Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1998 

FDIC
 

New York
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Norman Gertner,
 

Regional Economist
 

Karen A. Wigder,
 

Financial Analyst
 

In Focus This Quarter 

◆ The Asian Economic Crisis: Implications for the U.S. Economy—The 

economic crisis in Asia is now more than one year old, yet its consequences are still 

reverberating throughout the global economy. There are growing indications that 

some sectors of the U.S. economy are beginning to experience slower growth directly attributable to problems in Asia. Consequently, lenders should be cognizant of 

their customers’ exposure to global markets. Lending and strategic decisions predicated on an assumption of continued robust economic growth should be carefully 

scrutinized. See page 3. 

By Paul C. Bishop 

◆ CLOs Lure Another Major Bank Asset off the Balance Sheet— 

Securitization of corporate loans and bonds is in full swing, with 1997 issuance 

exceeding that of securities backed by credit card loans. Collateralized loan obligations (CLOs) and collateralized bond obligations, securities with deal- and issuerspecific risks, are potential bank investments that may grow in popularity if a 

current proposal to lower the risk weights for AAA-rated securities is enacted. 

Banks with an ample supply of low-margin commercial loans are expected to issue 

more CLOs to an increasingly demanding secondary commercial loan market. An 

institution’s CLO strategy may have implications that should be considered when 

evaluating its capital adequacy trends. See page 8. 

By Kathy Kalser and Allen Puwalski 

◆ The Payment System: Emerging Issues—The payment system is the 

heart of the U.S. economic infrastructure, moving value at the rate of 90 times the 

U.S. gross domestic product each year. The banking industry, although historically 

central to this movement, now faces a tangle of new technologies, new exposures, 

and new competitors that challenges its hold on the payments business. Its regulators face a different dilemma—that of how much intervention, if any, these changes 

warrant and how best to prevent the systemic exposures that increasingly large and 

rapid flows of money can create. Together, the issues they face frame a payment system that is fast becoming a technical and political contest. See page 14. 

By Gary Ternullo 

Regular Features 

◆ Regional Economy—The Region’s economy continues to prosper amid a 

national economic boom...fallout from the Asian crisis may harm selected industries, but so far effects in the Region appear limited...demographic trends may hinder demand for consumer loan products, housing, and retailing in the future. 

See page 20. 

By Norman Gertner 

◆ Regional Banking—The Region’s financial institutions remain healthy 

despite narrowing net interest margins and weakness in credit cards...the Asian crisis creates uncertainty for the Region’s financial institutions, both domestic and 

foreign...demographic trends in the Region raise long-term issues about growth 

strategies for its financial institutions. See page 24. 

By Karen A. Wigder 

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)
 

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

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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 New York 

Region’s Regional Outlook, please call Suzannah Susser at (212) 704-1482 or send an e-mail to 

ssusser@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 

Assistant Editors Gary L. Beasley 

Robert L. Burns 

Norman Gertner 

David T. Griffiths 

Suzannah L. Susser 

Karen A. Wigder 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

The Asian Economic Crisis:
 

Implications for the U.S. Economy
 

•	 The impact of the Asian economic crisis on the 

U.S. economy has been increasingly evident, with 

some sectors experiencing slower growth as conditions in Asia continue to deteriorate. 

•	 U.S. exports to Asia have decreased in recent 

months owing to falling demand for commodities, 

manufactured goods, and agricultural products. 

•	 Slower U.S. growth resulting from reduced export 

sales and lower corporate profits could affect 

institutions throughout the nation. 

The economic crisis in Asia is now more than one year 

old, yet the consequences of the unprecedented slide in 

currency values are still reverberating throughout the 

global economy. There are growing indications that 

some sectors of the U.S. economy are beginning to 

experience slower growth directly attributable to problems in the Asian economies. It is difficult to assess 

how significant and long-lasting the effects of the crisis 

will be, but it is clear that earlier views that the crisis 

would pass quickly and be followed by renewed growth 

were too optimistic. The consensus among economists 

and analysts now is that the recovery will be measured 

in years, not months. 

Causes of the Crisis 

Most economists agree that the Asian economies1 are in 

the midst of a steep and severe recession. For example, 

Indonesia’s gross domestic product fell by more than 12 

percent in the first half of 1998, a decline second only 

to the drop in economic activity in the Soviet Union following its collapse in the early 1990s. While Indonesia 

may be the most startling example of economic deterioration in Asia, the other Asian nations also have experienced weakened stock markets, falling real estate 

values, rising corporate bankruptcies, and growing 

problem loan portfolios among financial institutions. It 

is generally agreed (with the benefit of hindsight) that 

the conditions that precipitated these events included 

the following2

: 

1 Unless otherwise noted, “Asia” refers to the economies of China, 

Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, 

South Korea, Taiwan, and Thailand. 

•	 Reduced Export Competitiveness: Most of the 

Asian economies had effectively pegged their currencies to the U.S. dollar. Between mid-1995 and 

early 1997, the U.S. dollar increased in value by 

more than 42 percent against the Japanese yen and 

by 23 percent against the German mark. This 

increase significantly worsened the international 

competitiveness of many Asian firms relative to 

Japanese or European competitors in export markets, 

since the value of their currencies and the price of 

their exports rose along with the U.S. dollar. By late 

1995, export growth among the Southeast Asia 

economies was slowing, and by mid-1996 it was near 

zero. 

•	 Excess Production Capacity: Although Asian savings rates were among the highest in the world, 

domestic saving was not sufficient to fund the 

desired levels of investment in factories, roads, housing, and telecommunications. The resulting inflow of 

foreign capital funded rapid capacity expansion in 

key sectors such as autos, chemicals, and microchips. For example, capital inflows to Thailand 

totaled $1.9 billion in 1980 but rose to $15.2 billion 

by 1996. The increase in production capacity put 

downward pressure on prices and reduced earnings 

growth in key export sectors.3 

•	 Rapid Asset Price Appreciation: Real estate, land, 

and share prices on the region’s stock markets soared 

during the 1980s and early 1990s. In Indonesia, for 

example, the Jakarta Composite stock index 

2 A comprehensive survey of recent events and links to other information sources is available at the Asia Crisis Home Page, 

www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html. 3 A case in point is the growth of the auto industry. During the past 

several years, Korea invested heavily in new auto plants to satisfy 

both domestic and export demand. By 1999, Korean capacity is 

expected to reach 4.66 million light vehicles annually—2 million 

more than domestic demand. In Japan, excess capacity of 2.8 million 

vehicles is expected through 2002. Worldwide excess capacity in light 

vehicles is expected to reach more than 20 million units by 2002— 

more than the total 1997 production of General Motors, Ford, and 

Chrysler combined (Wall Street Journal, March 2, 1998). The result 

has been downward pressure on prices of domestically produced 

autos—down by 1.9 percent on the basis of the first-quarter 1998 producer price index—and imports, which have experienced price 

increases of less than 1 percent since mid-1996. 

New York Regional Outlook 3	 Third Quarter 1998 
In Focus This Quarter
 

increased by nearly 53 percent in the two-year period ending in the first quarter of 1997. 

•	 Deteriorating Credit Quality: Slower export 

growth and eroding competitiveness hampered Asian 

firms’ ability to repay debt incurred to finance the 

growing levels of investment. Some Korean conglomerates were burdened with a debt load equal to 

300 to 400 percent of equity. As much as two-thirds 

of this debt was short-term, with a maturity of less 

than 12 months. Additionally, the debt denominated 

in foreign currencies, such as the U.S. dollar, ballooned as local currency values dropped. With some 

firms struggling to repay mounting debt, banks 

began to experience a further deterioration in credit 

quality. 

Some of the uncertainty about the strength and speed 

of the recovery in Asia is attributable to concerns 

about the faltering Japanese economy. As the second 

largest economy in the world and the engine of 

growth in the region, Japan must have a healthy economy if sustainable growth is to occur in the rest of 

Asia. With Japan currently in a deep recession and the 

outlook for its economy clouded by the halting pace 

of financial reform efforts, there is considerable 

uncertainty about how quickly economic and financial weaknesses throughout the rest of Asia can be 

repaired. 

Impact on the U.S Economy 

The Asian financial crisis could affect the U.S. economy through several avenues. Some firms and industries 

may be directly exposed, especially if they have operations in Asia. 

Banks may be exposed through 

changes in the financial condition 

of Asian borrowers. Other firms 

may be less directly exposed to 

economic conditions but will be 

affected by changes in relative 

prices and trade flows between the United States and 

Asia. The drop in Asian purchases of U.S. exports has 

hit agricultural products, commodities, and manufactured goods. As some recent corporate earnings 

announcements have shown, the crisis has been associated with profit growth that has failed to meet the market’s expectations. 

Banking 

The U.S. banking industry has a smaller direct lending 

exposure to the Asian economies than either European 

or Japanese banks. As shown in Table 1, U.S. banks had 

outstanding loans of $22 billion at the end of 1997, 

which accounted for 8.5 percent of all international 

lending to Indonesia, Malaysia, the Philippines, South 

Korea, and Thailand. To the extent that exposures exist, 

however, large banks and not smaller regional or community banks account for most of the lending. While the 

overall direct lending exposure of the U.S. banking 

industry may be relatively small, the indirect exposure 

resulting from changing economic conditions in the 

United States as a result of the crisis could potentially 

affect small and large institutions in all areas of the 

country. 

Agriculture 

Key to understanding the impact on agriculture is the 

fact that in world markets, agricultural commodities are 

priced and traded in terms of U.S. dollars. The steep 

decline in value of Asia’s currencies means that the 

price of imported agricultural commodities has rapidly 

risen. Over a longer period, higher import prices tend to 

stimulate production in the importing countries that can 

displace demand for imports. Thailand, for example, is 

positioned to increase production of poultry and sugar. 

Other world producers, such as Australia, whose currency also has fallen in value, are now more competitive 

suppliers of some agricultural products to the Asian 

market than the United States. 

On the basis of analysis performed by the U.S. Department of Agriculture’s (USDA’s) Economic Research 

Services,4 U.S. exports of red meat and poultry are 

expected to drop by 5 to 6 percent in fiscal 1998 and 

1999 as a result of the Asian crisis. Exports of grains are 

projected to fall by at least 2 percent in fiscal 1999 as 

other world producers increase production in response to 

changing relative prices among major grain exporters. 

Overall, USDA expects agricultural exports to fall by 3 

to 6 percent in fiscal 1998 and 1999, compared with the 

level of exports had the Asian crisis not occurred. 

