Technologies, New

om

new twists on old ones. The

S

JO

RE

• Banking on the Internet: New 

Opportunities, New Risks - Internet banking pr

benefits. It also offers a host of new problems and some 

tradeoff is one that depository institutions and regulators

they stake out their positions in cyberspace. See page 6.

DIVISION OF

INSURANCE

JOHN D. WEIER,

ENIOR REGIONAL

 ANALYST

AN D. SCHNEIDER,

GIONAL ECONOMIST

Regu[ai Featuies

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1997
 

In Focus This Quaitei

• Will Credit Scoring Transform the Market for Small- FDIC CHICAGO Business Lending? - In an effort to reduce the cost of small-business lending, REGION some institutions are using credit scoring technology to reduce underwriting costs and

to grow their small-business lending portfolios, in some cases venturing into markets

well beyond their local economies. The ramifications could be significant. An

overreliance on credit scoring models could expose lenders to increased credit risks.

Over time, the traditional niche enjoyed by small banks in small-business lending could

come under considerable pressure. See page 3.

ises a wide range of new

 alike must grapple with as

+Regional Economy +Financial Markets +Regional Banking

· Manufacturing · Asset-Backed Securities · Overview

· Job Growth Slows · Bond Values · Consumer Lending

· Interest Rates Rise · Price/Earnings Ratios · Funding

· Household Finances · Year 2000 Conversions

· Commercial Real Estate · Subprime Lending

· Agriculture

 See page 10 See page 15 See page 20

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

Insurance Corporation for the following eight geographic regions:

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Center for current pricing on bulk orders.

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

more information or to provide comments or suggestions about the Chicago Region's Regional

Outlook, please call John Weier at (312) 382-7512 or send an e-mail to weier@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 Ricki Helfer

Director, Division of Insurance Arthur J. Murton

Editor George E. French

Managing Editor Stephen Linehan

Associate Editor Maureen E. Sweeney

Assistant Editors Paul C. Bishop

Steven K. Burton

Richard A. Brown

Diane Ellis

Kathy R. Kalser

Ronald L. Spieker

Publications Managers Nancy Maginn

Diane Ellis

Publication Date: April 24, 1997
 
In Focus This Quarter
 

WillfCreditfScoringfTransformfthefMarketffor
 

Small-BusinessfLending?
 

• 	 Small-business lending, traditionally a segment in

which small banks have enjoyed comparative

advantages, is receiving greater focus from

larger banks and nonbank financial companies.

• 	 Some insured institutions are beginning to rethink traditional approaches to small-business

loan underwriting to include the use of credit

scoring models.

• 	 The use of small-business lending credit scoring

models, while providing banks opportunities for

underwriting and servicing efficiencies, carries

with it a number of potential risks.

Background

As of 1994, there were more than 22

million small businesses in the U.S.,

making this a very attractive potential market for lenders. Smallbusiness lending has been a line of

business in which small banks have

been very successful given their traditional strong niche in relationship banking. Smallbusiness lending traditionally has been a relatively costintensive lending segment, since origination costs are

spread over smaller loan balances. Some institutions

are now beginning to use credit scoring technology to

reduce underwriting costs and to grow their smallbusiness lending portfolios. A number of larger banks,

especially, appear to be looking to the efficiencies of

credit scoring to help provide quick loan approvals and

more competitive loan rates. With the aid of this

technology, some institutions are rapidly expanding their

loan portfolios, in some cases venturing into markets

well beyond their local economies.

The Chicago Region may be especially sensitive to

changes in small-business lending patterns and practices

given its large number of community banks and thrifts.

In fact, small-business lending has been such a large

focus that, at midyear 1996, commercial banks in this

Region reported $37 billion of small-business loans, or

about 30 percent of all commercial and industrial loans.

(For purposes of this article, small-business lending

refers to loans categorized as commercial and industrial

loans with original amounts of $1 million or less reported on the June Call Reports.) There were 547 banks

in the Region with small-business loan exposures exceeding 100 percent of equity, and 121 banks with

exposures exceeding 200 percent of equity.

Though varying significantly from state-to-state, small

and midsize institutions hold over 50 percent of the

Region's small-business loan exposures (see Chart 1

next page). However, some large banking companies

have announced nationwide programs to increase their

market share of small-business lending. These nationwide programs may have been prompted by new credit

scoring technologies that have reportedly allowed some

companies to offer pre-approved lines of credit.

ThefGrowingfImportancefoffCreditfScoring

While credit scoring technology is not new, until recently it typically has been associated with consumer

lending, particularly with credit card lending. Primarily

using credit bureau information, credit scoring provides

lenders with a tool to rank risks or probabilities of

default, assigning statistically derived numerical ratings

or scores based upon a borrower's past experience with

paying debt.

Small-business credit scoring models are similar to

consumer credit scoring models in one significant

aspect -- the most important indicator of credit performance is the credit profile of the principals of the

business. These profiles are derived from consumer

credit bureau information.

A primary vendor of these scoring models has cited

analysis purporting to show that business financial statement information did not prove a useful indicator of

credit performance for small-business loans. The reasons for this result may be due to inconsistency in

financial statement quality and the difficulty in separating business entity cashflow information from the business owners' activities. Also, the relative importance

of principals' credit history and financial statement

information in predicting credit performance was found

to change somewhat with the size of the business -- the

larger the business the more important financial statements become in assessing performance.

Many institutions cite the potential cost savings inRegional Outlook	 3 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

CHART 1
 Cercent o0 Loans

 Asset Size o0 Small-Business Lenders Varies by State

(Sho\n by Bank Asset Size)

100%

80%

60%

40%

20%

0%

Illinois Indiana Michigan Ohio

Source: June 30, 1996, Bank Call Reports

volved in the underwriting process as one of the most

significant characteristics of credit scoring. In many

cases, with scoring technology, loan application processes have been streamlined to one page forms for

loans up to $50,000, not dissimilar to that of consumer

loan applications. In some cases, financial statements

are not required at all. Reducing paperwork helps to

reduce both processing time and costs. Table 1 illustrates how scoring has changed underwriting practices,

as reported by one large bank at a recent conference on

credit scoring. While it is impossible to know whether

the information presented in Table 1 is representative of

the way most institutions are using credit scoring models, it is clear that credit scoring may represent a major

departure from traditional underwriting methods.

Part of the reduction in underwriting costs may come

from improvements in the allocation of underwriting

resources. It has been argued that credit scoring allows

banks to more easily identify those applicants which are

clearly either approvals or denials. This process would

enable banks to reallocate their underwriting resources

more efficiently to those loans which pose intermediate

risks and require closer attention. Other advantages of

credit scoring systems that often are cited are greater

consistency in underwriting, better measures for pricing

strategies, and the potential to enhance the ability to

securitize small-business loans.

WhatfArefthefRisks?

Small-business lending has historically been a profitable area of bank lending. This situation is most likely

attributable to lenders thoroughly analyzing potential

customers, persistently monitoring their performance,

and building solid lending relationships. Credit scoring

for small-business lending raises the possibility that

O)er $10 Billion

$1 - $10 Billion

$2 0 Million - $1 Billion

 nder $2 0 Million

Wisconsin Region

some banks will forgo the traditional underwriting concepts of relationship lending in favor of a more massmarketing approach, in a manner similar to credit card

lending. To the extent that credit scoring is used to

rapidly gain new customers by either targeting out-ofterritory customers, or customers with less business

experience, the risk profile of an institution's smallbusiness lending portfolio may change. Any such

change in profile may be significant due to the risks

associated with newer borrowers. For example, new

firms tend to fail at an extremely high rate, with 53

percent of new businesses failing within the first four

years of inception (see Chart 2 next page). Larger, more

established commercial businesses tend not to exhibit

such volatile characteristics.

There are potential dangers associated with placing

undue reliance on credit scoring models. The predictive

TABLE 1

SMALL-BUSINESS LENDING: CREDIT SCORING

VERSUS TRADITIONAL LOAN UNDERW RITING

1993 1996 1997

PERCENT OF LOANS

REQUIRING ANNUAL 100% 20% - -

FINANCIAL STATEMENTS

PERCENT OF LINES

REVIEWED ANNUALLY 100% 0 - 5% - -

PROCESSING TIME FOR LOANS 3 1 1

OF $50,000 - $250,000 DAYS DAY HOUR

SOURCE: REPORTED BY A LARGE BANK AT A RECENT CONFERENCE ON

CREDIT SCORING.

