Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1999 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Millen L. Simpson,
 

Financial Analyst
 

Shayna M. Olesiuk
 

Economic Analyst
 

In Focus This Quarter 

◆ Falling Prices in Commodities and Manufacturing Pose Continuing 

Risks to Credit Quality—Falling prices are causing problems for a wide range 

of commodity industries—a collection of agricultural, mining, and manufacturing 

industries that produce standardized products and face global competition, mostly 

on the basis of price. Firms in these industries have experienced slow or negative 

profit growth even as they reduce payrolls to cut costs. There are signs that these 

trends are contributing to higher credit risk for insured institutions. The effects of 

these problems on local economies and community banks could grow if low prices 

persist. See page 3. 

By Richard A. Brown and Alan Deaton 

◆ Shifting Funding Trends Pose Challenges for Community Banks— 

Several long-term trends are making it more difficult for some institutions to economically fund asset growth with deposits in today’s marketplace. As a result, 

traditional measures of liquidity and liability composition for commercial banks 

reflected record-low levels of deposit funding at year-end 1998. The need to augment lagging deposit growth to meet loan demand has led many community banks 

to seek more wholesale funding sources, particularly borrowings. If the trend 

toward greater reliance on nondeposit funding continues, liability management 

may become more important and more challenging for community banks that have 

historically relied upon deposits for funding and net interest revenues for profitability. See page 11. 

By Allen Puwalski and Brian Kenner 

Regional Perspectives 

◆ Region’s Economic and Banking Conditions—The San Francisco 

Region’s economy continues to outpace the nation’s economy despite slowing 

employment growth...Declines in the Region’s manufacturing and agricultural 

sectors continue to present concerns...While most insured financial institutions 

continue to report strong earnings and asset quality, agricultural banks, particularly in Montana, are showing weakening agricultural loan quality...The Region’s 

mortgage lenders have significantly increased their reliance on noncore funds, partly because of the adverse effects of a relatively flat yield curve on institutions’ earnings...Rural community banks, faced with slowing population and deposit growth, 

have increased their reliance on noncore funds. See page 18. 

By the San Francisco Region 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 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/ 

publish/regout. For more information or to provide comments or suggestions about the San Francisco Region’s Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 808-8158 or send 

an e-mail to cphillips-olsen@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 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Falling Prices in Commodities and Manufacturing 


Pose Continuing Risks to Credit Quality
 

•	 Prices have fallen sharply across a wide range of 

commodities and manufactured goods. 

•	 Signs of stress are apparent in some industry 

sectors. 

•	 These trends are contributing to rising credit risk 

for insured institutions. 

•	 Effects on local economies and community banks 

could grow if low prices persist. 

The performance of the U.S. economy during the midto late-1990s has been generally positive for banking. 

Economic activity grew in 1998 at an inflation-adjusted 

rate of 3.9 percent for the second consecutive year. Continued low inflation has helped to hold interest rates low 

and extend the expansion into its ninth consecutive year. 

However, one downside of low inflation has been that 

firms in certain commodity industries have encountered 

slow or negative growth in revenues because of the low 

prices they receive for their products. 

Commodity industries are defined in this article as a 

collection of agricultural, mining, and manufacturing 

industries that produce standardized products and face 

global competition, mostly on the basis of price. Since 

the beginning of 1997, price weakness has extended 

across a wide range of commodity industries, from agricultural products to oil, chemicals, textiles, paper, semiconductors, steel, and even some segments of the auto 

industry. While many firms have retooled and restructured to cut costs, clear signs of financial stress have 

become apparent. 

The potential importance of problems in commodity 

industries to the FDIC was illustrated by the banking 

problems related to oil and agriculture during the 1980s 

and early 1990s. As documented in a 1997 study by the 

FDIC Division of Research and Statistics, regional 

economic dislocations related to declining farmland 

values and declining oil prices contributed to large 

increases in credit losses and the eventual failure of 

hundreds of federally insured banks and thrifts. The 

analogy to the 1980s is far from perfect—for example, 

oil and agriculture have not experienced booms comparable to those that preceded their collapse in the 

1980s—but exposures to commodity industries remain 

important for many insured institutions. 

This article summarizes recent adverse trends in commodity and manufacturing sectors and discusses why 

industry-sector problems are important in banking. It 

takes a high-level approach, emphasizing the economic 

fundamentals that are driving prices across the economy 

while ignoring many of the industry-specific factors 

that are also driving the performance of individual sectors. The goal is to evaluate the effects of these trends 

on bank credit quality if they persist through 1999 and 

beyond. 

Prices Have Been Declining across a Range 

of Commodities and Manufactured Goods 

Low inflation has been a boon for consumer spending 

and business investment during the economic expansion 

of the 1990s. As of March 1999, the Consumer Price 

Index had risen at an annualized rate of less than 2.0 

percent for 8 consecutive quarters and at an annualized 

rate of less than 4.0 percent for 

33 consecutive quarters. The 

prices of many popular and 

essential consumer goods— 

from computers to gasoline— 

have generally fallen throughout 

the decade, even as the prices of 

most services continue to rise 

steadily. Businesses, too, have 

benefited from the ability to 

purchase goods cheaply, as well as from the generally 

low interest rates that have accompanied low inflation. 

The declining average wholesale price of goods is 

reflected in Chart 1 (next page), which shows changes 

in the producer price index (PPI) and some of its key 

components since the beginning of 1997. The PPI 

focuses on goods, omitting changes in the price of services. The decline of nearly 5 percent in the PPI since 

the beginning of 1997 has been led by falling prices for 

mining products, petroleum, and steel. Moreover, economy-wide price declines for wholesale goods have been 

steady over time, with the PPI registering year-over-year 

declines for 26 consecutive months through May 1999. 

San Francisco Regional Outlook 3	 Third Quarter 1999 
In Focus This Quarter
 

CHART 1	 CHART 2 

Widespread Pricing Pressures Are Evident in the 

Components of the Producer Price Index 

Percent Change in Selected Components of the Producer Price 

Index, January 1997 to May 1999 

–45 

–40 

–35 

–30 

–25 

–20 

–15 

–10 

–5 

0 

Agricultural Prices Are Down Sharply Since 1997 

Percent Change in Reported Price Between 

January 1997 and May 1999 

Source: Wall Street Journal (Haver Analytics) 

Cotton 

Corn 

Hogs 

Wheat 

10 

5 

0 

–5 

–10 

–15 

–20 

–25 

–30 

–35 

–40 

Source: Bureau of Labor Statistics (Haver Analytics) All Commodities Lumber & Wood Chemicals Textiles Automobiles Electrical Machinery 

Iron & SteelPetroleumProductsMining 

3.3 

–4.0 

0.6 –1.9 –2.5 –2.5 

–10.0 

–19.8 

–33.2 

Although they are only indirectly included in the PPI 

numbers, the prices of several important agricultural 

commodities have also fallen substantially. Chart 2 

shows that the price of wheat has fallen by more than 35 

percent since January 1997, with the price of corn, 

hogs, and cotton also registering double-digit rates of 

decline. While the price of hogs has rebounded significantly since the end of 1998—more than doubling from 

its low of less than 15 cents per pound—prices for corn, 

wheat, and cotton continued to decline through May 

1999. 

Reasons for Broad-Based Commodity 

Price Weakness 

Pricing trends in disparate industries such as electronics 

and agriculture, or oil and steel, are driven in part by 

industry-specific factors. For example, weather patterns 

heavily influence agricultural prices, while global politics tends to drive world oil price levels. In manufacturing, technological developments can significantly alter 

the demand for a product or its cost of production, 

thereby influencing its market price. For example, 

improvements in semiconductor manufacturing techniques—from shrinking the size of chips to using larger 

silicon wafers—have significantly increased production 

yields in that industry during the 1990s.1 

However, the pervasiveness of recent price declines 

across a wide range of commodities and manufactured 

1 See “Semiconductor Industry Trends,” Standard and Poor’s Industry 

Surveys, May 27, 1999, p. 4. 

goods suggests that a number of common factors are 

driving prices lower: 

•	 Low inflationary expectations. Since 1980, inflation rates have gradually declined worldwide as central banks shifted their focus toward price stability. 

Disinflation has profoundly altered the expectations 

of investors, consumers, and businesses, and in the 

process has altered the course of events in individual markets and in the economy as a whole. As a 

result, commodities have lost much of their appeal 

as a hedge against inflation. This has contributed to 

a decline of more than 50 percent in the price of 

gold since 1980. The expectations of many businesses have also changed, because with less pricing 

power they must continually cut costs to remain 

competitive. 

•	 Overcapacity because of large-scale investment. 

Global investment in productive capacity accelerated 

during the early to mid-1990s in a number of commodity and manufacturing industries. Many U.S. 

firms have implemented new technologies and 

moved their operations closer to their markets or to 

areas where low-cost labor is available. For example, 

major U.S. and foreign automakers have invested billions of dollars in recent years in new production 

facilities in the emerging markets of Asia and Latin 

America as part of a “build-where-you-sell” strategy.2 Because these additions to capacity largely have 

not been offset by the closure of existing plants, analysts say that global productive capacity in autos 

2 Barbara McClellan, “Asia Woes Worsen,” Ward’s Auto World, 

November 1998, pp. 28–31. 

San Francisco Regional Outlook 4	 Third Quarter 1999 
In Focus This Quarter
 

could exceed demand by more than 20 million units 

annually by 2000.3 A similar situation has developed 

in the semiconductor industry, where capital investment in chipmaking equipment tripled between 1993 

and 1996, contributing to a glut of memory chips and 

plunging prices.4 

•	 Curtailed global demand in the wake of emerging 

market crises. The economic crises that have developed in Asia, Russia, and parts of Latin America 

since 1997 have crimped global demand for commodities and manufactured goods. For example, 

demand for new cars in Korea fell by 50 percent in 

1998.5 Asia received approximately 30 percent of 

U.S. feed grain exports in 1996, but declining Asian 

demand since then has contributed to a sharp decline 

in global grain prices. The slowdown of economic 

activity in crisis countries and the resulting decline 

in their demand for imports is only one factor that 

has hurt the pricing power of U.S. producers. Another problem is the pricing advantage conferred on 

countries that have experienced currency devaluation. Firms operating in a country that has devalued 

its currency experience a reduction in the price of 

their exports in U.S. dollar terms. This process further depresses the pricing power of U.S. farmers and 

businesses that sell their goods in global markets. 

Recently, there have been signs that some hard-hit Asian 

economies may soon begin to recover. However, the 

other factors cited above—low inflationary expectations and rapid investment in productive capacity—may 

well be longer-term trends. In any event, U.S. farmers 

and businesses that participate in commodity industries 

must be prepared for the possibility that pricing pressures will not dissipate in the near term. 

Signs of Stress Are Showing 

for Affected Industry Sectors 

As commodity prices continue to stagnate, signs of 

stress are emerging among firms in the commodity 

industries. A long-term trend toward reduced levels of 

employment in manufacturing has accelerated in the 

midst of the current economic expansion. Chart 3 shows 

that employment levels declined in a wide range of 

commodity industries in the 24 months ending in May 

3 “1997 Automotive Outlook,” Automotive Industries. This report is
 

available at http://www.ai-online.com.
 4 “Semiconductor Industry Trends” (1999), p. 3.
 

