Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1997 

FDIC
 

Memphis
 

Region
 

Division of
 

Insurance
 

Gary L. Beasley,
 

Regional Manager
 

David T. Griffiths,
 

Regional Economist
 

Robert L. Burns,
 

Financial Analyst
 

In Focus This Quarter 

◆ Bank Earnings: Competitive Pressures and Cyclical 

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

underwriting standards and other changes to risk management practices that can 

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

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

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

See page 3. 

By Ronald Spieker, Steve Linehan, George French 

◆ Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets—Commercial real 

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

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

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

Securitization vehicles such as commercial mortgage-backed securities and real 

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

See page 9. 

By Steven Burton, Gary Ternullo 

Regular Features 

◆ Regional Economy—Growth in the Region continued to decelerate 

through midyear 1997...the Region’s dependence on durable goods manufacturing 

and transportation may heighten its sensitivity to the national business cycle...new 

bank formation has been driven by economic activity. See page 14. 

By Gary L. Beasley, Scott C. Hughes 

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

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

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

form of Tier 1 capital. See page 19. 

By Kathy R. Kalser 

◆ Regional Banking—Strong earnings and renewed loan growth mark 

the second quarter...home equity loans gain popularity...noninterest income contributes to earnings performance...new bank formation increases. See page 23. 

By Gary L. Beasley, Robert L. Burns 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Information Center for current pricing on bulk orders. 

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

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

Outlook, please call Gary Beasley at (901) 821-5234 or send an e-mail to gbeasley@fdic.gov. 

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

reflect official positions of the Federal Deposit Insurance Corporation. Some of the information 

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

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

accuracy by the Federal Deposit Insurance Corporation. 

Chairman Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Managing Editor Stephen Linehan 

Associate Editor Maureen E. Sweeney 

Assistant Editors Suzannah L. Susser 

John D. Weier 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Bank Earnings: Competitive Pressures
 

and Cyclical Risks
 

•	 Rapid loan growth, record low credit losses, 

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

record levels. 

•	 Intense competition to preserve and attract 

business can lead to aggressive loan pricing, 

relaxed loan underwriting standards, increased 

portfolio concentrations, and other changes to 

risk-management practices that can reduce 

banks’ ability to sustain earnings and capital 

through a downturn. 

•	 As this economic expansion approaches an 

advanced age, prudent bankers will allow for the 

possibility of an adverse change in economic 

conditions. 

As the U.S. economic expansion continues through its 

seventh year, the banking industry continues to run at 

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

aggressive expansion of income sources, and vigorous 

cost-cutting. Some analysts argue that banking has 

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

cycle. 

Yet banks face risks that should not be overlooked. 

Assertions that bank earnings will be less sensitive to 

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

relaxed underwriting standards and easing of loan 

terms, or increased focus on business lines whose risks 

are difficult to manage. Policies that boost short-term 

shareholder returns, including high dividends and stock 

repurchase programs, can reduce banks’ capacity to 

weather a future downturn. There is evidence that these 

things are occurring to varying degrees in banking 

today. Accordingly, as this expansion reaches an 

advanced age, prudent bankers will give careful regard 

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

Credit Quality 

Variations in credit quality have been and are likely to 

remain for some time the primary source of large 

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

the risks of large swings in credit quality by adjusting 

underwriting standards and loan terms, by diversifying 

loan portfolio exposures, and by supplying adequate 

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

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

these factors during the expansion. 

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

shown in Chart 2, bank loan growth has exceeded 

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

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

loan losses has tended to follow episodes of rapid loan 

growth. 

Credit standards are important tools for individual 

banks to manage these cyclical fluctuations in credit 

quality. According to the Federal Reserve’s August 1997 

CHART 1 

Earnings Results Are Largely Driven by 

Provision Expenses 

-1.0% 

0.0% 

1.0% 

2.0% 

3.0% 

Return on Avg Assets 

Provision Exp/Avg Assets 

Source: Commercial Bank Call Reports 

-2.0% 

6-’85

12-’86

6-’88

12-’89

6-’91

12-’92

6-’94

6-’97

12-’95 

Memphis Regional Outlook 3	 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 2 CHART 3 

-15% 

-10% 

-5% 

0% 

5% 

10% 

15% 

20% 

1980 

GDP Growth 

Loan Growth 

Average Loan Growth Has Recently 

Outpaced Nominal GDP Growth 

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

199219941996 

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

Net Loan Loss Growth (%)

Loan Losses and Loan Growth Are Correlated 

-15 

-10 

-5 

0 

5 

10 

15 

-90 

-60 

-30 

0 

30 

60 

90 

Loan Growth 

Net Loan Loss Growth 

198019831986198919921995 

Senior Loan Officer Survey, during the preceding three 

months, a large percentage of banks had eased terms on 

commercial and commercial real estate loans, including 

reducing loan interest rates, increasing credit lines, and 

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

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

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

any widespread problems with underwriting practices 

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

were “frequently or commonly” funding speculative 

construction projects. About 18 percent of institutions 

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

loans that lack documentation of financial strength. 

Maintaining an adequate allowance for loan losses is 

another important way for banks to sustain earnings and 

capital during downturns. The aggregate allowance held 

by commercial banks has decreased from 2.74 percent 

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

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

Although in the aggregate these reserve numbers 

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

reserve levels ranged from 1.20 percent to 1.74 percent, 

the Office of the Comptroller of the Currency (OCC) 

recently issued an advisory letter expressing concern 

about declining reserve levels and the need to maintain 

an adequate allowance. This letter was a response to 

weakness in the credit card sector and to trends in the 

market for syndicated commercial loans, including 

increasing leverage, declining spreads, and a weakening 

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

Diversifying loan portfolios is another way for banks to 

help reduce susceptibility to economic downturns. It 

has often been noted that the trend toward interstate 

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

retain high concentrations of credit exposure to specific 

economic sectors. For example, commercial real estate 

lending and construction lending has been a source of 

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

Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets, banks 

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

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

real estate and construction exposures1 exceeding 200 

percent of equity and reserves. Concentrations and 

rapid growth do not necessarily portend difficulties, but 

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

sound underwriting policies and standards and the 

maintenance of adequate loss reserves. 

The most immediate concerns about credit quality have 

been expressed regarding credit cards and some other 

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

Memphis Regional Outlook 4 Fourth Quarter 1997 
In Focus This Quarter
 

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

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

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

accompanied the recession of 1990 to 1991. Noncurrent 

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

percent, and some examiners are commenting that these 

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

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

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

grew their home equity lines by more than 30 percent 

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

Except for credit cards and some other consumer loans, 

loan losses are at historically low levels. Nevertheless, 

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

this far into the expansion. Institutions that maintain 

strong underwriting standards, an adequate allowance 

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

Net Interest Margin 

Net interest margin (NIM) is another primary driver of 

bank earnings. Indeed, a sharp improvement in NIM 

TABLE 1 

CHART 4 

Rebound in ROA Since 1990 Fueled 

by Improved NIM and Asset Quality 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1984 1986 1988 1990 1992 1994 1996 

2.5% 

3.0% 

3.5% 

4.0% 

4.5% 

5.0% 

ROA 

Net charge-off ratio 

NIM 

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

NIM (%) 

helped lead the banking industry’s dramatic recovery 

from the last recession (see Chart 4). Commercial 

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

4.23 percent still remains near the top of the range 

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

next page). 