Commodities 

Asian countries have become increasingly important 

commodity consumers in recent years. As a result, com4 “World Agriculture and Trade,” Agricultural Outlook, pp. 10–11. 

New York Regional Outlook 4	 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

International Claims by Nationality of Reporting Bank 

End December 1997 

TOTAL INTERNATIONAL 

CLAIMS (MILLION U.S. $) 

U.S. 

CLAIMS PERCENT 

JAPAN 

CLAIMS PERCENT 

EUROPE* 

CLAIMS PERCENT 

OTHER 

CLAIMS PERCENT 

Indonesia 58,388 4,898 8.4 22,018 37.7 15,044 25.8 16,428 28.1 

Malaysia 

Philippines 

South Korea 

27,528 

19,732 

94,180 

1,786 

3,224 

9,533 

6.5 

16.3 

10.1 

8,551 

2,624 

20,278 

31.1 

13.3 

21.5 

12,997 

9,317 

29,614 

47.2 

47.2 

31.4 

4,194 

4,567 

34,755 

15.2 

23.1 

36.9 

Thailand 58,835 2,533 4.3 33,180 56.4 14,782 25.1 8,340 14.2 

Total 258,663 21,974 8.5 86,651 33.5 81,754 31.6 68,284 26.4 

* Includes France, Germany, Netherlands, and United Kingdom 

Source: Bank for International Settlements 

modity markets have been affected by falling demand for 

basic materials and fuels in Asia. The abrupt halt of construction activity in the region has reduced Asian imports 

of metals and metal products. Consequently, world copper and nickel prices fell more than 36 percent during the 

year ending June 1998. Asian developing countries also 

had stepped up their demand for petroleum products, 

accounting for two-thirds of the increase in world petroleum consumption between 1992 and 1996. As economic activity in Asia slowed, oil demand softened and world 

inventories expanded, causing prices to tumble from $20 

per barrel in July 1997 to less than $14 per barrel in June 

1998. To the benefit of U.S. consumers, the drop in oil 

prices has reduced the prices of gasoline and other 

refined petroleum products, but it has cut into profits of 

oil producers. While there are few indications of widespread financial problems in the industry, smaller and 

less geographically diversified producers may be exposed to adverse price and inventory changes. 

Manufacturing 

Asia accounts for a large and growing share of U.S. 

trade in manufactured goods. Between 1990 and 1996, 

U.S. exports of manufactured goods to Asia increased 

from $75 billion to more than $140 billion, accounting 

for nearly one-third of the increase in total U.S. exports 

of manufactured goods. For the U.S. economy as a 

whole, machinery, food products, and chemicals are the 

most exposed to a drop in Asia’s demand for U.S. 

exports. Together, these industries account for nearly 70 

percent of U.S. exports to Asia. 

Between 1990 and 1996, U.S. imports of manufactured 

goods from Asia rose from $176 billion to more than 

$285 billion. Increased imports from China accounted 

for about one-third of the gain. U.S. imports from Asia 

are dominated by machinery and manufactured goods, 

including electronics and semiconductors, which 

together account for 93 percent of imports. 

Asia’s demand for U.S. exports will continue to weaken 

following the dramatic increase in import prices resulting from the drop in currency values. The latest trade 

data show that the dollar volume of U.S. goods exports 

to Asia (including both manufactured goods and other 

commodities) fell by 22.5 percent in May 1998 compared with one year earlier (Chart 1). 

Changes in the volume of exports at the national level 

do not adequately describe the variation in the export 

exposure of different regions of the country. Chart 2 

(next page) shows the percentage of state-level exports 

CHART 1 

U.S. Exports to Asia Drop While Imports 

Continue Modest Growth 

Source: Bureau of the Census 

–25 

–20 

–15 

–10 

–5 

0 

5 

10 

15 

20 

Jan-96

Mar-96

May-96

Jul-96

Sep-96

Nov-96

Jan-97

Mar-97

May-97

Jul-97

Sep-97

Nov-97

Jan-98

Mar-98

May-98 

Percent Change - Year Ago

Imports Exports 

New York Regional Outlook 5 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Western and Midwestern State Exports Are
 

Vulnerable to Changes in Asian Demand
 

Percentage of Total 

State Exports Destined 

for Asia (1997) 

More than 30% (14) 

21% to 30% (16) 

10% to 20% (17) 

Less than 10% (4) 

Source: Bureau of the Census, International Trade Administration 

that are destined for Asia.5 Clearly, Western states are 

most exposed to changes in the demand for U.S. 

exports, especially electronics, transportation equipment, and industrial machinery. A significant share of 

exports from the Midwest also is destined for Asia, 

including chemicals and machinery such as construction equipment.6 

In the initial stages of the crisis, the consensus view 

suggested that the United States would be overwhelmed 

by cheap imports from Asia, as Asian countries exported their way to economic recovery. Although there has 

been an increase in U.S. imports from Asia, the growth 

has been well below expectations. In May 1998, goods 

imports were up by just 4.8 percent over the previous 

year. The reason that U.S. imports of Asian goods have 

not been greater is due in part to the severity of the economic downturn and the weakness of Asia’s financial 

institutions. Many Asian manufacturers are dependent 

5 The state-level export data are from the Export Locator series published by the Bureau of the Census. These data tabulate the value of 

exports as determined by the location of the exporter, which may differ from the location of the producer. Although these data are an 

imperfect measure of state-level export performance, they are still of 

value in assessing regional exposures and remain the most complete 

data available. 

6 A state-by-state analysis has been prepared by the U.S. Treasury and 

the U.S. Department of Commerce. 

on components imported from neighboring countries or 

purchased on world markets. With the drop in currency 

values, all imported goods, including finished goods 

and intermediate goods that are used in the manufacturing sector, have become more costly. At the same time, 

Asia’s weak financial systems have come under increasing pressure as the economic slump deepens. Many 

banks cannot, or will not, lend. Consequently, Asian 

firms cannot secure the capital to acquire imported 

inputs or to finance the sale of exports abroad. As the 

“credit crunch” abates, imports from Asia should 

rebound, placing greater pressure on U.S. manufacturers. 

Corporate Profits 

Profits of U.S. producers also will be affected by falling 

prices for import-competing goods and plummeting 

Asian demand for some U.S. exports. Although U.S. 

producers of import-competing goods will be under 

increasing competitive pressure, firms that use imported components from Asia will benefit from an effective 

reduction in costs. U.S. exporters may see disappointing 

Asian market profits offset by continuing strong sales in 

the U.S. and European markets. For these reasons, the 

impact of the crisis on corporate profits must be viewed 

in the context of gains and losses caused by changing 

relative prices of a firm’s products and inputs. 

A number of recent earnings announcements have 

failed to meet analysts’ expectations. According to 

IBES International,7 the crisis has contributed to a 

reduction of profit growth, although most of the slowdown is attributable to both falling prices and weak 

demand for semiconductors and oil. Operating profits 

of all companies tracked in the Standard & Poor’s 500 

stock index increased by 4.4 percent in the first quarter 

of 1998, the smallest increase since 1991. Excluding the 

energy and technology sectors, profits of the S&P 500 

firms increased by 8.6 percent in the first quarter. On 

the basis of these results, the impact of the crisis on corporate profits appears to be highly concentrated among 

firms in a few industries. 

Summary and Implications 

The consequences of the Asian economic crisis continue to unfold. The slowdown in growth in most Asian 

economies has already reduced U.S. export shipments 

and put downward pressure on prices of commodities 

and agricultural products. How long this trend will con7 As quoted in the Wall Street Journal, June 22, 1998, p. C1. 

New York Regional Outlook 6 Third Quarter 1998 
In Focus This Quarter
 

tinue is uncertain, but most analysts have dismissed the 

chances of a speedy recovery in Asia. Although most 

economists are not anticipating a recession in the 

United States in the foreseeable future, the indirect 

impact of the Asian crisis will be felt to some extent 

across most regions of the country. 

Lenders should be cognizant of their customers’ exposure to a continued drop in demand for exports or to further deterioration in the pricing environment. More 

generally, slower U.S. growth could affect even those 

borrowers that have little or no 

direct exposure to export markets. What is clear for insured 

institutions is that at this stage of 

the economic expansion and with 

a number of uncertainties about 

the global economic outlook, 

lending and strategic decisions 

predicated on an assumption of 

TABLE 2 

continued robust economic growth should be carefully 

scrutinized. 

References 

Asia Crisis Home Page. New York University. www. 

stern.nyu.edu/~nroubini/asia/AsiaHomepage.html. 

“Automobile Glut Worries Analysts Even as Some Cut 

Back on Output.” The Wall Street Journal. March 2, 

1998. 

The Importance of Asia to the State Economies. 1998. 

U.S. Treasury and U.S. Department of Commerce. 

www.treas.gov/press/releases/pr2317.htm. 

“World Agriculture and Trade.” Agricultural Outlook. 

United States Department of Agriculture, Economic 

Research Service. February 1998. 

Paul C. Bishop, Economist 

New York Region: Merchandise Exports to Asia—1997 

Includes China, Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and Thailand 

PERCENT 

EXPORT OF EXPORTS EXPORT 

VOLUME GROWTH TO ASIA BY EXPOSURE 

INDUSTRY SECTOR ($ MILLIONS) 1993-97 INDUSTRY* TO ASIA** 

TOTAL EXPORTS TO ASIA 26,108.9 29% 100% 24% 

TOP FIVE EXPORT INDUSTRIES 

CHEMICAL PRODUCTS 4,837.7 17% 19% 24% 

INDUSTRIAL MACHINERY & COMPUTERS 4,314.2 58% 17% 29% 

ELECTRIC & ELECTRONIC EQUIPMENT 3,626.2 59% 14% 31% 

SCIENTIFIC & MEASURING INSTRUMENTS 2,022.9 36% 8% 25% 

TRANSPORTATION EQUIPMENT 1,881.8 22% 7% 18% 

TOTAL OF TOP FIVE EXPORT INDUSTRIES 16,682.7 37% 64% 26% 

* Percent of region’s total exports to Asia from each of the top five export industries. 

** Percent of region’s total world exports for each industry destined for Asia. 

Source: International Trade Administration 

New York Regional Outlook 7 Third Quarter 1998 
In Focus This Quarter
 

CLOs Lure Another Major Bank Asset
 

off the Balance Sheet
 

•	 Securitization of corporate loans and bonds is in 

full swing, with 1997 issuance exceeding that of 

securities backed by credit card loans. 

•	 Collateralized loan obligation (CLO) and collateralized bond obligation (CBO) issuance has grown 

dramatically since 1996. Both CLOs and CBOs 

are potential bank investments that may grow in 

popularity if a current proposal to lower the risk 

weights for AAA-rated securities is enacted. 

