FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1997
 

FDIC DALLAS
 

REGION
 

DIVISION OF
 

INSURANCE
 

ALAN C. BUSH,
 

SENIOR REGIONAL
 

ANALYST
 

ADRIAN R. SANCHEZ,
 

REGIONAL ECONOMIST
 

JEFFREY A. AYRES
 

FINANCIAL ANALYST
 

In Focus This Quaitei
 

• Will Credit Scoring Transform the Market for SmallBusiness Lending? - In an effort to reduce the cost of small-business lending,

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.

• Banking on the Internet: New Technologies, New

Opportunities, New Risks - Internet banking promises a wide range of new

benefits. It also offers a host of new problems and some new twists on old ones. The

tradeoff is one that depository institutions and regulators alike must grapple with as

they stake out their positions in cyberspace. See page 7.

Regu[ai Featuies
 

+Financial Markets +Regional Banking

+Regional Economy · Asset-Backed Securities · Overall Conditions

 · Slower Job Growth · Bond Values · Number of Banks

 · Growth in Exports · Price/Earnings Ratios · Ag Banks in Oklahoma

 · High-Tech Exports · Challenges for Ag Banks

 · Construction in Denver

 · Retail and Apartments

See page 15 See page 20

See page 11

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 Dallas Region's Regional

Outlook, please call Alan Bush at (214) 220-3434 or send an e-mail to abush@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.

Commercial bank small­business lending exposures in

the Dallas Region are considerable. (For purposes of

this article, small­business lending refers to loans categorized as commercial and industrial loans with original

amounts of $1 million or less reported on the June Call

Reports.) At mid­year 1996, commercial banks in this

Region reported nearly $17 billion of small­business

loans, amounting to 37 percent of all commercial and

industrial loans. This is an increase of $1.1 billion or 7

percent from one year ago. There are 501 banks in the

Region with small­business loan exposures exceeding

100 percent of equity, and 113 banks with exposure

exceeding 200 percent of equity.

Small banks, those with assets under $1 billion, have a

substantial 65 percent share of the Regions' smallbusiness loans. In fact, almost one­half of all commercial and industrial loans of these institutions were loans

less than $100,000 (see Chart 1 next page). Small

banks' market share in this area may come under pressure, however. In Oklahoma and Texas, for example,

some large banking companies have announced nationwide programs to increase their market share of smallbusiness lending. Several of these companies reportedly are offering pre­approved and pre­qualified credit

through the use of credit scoring.

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. Based upon the enormous volume of

historical information on consumers contained in credit

bureaus, model developers link incidences of good and

bad credit performance with borrower characteristics.

Applicants then are compared to these credit performance indicators in order to make credit extension

decisions. While credit scoring has helped consumer

lenders reduce origination costs and to grow receivables at rapid rates, the recent rise in credit card

charge­offs has raised concerns about the effectiveness

of such models, or at least about how the models are

being used.

Small­business credit scoring is a relatively new concept in scoring technology, but is gaining more attention

from lenders. Small-business credit scoring models

are similar to consumer credit scoring models in one

significant aspect -- the most important indicator of

Regional Outlook	 3 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

CHART 1
 

Over $1 000 000

$250 000 - $1 000 000

$100 000 - $250 000

Under $100 000

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Over $1 000 000

$250 000 - $1 000 000

$100 000 - $250 000

Under $100 000

Small Banks Have Carved Out a Niche in Small-Business Lending

(Distribution of Commercial and Industrial Loans)

Source: June 30 1996 Bank Call Reports

Banks under $1 Billion in Total ,ssets

Banks over $10 Billion in Total ,ssets

credit performance is the credit profile of the principals of the business derived from consumer credit

bureau information. Other business information from

companies such as Dun and Bradstreet Corporation and

Experian (formerly TRW) also is used in the scoring

process.

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 small­business 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 involved 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 inTable 1 is representative of

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

significant 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 small­business loans.

WhatfArefthefRisks?

