Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1998 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

Craig A. Rice,
 

Regional Manager
 

Jeffrey W. Walser,
 

Regional Economist
 

John M. Anderlik,
 

Financial Analyst
 

In Focus This Quarter 

◆ 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—The Asian financial crisis brings uncertainty for the 

Region’s agriculture and aircraft industry...the dairy industry faces continued 

transformation...labor shortages persist in the Region. See page 16. 

By Jeffrey W. Walser 

◆ Regional Banking—1997 banking results are strong...but underwriting 

flags surface in growing loan portfolios...some North Dakota banks are feeling the 

effects of several poor years for wheat farmers...important differences are noted in 

the financial performance of rural and metropolitan community banks. See page 21. 

By John M. Anderlik, Craig A. Rice 

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 Kansas City 

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

crice@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman 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. 

Kansas City 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 

Kansas City 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 

Kansas City 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. 

Kansas City 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 

Kansas City 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 

Kansas City 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 manufacturKansas City 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. 

Kansas City 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 

Kansas City 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 

Kansas City 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. 

Kansas City 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 

Kansas City 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 

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

Asian Financial Crisis Brings Uncertainty to the
 

Region’s Agriculture and Aircraft Industries
 

• Economic turmoil in Asia affects exports of agricultural products and airplanes. 

• Dairy farmers in the Region face continuing changes in technology and government policy. 

• Labor shortages in some of the Region’s states may imply slower economic growth. 

The Asian financial crisis will likely reduce exports for 

key commodities produced in the Region and create 

price uncertainty. The Asian countries most severely 

affected by the economic crisis in late 1997—Indonesia, 

Korea, Malaysia, the Philippines, and Thailand—purchased about 12 percent of U.S. agricultural exports in 

1997. (Table 1 shows the importance of Asian countries 

as export destinations.) In addition, cancellation or 

delays in delivery of commercial airplanes to Asian airlines dims what has been a bright spot in job creation in 

Wichita. 

Boeing Employed 22,050 Workers in Wichita 

at the End of 1997 

Boeing supplied 77 percent of the commercial aircraft 

delivered to Asia in 1997. Early in February, Boeing 

TABLE 1 

Asia Is a Major Destination for 

U.S. Agricultural Products 

U.S. AGRICULTURAL EXPORTS ($BILLIONS) 

1995 1996 1997 

1998 

(FORECAST) 

DEC FEB 

ASIA 24.3 26.0 23.8 23.6 21.5 

JAPAN 10.7 11.9 10.7 10.9 10.3 

CHINA 2.4 1.8 1.8 1.6 1.6 

HONG KONG 1.4 1.5 1.6 1.7 1.7 

TAIWAN 2.6 2.9 2.6 2.4 2.4 

SOUTH 

KOREA 3.6 3.7 3.3 3.3 2.4 

S.E. ASIA 2.6 3.4 3.1 2.9 2.3 

SOUTH ASIA 1.0 0.7 0.7 0.8 0.8 

OTHER 

COUNTRIES 31.3 33.8 33.5 34.9 34.5 

TOTAL 55.6 59.8 57.3 58.5 56.0 

Note: All years are fiscal years. 

Source: U.S. Department of Agriculture, February 

1998 

executives announced they expected up to 60 aircraft to 

be canceled from a backlog of 360 units previously 

scheduled for delivery over the next three years. Currency devaluations and the economic slowdown have 

cut into the previously strong demand for air travel in 

Asia. In addition, devaluations have caused the price of 

airplanes, as measured in Asian currencies, to rise 

sharply. 

In mid-February, Boeing announced that it would be 

reducing its workforce by 12,000 people in the second 

half of 1998, down from the record level of 103,400 

workers at the end of 1997. Boeing executives were not 

specific about the location of the cutbacks but suggested that most reductions would come from the Commercial Aircraft Division, which includes the Wichita 

facility. Reduced demand and continuing reorganization 

resulting from the McConnell Douglas acquisition were 

contributing causes. 

Asia Buys Two-Thirds of U.S. Corn Exports 

According to industry analysts, corn prices in 1998 are 

subject to more than the usual level of uncertainty. In 

addition to the export picture, poor returns in the livestock sectors may reduce the use of feed corn, and 

expectations of increased acreage planted in 1998 will 

continue to contain the price of the 1997 crop. On the 

supply side, the Commonwealth of Independent States, 

China, and Eastern Europe are expected to displace 

demand for U.S. corn. The U.S. Department of Agriculture’s (USDA’s) baseline projection for the price of 

corn in the 1998–99 crop year is $2.60 a bushel versus 

$2.70 forecasted to be received by farmers in the 

1997–98 crop year. The USDA forecasts record plantings of 81.5 million acres in 1998, nearly half of which 

will be in the Kansas City Region. 

