Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1998 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Gary C. Zimmerman,
 

Regional Economist
 

Roger Stephens,
 

Financial Analyst
 

In Focus This Quarter 

◆ Gain-on-Sale Accounting Can Result in Unstable Capital Ratios and Volatile Earnings—The accounting for transferring and servicing financial assets causes asset sellers, particularly high-growth lenders, to recognize significant noncash income related to retained economic interests in the sold 

assets. This is true whether a company securitizes its own assets or sells its assets as 

a conduit to another securitizer. Values are often driven by management assumptions about future performance of the sold assets. Major writedowns of gain-on-sale 

assets by some finance and mortgage companies underscore the importance of careful scrutiny of these assumptions by banks and their supervisors. See page 3. 

By Allen Puwalski 

◆ How Will the Expansion End?—Analysts are now focusing on when 

and how the current expansion will end. Although no one can accurately predict 

when a recession will begin, two possible scenarios have emerged. Each scenario has 

important implications for lenders as they prepare for the possibility of slower economic growth or recession. See page 7. 

By Paul C. Bishop 

◆ Trends Affecting the Allowance for Loan and Lease Losses— 

In today’s environment, in which loan availability is abundant, growth is strong, and 

competition is fierce, some industry leaders and regulators have expressed concern 

about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the allowance for loan and lease losses (ALLL) relative to 

total loans at many insured institutions is declining. As the economic expansion 

reaches an advanced age, an important question for insured institutions is whether 

their ALLLs adequately reflect the risks associated with changing industry practices. See page 11. 

By Andrea Bazemore 

Regular Features 

◆ Regional Economy—The San Francisco Region continued to grow faster 

than the nation in 1997, and it is expected to do so again in 1998...the ill effects of 

the Asian crisis pose risks to some sectors...more than half of the Region’s exports 

go to Asia and more than three-quarters of those exports are concentrated in high 

tech, aerospace, and agriculture. See page 16. 

By Gary C. Zimmerman 

◆ Regional Banking—Banks and thrifts in the San Francisco Region posted their strongest performance in more than a decade...farm lending faces risks 

from the loss of federal price supports and weakened demand from Asia...some 

new banks are concentrating their lending in high-risk real estate lending. 

See page 22. 

By Catherine I. Phillips-Olsen, Roger Stevens 

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

Insurance Corporation for the following eight geographic regions: 

Atlanta Region (AL, FL, GA, NC, SC, VA, WV)
 

Boston Region (CT, MA, ME, NH, RI, VT)
 

Chicago Region (IL, IN, MI, OH, WI)
 

Dallas Region (CO, NM, OK, TX)
 

Kansas City Region (IA, KS, MN, MO, ND, NE, SD)
 

Memphis Region (AR, KY, LA, MS, TN)
 

New York Region (DC, DE, MD, NJ, NY, PA, PR, VI)
 

San Francisco Region (AK, AS, AZ, CA, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY)
 

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

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

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

publish/regout. For more information or to provide comments or suggestions about the San Francisco Region’s Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 974-4247 or send 

an e-mail to cphillips-olsen@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Gary L. Beasley 

Jack M.W. Phelps 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Gain-on-Sale Accounting Can Result in Unstable
 

Capital Ratios and Volatile Earnings 


•	 Gains generated from asset sales under SFAS 125 

rely on management assumptions about the lifetime performance of the assets sold and may not 

materialize in cash if the assumptions prove 

incorrect. 

•	 Gain-on-sale accounting has been most significant to securitizers, but nonsecuritizers can and 

do retain economic interests that give rise to significant gain-on-sale assets. 

•	 Finance companies seeking to shift attention from 

gain-on-sale assumptions may find willing bank 

correspondents. 

•	 The rating services have modified capital and 

earnings analysis in order to lessen what they consider distortions caused by SFAS 125. 

Statement of Financial Accounting Standards No. 125 

(SFAS 125),Accounting for Transfers and Servicing of 

Financial Assets and Extinguishing of Liabilities, 

causes asset sellers, particularly high-growth lenders, to 

recognize significant noncash income. Applying SFAS 

125, which became effective on January 1, 1997, can 

give rise to significant noncash gains and related assets 

if an economic interest is retained in assets sold. The 

value of retained interests in assets sold is quantified on 

the basis of management’s assumptions about future 

charge-off rates, repayment rates, and the rate used to 

discount the expected cash flows from the loans sold. 