5 Barbara McClellan (1998).
 

CHART 3 

Total Percent Change in Payroll Employment, May 1997 to May 1999 

Employment Levels Have Declined across a Wide 

Range of Commodity and Manufacturing Sectors 

* Percent change between 1997 and 1998 based on county-level estimates 

of payroll employment in agriculture and agricultural services 

Sources: Bureau of Labor Statistics (Haver Analytics); WEFA 

Electronics and Semiconductors 

Textiles 

Autos 

Primary Metals/Iron and Steel 

Chemicals 

Oil and Gas 

Mining 

Lumber and Paper 

Agriculture* 

–20 –15 –10 –5 0 

1999. The total manufacturing sector lost more than 

420,000 jobs during that period, while another 64,000 

jobs were lost in the mining sector, which includes oil 

and gas extraction. The trend toward lower levels of 

employment in mining and manufacturing not only 

reflects pricing pressures but also attempts by firms in 

these sectors to maintain profitability by investing in 

labor-saving technologies. 

The profit picture has begun to deteriorate as well for 

firms operating in commodity industries. Four-quarter 

trailing earnings through March 1999 for oil-sector 

firms in the Standard & Poor’s 500 dropped by more 

than 44 percent from a year ago (see Chart 4), while the 

earnings of steel firms fell by almost 32 percent. The 

losses experienced by firms in some of these industrial 

sectors extended to the farm sector as well, where net 

CHART 4 

–50 –40 –30 –20 –10 0 10 20 

Agriculture* 

Year-over-Year Percent Change in Earnings from Continuing Operations 

for S&P 500 Companies, by Sector, for the Year Ending in March 1999 

Earnings Have Declined across a Wide Range 

of Commodity and Manufacturing Sectors 

Oil and Gas 

* 1998 percent change in net farm income 

Sources: Standard and Poor’s (Bloomberg); U.S. Department of Agriculture 

Lumber and Paper 

Mining 

Chemicals 

Primary Metals/Iron and Steel 

Autos 

Textiles 

Electronics and Semiconductors 

San Francisco Regional Outlook 5	 Third Quarter 1999 
In Focus This Quarter
 

incomes fell by more than 7 percent in 1998, according 

to the U.S. Department of Agriculture. 

Affected Industries Have Found Ways to Cope 

with Pricing Pressures Thus Far 

Despite the signs of stress in industries where prices are 

weak or declining, U.S. farmers and industrial firms 

have shown themselves to be fairly resilient thus far in 

their ability to cope with the situation. Agricultural producers have been making greater use of carryover debt 

to keep their operations running even if they were not 

able to fully retire their operating loans during the previous crop year. The FDIC Report on Underwriting 

Practices shows that 29 percent of FDIC-supervised 

agricultural lenders reported at least a moderate 

increase in carryover debt during the six-month period 

ending in March 1999, compared with only 10 percent 

in March 1998. Although the use of carryover debt is 

not an uncommon practice in agriculture, it indicates 

that low prices and declining subsidies have contributed 

to financial stress for farmers. 

Many industrial firms have found ways to increase productivity and cut costs to offset declining revenues. 

Chart 5 follows trends in annual total revenue and costs 

for U.S. corporations operating in a selected group of 

commodity industries. It shows that growth in revenue 

and costs slowed noticeably in 1997. Both revenue and 

costs in these sectors declined in 1998, illustrating that 

firms in these sectors have needed to cut costs to preserve profit margins. Cost cutting in the manufacturing 

sector is further illustrated by a steady decline in the 

index of unit labor costs for manufacturing, which started from a value of 100 in 1992 and fell to less than 96 

CHART 5 

U.S. Corporations Operating in 

Commodity Industries Have Trimmed 

Costs to Offset Falling Revenue* 

* Totals represent a summation of revenues and costs for the following industry 

sectors, as reported by the Bureau of the Census: textile mill products, paper and 

allied products, chemicals and allied products, industrial chemicals and synthetics, 

petroleum and coal products, lumber and wood products, iron and steel, electrical 

and electronic equipment, motor vehicles and equipment, and mining. 

Source: Bureau of the Census (Haver Analytics) 

1992 1993 1994 1995 1996 1997 1998 

Billions of Dollars 

Costs 

Revenues 

1,250 

1,450 

1,650 

1,850 

2,050 

2,250 

by the first quarter of 1999. Falling unit labor costs 

means that the productivity of manufacturing workers is 

rising faster than the cost of their services. This trend 

demonstrates that manufacturing firms have been successful at implementing new technologies and new capital equipment to cut production costs. 

Cost savings and industry consolidation have been 

accomplished in part through mergers. According to 

Merger Stat, the dollar volume of merger and acquisition transactions involving U.S. firms exceeded $1.2 

trillion in 1998, an increase of more than 80 percent 

from 1997 levels. Both the number and dollar volume of 

mergers announced in 1998 far exceeded the volumes 

recorded during the “merger mania” of the 1980s. Some 

of the largest mergers announced in 1998 involved 

firms looking for ways to increase market share and cut 

costs in markets characterized by overcapacity. Examples include the $39 billion Daimler-Chrysler transaction announced in May 1998 and the $80 billion 

Exxon-Mobil transaction announced in December 

1998. Furthermore, merger activity recorded in early 

1999 suggests that total merger volume for the year 

could exceed the record pace of a year ago. 

Industries plagued by oversupply and weak prices 

require consolidation to reduce capacity and improve 

profit margins. Mergers and acquisitions represent a 

fairly orderly way for firms operating in a troubled 

industry to consolidate on their own terms. Bankruptcy 

filings are an alternative means for severely troubled 

firms to reduce capacity and achieve consolidation 

within an industry. Regardless of how industry consolidation is achieved, it often results in reductions in 

employment (such as those documented in Chart 3). 

However, from a lender’s perspective, an orderly consolidation process through mergers and acquisitions is 

preferable to a disorderly shakeout of firms through 

bankruptcies. 

Recent favorable capital market conditions have 

allowed firms in troubled industries to consolidate 

through mergers. Acquisitions are sometimes financed 

through corporate borrowings or, more commonly, by 

swapping equity shares that have been rising in value 

during the bull market of the 1990s.6 Recent consolidation in commodity industries could be depicted as an 

6 According to Loan Pricing Corporation’s Gold Sheets, syndicated 

and leveraged lending related to mergers and acquisitions reached a 

record high of $80 billion in the second quarter of 1998, which represents about 30 percent of the total syndicated and leveraged lending 

market for that period. 

San Francisco Regional Outlook 6 Third Quarter 1999 
In Focus This Quarter
 

orderly process, associated with record-high merger and 

acquisition activity, near-record-low business bankruptcy filings, and low credit losses on commercial and 

industrial (C&I) loans. However, a sudden change in 

financial market conditions characterized by sharply 

higher interest rates, lower stock values, or both could 

inhibit the ability of businesses to restructure and retool 

on their own. This could lead to a much more disorderly shakeout of firms accompanied by a rise in business 

bankruptcies and losses to lenders. 

Signs Point to Rising Credit Risk 

in the Commodity Industries 

In dollar terms, the largest commercial bank exposures 

to the commodity industries are in the portfolios of 

large banks. Chart 6 provides an estimated breakdown 

of the aggregate exposure of insured institutions to 

commodity industries based on corporate balance sheet 

information collected by the Bureau of the Census.7 The 

chart shows that the aggregate exposure of the bank and 

thrift industries to these sectors is approximately $206 

billion, or 26 percent of the total industry C&I portfolio. The largest single industry exposure is to the chemical industry, which represents approximately 9.5 

7 Because of the limitations of the data, bank exposures to corporations engaged in agriculture are not broken out in Chart 6. 

CHART 6 

Commodity Industries Make Up
 

Over One-Quarter of Bank C&I Loans
 

to Corporate Borrowers
 

Mining Total Loans Lumber & Paper* 3.2% 4.4% Outstanding

as of 12/31/98= Petroleum & Coal $778.3 Billion** 1.2% 

Electronics 

4.2% 

Chemicals* 

9.5% All Other 

73.5% Textiles
 

1.2%
 

Iron & Steel 

1.1% 

Automobiles 

1.7% 

* “Lumber & Paper” includes lumber and wood products and paper and allied 

products as reported by the Bureau of the Census; "Chemicals" includes chemical 

and allied products and industrial chemicals and synthetics as reported by the 

Bureau of the Census. 

** Total includes bank loans not elsewhere classified to the nonfarm nonfinancial 

corporate business sector as reported in the Flow of Funds. Component loan 

amounts represent short-term and long-term bank loans on corporate balance 

sheets, by sector, as reported by the Bureau of the Census. 

Sources: Bureau of the Census (Haver Analytics); Federal Reserve Board 

percent of bank C&I loans. In the syndicated loan market, where large U.S. banks dominate in terms of originations, about 25 percent of all loans made in 1998 were 

to firms operating in the manufacturing sector. 

A rough indicator of recent trends in the credit risk 

associated with bank loans to commodity industries can 

be found in expected default frequencies (EDFs) calculated by KMV Corporation. The EDF is an estimate of 

the probability that a firm will default on its bond obligations within one year.8 Chart 7 tracks the median EDF 

for firms operating in commodity industries compared 

with the median for all other firms rated by KMV. This 

chart shows that while the median EDF for commodity 

industries has consistently exceeded the median for all 

other firms in the recent past, this difference has 

widened appreciably since the middle of 1998. Over the 

past year, the median EDF for commodity industries has 

more than doubled, rising from 0.8 percent to 1.9 percent, while the median EDF for all other firms has doubled as well, from 0.6 percent to 1.2 percent. These data 

indicate that the level of credit risk associated with corporate borrowers has been increasing, led by an 

increased probability of default among firms operating 

in commodity industries. 

8 KMV’s proprietary calculation for EDF is based on 1) the current 

market value of the firm, 2) the structure of the firm’s current obligations, and 3) the vulnerability of the firm to large changes in market 

value. 

CHART 7 

The Default Risk of Firms Operating 

in Commodity Industries Has 

Risen over the Past Year 

Median Expected Default Frequency (EDF)* 

(Probability that a Firm Will Default on Bond 

Obligations within One Year) 

KMV’s proprietary calculation for EDF is based on 1) the current market value of the firm, 

2) the structure of the firm’s current obligations, and 3) the vulnerability of the firm to large 

changes in market value. 

* Sectors included in the calculation of EDF for commodity industries include 

the following KMV aggregates: agriculture; automotive; chemicals; electrical 

equipment; electronic equipment; lumber and forestry; mining; oil refining; oil, 

gas, and coal exploration and production; paper; semiconductors; steel and metal 

products; and textiles. 