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

Soybean Prices Are Expected to Be Lower 

In 1998, soybeans face lower demand from Asia and 

increasing competition from South American producers 

in world trade. According to the USDA’s April World 

Agriculture Supply and Demand Estimates, increased 

stocks and weakening export demand may depress soybean prices during the 1997–98 crop year as much as 

$0.85 below last year’s price of $7.38 a bushel. The 

USDA’s baseline price for soybeans harvested in 1998, 

the 1998–99 crop year, is $5.70 a bushel. Iowa and 

Minnesota will likely account for more than 25 percent 

of the nation’s production in 1998. 

Excess Supply Should Keep Wheat Prices Low 

Wheat production in 1997 was the highest in the 

decade, contributing to lower prices. Exports fell short 

of the previous years’, so accumulating stocks will likely continue to depress the market in 1998. In the northern plains’ wheat-growing area of North Dakota and 

Minnesota, farmers are faced with the additional concern of scab fungus, which has greatly reduced quality 

and production during the past few years. The USDA 

baseline price is $3.50 a bushel for the 1998–99 crop 

year, compared with $3.45 a bushel in 1997–98 and 

$4.30 in 1996–97. 

Poor Returns Are Expected for the 

Region’s Hog Producers 

The December Hogs and Pigs report showed a 7 percent annual increase in the nation’s hog population, as 

hog producers of all sizes responded to the persistent 

high prices in the first half of 1997. The USDA forecasts record hog production of 18.6 billion pounds, an 8 

percent increase from last year. Exports of pork actually declined in 1997, and the trend of rapid growth 

appears to have stalled. Returns to farmers in 1998 will 

be poor, with the greatest stress on the smaller producers, who have higher costs. Iowa, which has 15,000 hog 

farmers with fewer than 1,000 animals, will likely see 

more producers leaving the industry. 

Cattle Outlook Is Good Despite Asian Crisis 

Cattle receipts should improve in 1998 as prices of fed 

cattle (those being prepared for slaughter) strengthen. 

The USDA’s annual Cattle report, released in early February, showed a 1.9 percent decline in total inventories 

from a year ago and a 4 percent decline from the peak 

of the cattle cycle in 1996. Commercial beef production 

is predicted to decline 2.2 percent in 1998. Lower inventories of beef cattle should lead to further strengthening 

of feeder cattle prices in the coming year. The price of 

fed cattle did not advance significantly in the first quarter, but most industry observers expect an increase in 

the second quarter. Risks to cattle returns include large 

supplies of competing meat and poultry and likely deterioration of export markets to Asia. High-priced commodities such as beef have suffered the most from 

devaluations in Asia. During the first ten months of 

1997, beef exports to the countries most severely affected by the economic crisis comprised about 11 percent of 

total beef exports from the United States. Over the same 

period, Taiwan and Japan accounted for nearly 57 percent of beef exports. 

Region’s Dairy Industry Faces Continuing 

Transformation 

The dairy industry in the Midwest is undergoing a structural transformation driven by technological change, a 

geographic realignment of the sector, and recent 

changes in government policy mandated by the Federal 

Agricultural Improvement and 

Reform (FAIR) Act of 1996. 

Dairy production in the Kansas 

City Region accounted for $2.9 

billion of agricultural cash 

receipts in 1996, or 12.7 percent 

of the nation’s total dairy cash 

receipts. In 1997, the Region’s 

milk production comprised 12.8 percent of the U.S. 

total, compared with a 17.6 percent share for California 

and a 14.3 percent share for Wisconsin, the first- and 

second-ranking dairy-producing states. Chart 1 (next 

page) shows the geographic distribution of the Region’s 

1.3 million dairy cows. Sixty-five percent of the cows 

are in Minnesota and Iowa. 

Over the past two decades, milk production in the Midwest, including the Kansas City Region, has remained 

relatively flat. Since 1980, annual production declined 

6.4 percent in the Region, was essentially flat in Wisconsin, but grew more than 90 percent in California. 

The number of dairy farms in the Region has declined 

from 78,000 in 1980 to 23,600 in 1997, with 10,000 of 

them in Minnesota. During this period, almost all 

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

CHART 1 

Kansas City Region’s Dairy Cows Are 

Concentrated in the Northeast 

1997 Milk Cow Population in the Region 

1 dot = 100 cows 

Total = 1.3 million cows 

Source: U.S. Department of Agriculture 

growth in U.S. production has come from dairies in the 

western states, including Arizona, California, Idaho, 

and Texas. 