Regional Outlook 4 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

value of any credit scoring system may be substantially diminished if the model is used for unintended

purposes or customer types. Therefore, misuse of a

scoring system could expose an institution to considerable losses. Since only the largest banks have smallbusiness loan portfolios large enough to create statistically valid scoring models customized for their own

customer base, smaller companies should be especially

aware of potential misuse. This risk takes on added

meaning when one considers that a $1 million smallbusiness loan represents substantially more capital to a

$100 million bank than to a $10 billion bank. Adding

further uncertainty, small-business credit scoring has

been implemented during a period of relatively strong

performance by businesses, with commercial and industrial loan delinquency ratios near historical lows. How

well these models perform during an economic downturn remains to be seen.

Depending on the manner in which it is implemented,

credit scoring for small-business lending may represent

a fundamental shift in underwriting philosophy -- viewing a small-business loan as more of a high-end

consumer loan and, thus, granting credit more on the

strength of the principals' personal credit history and

less on the financial strength of the business itself.

While this may be appropriate in some cases, it is

important to remember that the income from small businesses remains the primary source of repayment of most

loans. Banks that do not analyze business financial

statements or periodically review their lines of credit

may lose an opportunity for early detection of credit

problems.

Competitive pressures in small-business lending are

increasing not only because of large banks' efforts to

expand their lending but also because of greater particiCHART 2

Business Dissolution Rate Sho\s Early Risk

100%

80%

3%

Cumulati)e Dissolution Rate

24%

62%

80%
 71%

60%
 

40%
 

20%
 

0%

1234 6 7 8 9 10

Years

Source: Small Business Administration

pation in the market by nonbank financial companies.

Several large firms, such as American Express, AT&T,

the Money Store, and GE Capital Services, are expanding their business lines to service the needs of small

businesses. These companies are offering smallbusiness credit cards, innovative new types of credit,

and adding other services such as consulting, accounting

and investment services. Some observers have suggested that the cost advantages of credit scoring may

cause small-business lending in the future to be dominated by 12 to 15 large banks or financial firms. Faced

with stiff competition, there may be strong motivation

for some institutions to increase the dollar threshold on

low documentation loans, streamline the process for

larger loans, or lower credit scoring thresholds for loan

approvals.

The most recent FDICfSurveyfoffUnderwritingfPractices and the FederalfReserve'sfSeniorf LoanfOfficer

OpinionfSurveyfonfBankfLendingfPractices both indicate that only a small percentage of banks reported an

easing of standards on small-business loans. Aggressive competitive pressures and loan growth goals were

seen as the main reasons for easing in these cases. With

regard to small-business credit scoring techniques, the

Federal Reserve survey pointed out that banks were

most commonly using creditscores for automatic acceptance or rejection of loans up to $50,000.

Summary

Credit scoring has the potential to transform the market

for small-business lending. The traditional niche enjoyed by small banks in this area may come under

tremendous pressure from larger banks and nonbank

companies employing this new technology. Credit scoring at a number of institutions is driving dramatic

changes in underwriting methods for small-business

lending. These changes may facilitate short-term revenue generation as business can be expanded rapidly

and underwriting costs can be slashed. It is extremely

important, however, that banks understand and control

the potential risks inherent in such a strategy. The

application of credit scoring to small-business lending

merits the close attention of both bankers and their

supervisors.

Andrea W. Bazemore, Banking Analyst

Regional Outlook 5 Second Quarter 1997
 
In Focus This Quarter
 

Banking on the Internet
 New Technologies, New Opportunities, New Risks

• 	 Despite the potential for lower transaction costs,

increased efficiency, and greater asset diversification, few banks do business through the Internet.

• 	 Although competitive risks are pushing banks to

create an Internet presence, operational risks

remain an obstacle to actually using those sites

for moving information or money.

• 	 The FDIC's Division of Supervision recently released examiner guidance on Internet banking

and is developing training programs for its examiners.

The Allure o Cyberbanking

On-line Banking is a comprehensive term for transactions conducted

over wires or from remote locations. It includes banking by telephone, banking by personal computer through a dial-up connection

and, more recently, banking over the

Internet. Internet banking, frequently

referred to as cyberbanking, is of particular interest to

banks because it exploits an existing and geographically

extensive public network infrastructure and promises a

range of new operating and marketing benefits. One

such benefit is the ability for an institution to expand its

trade area to include other cities, states, regions -- or

even countries -- without a commensurate expansion of

its branch structure. This greater geographic reach can

CHART 1

do more than simply increase volume. It also can offer

institutions -- particularly smaller ones -- the potential

to diversify their asset portfolios across multiple regions, leaving them less exposed to the economic

volatility of any single one. Another benefit is the lower

cost of Internet delivery. A March 1996, study by Booz,

Allen & Hamilton Inc. estimated an average Internet

transaction cost of $0.01 compared to $0.27 for an

ATM, $0.54 for a telephone, and $1.07 for a fullservice branch.

Slow Migration to the Future

Another 1996 study, this one by Grant Thornton in July

(see Chart 1), found that despite these potential benefits,

most banks established an Internet presence for appearance's sake -- being perceived as a leader, advertising

bank services or staying abreast of competitors -- rather

than with an intent to grow deposits or capture the

transaction economies that cyberbanking could provide.

Of the 44 Internet institutions surveyed, only one in three

expressed intentions to begin offering bill payment or

funds transfer over the Internet by the end of the second

quarter of this year. Even this subdued enthusiasm now

appears optimistic. Despite the perceived benefits and

the scarcity of competition, few banks have to date

ventured into this area in a meaningful way. According

to the Bankweb world-wide web site, only 800 or so

banks -- less than 1 percent of the industry -- have an

Internet site and only 18 of those permit transactions. In

the Chicago Region, 152 institutions have an Internet

presence but only three allow customers to pay bills or

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

Banking on Cybercommerce: A Survey of Internet Bank Product Plans

Source: Grant Thornton "Banking on Cybercommerce: A Survey of Internet Bank Product Plans"

Mid 199 

(Projected)

Mid 1996 (Actual)

Regional Outlook	 6 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

transfer funds. A major question, then, is why so few

institutions have chosen to exploit this medium? Some Concerns or the CyberBanker
 

Risk
 

The reason is risk. Banks are familiar with the control

of exposures found in proprietary or private payment

channels, but they are less comfortable with the new

risks attendant to a public network. On one hand, there

are operational exposures that convincingly argue

against rushing headlong into cyberspace. On the other

hand, there are competitive risks. Nonbank competitors

with strong foundations in cybertechnology pose a budding threat to the banks' historical payment-services

monopoly and argue with equal authority for an immediate Internet presence to gain or preserve market share.

These opposing forces help explain the large numbers of

banks establishing web sites that stop short of actually

moving information or money.

Of these two types, operational risks are the most

immediate and command the most attention. They derive from the formative state of both the technology

supporting on-line commerce, and the legal and regulatory structure governing its use. These risks include

theft or misappropriation of internal data or external

transmissions, transaction fraud, errors in underwriting

virtual transactions, liquidity shortfalls, changing technical standards, inadequate or geographically inconsistent

regulatory and legal infrastructure, noncompliance with

existing laws or regulations that were not designed for

an on-line world, and damage to an institution's reputation from the realization of any or all of these risks (see

Some Concerns or the CyberBanker,right).

Systemic Threats and a New Payments Model

In addition to bank-specific risks there are the systemic

threats that a public domain payments model could

bring. One of the key features of the Internet is redundancy. Any one of a large number of possible paths can

be used for a given transaction and therefore the failure

of any one path or node will not affect the functionality

of the network as a whole. This feature presents a

multitude of new and -- from a banker's perspective --

previously unconsidered points of vulnerability to

technologically-sophisticated miscreants. In a cyberworld of small value transactions, the effects of an

attack may not be much more severe than those which

accompany credit card crime. However, there is good

reason to expect that Internet transaction sizes will

continue to grow. According to one software vendor,

Internal Data Security. The Internet cannot distinguish

between customers and criminals. Invasive attacks can range

from simple vandalism to theft or destruction of proprietary

operating or customer data. Firewall software, data encryption, specialized hardware configurations and commercial

insurance can limit such exposures.