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
 

Small­business 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 small­business lending raises the possibility that

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 out­ofterritory 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). 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 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, small­business 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 small­business 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

CHART 2
 

Business Dissolution Rate Shows Early Risk

100%

80%

60%

40%

20%

0%

Years

Source: Small Business ,dministration

53%

Cumulative Dissolution Rates

24%

62%

71%

80%

1 2 3 4 5 6 7 8 9 10

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 small­business lending are

increasing not only because of large banks' efforts to

expand their lending but also because of greater participation 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 other services such as consulting, accounting and

investment services. Some observers have suggested

that the cost advantages of credit scoring may cause

small­business 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

banks 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 small­business loans. Aggressive competitive pressures and loan growth goals were

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

regard to small­business credit scoring techniques, the

Federal Reserve survey pointed out that banks were

most commonly using creditscores for automatic accepRegional Outlook 5 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

tance or rejection of loans up to $50,000.

Summary

Credit scoring has the potential to transform the market

for small­business 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 small­business

lending. These changes may facilitate short­term 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 small­business lending

merits the close attention of both bankers and their

supervisors.

Andrea W. Bazemore, Banking Analyst

Regional Outlook 6 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 Dallas Region, 104 institutions have an Internet

presence but only two 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	 7 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 8 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 9 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	 Robert Anderson, Review Examiner

Division or Supervision

Dallas Regional Orrice

(214) 220-3321

Carole Applegate, Review Examiner

Division or Compliance and Consumer Arrairs

Dallas Regional Orrice

(214) 220-3325

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	 10 Second Quarter 1997
 
Regular Features	 Regional Economy
 

High-Technology Exports Power Region's Economy
 

• 	 Economic growth in the Dallas Region was moderate in 1996.

• 	 The Region's exports totaled approximately $61 billion in 1996, or about 10 percent of all U.S. export sales

to the world.

• 	 A slower growing Denver economy should cool off that metropolitan area's rapid construction pace,

requiring lenders to carefully scrutinize future commercial real estate loans.

Employment Trends: Signs of a Slowdown?

The Dallas Region's economy continued slowing in

1996. Chart 1 shows that, after peaking in early 1995,

nonfarm employment growth has gradually decelerated.

Year-over-year growth of 2.8 percent in 1996 was the

Region's slowest in four years. Table 1 suggests that

the slowing in the Region's economic activity has been

broad based. Most major industry sectors recorded

slower job growth in 1996 compared to 1995.

Reasons for the Slowing

The following factors contributed to slower employment

growth in the Region last year.

Tight labor markets. The number of entrants into the

labor force has dropped dramatically over the past two

California, resulted in migration into the Region. However, in-migration has slowed because both the California and the Mexican economies are growing. A tight

labor supply has contributed to low unemployment rates;

both Texas and Colorado are enjoying some of the

lowest unemployment rates in 20 years.

Corporate restructuring. Competitive pressures and

brisk merger and acquisition activity have resulted in

layoffs and downsizing across a broad range of industries, including health care, energy, and transportation.

Rising costs. Although the Dallas Region continues to

enjoy a cost advantage in labor, housing, and commercial space relative to neighboring states, the cost differential has narrowed recently as a result of the Region's

TABLE 1

years in Colorado and Texas -- states which accounted

for 83 percent of the Region's total labor force in 1996.

Colorado and Texas saw labor force growth decelerate

from 5.2 percent and 2.5 percent, respectively, in 1994,

to 1.4 percent and 1.6 percent in 1996. Previously,

slow growth in other parts of the country, particularly

THE SLOWDOWN IN JOB GROWTH WAS

BROAD BASED

1995 1996

PRIVATE NONFARM EMPLOYMENT 4.0% 3.2%

GOODS PRODUCING 2.4% 2.8%

CONSTRUCTION 6.5% 6.0%

MANUFACTURING 1.9% 2.0%

SERVICES PRODUCING 3.9% 2.8%

TRANSPORTATION AND

PUBLIC UTILITIES

4.4% 2.7%

TRADE 3.8% 2.2%

FINANCE, INSURANCE AND

REAL ESTATE

0.4% 2.3%

SERVICES 6.0% 4.7%

GOVERNMENT 1.8% 0.9%

SOURCE: BUREAU OF lABOR STATISTICS, PAYROLL EMPLOYMENT SERIES

-2%

-1%

0%

1%

2%

3%

4%

5%

90 91 92 93 94 95 96

Dallas

 S 

Source: Bureau of Labor Statistics Nonfarm payroll employment, seasonally 

adjusted 

Year-over-Year

Job Growth Slows in the Dallas Region

CHART 1

Regional Outlook	 11 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

strong economic expansion over the past five years. As

noted in the Dallas Federal Reserve's January/February 1997 publication entitled the Southwest Economy,

Texas' cost differential with the nation is slowly narrowing. Meanwhile, the Colorado Legislative Council

(CLC) cited that increasing costs are eroding the competitive advantage Colorado enjoyed in the early 1990s.