The dairy industries in the traditional milk-producing 

areas and the Far West have diverged significantly. 

Dairies in the Midwest are typically smaller, are dependent on family labor, and usually grow their own feed 

and forage. Dairies in California are large, use hired 

labor, specialize in milk production, and buy their feed 

from outside suppliers. Table 2 compares the size structure of the dairy industry in some midwestern dairy 

states with California and the nation. 

California’s approach to dairying has led to a significant 

advantage in productivity. According to the USDA’s 

Milk Production report for 1997, California cows averaged 20,458 pounds of milk produced for the year, compared with 15,786 pounds for Minnesota and 15,442 for 

Wisconsin. Better use of genetics and reproductive 

technology and intensive management has led to the 

wide advantage in California and other western states. 

In the January 1995 Fedgazette, Edward Lotterman, 

economist at the Federal Reserve Bank of Minneapolis, 

suggested two reasons why the Midwest has fallen 

behind the western states: “[T]he ethos of the family 

farm is powerful in the region. Long-standing traditions 

and a broad consensus that society was best served by 

TABLE 2 

Small Dairy Farms Are Predominant 

in the Midwest 

DISTRIBUTION OF DAIRY COW POPULATION, 1996 

SIZE OF OPERATION, 

NUMBER BY NUMBER OF COWS 

OF COWS (% OF STATE TOTAL) 

(THOUSANDS) <50 <100 <200 >200 

MINNESOTA 570 29 41 17 13 

WISCONSIN 1,380 30 40 22 8 

CALIFORNIA 1,350 0 1 4 95 

U.S. TOTAL 9,191 15 26 20 39 

Source: U.S. Department of Agriculture 

farms of a size where most labor came from family 

members mitigated against the establishment of the 

large units that came to dominate the Southwest.... 

Even more importantly, federal policies long embodied 

an implicit promise to support milk prices where most 

farmers in every region could survive.”1 

Changes in government policy have reduced the amount 

of support provided, however. Reacting to budgetary 

pressures and large expenditures by the federal government to buy excess dairy products in the 1970s and 

1980s, Congress reduced the support price to $10.10 

per hundredweight in 1985. The FAIR Act of 1996 

began a phaseout of price supports by 2000. In the traditional dairying areas of the Midwest, the increased 

volatility of milk prices could accelerate the disappearance of smaller, higher cost dairy operations. 

Over the past several years, 500- to 600-cow dairies 

have begun to appear in Wisconsin and Minnesota, 

often as partnerships of two farmers, one who manages 

the dairy and one who produces feed. These midwestern 

farmers have adopted some of the techniques of western 

dairymen, with greater emphasis on genetic selection 

and management of feeding practices. 

At the same time, another trend is emerging in the western half of the Kansas City Region. According to a September 1997 report by the USDA, large dairy farms are 

beginning to appear in Kansas, Nebraska, and South 

Dakota, areas that have not traditionally been home to 

milk producers. Many industry observers predict that 

the area will attract more modern large dairies thanks to 

1 Edward Lotterman. “Ninth District Dairying Faces Dramatic 

Change.” Fedgazette, January 1995, pp. 1–7. Federal Reserve Bank of 

Minneapolis. 

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

access to feed, plentiful land, and sparse populations. In 

November 1997, the Omaha World-Herald reported 

that construction is beginning on dairies of 1,400 and 

1,800 cows in western Iowa. The larger facility is 

reported to cost more than $5 million to build. Dairies 

of this size are unprecedented in the area and have been 

financed by equity investors. 

Implications: Counties with the heaviest concentration 

of dairy farming, defined here as the 18 counties that 

each have more than 1 percent of the Region’s dairy 

cows, contained 73 agricultural banks at the end of 

1997, with a total of $3.1 billion in assets. These institutions are heavily concentrated in farm lending; that is, 

a 41.6 percent of their loans are made for agricultural or 

agricultural real estate purposes. 

The phaseout of price supports will increase the volatility of dairy farmers’ income. Greater price volatility 

will disproportionately affect the riskiness of smaller, 

higher-cost dairy operations and likely speed the consolidation of the industry. 

Changes in production practices needed to keep midwestern dairies competitive will require higher levels of 

management skill by farmers and more specialized 

expertise by the lenders that extend them credit. Many 

banks that currently carry dairy-related loans may have 

difficulty recruiting or developing the skilled personnel 

needed to serve the modernizing industry. In addition, 

the mega-dairies that have begun appearing in the western half of the Region have capital needs beyond the 

resources of most community banks. Continuing to 

profitably supply credit to the dairy industry may thus 

pose challenges for the management of banks in these 

areas. 