•	 These bonds may offer a higher yield than other 

AAA-rated securities, but they also may carry 

both deal- and issuer-specific risks that warrant 

closer scrutiny. 

•	 Banks with an ample supply of low-margin commercial loans are expected to issue more CLOs to 

an increasingly demanding secondary commercial loan market. 

•	 Securitizing investment-grade commercial loans 

has implications for capital adequacy. 

CBOs and CLOs are fixed-income securities that share 

many similarities with other asset-backed securities. In 

a CLO or CBO, commercial loans or bonds are pooled 

and securitized, and participation certificates in the 

underlying assets are sold to investors. The first CLO 

and CBO transactions occurred in the late 1980s, but 

issuance was slow until last year. During 1997, the estimated volume of corporate bonds and commercial loans 

securitized was $54 billion, more than double the 

amount securitized in 1996. In fact, the combined 

issuance of CBOs and CLOs in 1997 was more than the 

amount of credit card loans securitized during the year. 

The amount of securitized commercial loans and corporate bonds is expected to continue to grow this year, 

with an increasing number of deals backed by commercial loans1 (see Chart 1). 

1 CBOs/CLOs: An Expanding Securitization Product, p. 1, 

JP Morgan, September 1997. 

CBOs and CLOs: A Natural Development in the 

Asset-Backed Securities (ABS) Market 

The growth of the CLO market can be explained by several supply and demand factors. On the demand side, 

strong investor appetite for ABS has produced tremendous growth in the securitization of consumer loan segments such as credit card, auto, and home equity loans. 

The increasing comfort level of the capital markets with 

these asset classes and the various structures used to 

securitize them has facilitated the ABS market’s expansion into nonconsumer loans, including corporate debt 

obligations and bank commercial loans. CBO and CLO 

structures represent a natural progression from the securitization of a pool of consumer loans to the securitization of a diversified package of corporate bonds or bank 

loans. 

Increased standardization of terms among commercial 

lenders and more information flow on returns, defaults, 

and recoveries also have made commercial loans and 

corporate debt more desirable to institutional investors 

and an asset class viable for securitization. In addition, 

CLOs provide a way for investors, including banks, to 

own a credit-enhanced interest in a diversified pool of 

loans without directly owning the individual loans. 

Investors are increasingly considering collateralized 

bond and loan products as higher yielding alternatives 

to other ABS. 

CHART 1 

CBO and CLO Issuance Is Growing 

Source: JP Morgan 

0 

10 

20 

30 

40 

50 

60 

1990 1991 1992 1993 1994 1995 1996 1997 

($ Billions)

CBO CLO 

New York Regional Outlook 8	 Third Quarter 1998 
In Focus This Quarter
 

Foreign and, to a lesser extent, domestic banks have 

been large purchasers of CLOs and CBOs. Bank investment in CLOs and CBOs primarily has been in the most 

senior, highest investment-rated tranches. Together, foreign and domestic banks are estimated to have purchased almost one-half of the highest rated classes of 

CLO and CBO securities issued in 1997. Insurance 

companies dominated the purchase of the middle or 

mezzanine class of CLOs and CBOs.2 

Last year the Federal Financial Institutions Examination 

Council proposed lowering the risk weighting for AAArated ABS from 100 percent to 20 percent. Bank investment in AAA-rated ABS products, including CLOs and 

CBOs, could increase substantially if the proposal is 

approved. 

Lower Capital Requirements, Higher Return 

Ratios Attract Banks to CLO Market 

On the supply side, issuers of CLOs backed by investment-grade loans are motivated by regulatory capital 

treatment, return on capital, and relationship management. While the CLOs originated in the late 1980s were 

designed to purge the lender’s balance sheet of lower 

quality commercial loans, the recent bank-issued CLOs 

have been secured by higher credit quality, lower margin commercial and industrial loans. 

A bank that is capital constrained may view the CLO 

structure as an alternative to issuing additional equity. 

But more often, banks are motivated to securitize 

investment-grade commercial loans because by doing 

so they effectively subject themselves to the market’s 

capital requirements for such loans instead of their regulator’s. Tight competition has compressed the margin 

that banks earn on investment-grade loans to the point 

that more institutions are considering investment-grade 

lending to be an inefficient use of capital. As margins 

have declined, the CLO market has helped relationship 

managers rationalize lower pricing from the perspective 

of return on capital. Since investment-grade and non2 CBOs & CLOs—An Attractive Investment Class, p. 5, Merrill Lynch 

& Co., Inc., December 1997. 

investment-grade-performing commercial loans have 

the same risk weightings for regulatory capital purposes, removing the higher quality, lower yielding assets 

from the balance sheet tends to leave existing bank capital supporting higher return activities.3 In this way, a 

bank can improve certain profitability measures, but 

possibly with a higher risk profile. 

Table 1 (next page) illustrates the effects of a CLO on a 

bank’s capital and return ratios. In order to compare the 

on- and off-balance sheet transactions, the costs of the 

CLO and the associated reserve requirement are analogized to the on-balance sheet funding costs and capital 

requirement if the assets remained on the balance sheet. 

The assumptions reflect the spreads and reserve 

requirement of a typical transaction. While the execution of the CLO costs more than the on-balance sheet 

financing of the loans, the risk-adjusted return on capital (RAROC) is greater with the CLO. The reserve 

requirement is minimized by the tiering of tranches in 

the securitization, which provides credit enhancement 

to the senior classes. The reserve fund, if retained by the 

issuing bank, represents recourse to the bank from the 

sold assets and requires capital at 100 percent under 

“low-level” recourse. 

CLOs also may be used to facilitate corporate borrowing relationships. For example, banks that want to maintain relationships with corporate borrowers but are 

restrained by concentration limitations, either by borrower or by industry, may use CLOs to alleviate concentrations without disrupting borrower relationships. 

Large commercial banks with significant holdings of 

investment-quality commercial loans are likely candidates to issue CLOs. CLO issuance by investment banks 

could grow as these institutions secure a stronger foothold in the commercial loan market. In 1997, foreign 

banks were the primary issuers of CLOs, but more U.S. 

banks are expected to issue CLOs in the future. Japanese and Asian banks may increase their CLO activity as 

they come under pressure to improve capital ratios and 

remove distressed loans from their balance sheets. 

3 Pursuant to the Basle Accord, commercial loans generally receive a 

100 percent risk weighting regardless of the credit rating of the loan. 

Proponents of CLOs have argued that banks can improve their riskadjusted return on capital by removing the higher quality, lower earning commercial loans from the balance sheet. 

New York Regional Outlook 9 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

CLOs Can Facilitate a Higher RAROC on Investment-Grade Assets 

ASSUMPTIONS: 

AMOUNT OF LOANS IN CLO: $1 BILLION 

LOAN PORTFOLIO YIELD: LIBOR + 50 BPTS 

BANK FUNDING COSTS: LIBOR − 10 BPTS 

CLO FUNDING COSTS: LIBOR + 24 BPTS 

BANK RETAINS 1% RESERVE FUND: $10 MILLION 

BEFORE CLO 

YIELD LESS FUNDING COST (L+50) LESS (L− 10) = 60 BASIS POINTS 

NET SPREAD EARNED .006 × $1 BILLION = $6 MILLION 

RISK-BASED CAPITAL REQUIREMENT (8% ON $1 BILLION) = $80 MILLION 

RAROC $6 MILLION/$80 MILLION = 7.5% 

AFTER CLO 

YIELD LESS FUNDING COST (L+50) LESS (L+24) = 26 BASIS POINTS 

NET SPREAD EARNED .0026 × $1 BILLION = $2.6 MILLION 

RISK-BASED CAPITAL REQUIREMENT (100% OF RESERVE FUND) = $10 MILLION 

RAROC $2.6 million/$10 million = 26% 

Source: Bear, Stearns & Co. Inc. 

Arbitrage Opportunities Motivate Most 

Securitization of Subinvestment-Grade Debt 

Issuance of CLOs backed by subinvestment-grade loans 

and most CBOs, which commonly are backed by a mixture of bonds with a subinvestment-grade weighted average, typically is motivated by the potential to capitalize 

on wide spreads between investment and subinvestmentgrade debt. The securities backed by subinvestmentgrade collateral, often referred to as “arbitrage” CLOs 

and CBOs, contain higher yielding, riskier securities 

such as high-yield debt, distressed bonds, highly leveraged loans, and emerging market debt. By assembling a 

diversified pool of higher yielding investments, asset 

managers can limit aggregate event risk and create a 

security with a lower required yield than the underlying 

collateral. Securitizations can include a combination of 

loans and bonds and are sometimes referred to as collateralized debt obligations or CDOs. 

A Closer Look at CLO Structures 

While the structures of CLOs and CBOs are similar, 

banks’ involvement as issuers of CLOs, and the forces 

driving this issuance, elevate the importance of considering CLO structures. Chart 2 presents the basic structure of a CLO. Although specifics may vary, most CLOs 

use a stand-alone special purpose vehicle (SPV) or trust 

to purchase a diversified pool of assets from a bank 

originator or issuer. The purchase of the assets by the 

SPV is funded through the sale of debt securities to 

investors. The structure of the SPV may include one or 

more tranches of debt that are secured by the pool of 

assets owned by the SPV. The classes of debt are distinguished by their priority of claims on the cash flow from 

the collateral, with the most subordinated pieces functioning as an equity investment in the pool. 

The senior tranche is usually the largest, has the greatest amount of credit protection, and earns the highest 

credit ratings in the CLO structure. The rating of the 

senior class typically is higher than the average rating 

of the underlying pool of assets due to the tiering of 

claims among the debt classes and credit enhancement 

in the CLO. The junior tranches of debt may be below 

investment grade or not rated. The reserve or “equity” 

portion may be retained by the issuing entity as a form 

of credit enhancement or sold to third-party investors 

who want a potentially higher return investment. 

CLO collateral has included both funded and unfunded 

loan commitments, loan participations, and different 

types of credit default swaps. Loan assignments also 

may be transferred through a CLO but are less commonly included because of bank issuers’ desire to mainNew York Regional Outlook 10 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Simplified Collateralized Loan Obligation Structure 

Originating Bank 

Special Purpose Vehicle 

(Purchases assets from originator and 

sells debt and equity to investors) 

Senior Class A Notes 

(90% of debt) 

(Investment Grade) 

Mezzanine Class B Notes 

(9% of debt) 

Reserve 

(1%) 

(May be retained by bank) 

Proceeds 

Sale, assignment, or 

participation of loans or credit 

linked notes to special purpose 

vehicle (SPV) 

Assets purchased from 

originator are collateral for debt 

and equity issued by the SPV 

Relative size 

varies by deal 

Proceeds 

tain borrower relationships. The issuer may transfer the 

actual loan, the cash flow from the loan, or the default 

risk to investors. 