External Transmission Security. Because the Internet is an

open network, transaction messages are completely exposed,

rendering them vulnerable to theft or tampering. Message

encryption is a common response, but hardware or implementation flaws can circumvent it. This threat will increase

greatly if large value or interbank transactions migrate to the

Internet.

Transaction Fraud. Fraud takes two forms:misrepresentation during a transaction or repudiation following it. This

problem takes new dimensions in cyberspace because no

physical relationship with a customer exists. Encryption

protocols which include digital signatures are one response.

Biometric authentication schemes, the most commonly proposed being fingerprint or retinal verification, are another.

Difficulties with Virtual Underwriting. Even if your cyberborrowers are who they claim to be, there remain difficulties

in establishing their creditworthiness. The lack of a personal

relationship is one factor. The limited knowledge of local

employers and credit grantors that appear on applications is

another. Such difficulties could hasten and heighten dependency upon credit scoring models.

Liquidity Risks. Internet transaction volume and velocity

are expected to increase rapidly, potentially creatingtransactions which occur so rapidly as to exceed immediate bank

liquidity. Denial of service attacks, where a site isintentionally deluged with transactions in order to shut it down, also

can affect liquidity if affected customers decide to close their

accounts.

Lack of Technical Standards. An institution building an

early presence on the Internet is making a financial bet as to

which standards will endure.

Lack of Regulatory and Legal Infrastructure. Regulators

are waiting and observing. Future promulgated "bestpractices" may not be those which an institution has already

adopted. Similarly, a lack of legal precedent hinders criminal

and civil prosecution of cybercriminals. Even where precedent exists, it is frequently inconsistent across jurisdictions.

Reputation Risk. An image of solidity is a cornerstone of

banking. Internet banking confronts banks with more exposure and potentially greater publicity about losses.

Competitive Risks. Unlike the operational risks discussed

above, competitive risks accrue to institutions not securing an

Internet foothold. They involve the threat of lost market

share or payment system position to more aggressive peers

and nonbank competitors.

Regional Outlook 7 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

interbranch payments on the Internet are likely to begin

in 1997 with interbank activity to follow a year or so

later. This development would be a significant evolution because wholesale transactions are generally large

relative to bank liquidity. An attack or disruption of the

Internet payments mechanism for a single large transaction could conceivably pass liquidity shocks to other

banks in the same way that bad weather at a major

airport can disrupt air traffic throughout the country.

New Technologies, Old Reporting

The advent of fully transactional web sites also could

heat up bank competition for low cost deposits and

frustrate regulatory oversight in the process. One possibility is a "deposit arbitrageur," a hybrid of brokered

deposits and program trading in which a computer

program could search the Internet for the highest deposit

rates and immediately reallocate deposits accordingly.

In the long run, such activities could harmonize local

interest rates. In the short run, however, this rapid

turnover could mean substantial liquidity drains on institutions accustomed to local deposit monopolies. From

the regulatory perspective, this transaction velocity --

and its potential to rapidly alter bank balance sheets --

could present new challenges in a world of quarterly

Call Reports and examination intervals that can exceed

one year.

FDIC -- the CyberRegulator

New risks demand new supervision techniques and the

FDIC's Division of Supervision (DOS) has responded

with their recently-released electronic banking safety

and soundness examination guidance. Under that guidance, institutions having Internet sites are placed into

TABLE 1

one of three tiers based upon the "maturity" of their site.

Safety and soundness examination procedures focus on

bank policies, procedures and planning. The examination procedures are cumulative -- meaning that each

successive tier adds an additional level of scrutiny to

the tiers below -- and do not require a technical knowledge of Internet systems. "Information Specialist" involvement also varies by tier (see Table 1). A DOS

training program for all safety and soundness examiners

already has begun, and technical training for information

systems specialists is being developed. A new specialty, the electronic banking Subject Matter Expert,

also is being established.

Measured Steps in a New Environment

Banks increasingly are becoming distributors of

commodity-like products. As such, profitability may

become dependent upon both cost efficiencies and high

volume -- a combination sometimes argued as inconsistent with high-cost branch structures. Internet banking

offers institutions a means to compete in this new environment. It also offers new risks. Recognizing this

tradeoff, many banks have entered this realm with measured steps. Those who have not face risk of a different

sort. They face instead the risk that their competitive

position will pass to more innovative competitors --

competitors with new technologies and the drive to

accomplish old business in thoroughly new ways.

Gary Ternullo, Senior Financial Analyst

gternullo@rdic.gov

THE DIVISION OF SUPERVISION CLASSIFICATIONS FOR INTERNET BANKS

LEvEL 1 LEvEL 2 LEvEL 3

DESCRIPTION AN INFORMATION-ONLY

SITE

A SITE PERMITTING

ELECTRONIC

SUBMISSION OF LOAN

OR DEPOSIT

APPLICATIONS

TRANSACTIONAL SITE

OFFERING ELECTRONIC

BILL PAYMENT OR FUNDS

TRANSFER SERVICES

SPECIALIST

EXAMINATION

REQUIREMENT

(IN ADDITION TO

SAFETY AND

SOUNDNESS EXAM)

INFORMATION

SPECIALIST REVIEW

REQUIRED ONLY IF SITE

IS TIED INTO INTERNAL

BANK SYSTEMS.

CONSULTATION WITH

INFORMATION

SPECIALIST REQUIRED

TO DETERMINE IF

FURTHER REVIEW IS

WARRANTED.

CONCURRENT

INFORMATION

SPECIALIST EXAMINATION

REQUIRED.

Regional Outlook 8 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

For More In ormation:

Division o Supervision	 DOS currently is implementing examination guidance for safety and soundness examiners and developing training for technical specialists.

Cynthia Bonnette, Examiner

Chairman, New Banking Technologies Task Force

(202) 898-6583

Stephen White, Inrormation Systems Review Examiner

Chairman, Inrormation Systems Subcommittee

Federal Financial Institutions Examination Council Task Force on Supervision

(202) 898-6923

Division o Compliance and DCA is reviewing new banking technologies from a consumer protection, fair lendConsumer A airs ing and CRA perspective to provide guidance on compliance matters. DCA also is

coordinating outreach efforts with consumer community groups.

John Jackwood, Special Assistant to the Director

(202) 942-3854

Regional O ice Contacts	 Michael L. Jackson, Review Examiner (EDP)

Division or Supervision

Chicago Regional Orrice

(312) 382-7582

O ice o Policy Development	 OPD provides leadership in developing FDIC policies, including those addressing

new banking technologies. The office coordinates several interdivisional electronic banking efforts and represents the FDIC on the interagency U. S. Treasury

Consumer Electronic Payments Task Force.

Sharon Powers Sivertsen, Director

(202) 898-8710

Related Web Sites	 FDIC http://www.fdic.gov

FFIEC http://www.ffiec.gov

NETBanker http://www.netbanker.com

Bankweb http://www.bankweb.com

National Computer Security Assoc. http://www.ncsa.com

RSA Data Security Inc. http://www.rsa.com

Smart Card Resource Center http://www.smart-card.com

American Bankers Association http://www.aba.com

Regional Outlook	 9 Second Quarter 1997
 
Regular Features	 Regional Economy
 

Chicago Region's Economy Remains Healthy
 

• 	 Currently high levels of production and tight labor markets suggest that growth in manufacturing output

will be moderate and sustainable in the absence of a national downturn.

• 	 A pick-up that is under way in commercial construction has been accompanied by rapid growth in

construction-related lending by banks and thrifts. To date, new commercial space in the Region appears to

match expanding demand.

• 	 A significant share of low-income households face heavy debt burdens, and these consumers could be

severely strained by rising interest rates or an economic slump.

• 	 The 1996 Farm Bill may start influencing farmers' behavior this year even though many provisions will be

phased in over seven years. Because the legislation reduces protections for farm producers, risk management practices of farmers and their lenders may be tested.

