion of small banks, which as a group are more 

reliant on income from loans and investments.2 As of 

year-end 1999, 67 percent of the Region’s insured institutions held less than $100 million in assets, compared 

with 57 percent of the nation’s insured institutions. 

Colorado banks and thrifts reported the Region’s 

strongest performance during 1999. They continued to 

post an impressive performance, as evidenced by an 

TABLE 2 

ROA of 1.60 percent and return on equity (ROE) over 

21 percent, higher levels than posted by any other state 

in the Region. Steady asset yields combined with a low 

2.92 percent cost of funds contributed to an ROE that 

was 6 percentage points higher than the national average. Strong earnings at several of the state’s largest 

institutions helped raise the overall results. 

Colorado banks and thrifts enjoy low funding costs 

largely because non-interest-bearing deposits represented 18 percent of assets at year-end 1999, compared with 

11 percent for all banks in the nation. Likewise, core 

deposits held by Colorado insured institutions averaged 

73 percent of total assets at year-end 1999, ranking second in the nation. Past-due loan ratios stood at 1.62 percent, lower than the average for the nation, Region, or 

Dallas Region Profitability Remained Strong during 1999 

DALLAS 

DALLAS REGION 

REGION AGRICULTURAL NEW 

NATION REGION SUB S BANKS COLORADO MEXICO OKLAHOMA TEXAS 

RETURN ON 

ASSETS (%) 1.27 1.22 2.17 1.23 1.60 1.15 1.23 1.16 

RETURN ON 

EQUITY (%) 14.74 14.72 24.22 11.84 21.22 13.35 13.69 14.01 

NET INTEREST 

MARGIN (%) 3.93 4.25 4.86 4.41 5.07 4.58 4.18 4.10 

LEVERAGE 

RATIO (%) 7.82 7.92 9.02 10.16 7.57 7.44 8.20 7.96 

LOAN-TO-ASSET 

RATIO (%) 61.79 58.65 62.89 53.12 53.54 55.36 61.79 59.21 

PAST-DUE 

LOANS (%) 2.00 1.98 2.28 2.76 1.62 2.57 2.04 1.99 

CHARGE-OFF 

RATE (%) 0.54 0.43 .026 0.46 0.46 0.38 0.32 0.45 

RESERVE TO 

GROSS LOANS 

RATIO (%) 1.54 1.20 1.15 1.57 1.25 1.34 1.33 1.15 

RESERVE TO 

NONCURRENT 

(%) 170.13 137.35 102.80 119.21 217.22 130.17 140.35 129.01 

UNPROFITABLE 

(%) 7.33 5.80 2.27 3.87 6.53 6.25 6.45 5.33 

NUMBER OF 

INSTITUTIONS 10,220 1,379 308 310 199 64 310 806 

Source: December 31, 1999, Bank and Thrift Call Reports 

2 Small banks are defined as banks with $100 million or less in assets. 

Dallas Regional Outlook 6 Second Quarter 2000 
Regional Perspectives
 

any other state in the Region. However, in support of 

Colorado’s robust construction sector, real estate loans 

represented 64 percent of total loans at year-end 1999, 

up dramatically from 51 percent three years earlier. This 

rapid increase in real estate lending may be a cause for 

concern should the economy slow. 

Dallas Region Insured Financial Institutions 

Benefit from Low Cost of Funds, but Face 

Challenges in Rising Interest Rate Environment 

For several reasons, banks in the Dallas Region are 

unique. Some differences are based on problems banks 

experienced during the 1980s (see Dallas Regional 

Outlook, fourth quarter 1999). Others relate to a lower 

level of non-interest income, a mix of assests significantly different from the nation, and the low cost of 

funds enjoyed by the Region’s large number of small 

community banks. 

The Region’s institutions have maintained higher profitability levels compared with the nation, in large part 

because of a lower cost of funds (41 basis points lower 

than the nation), which is supported by the high volume 

of non-interest-bearing deposits. Nationally, core 

deposits represented 47 percent of total assets at yearend 1999, compared with a high of 65 percent in 1992 

(see Chart 5). During the same time, institutions in the 

Dallas Region enjoyed a relatively higher level of core 

deposits as a percentage of assets (core deposit rate) and 

reported less decline in this more stable form of funding. In fact, the gap between the nation’s and the Dallas 

Region’s core deposit rates has never been greater. In 

1988, for example, the difference was 7.5 percentage 

points. As of year-end 1999, it had more than doubled to 

15.6 percent. 

Dallas Region institutions also hold a higher percentage 

of non-interest-bearing deposits than those of the nation 

as a whole. At December 31, 1999, 16 percent of the 

Region’s total assets were held in non-interest-bearing 

deposits, compared with 11 percent for the nation. 

However, a recent legislative development may affect 

banks’ cost of funding. On March 29, 2000, the House 

Banking Committee passed House Resolution 4067, a 

proposal that would allow banks to pay interest on business accounts. While the bill’s language currently 

includes a three-year waiting period, the legislation, if 

enacted, could increase the cost of funding for most 

banks. 

The difference in funding costs between the Region and 

the nation is also attributable to the Region’s disproportionate share of small banks, which represent 67 percent 

of all its insured institutions. Smaller institutions may 

be able to provide more personal banking relationships, 

which may help them maintain high core-deposit levels. 

In any case, this more stable source of funding contrasts 

with the national trend but may be more prevalent in 

areas of the country with a greater proportion of small 

banks. While many institutions consider core deposits 

to be a source of long-term funding, these deposits can 

be interest-rate sensitive and may cause funding costs to 

increase in a rising rate environment. 

Larger banks, with access to a wider range of noninterest-income sources, traditionally have been more 

CHART 5 

Core Deposits Fall for Banks and Thrifts Nationwide 

while Dallas Region Institutions Maintain Strong Levels 

Percentage of Total Assets 

Note: Dallas Region data exclude NationsBank-Texas, which consolidated with NationsBank in 1998. 

Source: Bank and Thrift Call Reports 

80 

40 

45 

50 

55 

60 

65 

70 

75 

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

U.S. 

Dallas Region 

Less NationsBank-Texas 

Dallas Regional Outlook 7 Second Quarter 2000 
Regional Perspectives
 

successful than smaller banks at diversifying revenue 

streams. The NIM for the Region’s banks is 34 basis 

points higher than the NIM for the nation’s banks. Conversely, the Region’s 1.99 percent non-interest-income 

ratio significantly trails the nation’s ratio of 2.69 percent. 

While the nation has been shifting toward greater use of 

wholesale funding and away from core funding, financial institutions in the Dallas Region hold core deposits 

at a relatively high level of 65 percent of total assets. 

Importantly for the Region’s institutions, funding strategies have not shown material changes since 1992. However, while the makeup of liabilities has not changed 

significantly, the Region’s banks have shifted to longer 

maturities for a large portion of assets, potentially 

increasing these institutions’ vulnerability to rising 

interest rates. 