CLOs typically rely on an asset manager or servicer 

to “manage” or protect the investors’ interest in the 

collateral. The investment style or role of the asset 

manager may change depending on the purpose of the 

CLO. Securitizations that use an asset manager to 

actively manage the performance and market value of 

the collateral are referred to as “market arbitrage” or 

“market value” transactions. In these deals, the asset 

manager can trade assets into and out of the securitized 

pool in order to maximize the market value of the 

securitized portfolio. In contrast, most bank-issued 

CLOs are designed as “cash flow” transactions, in 

which the asset manager’s role is more as a servicer than 

as a portfolio trader. These structures rely primarily on 

the ability of the collateral to make stable cash flow payments over a predetermined period and emphasize 

the credit quality of the collateral and the predictability of interest and principal payments rather than liquidity and market performance, as in market value 

transactions. 

New York Regional Outlook 11 Third Quarter 1998 
In Focus This Quarter
 

An Introduction to Delinked 

and Linked CLO Structures 

The variables in structuring a CLO are many. The relative size of the senior and subordinated tranches, the 

form of credit enhancement, the ability of the asset 

manager or servicer to adjust the asset pool, and the 

method and degree to which ownership of the underlying loans is conveyed to investors vary among CLOs. 

Despite the variations, two basic structures have 

emerged: “delinked” structures and “linked” structures. 

The primary difference between these two is the extent 

to which the SPV “owns” the securitized assets. An 

issuer may consider many factors when determining the 

type of structure to use, including the ability or desire of 

the issuer to transfer the loans without notifying the borrower, the credit quality of the loans, the investment rating of the bank issuer, and the desired capital treatment 

of the securitized loan. 

In a delinked structure, the collateral is transferred from 

the issuer to the SPV. Delinked structures are generally 

treated as “true sales” for accounting purposes, and the 

loans in the CLO are removed from the issuer’s balance 

sheet. Delinked CLOs are structured to insulate the 

investor from the credit quality problems or insolvency 

of the issuer. Ratings on delinked CLOs are predicated 

on the projected performance of the collateral and the 

credit enhancement structure rather than the credit quality of the issuer. Some delinked CLOs are similar to 

structures used in credit card securitizations that capitalize on the flexibility of a revolving master trust. The 

master trust structure is advantageous because it allows 

for the securitization of different types of assets, such as 

fixed or floating rate or revolving or term loans. 

In linked transactions, also known as credit linked 

notes, the issuer retains ownership of the underlying 

collateral, and the cash flow generated by the collateral 

pool is conveyed or sold to the SPV. All or part of the 

credit risk from the underlying assets is transferred to 

the CLO investor using credit derivatives. As in 

delinked CLO structures, credit protection is provided 

through the layering or tranching of the debt sold and 

other credit enhancements. 

Investors in linked CLOs are not completely insulated 

from the credit risk of the issuer. Because the issuer 

retains ownership of the underlying loans, a default or 

bankruptcy by the issuer could affect the transmission 

of cash flow to the CLO investors. As a result, investors 

in linked CLOs bear both the credit risk of the securitized loan pool and, to some degree, the risk that the 

issuer may become insolvent. Because of this dual 

exposure, ratings on linked structures are typically 

capped by the credit rating of the issuer. 

The accounting and regulatory capital treatments of 

delinked and linked CLOs also differ. Linked structures 

generally do not qualify for sale treatment under generally accepted accounting principles because the assets 

remain under the control of the issuer. Issuers of linked 

CLOs may be granted some regulatory capital relief 

under the Basle Accord if the cash received from the 

securitization is assigned as collateral for the underlying 

loans. The Basle Accord, which governs capital adequacy requirements for Bank for International Settlements 

member countries, reduces the risk weighting on commercial loans that are secured by cash or certain types 

of risk-free marketable securities such as Treasury 

bills.4 While linked CLOs may provide some form of 

capital incentive for foreign banks under the Basle 

Accord, linked structures offer 

little relief to U.S. banks 

because U.S. banks must maintain minimum leverage capital 

ratios in addition to risk-based 

capital ratios. Since the securitized loans count as assets of 

the bank issuer in a linked 

structure, the leverage ratio 

(roughly, book equity to book assets) is not reduced. 

Consequently, the linked CLO structure has been more 

popular among foreign banks. 

The Role of Investment Rating Agencies 

Although the approach may vary among rating agencies, the criteria used to determine the investment rating 

for CLOs are similar. Rating agencies evaluate the ability of the securitization vehicle to make interest and 

principal payments to holders of the debt. This analysis 

requires an evaluation of the credit quality of the underlying collateral pool, including the projected cash flow 

4 Under the Basle Accord and the U.S. risked-based capital guidelines, 

assets collateralized by cash or Treasury securities generally receive a 

preferential risk-weighting that may range from 0 to 20 percent. For 

background information regarding the risk weightings for collateralized transactions applicable to federally regulated institutions, see 

Federal Deposit Insurance Corporation Financial Institution Letter 

number 64–96 dated August 22, 1996. 

New York Regional Outlook 12 Third Quarter 1998 
In Focus This Quarter
 

generated by the pool, the credit enhancement, and any 

additional protection provided to the investors based on 

the structure of the securitization. The rating agencies 

set limits on the amount of industry and borrower concentration in a pool and statistically evaluate the effect 

of diversification among loans when estimating potential defaults and losses from the securitized assets over 

the life of the transaction. If the underlying collateral is 

not already rated—most commercial loans are not—the 

rating agency will grade the underlying loans and assign 

a rating to the security on the basis of the credit quality 

of the loans and the underwriting criteria used by the 

lender. Estimates of default probabilities, timing of 

default, and recoveries in the event of default are 

assigned to the loans and vary by collateral type and 

credit grade. These estimates are generally based on historical default studies authored by the various rating 

agencies. 

Implications for Insured Institutions 

The advent of CLOs poses new opportunities and risks 

to banks. The ability to transfer all or part of a commercial loan’s credit risk to investors may have several consequences. When issuers of CLOs securitize their 

highest grade assets, they are effectively lowering the 

weighted average credit quality of their retained assets. 

An institution’s loan loss reserving policies and capital 

adequacy should take into account the implications of 

its CLO strategy. 

While the issuance of CLOs may be confined to larger 

banks that have considerable commercial loan portfolios, smaller banks or other types of institutions that 

desire a greater exposure to this type of lending may 

consider investing in CLOs. These instruments offer 

banks the opportunity to invest in a diversified pool of 

commercial loans. Because of credit enhancement features and diversification advantages, the most senior 

debt issued by the CLOs can earn a higher investment 

rating than the average rating on individual loans in the 

pool. Despite the investment rating, banks that invest in 

CLOs should be aware that CLO structures are less 

standardized than other ABS investments, and therefore, performance and underlying risk will be both 

issuer and deal specific. 

Kathy Kalser, Chief, Financial Sector Analysis Section 

Allen Puwalski, Senior Financial Analyst 

New York Regional Outlook 13 Third Quarter 1998 
In Focus This Quarter
 

The Payment System: Emerging Issues
 

•	 Essential to the transfer of value in the U.S. economy, the once-arcane and bank-centered payment 

system is undergoing considerable change as new 

technologies bring new opportunities, new exposures, and new competitors into the payments 

business. 

•	 For most banks, the major issues lie in smallvalue payments, where they struggle for advantage in adapting new technologies into new 

products and services while protecting their traditional payments business from technologically 

adept nonbank competitors. 

•	 For regulators and a handful of the largest banks, 

large-value payments present the most serious 

challenges, as technology has enabled increasing 

payment velocity and volume but also has created 

the potential for systemic failures. 

The payment system is the heart of the U.S. economic 

infrastructure, moving an estimated $670 trillion annually among consumers, businesses, financial institutions, and governments.1 Despite this volume—an 

amount equal to roughly 90 times the U.S. gross domestic product—the payment system remains transparent to 

most users because of its dependability in moving value 

safely. Historically, banks have been essential to this 

movement, reaping, according to the Bank Administration Institute, an estimated $117 billion each year in 

revenues both as payment agents and as the holders of 

the funds from which those payments are made. 

Broadly speaking, the payment system encompasses the 

numerous payment products, players, and the infrastructure that together transmit value throughout the 

economy. More specifically, it can be defined as a collection of individual systems constructed around specific payment products. Credit cards, for example, 

represent a payment system. So do debit cards, checks, 

foreign exchange, and even cash. This product-based 

definition is a relevant one for many bankers, since it 

centers on the products and services that generate revenue rather than on the less glamorous “back office” 

functions that are measured instead by their cost. A 

1 Estimate for 1996 from the National Automated Clearing House 

Association; www.nacha.org/resources/marketing/direct-payment/uspayments-96.gif. 

second definition segments the payment system by payment size. Using this definition, the payments world is 

divided into systems that carry small-value or retail 

payments and those that carry large-value or interbank 

payments. This latter classification is oriented more 

toward infrastructure than product but is convenient 

from a regulatory perspective because the seriousness 

of the risk posed varies considerably by payment size. 

However defined, the payment system today is a source 

of new opportunities and exposures—a result of a host 

of new technologies that the “information revolution” 

has spawned. These technologies create different issues 

for banks and regulators. For banks, the issues involve 

adapting the technologies into new products and services while protecting their payments business from 

nontraditional competitors that specialize in its creation 

and use. For regulators, the issues involve managing the 

risks—principally systemic risk—that accompany the 

large increases in payment volume and velocity enabled 

by technology. Taken together, these issues frame a payment system that can be both a political and a technological battleground, with significant incentives for 

participants to shape payment products and channels in 

a way that favors their own objectives. 

Small-Value Payments: 

A Technological Brawl 

Nowhere has the battle to shape the payment system 

been more contentious than in the small-value segment, 

where emerging information technology can best be 

leveraged into new fee-based retail products. There are 

two battles here. The first involves maintaining the 

monopoly over the payments infrastructure that connects each bank with the Federal Reserve and, by extension, with every other depository institution in the 

United States.2 While this infrastructure is interbank— 

that is, it is dedicated to settling accounts between institutions and does not directly extend to their 

customers—the ability to aggregate and settle individual retail payments through it has enabled the banking 

industry to maintain its centrality to the nation’s monetary flows. 

2 Depository institutions were granted exclusive access to this infrastructure upon its creation by the Federal Reserve Act of 1913. 

