FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1997
 

FDIC BOSTON
 

REGION
 

DIVISION OF
 

INSURANCE
 

DANIEL FRYE,
 

SENIOR REGIONAL
 

ANALYST
 

NORMAN WILLIAMS,

 REGIONAL ECONOMIST
 

CAMERON TABOR
 

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
 

+Regional Economy +Financial Markets +Regional Banking

 Economic Recovery Asset-Backed Securities Overall Conditions

 Massachusetts Bond Values Examination Results

Construction Price/Earnings Ratios Credit Card Lending

Home Sales Core Asset Growth

 Connecticut Earnings Strategies

Aerospace & Defense Net Interest Margins

Insurance & Banking

See page 11 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 Boston Region's Regional

Outlook, please call Dan Frye at (617) 320-1792 or send an e-mail to dfrye@fdic.gov.

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

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

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

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

the Federal Deposit Insurance Corporation.

Chairman 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.

Small­business loans (defined as commercial and industrial loans with original amounts of $1 million or less

and reported annually in June Bank and Thrift Call

Reports) represent a significant exposure and source of

revenue for insured institutions. The Boston Region's

insured institutions disclosed $8 billion of smallbusiness loans as of June 1996, 18 percent of total

commercial and industrial loans reported. For institutions under $1 billion in total assets, small­business

loans were 79 percent of total C&I loans, which underscores the relative importance these loans have to

smaller institutions (see Chart 1 next page).

A distinctive feature of this Region is the importance of

savings banks in small­business lending. Savings banks

in the Boston Region traditionally have made more

commercial loans than savings banks nationally, and

they hold a greater percentage of small­business loans to

assets. At June 30, 1996, savings banks accounted for

31 percent of all small­business loans by dollar volume

in the Region. Comparatively, the proportion of smallbusiness loans held by savings banks nationally is only

3 percent.

In the twelve month period ending June 1996, smallbusiness lending exposure declined by 4 percent in the

Region in contrast to a 7 percent increase nationwide.

New England's slow recovery may be contributing to

the disparity in growth rates between the Region and the

nation. Additionally, New England's small­business

recovery primarily has been driven by services and

technology firms companies that do not typically rely on

bank funding for capital needs. Many start­up companies in the Region also have benefited from heavy

investment by venture capital firms. Both Connecticut

and Massachusetts rank among the top 10 states in the

country in venture capital investment.

Thus far, the use of credit scoring for small­business

lending has not been widespread in the Boston Region.

However, the increasing level of competition for this

segment of the business should continue to put pressure

on pricing. As banks in the Region seek less expensive

means for generating small­business loans, they may

place increased reliance on credit scoring technologies.

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.

Small­business credit scoring models are similar to

Regional Outlook	 3 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

CHART 1

� $100M

$100M - $250M

$250M - $1MM

0ver $1MM

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

� $100M

$100M - $250M

$250M - $1MM

0ver $1MM

Institutions over $10 Billion in Total Assets

Small-Business Lending is Important to Small Banks

(Distribution of C&I Loans)

Source: June 30, 1996, Bank and Thrift Call Reports

Institutions under $1 Billion in Total Assets

 

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 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 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 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 small­business loan as more of a high­end

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 busiCHART 2
 

Business Dissolution Rate Shows Early Risk

100%

53%

Cumulative Dissolution Rate

24%

62%

71%

80%

1 2 3 4 5 6 7 8 9 10

80%

60%

40%

20%

0%

Years

Source: Small Business Administration

nesses 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 adding 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 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 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 acceptance or rejection of loans up to $50,000.

Regional Outlook 5 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

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 of 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 Boston Region, 78 institutions have an Internet presence but none of these institutions allow customers to

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
 

pay bills or transfer funds. A major question, then, is

why so few institutions have chosen to exploit this

medium?

