Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 2000 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Senior Financial
 

Analyst
 

Andrea Plante,
 

Economic Analyst
 

Regional Perspectives 

◆ Region’s Economic and Banking Conditions—The Boston Region’s economy continued to grow in 1999, but more slowly than a year ago. Insured institutions 

reported stable financial conditions; however, falling margins continued to depress 

profitability. Consumer and commercial loan growth remained strong. See page 3. 

◆ Region’s Insured Institutions Exhibit Increased Exposure to Interest Rate 

Risk—Recent trends suggest that many insured institutions in the Region have 

become increasingly exposed to rising interest rates. The concentration of assets that 

either mature or reprice in excess of five years has grown without offsetting extensions on the liability side. Because of the sensitivity of nonmaturity deposits to 

changing interest rates, institutions cannot rely solely on containing costs on nonmaturity deposits to manage interest rate risk in a rising rate environment. See 

page 7. 

By the Boston Region Staff 

In Focus This Quarter 

◆ Banking Risk in the New Economy—This article summarizes current economic conditions, with a primary focus on potential risks to insured depository 

institutions. It explores the implications of long-term trends that have led to the 

New Economy. Recent high rates of economic growth with low inflation have been 

made possible by increases in productivity arising from new technologies, higher 

investment spending by businesses, and large-scale industrial restructuring. Underlying these trends has been a financial environment that has largely accommodated 

the growing borrowing needs of consumers and businesses. Market-based financing, 

provided in large part through securitizations and mutual funds, has made capital 

readily available to start-up “new economy” firms as well as mature companies that 

seek to merge or restructure. Despite the clear benefits of market-based financing 

in supporting economic activity, there are also concerns. A recurrence of financial 

market turmoil, such as that experienced in fall 1998, has the potential to quickly 

change the currently positive economic outlook to one that is far more challenging. 

Detail is provided on commercial credit quality, market sources of revenue, and 

other risks to watch in banking. See page 13. 

By the Analysis Branch 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 Boston Region’s Regional 

Outlook, please call Daniel Frye at (781) 794-5678 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 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 
Regional Perspectives
 

Regional Perspectives
 

• The Boston Region’s economy experienced another year of solid growth in 1999, but the pace slowed from 

1998. 

•	 Home sales have moderated, while home resale prices continue to post strong gains as a result of dwindling 

inventory. 

•	 Insured institutions are reporting strong results despite lower net interest margins. Commercial loan growth 

remains strong. 

•	 Growing concentrations in long-term assets have exposed many of the Region’s insured institutions to rising interest rates. 

Region’s Economic and Banking Conditions
 

Economic Overview of 1999 

Employment Growth Slowed in 1999 

Nonfarm employment rose by 1.9 percent in the Region 

during 1999, a deceleration from the pace seen in the 

previous two years. This slowdown was in line with 

national trends. Only Maine posted a (modestly) higher 

employment advance for the year (see Chart 1). Maine 

and New Hampshire again showed the Region’s 

strongest percentage job gains, with growth even 

exceeding the nation’s. During first quarter 2000, job 

growth generally followed the prior year’s trend, 

although manufacturing showed a more moderate rate 

of decline. 

Minimal job growth during 1998 in the manufacturing 

sector developed into an outright decline last year, as 

the Region’s factory payrolls fell by 2.8 percent. This 

decline was greater than that seen nationally. However, 

the losses in New England factory payrolls bottomed 

out in second quarter 1999 as improving global 

economies and strong domestic demand helped lift 

manufacturing output. This improvement mitigated the 

decline in factory payrolls through the nine months ending March 2000. The most pronounced manufacturing 

job losses last year were in southern New England (see 

Chart 2). States such as Maine and Rhode Island continued to shed payrolls in old-line industries such as 

shoes, textiles, and paper mills in the former and misCHART 1	 CHART 2 % Change on Year Ago 

Most States Saw Slower Job Growth in 1999 

Source: Bureau of Labor Statistics 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

1998 

1999 

ME

NH

VT

MA

CT

RI

Region

Nation 

% Change on Year Ago 

Region’s Manufacturing Sector a Drag 

on 1999 Job Growth 

Source: Bureau of Labor Statistics 

–5 

–4 

–3 

–2 

–1 

0 

1 

2 

3 

4 

1998 1999 

VT

ME

NH

CT

MA

RI

Region

Nation 

Boston Regional Outlook 3	 Second Quarter 2000 
Regional Perspectives
 

cellaneous manufacturing (jewelry and metal goods) in 

the latter. Connecticut, Massachusetts, and New 

Hampshire experienced layoffs at certain aerospace/ 

defense-related plants as well as at some larger computer hardware facilities, primarily because of industry 

mergers and corporate restructuring. 

Unemployment Rates Fell Again in 1999 

The U.S. labor market tightened again in 1999, marking 

the seventh unemployment rate decline in as many 

years. New England followed this trend. The Region’s 

unemployment rate fell to an average of 3.3 percent last 

year (its lowest in 11 years), while the national unemployment rate averaged 4.2 percent in 1999. Last year, 

New Hampshire reported the Region’s lowest unemployment rate and Rhode Island its highest. The 

Region’s most populous states (Massachusetts and Connecticut) experienced modestly lower unemployment 

last year versus 1998. Rhode Island, Vermont, and 

Maine posted some of the larger declines. Rhode 

Island’s unemployment rate fell from 4.9 percent to 4.2 

percent, the largest decline in the Region. Through first 

quarter 2000, all the Region’s state seasonally adjusted 

unemployment rates remained below the nation’s rate, 

with Connecticut and Massachusetts achieving some of 

the largest declines since year-end 1999. 

Map 1 shows the Region’s county-level unemployment 

rates for 1999. While some areas of higher unemployment persist, the number of counties with unemployment exceeding that of the nation fell to 12, from 22 in 

1998. Unemployment rates of some counties—such as 

Bristol County, Massachusetts, and several counties in 

Maine and Vermont—remained above the nation’s, even 

though their actual unemployment rates declined from 

1998. Only three counties saw their unemployment rates 

increase from 1998. Grand Isle County, Vermont, and 

Franklin County, Maine, inched up a tenth of a percent 

each, to 5.0 and 6.8 percent, respectively. Oxford County, Maine, saw its unemployment rate exceed the 

nation’s in 1999 as it rose 0.3 percent from 1998 to 6.3 

percent. The Region’s highest unemployment rate 

remained in Washington County, Maine, at 8.3 percent 

(down from 9.5 percent in 1998). New England’s lowest 

unemployment rate was again found in New Hampshire 

(Grafton County, at 1.7 percent), although Vermont’s 

Chittenden County was a close second at 1.9 percent. 

Income 

At the time of this writing, personal income information 

was available for only the first three quarters of 1999. 

On the basis of that information and state population 

MAP 1 

The Region’s Highest Unemployment Rates 

Predominate in Maine’s Outer Counties 

Source: Bureau of Labor Statistics 

1999 

Unemployment 

Rate 

Below Region 

Exceeds Region 

Average 

Exceeds U.S. 

estimates for 1999, the Region’s income per capita rose 

5.2 percent from the same period in 1998. If this rate 

persisted during the fourth quarter, the Region’s income 

growth will have matched its 1998 pace and exceeded 

that of the nation for the sixth consecutive year. Other 

than the period surrounding the last recession 

(1989–93), the Region’s annual income growth has surpassed the nation’s over the past 20 years. As of this 

writing, it appeared that Connecticut was the only state 

in the Region to see an acceleration in its per capita 

income growth rate relative to 1998. 

Existing Home Sales and Prices 

Existing home sales in New England, as reported by the 

National Association of Realtors, are estimated1 to have 

increased by about 2 percent last year, after surging 

nearly 13 percent in 1998 (see Table 1). Nationally, sales 

volume also increased more slowly than in 1998. 

Growth moderated significantly in all states except 

Maine, which continued to advance at a very rapid pace. 

1 As of this writing, sales data were not reported for third quarter 1999 

in New Hampshire, for the last two quarters of 1999 in Maine, and for 

fourth quarter 1999 in Vermont. Annual percentage changes were 

derived for these states from available data and an annualized estimate was established. As a result of this estimation, the Region’s total 

sales for 1999 are also approximated. 

Boston Regional Outlook 4 Second Quarter 2000 
Regional Perspectives
 

TABLE 1 

Housing Activity Slowed in 1999, after Strong 1998 

(Percent Change on Year Ago) 

EXISTING RESIDENTIAL HOME PRICE 

HOME SALES* PERMITS INDEX 

1999 1998 1999 1998 1999 1998 

NATION 5.9 13.7 2.2 11.9 5.9 5.5 

REGION 2.3 12.6 –1.2 16.8 8.7 6.4 

CONNECTICUT 2.2 13.9 –13.7 27.4 5.7 5.3 

MAINE 13.3 13.8 –1.6 33.4 6.6 5.5 

MASSACHUSETTS –2.3 10.4 –1.4 12.0 10.9 7.2 

NEW HAMPSHIRE 1.9 13.1 8.6 6.8 9.3 6.6 

RHODE ISLAND 8.9 20.3 24.1 –1.1 3.8 4.2 

VERMONT 1.1 6.3 17.2 20.0 4.8 2.8 

* 1999 figures are estimated for Region, Maine, New Hampshire, and Vermont.
 

Sources: National Association of Realtors (sales), Census (permits), Fannie Mae/Freddie Mac (quality-constant price
 

index)
 

Sales in Massachusetts actually declined modestly in 

1999. Much of the slowdown in that state was reportedly the result of a limited inventory of homes for sale, particularly in the state’s dominant greater Boston market. 

As in 1998, strong demand coupled with declining 

inventory pushed the Region’s home resale prices almost 

9 percent higher, as measured by the Fannie Mae/Freddie Mac quality-constant home price index. This was the 

second consecutive year that the Region’s prices 

increased more rapidly than the nation’s (the Region 

lagged the nation between 1989 and 1997). Table 1 

shows the recent trend in home sales price appreciation, 

excluding the effect of new home sales (a small share of 

overall volume). Massachusetts generates the largest 

volume of sales in the Region and had the most dramatic appreciation last year, propelling the Region’s price 

index higher. Like Massachusetts, New Hampshire and 

Maine also saw home sale price gains in excess of the 

nation’s. Slower sales growth and the Region’s weakest 

job market likely weighed on the home price index in 

Rhode Island—the only state not to see an acceleration 

in price growth last year. In general, owner-occupied 

demand continues to dominate sales activity, although 

significant demand has arisen for second and vacation 

homes as well the past few years. There does not appear 

to be any significant speculative activity in home purchases at this time. Such action, and the unsustainable 

price appreciation it produced, preceded the Region’s 

home price collapse of the early 1990s. 