New York Regional Outlook 14	 Third Quarter 1998 
In Focus This Quarter
 

The second battle involves exploiting new technologies 

either to attract new customers or to serve existing ones 

more profitably. This battle is both highly visible and 

highly technical and underscores the potential of the 

passing of information to eclipse the passing of value as 

the most critical profit opportunity in payments. The 

best example of this potential is bill presentment, the 

process of posting vendor invoices—such as credit card 

or utility statements—on the Internet to facilitate electronic payment. The crucial question concerns where 

the customer transaction data will lie. If they lie on vendors’ sites or on the sites of nonbanks that concentrate 

such data, those entities will effectively “own” the customer by owning the information needed to cross-sell or 

otherwise add value during the billing process. Owners 

of customer-specific data also can tailor new services— 

a process that can develop loyalty as well as related 

sales. Losing this battle would be doubly costly for 

banks because, regardless of where the data reside, electronic payments will eliminate most of the float in the 

payment process, to the benefit of vendors and largely 

at the expense of banks. 

Another battle is building between banks and nonbanks 

with respect to digital cash and stored value applications. These applications are directed at the micropayment sector—that is, payments that are normally 

considered too small for credit cards. Whether they 

reside on a computer or a smart card, these applications 

substitute electronic data for actual cash, with the 

amount stored on each card covered dollar for dollar by 

balances on account with an issuer. The struggle is for 

the right to issue this value, and the American Bankers 

Association has contended that regulated depository 

institutions alone should be permitted to do so.3 The battle here is for more than just fees, for the interest on the 

balances that back this electronic value could provide 

issuers with substantial new sources of income. 

With some new payment technologies, the distinction 

between opportunity and risk can blur. As the Internet 

enables the distance between shopper and shopkeeper to 

increase, the need to authenticate unseen customers, 

merchants, and banks increases as well. At the same 

time, the open nature of the Internet requires that the 

privacy and integrity of transaction information be protected. The building blocks to accomplish this are neither simple nor easily interwoven—successfully 

combining cryptographic protocols, specialized security hardware, and existing information systems is a dif3 The Role of Banks in the Payments System of the Future, www. 

aba.com. 

Emerging Issues in 


Small-Value Payments
 

Maintaining the payment system monopoly. Access 

to Federal Reserve payment services has historically 

been limited to depository institutions. Maintaining 

that monopoly—and thus maintaining its centrality to 

current and future payment products and services—is 

an important issue to the banking industry. 

Electronic bill presentment is the process of presenting bills and receiving payments electronically. Internet 

bill presentment may be one of the most hotly contested services, because the owner of the site where invoices are posted could cross-sell to customers as well. 

Digital cash and stored value are applications in 

which electronic data substitute for cash. Such applications can run on either smart cards or personal computers. An important issue is who holds the balances that 

back electronic value, because, unlike with paper cash, 

issuers may be able to earn interest on the digital balances held by consumers. 

Securing online transactions. Ensuring the integrity, 

privacy, and authenticity of electronic transactions is 

widely desired by those engaged in electronic commerce. With larger payments, desirability will become 

necessity. Current implementations use combinations 

of encryption algorithms and specialized hardware. 

Banks as certificate authorities (CAs). Authenticating Internet payers and payees may require a complex 

public key infrastructure in which trusted organizations 

supply decryption keys to authenticate the counterparties to a transaction. Some banks are already acting as 

CAs. Others are weighing the benefits and largely 

uncertain exposures of providing such a service. 

Electronic Funds Transfer ’99 (EFT 99). On January 

2, 1999, the U.S. government will be required to make 

benefit and vendor payments electronically. This mandate raises issues of how to provide service to the “unbanked,” how to provide service internationally, and for 

vendors, how to integrate remittance data with the payment itself. 

Development of financial electronic data interchange (EDI) standards. For bank commercial customers to benefit from electronic payments, banks must 

be able to handle remittance information—information 

that accompanies payments and identifies sender and 

transaction detail. Standardizing such data is an important step in enabling banks to receive them and pass 

them on to their customers. 

Point of sale check truncation. Checks are costly to 

handle and time-consuming to collect. Check truncation reduces cost and eliminates float by converting the 

check into an electronic transaction at the point of sale. 

Although banks will have fewer checks to handle under 

check truncation, they will lose float and the return on 

investment in check-handling equipment. 

New York Regional Outlook 15 Third Quarter 1998 
In Focus This Quarter
 

ficult matter in itself if the whole is not to be weaker 

than the individual parts. 

The VISA and MasterCard Secure Electronic Transaction (SET) protocols, designed to protect Internet credit card transactions, illustrate the complexity that banks 

and their customers will need to navigate in securing 

online transactions. Under SET, all banks and merchants will use digital certificates to authenticate themselves to consumers and each other for each Internet 

transaction.4 These certificates are electronic messages 

that contain a decryption key for the sender that is itself 

authenticated by a trusted third party. The infrastructure 

for storing, distributing, and vouching for these keys, 

known as a Public Key Infrastructure (PKI), will contain several tiers of certificate authorities (CAs) and 

will be difficult and costly to implement. Banks not 

only will use these certificates, but many are considering becoming—or have already become—CAs themselves. While banks acting as certificate authorities 

may represent a logical progression in banking services, 

there is little evidence of a homogeneous legal infrastructure or legal precedent sufficient to guide digital 

signature disputes. These voids leave unanswerable the 

question of whether the expected gains from providing 

such services will compensate for the potentially longtailed liability from doing so. 

A major stimulus for electronic payments could come 

on January 2, 1999, when the U.S. government is 

required by law to convert its vendor and benefit payments from paper checks to electronic transfers—the 

so-called Electronic Funds Transfer ’99 (EFT 99) program. Three separate challenges arise from this mandate. The first is that the “unbanked”—those segments 

of the population that are socially, economically, or geographically distanced from a financially bank-centric 

world—must eventually be provided with a cost-effective means to receive, store, and spend their electronic 

value.5 The second challenge is that the EFT mandate 

applies internationally as well as domestically. Given 

the need for each international payment to settle in two 

currencies and countries, the ability to provide efficient 

cross-border EFT will vary considerably from country 

to country.6 

4 Depending upon card brand and SET version, consumer certificates 

may be required as well. 5 Because of resistance from bankers and benefit recipients, compliance waivers are envisioned that will make the program largely voluntary until the details of the special electronic transfer accounts 

(ETA) are worked out. 6 www.fms.treas.gov/eft. 

Perhaps more challenging to many financial institutions 

is that electronic payments to vendors, unlike those to 

individuals, will require electronic remittance data to 

accompany the payment itself. This information goes 

beyond simple routing instructions and includes the 

information—such as purchase order or invoice numbers—necessary for the vendor to apply the payment 

correctly. According to a study by Booz-Allen & 

Hamilton, only slightly more than 5 percent of financial 

institutions were able to receive and forward such remittance information as of early 1997.7 Developing this 

capacity will therefore be an industrywide challenge. 

Once again, there is an opportunity disguised as a cost. 

The development and implementation of financial electronic data interchange (financial EDI) standards will 

enable financial institutions to retain control of—and 

add value to—business-to-business transactions when 

commercial payments migrate to the Internet. 

The U.S. government is not alone in seeking an end to 

costly paper-based payments. Vendors too are pressing 

for the elimination of the slow check presentment 

process wherein checks must physically be moved 

from vendor to vendor bank to issuer bank before 

funds can be transferred. Point of sale check truncation 

shortens this process by converting the check into an 

electronic payment at the point of sale, leaving the customer with an executed check and the vendor with a 

transaction that will settle like a debit card—and in 

doing so eliminates much of the potential for check 

fraud. While this process is beginning to displace physical presentment, the outlook for banks is mixed. As 

the volume of checks that must be physically handled 

decreases, so too will the income from float and the 

returns from past investments in check-handling 

capacity. 

Large-Value Payments: Making the 

World a ‘Good and Final’ Place 

Unlike small-value payments, the issues surrounding 

large-value payments are not strategic ones for banks, 

and less technological wizardry pervades them. Instead, 

the common factor is the systemic risk posed by payment failures. For this reason, regulators—particularly 

the Federal Reserve and the world’s other central 

banks—take very seriously the payments “plumbing” 

that is otherwise obscure even to many bankers. In an 

7 Remittance Data Study, Booz-Allen & Hamilton; www.fms.treas. 

gov/eft/remit.html. 

New York Regional Outlook 16 Third Quarter 1998 
In Focus This Quarter
 

electronic and intangible world where a bank’s accumulated exposures can routinely exceed its equity, the overriding objective for payment system designers, users, 

and regulators is “good and final” payment—a term 

referring to funds that are both irreversible and fully 

collected. 

Recognition is building concerning the payment system’s vulnerability and just how critical it is to the 

U.S. economy. An October 1997 report issued by the 

President’s Commission on Critical Infrastructure 

Protection (PCCIP) warned that “the nation’s core payment systems...seem to present a serious physical vulnerability within the financial system.”8 The source of 

that vulnerability, in the eyes of the commission, 

stemmed not so much from a lack of security as from 

the critical importance of those systems to settling 

financial transactions throughout the economy and the 

lack of available alternatives if they failed. As such, it 

was feared that the payment infrastructure provides an 

enticing target for cyber-terrorists and information warriors and that such threats will only grow in the future. 

Concentration refers to the fact that while banks are 

central to payments and all enjoy equal access to Federal Reserve payment services, some banks are clearly 

more central than others. According to March 1998 Call 

Report data, a mere 25 banks hold nearly two-thirds of 

the U.S. banking industry’s transaction accounts.9 

Should one of these large banks suddenly fail, its inability to fund settlements could result in a loss of payment 

system liquidity and disruption of domestic and foreign 

financial systems alike. While this concentration is not 

new, what is new is the considerable increase in concentration that the new megamergers promise.10 How 

and whether to inoculate the payment system from the 

weight of these super-institutions will become an issue 

for the regulatory community. 

The criticality of a nation’s payment system is not confined within its own borders. Because of globalization 

and the increasing velocity of payments, threats to one 

8 www.pccip.gov/report_index.html, p. A39. 9 Transaction accounts, in essence, are those accounts from which 

third-party payments can be made. The data used here are based only 

on transaction accounts held on behalf of other public and private 

financial institutions here and abroad—accounts from which interbank transfers are made. 

10 As of March 31, 1998, the top three U.S. bank holding companies 

held approximately 25 percent of all reported interbank transaction 

deposits. The mergers announced through June 30, 1998, would 

increase that concentration to over 34 percent. 