Because the value of these assets changes when actual 

performance deviates from the assumptions, the quality 

of earnings, capital, and liquidity for a lender that relies 

significantly on gains on sale must be considered carefully. 

The recent writedowns of interest-only (IO) assets by a 

few major finance companies have led to a higher level 

of scrutiny of companies whose financial statements are 

influenced significantly by gain-on-sale accounting. 

The Securities and Exchange Commission has recently 

increased its scrutiny of publicly traded companies that 

use gain-on-sale accounting, and it may soon require 

assumptions regarding defaults, prepayments, and discount rates to be disclosed in financial statements. The 

same companies that enjoyed soaring stock performance thanks to high earnings growth caused by gainon-sale accounting have seen their stock values tumble 

as they have had to write down their gain-on-salerelated assets. 

Several major credit rating companies have recognized 

the significant effect of gain-on-sale accounting under 

SFAS 125 on interpreting financial statements. These 

companies have issued comments or reports dealing 

with SFAS 125’s effect on the quality of earnings and 

capital of the companies they rate and how they adjust 

their analysis as a result. The consensus of these papers 

is that gain-on-sale accounting for companies that securitize often results in significantly higher reported earnings and equity compared to balance sheet 

lenders—without, in many cases, materially changing 

the underlying economics or credit risk to the originator 

of the assets.1 Generally, the rating services have modified capital and earnings analysis in order to lessen 

what they consider distortions caused by SFAS 125. 

There Are Risks Associated with Gain-on-Sale 

Accounting 

The asset booked in connection with an SFAS 125 loan 

sale is an IO strip that represents the present value of 

future excess spread cash flows generated by the transferred assets. Generally, asset-backed securitizations, 

including some classified as mortgage-backed securities, are structured so that each month the expected cash 

flows from the underlying assets will be sufficient to 

pay the investor coupon, the trust expenses, the servicing fee, and net charge-offs. The cash flow that the 

underlying assets will generate each month cannot be 

known with certainty because the underlying asset may 

allow for variable principal payments (e.g., credit card 

accounts), or the borrowers may default. Securitizations 

are structured so that there is enough cushion between 

the expected cash flows and the required payments and 

1 Duff & Phelps Credit Rating Company, “Securitization and Corporate Credit Risk.” Special Report Financial Services Industry, July 

1997; T. E. Foley and M. R. Foley. “Alternative Financial Ratios for 

the Effects of Securitization Tools for Analysis.” Moody’s Special 

Comment, September 1997; H. L. Moehlman, R. W. Merrit, and N. E. 

Stroker. “Capital Implications of Securitization and Effect of SFAS 

125.” Fitch Research, September 16, 1997. 

San Francisco Regional Outlook 3	 Second Quarter 1998 
In Focus This Quarter
 

expected charge-offs to absorb fluctuations in actual 

cash flows and actual charge-offs. This cushion is 

excess spread. As actual cash flows vary from projections, so does the excess spread generated. 

According to SFAS 125, when a company sells assets 

and retains the right to future excess spread cash flows, 

the calculation of the gain on the sale includes the capitalization of this right. In many transactions, the gain 

on sale consists entirely of the fair value of the IO strip 

that represents this right—none of which is necessarily 

received in cash. In addition, with many transactions, 

cash receipt is further delayed while cash flows go to 

fund the spread account, which is analogous to an internal loan loss reserve. 

SFAS 125 states that quoted market prices in active 

markets are the best evidence of fair value and should 

be used whenever available. Although there have been 

some sales of these IO strips, the number of sales is not 

yet sufficient to constitute an active market. When market prices are not available, SFAS 125 states that the 

estimate of fair value should be based on the best information available. In practice, fair value of the excess 

spread is determined by present valuing the expected 

cash flows using a discounted cash flow model. 

The value of the right to future cash flows is determined 

on the basis of management’s assumptions about the 

charge-off rate, the average life of loans, and the rate 

used to discount the cash flows. These input assumptions drive the model results and, therefore, the magnitude of the gain. The stability of the value of the IO will 

depend greatly on the extent to which the input assumptions accurately describe the pool performance over the 

life of the transferred assets. Changes in economic or 

market conditions that were not anticipated in the initial 

cash-flow assumptions will likely cause the pool of 

loans to perform differently than initially projected. 

Gain-on-sale accounting is significant to securitizers. 