Some Concerns for 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 for 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

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
 

continue to grow. According to one software vendor,

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 guidTABLE 1

ance, institutions having Internet sites are placed into

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 Information:

Division of 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 of Compliance and DCA is reviewing new banking technologies from a consumer protection, fair lendConsumer Affairs 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 Office Contacts	 Tom O'Neil, Examination Specialist

Division or Supervision

Boston Regional Orrice

(617) 320-1743

Kip Child, Senior Community Arrairs Specialist

Division or Compliance and Consumer Arrairs

Boston Regional Orrice

(617) 320-1729

Office of 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
 

Boston Region: Will Past Problems Aggravate Any

 Future Downturn?
 

• 	 While New England's economy continues to expand at a steady pace, the Region's banks have experienced

only modest commercial loan growth.

• 	 The modest recovery in construction activity during the last few years apparently has not been accompanied by large­scale speculative building or significantly higher lending by area institutions.

• 	 Residential real estate markets in Massachusetts are fueling loan growth for the state's banks.

• 	 In Connecticut, growth in technology, services, and tribal gaming employment are helping to offset

continued declines in aerospace and defense, insurance, and banking.

New England Recovery Continues

Last year saw the Boston Region's nonfarm employment

increase 1.7 percent over 1995. This increase was

modestly below the national rate of 2 percent. Massachusetts accounts for almost one­half the Region's

employment base, with Connecticut holding another 25

percent. Both states have witnessed positive ob growth

for the last four years.

As businesses have expanded their employment and

revenues, tax receipts across the Region also have risen.

Chart 1 shows the relationship between overall business

activity (as measured by gross receipt and general sales

taxes) and commercial and industrial (C&I) lending at

all FDIC­insured institutions in the Boston Region.

Between 1992 and 1996, taxable receipts for the entire

Region increased at an average rate of 4.6 percent per

CHART 1

70

80

90

100

110

120

130

90 91 92 93 94 95 96

• 1996 estimated

•• year-end values

C&I Loans••

Source: U.S. Census and Bank and Thrift Call Reports

Index 1990=100

New England C&I Loan Growth Trailing Overall 

Business Activity

General Receipt/Sales Taxes•

year, while C&I loans grew by an average of 5.7

percent per year. Relative to 1990, however, tax receipts were 23.5 percent higher in 1996, while C&I loan

volume ended the year up only 6.4 percent.

Implications: Should New England experience a slowdown, the Region's modest commercial credit exposure

could result in fewer dollars at risk to declining credit

quality and rising default rates.

Will Past Problems Aggravate Any Future

Downturn?

As the Region's insured institutions see their loan portfolios grow (however modestly), concerns may arise

over the potential for an economic downturn. At this

time it does not seem likely that the Region will fall into

a recession on its own. New England generally is in

step with the nation in terms of turning points in employment and economic growth (both the U.S. and the Region's last troughs in nonfarm employment occurred

within two months of each other). As a result, a national

downturn would have a near­simultaneous dampening

effect on the Region's economy.

To determine what factors could pose risks to the New

England economy, it is useful to examine some of the

key sectors that amplified the severity of the last recession. Particular attention will be given in this article to

construction in Massachusetts and aerospace and defense manufacturing, insurance, and banking in Connecticut. Although these sectors still pose some downside risks to the Region's largest economies, their effect

on insured institutions today should be less severe than

what was seen in the early 1990s.

Regional Outlook	 11 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

Could Massachusetts' Real Estate Market Overheat (Again) Anytime Soon?

Although commercial construction activity has picked

up modestly during the current expansion, there has been

little in the way of new speculative building. The

greater Boston area dominates the state's commercial

real estate market, and most new construction there has

been in significantly pre­leased or built­to­suit sites.

In addition, the state's insured institutions have been on

the sidelines with respect to development loans. Although total construction employment in the Bay State

increased by almost 28 percent between 1992 and 1996,

annual average construction and land development loan

balances at all insured institutions actually fell 25 percent.

Some might argue that the pick­up in construction employment in recent years has arisen mostly from the

nation's largest infrastructure pro ect ­­ the multiyear

Central Artery/Tunnel pro ect in downtown Boston (the

"Big Dig"). This pro ect is an area of construction

activity in which there typically would be little demand

for funds from insured institutions ­­ and thus would

explain the lack of loan growth. However, this pro ect

is not the driving force behind the state's increase in

construction­related employment.