Emerging Issues in 


Large-Value Payments
 

Payment system vulnerability. According to the 

PCCIP, the nation’s core payment systems may present 

a serious physical vulnerability within the financial 

system. 

Payments concentration. Payment services are concentrated in a relatively few large banks, and that concentration is growing as megamergers are creating a 

smaller number of superbanks. 

Y2K. The Year 2000 problem threatens to disrupt payments by transmitting computer problems via the payment system from banks that have not fixed the 

problem to banks that have. 

The Euro. Bank and interbank systems in Europe 

and abroad must be modified to accept the Euro. In 

addition, the resources required to implement the 

Euro must be diverted from resolving Y2K problems. 

Foreign exchange settlement risk. Foreign exchange 

transaction exposures can be many times a bank’s capital. The failure of a major creditor to pay could drain 

essential liquidity from international markets. 

Achieving finality in gross payment systems. Making a given country’s domestic payments irrevocable 

and immediate is a major step in avoiding the international spillover of internal financial crises. 

Collateralizing net payment systems. According to 

the BIS, systems that do not permit immediate final 

settlement must be collateralized to ensure the eventual satisfaction of member positions in the event of a 

participant’s failure. Like finality, collateralizing helps 

prevent the internationalization of a domestic failure. 

country’s system become threats to those of other countries as well. There are a number of these emerging 

cross-border concerns. The most immediate and visible 

is the Year 2000 or Y2K problem. Because banks and the 

payment networks that join them are heavily computerized, the latent points of vulnerability to software and 

hardware failures have grown factorially with the number of interconnected internal and external systems. In 

this context, the concern is that any banks that have 

failed to correct their Y2K exposures will transmit that 

failure via the payment system to other institutions 

throughout the world, delaying or even arresting settlements in the process. This concern is heightened 

because, in both Asia and Europe, bank resources needed to fix Y2K are being consumed instead by more 

immediate problems. In Asia, it is surviving the decay in 

currencies and credits. In Europe, it is the Euro, which 

rates as an issue in itself—demanding the modification 

New York Regional Outlook 17 Third Quarter 1998 
In Focus This Quarter
 

of bank and interbank payment systems throughout the 

world in anticipation of that currency’s January 1, 1999, 

launch. 

Although less well known to the general public, foreign 

exchange settlement risk remains of considerable concern to the Bank for International Settlements (BIS) and 

its member central banks. This exposure arises because 

cross-border payments, unlike domestic payments, have 

no single central bank to guarantee settlement, leaving 

U.S. banks exposed to their foreign counterparties and 

correspondents—sometimes for several days—for more 

than $244 billion in daily trades.11 Potential solutions to 

this problem include netting—offsetting risks so that 

only the differences are due—and simultaneous settlement. An ongoing effort by several of the world’s largest 

banks to provide simultaneous cross-border settlement, 

a project known as the Continuous Linked Settlement 

Bank, will require considerable international cooperation since it will effectively span the central banks in 

each country whose currency it settles. 

Efforts by individual countries to solidify their payments infrastructure are ongoing as well. Achieving 

finality in payments—a term meaning that a completed 

payment is irrevocable—is the most prevalent, and recognizes that payments must be irreversible to establish 

the liquidity for those that follow. One way of speeding 

up finality is with real time gross settlement (RTGS) 

systems. “Real time” means that there is no delay in settlement. “Gross settlement” means that transactions are 

settled in the full amount for which the original payment 

instructions were entered. FedWire, the U.S. Federal 

Reserve’s large-value payment system, is an RTGS system. Many other countries also have them, and still 

more are developing or planning them. Complementary 

to RTGS systems are net or provisional settlement systems, which total up the accumulated debits and credits 

for each participant over the course of some period— 

usually one day, offset them against each other, and settle at the end of the period. The New York Clearing 

House’s Clearing House Interbank Payment System is 

one such system. Although their use leads to smaller, or 

netted, settlement amounts for each participant and substantially lower liquidity demands on the payment system as a whole, payments in such systems are not final 

until the last creditor pays. Thus, there is a daily threat 

of recalculation and a potentially fatal change in mem11 Settlement Risk in Foreign Exchange Transactions, March 1996, 

and Central Bank Survey of Foreign Exchange and Derivatives Market Activity, May 1996; Bank for International Settlements; 

www.bis.org/publ. 

Sources of Additional Payment
 

System Information
 

Electronic Bill Presentment 

Checkfree . . . . . . . . . . . . .www.checkfree.com/ebill 

Microsoft-First Data 

Corp . . . . . . . . . . . . . .www.msfdc.com 

Digital Cash and Stored Value 

Cybercash . . . . . . . . . . . .www.cybercash.com 

Digicash . . . . . . . . . . . . .www.digicash.com 

Mondex . . . . . . . . . . . . . .www.mondex.com 

VISACash . . . . . . . . . . . .www.visa.com 

Securing Online Transactions 

Certicom . . . . . . . . . . . . .www.certicom.com 

Entrust . . . . . . . . . . . . . .www.entrust.com 

RSA . . . . . . . . . . . . . . . .www.rsa.com 

SETCO . . . . . . . . . . . . . .www.setco.org 

Certificate Authorities 

Certco . . . . . . . . . . . . . . .www.certco.com 

Digital Signature Trust . . .www.digsigtrust.com 

GTE Cybertrust . . . . . . . .www.cybertrust.gte.com 

Verisign . . . . . . . . . . . . . .www.verisign.com 

Electronic Funds Transfer ’99, Financial 

EDI, and POS Check Truncation 

National Automated 

Clearing House 

Association . . . . . . . . .www.nacha.org 

U.S. Treasury Financial 

Management Service . .www.fms.treas.gov/eft 

Payment System Vulnerability 

President’s Commission on 

Critical Infrastructure 

Protection . . . . . . . . . .www.pccip.gov 

The Euro, Foreign Exchange 

Settlement Risk, Payments Finality, 

and Collateralization 

Bank for International 

Settlements (BIS) . . . .www.bis.org/publ 

Federal Reserve Board 

of Governors . . . . . . . .www.ny.frb.org 

New York Clearing 

House Association . . .www.chips.org 

U.S. Federal Reserve . . . .www.bog.frb.fed.us 

New York Regional Outlook 18 Third Quarter 1998 
In Focus This Quarter
 

bers’ liquidity positions if a major creditor bank fails. 

For such systems, the BIS is encouraging member collateralization levels sufficient to cover at least one, and 

preferably two, of each system’s largest net creditor 

banks at any one time.12 While these are not new issues 

in developed nations, the increasing extent to which 

financially underdeveloped and underregulated countries are involved in global payments confers new 

importance on the development of finality and collateralization in payment systems worldwide. 

Differing Perceptions, Common Threat 

Banks are united neither in their perceptions of these 

issues nor in their desire for regulation to address them. 

With respect to small-value payments, large and small 

banks have disagreed over whether the Federal Reserve 

should withdraw from providing retail payment services—a debate that ended in favor of the small bank 

faction earlier this year when the Fed announced that it 

would remain an active and, according to some large 

banks at least, a subsidized competitor in clearing and 

12 Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy report), 

November 1990; BIS; www.bis.org/publ. 

settlement. There also has been disagreement, again 

along lines of size, over whether the issuance of new 

products such as stored value cards should be limited to 

regulated depository institutions. In large-value payments, the differences are due more to relevancy than 

competition. Few small banks will feel compelled to 

address foreign exchange exposures or the vulnerabilities of the national and international payments infrastructure. 

Whatever their individual perceptions of the issues surrounding the payment system, all banks are susceptible 

to its interruption. Likewise, they are strategically vulnerable—individually and as an industry—if they fail to 

preserve their role as a trusted gateway for the settlement of their customers’ obligations. This is perhaps the 

most critical of all payments issues facing banks, for 

while their daily operations may depend on their continued success in maintaining the payment system’s 

dependability, nothing short of their payments franchise 

may rest on their ability to market this success to their 

customers as a feature essential to the entire range of 

current—and future—payment services. 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

New York Regional Outlook 19 Third Quarter 1998 
Regular Features	 Regional Economy
 

New York Region: Asian Crisis and Poor Demographics
 

Pose Short- and Long-Term Exposure
 

•	 The New York Region’s economy continues to prosper while the national economy booms. 

•	 Fallout from the Asian crisis may harm selected industries, but so far the effects appear muted in the 

Region. 

•	 Unfavorable demographic trends may hinder long-term economic growth in housing and retailing. 

Region’s Economy Continues to Thrive 

The New York Region’s economy continues to prosper 

during one of the longest national economic expansions 

on record. The nation’s real gross domestic product rose 

a strong 3.8 percent in 1997 and another 5.4 percent on 

an annual basis in the first quarter of 1998. The Region 

added about 315,000 jobs in the first quarter, a 1.5 percent increase over the prior year. All states in the Region 

are experiencing employment growth (see Chart 1). 

In contrast to other Regions, where economic and job 

growth has been faster but perhaps more volatile, a slow 

and steady pace has characterized growth in the New 

York Region. Reflecting the job gains, unemployment 

rates throughout the Region continue to fall. Except for 

Puerto Rico, which is experiencing a job slowdown, 

most states have been reporting their lowest unemployment rates in almost a decade. However, most state 

unemployment rates are still above the national average. 

The exception is Delaware, with a 3.4 percent unemployment rate in the first quarter of 1998, one of the 

lowest rates in the nation. 

CHART 1 

Source: Bureau of Labor Statistics 

All States in the Region Are Enjoying 

Employment Growth 

Employment Growth 

1Q97 to 1Q98 

3 to 4 Percent 

2 to 2.9 Percent 

1 to 1.9 Percent 

Despite the positive trends, two important factors 

threaten the Region’s economic growth and expose 

financial institutions to risk. The short-term factor is the 

Asian crisis, which in the next two years could dampen 

export growth and hurt Regional industries whose products compete directly with Asian goods. The second 

factor, which has longer term implications, is the lack of 

population growth in general, but especially in the age 

cohort between 25 and 34 years old. Most household 

formation begins during these ages, starting the demand 

for homes and family-related retail products and ultimately for banking services. The Region has been experiencing less demand for housing and retail products 

than other parts of the nation as this cohort has continued to decline. 

Local Effects of the Crisis from 

the Asian 10 Countries1 

The financial and economic crisis in Asia resulted from 

a number of factors, including weak financial oversight, 

inability to maintain domestic currencies pegged to the 

dollar, and growth in speculative investment (see The 

Asian Economic Crisis: Implications for the U.S. 