The result may be fewer corporate relocations and

expansions as compared to previous years.

Exports Are a Key Factor in the Region's Robust Growth

International trade is becoming a critical component of

the Region's economy and explains,

in large, part why the Dallas Region

has enjoyed robust employment

growth in recent years. Businesses

from the Dallas Region are estimated

to have shipped nearly $61 billion of

merchandise to foreign countries in

1996, or almost 10 percent of all U.S.

export sales. Between 1993 and 1995, U.S. export sales

grew 25 percent, compared to 30 percent for the Region.

A large portion of the Region's exports are shipped to

Mexico. Mexico was the destination for nearly onequarter of the Region's exports in 1995 (see Chart 2). In

comparison, exports to Mexico from outside the Dallas

Region amounted to only 6 percent of total U.S. exports.

High-Technology Exports Lead the Way

The acceleration of exports from the Region in recent

CHART 2

Mexico Is the Region's Dominant Export Market

Rest of 

Mexico World

23%

Latin

Japan America 

 % 11%

European 

nion 18%

years has been due, in part, to the Region's strong base

of high-technology industries. The Region's comparatively low costs, its supply of highly

educated labor, and its rapidly

growing markets have made it a

choice site for biotechnology and

high-technology firms. Because of

its considerable base of hightechnology industries, the Dallas

Region has benefited disproportionately from the recent gains in world tradeg

"High-technology industries" can be defined in various

ways, such as by a certain threshold percentage of

technical workers or the dollar amount of spending

devoted to research and development. For this article,

high-technology industries will be defined simply as

those industries within the standard industrial classifications of electronics and other electrical equipment,

industrial machinery and computers, and scientific and

measuring instruments.

In 1995, these three industries accounted for slightly

more than $30 billion in export sales, or about 53

percent of all exports from the Dallas Region. In

comparison, exports from these same industries -- excluding the Dallas Region -- accounted for only 37

percent of total U.S. export sales (see Table 2).

Contributing to the burgeoning growth in hightechnology exports have been the following factors:

Increased global tradingg The reduction of trade

barriers and the promotion of world trade through

agreements such as the North American Free Trade

Agreement and General Agreement on Tariffs and Trade

TABLE 2

lEADING ExPORTS FROM THE U.S. AND THE

REGION BY INDUSTRY SHARES -- 1995

U.S. REGION

INDUSTRIAL MACHINERY AND

COMPUTERS

ELECTRONICS AND OTHER

ELECTRICAL EQUIPMENT

SCIENTIFIC AND MEASURING

INSTRUMENTS

16.7%

14.9%

5.5%

27.3%

21.1%

4.4%

 TOTAL 37.1% 52.8%

SOURCE: U.S. CENSUS BUREAU

28%

Canada

13%

Source: Office of Trade and Economic Analysis, Department of Commerce

Regional Outlook 12 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

have led to greater trading between nations.

The spread of free market reform. The growing

introduction of market-based economies to formerly

communist nations and the industrialization of China's

economy have contributed to these nations' increasing

appetites for U.S. goods.

The privatization of Latin American economies.The

privatization of formerly government-owned enterprises

in Argentina, Brazil, Chile, and Mexico has opened the

door for an influx of U.S. capital goods.

A rebounding Mexican economy. In 1996, Mexico,

the Region's largest trading partner, had its best year of

economic growth since 1990, with growth in gross

domestic product (GDP) of 5.1 percent. A stronger

Mexican economy usually translates into greater export

growth from the Dallas Region. Several economists

who follow the Mexican economy expect GDP growth

of between 4.5 percent to 5.5 percent in 1997.