Lengthening Maturity Distribution Increases 

Vulnerability to Rising Interest Rates 

Dallas Region institutions hold a higher proportion of 

securities to assets than the nation does (26 percent 

compared with 19 percent as of December 31, 1999). In 

fact, 394 institutions in the Region hold over 40 percent 

of assets in securities. Despite generally rising interest 

rates, maturities for securities, most notably for the 

Region’s holdings of mortgage-backed securities 

(MBS),3 have remained extended. MBS with maturities 

in excess of 15 years, as of year-end 1999, stood at 63 

CHART 6 

percent of total MBS, up from 40 percent just two years 

ago (see Chart 6). In comparison, 48 percent of MBS 

portfolios nationwide were held in long-term securities, 

up from 33 percent in June 1997. 

Price volatility and interest rate movements affected the 

value of securities held by banks during 1999. At 

December 31, 1999, the account used to track unrealized gains or losses from securities available for sale 

was a negative $1.3 billion, a $1.6 billion decline over 

year-end 1998 (see Chart 7). Although this decline represents only a fraction of total assets, it accounts for 6 

percent of equity capital. Moreover, securities classified 

as held to maturity (representing 22.5 percent and 18.5 

percent of all securities in the Region and nation, 

respectively) are carried on the balance sheet at book 

value without adjustments for changes in value. The 

depreciation for these securities increased $800 million 

during 1999, or 3 percent of equity. If interest rates continue to rise, the income from these securities will be 

lower than market rates. And, as noted previously, this 

adverse effect on interest income would likely result in 

a decline in the overall NIM. 

A combination of greater dependence on securities interest income and the yield curve’s shape prompted the 

Region’s banks to extend the maturity distribution of 

securities portfolios during 1998. As shown in Chart 8, 

the yield curve was relatively flat up to the 20-year mark. 

To attain a higher yield, the Region’s banks extended 

maturities dramatically. For example, the dollar volume 

CHART 7 

The Lengthening Maturity Distribution of
 

Mortgage-Backed Securities Investments
 

Increases Vulnerability to Rising Interest Rates
 Maturity Distribution of Mortgage- Backed Securities (MBS) (Percent of Total MBS) 100 

90 

80 

70 

60 

50 

40 

30 

20 

10 

0 

39.6% 56.3% 63.4% 47.9% 

December December December December 

1997 1998 1999 1999 

Region Nation 

Less than 5 Years 5–15 Years Over 15 Years 

Source: Bank and Thrift Call Reports 

Rising Interest Rates Greatly Reduced the 

Region’s Combined Retained Earnings as Losses 

in Securities Available for Sale Climb 

–1,500 

–1,000 

–500 

500 

1,000 

4.00 

4.50 

5.00 

5.50 

6.00 

6.50 

7.00 

Sources: U.S. Treasury (Haver Analytics); Bank and Thrift Call Reports 

Available-for-Sale 

Gain/Loss 

10-Year Treasury Rate 

Dallas Region Available-for-Sale

Gain/Loss ($ Millions)

10-Year Treasury Rate (Percent) 

Dec 

’95 

Jun 

’96 

Dec 

’96 

Jun 

’97 

Dec 

’97 

Jun 

’98 

Dec 

’98 

Jun 

’99 

Dec 

’99 

3 MBS represented 14 percent of the Region’s total assets and 53 percent of total securities as of year-end 1999. 

Dallas Regional Outlook 8 Second Quarter 2000 
Regional Perspectives
 

CHART 8 CHART 9 

Treasury Yield Curve Shows Upward 

Shift and Inversion 

Interest Rates for Various Treasury

Maturities (%) 

Source: U.S. Treasury (Haver Analytics) 

7.00 

4.00 

4.50 

5.00 

5.50 

6.00 

6.50 

30-Yr 

December 1998 

July 1999 

March 2000 

3-Mo 6-Mo 1-Yr 2-Yr 3-Yr 5-Yr 7-Yr 10-Yr 20-Yr

Net Interest Margins (NIMs) for Banks and Thrifts 

Nationwide Declined while the Dallas Region 

Institutions’ NIMs Remained Stable 

3.70 

3.80 

3.90 

4.00 

4.10 

4.20 

4.30 

4.40 

4.50 

1993 1994 1995 1996 1997 1998 1999 

Net Interest Margin (%) 

Note: Dallas Region data exclude NationsBank-Texas, which consolidated with 

NationsBank in 1998. 

Source: Bank and Thrift Call Reports 

Dallas Region 

Less NationsBank-Texas 

Nation 

of MBS with maturities of at least 15 years increased in 

the Region by 57 percent during 1998 alone. 

Shifting Yield Curve Presents Challenges 

to Banks 

The Federal Reserve has raised short-term interest rates 

five times for a total of 175 basis points since June 30, 

1999. Consequently, the short-term side of the yield 

curve has risen dramatically from July 1999 to March 

2000 (see Chart 8). On January 13, 2000, the Treasury 

announced the implementation of a plan to buy back as 

much as $30 billion in older, higher-interest-rate debt, 

causing the long-term side of the yield curve to fall. The 

combination of these two factors has created an inverted 

yield curve, inverting at the two-year mark. Traditionally, an inverted yield curve is considered a harbinger of a 

recession as short-term interest rates exceed long-term 

rates. However, the Treasury’s action may be complicating this scenario. While short-term rates have risen faster 

than long-term rates, the entire yield curve is significantly higher than it was at year-end 1998, causing stress 

for holders of fixed-rate securities. 

Dallas Region Net Interest Margin Unaffected 

by Rate Increases...So Far 

Increases in Treasury interest rates have not yet translated into lower NIMs in the Region; however, Dallas 

Region institutions are vulnerable. First, asset yields 

may be exposed because of the large portion of the 

Region’s assets invested in long-term fixed-rate securities. As rates increase, the values of the fixed-rate securities decline, and the income received is less than the 

prevailing market rate. The Region’s banks’ extension of 

MBS maturities over the past three years highlights this 

risk. 

Second, on the interest expense side, the Region’s funding advantages—strong core deposits and a high volume of non-interest-bearing deposits—may become 

more vulnerable in a rising interest rate environment. 

Although core deposits have historically been stable 

sources of funding and may be less price sensitive than 

other funding sources, the majority of these deposits 

display some sensitivity to changes in interest rates and 

may pressure interest expense in an increasingly competitive marketplace. In addition, pending legislation 

that would allow for the payment of interest on business 

checking accounts would likely raise banks’ costs. Likewise, customers who hold large balances in belowmarket or non-interest-bearing accounts may shift 

excess funds into higher-interest-bearing accounts or 

move funds to other institutions, perhaps dramatically 

increasing the cost of funding. 

The NIM for the nation declined from 4.2 percent in 

1993 to 3.9 percent in 1999 (see Chart 9). During this 

time, Dallas Region insured financial institutions maintained a NIM consistently above 4.2 percent. However, 

it takes time for the effects of changes in interest rates 

to be reflected in the income statement. Consequently, 

even though the NIM has not been affected, profitability may come under pressure eventually. 

Dallas Regional Outlook 9 Second Quarter 2000 
Regional Perspectives
 

Conclusion 

While it takes time for interest rate changes to be 

reflected in earnings, profit, and equity, holding a higher allocation of long-term maturities may expose institutions to higher levels of interest rate risk. As a result, 

an analysis of how a bank’s balance sheet structure 

would weather different interest-rate scenarios is an 

important component of risk management, particularly 

if current holdings include a higher distribution of longterm maturities. 

