Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 1998 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

Craig A. Rice,
 

Regional Manager
 

Jeffrey W. Walser,
 

Regional Economist
 

John M. Anderlik,
 

Financial Analyst
 

In Focus This Quarter 

◆ Y2K—Preventing the Year 2000 (Y2K) computer problem is becoming ever more 

costly as the time and resources left to do so disappear. Equally costly, according to 

some estimates, will be the litigation that follows in the problem’s wake. A failure to 

address Y2K exposures immediately and successfully may amount to a gamble backed 

by the value of the bank franchise and the officers and directors who run it. See page 3. 

By Gary Ternullo 

◆ Trends in Commercial Real Estate Loan Pricing and 

Underwriting—An abundant supply of financing is placing pressure on commercial real estate loan pricing and underwriting standards. Underwriting standards are being increasingly influenced by the rapid growth in commercial 

mortgage-backed securities and real estate investment trusts. While many within the 

industry believe that broader public funding of commercial real estate projects will 

lead to greater market transparency and improved underwriting discipline, there 

are a number of unique risk considerations related to the rapid growth and continuing development of these alternative funding sources. See page 7. 

By Steven Burton 

◆ Total Return:A Useful Tool for Monitoring Investment Portfolio 

Risk—The Federal Financial Institutions Examination Council is rescinding the 

1991 policy that required “high-risk” testing for mortgage derivative products and 

has released for comment a policy encouraging risk management across all types of 

instruments on an investment portfolio basis. Total return, a concept that includes 

fluctuations in market value, is a useful tool for measuring the performance of an 

investment portfolio and providing information about market risk at the portfolio 

level. See page 13. 

By Allen Puwalski 

Regular Features 

◆ Regional Economy—After two decades of strong growth, the rural manufacturing sector faces increasing competition and a mismatch of skills with labor 

requirements...the viability of many small Nebraska communities may be at risk 

owing to dwindling population...agricultural production contracts are changing the 

way bankers and farmers do business in the Midwest. See page 16. 

By Jeffrey Walser 

◆ Regional Banking—The Region’s farm banks face competition for borrowers from a financially strong Farm Credit System...commercial banks are 

increasingly using Federal Home Loan Bank advances, a funding source that offers 

advantages but also poses risks...the fastest growing banks in the Region have higher than average risk in their balance sheets. See page 21. 

By John M. Anderlik, Craig A. Rice, Julia A. Kuhn 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

form found on the back cover to the FDIC Public Information Center. Contact the Public 

Information Center for current pricing on bulk orders. 

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

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

Region’s Regional Outlook, please call Craig Rice at (816) 234-8034 or send an e-mail to 

crice@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 

Assistant Editors Daniel Frye 

Craig A. Rice 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Y2K: Banking in the twenty-first century may provide
 

grand new opportunities—but you have to get there first
 

•	 As a result of a three-decades-old programming 

convention, January 1, 2000, may find some computer systems unable to function correctly, if at 

all. Links within and between systems and organizations make the problem a complex one. 

•	 Cures are expected to be difficult and costly. If 

those cures fail, litigation could be equally costly, 

and much of it may be aimed at directors and 

officers. 

•	 Accordingly, senior bank management should be 

actively involved in making sure the cure takes 

place. A failure to do so amounts to a gamble 

backed by the value of the bank franchise and 

those who run it. 

Complex Problem, Complex Cure 

By now the story is well known. At midnight on 

December 31, 1999, computer systems that process 

dates using only the last two digits of a year will cease 

to function correctly, if at all. Equipment that contains 

embedded systems—chips or circuitry designed to perform specific functions—also may fail. And the problem is pervasive. It lies within systems and between 

systems, in both software and hardware. The large number of ways dates are used, the number of places they 

can occur, and the number of creative ways for naming 

them confounds an accurate assessment. 

Fixing the Year 2000 (Y2K) problem will require considerable time and effort. Computers and applications 

must be inventoried, examined for date usage, corrected 

where necessary, and then tested—not just by themselves but in combination with every other system with 

which they interact. This includes not only a bank’s own 

systems but also those of its servicers, correspondents, 

customers, vendors, and trading counterparties. 

Moreover, there are a variety of ways to address the 

problem, ranging from expanding date fields to four 

digits to simply subtracting 28 years from every date 

before processing—any of which could introduce new 

incompatibility problems when systems that have been 

fixed in different ways attempt to interact.1 And because 

not all systems can be corrected at once, interfaces or 

bridges between corrected and uncorrected systems also 

must be developed to maintain business system continuity. Most important, it must all be done before the 

non-negotiable deadline of December 31, 1999. 

For bank management, there are two ways to find out 

how serious the problem will be. The first is to commit 

resources to determining just how exposed the bank’s 

systems are—the first concrete step in actually solving 

the problem. The second is to gamble the franchise by 

doing little or nothing and letting the century date 

change provide the ultimate stress test. 

Costs 

The costs of a cure are many. First, there are the costs of 

actually finding and fixing the problem. Estimates of 

this cost have ranged widely, although the Gartner 

Group’s estimate of $300 to $600 billion worldwide is 

the most widely quoted. Using a different approach, 

Software Productivity Research (SPR) places the global number at over $1.3 trillion, including a $176 billion 

slice for the United States alone. Then there are the estimated costs of litigation. At the low end, SPR places 

them at $300 billion globally and projects that fully onethird of that amount will be generated in the United 

States. At the high end, the Giga Information Group 

sees a much more litigious future—estimating that 

Y2K-related legal costs could exceed $1 trillion. 

Significant opportunity costs may accrue as well, and 

the degree to which Y2K-related outlays fail to provide 

1 Every 28 years the same combination of dates and days recurs. 

Subtracting 28 years from a date before processing and then adding 

them back upon output has been suggested as a temporary but partial 

remedy because it permits applications to continue measuring time by 

subtracting two-digit years from each other. Windowing is another 

partial correction whereby some two-digit years—say those less than 

“50,” for example—are assumed to be preceded by “20” (thus “49” 

becomes “2049” in date calculations) while the remainder are 

assumed to be preceded by a “19” (thus “50” becomes “1950”). Both 

approaches only delay the need for permanent corrections. 

Kansas City Regional Outlook 3	 First Quarter 1998 
In Focus This Quarter
 

more efficient or functional systems will serve as a 

starting point for measuring the value of technology 

investments forgone. These forgone improvements will 

be especially costly for institutions that have started 

their repairs too late. They may find not only that the 

time for system improvements and upgrades has slipped 

away, but that they have insufficient time for anything 

beyond a patchwork solution that will continue to cost 

them beyond the year 2000. 

At the macro level, the tally of potential Y2K costs 

includes declining stock values, business failures, and 

recession. J.P. Morgan has estimated that as much as 40 

percent of organizations’ remediation costs have not 

been accounted for in their information technology budgets, presumably indicating that many firms will see 

their share value erode as the costs of Y2K fixes and 

related losses are priced into their future earnings. The 

cost of not being Y2K compliant might be substantial as 

well. According to the Gartner Group, as many as one 

in two firms may discover just how substantial as they 

head into 1999 with even their most mission-critical 

systems unfixed. The potential for these firms to fail 

looms large among the factors that have led Edward 

Yardeni, chief economist at Deutsche Morgan Grenfell, 

to assign a 40 percent chance of recession in the year 

2000. Peter de Jager, a consultant who also has commented extensively on Y2K issues, went even further, 

suggesting that 1 percent of all businesses would fail 

because of Y2K problems. Whatever the eventual 

number, many of these businesses will also be bank 

borrowers. 

Systems and Systemic Risks 

More immediate than the risk of borrower failures is the 

risk that a bank’s own systems may fail. Banks are heavily dependent on software applications that employ 

dates. Among other things, they use them for calculating interest paid or due and for managing the horizons 

of their assets and liabilities. If these applications begin 

returning erroneous calculations, bank operations could 

be seriously disrupted.2 If they fail altogether, the bank’s 

2 For example, interest due from borrowers for a one-year period 

beginning in 1999 and ending in 2000 might be calculated not as one 

year’s interest due but rather as nearly one century of interest payable 

(00 − 99 = − 99) if only the last two digits of the year are used in the 

calculation. Similarly, any other time calculation that straddles the 

century date change might return answers wrong in both size and 

sign. 

credibility—and hence its franchise value—can be substantially damaged or even irrevocably lost. 

The solution is often described in software terms, but 

executable software is not the only problem. Correcting 

software to process four-digit years does little good if 

bank databases that store the critical information about 

who owes what to whom and when still store them in 

two-digit form. Hardware is another critical area. 

Nearly all electronic devices have embedded, permanently programmed chips that can be difficult to find 

because the functions they perform are not always 

apparent. This situation could lead to a host of nuisances, with automated teller machines, point-of-sale 

terminals, bank vaults, check and credit card processing 

equipment, and even building systems succumbing to 

the Y2K problem. 

This dependence on external components and services 

creates a systemic exposure as well. The substantial 

efficiencies that now exist in transmitting payments 

among and between banks and borrowers are a direct 

result of technology. Servicers and 

clearinghouses fulfill computerintensive intermediary roles in this 

high-velocity business—pooling 

payments from those who owe and 

redistributing them among those 

to whom they are due. Anything 

that interrupts these flows can 

have a substantial impact on the ability of banks to settle with their customers and with each other. 

Accordingly, both the Bank for International 

Settlements and the U.S. Federal Reserve are concerned 

about the Y2K threat for two reasons—first because it 

can interrupt the operations of systems dedicated to 

making interbank payments and second because it can 

interrupt the operations of the individual participants 

and generate a liquidity shock that could cause other 

institutions to fail. 

Unfortunately for banks, even a fully successful, 

industry-wide Y2K fix will not completely mitigate 

their risk. The year 2000 story is simply too dramatic 

and lends itself too well to sensationalism. Therefore, 

in addition to managing the cure, bankers will have to 

manage the perceptions of their customers and of the 

public at large—a considerable challenge given that a 

loss of confidence by a small number of customers 

could precipitate liquidity problems for institutions 

even in the absence of a genuine threat. 

Kansas City Regional Outlook 4 First Quarter 1998 
In Focus This Quarter
 

Liability in the Executive Suite 

It bears frequent repeating that Y2K is a business problem and not just a technical one. Its intricacies go 

beyond those of the systems themselves and extend into 

the labyrinth of business relationships and fiduciary 

obligations that bind directors and officers—and the 

assorted attorneys, auditors, consultants, and service 

providers who assist them—to their banks. Through this 

network could pass liability and litigation that could be 

several times the cost of fixing the problem itself. And 

although the problem may have had a technical origin, 

claims would likely be directed against those with deeper pockets who jointly and severally, it will be argued, 

should have corrected or disclosed the institution’s Y2K 

exposures. 