These factors have combined to produce a surge in

high-technology exports from this Region. Industrial

machinery and computer exports grew by 30 percent

between 1993 and 1995. Exports of electric and electronic equipment grew by more than one-half over the

same period. There is little doubt that high-technology

exports have helped stimulate the Region's economy.

Nonetheless, from the standpoint of lenders, increased

dependence on high-technology exports could make the

Region more susceptible to volatility in the hightechnology sector, fluctuating exchange rates, and the

economic problems of its major trading partners.

Construction in Denver Remained Strong in

1996.

According to the Colorado Legislative Council's DeCHART 3

Denver's Retail Vacancy Rate Is
 

on the pswing Again

Vacancy rate

25%

20%

15%

10%

5%

0%

8 88 89 90 91 92 93 94 95 96

Source: F W Dodge Data point for 1996 is from the third quarter

cember 1996 forecast, the state had more nonresidential
 

building activity underway by year-end 1996 (as measured by inflation-adjusted value and square footage)
 

than at any time during the last

decade. This activity came on the

heels of substantial growth in past

years. Since 1991, the amount of

retail, office and industrial square

feet constructed in the state was

24.5 million, 11.6 million, and 7.5

million, respectively. A tremendous amount of this construction activity occurred in the

Denver metropolitan area.

Although local real estate experts believe construction

activity in Denver may have reached a peak in 1996,

they also believe there is a sufficient number of projects

in the pipeline to sustain a high level of new construction in 1997.

Denver's office vacancy rates are generally low, and the

demand for office space, particularly in suburban markets, remains strong. Office employment growth is still

occurring, especially in the financial sector. Industrial

vacancy rates also are very low, and are the result of

strong demand for industrial space caused by the influx

and expansion of high-technology industries, particularly firms that are export oriented.

.but the Retail and Apartment Markets Bear

Watching in 1997.

The Colorado Legislative Council, in its March 1997

publication, singled out the retail and upscale apartment

(monthly rents over $800) markets as two candidates

likely to achieve overbuilt status sometime in 1997.

Denver has a high retail vacancy rate (almost 15 percent

in the third quarter of 1996 according to F.W. Dodge)

that continues to rise.

Consumers were cited as unlikely to spend as much this

year in the face of slower job and income growth, rising

debt levels, and the alleviation of earlier pent-up demand. Moreover, the shake out among "Big Box"

retailers could put more retail space onto the market,

lessening the demand for retail projects currently in the

pipeline. Examples of retailers who have closed stores

recently in the Denver area are Media Play, Home

Express and Incredible Universe.

The apartment market (5 units or more) in Denver saw a

surge in construction activity during the period 1994 to

1996. Over twice as many multifamily permits were

filed in the past three years (16,275) as in the previous

six years (7,973). However, the level of in-migration is

Regional Outlook 13 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

predicted to taper off slightly and job growth is expected to slow, which may have an effect on the demand

for multifamily housing.

Implications for Banks. Denver's economy enjoyed

another strong year of economic growth enabling the

area to absorb the amount of new space coming on-line

in most categories of construction in 1996. However,

real estate foreclosures rose nearly 15 percent in the

metropolitan Denver area last year, the first increase in

8 years, and bankruptcies inColorado rose 20 percent in

1996. Area forecasters also are calling for a moderation of job growth in 1997. Therefore, lenders may need

to adjust their loan underwriting standards to reflect the

possibility that economic growth in the Denver area may

fail to keep pace with the growth recorded in recent

years. In this regard, the retail and multifamily sectors

may merit special attention.

Adrian Rangel Sanchez, Regional Economist

Regional Outlook 14 Second Quarter 1997
 
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 Dallas Region's Bank Index both

outperformed the S&P 500, gaining 12 percent and 17 percent, respectively, compared to an almost 8 percent gain for the S&P 500.

• 	 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

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,

CHART 1
 

0

25

50

75

100

125

150

175

1993 1994 1995 1996

ABS Issuance Is on the Rise

Sou ce: Bloombe g, nside MBS and ABS

$ Billion

 e it a 

Auto 

Home Equity

 the 

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

ompa ison of Sp ea s to T easu ies fo Asset-Backe Secu ities -- 2-Yea Matu ity

Auto

 a

Sou ce: P u ential Secu ities

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-Ma 

-0.5%

-0.3%

-0.1%

0.1%

0.3%

0.5%

Mo el

Po tfolio

Sou ce: Bloombe g

5-yea 

T easu y

Mo el Po tfolio's Value Relati6e to 5-Yea 

T easu y Yiel (Pe cent hange) T easu y Yiel u 6e Shows Little

hange Since Septembe 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-y . 7-y . 30-y .