Dallas Region Staff 

Dallas Regional Outlook 10 Second Quarter 2000 
In Focus This Quarter
 

Banking Risk in the New Economy
 

The Division of Insurance periodically assesses conditions in the economy and the banking industry to identify and evaluate trends that could adversely affect the 

performance of insured depository institutions. At this 

time, the banking industry as a whole continues to 

enjoy record profits and solid financial ratios.1 Much of 

the industry’s strength derives from the remarkable performance of the U.S. economy, which has been expanding for the past nine years. This article explores factors 

that have shaped this unusually robust economic environment and discusses how changes in the economy 

may create new types of risks for insured depository 

institutions. 

During 1999, the FDIC reported the first annual loss for 

the Bank Insurance Fund since 1991. This loss primarily resulted from an uptick in unanticipated and highcost bank failures. Some of these failures were 

associated with high-risk activities such as subprime 

lending, and some were related to operational weaknesses and fraud. The emergence of these problems in 

the midst of a strong economic environment raises concerns about how the condition of the banking industry 

might change if economic conditions deteriorate. 

The Longest U.S. Expansion 

In February 2000, the U.S. economy entered its 108th 

month of expansion, making this the longest period of 

uninterrupted growth in U.S. history.2 This recordsetting performance has also been marked by a recent 

acceleration in the rate of real gross domestic product 

(GDP) growth, which has exceeded 4 percent in each 

year since 1997. Meanwhile, price inflation has 

remained relatively subdued. The core inflation rate, 

which excludes the volatile food and energy components, was just 2.1 percent in 1999, the lowest core rate 

since 1965. 

Recent economic conditions have been highly conducive to strong loan growth, low credit losses, and 

record earnings for the banking industry. The important 

1 For a recent summary of financial performance and condition of the 

banking and thrift industries, see the FDIC Quarterly Banking Profile, fourth quarter 1999, http://www2.fdic.gov/qbp/. 2 The chronology of U.S. business cycles is available from the National Bureau of Economic Research, http://www.nber.org/cycles.html. 

question going forward is how long these favorable conditions might last. Is this remarkable economic performance the result of some long-term upward shift in the 

pace of economic activity, or is it the temporary result 

of a few transitory factors? More important, are there 

new and unfamiliar dangers that, at some point, could 

significantly impair banking industry performance? To 

evaluate these questions, we must assess the factors that 

have contributed to recent economic performance and 

think ahead to possible developments that could end this 

expansion. 

What Is the New Economy? 

The term used most often to describe the recent period 

of economic performance has been somewhat controversial: the New Economy. Much of the controversy has 

arisen because people interpret the term in different 

ways. Wall Street analysts use the term to refer to the 

high-technology sectors of the economy, such as computers and software, biotechnology, and especially the 

Internet. Some of these New 

Economy firms have been able to 

raise large amounts of capital and 

command market valuations in 

the tens of billions of dollars well 

in advance of earning a profit or 

even booking significant cash 

revenues. 

Economists tend to employ the term New Economy in a 

slightly different way. To them, it refers to evidence that 

some of the traditional economic relationships have 

changed. For example, intangible assets now appear to 

play a much larger role in the valuation of investments 

than they have in the past.3 Firms in some industries 

now may exhibit increasing returns to scale (rather than 

diminishing returns), reflecting the fact that the value of 

their product rises as it becomes a de facto industry 

standard.4 Individual decision making, too, may be 

changing. Some believe that investors have reduced the 

risk premium they demand to hold equity positions 

3 Nakamura, Leonard. Federal Reserve Bank of Philadelphia. 

July/August 1999. Intangibles: What Put the New in the New Economy? Business Review. http://www.phil.frb.org/files/br/brja99ln.pdf. 4 Brown, William S. March 2000. Market Failure in the New Economy. Journal of Economic Issues, 219–27. 

Dallas Regional Outlook 11 Second Quarter 2000 
In Focus This Quarter
 

because of their perception that holding equity is not, 

after all, substantially riskier than holding debt.5 Such a 

shift in investor attitudes could help explain why the 

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

recently approached all-time highs.6 

Perhaps the most important underlying change in the 

economy is the relationship between high rates of economic growth and changes in inflation. Economists have 

long maintained that rapid growth in economic activity 

has a tendency to lead to excess demand for goods (thereby raising consumer and producer prices) and excess 

demand for labor (thereby raising wage rates). But during 

the late 1990s, as growth accelerated and inflation 

remained low, economists began to reevaluate their 

notions of these trade-offs. Some argued that the low rate 

of inflation during this expansion was the fortunate result 

of temporary factors, such as a strong dollar and low 

energy prices, both of which could diminish or reverse 

direction over time.7 Only a few analysts were so bold as 

to suggest that the fundamental workings of the economy 

had changed in such a way as to allow a sustained period 

of high economic growth with low inflation. 

An early Wall Street description of the New Economy 

appeared in an article released by Goldman Sachs in 

January 1997.8 It describes a number of fundamental 

changes in the economy—driven by global competition 

and advancing technology—that may permit business 

cycle expansions to last longer than they have in the 

past. At the same time, it warned that longer economic 

expansions might have a tendency to contribute to 

greater financial excess and the possibility of more 

severe recessions and more sluggish recoveries. 

If this hypothesis is correct, and an emerging New 

Economy would contribute to longer expansions and 

more severe recessions, there may be implications for 

how banks manage risks. Since the Great Depression, 

U.S. business cycle recessions have not necessarily been 

catalysts for large numbers of bank and thrift failures. 

5 January 24, 2000. Has the Market Gone Mad? Fortune.
 6 September 1999. Earnings: Why They Matter. Money.
 7 Brown, Lynn Elaine. Federal Reserve Bank of New England.
 

May/June 1999. U.S. Economic Performance: Good Fortune, Bubble,
 

or New Era? New England Economic Review. http://www.bos.frb.org/
 

economic/pdf/neer399a.pdf, and Brinner, Roger E. Federal Reserve
 

Bank of New England. January/February 1999. Is Inflation Dead?
 

New England Economic Review. http://www.bos.frb.org/economic/
 

pdf/neer199c.pdf.
 

8 Dudley, William C., and Edward F. McKelvey. January 1997. The
 

Brave New Business Cycle: No Recession in Sight. U.S. Economic
 

Research, Goldman Sachs.
 

During the period from 1983 to 1989, when the U.S. 

economy was in the midst of a long expansion, some 

1,855 insured banks and thrifts failed. This wave of 

failures has been attributed to a variety of factors, 

including severe regional economic downturns, realestate-related problems, stress in the agricultural sector, 

an influx of newly chartered banks and banks that converted charters, and high nominal interest rates.9 However, the potential for significantly more severe national 

recessions would represent largely uncharted territory 

that could cause losses and loss correlations to depart 

from historical norms, posing a new set of risk management challenges for the industry going forward. 

