Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1998 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Financial Analyst
 

In Focus This Quarter 

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

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

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

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

By Allen Puwalski 

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

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

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

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

By Paul C. Bishop 

◆ Trends Affecting the Allowance for Loan and Lease Losses— 

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

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

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

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

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

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

By Andrea Bazemore 

Regular Features 

◆ Regional Economy—For many New England communities, hospitals or 

other large health services facilities are major local employers...recently, the health 

care industry’s job growth has weakened, a trend that is of interest to insured institutions serving these areas...in early 1998, Asia’s economic crisis was having only a 

modest effect on the Region’s economy in the form of declining exports, scattered 

layoffs, and lower college enrollments by Asian students. See page 16. 

By Norman Williams 

◆ Regional Banking—Strong asset quality and efficiency gains push profitability...loan growth and asset growth are brisk...core deposit growth is disappointing...nonbank competitors continue to pick up market share...consumer 

credit problems remain on the horizon. See page 20. 

By Daniel Frye, Cameron Tabor 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

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

Region’s Regional Outlook, please call Daniel Frye at (781) 320-1792 or send an e-mail to 

dfrye@fdic.gov. 

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

official positions of the Federal Deposit Insurance Corporation. Some of the information used in 

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Gary L. Beasley 

Jack M.W. Phelps 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Gain-on-Sale Accounting Can Result in Unstable
 

Capital Ratios and Volatile Earnings 


•	 Gains generated from asset sales under SFAS 125 

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

materialize in cash if the assumptions prove 

incorrect. 

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

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

•	 Finance companies seeking to shift attention from 

gain-on-sale assumptions may find willing bank 

correspondents. 

•	 The rating services have modified capital and 

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

Statement of Financial Accounting Standards No. 125 

(SFAS 125),Accounting for Transfers and Servicing of 

Financial Assets and Extinguishing of Liabilities, 

causes asset sellers, particularly high-growth lenders, to 

recognize significant noncash income. Applying SFAS 

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

give rise to significant noncash gains and related assets 

if an economic interest is retained in assets sold. The 

value of retained interests in assets sold is quantified on 

the basis of management’s assumptions about future 

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

discount the expected cash flows from the loans sold. 

Because the value of these assets changes when actual 

performance deviates from the assumptions, the quality 

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

significantly on gains on sale must be considered carefully. 

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

few major finance companies have led to a higher level 

of scrutiny of companies whose financial statements are 

influenced significantly by gain-on-sale accounting. 

The Securities and Exchange Commission has recently 

increased its scrutiny of publicly traded companies that 

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

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

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

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

Several major credit rating companies have recognized 

the significant effect of gain-on-sale accounting under 

SFAS 125 on interpreting financial statements. These 

companies have issued comments or reports dealing 

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

capital of the companies they rate and how they adjust 

their analysis as a result. The consensus of these papers 

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

lenders—without, in many cases, materially changing 

the underlying economics or credit risk to the originator 

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

what they consider distortions caused by SFAS 125. 

There Are Risks Associated with Gain-on-Sale 

Accounting 

The asset booked in connection with an SFAS 125 loan 

sale is an IO strip that represents the present value of 

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

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

flows from the underlying assets will be sufficient to 

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

underlying assets will generate each month cannot be 

known with certainty because the underlying asset may 

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

accounts), or the borrowers may default. Securitizations 

are structured so that there is enough cushion between 

the expected cash flows and the required payments and 

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

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

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

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

Stroker. “Capital Implications of Securitization and Effect of SFAS 

125.” Fitch Research, September 16, 1997. 

Boston Regional Outlook 3	 Second Quarter 1998 
In Focus This Quarter
 

expected charge-offs to absorb fluctuations in actual 

cash flows and actual charge-offs. This cushion is 

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

According to SFAS 125, when a company sells assets 

and retains the right to future excess spread cash flows, 

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

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

that represents this right—none of which is necessarily 

received in cash. In addition, with many transactions, 

cash receipt is further delayed while cash flows go to 

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

SFAS 125 states that quoted market prices in active 

markets are the best evidence of fair value and should 

be used whenever available. Although there have been 

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

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

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

spread is determined by present valuing the expected 

cash flows using a discounted cash flow model. 

The value of the right to future cash flows is determined 

on the basis of management’s assumptions about the 

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

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

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

life of the transferred assets. Changes in economic or 

market conditions that were not anticipated in the initial 

cash-flow assumptions will likely cause the pool of 

loans to perform differently than initially projected. 

Gain-on-sale accounting is significant to securitizers. 

To illustrate the significance of the IO account to a 

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

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

asset constituted over half of total revenue and over 

eight times net income. The revaluation of the IO was 

necessitated by higher-than-expected prepayment rates. 

Current market conditions were not anticipated by 

many companies that benefited from high earnings 

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

securitizers have reduced the carrying value of their IO 

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

higher prepayment rates. Writing down an IO strip 

largely represents a company’s admission that it will not 

generate on a cash basis income that was booked previously. 

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

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

losses is noteworthy and reflects the growing influence 

of subprime securitizations on the index and the related 

decline in underwriting standards as competition has 

increased in this market. Loans originated in 1995 and 

1996 are causing progressively larger and earlier losses. 

After 21 months of seasoning, the cumulative loss rate 

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

times the loss rate experienced by the 1994-originated 

cohort at the same age. Despite the continued low loss 

rates for the home equity market in general, subprime 

lenders are experiencing accelerated loss rates that are 

eroding the value of their interests in excess spreads. 

There may be a tendency for management to base 

assumptions about expected loss rates on loans sold 

solely on past experience with similar loans. Such an 

approach may not capture changes in market conditions 

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

that loss rates on home equity loans, including first 

liens, have been trending upward rapidly. This trend 

implies that when estimating loss rates, management 

should consider the potential for changes in market conCHART 1 

Vintage Analysis of Home Equity Loan 

Securitizations 

Source: Moody’s Investor Services 

0.00 

0.05 

0.10 

0.15 

0.20 

1 3 5 7 9 11 13 15 17 19 21 

Cumulative 

Loss (%) 

1994 

1995 

1996 

Months 

Boston Regional Outlook 4 Second Quarter 1998 
In Focus This Quarter
 

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

performance of similar assets. 

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

have contributed to the rise. One factor is the trend 

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

additional cash from their homes without waiting to pay 

down principal. Mortgage bankers report the tendency 

of some subprime borrowers, often debt consolidators, 

to maintain outstanding balances at the highest possible 

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

to amortize existing debt. 

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

growth. To continue to grow volume, lenders have been 

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

borrowers, it has been normal to expect that they would 

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

before they would find it economical to refinance. Stiff 

competition for volume has allowed borrowers to find 

better rates without credit curing and has stimulated 

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

curve are likely to increase prepayment rates. 

In standard finance theory, uncertainty about the future 

level of losses and prepayment rates is compensated for 

by discounting the cash flows at a higher rate. Some 

analysts advocate using a discount rate similar to the 

required rate of return for equity investments. Faced 

with changing conditions, one large finance company 

that specializes in high LTV lending announced in 

December 1997 that it was increasing the discount rate 

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

percent. 

