Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 2000 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

John M. Anderlik,
 

Regional Manager
 

Jeff W. Walser,
 

Regional Economist
 

Richard D. Cofer,
 

Jr.,
 

Senior Financial
 

Analyst
 

Regional Perspectives 

◆ Kansas City Region community banks have experienced compression in net interest margins since 1992 even though they have increased loanto-asset ratios significantly, a tactic that has helped to boost margins in the past. 

The compression in net interest margins can be attributed largely to increasing 

competitive pressures on both sides of the balance sheet. Should the economy weaken, declining loan-to-asset ratios could depress margins further. In addition, many 

banks have been increasing levels of credit risk or interest rate risk to compensate 

for narrowing margins, which could heighten their vulnerability to an economic 

downturn. See page 3. 

By Richard D. Cofer, Jr., Senior Financial Analyst 

John M. Anderlik, CFA, Regional Manager 

In Focus This Quarter 

◆ Emerging Risks in an Aging Economic Expansion—This article focuses 

on the potential risks of current economic conditions to insured depository institutions. Although the current conditions may appear to be ideal, some imbalances are 

emerging: rising energy prices, tight labor markets, a less robust stock market, a 

large trade deficit and strong U.S. dollar, rising household debt burdens, increased 

corporate leverage and rising potential default risk, and, in some metropolitan 

areas, overheated housing and commercial real estate markets. At the same time, 

aggregate risk within the banking industry appears to have risen, as evidenced by 

softening profitability, growing reliance on noncore funding, heightened levels of 

interest rate risk, and increasing concentrations in traditionally higher-risk loan 

categories. A confluence of these trends could heighten the vulnerability of some 

insured institutions. See page 11. 

By the Division of Insurance Staff 

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

Insurance Corporation as an information source on banking and economic issues for insured 

financial institutions and financial institution regulators. It is produced 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, FJ, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY) 

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

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

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

more information or to provide comments or suggestions about the Kansas City Region’s Regional Outlook, please call John Anderlik at (816) 234-8198 or send an e-mail to janderlik@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 

REVISION: 

The article “Ranking Metropolitan Areas at Risk for Commercial Real Estate Overbuilding” in 

the Third Quarter 2000 issue of the Regional Outlook has been revised to correct a data-related 

error. The revision affects Chart 4 and Chart 11 of the report. Please see www.fdic.gov/bank/ 

analytical/regional/ro20003q/correction.html for revised versions of Chart 4 and Chart 11, along 

with an additional explanation of how the revision affects the article. 
Regional Perspectives
 

Regional Perspectives
 

• Kansas City Region community banks have experienced compression in net interest margins since 1992, 

largely because of competitive pressures on both sides of the balance sheet. 

•	 This compression has occurred even though banks have increased loan-to-asset ratios greatly, a tactic that 

typically helps to boost margins. During past economic expansions, increasing loan-to-asset ratios led to 

higher aggregate net interest margins. 

•	 Should the economy weaken, net interest margins could continue to decline because of falling loan-to-asset 

ratios. Banks also could experience asset quality or interest rate risk problems because of attempts to compensate for narrowing margins. 

Declining Net Interest Margins and Rising Loan-to-Asset Ratios—
 

a Disturbing Paradox
 

Commercial banks with total assets under $250 million,1 the vast majority of the Kansas City Region’s 

insured institutions, have benefited greatly from the 

continuing, record-setting economic expansion. This 

business cycle, which finished its thirty-eighth uninterrupted quarter of expansion in September 2000, has 

provided the setting for the best of scenarios: strong 

asset and loan growth coupled with low credit losses 

and record profitability. 

As of midyear 2000, the Region’s small community 

banks continue to report strong financial performance. 

Asset quality is sound; as seen in Chart 1, aggregate 

CHART 1 

Past-Due Loans in the Region Remain Low 

and Reserves Remain Strong 

5 

delinquent and noncurrent loan levels remain low, particularly in relation to reserve levels, and are well below 

the levels of the late 1980s and early 1990s. Although 

capital ratios have declined in recent years, they remain 

high relative to historic levels. As seen in Chart 2, the 

moderate deterioration in capital can be attributed to 

unrealized losses on securities portfolios, which have 

grown as interest rates have risen. Strong earnings performance compared with historical levels has been the 

primary reason banks have been able to maintain adequate capital levels while achieving significant asset 

growth. 

However, despite these favorable conditions, a significant problem has emerged for many commercial banks: 

narrowing net interest margins (NIMs). This article, the 

first of two in a series, examines the factors contributCHART 2 

Loan loss reserves 

Noncurrent 

loans 

Loans past-due 

30–89 days 

’89 ’90 ’91 ’92 ’93 ’94 95 ’96 ’97 ’98 ’99 ’00 

Percentage of Total Loans 4 Capital Levels in the Region Dropped in 1999 

but Remain High by Historical Standards 

3 11.0 Leverage ratio without 

effect of unrealized 

losses 

Leverage 

ratio 

2 

1 

Leverage Ratio (%) 

10.5 

10.0 

9.5 

June 9.0

Source: Bank Call Reports, community banks
 

8.5
 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 1 As of December 31, 1999, FDIC-insured commercial banks with June 

Note: Unrealized losses were not calculated before 1994. 

Source: Bank Call Reports, community banks total assets less than $250 million represented 93 percent of the total 

commercial banks in the Region. 

Kansas City Regional Outlook 3	 Fourth Quarter 2000 

0 
Regional Perspectives
 

ing to NIM compression and how they have affected 

banks on an aggregate level. The current economic 

expansion differs from those of the 1970s and 1980s in 

that it has been characterized by rising loan-to-asset 

(LTA) ratios and declining NIMs. Historically, LTA 

ratios and NIMs have moved in the same direction. The 

article concludes with a look at how current NIM compression and insured institutions’ responses to it could 

affect the Region’s banks adversely. As a follow-up, the 

first quarter 2001 Regional Outlook article will examine how groups of banks have reacted differently to the 

factors contributing to NIM compression, creating significantly different risk profiles. 

Net Interest Margin Compression Has Been 

Significant and Widespread 

In the aggregate, the Region’s 1,754 community banks2 

have experienced compression in NIMs since 1992.3 

After peaking at 4.50 percent in 1992, the aggregate 

NIM fell five out of seven years to 4.23 percent in 1999 

(see Chart 3). This compression caused pretax return on 

assets (ROA) to drop 16 basis points, from 1.78 percent 

to 1.62 percent, over the same period. During this time, 

slight improvements in reported total noninterest 

income, noninterest expense, and loan loss provision 

CHART 3 

Net Interest Margins Have Slipped,
 

and Net Interest Income Remains Important
 

expense as a percentage of total average assets kept the 

pretax ROA from falling further. 

Since 1992, 1,288, or 73 percent of the Region’s community banks, reported a decline in NIMs. Of banks 

that experienced NIM compression, the median decline 

was 52 basis points. Chart 4 emphasizes the widespread 

declines by showing the distribution of NIMs among 

community banks in 1992 and 1999. Clearly, the NIM 

distribution has turned downward in the past seven 

years (as shown by the shift of the curve to the left), 

illustrating that NIM declines have not been concentrated in a few institutions. 

The declining NIM trend and its effect on net income is 

perhaps a greater concern for banks in the Kansas City 

Region than elsewhere because this Region is dominated by smaller banks. Smaller institutions typically rely 

more heavily on NIM to generate revenue than do larger banks. Large financial institutions (banks and thrifts 

with total assets of $1 billion or more) have diversified 

their revenue sources over the past 10 to 15 years. The 

broader array of product offerings enables them to generate higher levels of noninterest income. As a result, 

they have reduced reliance on net interest income (NII). 