The Productivity Revolution 

As the essential element that links faster economic 

growth and low inflation, productivity growth is the cornerstone of the New Economy. Productivity refers generally to the amount of output that can be obtained from 

a fixed amount of input. Labor productivity is usually 

measured in terms of output per hour. Chart 1 shows 

that output per hour in manufacturing has risen at an 

average annual rate of 4.5 percent during the current 

expansion, compared with rates of just over 2.5 percent 

in the three previous long economic expansions. Moreover, productivity growth accelerated in 1999 to a rate 

of 6.3 percent. Why is productivity growing so fast now 

compared with previous expansions? Even economists 

who believe that economic relationships have fundaCHART 1 

Productivity Has Grown at a Faster Rate in This 

Expansion than in Previous Long Expansions 

Average Year-over-Year Growth 

in Manufacturing Output per Hour 

5.0% 

4.0% 

3.0% 

2.0% 

1.0% 

0.0% 

1961–69 1975–79 1983–90 1991–2000 

Source: Bureau of Labor Statistics (Haver Analytics) 

9 FDIC Division of Research and Statistics. 1997. History of the 

Eighties: Lessons for the Future, Vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s, 16–17. http://www. 

fdic.gov/bank/historical/history/contents.html. 

Dallas Regional Outlook 12 Second Quarter 2000 
In Focus This Quarter
 

mentally changed are hard-pressed to explain why all of 

the factors came together in the late 1990s and not 

before.10 Still, explanations for the increase in productivity tend to focus on three main factors. 

Increased Competition. Expanding global trade during 

the 1980s and 1990s has subjected U.S. firms to new 

competition from around the world. Annual U.S. 

exports of goods and services grew by over 230 percent 

(after inflation) between 1982 and 1999, while imports 

grew by 315 percent. The construction of new production facilities around the world in industries such as 

autos and chemicals has led to excess manufacturing 

capacity that has kept prices low. In other industries, 

including air travel, trucking, telecommunications, and 

banking, competition has been intensified through 

domestic deregulation. Facing intense competitive pressures and a low rate of general price inflation, firms 

cannot rely on annual price increases to help expand 

top-line revenue. Instead, there is pressure to continually cut costs in order to increase earnings. For many 

firms, this means adopting new technologies and new 

ways of organizing operations. 

Expanded Investment. U.S. firms of all sizes have 

invested in new technologies at a rapid pace during this 

expansion. Chart 2 shows that business investment in 

equipment and software represents almost one-quarter 

of total net GDP growth during this expansion, comCHART 2 

Business Investment in Equipment and Software
 

Has Been Robust during This Expansion
 

Average Percent Contribution of Real Investment 

in Durable Equipment and Software 

to Net GDP Growth by Expansion 

25 

20 

15 

10 

5 

0 

1961–69 1975–79 1983–90 1991–99 

Note: GDP = gross domestic product
 

Source: Bureau of Economic Analysis (Haver Analytics)
 

10 One possible explanation is that there is a learning curve for adopting new technologies and that technology diffusion is an inherently 

slow process. David, Paul A. Organization for Economic Cooperation 

and Development. 1991. Computer and Dynamo: The Modern Productivity Paradox in a Not-Too-Distant Mirror. In Technology and 

Productivity: The Challenge for Economic Policy, 315–47. 

pared with around 15 percent or less during previous 

long expansions. While this investment has been motivated by the need to cut costs, it has also been fueled by 

the availability of new computer technologies that have 

fallen in cost over time and by the ready availability of 

financial capital on favorable terms. 

Industrial Restructuring. The third aspect of the productivity revolution is large-scale restructuring in the 

U.S. corporate sector. Chart 3 shows that both the annual number and dollar volume of mergers in the late 

1990s far exceeded the pace of the so-called merger 

mania of the late 1980s. Two classes of firms are leading the new wave of mergers. First, companies in 

mature industries such as oil, autos, and banking are 

faced with excess productive capacity and intense price 

competition. For these firms, mergers are useful in 

expanding market share and removing redundant operations. Second, the largest dollar volume of mergers is in 

some of the most volatile emerging industries, including telecom, media, and the Internet. It is in these sectors of the economy, in particular, where the business 

models are evolving rapidly and where technological 

standards are still being determined. Firms in these 

industries that can grow rapidly through mergers have 

the chance to achieve long-term market dominance in 

what appear to be some of the fastest growing industries 

of the new century. 

The implications of the productivity revolution for the 

banking industry have been decidedly positive. Higher 

productivity has allowed a long expansion and faster 

economic growth with low inflation, all of which are 

conducive to robust financial performance by depository institutions. Higher rates of business investment 

CHART 3 

Note: M&A = merger and acquisition 

Source: Houlihan Lokey’s Mergerstat 

The Volume of Corporate Mergers Set 

Another New Record in 1999 

Number of M&A Deals M&A Deal Value, Billions of Dollars 

’70 ’72 ’74’76’78’80 ’82 ’84’86 ’88 ’90’92’94’96 ’98 

0 

2,000 

4,000 

6,000 

8,000 

10,000 

1,000 

1,200 

1,400 

1,600 

0 

200 

400 

600 

800 

Dallas Regional Outlook 13 Second Quarter 2000 
In Focus This Quarter
 

have generated demand for credit that is supplied, in 

part, by banks and thrifts. Perhaps most important, the 

recent large-scale industrial restructuring has been 

highly supportive of strong business credit quality. This 

process has moved economic resources to more productive uses in an orderly fashion, without the high levels 

of bankruptcies and defaults that often accompany 

industrial restructuring. Given the volumes of corporate 

assets that have changed hands in recent years (more 

than $1.4 trillion in 1999 alone), it is fortunate indeed 

that this restructuring has proceeded in this fashion. 

The Role of the Capital Markets 

A critical factor in heightened business investment and 

restructuring during this expansion has been the 

remarkably favorable conditions in the financial markets. Financial capital has generally been readily available to business borrowers, usually on favorable terms. 

One factor that has held down the cost of capital for 

publicly traded corporations has been sharply rising 

stock prices. Many of these firms have been able to use 

equity shares as a currency with which to finance mergers. Furthermore, existing accounting rules do not 

always require the amortization of good will that comes 

onto the balance sheet as a result of a merger.11 

By far the largest amount of external business financing 

has been debt financing. U.S. nonfinancial corporations 

issued net debt in the amount of $535 billion in 1999 

and repurchased equity shares, on net, for the sixth consecutive year. Businesses have used this debt to purchase capital equipment, finance mergers, and buy back 

equity shares. This increase in debt issuance has not 

been limited to highly rated corporations. Venture capital financing amounted to almost $15 billion in the 

fourth quarter of 1999 alone, with over 60 percent of 

that amount going to Internet firms.12 

Banks have been active participants in nearly every 

facet of this financing activity. Syndicated loan origination volumes rose by 17 percent in 1999 to just over 

$1 trillion, despite relatively high credit costs and facility fees, factors that helped keep total volume below 

1997’s record $1.1 trillion in issuance. Syndicated loans 

to leveraged companies also rose 17 percent in 1999 to 

a record $320 billion. More impressive still was the 

growth in high-yield transactions, which rose nearly 50 

11 April 17, 2000. Techdom’s New Bean-Counting Battle. Business 

Week. 