The IO Strip Asset Is Growing at Insured 

Depository Institutions 

As of December 31, 1997, only 30 institutions reported 

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

However, some institutions have booked gains that 

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

did not properly report the assets. Therefore, the current 

reporting may understate the prevalence of the asset. 

Furthermore, the recent attention to gain-on-sale 

accounting from the public equity markets has at least a 

few large finance and mortgage companies seeking 

business strategies that shed IO strip-related volatility 

from their financial statements. One such strategy 

already in use is to leave the economic interest in excess 

spread with the correspondents that originate the loans. 

This is done as follows: The correspondent originates 

loans for purchase by a finance company. The finance 

company pays par for the loans, and instead of being 

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

seller retains the right to excess spread generated over 

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

asset that capitalizes this right to receive future cash 

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

whether it arises directly from a securitization or from a 

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

widely by finance and mortgage companies, then IO 

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

For insured depository institutions, the capital effects of 

SFAS 125 need to be evaluated carefully. Analysis of the 

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

volatility of the IO strip. Insured institutions that engage 

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

to distortions similar to those of nonbank financial 

companies. 

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

CHART 2 

IO Strip Is Growing at Insured Institutions 

Source: Bank & Thrift Call Reports 

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

3.00 

1Q97 2Q97 3Q97 4Q97 

$Billion 

120 

130 

140 

150 

160 

Number of Institutions 

Number of Institutions 

IO Strip 

Boston Regional Outlook 5 Second Quarter 1998 
In Focus This Quarter
 

appear high by traditional bank standards. For several 

reasons, the leverage ratio can appear particularly high. 

First, although the asset may be more volatile than 

mortgage serving rights, there is no limit to the amount 

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

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

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

institution’s dividend policy. Third, the denominator of 

the leverage ratio is reduced by the sale because the 

loans are no longer assets of the bank. The cumulative 

result can be a significant boost to the leverage ratio. 

Several insured institutions report an IO strip at greater 

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

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

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

originating and selling subprime mortgages to a major 

securitizer, one institution has amassed IO assets that it 

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

The institutions that have concentrations of 25 percent 

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

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

Public debt markets or banks that lend to these finance 

companies appear to require significantly higher capital 

levels than regulatory minimums required for banks. 

The potential for growth of the IO 

strip asset at insured institutions 

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

significantly less capital for IO 

asset exposure than the public 

equity markets. Perhaps more 

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

markets exemplifies the speed with which exposure to 

risk can be acquired through the securitization market. 

Strong demand for asset-backed securities coupled with 

changing accounting emphases, which in this case favor 

asset sellers, can lead quickly to substantial exposures. 

Allen Puwalski, Senior Financial Analyst 

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

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

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

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

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

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

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

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

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

traditional one- to four-family mortgage lending is 

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

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

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

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

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

Boston Regional Outlook 6 Second Quarter 1998 
In Focus This Quarter
 

How Will the Expansion End?
 

•	 Despite a very low unemployment rate and high 

industry capacity utilization, inflation has been 

unusually subdued during this expansion, with 

price declines in some sectors. 

•	 After seven years of expansion, most analysts 

expect the economy’s growth to slow in the coming 

months. 

•	 The last seven expansions have ended with an 

inflation-driven increase in short-term interest 

rates; in contrast, some analysts believe that the 

next recession will be caused by a period of falling 

prices for commodities, finished goods, and perhaps wages. 

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

economic growth should scrutinize and test those 

decisions against possible adverse change in economic conditions. 

The current economic expansion is the third longest on 

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

expansion began, more than 15 million new jobs have 

been created and inflation-adjusted gross domestic 

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

fact, the unemployment rate reached a 24-year low 

when it fell to 4.6 percent in November 1997 and again 

in February 1998. At the same time, inflation has 

remained unusually low, at only 2.3 percent during 

1997. 

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

one can accurately predict when the expansion will end, 

two related but competing theories about how it will end 

have emerged in recent months. The first and more 

familiar scenario occurs when the Federal Reserve 

increases short-term interest rates to prevent a rapid 

increase in inflation caused by an overheating economy. 

The second scenario, a deflation-induced contraction, is 

less familiar in the context of recent recessions. This 

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

Whatever the cause of the next downturn, its effects are 

likely to be important for the performance of lenders. 

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

reflected in a number of indicators: Inflation-adjusted 

GDP fell by 2 percent; the number of business failures 

rose by nearly 40 percent; unemployment increased by 

more than 40 percent to 9.8 million; the unemployment 

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

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

drivers of bank performance will likely result. 

How Have Economic Expansions 

Usually Ended? 

Although to some extent each business cycle is unique, 

virtually all of the post–World War II expansions have 

shown a similar characteristic: Toward the end of the 

expansion, inflation has accelerated. As the economy 

expands, the prices of inputs, including the wages of 

workers, are bid up as firms compete for resources to 

meet demand. The overall inflation rate will rise if 

prices increase across a large number of industries. Left 

unchecked, an increase in the overall price level may 

itself feed back into the labor market through demands 

for higher wages. 

By raising short-term interest rates, the Federal Reserve 

can limit what might otherwise lead to a rapid increase 

in both wages and prices. Higher interest rates will 

reduce sales of capital goods, housing, and consumer 

durables, the demand for which is very sensitive to the 

level of interest rates. One reflection of this sensitivity 

is the changing pattern of loan growth over the business 

cycle. During periods of expansion, the demand for 

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

durables. If short-term interest rates are increased in 

response to inflationary pressures, loan growth will 

slow as businesses and consumers reduce their demand 

for loans. If interest rates continue to increase, loan 

growth may decline as it has done before and during 

each recession. The cyclical movement of loan growth 

(with vertical bars indicating periods of recession) is 

shown in Chart 1 (next page). 

Looking more closely at short-term interest rates, Chart 

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

Boston Regional Outlook 7	 Second Quarter 1998 
In Focus This Quarter
 

CHART 1	 expansion began. During the expansion between 1975 

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

approximately 6 percent until the twelfth quarter of the 

–5 

0 

5 

10 

15 

20 

25 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 

Percent Change—Year Ago 

expansion, after which it accelerated to more than 12 

percent by the end of the 20-quarter expansion. 

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

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

contrast, there are few signs of accelerating consumer 

price inflation during the current expansion. In fact, it 

appears that the rate of inflation is declining; the United 

States has experienced disinflation.1 Second, among 

Source: Federal Reserve 

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

should be noted that an increase in rates is not sufficient 

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

followed by a period of rapid growth that lasted until 

1990. More recently, the increase in rates during 1994 

was accompanied by a slowdown in the economy, but 

not a recession. 

What Is Different about Inflation 

during This Expansion? 

With history as a guide, one would expect inflation to 

rise as the current expansion matures. Chart 3 illustrates 

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

shows the inflation rate at various points after the 

CHART 2 

expansions that have lasted more than 20 quarters, the 

current rate of inflation is one of the lowest since World 

War II. Consumer inflation is both decreasing and low 

by historical standards. 

What Are the Two Views about 

Future Inflation? 