Labor Shortages in the Kansas City Region Are 

More Than a Short-Term Annoyance 

In 1997, all seven states of the Kansas City Region had 

average unemployment2 rates below the national average. All the Region’s states except Missouri have averaged less than the national rate for the past decade. In 

1997, as the nation’s economic expansion entered its 

seventh year, the shortage of workers became apparent 

2 Unemployment is defined by the U.S. Department of Labor as the 

ratio of the number of currently unemployed persons to the total labor 

force. The labor force is defined as all persons working plus those 

who are actively looking for work. 

throughout the Region, as employers in many sectors 

had difficulty finding workers. Labor shortages became 

especially acute in Iowa, Nebraska, South Dakota, and 

North Dakota. This section will examine labor markets 

in Iowa as a case study of an economy experiencing 

labor shortages. 

Iowa’s unemployment rate has been less than the national number since 1987, as shown in Chart 2. With the 

onset of the expansion in the 1990s, Iowa’s rate diverged 

farther from the national rate. 

At the end of 1997, 47 percent of employment in Iowa 

was in the state’s ten metropolitan counties, while 53 

percent was in the rural counties. Over the past decade, 

unemployment in the rural counties has averaged 0.4 

percent higher than the rate for metropolitan counties. 

The persistent difference between the Iowa and national unemployment rates stems from differences in the 

structure of their labor markets. The long-run or permanent level of unemployment depends in part on the ease 

with which workers are able to find and change jobs. 

Officials at the Iowa Workforce Development Agency 

(IWDA) suggest the relatively high educational attainment of non-college-educated workers contributes to 

the employability of Iowa workers. Additionally, the 

Iowa economy has less specialized employment needs. 

According to the Claritas economic profile, Iowa’s 

workforce has a white collar/blue collar ratio of 1.97, 

compared with the national ratio of 2.25. The other contributor to the lower unemployment rate is the flexibility of Iowa’s labor force. According to the IWDA, Iowa 

has traditionally had a higher than average female labor 

force participation rate. Women with work experience 

CHART 2 

0 

2 

4 

6 

8 

10 

1987 1989 1991 1993 1995 1997 

Unemployment Rate (%)

United States 

Iowa 

Iowa’s Unemployment Rate Has Bettered 

the National Average for the Past Decade 

Note: Data presented are monthly. 

Source: Bureau of Labor Statistics 

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

have joined the labor force as demanded, expanding the 

pool of available workers. 

In 1997, a shortage of workers became apparent in the 

Iowa economy. Press reports of unusual efforts to 

recruit workers suggest the depth of the labor shortage. 

According to an October 13, 1997, article in the Des 

Moines Business Record, employers are recruiting from such nontraditional populations as the 

disabled who have not been in the 

labor force, political refugees, and 

high school students. Temporary 

employment agencies also cannot 

fill all their positions. The Des 

Moines Register reported in 1997 

that several Iowa companies were recruiting at Army 

bases in Texas to draw new workers to Iowa. 

Jeff Nall of the IWDA, as reported by the Dow Jones 

Capital Markets Report of February 11, 1998, believes 

that the shortage of workers may make some companies 

leery of expanding or locating in Iowa. Nall told Iowa 

lawmakers that wages in that state have tended to be 

below the national average but that from 1994 to 1996, 

the latest year for which figures are available, wage 

rates in Iowa increased faster than the rate of inflation. 

Nall commented, “These are long-term trends that will 

last beyond the economic growth we are experiencing.” 

The current shortage of workers in Iowa is only highlighting a long-term trend. Since 1980, the U.S. labor 

force has grown at an annual rate of 1.4 percent, while 

Iowa’s labor force has grown at a rate of 0.6 percent. 

Iowa’s population is relatively elderly, with an average 

age a full year above the national average, and the proportion of its population older than 65 was 15.9 percent 

in 1997, compared with the national proportion of 13.3 

percent. Looking toward the future, the U.S. Department of Education forecasted enrollments in public 

high schools in 2007. While U.S. enrollment was 

expected to grow 13 percent between now and 2007, 

Iowa’s enrollment was expected to decline 1.8 percent. 

The policy responses to Iowa’s demographic trends are 

limited. The use of state-financed economic incentives 

to attract outside industry has not been a popular strategy in Iowa and has come under criticism at the federal 

level. The age structure of the population cannot easily 

be changed in the short or medium term. 

The structure of the labor market in Iowa and other 

states of the Region may constrain growth, both in 

attracting newcomers and in accommodating expansion 

in existing businesses. The states of the Kansas City 

Region were successful in attracting manufacturing 

employment in the 1980s, as companies sought to take 

advantage of lower wages in rural areas. The low unemployment rates currently observed suggest that it may be 

difficult to sustain the recent pattern of growth in the 

Region. 