The banking industry’s rapid loan growth in recent 

years has been one of the factors supporting the current 

high NIM. (Since loans generally yield more than 

securities, a higher proportion of loans generally 

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

rapid loan growth indefinitely, however. Accordingly, a 

Rapid Loan Growth Is 

Occurring at a Significant 

Number of Institutions 

(4 qtrs growth ending 6/97) 

TOTAL LOANS AND LEASES 

CONSTRUCTION LOANS 

COMMERCIAL REAL ESTATE LOANS 

TOTAL CRE 

1-4 FAMILY RESIDENTIAL LOANS 

HOME EQUITY LINES 

TOTAL RESIDENTIAL 

CREDIT CARD LOANS AND RELATED PLANS 

OTHER CONSUMER LOANS 

TOTAL CONSUMER LOANS 

COMMERCIAL LOANS 

Source: Bank & Thrift Call Reports 

Memphis Regional Outlook 

Percentage of Institutions with Loan 

Category Growth Approximating 

20% to 30% 30% or Total 

More Over 20% 

11 13 24 

4 36 40 

9 27 37 

10 28 38 

11 17 29 

4 25 29 

12 18 29 

4 17 21 

9 18 27 

9 18 27 

9 26 35 

5 Fourth Quarter 1997 
In Focus This Quarter
 

TABLE 2 

1997 Commercial Bank Performance Compared with Historical Averages 

INDUSTRY AVERAGES 

6/30/97 1984-1996 

ANNUALIZED LOW HIGH 

(%) (%) (%) 

NET INTEREST INCOME/AVERAGE EARNING ASSETS 4.23 3.89 4.36 

X AVERAGE EARNING ASSETS/AVERAGE ASSETS 86.50 86.21 88.42 

= NET INTEREST INCOME/AVERAGE ASSETS 3.66 3.36 3.89 

+ NONINTEREST INCOME/AVERAGE ASSETS 2.13 1.10 2.13 

− NONINTEREST EXPENSE/AVERAGE ASSETS 3.50 3.05 3.90 

− PROVISION EXPENSE/AVERAGE ASSETS 0.40 0.28 1.28 

+ OTHER ITEMS/AVERAGE ASSETS 0.03 − 0.02 0.15 

− TAXES/AVERAGE ASSETS 0.68 0.18 0.64 

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

Source: Bank & Thrift Call Reports 

risk in the current environment is that in the effort to 

support their NIM by generating new lending, banks 

may make compromises in loan underwriting, pricing, 

and portfolio diversification. 

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

the liability side, over the past six years, commercial 

banks’ average annual deposit growth rate of 3.2 percent 

has been outpaced by the 4.9 percent average annual 

growth rate of earning assets. As a result, nondeposit 

borrowings have increased significantly in importance, 

rising from about 12.6 percent of earning assets in 1991 

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

nondeposit borrowings has exceeded the average cost of 

deposits over the period by an average of 135 basis 

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

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

available to small savers; its effect is that bank funding 

is becoming more expensive and more interest-rate 

sensitive. 

On the asset side, pricing pressures also are frequently 

cited as contributing to sluggish NIM. For example, in 

the aforementioned syndicated lending market, average 

interest spreads charged to noninvestment-grade large 

customers have dropped more than 63 basis points 

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

are being done at minimal or no risk-adjusted spreads 

simply to preserve lending relationships. Increased 

securitization of various asset types has also had effects 

on pricing. By increasing the depth and liquidity of the 

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

competitive pressures on institutions not able to achieve 

the volumes necessary to efficiently utilize this new 

funding vehicle. 

The thin spreads available from high-quality lending 

may tempt some institutions to finance higher yielding, 

riskier credits in an effort to preserve or boost profit 

margins. For example, recent forays by some banks into 

subprime lending (see Subprime Lending: A Time for 

Caution, Third Quarter 1997) may be one indication of 

how competitive pressures on NIMs are affecting bank 

behavior. Over the long term, institutions that manage 

their NIMs with a prudent regard for how their newly 

booked business may fare during a cyclical downturn 

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

Growth in Noninterest Income 

Industry analysts often cite the increasing contribution 

of fees and other sources of noninterest income as 

evidence of the evolution of the banking industry. As 

Chart 5 (next page) illustrates, for commercial banks 

with over $1 billion in assets, noninterest income now 

averages over 40 percent of net revenue (net interest 

income plus noninterest income). In contrast, banks 

Memphis Regional Outlook 6 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 5 Other measures of productivity have shown similar 

Noninterest Revenue to Net Revenue* 

Banks Over $1 Billion 

Banks Under $1 Billion 

Source: Commercial Bank Call Reports 

* Net Revenue = Net interest income plus noninterest income 

10 

20 

30 

40 

50 

6-’85 

Net Revenue (%) 

6-’876-’896-’916-’936-’956-’97 

improvement. For example, commercial banking assets 

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

between 1984 and 1997. 

Growth in overhead expense has been contained largely 

through consolidation, technological advances, and low 

levels of problem assets. Mergers have resulted in the 

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

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

products and services. Favorable economic conditions 

have reduced costs associated with loan collection and 

asset workouts. 

Whether the downward trend in overhead expenses will 

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

traditional banking activities, with only 25 percent of 

revenue from these noninterest sources. 

Noninterest income growth is being driven both by new 

business lines and higher deposit-related fees. 

Examples include fees from sales of mutual funds and 

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

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

affected the growth in reported noninterest income. 

With the exception of trading revenue, noninterest 

income has historically shown a growth trend that has 

not been especially sensitive to economic cycles. 

However, newer fee-based businesses such as mortgage 

banking, mutual funds, and securities underwriting may 

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

reduce banks’ historical exposure to economic cycles. 

The Effect of Expense Control 

on Earnings Performance 

Cost-cutting efforts in banking continue to show their 

effects. Since 1991, commercial banks’ efficiency 

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

continue is an open question. Should problem loans 

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

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

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

Tower Group Survey of Information Technology 

Services in Banking noted that the banking industry is 

“faced with an aging IT infrastructure.” The survey 

suggests that most technology-related expenses could 

increase at a 5.6 percent compounded growth rate until 

the year 2000 and that expenses for outside services 

could increase 11 percent over the same period. The 

ability to generate future revenue gains may depend on 

additional bank investment not only in technology but 

also in the development of new products and services. 

CHART 6 

Commercial Banks’ Efficiency Ratio*
 

Is Steadily Improving
 

70% 

68% 

66% 

64% 

62% 

60% 

58% 

56% 

1984198619881990199219941996 

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

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

Memphis Regional Outlook 7 Fourth Quarter 1997
 

2 
In Focus This Quarter
 

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

example, reductions in personnel, or excessive reliance 

on automated underwriting procedures (see Will Credit 

Scoring Transform the Market for Small-Business 

Lending? Second Quarter 1997), may raise concerns 

about the effectiveness of internal administration and 

control processes. Cost-cutting that cuts too deeply into 

customer service can erode franchise value. Mergers 

can reduce redundant expense, but at some point there 

may be diseconomies to managing a large organization. 

The Role of Capital in the Management 

of Earnings 

Management, shareholders, and analysts often evaluate 

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

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

continue to grow ROE and EPS; these objectives have 

been made progressively more difficult to attain by the 

significant level of capital that has built up over the past 

five years. 

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

recent rash of mergers and acquisitions, high dividend 

payout ratios, increased stock repurchases, and the 

development of alternative types of hybrid capital such 

as trust preferred stock (see Financial Markets). For 

example, during 1995 and 1996, major merger and 

acquisition deals included some $835 billion in bank 

and thrift assets. During 1996, commercial banks with 

over $1 billion in assets had an average dividend payout 

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

assets averaged 55 percent for 1996 and 52 percent for 

1994. In addition, banks and bank holding companies 

have issued some $21 billion in trust preferred stock 

during the last nine months, some of which has been 

used to fund the almost $42 billion in share repurchase 

programs announced by large banks during 1996 and 

early 1997.3 

While the book value of equity and other capital ratios 

has increased at the aggregate industry level, a number 

of banks are reporting declines in equity capital and 

leverage capital ratios despite positive earnings (see 

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

CHART 7 

An Increasing Number of Profitable Banks Are
 

Reducing Tier 1 Capital*
 

Number of Banks 

800 

600 

400 

200 

0 

1992 1993 1994 1995 1996 

* Both Tier 1 dollar amount and ratio 

Source: Commercial Bank Call Reports 

age capital accounts going forward will depend largely 

on having earnings available above the levels needed to 

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

and examiners will need to carefully review strategies 

that increase bank leverage or increase business risk 

without considering the potential effects of a downturn 

in credit quality or other weakening in the economy. 