Two views have developed about how the current 

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

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

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

increasing at a progressively slower rate over time. Deflation is 

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

inflation rate. 

CHART 3 

Federal Funds Rate and Recent 

Recessions 

0 

5 

10 

15 

20 

1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 

Federal Funds Rate (percent) 

Source: Federal Reserve 

Consumer Price Inflation during Four Longest 

Postwar Expansions 

0 

2 

4 

6 

8 

10 

12 

14 

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

Quarters after Start of Expansion 

Percent 

1975–1980 

1982–1990 

1961–1969 

1991–present 

Note: Prices exclude food and energy 

Source: Bureau of Labor Statistics 

Boston Regional Outlook 8	 Second Quarter 1998 
In Focus This Quarter
 

whether to change short-term interest rates may be 

influenced by arguments on either side of the debate. 

The Traditional View 

Although inflation has been tame during this expansion, 

adherents of the traditional view believe that impending 

inflation still poses a danger to the longevity of the 

expansion. Evidence cited to support this view includes 

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

include low energy prices, inexpensive imports, and 

brisk domestic and international competition. These 

factors have delayed the onset of inflationary pressures, 

but they will not remain favorable indefinitely. The 

underlying dynamics have not changed significantly 

from those that led to rising inflation during every other 

recent economic expansion. This is also the view of the 

Federal Reserve Open Market Committee, as stated in 

the minutes of its November 12, 1997, meeting: 

The reasons for the relative quiescence of inflation 

were not fully understood, but they undoubtedly 

included a number of special factors...the risks 

remained in the direction of rising price inflation 

though the extent and timing of that outcome were 

subject to considerable debate. 

—Federal Reserve Bulletin, February 1998, p. 104 

The Deflation View 

Alternatively, some analysts suggest that a recession 

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

low and falling inflation rate in the United States, even 

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

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

growth will not translate as readily as before into price 

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

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

financial crisis. 

What Does the Evidence Show? 

Because determining economic policy is necessarily a 

forward-looking process, policymakers look at many 

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

either the inflation or deflation scenario. 

Wage Growth 

The national unemployment rate is currently very low, 

signaling that labor markets are near capacity in terms 

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

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

growth has increased. Since 1993 the rate of growth has 

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

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

Capacity Utilization 

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

Utilization has been around 83 percent since mid-1997, 

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

Commodity Prices 

Many commodities, such as metals, crude oil, and 

unprocessed food products, have exhibited weak prices 

during the past several months. Between mid-1996 and 

early 1998, the Knight-Ridder Commodity Research 

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

the decline was a 35 percent decrease in crude oil 

prices. 

Finished Goods Prices 

Since the data show that both labor and physical capital 

are at high rates of utilization, the traditional inflation 

scenario suggests that there will be increasing price 

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

as they leave the factory. The price of finished goods 

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

monthly basis, prices declined during eight months in 

1997. 

Service Sector Prices 

The service sector accounts for a growing portion of all 

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

costs generally account for a much higher percentage of 

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

ing industries. Additionally, many service industries 

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

in the service sector are generally higher than in the 

goods sector. Service sector inflation has, however, 

been on a downward trend, falling from 5.5 percent in 

1990 to 3.1 percent in 1997. 

Import Prices 

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

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

early 1996. Within that group, capital goods prices have 

decreased by 12 percent over the same period. 

One factor that will continue to put downward pressure 

on prices is the turmoil in Asian markets. Asian 

exporters are now much more competitive with the rest 

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

Asian producers will be under greater pressure to cut 

prices. At the same time, reduced Asian demand for 

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

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

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

growth. 

From this brief review, it is apparent that signs of 

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

labor markets are at or near full effective capacity, and 

the utilization of factories and physical capital is also 

very high. There is little evidence that these factors are 

causing an increase in prices at either the producer or 

consumer levels. 

How Will the Expansion End? 

Although no one can accurately determine when the 

expansion will end, most analysts are predicting slower 

economic growth in the second half of 1998. Indicators 

such as the unemployment rate suggest that growth will 

be limited by the availability of labor needed to produce 

an increasing supply of goods and services. Weak or 

declining output prices in some sectors could act as a 

further constraint on economic growth. 

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

increase in short-term interest rates appears to be the 

more prevalent view. Nevertheless, the possibility that 

the next economic downturn might be triggered by the 

ripple effects of declining output prices should not be 

dismissed, especially in light of the potentially adverse 

and less familiar risks associated with deflation. What is 

clear for insured institutions is that at this stage of the 

economic expansion, lending and strategic decisions 

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

conditions. 

Paul C. Bishop, Economist 

Why Might Deflation 


Be a Concern?
 

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

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

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

environment, the opposite is true—a dollar in the 

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

In a deflation scenario, debtors would see the real 

value of their financial obligations rise and might 

therefore be hesitant to borrow. A fixed monthly 

mortgage payment, for example, would be paid 

back with increasingly valuable dollars over time. 

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

inflation-adjusted debt repayments that increase 

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

card balances, would become increasingly onerous. 

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

would worsen their financial position. At the very 

least, deterioration in credit quality would be 

expected, along with an increase in the number of 

business and personal bankruptcies. 

Boston Regional Outlook 10 Second Quarter 1998 
In Focus This Quarter
 

Trends Affecting the Allowance for
 

Loan and Lease Losses
 

•	 Allowance for loan and lease loss (ALLL) levels 

are declining relative to total loans. 

•	 Some industry leaders and regulators have 

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

portfolios. 

•	 Significant growth in riskier loan types calls 

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

Weakening underwriting standards and significant 

growth in riskier loan types have increased the risk 

exposures of some insured institutions to an economic 

downturn. Meanwhile, the ALLL relative to total loans 

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

type and discusses the factors analysts consider when 

evaluating the adequacy of the ALLL. Special attention 

is given to issues related to the volatility of loan losses 

and the composition of the loan portfolio. 

Historical Perspective on the Allowance 

for Loan and Lease Losses 

The nation is currently witnessing one of the longest 

economic expansions since World War II. It is to be 

expected that some institutions will reduce their ALLL 

CHART 1 

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

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

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

for commercial banks has declined to the lowest point in 

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

have not kept pace with new loan growth. In some 

cases, banks have determined that their allowances are 

higher than necessary and have taken negative loan loss 

provisions, which are credited back to income. 

This decline in reserve coverage has been broad based, 

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

and large multinational banks have significantly 

reduced the level of reserves to total loans in recent 

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

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

have reduced ALLL ratios by slightly over 37 percent, 

or 98 basis points, over the same period. 