Source: KMV Corporation 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

Firms in Other Industry Sectors 

Firms in Commodity Industries 

05/96 12/96 07/97 02/98 09/98 04/99 

San Francisco Regional Outlook 7 Third Quarter 1999 
In Focus This Quarter
 

Effects on Local Economies and 

the Banks That Operate in Them 

The economic effects of adversity in commodity industries tend to be most severe in local areas that depend 

heavily on these sectors for employment and income. In 

the 1980s, problems in the agricultural and oil sectors 

kicked off a “rolling recession” that spread through the 

Plains states and oil-producing regions of the southcentral and western states. In agricultural regions, farmland values began to decline around 1981, contributing 

to the failure of hundreds of FDIC-insured banks 

between 1984 and 1990.9 Similarly, declining oil prices 

in the mid-1980s contributed to the failure of federally 

insured banks and thrifts in Texas, Oklahoma, 

Louisiana, and other states, while the attempts of some 

institutions to diversify into risky real estate investments resulted in still more failures. The FDIC’s analysis of these episodes emphasizes how industry-sector 

problems can affect local economies and bank credit 

quality.10 Moreover, the study shows that there can be a 

significant lag between the onset of industry-sector 

problems and the emergence of performance problems 

9 Federal Deposit Insurance Corporation, 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. pp. 275–276, http://www.fdic.gov/databank/hist80/
 

index.html.
 

10 Federal Deposit Insurance Corporation (1997). See Chapters 8 


and 9.
 

TABLE 1 

in the banking industry. Although banks with direct 

credit exposures to a troubled industry are likely to be 

affected first, virtually all banks that operate in areas 

that are heavily dependent on a troubled sector will 

eventually have to contend with the indirect effects on 

the local economy. 

To evaluate the extent of local economic effects that 

might have resulted from the recent adverse trends in 

the commodity industries, we have conducted analysis 

on 1,027 U.S. counties identified as particularly dependent on at least one commodity industry (see Table 1 for 

a list of the commodity industries studied).11 The purpose of this analysis is not to identify every county that 

might be affected by these trends; instead, this analysis 

focuses on the U.S. counties most concentrated in the 

commodity industries and determines if these counties 

and banks that operate in them are showing any symptoms of widespread distress. 

Table 2 compares 1998 average job growth and unemployment rates in these “most concentrated counties” 

against the average for all U.S. counties. This comparison shows that the concentrated counties tended to have 

moderately lower job growth and higher unemployment 

than the U.S. average. However, further analysis shows 

11 Counties identified as being highly dependent on one or more commodity industries had an average population of 36,250 in 1998 versus 

86,055 for all U.S. counties. 

U.S. Counties Most Concentrated in Commodity Industries 

by 1998 Payroll Employment 

NUMBER OF 

PERCENT OF COUNTIES WITH 

1998 COUNTY EMPLOYMENT 

EMPLOYMENT IN CONCENTRATION STATES WITH THE MOST 

THE INDUSTRY IN 1998 DESIGNATED COUNTIES 

AGRICULTURE >30 295 TX, NE, SD, KS, MO 

LUMBER AND PAPER >5 305 GA, AL, MS, AR 

OIL AND GAS >5 83 TX, OK, LA 

CHEMICALS >5 46 TN, IL, NC, TX 

STEEL >5 70 KY, OH, AR, IN 

AUTOS >5 118 MI, IN, OH, KY, TN 

TEXTILES >5 156 GA, NC, SC, VA, AL 

ELECTRONICS AND SEMICONDUCTORS >5 33 TX, NY, IN, IA 

Any Commodity Industry N/A 1,027 TX, GA, NC, TN, AL 

All U.S. Counties N/A 3,142 N/A 

Source: WEFA, based on data from the Bureau of Labor Statistics 

San Francisco Regional Outlook 8 Third Quarter 1999 
In Focus This Quarter
 

TABLE 2 

Relative Economic Performance of Counties 

Most Concentrated in Commodity Industries 

1998 AVERAGE 1998 AVERAGE 

EMPLOYMENT GROWTH (%) UNEMPLOYMENT RATE (%) 

AGRICULTURE 1.1 4.8 

LUMBER AND PAPER 1.3 6.9 

OIL AND GAS 1.4 5.6 

CHEMICALS 1.3 6.0 

STEEL 1.7 5.6 

AUTOS 1.8 4.4 

TEXTILES 0.9 5.1 

ELECTRONICS AND SEMICONDUCTORS 1.9 3.7 

Any Commodity Industry 1.3 5.5 

All U.S. Counties 1.6 5.1 

Source: Bureau of Labor Statistics, Household Survey (Haver Analytics) 

that the current situation is not unusual in that job markets in concentrated counties have tended to consistently underperform other U.S. counties over the past two 

decades. On the whole, the economic picture did not 

noticeably deteriorate in 1998 for the concentrated 

counties. Average unemployment declined in 1998 for 

every group of concentrated counties except oil counties, and average job growth increased in every group of 

counties except textile counties. These data indicate that 

while recent problems in the commodity industries 

might be having severe effects in specific areas, these 

problems had not translated into a broader weakening of 

economic performance through the end of 1998. 

The financial performance of insured institutions operating in concentrated counties is evaluated in Table 3 

(next page). The table provides average C&I loan performance and profitability ratios for 1,915 banks and 

thrifts identified as having at least 25 percent of their 

deposits in at least one of the concentrated counties as 

of June 1998.12 The average C&I loan charge-off ratio 

for concentrated counties overall was higher than the 

U.S. average, driven largely by higher average charge12 This analysis identifies the location of deposits by county through 

the Summary of Deposits report for June 1998, the most recent report 

available. The analysis is limited to institutions reporting at least $1 

million in C&I loans as of December 31, 1998. Institutions operating 

in one or more concentrated counties and meeting all the selection 

criteria averaged $195 million in total assets as of December 31, 

1998, compared with an average of $733 million in assets for institutions operating in any U.S. county. 

offs in both agricultural and oil and gas counties. Comparisons of past-due and noncurrent C&I loans also 

indicate that institutions operating in agricultural and 

oil and gas counties tend to have more problem credits 

than the U.S. average.13 During the 12 months ending in 

December 1998, the average noncurrent loan ratio 

jumped from 4.8 percent to 6.1 percent for institutions 

operating in agricultural counties, while the average 

ratio rose from 2.7 percent to 3.8 percent for institutions 

operating in oil and gas counties. 

These results indicate that while profitability in 1998 

remained solid for the average bank operating in concentrated counties, credit losses appeared to be on the 

rise in agricultural and oil and gas counties. However, 

because this analysis relies on annual data that extend 

only through 1998, it is by design a backward-looking 

test for the local effects of problems in the commodity 

industries. There is every reason to expect these credit 

problems to intensify over time if commodity prices 

remain low.14 These considerations suggest that bankers 

in commodity-dependent counties should continually 

13 Past-due loans are defined as loans that have been past due for 30 

to 89 days. Noncurrent loans are defined as loans that have been past 

due for 90 or more days plus loans placed in nonaccrual status. 

14 For more information on how the agricultural outlook could affect 

FDIC-insured institutions, see the statement of FDIC Chairman 

Donna Tanoue to the Committee on Agriculture, U.S. House of 

Representatives, February 12, 1999, http://www.fdic.gov/publish/ 

speeches/99spchs/spc13apr.html. 

San Francisco Regional Outlook 9 Third Quarter 1999 
In Focus This Quarter
 

TABLE 3 

Relative Financial Performance of Insured Institutions Operating in Counties 

Most Concentrated in Commodity Industries 

NUMBER OF AVERAGE C&I AVERAGE AVERAGE NET 

BANKS WITH AT LOANS PAST DUE NONCURRENT C&I LOAN 

INCLUDES ONLY INSURED LEAST 25% OF 30 TO 89 DAYS, C&I LOANS, CHARGE-OFFS, AVERAGE 

INSTITUTIONS WITH DEPOSITS IN A AS PERCENT AS PERCENT AS PERCENT OF RETURN ON 

AT LEAST $1 MILLION DESIGNATED OF LOANS, OF LOANS, AVERAGE LOANS, ASSETS, 

IN C&I LOANS COUNTY 12/31/98 12/31/98 1998 1998 

AGRICULTURE 416 5.08 6.12 1.58 1.16 

LUMBER AND PAPER 465 3.38 1.89 0.78 1.21 

OIL AND GAS 163 3.44 3.78 1.18 1.29 

CHEMICALS 81 2.47 2.97 0.79 1.18 

STEEL 186 2.53 2.06 0.59 1.08 

AUTOS 341 2.64 2.05 0.66 1.12 

TEXTILES 264 2.91 1.92 0.70 1.10 

ELECTRONICS AND 

SEMICONDUCTORS 107 2.71 2.36 0.68 0.87 

Any Commodity 

Industry 1,915 3.39 3.03 0.93 1.13 

All U.S. Counties 8,485 2.91 2.50 0.76 1.05 

Noncurrent loans include loans past due 90 or more days plus loans placed on nonaccrual status. 


C&I = Commercial and industrial.
 

Sources: Summary of Deposits, Division of Research and Statistics, FDIC; Bank and Thrift Call Reports (Research
 

Information System)
 

monitor their local economy for signs of stress related 

to problems in the commodity industries. 

Conclusion 

Businesses operating in a range of commodity and manufacturing industries continue to grapple with weak or 

declining prices. This problem is not solely the result of 

industry-specific factors; it is part of long-term economic trends that may continue for some time. Signs of 

stress among firms in these industries are apparent in 

the form of declining levels of employment and slow or 

negative profit growth. However, there are few signs to 

date of any disorderly industry shakeouts involving 

widespread business bankruptcies and losses to lenders. 

Thus far, most firms have managed to cope with 

the situation by cutting costs and consolidating operations through mergers. At the same time, more forwardlooking indicators show that the level of credit risk 

associated with commodity industries may be on the 

rise. An analysis of the U.S. counties most heavily 

dependent on these industries showed few signs of a 

widespread deterioration in the performance of their 

economies or in the profitability of their local depository institutions through the end of 1998. However, there 

are signs of rising credit losses among local depository 

institutions in counties with the highest concentrations 

of agriculture and oil and gas extraction. A continuation 

of today’s weak pricing picture in these industries has 

the potential to result in higher credit losses for insured 

institutions during the next few years. 

Richard A. Brown, Chief, 

Economic and Market Trends Section 

Alan Deaton, Economic Analyst 

San Francisco Regional Outlook 10 Third Quarter 1999 
In Focus This Quarter
 

Shifting Funding Trends Pose Challenges 


for Community Banks 


•	 Several long-term trends are making it more difficult for some institutions to economically fund 

asset growth with deposits in today’s marketplace. 

•	 Lagging deposit growth in recent years has resulted in greater reliance on alternative funding 

sources to meet loan demand. 

•	 Liability management may become more important and more challenging for community banks 

that have historically relied upon deposits for 

funding and net interest revenues for profitability. 

For the past few years, assets have been expanding 

faster than deposits at many commercial banks. The 

result is an increased reliance on equity and borrowings 

for funding. Since 1992, commercial bank assets have 

grown at an average annual rate of 6.3 percent compared with a 3.9 percent average annual growth rate for 

deposits. Traditional measures of liquidity and funding 

for commercial banks reflected record-low levels of 

deposit funding at year-end 1998. Large commercial 

banks have traditionally made greater use of nondeposit 

funding alternatives. However, many community 

banks,1 which have typically relied more on deposit 

funding, may face liability management challenges as a 

result of shifting funding trends. This article surveys the 

factors influencing the ability of banks to fund loan 

growth with deposits, discusses community bank funding trends, and considers the implications of these 

trends for community banks. 