Residential Building Permits 

After surging almost 17 percent in 1998, residential 

permit issuance in the Region slid modestly in 1999. 

Because Massachusetts and Connecticut lead the 

Region in the number of permits issued each year, 

weakness in these states can weigh heavily on regional 

activity. Issuance in Connecticut, one of the Region’s 

most heated markets in 1998, declined by nearly 14 

percent last year, while Maine and Massachusetts each 

saw a modest drop in permit issuance (see Table 1). 

None of these shifts are particularly surprising, given 

the significant gains these states experienced in the 

previous year. Rhode Island experienced a turnaround 

in permit issuance last year. Although growth in permit 

issuance eased in 1999 for Vermont, the state’s twoyear average gain was the highest for the Region. During first quarter 2000, permit issuance fell about 2 

percent across the Region from the same period in 

1999. Maine and Rhode Island posted double-digit 

advances, while all other states in the Region saw 

declines from a year earlier. The first quarter trend may 

not imply much for the overall pattern in 2000, as most 

of the Region’s residential construction activity occurs 

in the final three quarters of every year. Still, over the 

past ten years in the Region, the year-ago percent 

changes for first quarter and fourth quarter permit 

issuance (year-to-date) demonstrated a positive correlation of about 0.80. If this relation continues, the first 

quarter trend may signal a downturn in residential 

building in the Region this year. 

Boston Regional Outlook 5 Second Quarter 2000 
Regional Perspectives
 

Banking Overview of 1999 

Boston Region insured institutions reported stable 

financial conditions in 1999 (see Table 2). Insured institutions in the Region (excluding credit card institutions) 

reported an aggregate return on assets of 1.09, down 

slightly from 1998 because of merger-related charges in 

the Region’s larger institutions. The profitability of the 

Region’s insured institutions was weighed down by a 

declining net interest margin (NIM), which has fallen 

23 basis points from 1997, largely because of the 

lengthy refinancing wave that persisted between 1997 

and early 1999. While profitability has softened slightly, 

asset quality indicators remain generally favorable. Pastdue ratios in the Region’s institutions continued downward, falling 11 basis points in 1999, to 1.57 percent. 

Net charge-offs remained stable at 0.44 percent of total 

loans. Noncore funding as a percentage of assets continued to increase in all asset size categories in the Region. 

Overall, the Region’s insured institutions continue to 

perform well compared to the nation. 

Commercial and industrial (C&I) loans and consumer 

loans continue to drive loan growth in the Region. C&I 

TABLE 2 

loan growth has been brisk over the past two years; the 

Region’s insured institutions report a median C&I 

growth rate of 16 percent, up from 12 percent in 1998. 

While robust C&I loan growth has occurred throughout 

the Region, growth in consumer loans is primarily driven by the Region’s larger lenders and has not been as 

widespread. Consumer loan growth remained stable in 

1999, with an aggregate growth rate of 10 percent, up 

slightly from 9 percent the previous year. Net chargeoffs of consumer and C&I loans increased slightly from 

1998 to 1999 as a result of increases at the larger institutions in the Region. 

Merger and acquisition activity slowed in 1999 because 

of precautions and concerns regarding the year 2000 

date change. The number of insured institutions in the 

Region decreased to 420 at year-end 1999 from 434 a 

year earlier. De novo activity approximated the pace of 

1998, as four new institutions opened for business in 

1999 compared with five in 1998. Two of these new 

banks are headquartered in Connecticut, increasing the 

number of de novos in the state to six in the past two 

years, two-thirds of the Region’s de novo activity during 

that period. 

Financial Performance Remains Solid despite Falling Margins 

> $1 BILLION – 

BOSTON REGION* < $1 BILLION* < $25 BILLION* > $25 BILLION* 

DEC DEC DEC DEC DEC DEC DEC DEC DEC DEC DEC DEC 

’99 ’98 ’97 ’99 ’98 ’97 ’99 ’98 ’97 ’99 ’98 ’97 

RETURN ON 

ASSETS 1.09 1.20 1.24 1.04 1.09 1.09 1.15 1.21 1.16 1.07 1.22 1.32 

NET INTEREST 

MARGIN 3.80 3.88 4.03 3.88 3.91 4.08 3.75 3.79 3.96 3.80 3.93 4.04 

PAST-DUE RATIO 1.57 1.68 1.97 1.42 1.87 2.30 1.19 1.69 1.98 1.89 1.59 1.80 

NET CHARGEOFF RATIO 0.44 0.43 0.38 0.07 0.10 0.14 0.21 0.22 0.28 0.76 0.73 0.55 

CORE 

DEPOSITS/ASSETS 47.64 53.73 57.17 70.39 72.46 74.43 61.09 66.66 67.66 32.23 38.81 43.99 

NONCORE 

FUNDING/ASSETS 40.18 34.58 31.63 18.55 15.94 14.24 29.87 24.55 23.15 53.60 47.92 43.76 

* All data exclude credit card institutions.
 

Source: Bank and Thrift Call Reports; reported on a merger-adjusted basis
 

Boston Regional Outlook 6 Second Quarter 2000 
Regional Perspectives
 

Interest Rate Risk Trends
 

Concentrations in Mortgage-Related 

Investments Elevate Interest Rate Risk 

In the previous edition of the Boston Regional Outlook, 

it was noted that the Region’s insured institutions displayed a relatively lower risk profile than institutions in 

other parts of the country, in large part because the 

Region is heavily populated with savings institutions. 

These institutions have traditionally concentrated 

investments in residential real estate loans and mortgagebacked securities, assets that have historically contained 

very low credit risk. In addition, the Region’s commercial banks typically hold a greater percentage of earning 

assets in residential-real-estate-related investments than 

do their peers. This large overall investment in mortgagerelated assets, while reducing credit risk, results in 

above-average levels of interest rate risk for many institutions in the Region. Recent trends suggest that many 

insured institutions in the Region have become increasingly exposed to rising interest rates. The following discussion evaluates events and trends that contribute to 

this exposure, as well as the long-term implications of 

this heightened interest-rate risk posture. 

1997 Refinancing Wave Revisited 

During 1997, long-term interest rates began a slow and 

steady decline that resulted in an upswing of refinancing activity. The mortgage refinancing index, published 

by the Mortgage Bankers Association of America 

(MBA), was nearly twice as high in the second half of 

the year as it was in the first, and was reaching levels 

attained during the refinancing waves seen earlier in the 

decade. What was different about this renewed refinancing wave relative to those seen in the early 1990s 

was that applications for mortgage refinancing were 

primarily for fixed-rate loans because of a general flattening of the yield curve as the year progressed. This 

shift in consumer preference for fixed-rate mortgages 

was discussed extensively in the Boston Regional Outlook, first quarter 1998. That article also suggested that 

New England banking institutions could experience a 

disproportionately high volume of refinancing activity 

caused by several factors beyond those generated by 

lower interest rates alone. The reader is encouraged to 

review the earlier article for a detailed discussion of 

those factors. 

Several concerns were raised at that time, particularly in 

the event that the yield curve remained low and flat for 

a prolonged period. These concerns included the potential for a general easing of underwriting standards to 

generate the volume needed to replace elevated runoff; 

impairment of mortgage-servicing-related assets, 

including interest-only strips; and declining NIMs. 

However, the greater concern raised at that time centered on how the Region’s insured institutions ultimately positioned themselves for the future during a 

prolonged period of refinancing activity, most of which 

would be directed toward fixed-rate instruments. Low 

long-term rates were attracting borrowers into longterm structures, while depositors remained averse to any 

long-term deposit instrument. 

A prolonged low, flat yield curve may create an environment that could cause insured institutions to get 

“whipsawed” by rapidly rising interest rates if the 

changing interest rate risk posture of an institution is not 

managed carefully. In a whipsaw scenario, (1) interest 

rates drop and the yield curve flattens; (2) rates remain 

low long enough for a significant portion of earning 

assets to lengthen in duration while liabilities remain 

short; and (3) a sharp increase in interest rates, particularly short-term rates, results in rapidly rising funding 

costs while asset yields adjust more slowly, depressing 

NIMs and earnings. 

Asset Duration Increases as Refinancing 

Wave Extends into Early 1999 

As we progressed into 1998, interest rates continued to 

fall and the yield curve remained flat, giving rise to an 

unprecedented refinancing boom that extended through 

the second quarter of 1999. During this stretch, over 90 

percent of refinancing activity was into fixed-rate mortgages, according to the MBA, and a great deal of the 

activity was conversions from existing adjustable-rate 

mortgages, the primary investment vehicle for many of 

the Region’s insured institutions. As can be seen in 

Chart 3 (next page), a significant extension of mortgage 

portfolio maturities in the Region resulted. The shift has 

been significantly large for state-chartered savings 

institutions, where the median percentage of residential 

first lien mortgages maturing or repricing after five 

years rose to 57 percent as of December 31, 1999, up 

from only 36 percent in June 1997. While comparable 

data are not available for the Region’s federally chartered thrifts, the median percentage of residential-realestate-related assets held, or backed by, adjustable-rate 

Boston Regional Outlook 7 Second Quarter 2000 
Regional Perspectives
 

CHART 3 CHART 4 

Longer Mortgage Maturities Are Contributing 

to Rising Levels of Interest Rate Risk 

Percentage of Mortgages*

Maturing/Repricing in: 

> 5 Yrs 

3–5 Yrs 

1–3 Yrs 

< 1 Yr 

6/30/97 12/31/99 

36 51 

9 13 

17 12 

38 24 

60% 40% 20% 0% 20% 40% 60% 

* Residential first liens 

Source: Call Reports: Boston Region, merger adjusted (excluding TFR filers) 

TFR = Thrift Financial Reports 

Median Percentage of

Respective Loan Class 

Terms Are Lengthening in the Commercial Sector 

20 

30 

40 

50 

60 

70 

80 

90 

Source: Call Reports: Boston Region (excluding TFR filers) Jun ’97 

CRE > 5 yrs (Commercial Banks) 

CRE > 5 yrs (Savings Banks) 

C&I > 3 yrs (Commercial Banks) 

C&I > 3 yrs (Savings Banks) 

Aug ’97

Oct ’97

Dec ’97

Feb ’98

Apr ’98

Jun ’98

Aug ’98

Oct ’98

Dec ’98

Feb ’99

Apr ’99

Jun ’99

Aug ’99

Oct ’99

Dec ’99 

loans was 40 percent at year-end 1999. That percentage 

hovered near 60 percent three years ago. The remaining 

analysis is limited to those institutions filing Call 

Reports, although it is expected that the experience of 

federally chartered thrifts (which file Thrift Financial 

Reports [TFRs]) would be similar to that of state-chartered savings institutions, as the asset compositions are 

similar. 