To illustrate the significance of the IO account to a 

securitizer’s reported income, consider one major subprime lender. During fiscal year 1997, this company’s 

IO asset grew by over $141 million. Despite a $28 million writedown of the IO asset, the net growth of the 

asset constituted over half of total revenue and over 

eight times net income. The revaluation of the IO was 

necessitated by higher-than-expected prepayment rates. 

Current market conditions were not anticipated by 

many companies that benefited from high earnings 

related to gain-on-sale accounting. Several other major 

securitizers have reduced the carrying value of their IO 

assets in the face of either rising charge-off rates or 

higher prepayment rates. Writing down an IO strip 

largely represents a company’s admission that it will not 

generate on a cash basis income that was booked previously. 

Chart 1 displays the cumulative charge-off rates by vintage for Moody’s index of home equity loan securitizations. The index consists mostly of prime mortgages, so 

the loss rates are still low. However, the rising trend in 

losses is noteworthy and reflects the growing influence 

of subprime securitizations on the index and the related 

decline in underwriting standards as competition has 

increased in this market. Loans originated in 1995 and 

1996 are causing progressively larger and earlier losses. 

After 21 months of seasoning, the cumulative loss rate 

on loans originated in 1996 is .17 percent—almost six 

times the loss rate experienced by the 1994-originated 

cohort at the same age. Despite the continued low loss 

rates for the home equity market in general, subprime 

lenders are experiencing accelerated loss rates that are 

eroding the value of their interests in excess spreads. 

There may be a tendency for management to base 

assumptions about expected loss rates on loans sold 

solely on past experience with similar loans. Such an 

approach may not capture changes in market conditions 

and trends. For example, the Moody’s data demonstrate 

that loss rates on home equity loans, including first 

liens, have been trending upward rapidly. This trend 

implies that when estimating loss rates, management 

should consider the potential for changes in market conCHART 1 

Vintage Analysis of Home Equity Loan 

Securitizations 

Source: Moody’s Investor Services 

0.00 

0.05 

0.10 

0.15 

0.20 

1 3 5 7 9 11 13 15 17 19 21 

Cumulative 

Loss (%) 

1994 

1995 

1996 

Months 

San Francisco Regional Outlook 4 Second Quarter 1998 
In Focus This Quarter
 

ditions over the life of the sold assets as well as the past 

performance of similar assets. 

Like loss rates, prepayment rates have risen substantially in the subprime mortgage market. Several factors 

have contributed to the rise. One factor is the trend 

toward higher loan-to-value (LTV) loans in the mortgage market, which has allowed borrowers to obtain 

additional cash from their homes without waiting to pay 

down principal. Mortgage bankers report the tendency 

of some subprime borrowers, often debt consolidators, 

to maintain outstanding balances at the highest possible 

LTV. With maximum LTV ceilings rising, debt consolidators can refinance home equity loans without having 

to amortize existing debt. 

Another important factor contributing to rising prepayment rates is competition among lenders for volume 

growth. To continue to grow volume, lenders have been 

sacrificing margins on loans to offer a better rate to borrowers. When estimating prepayment rates for subprime 

borrowers, it has been normal to expect that they would 

need to improve their credit rating, or “credit cure,” 

before they would find it economical to refinance. Stiff 

competition for volume has allowed borrowers to find 

better rates without credit curing and has stimulated 

them to refinance prior to the time estimated at origination. Falling interest rates and a relatively flat yield 

curve are likely to increase prepayment rates. 

In standard finance theory, uncertainty about the future 

level of losses and prepayment rates is compensated for 

by discounting the cash flows at a higher rate. Some 

analysts advocate using a discount rate similar to the 

required rate of return for equity investments. Faced 

with changing conditions, one large finance company 

that specializes in high LTV lending announced in 

December 1997 that it was increasing the discount rate 

it uses to value new IO strips from 12.5 percent to 33 

percent. 

The IO Strip Asset Is Growing at Insured 

Depository Institutions 

As of December 31, 1997, only 30 institutions reported 

this IO asset at more than 5 percent of tier 1 capital. 

However, some institutions have booked gains that 

should have given rise to a call-reportable IO strip but 

did not properly report the assets. Therefore, the current 

reporting may understate the prevalence of the asset. 

Furthermore, the recent attention to gain-on-sale 

accounting from the public equity markets has at least a 

few large finance and mortgage companies seeking 

business strategies that shed IO strip-related volatility 

from their financial statements. One such strategy 

already in use is to leave the economic interest in excess 

spread with the correspondents that originate the loans. 