Factors Influencing Deposit Funding Trends 

The percentage of commercial bank assets, particularly 

loans, funded with deposits has declined steadily in the 

1990s. As shown in Chart 1, the industry’s ratios of 

deposits to assets and loans to deposits reflect a longerterm shift away from deposit funding. Although the 

level of these industry ratios is heavily influenced by 

larger banks, the trend toward lower deposit funding 

exists for both large banks and community banks and 

points to secular factors that are affecting banks’ ability 

to raise deposits in step with asset growth. 

Trends in Household Wealth Accumulation 

One factor affecting the ability of banks to attract 

deposits is the recent trend in the way households are 

amassing wealth. While the total wealth of U.S. households has soared in recent years because of unrealized 

capital gains on housing and investments, annual net 

purchases of new financial assets2 by households as a 

percentage of disposable income have actually trended 

downward since the mid-1980s (see Chart 2, next page). 

A falling personal savings rate and fewer purchases of 

financial assets may suggest that households are more 

comfortable consuming a higher percentage of current 

income as long as capital gains are adding to their accumulated wealth. However, because households have 

been setting aside less of their current income for savings, the pool of new funds available to purchase bank 

deposits has been growing more slowly. 

Higher-Yielding Investment Alternatives 

At the same time that households have been setting 

aside less of their current income for savings, the share 

of total new household savings flowing into bank 

deposits has declined in the 1990s as competition from 

higher-yielding alternatives has increased. During the 

1980s, over 30 percent of the cumulative net increase in 

2 Financial assets are defined as deposits, money market and mutual 

fund shares, credit market instruments, corporate equities, life insurance reserves, pension fund reserves, and trust reserves. 

CHART 1 

The Deposit-to-Asset and Loan-to-Deposit
 

Ratios Reflect Reduced Deposit


 Funding for Commercial Banks
 

Recession 

Ratio (%) Deposit-to-Asset Ratio 

90 

85 

80
 

75
 

70
 

65
 

60
 

55
 

50
 

Loan-to-Deposit Ratio 

’70 ’74 ’78 ’82 ’86 ’90 ’94 ’98 

Sources: FDIC Historical Statistics on Banking; Research Information System 1 Defined here as banks with total assets of $1 billion or less. 

San Francisco Regional Outlook 11	 Third Quarter 1999 
In Focus This Quarter
 

CHART 2 

Total Annual Additions* to Financial Assets 

of Households and Nonprofit Organizations 

Have Declined with Personal Savings Rate 

Percentage of Disposable 

Personal Income 

Net Acquisition 

15 

10 

5 

0 

20 

of Financial Assets 

Personal Savings 

’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

* Excludes capital gains 

Sources: Federal Reserve Board; Flow of Funds 

financial assets by households and nonprofit organizations flowed into deposits. In contrast, less than 15 percent of the cumulative net increase in financial assets 

has flowed into deposits during the 1990s, although an 

increasing proportion has been allocated to deposits in 

recent years. 

Not only do banks face intensifying competition from 

other banks and thrifts, as indicated by 66 percent of the 

respondents in Grant Thornton’s 1999 Sixth Annual 

Survey of Community Bank Executives,3 but they also 

3 Grant Thornton’s 1999 Sixth Annual Survey of Community Bank 

Executives, “Community Banks: A Competitive Force,” http://www. 

grantthornton.com/resources/finance/banksurvey99/survey99w.html. 

CHART 3 

face increasing competition from mutual funds and 

other nonbank financial service providers, such as credit unions. 

Mutual Funds. Increasingly, consumers are pursuing 

higher yields by investing in mutual funds. Beyond 

yields, however, many mutual fund companies also are 

competing effectively with banks on the basis of convenience by offering money market accounts that allow 

check writing, automated teller machine cards, and 

check cards. Chart 3 shows the changes in the composition of household liquid assets during the 1990s. In 

1990, bank deposits constituted 38 percent of households’ liquid assets versus 11 percent for mutual funds 

and money market funds; at year-end 1998, the shares 

were nearly even. While some of the change in composition can be explained by rising mutual fund share 

prices, other measures indicate a shifting preference for 

mutual funds as a savings vehicle. For example, data 

from the Investment Company Institute show that net 

inflows into mutual funds have exceeded net increases 

in insured institution deposit accounts in all but three 

quarters during this economic expansion. Moreover, the 

first quarter of 1999 marked the seventeenth consecutive quarter that mutual fund inflows outstripped 

increases in deposits for all FDIC-insured institutions. 

Credit Unions. In addition to mutual funds, credit 

unions also are formidable competitors for consumer 

savings. Membership in credit unions has increased 

more than 20 percent over the past decade, while 

deposits and share accounts have risen by over 90 perHouseholds Are Holding a Greater Share of Liquid Assets in Mutual Funds 

1990 1998 

U.S. Government 

Securities
 

7%
 

Equities, Bonds, 

and 

Commercial 

Paper 44% 

Money Market 

Fund Shares 

5% 

Mutual Fund
 

Shares
 

6%
 

Bank Deposits 

(excl. Foreign) 

38% 

Money Market Mutual Fund 

Fund Shares Shares 

7% 22% 

Equities, Bonds, Bank Deposits 

and Commercial (excl. Foreign) 

Paper 35% 30% 

U.S. Government 

Securities
 

6%
 

Source: Federal Reserve Board 

San Francisco Regional Outlook 12 Third Quarter 1999 
In Focus This Quarter
 

cent.4 Credit unions also offer federal insurance on share 

accounts as well as competitive rates on comparable 

deposit-type vehicles relative to other types of financial 

institutions. For example, according to information from 

the National Credit Union Association, on average, 

credit unions have offered rates on one-year share certificates in excess of one-year bank certificates of 

deposit in nine of the past ten years. As shown in Chart 

4, average rates paid by credit unions on one-year share 

certificates over the 12 months ending May 1999 were 

consistently higher than rates offered by banks or thrifts 

and approached retail rates offered by brokerages. 

Demographic Shifts 

Some analysts maintain that rural community banks 

face additional funding challenges as a result of demographic shifts. According to the Federal Reserve Bank 

of Kansas City, rural bankers perceive that sluggish 

deposit growth is at least partially attributable to the 

migration of deposits to cities as urban-dwelling heirs 

of rural depositors relocate funds. While evidence for 

this deposit migration remains anecdotal, economists at 

the Federal Reserve Bank of Kansas City indicate that 

the demographic shift is still in process, and its full 

effect may not be felt for some time. Further challenging deposit growth for banks, additional evidence suggests that urban dwellers tend to place less of their 

4 Center for Credit Union Research, “Credit Union FAQ,” http:// 

wiscinfo.doit.wisc.edu/bschool/cu/cufaq.html. 

CHART 4 

Bank One-Year CD Rates Have Recently Lagged
 

Those Offered by Competitors
 

Average Retail Rates Offered for 

One-Year Certificates (%) 

6.0 

3.0 

3.5 

4.0 

4.5 

5.0 

5.5 

Thrifts 

Credit Unions 

Banks 

Brokerages 

Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 

’98 ’98 ’98 ’98 ’98 ’98 ’98 ’99 ’99 ’99 ’99 ’99 

Sources: BanxQuote and Bank Rate Monitor 

savings in banks than their rural counterparts do.5 This 

trend poses additional consequences for bank deposits 

as rural populations migrate to suburban areas. 

Community Bank Funding Trends 

Community banks traditionally rely more heavily upon 

core deposit funding than larger banks do. For example, 

Chart 5 (next page) shows that 72 percent of aggregate 

community bank assets were funded with core deposits 

at year-end 1998. In contrast, 43 percent of aggregate 

large bank assets at year-end 1998 were funded with core 

deposits. This difference in liability structures reflects 

large banks’ broader use of wholesale funding alternatives and greater access to capital markets instruments. 

While large banks have responded to factors influencing deposit 

growth by making greater use of 

alternative funding sources, 

funding options for community 

banks tend to be more limited. 

Because of high fixed costs, community banks may find 

it more difficult than larger institutions to make costeffective use of capital market instruments such as securitizations or public debt and equity offerings (see 

“Industry Consolidation Presents Unique Risks and 

Challenges for Community Banks,” Regional Outlook, 

Fourth Quarter 1998, for a discussion of additional nondeposit funding sources for community banks). 

The need to augment lagging deposit growth to meet 

loan demand has led many community banks to acquire 

more noncore funds. These funds include time deposits 

greater than $100,000, borrowings, foreign deposits, 

brokered deposits, and demand notes. At year-end 1998, 

nearly 75 percent of community banks held noncore liabilities representing 10 percent or more of total liabilities. As recently as 1993, only 42 percent of community 

banks exceeded that threshold. Moreover, over the same 

five-year period, the ratio of core deposits (defined here 

as total deposits less time deposits greater than 

$100,000 and brokered deposits) to total deposits for all 

community banks declined each quarter. 

5 William R. Keeton, Federal Reserve Bank of Kansas City. “Are 

Rural Banks Facing Increased Funding Pressures? Evidence from 

Tenth District States.” Economic Review, Second Quarter 1998, p. 56. 

Also see “Regional Banking,” Regional Outlook, Kansas City Edition, Second Quarter 1998, p. 24. 

San Francisco Regional Outlook 13 Third Quarter 1999 
In Focus This Quarter
 

CHART 5 

Community Banks Relied More Heavily than Large Banks on Core Deposits* at Year-End 1998 

Large Banks Community Banks 

(total assets over $1 billion) (total assets under $1 billion) 

* Core deposits include total domestic deposits less time deposits greater than $100,000 and brokered deposits issued in denominations of less than $100,000. 

Source: Bank Call Reports (Research Information System) 

Other 

Domestic 

Deposits 

7% 

Borrowings 

16% 

Other 

Liabilities 

12% 

Equity and 

Subordinated 

Debt 

9% 

Core 

Deposits 

43% 

Foreign 

Deposits 

13% 

Other Domestic 

Deposits 

11% 

Borrowings 

6% 

Other 

Liabilities 

1% 

Equity and 

Subordinated Debt 

10% 

Core 

Deposits 

72% 

As community banks’ use of noncore funds has 

increased, they are relying more on federal funds purchased, repurchase agreements, other borrowings, 

demand notes, and mortgages (collectively referred to 

as borrowings). After adjusting for mergers, borrowings 

funded 12 percent of new community bank asset growth 

from 1992 through 1998—three times more than the 

percentage of new asset growth funded by borrowings 

from 1985 to 1990. Possibly reflecting a shift toward 

greater acceptance of wholesale funding by community 

bankers, growth in borrowings has been largely driven 

by increased use of nonovernight borrowings,6 which 

have become the dominant form of borrowings at community banks. As shown in Chart 6, the proportion of 

community banks reporting nonovernight borrowings 

has doubled in the 1990s. This trend coincides with 

growing community bank membership in the Federal 

Home Loan Bank (FHLB) system and increasing use of 

FHLB borrowings. 