While the bank failures of the late 1980s and early 

1990s are often attributed to unforeseen economic 

events, it will be difficult to assert such a defense for a 

failure to address the Y2K problem. It is simply too visible and offers too much advance notice. This is one reason why the potential potency of Y2K litigation should 

be taken seriously. Moreover, placing the blame, no 

matter how well deserved, at the feet of vendors and 

consultants may offer little protection. The Federal 

Financial Institutions Examination Council (FFIEC) 

has indicated that senior bank management should be 

fully aware of their vendors’ progress and develop contingency plans should those vendors fail.3 This pronouncement has elevated the standard for prudent Y2K 

actions in such a way as to make imperative the active 

involvement of top bank management in both solving 

3 Safety and Soundness Guidelines Concerning the Year 2000 Business 

Risk, December 1997. The full text is available on the FFIEC website 

at www.ffiec.gov. 

Managing the Y2K Process 

On May 5, 1997, the Federal Financial Institutions Renovation. Renovation includes not only fixing the 

Examination Council—an interagency group com- problem internally but monitoring the efforts of cusposed of the Federal Deposit Insurance Corporation, tomers, counterparties, vendors, and service 

Federal Reserve, Office of the Comptroller of the providers. The prudent execution of due diligence and 

Currency, Office of Thrift Supervision, and National best practices at this stage will provide a measure of 

Credit Union Administration—released a statement confidence that exposures have been addressed. It 

on Year 2000 project management awareness that will also provide a measure of protection from liabilincluded an outline of the Y2K management process. ity claims should problems nevertheless emerge. 

That outline identified five phases that each financial 

institution would have to navigate in identifying and Validation. Validation means testing how a bank’s 

fixing its Y2K exposures: systems will respond on their own as well as when 

connected with those outside the bank. The FFIEC 

Awareness. Before Y2K exposures can be fixed, they believes that one full year should be available for testmust be seen as problems. Creating awareness, how- ing and correcting problems that either remain or are 

ever, is not easy because the pervasiveness of compo- introduced by the renovation process. Accordingly, 

nents and intersystem links that can harbor or pass the institutions should plan on completing the previous 

problem create complexities that are neither intuitive three phases by the end of 1998. 

nor easily quantified. However, it is critical that senior 

managers understand the problem and fully support Implementation. Testing corrected systems to ensure 

the commitment of resources to fixing it. their compliance does not complete the process. The 

final step is to gain acceptance by the users as to the 

Assessment. In this phase, all information systems, ability of the system to satisfy business requirements. 

electronic equipment, and building systems must be A failure at this stage will require further correction 

evaluated for specific Y2K exposures. Remediation or the implementation of contingency plans. 

plans must then be devised. In addition to plans for 

fixing the problem, contingency plans will be needed For the full text of this and other FFIEC guidance, see
 

as a precaution against unforeseen Y2K failures orig- the FFIEC website at www.ffiec.gov.
 

inating from both within and outside the bank.
 

Kansas City Regional Outlook 5 First Quarter 1998 
In Focus This Quarter
 

the problem and ensuring that the franchise will be protected if one or more of those solutions fail. 

Betting the Franchise 

The FFIEC has divided Y2K remediation into five 

phases—awareness, assessment, renovation, validation, 

and implementation (see Inset 1, page 5). As a benchmark for progress, the FFIEC has indicated that the validation phase—the phase in which testing of Y2K fixes 

is conducted—should be well under way for all banks 

by the end of 1998. This leaves less than a year for laggards to complete the first three phases. Banks that are 

not devoting adequate resources to identify and address 

their exposures need to be aware that the consequences 

of delay or inaction could be severe. The bank supervisory agencies, Congress, and the financial markets are 

taking the risk to heart. So too are attorneys intent on 

sharing in what has been described as potentially the 

most expensive litigation in history. 

Insurance companies are concerned as well, as evidenced by extremely high Y2K policy premiums or outright refusal to write Y2K coverage. Thus, any business 

interruptions and liability that emerge may have to be 

financed from the bank income statement and balance 

sheet. As such, a bet that Y2K will not be a problem 

might well amount to a gamble backed by the bank franchise and those who run it. (See Inset 2 below for additional sources of information.) 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

For Further Information 

Further information on the Y2K problem can be obtained from banking regulatory agencies at the websites shown 

below. 

Federal Deposit Insurance Corporation (FDIC) www.fdic.gov 

Federal Financial Institutions Examination Council (FFIEC) www.ffiec.gov 

U.S. Federal Reserve Board of Governors www.bog.frb.fed.us 

National Credit Union Administration (NCUA) www.ncua.gov 

Office of the Comptroller of the Currency (OCC) www.occ.treas.gov 

Office of Thrift Supervision (OTS) www.ots.treas.gov 

The following websites contain additional information concerning the Y2K problem. Their inclusion here does 

not serve as an endorsement by the FDIC of any information contained therein. 

Market Partners Inc.—Year 2000 Resources for Banks www.marketpartners.com 

Gartner Group—Technology Consultant www.gartner.com 

Software Productivity Research (SPR)—Technology Consultant www.spr.com 

De Jager LLC (Peter de Jager)—Technology Consultant www.year2000.com 

Giga Information Group—Technology Consultant www.gigaweb.com 

Y2K LLC (Williams, Mullen, Christian & Dobbins)—Attorneys www.Y2K.com 

Economics Network (Dr. Edward Yardeni)—Economist www.webcom.com/yardeni 

Kansas City Regional Outlook 6 First Quarter 1998 
In Focus This Quarter
 

Trends in Commercial Real Estate 

Loan Pricing and Underwriting 

•	 An abundant supply of capital is placing signifi- CHART 1 

cant pressure on commercial real estate loan Banks’ Commercial Real Estate and pricing. Construction Lending Rebounds 

• Considerable evidence suggests that a large per- Construction Loans 

centage of insured institutions are easing commercial real estate and construction lending 

underwriting standards. 

• The rapid rise in commercial mortgage-backed 

securities and real estate investment trust funding 

could change the way banks underwrite commercial real estate loans and have important effects 

on their competitive position in the lending 

Year-over-Year (%) Growth

20 Commercial Real Estate Loans 

10 

0 

–10 

–20 

–30 

YE90 YE91 YE92 YE93 YE94 YE95 YE96 3Q97 

markets. 

As reported in last quarter’s Regional Outlook, banks 

provided the largest share of funding for commercial 

real estate during 1995 and 1996 compared with all 

other financing sources (see Strong Demand and 

Financial Innovation Fuel Rebounding Commercial 

Real Estate Markets). Chart 1 shows that banks’ commercial real estate and construction lending continues 

to increase and that year-over-year growth rates in these 

two loan categories are accelerating. At the same time, 

however, alternative funding sources in the form of 

commercial mortgage-backed securities (CMBS) and 

real estate investment trusts (REITs) are also experiencing significant growth. Commercial Mortgage Alert 

reports that $26 billion in CMBS was issued through 

September 1997, up from $17 billion for the same period in 1996. The same publication projects that CMBS 

issuance will top $40 billion during 1997, compared 

with last year’s record issuance of $29.8 billion. 

Measures of REIT activity also indicate impressive 

growth. According to the National Association of Real 

Estate Investment Trusts, REITs issued $26.3 billion in 

equity through October, compared with $12.3 billion 

for all of 1996. In addition, REIT market capitalization 

rose $50 billion (64 percent) through the first nine 

months of 1997. 

While it is good news to borrowers, the abundance of 

capital for commercial real estate projects raises the 

often-quoted concern that “too much money is chasing 

too few deals.” Market observers worry that fierce competition and an excessive supply of financing are leadSource: Commercial Bank Call Reports 

ing to both inadequate loan pricing relative to risks 

borne by lenders and looser loan underwriting standards. This article examines current trends in commercial real estate loan pricing and loan underwriting. It 

also explores the possible influences of CMBS and 

REITs on loan underwriting practices and commercial 

real estate markets. 

An Abundance of Capital Has Placed 

Significant Pressure on Commercial Real 

Estate Loan Pricing 

Chart 2 (next page) shows that prime-graded commercial mortgage spreads have steadily declined since 1992 

and are now at levels not seen since the real estate boom 

years of 1988 and 1989. At 113 basis points above tenyear treasuries, current spreads on ten-year commercial 

mortgages are only slightly higher than A-rated ten-year 

industrial corporate bonds, which traded at spreads of 

66 basis points over comparable-term treasuries as of 

September 1997. Some property sectors have experienced more narrowing of spreads than others. 

American Council of Life Insurance (ACLI) data show 

that mortgage spreads relative to treasuries compressed 

31 basis points for industrial, 22 basis points for hotel, 

21 basis points for retail, 11 basis points for multifamily, and 10 basis points for office real estate from March 

1996 to March 1997. Moreover, because of continuing 

downward pressure, current pricing varies little across 

Kansas City Regional Outlook 7	 First Quarter 1998 
In Focus This Quarter
 

CHART 2 CHART 3 

Commercial Mortgage Spreads Are Pricing Narrows between High- and 

Tightening 

Basis Point Spread over

Ten-Year Treasuries 

Source: Barron’s/John B. Levy 

0 

50 

100 

150 

200 

250 

Jan ’87Jan ’89Jan ’91Jan ’93Jan ’95Jan ’97 

Spread between AAA and BBB


Grades (Ten-Year Average Life)
 

Medium-Grade CMBS 

Basis Points 

140 

120 

100 

80 

60
 

40
 

20
 

0 

Q1 ’95Q3 ’95Q1 ’96Q3 ’96Q1 ’97Q3 ’97 

Source: Nomura Securities International 

the quality spectrum. For instance, Chart 3 indicates 

that spreads between AAA- and BBB-rated CMBS have 

narrowed considerably since year-end 1995, from 110 

basis points to a scant 28 basis points. 

It seems likely that competitive factors will continue to 

place pricing pressure on lenders. The relatively recent 

entrance of Wall Street firms into the financing arena 

via conduits is a striking example of just how competitive the market for commercial real estate financing has 

become.1 Conduits are rapidly becoming the dominant 

issuer of CMBS and underlie much of the rapid growth 

in CMBS noted above. Through the first nine months of 

1997, Commercial Mortgage Alert reported that conduits accounted for 50 percent of total CMBS issuance, 

compared with 30 percent during the same period in 

1996. 