While employment in heavy construction did rise almost

34 percent between 1992 and 1996, this rise accounted

for only 14 percent of the net gain in construction obs

during this time. Most of the

growth occurred in nonpublic

construction (specialty trades

and general contractors), which

rose by about 27 percent over the

last four years. This growth represented ob generation mostly

tied to construction of new residential and nonresidential structures ­­ areas where banks and savings institutions traditionally have provided significant funding.

Chart 2 highlights the restrained growth in construction

lending in Massachusetts.

Implications: Market fundamentals at the present time

do not appear to point toward an overbuilt market ­­

office and industrial vacancy rates around Boston are

among the lowest in the nation, while overall construction employment and commercial building activity remain well below their late­1980s peak. These fundamentals generally should cushion insured institutions'

CHART 2
 

0

4

8

12

88 89 90 91 92 93 94 95 96

0

50

100

150

Construction/Land

Development Loans

($ billions, avg. of 

qtr.-end data)

Noninfrastructure 

Construction Employment

(000s, annual average)

Construction Lending in Massachusetts Is

Lagging Sector's Recovery

Source: Bureau of Labor Statistics and Bank and Thrift Call Reports

existing real estate portfolios if the commercial market

experiences a downturn.

Massachusetts' Home Sales Supporting Loan

Growth

Existing home sales have risen dramatically across

Massachusetts since 1990. The elimination of rent

controls around the greater­Boston area, the lack of

quality rental housing, steady ob growth, low mortgage

rates, and high consumer confidence all have led to

greater sales and median home

prices.

In 1996, existing home sales

umped 21 percent across the

state. The number ofsales tracked

through the Massachusetts Association of Realtors set a new

record, beating the prior all­time high achieved in 1987.

Even the state's previously overbuilt condominium market has seen a resurgence in both sales and prices.

Chart 3 (next page) illustrates the state's escalating

appetite for owned homes and the effect it has had on

mortgage origination volume at insured institutions. Although mortgages on 1­to­4 family homes grew little

during the first few years of the recent home­sales boom,

they began to increase within the last two years. Volume rose 4 percent in 1995 and 5.3 percent in 1996,

after remaining essentially unchanged between 1991 and

1994.

Regional Outlook 12 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

CHART 3
 

Massachusetts Mortgage Lending 

Catching Up to Home Sales

Existing Home Sales 1-4 Family Mortgages

(000s) ($ billions, avg. of qtr.-end)

100 44

80 42

60 40

40 38

20 36

89 90 91 92 93 94 95 96

Source: National Association of Realtors and Bank and Thrift Call Reports

Implications: Industry sources expect home­sales activity to level off or decline modestly in 1997. Building

activity has been modest, with the level of permits

statewide up only 5 percent between the end of 1992

and 1996. Because housing construction and unsold

inventory have not accelerated dramatically during the

current cycle, it is not likely that there will be a repeat

of the 1980s glut of condominiums or other overbuilding

of residential real estate in Massachusetts in the near

future. In most cases, this situation should mitigate risks

to residential lenders in the event of an economic slowdown.

Defense and Insurance Still Downsizing in Connecticut

The last recession was particularly hard in Connecticut

because of secular effects that amplified the cyclical

decline. Prime examples include the mass layoffs in

aerospace and defense manufacturing, insurance, and

banking associated with consolidation in these industries. Although the statewide share of labor income and

obs related to aerospace and defense, insurance, and

banking may seem modest (see discussion below), local

effects from defense and financial industry downsizing

have been significant (e.g., the high office vacancy rates

in Hartford due to shrinking insurance and banking

employment).