This is done as follows: The correspondent originates 

loans for purchase by a finance company. The finance 

company pays par for the loans, and instead of being 

paid an origination fee or a premium for the loans, the 

seller retains the right to excess spread generated over 

the life of the loan. The seller books a gain and an IO 

asset that capitalizes this right to receive future cash 

flows. The nature of the IO asset is exactly the same 

whether it arises directly from a securitization or from a 

sale of loans to a securitizer. If this strategy is used 

widely by finance and mortgage companies, then IO 

strips are likely to grow among institutions that originate loans for sale to these companies (see Chart 2). 

For insured depository institutions, the capital effects of 

SFAS 125 need to be evaluated carefully. Analysis of the 

financial statements and leverage ratios of insured institutions should consider fully issues related to the quality of earnings and the stability of capital posed by the 

volatility of the IO strip. Insured institutions that engage 

in significant asset sales while retaining economic interests that give rise to SFAS 125–related assets are subject 

to distortions similar to those of nonbank financial 

companies. 

The activity of originating and selling loans and booking associated gains can lead to capital ratios that 

CHART 2 

IO Strip Is Growing at Insured Institutions 

Source: Bank & Thrift Call Reports 

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

3.00 

1Q97 2Q97 3Q97 4Q97 

$Billion 

120 

130 

140 

150 

160 

Number of Institutions 

Number of Institutions 

IO Strip 

San Francisco Regional Outlook 5 Second Quarter 1998 
In Focus This Quarter
 

appear high by traditional bank standards. For several 

reasons, the leverage ratio can appear particularly high. 

First, although the asset may be more volatile than 

mortgage serving rights, there is no limit to the amount 

of IO strip that a bank can include in tier 1 capital. Second, the amount of IO strip booked increases capital by 

a gain on the net of the tax effect. The extent to which 

the amount remains in capital depends, of course, on the 

institution’s dividend policy. Third, the denominator of 

the leverage ratio is reduced by the sale because the 

loans are no longer assets of the bank. The cumulative 

result can be a significant boost to the leverage ratio. 

Several insured institutions report an IO strip at greater 

than 25 percent of tier 1 capital. For an institution whose 

primary line of business is originating and selling subprime mortgages, the asset can quickly reach a level 

exceeding tier 1 capital. In a little more than a year of 

originating and selling subprime mortgages to a major 

securitizer, one institution has amassed IO assets that it 

has valued at more than 150 percent of tier 1 capital. 

The institutions that have concentrations of 25 percent 

or more of tier 1 capital in IO assets have a median 

leverage ratio of about 11 percent. In contrast, the median equity capital ratio for nonbank mortgage securitizers tracked by SNL DataSource is about 30 percent. 

Public debt markets or banks that lend to these finance 

companies appear to require significantly higher capital 

levels than regulatory minimums required for banks. 

The potential for growth of the IO 

strip asset at insured institutions 

seems strong. In some circumstances, minimum capital standards for banks may require 

significantly less capital for IO 

asset exposure than the public 

equity markets. Perhaps more 

important, the quick rise of the significance of gain-onsale accounting to the mortgage and consumer credit 

markets exemplifies the speed with which exposure to 

risk can be acquired through the securitization market. 

Strong demand for asset-backed securities coupled with 

changing accounting emphases, which in this case favor 

asset sellers, can lead quickly to substantial exposures. 

Allen Puwalski, Senior Financial Analyst 

Risk-Based Capital (RBC) Treatment of the Gain-on-Sale–Related IO Asset 

If the IO asset derives from excess spread that absorbs tions does not necessarily preclude subprime mortcharge-offs from the sold assets, then the IO strip con- gages in general from receiving the reduced risk 

stitutes recourse from the sold assets for RBC pur- weighting. Although the capital standards require that 

poses. RBC standards require capital to be held mortgages be prudently underwritten to qualify for 

against this exposure. In general, the capital require- the 50 percent risk weighting, it is not entirely clear 

ment for this exposure is the amount of capital that how the term “prudently underwritten” applies to subwould have been required for the assets had they not prime mortgages. A higher expected loss rate alone 

been sold. If the sold assets are one- to four-family may be insufficient cause for presuming that the 

residential mortgages, they may receive a 50 percent mortgages are not prudently underwritten. 