The refinancing and extension pressure has not been 

limited to residential portfolios. The median percentage 

of nonresidential real estate loans maturing in excess of 

three years has risen from 21 percent to 34 percent since 

June 1997, with the majority of the migration related to 

loans that historically repriced within three months, presumably prime-rate-based credits. Since June 1997, 

Call Report filers have separately reported the volume 

of commercial loans that mature in excess of three years 

and the volume of commercial real estate loans that 

mature in excess of five years. Chart 4 shows the trend 

for these categories as a percentage of total commercial 

and commercial real estate loans, respectively. While 

the reported totals do include loans with variable interest rates, the lengthening maturities clearly suggest that 

the extension of duration for nonresidential real estate 

loans is centered in these categories. The chart also 

depicts a clear easing in terms of commercial credits 

resulting from extending maturities that raises credit 

risk to the extent that lenders are potentially locked in to 

borrowers for longer periods. Savings institutions have 

been particularly willing to extend maturities in the 

commercial real estate category. 

Borrower preference for fixed-rate financing has clearly driven the extension of maturities noted in loan portfolios. However, holding these loans has raised the level 

of banks’ exposure to rising interest rates. Institutions 

can mitigate this risk through active management of 

securities portfolios, extending liabilities, or off-balancesheet mechanisms. The following section looks at trends 

in these aspects of overall asset/liability management. 

Risk Mitigation Activities Are Generally Lacking 

The first quarter 1998 Regional Outlook article suggested that many institutions would be faced with the 

decision to either book long-term assets or sell them 

and reinvest in shorter duration instruments, the latter of 

which would put downward pressure on earnings. The 

magnitude of the refinancing was so great that most 

institutions were unwilling to retain the interest rate risk 

associated with the 15- and 30-year fixed-rate mortgages 

that were being originated. As a result, a great deal of 

this paper was securitized. However, NIMs were falling 

steadily through this period, and in response, many 

institutions opted to hold the securitized loans to offset 

declining margins. In addition, rather than shortening 

the nonmortgage sector of the securities portfolio, many 

institutions have actually lengthened maturities to pick 

up higher returns than those offered on the very short 

end of the yield curve (see Chart 5). 

As a result of these shifts, both market and management 

driven, the concentration of assets that either mature or 

reprice in excess of five years has tremendously 

increased. The trend has been particularly evident in the 

Region’s savings institutions, where the median percentage of mortgage-related assets to total earning 

assets is 58 percent (30 percent for commercial banks). 

Boston Regional Outlook 8 Second Quarter 2000 
Regional Perspectives
 

CHART 5 

Source: Call Reports: Boston Region (excluding TFR filers) 

While Customer Preference Drives Loan Maturity Extension, 

the Duration of Securities Reflects Portfolio Management Decisions 

Median Share of Mortgage-Backed

Securities Maturing/Repricing

> 5 Years

10 

15 

20 

25 

30 

0 

5 

0 

10 

20 

30 

40 

50 

60 

70 

80 

90 

Commercial Banks 

Savings Banks 

Commercial Banks 

Savings Banks 

Median Share of Other Securities

Maturing/Repricing > 5 Years 

Jun 

’97 

Dec 

’97 

Mar 

’98 

Sep 

’97 

Jun 

’98 

Dec 

’98 

Sep 

’98 

Mar 

’99 

Jun 

’99 

Dec 

’99 

Sep 

’99 

Jun 

’97 

Dec 

’97 

Mar 

’98 

Sep 

’97 

Jun 

’98 

Dec 

’98 

Sep 

’98 

Mar 

’99 

Jun 

’99 

Dec 

’99 

Sep 

’99 

These institutions, which outnumber commercial banks 

by nearly a 2.5:1 margin, also have been aggressively 

expanding the commercial sectors of loan portfolios in 

an effort to diversify away from large holdings of residential real estate loans. As seen in Chart 4, savings 

institutions have been willing to book longer-term commercial credits, particularly in the real estate sector. The 

competitive pressure posed by savings institutions 

appears to have had a disparate effect on the Region’s 

commercial banks as these institutions have increased 

the concentration in long-term assets at a much greater 

pace than that seen for commercial banks nationally 

(see Chart 6). 

While there has been a significant extension of maturities on the asset side of the balance sheet, the liability 

side has been a decidedly different story. The maturity 

structure of time deposits for the Region’s insured institutions has steadily shortened since mid-1997. At that 

time, approximately 73 percent of all time deposits 

matured within one year. That percentage increased to 

77 percent by year-end 1999. There has been some 

lengthening of borrowings to offset the shortening of 

deposit liabilities; however, the overall duration of liabilities with fixed maturities has remained fairly stable. 

In addition, longer-term borrowings contain a significant percentage of advances that are callable if interest 

rates rise appreciably. Thus, liabilities would shorten at 

the same time that asset duration would be increasing 

because of a further dampening of prepayment activity 

on mortgage-related assets. With recent increases in 

interest rates, prepayment rates have already fallen to 

“normal” levels, because most outstanding residential 

loans now bear coupons that are below current market 

rates and refinancing activity is low. 

In summary, there appears to be little change in the 

maturity structure of time deposits and borrowings to 

offset the growth in long-term assets. In addition, institutions are not using off-balance-sheet mechanisms to 

mitigate the increasing risk. Approximately 12 percent 

of the Region’s commercial banks and only 3 percent of 

the savings institutions reported interest rate derivative 

holdings as of December 1999, and these percentages 

have not changed materially since mid-1997. Therefore, it appears that the ability to hold down the cost of 

nonmaturity deposits is becoming increasingly important as an interest rate risk management tool. Nonmaturity deposits (NMDs) are a significant portion of 

interest-bearing liabilities (IBLs) for the Region’s 

insured institutions. The median percentage of NMDs 

to IBLs for commercial banks and savings institutions 

is 45 percent and 42 percent, respectively. These levels 

CHART 6 

Growing Concentration in Long-Term Assets 

Elevates Interest Rate Risk 

0 

10 

20 

30 

40 

50 

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

Nation: 

Savings Banks 

Region: 

Savings Banks 

Nation: 

Commercial Banks 

Region: 

Commercial Banks 

Source: Call Reports (excluding TFR filers) Median Long-Term Assets as a Percentage of Total Earning Assets 

Boston Regional Outlook 9 Second Quarter 2000 
Regional Perspectives
 

compare favorably with national median levels of 38 

percent and 36 percent and may provide New England 

institutions with a little more flexibility to manage 

costs and control interest rate risk. While these deposits 

do not show the same sensitivity to interest rate movements as do borrowings and time deposits, there is 

some sensitivity to interest rate swings, particularly in 

money market deposit accounts (MMDAs) and savings 

deposits. The key question is, how sensitive are these 

deposits? The presumption of a low sensitivity for 

interest rate risk management and measurement purposes may be a problem for some institutions in a 

rapidly rising interest rate environment, to the extent 

that the assumption leads to the adoption of a highly 

liability-sensitive risk posture. 

Chart 7 depicts an analysis undertaken to evaluate the 

sensitivity of nonmaturity deposit balances to interest 

rate changes. The analysis evaluated the effective cost of 

each nonmaturity deposit type (MMDA, Savings, NOW) 

for all insured institutions (excluding TFR filers) for the 

years 1987 to 1999. All institutions were segregated into 

ten deciles for each period, based on the effective cost of 

their deposits during each year. The median cost and 

median growth rate were then determined for each 

decile. The points plotted in Chart 7 are the median 

growth rates for all deciles, for each year, compared with 

the number of basis points that the median cost of those 

deposits was below the average Federal Funds rate for 

each respective year (NMD spread). As the chart suggests, there appears to be a certain spread beyond which 

depositors will seek alternative investments, either within the institution in a higher yielding instrument or elsewhere. In either case, the deposit flight must be replaced 

with higher cost funding, effectively raising the sensitivity of the deposit class. 

The chart shows the growth vs. spread patterns for 

MMDA and savings deposits, as these depositors clearly demonstrate a willingness to seek alternative investment vehicles if rates fall below certain thresholds 

relative to market rates. For NOW accounts, the relationship is not as clear, as these accounts are transaction 

oriented as opposed to the investment-oriented savings 

and MMDA accounts. Institutions paying the lowest 

rates on NOW accounts generally post nominal growth, 

although these institutions also have a lower percentage 

of deposits in NOW accounts than do more aggressive 

rate payers. 

Generally speaking, NMD spreads have widened during periods of rising interest rates because of the industry tendency to lag deposit rates to protect earnings in 

such an environment. Table 3 sets forth, by decile, the 

median growth rates and NMD spread for MMDA 

accounts for the institutions discussed above. As can be 

seen, there was a significant outflow of MMDA 

deposits in 1988–89 and 1994–95. These periods correspond with Federal Reserve increases in the targeted 

Federal Funds rate of 331 basis points and 300 basis 

points, respectively. For comparative purposes, the 

median loss rates for MMDA deposits for the Region’s 

savings institutions in 1989 and 1995 were 18 percent 

and 15 percent, respectively. The median decline for 

commercial banks was 12 percent for both years. Savings deposits behave in a similar manner to MMDA 

deposits; however, the growth rates are less volatile. 