Many industry participants see conduits and REITs as 

significant and increasing competitive threats to traditional lenders. For example, a recent issue of 

Commercial Real Estate South discussed the continuing expansion of conduit business into a much wider 

range of property and credit quality types. This publication noted that conduits have a particular incentive to 

aggressively pursue higher quality loans in order to 

strengthen pools that contain weaker credits. Such 

aggressiveness threatens to squeeze banks’ profit margins on low-risk deals, which might give banks an 

incentive to pursue lower quality credits. Given their 

focus on larger credits, conduits presently pose a competitive threat primarily to larger lenders. However, the 

1 Conduits are entities created to originate mortgage loans for distribution to investors in the secondary market. 

rapid growth of capital within the industry may eventually force larger lenders to target smaller markets, which 

would in turn increase competition at the regional or 

local community level. While their influence is less 

direct, the growing use of REITs to finance commercial 

real estate projects also places pressure on loan pricing 

spreads, since lenders must compete for a smaller pool 

of customers. With their access to a seemingly limitless 

source of public funding, REITs could pose a particular 

threat to community bankers by dominating certain geographic markets or property sectors. 

Narrowing pricing spreads raise concerns over whether 

lenders are being adequately compensated for the operational, funding, credit, and market risk inherent in 

originating, servicing, and holding commercial real 

estate loans. More important, tightening spreads raise 

prospects that lenders will ease other loan terms and 

relax loan standards to the extent that they are unable to 

differentiate their product based solely on price. While 

such easing may enable lenders to retain business in the 

face of stiff competition, imprudent underwriting could 

ultimately lead to higher loan losses than would otherwise be the case in the event of a downturn in commercial property markets. 

Are Commercial Real Estate Loan Underwriting 

Standards Becoming Looser? 

Most industry experts have argued that the memory of 

the real estate downturn of the late 1980s and early 

1990s keeps lenders from becoming overly aggressive 

in making commercial real estate loans despite the 

abundance of funding alternatives currently available to 

Kansas City Regional Outlook 8 First Quarter 1998 
In Focus This Quarter
 

borrowers. These experts point out that today’s loan-tovalue (LTV) ratios are lower than they were at the peak 

of the last real estate boom, that lenders are concentrating more on obtaining adequate debt-coverage ratios, 

and that lenders are requiring borrowers to bring more 

cash equity to the table. One might also argue that practices have improved and become much more uniform 

with the implementation of regulatory appraisal standards and the adoption of interagency guidelines for 

real estate lending policies. Rating agencies impose 

additional guidelines and standards as lenders originate 

loans for possible sale into the secondary markets. 

While information about specific quantitative underwriting criteria applied to new loan originations by 

commercial banks is not readily available, some sense 

of industry trends may be gleaned from competitors’ 

practices. For example, the ACLI performs a quarterly 

survey of underwriting criteria for commercial real 

estate loan commitments originated by major life insurance lenders. The ACLI’s second quarter 1997 survey 

indicated that new commitments (total volume of $4.1 

billion) had a weighted average LTV for all property 

types of 66 percent and a weighted average debt-coverage ratio (DCR)2 of 1.6 times. These figures compare 

favorably to an LTV ratio in late 1989 approaching 75 

percent and a DCR just under 1.3 times. 

ACLI data suggest that recent commercial mortgage 

originations are better supported by borrower equity 

and property cash flows than they were in the late 

1980s. It is important to recognize, however, that LTV 

and DCR ratios are driven largely by market conditions 

and expectations. Property valuations take into account 

recent sales and expected cash flows, and cash flows 

available to service debt are based on projected net 

operating revenues, which often incorporate projected 

increases in rents and other revenue sources. In other 

words, the overwhelmingly favorable conditions in 

today’s real estate markets may also be a factor in the 

improved LTV and DCR ratios. Keeping in mind the 

cyclical nature of real estate, one can easily see how a 

shift from today’s positive outlook to a more pessimistic 

outlook might result in a sharp reversal in these commonly cited ratios. 

Notwithstanding these quantitative considerations, 

there are indications that banks are easing commercial 

2 The debt-coverage ratio measures annual net operating income generated by a property relative to annual principal and interest payments 

due on the underlying loan. 

real estate underwriting standards. This evidence, 

derived from industry and examiner surveys conducted 

by the three banking agencies, includes the following 

observations: 

•	 In the Office of the Comptroller of the Currency’s 

(OCC’s) 1997 Survey of Credit Underwriting 

Practices, OCC examiners reported eased commercial real estate lending standards in 38 percent of 

banking companies surveyed. For comparison purposes, the 1996 survey reported eased standards in 

16 percent of banking companies surveyed. Among 

institutions with eased lending standards in the 1997 

survey, examiners noted a 75 percent incidence of 

reductions in loan fees or rate spreads, a 43 percent 

incidence of eased guarantor requirements, and a 29 

percent incidence of lower collateral requirements. 

Examiners cited competitive factors and a change in 

economic outlook as the main reasons for changes in 

underwriting standards. 

•	 Chart 4 summarizes current and historical results of 

the Federal Reserve Board Senior Loan Officer 

Opinion Survey for responses to the question of 

whether bank credit standards for approving applications for commercial real estate loans have eased, 

tightened, or remained unchanged. These survey 

results show that banks have had a tendency to ease 

underwriting standards since the fourth quarter of 

1996. This tendency appears to have become 

stronger through the third quarter 1997 survey but 

moderated somewhat in the most recent survey. The 

most recent survey showed that large banks (over 

$15 billion in assets) were much more likely to indicate easing commercial real estate standards than 

CHART 4 

Survey Shows Tendency to Ease Commercial 

Real Estate Underwriting Standards 

Percentage 

Source: FRB Senior Loan Officer Opinion Surveys 

2Q96 3Q96 4Q96 1Q97 2Q97 3Q97 4Q97 

–15 

–10 

–5 

0 

5 

10 

15 

20 

25

 % Respondents Tightening

 % Respondents Easing

 Net % Tightening (Easing) 

Kansas City Regional Outlook 9	 First Quarter 1998 
In Focus This Quarter
 

smaller banks. Specifically, 21 percent of large 

banks reported easing standards, while only 3 percent reported tightening standards. In comparison, 

only 9 percent of smaller banks reported easing 

standards, while 13 percent reported tightening 

standards. 

•	 Results from the FDIC Report on Underwriting 

Practices indicate possible easing of standards for 

construction and development (C&D) loans at 

FDIC-supervised banks. A comparison of examiner 

responses for the third quarter 1997 survey (covering 

examination reports filed from April through 

September 1997) with responses for the third quarter 

1996 survey leads to the following observations3

: 

•	 The percentage of banks frequently or commonly 

originating C&D loans tied to speculative projects 

(that is, projects lacking meaningful preleasing or 

presales, or loans without a formal take-out commitment for permanent financing following completion 

of construction) rose markedly, from 11 percent to 

29 percent. 

•	 The percentage of banks frequently or commonly 

granting C&D loans without considering alternative 

repayment sources other than income generated by 

the project being financed rose significantly, from 8 

percent to 20 percent. 

•	 The percentage of banks frequently or commonly 

basing C&D loans on unrealistic appraisals rose 

from 5 percent to 11 percent. 

•	 The percentage of banks frequently or commonly 

funding or deferring interest payments during the 

term of construction loans rose from 7 percent to 15 

percent. 

Much of the commentary in recent issues of various 

trade journals echoes the results of these regulatory surveys.4 In brief, many industry participants are seeing a 

higher incidence of (1) banks funding construction loans 

without preleasing commitments on major portions of 

rentable space, (2) banks easing LTV ceilings, (3) 

3 The authors of this survey note that comparisons of survey results 

across time periods must be interpreted with caution since the survey 

samples are dictated principally by examination scheduling factors. 

As a result, sample populations may be materially different from one 

period to another. 

lenders curtailing reserve requirements for such items as 

tenant improvements and insurance, and (4) nonrecourse 

lending. Some industry participants have also noted the 

increasing acceptance of “trended rents,” whereby property valuations are based on positive rent projections 

extrapolated several years into the future. Of course, 

these trended rents will hold true only if economic circumstances remain favorable for extended periods— 

an assumption that may not be reasonable given 

the cyclical nature of real estate coupled with 

the advanced age of the current economic 

expansion. 

With a combination of relatively low 

interest rates, rising real estate prices, 

and an expanding economy, it is perhaps not too surprising that some 

lenders have eased commercial real 

estate underwriting standards. Such 

easing may be a natural response to 

improved confidence in the real estate 

markets. However, indicators that show 

loosening standards may also be warning flags that lenders have succumbed to tighter pricing 

and competitive pressures. To avoid losses like those 

sustained by banks during the last real estate downturn, 

prudent lenders will refrain from incorporating unrealistic expectations into their lending practices. 

CMBS Could Change the Way 

Lenders Underwrite Loans 

Much as residential mortgage lending standards were 

shaped by the advent of mortgage-backed securities, 

CMBS promise to change the way banks underwrite and 

service commercial real estate loans. For instance, lending terms and practices could become increasingly standardized as lenders attempt to improve the liquidity and 

marketability of their commercial mortgage portfolios. 

Banks that choose to deviate from these emerging standards will sacrifice flexibility in terms of their ability to 

manage portfolio risks and respond rapidly to liquidity 

demands. 

The ability to securitize commercial real estate loans 

also may fundamentally alter the way lending decisions 

4 See, for example, Commercial Real Estate South, “Public Markets 

Fuel Financing Glut” (October 1997); Midwest Real Estate News, 

“Wall Street and Main Street Squeeze Lenders” (October 1997); and 

Commercial Property News, “Michelson, Greenland Seize Low 

CMBS Spreads” (1 May 1997). 

Kansas City Regional Outlook 10	 First Quarter 1998 
In Focus This Quarter
 

are made. Before the development of CMBS markets, 

loan approval was essentially a binary, good-or-bad, 

accept-or-reject decision whose primary focus was on 

the credit risk inherent in a single asset. In contrast, the 

most important elements in CMBS are deal structure, 

price execution for multiple tranches, credit enhancements, and portfolio composition. Here, the loan originator is more likely to use a portfolio approach in 

making credit decisions: That is, how will this loan 

enhance the expected return and risk diversification of 

the overall pool? 