Jeffrey W. Walser, Regional Economist 

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

1997 Results Are Strong, but
 

Risks Remain on the Horizon
 

•	 Financial results for 1997 continue to indicate satisfactory performance by the Region’s banks and thrifts 

in the aggregate. 

•	 Some institutions face risks associated with rapid loan growth, weakening underwriting standards, and 

tightening liquidity ratios. 

•	 Farm banks in the wheat-growing areas of North Dakota report increases in delinquent loans. 

•	 Rural banks could face challenges as their competitive landscape changes. 

The Region’s financial institutions, in aggregate, ended 

1997 in continued satisfactory condition, and in even 

better financial condition than when the year began. 

Financial results indicate that in 1997 capital levels 

increased, earnings improved, and past-due loans 

remained stable at 2.3 percent of total loans, a low level 

by historical standards. However, the results also illuminate three areas of potential risk for the Region’s institutions: rapid loan growth coupled with weakening 

underwriting standards, the continued tightening of key 

liquidity measures, and elevated loan delinquency levels 

in farm banks in the wheat-growing area of northeast 

North Dakota. 

Underwriting Flags Surface in 

Growing Loan Portfolios 

Aggregate loan growth at a large sample of community 

banks1 was 12 percent in 1997, marking seven consecutive years of positive, increasing loan growth. According to surveys done by the FDIC, the Office of the 

Comptroller of the Currency, and the Federal Reserve,2 

the growth comes amid increasing evidence that underwriting standards are easing. 

1 The sample for this article included the 1,993 FDIC-insured banks 

and thrifts in the Region that had under $250 million in assets as of 

December 31, 1997, and had not been involved in mergers in the previous seven years. The merger exclusion was to eliminate loan growth 

normally associated with mergers. Only institutions in continuous 

existence since December 31, 1990, were considered in the sample. 

2 FDIC’s Report on Underwriting Practices for April to November of 

1997; the Office of the Comptroller of the Currency’s national 1997 

Survey of Credit Underwriting Practices; and the Federal Reserve’s 

November 1997 Senior Loan Officer Opinion Survey on Bank 

Lending Practices. 

Since December 31, 1990, the 1,993 institutions sampled have increased their loan portfolios 70 percent, 

from $36.4 billion to $62.1 billion. While increasing 

loans are expected during an economic expansion, the 

high growth rates experienced at this stage of what has 

been a long expansion raise questions about the potential impact on asset quality in the next economic downturn. In that regard, Federal Reserve Chairman Alan 

Greenspan recently joined a growing list of bank regulators and others in cautioning bankers about the new 

loans. In February he warned, “All too often at this stage 

of the business cycle, the loans that banks extend make 

up a disproportionate share of total nonperforming 

loans.”3 

Loan-to-Asset Ratios Continue to Increase 

Loan growth contributed significantly to an increase in 

aggregate loan-to-asset ratios in the Region, from 56 

percent as of December 31, 1991, to 67 percent as of 

December 31, 1997. Chart 1 (next page) shows that this 

trend is broad-based in the Region, as the percentage of 

institutions with loan-to-asset ratios in each category 

has generally shifted to higher levels. Bankers have been 

resourceful in funding the loan growth. Core deposits 

have fallen from 74 percent of total assets in 1990 to 68 

percent in 1997. Consequently, it is becoming increasingly important for bank managements to understand 

how the use of nontraditional sources of funding affects 

their institutions’ interest rate risk exposure. 

3 Speech to Congress, February 24, 1998. 

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

CHART 1 higher levels of loan delinquency; the 40 farm banks in 

0 

10 

20 

30 

40 

0 20 40 60 80 100 

% of Institutions 

Source: Bank and Thrift Call Reports 

Loan Growth Has Caused Loan-to-Asset Ratios 

to Shift Significantly since 1991 

Loan-to-Asset Ratio (%) 

12/31/91 

12/31/97 

Northeast North Dakota Farm Banks 

Are Showing Loan Problems 

While financial institutions in the Region as a whole 

continue to experience satisfactory asset quality, banking results from 1997 indicate some weaknesses in loan 

portfolios in North Dakota’s farm banks.4 Overall, as of 

December 31, 1997, farm banks in North Dakota had 

delinquent loans5 totaling 3.1 percent of total loans, 

while farm banks in the Region’s other six states had an 

aggregate delinquent loan ratio of 2.1 percent. Further 

analysis indicates that banks headquartered in the northeast quadrant of North Dakota are experiencing even 

4 A farm bank is a bank with agricultural and agricultural real estate
 

loans of at least 25 percent of total loans.
 