• 	 Given these considerations, insured institutions in the Chicago Region may face moderate loan growth and

continuing problems with portfolio segments such as credit cards.

Production Rebound in 1996 Set the Stage for

Economy in Early 1997

Growth in factory output almost stalled about one year

ago (see Chart 1) because excess inventories held by

auto dealers and other firms necessitated slower production. After this adjustment, manufacturing output

resumed its growth and now is expanding by more than

4 percent annually. This situation is positive for the

Region, which is heavily influenced by developments in

the manufacturing sector.

Evenfso, manyfmanufacturersfinfthefRegionfareffacing

prospectsf off moderatef growth. This condition is the

result of limited additional demand for many types of

manufactured goods in the seventh year of the cyclical

expansion. For example, if auto makers' sales forecasts

of 15.5 million units are realized this year, the associated gain from 1996 will be only 3 percent or so. This

pace pales in comparison with the 8 percent gains in

1993 and 1994, when the cyclical expansion was

younger. In turn, slow growth in the motor vehicle

sector will generate dampening spill­over effects to

steel, tires, glass, and other related industries in the

Chicago Region.

Implications: Growth in commercial and industrial

(C&I) loans (see Chart 1) tends to lag shifts in the pace

of manufacturing activity. Nationwide, C&I loan growth

slowed to 6.7 percent last year from 12.7 percent in

1995. In the Chicago Region, growth slowed a bit less

sharply, to 8.8 percent from 13.7 percent.

If the historical relationship between industrial production and loans shown in Chart 1 continues to hold, a

moderate pick­up in C&I loan growth may develop this

year. This expectation is consistent with findings in the

Federal Reserve's January Survey of Senior Loan

Officers. Recent employment trends (see Chart 2) hint

that demand for loans from the construction and financeinsurance­real estate (FIRE) sectors might expand more

rapidly than from some other sectors if last year's job

trends carry over into 1997.

CHART 1

C10%

C5%

0%

5%

10%

15%

-anCrr-anCrr-anCr0-anC00-anC01-anC02-anC0C-anC0 -anC05-anC0 -anC0r

'&I Loans*

'&I Loans Trail Industrial Production 

Recession

Source: Federal Reserve Board

Percent 'hange from 12 months Earlier

Production

 *lagged 12 months

RegionalfOutlook	 10 SecondfQuarterf1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features	 Regional Economy
 

CHART 2
 

C50 0 50 100 150 200 250

All Other

Services

Wholesale & Retail Trade

Manufacturing

Source: Bureau of Labor Statistics Annual 'hange, Thousands of -obs

Broad Based Slowing of -ob Growth in the 'hicago Region

1005

100 

100 

Job Growth Is Slowing.

Slower growth in demand and production already is

reflected in the job market (see Chart 2). Jobfgainsfin

thef Regionf slowedf tof 292,100f lastf year,f justf over

one-halffasflargefasfinf1995. The softening was broad

based among industries. In fact, 26,700 factory jobs

were lost despite the rebound in manufacturing output.

Only the construction and FIRE sectors saw a pick­up,

but they account for less than 10 percent of the Region's

total employment.

Despitefthefslowingfinfjobfgrowth,fthefRegion'sfunemploymentfratefremainsflow.ffThe 4.5 percent unemployment rate for the Region at year­end reflected tighter

labor­market conditions than nationally, where the rate

was 5.3 percent. As a result of the continuing demand

for workers and the current tightness in labor markets,

wages are being bid up in a number of industries.

Wages of manufacturing employees, for example, rose

by 3.3 percent last year, faster than the 2.9 percent

advance in 1995 and the largest increase since 1991.

.But Wage Gains Raise Policy Concerns

The acceleration in wage gains is just one of many

indicators being monitored by policymakers. In late

March, the Federal Reserve Board responded to persistent strength in demand and the potential risk of inflationary imbalances by raising the target federal funds

rate by 25 basis points. Many banks reacted by raising

their prime rates by an equal amount. The policy action

was the first move toward restraint in more than two

years. Should rates rise significantly in the coming

months, activity in the interest­sensitive manufacturing

sector likely would be dampened.

Implications: Should interest rates continue to rise,

insured institutions could be affected in a number of

ways:

• 	 Loan demand from interest­sensitive industries

likely will weaken, and some borrowers may encounter repayment difficulties.

• 	 Profitability is typically squeezed in a rising­rate

environment because funding costs tend to rise

more quickly than earnings on assets.

• 	 Rising interest rates reduce the market value of

fixed­rate securities.

• 	 Banks that have shifted away from traditional core

deposits as a funding source may face higher and

more volatile funding costs as they borrow at market rates (see Chicago Region Banks and Thrifts

React to Changing Environment).

Mixed Developments in Household Finances

On the surface, high and rising bankruptcy rates in the

Region seem hard to reconcile with low unemployment

rates and generally prosperous economic conditions.

Heavy debt burdens among some higher­risk borrowers

and a late­1994 change in the bankruptcy law, which

was followed by a surge in Chapter 7 filings, help

explain some of the seeming contradiction.

A recent study of consumer finances by the Federal

Reserve suggests that households' currently high debt

obligations do not imply dire macroeconomic implications. For example, the ratio of debt payments to family

income was 15.4 percent in 1995 for all families. This

ratio differs little from 15.8 percent in 1992 and 15.6

percent in 1989. (These statistics reflect the ratio of

debt payments to income for all families, not just those

with debt outstanding.)

Soffarfthisfdecade,fhowever,fdebtfpaymentsfrelativefto

RegionalfOutlook	 11 SecondfQuarterf1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

CHART 3
 

0%

1%

2%

C%

 %

5%

 %

r%

0ecCrr0ecCrr0ecCr00ecC000ecC010ecC020ecC0C0ecC00ecC050ecC0

C15%

C5%

5%

15%

25%

'redit 'ard 'ommitments Fall and 'hargeCOff Rate 'limbs in 'hicago Region

'ommitment Growth* 'hargeCOff Rate

Source: Bank and Thrift 'all Reports * percent changes from quarters ear

incomefhavef risenfforflower-incomeffamilies.ffAmong

families with incomes less than $10,000, debt payments

increased from 16.2 percent of income in 1989 to 21.1

percent in 1995. Thef sharef offfamiliesfwithfincomes

betweenf $10,000f andf $24,999 andf debtf payments

equalftof40fpercentforfmorefoffincomefroseffromf13.9

percentfinf1989ftof16.9fpercentfinf1995.

In contrast, high­income families experienced an easing

of debt­payment burdens over the same period. Mortgage real estate financing accounted for a good deal of

the decline. Thesef divergentftrendsfreflectfthatf debt

loadsf off low-incomef groupsfaref alreadyf quitef heavy

andfsuggestfthatfthefrepaymentfabilityfoffthesefhouseholdsf couldf bef severelyf strainedf iff incomef growth

falters.

Problems with consumer credit have been well documented. Creditf cardf charge-offsf remainf af concern

(see Chart 3) becausef thefdeteriorationfinfthesefloan

portfoliosf hasf occurredf despitef favorablef economic

conditions. Past-duefresidentialfmortgagefloans have

increasedfinftandemfwithfcreditfcardfdelinquencies. In

the Midwest (which covers the FDIC's Chicago and

Kansas City Regions), conventional mortgage loans

past­due by 30 days are currently below their early

1996 peak but remain elevated at 1.71 percent. Associated with this rise has been a recent increase in the rate

of initiated foreclosures to 0.14 percent from a low of

0.08 percent two years ago.

Implications: Growth in credit card commitments has

slowed in this Region since warning signals developed

over one year ago (see Chart 3). Nevertheless, commitments in this Region stand about seven times larger than

balances outstanding, thus generating large potential

exposure for some institutions. If the economy should

slump, the quality of this portfolio could worsen despite

the corrective actions already undertaken by banks and

thrifts.