For example, in 1995 the median loss rate for savings 

CHART 7 

Source: Call Reports (excluding TFR filers) 

Depositors Seek Alternative Investments When Deposit Rates Lag Market Interest Rates 

Money Market Deposit Accounts 

Rate Paid Minus Average Fed Funds (%) 

Annual Growth (%) 

Savings Deposits 

(20) 

(10) 

0 

10 

20 

30 

40 

50 

Annual Growth (%) 

(20) 

(10) 

0 

10 

20 

30 

40 

–6 –4 –2 0 2 –6 –4 –2 0 2

Rate Paid Minus Average Fed Funds (%) 

Boston Regional Outlook 10 Second Quarter 2000 
Regional Perspectives
 

TABLE 3 

Wide Spreads during Periods of Rising Interest Rates Have Led to Deposit Runoff 

ANNUAL PERCENT CHANGE IN MONEY MARKET DEPOSIT ACCOUNTS (MMDAS) 

DECILE* ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

1 –8.26 –9.82 –17.30 –3.33 6.17 6.83 –1.07 –9.42 –14.21 –3.96 –1.68 3.92 0.79 

2 –8.13 –9.54 –16.70 –3.49 9.66 5.96 0.15 –7.07 –12.85 –2.18 –2.29 2.20 –0.26 

3 –5.86 –9.63 –16.64 –1.29 10.44 6.15 –0.95 –7.83 –10.71 –2.71 –1.63 2.59 1.30 

4 –4.80 –8.67 –14.04 –1.16 11.69 8.56 –0.89 –6.83 –10.83 –0.81 –1.05 4.29 2.80 

5 –5.55 –7.71 –13.02 0.66 12.93 9.65 1.12 –7.73 –7.68 1.42 1.44 9.28 7.12 

6 –5.98 –6.60 –9.90 3.38 14.35 10.95 2.38 –6.94 –7.73 3.01 3.83 11.22 8.98 

7 –5.31 –7.05 –8.45 5.26 15.50 11.29 3.71 –5.47 –4.96 5.28 7.61 16.38 12.50 

8 –3.55 –5.10 –5.39 6.78 15.31 12.38 4.71 –6.27 0.41 9.79 13.59 21.08 13.99 

9 –1.36 –2.68 –0.87 10.20 15.99 16.36 6.74 –3.10 5.09 16.87 16.86 25.30 20.70 

10 3.10 1.67 9.33 17.22 20.29 21.34 8.76 4.48 21.05 24.85 28.79 36.43 27.29 

MEDIAN MMDA RATE PAID IN EACH DECILE LESS THE EFFECTIVE FEDERAL FUNDS RATE 

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

1 –2.12 –2.84 –4.35 –3.29 –1.30 –0.69 –0.81 –2.06 –3.53 –3.07 –3.24 –3.18 –2.98 

2 –1.68 –2.50 –4.00 –2.91 –0.91 –0.39 –0.53 –1.81 –3.17 –2.71 –2.81 –2.71 –2.48 

3 –1.54 –2.34 –3.80 –2.72 –0.76 –0.25 –0.44 –1.68 –2.98 –2.50 –2.57 –2.44 –2.21 

4 –1.43 –2.24 –3.63 –2.57 –0.61 –0.14 –0.33 –1.56 –2.84 –2.32 –2.43 –2.27 –1.99 

5 –1.35 –2.13 –3.45 –2.40 –0.55 –0.05 –0.24 –1.46 –2.69 –2.21 –2.26 –2.10 –1.81 

6 –1.26 –2.04 –3.28 –2.24 –0.47 0.06 –0.16 –1.37 –2.56 –2.05 –2.08 –1.88 –1.59 

7 –1.17 –1.92 –3.12 –2.08 –0.38 0.16 –0.06 –1.26 –2.38 –1.88 –1.86 –1.62 –1.35 

8 –1.05 –1.77 –2.87 –1.87 –0.27 0.29 0.03 –1.16 –2.15 –1.64 –4.57 –1.35 –1.12 

9 –0.86 –1.53 –2.48 –1.56 –0.12 0.45 0.19 –0.98 –1.81 –1.29 –1.24 –1.04 –0.83 

10 –0.41 –1.03 –1.73 –0.99 0.23 0.79 0.54 –0.58 –1.18 –0.77 –0.75 –0.63 –0.46 

EFFECTIVE FEDERAL FUNDS RATE 

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

6.66 7.57 9.22 8.10 5.69 3.52 3.02 4.20 5.84 5.30 5.46 5.35 4.97 

* Each decile represents the lowest to the highest 10 percent of institutions based on average rates paid on MMDA 

deposits for the respective period. 

Source: Call Reports (excluding TFR filers) 

deposits for both commercial and savings institutions 

was approximately 11 percent. 

In 1999, the median cost of MMDA deposits was 

approximately 3 percent, 300 basis points below the targeted Federal Funds rate at the time of this writing. In 

1989 and 1995, the two years registering the greatest 

level of deposit outflows, the median cost of these 

accounts averaged 257 and 283 basis points under the 

average Federal Funds rate, respectively. The NMD 

spread for savings accounts has also widened to levels 

seen in those earlier periods. With NMD spreads already 

at historically wide levels, MMDA and savings deposit 

balances may be at risk if acceptable rates (in the eyes of 

the depositor) are not maintained as interest rates rise. In 

light of the prospects for further rate increases, relying 

on an asset/liability management strategy centered on 

holding down NMD costs may be unwise. 

While interest rate risk is difficult to quantify from the 

information in Call Reports, aggregate trends can be 

evaluated by creating proxy instruments for each interestbearing asset and liability based on the reported time to 

repricing and/or maturity. Then earnings and equity at 

Boston Regional Outlook 11 Second Quarter 2000 
 

Regional Perspectives
 

risk can be broadly estimated by projecting cash flows 

for each reported category and by evaluating changes 

based on varying assumptions relative to the sensitivity 

of nonmaturity deposits to rate changes. An analysis 

was performed to determine general trends in exposure 

to rising interest rates, as this scenario appears to pose 

the greatest risk to the Region’s insured institutions at 

present. Two broad observations were derived from this 

analysis. The first (and no surprise) is that short-term 

exposure to higher rates, as measured by traditional gap 

analysis, has risen significantly, even when low sensitivity estimates are used for NMDs. More important, 

however, is that the duration of the exposure has 

increased as well, particularly for institutions with high 

concentrations in long-term assets. Historically, bank 

balance sheets were structured so that liability-sensitive 

positions that exceeded a one-year time horizon would 

generally reverse in years two and three because of 

maturing or repricing adjustable rate or balloon mortgages. Because of the refinancing-driven restructuring 

of balance sheets, this pool of assets has dwindled in 

many institutions, and, as a result, a highly liability-sensitive posture could persist for a number of years, as was 

the case for many thrifts in the early 1980s. 

Maturity Imbalances Heighten Importance 

of Risk-Reduction Strategies 

Interest rates have been rising since mid-1999, resulting 

in a sharp decline in refinancing activity. The share of 

new residential mortgage applications composed of 

adjustable rate instruments has risen to approximately 

25 percent of all volume, but the yield curve remains 

generally flat and borrowers continue to lean toward 

fixed-rate financing. Long-term financing that might 

ordinarily be priced at some spread over the prime rate 

(presently 9 percent) also remains attractive for commercial borrowers. Thus, it will be difficult to correct 

the imbalances that exist in many institutions’ interest 

rate risk postures through the normal course of business 

in a reasonably short period. With interest rates poised 

to continue rising, institutions should carefully assess 

current exposure to rising rates, including the price 

behavior of NMDs, and take appropriate action to mitigate any undue exposure. Net interest income remains a 

significant percentage of the operating income for the 

median savings bank (91 percent) and commercial bank 

(85 percent) in the Region. For many institutions, margin erosion arising from excessive exposure to higher 

interest rates could translate into sharply lower earnings 

or outright losses. On a stand-alone basis, this exposure 

to rising interest rates would likely not result in a significant 

problem. However, periods of rising/high interest rates have 

often been followed by a slowdown of economic activity or a 

recession. Institutions with weak earnings postures at 

the onset of an economic downturn will be least able to 

absorb rising credit losses through current earnings. 

Fortunately, the third leg of the whipsaw scenario—a 

prolonged period of high interest rates—has not played 

out, and may not occur. Rates have started to rise but not 

significantly, and expectations are that short-term rates 

will rise only another 50 to 75 basis points. If this happens, no harm, no foul. However, market expectations 

have underestimated the actual course of events many 

times in the past. Interest rate risk management must 

ensure that an institution can weather conditions that 

can be reasonably expected to occur. A 300–400-basispoint rise in rates has not been particularly uncommon 

in the past and may sometimes be driven by unanticipated international events. Under such conditions, many 

institutions, as presently postured, would likely experience heavy margin erosion. Steps should be taken to 

mitigate excessive exposure while the opportunity to do 

so exists. 

Securities portfolios, for the most part, have nominal 

levels of depreciation and can be restructured to mitigate the rising risk embedded in loan portfolios. Other 

balance-sheet-restructuring activities or off-balancesheet-hedging strategies also can be used to lower the 

level of interest rate risk. Clearly, the cost associated 

with any risk reduction strategy could affect near-term 

earnings, but the cost of not protecting against a significant rise in interest rates could be far greater. 

Boston Region Staff 

Boston Regional Outlook 12 Second Quarter 2000 
In Focus This Quarter
 

Banking Risk in the New Economy
 

The Division of Insurance periodically assesses conditions in the economy and the banking industry to identify and evaluate trends that could adversely affect the 

performance of insured depository institutions. At this 

time, the banking industry as a whole continues to 

enjoy record profits and solid financial ratios.1 Much of 

the industry’s strength derives from the remarkable performance of the U.S. economy, which has been expanding for the past nine years. This article explores factors 

that have shaped this unusually robust economic environment and discusses how changes in the economy 

may create new types of risks for insured depository 

institutions. 

During 1999, the FDIC reported the first annual loss for 

the Bank Insurance Fund since 1991. This loss primarily resulted from an uptick in unanticipated and highcost bank failures. Some of these failures were 

associated with high-risk activities such as subprime 

lending, and some were related to operational weaknesses and fraud. The emergence of these problems in 

the midst of a strong economic environment raises concerns about how the condition of the banking industry 

might change if economic conditions deteriorate. 

The Longest U.S. Expansion 

In February 2000, the U.S. economy entered its 108th 

month of expansion, making this the longest period of 

uninterrupted growth in U.S. history.2 This recordsetting performance has also been marked by a recent 

acceleration in the rate of real gross domestic product 

(GDP) growth, which has exceeded 4 percent in each 

year since 1997. Meanwhile, price inflation has 

remained relatively subdued. The core inflation rate, 

which excludes the volatile food and energy components, was just 2.1 percent in 1999, the lowest core rate 

since 1965. 