External rating agencies will become increasingly 

important as CMBS markets expand, since these agencies’ guidelines will effectively dictate the underwriting 

standards applied to securitized loans. While such standardization could arguably improve market discipline 

and loan performance disclosure, there are several 

potential risks to consider as the CMBS markets evolve: 

•	 While rating agencies do incorporate qualitative considerations into their analysis, issue ratings and credit enhancement level decisions are driven primarily 

by quantitative factors, namely debt service coverage 

and expected loss levels. Moreover, most of the qualitative factors the agencies consider involve an 

analysis of portfolio balance and pool diversification. Hence, weak or poor qualitative standards (for 

example, lack of alternative repayment sources or 

minimal borrower equity in the project) applied to 

individual loans within the pool may receive only 

secondary consideration. A quantitative perspective 

also ignores such immeasurable factors as borrower 

“character” and the existence of long-standing 

lender-borrower relationships. 

•	 Rating agencies cannot be relied upon as a backstop 

to unsound underwriting practices. While they generally review a substantial volume of the loans within a pool, typically the largest individual credits, they 

are not practically able to review every credit in the 

securitization. Some within the industry have even 

suggested that investment bankers commonly move 

one problem property, discovered through one 

agency’s sample, into pools reviewed by another 

agency in the hope that it will not be sampled. 

•	 Competition among the rating agencies could 

become a factor in the underwriting process. This 

“shopping of the agencies” could result in continual 

pressure for rating agencies to ease their underwriting guidelines. 

•	 In theory, bank-issued CMBS transfer much of the 

underlying credit risk associated with commercial 

real estate lending to investors. However, like other 

types of asset securitization, CMBS raise concerns 

over the degree to which banks will voluntarily 

absorb investor losses. Bank issuers may be more 

likely than nonbank issuers to provide voluntary support to poorly performing CMBS for at least two reasons: A tarnished reputation in one aspect of a bank’s 

operations could carry over to other business activities like deposit taking and borrowing due to a bank’s 

broad brand name association within the marketplace; and banks often have greater financial 

resources than nonbanks with which to support securitization activities. 

Because the rapid growth in CMBS has been a relatively recent phenomenon, current underwriting guidelines 

applied by the rating agencies to CMBS have not been 

tested during a cyclical downturn in real estate prices. It 

remains to be seen how the market will react to rising 

loan losses that result in investor losses. 

Will Increased Public Funding through CMBS 

and REITs Improve Market Discipline? 

Many contend that the increased transparency brought 

to the market by CMBS will temper cyclical swings in 

real estate values. This viewpoint argues that investors 

will serve as a constraint against the natural tendency to 

overbuild commercial real estate during boom periods, 

since less funding will be allocated to segments of the 

market where excess capacity exists. This viewpoint 

presupposes that the investing public is sophisticated 

enough to recognize when markets are out of balance 

and when projects are economically infeasible. In this 

sense, CMBS shift much of the burden of monitoring 

credit quality standards and credit performance from 

lenders to public investors. 

In contrast, others have argued that lenders are much 

better suited than investors to make judgments about 

credit quality standards and project feasibility. This line 

of reasoning suggests that the increase in public ownership of property through CMBS and REITs could actually reduce market discipline, since the most 

sophisticated participants with access to the best information (that is, lenders) may come to have less at stake 

in making prudent credit decisions. Of course, excessive losses attributable to any one CMBS issuer might 

lead to differentiation in pricing based on investors’ 

Kansas City Regional Outlook 11	 First Quarter 1998 
In Focus This Quarter
 

perceptions of the quality of underwriting applied by 

specific issuers.5 

Putting market efficiency arguments aside, the sheer 

volume of REIT and CMBS activity causes some concern over the extent to which such financing is driving 

property valuations. With such an abundance of capital 

flowing into the commercial real estate market, it is perhaps easy to see why lenders might opt to ease standards 

rather than lose business. However, to the extent securitization activities are driving decisions in today’s commercial real estate markets, lenders might wish to 

consider how property values would react if the availability of such financing were sharply diminished. The 

most recent real estate downturn provided a ready 

example of how tighter credit availability compounded 

the effects of declining commercial property values by 

limiting the ability of lenders to sell distressed properties. While there may not be consensus on whether 

CMBS and REITs will temper cyclical price swings, the 

underwriting standards and practices evolving in 

response to these financing vehicles will likely play a 

crucial role in determining the magnitude of losses 

experienced by investors and banks during the next 

downturn in commercial property values. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Selected Articles
 

for Further Reading
 

Bloomfield, Craig. “Michelson, Greenland Seize 

Low CMBS Spreads.” Commercial Property News. 

1 May 1997. p. 33. 

“CMBS Issuance Seen Topping $40 Billion.” 

Commercial Mortgage Alert. 10 November 1997. 

p. 1. 

Fitch Investor Services, Inc. “Commercial 

Mortgage Stress Test.” Fitch Research: Structured 

Finance Special Report. 8 June 1992. 

Office of the Comptroller of the Currency. Advisory 

Letter 97-3: Credit Underwriting Standards and 

Portfolio Credit Risk Management. 3 March 1997. 

Sinderman, Martin. “Public Markets Fuel 

Financing Glut.” Commercial Real Estate South. 

October 1997. p. 1. 

Wolf, Barney. “Wall Street and Main Street 

Squeeze Lenders.” Midwest Real Estate News. 

October 1997. p. 1. 

5 The evolution of the credit card securitization markets is one example of how investors now differentiate between issuers in terms of 

pricing. 

Kansas City Regional Outlook 12 First Quarter 1998 
In Focus This Quarter
 

Total Return: A Useful Tool for
 

Monitoring Investment Portfolio Risk
 

•	 The Federal Financial Institutions Examination 

Council (FFIEC) is replacing the 1991 policy that 

contained a specific “high-risk test” for mortgage 

derivative products (MDPs) held by insured institutions with a policy that encourages risk management across all types of instruments on an 

investment portfolio basis. 

•	 A good way to start measuring portfolio risk is by 

monitoring an appropriate measure of return. 

•	 Total return, a concept that includes fluctuations 

in market value, is a more appropriate tool than 

simple yield for measuring the performance of an 

investment portfolio, especially one that contains 

bonds with embedded options. 

The Federal Financial Institutions Examination Council 

(FFIEC) has released for comment a new Joint Agency 

Policy Statement on Investment Securities and EndUser Derivatives Activities that will replace a statement 

issued February 3, 1992. While much of the content of 

the former statement has been retained, the section 

requiring specific “high-risk” testing for mortgage 

derivative products (MDPs) has been eliminated. The 

“high-risk” test applied specifically to bonds collateralized by residential mortgage pass-through certificates 

or whole loans but that distributed cash flows to bondholders on a basis other than pro rata.1 

The goal of the original policy statement was to deter 

banks from investing in products that presented risks 

that they were not able to adequately monitor and control. MDPs were singled out because of their rapid 

growth, nontraditional and potentially risky nature, and 

common use by insured financial institutions. The new 

policy states that, as a sound management practice, 

institutions should conduct prepurchase and ongoing 

analysis of all their investments at a level appropriate to 

the size and complexity of those holdings. 

1 A security was deemed “high risk” if it exhibited any of the following characteristics: (1) it had a weighted average life of more than ten 

years; (2) its average life extended by more than four years or shortened by more than six years from a 300 basis point parallel shift in 

rates; (3) its price changed by more than 17 percent given a 300 basis 

point parallel shift in rates. 

The policy change is in part a response to increasing 

bank investment in securities that have complex cash 

flows analogous to MDPs but that escaped the analysis 

requirement of the previous policy. Mortgage index 

amortizing notes are an example of popular bank investments that potentially exhibit all the risks of MDPs but 

were not subject to the testing requirement of the soonto-be rescinded policy because they are not collateralized by mortgages. Callable agency and “step-up” 

bonds are popular bank investments because they offer 

a slightly larger spread to Treasury than noncallable 

agency securities, and they were not subject to the 

“high-risk” test under the old policy. However, the additional yield offered on these kinds of securities compensates the investor for assuming additional risk. 

Appropriately measuring portfolio return can enhance 

the ability to monitor the extent to which these kinds of 

securities put future earnings at risk. 

Total Return Analysis Is a Useful Tool for 

Analyzing Risk at the Portfolio Level 

Total return analysis is a basic but useful tool that can 

alert management to the level of certain risks in an 

investment portfolio. It can also provide information 

that is useful for validating the assumptions used in 

more sophisticated models. Total return is calculated 

from three components: beginning price, income and 

reinvested cash flow, and ending price (market value) at 

a horizon date. Total return incorporates the change in 

the market value of the investment, resulting in a more 

comprehensive measure of performance than other 

measures that ignore such changes. Monitoring total 

return on a portfolio basis can provide institutions with 

important information about the risks inherent in the 

portfolio and how these risks may be changing over 

time. 

In two articles in the ABA Banking Journal,

2 Nicholas 

Betzold and Richard Berg convincingly dispute the 

2 The articles were published in December 1996 and April 1997. 

Reprints of the articles are available at the ABA Banking Journal website at http://www.banking.com.aba/backissues.htm. 

Kansas City Regional Outlook 13	 First Quarter 1998 
In Focus This Quarter
 

view that if the investment strategy is to buy and hold to 

maturity, total return is not relevant. Consider the following example. In 1990, Bank A purchases a sevenyear security yielding 8.83 percent that is callable after 

three years. At the same time, Bank B buys a noncallable seven-year agency security yielding 8.53 percent. For three years, Bank A’s bond yields 30 basis 

points more than Bank B’s. However, from 1990 to 

1993, interest rates fell almost 300 basis points. Bank 

A’s bond would likely be called, forcing the bank to 

reinvest at a significantly lower rate for the remaining 

four years of the seven-year investment horizon. Over 

the seven-year horizon, Bank A could expect an average 

yield that is about 150 basis points less than Bank B’s. 

From the yield perspective, 

Bank A enjoyed three years of 

superior performance. However, during those three years, 

monitoring total return might 

have revealed a less favorable 

but more accurate picture of 

Bank A’s performance relative 

to Bank B’s. Here is why: As 

rates fell from 1990 to 1993, bonds gained in value. 

However, as rates fell, the market value of the callable 

security would have gained incrementally less than the 

noncallable bond because each downward tick in rates 

increased the expectation that the bond would be called, 

and the higher coupon would be earned over a shorter 

period. In contrast, the noncallable security’s market 

value would have enjoyed the full benefit of the falling 

rate environment because its maturity and cash flows 

are fixed. 

The disparate change in the market value of the two 

bonds reflects the fact that Bank A, in essence, sold a 

call option to the bond issuer. The issuer bought the 

right to repurchase the debt at par after three years. 