5 Delinquent loans are those reported on Call Reports as being 30 or
 

more days past due or on nonaccrual status.
 

CHART 2 

Farm Banks in Northeast North Dakota Are
 

Showing Loan Quality Problems
 

that area posted an aggregate delinquency ratio of 3.9 

percent. Chart 2 illustrates the differences in farm bank 

delinquency rates in the Region and shows how the loan 

quality of northeast North Dakota’s farm banks has 

been deteriorating for several years. 

The reason for the farm bank loan problems in that area 

is not the flooding of 1997, although it surely caused 

headaches for bankers there. Rather, the problems stem 

from scab disease, a fungus that infects grain kernels 

and cuts yields and reduces quality (although increased 

moisture from the flooding probably contributed to the 

scab problem in 1997). Scab has adversely affected 

grain yields in northeast North Dakota in each of the 

past five years, but it was particularly devastating in 

1997. Industry analysts estimate that the disease cost 

North Dakota wheat and barley farmers $355 million in 

1997 alone, and the ripple effect on the state’s economy 

was estimated to be much larger. 

As if the poor yields were not enough, grain prices were 

dramatically lower in 1997 compared with 1996, which 

only deepened farmers’ troubles. Refer to Asian Financial Crisis Brings Uncertainty to the Region’s Agriculture and Aircraft Industries, in this issue, for details 

regarding wheat and its outlook. 

Unfortunately, the burgeoning loan problems may deepen in 1998, since the agricultural climate is not expected to improve. Most important, wheat prices are not 

expected to recover to 1996 levels. In North Dakota, 

low wheat prices could cause farmers to lose money 

again in 1998 even if scab abates and they achieve normal yields. For example, an analysis by the North 

Dakota State University states that it costs farmers 

$3.71 to produce a bushel of spring wheat in the area it 

refers to as Northeast North Dakota.6 Based on futures 

prices in April 1998, this year northeast North Dakota’s 

wheat farmers could lose money on each bushel they 

Delinquent Loans as % of Total Loans 

produce.7 Second, several poor crop years have 5.0 

4.0 

3.0 

2.0 

1.0 

0.0 

NE North Dakota 

Rest of 

Region 

Rest of North 

Dakota 

1994 1995 1996 1997 

6 “Projected 1998 Crop Budgets Northeast North Dakota” by Andy 

Swenson and Ron Haugen, at http://www.ext.nodak.edu/extpubs/ 

agecon/ecquides/ne-pro1w.htm. The area the analysis refers to as 

Northeast North Dakota is a subset of the northeast quadrant of North 

Dakota referred to in this article. 7 The settle price for spring wheat available for September delivery in 

Minneapolis was $3.73 a bushel on April 17, 1998. The basis, or difference between what local grain elevators pay farmers and the Minneapolis exchange, is approximately $0.50 to $0.60, depending on the 

elevator’s location. This means that if the futures price holds, farmers 

Note: Data are for banks with concentrations in agricultural loans only. in northeast North Dakota will receive approximately $3.20 a bushel Source: Bank and Thrift Call Reports in September for spring wheat that costs them $3.71 to produce. 

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

increased farmers’ debt burden, as can be seen in farm 

banks through increased levels of carryover debt.8 Such 

debt increases farmers’ costs through interest expense 

and may make it more difficult for them to obtain loans 

in the future. 

Rural and Metropolitan Banking Are Different 

There are several important differences in the way the 

Region’s small banks9 earn their money, depending on 

whether they are located in metropolitan or rural counties. This section will discuss those differences and their 

implications, particularly for rural banks. 

At first glance, it would appear that the Region’s 2,114 

small banks, of which 427 are headquartered in metropolitan counties and the remainder in rural counties, are 

similarly profitable. In 1997, metropolitan banks posted 

a return-on-assets (ROA) figure of 1.26 percent, while 

rural banks posted a similar 1.23 percent. Since 1993, 

when rural banks’ ROA exceeded that of metropolitan 

banks by 17 points, the largest gap in after-tax earnings 

has been only 8 basis points. 

However, if we examine pretax profitability, which is a 

more stable indicator of income,10 the variation in earnings between metropolitan and rural banks widens. As 

Chart 3 shows, pretax profitability illuminates the 

increasing profitability of metropolitan banks versus 

rural banks in recent years. Since 1992, metropolitan 

banks have gained 28 basis points over rural banks in 

the pretax ROA ratio. 