Recent economic conditions have been highly conducive to strong loan growth, low credit losses, and 

record earnings for the banking industry. The important 

1 For a recent summary of financial performance and condition of the 

banking and thrift industries, see the FDIC Quarterly Banking Profile, fourth quarter 1999, http://www2.fdic.gov/qbp/. 2 The chronology of U.S. business cycles is available from the National Bureau of Economic Research, http://www.nber.org/cycles.html. 

question going forward is how long these favorable conditions might last. Is this remarkable economic performance the result of some long-term upward shift in the 

pace of economic activity, or is it the temporary result 

of a few transitory factors? More important, are there 

new and unfamiliar dangers that, at some point, could 

significantly impair banking industry performance? To 

evaluate these questions, we must assess the factors that 

have contributed to recent economic performance and 

think ahead to possible developments that could end this 

expansion. 

What Is the New Economy? 

The term used most often to describe the recent period 

of economic performance has been somewhat controversial: the New Economy. Much of the controversy has 

arisen because people interpret the term in different 

ways. Wall Street analysts use the term to refer to the 

high-technology sectors of the economy, such as computers and software, biotechnology, and especially the 

Internet. Some of these New 

Economy firms have been able to 

raise large amounts of capital and 

command market valuations in 

the tens of billions of dollars well 

in advance of earning a profit or 

even booking significant cash 

revenues. 

Economists tend to employ the term New Economy in a 

slightly different way. To them, it refers to evidence that 

some of the traditional economic relationships have 

changed. For example, intangible assets now appear to 

play a much larger role in the valuation of investments 

than they have in the past.3 Firms in some industries 

now may exhibit increasing returns to scale (rather than 

diminishing returns), reflecting the fact that the value of 

their product rises as it becomes a de facto industry 

standard.4 Individual decision making, too, may be 

changing. Some believe that investors have reduced the 

risk premium they demand to hold equity positions 

3 Nakamura, Leonard. Federal Reserve Bank of Philadelphia. 

July/August 1999. Intangibles: What Put the New in the New Economy? Business Review. http://www.phil.frb.org/files/br/brja99ln.pdf. 4 Brown, William S. March 2000. Market Failure in the New Economy. Journal of Economic Issues, 219–27. 

Boston Regional Outlook 13 Second Quarter 2000 
In Focus This Quarter
 

because of their perception that holding equity is not, 

after all, substantially riskier than holding debt.5 Such a 

shift in investor attitudes could help explain why the 

price-to-earnings ratio for the S&P 500 index has 

recently approached all-time highs.6 

Perhaps the most important underlying change in the 

economy is the relationship between high rates of economic growth and changes in inflation. Economists have 

long maintained that rapid growth in economic activity 

has a tendency to lead to excess demand for goods (thereby raising consumer and producer prices) and excess 

demand for labor (thereby raising wage rates). But during 

the late 1990s, as growth accelerated and inflation 

remained low, economists began to reevaluate their 

notions of these trade-offs. Some argued that the low rate 

of inflation during this expansion was the fortunate result 

of temporary factors, such as a strong dollar and low 

energy prices, both of which could diminish or reverse 

direction over time.7 Only a few analysts were so bold as 

to suggest that the fundamental workings of the economy 

had changed in such a way as to allow a sustained period 

of high economic growth with low inflation. 

An early Wall Street description of the New Economy 

appeared in an article released by Goldman Sachs in 

January 1997.8 It describes a number of fundamental 

changes in the economy—driven by global competition 

and advancing technology—that may permit business 

cycle expansions to last longer than they have in the 

past. At the same time, it warned that longer economic 

expansions might have a tendency to contribute to 

greater financial excess and the possibility of more 

severe recessions and more sluggish recoveries. 

If this hypothesis is correct, and an emerging New 

Economy would contribute to longer expansions and 

more severe recessions, there may be implications for 

how banks manage risks. Since the Great Depression, 

U.S. business cycle recessions have not necessarily been 

catalysts for large numbers of bank and thrift failures. 

5 January 24, 2000. Has the Market Gone Mad? Fortune.
 6 September 1999. Earnings: Why They Matter. Money.
 7 Brown, Lynn Elaine. Federal Reserve Bank of New England.
 

May/June 1999. U.S. Economic Performance: Good Fortune, Bubble,
 

or New Era? New England Economic Review. http://www.bos.frb.org/
 

economic/pdf/neer399a.pdf, and Brinner, Roger E. Federal Reserve
 

Bank of New England. January/February 1999. Is Inflation Dead?
 

New England Economic Review. http://www.bos.frb.org/economic/
 

pdf/neer199c.pdf.
 

8 Dudley, William C., and Edward F. McKelvey. January 1997. The
 

Brave New Business Cycle: No Recession in Sight. U.S. Economic
 

Research, Goldman Sachs.
 

During the period from 1983 to 1989, when the U.S. 

economy was in the midst of a long expansion, some 

1,855 insured banks and thrifts failed. This wave of 

failures has been attributed to a variety of factors, 

including severe regional economic downturns, realestate-related problems, stress in the agricultural sector, 

an influx of newly chartered banks and banks that converted charters, and high nominal interest rates.9 However, the potential for significantly more severe national 

recessions would represent largely uncharted territory 

that could cause losses and loss correlations to depart 

from historical norms, posing a new set of risk management challenges for the industry going forward. 

The Productivity Revolution 

As the essential element that links faster economic 

growth and low inflation, productivity growth is the cornerstone of the New Economy. Productivity refers generally to the amount of output that can be obtained from 

a fixed amount of input. Labor productivity is usually 

measured in terms of output per hour. Chart 1 shows 

that output per hour in manufacturing has risen at an 

average annual rate of 4.5 percent during the current 

expansion, compared with rates of just over 2.5 percent 

in the three previous long economic expansions. Moreover, productivity growth accelerated in 1999 to a rate 

of 6.3 percent. Why is productivity growing so fast now 

compared with previous expansions? Even economists 

who believe that economic relationships have fundaCHART 1 

Productivity Has Grown at a Faster Rate in This 

Expansion than in Previous Long Expansions 

Average Year-over-Year Growth 

in Manufacturing Output per Hour 

5.0% 

4.0% 

3.0% 

2.0% 

1.0% 

0.0% 

1961–69 1975–79 1983–90 1991–2000 

Source: Bureau of Labor Statistics (Haver Analytics) 

9 FDIC Division of Research and Statistics. 1997. History of the 

Eighties: Lessons for the Future, Vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s, 16–17. http://www. 

fdic.gov/bank/historical/history/contents.html. 

Boston Regional Outlook 14 Second Quarter 2000 
In Focus This Quarter
 

mentally changed are hard-pressed to explain why all of 

the factors came together in the late 1990s and not 

before.10 Still, explanations for the increase in productivity tend to focus on three main factors. 

Increased Competition. Expanding global trade during 

the 1980s and 1990s has subjected U.S. firms to new 

competition from around the world. Annual U.S. 

exports of goods and services grew by over 230 percent 

(after inflation) between 1982 and 1999, while imports 

grew by 315 percent. The construction of new production facilities around the world in industries such as 

autos and chemicals has led to excess manufacturing 

capacity that has kept prices low. In other industries, 

including air travel, trucking, telecommunications, and 

banking, competition has been intensified through 

domestic deregulation. Facing intense competitive pressures and a low rate of general price inflation, firms 

cannot rely on annual price increases to help expand 

top-line revenue. Instead, there is pressure to continually cut costs in order to increase earnings. For many 

firms, this means adopting new technologies and new 

ways of organizing operations. 

Expanded Investment. U.S. firms of all sizes have 

invested in new technologies at a rapid pace during this 

expansion. Chart 2 shows that business investment in 

equipment and software represents almost one-quarter 

of total net GDP growth during this expansion, comCHART 2 

Business Investment in Equipment and Software
 

Has Been Robust during This Expansion
 

Average Percent Contribution of Real Investment 

in Durable Equipment and Software 

to Net GDP Growth by Expansion 

25 

20 

15 

10 

5 

0 

1961–69 1975–79 1983–90 1991–99 

Note: GDP = gross domestic product
 

Source: Bureau of Economic Analysis (Haver Analytics)
 

10 One possible explanation is that there is a learning curve for adopting new technologies and that technology diffusion is an inherently 

slow process. David, Paul A. Organization for Economic Cooperation 

and Development. 1991. Computer and Dynamo: The Modern Productivity Paradox in a Not-Too-Distant Mirror. In Technology and 

Productivity: The Challenge for Economic Policy, 315–47. 

pared with around 15 percent or less during previous 

long expansions. While this investment has been motivated by the need to cut costs, it has also been fueled by 

the availability of new computer technologies that have 

fallen in cost over time and by the ready availability of 

financial capital on favorable terms. 

Industrial Restructuring. The third aspect of the productivity revolution is large-scale restructuring in the 

U.S. corporate sector. Chart 3 shows that both the annual number and dollar volume of mergers in the late 

1990s far exceeded the pace of the so-called merger 

mania of the late 1980s. Two classes of firms are leading the new wave of mergers. First, companies in 

mature industries such as oil, autos, and banking are 

faced with excess productive capacity and intense price 

competition. For these firms, mergers are useful in 

expanding market share and removing redundant operations. Second, the largest dollar volume of mergers is in 

some of the most volatile emerging industries, including telecom, media, and the Internet. It is in these sectors of the economy, in particular, where the business 

models are evolving rapidly and where technological 

standards are still being determined. Firms in these 

industries that can grow rapidly through mergers have 

the chance to achieve long-term market dominance in 

what appear to be some of the fastest growing industries 

of the new century. 