Federal Home Loan Bank Membership 

Over the past five years, community banks have substantially increased their membership and participation 

in the FHLB system. According to data from the Federal Housing Finance Board, for the five-year period 

ending in 1998, the percentage of FDIC-insured community banks that were members of the FHLB more 

than doubled to 50 percent. Over the same period, FHLB 

advances outstanding for community banks grew by 

more than 50 percent to $47 billion. At year-end 1998, 

6 Nonovernight borrowings are defined here as all borrowings other 

than federal funds purchased and repurchase agreements. 

FHLB advances represented approximately 80 percent 

of all nonovernight borrowings for community banks. 

Analysts have cited a number of reasons why community banks are joining the FHLB system. Community 

banks are using FHLB advances to meet contingent liquidity needs, manage interest rate risk, fund new asset 

growth, and leverage capital to maintain or boost 

returns on equity. Recent surveys indicate that FHLB 

advances will continue to have a role in community 

bank liability management. Almost one-half of respondents to Grant Thornton’s 1999 Annual Survey of 

Community Bank Executives considered FHLB borrowings an important funding source over the next three 

years, and 43 percent plan to increase the use of FHLB 

advances in 1999. Similarly, the American Bankers 

Association’s 1999 Community Bank Competitiveness 

CHART 6 

’97 

0 

10 

20 

30 

40 

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

The Percentage of Community Banks Reporting 

Nonovernight Borrowings* Is Rising 

Community Banks 

Reporting Nonovernight 

Borrowings (%) 

* Includes all borrowings other than federal funds purchased and repurchase 

agreements 

Source: Bank Call Reports (FDIC Research Information System) 

San Francisco Regional Outlook 14 Third Quarter 1999 
In Focus This Quarter
 

Survey7 reported that FHLB advances are the preferred 

nontraditional funding product. In addition, legislative 

changes enacted in third-quarter 1998 have eased membership requirements for banks with assets less than 

$500 million, significantly increasing access to FHLB 

advances for smaller banks in rural areas. 

Implications of Funding Trends 

for Community Banks 

According to community banker opinion surveys, the 

trend toward greater reliance on noncore or alternative 

funding sources appears likely to continue. Grant 

Thornton’s 1999 Annual Survey of Community Bank 

Executives found that 75 percent of community bankers 

expect funding with core deposits to be more difficult in 

three years than it is today. Moreover, more than 20 percent of community bankers responding to the American 

Bankers Association’s 1999 Community Bank Competitiveness Survey do not expect to derive the bulk of their 

funding from deposits five years from now. Liability 

management is an important aspect of a bank’s operations and a key driver of interest expense. Responses to 

funding challenges will likely influence strategic business decisions that shape the risk profiles of insured 

institutions, particularly community banks that historically have relied more heavily upon core deposits to fund 

asset growth and net interest income for profitability. 

A fundamental challenge that confronts bank management is the strategic response to the increased costs 

associated with wholesale funding sources. As shown in 

Chart 7, the reported interest costs of nondeposit funding alternatives, such as federal funds purchased and 

repurchase agreements, subordinated notes, and FHLB 

advances, have traditionally exceeded the interest cost 

of core deposits for commercial banks. Therefore, as 

institutions that have typically relied upon core deposits 

increase the use of nondeposit sources, funding costs 

will likely rise relative to asset yields. As a result, net 

interest margins (NIMs) may be pressured. 

To some extent bank managers may be able to offset the 

higher interest costs of wholesale funding strategy by 

improving efficiency through greater management of 

overhead expenses and increases in noninterest income. 

However, community banks face challenges to their 

ability to increase noninterest income (see “Industry 

Consolidation Presents Unique Risks and Challenges 

CHART 7 

Subordinated Debt 

FHLB Advances 

0 

1 

2 

3 

4 

5 

6 

7 

8 

’93 ’94 ’95 ’96 ’97 ’98 

Reported Interest Cost for Commercial Banks (%) 

Nondeposit Alternatives Have Typically Cost 

More than Core Deposits 

Federal Funds 

Core Deposits* 

* Core deposit costs equal interest expense on total deposits minus time deposits 

greater than $100,000 divided by average total deposits minus average time 

deposits greater than $100,000. 

Sources: Bank Call Reports (FDIC Research Information System) and Federal 

Home Loan Bank (FHLB) System Annual Reports 

’ 

for Community Banks,” Regional Outlook, Fourth 

Quarter 1998), and there are limits to cost cutting. If 

banks are unable to fully offset higher funding costs 

with increases in noninterest income or reductions in 

noninterest expenses, overall profitability could suffer. 

Community bankers in the upper Midwest expressed 

this concern in a 1998 survey conducted by The Federal Reserve Bank of Minneapolis, which found that 57 

percent of respondents expect the shift away from 

deposit funding to decrease bank profitability.8 As bank 

managers search for additional ways to offset the relative rise in funding costs, they may be tempted to 

increase asset yields by pursuing additional portfolio 

risk, in the form of credit or market risk, to generate 

higher asset yields. 

Funding challenges also could alter the liquidity and 

interest rate risk positions of community banks. The relative complexity and volatility of some nondeposit 

sources require greater expertise and attention to assetliability policies and practices to avoid unexpected 

liquidity strains or exposures to changing interest rate 

environments. Strategies that result in the pledging of 

liquid assets, overreliance on purchased funds, or concentrations in price-sensitive long-term assets could 

adversely affect a bank’s relative liquidity or interest 

rate risk position. Moreover, interest rate risk management can be further challenged by the complexity of 

nondeposit funding sources. For instance, some FHLB 

advances may contain embedded options that required 

greater expertise and attention to policies and practices 

that, if not managed properly, could lead to undesirable 

outcomes if interest rates change adversely. 

7 ABA Banking Journal, February 1999, p. 30. 8 Fedgazette, July 1998, p. 2. 

San Francisco Regional Outlook 15 Third Quarter 1999 
In Focus This Quarter
 

Differences between Community Banks with 

High and Low Levels of Core Deposit Funding 

To evaluate how a shift from a core deposit funding 

strategy might change the profile of a community bank, 

TABLE 1 

performance and condition measures for community 

banks that rely most heavily on core deposits were contrasted with those that are least reliant on core deposit 

funding. Table 1 compares 1998 funding, earnings, and 

asset performance measures for these community bank 

Comparison of Banks with High and Low Levels of Core Deposit Funding 

ALL COMMUNITY BANK COMMUNITY BANK 

COMMUNITY BANKS1 AGRICULTURAL LENDERS2 COMMERCIAL LENDERS3 

HIGH CORE LOW CORE HIGH CORE LOW CORE HIGH CORE LOW CORE 

DEPOSIT DEPOSIT DEPOSIT DEPOSIT DEPOSIT DEPOSIT 

FUNDING4 FUNDING4 FUNDING FUNDING FUNDING FUNDING 

Selected Aggregate Measures 

NUMBER OF BANKS IN GROUP 405 405 106 51 126 185 

MEDIAN TOTAL ASSETS ($000S) 46,244 118,358 23,274 58,223 69,479 130,923 

MEMBERS OF FHLB (%) 32.10 49.38 17.92 47.06 38.89 50.81 

HAVE OUTSTANDING FHLB ADVANCES (%) 7.65 40.25 6.60 45.10 7.14 38.38 

Selected Median Liquidity and Funding Measures (%) 

1998 GROWTH IN TOTAL ASSETS 9.02 11.16 5.96 6.42 12.75 18.50 

1998 GROWTH IN TOTAL DEPOSITS 9.74 8.79 6.40 5.31 13.56 11.93 

1998 GROWTH IN BORROWINGS (50.00) 28.62 (64.49) 31.85 (51.87) 42.87 

1998 GROWTH IN TOTAL EQUITY CAPITAL 5.93 7.53 3.46 5.39 9.94 8.85 

TOTAL DEPOSITS-TO-TOTAL ASSETS RATIO 91.04 75.68 90.35 80.22 91.23 77.94 

CORE DEPOSITS-TO-TOTAL ASSETS RATIO 87.29 53.87 87.10 55.81 87.21 54.03 

BORROWINGS TO TOTAL ASSETS RATIO 0 9.58 0 4.15 0 8.55 

TOTAL EQUITY CAPITAL TO TOTAL ASSETS RATIO 8.25 10.24 9.00 10.09 7.74 10.16 

Selected Median Performance Ratios (%) 

RETURN ON EQUITY 12.65 10.19 11.10 10.93 14.49 9.52 

RETURN ON ASSETS 1.07 1.04 1.01 1.19 1.10 0.92 

NET INTEREST MARGIN 4.76 4.03 4.51 3.98 5.25 4.22 

GROSS EARNING ASSET YIELD5 8.17 8.02 8.24 7.89 8.45 8.26 

COST OF FUNDING EARNING ASSETS6 3.33 4.07 3.74 4.05 3.21 4.05 

NONINTEREST INCOME TO AVERAGE ASSETS 0.76 0.61 0.59 0.44 1.01 0.64 

NONINTEREST EXPENSE TO AVERAGE ASSETS 3.49 2.90 3.23 2.40 3.99 3.12 

EFFICIENCY RATIO7 69.01 63.68 68.59 57.48 68.99 67.00 

Selected Median Credit Quality Measures (%) 

NONPERFORMING ASSETS TO TOTAL ASSETS RATIO 0.39 0.44 0.40 0.51 0.46 0.61 

NONCURRENT LOANS TO TOTAL LOANS RATIO 0.53 0.72 0.53 1.02 0.52 0.77 

NET LOAN CHARGE-OFF RATIO 0.11 0.12 0.04 0.15 0.14 0.11 

1998 GROWTH IN NONPERFORMING ASSETS (9.10) 7.50 10.57 11.79 (17.32) 23.97 

1998 GROWTH IN NET LOAN LOSSES 6.09 10.24 (3.90) 23.73 9.59 30.64 

1 Community banks are banks with $1 billion or less in total assets. 

2 Agricultural lenders are banks with 25 percent or more of assets in agricultural real estate loans or agricultural production loans.
 

3 Commercial lenders are banks with 25 percent or more of assets in commercial and commercial real estate loans.
 

4 High core deposit funding group is composed of community banks with core deposits-to-assets ratios in the top 5
 

percent of all community banks, excluding those with equity-to-assets ratios in excess of 25 percent. The low core
 

deposit funding group is composed of community banks with core deposits-to-assets ratios in the bottom 5 percent
 

of all community banks.
 

5 Gross earning asset yield equals interest income divided by average earning assets.
 

6 Cost of funding earning assets equals interest expense divided by average earning assets.
 

7 Efficiency ratio equals noninterest expense divided by the sum of net interest and noninterest income.
 

FHLB = Federal Home Loan Bank
 

Sources: Bank Call Reports (Research Information System); Federal Housing Finance Board 


San Francisco Regional Outlook 16 Third Quarter 1999 
In Focus This Quarter
 

groups. High core deposit funders are defined as those 

community banks with core deposit-to-asset ratios in 

the top 5 percent of all community banks at year-end 

1998. Low core deposit funders are those community 

banks with a core deposit-to-asset ratio in the bottom 5 

percent.9 A similar comparison is included for agricultural banks and commercial lending specialists, which 

combined make up roughly 60 percent of each of the 

total community bank funding groups. 