Community banks have not generated the same growth 

in noninterest income, so NII remains very important 

for them. This can be seen in Chart 3, which shows that 

NII represents a significant portion of community 

banks’ net operating revenue.4 Community banks’ 

aggregate ratio of NII to net operating revenue was 84.8 

percent in 1999, while the national ratio for banks and 

Net Interest Margin (%)

NII to Net Operating Revenue (%) 

3.9 

4.0 

4.1 

4.2 

4.3 

4.4 

4.5 

4.6 

80 

82 

84 

86 

88 

margin (left scale) 90

Net interest income 

to net operating 

revenue (right scale) 

Net interest 

CHART 4 

Declining Net Interest Margins Have Been 

Widespread in the Region 

Note: NIM = net interest margin 

Source: Bank Call Reports, community banks Percentage of Banks with NIM in Each Range 

NIM Ranges (%) 

0 

2 

4 

6 

8 

10 

12 

14 

16 

<3.0 3.6 4.2 4.8 5.4 >6.0 

1999 

1992 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

Note: NII = net interest income 

Source: Bank Call Reports, community banks 

We define community banks as FDIC-insured commercial banks 

with total assets less than $250 million as of year-end 1999 that meet 

the following criteria: have been in operation throughout the 1990s 

and were in operation for at least three years as of January 1, 1990; 

are not considered credit card banks (banks with at least 50 percent of 

total loans in credit card receivables); and have not utilized pushdown accounting treatment owing to merger in the 1990s. 4 Net operating revenue is net interest income plus noninterest 3 Unless otherwise noted, any year date refers to year-end. income.
 

Kansas City Regional Outlook 4 Fourth Quarter 2000
 

2 
Regional Perspectives
 

thrifts with total assets under $1 billion was slightly 

under 75 percent. The ratio was even lower, at less than 

60 percent,5 for institutions with assets of greater than 

$1 billion. 

Competitive Forces Are Compressing 

Net Interest Margins 

Strong competitive pressures on both sides of community banks’ balance sheets are responsible for the 

declining NIMs. On the asset side, loan competition has 

grown significantly during the 1990s. Small banks are 

experiencing more competition from larger banks that, 

spurred by desire for growth and the ability to branch 

interstate, continue to expand into new markets. The 

growth in credit union membership and the numbers of 

finance companies and mortgage lenders, as well as a 

surge in business-affiliated financing arrangements 

such as company-branded credit cards and lines of credit, illustrates the increase in nonbank competition. 

These nontraditional arrangements come from an everexpanding array of businesses, ranging from retail 

shopping to home improvement and farm implement 

dealerships. Moreover, a surge in the lending activities 

of government-sponsored enterprises, such as Farm 

Credit System institutions, has had a direct competitive 

impact. Competition from new and unexpected sources 

could intensify as the enactment of the Gramm-LeachBliley Act of 1999 promotes the entry of new competitors into the banking arena.6 

This increased competition for loans has contributed to 

an ongoing decline in loan yields since 1995. Overall, 

aggregate community bank loan yields gradually 

declined an average of 7 basis points per year from 1995 

through 1998, and then plummeted 38 basis points in 

1999. Some of the 1999 slide can also be attributed to 

interest rate movements; as the yield curve flattened in 

1997 and 1998, competitive pressures prompted 

bankers to slide further out along the yield curve to meet 

borrower demand for longer-term, fixed-rate loans. 

On the liability side of the balance sheet, competitive 

pressures for retail deposits have hindered community 

5 Puwalski, Allen. Federal Deposit Insurance Corporation. May 2000. 

Increasing Interest Rate Risk at Community Banks and Thrifts. Bank 

Trends, p. 1. 6 For further detail on the Gramm-Leach-Bliley Act of 1999 and unitary thrifts, see “New Banking Entrants Could Soon Alter the 

Region’s Competitive Landscape,” Regional Outlook, fourth quarter 

1999. 

banks’ ability to maintain high levels of core deposits.7 

These pressures include increased industry competition 

as well as strong disintermediation of funds into nonbank investments such as mutual funds. Furthermore, 

household savings rates continue to decline nationally, 

magnifying these competitive pressures by reducing the 

pool of available funds that financial institutions can 

pursue. Demographic trends specific to the Kansas City 

Region also have contributed to the reduction in potential deposits for many community banks.8 Most rural 

counties in the Region have been losing population for 

decades, and some are losing population at an accelerating rate, making it difficult for banks to raise funds 

locally. 

Because of these trends, banks’ core deposit levels have 

not kept pace with asset growth, and, as a result, insured 

institutions in the Region have increased reliance on 

noncore funds. As seen in Chart 5, community banks’ 

core deposits-to-assets ratio has declined every year 

since 1992, from 82.9 percent then to 75.4 in 1999. 

Conversely, noncore funds have grown from 6.7 percent 

of total assets in 1992 to 14.5 percent in 1999. Since 

noncore funding generally carries a higher cost than 

core deposits, this shift has contributed to higher interest expenses, applying downward pressure on NIMs. 

CHART 5 

In the Region, Use of Noncore Funds Has 

Grown as Core Deposits Fund Fewer Assets Percentage of Total Assets 

Source: Bank Call Reports, community banks 

Percentage of Total Assets 

70 

75 

80 

85 

0 

5 

10 

15 

Core deposits 

(left axis) 

Brokered deposits 

(right axis) 

Large CDs (right axis) 

Other borrowings 

(right axis) 

’91’90 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

7 Core deposits are defined as the average of total deposits, less time 

deposits of $100,000 or more, less deposits in foreign offices. 

8 For further detail on these demographic changes and their impact on 

community banks, refer to “Depopulation Threatens the Viability of 

Many of the Region’s Rural Counties,” Regional Outlook, first quarter 2000. 

Kansas City Regional Outlook 5 Fourth Quarter 2000 
Regional Perspectives
 

Increasing LTA Ratios Have Buoyed NIMs, but 

Not as Much as during Prior Expansions 

Although competitive trends on both sides of the balance sheet have contributed to NIM compression, community banks’ higher loan volumes have helped support 

NIMs. Because loans typically generate higher yields 

than other earning assets, such as securities, banks commonly increase lending in an economic expansion while 

liquidating lower-yielding securities. Conversely, in an 

economic downturn, loan demand declines and banks 

tend to prefer the relative safety of securities portfolios. 

What is striking about the current economic expansion 

is its unprecedented length, which has encouraged community banks to increase the aggregate LTA ratio from 

48.7 percent in 1990 to 62.4 percent in 1999, the highest level ever reported.9 Over the same period, community banks’ aggregate securities-to-assets ratio declined 

from 37.7 percent to 27.7 percent. Chart 6 illustrates 

these movements. 

A strong positive link exists between banks’ LTAs and 

NIMs in that, at least in the aggregate, banks that are 

willing to accept the credit risk of making more loans 

have been rewarded by higher NIMs. Refer to Table 1, 

which divides community banks into quintiles based on 

1999 LTA ratios. The table shows that community banks 

in the higher LTA quintiles reported higher NIMs than 

banks in the lower LTA quintiles. Moreover, in general, 

CHART 6 

The Region’s Community Banks Have
 

Shifted Significantly from Securities to Loans
 

Percent 

70 

60 

50 

40 

30 

20 

Securities to 

assets 

Loans to 

assets 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

Source: Bank Call Reports, community banks 

9 The earliest year for which usable data were available is 1973. 

banks reporting high LTAs in 1999 grew loan volume to 

the highest level and experienced the least NIM compression since 1992.10 

Although it is generally true that community banks 

with high LTA ratios have been rewarded with higher 

NIMs during this economic expansion, in prior expansions the relationship between 

loan levels and margins was 

much stronger. As seen in Chart 

7, there was a strong relationship 

between the LTA ratio and NIM 

throughout the 1970s and 1980s, 

as changes in LTA ratios were 

followed by parallel changes in 

NIMs. Both the aggregate LTA 

and NIM moved upward during expansionary periods 

(such as the early 1970s and late 1980s) and downward 

during recessionary periods (such as the prolonged 

agricultural crisis of the early and mid-1980s). History 

shows that if all else remains equal, increases in higher-yielding loans will push NIMs higher. 