The low level of nonperforming and charged-off loans, 

coupled with prevailing favorable economic conditions, 

is doubtless a significant factor in the reduction of 

Boston Regional Outlook 11 Second Quarter 1998 

Commercial Bank Reserves at Lowest Point in a Decade 

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

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

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

% of Loans

Current 

Expansion 

Recessionary 

periods 
In Focus This Quarter
 

TABLE 1 

Commercial Bank Allowance for Loan and Lease Losses to 

Total Loans by Lender Type 

TYPE OF LENDER 

NUMBER OF 

BANKS 

ASSETS 

($BILLIONS) 1997 1996 1995 1994 1993 

MULTINATIONAL 

COMMERCIAL 

CREDIT CARD 

MORTGAGE 

AGRICULTURAL 

11 

3,207 

67 

286 

2,373 

$1,383 

$1,915 

$202 

$120 

$120 

2.14 

1.63 

4.21 

1.26 

1.53 

2.25 

1.71 

3.48 

1.45 

1.66 

2.55 

1.90 

3.21 

1.45 

1.69 

2.83 

2.16 

2.89 

1.69 

1.75 

3.10 

2.37 

3.35 

1.87 

1.83 

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

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

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

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

Source: Bank Call Reports 

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

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

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

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

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

first quarter 1997, for a detailed discussion of consumer 

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

loss rate is down significantly from levels in the early 

1990s (see Chart 2). 

As the economic expansion reaches an advanced age, 

an important question for insured institutions is 

whether their ALLLs adequately reflect the risks assoCHART 2 

Source: Bank Call Reports 

Asset Quality Indicators Are at Historically 

Favorable Levels 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1985 1987 1989 1991 1993 1995 1997

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

Charge-off 

Rates 

Nonperforming 

Loan Rates 

% of Total Loans 

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

underwriting trends and loan delinquency patterns, a 

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

Trends in Underwriting Prompt 

Regulatory Cautions 

Over the past year, various underwriting and lending 

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

have noted easing of terms and weakening underwriting 

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

was centered in the commercial real estate (CRE) and 

commercial and industrial (C&I) loan categories 

(Chart 3). 

In the FDIC’s Report on Underwriting Practices for 

April 1997 through September 1997, examiners noted 

“above-average” risk in current underwriting practices 

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

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

852 institutions examined that were making business 

loans had poor underwriting standards, including lack 

of documentation of the borrower’s financial strength 

Boston Regional Outlook 12 Second Quarter 1998 
In Focus This Quarter
 

(21 percent) and poor and unpredictable loan repayment 

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

specifically involved in asset-based business lending, 

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

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

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

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

The Federal Reserve’s Senior Loan Officer Opinion 

Survey for November 1997 and February 1998 both 

indicated some easing of commercial business lending 

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

Credit Underwriting Practices stated that the level of 

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

These underwriting trends have resulted in increased 

risk profiles for some insured institutions, while ALLL 

ratios at some institutions continue to decline. 

In August 1997, the OCC issued an Advisory Letter 

voicing its concern about declining allowance levels in 

commercial banks. The OCC cited as primary concerns 

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

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

found that some banks were using flawed reserve 

CHART 3 

Loan Growth in 1997 Centered in
 

Commercial Loans
 

% of Total Loan Growth 

–30 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

70 

80 

Commercial

Consumer

Residential

Mortgages

CRE 

C&I 

Other 

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

Source: Bank Call Reports 

methodologies for estimating loan loss rates, including 

an overreliance on historical loss rates. 

Factors Affecting Adequacy 

of the ALLL 

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

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

delinquency levels. These ratios are evaluated against 

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

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

than normal losses in consumer lending spurred by 

increased bankruptcy filings and the migration of loans 

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

loan portfolio may therefore need to attach more weight 

to recent loan loss data in setting the allowance, since 

historical trends may not adequately reflect reserving 

needs. 

Insured institutions exhibit different management and 

portfolio characteristics that significantly influence the 

level of the allowance. These characteristics include the 

diversification of a loan portfolio (diversification by 

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

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

and nonperforming loans, underwriting practices, and 

economic conditions. 

New techniques continue to be developed to improve 

the reliability of allowance estimates. Management 

information systems, which enable the collection of 

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

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

economic cycles in the review of historical loss and 

delinquency data all are aiding bankers in the reserving 

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

role of judgment in assessing ALLL adequacy. 

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

Boston Regional Outlook 13 Second Quarter 1998 
In Focus This Quarter
 

CHART 4 

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

than Mortgage Loss Rates 

Source: Bank Call Reports 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1991 1992 1993 1994 1995 1996 1997 

Loan Loss Rates (%)

Commercial Real Estate Loans 

Commercial & Industrial Loans 

Residential Mortgages 

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

loan losses have diverged or might diverge from the 

long-run averages. Volatility in loan losses can result 

from changes in the business cycle, local economic 

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

relying on a historic average loan loss calculation to 

derive its reserve level could find itself underreserved if 

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

loan losses than it had anticipated simply on the basis of 

past performance. 

Generally, different types of loans experience varying 

loan loss rates because of the inherently different risks 

and varying levels of volatility within each type. Chart 

4 shows that commercial loans, such as commercial and 

industrial loans and commercial real estate, historically 

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

been higher, they have been more volatile over the 

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

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

Banks that adopt more liberal underwriting policies and 

high loan growth objectives may experience greater 

loan default risk and greater volatility in loan loss rates 

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

and stable loss rates on average. The recent growth in 

subprime and high loan-to-value mortgage lending, 

however, may result in increased volatility and losses 

for some lenders going forward. 

All of these factors suggest that ALLLs would be 

expected to vary considerably both over time and across 

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

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

Report. This makes it difficult to estimate how much of 

the ALLL is attributable to a particular loan type or to 

compare allowance levels for banks with significantly 

different loan portfolios. Table 2 shows the results of a 

statistical regression estimation of commercial bank 

allowance allocations across the various loan types for 

TABLE 2 

ALLL Allocations Have Varied over Time and by Loan Type 

(Commercial Banks under $1 Billion)* 

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

C&I 

CRE 

MORTGAGES 

CREDIT CARDS 

1.71 

1.44 

0.92 

4.47 

1.85 

1.54 

1.00 

4.42 

1.87 

1.77 

1.05 

3.32 

2.06 

1.83 

1.19 

3.11 

2.14 

1.97 

1.22 

3.20 

2.29 

2.02 

1.07 

3.29 

2.45 

1.99 

0.91 

3.59 

* Estimated regression results 

Source: Bank Call Reports 

Boston Regional Outlook 14 Second Quarter 1998 
In Focus This Quarter
 

1991 through 1997 for commercial banks with under $1 

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

received relatively higher allowance allocations than 

residential mortgage loans, indicating that banks saw 

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

consistently received higher allocations than the other 

loan categories, and the allocations have increased in 

recent years owing to the increased delinquencies and 

charge-offs in this area. 

Conclusions 

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

current conditions that may cause losses to differ from 

past experience. Increased losses could result from 

adverse economic developments, from changes in 

banks’ appetite for taking risk, or 

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

increasing some banks’ risk exposure to an economic downturn. 

Institutions with high concentrations in riskier loans, significant 

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

for such institutions, the adequacy of the ALLL and its 

methodologies merits close scrutiny. 

Andrea Bazemore, Banking Analyst 

Boston Regional Outlook 15 Second Quarter 1998 
Regular Features	 Regional Economy
 

Health Care Industry Is a Significant Player
 

in Boston Region’s Economy
 

•	 During the last recession, hospitals, clinics, and other medical service providers as a group increased their 

New England payrolls, while total nonfarm employment declined. 