Summary 

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

time when banks’ traditional business lines are coming 

under greater competitive pressure than ever. While the 

industry as a whole is adapting well to these competitive 

pressures, there may be a tendency for some insured 

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

The nature of banking is to profit by taking calculated 

risks, and naturally more profits will be made during the 

expansionary phase of a cycle than during a downturn. 

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

will be those that allow for the possibility of an adverse 

change in business conditions, and prudently balance 

the levels of risk taken with the expected returns. 

Ronald Spieker, Chief, Depository Institutions Section 

Steve Linehan, Assistant Director, Analysis Branch 

George French, Deputy Director 

Memphis Regional Outlook 8 Fourth Quarter 1997 
In Focus This Quarter
 

Strong Demand and Financial Innovation Fuel
 

Rebounding Commercial Real Estate Markets
 

•	 Commercial banks are leading a resurgence in 

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

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

•	 New funds directed toward commercial real estate 

are being increasingly supported by commercial 

mortgage-backed securities and real estate investment trusts. 

•	 Some analysts have expressed concern that these 

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

loan pricing. 

In the wake of declining values and the large losses of 

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

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

involves the major changes taking place in how real 

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

banks—who is financing this expanding activity. 

Commercial Banks Show Renewed Interest 

in Commercial Real Estate 

Strong evidence of commercial real estate’s rebound 

can be seen in its renewed attractiveness to lenders. 

TABLE 1 

Federal Reserve figures show that nearly $58 billion of 

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

lending pales in comparison with that of the late 

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

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

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

billion net increase in mortgage lending during 1995 

and 1996. 

Perhaps the most convincing evidence of commercial 

real estate’s recovery comes from the market itself. 

Rising prices and tightening supplies of space in most 

major markets and for most property types suggest a 

growing demand for new commercial property stock. 

Numerous indices and market studies support this 

notion: 

•	 As measured by Koll/NREI national composites, 

prices and rents turned up sharply after 1993, with 

rents surpassing their 1988 to 1989 levels by 1995 

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

rates saw increases exceeding 20 percent in 1996.1 

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

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

Diego. 

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

1991 1992 1993 1994 1995 1996 

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

COMMERCIAL BANKS 3.1 − 8.4 − 4.3 7.5 18.0 18.7 

CMBSS 1.3 8.7 10.3 11.3 10.6 16.1 

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

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

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

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

REIT EQUITY OFFERINGS 1.6 2.0 13.2 11.1 8.2 13.0 

PENSION FUNDS − 4.8 − 4.3 − 0.7 9.6 13.8 14.3 

ALL OTHER SOURCES 8.1 5.4 5.0 0.9 − 0.5 3.0 

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

Investment Research 

Memphis Regional Outlook 9	 Fourth Quarter 1997 
In Focus This Quarter
 

•	 Property capitalization rates, which measure the 

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

These falling rates indicate that investors are paying 

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

not yet caught up with rents, which now exceed their 

previous highs in some markets, suggesting that the 

current recovery is not yet peaking. 

•	 Declining vacancy rates reflect strong demand for 

office properties, which Grubb & Ellis cast as the 

hottest sector in its 1997 forecast. Nationwide, office 

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

3). Moreover, Torto-Wheaton Research estimates 

that 21 of the 56 metropolitan areas it tracks had 

single-digit vacancy rates at the end of first quarter 

1997. Not surprisingly, many of the tightest markets 

are those with the greatest rent inflation. 

While the unrestrained commercial development of the 

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

shadow is fading as declining vacancy rates and rising 

rental rates for existing properties fuel optimism 

among lenders and investors and strengthen the case 

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

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

projections rather than solely on the basis of competitive pressures. 

Borrowers’ Financing Options Expanding 

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

broader and more competitive financing market has 

emerged. In this market, financing often bypasses 

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

debt or the properties themselves, parceling them into 

smaller, more standardized, and thus more liquid pieces 

that are attractive to institutional and individual 

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

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

trusts (REITs) have played in funding commercial real 

estate over the past five years. This increase in public 

CHART 1 

Prices and Rents on Upswing Nationwide 

Index (1986 = 1.00)
 

1.30
 

1.20
 Rents
 

1.10
 

1.00
 Prices
 

0.90
 

0.80
 

1990 1991 1992 1993 1994 1995 1996 

Source: Koll National Real Estate Index 

CHART 2 

Property Capitalization Rates Dropping 

8.0 

8.5 

9.0 

9.5 

10.0 

10.5 

11.0 

11.5 

1990 1991 1992 1993 1994 1995 1996 1997 

Overall Cap Rates (%)

Office 

Retail 

Apartment 

Source: Donaldson, Lufkin & Jenrette 

CHART 3 

National Downtown and Suburban
 

Class A Vacancy Rates Falling
 

8 

13 

18 

23 

Downtown 

Suburban 

Vacancy Rates (%) 

1988 1989 1990 1991 1992 1993 1994 1995 1996 

Source: CB Commercial / Torto-Wheaton Research 

Memphis Regional Outlook 10	 Fourth Quarter 1997 
In Focus This Quarter
 

financing left financial institutions in 1996 with 

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

a decade before. 

From a lender’s perspective, CMBSs offer several 

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

production and servicing activities while avoiding the 

excessive concentrations of credit risk that plagued 

lenders during the last real estate downturn.2 According 

to Commercial Mortgage Alert, outstanding CMBSs 

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

new issuance. While outstanding volume is still dwarfed 

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

has been remarkable considering that such securities 

were virtually nonexistent prior to 1991. 

At present, most commercial banks are not active in 

issuing CMBSs, accounting for only $2.6 billion of 

CMBS issuance in 1996, according to E&Y Kenneth 

Leventhal Real Estate Group. Rather, the primary 

source of these securities is investment banks, which 

generate substantial fees by converting existing loans 

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

to originate mortgage loans for distribution to investors 

in the secondary market. Nomura Securities 

International estimates that such conduits accounted 

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

double the volume of 1995. Only a handful of the 

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

1996. Aside from this relatively small number of bank 

competitors, investment banks are among the largest 

and most active conduit issuers. 

There is no fundamental reason why banks cannot take 

greater part in the rapidly growing CMBS market. In 

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

to facilitating loan demand, evaluating repayment risk, 

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

many analysts and rating agencies have recently expressed concern 

over recourse arrangements, both contractual and voluntary, whereby 

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

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

like that for MBSs, standardized underwriting may 

enable small institutions to remain competitive either by 

cooperatively forming their own conduits or by selling 

their loans to existing conduits. 

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

assets raises a number of efficiency issues for direct 

lenders. Securitization provides property developers and 

owners access to a much larger pool of potential funding 

sources and a wider array of funding options. Moreover, 

the costs of public financing reflect efficiencies born of 

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

securitized debt more easily than could be done with 

whole loans. While improved efficiencies are a positive 

aspect of the growth in securitized investments, these 

efficiencies threaten to dictate bank pricing, thereby 

potentially reducing margins or driving institutions to 

lend on less economically feasible projects in an effort to 

preserve margins and market share. 

REITs: An Alternative to Traditional 

Capital Sources 

Commercial real estate financing is evolving in other 

ways. REITs have become major players in the industry 

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

estate through purchases of equity in the REIT. The 

REIT itself holds title to the underlying properties and, 

provided it meets certain requirements, can directly pass 

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

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

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

Accompanying this rise in capitalization has been an 

equally dramatic rise in bank lending to REITs. 

According to Loan Pricing Corporation, bank lending 

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

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

a tenfold increase over the period 1990 to 1992. 