However, beginning in 1992, NIMs and LTA ratios 

began to move in opposite directions. The aggregate 

NIM actually declined 27 basis points from 1992 to 

1999, while over the same period the aggregate LTA 

ratio rose 13.2 percentage points. The last large increase 

in LTAs reported by community banks occurred in the 

1970s, when an 8.0 percentage point increase in the 

aggregate LTA ratio between 1973 and 1979 was associated with a 92-basis-point jump in the aggregate NIM. 

Why has this occurred? It is unlikely that the strong 

connection between the LTA ratio and NIM has disappeared. Intuitively, it appears that increasing levels of 

performing, higher-yielding loans in place of securities 

will affect NIMs positively. The more likely explanation 

is that the competitive forces described earlier, which 

have been placing downward pressure on community 

bank margins during this economic expansion, did not 

exert as much influence in earlier decades. As a result, 

higher LTA ratios are pushing up NIMs, but have been 

more than offset recently by other factors that have been 

pressuring NIMs downward. 

10 The second article in this series will highlight community banks 

that have reported exceptions to this observation (i.e., reported high 

LTAs but low NIMs or vice versa). 

Kansas City Regional Outlook 6 Fourth Quarter 2000 
 

 

Regional Perspectives
 

TABLE 1 

In Aggregate, Higher LTA Ratios in the Region Lead to Higher NIMs 

1999 LTA LTA CHANGE NIM CHANGE 

QUINTILE BREAKS (%) LTA 1999 NIM 1999 1992–1999 1992–1999 

QUINTILE 1 < 50.8 41.9 3.78 5.9 –0.44 

QUINTILE 2 50.8–58.2 54.4 3.96 8.4 –0.41 

QUINTILE 3 58.2–64.3 61.5 4.23 10.1 –0.33 

QUINTILE 4 64.3–71.1 67.7 4.35 13.2 –0.23 

QUINTILE 5 > 71.1 76.8 4.61 17.5 –0.12 

ALL BANKS 62.4 4.23 12.5 –0.27 

LTA = loan to asset; NIM = net interest margin 

Source: Bank Call Reports, community banks 

Banks Have Accepted Higher Credit and Market 

Risk to Overcome Competitive Pressures 

To compensate for the competitive factors compressing 

NIMs, community banks have increased levels of credit 

risk and market (interest rate) risk. For example, community banks have increased LTA levels and heightened 

credit risk within loan portfolios. As shown in Chart 7, 

community banks have pushed the aggregate LTA to its 

highest reported level. Community banks last experienced an LTA ratio close to the current level nearly 20 

years ago, when the LTA ratio peaked at 58.4 percent 

prior to the agricultural crisis of the 1980s. Since loans 

are generally higher-risk investments than other earning 

assets, higher LTA ratios suggest heightened credit risk 

and possibly a higher tolerance for risk by management. 

In fact, history has shown a direct and strong connection 

between bank failures and high LTAs.11 

CHART 7 

In addition to increasing loan volumes, community 

banks have made some significant changes to the loan 

mix, potentially increasing credit risk. For example, 

aggregate loan portfolios have shifted toward a higher 

concentration of commercial real estate loans,12 which 

typically carry more credit risk than other types of loans 

and have experienced higher charge-off rates in prior 

economic downturns. Community banks’ aggregate 

proportion of commercial real estate loans to total loans 

has increased from 10.8 percent in 1990 to 17.3 percent 

in 1999. 

Moreover, community bankers may have increased market risk by repositioning a sizable amount of loan portfolios farther out on the repricing timeline. After remaining 

constant from 1992 to 1995, the volume of loans that 

reprice within 12 months declined from 60 percent in 

1995 to 50 percent in 1999. Chart 8 (next page) shows 

Note: This chart was assembled using commercial banks with less than $250 million in assets and excludes de novo banks for their first three years of existence and credit 

card banks. In addition, banks that were involved in a push-down merger were excluded for the year when the merger occurred. Community banks, as defined in this article, 

differ slightly from this definition. This difference was necessary to build the chart back to 1973, because community banks were paired back only to 1990. Numerical differences 

between reported results of community banks and the set of banks used for this analysis are minimal. 

LTA = loan to asset; NIM = net interest margin 

Source: Bank Call Reports 

Increasing LTA Ratios Contributed to Higher NIMs during Prior Expansions, 

but LTA Ratios and NIMs Diverged in the 1990s 

Net Interest Margin (%)

NIM (left axis) 

LTA Ratio (%) 

LTA (right axis) 

’73 ’75 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 

3.6 

3.8 

4.0 

4.2 

4.4 

4.6 

4.8 

5.0 

45 

50 

55 

60 

65 

12 Commercial real estate is defined as construction and development 11 FDIC Division of Research and Statistics. 1997. History of the loans secured by real estate, commercial real estate, and multifamily 

Eighties—Lessons for the Future, pp. 68–75. residential real estate. 

Kansas City Regional Outlook 7 Fourth Quarter 2000 
Regional Perspectives
 

CHART 8 

Community Banks Have Been Lengthening
 

Loan Repricing Intervals
 

1995 1999 

Repricing Interval

>5 Years 

1–5 Years 

<1 Year 60 

33 

7 

50 

39 

11 

60 40 20 0 20 

Percentage of Total Loans 

Source: Bank Call Reports, community banks 

40 60 

the magnitude of this change in the aggregate repricing 

structure of community banks between 1995 and 1999. 

Most of the change occurred in the repricing interval 

between one and five years, which increased from 31 

percent of total loans in 1992 to 39 percent by 1999. The 

volume of long-term (reprice in five years or more) loans 

also has increased since 1995, as a flattening yield curve 

increased borrower interest in long-term, fixed-rate 

loans. Longer loan repricing terms could generate higher yields, but also could increase vulnerability to upward 

interest rate movements. 

Looking Ahead Should the Economy Slow 

First, we must ask this question: Are the competitive 

pressures that are affecting community banks cyclical, 

meaning that they will reverse when the business cycle 

turns downward, or are they secular? If they are cyclical, then they can be expected to dissipate in a recession. However, if they represent permanent changes to 

the competitive landscape, this fact could suggest a new 

paradigm of lower NIMs for community banks. 

We believe that most of the current forces are secular 

competitive pressures that did not exist or were not as 

intense in prior periods. Legislative, demographic, technological, and other changes have increased competition significantly for community banks. These new 

competitive forces cannot be expected to dissipate in the 

next recession. 

•	 Competition from banking institutions has increased. 

The enactment of the Riegle-Neal Interstate Banking 

and Branching Efficiency Act of 1994, providing for 

nationwide interstate branching, created a new competitive battleground for banking services. Larger 

institutions are slowly entering markets that traditionally had been served by smaller banks. 

•	 Competition from nonbanking entities has increased. 

Finance companies, mortgage companies, equipment dealers, and other nonbank players have 

entered the loan markets, placing pressure on bank 

loan yields. Credit unions continue to gain membership, spurred by consumer interest and the Credit 

Union Membership Access Act of 1998, which 

broadens the ability of federally chartered credit 

unions to expand membership bases. The GrammLeach-Bliley Act of 1999 has enabled nonfinancial 

companies to offer banking services. 

•	 Depopulation trends are intensifying. Many banks in 

the Region are finding it difficult to attract deposits 

in declining communities, and depopulation trends 

will not reverse in an economic downturn. In fact, 

they could intensify. 