The implications of the productivity revolution for the 

banking industry have been decidedly positive. Higher 

productivity has allowed a long expansion and faster 

economic growth with low inflation, all of which are 

conducive to robust financial performance by depository institutions. Higher rates of business investment 

CHART 3 

Note: M&A = merger and acquisition 

Source: Houlihan Lokey’s Mergerstat 

The Volume of Corporate Mergers Set 

Another New Record in 1999 

Number of M&A Deals M&A Deal Value, Billions of Dollars 

’70 ’72 ’74’76’78’80 ’82 ’84’86 ’88 ’90’92’94’96 ’98 

0 

2,000 

4,000 

6,000 

8,000 

10,000 

1,000 

1,200 

1,400 

1,600 

0 

200 

400 

600 

800 

Boston Regional Outlook 15 Second Quarter 2000 
In Focus This Quarter
 

have generated demand for credit that is supplied, in 

part, by banks and thrifts. Perhaps most important, the 

recent large-scale industrial restructuring has been 

highly supportive of strong business credit quality. This 

process has moved economic resources to more productive uses in an orderly fashion, without the high levels 

of bankruptcies and defaults that often accompany 

industrial restructuring. Given the volumes of corporate 

assets that have changed hands in recent years (more 

than $1.4 trillion in 1999 alone), it is fortunate indeed 

that this restructuring has proceeded in this fashion. 

The Role of the Capital Markets 

A critical factor in heightened business investment and 

restructuring during this expansion has been the 

remarkably favorable conditions in the financial markets. Financial capital has generally been readily available to business borrowers, usually on favorable terms. 

One factor that has held down the cost of capital for 

publicly traded corporations has been sharply rising 

stock prices. Many of these firms have been able to use 

equity shares as a currency with which to finance mergers. Furthermore, existing accounting rules do not 

always require the amortization of good will that comes 

onto the balance sheet as a result of a merger.11 

By far the largest amount of external business financing 

has been debt financing. U.S. nonfinancial corporations 

issued net debt in the amount of $535 billion in 1999 

and repurchased equity shares, on net, for the sixth consecutive year. Businesses have used this debt to purchase capital equipment, finance mergers, and buy back 

equity shares. This increase in debt issuance has not 

been limited to highly rated corporations. Venture capital financing amounted to almost $15 billion in the 

fourth quarter of 1999 alone, with over 60 percent of 

that amount going to Internet firms.12 

Banks have been active participants in nearly every 

facet of this financing activity. Syndicated loan origination volumes rose by 17 percent in 1999 to just over 

$1 trillion, despite relatively high credit costs and facility fees, factors that helped keep total volume below 

1997’s record $1.1 trillion in issuance. Syndicated loans 

to leveraged companies also rose 17 percent in 1999 to 

a record $320 billion. More impressive still was the 

growth in high-yield transactions, which rose nearly 50 

11 April 17, 2000. Techdom’s New Bean-Counting Battle. Business 

Week. 

12 May 2000. Venture financing data are derived from a PriceWaterhouseCoopers/Money Tree survey, as cited in Upside, 43. 

percent in 1999 to $190 billion. It is difficult to determine precisely how much syndicated loan exposure 

resides on the books of insured institutions or, more 

important, how much high-yield exposure is retained by 

commercial banks. Loan Pricing Corporation estimates that 64 percent of high-yield volume in the first 

half of 1999 was retained by banks.13 Insured commercial banks are the dominant originators of syndicated 

loans, with a 79 percent market share of investmentgrade originations and a 56 percent market share of 

non-investment-grade originations in 1999. Commercial banks have also expanded their presence in the venture capital market. For some of the largest banks, 

profits from venture capital operations account for a 

large portion of total earnings. Chase Manhattan reported venture capital investment earnings of $2.3 billion in 

1999, accounting for 22 percent of total net income.14 

Innovation in the capital markets continues to provide 

new and more efficient vehicles for business financing. 

For example, issuance of asset-backed securities totaled 

$346 billion in 1999, up from only $50 billion in 1990. 

In this ongoing revolution in finance, market-based 

intermediaries, such as mutual funds and asset pools, 

have assumed an increasing role in the credit markets. 

Chart 4 shows that net holdings of credit market instruments by mutual funds, government-sponsored enterprises, and asset pools exceeded the debt held by 

depository institutions for the first time in 1997. 

CHART 4 

Market-based Lending Is Becoming More 

Important as a Source of Business Financing 

Share of Total Net 

Credit Market Lending1 

70% 

60% 

50% 

40% 

30% 

20% 

10% 

0% 

Market-based Lenders3 

Depository Institutions2 

’60 ’63 ’66 ’69 ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 ’99 

1 Total net credit market lending is defined as net holdings of open-market paper,
 

government and municipal securities, corporate and foreign bonds, mortgages,
 

and other loans.
 

2 Depository institutions include commercial banks, savings institutions, and credit
 

unions.
 

3 Market-based lenders include mutual funds, closed-end funds, government-


sponsored enterprises, and asset pools.
 

Sources: Federal Reserve Board (Haver Analytics); Regional Financial Associates
 

13 September 13, 1999. Junk Loan Market Is Feeling the Pinch of 

Oversupply and Rising Interest Rates. The Wall Street Journal. 14 April 3, 2000.What’s Really Driving Banks’ Profits. Business Week. 

Boston Regional Outlook 16 Second Quarter 2000 
In Focus This Quarter
 

While the expansion in market-based financing has 

made credit more available to business and consumer 

borrowers, it also creates some concerns. One issue is 

the susceptibility of the financial markets to periodic 

bouts of turmoil. These episodes, such as the one triggered by the Russian government bond default and the 

near-failure of the Long Term Capital Management 

hedge fund in the fall of 1998, can result in the interruption of capital flows even to creditworthy borrowers. 

During the 1998 episode, private yield spreads widened 

sharply as investors sought the safety of U.S. Treasury 

securities. Some companies that had planned to issue 

debt to the markets during that period were unable to do 

so. For companies whose business models depend heavily on a continuous supply of liquidity from the financial markets, the effects of these episodes can be 

catastrophic. For example, the relatively short-lived 

episode of financial turmoil during late 1998 resulted in 

significant liquidity problems for a number of commercial mortgage firms. Nomura, Lehman Brothers, CS 

First Boston, and others incurred losses, while Criimi 

Mae, Inc., was forced to declare bankruptcy. 

Because market-based financing has played such a large 

role in facilitating the orderly restructuring of the U.S. 

economy through mergers and the formation of new 

businesses, a recurrence of financial market turmoil 

could contribute to the end of the current expansion. 

Moreover, such an event could have serious consequences for business credit quality. A prolonged interruption of market-based financing could, in this very 

competitive economic environment, prevent businesses 

from restructuring themselves through mergers and 

deprive them of capital needed to invest in cost-cutting 

technologies. The loss of financial flexibility would 

leave businesses much more vulnerable to the effects of 

CHART 5 

competition and could result in more firms seeking 

bankruptcy protection. Such a scenario has the potential 

to bring about a significant increase in charge-off rates 

for business lenders. 

Financial Imbalances 

Another concern that arises from increased dependence 

on market-based financing is that it may contribute to 

the emergence of financial imbalances in the economy. 

These imbalances could, in turn, increase the potential 

for financial market turmoil as a result of some unforeseen shock to the markets. 

As recently as 1993, the public deficit was near the top 

of the list of economists’ concerns about the U.S. economy. During that year, the combined deficit of the federal, state, and local government sectors exceeded $300 

billion. However, on the strength of a long economic 

expansion, lower interest rates, and lower federal spending on defense, the consolidated government sector 

posted its second consecutive surplus in 1999 (Chart 5). 

As the government has moved from deficit to surplus, 

households and businesses have continued to borrow 

hundreds of billions of dollars every year. Taken together, the annual net borrowing of businesses and households has been referred to as the “private deficit.” In 

1999, the private deficit narrowed to $913 billion from 

a record $1.02 trillion the year before. Although this private borrowing indicates confidence on the part of consumers and businesses about future prospects, it also 

raises concerns about the ability to service debt if interest costs rise or if incomes level off or decline. 

Boston Regional Outlook 17 Second Quarter 2000 

Flow of Net Sectoral Lending 

(Lending Less Borrowing), 

in Billions of Dollars Domestic Financial Sector 

Note: “Nonfinancial business” includes farm and nonfarm, corporate and noncorporate businesses. 

Source: Federal Reserve Board (Haver Analytics) 

Net Borrowing by Businesses and Households Represents a Growing “Private Deficit” 

–1,200 

–900 

–600 

–300 

0 

300 

600 

900 

1,200 

Foreign Sector 

Nonfinancial Business 

Households 

Government 

’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 
In Focus This Quarter
 

The largest part of the private deficit was again 

financed in 1999 by domestic financial institutions 

($649 billion) and an inflow of capital from abroad 

($207 billion). Both of these sources of financing are 

potential causes for concern. The rapid expansion in 

credit created by the financial sector raises questions 

about credit quality. Financial institutions theoretically 

serve as the gatekeepers of the economy, financing only 

the most creditworthy projects and rejecting those that 

are not viable. The sheer volume of credit extended to 

businesses and households—almost $1.4 trillion in new 

net lending over the past two years—raises the possibility that underwriting has become more lax and that 

average credit quality is slipping. (See the inset box on 

page 17 for a discussion of recent trends in commercial 

credit quality.) 

Reliance on inflows of foreign capital raises a different 

set of issues. The fact that the U.S. economy has been 

growing significantly faster than the economies of its 

major trading partners has contributed to a U.S. trade 

deficit that reached $268 billion in 1999 and could 

exceed $300 billion in 2000. This deficit puts hundreds 

of billions of dollars annually in the hands of foreign 

investors. As long as foreign investors largely choose to 

reinvest their excess dollars in U.S. factories and financial instruments, as has been the case in recent years, 

the United States can continue to enjoy a strong dollar 

and relatively low inflation and low interest rates. However, if foreign investors should choose to invest elsewhere, they must sell their dollars in foreign exchange 

markets. Doing so would put downward pressure on the 

dollar and upward pressure on U.S. inflation and interest rates. 

Recent Shocks to the U.S. Economy 

Despite the potential for a declining dollar as a result of 

U.S. reliance on foreign capital, other adverse developments have confronted the U.S. economy over the past 

year. The two factors of most consequence to the macroeconomic outlook have been rising energy costs and rising interest rates. These trends have played a role in 

recent equity market volatility that may have implications for the future direction of the economy. 

Rising Energy Prices. After declining to a low of 

around $10 per barrel in December 1998, oil prices have 

risen dramatically over the past year and a half. The spot 

price per barrel of West Texas Intermediate crude 

peaked in March 2000 at just under $30 before declining slightly in April. The rapid increase in oil prices during 1999 was sparked by a cutback in output by oilproducing nations that was instituted just as global economic growth was recovering from the crisis of 1998. 