This comparison reveals several differences. First, a 

tradeoff between heavy reliance on core funding and 

asset growth is evident. Median measures for the groups 

indicate that the typical bank that relies less on core 

deposit funding is larger and growing faster than the 

typical bank in the high core funding group. Second, 

less core deposit funding appears to be associated with 

a lower NIM, primarily the result of higher funding 

costs. However, overall profitability 

is similar between the groups 

mainly because of a lower ratio 

of overhead expenses to average assets for the low core 

funders. These characteristics are also evident across 

the agricultural and commercial specialists groups. 

Asset quality indicators suggest that the low core funding groups may exhibit greater credit risk. Although 

higher asset yields resulting from increased portfolio 

risk are not evident, median measures for each low core 

funding group reflect higher levels of noncurrent loans 

and higher growth in nonperforming assets and net loan 

losses relative to its high core funding group counter9 These groups exclude community banks with equity-to-asset ratios 

greater than 25 percent. 

part. For example, the median growth in nonperforming 

assets for commercial lending specialists with less 

reliance upon core deposits was nearly 24 percent in 

1998 versus a 17 percent decline for the high core funding group. 

Summary and Conclusions 

Commercial banks have been experiencing a long-term 

trend toward lower deposit funding of loans and assets. 

Increasing competition among banks and from thrifts, 

nonbanks, and higher-yielding investment alternatives 

has made it more difficult and expensive for some 

banks to attract deposits in step with asset growth. 

While some nondeposit funding alternatives may provide a stable source of funds for insured institutions 

(especially those located in areas characterized by 

aggressive competition and slow deposit growth), better 

matching of asset cash flows, and greater flexibility in 

asset-liability management, they also may pose certain 

risks. To some extent community banks may be able to 

manage noninterest expense and noninterest income to 

offset the relative increase in interest expense incurred 

to acquire nondeposit funding sources. However, if 

overall profitability suffers, banks may be tempted to 

pursue additional portfolio risk to generate higher offsetting asset yields. As a result, liability management 

may become more challenging for community banks 

that have historically relied upon deposits for funding 

and net interest revenues for profitability. In addition, 

the complexity of some nondeposit funding sources 

requires greater expertise and attention to policies and 

practices to avoid unexpected liquidity strains or exposures to changing interest rate environments. 

Allen Puwalski, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

San Francisco Regional Outlook 17 Third Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

•	 Despite a modest slowing combined with specific concerns in the manufacturing and agriculture sectors, the 

San Francisco Region’s economy continued to expand faster than the nation’s economy. 

•	 Most insured financial institutions in the Region continued to report healthy financial conditions. However, 

stresses are apparent in the Region’s farm banks,1 particularly in Montana, where almost 7 percent of the 

agricultural loans are past due. 

•	 The gap between loan and core deposit growth in the Region’s insured financial institutions has led some 

institutions to increase their reliance on noncore funding.2 This strategy may create new challenges for managing liquidity, interest rate, and operational risks. 

Regional Economic and Banking Conditions 

The Region’s Economic Growth Outpaced the 

Nations’ through May 1999, but Concerns in the 

Manufacturing and Agriculture Sectors Remain 

Employment growth in the San Francisco Region 

slowed modestly during the first five months of 1999 

relative to the same period in 1998,3 partly because of a 

weakening in California’s manufacturing sector. 

Despite this slowdown, the Region’s employment 

growth rate exceeded the nation’s during this period as 

a result of solid performances in the construction, government, and services sectors. Specifically, employment 

growth rates in Nevada, Idaho, and Oregon were 

stronger in 1999 than in 1998, while Montana saw 

moderate nonfarm job growth. However, several states 

in the Region experienced a weakening in job growth, 

including California, Arizona, Washington, Utah, 

Alaska, and Wyoming. The labor markets in these six 

states account for about 80 percent of the Region’s nonfarm employment. Employment growth in Hawaii 

remained relatively soft through May 1999 but showed 

only a modest decline from year-earlier levels. 

Various measures illustrated the Region’s modest economic deceleration in the first five months of 1999. 

Declines in manufacturing and mining were evident but 

were nearly offset by gains in the construction, govern1 An agricultural or farm bank is an insured institution with agriculture loans greater than 25 percent of total loans. 

2 Noncore funding sources include certificates of deposit greater than 

$100,000, foreign deposits, federal funds purchased and repurchase 

agreements, all other borrowed money, and all deposits acquired 

through a deposit broker. 

3 Growth rates are computed using data that are not seasonally adjusted, year-to-date averages unless otherwise noted. 

ment, and service sectors, which were outpacing 1998 

growth rates through May 1999 (see Chart 1). In addition, movement of per capita personal income levels 

appeared to indicate a slowing in the Region’s growth 

rate. Finally, the pace of single-family housing permit 

issuance slowed in eight of the Region’s states in early 

1999, suggesting that the advance in residential construction in the Region also had weakened since the 

beginning of the year. 

The Region’s economy has been adversely affected by a 

sharp slowdown in manufacturing employment growth 

as well as declines in agriculture owing to weak commodity prices. Oregon, Utah, Washington, and California continued to experience job losses in the 

manufacturing sector during the first five months of 

1999 compared with the same period in 1998, while 

Arizona saw much slower growth in the sector. This 

CHART 1 Percent Change from Year Ago 

San Francisco Region Nonfarm Employment 

Growth Slows in Most Sectors 

Source: Bureau of Labor Statistics via Haver Analytics, not seasonally adjusted 

1998 

Jan–May 1999 

Mining

Manufacturing

Construction

Services

Government

Trade

FIRE

Total 

Transportation

and 

Public Utilities 

10 

–6 

–4 

–2 

0 

2 

4 

6 

8 

San Francisco Regional Outlook 18	 Third Quarter 1999 
0

Regional Perspectives
 

slowdown was most likely due to a general slowdown in 

export demand from Asia (see Regional Outlook, Second Quarter 1999). In addition, agribusiness in the 

Region felt the strain of very low commodity prices. For 

example, the average national price of wheat, one of the 

most important crops in the Region, fell from $5.44 per 

bushel in 1996 to $3.20 in 1998. This downward trend 

suggests potential for deterioration in Montana, Washington, and Idaho, the three states in the Region ranked 

in the top ten for wheat production nationally by the 

United States Department of Agriculture (USDA). 

As of the first quarter of 1999, problems were most 

apparent in Montana’s insured institutions in the form of 

rising delinquency rates on agricultural loans. 

Year-end 1998 data show that the San Francisco Region 

continued to post relatively low levels of per capita personal income relative to the nation. Per capita personal 

income can serve as an indicator of an area’s growth 

potential. As shown in the second column of Table 1, 

only three states—Washington, Arizona, and California—ranked higher than the national average in per 

capita personal income growth between 1997 and 1998. 

However, of particular note, Utah dropped below the 

U.S. rate of per capita personal income growth in 1998 

after growing faster than the nation since 1995. The 

remaining seven states ranked in the lowest 20 percent 

of the nation in per capita personal income growth in 

1998. Table 1 shows the ranking of states in the San 

Francisco Region by 1998 levels of per capita income. 

TABLE 1 

Again, Washington ranked highest in the Region, suggesting that jobs created in the state (in fields such as 

aerospace and software) were more likely to generate 

higher average wage levels. It should also be noted that 

Hawaii ranked last in growth rate of per capita personal 

income and fell below the average national level of per 

capita personal income for the first time since 1959. 

Preliminary permit data seemed to indicate that the 

Region’s housing markets were also moderating. Housing permits issued during the year can serve as a leading indicator for trends in economic activity. For the 

first four months of 1999, total residential building permits in the Region increased only 3.6 percent over 1998 

levels. Although housing permit issuance typically 

increases in the late spring and summer months, the 

growth rate for 1999 does not appear to be on pace with 

the 9.5 percent growth in 1998. California, Hawaii, and 

Wyoming were the only states to post increases in permits during early 1999. The seemingly large percentage 

increases in California and Hawaii may have been due, 

in part, to the fact that the two states were recovering 

from a lower base. Similarly, Wyoming’s permit growth 

may have been misleading, given typically large fluctuations in year-to-date comparisons for that state. In 

other markets, such as Las Vegas, however, a gradual 

slowdown in housing markets might be beneficial, as 

the rate of household formation has been lagging new 

building during the past several years (see Regional 

Outlook, First Quarter 1999). 

Per Capita Personal Income Growth Was Slow in Most of the Region’s States 

1998 PER 1997–98 

CAPITA INCOME % GROWTH NATIONAL RANK NATIONAL RANK 

LEVEL RATE (1997–98 GROWTH RATE) (1998 LEVEL) 

WASHINGTON $27,961 5.7 3 10 

ARIZONA $23,060 4.8 13 35 

CALIFORNIA $27,503 4.5 21 12 

UTAH $21,019 4.1 31 45 

OREGON $24,766 3.5 40 26 

IDAHO $21,081 3.4 43 43 

ALASKA $25,675 2.8 46 20 

MONTANA $20,172 2.6 47 47 

NEVADA $27,200 2.6 48 14 

WYOMING $23,167 2.5 49 34 

HAWAII $26,137 2.1 50 17 

United States $26,412 4.4 

Source: Bureau of Economic Analysis via Haver Analytics 

San Francisco Regional Outlook 19 Third Quarter 1999 
Regional Perspectives
 

Banking Conditions in the San Francisco 

Region Improve in 1999 

Despite the San Francisco Region’s slower economic 

growth in early 1999, insured institutions reported that 

return on assets (ROA) increased from 1.08 percent at 

year-end 1998 to 1.27 percent as of March 31, 1999. 

The first-quarter return tracks the national level and the 

Region’s performance for the first quarter of 1998. 

Although profits throughout the Region continue to be 

pressured by a declining net interest margin (NIM), 

lower provision expenses for the allowance for loan and 

lease losses (ALLL) boosted profits at commercial 

banks. Improved profits at the Region’s commercial 

banks offset a slight decline in the reported returns of 

savings institutions. In addition, the Region’s insured 

financial institutions reported higher capital ratios and 

improved credit quality during the first quarter of 1999. 

However, asset quality declined at farm banks in several 

states, likely as a result of lower agricultural commodity prices. Furthermore, Hawaii’s insured institutions 

continued to post improved, but below peer, returns 

because of the state’s weak economy. Several of the 

Region’s insured financial institutions, particularly 

mortgage lenders4 and rural community banks,5 are 

relying more heavily on noncore funding sources. 

Low commodity prices and decreased exports have negatively affected the Region’s farmers and farm banks, 

particularly those headquartered in Montana. ROA of 

the Region’s 94 agricultural banks, with total assets of 

$7.4 billion, dipped to 1.18 percent during the first 

quarter of 1999, lagging returns reported a year earlier 

(1.29 percent) and for the full year of 1998 (1.34 percent). As shown in Chart 2, past-due agricultural loans6 

at these institutions continue to edge up and represent 

5.23 percent of total agricultural loans. Chart 2 also 

shows that the ALLL coverage of noncurrent loans7 at 

the Region’s agricultural banks has not kept pace with 

the rise in problem credits. While Chart 2 does show 

that these two ratios vary seasonally, the coverage ratio 

is lower than its March 1998 level, and the past-due 

4 A mortgage lender is defined as any institution with more than 50 

percent of total assets in residential mortgage loans or mortgagebacked securities. 