In addition, the apparent earnings parity does not hold 

if we analyze pretax earnings’ components: net interest 

income, noninterest income, noninterest expense, and 

provision for loan losses. Metropolitan and rural banks 

differ in each of these areas. 

8 In North Dakota bank examinations performed by the FDIC between 

April 1, 1997, and September 30, 1997, examiners noted a “moderate 

increase in carryover debt” in 32 percent of institutions. This figure is 

twice that for the Region as a whole, or 16 percent of institutions. 

9 To analyze the differences in earning streams between rural and metropolitan institutions, we gathered banking information for all FDICinsured commercial banks in the Kansas City Region since 1992. We 

then focused on only those banks that had less than $250 million in 

assets as of December 31, 1997, and had been in continuous operation since and including December 31, 1992. No merger adjusting 

was performed on these institutions. 

10 Because taxes paid by individual banks show great year-to-year 

volatility and because Subchapter S corporation filers currently post 

very little tax expense, pretax profits will be the focus of this section. 

CHART 3 

1.5 

1.6 

1.7 

1.8 

1.9 

2.0 

1993 1994 1995 1996 1997 

Metropolitan Banks Now Are Slightly More 

Profitable than Rural Banks 

Metropolitan 

Banks 

Rural Banks 

Source: Bank Call Reports 

Pretax Return 

on Assets (%) 

Net Interest Income 

Metropolitan banks have higher net interest margins11 

than rural banks. As shown in Chart 4, in 1997 metropolitan banks posted an aggregate net interest margin of 

4.76 percent—a level far higher than the 4.27 percent 

ratio posted by their rural counterparts. This advantage 

has existed throughout the sample period, rising from a 

low of 33 basis points in 1993. 

Metropolitan banks’ advantage in the net interest margin is twofold: They earn more interest on every dollar 

of earning assets, and they fund them more cheaply than 

rural banks. First, metropolitan banks earned an average 

of 18 basis points more on each dollar of earning assets 

11 The net interest margin is calculated by dividing net interest income 

by the average earning assets figure for the period. 

CHART 4 

4.2 

4.3 

4.4 

4.5 

4.6 

4.7 

4.8 

4.9 

1993 1994 1995 1996 1997 

Metropolitan Banks Consistently Register Higher 

Net Interest Margins than Rural Banks 

Metropolitan 

Banks 

Rural Banks 

Source: Bank Call Reports 

Net Interest 

Margins (%) 

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

over the analysis period. Because small institutions do 

not report loan yields by distinct loan type, we do not 

have data to suggest that metropolitan banks are simply 

charging more than rural banks on similar credits. This 

argument does not appear logical anyway, given the 

more competitive metropolitan banking environment. 

Still, we can offer two possible explanations for metropolitan banks’ yield advantage. First, on similar loan 

types, metropolitan banks may be lending to riskier borrowers, which would likely result in higher interest 

rates. As we will discuss later, metropolitan banks provide more to their loan loss reserves, which may indicate higher risk in their loan portfolios. Second, 

differences in loan composition between metropolitan 

and rural banks could play a role. As would be expected, rural banks have a much greater proportion of agricultural loans than metropolitan banks do, while 

metropolitan banks have a commensurately higher level 

of commercial and nonresidential (i.e., commercial) 

real estate loans. 

Metropolitan banks also have a lower cost of funds than 

rural banks. As shown in Table 1, metropolitan banks 

currently have a 13-basis-point advantage in this area, 

and this advantage has averaged 18 basis points over the 

analysis period. The reason appears to lie not in the rates 

paid on deposits, but rather in the composition of 

deposits. Namely, metropolitan banks have more than a 

full percentage point more core deposits (in relation to 

total assets) than rural banks do; rural banks make up 

TABLE 1 

Metropolitan and Rural Banks’ 

Earnings Are Different In Many Ways 

AS OF 12/31/97 

METRO RURAL 

% OF AVERAGE ASSETS 

NET INTEREST INCOME 4.37 3.95 

PROVISION EXPENSE 0.21 0.18 

NONINTEREST INCOME 0.87 0.68 

NONINTEREST EXPENSE 3.21 2.71 

PRETAX INCOME 1.82 1.74 

OTHER RATIOS 

NET INTEREST MARGIN 4.76 4.27 

YIELD ON EARNING ASSETS 8.41 8.19 

COST OF INTEREST-BEARING 

LIABILITIES 4.50 4.63 

CORE DEPOSITS/ASSETS 78.69 77.04 

DEMAND DEPOSITS/ASSETS 14.86 10.28 

Source: Bank Call Reports 

this difference in large time deposits, which typically 

carry higher rates of interest than core deposits. In addition, the makeup of core deposits differs significantly: 

Metropolitan banks have the advantage that 4.6 percent 

more of their assets are funded by demand deposits than 

those of rural banks. Since demand deposits carry no 

interest burden, such a composition is responsible for 

much of metropolitan banks’ advantage in funding 

costs. 