The rise in REIT capitalization can be attributed in part 

to pent-up institutional demand for real estate. REITs 

Memphis Regional Outlook 11 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 4 

REIT Capitalization Soaring 

400 

350 

300 

250 

200 

150 

100 

50 

0 

1996

have a particular appeal to fund managers since they 

offer the benefits of investment diversification without 

the dual headaches of property management and asset 

illiquidity. Aside from the direct credit risk posed by 

lending to REITs, their rising popularity confronts banks 

with an indirect threat as well—the threat that banks 

could be crowded out of lending opportunities if 

investors find REIT funding structures more attractive 

from a cost and control standpoint. The degree to which 

this crowding out may occur is unclear, for according to 

Nomura Research, REITs historically have borrowed 40 

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

over half of this borrowing takes place through public 

offerings of secured and unsecured debt, leaving only a 

small portion to be financed by banks and other private 

lenders. Because REITs tend to focus on the highest 

quality projects, their increasing presence also creates 

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

Many analysts have also expressed unease over the rapid 

rise in the valuations of REITs, some of whose shares 

are priced at a considerable premium to the properties 

themselves. Anecdotal evidence suggests that premiums 

as high as 40 percent over market value have been paid 

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

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

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

fairly nominal amount of overall real estate holdings, 

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

80

70 

60 

50 

40 

30 

20 

10 

0 

Market Capitalization (Left Scale) 

Number of REITs (Right Scale) 

$ Billions 

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 

Source: National Association of Real Estate Investment Trusts

Commercial Real Estate Securitization: 

Some Broader Implications 

Maturing CMBS markets could eventually improve the 

overall stability of commercial real estate markets not 

only by improving market liquidity but also by enabling 

investors to diversify and share their credit exposures 

among a greater number of participants. In addition, 

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

more uniform and prudent underwriting standards. 

However, concern naturally arises because CMBSs are 

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

downturn. This situation leads to questions concerning 

the impact they will have on property values and market 

liquidity and whether today’s underwriting terms, driven 

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

standardized structures underlying these securities offer 

enough flexibility to borrowers to renegotiate loan 

terms—a critical workout tool during times of financial 

stress. The answers to these questions will ultimately 

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

There are also questions about how REITs will affect 

commercial real estate markets. One argument is that 

the appetite for REIT investments, combined with the 

premiums that the trusts can pay for properties, will 

push the price of commercial space beyond sustainable 

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

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

estate values. The contrary view holds that REITs will 

improve market efficiency by providing continuous 

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

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

cycles. 

As an investment, commercial real estate is quickly 

regaining the broad favor it lost during the last market 

downturn. But the channels through which a lender or 

investor can participate in this market are expanding 

even more dramatically. Investment exposures to real 

estate are no longer effectively limited to private equity 

or debt. The choices are multiplying, with liquid public 

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

based instruments—instruments such as swaps, options, 

and property derivatives—that will permit the tailoring, 

hedging, and even creation of synthetic real estate 

investment positions. Although financial institutions are 

participating in this revival, it is clearly a different world 

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

how best to compete against—or participate in—these 

new real estate financing strategies. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

Memphis Region: There Is
 

Widespread Participation in
 

Commercial Real Estate
 

Lending Growth
 

Direct commercial real estate (CRE) lending (construction and nonresidential) is important to many of 

the Memphis Region’s insured institutions. Almost 50 

percent of banks and thrifts in the Region reported 

aggregate exposures in this lending type exceeding 

Tier 1 capital at midyear 1997. In addition, some of 

CHART 5 

these institutions, and others with less exposure, registered very strong CRE loan growth over the past 

year. In total, just under 40 percent of Memphis 

Region institutions had CRE loan growth of 20 percent or higher. This group includes small and large 

institutions (under and over $100 million in total 

assets) in percentages approximating the distribution 

for the Region as a whole. These banks and thrifts are 

geographically dispersed, in metropolitan and nonmetropolitan areas alike (see Chart 5). 

Gary L. Beasley, Regional Manager 

CRE Loan Growth Is Widespread in the Memphis Region
 

% of Institutions with 

20% or Higher CRE 

Growth 

(Headquarter location 

by county) 

None (166) 

0-33% (43) 

33-50% (119) 

Over 50% (108) 

# Counties 

Source: Bank & Thrift Call Reports 

Memphis Regional Outlook 13 Fourth Quarter 1997 
Regular Features	 Regional Economy
 

Growth Continues to Moderate in the Memphis Region
 

• Growth continues to decelerate as the Memphis Region moves further away from its cyclical peak. 

•	 Manufacturing’s strong presence may make the Memphis Region more susceptible to fluctuations in the 

national business cycle. 

•	 The transportation industry remains a vital source of growth for the Memphis Region, despite transformations within the industry. 

• New bank formation—a response to areas of strong growth? 

Quarterly Update 

The economic expansion in the Memphis Region has 

slowed since its peak in 1994; by 1996, job growth fell 

below the national average. Moreover, while gains at the 

national level accelerated, growth in the Region continued to decelerate in the first half of 1997 to its lowest 

level since 1991 (see Chart 1). Throughout 1997, all 

areas of the Region’s economy have seen slowing levels 

of growth. Of particular note, however, has been a continued slowdown in job growth among many of the 

Region’s industrial sectors. Manufacturing employment 

accounts for 18.6 percent of the Region’s total payrolls, 

compared with 15.3 percent at the national level. 

Manufacturing can be broadly classified into two types 

of production: durable and nondurable. Performance in 

these two sectors traditionally has tracked closely in the 

Memphis Region, except for greater volatility in the 

durable goods industries. Since 1993, however, there 

has been a divergence in performance between these 

sectors. While nondurable goods manufacturing lost 

CHART 1 

Job Growth Ebbs after 1994 Peak 

% Change 

* Year-over-year percent change, first half of 1997 

Source: Bureau of Labor Statistics 

–2.0 

–1.0 

0.0 

1.0 

2.0 

3.0 

4.0 

1990 1991 1992 1993 1994 1995 1996 1997* 

Memphis Region United States 

5.0 

more than 40,000 jobs, employment in durable goods 

manufacturing increased by 60,000 from 1993 to 1995, 

before experiencing a slight decline in 1996. The 

greater presence of durable goods manufacturing in the 

Region could make its economy more susceptible to 

fluctuations in the business cycle. 

Growth in Kentucky Leads the Region 

In June 1997, employment in Kentucky was up 2.1 percent from a year earlier. While this increase was the 

highest in the Region by a wide margin, it was still 

below the national average and slowed throughout the 

first half of the year. The fastest-growing manufacturing 

industries in the state are fabricated metals and paper 

products. The transportation equipment sector, which 

includes automobile-related production, continues to 

add jobs as well, particularly in the northern portions of 

the state. Despite its apparent strength, manufacturing 

remains highly vulnerable to trends in the national business cycle. Growth at the national level picked up during the first half of 1997, perhaps contributing to 

sustained demand for industrial goods nationwide. 

Should the nation’s economy slow, however, demand 

may weaken, which will have an adverse effect on 

growth among the state’s manufacturers. 

Louisiana’s Economy Slows 

Louisiana’s economic performance continues to deteriorate, although some healthy pockets in the state’s economy remain. In June 1997, employment in the state was 

up 1.1 percent from a year earlier, or about half the 

national average rate of increase. As of midyear 1997, 

manufacturing employment in the state was flat, with 

payrolls about even with the previous year. Most of this 

Memphis Regional Outlook 14	 Fourth Quarter 1997 
Regular Features Regional Economy
 

sector’s weakness stems from losses in nondurable 

goods production. Although some jobs have been lost in 

chemicals and petroleum, most of the decline is a result 

of ongoing erosion in the textile and apparel industry. 

This trend appears likely to continue through 1997, 

given the August announcement that Fruit of the Loom 

would lay off 2,380 employees at garment factories in 

St. Martin, St. Vermilion, and St. Landry Parishes in 

October. The local residents are reported to be very concerned about the long-term prospects for retaining the 

remaining 1,870 jobs. On the durable goods production 

side, gains continue, driven by strong demand for oil 

rigging equipment. Employment in oil and gas extraction is up 5.2 percent from a year ago. The growth primarily benefits the southern half of the state, where 

oil-related manufacturing is concentrated. 