•	 Recent trends and legislative developments point toward the possibility of slower growth in total health care 

industry payrolls in New England and the nation over the next few years. 

•	 For many New England communities, hospitals or other large health services facilities are major local 

employers. This has implications for the systemic credit risk of insured institutions serving these areas. 

• In early 1998, Asia’s economic crisis was beginning to have a modest effect on the Region’s economy in the 

form of declining exports, scattered layoffs, and lower college enrollments by Asian students. 

Rapid Growth in Nationwide Health Care 

Demand Has Slowed in Recent Years 

In the 14 years before 1994, personal consumption 

expenditures (PCE) on medical care services generally 

rose at a faster rate than the growth in the U.S. economy, as demographic factors and an increasing emphasis 

on high-cost technology fueled health care spending. In 

recent years, however, that gap has narrowed. Chart 1 

illustrates the relative cooling of medical care spending 

growth, with outlays essentially level at just below 11 

percent of gross domestic product (GDP) since 1993. 

This slowdown in the rate of growth was concurrent 

with the increased use of lower cost managed care plans 

CHART 1 Percent of GDP 

Health Care Spending Growth Has Leveled Off 

(Personal Consumption Expenditures 

on Medical Care as a Share of GDP) 

12 

10 

8 

6 

4 

2 

0 

1980 1985 1990 1995 

Source: U.S. Bureau of Economic Analysis 

by large employers. Greater government and private 

sector pressures on pharmaceutical makers and service 

providers to control cost increases also have played a 

part. 

Widespread resistance to price increases that greatly 

exceed the rate of inflation has helped fuel a consolidation of players in the industry in recent years, and this 

trend shows no sign of abating. As a result, the industry 

could be positioned for a sustained period of much 

slower growth over the next several years. During the 

last recession, health care payroll growth in New England helped to offset job losses in other sectors. Without 

an exuberant health services industry, the Boston 

Region’s economy would have less of a safety net during the next period of economic contraction. 

Health Services Have Been a Major Force 

in the Region’s Job Gains this Decade 

Between 1989 and 1997, health services employment 

rose by almost 30 percent in the United States, while 

total nonfarm payrolls increased only about 13 percent. 

During the last recession, Boston Region employment 

in the health services industry (Standard Industrial 

Classification [SIC] code 80) never ceased its upward 

climb. By 1997, regional health services payrolls stood 

about 24 percent above where they were in 1989. In 

contrast, total nonfarm employment in New England 

dropped between 1990 and 1992, and by 1997 had only 

just returned to its 1989 level. Chart 2 highlights these 

trends in the Region’s employment. 

Boston Regional Outlook 16	 Second Quarter 1998 
130 

120 

110 

Regular Features	 Regional Economy
 

CHART 2	 health services to nonfarm job growth during this 

expansion. Employment in Region’s Health Care Industries
 

Was Not Affected by Last Recession
 In many smaller towns and communities across the 

Region, health care services firms are typically among 

Health Services Employment 

Total Nonfarm Employment 

the largest employers. Chart 4 is based on data reported 

to Dun & Bradstreet. The map shows the number of top 

Index 1989 = 100 

ten employers in each county that are in the health services industry (including public and nonprofit facilities, 

psychiatric and other nonacute care facilities, and related services not classified under SIC code 80). In 18 of 

the counties, a health care services firm is the single 

largest employer. Further, in all but three counties, at 

least one of the top ten employers is a health services 

firm. 

Strong Health Care Employment Gains 

May Not Continue 

Employment growth in New England’s health services 

has been moderating in recent years, from annual rates 

near 4 percent in 1992 and 1993 to just 1.3 percent in 

1997. This slowdown has occurred at the national level 

as well and may be an indication that years of consolidation are finally beginning to take a toll on the industry’s payrolls (see Chart 5, next page). However, it is 

important to note that although growth may be settling 

into a slower pattern for the medium term because of 

CHART 4 

The Region Is Highly Dependent on Health
 

Care and Related Employment
 

(Number of Top Ten Employers in Health Care)
 

4 to 5 

3 

2 

1 

none 

100 

90 

1989 1991 1993 1995 1997 

Source: U.S. Bureau of Labor Statistics 

There Is a High Concentration of Health Care 

Jobs in New England States 

Despite the fact that health services payrolls in the 

Region did not grow as rapidly as they did for the nation 

as a whole during the past several years, every state in 

New England continues to hold a larger concentration 

of health services employment than the nation as a 

whole (see Chart 3). 

Rhode Island has had the Region’s highest concentration of health services jobs since 1989. Rhode Island’s 

sustained high concentration is due, at least in part, to 

long-running, large-scale declines in manufacturing 

payrolls and generally sluggish job growth in other sectors in recent years, rather than to any absolute advantage in its health services industry. This combination of 

factors has given the state the Region’s highest ratio of 

CHART 3 

Region’s States Are More Reliant than 

the Nation on Health Care Jobs 

Source: U.S. Bureau of Labor Statistics 

0 

2 

4 

6 

8 

10 

12 

CT MA ME NH RI VT Region 

Percent 

United States 

(Health Services as Share of Nonfarm Jobs in 1997) 

Boston Regional Outlook 

Source: Dun & Bradstreet 

17 Second Quarter 1998 
Regular Features Regional Economy
 

CHART 5 

Ebbing Health Services Employment Growth 

May Negatively Affect New England’s Economy 

Source: U.S. Bureau of Labor Statistics 

0 

1 

2 

3 

4 

5 

1990 1991 1992 1993 1994 1995 1996 1997 

Percent 

United States 

New England 

(Change from Prior Year) 

consolidation, long-run demographic forces should 

ensure future surges in demand (and most likely 

employment) for this industry. 

New England’s health services payrolls are likely experiencing a more acute effect from consolidation than 

those of the nation as a whole because several of the 

Region’s states are among the nation’s highest in terms 

of market share of managed care operations. A survey 

by Hoechst Marion Roussel in its Managed Care 

Digest1 ranked Massachusetts number one in both 

1994 and 1995 (the latest year for which data were 

available), with 42 percent and 49 percent shares, 

respectively. New Hampshire moved from eleventh 

place in 1994 to second in 1995 (from 25 percent to 44 

percent). In 1995, Connecticut ranked eighth and 

Rhode Island fifteenth. Vermont and Maine were much 

less influenced by managed care operations, with market share rates of 23 percent and 15 percent, respectively, in 1995. 

Managed care organizations such as health maintenance 

organizations tend to exert significant cost control pressure on member facilities. As a result, payrolls (as one 

of the largest expense items) become primary targets for 

facilities to cut costs and bolster margins squeezed by 

fixed reimbursements per patient (“capitation”) and 

other revenue- and price-control methods. 

1 Standard & Poor’s Industry Surveys, Healthcare: Managed Care, 

July 3, 1997 

Earnings at health services firms could be further 

squeezed by pending legislation. A leading proposal 

would make it easier for patients and member physicians to litigate against managed care plans (such litigation has been banned by federal law since 1974). 