risk weighting. Subprime mortgages are not necessarily precluded from receiving this weighting. The rationale for reducing the capital requirement for 

traditional one- to four-family mortgage lending is 

In order to apply the 50 percent risk weighting, the related to the maturity of the market and consistently 

capital standards require that one- to four-family res- low loss rates. As noted above, the subprime mortgage 

idential mortgages be fully secured and prudently market is changing rapidly, and loss rates can be much 

underwritten. The “fully secured” requirement pre- higher than in traditional mortgage lending. Accordcludes high-LTV loans with LTV ratios of greater ingly, bank managements need to be aware of the 

than 100 percent from receiving reduced capital potential volatility and risks associated with gain-onrequirements, but the language of the RBC regula- sale assets associated with subprime mortgages. 

San Francisco Regional Outlook 6 Second Quarter 1998 
In Focus This Quarter
 

How Will the Expansion End?
 

•	 Despite a very low unemployment rate and high 

industry capacity utilization, inflation has been 

unusually subdued during this expansion, with 

price declines in some sectors. 

•	 After seven years of expansion, most analysts 

expect the economy’s growth to slow in the coming 

months. 

•	 The last seven expansions have ended with an 

inflation-driven increase in short-term interest 

rates; in contrast, some analysts believe that the 

next recession will be caused by a period of falling 

prices for commodities, finished goods, and perhaps wages. 

•	 Insured institutions that base lending and strategic decisions on assumptions of continued robust 

economic growth should scrutinize and test those 

decisions against possible adverse change in economic conditions. 

The current economic expansion is the third longest on 

record since World War II. Since mid-1991, when the 

expansion began, more than 15 million new jobs have 

been created and inflation-adjusted gross domestic 

product (GDP) has increased by nearly 20 percent. In 

fact, the unemployment rate reached a 24-year low 

when it fell to 4.6 percent in November 1997 and again 

in February 1998. At the same time, inflation has 

remained unusually low, at only 2.3 percent during 

1997. 

Analysts are now focusing on when and under what circumstances the current expansion will end. While no 

one can accurately predict when the expansion will end, 

two related but competing theories about how it will end 

have emerged in recent months. The first and more 

familiar scenario occurs when the Federal Reserve 

increases short-term interest rates to prevent a rapid 

increase in inflation caused by an overheating economy. 

The second scenario, a deflation-induced contraction, is 

less familiar in the context of recent recessions. This 

scenario posits a period of falling prices for commodities, finished goods, and, under the most severe circumstances, even wages. 

Whatever the cause of the next downturn, its effects are 

likely to be important for the performance of lenders. 

During the 1990–91 recession, for example, the widespread deterioration of economic conditions was 

reflected in a number of indicators: Inflation-adjusted 

GDP fell by 2 percent; the number of business failures 

rose by nearly 40 percent; unemployment increased by 

more than 40 percent to 9.8 million; the unemployment 

rate peaked at more than 7 percent; single-family housing starts fell by almost 22 percent; and the bank card 

delinquency rate increased from 2.4 percent to 3.3 percent. This experience suggests that no matter what triggers the next downturn, dramatic adverse changes in the 

drivers of bank performance will likely result. 

How Have Economic Expansions 

Usually Ended? 

Although to some extent each business cycle is unique, 

virtually all of the post–World War II expansions have 

shown a similar characteristic: Toward the end of the 

expansion, inflation has accelerated. As the economy 

expands, the prices of inputs, including the wages of 

workers, are bid up as firms compete for resources to 

meet demand. The overall inflation rate will rise if 

prices increase across a large number of industries. Left 

unchecked, an increase in the overall price level may 

itself feed back into the labor market through demands 

for higher wages. 

By raising short-term interest rates, the Federal Reserve 

can limit what might otherwise lead to a rapid increase 

in both wages and prices. Higher interest rates will 

reduce sales of capital goods, housing, and consumer 

durables, the demand for which is very sensitive to the 

level of interest rates. One reflection of this sensitivity 

is the changing pattern of loan growth over the business 

cycle. During periods of expansion, the demand for 

loans grows rapidly as businesses and households borrow to finance purchases of capital goods and consumer 

durables. If short-term interest rates are increased in 

response to inflationary pressures, loan growth will 

slow as businesses and consumers reduce their demand 

for loans. If interest rates continue to increase, loan 

growth may decline as it has done before and during 

each recession. The cyclical movement of loan growth 

(with vertical bars indicating periods of recession) is 

shown in Chart 1 (next page). 