The OPEC nations and other major oil producers 

reached a new agreement in March 2000 that provides 

for a production increase of some 1.5 million barrels a 

day. But, because demand is rising and gasoline inventories remain lean, analysts do not look for a significant 

decline in gasoline prices in the near term.15 

The effects of higher oil prices on the U.S. economy at 

this time are uncertain. According to some estimates, 

the economy is only half as dependent on oil as it was 

25 years ago, when the United States was experiencing 

the effects of its first “oil shock.”16 Still, higher oil 

prices were responsible for nearly all the increase in 

consumer price inflation during 1999. While year-overyear growth in the Consumer Price Index rose from 1.6 

percent in December 1998 to 2.7 percent in December 

1999, the core rate of inflation (excluding food and 

energy items) actually fell. The question now is whether 

higher energy prices will be passed along to the rest of 

the economy through rising wage and price demands 

during the remainder of 2000. 

Rising Interest Rates. From low points at the end of 

1998, both short-term and long-term interest rates have 

risen substantially, contributing to a higher cost of debt 

service for businesses and households. At the short end 

of the yield curve, the Federal Reserve (the Fed) raised 

the Federal Funds rate six times between June 1999 and 

May 2000, for a total increase of 175 basis points. 

While part of this increase merely reversed the reduction in rates that took place in late 1998, the Fed also 

voiced concerns that inflationary pressures might be 

emerging because of continued rapid U.S. economic 

growth. Given the stated commitment of the Federal 

Reserve to price stability, most analysts expect the Fed 

to continue to push short-term rates higher until growth 

in the economy slows to a more sustainable pace.17 

Bond markets also pushed up long-term interest rates 

during this period. The yield on the ten-year Treasury 

15 Energy Information Agency (U.S. Department of Energy). April
 

2000. Short-Term Energy Outlook. http://www.eia.doe.gov/emeu/
 

steo/pub/contents.html.
 

16 March 11, 2000. Fueling Inflation? The Economist.
 17 See, for example, U.S. House of Representatives. February 17,
 

2000. Testimony of Chairman Alan Greenspan Before the Committee
 

on Banking and Financial Services. http://www.federalreserve.gov/
 

boarddocs/hh/2000/February/Testimony.htm.
 

Boston Regional Outlook 18 Second Quarter 2000 
In Focus This Quarter
 

As Commercial Credit Quality 

Indicators Slip, Trends in Commercial 

Lending Come to the Forefront 

Commercial lending, which includes both commercial 

and industrial (C&I) and commercial real estate (CRE) 

loans, represents the greatest source of credit risk to 

insured institutions and the deposit insurance funds. C&I 

loan growth continued to be strong in 1999, although it 

did moderate from 1998 levels, and recent underwriting 

surveys have reported a slight tightening of terms.18 Nevertheless, there are signs that commercial credit quality is 

deteriorating.19 Most notably, as seen in Chart 6, C&I loan 

charge-off rates, corporate bond defaults, and corporate 

bond rating downgrades relative to upgrades have all 

been trending upward recently. For example, C&I loan 

loss rates rose to 0.56 percent of total loans in 1999, nearly double the rate of loss experienced in 1997. Although 

C&I loan loss levels are well below historical highs experienced throughout the 1980s and early 1990s, these signs 

of credit quality deterioration are occurring despite 

extremely favorable economic conditions. 

At least three factors have contributed to weakening in 

corporate credit quality. First, corporate indebtedness has 

been rising, as businesses have been spending to increase 

productivity, cut costs, repurchase equity, and finance 

mergers and acquisitions. The second factor relates to a 

greater risk appetite in the financial markets. For example, originations of leveraged syndicated loans—in particular, highly leveraged loans—have tripled over the past 

five years. Finally, stresses within industry sectors hard 

hit by structural changes, global competition, and deflationary pressures have resulted in challenges for 

borrowers. 

Construction and development (C&D) lending continues 

to be one of the fastest growing segments of banks’ loan 

portfolios, while loss rates among CRE and C&D loans 

remain extremely low. However, there are indications 

that conditions could be worsening in some markets. In 

particular, as shown in Chart 7, strong office completions and construction activity have begun to outpace 

absorptions and are projected to continue to do so over 

the next several years. Moreover, these trends have 

implications for vacancy rates. The national office 

vacancy rate moved higher during 1999 for the first time 

since 1991 and is projected to climb higher. 

In addition, some local CRE markets continue to show 

signs of overbuilding. Last year, the FDIC’s Division of 

Insurance identified nine markets in which the pace of 

construction activity threatened to outstrip demand for at 

least two property sectors.20 Seven of these nine markets 

reported an increase in office vacancy rates in 1999. 

CHART 6 

0.0 

1.0 

2.0 

3.0 

4.0 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

Note: C&I = commercial and industrial 

Source: Moody’s; Bank and Thrift Call Reports (Research Information System) 

Deteriorating Indicators Suggest Weakening 

Business Credit Quality 

Insured Institution C&I 

Charge-off Rate 

Corporate Bond 

Default Rate 

Bond Ratings 

Downgrades to 

Upgrades (columns) 

18 Both the 1999 Senior Loan Officer Opinion Survey (Federal 

Reserve Board) and 1999 Survey of Credit Underwriting Practices 

(Office of the Comptroller of the Currency) point to more stringent 

C&I loan terms since the latter part of 1998. This tightening follows a four-year period of easing C&I loan standards and predominantly reflects an increase in loan pricing. 

19 For additional detail, see Sothoron, Arlinda, and Alan Deaton. 

FDIC Division of Insurance. First quarter 2000. Recent Trends 

Raise Concerns about the Future of Business Credit Quality. 

Regional Outlook. http://www.fdic.gov/bank/analytical/regional/ 

ro20001q/na/Infocus1.html. 

20 These markets are Charlotte, Orlando, Salt Lake City, Dallas, Las 

Vegas, Phoenix, Nashville, Atlanta, and Portland. See Burton, 

Steve. FDIC Division of Insurance. First quarter 1999. Commercial Development Still Hot in Many Major Markets, But Slower 

Growth May Be Ahead. Regional Outlook. http://www.fdic.gov/ 

bank/analytical/regional/ro19991/na/Infocus2.html. 

CHART 7 

0 

20,000 

40,000 

60,000 

80,000 

100,000 

120,000 

140,000 

’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 

0% 

5% 

10% 

15% 

20% 

Source: CB Commercial/Torto Wheaton Research 

U.S. Office Vacancies Rose Last Year 

for the First Time since 1991 

Completions, Absorption 

(000 sq. ft.) Vacancy

 Rate 

Completions 

Absorption 

Projected

Actual 

Boston Regional Outlook 19 Second Quarter 2000
 
In Focus This Quarter
 

note rose from a low of 4.5 percent in October 1998 to 

6.5 percent by May 2000. Analysts have cited renewed 

demand for credit by a recovering world economy as 

well as concerns about inflation arising from the 

increase in energy prices as factors behind the rise in 

long-term rates. 

Higher energy costs and higher interest rates do not 

appear to have significantly slowed the pace of U.S. 

economic activity during the first quarter of 2000. The 

preliminary estimate of real gross domestic product 

growth during the quarter was 5.4 percent—a slowdown 

from the 7.3 percent rate of the fourth quarter of 1999 

but still well above what is considered a sustainable 

pace. Home construction, usually a sector that is particularly sensitive to movements in long-term interest 

rates, has remained surprisingly resilient. Still confident 

of their future prospects, homebuyers have increasingly 

turned to adjustable-rate mortgages to avoid some of the 

immediate costs of higher fixed mortgage rates. 

As for the business sector, higher costs for energy and 

debt service are most significantly affecting “Old Economy” firms that purchase commodity inputs and carry 

significant debt on their balance sheets. Airline companies in the S&P 500, for example, posted a year-overyear decline of 27 percent in net income from 

continuing operations during the first quarter of 2000.21 

Analysts have argued that New Economy firms, by contrast, are less vulnerable to recent economic shocks 

because they tend to carry little debt and consume relatively little energy. 

Equity Market Volatility. The notion that New Economy 

firms are less vulnerable to the effects of higher energy 

costs and higher interest rates may be one of the reasons 

that equity shares of firms in the technology sector 

began to dramatically outperform the broader market, 

beginning around the middle of 1999. Chart 8 shows 

that the technology-heavy NASDAQ index performed 

more or less in tandem with the Dow Jones Industrial 

Average between the end of 1996 and the middle of 

1999, but thereafter the NASDAQ soared far ahead of 

the Dow. Between October 1, 1999, and February 29, 

2000, the NASDAQ rose by 72 percent while the Dow 

declined by 4 percent. Moreover, this striking divergence between the equity returns of Old and New Economy companies was not limited to the U.S. markets. 

Parallel trends were observed in Europe, Japan, Korea, 

21 Bloomberg. The S&P 500 airline industry is composed of AMR 

Corp., Delta Air Lines, Southwest Airlines, and U.S. Airways Group. 

CHART 8 

and Hong Kong. The similarity in performance of the 

high-tech sectors across three continents suggests a 

worldwide flow of liquidity from investors to the shares 

of technology firms. 

However, emerging concerns about the technology sector contributed to significant volatility in technology 

0 

50 

100 

150 

200 

250 

300 

350 

400 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

Tech Stocks Have, Until Recently, Far 

Outperformed “Old Economy” Stocks Worldwide 

January 1997 = 100 

United States 

NASDAQ 

DJIA 

May 12, 2000 

0 

200 

400 

600 

800 

1,000 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

January 1997 = 100 

EASDAQ 

Bloomberg European 500 

May 12, 2000 

Europe 

0 

50 

100 

150 

200 

250 

300 

January 1997 = 100 

Japan 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

JASDAQ 

Nikkei 225 

May 12, 2000 

Boston Regional Outlook 20 Second Quarter 2000 
In Focus This Quarter
 

shares during March and April 2000. The NASDAQ 

index lost 30 percent of its value between March 10 and 

May 12, 2000. Analysts cited the Justice Department 

finding against Microsoft and doubts about the ultimate 

profitability of business-to-consumer Internet firms as 

two factors in the sell-off. 