Bank A was compensated for selling this right to the 

issuer with increased yield. In the example, the issuer’s 

option to call the bond would have gained value as rates 

fell. The increasing positive value of the call option to 

the issuer represents an increasing negative value to the 

bondholder and erodes the value of the bond. 

Step-up bonds present reinvestment risk similar to that 

of generic callable bonds, but with the added complexity of a coupon that rises, usually annually, if the bonds 

are not called. Total return analysis would similarly 

reveal adverse changes in the value of the embedded 

call options and the extent to which the additional 

coupon is compensating for call risk. 

UBPR Yield 

Bank management often uses the portfolio yield that is 

calculated in the Uniform Bank Performance Report 

(UBPR) to assess performance of the bank’s securities 

portfolio against its peers. This yield measure is calculated by dividing annualized book income on a tax 

equivalent basis (plus or minus amortization or accretion of any premium or discount) by the amortized cost 

of the securities. This measure of present yield says little about potential future yield and the extent to which, 

because implicit options have been sold, the latter has 

been put at risk for the sake of the former. 

Total return measures the risk-adjusted return of a portfolio more closely than yield because it incorporates 

changes in reinvestment risk over time. Ultimately, a 

portfolio manager who earns total returns consistently 

higher than average will earn more in terms of simple 

yield. Conversely, a manager who earns less in terms of 

total return will eventually find an unfavorable reinvestment environment that will erode reported yield. 

The popularity of using yield to gauge the performance 

of bank securities portfolios may be due to the convenient presentation of bank peer portfolio yields in the 

UBPR. Some managers may be reticent to evaluate 

portfolio performance using total return without a peerlike benchmark for calibrating total return expectations. 

Betzold and Berg have devised an investment portfolio 

index (introduced in the April 1997 ABA Banking 

Journal) that is designed to track the total return of a 

typical bank portfolio composed of the same percentages of investment sectors as the average bank. The 

portfolio on which the index is based is rebalanced 

monthly as principal pays down, and it is rebalanced 

quarterly to reflect the latest Call Report data on portfolio allocations. Table 1 depicts the investment weighting of the index as of December 31, 1996, based on 

September 30, 1996, Call Report data. 

According to Betzold and Berg, this index produced 

total returns that closely approximated those of the actuKansas City Regional Outlook 14 First Quarter 1998 
In Focus This Quarter
 

al median bank total portfolio measured by Call Report 

data from 1993 through third quarter 1997.3 They concluded that their index seems to provide a reasonable 

proxy for the total return of the “average” bank investment portfolio. 

Chart 1 shows the performance of the index so far this 

year.4 Changes in the index value over time can be translated into total returns that approximate the median 

bank portfolio’s total return. For example, the annualized total return for the index from year-end 1996 

through third quarter 1997 was 6.72 percent and is calculated as follows: 

Calculate the bond equivalent semiannual yield 

and express the semiannual bond equivalent yield 

as an effective annual yield. 

4

: 105.00 3

6.72% = 100 [(:) − 1

100.00 ]

The performance of the index for 1997 suggests that 

banks’ total investment portfolio returns were highly 

negatively correlated with changes in the five-year 

Treasury rate (see Chart 2). This finding indicates that 

changes in total return from period to period can provide useful information about the level of a portfolio’s 

interest rate sensitivity. As emphasized above, these 

changes in total return over time include the effects of 

changes in market value of any call options on a bank’s 

investment securities and hence provide information 

about the degree to which future income is at risk. 

Given the increasing level of optionality embedded in 

the average bank securities portfolio—even if it arises 

solely from callable agency debt and “step-up” structured notes—yield should not be the sole measure of 

overall portfolio performance. Total return analysis is an 

appropriate supplement that gauges the risk-return characteristics of an investment strategy that involves selling 

implicit options. 

Allen Puwalski, Senior Financial Analyst 

3 While the Call Report does not contain the information necessary to
 

compute total return precisely, the authors computed an estimate
 

using the reported yield and market value data.
 

4 The index is published monthly in the ABA Banking Journal.
 

TABLE 1 

Composition of Betzold Berg Index 

December 31, 1996 

PERCENT 

SECURITY TYPE OF INDEX 

TREASURIES 24.52 

AGENCIES 24.38 

MUNICIPAL BONDS 12.26 

FIXED-RATE MORTGAGE OR 

MORTGAGE-RELATED PRODUCTS 19.93 

OTHER SECURITIES 6.09 

ADJUSTABLE-RATE SECURITIES 13.00 

Source: Bank and Thrift Call Reports, September 30, 

1996 

CHART 1 Index Value 

Index Tracks the Total Return of an 

“Average” Bank Portfolio 

Source: ABA Banking Journal 

100.84 

104.31 

Dec Jan Feb Mar Apr 

100 

101 

102 

103 

104 

105 

106 

May Jun Jul Aug Sep 

100.51 100.71 

101.49 

102.23 

103.06 

104.03 

105.00 

100.00 

CHART 2 

Total Return Index Is Correlated 

to Changes in Interest Rates 

Source: ABA Banking Journal, Bloomberg 

5-year Treasury 

(right scale) 

Betzold Berg Index 

(left scale) 

Percent Change Percent Change 

–10 

–5 

0 

5 

10 

Jan-97

Feb-97

Mar-97

Apr-97

May-97

Jun-97

Jul-97

Aug-97

Sep-97 

–0.20 

0.00 

0.20 

0.40 

0.60 

0.80 

1.00 

Kansas City Regional Outlook 15 First Quarter 1998 
Regular Features	 Regional Economy
 

Kansas City Region: Globalization and Technological
 

Change Challenge Rural Manufacturing
 

•	 After two decades of strong growth, the rural manufacturing sector faces increasing competition and a mismatch of skills with labor requirements. 

•	 Half of Nebraska’s counties have lost population since 1980, and the viability of many small communities 

may be at risk. 

•	 Agricultural production contracts are changing the way bankers and farmers do business in the Midwest. 

Rural Manufacturing Faces Uncertain Prospects 

Manufacturing in the Region’s nonmetropolitan counties has experienced significant growth in the past 

decade. From 1985 to 1994, manufacturing employment grew from 383,000 jobs to 517,000 jobs, an 

increase of 35 percent. During the same period, manufacturing jobs in metropolitan counties declined 3.4 percent to 878,000 jobs. As shown in Chart 1, growth in 

rural counties has outpaced that in urban counties every 

year since 1986. 

According to an analysis by economists at the Kansas 

City Federal Reserve Bank, using 1991 data, food processing was the most common type of manufacturing in 

the Region, accounting for 19.6 percent of the total. 

This compares to only 9.2 percent for the United States 

as a whole. The rural counties of the Region were also 

above the U.S. average in the manufacture of lumber 

and wood, leather products, and machinery. They trailed 

CHART 1 

Rural Manufacturing Growth Has Outpaced
 

Metropolitan Growth since 1986
 

the U.S. share in production of chemicals, primary metals, electronic equipment, and instruments. 

Over the past three decades, the growth of rural manufacturing has been a significant contributor to economic growth in the Region’s rural areas, employing farmers 

who left agriculture or providing a second income for 

part-time farmers. Manufacturing plants have been an 

important source of tax dollars to support local school 

and government needs, and manufacturing has provided 

important business for local vendors and service 

providers. 

Despite its past success, many industry observers 

believe that rural manufacturing is threatened by recent 

trends in the marketplace. A 1996 survey of rural manufacturing by the U.S. Department of Agriculture 

found a “clear rural gap in the use of advanced telecommunications and production technologies.”1 The study 

concludes that the technological gap in rural plants is 

largely a result of the industry mix. The technology 

component of food processing is somewhat less than 

that of electronics manufacturing. The predominance of 

lower technology industries in the rural sector leads to 

important long-term risks for the sector. 

Growth Rate (%)	 Much of the expansion in rural manufacturing in the 10 

8 

6 

4 

2 

0 

–2 

–4 

Manufacturing Rural Employment 

1994 

Metro 517,000

1970s and 1980s occurred as firms sought lower land 

and labor costs away from the cities. But the advantage 

of low wages is not unique to the rural United States. 

Globalization of competition, as advanced by the North 

American Free Trade Agreement (NAFTA) and the 

World Trade Organization (WTO), will likely disproportionately affect nonmetropolitan manufacturers who 

tend to rely on unskilled labor, standardized products, 

878,000 

1985 1988 1991 1994 

Source: County Business Patterns, U.S. Census 

1 “1996 Rural Manufacturing Survey.” Economic Research Service, 

USDA. p. 8. 

Kansas City Regional Outlook 16 First Quarter 1998 
Regular Features	 Regional Economy
 

and routinized production practices. Manufacturers of 

low-technology products will be most susceptible to 

competition from producers in Mexico and Asia. In the 

longer run, U.S. manufacturers may favor offshore locations over rural domestic sites. 

As globalization has increased, manufacturers have 

been moving toward more flexibility in production 

processes. Computer-aided design, computer-aided 

manufacturing, and just-in-time inventories are some of 

the strategies manufacturers have adopted to reduce 

costs and cycle time in their processes. These strategies 

have changed the skills mix, requiring higher levels of 

skills for both manager and workers, and the rural workforce may not be prepared for these kinds of changes. 

Respondents to the Rural Manufacturing Survey were 

asked to rank potential problems related to implementation of new technologies and management practices. 

The leading problem listed was “adequacy of worker 

skills.” The rural workforce has lagged the urban workforce in formal educational attainment and has had 

fewer opportunities for exposure to new technologies 

and strategies. 

Implications: Past growth in rural manufacturing is 

unlikely to be sustained in the next decade. Competition 

from offshore and the shift to processes that require 

higher levels of skill and training will likely work to the 

sector’s disadvantage. Slower growth or even reductions 

in manufacturing employment in rural counties could 

have a negative effect on the revenues earned by local 

businesses and the taxes collected by local government. 

Rural communities will have to pay close attention to 

the quality and focus of education if they wish to adapt 

to the changing needs of manufacturing employers. 

Rural Counties in Nebraska Continue 

to Lose Population 

According to population estimates for 1996 released by 

the U.S. Census Bureau, 46 of Nebraska’s 93 counties 

have lost population in the 1990s. These 46 rural counties also saw declines in population in the 1980s. Since 

the 1990 Census, the state’s total nonmetropolitan population has grown at a modest 0.2 percent annual rate, 

while the metropolitan areas of Omaha and Lincoln 

have grown at a 1.2 percent annual rate. 