The importance of the oil and gas industry to the health 

of other sectors, such as manufacturing, highlights 

Louisiana’s vulnerability to business cycles and other 

economic factors. Currently, the oil industry is experiencing a period of expansion. If growth slows or the 

price of oil declines, the impact would filter through the 

entire state’s economy. 

Tennessee Increases Dependence on 

Cyclical Manufacturing 

After experiencing a strong rebound from the recession 

earlier in the decade, Tennessee’s economy slowed substantially in 1996, posting job growth of 1.4 percent, 

compared with the national average of 2.7 percent. A 

major source of the deceleration in growth in 1996 was 

a 3.1 percent drop in total manufacturing employment, 

which rivaled the declines that occurred in 1991’s recession. Losses were particularly severe in the textile and 

apparel industry, which saw several plant closures and 

layoffs during the year (see Chart 2). Although erosion 

of its job base is expected to continue as it confronts 

overseas competition, the rate at which the textile and 

apparel industry has lost jobs has abated during 1997. 

While Tennessee’s traditional industries, such as textiles 

and apparel, experienced large losses in 1996, newer 

industries, such as automobile manufacturing, fared 

better and have added jobs during 1997. In June 1997, 

year-over-year job growth in the manufacture of transportation equipment stood at 2.3 percent while overall 

manufacturing payrolls in the state were down 1.3 percent. Nonetheless, this industry remains tightly bound 

to the nation’s business cycle; thus, a cyclical downturn 

CHART 2 

Job Growth in Tennessee’s Textile and Apparel 

Industry Continues to Lag 

–0.20 

–0.15 

–0.10 

–0.05 

0.00 

0.05

% Change from 1 Year Earlier Source: Bureau of Labor Statistics 

1990 1991 1992 1993 1994 1995 1996 1997 

could adversely affect Tennessee’s automotive industry. 

Domestically produced retail automobile sales in the 

United States peaked in 1994 and have since generally 

trended downward (see Chart 3). In the second quarter 

of 1997, sales were down 10.4 percent from the previous year; however, some of the decline may be attributable to the increase in imported car sales, which account 

for 15.9 percent of retail car sales, rather than to the 

nation’s position in the business cycle. In the second 

quarter of 1997, unit retail sales of imported cars were 

up 1 percent from a year earlier. The slowdown in automotive sales is already affecting Spring Hill–based 

Saturn Motors, which is scheduled to reduce production 

by 1,000 cars per week through the end of 1997. 

However, Saturn’s 8,500 employees will continue on the 

payroll for now, shifting some of their time to training. 

Manufacturing Declines Persist in Arkansas 

The economy of Arkansas continues to slow, and manufacturing remains a drag on growth. In June 1997, yearover-year job growth in Arkansas was 0.8 percent. 

Although manufacturing was the only sector that continued to see job losses, its influence on Arkansas’s economy, with 23 percent of total employment, was enough to 

constrain faster overall growth. Manufacturing in 

Arkansas is dominated by food processing, particularly 

in poultry, which has risen in importance over the past 

several years. In 1970, food processing accounted for 15 

percent of all manufacturing jobs; by 1996, its share had 

risen to 23 percent. This industry is unique in that it is 

relatively immune to business cycle fluctuation and it is 

not involved in a secular decline such as that in the 

textile and apparel industry. While food processing traMemphis Regional Outlook 15 Fourth Quarter 1997 
Regular Features Regional Economy
 

ditionally has been a source of growth for Arkansas, 

competitive pressures from other poultry-producing 

states, such as Georgia, are building in the South. 

Manufacturing: Still a Potent Force 

in Mississippi 

Mississippi posted just a 0.2 percent increase in total 

employment during the year ending June 1997, well 

below the national average. Most of the economy’s 

weakness can be traced to the state’s critical manufacturing sector. Like the rest of the nation, Mississippi has 

seen a slow erosion of manufacturing’s share of total 

employment. In 1972, 32 percent of all employment in 

Mississippi was in manufacturing, and nearly a quarter 

of manufacturing jobs were in the textile and apparel 

industry. By 1996, only 23 percent of Mississippi’s jobs 

were in manufacturing. Nonetheless, the role of manufacturing in the state remains comparatively large— 

only 15 percent of employment nationwide is in 

manufacturing. The declining fortunes of the textile and 

apparel industry have been a drag on the state’s economy over the past 25 years, as plant closings and layoffs 

in the face of overseas competition have taken their toll. 

In 1996, losses in the nation’s textile and apparel industry were particularly acute, with employment falling by 

6.9 percent. In Mississippi, the declines were more 

severe, with an 18 percent drop in the industry’s payrolls. 

One of the fastest-growing areas in the state’s economy, 

particularly along the coast and in northwest portions of 

the state, is the tourist and gaming industry, which has 

added thousands of jobs to the economy in recent years. 

According to Southern Business and Development, 

Mississippi holds the Southeast’s top two job-generating development projects: Biloxi’s $500 million Beau 

Rivage casino project, which is expected to yield 4,700 

jobs, and Tunica’s $250 million Grand Casino project, 

which could create as many as 3,500 new jobs. 

Implications: Although the nation continues to see sustained gains in employment, the Memphis Region’s 

economy has slowed. In part, manufacturing’s strong 

presence in the Region and its impact on other sectors 

have played a role in the economy’s recent slowdown. 

Growth in cyclically vulnerable industries could 

increase the Region’s exposure to a national downturn, 

which in turn could result in greater volatility in credit 

quality. 

Role of the Transportation 

Industry in the Memphis Region 

The transportation industry*, particularly railroads, has traditionally 

played a vital role in the Memphis 

Region’s economy. In 1996, transportation accounted for 324,000 

jobs (4 percent of total employment in the Region), making 

the industry about 17 percent more heavily concentrated here than in the nation. The transportation industry is 

also a fast-growing area of the economy, with employment increasing at an annual rate of 3.4 percent since 

1988, compared with the 2.5 increase in the Region’s 

total employment. The prominence of the Memphis 

Region’s transportation industry is a result of its geographic location and geophysical attributes. The Region 

is located along a north-south transportation corridor, 

linking the Great Lakes industrial basin to markets in 

the South. Since the passage of the North American 

Free Trade Agreement (NAFTA), this corridor has been 

extended to include Mexico and Canada. The Memphis 

Region, particularly Louisiana, also benefits from the 

presence of comparatively cheap barge traffic on the 

Mississippi River, which provides Midwest farm 

exports with a gateway to the rest of the world via ports 

in New Orleans and is also a major port of entry for the 

nation’s imports. 

The transportation industry has gone through a striking 

transformation over the past several decades as shipments have increasingly been carried by trucking rather 

than by rail. According to a Standard & Poor’s Industry 

Survey, during the 1940s, 60 percent of intercity freight 

traffic was handled by the railroads; by the end of the 

1970s, this share had fallen to 35.7 percent. During the 

1980s, the nation’s railroads experienced something of a 

renaissance by joining forces with the trucking industry—using rail transport for long hauls and off-loading 

to trucks for local distribution. Railroads also have capitalized on their economies of scale by shipping bulk 

goods such as grains, coal, chemicals, and lumber. This 

specialization has allowed railroads to recoup intercity 

traffic market share. Coal, in particular, played a major 

role in the reemergence of rail traffic during the 1980s. 

* The transportation industry is a subset of transportation, communication, and public utilities and includes, according to the Standard 

Industrial Classification codes, employment in railroads, local and 

interurban passenger transit, trucking and warehousing, water transportation, transportation by air, pipelines (except natural gas), and 

transportation services. 

Memphis Regional Outlook 16 Fourth Quarter 1997 
Regular Features Regional Economy
 

According to the Association of American Railroads, 

coal accounts for 39.5 percent of the nation’s rail tonnage. In the coal-rich Memphis Region, the importance 

of coal for railroads is even higher, accounting for 89 

percent of all tonnage in Kentucky. 