Several states across the nation, including some in the 

Boston Region, are currently entertaining consumerprotection legislation that could increase managed care 

companies’ regulatory burdens, adding costs and potentially cutting revenues. New Hampshire has legislation 

pending that might limit (through preadmission screening) the flow of new patients to nursing facilities. This 

plan, designed to limit growth in state Medicaid outlays 

(about 60 percent of U.S. nursing home revenues in 

1996 came from Medicaid), potentially would reduce 

nursing facilities’ revenues and earnings. 

Recent cuts and alterations in Medicare and Medicaid 

also may hinder the rapid growth in home health care 

firms and adversely affect nursing homes and teaching 

hospitals (of which the Boston Region has a disproportionate share). Home health care firms often employ 

nurses and other professionals once limited to work at 

hospitals and other facilities. 

A survey of 40 home health care firms by the Home & 

Health Care Association of Massachusetts released in 

April indicated that, because of recent reductions in 

Medicare reimbursement for home health care, 60 percent of firms surveyed expected to lay off staff this year. 

About 10 percent had already reduced their payrolls. 

According to the association, there are 175 home health 

care firms in Massachusetts, employing about 18,000 

workers. The association predicted that layoffs at the 

state’s home health care firms will be “considerable.” 

Growth in home care has been quite pronounced in 

recent years (because of the industry’s young age). 

Although its employment remains far smaller than that 

of hospitals and doctors’ offices/clinics, home care’s 

rapidly advancing payrolls have helped to offset 

declines at traditional health services establishments 

(see Chart 6, next page). 

Implications: Insured institutions with expertise in 

lending to the health services industry may find increasing opportunities to fund merger/consolidation-related 

deals in 1998. Such opportunities would help offset an 

expected decline in overall loan demand growth should 

Boston Regional Outlook 18 Second Quarter 1998 
500 

400 

300 

Regular Features	 Regional Economy
 

CHART 6	 the economy slow. Also, many hospitals continue to 

place a priority on funding plant expansions, improve- Home Care Is One of the Nation’s Fastest­ ments, and new equipment acquisitions to distinguish Growing Employers themselves from their competitors (in the case of standalone facilities) or to better fit into a hospital system/ 

alliance or provider network. 

U.S. Home Care Employment 

U.S. Health Services

 Employment 

Index 1985 = 100

200 

Systemic credit risks may be greater for institutions 

serving local markets with one or more large employers 

in this industry. With the strength of the local economy 

tied to the ongoing operations of a health care facility, a 

merger-related closure or reduction in employment 

could severely affect commercial, real estate, and con­ 100 

1985 1987 1989 1991 1993 1995 1997 sumer credit portfolios of local insured institutions. 

Source: U.S. Bureau of Labor Statistics 

Boston Region Economic Update 

The Region and the nation are expected to see some 

moderation in economic growth in 1998, caused in 

part by the economic problems in Asia. Because the 

Region’s exposure to Asia is only “average,” it is likely that the effect here will be less than what is expected in some other parts of the nation, such as 

California. 

Anecdotal reports seem to indicate that local fallout 

(declining sales, modest layoffs, or both) from Asia’s 

economic woes has been limited to manufacturers and 

others with direct sales to the troubled Asian countries. Those affected include leather and textile, semiconductor, and scientific instrument manufacturers; 

makers of semiconductor manufacturing equipment; 

and local colleges and universities that “export” education services by enrolling students from the affected countries. Also, firms whose products compete 

with imports from Asia, such as Rhode Island jewelry 

makers and the Region’s toy manufacturers, are seeing increased pricing and margin pressure and 

reduced sales in domestic and international markets. 

In gauging the ultimate effect of Asia’s problems on 

the Region, it is useful to examine merchandise 

export data.2 Nationally, exports to the “Asian Ten” 

Norman Williams, Regional Economist 

same, at 28 percent of total exports and an estimated 

2.3 percent of the Region’s combined six-state gross 

state product (GSP) in 1997. 

Maine was the only state in this Region to greatly 

exceed the U.S. concentration of exports to the Asian 

Ten in 1997. Asian exports accounted for 42 percent 

of Maine’s total exports, up sharply from a 32 percent 

share in 1996. However, the value of the exports was 

equivalent to 2.3 percent of the state’s GSP in 1997 

(as estimated by the author)—no more significant 

than the averages for the nation or the Region. For the 

past several years, Maine’s highest value export category has been electronics and electrical equipment 

(such as semiconductors and computer parts). This 

category accounted for one-third of the value of total 

exports and 64 percent of the value of exports to the 

Asian Ten in 1997. Paper products accounted for 

another 13 percent of exports to Asia last year. 

CHART 7 

Region’s Exporters Have Limited Exposure
 

to Weak Asian Markets
 

(1997 Merchandise Exports to Asian Ten)
 

50 

Percent of Total Exports 

40 

30 

20 

10 

0 

nations—China, Hong Kong, Indonesia, Japan, 

Malaysia, the Philippines, Singapore, South Korea, 

Taiwan, and Thailand—accounted for 27 percent of 

total exports (see Chart 7) and 2.3 percent of GDP in 

1997. In New England, Asian Ten sales were about the 

United States 

2 Census’ exporter location series was used in this analysis, which CT ME MA NH RI VT 

is based on where an export sale is reported, not where the under- Source: International Trade Administration, Census (exporter location series) 

lying merchandise is manufactured. 

Boston Regional Outlook 19	 Second Quarter 1998 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

•	 Strong asset quality and gains in efficiency continue to drive profitability measures to new highs. 

•	 Loan growth is accelerating, and commitment growth suggests the trend will continue. 

•	 Asset growth continues to outstrip core deposit growth, resulting in greater dependence on noncore funding 

sources. 

•	 Consumer credit problems appear to be stabilizing but bear watching. 

Overview of Financial Performance 

The Boston Region’s insured institutions performed 

admirably in 1997 by many measures. Strong asset 

quality and noninterest income growth, coupled with 

ongoing gains in operating efficiency, continue to drive 

earnings to record levels. In 1997, the 452 insured institutions in the Region posted a collective return on assets 

(ROA) of 1.29 percent and a return on equity (ROE) of 

14.97 percent. Both of these profitability measures 

compare favorably with the national averages of 1.19 

percent and 14.07 percent, respectively, and represent 

solid increases over prior-year performance. The strong 

performance is driven largely by subsidiaries of the 

Region’s three largest banking organizations (“Big 

Three”). These institutions account for 51 percent of the 

Region’s total assets. However, as Table 1 indicates, the 

improved operating performance was broad based, with 

TABLE 1 

both large and small institutions finishing the year on a 

strong note. Only seven institutions (1.5 percent) reported operating losses during the year, and four of those 

institutions have been open for less than two years. The 

percentage of institutions reporting losses is approximately one-third the national rate. 

This financial performance continues to be reflected 

favorably in examination results. The average composite CAMEL rating for the Region’s insured institutions 

fell to 1.68 at year-end, the lowest that measure has been 

since March 1988. For examinations conducted during 

1997, only four institutions were downgraded to a less 

than satisfactory level (composite rating of 3, 4, or 5), 

with 14 being upgraded to the satisfactory level. At 

year-end 1997, only 1 percent of the Region’s banking 

assets was held by institutions with less than satisfactory composite CAMEL ratings. 