3§12§97

12§31§96

9§30§96

Sou ce: Bloombe g

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

CHART 5

Improving 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 Composite Bank Index

gained 37 percent compared to a 20 percent gain for the

S&P 500. As shown in Chart 5, the Dallas Region's

Bank Index (DRBI) gained more than 17 percent in the

fourth quarter 1996. While both the DRBI and the S&P

Composite Bank Index, both returned about 37 percent

for the full year, the DRBI's gains have shown less

variability. 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 DRBI is up only 9 percent compared to an almost

20 percent gain for the S&P 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-Ma 

S&P 500

0allas Region's Bank In ex

S&P Bank In ex

Sou ce: Bloombe g,American Banker

hange f om 9§30§96

The 0allas Region's Bank In ex utpe fo me the S&P 500 but not the S&P Bank In ex

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

Ma -94

-un-94

Sep-940ec-94

Ma -95

-un-95

Sep-950ec-95

Ma -96

-un-96

Sep-960ec-96

Ma -97

S&P Majo Regional Bank In ex's

Relati6e P§E Ratio Is Rising

P§E Majo 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
 

Current Regional Banking Conditions
 

• 	 Overall, the strength of the Region's economy has provided a foundation for continuing favorable bank

performance; however, modest increases in loan losses persist.

• 	 The number of banks in the Region is falling due to mergers, especially involving smaller banks under $50

million, while the number of bank offices is rising.

• 	 Agriculture banks show capital strength, but their performance has weakened and competition for market

share is heating up.

Overall Conditions

Supported by a strong economy in the Dallas Region,

insured financial institutions reported a strong performance for 1996: an unparalleled net income of $4.75

billion was reported by banks and thrifts in the Region.

As measured by return on assets (ROA), the Region's

1.31 percent level for 1996 surpassed the nation's 1.10

percent. The asset-weighted Tier 1 capital ratio increased modestly from 7.61 percent to 7.77 percent

(compared to the national average of 7.67 percent).

The Region's performance was driven by a strong net

interest margin (4.18 percent compared to 4.06 percent

for the nation) and advancing noninterest income (1.88

percent of earning assets compared to 1.73 percent at

year end 1995). Detracting from earnings performance

were increases in provisions for loan losses and overhead expense.

Loan loss provisions climbed for the third consecutive

year and reached 23 basis points of average assets.

Similarly, net charge-offs have begun to climb after

reaching an low point in 1994 (see Chart 1). Overhead

expenses, at 3.94 percent of average assets at year-end

1996, increased 17 basis points since year-end 1995.

While consumer lending (particularly credit card loans)

has captured the attention of bankers, regulators and the

public, data reported by the Dallas Region's Call Report filers show real estate loans and commercial and

industrial loans also were important contributors to the

upward shift in loans past due greater than 30 days (see

Chart 2).

Rapid Decline in the Number of Banks in the

Region

As Table 1 (next page) depicts, there has been a rapid

decline in the number of banks in this Region over the

past six years. The Region's 30 percent decline in the

number of banks exceeded the nation's 24 percent decline from year-end 1990 to year-end 1996. This

decline in the number of banks was led by Texas (334),

but Colorado's 49 percent reduction was the largest

CHART 1	 CHART 2
 

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

90 91 92 93 94 95 96

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Charge-Offs to 

Total Loans

Source: Bank and Thrift Call Reports

Loan Provisions 

to Avg. Assets

Charge-Offs Have Bottomed Out and Are 

Creeping Upward...

. . .and the Increase in Delinquencies

 is Broad Based

% Past Due 

96 > 30 Days 95

3.0 94

2.5

2.0

1.5

1.0

0.5

0.0

Real Estate Installment Commercial Total Loans

Source: Bank and Thrift Call Reports

Regional Outlook	 20 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

TABLE 1
 

THE NUMBER OF INSURED INSTITUTIONS IN

THE DALLAS REGION HAS DECLINED

1990 1992 1994 1996

% CHANGE

90·96

Co

NM

TX

oK

 466

 104

 1,263

 446

 369

 97

1,153

 413

 295

 82

 1,040

 362

 238

 79

 929

 345

·49%

·24%

·26%

·23%

RE·

GION

U.S.