Some institutions are reacting to the increased riskiness

of, and increased competition for, unsecured consumer

loans by encouraging customers to switch to home equity loans. The latest Federal Reserve Survey of

Senior Loan Officers, however, reported that about

one­third of the responding institutions also eased standards recently for home equity loans, in some cases

because they were entering the market for low­ or

no­equity loans. Other reports suggest that a few

lenders (not necessarily banks or thrifts) are allowing

very aggressive loan­to­value ratios on home equity

loans.

Commercial Real Estate Has Perked Up

CHART 4

10

12

1 

1 

1r

20

0ecCr 0ecCrr0ecCrr0ecCr00ecC000ecC010ecC020ecC0C0ecC00ecC050ecC0

Source: Bank and Thrift 'all Reports

Recession

Real Estate 'onstruction Loans Are on

the Rise in the 'hicago Region� Billion

RegionalfOutlook 12 SecondfQuarterf1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

TABLE 1
 

VACANCY RATES ARE MIXED FOR COMMERCIAL REAL ESTATE

1990 1991 1992 1993 1994 1995 1996

SUBURBAN OFFICES

CHICAGO 20.4 19.8 19.3 18.1 16.0 13.0 11.6

CINCINNATI (OH·KY·IN) 21.1 21.5 20.3 17.8 15.7 13.8 11.2

CLEVELAND 19.2 18.6 17.1 15.5 13.2 11.7 10.0

COLUMBUS 19.3 17.5 14.1 10.4 8.8 8.3 8.7

bETROIT 19.8 20.1 20.6 19.1 17.3 14.2 10.6

INDIANAPOLIS 23.3 23.5 21.8 19.2 14.9 11.4 8.4

MINN.·ST.PAUL (MN·WI) 21.6 20.5 18.7 13.8 10.6 8.4 6.0

ST. UOUIS (MO·IU) 14.8 14.3 13.6 12.0 8.3 8.4 7.1

bOWNTOWN OFFICES

CHICAGO 14.0 15.0 17.9 19.7 18.6 17.9 16.4

CINCINNATI (OH·KY·IN) 12.3 15.2 15.7 15.8 14.7 14.7 14.3

CLEVELAND 12.8 18.8 22.3 22.7 21.4 19.1 17.8

COLUMBUS 12.3 12.5 12.4 10.8 7.0 6.7 7.5

bETROIT 13.2 14.6 16.0 19.8 21.0 20.2 20.4

INDIANAPOLIS 20.2 19.7 20.5 20.0 20.5 17.7 17.3

MINN.·ST.PAUL (MN·WI) 15.6 16.5 19.2 16.3 12.0 10.5 9.0

ST. UOUIS (MO·IU) 21.9 22.6 21.3 20.2 19.6 18.1 18.1

INbUSTRIAL SPACE

CHICAGO 8.0 9.8 10.5 9.2 8.2 6.7 7.4

CINCINNATI (OH·KY·IN) 3.5 3.8 6.1 5.6 4.1 2.8 3.0

CLEVELAND 8.5 7.7 8.8 11.4 9.5 6.8 7.1

COLUMBUS 5.8 6.5 6.2 3.7 3.8 6.0 7.1

bETROIT 3.1 4.7 5.3 7.3 6.4 4.8 4.9

INDIANAPOLIS 7.4 6.7 6.3 4.8 4.1 4.1 5.2

MINN.·ST.PAUL (MN·WI) 5.9 7.0 5.8 4.0 3.4 3.9 4.1

ST. UOUIS (MO·IU) 3.9 2.6 2.4 4.2 5.3 5.5 4.2

SOURCE: CB COMMERCIAL PROPERTY INFORMATION SYSTEMS

Expanding commercial real estate activity in the

Chicago Region is in line with national trends. Among

thef Region'sf banksf andf thrifts,f thisf expansionf has

triggeredf af 42f percentf increasef inf constructionf and

landfdevelopmentfloansfsincefearlyf1994 (see Chart 4

previous page).

Declining vacancy rates for offices illustrate that space

added in the past few years has been quickly absorbed,

especially in suburban markets (see Table 1). Vacancy

rates for industrial space, in contrast, generally edged

up in the past year or two. The industrial vacancy rate

for Columbus, though, has almost doubled since 1993,

shifting from the lowest in the Region to among the

highest. The upturn is widespread among major cities

and suggests that construction in recent years may have

supplied sufficient industrial space to meet much of the

Region's current needs.

Table 1 illustrates that vacancy rates vary widely among

cities over extended periods of time. Consequently,

attention should be paid not only to the vacancy rate

level when evaluating conditions in a specific market

but also to its direction and rate of change.

Implications: One lesson of the 1980s is that commercial real estate projects have a long gestation period.

During this time period, a market's balance between

supply and demand can shift dramatically and weaken

borrowers' ability to service associated debt. Therefore, the combination of rapid construction growth and

rising vacancy rates (in any area and for any type of

building) should be regarded as a cautionary signal.

Reports of increased construction on a speculative basis

(i.e., lacking meaningful "take­out" financing or occupancy commitments) or of minimal equity involvement

by developers also would raise concerns. To date,

however, the FDIC's surveys of underwriting standards

suggest that banks and thrifts are not participating significantly in the trend of rising speculative construction that

has been mentioned in the press.

RegionalfOutlook 13 SecondfQuarterf1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

Agriculture in Transition

Inf thef aftermathf off lastf year'sf volatilef grainf prices

andfproblemsfwithfhedgingfcontracts,ftheffarmfsector

nowf facesfsomef significantf changesf inf federalf farm

programs.ffThe seven­year adjustment period under the

1996 Farm Bill will be one for learning how to manage

potentially greater income volatility and perhaps new

types of risk. Fortunately, most sectors of the agricultural economy are in a healthy condition as this transition gets under way.

Last season, prices for corn, soybeans, milk (see Chart

5) and hogs all rose significantly and helped boost net

farm income. Various reports indicate that high crop

prices also drove up prices for farmland. In the year

ending in September 1996, the value of good farmland

climbed by 14 percent in Illinois and 12 percent in

Indiana, according to the Federal Reserve Bank of

Chicago. The rate of appreciation softened in the

second half of the year as crop prices retreated from

their peaks. Evenfso, midwesternffarmlandfpricesfhave

beenfonfthefrisefforfthefpastffivefyears.

Implications: Farm incomes may become more volatile

and farmers may face additional pressure to hedge in

response to reduced protection from the government.

Some farmers are comfortable using instruments such as

futures contracts and options to establish prices for

crops not yet harvested, but others are not. In fact, some

producers may be increasingly reluctant to use available

hedging tools after recent difficulties with hedge­toarrive contracts.

CHART 5
 

1

C

5

r

0

11

-anCr0 -anC01 -anC0C -anC05 -anC0r

Beans and 'orn

r

10

12

1 

1 

Milk

Milk

'orn Soybeans

Source: U.S. 0epartment of Agriculture

� per Bushel

Recent Volatility in Grain and Milk Prices

� per 'wt

Farmers may turn to their bankers, among others, for

help in learning how to manage their liquidity and risks

in the new environment. Bankers may need to consider

whether steps taken by farmers sufficiently protect

against downside risks and whether credit terms need to

be adjusted to adequately protect the lender.

JoanfD.ffSchneider,fRegionalfEconomist

RegionalfOutlook 14 SecondfQuarterf1997
 
Regular Features	 Financial Markets
 

Financial Markets
 

• 	 While demand for asset-backed securities continues to be strong, further deterioration in consumer credit

quality could have adverse effects on both investors and issuers.

• 	 Although there has been little net change in the Treasury yield curve between September 30, 1996, and

early March 1997, rates in the 5-year to 30-year segment of the yield curve did fluctuate modestly during

this time period.

• 	 During the fourth quarter 1996, the S&P Composite Bank Index and the Chicago Region's Bank Index

(CRBI) both outperformed the S&P 500, gaining 12 and 11 percent, respectively, compared to an almost 8

percent gain for the S&P 500. So far in 1997, the CRBI has lagged the S&P Composite Bank Index.

• 	 Banks' price/earnings ratios relative to the broader market have been trending upward since 1994,

perhaps signaling an improved perception of the quality of bank earnings.