•	 Technological advances have enabled consumers to 

shop for loan and deposit rates from an array of 

sources. The advent of the Internet, electronic funds 

transfer mediums, and the proliferation of moneymanagement information has begun to blur the 

demarcation of traditional banking services. These 

developments are creating savvier consumers and 

enabling them to shop a broader market for financial 

services. Generally, consumers are much more educated about their investment options, are willing to 

invest more in equities and bonds to maximize 

returns, and can now easily learn the pricing schedule of a much broader market and can act on that 

information with ease. As a result, both banks and 

nonbank financial service providers find themselves 

in a competitive market that continues to grow from 

local to regional and beyond. 

These changes could lead to the development of a new 

relationship between LTA ratios and NIMs. The 1990s 

could be the first example of a systemic downward shift 

in community banks’ NIMs. The result would be that 

rising LTA ratios would not boost NIMs to the high levels previously experienced. Should a recession occur, 

these secular changes could push NIMs even lower. 

However, while many of the current competitive pressures appear to be secular, they also are cyclical to some 

degree. For example, strong investment in equity marKansas City Regional Outlook 8	 Fourth Quarter 2000 
Regional Perspectives
 

kets, driven by returns that banks cannot match, has CHART 9 

placed upward pressure on deposit rates. However, an Net Interest Margins Have Been Distorted economic downturn very likely would affect equity and by Rapidly Increasing LTA Ratios bond markets adversely, making the returns and safety 

of bank deposits more attractive. 4.8 

Regardless of whether the competitive pressures of the 4.6

1990s result in a permanent reduction in community 

banks’ NIMs, one cyclical adjustment will be made, 

assuming historical trends hold: The aggregate LTA 

Percent 4.4 

ratio will decline when the business cycle turns. Recall 4.2 

Chart 7, which shows that the trend of the LTA ratio 

generally mirrors the business cycle. The LTA ratio 4.0 

NIM—Community banks with 

small LTA changes 

NIM—All 

community banks 

declined during each economic downturn, particularly ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99

during the 1980s, when farm banks’ LTA ratios plunged 

as a result of the agricultural crisis. During recessions, 

the demand for loans declines as businesses and consumers retrench. Concurrently, the supply of credit 

shrinks, as increasing noncurrent loan levels reduce 

bankers’ willingness to lend. 

While rapidly increasing LTA ratios helped support 

NIMs against competitive pressures during the 1990s, 

rapidly declining LTA ratios could cause NIMs to plummet. As Chart 7 shows, in the past declining LTA ratios 

were followed quickly by declining NIMs. The difference this time is that secular competitive forces may 

cause NIMs to be lower than in prior decades. 

If LTAs decline to historically “normal” levels during 

the next economic downturn, how far could NIMs fall? 

To suggest an answer to this question we conducted two 

analyses, both of which seek to determine how banks 

would have fared in the 1990s given the competitive 

forces that existed, but assuming that LTA ratios 

remained at 1992 levels. As illustrated in Chart 7, the 

aggregate LTA ratio in 1992 is approximately the “normal” level seen in relatively stable periods (1973 to 

1975, 1981 to 1983, 1988 to 1992), reflecting neither 

the peak nor trough of economic cycles. 

The first analysis examined community banks that did 

not share in the robust LTA ratio growth in the 1990s. 

Since these 352 institutions13 were subject to the same 

competitive pressures as their peers, yet did not mask 

the effect on NIMs by significantly increasing LTA 

ratios, their NIM performance in the 1990s provides 

insight into what other banks may experience should 

LTA ratios decline. As illustrated by Chart 9, while 

13 We examined community banks that showed a cumulative change 

between –2.0 and 5.0 percentage points in LTA ratios between 1992 

and 1999. 

Notes: LTA = loan to asset; NIM = net interest margin
 

Source: Bank Call Reports, community banks
 

these banks experienced a higher aggregate NIM than 

all community banks in 1992, this gap closed over the 

next seven years; these institutions reported a 54-basispoint drop in the aggregate NIM, compared with a 27­

basis-point drop for all community banks. On the 

positive side, these banks may not experience the same 

declines in NIMs during the next economic downturn 

as other community banks because their NIMs already 

reflect the competitive forces that are compressing 

margins. 

For the second analysis, we constructed a model, holding LTA ratios of the 1,754 banks constant at 1992 levels. This model suggests, holding all other factors equal, 

how community bank NIMs might have been affected 

by increased competition without the benefit of rising 

LTA ratios. The results, presented in Chart 10 (next 

page), show a wide disparity between actual and modeled NIM performance from 1992 through 1999. The 

actual aggregate NIM was 4.23 percent, while the 

aggregate NIM holding LTAs at 1992 levels was 3.85 

percent, suggesting that increasing LTA ratios have 

boosted NIMs by 38 basis points. 

In addition to their vulnerability to declining LTA 

ratios, community banks would experience heightened 

vulnerability to credit risk and market risk in an economic downturn because they have accepted more 

exposure in both areas. It is noteworthy that much of the 

additional credit risk and market risk exposure has 

occurred in the latter part of this economic expansion. 

For example, loan growth rates in the past four years 

have been much greater than those of the first five years 

of the expansion. Moreover, much of the potential 

increase in interest rate risk depicted in Chart 8 

Kansas City Regional Outlook 9 Fourth Quarter 2000 
Regional Perspectives
 

CHART 10 

A Hypothetical Model Confirms Net Interest 

Margins Have Been Distorted 

by Rapidly Increasing LTA Ratios 

Notes: LTA = loan to asset; NIM = net interest margin 

Source: Bank Call Reports, community banks Percent 

Hypothetical NIM (holding LTA 

constant at 1992 levels) 

Reported NIM 

LTA distortion 

’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

3.6 

3.8 

4.0 

4.2 

4.4 

4.6 

occurred in the past three years. These significant 

changes have helped mitigate NIM compression. At this 

stage of the economic expansion, this situation raises 

questions about the potential impact on asset quality 

should the economy falter. As Federal Reserve Board 

Chairman Alan Greenspan noted in 1998, “All too often 

at this stage of the business cycle, the loans that banks 

extend make up a disproportionate share of total nonperforming loans.”14 The next recession will show 

whether community banks in the Kansas City Region 

have managed risks wisely, and whether earnings performance throughout the expansion was commensurate 

compensation for taking the additional risk. 

Richard D. Cofer, Jr. 

Senior Financial Analyst 

John M. Anderlik, CFA 

Regional Manager 

14 Speech to Congress. February 24, 1998. 

Kansas City Regional Outlook 10 Fourth Quarter 2000 
In Focus This Quarter
 

Emerging Risks in an Aging Economic Expansion
 

•	 The economy and the banking and thrift industries are reporting generally healthy conditions. 

However, the economic expansion is aging, and it 

is unlikely that the vigor experienced during the 

first half of 2000 can be sustained. 

•	 Likewise, record banking and thrift industry 

profits, healthy capital cushions, and good asset 

quality of recent years may not be sustainable. 

Declining net interest margins, rising commercial 

loan losses, tighter liquidity, and riskier asset 

composition are among the warning signs that 

industry performance may have peaked for this 

business cycle. 

•	 Specific areas of concern include growing reliance 

on noncore funding; heightened interest rate risk; 

increased exposure to market-sensitive revenues; 

deteriorating credit quality; rising leverage 

among businesses and households; and signs of 

imbalance in some residential and commercial 

real estate markets. 

Although no readily apparent situations or imbalances 

suggest that a recession or widespread banking problems will develop in the near term, warning signs are 

present. A highly competitive banking industry shapes 

the environment in which pressures on insured institutions are unfolding. The presence of a large share of 

newly chartered banks in some areas appears to be raising the risk profile among all institutions in certain markets. Publicly owned companies remain under intense 

pressure to grow earnings and increase shareholder 

value. In addition, local banking environments exist in 

which a confluence of risks is generating heightened 

vulnerability for all participants, even during healthy 

economic times. Complacency in these environments 

may have negative repercussions for many insured institutions going forward. 