 2,279

15,158

 2,032

13,852

 1,779

12,603

 1,591

11,452

·30%

·24%

SOURCE: BANK STRUCTURE DATA

percentage decrease. The large number of banks in

Texas and Colorado, both former unit banking states,

made each of those states ripe for consolidation.

Bank failures played only a small role in the Region's

consolidation. From year-end 1990 through year-end

1996, the Dallas Region experienced a reduction of 688

insured institutions. Of these, only 65 were due to

failure. Of the 65 failures, 54 were in Texas.

Consolidation has been driven by mergers and has

resulted in fewer but larger banks (see Chart 3). Largebank asset growth has significantly outpaced smallbank asset growth: the average asset size of the largest

25 percent of banks in this Region grew 72 percent from

year-end 1990 to year-end 1996, from $459 million to

$791 million. The smallest 25 percent of banks, in

contrast, grew from $14 million to $19 million, or 37

percent over the same time period. In addition, the

number of small banks is declining rapidly. In 1990,

there were 1,390 banks under $50 million in the Region.

At the end of 1996, that number declined by 49 percent,

to 711. Many of these banks became branch locations

through mergers and acquisitions, fueling growth of

larger institutions. During 1990 through 1996, the number of domestic offices in the Region increased by 402

from 6,267 to 6,669, and the average institution size

increased substantially from $141 million to $233 million.

Does the declining number of small banks reflect an

inability of these banks to compete? Not necessarily,

but the profitability structure for different sized banks

may be changing with the introduction of larger geographic boundaries, new technologies and increased

nonbank competition (see Will Credit Scoring Transform the Market for Small-Business Lending? and

Banking on the Internet). Recently, Bank of America

announced divestiture of 68 branches located in small

Texas markets. Elsewhere,

KeyCorp has announced an intent to sell more than 140

branch locations in primarily

rural areas. A plausible interpretation of the Bank of America and KeyCorp branch divestitures is that the overhead

necessary to provide the personal service needed to run a successful small bank

operation may not fit the profitability requirements of a

large bank. Thus, this type of service may differentiate

the small bank from the large bank and provide the

smaller institutions with a measure of protection from

large-bank acquisition.

Such an interpretation is consistent with the view of

many analysts and industry leaders that large banks are

gaining a profitability edge because of their ability to

tap the benefits of scale and diversification. As the

landscape of banking tilts more to fee-based services,

the advantages of scale may become increasingly important. To prosper in this environment, many industry

observers argue that small community banks will need

to emphasize core competencies and localized, personal

service that institutions headquartered many miles (or

states) away may find difficult to match.

A December 1995 study by the Federal Reserve Bank

of Philadelphia predicts that midsized banks will have

the most difficulty in competing with the large banks, in

terms of resources, to achieve scale economies. Additionally, the study argues that it is more difficult for

midsized banks to diversify risk. Accordingly, midsized

banks may be less able to shield themselves from

acquisition or merger, and prospects for a barbell

shaped distribution of banks, by size, are increasing.

CHART 3

0

100

200

300

400

90 91 92 93 94 95 96

0

500

1,000

1,500

2,000

2,500

Source: Bank and Thrift Call Reports

The Region's Population of Banks Is

Decreasing but Assets Climb Assets

$Billions

 of Banks in Region

Regional Outlook 21 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

Agriculture Banks Remain Strong, but Oklahoma Banks Are Feeling the Effects of the

Drought

The solid condition of the Region's agriculture banks

(ag banks), in general, appears to have helped them

withstand borrowers' problems related to weak yields

in wheat and cotton and the depressed cattle prices

brought on by last summer's

drought. Ag banks are defined as

institutions with agricultural loans

of 25 percent or more of gross

loans. Ag banks in Oklahoma

continue to hold stronger capital

positions as a group than do nonagriculture banks in the state.

However, Oklahoma was among

the states most severely affected

by the drought and, as a result, asset quality problems

are appearing at a number of Oklahoma ag banks,

particularly the smaller banks.