12 May 2000. Venture financing data are derived from a PriceWaterhouseCoopers/Money Tree survey, as cited in Upside, 43. 

percent in 1999 to $190 billion. It is difficult to determine precisely how much syndicated loan exposure 

resides on the books of insured institutions or, more 

important, how much high-yield exposure is retained by 

commercial banks. Loan Pricing Corporation estimates that 64 percent of high-yield volume in the first 

half of 1999 was retained by banks.13 Insured commercial banks are the dominant originators of syndicated 

loans, with a 79 percent market share of investmentgrade originations and a 56 percent market share of 

non-investment-grade originations in 1999. Commercial banks have also expanded their presence in the venture capital market. For some of the largest banks, 

profits from venture capital operations account for a 

large portion of total earnings. Chase Manhattan reported venture capital investment earnings of $2.3 billion in 

1999, accounting for 22 percent of total net income.14 

Innovation in the capital markets continues to provide 

new and more efficient vehicles for business financing. 

For example, issuance of asset-backed securities totaled 

$346 billion in 1999, up from only $50 billion in 1990. 

In this ongoing revolution in finance, market-based 

intermediaries, such as mutual funds and asset pools, 

have assumed an increasing role in the credit markets. 

Chart 4 shows that net holdings of credit market instruments by mutual funds, government-sponsored enterprises, and asset pools exceeded the debt held by 

depository institutions for the first time in 1997. 

CHART 4 

Market-based Lending Is Becoming More 

Important as a Source of Business Financing 

Share of Total Net 

Credit Market Lending1 

70% 

60% 

50% 

40% 

30% 

20% 

10% 

0% 

Market-based Lenders3 

Depository Institutions2 

’60 ’63 ’66 ’69 ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 ’99 

1 Total net credit market lending is defined as net holdings of open-market paper,
 

government and municipal securities, corporate and foreign bonds, mortgages,
 

and other loans.
 

2 Depository institutions include commercial banks, savings institutions, and credit
 

unions.
 

3 Market-based lenders include mutual funds, closed-end funds, government-


sponsored enterprises, and asset pools.
 

Sources: Federal Reserve Board (Haver Analytics); Regional Financial Associates
 

13 September 13, 1999. Junk Loan Market Is Feeling the Pinch of 

Oversupply and Rising Interest Rates. The Wall Street Journal. 14 April 3, 2000.What’s Really Driving Banks’ Profits. Business Week. 

Dallas Regional Outlook 14 Second Quarter 2000 
In Focus This Quarter
 

While the expansion in market-based financing has 

made credit more available to business and consumer 

borrowers, it also creates some concerns. One issue is 

the susceptibility of the financial markets to periodic 

bouts of turmoil. These episodes, such as the one triggered by the Russian government bond default and the 

near-failure of the Long Term Capital Management 

hedge fund in the fall of 1998, can result in the interruption of capital flows even to creditworthy borrowers. 

During the 1998 episode, private yield spreads widened 

sharply as investors sought the safety of U.S. Treasury 

securities. Some companies that had planned to issue 

debt to the markets during that period were unable to do 

so. For companies whose business models depend heavily on a continuous supply of liquidity from the financial markets, the effects of these episodes can be 

catastrophic. For example, the relatively short-lived 

episode of financial turmoil during late 1998 resulted in 

significant liquidity problems for a number of commercial mortgage firms. Nomura, Lehman Brothers, CS 

First Boston, and others incurred losses, while Criimi 

Mae, Inc., was forced to declare bankruptcy. 

Because market-based financing has played such a large 

role in facilitating the orderly restructuring of the U.S. 

economy through mergers and the formation of new 

businesses, a recurrence of financial market turmoil 

could contribute to the end of the current expansion. 

Moreover, such an event could have serious consequences for business credit quality. A prolonged interruption of market-based financing could, in this very 

competitive economic environment, prevent businesses 

from restructuring themselves through mergers and 

deprive them of capital needed to invest in cost-cutting 

technologies. The loss of financial flexibility would 

leave businesses much more vulnerable to the effects of 

CHART 5 

competition and could result in more firms seeking 

bankruptcy protection. Such a scenario has the potential 

to bring about a significant increase in charge-off rates 

for business lenders. 

Financial Imbalances 

Another concern that arises from increased dependence 

on market-based financing is that it may contribute to 

the emergence of financial imbalances in the economy. 

These imbalances could, in turn, increase the potential 

for financial market turmoil as a result of some unforeseen shock to the markets. 

As recently as 1993, the public deficit was near the top 

of the list of economists’ concerns about the U.S. economy. During that year, the combined deficit of the federal, state, and local government sectors exceeded $300 

billion. However, on the strength of a long economic 

expansion, lower interest rates, and lower federal spending on defense, the consolidated government sector 

posted its second consecutive surplus in 1999 (Chart 5). 

As the government has moved from deficit to surplus, 

households and businesses have continued to borrow 

hundreds of billions of dollars every year. Taken together, the annual net borrowing of businesses and households has been referred to as the “private deficit.” In 

1999, the private deficit narrowed to $913 billion from 

a record $1.02 trillion the year before. Although this private borrowing indicates confidence on the part of consumers and businesses about future prospects, it also 

raises concerns about the ability to service debt if interest costs rise or if incomes level off or decline. 

Dallas Regional Outlook 15 Second Quarter 2000 

Flow of Net Sectoral Lending 

(Lending Less Borrowing), 

in Billions of Dollars Domestic Financial Sector 

Note: “Nonfinancial business” includes farm and nonfarm, corporate and noncorporate businesses. 

Source: Federal Reserve Board (Haver Analytics) 

Net Borrowing by Businesses and Households Represents a Growing “Private Deficit” 

–1,200 

–900 

–600 

–300 

0 

300 

600 

900 

1,200 

Foreign Sector 

Nonfinancial Business 

Households 

Government 

’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 
In Focus This Quarter
 

The largest part of the private deficit was again 

financed in 1999 by domestic financial institutions 

($649 billion) and an inflow of capital from abroad 

($207 billion). Both of these sources of financing are 

potential causes for concern. The rapid expansion in 

credit created by the financial sector raises questions 

about credit quality. Financial institutions theoretically 

serve as the gatekeepers of the economy, financing only 

the most creditworthy projects and rejecting those that 

are not viable. The sheer volume of credit extended to 

businesses and households—almost $1.4 trillion in new 

net lending over the past two years—raises the possibility that underwriting has become more lax and that 

average credit quality is slipping. (See the inset box on 

page 17 for a discussion of recent trends in commercial 

credit quality.) 

Reliance on inflows of foreign capital raises a different 

set of issues. The fact that the U.S. economy has been 

growing significantly faster than the economies of its 

major trading partners has contributed to a U.S. trade 

deficit that reached $268 billion in 1999 and could 

exceed $300 billion in 2000. This deficit puts hundreds 

of billions of dollars annually in the hands of foreign 

investors. As long as foreign investors largely choose to 

reinvest their excess dollars in U.S. factories and financial instruments, as has been the case in recent years, 

the United States can continue to enjoy a strong dollar 

and relatively low inflation and low interest rates. However, if foreign investors should choose to invest elsewhere, they must sell their dollars in foreign exchange 

markets. Doing so would put downward pressure on the 

dollar and upward pressure on U.S. inflation and interest rates. 