Another trend in the Memphis Region’s transportation 

industry that began in the 1980s is the emerging importance of the air freight industry, especially in 

Tennessee, where the largest private employer is 

Memphis-based Federal Express. In 1970, air transport 

accounted for just 4 percent of transportation, communication, and public utilities employment in the state; by 

1990, the share had risen to 20 percent. 

Implications: A major vulnerability of the transportation industry in the Memphis Region, as well as at the 

national level, is its heavy dependence on the flow of 

commerce. Disruptions such as recessions, strikes within the industry or in other sectors of the economy, and 

even weather conditions can reduce traffic and place 

stress on the industry. This is one reason why transportation industry growth, although higher on average, 

is more volatile than growth in the overall economy, and 

TABLE 1 

why credit quality and demand for lending may also 

exhibit volatility. 

New Banking Formation in the 

Memphis Region 

Data suggest that there may be links in the Memphis 

Region between the formation of new banks and economic growth. This relationship may exist on two levels. First, a recent group of new banks appears to have 

been formed during a surge in the Region’s cyclical 

growth (see Table 1). 

Second, the relationship between economic growth and 

new bank formation can be expanded to a more detailed 

level of analysis to include geographic variation. 

Between 1990 and the second quarter of 1997, 56 new 

commercial banks and savings institutions were formed 

in the Memphis Region. (Institutions formed as part of 

a corporate reorganization and those created to acquire 

the assets or liabilities of another institution were omitted from this analysis.) Chart 3 (next page) indicates 

that most new banks were formed within metropolitan 

New Banking Activity Follows Surge in Job Growth 

1990 1991 1992 1993 1994 1995 1996 1997 

NEW COMMERCIAL BANKS 

ARKANSAS 

KENTUCKY 

LOUISIANA 

MISSISSIPPI 

TENNESSEE 

1 

4 

0 

0 

3 

0 

1 

0 

0 

1 

0 

3 

0 

0 

2 

0 

1 

0 

0 

1 

1 

1 

0 

0 

1 

1 

1 

0 

0 

4 

1 

8 

0 

2 

3 

2 

2 

2 

0 

2 

TOTAL MEMPHIS REGION 8 2 5 2 3 6 14 8 

NEW SAVINGS INSTITUTIONS 

ARKANSAS 

KENTUCKY 

LOUISIANA 

MISSISSIPPI 

TENNESSEE 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

1 

0 

0 

0 

1 

1 

0 

0 

0 

0 

1 

0 

0 

0 

1 

1 

0 

0 

0 

0 

1 

0 

0 

1 

0 

0 

0 

0 

0 

TOTAL MEMPHIS REGION 0 0 1 2 1 2 2 0 

GRAND TOTAL 8 2 6 4 4 8 16 8 

JOB GROWTH* 2.3 0.4 2.2 3.1 4.0 2.9 1.7 1.6 

* Year-over-year percent change, first half 1997 

Source: Bank and Thrift Call Reports 

Memphis Regional Outlook 17 Fourth Quarter 1997 
Regular Features Regional Economy
 

CHART 3 

Location of New Banks: 1990 –1997Q2 

New Bank 

County within 

Metropolitan Area 

Source: Bank and Thrift Call Reports 

areas or in nearby counties that had above-average economic growth. (Of the 56 new banks, only 6 were outside these areas, and those 6 were located in rural 

counties in southeastern Kentucky). 

Implications: Formation of new banks in the Memphis 

Region has been associated with strong job growth. 

Accordingly, the Region’s recent deceleration in economic growth could lead to a drop-off in new bank formation. Moreover, new institutions that were formed 

during a period of high growth may need to consider the 

possibility of a slowing in growth in the Region. See the 

Current Regional Banking Conditions segment for a 

discussion of the performance of new institutions. 

Gary L. Beasley, Regional Manager 

Scott C. Hughes, Atlanta Regional Economist 

Memphis Regional Outlook 18 Fourth Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

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

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

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

preferred dividends. 

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

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

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

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

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

institutions moved quickly to issue trust preferred stock. 

Trust preferred stock can be a less expensive form of 

Tier 1 capital for bank holding companies because of 

the tax deductibility of the dividend payments paid on 

this type of preferred stock. 

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

1996 through June 1997.1 The dollar amount of trust 

preferred stock issued represented almost 95 percent of 

the incremental amount of Tier 1 capital added by those 

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

to fund stock buyback programs. As an example of the 

relative importance of these stock buyback programs, 

one large bank holding company’s Tier 1 capital ratio 

would be 7.25 percent excluding the trust preferred 

shares, and 8.34 percent including the shares. 

Rating agencies and investment analysts have argued 

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

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

and the ability of investors to accelerate their claims 

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

Call Reports. 

2 Trust preferred dividends, unlike dividends on traditional preferred 

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

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

plating issuing trust preferred stock should be aware of 

the concerns expressed by rating agencies and of the 

possibility that excessive reliance on debt-like capital 

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

Trust Preferred Structure 

Provides a Tax-Advantaged 

Capital Funding Alternative 

Trust preferred shares, also 

known as capital securities, are 

traded under different names 

depending on the underwriter, payment terms, and 

maturity. Some of the more common acronyms include 

TOPRS (Trust Originated Preferred Shares), QUIPS 

(Quarterly Income Preferred Shares), and MIPS 

(Monthly Income Preferred Shares). 

Although trust preferreds are issued under different 

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

next page). A non-taxpaying subsidiary, or “trust,” of 

the bank holding company is formed. The trust issues 

two classes of stock: common and preferred shares. The 

common stock of the trust subsidiary is owned by the 

bank holding company, and the trust preferred stock is 

sold to investors. The trust upstreams the proceeds from 

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

note with terms identical to the trust preferred shares. 

(The subordinated note must be the sole asset of the 

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

On a consolidated basis, the trust preferred stock is 

treated as a minority interest of the bank holding company, and the subordinated note is eliminated as interMemphis Regional Outlook 19	 Fourth Quarter 1997 
Regular Features Financial Markets
 

CHART 1
 

How Is Trust Preferred Stock Structured 

to Count as Tier 1 Capital? 

Trust Preferred 

Proceeds 

Trust Preferred Shares 

Dividend Payments—funded by interest 

received on subordinated note 

Investors in Trust 

Preferred Shares 

Trust Subsidiary 

Issues trust preferred shares 

(structured as a non-taxpaying entity) 

Trust Preferred Proceeds 

(Trust preferred shares treated as 

minority interest by BHC and 

counted toward Tier 1 capital) 

Subordinated Note—same coupon 

and payment terms as trust preferred 

shares, booked as intercompany debt 

and eliminated upon consolidation 

Interest Payments—paid with 

before-tax dollars by the BHC 

Bank Holding Company 

(BHC) 

(BHC owns common stock of 

trust subsidiary) 

Memphis Regional Outlook 20 Fourth Quarter 1997
 
Regular Features Financial Markets
 

company debt. The interest paid by the bank holding 

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

fund the dividends on the trust preferred shares. In 

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

the investors in the trust preferred shares. 

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

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

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

accelerate the claim against the bank holding company. 

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

stockholders of the bank holding company. 

Trust preferred shares typically have maturities of 30 

years or more and contain call options and redemption 

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

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

Banks are not permitted to count trust preferred stock 

toward Tier 1 capital because of the cumulative feature 

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

1 capital as cumulative preferred stock, including trust 

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

Risk-Based Capital Standards set by the Basle Accord. 

Bank Holding Companies of All Sizes 

Have Issued Trust Preferred Stock 

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

federal budget. Bank holding companies rushed to take 

advantage of a potentially short-lived tax loophole, 

while investors were attracted by the opportunity to 

earn higher rates than on similarly rated bank debt. 

Bank holding companies have used proceeds from trust 

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

subsidiaries, to finance acquisitions, and to buy back 

common stock. 