Aerospace and Defense Manufacturing: With the end

of the Cold War, procurement spending on aerospace

and defense hardware began declining in the late 1980

­­ with adverse effects on private­sector suppliers and

local economies. (The closing of military installations

also has hurt many local communities across the country

and the Region, but is not examined

here). Aerospace and defense manufacturing employment began to dropoff in Connecticut by 1989 and has

continued that trend ever since. (For

the purposes of this article and due

to constraints on the availability of

detailed data, aerospace and defense employment is

defined to include all obs in transportation equipment

and instrument manufacturing). Chart 4 highlights this

sector's decline ­­ which has continued even as the

state's overall employment levels have begun growing

again.

By 1996, obs in Connecticut's defense industry were

about 35 percent below their 1988 peak. During the

1980s defense build­up, employment in that industry

accounted for 7 to 8 percent of Connecticut's total ob

count and about 10 percent of the state's labor income.

By 1996, defense obs accounted for only about 4.5

percent of total employment and 6 percent of income. In

the mid­1980s, Connecticut's share of labor income

from defense was about four times that of the broader

U.S. economy; in 1996, the state was three times more

reliant on defense income than the nation as a whole.

The downsizing trend of the last eight years is likely to

continue. Despite a pick­up in nondefense­related aircraft and parts demand, one of the state's largest suppliers has indicated plans for further layoffs in 1997.

Current federal budget plans also may negatively affect

local defense obs over the next few years. In particular, the current budget cuts prior helicopter procurement

plans, while spending on development of the next generation of fighter aircraft and additional nuclear subCHART 4

1,300

1,400

1,500

1,600

1,700

80 85 90 95

70

90

110

130

• Includes employment in instruments (SIC code 38) and transportation 

equipment (SIC code 37)

Aerospace and 

Defense Jobs • (000)

Source: Bureau of Labor Statistics

Total Nonfarm

Jobs (000)

Connecticut's Defense Industry Continues to 

Downsize, but Total Employment Is Rising

Regional Outlook 13 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

marines is under scrutiny by the Pentagon and Congress.

Any cuts in these areas would hit Connecticut's defense

suppliers particularly hard given their focus on aircraft

engine and parts, submarine, and helicopter production.

Insurance and Banking: In addition to defense, the

state's insurance and banking industries also have been

consolidating. The consolidation among banks is a

common story nationwide, and Connecticut's industry

has been no different. In the insurance business, consolidation and ob losses in the state largely have been

confined to life insurance carriers.

Travails in the insurance industry,

such as losses due to bad real

estate investments and increased

nonindustry competition, have led

to a shakeout of weaker firms.

Chart 5 shows the recent trend in

insurance employment. Like defense, insurance payrolls continue

to decline. Employment in the industry fell 14 percent

between the 1991 peak and 1996, mainly due to a drop

among life insurance underwriters. Despite the large

ob losses, the state's reliance on the insurance industry

as a source of income continues to be about three times

that of the U.S. (where it has held for the last decade).

While not shown on Chart 5, banking obs dropped by

38 percent between 1989 and 1996 ­­ falling 6.5 percent

in the last year alone. The potential exists for further ob

cuts. In the absence of strong economic growth, Connecticut's institutions generally will increase market

share and revenues at the expense of other players in the

industry. Connecticut's reliance on labor income from

banking is no more than that seen in the broader U.S.

economy.

Despite Consolidating Sectors, Connecticut

Economy Faces Lower Risks Today

Although consolidation and ob losses seem likely to

continue in defense, insurance, and possibly banking

over the near term, this sectoral decline should represent less of a drag on the state's economy than in prior

years. As noted in Charts 4 (previous page) and 5, total

nonfarm employment has been rising across the state.

CHART S
 

1300

1400

1500

1600

1700

80 85 90 95

50

60

70

80

90

Insurance Jobs

(000)

Source: Bureau of Labor Statistics

Total Nonfarm

Jobs (000)

Life Insurance Has Accounted for Most of

Connecticut's Lost Insurance Jobs

Job growth in tribal gaming, technology (such as fiberoptics, lasers, and software), and services have more

than offset the declines in consolidating industries.

Implications: As evidenced by the state's positive

overall ob and income growth, Connecticut's downsizing industries should remain a modest drag on growth.