The 46 Nebraska counties that have lost population in 

the 1980s and the 1990s share a number of common 

characteristics, including the following: 

•	 Small population. The 46 counties had an average 

population of 4,812 in 1996, and only 4 counties of 

the group had populations of more than 10,000, 

while 6 of the counties had populations of less than 

1,000. By comparison, Nebraska’s other 41 nonmetropolitan counties, each of which gained population in the 1990s, had an average population of 

14,237 in 1996. 

•	 Dependence on agriculture. According to the United 

States Department of Agriculture’s classification, 42 

of the 46 counties have agriculture as their most 

important industry. The Censuses of Agriculture 

document a decline in the number of farms in 

Nebraska from 60,243 in 1982 to 52,923 in 1992, a 

12 percent decline. During the 1980s and 1990s, the 

long-range trend of consolidation in agriculture has 

continued in Nebraska. Increased mechanization of 

agriculture has displaced both farm operators and 

laborers, many of whom migrated from rural counties to metropolitan counties. 

•	 Declining level of retail activity. Since the 1970s, a 

significant number of retail businesses have disappeared from the rural counties in the Midwest. 

Improved transportation and competition from 

national retailers have drawn shoppers to neighboring larger cities. One measure of rural retail trade 

patterns is the “retail pull factor” developed by Dr. 

Kenneth Stone of Iowa State University. The pull 

factor is calculated by dividing per capita retail sales 

for a particular county by per capita sales for the 

state. The result is adjusted to reflect differences in 

per capita income across counties. A pull factor of 

greater than one suggests the county attracts retail 

trade from other counties. A value less than one suggests residents of that county travel elsewhere to 

make retail purchases. A calculation of pull factors 

for the 46 Nebraska counties losing population in the 

1990s shows that 45 of the counties have had factors 

of less than one since 1970, indicating a deficit of 

retail expenditures. The pull factors of the great 

majority of the counties have declined since 1970. 

Table 1 (next page) illustrates the trend of the retail 

pull factor of the 46 counties. The table shows an 

average pull factor of 0.52 in 1996, implying that 

residents of these areas made an average of 48 percent of their retail expenditures outside their home 

counties, suggesting a continuing decline in local 

retail outlets. 

Observers have divergent opinions about the future of 

the declining rural counties of Nebraska. Dr. Charles 

Kansas City Regional Outlook 17	 First Quarter 1998 
Regular Features Regional Economy
 

TABLE 1 

Retail Activity Declines in 

46 Nebraska Counties 

YEAR INCOME-ADJUSTED PULL FACTOR 

1970 0.80 

1980 0.83 

1990 0.50 

1991 0.53 

1992 0.51 

1993 0.58 

1994 0.57 

1995 0.52 

1996 0.52 

Note: Pull factors of less than 1.00 indicate net 

retail outflows 

Source: Retail data from Nebraska Department of 

Revenue; pull factors calculated by author 

Lamphear, an economist at the University of Nebraska, 

argues that the disappearance of some rural communities may be inevitable. Dr. Lamphear was quoted in the 

July 6, 1997, edition of the Omaha World-Herald, 

“Some towns will come back; some won’t. What is happening is part of a natural movement, a changing settlement pattern that has been under way for most of this 

century....Infrastructure does take some dollars to 

maintain. The real truth is that neither local communities nor the state can afford to bring them all up to standards. We have to let some go.” 

In an October 6, 1997, article in the Omaha WorldHerald, Dr. Thomas Pogue, an economist from the 

University of Iowa, argued that the decline of rural areas 

will not be as detrimental as many believe and suggested strategies for small communities to remain viable. 

“We’re moving from a rural agrarian environment to a 

more consolidated urban country. To make the transition, rural communities will have to adapt to global 

changes and expand their economic opportunities 

beyond traditional agricultural and natural resourcerelated industries.” 

While the decline in population may not be reversible, 

opportunities for those who remain in sparsely populated areas have potential for improvement. Advances in 

communication technology can improve both employment opportunities and the quality of life in remote 

communities. For example, Cambridge, Nebraska, a 

town of 1,107 people in Furnas County, has attracted 

immigrants by maintaining a modern hospital, spending 

to keep its schools technologically current, and providing low-cost access to the Internet through its independent telephone company. 

Implications for Banks: Declining populations will 

likely have negative consequences for the ability of 

banks in the 46 counties to attract profitable loan and 

deposit customers. Over the longer term, the advancing 

average age of the population in these counties poses 

further risks to the deposit base, as wealth leaves the 

community after the deaths of local residents. 

Contract Agriculture Appears in the Midwest— 

What Does It Mean for Farmers and Bankers? 

During the past three years, production contracts have 

been adopted by increasing numbers of hog farmers in 

the Region. Similar contracts have been used in the 

broiler (chicken) industry in Southern states for more 

than 30 years and were introduced on a large scale in the 

hog industry in North Carolina beginning in the late 

1980s. Both the broiler industry and the North Carolina 

hog industry have enjoyed sustained significant growth 

and technological improvement in systems centered on 

production contracting. Production contracts have also 

begun to appear in the grain industry, as specialized 

high-value crops become more important. One industry 

observer predicts that 25 percent of all grain may be 

produced under contract within the next decade. 

Contracts have attracted the most attention in recent 

years as they have been introduced into the traditional 

hog-raising states of the Midwest. 

The traditional Midwestern hog grower typically breeds 

and raises pigs in specialized buildings, feeding them 

grain that is purchased or grown on the farm. When the 

pigs reach maturity, at about six months of age, the 

grower sells them to a packer or buying station at the 

current market price. The grower often has a long-term 

loan to finance the buildings that house the hogs and an 

annual operating loan to finance feed expenses. Under 

the traditional arrangement, the grower assumes all 

production-related risks, such as the health and performance of the animals, and all marketing risks, primarily price. 

The hog production contract widely used in North 

Carolina establishes a new division of labor. The example discussed in this article will be the finishing contract, by far the most common in the industry. Under 

this arrangement the contractor supplies young pigs 

about eight to ten weeks old to the grower, who feeds 

them until they are about six months old and weigh 250 

Kansas City Regional Outlook 18 First Quarter 1998 
Regular Features Regional Economy
 

pounds. Table 2 illustrates the respective responsibilities 

of the contractor and the grower. 

The grower is compensated for raising the pigs based on 

the size of the facilities, the number of pigs grown to 

maturity, and sometimes on the efficiency with which 

the pigs convert feed to meat. The contractor makes all 

decisions about feed, veterinary care, and marketing, 

and assumes all price risks in the live hog market. 

The contracting strategy allows the contractor to concentrate on identifying and developing superior genetics, discovering optimal feeding strategies, and 

developing marketing relationships. The details of 

everyday management of the hog production operation 

are left to the individual growers, who are strongly 

motivated by the terms of the contract. The contract 

arrangement allows the grower to engage in livestock 

production with less risk and requires less skill and 

experience. 

The November 17, 1997, issue of the National Hog 

Farmer presents an example of the payoff of a production contract to a grower. (See table 3.) 

At this scale, the returns to the grower are not large, 

but the labor required may be as little as one hour a 

day. Contract hog production is increasingly being 

used as supplementary income by those with other 

employment. 

The appearance of contract production is changing the 

skills and information that bankers need to evaluate 

loans to hog growers. Mark Drabenstott, an economist 

at the Kansas City Federal Reserve Bank, predicts one 

effect of contract production on the banks that support 

TABLE 2 

Hog-Finishing Contract— 

Division of Responsibilities 

CONTRACTOR PROVIDES 

HOGS 

FEED 

VETERINARY CARE 

MARKETING 

GROWER PROVIDES 

FACILITIES—SPECIALIZED BUILDINGS 

UTILITIES 

LABOR 

TABLE 3 

Returns to a Typical 

Hog-Finishing Contract 

1,000-HEAD FINISHING BARN 

CAPITAL COST $160,000 

YEARLY AMORTIZATION $26,000 

PAYMENTS TO GROWER $32,000 

RETURN TO GROWER $6,000 

Source: National Hog Farmer, November 17, 1997 

the hog industry: “Industrialization will have the effect 

of reducing the amount of marketing risk that a farmer 

faces. At the same time, however, it will increase the 

‘relationship’ risk. That is, the value of the farm loan 

will depend critically on the performance of the contractor. Because these contractors will generally be 

large, complex companies, the task of evaluating the 

financial quality of the relationship will be difficult. 

Large farm lenders who can devote a special staff to 

analyzing such risk will have a clear advantage over 

small lenders.”2 

Some large commercial banks and the Farm Credit 

System have begun negotiating “master loans” with hog 

contractors, in which the lenders provide financing for 

hog houses for all the growers associated with a contractor. After the lender has evaluated the financial and 

operational soundness of the contractor, it can extend 

loans to the associated growers, who have already been 

screened by the contractor. This strategy tends to 

exclude many community banks that lack the lending 

capacity and analytical experience to structure such 

deals. 

A conference for lenders to the hog industry, sponsored 

by the National Pork Producers Council in October 

1997, addressed some of the new kinds of information 

and relationships needed for bankers to adapt to 

changes in the industry. In general, the fast pace of technological and organizational change in the industry 

requires bankers to keep current and develop forecasting skills necessary for evaluating new kinds of production projects. In order to negotiate with and evaluate 

contractors, many bankers will need to develop more 

specialized and deeper expertise. 

2 M. Drabenstott, “The IndUStrialization of US Agriculture.” Federal 

Reserve Bank of Kansas City (www.agribiz.com/fbFiles/readings/ 

KC_FED.html). 

Kansas City Regional Outlook 19 First Quarter 1998 
Regular Features Regional Economy
 

Implications of Contract Production for Agriculture 

Bankers: Large contractors will have the ability to 

attract financing from outside the banking sector. 

Existing contractors have used commercial paper and 

bonds to finance expansion. The larger size and geographic scope of contracting companies allows them to 

attract other sources of capital. 

Individual community banks may have difficulty competing with large banks that offer master loans to contractors and their growers at competitive interest rates. 

Even where smaller banks successfully compete for 

loans to farmers, contracting arrangements could 

reduce the demand for operating loans. Competitive 

pressure from contract farmers could accelerate the disappearance of smaller, traditional producers. Higher 

costs of production and fewer food processors willing to 

buy from the smaller growers could contribute to further declines in their numbers. In the case of the hog 

industry, smaller farmers who traditionally have used 

hog production as a diversification strategy, feeding 

corn to hogs to add value to the grain, may no longer 

have that option. Community banks that have lent to the 

traditional producer could see less of this business and 

lower returns to farms that leave the hog industry. 