As the tax advantage of the trust preferred stock 

remained intact through the budget negotiations, the 

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

under $2.5 billion in the second quarter. Trust preferred 

issuance by larger banks declined as some approached 

their limit on Tier 1 trust preferred, while more smaller 

banks took advantage of the market for trust preferred 

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

banks in various size categories that have issued trust 

preferred stock in recent quarters.) Investment bankers 

are reportedly working on new structures that may make 

it easier and more cost effective for smaller institutions 

to issue these capital securities, perhaps through some 

pooling arrangement. 

REIT Preferred Stock—Another Type 

of Tax-Advantaged Tier 1 Capital 

Prior to the Federal Reserve’s announcement last 

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

institutions to issue tax-advantaged preferred shares. 

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

In an REIT preferred structure, the issuer establishes a 

corporation that elects REIT tax status. Proceeds from 

the preferred shares that are sold to investors are used to 

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

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

CHART 2 

More Small Institutions Issue Trust
 

Preferred Stock
 

Bank Size 

Number of < $10 billion Banks 

$10-100 billion 30 

$100+ billion 25 

20 

15 

10 

5 

0 4Q96 1Q97 2Q97 

Source: Keefe, Bruyette & Woods 

Memphis Regional Outlook 21 Fourth Quarter 1997 
Regular Features Financial Markets
 

operating costs and preferred dividends. As long as the 

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

are tax deductible by the holding company. 

Will the Tax-Advantaged Status of Trust 

Preferred Stock Continue? 

Although the tax-advantaged status of trust preferred 

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

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

that eliminated the tax-advantaged status of a specific 

type of preferred stock known as Step-Down preferred 

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

means of raising tax advantaged Tier 1 capital. 

Issues and Concerns 

A number of bank holding companies have embarked 

on stock buyback programs financed by trust preferred 

stock issuance, thereby boosting earnings per share by 

reducing the number of common shares outstanding, 

while maintaining Tier 1 regulatory capital ratios. 

Rating agencies and investment analysts, however, 

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

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

holding companies with trust preferred stock in excess 

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

some analysts that trust preferred stock is a weaker 

form of Tier 1 capital than other forms of capital such 

as common and perpetual preferred stock, because of 

its limited life and treatment upon a liquidation of the 

trust. 

A recent regulatory interpretation has underscored the 

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

the Comptroller of the Currency (OCC) has determined 

that investments by banks in trust preferred stock 

should be treated as investments in debt securities.4 The 

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

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

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

Banking organizations should be aware of the views of 

rating agencies and bank analysts toward trust preferred 

stock. In times of economic stress, excessive reliance on 

debt-like capital instruments could result in increased 

financial fragility of the overall organization, a higher 

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

service the obligations (explicit or implicit) of the 

holding company could attract the attention of bank 

regulators. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

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

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

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

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

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

to shareholders. 

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

preferred stock would be treated as Type III investments under 12 

CFR Section 2 1.2 (k). 

Memphis Regional Outlook 22 Fourth Quarter 1997 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

•	 Banks and thrifts in the Memphis Region reported strong performance in the second quarter. 

•	 Home equity loans continue to gain popularity. 

•	 Increased fee income has boosted earnings, particularly at the Region’s larger banks. 

•	 New bank performance has benefited from the strong economy. 

Second-Quarter Reports Show Strong 

Performance and Renewed Loan Growth 

Commercial banks and thrifts in the Memphis Region 

posted continued strong results for the second quarter of 

1997, as shown in Chart 1, including: 

•	 improving aggregate return on assets by 7 basis 

points, to 1.35 percent of average assets; 

•	 maintaining leverage capital just below 9 percent of 

average assets; and 

•	 reducing the level of nonperforming assets and pastdue loans. 

After slowing to a 4 percent annualized rate in the first 

quarter of 1997, loan growth for banks and thrifts in the 

Region increased to an annualized rate of 9.6 percent 

for the second quarter of 1997. Slower first-quarter loan 

growth has been typical for the Region in recent years: 

CHART 1 

Memphis Region Institutions Continue to
 

Show Financial Strength
 

Percent 

9 

8 

7 

6 

5 

4 

3 

2 

1 

0 

1995 

YTD 1997 

1996 

Tier 1 Return on Net Interest 

Leverage Assets Margin 

Source: Bank and Thrift Call Reports 

First- and second-quarter loan growth in 1997 mirrored 

that for the first and second quarters of 1996. 

The market for home equity loans has been particularly 

active. Although the funded portion of home equity 

loans represented only 2.4 percent of the Region’s total 

loans at mid-1997, this lending segment continues to 

exhibit rapid growth. After growing by almost 23 percent during 1996, home equity loan balances grew at a 

26 percent annualized rate through the first half of 

1997. While growth rates are faster for larger institutions, banks of all asset sizes are experiencing doubledigit growth in the funded portions of home equity 

lines. Further, the growth in home equity balances does 

not just represent the funding of existing lines; the 

unfunded amount available on home equity lines continues to increase as well. As of June 30, 1997, the 

unfunded amount available on home equity lines of 

credit for commercial banks was $3.7 billion, compared 

with $3.6 billion in funded balances. 

Delinquencies and loss rates on home equity lines rose 

in 1996 compared with 1995; however, by June 30, 

1997, delinquencies were down to a two-year low of 1.4 

percent. Delinquency ratios for the Region’s home equity loans tend to decline in the second quarter of each 

year. The current decline is due in part to the large 

increases in balances in the second quarter, but the overall level of delinquencies has also declined in 1997. 

Loss rates on home equity loans through the first six 

months of 1997 are in line with 1996 charge-off results, 

at approximately 0.1 percent of loan balances. 

The growth in home equity lending may be driven by a 

number of factors. Consumers may be increasingly 

using home equity lines instead of credit cards. Home 

equity lines are usually offered at lower rates than those 

available on credit cards and carry the added advantage 

of potential tax deductibility. For these reasons, home 

equity lines often are used for debt consolidation. Also, 

Memphis Regional Outlook 23	 Fourth Quarter 1997 
Regular Features Regional Banking
 

banks are making it easier for borrowers to use such 

lines by reducing closing costs and raising loan-to-value 

limits. 

Implications: Home equity loans have experienced 

lower loss rates than other types of consumer lending, 

which suggests that growth in home equity lending 

would tend to reduce aggregate credit risk for the 

Region’s institutions. However, historical measures may 

not be good indicators of future results, as the current 

growth in home equity lending has been accompanied 

by changes in underwriting standards, such as higher 

loan-to-value ratios. Also, to the extent that the growth 

in home equity lending represents a further increase in 

consumer debt levels rather than a restructuring of debt, 

overall concern with consumer borrowing patterns 

remains. 

Focus on Fee Income 

Earnings in the banking industry continue to climb, 

with fee income constituting an increasing share of the 

revenue. Nationwide, noninterest income now represents more than one-third of net operating revenue (the 

sum of net interest income and noninterest income). As 

shown in Chart 2, the relative importance of fee income 

to the Region’s aggregate earnings performance has 

increased. In dollar terms, aggregate noninterest income 

for the Region’s commercial banks has climbed from 

$1,894 million at year end 1990 to $3,350 million at 

year end 1996. As of June 30, 1997, noninterest income 

constituted 27.7 percent of net operating revenue for 

banks and thrifts in the Memphis Region. While this 

growth in fee income follows the nationwide trend, nonCHART 2 

Source: Bank Call Reports 

Noninterest Income Increases Share of 

Quarterly Net Operating Revenue 

15% 

20% 

25% 

30% 

35% 

40% 

19901991199219931994199519961997 

National 

Memphis Region 

interest income for the Region’s banks remains well 

below the national level. 

Large institutions have been driving this trend, with 

smaller institutions continuing to focus on core banking 

activities. As shown in Chart 3, the relative importance 

of noninterest income for commercial banks with assets 

under $100 million has changed very little from 1990. 

(Chart 3 has been adjusted to exclude three specialpurpose commercial banks from the group of banks 

with less than $100 million in total assets.) 