Recent Shocks to the U.S. Economy 

Despite the potential for a declining dollar as a result of 

U.S. reliance on foreign capital, other adverse developments have confronted the U.S. economy over the past 

year. The two factors of most consequence to the macroeconomic outlook have been rising energy costs and rising interest rates. These trends have played a role in 

recent equity market volatility that may have implications for the future direction of the economy. 

Rising Energy Prices. After declining to a low of 

around $10 per barrel in December 1998, oil prices have 

risen dramatically over the past year and a half. The spot 

price per barrel of West Texas Intermediate crude 

peaked in March 2000 at just under $30 before declining slightly in April. The rapid increase in oil prices during 1999 was sparked by a cutback in output by oilproducing nations that was instituted just as global economic growth was recovering from the crisis of 1998. 

The OPEC nations and other major oil producers 

reached a new agreement in March 2000 that provides 

for a production increase of some 1.5 million barrels a 

day. But, because demand is rising and gasoline inventories remain lean, analysts do not look for a significant 

decline in gasoline prices in the near term.15 

The effects of higher oil prices on the U.S. economy at 

this time are uncertain. According to some estimates, 

the economy is only half as dependent on oil as it was 

25 years ago, when the United States was experiencing 

the effects of its first “oil shock.”16 Still, higher oil 

prices were responsible for nearly all the increase in 

consumer price inflation during 1999. While year-overyear growth in the Consumer Price Index rose from 1.6 

percent in December 1998 to 2.7 percent in December 

1999, the core rate of inflation (excluding food and 

energy items) actually fell. The question now is whether 

higher energy prices will be passed along to the rest of 

the economy through rising wage and price demands 

during the remainder of 2000. 

Rising Interest Rates. From low points at the end of 

1998, both short-term and long-term interest rates have 

risen substantially, contributing to a higher cost of debt 

service for businesses and households. At the short end 

of the yield curve, the Federal Reserve (the Fed) raised 

the Federal Funds rate six times between June 1999 and 

May 2000, for a total increase of 175 basis points. 

While part of this increase merely reversed the reduction in rates that took place in late 1998, the Fed also 

voiced concerns that inflationary pressures might be 

emerging because of continued rapid U.S. economic 

growth. Given the stated commitment of the Federal 

Reserve to price stability, most analysts expect the Fed 

to continue to push short-term rates higher until growth 

in the economy slows to a more sustainable pace.17 

Bond markets also pushed up long-term interest rates 

during this period. The yield on the ten-year Treasury 

15 Energy Information Agency (U.S. Department of Energy). April
 

2000. Short-Term Energy Outlook. http://www.eia.doe.gov/emeu/
 

steo/pub/contents.html.
 

16 March 11, 2000. Fueling Inflation? The Economist.
 17 See, for example, U.S. House of Representatives. February 17,
 

2000. Testimony of Chairman Alan Greenspan Before the Committee
 

on Banking and Financial Services. http://www.federalreserve.gov/
 

boarddocs/hh/2000/February/Testimony.htm.
 

Dallas Regional Outlook 16 Second Quarter 2000 
In Focus This Quarter
 

As Commercial Credit Quality 

Indicators Slip, Trends in Commercial 

Lending Come to the Forefront 

Commercial lending, which includes both commercial 

and industrial (C&I) and commercial real estate (CRE) 

loans, represents the greatest source of credit risk to 

insured institutions and the deposit insurance funds. C&I 

loan growth continued to be strong in 1999, although it 

did moderate from 1998 levels, and recent underwriting 

surveys have reported a slight tightening of terms.18 Nevertheless, there are signs that commercial credit quality is 

deteriorating.19 Most notably, as seen in Chart 6, C&I loan 

charge-off rates, corporate bond defaults, and corporate 

bond rating downgrades relative to upgrades have all 

been trending upward recently. For example, C&I loan 

loss rates rose to 0.56 percent of total loans in 1999, nearly double the rate of loss experienced in 1997. Although 

C&I loan loss levels are well below historical highs experienced throughout the 1980s and early 1990s, these signs 

of credit quality deterioration are occurring despite 

extremely favorable economic conditions. 

At least three factors have contributed to weakening in 

corporate credit quality. First, corporate indebtedness has 

been rising, as businesses have been spending to increase 

productivity, cut costs, repurchase equity, and finance 

mergers and acquisitions. The second factor relates to a 

greater risk appetite in the financial markets. For example, originations of leveraged syndicated loans—in particular, highly leveraged loans—have tripled over the past 

five years. Finally, stresses within industry sectors hard 

hit by structural changes, global competition, and deflationary pressures have resulted in challenges for 

borrowers. 

Construction and development (C&D) lending continues 

to be one of the fastest growing segments of banks’ loan 

portfolios, while loss rates among CRE and C&D loans 

remain extremely low. However, there are indications 

that conditions could be worsening in some markets. In 

particular, as shown in Chart 7, strong office completions and construction activity have begun to outpace 

absorptions and are projected to continue to do so over 

the next several years. Moreover, these trends have 

implications for vacancy rates. The national office 

vacancy rate moved higher during 1999 for the first time 

since 1991 and is projected to climb higher. 

In addition, some local CRE markets continue to show 

signs of overbuilding. Last year, the FDIC’s Division of 

Insurance identified nine markets in which the pace of 

construction activity threatened to outstrip demand for at 

least two property sectors.20 Seven of these nine markets 

reported an increase in office vacancy rates in 1999. 

CHART 6 

0.0 

1.0 

2.0 

3.0 

4.0 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

Note: C&I = commercial and industrial 

Source: Moody’s; Bank and Thrift Call Reports (Research Information System) 

Deteriorating Indicators Suggest Weakening 

Business Credit Quality 

Insured Institution C&I 

Charge-off Rate 

Corporate Bond 

Default Rate 

Bond Ratings 

Downgrades to 

Upgrades (columns) 

18 Both the 1999 Senior Loan Officer Opinion Survey (Federal 

Reserve Board) and 1999 Survey of Credit Underwriting Practices 

(Office of the Comptroller of the Currency) point to more stringent 

C&I loan terms since the latter part of 1998. This tightening follows a four-year period of easing C&I loan standards and predominantly reflects an increase in loan pricing. 

19 For additional detail, see Sothoron, Arlinda, and Alan Deaton. 

FDIC Division of Insurance. First quarter 2000. Recent Trends 

Raise Concerns about the Future of Business Credit Quality. 

Regional Outlook. http://www.fdic.gov/bank/analytical/regional/ 

ro20001q/na/Infocus1.html. 

20 These markets are Charlotte, Orlando, Salt Lake City, Dallas, Las 

Vegas, Phoenix, Nashville, Atlanta, and Portland. See Burton, 

Steve. FDIC Division of Insurance. First quarter 1999. Commercial Development Still Hot in Many Major Markets, But Slower 

Growth May Be Ahead. Regional Outlook. http://www.fdic.gov/ 

bank/analytical/regional/ro19991/na/Infocus2.html. 