The effect on loan portfolios from the state's recession

lingers today. Although C&I lending increased steadily

between 1991 and 1996, balances in 1996 (ad usted for

out­of­state mergers) were still about 12 percent below

pre­recession levels. Consumer loan balances (mergerad usted) also are about 13 percent below their 1989

volume. Given their smaller portfolios and modest loan

growth, the state's institutions should not be as heavily

exposed to a potential downturn as they were prior to

the last recession.

Norman Williams, 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 Boston Region's Bank Index

(BRBI) both outperformed the S&P 500, each gaining about 12 percent, respectively, compared to an almost 8 percent gain for the S&P 500. So far in 1997, the BRBI has outperformed both the S&P Composite Bank Index and 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 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 Composite Bank Index

gained 37 percent compared to a 20 percent gain for the

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

Bank Index (BRBI) gained almost 12 percent in the

fourth quarter 1996. The BRBI gained almost 31 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 BRBI is up 23 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. The BRBI has been driven particularly

by the strong stock performance of Fleet Financial

Group Inc, which is up 25 percent, through March 7,

1997. Fleet's stock has rallied on speculation that

Chase Manhattan Corp. is planning a takeover bid.

Chase's Chief Executive Officer, Walter Shipley, has

denied that any such bid is planned.

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

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

Boston Region's Bank Index

S&P Bank Index

Source: Bloomberg,Ameriian Banker

Change from 9§30§96

The Boston Region's Bank Index utperformed the S&P 500 and the S&P Bank Index

Regional Outlook 18 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

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

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 manCHART 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 

agement of overhead expenses. Another factor contributing to higher bank P/E ratios could include speculation on bank stocks as investors anticipate potential

acquisitions.

Allen Puwalski, Banking Analyst

Kathy R. Kalser, Chief,

Financial Sector Analysis Section

Regional Outlook 19 Second Quarter 1997
 
Regular Features Regional Banking
 

Regional Banking Conditions
 

• The Boston Region's insured institutions have come full circle from the problems of the last recession.

• Credit card debt continues to cloud an otherwise bright asset quality picture.

• Lackluster growth in core loans and deposits points to increased competition for market share.

• Structural changes in funding mix may have negative long-term implications.

Region's Banking Health Comes Full Circle

The overall condition of the New England banking

industry continues to improve as positive economic

factors coupled with the long period of relatively low

interest rates have resulted in earnings and capital levels that now exceed pre-recession levels. In 1996,

insured institutions in the Boston Region had return on

assets (ROA) exceeding the national average for the

first time since 1988. An aggregate ROA of 1.16

percent was attained, with commercial banks earning

1.29 percent and savings banks 0.95 percent. Only 4

percent (18 companies) of the Region's insured institutions reported losses for the full year, the lowest level

since 1986. At the height of the recession, nearly

one-half of all insured institutions in the Region were

operating at a loss.

As of year-end 1996, the Tier 1 leverage ratio was 7.91

percent and has risen 95 basis points since year-end

1992. The increase in capital ratios was more pronounced at small and midsized institutions; larger institutions tend to maintain higher degrees of leverage to

enhance returns on equity. As demonstrated in Chart 1,

the median Tier 1 leverage ratio for both commercial

and savings banks has risen at a faster pace than the

average for the Region as a whole.

Best xamination Results Since Implementation

of the Uniform Financial Institutions Rating

System

As conditions have improved, on-site examinations

have noted steady and significant improvement in the

overall financial condition of supervised institutions in

the Region. The average composite CAMEL (now

CAMELS) rating assigned for all examinations conducted in 1996 was 1.78, the lowest that measure has

been since the Uniform Financial Institutions Rating

System was implemented in 1979. In fact, 1996 was the

first time that the average of the CAMEL rating's five

individual components were each below "2." As Chart

2 indicates, the number of FDIC-insured bank failures is

returning to pre-recession levels. In the period between

the FDIC's inception in 1933 and the onset of the last

recession in 1989, the Region averaged only one failure

every three years.