Imbalances Are Appearing amid a Healthy 

Macroeconomic Environment 

The performance of the U.S. economy contributes to the 

opportunities and risks financial institutions face. The 

current cyclical expansion, now nine and one-half years 

old, is displaying signs of aging while setting a record 

for longevity. A consensus forecast calls for moderate 

real gross domestic product (GDP) growth through 

2001, following robust gains in the first half of 2000. 

Current conditions might be called a “soft landing,” in 

which real GDP growth slows to a sustainable noninflationary rate of 2.5 to 3.5 percent, and unemployment 

hovers around recent rates. 

Although the current macroeconomic environment 

might appear to be the best of all possible worlds, areas 

of concern exist. One is that sustained prosperity tends 

to foster higher levels of risk taking, overconfidence, 

and complacency. For example, the turmoil in world 

foreign exchange and financial markets during 1997 

and 1998 illustrates how dramatic imbalances can 

develop and trigger disruptive adjustments even during 

healthy economic times. 

Currently, no specific situation or imbalance seems to 

threaten the viability of the expansion. However, as 

detailed below, several likely will contribute to slower 

economic growth. Situations that warrant monitoring 

include the following: 

•	 The repercussions from higher energy prices are 

unfolding. Historically, oil price shocks have weakened several other long-lived economic expansions. 

•	 Short-term interest rates rose over the past year while 

longer-term rates declined, resulting in a modest 

inversion of the yield curve. This relationship may 

inhibit the profitability of some lenders’ practice of 

borrowing short term and lending longer term and 

also complicate the interest rate risk management 

process for some insured institutions. 

•	 Continuing low unemployment suggests that demand 

for additional workers will go unfilled, thus limiting 

economic growth or triggering bidding wars that 

increase workers’ compensation and, potentially, 

inflation. 

•	 Stock market sentiment is no longer strongly bullish. 

A pullback from high valuations and optimism could 

trigger negative repercussions on consumers’ net 

worth and spending as well as on the level of business investment. 

•	 A large international trade deficit and strong U.S. 

dollar may be an unsustainable combination over the 

Kansas City Regional Outlook 11	 Fourth Quarter 2000 
In Focus This Quarter
 

long run. Meanwhile, repatriated profits of U.S. corporations are being trimmed by the dollar’s strength 

relative to the euro and other currencies. 

•	 Household debt burdens are historically high, with 

leverage rising the most in recent years among lowand middle-income households. These households’ 

access to credit has increased as lenders competed 

more fiercely for customers. 

•	 Corporations are more highly leveraged, and potential default risk rose in the past year across a range of 

industries. Meanwhile, downgrades of publicly traded corporate debt issues are exceeding upgrades by a 

2 to 1 ratio. 

•	 In some metropolitan areas, overheated housing markets are developing, in which home prices are rising 

dramatically and exceeding gains in median 

incomes. 

•	 Potential signs of excess commercial real estate construction are appearing in several urban areas where 

banks’ construction loan growth also is strong. 

Economic indicators of what lies ahead are not clearcut, and each possible scenario contains a set of potential challenges for insured institutions and regulators. 

Should economic growth slow considerably, current 

vulnerabilities, such as highly leveraged borrowers’ 

debt loads and overheated housing markets, could worsen significantly. As evidenced by the rash of bank failures during the 1980s, it doesn’t always take a national 

recession for problems to develop. Alternatively, sustained rapid growth might foster new vulnerabilities and 

allow current imbalances to intensify or build up. For 

example, speculative construction could accelerate, 

stock market volatility could increase, or ballooning 

trade deficits could generate turmoil in foreign 

exchange markets. 

Signs of Strain Are Also Appearing 

amid Healthy Banking and Thrift Industries 

With the long economic expansion as a backdrop, 

insured institutions in the aggregate are performing 

very well. However, the record profits attained in recent 

years may not be sustainable. The losses posted recently by several large institutions are striking examples of 

increased appetite for risk resulting in significant financial loss during a period of strong economic growth. 

While these are isolated instances, they are indicative of 

the increasingly competitive environment facing the 

financial services industry. 

Overall industry profitability is beginning to soften, led 

primarily by rising commercial loan losses at large institutions and declining net interest margins in institutions 

of all sizes. Credit card loss rates, which had been 

steadily falling since late 1997, have stalled in recent 

quarters, suggesting that recent increases in interest 

rates and energy costs not only are affecting businesses 

but also are taking a toll on some consumers. Other 

signs suggesting that aggregate risk within the system 

has risen include the growing reliance on noncore funding to support asset growth, heightened interest rate risk 

at many institutions, growing concentrations in traditionally higher-risk loan classes, and a shift in institutions’ overall asset mix toward higher-risk categories. A 

brief discussion of these risks follows. 

Funding Patterns Heighten Liquidity Concerns 

Lackluster core deposit growth is placing pressure on 

bank earnings and contributing to rising liquidity risk in 

the banking system. During the past five years, the compounded annual rate of core deposit growth for all 

insured institutions was just 2.8 percent. Assets over this 

time grew at a 6.6 percent rate. Accordingly, a significant portion of the industry’s growth has been funded by 

noncore sources (see Chart 1). The higher cost and rate 

sensitivity of these funds put downward pressure on net 

interest margins, particularly in a rising rate environment. 

CHART 1 

Most of $2 Trillion of Asset Growth since 1995
 

Was Funded with Noncore Funds
 

Subordinated Debt 

and Other Liabilities

 5% 

9% 

Equity 

22%
 

Core Deposits
 

64%
 

Noncore Funding
 

Source: Bank and Thrift Call Reports, June 2000 and June 1995 

Kansas City Regional Outlook 12	 Fourth Quarter 2000 
In Focus This Quarter
 

To compensate for higher funding costs, the industry 

has pursued growth in higher-yielding asset classes that 

are traditionally both riskier and less liquid. For example, almost 37 percent of the asset growth in the past 

five years has come from nonresidential real estate and 

commercial and industrial loans. 

For institutions that fund illiquid assets with wholesale 

sources, any adverse events that trigger a lack of confidence in the institution may result in higher funding 

costs, thus placing further pressure on margins. In 

efforts to obtain funding, an institution also may pledge 

a greater portion of its best quality assets as collateral, 

further reducing liquidity. Finally, in instances where 

funding needs have exceeded available liquidity, the 

forced sale of illiquid assets to meet funding outflows 

could result in losses if market conditions are unfavorable. Presumably, the FDIC, as insurer, would suffer 

greater losses if such an institution failed, because it 

would be relying on proceeds from the liquidation of 

less liquid, and potentially lower-quality, assets to satisfy 

the claims of insured depositors. 

Subprime lenders, in particular, tend to rely heavily on 

noncore funding to pursue aggressive growth strategies. 

Chart 2 illustrates the extent to which noncore funding 

exceeds the level of liquid assets for this group. The 

chart suggests the difficulty these institutions may 

encounter if forced to convert assets to meet funding 

outflows. Although subprime lenders may use noncore 

sources to fund riskier assets to a greater extent than the 

industry at large, this illustration exemplifies a systemic 

trend that is raising liquidity risk industrywide and is 

increasing risk to the insurance funds. 

Increasing Levels of Interest Rate Risk 

Challenge Some Institutions 

The refinancing boom of the late 1990s spurred a significant shift into longer-maturity assets for many 

insured institutions. During this period, a vast majority 

of mortgage borrowers opted for longer-term, fixed-rate 

loans, which they obtained at historically low rates. A 

great deal of the higher-rate or adjustable-rate loans that 

borrowers refinanced were held in the portfolios of 

insured institutions, which contributed to a general 

lengthening of the maturity of assets held at insured 

institutions. 

The trend toward longer-term, fixed-rate assets has been 

particularly pronounced among mortgage lenders. For 

example, state-chartered savings banks, which are traditionally mortgage lenders, have experienced a dramatic 

increase in long-term assets. As of June 30, 2000, 

almost 45 percent of the median savings bank’s earning 

assets were not scheduled to reprice for five years or 

longer (see Chart 3). 