Looking more closely at short-term interest rates, Chart 

2 (next page) illustrates the federal funds rate during the 

San Francisco Regional Outlook 7	 Second Quarter 1998 
In Focus This Quarter
 

CHART 1	 expansion began. During the expansion between 1975 

and 1980, for example, the inflation rate was nearly 12 Commercial Bank Loan Growth percent at the start of the expansion but fell to just over during the Business Cycle 6 percent after four quarters. Inflation remained at 

approximately 6 percent until the twelfth quarter of the 

–5 

0 

5 

10 

15 

20 

25 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 

Percent Change—Year Ago 

expansion, after which it accelerated to more than 12 

percent by the end of the 20-quarter expansion. 

The current inflation trend differs from previous expansions in two ways. First, by the later stages of previous 

expansions, inflation was accelerating (see Chart 3). In 

contrast, there are few signs of accelerating consumer 

price inflation during the current expansion. In fact, it 

appears that the rate of inflation is declining; the United 

States has experienced disinflation.1 Second, among 

Source: Federal Reserve 

last seven business cycles. While an increase in shortterm interest rates has preceded each recession, it 

should be noted that an increase in rates is not sufficient 

to induce a recession. An increase in rates in 1984 was 

followed by a period of rapid growth that lasted until 

1990. More recently, the increase in rates during 1994 

was accompanied by a slowdown in the economy, but 

not a recession. 

What Is Different about Inflation 

during This Expansion? 

With history as a guide, one would expect inflation to 

rise as the current expansion matures. Chart 3 illustrates 

consumer price inflation during the four longest postwar expansions, including the current one. The chart 

shows the inflation rate at various points after the 

CHART 2 

expansions that have lasted more than 20 quarters, the 

current rate of inflation is one of the lowest since World 

War II. Consumer inflation is both decreasing and low 

by historical standards. 

What Are the Two Views about 

Future Inflation? 

Two views have developed about how the current 

expansion will end. The debate, couched in terms of the 

expected rate of future inflation, is of more than academic concern. The Federal Reserve’s decision about 

1 In popular discussions of inflation rates and the price level, terminology is sometimes used loosely. To clarify, a declining rate of inflation, properly described as disinflation, means that prices are 

increasing at a progressively slower rate over time. Deflation is 

defined as a generally falling price level or, equivalently, a negative 

inflation rate. 

CHART 3 

Federal Funds Rate and Recent 

Recessions 

0 

5 

10 

15 

20 

1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 

Federal Funds Rate (percent) 

Source: Federal Reserve 

Consumer Price Inflation during Four Longest 

Postwar Expansions 

0 

2 

4 

6 

8 

10 

12 

14 

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 

Quarters after Start of Expansion 

Percent 

1975–1980 

1982–1990 

1961–1969 

1991–present 

Note: Prices exclude food and energy 

Source: Bureau of Labor Statistics 

San Francisco Regional Outlook 8	 Second Quarter 1998 
In Focus This Quarter
 

whether to change short-term interest rates may be 

influenced by arguments on either side of the debate. 

The Traditional View 

Although inflation has been tame during this expansion, 

adherents of the traditional view believe that impending 

inflation still poses a danger to the longevity of the 

expansion. Evidence cited to support this view includes 

a very low unemployment rate and rising inflationadjusted wages. The reasons for the low inflation rate 

include low energy prices, inexpensive imports, and 

brisk domestic and international competition. These 

factors have delayed the onset of inflationary pressures, 

but they will not remain favorable indefinitely. The 

underlying dynamics have not changed significantly 

from those that led to rising inflation during every other 

recent economic expansion. This is also the view of the 

Federal Reserve Open Market Committee, as stated in 

the minutes of its November 12, 1997, meeting: 

The reasons for the relative quiescence of inflation 

were not fully understood, but they undoubtedly 

included a number of special factors...the risks 

remained in the direction of rising price inflation 

though the extent and timing of that outcome were 

subject to considerable debate. 

—Federal Reserve Bulletin, February 1998, p. 104 

The Deflation View 

Alternatively, some analysts suggest that a recession 

may be brought about by a period of deflation. Advocates of this scenario base their view on the unusually 

low and falling inflation rate in the United States, even 

after seven years of economic expansion. They also suggest that the national economy of the 1990s is markedly different from that of the 1970s and 1980s. Intense 

global competition is now the norm and not the exception. Worker productivity growth is believed to be higher than the official data show, meaning that wage 

growth will not translate as readily as before into price 

increases. The U.S. economy is more prone to a period 

of falling prices than at any time in the recent past, especially in view of decreasing rates of inflation and deflationary forces originating from the ongoing Asian 

financial crisis. 