5 A rural community bank is a commercial bank with total assets less 

than $1 billion, not located in a metropolitan statistical area. Rural 

community banks exclude credit card, mortgage, consumer, and other 

specialty lenders, as well as Utah’s Industrial Loan Companies. 

6 Past-due agricultural loans are agricultural loans and leases 30 days 

and over past due plus agricultural loans on nonaccrual. 

7 Noncurrent loans are loans 90 days and over past due plus loans on 

nonaccrual. 

CHART 2 

Reserve Coverage of Nonperforming Loans 

Declines at Region’s Agricultural Banks 

Percent 

Agricultural Banks: Banks with 25% or more of their total loans in agricultural 

production and farm real estate loans 

Source: Bank Call Reports 

Percent 

Past-Due 

Agricultural 

Loans (Left Axis) 

Coverage Ratio 

(Right Axis) 

0 

1 

2 

3 

4 

5 

6 

0 

20 

40 

60 

80 

100 

120 

140 

1Q 

’99 

3Q 

’96 

4Q 

’96 

1Q 

’97 

2Q 

’97 

3Q 

’97 

4Q 

’97 

1Q 

’98 

2Q 

’98 

3Q 

’98 

4Q 

’98 

agricultural loan ratio is higher than its March 1997 levels. The deterioration in agricultural loan quality is significant for agricultural banks because agricultural 

loans represent, in aggregate, 42 percent of total outstanding loans at these institutions. 

In Montana, where over 50 percent of the Region’s farm 

banks are headquartered, total past-due agricultural 

loans at these banks accounted for 6.99 percent of the 

total outstanding agricultural loans as of March 31, 

1999. In the aggregate, Montana’s farm banks have the 

Region’s highest agricultural loan past-due ratio. This 

ratio also substantially exceeds the past-due agricultural loan ratio of 4.28 percent at peer institutions nationwide as of March 31, 1999. In addition, the ALLL 

coverage of noncurrent loans and leases in Montana’s 

agricultural banks continues to decline. In fact, during 

the first quarter, the coverage ratio in Montana’s agricultural banks declined to 71 percent. Not only is this 

ratio the lowest statewide coverage ratio of peer institutions in the San Francisco Region, but it is also well 

below the aggregate average coverage ratio of 120 percent for all agricultural banks nationwide. 

Although improving, banking performance in Hawaii’s 

14 financial institutions, with total assets of almost $31 

billion, continues to be hampered by Hawaii’s subpar 

economic performance and poor real estate market, as 

well as lingering effects of the Asian economic crisis. 

The annualized ROA for the first quarter of 1999 for all 

insured Hawaiian institutions rose to 0.98%, but remains 

well below the nation’s and the Region’s ROAs of 1.27 

percent. Hawaii’s community banks appear to be improving but continue to fare worse than the state’s larger 

financial institutions, primarily because of their lack of 

San Francisco Regional Outlook 20 Third Quarter 1999 
Regional Perspectives
 

geographic diversification. Combined ROA at community banks increased to 0.70 percent as of March 31, 1999, 

after falling to a low of 0.22 percent at year-end 1998. 

Although some progress is noted in asset quality, in 

aggregate, the community bank past-due ratio remains 

the highest in the Region at 5.5 percent and is more than 

double the Region’s and the nation’s peer institution pastdue ratio of 2.4 percent at March 31, 1999. 

Over the past several years, the Region’s strong economy has stimulated credit demand throughout the majority of the Region’s states. Rapid loan growth in many of 

the Region’s institutions is occurring during a time 

when traditional, low-cost core deposits8 have become 

more difficult to acquire. As shown in Chart 3, noncore 

funding sources, particularly borrowings, have comprised an increasing share of total assets since 1992, 

when much of the Region began to emerge from the 

1990–91 recession. Noncore funds now account for a 

8 Core deposits are defined as all transaction accounts, money market 

deposit accounts, savings accounts, and certificates of deposit less 

than $100,000. 

CHART 3 

Increased Reliance on Noncore Funding 

in the San Francisco Region 

Equity Capital 

Borrowed Money 

Certificates of Deposit >$100,000 

Certificates of Deposit <$100,000 

Money Market Deposit and Savings Accounts 

Transaction Accounts 

Foreign Deposits, Subordinated Debt, and Other Liabilities 

Percentage of Total Assets 

0 

20 

40 

60 

80 

100 

Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar 

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

Source: Bank and Thrift Call Reports (adjusted for mergers) 

higher percentage of the Region’s total assets than at 

any time in the past ten years. While increases in noncore funding are evident in most of the Region’s insured 

institutions, the rise in noncore funding is particularly 

evident in the Region’s mortgage lenders and rural 

community banks. 

San Francisco Region Institutions Alter Their Funding Strategies
 

National macroeconomic forces, such as higher relative 

yields in the stock market, lower consumer savings 

rates, and increasing competition from non-FDICinsured financial service providers, have created a 

noticeable gap between core deposit and loan growth in 

FDIC-insured financial institutions (see Shifting Funding Trends Pose Challenges for Community Banks, 

page 11). Additionally, during this expansion, federal 

legislation has allowed smaller commercial banks with 

residential mortgage loans to gain access to wholesale 

funding sources that were previously available only to 

large commercial banks and savings banks. 

Mortgage Lenders: Profitability Pressure 

and Increasing Reliance on Borrowings 

The most noteworthy change in funding strategy has 

occurred among the Region’s mortgage lenders, which 

held over 33 percent of the Region’s total assets as of 

March 31, 1999. As shown in Table 2 (next page), the 

Region’s mortgage lenders have significantly 

increased their loan-to-deposit ratios and use of noncore funds. Of particular note is mortgage lenders’ 

increased reliance on other borrowings, which has 

coincided with a material drop in the percentage of 

assets funded with retail certificates of deposit (CDs).9 

While the trend toward increased reliance on borrowing is particularly pronounced among the Region’s 

mortgage lenders with total assets greater than $1 billion, the trend is also evident among the Region’s 

smaller mortgage lenders. 

While several macroeconomic forces and industry 

trends may explain the increased use of borrowings and 

reduced emphasis on retail CDs among the Region’s 

mortgage lenders, pressure on earnings—attributable to 

a relatively flat yield curve from 1990 to 1998—appears 

to be the main reason. Charts 4 through 6 show that 

mortgage lenders’ net interest margins are particularly 

sensitive to the direction of interest rate movements and 

changes in shape of the yield curve; these charts also 

show that non-mortgage lenders’ net interest margins 

have been essentially flat since 1990. Chart 4 (next 

page) shows that mortgage lenders benefited from 

falling interest rates and the steepening yield curve, 

9 Retail CDs are CDs in denominations of less than $100,000. 

San Francisco Regional Outlook 21 Third Quarter 1999 
Regional Perspectives
 

TABLE 2 

Mortgage Lending Specialists Dramatically Change Their Liability Structure 

MORTGAGE LENDING SPECIALISTS OTHER INSTITUTIONS 

YEAR MAR 94 MAR 95 MAR 96 MAR 97 MAR 98 MAR 99 MAR 94 MAR 95 MAR 96 MAR 97 MAR 98 MAR 99 

LOANS TO DEPOSITS 96.3% 103.6% 108.0% 115.3% 121.5% 131.9% 76.78% 84.27% 82.84% 82.94% 84.20% 84.52% 

RETAIL CDS/TA 34.6% 35.1% 32.4% 30.3% 24.1% 16.0% 16.08% 17.26% 17.99% 17.39% 16.82% 15.41% 

BORROWINGS/TA 16.6% 22.9% 25.8% 27.5% 31.2% 39.6% 8.54% 11.14% 10.11% 8.30% 8.36% 9.02% 

NONCORE FUNDS/TA 26.3% 32.4% 35.8% 37.7% 41.6% 49.7% 17.81% 21.80% 21.29% 20.76% 21.32% 22.31% 

ADJUSTABLE-RATE 

MORTGAGES/TA 39.60% 42.55% 41.21% 44.22% 41.01% 34.20% 7.08% 8.75% 7.28% 6.35% 5.71% 4.55% 

MORTGAGE-BACKED 

SECURITIES/TA 15.31% 18.70% 20.07% 17.94% 19.60% 25.69% 10.83% 9.57% 8.70% 7.90% 7.37% 8.32% 

Notes: TA=Total Assets
 

Mortgage lenders include any institution with 50% or more of total assets in residential mortgage loans or 


mortgage-backed securities.
 

Other institutions are those insured institutions that are not mortgage, credit card, or international lenders.
 

Source: Bank and Thrift Call Reports (adjusted for mergers)
 

denoted by the movement from yield curve A to B, from 

1990 through 1993. Mortgage lenders, however, were 

hurt significantly by rising interest rates and the flattening yield curve from 1993 through 1995, denoted in 

Chart 5 as the movement from yield curve B to C. Margins have not materially changed, although interest rates 

fell, from 1995 through 1998 because of the almost parallel downward shift in the yield curve, shown by the 

movement from C to D in Chart 6. According to Thrift 

Investor, profits have been squeezed in this flattened 

yield curve and stagnant NIM environment because of 

borrowers’ preferences for fixed-rate loans—which 

mortgage lenders generally sell to the secondary market 

for interest rate risk purposes. This interest rate environment also makes the origination and retention of 

adjustable-rate mortgages more difficult. 

CHART 4 

Although the flattened yield curve has made generating 

earnings growth more challenging for the Region’s 

mortgage lenders, it also has presented unique funding 

opportunities, particularly for mortgage lenders that are 

members of the Federal Home Loan Bank (FHLB) system. When the yield curve is flat, longer-term borrowings are increasingly competitive with shorter-term 

funding options. Research reports from several brokerage houses, including Morgan Stanley Dean Witter 

(November 1998 and April 1999), JP Morgan (March 

1999), and Lehman Brothers (April 13, 1999), suggest 

that some of the Region’s larger mortgage lenders may 

be replacing higher cost retail CDs with borrowings. 

Anecdotal evidence suggests that some smaller mortgage lenders also have used this strategy. 