Just as recent growth trends for noninterest income 

vary by size of institution, so does the composition of 

noninterest income. Chart 4 shows that smaller banks 

rely on service charges and other fees on deposit 

accounts as their primary source of noninterest income. 

Larger banks are more heavily involved in other 

sources of noninterest income. Expansion of these 

other sources of income has been a major contributing 

factor in the overall growth of noninterest income for 

larger institutions. “Other Fee” income shown in the 

chart includes all commissions and fees other than 

those for deposit accounts. “Other” noninterest income 

includes items such as fiduciary income, gains from 

sales of assets, rental income on other real estate, and 

trading revenue.* 

The growth in noninterest income has included some 

increases in traditional items such as service charges on 

deposit accounts and trust fees. Institutions also are 

* Results depicted in Chart 4 omit one institution with total assets 

between $100 million and $1 billion that specializes in credit card 

operations. 

CHART 3 

Smaller Banks’ Fee Income Lags the Region Noninterest Income/Average Assets

1.75 

1.50 

1.25 

1.00 

0.75 

0.50 

0.25 

0.00 

All Banks 

Banks < $100MM in Assets 

1990 1991 1992 1993 1994 1995 1996 

Source: Bank Call Reports 

Memphis Regional Outlook 24 Fourth Quarter 1997 
Regular Features Regional Banking
 

CHART 4 

Sources of Noninterest Income Vary by
 

Institution Asset Size
 

0 

10 

20 

30 

40 

50 

60 

70 

Less than 

$100 Million 

$100 Million Over $1 

% of Total 

Fees on 

Deposits Other 

Other Fees 

to $1 Billion Billion 

Source: Bank Call Reports 

expanding their sources of revenue through the sale of 

nondeposit products such as insurance, mutual funds, 

and annuities. Revenue from these sales activities is 

growing as more institutions offer these products, but it 

does not yet represent a significant source of earnings. 

During 1996, income from mutual fund and annuity 

sales fees for the Region’s banks contributed just 2.4 

percent of noninterest income. 

Participation in these nondeposit sales activities is not 

limited to larger banks, although sales volume and revenue are concentrated in these institutions. Increasing 

numbers of smaller banks offer the products, often more 

as a service and convenience for traditional customers 

than as a profit center. For example, 32 of 104 institutions in the Region reporting annuity sales during the 

second quarter were institutions with less than $100 

million in assets. Additionally, the 158 institutions 

reporting mutual funds sales included 33 smaller banks. 

This level of reported involvement still represents a 

modest segment of the 701 smaller banks in the Region. 

Implications: Expanded fee income can provide an 

opportunity for both improved earnings performance 

and diversification of revenue. While this diversification of income sources should theoretically reduce 

aggregate risk, individual banks may be taking on new 

risks or elevating historically low-risk areas. For example, reputation risk for a community bank may be substantially increased through the offering of mutual 

funds and annuities. Customers may associate the performance of the investment products they purchase 

from their bank with the bank itself. This could lead to 

customer dissatisfaction, a loss of traditional banking 

business with the customer, or litigation. Changing risks 

have led to increased regulatory attention being directed to some of these activities. For example, in May of 

this year, the FDIC’s Division of Supervision issued 

expanded guidance on nondeposit investment product 

sales. 

New Bank Formation Is Strong, 

Particularly in Kentucky and Tennessee 

The opening of 22 new commercial banks in the span of 

18 months (the period ending June 30, 1997) and 14 

approved but unopened institutions provides the setting 

to assess new bank formation in the Region. Chartering 

of new banks has been geographically concentrated during the decade. Kentucky and Tennessee, the largest 

and most robust state economies in the Region this 

decade, are home to 80 percent of the newly formed 

banks reviewed in this article. On the other extreme, 

Louisiana and Mississippi together account for only 8 

percent of the new banks. The Growth Continues to 

Moderate in the Memphis Region section contains a 

discussion on the relationship between economic conditions and the formation of new banks. A map detailing 

the locations of new banks and a table listing activity by 

state also are contained in that section. 

Financial data in Table 1 (next page) show that banks 

chartered during the period 1992 to 1995, henceforth 

the “boom” group of banks, benefited from the expansive economic conditions that have existed since their 

inception. However, somewhat surprisingly, their early 

earnings performance was only modestly better than 

that of banks chartered during the economic downturn 

of 1990 to 1991. The modest difference in the performance of the groups is demonstrated by the similarity in 

the time it took to reach profitability. Conversely, banks 

formed during the boom period grew their deposits 

faster and held a greater proportion of their assets in 

loans than those formed during the downturn. 

Average loan-to-asset levels for both the boom and 

downturn groups reached almost 70 percent at mid1997, compared with just under 64 percent for the 

Region. This variance may be attributable in part to the 

fact that all but two of the institutions in those groups 

are located in Tennessee or Kentucky, the two states that 

have experienced the most robust economic condition 

in the Region this decade. 

Formations of new banks in the Region often appear to 

be a response to banking consolidation. Thirteen of the 

Memphis Regional Outlook 25 Fourth Quarter 1997 
Regular Features Regional Banking 

TABLE 1 

New Bank Performance Has Varied Relative to Economic Conditions 

FIRST YEAR TIER 1 TRAILING 

GROUP QUARTERS TO DEPOSIT LOANS TO EQUITY LEVERAGE ROA 

PROFITABILITY MULTIPLE ASSETS RATIO 6/30/97 6/30/97 

DOWNTURN 5.22 5.40 57.56 16.23 8.44 1.02 

BOOM 4.93 6.35 64.72 14.13 10.61 0.72 

NEW NA 7.21 56.08 12.23 12.39 NA 

Note: Deposit multiple is deposit total after one year to initial capitalization. 

Source: Bank Call Reports 

22 banks in the “new” group are located in counties 

where institutions were purchased after January 1995, 

often by large banks in the Region or their holding companies. The apparent relationship is even stronger when 

the scope is limited to the most active two states for new 

banks, Tennessee and Kentucky. In those states, 80 percent of the counties hosting new institutions experienced one or more purchase transactions. Further 

evidence of the correlation has come in the form of 

New Bank Analysis Background 

The institutions reviewed here consist of 46 commercial banks that opened between January 1990 

and June 1997. Institutions created pursuant to a 

reorganization or to assume the assets or liabilities 

of other institutions were excluded to prevent skewing of performance measures. Likewise, two niche 

banks were excluded—one a bankers’ bank, the 

other a credit card processor. Data were analyzed by 

segregating the institutions into three subgroups. 

The “downturn” group includes nine institutions 

opened during 1990 and 1991, when recessionary 

conditions existed. The “boom” group includes 15 

institutions that opened between January 1, 1992, 

and December 31, 1995, a period of economic 

expansion. The “new” group includes the remaining 22 institutions, all of which have opened since 

January 1, 1996. 

announcements on the formation of several new banks, 

which noted that the organizing groups include officers, 

directors, and shareholders of banks recently involved 

in a takeover. 

New bank formation is also driven by economic activity: Almost all new banks this decade were chartered in 

or near metropolitan areas. Metropolitan areas have 

been attractive to bank acquirers and those contemplating forming a new bank, because they have been the primary beneficiaries of the strong job growth experienced 

in the Region since 1991. Refer to the Growth 

Continues to Moderate in the Memphis Region section 

for further discussion of the influence of the economy 

on new bank formation. 

Implications: The potential for an adverse turn in economic conditions is always present. The significant 

number of newly insured institutions raises concerns 

over the potential consequences of such an event for 

those banks, especially when one considers that new 

banks tend to experience higher failure rates than more 

established institutions. Nevertheless, performance of 

an admittedly small group of newly insured institutions 

suggests that well-conceived, adequately capitalized, 

and closely supervised new banks can weather limited 

periods of economic downturn. 

Gary L. Beasley, Regional Manager 

Robert L. Burns, Financial Analyst 

Memphis Regional Outlook 26 Fourth Quarter 1997 
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