Economy). It is still too early to assess the specific 

financial effects of the Asian crisis on industries in the 

Region. Nevertheless, the crisis has potential adverse 

consequences for industries that export goods to Asia if 

demand for their products is reduced. 

When measured in terms of gross state product, merchandise exports to the Asian 10 countries represent 

only a small component of each state’s overall economy 

(see Chart 2). However, 1997 statistics from the Federal 

1 The Asian 10 countries are China, Hong Kong, Indonesia, Japan, 

Malaysia, the Philippines, Singapore, South Korea, Taiwan, and 

Thailand. 

New York Regional Outlook 20	 Third Quarter 1998 
Regular Features Regional Economy
 

CHART 2 CHART 3 

Note: Data for Puerto Rico are not available. 

Sources: Federal Office of Trade and Analysis and Regional Financial Associates. 

Asian Exports Are a Limited Part of 

Gross State Product... 

0 

1 

2 

3 

4 

5 

6 

DE MD NJ NY PA US 

Percent of Gross State Product 

...But Represent a Higher Percentage 

of Total Exports 

Source: Federal Office of Trade and Analysis. 

0 

10 

20 

30 

40 

DE MD NJ NY PA PR US 

Percent of Total Exports 

Office of Trade and Analysis show that the Region 

exported $26 billion in merchandise to the Asian 10 

countries, representing nearly one-quarter of the 

Region’s total exports. As a percentage of total goods 

export dollars, Delaware has the highest exposure to the 

Asian 10 countries, followed by New York and New 

Jersey (see Chart 3). Asian export exposure in 

Delaware is centered on chemical products. In New Jersey and Pennsylvania, export exposure is primarily 

focused in the manufacture of drugs and allied chemical 

products and electronic equipment. In New York, export 

exposure lies in the industrial machinery, chemical, and 

agricultural industries. In addition, the apparel industry, 

a leading manufacturing sector and major employer of 

blue-collar workers in New York City, is very sensitive 

to the currency valuation pressures stemming from the 

Asian crisis. Because the apparel industry requires very 

quick turnaround and has relatively light plant and 

equipment requirements, manufacturers can shift production locations quickly. 

Despite Limited Exposure to Asia, Risks Remain 

Although the Region’s exposure to the Asian crisis 

appears somewhat limited, potential risks remain. Most 

analysts are concerned that the crisis is far from over. A 

number of the Region’s domestic manufacturers have 

already reported lower profits as a result of declining 

export sales and falling prices in the United States. 

These trends are expected to continue along with the 

crisis. Lower cost Asian imports are helping to lower 

inflationary pressure on commodities such as chemicals 

and manufactured goods such as apparel. However, 

falling prices without an equivalent boost in productivity are putting downward pressure on corporate earnings, thereby weakening the Region’s economy. 

Another major concern is that the crisis will spread to 

other parts of the world, such as Latin America or even 

Europe. Analysts have already noted outflows of cash 

from Latin American mutual funds, while forecasts of 

1998 Latin American corporate profits are being 

reduced. If the Latin American situation worsens, exposure by the Region’s banks would be far greater because 

exposure to Latin America is much higher than exposure to Asia. While the effects on Latin America are not 

yet clear, a recession there would pose an additional 

threat to banks. 

The continuing volatility of the world’s stock markets 

and a closely linked global economy also mean that the 

U.S. stock market could suffer if investors perceive a 

sharper than expected decline in U.S. corporate earnings. Because of this Region’s dependency on Wall 

Street and the financial sector in general for jobs and 

income, a sharp and sustained sell-off in the stock market resulting from instability abroad would have serious 

consequences for its economy. A worsening of the 

Japanese economy, in particular, could have detrimental 

economic and political consequences for the United 

States and the Region. In the first quarter of 1998, the 

Japanese economy shrank 5.3 percent compared with 

the previous quarter, worse than even the most pessimistic forecasts. The Japanese economy is in its worst 

recession in more than two decades. 

New York Regional Outlook 21 Third Quarter 1998 
Regular Features Regional Economy
 

Demographic Trends May Pose 

Longer Term Risk 

Despite the expansion in both the nation and the 

Region, demographic trends are less favorable for 

longer term economic growth. In general, the Region’s 

population is growing more slowly than the national 

average. Slower population growth has been associated 

with a sluggish economy, and often these two factors 

seem to work together. Young people tend to leave areas 

where they perceive less economic opportunity. This 

trend may worsen economic conditions further, as the 

area is deprived of a vital resource. The result is a downward economic cycle that is difficult to reverse. In the 

Region, areas of declining population growth are noted 

in upstate New York and western and northern Pennsylvania (see Chart 4). These areas generally exhibit weak 

economic conditions and slow population growth. 

Many of the Region’s major cities also are losing residents and have sluggish economies (see Regional Outlook, first quarter 1998). 

More important, the age cohort between 25 and 34 is 

declining faster in this Region than elsewhere. This 

cohort is essential to long-term economic growth 

because it forms the basis of future demand for items 

such as housing, automobiles, and purchases related to 

child-rearing. Most households make an initial move 

into homeownership between the ages of 25 and 34. The 

CHART 4 

Source: Bureau of the Census 

Parts of Western and Northern Pennsylvania as 

Well as Upstate New York Have Experienced 

Population Declines 

County Population Changes 

1992 to 1997 

10 to 25 Percent 

0 to 9.9 Percent 

–25 to 0 Percent 

number of individuals entering the housing market for 

the first time drives demand and allows existing homeowners to trade up. Partly because of the decline in this 

age cohort, permits for the construction of new singlefamily homes in the New York Region have lagged 

behind the nation (see Chart 5). Although other factors 

such as interest rates, employment, and availability of 

space are important determinants of housing demand, 

this basic demographic limitation will continue to 

lessen demand for new homes and may eventually curtail construction, home equity, and residential real estate 

loans (see Current Regional Banking Conditions). 

In addition, the unfavorable demographic trends combined with fewer new homes being built and purchased 

mean that fewer dollars will be spent on retail goods. 

When a household buys a home, it generally increases 

retail spending in order to furnish the home. When children are born, retail spending also increases to meet the 

needs of a growing family. As the population ages, some 

of this spending is reduced, going instead for services 

such as health care. Partly as a result of these demographic trends, retail sales in the Region have lagged 

behind the nation during the 1990s. Economists expect 

that this trend, too, will continue to limit banks’ local 

market lending opportunities (see Chart 6). 

New retail space combined with slower absorption has 

pushed up vacancy rates throughout the Region (see 

Chart 7). Over 8 million square feet of new retail space 

was added to the New York Region market in 1996 and 

more than 9 million in 1997, increasing vacancy rates 

from 7.2 percent in 1995 to 7.8 percent in 1997. This 

trend mirrors trends in the nation. Moreover, according 

to the FDIC Real Estate Report, a large number of 

CHART 5 

Permits for Single-Family Homes Have Not Kept 

Pace With the Nation 

Index Value


130
 

United States 120 

110 

100
 

90
 

80
 

70
 

60
 

50
 

N.Y. Region 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 

Source: Bureau of the Census 

New York Regional Outlook 22 Third Quarter 1998 
Regular Features Regional Economy
 

CHART 6 

Retail Sales in the Region Trail the Nation 

Index Value 

120 

110 United States
 

100
 

N.Y. Region 90 

80 

’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

Source: Department of Commerce and Bureau of Labor Statistics. Sales have 

been adjusted for inflation. 

retail real estate projects are in the planning stage 

throughout the Region. For example, in the Philadelphia area, efforts are in the final planning stage to add 

over 1.5 million square feet of new retail space, while in 

the Washington, D.C., area, efforts also in the final 

planning stage would add over 1.3 million square feet of 

new retail space. While the suburban economies around 

these cities have been growing, the central-city areas 

have experienced declining populations and weak 

economies over the past decade. 

In view of the unfavorable demographic trends, competition among banks for a slow-growing pool of consumer and business loan applicants may intensify. 

Competition may lead to looser underwriting standards 

to sustain growth. With potentially less demand for residential real estate, consumer, retail business, and retail 

real estate loans, banks may have to rely more on other 

forms of revenue enhancements, such as increased fees 

CHART 7 

Retail Vacancy Rates Have Begun to Rise 

Source: FDIC Division of Research and Statistics, The Real Estate Report 

(Summary for the NY Region.) 

0 

2 

4 

6 

8 

10 

12 

’91 ’92 ’93 ’94 ’95 ’96 ’97 

0 

5 

10 

15 

20 

25 

Percent Vacancy Rate Sq. Feet, 000s 

(left scale) 

Absorption 

Net New Supply 

or additional services, to maintain profitability. Retail 

real estate projects should be scrutinized to ensure feasibility, particularly in relation to other planned projects 

and the ability of the local markets to sustain economic 

growth. 

Norman Gertner, Regional Economist 

For More Information 

“Japan’s Real Crisis.” Business Week. May 18, 1998. 

Office of the State Deputy Comptroller for the City of 

New York. The East Asian Economic Crisis. Technical Memorandum 1-99. April 27, 1998. 

Regional Economic Studies Institute. 1998 Economic 

Outlook Conference. Baltimore, Md.: Towson State 

University, December 1997. 

New York Regional Outlook 23 Third Quarter 1998 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

•	 Financial institutions in the New York Region report strong profits and solid financial conditions. 

•	 The Asian crisis poses risk to insured institutions in the New York Region. 

•	 The New York Region’s weak demographic profile suggests banks may eventually struggle for growth in 

their most traditional consumer business lines. 

Financial Condition Remains Strong 

The Region’s banks and thrifts reported healthy financial conditions in the first quarter of 1998 (see Table 1). 

Insured institutions in the New York Region posted 

strong income figures. However, the high return-onassets ratio was boosted by nonrecurring extraordinary 

gains that totaled 11 percent of aggregate net income. 

The ratio of net operating income to average assets, 0.96 

percent, is at its lowest level in two years. Although 

financial institutions have been able to bolster earnings 

by increasing efficiency and emphasizing fee income as 

a revenue source, the continuing trend of lower net 

interest margins is affecting the bottom line. Capital 

ratios remain strong but continue the slightly downward 

trend seen over the past several quarters. Past-due ratios 

are declining as well, reflecting improvement in commercial and residential real estate loan portfolios. The 

primary area of weakness continues to be in the credit 

card loan portfolio. Nonperforming credit card loans as 

a percentage of total credit card loans are higher than in 

early 1997 despite continuing high charge-off levels. 

Further, a larger portion of nonperforming credit card 

loans are in the more severe “90 days and over past due” 

category than in previous periods, suggesting a prolonged weakness that will not be quickly corrected. 