Fixed-rate mortgage-related assets at federally chartered thrifts have risen similarly. From year-end 1995 

through first quarter 2000, the percentage of fixed-rate 

mortgage-related assets at thrifts with assets less than 

$1 billion rose from 49 percent to 60 percent of 

mortgage-related assets. Some thrifts and savings 

banks, therefore, have significant exposure to rising 

rates from low-yielding long-term assets. 

CHART 2 $ Billions 

Source: FDIC Division of Supervision and Bank and Thrift Call Reports (data are 

merger adjusted) 

Subprime Lenders’ Growing Dependence

 on Noncore Funding Strains Liquidity 

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

0 

30 

60 

90 

All other loans 

Residential real estate loans 

Securities and shortterm investments 

Columns: Noncore funding 

CHART 3 

Growing Concentration in Long-Term 

Assets Elevates Interest Rate Risk 

Source: Bank Call Reports, excluding Thrift Financial Report filers 

Share of Assets Maturing or Repricing in Five Years or Longer 

Relative to Total Earning Assets (median percentage) 

Percent 

Savings Banks 

Commercial Banks 

50 

0 

10 

20 

30 

40 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00

Kansas City Regional Outlook 13 Fourth Quarter 2000 
In Focus This Quarter
 

While most commercial banks do not have as high 

exposure to rising rates as savings banks, some may 

have taken on significant risk. The median savings bank 

has a ratio of long-term assets to earning assets that corresponds to the ratio level for the 93rd percentile of 

commercial banks. Although the 93rd percentile is in 

the tail of the commercial bank distribution, almost 600 

commercial banks have a concentration in long-term 

assets that exceeds that of the median savings bank. 

These institutions may be exposed to significant interest rate risk as well. 

While assets have lengthened considerably for many 

institutions, there has not been a corresponding extension of liabilities. To the contrary, funding pressures are 

tending to make bank liabilities more rate sensitive. 

These diverging trends generate concern, especially in a 

rising interest rate environment. That is, rate increases 

drive up the cost of funds more rapidly than earning 

asset yields at institutions with liability-sensitive interest rate risk postures. In a significantly higher interest 

rate environment, many institutions’ current postures 

likely would cause heavy margin erosion. 

Most institutions that have high concentrations in longterm assets also have strong capital and an asset mix 

that contains lower credit risk than that of many other 

institutions. Among savings banks, interest rate risk primarily arises from significant concentrations in residential mortgage loans, whereas the typical commercial 

bank’s exposure is more likely to arise from large holdings of long-term securities. However, some institutions 

with concentrations in long-term assets also may have 

lower capital levels, a higher-risk asset mix, or poor 

earnings. Rising rates could weaken these institutions 

and make it more difficult for them to weather adverse 

economic or other developments. 

Dependence on Market-Sensitive Revenues 

Increases Earnings Volatility for Some 

Institutions 

During the recent generally favorable conditions in financial markets, the share of revenue earned from business 

lines susceptible to financial market volatility has 

increased substantially for some of the industry’s largest 

institutions. Among these revenue sources are fees and 

gains from asset management, brokerage, investment 

banking, venture capital, and trading activities. The 19 

institutions most active in these lines of business earned 

over 26 percent of their net operating income from such 

sources in the second quarter of 2000. Other large institutions also have reported a growing dependence on these 

volatile sources of revenue. 

Turbulence in the financial markets has led to greater 

earnings volatility for some of these institutions. Stress 

in the financial markets could weaken the demand for 

underwriting services or significantly reduce trading 

revenues or venture capital gains. Furthermore, the 

same factors that are causing volatility in the financial 

markets could hamper loan growth and lead to slower 

revenue growth from core business lines. Should 

increased earnings volatility from exposure to marketsensitive revenues combine with slower revenue growth 

from core business lines, some institutions could face 

significant earnings challenges. 

The Rising Level of Problem Business Loans 

Is Centered in Large Banks 

Second quarter 2000 commercial and industrial (C&I) 

credit quality indicators at banks deteriorated for the 

eighth consecutive quarter. Noncurrent C&I loans— 

those on nonaccrual status plus those 90 days or more 

past-due—rose 13 percent over first quarter 2000 levels 

to $14.5 billion, or 1.4 percent of total C&I loans. Noncurrent loan levels for the period ending June 2000 were 

40 percent higher than the year-earlier level. Net C&I 

loan loss rates also continue to edge higher but remain 

well below those experienced by banks in the late 1980s 

and early 1990s.1 

Large banks, particularly those active in syndicated 

lending, are bearing the brunt of deteriorating C&I loan 

quality. Recent increases in criticized and classified 

shared national credits (SNCs), which are loans exceeding $20 million that are shared among three or more 

lending institutions, are illustrated in Chart 4. In the 

2000 SNC review, criticized and classified credits 

increased 44 percent over 1999 levels to 5.1 percent of 

total SNC commitments. Furthermore, the bulk of the 

increase was in the more severe classified categories, 

which now comprise 64 percent of total criticized and 

classified credits, compared with 54 percent at the yearearlier review. 

11

During second quarter 2000, banks posted an annualized net C&I 

loss rate of 0.67 percent, up from 0.55 percent for second quarter 

1999. For comparison purposes, net quarterly annualized C&I loss 

rates averaged 1.11 percent from fourth quarter 1991 to fourth quarter 

1993. 

Kansas City Regional Outlook 14 Fourth Quarter 2000 
In Focus This Quarter
 

CHART 4 

Note: C&I = commercial and industrial; SNC = shared national credit 

Source: Shared National Credit Program 

Syndicated Loan Problems Are on the Rise 

Percent

$ Billions 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

Criticized and 

Classified SNC Loan 

Commitments (right 

scale) 

Percentage of SNC 

Commitments Criticized 

and Classified (left scale) 

0 

2 

4 

6 

8 

10 

12 

14 

16 

0 

20 

40 

60 

80 

100 

120 

140 

C&I loan quality indicators continue to deteriorate 

despite generally favorable economic conditions. Three 

factors explain much of this deterioration: certain weak 

industries, rising corporate debt burdens, and the seasoning of syndicated loans underwritten from 1997 to 

1998, when many banks significantly eased business 

lending standards. 

Industry Sector Weaknesses 

The financial stresses facing healthcare and entertainment companies (cinema operators in particular) have 

been well publicized. While the healthcare and entertainment sectors have contributed significantly to the 

decline in commercial credit quality, problems within 

these two sectors do not account for the full extent of 

the increase in noncurrent loans and problem SNC 

loans. Both of these sectors are within the broader services sector, which experienced a $4.6 billion increase 

in criticized and classified credits from the 1999 to the 

2000 SNC review. However, this increase accounts for 

only 15 percent of the $30.8 billion increase in criticized and classified SNCs overall.2 The expected 

default probabilities evident in market-based information can be used to identify other industry sectors experiencing financial stress. KMV LLC has developed a 

model that uses publicly available information to estimate the likelihood of default of individual firms.3 

2 See the interagency release of SNC results at www.occ.treas.gov/
 

ftp/release/2000-78a.pdf.
 

3 KMV Credit Monitor® uses information from a firm’s equity prices
 

and financial statements to derive KMV’s Expected Default Frequency (EDFTM), which is the probability of the firm defaulting within a
 

one-year period. The main determinants of a firm’s likelihood of
 

default: the firm’s asset value, the volatility of the firm’s asset value,
 

and the degree of financial leverage.
 

KMV’s model is used by many lenders to monitor and 

evaluate obligor risk and credit risk trends. Applied to 

the analysis of industries, the output of KMV’s model is 

just one of a number of indicators that suggest weaknesses in certain industry sectors. 

Sectors that include a high proportion of firms with 

high default probabilities (median one-year default 

probabilities exceeding 4 percent) are shown in Chart 5. 