The Asset-Backed Securities Market: The CHART 1

Effects of Weakened Consumer Loan Quality

Asset­backed securities (ABS) are debt securities that

are backed by loans such as credit cards, car loans, and

home equity loans. Over the past ten years, the ABS

market has grown dramatically. In 1996, the issuance of

ABS was $167 billion, up from $65 billion issued in

1993 as illustrated in Chart 1. Commercial banks and

credit card companies accounted for approximately 35

percent of total ABS issuance last year. Major buyers

of ABS were mutual funds, insurance companies, corporations, and foreign and domestic banks. Although it is

difficult to quantify the amount of bank investment in the

ABS market, market participants have observed that

small and midsized banks have recently increased their

holdings of ABS.

Monoline credit card banks and large banks with significant credit card operations have been particularly active ABS issuers. Issuing banks generally structure

ABS transactions as nonrecourse sales (loans that cannot be "put back" to issuers upon default), which results

in the removal of the assets from the bank's balance

sheet and lowers capital requirements. In order to

receive investment grade ratings on their ABS, issuers

must provide credit support either in the form of overcollateralization, reserve accounts, or third party credit

enhancement from bond insurers.

Bank issuers benefit from the sales treatment of assets

into the security without completely severing their economic interest in the income generated by the assets.

The economic interest results when the revenue generated by the sold assets after charge­offs, servicing fees,

0

25

50

75

100

125

150

175

1993 1994 1995 1996

ABS Issuance Is on the Rise

Source: Bloomberg, nside MBS and ABS

$ Billion

Credit Card 

Auto 

Home Equity

 ther 

and interest coupon payment is recognized as income by

the issuer. This surplus is referred to as excess spread.

Banks that issue ABS usually continue to service the

underlying assets, which not only generates servicing

income but also permits customer relationships to continue.

Delinquency and charge­off rates rose in 1996 on consumer loans, particularly in credit cards and auto loans.

Despite this rise, the difference between ABS and Treasury yields of similar maturity did not increase. As

Chart 2 (next page) shows, the average spread to the

two­year Treasury note on selected ABS products continued to tighten during 1996. The lack of widening

spreads despite the overall weakening in consumer

credit quality reflects strong demand from an expanding

investor base, which increasingly includes overseas

Regional Outlook	 15 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

buyers. Spreads on selected credit card and auto ABS

products began to increase during the first quarter of

1997, however, as investors reacted to higher than

expected charge­offs reported by some of the larger

issuers.

The increasing frequency of rating agencies' reviews for

possible downgrades of credit card transactions, as

well as problems in the auto finance sector, have raised

some concerns in the ABS market. How would a further

deterioration in consumer credit affect the ABS market?

For the issuer, higher charge­offs, absent a corresponding increase in fees or rates, reduces the excess spread

from the ABS. If deterioration worsens, the ABS face

potential rating downgrades. This situation may compel

the issuer to improve the overall loan quality in the ABS

or face what is termed an "early amortization" event.

An early amortization event may result in the termination

of the ABS issue prior to the maturity date. Once an

early amortization occurs, new receivables associated

with the accounts in the asset­backed security no longer

move into the security but must be funded by the bank on

their balance sheet and accounted for in determining

capital requirements. In addition, an issuer's access to

the ABS market may become more costly after an early

amortization if investors demand higher yields on subsequent issues.

For the investor, the threat of a ratings downgrade

usually impairs the market value of the security. Investors also may forfeit some interest income in an early

amortization because principal may be paid prior to the

scheduled maturity date. ABS investors would lose

principal, however, only if the deterioration in the

quality of the underlying loans is severe enough to

deplete the entire credit support. The high level of

credit support demanded by rating agencies on existing

CHART 2

ABS deals minimizes the risk of principal loss by

investors.

During 1996, some bankcard issuers took steps to prevent a ratings downgrade or a possible early amortization. Methods used by bank issuers to support deteriorating ABS have included the sale of new receivables at

a discount, the repurchase of low quality receivables

from the issue, and the infusion of additional cash into a

reserve account of the ABS. However these strategies

were specifically cited by the Office of the Comptroller

of the Currency (OCC) as actions that could be considered recourse and require full risk­based capital treatment for the assets in the particular ABS issue. The

FDIC is working with other regulatory agencies through

the Federal Financial Institutions Examination Council

(FFIEC) on new Risk­Based Capital Guidelines that are

expected to address limitations on post­sale actions and

capital requirements for direct credit substitutes or

credit enhancements for ABS.

Given the continuing trend of higher charge­offs and

delinquencies for credit card loans, investors consider

the ABS market less homogeneous in terms of issuer

quality and therefore are scrutinizing the securitizations

of issuers more closely. Although the risks vary by ABS

issuer, banks that issue or invest in the ABS market

should be cognizant of the changing market conditions

and potential risks associated with ABS.

Changes in Interest Rates and Bond Values

Chart 3 (next page) shows little change in the Treasury

yield curve between September 30, 1996, and early

March 1997. What this chart does not show, however,

is how rates in the 5­year to 30­year segment of the yield

0

25

50

75

100

125

150

175

3§20§97

12§16§96

6§3§969§9§96

2§26§96

11§20§95

 §14§95

5§ §95

1§30§95

10§24§94

4§11§947§1 §94

1§3§94

2§17§925§25§92 §31§9212§7§923§15§936§21§939§27§93

11§11§91

 §5§91

1§21§914§29§91

Comparison of Spreads to Treasuries for Asset-Backed Securities -- 2-Year Maturity

Auto

Card

Source: Prudential Securities

Basis Points

Home Equity

Regional Outlook 16 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

CHART 3 CHART 4
 

-4%

-2%

0%

2%

4%

4- ct

1 - ct

1-zo6

15-zo629-zo6

13-0ec27-0ec

10--an24--an

7-Leb

21-Leb

7-Mar

-0.5%

-0.3%

-0.1%

0.1%

0.3%

0.5%

Model

Portfolio

Source: Bloomberg

5-year

Treasury

Model Portfolio's Value Relati6e to 5-Year

Treasury Yield (Percent Change) Treasury Yield Cur6e Shows Little

Change Since September 30, 1996

5.0%

5.2%

5.4%

5.6%

5. %

6.0%

6.2%

6.4%

6.6%

6. %

7.0%

3-mo. 2-yr. 7-yr. 30-yr.

3§12§97

12§31§96

9§30§96

Source: Bloomberg

curve fluctuated during this time period. The path of

yields on Treasury bonds with 5­year through 30­year

maturities changed directions four times, rising or

falling by more than 30 basis points. Movements in the

shorter segment of the yield curve have been less pronounced.

In order to consider the effect that these rate swings may

have had on banks' fixed income portfolios, Chart 4

shows the percent change in the yield on the 5­year

Treasury and the percent change in the market value of a

model bank portfolio created by the Division of Insurance. The presentation of this model portfolio extends

an analysis that was introduced in the first quarter 1997

edition of the Regional Outlook, which looked at the

market values of several common fixed income instruments relative to interest rate movements.

TABLE 1

In order to enhance the model portfolio's applicability

to bank portfolios, the type and amount of the securities

chosen for the portfolio are based on an aggregation of

securities­related Call Report data. The limitations of

Call Report data concerning the maturity distribution of

securities required that assumptions be made when

choosing the maturity of the securities for the model

portfolio. An effort was made, however, to construct a

model portfolio that approximates, in the aggregate, the

maturity distribution of the aggregate commercial bank

portfolio. The model portfolio is shown in Table 1.