TABLE 1 

The Asian Crisis Brings Uncertainty to 

Financial Institutions 

The currency crises in Asia have brought turmoil to that 

area and uncertainty to the rest of the world. As Asia 

struggles to recover, the U.S. economy is being affected 

in a variety of ways (see The Asian Economic Crisis: 

Implications for the U.S. Economy and New York 

Region: Asian Crisis and Poor Demographics Pose 

Short- and Long-Term Exposure). 

What does the Asian crisis mean for financial institutions in the New York Region? New York’s money center banks have felt and will continue to feel the most 

direct effects. These multinational players, in addition to 

having direct loan exposure to Asia, also have substantial fee-generating businesses in that area. Industry analysts indicate that a slowdown in advisory business in 

Asia could translate into dampened earnings throughout 

1998 for these banks. However, many banks appear to 

have learned a lesson about investing in volatile emerging markets from the Latin American debt crisis in the 

1980s. Money center banks have comparatively little 

direct credit exposure to the five most troublesome 

Asian markets—Indonesia, Malaysia, the Philippines, 

South Korea, and Thailand. According to industry anaNew York Region Institutions Continue to Show Strength 

3/31/98 3/31/97 3/31/96 

RETURN ON ASSETS 1.13 1.13 0.85 

NET INTEREST MARGIN 3.40 3.61 3.77 

RETURN ON EQUITY 15.03 15.08 10.99 

TIER 1 LEVERAGE 7.09 7.32 7.31 

NONCURRENT ASSETS/TOTAL ASSETS 0.84 0.91 1.11 

PAST DUE LOANS (%) 2.59 2.85 2.95 

NONPERFORMING CREDIT CARD LOANS (%) 4.84 4.76 4.02 

CREDIT CARD CHARGE-OFFS (%) 5.01 5.05 4.08 

Source: Bank and Thrift Call Reports 

New York Regional Outlook 24	 Third Quarter 1998 
Regular Features Regional Banking
 

lysts, these credits equal about one-fifth the exposure 

money center banks had to Latin America in the 1980s. 

Perhaps the biggest risk to insured institutions is the 

uncertainty surrounding the effects of the Asian crisis 

on the U.S. economy. Banks’ financial conditions tend 

to follow the business cycle. A slowdown in the economy generally does not bode well for the health of the 

industry. The New York Region’s institutions may face 

pressure on several fronts. Corporate borrowers, especially those with ties to Asia, could experience weakened demand for products, which would cut into their 

profits and negatively affect capacity to repay debt. 

Some manufacturers in the Region already are reporting 

a decline in exports and have given indications of lower 

future earnings. 

The Asian crisis also has created a volatile U.S. stock 

market. The New York Region’s economy, with its heavy 

dependence on the financial services industry, particularly Wall Street, would be significantly affected by any 

instability caused by a sustained stock market downturn 

(see New York Region: Asian Crisis and Poor Demographics Pose Short- and Long-Term Exposure). 

Another area of uncertainty lies 

with Japan. Analysts opine that 

Asia can recover only with the 

assistance of a strong Japan. Yet 

Japan’s economy, which has been 

in the doldrums for most of the 

1990s, has slipped into recession. 

Many market analysts and economists expect the Asian economies to contract sharply 

this year and take five or more years to recover. Forecasts indicate that such a prolonged downturn in Asia 

will reverberate through other economies around the 

globe. 

$ 

Another aspect of Japan’s problems lies with its financial institutions. Japanese banks, which are incurring 

huge loan losses in an effort to slash the burden of bad 

debt already on their books from years of domestic troubles, have the largest credit exposure to their Asian 

neighbors. Japanese banks boosted their lending activities in Asia over the past several years in an attempt to 

compensate for problems at home. Now, the economic 

frailty at home and the financial crisis in the other Asian 

countries pose a double threat to their earnings. Though 

Asian loans held by Japanese banks represent only 3 to 

4 percent of total loans, in some cases that exposure is 

greater than the banks’ core capital. Reserves against 

these loans are eating away at an already weak capital 

base. One side effect is that Japanese banks have had to 

curtail lending, which is contributing to credit tightness 

both in Japan and elsewhere in Asia. Another result of 

this turmoil is that Japanese banks have been downgraded by ratings services such as Fitch IBCA and 

Moody’s, which will increase borrowing costs and further hamper earnings. 

Asian Banks Reevaluating Their Role 

in the United States 

Another effect of the Asian crisis is that many Asian 

financial institutions are altering their strategy in the 

United States. This effect is particularly important to the 

New York Region, which holds the majority of foreign 

banking assets in the country (see Regional Outlook, 

fourth quarter 1997). 

The crisis has prompted Asian banks to retreat from the 

United States. Twenty-one foreign branches, agencies, 

and representative offices in New York City closed in 

1997. Many were offices of Asian banks. Japan, which 

has the most U.S. bank assets of any foreign country, 

experienced a 5 percent decline in total assets in the 

United States in 1997 versus 1996. South Korean institutions, which steadily increased their U.S. presence in 

1996 and the beginning of 1997, have since retrenched 

significantly. Their assets in the United States were 

down more than 30 percent, from $18 billion at the end 

of 1996 to $12.6 billion at year-end 1997. The results of 

these changes are already being felt. Branches and 

agencies of foreign banks are lending less to U.S. businesses and tightening underwriting standards. In addition, there are reports that they are increasing the cost of 

credit lines and widening spreads over base rates. 

The syndicated lending market, in which the New York 

Region has a significant number of large players, has 

been particularly affected by Japan’s recent retrenchment. This is not necessarily a negative, however. As 

competition has lessened, domestic banks have been 

able to widen spreads and raise commitment fees, 

reversing a trend toward razor-thin margins and minimal fees that have been squeezing banks in the syndicated lending market for some time. Deals that are not 

priced to reflect investors’ heightened demands are 

finding fewer participants and sometimes require 

restructuring to stimulate demand. Yet, the general 

retreat of Japanese banks from the syndicated lending 

market has not hampered loan volume. According to 

Securities Data Co., the syndicated lending market, 

with $227 billion of volume in the first quarter of 1998, 

is posed to surpass 1997’s record $1 trillion. 

New York Regional Outlook 25 Third Quarter 1998 
Regular Features Regional Banking
 

Demographics Indicate a Struggle 

for Growth in Consumer Lending 

Slow population growth has hampered this Region’s 

economy, a trend that is likely to continue in the long 

term. The Region faces a declining population of 25- to 

34-year-olds, the prime demographic group for major 

spending on housing and consumer items (see New York 

Region: Asian Crisis and Poor Demographics Pose 

Short- and Long-Term Exposure). In the long term, 

this trend could create a more competitive environment 

for the Region’s financial institutions. 

Many factors affect loan demand at any given time. 

Currently, low interest rates, low unemployment, and a 

strong economy are spurring the residential housing 

market. The Region traditionally has significantly less 

of its total loan portfolio invested in mortgage loans 

than the rest of the nation (see Chart 1). Mortgage concentration levels are affected by the composition of the 

Region’s banks, especially the number of large national 

and multinational institutions, which tend to focus on 

commercial lending and other products instead of residential mortgages. Nonetheless, despite the strong 

housing markets seen throughout the Region in the past 

year, the Region’s mortgage loan portfolios grew only 

about half as much as the national average. Growth is 

not spurred only by a strong economy. Demographics 

will undoubtedly play a larger part in future growth, 

especially if the economy falters. 

Regional demographics will also affect home equity 

and consumer loans. Younger adults are primary purchasers of such items as cars, home improvements, and 

other products associated with household formation and 

CHART 1 

raising families. These purchases generally lead to debt. 

Although other factors undoubtedly affect these loan 

categories, demographic trends play a significant role in 

stimulating demand. The New York Region has consistently posted sluggish growth in home equity and consumer loans (excluding credit card loans) over the past 

five years (see Charts 2 and 3). 

The Region’s changing demographic profile poses a 

challenge for financial institutions, especially community banks. Larger regional or national banks with vast 

interstate operations can shift focus to other, faster 

growing markets with more favorable demographic 

trends. But community banks with limited branching 

beyond their own local markets must find new ways to 

expand and retain an aging customer base. An aging 

customer base implies weakened demand for mortgages 

and installment loans. Less demand for such traditional 

consumer banking products may force banks to weaken 

underwriting standards or pursue growth through other 

business lines to maintain or increase market share, 

leading to a potential increase in bank risk profiles. As 

baby boomers age and save for retirement, demand for 

savings and investment products will increase. The 

competition for these assets is and will continue to be 

intense. Financial institutions of all sizes must develop 

clear marketing strategies in order to compete effectively on this front. 

Banks will have to assess their long-term goals and 

strategies with the Region’s demographics in mind. Risk 

management will be especially critical as banks attempt 

to differentiate their products and services. Underwriting standards and other criteria will have to be balanced 

against the desire for growth. Also, educating conCHART 2 

Region Has Fewer Mortgages Than the Nation 

Source: Bank and Thrift Call Reports 

10% 

15% 

20% 

25% 

30% 

35% 

40% 

Dec-92 

Dec-93 

Dec-94 

Dec-95 

Dec-96 

Dec-97 

Mar-98 

Mortgages/Total Loans

NY Region 

Rest of U.S 

Region Sees Slow Home Equity Loan Growth 

All data as of March 31, 1996. 

Source: Bank and Thrift Call Reports 

–6.0 

–4.0 

–2.0 

0.0 

2.0 

4.0 

6.0 

8.0 

10.0 

12.0 

Percent Change 

NY Region 

Nation 

1993 1994 1995 1996 1997 1998 

New York Regional Outlook 26 Third Quarter 1998 
Regular Features Regional Banking
 

CHART 3 

Consumer Loan Demand Is Relatively Weak 

Percent Change 

13.0
 

9.0
 

5.0
 

1.0
 

–3.0 

1993 1994 1995 1996 1997 1998 

Nation 

NY Region 

Data as of March 31, 1998.
 

Source: Bank and Thrift Call Reports
 

sumers about new savings products will be important, 

as banks expand their business lines to sell mutual funds 

and other nondeposit investment products. Sound planning and clear policies and strategies will be the most 

effective way to deal with the Region’s long-term demographic changes. 

Karen A. Wigder, Financial Analyst 

For More Information 

“Despite Setbacks, FBO Assets Still Grow.” Thomson’s 

International Banking Regulator. June 1, 1998. 

“Rating Changes.” Fitch IBCA. May 20, 1998. 

“Rating Changes.” Moody’s Investors Service. May 27, 

1998. 

New York Regional Outlook 27 Third Quarter 1998 
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