CHART 7 

0 

20,000 

40,000 

60,000 

80,000 

100,000 

120,000 

140,000 

’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 

0% 

5% 

10% 

15% 

20% 

Source: CB Commercial/Torto Wheaton Research 

U.S. Office Vacancies Rose Last Year 

for the First Time since 1991 

Completions, Absorption 

(000 sq. ft.) Vacancy

 Rate 

Completions 

Absorption 

Projected

Actual 

Dallas Regional Outlook 17 Second Quarter 2000
 
In Focus This Quarter
 

note rose from a low of 4.5 percent in October 1998 to 

6.5 percent by May 2000. Analysts have cited renewed 

demand for credit by a recovering world economy as 

well as concerns about inflation arising from the 

increase in energy prices as factors behind the rise in 

long-term rates. 

Higher energy costs and higher interest rates do not 

appear to have significantly slowed the pace of U.S. 

economic activity during the first quarter of 2000. The 

preliminary estimate of real gross domestic product 

growth during the quarter was 5.4 percent—a slowdown 

from the 7.3 percent rate of the fourth quarter of 1999 

but still well above what is considered a sustainable 

pace. Home construction, usually a sector that is particularly sensitive to movements in long-term interest 

rates, has remained surprisingly resilient. Still confident 

of their future prospects, homebuyers have increasingly 

turned to adjustable-rate mortgages to avoid some of the 

immediate costs of higher fixed mortgage rates. 

As for the business sector, higher costs for energy and 

debt service are most significantly affecting “Old Economy” firms that purchase commodity inputs and carry 

significant debt on their balance sheets. Airline companies in the S&P 500, for example, posted a year-overyear decline of 27 percent in net income from 

continuing operations during the first quarter of 2000.21 

Analysts have argued that New Economy firms, by contrast, are less vulnerable to recent economic shocks 

because they tend to carry little debt and consume relatively little energy. 

Equity Market Volatility. The notion that New Economy 

firms are less vulnerable to the effects of higher energy 

costs and higher interest rates may be one of the reasons 

that equity shares of firms in the technology sector 

began to dramatically outperform the broader market, 

beginning around the middle of 1999. Chart 8 shows 

that the technology-heavy NASDAQ index performed 

more or less in tandem with the Dow Jones Industrial 

Average between the end of 1996 and the middle of 

1999, but thereafter the NASDAQ soared far ahead of 

the Dow. Between October 1, 1999, and February 29, 

2000, the NASDAQ rose by 72 percent while the Dow 

declined by 4 percent. Moreover, this striking divergence between the equity returns of Old and New Economy companies was not limited to the U.S. markets. 

Parallel trends were observed in Europe, Japan, Korea, 

21 Bloomberg. The S&P 500 airline industry is composed of AMR 

Corp., Delta Air Lines, Southwest Airlines, and U.S. Airways Group. 

CHART 8 

and Hong Kong. The similarity in performance of the 

high-tech sectors across three continents suggests a 

worldwide flow of liquidity from investors to the shares 

of technology firms. 

However, emerging concerns about the technology sector contributed to significant volatility in technology 

0 

50 

100 

150 

200 

250 

300 

350 

400 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

Tech Stocks Have, Until Recently, Far 

Outperformed “Old Economy” Stocks Worldwide 

January 1997 = 100 

United States 

NASDAQ 

DJIA 

May 12, 2000 

0 

200 

400 

600 

800 

1,000 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

January 1997 = 100 

EASDAQ 

Bloomberg European 500 

May 12, 2000 

Europe 

0 

50 

100 

150 

200 

250 

300 

January 1997 = 100 

Japan 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

JASDAQ 

Nikkei 225 

May 12, 2000 

Dallas Regional Outlook 18 Second Quarter 2000 
In Focus This Quarter
 

shares during March and April 2000. The NASDAQ 

index lost 30 percent of its value between March 10 and 

May 12, 2000. Analysts cited the Justice Department 

finding against Microsoft and doubts about the ultimate 

profitability of business-to-consumer Internet firms as 

two factors in the sell-off. 

Equity market volatility also poses a threat to the economic outlook. One concern is the so-called “wealth 

effect” that a declining stock market may have on consumer spending. Since 1995, rising stock prices have 

helped raise the market value of equities held by U.S. 

households, plus their holdings of mutual funds, by 

some $5.7 trillion. This windfall is an important reason 

that households have continued to reduce annual personal savings (to just 2.4 percent of disposable income 

in 1999) and increase spending on homes, autos, and 

other consumer goods. Although it is uncertain what 

effect a prolonged stock market correction might have 

on consumer spending, the potential wealth effect has 

surely grown as more households hold a higher percentage of wealth in corporate equities and mutual fund 

shares. (See the inset box at right for a discussion of 

how financial market volatility could affect banks.) 

The Economic Outlook 

Despite the effects of rising energy costs, increasing 

interest rates, and equity market volatility, the U.S. 

economy continues to grow at a robust pace. The consensus forecast of 50 corporate economists surveyed by 

the May 1999 Blue Chip Economic Indicators suggests 

that the economy will grow by 4.7 percent in 2000, 

while consumer prices are projected to rise by 3.0 percent from 1999 levels. Short-term interest rates are projected to rise only slightly by year-end from early May 

levels. In short, the consensus forecast indicates that the 

New Economy formula of rapid economic growth combined with low inflation will continue for the foreseeable future. If actual events conform to this forecast, the 

result will likely be another year of generally low loan 

losses and solid earnings for much of the banking 

industry. (See the inset box on the following page for a 

discussion of other risks to watch in banking.) 

Clearly, risks are associated with the economic outlook. 

Recently, higher oil prices and higher interest rates have 

been the most visible signs of trouble for the economy. 

New Economy companies may be less vulnerable to 

these effects, but even these firms have experienced a 

sharp decrease in equity valuations as investors reevalFinancial Market Volatility Could 

Pare Earnings for Banks Most 

Reliant on Market Sources of 

Revenue 

FDIC-insured banks are deriving an increasing proportion of earnings from noninterest sources (see 

Chart 9), particularly market-sensitive sources of revenue. This is especially true for larger institutions. 

According to Deutsche Banc Alex. Brown, the 18 

most active generators of market-sensitive sources of 

revenue earned over 25 percent of net operating revenue from these potentially volatile business lines.22 

While market-sensitive sources help to diversify revenue streams, they can also introduce increased 

income volatility in the event of financial market turbulence. Deutsche Banc Alex. Brown also reports that 

for those 18 banks that generated the largest amounts 

of market-sensitive revenues during the third quarter 

of 1998, the share of total revenue derived from 

market-sensitive sources declined from 23 percent to 

13 percent. Thus, a more sustained downward trend in 

the financial markets could particularly affect the 

earnings of large banking companies that rely heavily 

on income from sources such as venture capital, asset 

management and brokerage services, and investment 

banking. 

CHART 9 

15 

30 

45 

60 

75 

90 

1970s 1980s 1990s 

Noninterest Revenues Account for a Growing 

Share of Bank Net Operating Revenue 

Percentage of Net Operating Revenue* 

* Net operating revenue is the sum of net interest income and 

noninterest income. 