As shown in Table 1, the total market value of the

portfolio changed less than one­half of 1 percent since

September 30, 1996. The portfolio's period­high value,

representing a 1.51 percent increase from September 30,

1996, occurred on November 29, 1996, when the 5­year

TYPE OF SECURITY PAR

VALUE

PERCENT

OF

PORTFOLIO

MATURITY

OR

WAL

PERCENT

CHANGE

FROM

9/30/96

TO

12/31/96

PERCENT

CHANGE

FROM

12/31/9

6 TO

3/12/97

PERCENT

CHANGE

FROM

9/30/96

TO

3/12/97

U.S. TREASURY 5.6% 2,000 20% 1YR 0.35% •0.05% 0.30%

FNMA AGENCY 5.8% CALLABLE 1,200 12% 2YR 0.59% •0.25% 0.34%

STATE COUNTY MUNICIPAL GO 4.8% 800 8% 11YR 1.95% •0.64% 1.95%

FNMA MORTGAGE PASSTHROUGH 7.5% 3,000 30% 8YR 1.08% •0.30% 0.78%

FNMA (REMIC) 8.0% PAC 2,000 20% 2.5YR 0.58% •0.68% •0.10%

CREDIT CARD ASSET•BACKED SECURITY 1,000 10% 5YR 0.10% 0.00% 0.10%

TOTAL 10,000 100% 4.85YR 0.77% •0.29% 0.48%

Regional Outlook 17 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

Treasury rate fell to its period­low

of 5.83 percent. Observe that,

while longer term rates fluctuated

modestly over the reporting period,

the reasonably short weighted average life (WAL) of the portfolio

further moderated the value

changes sustained by the portfolio.

Changes in the value of the model portfolio demonstrate

a higher correlation to changes in the 5­year Treasury

yield than to other maturities along the yield curve

because the 5­year bond's maturity better matches the

WAL of the model portfolio. Even though the 30­year

Treasury rate is often cited as a benchmark for daily rate

changes, it may not be the most significant rate in

assessing exposures of bank securities portfolios to

changes in interest rates.

On March 25, 1997, the Federal Reserve Open Market

Committee met and raised the target federal funds rate

25 basis points to 5.50 percent. By the following day,

the 5­year Treasury yield had risen to 6.66 percent, 23

basis points higher than the 5­year Treasury yield dated

March 12, 1997, displayed in Chart 3 (previous page).

The rise in rates from March 12 to March 26 caused the

model portfolio's market value to fall 0.56 percent to

$9,965.

This model portfolio will be used regularly to show the

effects on bond values of interest rates movements from

quarter to quarter. It also will be used from time to time

to illustrate how investment choices that portfolio managers make concerning duration, optionality, and other

risk factors affect a portfolio's relative volatility.

Banks' Stock Prices and Price/Earnings Ratios

Continued to Rise in 1996. Is the Market ImCHART 5

proving its Perception of the Quality of Bank

Earnings?

During the fourth quarter of 1996, the S&P Composite

Bank Index outperformed the S&P 500, gaining over

12 percent compared to an almost 8 percent gain for

the S&P 500. The fourth quarter results topped off a

year during which the S&P bank index gained 37 percent

compared to a 19 percent gain for the S&P 500. As

shown in Chart 5, the Chicago Region's Bank Index

(CRBI) gained a little less than 11 percent in the fourth

quarter 1996. The CRBI gained 25 percent for the full

year 1996: enough to outperform the S&P 500 but not

the S&P Composite Bank Index. The year's moderate

economic growth, contained inflation, and favorable

interest rates are credited for providing a friendly environment for bank stocks. As 1997 began with much the

same economic conditions, bank equities have continued

to do well. The CRBI has gained 15 percent compared

to almost an almost 20 percent gain for the S&P composite bank index and a 9 percent gain for the S&P 500

through March 7, 1997.

While appreciating stock prices provide an obvious

positive signal about the health of the industry, the

market provides other information about the prospects

for the industry through the price/earnings (P/E) ratio.

The P/E ratio presents the price of a company's stock as

a multiple of its earnings per share and is derived by

dividing the stock's market value by the company's

earnings per share. Typically investors are willing to

pay a higher price for a company with earnings that are

expected to be consistent and growing. However, firms

with more volatile earnings are generally penalized by

investors in terms of stock price and lower P/E ratios.

Generally, a higher P/E ratio can be interpreted to mean

that investors have more confidence in the outlook for

0%

10%

20%

30%

40%

30-Sep

11- ct25- ct

-zo6

22-zo6

6-0ec

20-0ec31-0ec

10--an24--an

7-Leb

21-Leb

7-Mar

S&P 500

Chicago Region's Bank Index

S&P Bank Index

Source: Bloomberg, American Banker

Change from 9§30§96

The Chicago Region's Bank Index utperformed the S&P 500 but not the S&P Bank Index

Regional Outlook 18 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

future earnings performance.

The relationship between bank P/E ratios and the P/E

ratios for the broader market provides further insight

into the market's perception of the quality of bank

earnings compared to other firms. Historically, bank

P/E ratios have been lower in the aggregate as compared to the rest of the market. The rationale posed for

this discounted bank P/E ratio relative to the broader

market has been that the primary sources of bank revenue, deposit taking and lending activities, traditionally

have been viewed as being more volatile because they

are prone to rising and falling with changes in the

business cycle. For example, despite recording some of

the highest quarterly return on equity averages ever at

the end of 1993, the P/E ratio of the major regional bank

index was at a level that was still only about 50 percent

of the broader market P/E.

Over the past two years the magnitude of the banking

sector's P/E discount has declined. As seen in Chart 6,

the P/E discount has gone from 50 percent to only 24

percent (a relative P/E ratio of 76 percent). The higher

P/E ratio may represent a view by market participants

that bank earnings are becoming less sensitive to the

business cycle, perhaps as a result of geographic or

product­related diversification and more efficient management of overhead expenses. Another factor contributing to higher bank P/E ratios could include speculation on bank stocks as investors anticipate potential

CHART 6
 

45%

55%

65%

75%

 5%

0ec-93

Mar-94

-un-94

Sep-940ec-94

Mar-95

-un-95

Sep-950ec-95

Mar-96

-un-96

Sep-960ec-96

Mar-97

S&P Major Regional Bank Index's

Relati6e P§E Ratio Is Rising

P§E Major Regional Banks § P§E S&P 500

Source: Bloomberg 

acquisitions.

Allen Puwalski, Banking Analyst

Kathy R. Kalser, Chief,

Financial Sector Analysis Section

Regional Outlook 19 Second Quarter 1997
 
Regular Features	 Regional Banking
 

Chicago Region Banks and Thrifts React to Changing
 

Environment
 

• 	 The condition of insured institutions in the Region remains sound, but structural changes may challenge

existing internal control systems.

• 	 The Region's banks and thrifts have reduced growth rates in consumer lending, but other loan portfolio

segments experienced substantial growth in 1996. Overall, loans increased over 7 percent for the year.

• 	 Funding strategies also are changing, with noncore sources playing a more important role.

• 	 Without sufficient planning, insured institutions and their customers may be adversely affected by the Year

2000 problem, as costs to correct related flaws in computer systems are expected to increase as the

Overview

On an aggregate basis, the Region's banks and thrifts

continue to reflect relatively strong financial conditions

(see Chart 1). During 1996, they:

• 	 maintained leverage capital at about 8 percent of

average assets despite a significant increase in

dividends paid;

• 	 improved their aggregate return on assets to 1.1

percent; and

• 	 except for consumer loan portfolios, reported low

nonperforming and past­due asset levels.

Overall performance was positively influenced by a

stable economy in the Region and is impressive in light

of the significant structural shifts now occurring in the

banking industry. Among these are:

CHART 1

0

1

2

3

4

5

6

7

8

9

Return on

Assets

Net Interest

Margin

NPA* to

Assets

Tier 1

Leverage

Chicago Region Institutions Continue to Show 

Financial Strength

Source: Bank and Thrift Call Reports Percent 

* Nonperforming Assets

1994 1995 1996

• 	 industry consolidation (the Region has 702 fewer

insured institutions today than six years ago);

• 	 technological advances; and

• 	 increased competitive pressures from nonbank

lenders.

In order to manage the effects of these changes and

maintain profitability, the Region's institutions have

altered growth patterns in their loan portfolios and

funding bases. While these changes may make banks

and thrifts more competitive, they also are likely to

challenge existing internal control systems.

Institutions Shift Growth Emphasis from Consumer Lending

A slowing of consumer loan growth is one notable

example of changing lending patterns. Consumer portfolios (including credit cards) remained weaker than other

loan portfolio segments throughout 1996. Weaknesses

included rising charge­off rates and past­due loan levels

(see Chart 2 next page). The Chicago Region's institutions reacted to concerns with these loans in various

ways, including:

• 	 reviewing and improving underwriting standards;

• 	 selling loans through the securitization process; and

• 	 converting unsecured credits into home equity

loans.