Ag banks with assets under $100 million make up 35

percent of all banks in Oklahoma -- higher than any other

state in the Region. The combination of this dependence, the severity of the drought in certain pockets of

Oklahoma, and higher feed costs, helps to explain the

increase in problem asset indicators for these banks.

Net charge-offs in Oklahoma ag banks with assets under

$100 million increased from 0.37 percent to 0.59 percent during 1996, while nonperforming assets to total

assets increased from 0.91 percent to 1.26 percent.

Comparably, the Region's totals for net charge-offs and

nonperforming assets to total assets were reported at

0.36 percent and 0.69 percent, respectively.

These asset quality problems are likely due to the

substantial declines in both yield and production of

wheat, the state's primary crop. According to the

National Agriculture Statistical Service, wheat yields

in Oklahoma decreased 34 percent (29 bushels per

acres to 19 bushels) from 1993 through 1996, and wheat

production declined by 40 percent from 156.6 million

bushels to 93.1 million bushels. In addition to the poor

wheat condition, cattle conditions also have been weak.

According to Dr. Kim Anderson, an Agricultural

Economist at Oklahoma State University, 70 percent of

Oklahoma's agricultural economy is centered in livestock. As a result, many Oklahoma livestock producers

were affected by the 42 percent rise in average feed

corn prices between 1995 and 1996, poor haying conditions from the drought, and weak cattle prices.

Market Pressure Is Heating Up and Small Ag

Banks Are Facing Some Difficult Challenges

Currently, there are three primary areas that present

challenges to small ag banks. First, large banks are

increasing their market share of farm lending. Since

1993, banks under $100 million in this Region have seen

their share of farm loans decline from 60 percent of the

Region's total to 51 percent at year-end 1996. Concurrently, banks with assets between $1 billion and $10

billion almost doubled their share from 8 percent to 15

percent, in part a result of large-bank acquisitions of

small banks. Several large banks are initiating farm

lending programs to take advantage of scale that comes

with size. Large banks may be better able to provide

borrowers with the resources necessary to address price

and income volatility risks arising from the 1996 Farm

Bill. Moreover, larger, more diversified banks may be

in a better position to withstand additional risks as the

government safety net for farmers is curtailed with the

implementation of the 1996 Farm Bill.

Second, in addition to competition by larger banks,

financing from "input" companies, such as implement

manufacturers and seed and feed companies with financing subsidiaries, is encroaching on banks' agriculture lending. Companies like John Deere are taking

advantage of the ability to

provide the convenience of

both the inputs and financing

at aggressive pricing made

possible because of largescale funding. Given that

non-real estate farm loans

(operating loans) account

for 63 percent of banks' agriculture lending, this battle

for market share with input providers is striking at the

largest segment of bank lending to farmers.

Finally, the Farm Credit System (FCS) is renewing its

challenge for market share after years of credit quality

and image problems brought on by the farm crisis of the

1980s. From 1994 to 1996, FCS increased its market

share from 24.4 percent to 25.6 percent through

government-backed land and operating loans funded

through access to the capital markets. According to the

U.S. Department of Agriculture (USDA), banks held

39.4 percent of total farm debt in 1996, down from 39.8

percent in 1995. Although only a modest decrease, it is

the first time that banks' market share has declined since

the 1980s. The USDA expects the share to drop a

another percentage point in 1997.

Regional Outlook 22 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

CHART 4
 

0

1,000

2,000

3,000

4,000

5,000

6,000

92 93 94 95 96

All Other Farm Loans $Billions

Banks' Farm Lending Continues to Grow Slowly

Farm Real

Estate Loans

Source: Bank Call Reports

As Chart 4 illustrates, farm real estate lending by banks

continues a slow pattern of growth. As just discussed,

however, growth in farm operating loans is coming

under pressure from aggressive nonbank credit

providers. For many small ag banks, this challenge

for market share could influence either underwriting

standards or pricing, or both. The increased competitive pressures from large banks and nonbanks, coupled

with changes brought about by the 1996 Farm Bill, mean

the challenge for small ag banks could be substantial.

 Alan C. Bush, Senior Regional Analyst

Regional Outlook 23 Second Quarter 1997
 
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