Using entertainment as an example, the bars in the chart 

show that in September 2000, one-half of publicly held 

entertainment firms had greater than an 8 percent 

chance of defaulting on their obligations within one 

year. In September 1999, this same proportion of entertainment companies had a substantially smaller (6 percent) chance of defaulting within a 12-month period. 

The median likelihood of default for all the industries 

shown in the chart far exceeds that of Standard & 

Poor’s-rated, BB-grade (sub-investment-grade) obligors 

as of September 2000, as indicated by the dotted line in 

the chart. 

Rising Corporate Debt Burdens 

U.S. corporate debt burdens, as measured by the debtto-net-worth ratio for nonfarm, nonfinancial businesses, 

continue to increase. This ratio reached 83 percent in 

the second quarter of 2000, up from 72 percent as of 

year-end 1996. Although debt burdens remain below the 

1988–1992 average of almost 87 percent, U.S. businesses are nevertheless becoming increasingly vulnerable to rising credit costs and disruptions in credit 

availability. 

CHART 5 Median Expected Default Frequency (EDFTM) (percent) 

Various Industries Show High Levels 

of Expected Default Risk 

Comparative EDFTM

 of S&P Bonds Rated BB 

(as of September 2000) 

Source: Credit MonitorTM ©2000, KMV LLC, all rights reserved 

Entertainment 

HealthcareWholesale Trade 

Apparel &Textile

Misc. Manufac. LodgingMining 

AgricultureConstruction 

Retail

0 

1 

2 

3 

4 

5 

6 

7 

8 

9

 September 1999

 September 2000 

Kansas City Regional Outlook 15 Fourth Quarter 2000 
In Focus This Quarter
 

Seasoning of 1997–1998 Vintage Loans 

Results of recent supervisory surveys suggest that 

banks are tightening terms and conditions on loans to 

small-, middle-, and large-market obligors. However, 

this tightening follows a relaxation of standards in prior 

years that has contributed to a heightened level of risk 

in banks’ loan portfolios.4 Not coincidentally, the period 

between 1995 and 1998 saw a sharp rise in the proportion of lower-graded, higher-risk credits categorized as 

leveraged transactions by Loan Pricing Corporation. 

Leveraged loan originations—those priced at 150 basis 

points or more over the London Inter-Bank Offer Rate 

(LIBOR)—rose from 12 percent of total syndicated 

loan originations in 1995 to 31 percent in 1999. According to a recent Standard and Poor’s commentary, many 

banks have acknowledged that 1997 and 1998 vintage 

credits are beginning to produce higher problem loan 

levels.5 

Household Sector’s Leverage Is High, 

and Imbalances Are Appearing 

Consumers are enjoying the benefits of the economic 

expansion, as jobs are plentiful, home ownership 

remains generally affordable, and credit seems to be 

readily available for financing motor vehicles and other 

major purchases. These conditions contributed to record 

high sales of cars and light trucks during the first nine 

months of 2000, helping sustain the consumer spending 

growth shown in Chart 6. One corollary of high vehicle 

sales, however, is softening prices for used vehicles. 

Consequently, some lessors—including banks—are 

realizing lower-than-expected residual values on leased 

vehicles, which, in turn, are triggering losses in their 

lease portfolios. This situation illustrates one problem 

that lenders can encounter even in good economic 

times. 

Spending growth remained robust in recent quarters 

even as gains in disposable income slowed. The gap 

between income and spending growth is “financed” as 

households draw down savings, tap capital gains, refinance mortgages, assume more debt, or undertake some 

combination of these measures. 

4 See Federal Reserve Board’s Senior Loan Officer Opinion Survey on 

Bank Lending Practices for May and August 2000 and Surveys of 

Credit Underwriting Practices for 1999 and 2000 from the Office of 

the Comptroller of the Currency. 

5 “U.S. Bank Loan Portfolios Reflect Rise in Corporate Bond 

Defaults.” July 20, 2000. Standard and Poor’s Commentary. 

CHART 6 

Household Spending Growth 

Exceeds Income Growth 

Source: Bureau of Economic Analysis via Haver Analytics, Inc. 

Real Consumption Spending 

Real Disposable Income 

7 

–1 

0 

1 

2 

3 

4 

5 

6

Annual Growth Rate (percent) 

’86 ’87 ’88 ’89 ’90 ’91’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99’00 

Quarter 3 

From 1995 through 1998, and likely since then, the 

increase in both leverage and debt servicing burdens has 

been concentrated among low- and middle-income 

households. Among families holding debt in 1998, debt 

payments exceeded 40 percent of disposable income for 

nearly 20 percent in the $10,000 to $24,999 income 

group and nearly 14 percent in the $25,000 to $49,999 

group.6 One concern is that these debt-laden families 

may have inadequate financial resources to make payments should adverse conditions or job loss occur. In 

such instances, lenders could be doubly affected if 

households draw on their credit card and home equity 

lines of credit, further compromising their repayment 

ability, in order to sustain spending in excess of income. 

The recent rise in credit card losses in banks’ card portfolios and rising losses in the portfolios of subprime 

lending specialists may indicate that strains among 

some households are spilling over to lenders. Moody’s 

Investors Service expects credit card losses to rise 

through 2001, according to a recent analysis of 

prospects for the U.S. credit card industry. 

Overheated residential real estate markets in several 

metropolitan statistical areas (MSAs) may be another 

warning of economic imbalances. Dramatic gains in 

home resale prices in San Francisco stand out (see Chart 

7), but this market is not alone in experiencing appreciation considerably higher than income growth. In 

some markets, where financial-services or informationtechnology workers are concentrated, bidding wars for 

properties may reflect the fact that affordability is 

6 Kennickell, Arthur B., Martha Starr-McCluer, and Brian J. Surette. 

January 2000. “Recent Changes in U.S. Family Finances: Results 

from the 1998 Survey of Consumer Finances.” Federal Reserve 

Bulletin. Vol. 86, 1–29. 

Kansas City Regional Outlook 16 Fourth Quarter 2000 
In Focus This Quarter
 

enhanced by gains in wealth rather than in income. 

Even so, similar surges in home resale prices in the 

past often were not sustainable. The subsequent years 

of stagnant or falling collateral values caused financial 

stress among some homeowners and their lenders. 

Further concern about residential real estate lenders 

arises because pockets of speculative construction 

under way in some markets may produce units that 

become increasingly difficult to sell at anticipated asking prices. 

Construction and Development 

Loan Growth Is Accelerating 

Commercial real estate (CRE) construction across all 

property sectors has grown during this expansion, with 

office construction particularly active. The amount of 

office space completed in mid-2000 was the largest 

since 1989 and is projected by Torto Wheaton Research 

to continue rising. Not surprisingly, construction and 

development (C&D) loan volume, growth rates, and 

concentrations are trending upward rapidly. While total 

private real estate spending grew about 6.5 percent over 

the four quarters ending midyear 2000, C&D loans at 

insured institutions rose by 26 percent. C&D loan 

growth has remained above 20 percent since 1997, and 

the aggregate volume of C&D loans is the highest since 

1989. 

Such growth is contributing to higher concentrations of 

C&D loans relative to Tier 1 capital. At current levels, 

concentrations do not begin to approach those of the 

late 1980s. However, several metropolitan areas have a 

CHART 7 

Median Home Resale Prices Soar 

in San Francisco Bay Area 

Percent Change from

Four Quarters Earlier 

35 

30 

25 

20 

15 

10 

5 

0 

–5 

–10 ’80 

’82 

’84 

’86 

’88 

’90 

’92 

’94 

’96 

’98 

’00

Quarter 1 

Source: National Association of Realtors via Haver Analytics, Inc. 

large percentage of insured institutions reporting high 

and rising concentrations. Table 1 (next page) shows 

MSAs with at least 15 nonspecialized community 

banks7 and at least one-third of those institutions reporting concentrations in C&D loans equal to at least 100 

percent of Tier 1 capital. The Atlanta MSA stands out. 