Contract production arrangements will likely become 

more common in all sectors of agriculture, including 

grain farming. Bankers may have to adopt new lending 

practices that include analysis and evaluation of the 

contractors working with farmers. 

Jeffrey Walser, Regional Economist 

Kansas City Regional Outlook 20 First Quarter 1998 
Regular Features	 Regional Banking
 

Regional Banking Conditions: Government-Sponsored 

Enterprises Change the Competitive Landscape 

•	 The Farm Credit System appears poised to make inroads into the market share of the Region’s banks in the 

agricultural lending sector. 

•	 Federal Home Loan Bank advances offer advantages and pose risks to the Region’s banks. 

•	 Banks growing the fastest display higher risk by a number of measures and may be susceptible to an economic downturn. 

Commercial Banks Faced with Formidable 

Competition from Farm Credit System 

Institutions 

Farm Credit System (FCS) institutions are gaining farm 

debt market share at the expense of commercial banks. 

The increased competition comes at a time when commercial banks, particularly small rural institutions, are 

facing increased competition on both sides of the balance sheet. 

A combination of factors crippled FCS during the 

1980s. FCS loan interest rates were based on the average cost of its borrowings, which consisted primarily of 

long-term, fixed-rate, noncallable bonds. When shortterm market rates declined, FCS was not able to adjust 

its loan interest rates downward, and consequently, its 

loan products became uncompetitive and its best borrowers refinanced elsewhere. The problems in the agricultural economy led to substantial loan losses and an 

increase in operating costs, caused in part by servicing 

the bad loans. The FCS institutions collectively lost $4.8 

billion over two years, and in 1987 Congress approved 

a $1.26 billion bailout. FCS’s market share of farm debt 

declined from a high of 34 percent in 1982 to just 24 

percent in 1994. In part as a result of FCS’s decline, 

commercial banks increased their share from 22 percent 

to 39 percent1 during the same period. 

Recent data from the U.S. Department of Agriculture 

indicate that FCS institutions have stopped the loss of 

market share. In addition, there are reasons to believe 

1 United States Department of Agriculture, Situations and Outlook 

Report, February 1997. 

that these institutions are poised to gain back lost market share: 

•	 High level of capital and reserves. Two district FCS 

institutions (AgAmerica and Agribank) covering the 

Kansas City Region report capital levels far exceeding regulatory requirements2 and loan loss reserves 

at more than 3 percent of loans. This financial flexibility will allow for continued growth. 

•	 Efficiency. AgAmerica and Agribank both reported 

efficiency ratios3 of around 45 percent, a level indicating substantially lower overhead expense than the 

Region’s commercial farm banks, which have an 

average efficiency ratio of 59 percent. This cost 

advantage may allow FCS institutions to maintain 

profitable margins while lowering loan rates to gain 

market share. 

•	 Market power. Even though FCS institutions are a 

collection of hundreds of smaller associations, they 

enjoy the advantages of being associated with large 

district banks such as AgAmerica and Agribank. 

These large institutions bring technological and marketing expertise to the smaller institutions, in contrast to what is available to smaller commercial 

banks. Innovations developed by the district banks, 

such as credit-scoring models tailored for farm 

loans, provide cost advantages to the associations. In 

addition, their network allows them to make larger 

loans than local but smaller commercial banks could 

make. 

2 The Farm Credit Administration requires permanent capital of at 

least 7 percent of risk-adjusted assets and off-balance sheet commitments. 

3 The efficiency ratio is defined as noninterest expense divided by net 

interest income and other operating income. 

Kansas City Regional Outlook 21	 First Quarter 1998 
Regular Features	 Regional Banking
 

•	 Improved interest rate risk management. The FCS 

has instituted comprehensive asset/liability programs 

to manage interest rate risk. At AgAmerica,4 for 

example, the duration of interest-bearing assets and 

liabilities are nearly matched, providing a fairly predictable net interest margin. 

Bankers throughout the Region are stating that FCS 

institutions increasingly are cutting their loan rates to 

attract new customers. While we possess no empirical 

data to support this, both AgAmerica and Agribank 

report they are facing increased competition from banks 

and insurance companies. In its 1996 annual report, 

AgAmerica stated, “Competitive pressures on loan 

interest rates remain high in the District territory. The 

District’s associations have been facing significant 

competition from insurance companies and rural agricultural, regional, and national banks. The District’s 

associations have had to reduce loan spreads to remain 

competitive....” Despite the increased competition, 

AgAmerica reported a 7 percent loan growth rate in 

1996. Commercial banks nationwide only experienced 

a 2 percent growth rate in agricultural loans. 

Implications: The FCS competes vigorously for prime 

agricultural borrowers. In fact, customers of FCS institutions typically are more financially secure and are 

larger operators than borrowers at commercial banks.5 If 

the FCS actively pursues growth strategies, commercial 

banks will likely face intense competition for their most 

desirable borrowers. FCS may be able to compete for 

smaller agricultural loan customers as well. In particular, FCS institutions employ expedited loan processes, 

which may include credit scoring, which could enable 

them to compete for customers who have primarily been 

served by commercial banks. 

Fifty-eight percent of banks in the Kansas City Region 

are farm banks.6 Competitive pressures on loan pricing 

and terms for these institutions are likely to remain 

intense. Therefore, maintaining a profitable niche of 

business and cost-efficient operations, without taking 

excessive risk, will continue to challenge bank 

management. 

4 1996 Annual Report, AgAmerica Farm Credit District. The
 

AgAmerica territory includes the Kansas City Region states of Iowa,
 

Nebraska, and South Dakota.
 

5 USDA, Koenig and Dodson, 1995.
 

6 A farm bank is defined as having more than 25 percent of total loans
 

in agricultural real estate and operating loans.
 

FHLB Advances: Advantages 

and Potential Risks 

In the Third Quarter 1997 Regional Outlook, we discussed the Region’s strong loan growth and consequent 

strain on liquidity in light of slow deposit growth. One 

source of alternative funding available to commercial 

banks and thrifts is the Federal Home Loan Bank 

(FHLB) system, which makes loans (called advances) 

to member institutions to fund residential loans. 

Nationally and in the Region, increasing numbers of 

commercial banks are becoming members of the system 

and using FHLB advances to augment retail deposits. 

FHLB advances offer both advantages and possible 

risks for this Region’s institutions. 

Since 1990, commercial banks that make long-term residential loans or invest in mortgage-backed securities7 

have been allowed to join the FHLB system. In the 

Kansas City Region, nearly half of all FDIC-insured 

institutions (949 commercial banks and 142 thrifts) are 

members of the FHLB system.8 By comparison, at the 

end of 1995, 737 banks and 154 thrifts were 

members. Financial institutions headquartered in North Dakota, South 

Dakota, Minnesota, Iowa, and 

Missouri belong to the Des 

Moines FHLB, while Kansas 

and Nebraska financial 

institutions are members 

of the Topeka FHLB. 

The FHLBs offer many different types of advances, all 

of which must be secured by qualifying assets (those 

upon which membership was based). Advances can 

have fixed rates or adjustable rates tied to any one of a 

number of indices. Most advances have maturities ranging from 1 day to 15 years; advances to fund community development loans can have maturities of up to 30 

years. Many advances have embedded put and call 

options, and many also carry substantial prepayment 

penalties. The FHLBs also offer letters of credit and 

lines of credit. 

7 Of several statutory requirements to become a member of the FHLB 

system, the most important is that member institutions must maintain 

residential mortgage loans equal to at least 10 percent of their total 

assets. 

8 Kansas and Nebraska membership figures are as of 11/5/97; 

Missouri, Iowa, Minnesota, North Dakota, and South Dakota figures 

are as of 9/30/97. 

Kansas City Regional Outlook 22	 First Quarter 1998 
Regular Features Regional Banking
 

The cost of most FHLB advances is higher than retail CHART 1 

deposits but, unlike deposits, they require little staff Borrowings Are Becoming More Important time to service and do not require reserves or deposit as a Funding Source for Small Banks insurance premiums. In addition, many FHLB products 

2.5 represent unique funding sources for commercial banks 

—most do not have alternative 15-year sources of 

funds, for example. The FHLBs also offer amortizing 

advances, which can be used to fund amortizing assets 

such as 15-year mortgage loans. Such advances are 

sometimes purchased with embedded put options that 

allow institutions to prepay advances in full or in part to 

more closely match prepayments in their loan portfolios. 

In this Region, banks are increasingly supplementing 

their slow-growing retail deposits with FHLB borrowings. Although Call Reports do not track FHLB borrowings specifically, such borrowings likely make up a 

large portion of Call Reports’ “other borrowed money” 

figures. As shown in Chart 1, other borrowings at 2,171 

small institutions9 in the Region have more than doubled in the three years since June 30, 1994. According 

to the Des Moines and Topeka FHLBs, as of September 

30, 1997, institutions in the Region had outstanding 

advances of approximately $11 billion. The most popular products are short-term LIBOR advances used primarily by large banks; these advances represent about 

45 percent of the total advances outstanding. Long-term 

fixed-rate advances used by all sizes of banks make up 

another 35 percent of the advances. 

Implications: Given the Region’s continued strong loan 

growth and slow deposit growth, it is likely that commercial banks will continue to become members of the 

FHLB system and use their products. FHLB advances 

may become an integral part of the asset/liability and 

liquidity strategies of this Region’s banks in the near 

future. 

Despite the advantages of FHLB advances, they are not 

entirely without risk. The consequences of inappropriate use of advances may be harsh. These include 

increased interest rate risk and lower earnings as a 

result of substantial prepayment penalties or having 

advances called when interest rates increase. To help 

banks make informed choices, the Des Moines FHLB is 

offering a service to banks that analyzes their balance 

sheets using an interest rate risk model to determine 

9 The small institutions referred to here are the same institutions 

described in footnote 10 under “High-Growth Institutions Carry 

Higher-than-Average Risk.” 

“Other Borrowed Money”as Percent of Total Assets 

2.0 

1.5 

1.0 

0.5 

6/94 6/95 6/96 6/97 

0.0 

Note: For banks and thrifts under $250 million in the Kansas City Region
 

Source: Bank and Thrift Call Reports
 

appropriate strategies for using advances. According to 

a senior financial analyst at the Des Moines FHLB, five 

banks in its district were taking advantage of this service as of early November 1997. 