Noninterest Income 

Metropolitan banks have a significant advantage in 

earning funds in other ways as well. As Table 1 indicates, in 1997 metropolitan banks made an average of 

19 basis points more noninterest income per dollar of 

assets than rural banks did. Service charges on deposit 

accounts are responsible for more than half that difference. Metropolitan banks also earn higher income from 

trust and trading department activities and “other” fees 

unrelated to deposits, such as the issuance of letters of 

credit or mortgage servicing. It should be noted, however, that metropolitan banks’ advantage has dwindled 

from 39 basis points in 1993, as rural banks have incrementally closed the gap in several fee categories. 

Noninterest Expense 

While metropolitan banks had higher interest and noninterest income, rural banks offset this advantage by 

having much lower operating expenses. As illustrated in 

Chart 5, rural banks’ noninterest expense was much 

lower than that of metropolitan banks throughout the 

analysis period, but that gap is narrowing. As shown in 

Table 1, rural banks have lower costs in all operating 

categories: personnel, premises and equipment, and 

other noninterest expenses (such as data processing and 

CHART 5 

2.4 

2.8 

3.2 

3.6 

1993 1994 1995 1996 1997 

% of Average Assets 

Rural Banks Have Lower Operating Costs, 

but the Gap Is Narrowing 

Metropolitan 

Banks 

Rural Banks 

Source: Bank Call Reports 

72 basis points 

50 basis points 

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

supplies); this fact likely reflects the lower cost of labor, 

land, and materials in most rural areas. Adding to metropolitan banks’ personnel and other expenses is their 

higher proportion of demand deposits, which reduces 

interest expense but increases other costs because of the 

increased personnel and facilities necessary to process 

such accounts. 

The fact that metropolitan banks have narrowed the gap 

in noninterest expenses considerably over the past four 

years partly explains how their pretax ROA has 

improved in relation to that of rural banks. In fact, since 

1992, metropolitan banks have reduced their expenditures in all operating expense categories in relation to 

total assets, while rural banks actually increased their 

salaries and premises expenses. 

A standard industry measure of banks’ cost containment 

is the efficiency ratio,12 which shows how much it costs 

for a bank to generate one dollar of income. As shown 

in Chart 6, rural banks, thanks to their lower operating 

costs, operate more efficiently than metropolitan banks, 

but their advantage in the efficiency ratio has diminished from 6.3 percent in 1993 to 2.7 percent in 1997. 

Provision Expense 

Metropolitan banks have provided slightly more toward 

loan loss reserves than rural banks in every period analyzed. This fact may indicate that metropolitan banks 

are making slightly riskier loans, which would benefit 

their yields but also require higher reserves. 

Implications: The most important points made in this 

analysis have to do with improvement in generating 

income and cutting operating costs on the part of metropolitan banks compared with rural banks. Metropolitan banks, faced with very strong competition from 

many financial institutions during this decade, have 

12 The efficiency ratio is calculated by dividing noninterest expense by 

the sum of net interest income and noninterest income. 

CHART 6 

55 

57 

59 

61 

63 

65 

67 

1993 1994 1995 1996 1997 

Efficiency Ratio (%) 

Rural Banks Operate at Greater Efficiency, 

but Their Advantage Is Diminishing 

Metropolitan 

Banks 

Rural Banks 

Source: Bank Call Reports 

628 basis points 

267 basis points 

been forced to find new lending niches, compete actively for cheaper deposits, and reduce costs in order to survive. As a result of their evolution, metropolitan banks 

are now more profitable than their rural counterparts, 

even though rural banks have historically faced less 

competition owing to their geographic remoteness from 

competing institutions. 

However, the geographic insulation of rural banks may 

erode in the next few years, thereby posing challenges 

and putting pressure on earnings. The continued migration of large banks into rural areas, coupled with the 

advent of Internet delivery of financial products and 

services, could increase competition for the loans and 

funds that rural banks have depended on throughout 

their existence. As financial products become more like 

commodities, rural banks could face significantly more 

price competition than previously existed. The result for 

rural banks could include pressures to accept a higher 

risk profile in order to attract and keep business. Maintaining a profitable niche without undue levels of risk 

will continue to be an important management challenge 

for these institutions. 

John M. Anderlik, Financial Analyst 

Craig A. Rice, Regional Manager 

Kansas City Regional Outlook 25 Second Quarter 1998 
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