Profits Rise on Continued Improvement 

in Asset Quality and Operating Efficiency 

ASSETS ASSETS 

NATION BOSTON REGION BIG THREE* > $1 BILLION** ≤ $1 BILLION** 

1997 1996 1997 1996 1997 1996 1997 1996 1997 1996 

ROA 1.19 1.10 1.29 1.13 1.35 1.18 1.15 1.05 1.05 0.98 

ROE 14.07 13.32 14.97 13.31 17.89 15.29 13.09 12.14 10.36 9.89 

PAST-DUE RATIO 2.27 2.45 2.02 2.66 1.82 2.53 2.01 2.50 2.28 2.92 

NET CHARGE-OFFS/ 

LOANS 0.56 0.53 0.44 0.48 0.57 0.57 0.29 0.36 0.15 0.26 

TIER 1 LEVERAGE 7.63 7.66 7.71 7.89 6.49 7.10 7.57 7.52 9.79 9.66 

EFFICIENCY RATIO*** 60.70 63.40 63.30 65.50 61.80 64.80 63.50 66.20 64.60 65.10 

* Subsidiaries of the three largest banking organizations headquartered in the Region 

** Excluding subsidiaries of the Big Three 

*** Efficiency ratio = Noninterest expense / (net interest income + noninterest income) 

Source: Bank and Thrift Call Reports. All prior period data have been adjusted for merger and consolidation 

activity. 

Boston Regional Outlook 20	 Second Quarter 1998 
Regular Features Regional Banking
 

Asset Growth Accelerates in 

Strengthening Economy 

The Region’s insured institutions registered aggregate 

asset growth of 8.2 percent for the year (adjusted for 

merger and consolidation activity), well ahead of the 

compounded annual growth rate of 2.6 percent realized 

over the prior five-year period. The strong New England 

economy, coupled with diversification into nationally 

and internationally based loans and investments on the 

part of the Region’s largest banking organizations, contributed to this growth. Loans were up 6.7 percent, with 

the course of growth taken by institutions of varying 

asset size being decidedly different. 

The Region’s largest banking organizations have 

focused on commercial loans and have actually curtailed investment in nonresidential real estate and consumer loans. These institutions often use risk-adjusted 

return on capital (RAROC) models to determine credit 

relationship and business line profitability. These models attempt to determine whether a specific group of 

assets is generating returns in excess of the institution’s 

cost of capital or, in short, creating shareholder wealth. 

Institutions divest certain borrowing relationships and 

business lines that do not meet internal RAROC goals 

and, as a result, open the door for small and midsize 

banks to pick up additional business. The Region’s 

remaining institutions have filled the void left by the 

Big Three, and institutions with total assets of less than 

$1 billion have been particularly active in real estate 

lending (see Table 2). 

TABLE 2 

Competition remains keen and may in fact be heating 

up as institutions face heavy cash inflows resulting from 

the elevated level of refinancing activity that has 

occurred in 1998. Various underwriting surveys conducted by the three federal bank regulatory agencies 

have noted thinner spreads and easing of underwriting 

standards, and recent surveys appear to indicate that the 

trend toward easing continues at institutions of all sizes. 

The willingness of smaller institutions to take on assets 

that do not meet RAROC limits of the larger lenders 

may be contributing to their recent pickup in lending 

activity. Price competition may be the primary reason 

that loans, particularly lower quality loans, fail to meet 

the RAROC goals of the larger institutions. The higher 

yields required in RAROC models to compensate for 

higher risk are undercut by smaller institutions seeking 

to expand their portfolios. Clearly, consolidation within 

the larger organizations is creating an opportunity for 

community banks to garner increased market share of 

sound credits, but they must take care to maintain credit quality. In short, smaller institutions should ensure 

that business being won from the larger organizations is 

soundly underwritten and adequately priced to compensate for inherent credit risk. 

Federal Reserve Board Chairman Alan Greenspan 

recently addressed the heightened competition brought 

about by the strong economy, stating, “We should all be 

aware that such an environment tends to reduce prudence.” He added that in such an environment, insured 

institutions “tend to take a little too much risk for far too 

little return.” Finally, in his Humphrey-Hawkins testimony in February, he stated, “we must be concerned 

Small Institutions Are Grabbing a Larger Share of the Commercial Real Estate Pie 

1997 Growth Rates (%) 

BIG THREE ASSETS > $1 BILLION* ASSETS ≤ $1 BILLION* 

ASSETS 8.1 8.3 8.6 

LOANS 6.8 5.9 8.8
 

COMMERCIAL REAL ESTATE
 0.2 2.2 10.3
 

RESIDENTIAL REAL ESTATE
 17.1 2.9 7.7
 

COMMERCIAL & INDUSTRIAL
 21.5 11.5 11.6
 

CONSUMER
 − 24.1 20.0 9.3 

LOAN COMMITMENTS** 28.6 20.8 19.8 

CORE DEPOSITS − 1.4 3.0 5.1 

NONCORE FUNDING 19.7 29.4 25.8 

* Excluding trust specialists, credit card specialists, and Big Three subsidiaries 

** Excluding credit cards 

Note: All data are merger adjusted. 

Source: Bank and Thrift Call Reports 

Boston Regional Outlook 21 Second Quarter 1998 
Regular Features Regional Banking
 

about becoming too complacent about evaluating repayment risks. All too often at this stage of the business 

cycle, the loans that banks extend later make up a disproportionate share of total nonperforming loans.” 

These words of caution should not be taken lightly. 

Lackluster Core Deposit Growth Is 

Not Deterring Loan Activity 

Asset growth was strong in 1997, but core deposits did 

not follow suit, rising only 2.1 percent on a mergeradjusted basis. In the prior five-year period, core 

deposits actually declined slightly. As a result, the percentage of assets funded with core deposits has fallen 

steadily and is now 57 percent for the Region as a whole 

(see Chart 1). The Big Three banking subsidiaries actually registered a decline of 1.4 percent for the current 

period, as smaller institutions increased market share, 

primarily driven by banks with total assets of less than 

$1 billion. Excluding trust and credit card specialists, 

these institutions registered core deposit growth of 5.1 

percent, while all other banks over $1 billion saw core 

deposits rise 3.0 percent for the year. For all three 

groups of institutions, however, a greater reliance on 

noncore funding is evident. Chart 2 shows mergeradjusted growth rates for core deposits, loans, and loan 

CHART 2 

CHART 1 

Slow Core Deposit Growth Raises Reliance 

on Potentially Volatile Liabilities to Fund 

Asset Expansion 

* All prior period data have been adjusted for merger and consolidation activity. 