These actions, in addition to possible changing consumer behaviors in the Midwest and competitive pressures from nonbanks, resulted in a substantially reduced

rate of growth (1 percent) for consumer portfolios in

1996. This pull­back is consistent with how insured

Regional Outlook	 20 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

CHART 2
 

0%

5%

10%

15%

20%

0ecq900ecq910ecq920ecq930ecq940ecq950ecq96

1.0%

1.5%

2.0%

2.5%

3.0%

4 uarter

 rowth

Source: Bank and Thrift Call Reports

Chicago Region Consumer Lending Cools as

ChargeqOffs Increase uarterl 

Chargeqoffs

institutions have historically reacted to problems in

other segments of their portfolios, such as construction

and commercial real estate in the late 1980s and early

1990s.

With consumer lending falling off, the Region's institutions focused on growth in commercial loans and residential real estate loans (both increased between 8

percent and 9 percent in 1996). In addition, some

smaller portfolio segments showed even higher growth

rates. These include:

• Construction/Development 14 percent

• Home Equity Loans 14 percent

• Lease Financing 35 percent

Lease financing activity is currently centered in larger

institutions (mostly in Ohio), while construction and

home equity loan growth is widespread among small

and large institutions throughout the Region. For example, over one­third of insured banks and thrifts in the

Region had growth rates of 30 percent or greater in

construction loans during the year. Though many

continued to reflect minimal exposures in this area,

over 300 Chicago Region institutions had aggregate

real estate construction loans that exceeded 50 percent of Tier 1 capital at year­end 1996.

Implications: Loan production emphasis will likely

continue to shift between different lending segments

based upon economic conditions, available expertise,

and perceived profitability. Shifting emphasis and rapid

growth rates are not necessarily precursors to future

problems. However, growth may place stress on insured institutions' management and control systems.

Therefore, bank and thrift managers should ensure that

loan production does not outpace underwriting and loan

review resources.

Given past problems with commercial real estate lending, recent construction loan growth is of special interest (see Chicago Region's Economy Remains

Healthy).

Funding Patterns also Are Changing

Loan growth and changing funding strategies have resulted in an aggregate loan­to­deposit ratio of about 90

percent for the Region at year­end 1996 ­­ an all­ time

high for the decade (see Chart 3). Nearly one­half of

institutions in the Region reported loan­to­deposit ratios

exceeding 75 percent at year­end 1996 (see Chart 4 next

page). About one­half of this group were small banks

(under $100 million in assets).

Loan­to­deposit ratios normally have increased during

periods of economic growth because lending tends to

pick up. Banks also are now relying more on noncore

sources to fund this growth (see Chart 5 next page). The

current emphasis on noncore funding appears to be due,

in part, to stiff competition from financial service companies. These entities have made numerous alternative

investments available to consumers who traditionally

invested in insured deposits.

In addition, banks have found some noncore funding

cheaper than raising deposits. This situation may be

especially true in the Chicago Region where large banks

in some major metropolitan areas tend to pay higher

rates on certificates of deposit than the U.S. average.

Some of the funding sources used as alternatives to core

deposits include foreign deposits, large time deposits,

short­term debt, and Federal Home Loan Bank (FHLB)

advances. While only the largest institutions tend to use

CHART 3

55

65

75

85

95

0ecq900ecq910ecq920ecq930ecq940ecq950ecq96

LoanqtoqAssets

Loanqtoq0eposits

Source: Bank and Thrift Call Reports

Rising Loanqtoq0epositVAsset Ratios Indicate

Structural Change in the Chicago Region

Percent

Regional Outlook 21 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

items such as foreign deposits, FHLB debt has become CHART S

rather common. Nationwide, almost 4,000 commercial

55%

60%

65%

70%

75%

0ecq900ecq910ecq920ecq930ecq940ecq950ecq96

Core 0eposits to Assets

15%

20%

25%

30%

35%

Noncore Funding to Assets

Core 0eposits

Noncore Funding

Source: Bank and Thrift Call Reports

Chicago Region Institutions Alter Funding 

Strategies

banks were members of the FHLB system as of September 30, 1996.

Implications: In the aggregate, Ohio institutions have the

Region's highest loan­to­deposit ratio, exceeding 100

percent. However, a number of banks and thrifts in the

Region show this structural shift toward more noncore

funding. This trend may continue if insured institutions

continue to face intense competition for deposits.

Increased use of noncore funding may lead to more

volatile funding costs in a rapidly changing interest rate

environment. However, some noncore sources, such as

longer­term FHLB advances, can be relatively stable.

Another mitigating factor is that institutions dependent

upon noncore funding generally have loan portfolios concern primarily relates to the fact that the year portion
 with a sizable amount of consumer­related credits. The
 

cash flows from the amortization and sale of these

instruments can provide a substantial source of liquidity

for individual institutions. Securitization of consumer

mortgage and credit card debt also may establish more

favorable avenues for obtaining funding.

Thus far, the described funding changes have not impeded aggregate loan production or adversely affected

liquidity. Nevertheless, it is important that bank and

thrift managers recognize changes to funding structures

and ensure procedures are in place to adequately assess

and manage liquidity risk, especially if an institution

obtains a large portion of funding from limited sources.

Recognizing Risks and Costs Related to Year

2000 Conversions

Significant concern has been registered over the potential impact of the year 2000 on computer systems. This

CHART 4

Trend Toward Higher Loanqtoq0eposit Ratios is

W idespread
 Ratio
 100%

of dates in many computer systems is represented by just

two digits (i.e., 96 for 1996). Therefore, some systems

may interpret the date 01/01/00 as January 1, 1900,

rather than January 1, 2000.

The effect on financial institutions may be especially

significant because of their heavy use of computer technology. For example, deposit records, loan records,

and management reports may be inaccurate if this flaw is

not corrected. In addition, bank customers may experience similar problems that have the potential to disrupt

their ability to conduct business or repay their debt.

During the second half of 1996, the Financial Accounting Standards Board Emerging Issues Task Force

reached a consensus on the accounting treatment for this

issue. In summary, it requires that both internal and

external costs associated with modifying internal­ use

software to address the year 2000 problem be charged

to expense as incurred.

Implications: Costs related to correcting any computer

system flaws related to the Year 2000 will vary from

firm to firm. Some experts estimate that costs may range

from 50 cents to $1.50 per line of code. Those who

delay are likely incurring much larger expenses.

< 50%

80%

Percentage of Institutions

While these costs may be significant, lack of attention to
 

this issue may be much more costly in terms of business
 

disruption, potential computer systems failures, and
 

degradation of financial control systems. Banks and
 

thrifts should have appropriate plans in place to correct
 

any significant flaws in their computer systems. In that
 

50 q 65% 60%

65 q 75% 40%

20%

75% +

0% regard, the FDIC's Division of Supervision recently
 

issued Year 2000 Workprogram Procedures to assist
 

examiners in raising the awareness of insured institu1990 1991 1992 1993 1994 1995 1996

Source: Bank and Thrift Call Reports

Regional Outlook 22 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

tions to the potential problems surrounding this issue.

Publicity Surrounding Subprime Lending Highlights Areas of Concern

Several subprime lenders have experienced difficulties

lately. Problems noted have primarily revolved around

the adequacy of reserves for their higher risk loan

portfolios.

Estimated volumes of subprime lending activity have

varied widely. Some news accounts estimated subprime mortgage lending at over $120 billion, while

subprime new and used auto loans were estimated at

over $70 billion in 1996.

Much of this type of lending activity is conducted by

nonbank entities. However, insured institution involvement in the form of direct loans and backup lines of

credit to independent finance companies may be growing. In addition, some banking companies, seeing the

potential for substantial profits, have directly entered

this market.

Implications: The onslaught of bad press may have

some fallout effect. In the short­term, this fallout could

negatively affect the value of asset­backed securities

related to subprime loans. In addition, insured institutions that directly participate in this market also may be

affected by a reduced ability to securitize and sell

subprime loans at an acceptable price.

John D. Weier, Senior Regional Analyst

Carol E. Rada, Examiner, Division of Supervision

Regional Outlook 23 Second Quarter 1997
 
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