CHART 1 CHART 2
 

Improvement in Capital Strength Is Broad Based 

Tier 1 

Leverage % Median for Commercial Banks

9 5

Median for Savings Banks

9 0

8 5

8 0

7 5

7 0 Aggregate Average for All Insured Institutions

6 5

6 0

1992 1993 1994 1995 1996

Source: Bank Call Reports and Thrift Financial Reports

Banking Conditions in the Region 

Come Full Circle

Avg CAMEL Region's 

Rating Bank Failures

4 0 60 53

3 5 50

3 03 eak 

3 0 40 in 1991 

2 5 30

2 0 20

1 5 1 78 10

1 0 0

1980 1982 1984 1986 1988 1990 1992 1994 1996

Source: FDIC 

Regional Outlook 20 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

Credit Cards Continue to vidence Weakness

Asset quality continues to improve, with credit card

lending the only asset sector reflecting any significant

deterioration. As noted in the first quarter 1997 edition

of the Regional Outlook, personal bankruptcies continue to rise to record levels, and credit card delinquencies and losses have risen in lock step with that trend.

Delinquencies rose to 4.1 percent from 3.2 percent one

year ago and net charge-offs were 3.3 percent compared

to 2.5 percent in the prior period. Both delinquencies

and charge-offs are below the national average. However, in this Region, credit card loans grew nearly 50

percent in 1996, which masks the true performance of

the underlying seasoned portfolio of loans. If net losses

are related to outstandings at the beginning of the year,

the Region's loss rates fall in line with the national

average.

Credit cards are dominated by a few players in the

Region who thus far have demonstrated an ability to

maintain profitable operations through difficult periods.

However, losses and delinquencies have risen to near

record levels in a period of moderate economic growth

and will likely go higher if the economy softens. Additional interest rate increases following the recent tightening by the Federal Reserve also may put pressure on

consumer debt payment capacity. The consumer sector

remains an area deserving close scrutiny.

Core Asset Growth Continues to Lag the Nation

After adjusting for a major restructuring of Fleet Financial Group's New England banking franchise in anticipation of its acquisition of New Jersey-based NatWest

Bank, asset growth in this Region was approximately 6

percent in 1996. Nearly one-half of the growth appears

CHART 3

to be attributable to factors not directly related to the

Region's economic growth; specifically, national credit

card programs, loans to other financial institutions,

foreign loans, and goodwill. The remaining growth was

centered in securities, which suggests that loan demand

remains subdued within the Region.

While total loan growth in the Region did not keep pace

with the nation, significant growth was noted in construction loans (up 17 percent) and leases (up 17 percent). As certain real estate markets have tightened,

particularly around greater Boston and in Fairfield

County, CT, construction activity has shown some signs

of life. While the rate of growth in construction loans is

significant, exposure to this sector by the Region's

banks remains well below prerecession levels. As Chart 3 indicates, the number of institutions with

exposure exceeding 100 percent of

equity capital is small relative to the

boom period leading up to the last

recession. At year-end, construction

loans of $3.5 billion approximated 1

percent of assets and 13 percent of

equity for all insured institutions in

the Region. In contrast, at the peak of

the building boom in 1988, construction loans totaled

nearly $22 billion, 94 percent of total equity, and were

a primary causative factor in many of the bank failures

that followed.

Institutions Take Different Roads to Restore

Profits

From an aggregate perspective, the Region's earnings

performance has improved consistently over the past

five years, from a reported ROA of 0.53 percent in 1992

to 1.16 percent for the current year. As seen in Table 1,

181

94%

0

20

40

60

80

100

120

140

160

180

200

1988 1989 1990 1991 1992 1993 1994 1995 1996

Source: Bank and Thrift Call Reports

Construction Loan Exposure Remains Well Below re-Recession Levels

15 Banks, 13% of

Equity as of 12_96

Banks with

Construction Loans

> 100% of Equity

Total Construction

Loans to Total

Equity Capital (%)