Sixty-five percent of Atlanta’s 85 nonspecialized community institutions reported C&D loans exceeding 100 

percent of Tier 1 capital on June 30, 2000, and 35 percent reported a concentration exceeding 200 percent. 

The aggregate C&D concentration for all 85 institutions 

in the MSA was 156 percent, the highest among MSAs 

with at least 15 institutions of similar size and nature. 

Several other markets also include significant shares of 

institutions with high concentration levels. 

Nine of the 16 markets highlighted in Table 1 not only 

have a relatively high percentage of C&D loan exposure but also appear vulnerable to overbuilding in two 

or more property types.8 While these markets show no 

clear signs of emerging economic stress, lenders there 

clearly may be at greater risk should economic or real 

estate conditions sour. Other concerns regarding CRE 

lending arise from a recent Office of the Comptroller 

of the Currency survey, which reports heightened 

credit risk in CRE portfolios and predicts it will 

increase through 2001. In addition, respondents to a 

midyear 2000 FDIC survey of examiners reported 

more frequent comments about excess office and retail 

space. 

Increasing Share of De Novo Institutions 

Raises the Stakes in Some Markets 

A common element among the metropolitan markets 

listed in Table 1 (next page) is the presence of newer 

institutions. In 10 of the 16 markets, at least 20 percent 

of the nonspecialized community institutions are less 

than three years old. The drive to build market share 

among these institutions, particularly if they are publicly traded entities, is increasing the competitive pressure on banks and thrifts in these markets. In some 

instances, the aggregate cost of deposits within the 

MSAs has risen faster than in the nation as a whole, risk 

7 The term “nonspecialized community bank” refers to institutions 

with total assets under $1 billion that are not specialty institutions 

such as credit card or trust banks. 

8 See “Ranking Metropolitan Areas at Risk for Commercial Real 

Estate Overbuilding,” Regional Outlook, third quarter 2000, which 

identifies markets where new construction is high relative to existing 

stocks of space. 

Kansas City Regional Outlook 17 Fourth Quarter 2000 
In Focus This Quarter
 

TABLE 1 

High C&D Loan Exposure Appears in Various MSAs 

SHARE (%) OF AGGREGATE C&D LOANS 

MSAS WITH 15 OR INSTITUTIONS* WITH C&D RELATIVE TO AGGREGATE 

MORE NONSPECIALIZED CONCENTRATIONS > OR = TIER 1 CAPITAL (AS %) 

COMMUNITY INSTITUTIONS* 100% OF TIER 1 CAPITAL IN THIS MSA* 

ATLANTA, GA 65 156 

PHOENIX–MESA, AZ 56 131 

MEMPHIS, TN–AR–MS 52 154 

PORTLAND–VANCOUVER, OR–WA 47 146 

OAKLAND, CA 47 163 

NASHVILLE, TN 44 103 

RIVERSIDE–SAN BERNARDINO, CA 42 110 

SAN DIEGO, CA 41 90 

GRAND RAPIDS–MUSKEGON–HOLLAND, MI 40 81 

SEATTLE–BELLEVUE–EVERETT, WA 39 98 

SALT LAKE CITY–OGDEN, UT 38 56 

FORT WORTH–ARLINGTON, TX 38 110 

DALLAS, TX 36 95 

LAS VEGAS, NV–AZ 35 119 

LEXINGTON, KY 34 80 

DENVER, CO 33 113 

*Sample includes institutions with total assets under $1 billion that are not specialty institutions such as credit 

card or trust banks. 

Note: Boldface indicates major MSAs identified at risk for excess commercial real estate construction in Regional 

Outlook, third quarter 2000. 

C&D = construction and development, MSA = metropolitan statistical area 

Source: Bank and Thrift Call Reports for June 30, 2000 

profiles are being elevated, and aggregate leverage ratios 

are falling, despite the influx of capital from the new 

institutions. Highly competitive environments have the 

potential to increase risk taking by negatively affecting 

underwriting standards and balance sheet composition. 

Farm Sector Challenges Continue 

Much of the agricultural industry is experiencing 

stress because of low commodity prices, compounded 

in some areas by low yields resulting from weather- or 

disease-related problems. Strong global competition 

and high worldwide production during the past several years have resulted in large crop inventories, 

depressed prices, and limited prospects for a price 

turnaround in the near term. In the aggregate, record 

levels of government payments have helped the 

nation’s farms maintain a generally stable financial 

condition but have not eliminated the stress in this sector. In fact, the U.S. Department of Agriculture projects that at least one in four farm businesses in several regions9 will not cover net cash expenses in 2000, 

suggesting that the viability of highly leveraged farmers may be in question. 

Fortunately, the aggregate condition of nearly 2,100 

insured agricultural banks—institutions with 25 percent 

or more of loan portfolios in agricultural credits— 

remains healthy. Generally, agricultural banks continue 

to report favorable asset quality, earnings, and capital 

positions. However, they are experiencing somewhat 

elevated levels of noncurrent loans compared with 

nonagricultural institutions. Agricultural banks are disproportionately represented among the weakest 25 percent of institutions nationwide in terms of noncurrent 

9 These are USDA’s Basin and Range, Mississippi Portal, Fruitful 

Rim, and Southern Seaboard regions. See www.ers.usda.gov/ 

briefing/farmincome/fore/regional/regional.htm. 

Kansas City Regional Outlook 18 Fourth Quarter 2000 
In Focus This Quarter
 

loan levels. In addition, rising levels of carryover debt at 

farm banks may translate into higher losses in the future 

if commodity prices remain low. 

The strains in the farm sector also have implications for 

nonfarm banks in agricultural areas. In several agriculturedependent states, such as Montana and the Dakotas, for 

example, where farmers’ earnings are depressed and the 

economies not well diversified, nonagricultural banks 

are reporting higher noncurrent levels than insured 

institutions elsewhere in the nation. 

Summary 

The long-lived economic expansion has contributed to 

the banking and thrift industries’ record levels of profitability and asset quality. However, as the expansion has 

matured, both consumer and corporate leverage has risen 

considerably. Bank liquidity is becoming increasingly 

strained by lackluster core deposit growth, which has 

been insufficient to fund strong loan demand. This trend 

has resulted in a decided shift into higher-risk asset 

classes to mitigate margin pressures arising from the 

greater reliance on noncore-funding sources. Furthermore, interest rate risk has risen significantly for many 

institutions, and after nearly a decade of improving asset 

quality, the level of problem loans is increasing. 

Clearly, high levels of profitability in recent years have 

been achieved, in part, by an increased appetite for risk. 

Concern arises because insured institutions’ current 

profitability is being negatively affected by some recent 

trends, despite the sustained economic expansion. And, 

while capital levels have remained fairly stable, the 

amount of risk being leveraged on the industry’s capital 

base is on the rise. Just as a rising tide is said to float all 

boats, a strong economy can mask potential problems 

that will become evident should the economic tide turn, 

particularly in institutions or markets where aboveaverage risk is concentrated. Insured institutions’ safety 

and soundness may be most vulnerable in situations 

where banks and thrifts are exposed to multiple challenges, whether because of strategic decisions or 

because of repercussions from economic and banking 

forces beyond their control. 

Daniel Frye, Regional Manager 

Joan D. Schneider, Regional Economist 

Steve Burton, Senior Banking Analyst 

Allen Puwalski, Senior Financial Analyst 

Ronald Spieker, Chief, Regional Programs 

and Bank Analysis 

The authors would like to acknowledge 

the Washington and regional staff of 

both the Division of Insurance and 

the Division of Supervision for their 

analyses and comments, which were 

instrumental in writing this article. 

Kansas City Regional Outlook 19 Fourth Quarter 2000 
✁
 

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