Another potential risk to banks is the possible inclination of bankers to leverage their balance sheets with 

FHLB advances. In fact, the FHLB is advocating that its 

members use advances to rapidly increase assets and 

reduce capital levels if they are in excess of regulatory 

minimum levels. The idea is that banks can improve 

their return on equity from the spread of the yield on the 

new assets (presumably loans if loan demand exists, 

otherwise mortgage-backed securities) over the cost of 

the advances. While it is true that many banks have capital levels in excess of regulatory minimums, bankers 

should review their banks’ risk profiles before attempting any growth strategy. From a regulatory perspective, 

capital adequacy is not simply based on ratios but 

depends on a number of factors, including management’s ability, asset quality, balance sheet concentrations, and other risk characteristics. Regulatory 

minimum capital ratios are in some sense a lowest common denominator; higher capital ratios may be necessary for banks with higher risk exposure. 

For additional information regarding banks’ use of 

FHLB products, please contact Julia A. Kuhn, Senior 

Capital Markets and Securities Specialist for the 

FDIC’s Division of Supervision, at jkuhn@fdic.gov or 

(816) 234-8071. 

Kansas City Regional Outlook 23 First Quarter 1998 
Regular Features Regional Banking
 

High-Growth Institutions Carry 

Higher-than-Average Risk 

Past articles in the Regional Outlook have discussed 

strong loan growth in the Region. This article examines 

the institutions with fewer than $250 million in assets 

that have exhibited the strongest asset growth over the 

past three years. In particular, this article compares the 

highest quintile (the top 20 percent) of growth banks— 

the 434 banks and thrifts that posted at least 32 percent 

growth over the past three years that this article refers to 

as “top-quintile banks”—with the entire sample of institutions.10 We discuss where these institutions are located, how they funded their growth, and whether they 

have been taking on measurably more risk as a result of 

their growth strategies. 

Where Top-Quintile Banks Are Located: One would 

expect that top-quintile banks would be located in primarily metropolitan areas, which offer more opportunities to expand loan and deposit bases. A location 

analysis of top-quintile banks indicates some concentration of such institutions in metropolitan areas (these 

locations have 39 percent of top-quintile banks but only 

21 percent of all institutions in the sample), but also 

shows that many rural areas have high-growth institutions. In fact, most top-quintile banks are located in 

rural counties, and more than one-third are located in 

the most rural counties (those with less than 20,000 

urban residents and not adjacent to metropolitan counties). Top-quintile banks also tend to be located in the 

Region’s eastern states (Minnesota, Iowa, and Missouri) 

and the very eastern portions of the western states, 

probably because of the comparatively robust economic 

activity in these areas. 

How Top-Quintile Banks Are Funded: On average,11 

top-quintile banks grew their assets from $42 million to 

$64 million in the three years ending June 30, 1997. By 

contrast, the average institution sampled grew from $43 

million to $51 million over that period. As expected, 

loan growth spurred top-quintile banks’ asset growth; 

10 The sample for this article included the 2,171 FDIC-insured banks 

and thrifts in the Region that had fewer than $250 million in assets as 

of June 30, 1997, and had not been involved in mergers in the prior 

three years. Only institutions in continuous existence since June 30, 

1994, were considered in the sample. In addition to institutions 

involved in mergers, we excluded three banks from the sample that 

had extreme and unusual decreases in total assets. For analysis, the 

institutions were sorted by three-year growth rates (from June 30, 

1994, to June 30, 1997) and segmented by quintiles. 

11 “Average” in this article refers to the weighted average of the 434 

top-quintile and 2,171 total institutions in the sample, respectively. 

on average, these institutions increased their loan portfolios by $17 million. 

Most of the funding for this growth came from deposit 

growth or, more important, core deposit growth. 

Deposits for the average top-quintile bank grew by $18 

million—slightly more than loans—and core deposits 

grew by $15 million. In contrast, the entire sample of 

institutions funded only $5 million of their $8 million 

loan growth with additional core deposits. So, despite 

the commonly held notion that rapid asset growth is 

usually funded by “hot money” (noncore sources such 

as large certificates of deposit or brokered funds), topquintile banks in the Region actually did a better-thanaverage job of funding their loan growth with core 

deposit growth. 

Not surprisingly, top-quintile banks also used other 

sources to fund their growth. In particular, the average 

top-quintile bank’s other borrowings increased 297 percent over the three years, from $616,000 to $2.4 million. 

Although Call Reports do not itemize these borrowings, 

they are likely the result of increased bank participation 

in the FHLB system (refer to FHLB Advances: 

Advantages and Potential Risks in this article for further details). 

Are Top-Quintile Banks More Risky? By traditional 

measures, top-quintile banks have more risk than the 

typical institution in the Region. In particular, top-quintile banks have lower capital, liquidity, and loan loss 

reserve levels than banks from the entire sample. Table 

1 shows that the average top-quintile bank’s equity capital ratio12 is 153 basis points below that of the average 

bank in the sample. In addition, top-quintile banks have 

a much higher average loans-to-assets ratio, which indicates that they have less liquid assets to fund unexpected cash outflows. Top-quintile banks also have lower 

loan loss reserves as a percentage of total loans. 

Top-quintile banks also differ from other banks in their 

loan portfolio composition. As shown in Table 2, the 

most significant difference is that top-quintile banks 

have significantly fewer agricultural and agricultural 

real estate loans, a likely result of the aforementioned 

tendency for high-growth banks to be located in metropolitan areas. Top-quintile banks have a proportionately 

12 The equity capital ratio used in this article is period-ending equity 

capital divided by period-ending total assets as reported in Bank and 

Thrift Call Reports. In contrast, regulatory ratios use an average total 

assets denominator. 

Kansas City Regional Outlook 24 First Quarter 1998 
Regular Features Regional Banking
 

TABLE 1 

Financial Ratios Illustrate Top-Quintile Banks’ 

Lower Capital and Liquidity Levels 

TOP-QUINTILE BANKS (%) ALL BANKS SAMPLED (%) 

FINANCIAL RATIOS 6/94 6/97 CHANGE 6/94 6/97 CHANGE 

EQUITY CAPITAL RATIO 9.42 8.92 − 0.50 10.08 10.45 0.37 

LOANS/ASSETS 63.86 68.22 4.36 55.72 61.39 5.67 

DELINQUENT LOANS/LOANS 1.77 2.11 0.34 2.03 2.25 0.22 

ALLL/LOANS 1.38 1.20 − 0.18 1.61 1.43 − 0.18 

ALLL/NON-CURRENT LOANS 198.02 155.08 − 42.94 172.86 152.69 − 20.17 

Note: ALLL = Allowance for Loan and Lease Losses 

Source: Bank and Thrift Call Reports 

larger commercial and industrial loan portfolio, particularly in the larger-loan segment. The incidence of larger commercial loans in top-quintile banks may indicate 

concentrations to individual borrowers not seen in the 

rest of the sample. In addition, while top-quintile banks 

have a larger percentage of real estate loans (which, 

because of their secured nature, are generally less risky 

than many other types of loans), much of the difference 

is the result of top-quintile banks’ heavier reliance on 

the traditionally more risky construction and commercial real estate segments. 

Much of the increased risk of top-quintile banks compared with other banks comes from their risk profile at 

the beginning of the analysis period. Although in June 

TABLE 2 

1994 the average top-quintile bank and the average 

overall sample bank were approximately the same size, 

top-quintile banks already had lower capital, liquidity, 

and loan loss reserve levels. And except for decreasing 

agricultural loans in favor of commercial and construction loans, top-quintile banks’ loan composition has not 

changed significantly in the past three years. 

However, top-quintile banks have increased their overall 

risk compared to the sample over the past three years. 

For example, to facilitate their growth, top-quintile 

banks reduced their equity capital ratios while overall 

banks improved their ratios by 37 basis points. In addition, top-quintile banks’ loan quality has deteriorated 

faster (but still remains slightly better) than that of the 

Top-Quintile Banks’ Loan Composition Shows 

Higher Balances in Riskier Loan Categories 

% OF TOTAL LOANS 

TOP-QUINTILE BANKS ALL BANKS SAMPLED 

SELECTED LOAN CATEGORIES 6/94 6/97 CHANGE 6/94 6/97 CHANGE 

AGRICULTURE LOANS 12.5 9.9 − 2.9 20.6 17.0 − 3.6 

COMM. AND IND. LOANS 17.8 18.7 0.9 14.7 15.8 1.1 

UNDER $100,000 10.8 9.4 − 1.4 9.9 9.4 − 0.5 

$100,000–$250,000 2.7 3.1 0.4 1.8 2.1 0.3 

$250,000–$1,000,000 3.5 4.5 1.0 2.5 3.1 0.6 

CONSUMER LOANS 13.0 12.5 − 0.5 12.5 12.0 − 0.5 

REAL ESTATE LOANS 55.8 57.4 1.6 50.9 53.6 2.7 

RE AGRICULTURAL 6.1 5.4 − 0.7 9.2 8.8 − 0.4 

CONSTRUCTION 4.2 5.3 1.1 2.3 3.2 0.9 

RE NONRESIDENTIAL 13.3 14.4 1.1 10.6 11.5 0.9 

RE RESIDENTIAL 30.3 30.5 0.2 27.4 28.8 1.4 

Note: RE = Real Estate 

Source: Bank and Thrift Call Reports 

Kansas City Regional Outlook 25 First Quarter 1998 
Regular Features	 Regional Banking
 

overall sample; as a result, top-quintile banks’ ratio of 

loan loss reserves to noncurrent loans has declined to 

that of the overall sample. 

Implications: While the analysis shows that the 434 

top-quintile banks as a whole have a higher-than-average risk profile, individual banks may have considerably more risk than the figures convey. For example, 

many top-quintile banks have displayed enormous 

growth rates in certain higher-risk loan categories in the 

past three years: 

•	 167 banks doubled their commercial real estate 

loans; of these, 43 tripled them and another 28 quintupled them. 

•	 154 banks doubled their commercial and industrial 

loans, and 19 of those quintupled them. 

•	 166 banks doubled their construction loans, and 110 

of those tripled them. 

•	 113 banks doubled their consumer loans despite the 

national increase in bankruptcy filings. 

Because of their heightened risk exposure, these institutions may be especially vulnerable to a downturn in the 

national business cycle or the onset of adverse local 

economic conditions. 

John M. Anderlik, Financial Analyst 

Craig A. Rice, Regional Manager 

Julia A. Kuhn, Senior Capital Markets 

and Securities Specialist 

Kansas City Regional Outlook 26	 First Quarter 1998 
✁
 

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