Regional Outlook 21 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

TABLE 1
 

KEY COMPONENTS OF THE REGION'S EARNINGS PERFORMANCE

% OF AVERAGE ASSETS 1996 1995 1994 1993 1992

NET INTEREST INCOME

NONINTEREST INCOME

NONINTEREST EXPENSE

LOAN LOSS PROVISIONS

3.60

2.21

3.81

0.19

3.69

1.86

3.76

0.23

3.70

1.77

3.78

0.21

3.74

1.61

3.90

0.38

3.56

1.66

3.95

0.70

NET INCOME 1.16 1.01 0.96 0.82 0.53

SOURCE: BANK AND THRIFT CALL REPORTS

the improvement is largely attributable to considerable

growth in noninterest income and a steady decline in the

provision for loan losses. Improved earnings are evident for institutions of all sizes; however, large and

small banks have taken different paths to achieve this

earnings growth.

Large and specialized banking firms have actively

sought out means to expand and diversify fee-based

revenue sources. For example, trust fees account for

approximately two-thirds of the increase in the Region's

noninterest income as measured against average assets

and have been particularly strong in the past two years.

A buoyant stock market has contributed to solid growth

in assets under management and has resulted in strong

trust-fee growth. The bulk of this growth is centered in

only ten companies that account for 94 percent of all

trust fees. Other fees, such as those derived from

mortgage servicing, investment advisory services, and

credit card operations, have generated most of the remaining growth in noninterest income. This growth also

is mostly centered in the larger banks and specialized

institutions.

In contrast, most insured institutions have had little

success expanding revenue sources significantly beyond

the traditional balance sheet based mechanisms. As

Chart 4 depicts, the median level of noninterest income

to assets for both commercial and savings institutions in

the Region has been flat over the past five years.

Most institutions have improved profitability through the

more traditional mechanisms of margin management,

cost containment, and lower loan loss provisions. For

these institutions, strong net interest margins have been

the primary contributing factor to the earnings rebound.

Several factors have contributed to this strength, including a steady decline in nonperforming assets and a

growing tangible equity base. However, two other

factors stand out as being critical to the maintenance of

strong margins.

Margins Boosted by Favorable Interest Rates

and Management of Nonmaturity Deposit Costs

First, insured institutions have benefited from a historically wide spread between the prime rate and short-term

market rates, such as the federal funds rate, which has

approximated 300 basis points since 1990. Prior to this

time, the spread averaged well under 200 basis points.

The widening of the basis between these measures has

had a positive impact on portfolio yields, particularly in

institutions that have a higher percentage of loans tied to

this index.

Second, managing the cost of nonmaturity deposits

(savings, NOW, and money-market deposit accounts)

has been a major contributor to maintaining strong net

interest margins over the past three years. In 1996,

CHART 4

1992

1993

1994

1995

1996

0 0 0 2 0 4 0 6 0 8 1 0

1992

1993

1994

1995

1996

Most of the Region's Insured Institutions

Show Little Growth in Fee Income

Source: Bank and Thrift Call Reports

Savings Banks

Commercial

Banks

Noninterest Income_Average Assets

Regional Outlook 22 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

average short-term market interest rates were approximately 225 basis points higher than in 1993. The cost

of nonmaturity deposits for the Region's insured institutions rose only 30 basis points over that timeframe.

In short, a favorable interest-rate environment and bank

funding mix combined to produce high net interest margins for institutions in this Region following the last

recession. These conditions are not likely to last indefinitely, however.

Core deposits at the Region's banks and thrifts have

been flat for several years. Core deposits now fund

approximately 60 percent of the Region's assets, down

from 64 percent one year ago and 68 percent in 1993.

Additionally, there has been an ongoing shift from lower

cost NOW and savings accounts into retail certificates

of deposit and money-market deposit accounts. This

shift, coupled with increased reliance on noncore funding actually has offset the benefit that has been derived

from holding down costs on nonmaturity deposits. Institutions that historically have relied heavily on nonmaturity deposits are actually experiencing declining net

interest margins as a result of the shifting funding mix.

This trend is likely to continue and may accelerate if

interest rates continue to rise.

Daniel E. Frye, Senior Regional Analyst

Regional Outlook 23 Second Quarter 1997
 
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