Sources: FDIC Historical Statistics on Banking; FDIC Quarterly Banking 

Profile 

Net Interest Income Noninterest Income 

0 

22 Net operating revenue is the sum of interest income and 

noninterest income less interest expense. According to 

Deutsche Banc Alex. Brown, these companies are Bank of 

America Corporation; Bank of New York Company, Inc.; 

Bank One Corporation; Bank Boston; BB&T Corporation; 

Chase Manhattan Corporation; Citigroup, Inc.; First Union 

Corporation; FleetBoston Financial; JP Morgan; KeyCorp; 

Mellon Financial Corporation; National City Corporation; 

PNC Bank Corp.; SunTrust Banks, Inc.; US Bancorp; 

Wachovia Corporation; and Wells Fargo & Company. 

Dallas Regional Outlook 19 Second Quarter 2000 
In Focus This Quarter
 

Other Risks to Watch in Banking
 

Subprime Lending 

•	 Subprime consumer loan portfolios contributed to 

the large losses associated with recent high-cost 

bank failures. During 1999, the FDIC reported the 

first annual loss for the Bank Insurance Fund since 

1991. The loss was primarily the result of an uptick in 

unanticipated and high-cost bank failures. FDICinsured institutions with at least 20 percent of Tier 1 

capital in subprime loans accounted for 6 of the 13 

bank failures that occurred between January 1998 and 

March 2000. Fraud and inappropriate accounting for 

residuals also played a role in some of these failures.23 

•	 Subprime lending remains an area of concern. 

Insured depository institutions that engage in subprime lending represent a disproportionate share of 

problem institutions. Of the 79 banks and thrifts on 

the problem bank list as of year-end 1999, 21 percent 

were institutions with at least 20 percent of their Tier 

1 capital in subprime loans.24 

Agricultural Lending 

•	 While a majority of agricultural institutions remain 

relatively strong, external conditions have put pressure on some agricultural producers. Many agricultural areas are experiencing low commodity prices as 

well as weather- and disease-related problems. Strong 

global competition and high worldwide production 

over the past several years have resulted in increasing 

inventories of many crops and poor prospects for a 

price turnaround in the near term. Moreover, in spite 

of record government farm payments in 1999, the 

U.S. Department of Agriculture projects that in the 

year 2000 one in four farms will not cover cash 

expenses, up to 20 percent of farmers will experience 

repayment problems, and 5 percent of farmers will be 

“vulnerable.”25 

23 See Puwalski, Allen. FDIC Division of Insurance. Second 

quarter 1998. Gain-on-Sale Accounting Can Result in Unstable 

Capital Ratios and Volatile Earnings. Regional Outlook. http:// 

fdic01/division/doi/outlook/2q1998/atlanta/infocus1.html. 

24 The problem bank list includes all insured depository institutions rated a composite “4” or “5.” 

25 “Vulnerable,” as defined by the U.S. Department of Agriculture 

Economic Research Service, applies to institutions that have 

debt/asset ratios above 0.40 and negative income such that they 

cannot meet current expenses or reduce existing indebtedness. 

•	 Some signs point to growing stress for agricultural 

institutions. Forty-two percent of FDIC-supervised 

banks active in agricultural lending showed a moderate or sharp increase in the level of carryover debt 

during third quarter 1999, compared with just 26 percent during third quarter 1998.26 In addition, net loan 

loss rates for agricultural production loans increased 

in 1999 to the highest level since 1991. However, at 

0.32 percent, the 1999 net loss rate is just one-tenth 

the rate experienced during the height of the agricultural crisis of the mid-1980s.27 

Operational Risk 

•	 Operational risks are becoming more prominent in 

the banking industry. Driven by consolidation and 

expansion into new product lines and markets, financial institutions are seeing an increase in operational 

complexity. Operational risk encompasses a host of 

factors not related to credit or market activities, 

including risks associated with processing transactions, legal liability, fraud, strategic missteps, and 

internal control weaknesses. Operational risks tend to 

be more pronounced when institutions engage in 

rapid growth, far-flung operations, and complex business processes. 

•	 Greater attention is being paid to operational risks 

in the financial industry. Recently, analysts have 

noted that the pressure to meet ambitious postmerger 

earnings predictions can result in cost-cutting measures that jeopardize the comprehensiveness and 

integrity of risk-management systems. In addition, 

the role that fraud has played in recent bank problems 

and failures reinforces the importance of adequate 

internal controls and audit procedures. The significance of operational risks to financial institutions has 

been noted in industry surveys and informationsharing efforts among financial firms.28 NetRisk Inc., 

a Greenwich, Connecticut, consulting firm, recently 

estimated that operational losses among financial 

institutions have exceeded $40 billion over the past 

five years. 

26 September 1999. FDIC Report on Underwriting Practices. 27 See Anderlik, John M., and Jeffrey W. Walser. FDIC Division of 

Insurance. Third quarter 1999. Agricultural Sector Under Stress: 

The 1980s and Today. Regional Outlook. http://www.fdic.gov/ 

bank/analytical/regional/ro19993q/kc/agricult.html. 

28 For additional detail, see March 2000. Operational Risk: The 

Next Frontier. RMA/PricewaterhouseCoopers Survey. April 6, 

2000. Tech Bytes: Banks Join Forces Against Operational Risk. 

American Banker. 

Dallas Regional Outlook 20	 Second Quarter 2000 
In Focus This Quarter
 

uate the long-term prospects. Equity market volatility 

threatens to dampen consumer confidence and the ability of businesses to continue to merge, restructure, and 

invest. 

The economy has become particularly dependent on 

financing delivered through the capital markets. In this 

more permissive financial environment, rising debt levels and greater dependence on foreign capital have 

emerged as financial imbalances that may contribute to 

future problems for the economy. Businesses and 

households with high levels of debt are more vulnerable 

to problems if interest rates continue to rise or income 

growth falters. Rapid credit creation by the domestic 

financial sector suggests the possibility of lax credit 

underwriting standards. Reliance on foreign capital 

raises concerns about what would happen to the value of 

the dollar and to domestic inflation if foreign investors 

decide to invest elsewhere. 

Some analysts suggest that the New Economy, driven by 

increased productivity, heightened competition, and 

robust investment, may be characterized by longer 

expansions. Financial market imbalances may, however, 

contribute to deeper recessions and more sluggish 

recoveries compared with earlier business cycles. 

For the banking industry, it is clear that a recession 

would mean slower loan growth, deteriorating credit 

quality, and impaired profitability. But the biggest 

threat to the banking industry is a recession that is tied 

to disruptions in the financial markets. The ready availability of financing to start new businesses and restructure old businesses has been key to the New Economy. 

The process by which businesses have invested and 

restructured in response to competition has been orderly from the perspective of bank creditors. If this 

process should be disrupted, we could see a much more 

disorderly process, with more bankruptcies and higher 

losses to lenders. 

This article was prepared and coordinated by the management and staff of the Analysis Branch of the Division of 

Insurance. Contributions and feedback from analysts across the Division were essential to its completion. 

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

Richard A. Brown, Chief, Economic and Market Trends Section 

Steve Burton, Senior Banking Analyst 

Steven C. Cunningham, formerly Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, formerly Senior Financial Analyst 

Mary L. Garner, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Thomas A. Murray, Senior Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Arlinda Sothoron, Senior Financial Analyst 

Ronald Spieker, Chief, Regional Programs and Bank Analysis 

Dallas Regional Outlook 21 Second Quarter 2000 
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