CHART 5 

Interest Rate (Percent) 

Falling Interest Rates and Steepening Yield 

Curve: 1990 and 1993 

US Tsy 

3 month 

US Tsy 

6 month 

US Tsy 

1 year 

US Tsy 

2 year 

US Tsy 

5 year 

US Tsy 

10 year 

US Tsy 

30 year 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

Sources: Bank and Thrift Call Reports (adjusted for mergers); Board of Governors 

of the Federal Reserve Release H.15 

B. December 1993 Yield Curve 

A. December 1990 Yield Curve 

December December 

1993 1990 Change 

Mortgage Lenders: Net Interest Margin 3.32% 2.41% 0.91% 

Other Institutions: Net Interest Margin 5.00% 4.96% 0.04% 

Interest Rate (Percent) 

Rising Interest Rates and 

Flattening Yield Curve: 1993 and 1995 

US Tsy 

3 month 

US Tsy 

6 month 

US Tsy 

1 year 

US Tsy 

2 year 

US Tsy 

5 year 

US Tsy 

10 year 

US Tsy 

30 year 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

Sources: Bank and Thrift Call Reports (adjusted for mergers); Board of Governors 

of the Federal Reserve Release H.15 

B. December 1993 Yield Curve 

C. December 1995 Yield Curve 

December December 

1995 1993 Change 

Mortgage Lenders: Net Interest Margin 2.73% 3.32% (0.59%) 

Other Institutions: Net Interest Margin 5.04% 5.00% 0.04% 

San Francisco Regional Outlook 22 Third Quarter 1999 
Regional Perspectives
 

Profitability pressures that some mortgage lenders 

have encountered have prompted them to increase 

financial leverage to improve return on equity and 

earnings per share. These leveraging strategies generally involve the borrowing of wholesale funds to purchase mortgage-backed securities, which are generally 

collateralized by fixed-rate mortgages previously sold 

into the secondary market. Brokerage house research 

reports suggest that such strategies have been more 

prevalent among the larger mortgage lenders in the 

Region, which have had problems generating asset 

growth because of high prepayment levels on their 

adjustable-rate mortgage portfolios. Table 2 supports 

the reports’ conclusions and shows an increasing percentage of mortgage-backed securities on mortgage 

lenders’ balance sheets since 1995, coinciding with 

increases in borrowings and declines in adjustable-rate 

mortgages during that time. 

Implications: Many mortgage lenders in the Region 

have experienced profitability pressure because of a relatively flat yield curve, prompting changes in their 

funding patterns. In response, some of the Region’s 

mortgage lenders appear to be increasing their reliance 

on borrowings at the expense of retail CDs. Industry 

experts suggest that some mortgage lenders, particularly larger ones, may be using leverage to generate asset 

growth and increase return on equity and earnings per 

share. These strategies, however, may result in increased 

levels of interest rate risk if potential maturity, interest 

rate index, or optionality mismatches are not properly 

addressed. Because of the sensitivity of mortgage 

lenders’ net interest margins to interest rate changes, 

future changes in yield curve structure or the general 

level of interest rates may cause strategies that were 

profitable while the yield curve was flat to suddenly 

become unprofitable. 

Funding Trends in the Region’s Non-Mortgage 

Lenders—Important Differences Emerge in 

San Francisco Region Community Banks 

Unlike the Region’s mortgage lenders, non-mortgage 

lenders, with the exception of rural community banks, 

have not seen material increases in their loan-to-deposit 

ratios. In fact, deposit growth at community banks 

located in metropolitan areas has kept pace with loan 

growth. Conversely, community banks located in the 

Region’s rural areas have seen a steady increase in their 

loan-to-deposit ratios (see Chart 7). Some economists 

have noted that the rise in rural banks’ loan-to-deposit 

CHART 6 

A Nearly Parallel Shift Downward in the 

Yield Curve: 1995 and 1998 

Interest Rate (Percent) 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

D. December 1998 Yield Curve 

C. December 1995 Yield Curve 

US Tsy US Tsy US Tsy US Tsy US Tsy US Tsy US Tsy 

3 month 6 month 1 year 2 year 5 year 10 year 30 year 

December 

1998 

December 

1995 Change 

Mortgage Lenders: Net Interest Margin 

Other Institutions: Net Interest Margin 

2.85% 

5.00% 

2.73% 

5.04% 

0.12% 

(0.04%) 

Sources: Bank and Thrift Call Reports (adjusted for mergers); Board of Governors 

of the Federal Reserve Release H.15 

CHART 7 

Noncore Funds to Assets (Percent) 

Since 1989, Rural Community Banks’ Loan-toDeposit Ratios Have Increased Considerably 

Source: Bank and Thrift Call Reports (adjusted for mergers) 

Mar 

’89 

Mar 

’90 

Mar 

’91 

Mar 

’93 

Mar 

’94 

Mar 

’95 

Mar 

’96 

Mar 

’97 

Mar 

’98 

Mar 

’99 

Mar 

’92 

Loans to Deposits (Percent)

Noncore Funds to Assets 

Loan-to-Deposit Ratio 

50 

55 

60 

65 

70 

75 

80 

0 

5 

10 

15 

20 

25 

ratios does not represent a liquidity crisis but a return to 

normal levels after the rural lending slump of the 1980s. 

However, others suggest that the increase represents significant liquidity pressure that could force rural banks 

to curtail lending.10 In the San Francisco Region, loanto-deposit ratios between metropolitan and rural community banks contrast sharply. 

One explanation could be population growth. In the 

Region’s faster growing states, such as Arizona and 

Nevada, population growth has occurred primarily in 

metropolitan areas, where essentially all of these states’ 

community banks are located. The Region’s slower 

growing states are either remotely located, such as 

10 See William R. Keeton, “Are Rural Banks Facing Increased Funding Pressure? Evidence from the Tenth District States,” Federal 

Reserve Bank of Kansas City, Economic Review, Second Quarter 

1998. 

San Francisco Regional Outlook 23 Third Quarter 1999 
Regional Perspectives
 

CHART 8 

Population and Community Bank Core


 Deposit Growth Correlate Strongly
 

osit

30 

Dep

25 AZ 

ore

ent)

20 

e C

(Perc

15 OR ID 

th

10 AK WA UT

Five-Year Averag

Grow

5 CA 

WY MT 

0 

HI 

–5 

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 

Five-Year Average Population Growth (Percent) 

Sources: Bank and Thrift Call Reports (adjusted for mergers); U.S. Census 

Bureau via Haver Analytics 

NV 

5.0 

Hawaii and Alaska, or largely rural, such as Montana 

and Wyoming. (The majority of Montana’s and 

Wyoming’s community banks, 88 percent and 82 percent, respectively, are located in rural counties.) Chart 

8 shows that core deposit growth and population 

growth for the Region’s community banks appear 

strongly correlated. This finding coincides with the 

July 1998 Federal Reserve Bank of Minneapolis 

FedGazette article entitled “Declining Deposits...Is It 

All Bad News?” which stated, “The demographic trend 

of falling population will also make it hard for banks 

relying on local populations to fund through insured 

deposits.” This article notes declining population in 

TABLE 3 

several rural counties in the Federal Reserve Bank of 

Minneapolis District, which includes Montana. 

Faced with slower population growth and an increasing 

gap between loan and core deposit growth, the San 

Francisco Region’s rural community banks have relied 

increasingly on alternative funding sources. One source, 

the FHLB system, opened to commercial banks with the 

1989 passage of the Financial Institutions Reform and 

Recovery Act. This legislation allowed commercial 

banks with at least 10 percent of their assets in residential mortgages and mortgage-backed securities to 

become FHLB members. Additionally, a recent change 

in the definition of a residential mortgage loan that 

allowed certain agricultural loans to qualify as collateral for FHLB advances permitted increased access to 

funds for more rural, agricultural community banks. As 

Table 3 shows, community banks in the San Francisco 

Region have increasingly become FHLB members and 

have increased their use of FHLB advances. Further, 

Map 1 (next page) shows that FHLB membership is 

higher, as a percentage of total banks, in the rural counties of Idaho, Montana, Oregon, Washington, and 

Wyoming than in the metropolitan counties. 

The change in the definition of qualified collateral for 

FHLB advances to include more agricultural credits has 

been particularly beneficial to Montana’s community 

banks, most of which are considered agricultural banks. 

These community banks, hard hit by problems in the 

Community Banks, Especially in Montana, Rely More on FHLB Borrowings 

DEC 95 DEC 96 DEC 97 DEC 98 MAR 99 

SAN FRANCISCO REGION COMMUNITY BANKS 

FHLB MEMBERS 223 264 288 304 313 

MEMBERS AS % OF BANKS 33% 41% 47% 52% 56% 

BORROWINGS/ASSETS 2.57% 3.18% 3.08% 3.87% 3.55% 

FHLB ADVANCES OUTSTANDING (000) 607,174 805,891 854,062 1,337,271 1,492,525 

FHLB ADVANCES/OTHER BORROWINGS 60.53% 53.73% 53.10% 62.56% 76.15% 

MONTANA COMMUNITY BANKS 

FHLB MEMBERS 36 42 44 45 49 

MEMBERS AS % OF BANKS 37% 44% 47% 54% 59% 

BORROWINGS/ASSETS 4.39% 5.10% 4.18% 4.66% 5.02% 

FHLB ADVANCES OUTSTANDING (000) 30,723 64,880 84,663 133,469 152,573 

FHLB ADVANCES/OTHER BORROWINGS 82.02% 94.92% 99.42% 98.54% 99.04% 

Notes: Community banks include all commercial banks with total assets less than $1 billion, with the exception of 

credit card, consumer, mortgage, industrial loan companies, and other specialty lenders. 

Sources: Bank Call Reports; Federal Home Loan Bank System 

San Francisco Regional Outlook 24 Third Quarter 1999 
Rural 

Regional Perspectives
 

MAP 1 

agricultural sector, rely increasingly on FHLB advances 

for funding. Additionally, Montana’s community banks, 

despite an average asset size of only $65 million, are 

second only to Hawaii’s community banks in the perSources: Bank and Thrift Call Reports; Federal Home Loan Bank System 

San Francisco Region Community Bank Federal 

Home Loan Bank System Membership by County 

50% to 100% 

10% to 50% 

Up to 10% 

Community Banks 

by County Percent of 

Community Banks in 

a County That Are 

FHLB Members 

(94) 

Metropolitan (54) 

Rural and Metropolitan 

Counties in the San 

Francisco Region 

Counties with 

Community Banks 

centage of total assets funded with borrowings. The 

increase in FHLB advances outstanding at Montana’s 

community banks, however, is not surprising given their 

rural location, the stress in the agricultural sector, and 

the change in the definition of a residential mortgage 

loan. 

Implications: The increased reliance on noncore funding sources at community banks could increase these 

institutions’ levels of liquidity, operational, and interest 

rate risk. In particular, reliance on any one funding 

source could present problems if the institution’s financial condition deteriorates. The potential for an increase 

in liquidity pressure could be more relevant to the 

Region’s rural community banks, which are experiencing increasing loan-to-deposit ratios and, in general, 

have more limited access to alternative funding sources 

than metropolitan community banks. Montana is a case 

in point, as stress in the agricultural sector has begun to 

erode some community banks’ asset quality. Further, the 

level of operational risk could be heightened in the 

event that management of an insured financial institution is not familiar with how to use wholesale funding 

sources. Finally, wholesale funding sources also create 

new challenges in asset-liability and interest rate risk 

management. 

San Francisco Region Staff, 

Norm Williams, Economist, Boston Region Office 

San Francisco Regional Outlook 25 Third Quarter 1999 
✁
 

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Chicago _________ Memphis _________ 

Federal Deposit Insurance Corporation 

Washington, DC 20429-9990 

OFFICIAL BUSINESS 

PENALTY FOR PRIVATE USE, $300 

BULK RATE
 

MAIL
 

Postage &
 

Fees Paid
 

FDIC
 

Permit No. G-36