What Does the Evidence Show? 

Because determining economic policy is necessarily a 

forward-looking process, policymakers look at many 

indicators to determine the likely future course of inflation. A brief review of some of the more popular indicators reveals contradictory readings that can support 

either the inflation or deflation scenario. 

Wage Growth 

The national unemployment rate is currently very low, 

signaling that labor markets are near capacity in terms 

of their ability to create new jobs. The nation’s unemployment rate was below 5 percent for nine months during 1997. This rate has been well below what many 

analysts thought possible without a sharp rise in inflation. As labor market conditions have tightened, wage 

growth has increased. Since 1993 the rate of growth has 

been on a steady upward trend, from a low of just over 

2 percent to about 4 percent in the first quarter of 1998. 

Capacity Utilization 

Capacity utilization, the percentage of industrial capacity that is currently in use, has risen since early 1997. 

Utilization has been around 83 percent since mid-1997, 

a threshold rate that has traditionally signaled impending inflationary pressures at factories, mines, and utilities. 

Commodity Prices 

Many commodities, such as metals, crude oil, and 

unprocessed food products, have exhibited weak prices 

during the past several months. Between mid-1996 and 

early 1998, the Knight-Ridder Commodity Research 

Board Price Index fell by more than 15 percent. Key to 

the decline was a 35 percent decrease in crude oil 

prices. 

Finished Goods Prices 

Since the data show that both labor and physical capital 

are at high rates of utilization, the traditional inflation 

scenario suggests that there will be increasing price 

pressures. In the manufacturing sector, such price pressures would likely show up first in the prices of goods 

as they leave the factory. The price of finished goods 

rose by only 0.4 percent during 1997, however. On a 

monthly basis, prices declined during eight months in 

1997. 

Service Sector Prices 

The service sector accounts for a growing portion of all 

output and employment in the U.S. economy. Labor 

costs generally account for a much higher percentage of 

input costs in the service sector than in the manufacturSan Francisco Regional Outlook 9 Second Quarter 1998 
In Focus This Quarter
 

ing industries. Additionally, many service industries 

operate in local markets and are insulated from national or global competition. Consequently, inflation rates 

in the service sector are generally higher than in the 

goods sector. Service sector inflation has, however, 

been on a downward trend, falling from 5.5 percent in 

1990 to 3.1 percent in 1997. 

Import Prices 

Since early 1996, import prices have fallen precipitously. The decline is due in part to the rising value of the 

dollar, which has reduced the cost of imports. Nonpetroleum import prices have fallen by 5 percent since 

early 1996. Within that group, capital goods prices have 

decreased by 12 percent over the same period. 

One factor that will continue to put downward pressure 

on prices is the turmoil in Asian markets. Asian 

exporters are now much more competitive with the rest 

of the world, following the drop in the value of their currencies. Consequently, U.S. firms that compete with 

Asian producers will be under greater pressure to cut 

prices. At the same time, reduced Asian demand for 

U.S. exports could lead to a ballooning trade deficit and 

a softening of export prices. In January 1998, for example, the United States reported a record-breaking trade 

deficit of $12 billion, caused in part by slower export 

growth. 

From this brief review, it is apparent that signs of 

impending inflation are at best mixed. Clearly, U.S. 

labor markets are at or near full effective capacity, and 

the utilization of factories and physical capital is also 

very high. There is little evidence that these factors are 

causing an increase in prices at either the producer or 

consumer levels. 

How Will the Expansion End? 

Although no one can accurately determine when the 

expansion will end, most analysts are predicting slower 

economic growth in the second half of 1998. Indicators 

such as the unemployment rate suggest that growth will 

be limited by the availability of labor needed to produce 

an increasing supply of goods and services. Weak or 

declining output prices in some sectors could act as a 

further constraint on economic growth. 

Among economists, the traditional view that the expansion will end following a rise in inflation and an 

increase in short-term interest rates appears to be the 

more prevalent view. Nevertheless, the possibility that 

the next economic downturn might be triggered by the 

ripple effects of declining output prices should not be 

dismissed, especially in light of the potentially adverse 

and less familiar risks associated with deflation. What is 

clear for insured institutions is that at this stage of the 

economic expansion, lending and strategic decisions 

predicated on an assumption of continued robust economic growth should be carefully scrutinized and considered in light of a possible deterioration of economic 

conditions. 