Equity market volatility also poses a threat to the economic outlook. One concern is the so-called “wealth 

effect” that a declining stock market may have on consumer spending. Since 1995, rising stock prices have 

helped raise the market value of equities held by U.S. 

households, plus their holdings of mutual funds, by 

some $5.7 trillion. This windfall is an important reason 

that households have continued to reduce annual personal savings (to just 2.4 percent of disposable income 

in 1999) and increase spending on homes, autos, and 

other consumer goods. Although it is uncertain what 

effect a prolonged stock market correction might have 

on consumer spending, the potential wealth effect has 

surely grown as more households hold a higher percentage of wealth in corporate equities and mutual fund 

shares. (See the inset box at right for a discussion of 

how financial market volatility could affect banks.) 

The Economic Outlook 

Despite the effects of rising energy costs, increasing 

interest rates, and equity market volatility, the U.S. 

economy continues to grow at a robust pace. The consensus forecast of 50 corporate economists surveyed by 

the May 1999 Blue Chip Economic Indicators suggests 

that the economy will grow by 4.7 percent in 2000, 

while consumer prices are projected to rise by 3.0 percent from 1999 levels. Short-term interest rates are projected to rise only slightly by year-end from early May 

levels. In short, the consensus forecast indicates that the 

New Economy formula of rapid economic growth combined with low inflation will continue for the foreseeable future. If actual events conform to this forecast, the 

result will likely be another year of generally low loan 

losses and solid earnings for much of the banking 

industry. (See the inset box on the following page for a 

discussion of other risks to watch in banking.) 

Clearly, risks are associated with the economic outlook. 

Recently, higher oil prices and higher interest rates have 

been the most visible signs of trouble for the economy. 

New Economy companies may be less vulnerable to 

these effects, but even these firms have experienced a 

sharp decrease in equity valuations as investors reevalFinancial Market Volatility Could 

Pare Earnings for Banks Most 

Reliant on Market Sources of 

Revenue 

FDIC-insured banks are deriving an increasing proportion of earnings from noninterest sources (see 

Chart 9), particularly market-sensitive sources of revenue. This is especially true for larger institutions. 

According to Deutsche Banc Alex. Brown, the 18 

most active generators of market-sensitive sources of 

revenue earned over 25 percent of net operating revenue from these potentially volatile business lines.22 

While market-sensitive sources help to diversify revenue streams, they can also introduce increased 

income volatility in the event of financial market turbulence. Deutsche Banc Alex. Brown also reports that 

for those 18 banks that generated the largest amounts 

of market-sensitive revenues during the third quarter 

of 1998, the share of total revenue derived from 

market-sensitive sources declined from 23 percent to 

13 percent. Thus, a more sustained downward trend in 

the financial markets could particularly affect the 

earnings of large banking companies that rely heavily 

on income from sources such as venture capital, asset 

management and brokerage services, and investment 

banking. 

CHART 9 

15 

30 

45 

60 

75 

90 

1970s 1980s 1990s 

Noninterest Revenues Account for a Growing 

Share of Bank Net Operating Revenue 

Percentage of Net Operating Revenue* 

* Net operating revenue is the sum of net interest income and 

noninterest income. 

Sources: FDIC Historical Statistics on Banking; FDIC Quarterly Banking 

Profile 

Net Interest Income Noninterest Income 

0 

22 Net operating revenue is the sum of interest income and 

noninterest income less interest expense. According to 

Deutsche Banc Alex. Brown, these companies are Bank of 

America Corporation; Bank of New York Company, Inc.; 

Bank One Corporation; Bank Boston; BB&T Corporation; 

Chase Manhattan Corporation; Citigroup, Inc.; First Union 

Corporation; FleetBoston Financial; JP Morgan; KeyCorp; 

Mellon Financial Corporation; National City Corporation; 

PNC Bank Corp.; SunTrust Banks, Inc.; US Bancorp; 

Wachovia Corporation; and Wells Fargo & Company. 

Boston Regional Outlook 21 Second Quarter 2000 
In Focus This Quarter
 

Other Risks to Watch in Banking
 

Subprime Lending 

•	 Subprime consumer loan portfolios contributed to 

the large losses associated with recent high-cost 

bank failures. During 1999, the FDIC reported the 

first annual loss for the Bank Insurance Fund since 

1991. The loss was primarily the result of an uptick in 

unanticipated and high-cost bank failures. FDICinsured institutions with at least 20 percent of Tier 1 

capital in subprime loans accounted for 6 of the 13 

bank failures that occurred between January 1998 and 

March 2000. Fraud and inappropriate accounting for 

residuals also played a role in some of these failures.23 

•	 Subprime lending remains an area of concern. 

Insured depository institutions that engage in subprime lending represent a disproportionate share of 

problem institutions. Of the 79 banks and thrifts on 

the problem bank list as of year-end 1999, 21 percent 

were institutions with at least 20 percent of their Tier 

1 capital in subprime loans.24 

Agricultural Lending 

•	 While a majority of agricultural institutions remain 

relatively strong, external conditions have put pressure on some agricultural producers. Many agricultural areas are experiencing low commodity prices as 

well as weather- and disease-related problems. Strong 

global competition and high worldwide production 

over the past several years have resulted in increasing 

inventories of many crops and poor prospects for a 

price turnaround in the near term. Moreover, in spite 

of record government farm payments in 1999, the 

U.S. Department of Agriculture projects that in the 

year 2000 one in four farms will not cover cash 

expenses, up to 20 percent of farmers will experience 

repayment problems, and 5 percent of farmers will be 

“vulnerable.”25 

23 See Puwalski, Allen. FDIC Division of Insurance. Second 

quarter 1998. Gain-on-Sale Accounting Can Result in Unstable 

Capital Ratios and Volatile Earnings. Regional Outlook. http:// 

fdic01/division/doi/outlook/2q1998/atlanta/infocus1.html. 

24 The problem bank list includes all insured depository institutions rated a composite “4” or “5.” 

25 “Vulnerable,” as defined by the U.S. Department of Agriculture 

Economic Research Service, applies to institutions that have 

debt/asset ratios above 0.40 and negative income such that they 

cannot meet current expenses or reduce existing indebtedness. 

•	 Some signs point to growing stress for agricultural 

institutions. Forty-two percent of FDIC-supervised 

banks active in agricultural lending showed a moderate or sharp increase in the level of carryover debt 

during third quarter 1999, compared with just 26 percent during third quarter 1998.26 In addition, net loan 

loss rates for agricultural production loans increased 

in 1999 to the highest level since 1991. However, at 

0.32 percent, the 1999 net loss rate is just one-tenth 

the rate experienced during the height of the agricultural crisis of the mid-1980s.27 

Operational Risk 

•	 Operational risks are becoming more prominent in 

the banking industry. Driven by consolidation and 

expansion into new product lines and markets, financial institutions are seeing an increase in operational 

complexity. Operational risk encompasses a host of 

factors not related to credit or market activities, 

including risks associated with processing transactions, legal liability, fraud, strategic missteps, and 

internal control weaknesses. Operational risks tend to 

be more pronounced when institutions engage in 

rapid growth, far-flung operations, and complex business processes. 

•	 Greater attention is being paid to operational risks 

in the financial industry. Recently, analysts have 

noted that the pressure to meet ambitious postmerger 

earnings predictions can result in cost-cutting measures that jeopardize the comprehensiveness and 

integrity of risk-management systems. In addition, 

the role that fraud has played in recent bank problems 

and failures reinforces the importance of adequate 

internal controls and audit procedures. The significance of operational risks to financial institutions has 

been noted in industry surveys and informationsharing efforts among financial firms.28 NetRisk Inc., 

a Greenwich, Connecticut, consulting firm, recently 

estimated that operational losses among financial 

institutions have exceeded $40 billion over the past 

five years. 

26 September 1999. FDIC Report on Underwriting Practices. 27 See Anderlik, John M., and Jeffrey W. Walser. FDIC Division of 

Insurance. Third quarter 1999. Agricultural Sector Under Stress: 

The 1980s and Today. Regional Outlook. http://www.fdic.gov/ 

bank/analytical/regional/ro19993q/kc/agricult.html. 

28 For additional detail, see March 2000. Operational Risk: The 

Next Frontier. RMA/PricewaterhouseCoopers Survey. April 6, 

2000. Tech Bytes: Banks Join Forces Against Operational Risk. 

American Banker. 

Boston Regional Outlook 22	 Second Quarter 2000 
In Focus This Quarter
 

uate the long-term prospects. Equity market volatility 

threatens to dampen consumer confidence and the ability of businesses to continue to merge, restructure, and 

invest. 

The economy has become particularly dependent on 

financing delivered through the capital markets. In this 

more permissive financial environment, rising debt levels and greater dependence on foreign capital have 

emerged as financial imbalances that may contribute to 

future problems for the economy. Businesses and 

households with high levels of debt are more vulnerable 

to problems if interest rates continue to rise or income 

growth falters. Rapid credit creation by the domestic 

financial sector suggests the possibility of lax credit 

underwriting standards. Reliance on foreign capital 

raises concerns about what would happen to the value of 

the dollar and to domestic inflation if foreign investors 

decide to invest elsewhere. 

Some analysts suggest that the New Economy, driven by 

increased productivity, heightened competition, and 

robust investment, may be characterized by longer 

expansions. Financial market imbalances may, however, 

contribute to deeper recessions and more sluggish 

recoveries compared with earlier business cycles. 

For the banking industry, it is clear that a recession 

would mean slower loan growth, deteriorating credit 

quality, and impaired profitability. But the biggest 

threat to the banking industry is a recession that is tied 

to disruptions in the financial markets. The ready availability of financing to start new businesses and restructure old businesses has been key to the New Economy. 

The process by which businesses have invested and 

restructured in response to competition has been orderly from the perspective of bank creditors. If this 

process should be disrupted, we could see a much more 

disorderly process, with more bankruptcies and higher 

losses to lenders. 

This article was prepared and coordinated by the management and staff of the Analysis Branch of the Division of 

Insurance. Contributions and feedback from analysts across the Division were essential to its completion. 

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

Richard A. Brown, Chief, Economic and Market Trends Section 

Steve Burton, Senior Banking Analyst 

Steven C. Cunningham, formerly Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, formerly Senior Financial Analyst 

Mary L. Garner, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Thomas A. Murray, Senior Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Arlinda Sothoron, Senior Financial Analyst 

Ronald Spieker, Chief, Regional Programs and Bank Analysis 

Boston Regional Outlook 23 Second Quarter 2000 
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