Core Deposits = Total Deposits – (Certificates of Deposit > $100,000 and Foreign 

Deposits) 

Source: Bank and Thrift Call Reports 

40 

50 

60 

70 

80 

90 

1992 1993 1994 1995 1996 1997 

Boston Region 

Assets > $1 billion 

Assets < $1 billion 

“Big 3”

Core Deposits/Total Assets* (%) 

commitments, by county, for all insured institutions 

headquartered in the county with total assets of less 

than $1 billion as of December 31, 1997. Institutions of 

this size are typically community based and are considered a good barometer of local conditions. As the chart 

indicates, the relative weakness of core deposit growth 

compared with loan growth was widespread in 1997, 

and loan commitment growth at these institutions suggests that the trend toward greater dependence on noncore funding will continue through 1998. As shown in 

Loans and Commitments Are Growing Well Ahead of Deposits throughout the Region 

Core Deposits Loans Loan Commitments 

Over 10% 

5% to 10% 

Other 

1997 Growth: 

Note: All insured institutions with assets less than $1 billion. Data reported by insured institution headquarters location, not customer location. 

Source: Bank and Thrift Call Reports (merger adjusted) 

Boston Regional Outlook 22 Second Quarter 1998 
Regular Features Regional Banking
 

Table 2, loan commitment growth was stronger and core 

deposit growth weaker for the larger institutions, which 

suggests that the trends depicted in Chart 1 will continue for these institutions as well. 

To date, this shift toward noncore funding has not hurt 

net interest margins, as a favorable interest rate environment has enabled the industry to hold down the cost 

of core deposits with minimal disintermediation. The 

spread between the earning asset yield and the cost of 

funds continues to narrow as a result of competition and 

an ongoing shift from nonmaturity deposits to higher 

cost certificates of deposit. However, the erosion in 

spread has been offset by the positive effect of higher 

levels of capital and demand deposits, and lower levels 

of nonaccrual loans. 

Maintaining a low-cost pricing posture for core deposits 

has supported margins; however, lackluster growth has 

resulted, and nonbank competitors continue to pick up 

market share. For example, according to the National 

Credit Union Administration, Boston Region–based 

credit unions registered deposit growth of 6.5 percent in 

1997. Also, on a national scale, the Federal Reserve 

Board’s Flow of Funds Report (Fourth Quarter 1997) 

shows that household investment in money market 

mutual funds has been growing at a rate in excess of 20 

percent over the past three years. While holding down 

deposit costs has clearly propped up earnings in the near 

term, in the long run, this strategy could reduce the ability to manage funding costs, and it heightens the importance of sound liquidity and funds management 

practices. 

Consumer Credit Problems May Be Stabilizing 

but Remain at High Levels 

In the first-quarter 1997 Regional Outlook, the issue of 

rising personal bankruptcies and consumer credit losses 

was explored in detail. At that time, personal bankruptcies were at all-time highs and credit card losses were 

approaching levels not seen since the last recession. In 

1997, personal bankruptcies reached a new high, as did 

net credit card losses. While the trend remains of concern, particularly because these levels are being met 

during a period of excellent economic performance, 

some signs have recently emerged suggesting that the 

deterioration in the consumer sector may be stabilizing. 

According to the American Bankruptcy Institute, 

335,000 personal bankruptcies were filed nationally 

during the fourth quarter of 1997, down slightly from 

the peak of 353,000 reached in the second quarter. 

While the slowdown is a positive sign, fourth-quarter 

filings were still 12 percent ahead of the year-earlier 

quarter. For the full year, personal bankruptcy filings 

reached nearly 1.4 million and were 20 percent higher 

than in 1996. The slowdown in filings in the latter half 

of 1997 suggests that the filing rates are at least beginning to stabilize, although they remain at a high level. 

Another indication of stabilization was reported by 

Fitch IBCA in April 1998, citing a VISA report that 

first-quarter 1998 personal bankruptcy filings were 

estimated to be slightly below the year-earlier period. 

Fitch indicates that this would be the first year-overyear decline since 1994. 

Bankruptcies in New England increased 31 percent in 

1997, with Maine, Massachusetts, New Hampshire, 

and Vermont each reporting increases in excess of 30 

percent, placing these states among the top ten in the 

country in terms of percentage increase. While the rate 

of increase in the Region is rapid, personal bankruptcy 

filings are typically low relative to the nation as a 

whole. Based on the Census Bureau’s preliminary 1997 

population estimates, the national filing rate was 5.0 per 

thousand persons, while the New England rate was 3.9 

per thousand. Only Rhode Island (5.4 per thousand) 

registered a filing rate in excess of the national rate, and 

of the states with the greatest rate of increase, only New 

Hampshire (4.0 per thousand) was above the average for 

the Region. 

Ongoing consumer problems continue to be reflected in 

the loss rates on consumer loans for the Region’s and 

nation’s insured institutions. As Chart 3 (next page) 

indicates, for the nation as a whole, the annualized net 

charge-off rate on credit card loans rose to a record high 

of 5.3 percent during the latter half of 1997, well above 

the highs reached during the recession of the early 

1990s. The Region’s loss experience is tracking closely 

with the national average. 

Certain indicators suggest that net charge-offs will continue to be high through 1998. The percentage of credit 

card loans 30 days or more past due increased to 4.76 

percent as of December 31, 1997, 22 basis points higher than the prior year-end. Therefore, insured institutions are entering 1998 with a greater volume of 

potential problems. Additionally, the rate of currentquarter recoveries to prior-quarter charge-offs has fallen steadily since 1995, from a peak of 22 percent to a 

low of 14 percent in the fourth quarter of 1997. This 

Boston Regional Outlook 23 Second Quarter 1998 
Regular Features Regional Banking
 

CHART 3 

trend may result from less timely recognition of losses 

in an effort to temper the rise in reported charge-offs 

(which also may be contributing to the rise in delinquencies). Another contributing factor may be a rise in 

the percentage of personal bankruptcy filers who are 

opting for Chapter 7 to 73 percent in 1997, compared 

Source: Bank and Thrift Call Reports 

Despite Solid Economy, Credit Card 

Charge-Offs* Have Exceeded High Point 

Reached during Last Recession 

* Quarterly, at annual rates 

1 

2 

3 

4 

5 

6 

Charge-Offs as

% of Credit Card Loans

Nation 

Boston Region 

1990 1991 1992 1993 1994 1995 1996 1997

with 69 percent a year earlier. Chapter 7 filers typically 

relinquish nonexempt property for liquidation and have 

remaining debts extinguished (i.e., not recoverable by 

creditors), whereas Chapter 13 filers try to work out 

some partial satisfaction of debt. 

Direct exposure to consumer loans for the Region’s 

insured institutions is modest, at 11 percent of total loans 

and 90 percent of tangible net worth. Nevertheless, consumer spending represents nearly two-thirds of the 

nation’s economic activity, and any shocks to consumer 

confidence, such as a prolonged stock market correction, could rapidly spill over to other sectors of the loan 

portfolio if consumers rein in spending. The effects 

could be significant if the contraction in spending is 

severe enough to throw the nation into recession. While 

the credit situation appears to be stabilizing, the consumer sector should continue to be closely monitored. 

Daniel Frye, Regional Manager 

Cameron Tabor, Financial Analyst 

Boston Regional Outlook 24 Second Quarter 1998 
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