Paul C. Bishop, Economist 

Why Might Deflation 


Be a Concern?
 

The most significant difference between the inflation and deflation scenarios is reflected in the 

response of financial markets. One of the consequences of inflation is that a dollar in the future is 

of less value than today’s dollar. In a deflationary 

environment, the opposite is true—a dollar in the 

future will buy more goods and services than a dollar today. 

In a deflation scenario, debtors would see the real 

value of their financial obligations rise and might 

therefore be hesitant to borrow. A fixed monthly 

mortgage payment, for example, would be paid 

back with increasingly valuable dollars over time. 

Asset values could fall, especially since the purchase of an asset, such as a house, would require 

inflation-adjusted debt repayments that increase 

through time. Likewise, consumer credit debt obligations, such as payments on outstanding credit 

card balances, would become increasingly onerous. 

For households already experiencing credit problems, the prospect of a period of sustained deflation 

would worsen their financial position. At the very 

least, deterioration in credit quality would be 

expected, along with an increase in the number of 

business and personal bankruptcies. 

San Francisco Regional Outlook 10 Second Quarter 1998 
In Focus This Quarter
 

Trends Affecting the Allowance for
 

Loan and Lease Losses
 

•	 Allowance for loan and lease loss (ALLL) levels 

are declining relative to total loans. 

•	 Some industry leaders and regulators have 

expressed concern about the loosening of underwriting standards and greater risk in bank loan 

portfolios. 

•	 Significant growth in riskier loan types calls 

attention to the need to scrutinize closely the adequacy of the allowance. 

Weakening underwriting standards and significant 

growth in riskier loan types have increased the risk 

exposures of some insured institutions to an economic 

downturn. Meanwhile, the ALLL relative to total loans 

has declined in recent years. This article provides information on trends in the ALLL over time and by loan 

type and discusses the factors analysts consider when 

evaluating the adequacy of the ALLL. Special attention 

is given to issues related to the volatility of loan losses 

and the composition of the loan portfolio. 

Historical Perspective on the Allowance 

for Loan and Lease Losses 

The nation is currently witnessing one of the longest 

economic expansions since World War II. It is to be 

expected that some institutions will reduce their ALLL 

CHART 1 

coverage during periods of improved economic conditions. However, in the current environment—in which 

loan availability is abundant, growth is strong, and competition is fierce—some industry leaders and regulators 

have expressed concern about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the ALLL relative to total loans 

for commercial banks has declined to the lowest point in 

a decade (see Chart 1). This allowance ratio has diminished because commercial banks’ loan loss provisions 

have not kept pace with new loan growth. In some 

cases, banks have determined that their allowances are 

higher than necessary and have taken negative loan loss 

provisions, which are credited back to income. 

This decline in reserve coverage has been broad based, 

with the exception of credit card specialists. Commercial banks with concentrations in commercial lending 

and large multinational banks have significantly 

reduced the level of reserves to total loans in recent 

years. Table 1 (next page) shows that since 1993, ALLL 

ratios at both commercial lending banks and multinational banks have declined 31 percent. Moreover, commercial lending banks with assets exceeding $10 billion 

have reduced ALLL ratios by slightly over 37 percent, 

or 98 basis points, over the same period. 

The low level of nonperforming and charged-off loans, 

coupled with prevailing favorable economic conditions, 

is doubtless a significant factor in the reduction of 

San Francisco Regional Outlook 11 Second Quarter 1998 

Commercial Bank Reserves at Lowest Point in a Decade 

Source: FDIC Historical Statistics on Banking, National Bureau of Economic Research, Inc. 

1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

% of Loans

Current 

Expansion 

Recessionary 

periods 
In Focus This Quarter
 

TABLE 1 

Commercial Bank Allowance for Loan and Lease Losses to 

Total Loans by Lender Type 

TYPE OF LENDER 

NUMBER OF 

BANKS 

ASSETS 

($BILLIONS) 1997 1996 1995 1994 1993 

MULTINATIONAL 

COMMERCIAL 

CREDIT CARD 

MORTGAGE 

AGRICULTURAL 

11 

3,207 

67 

286 

2,373 

$1,383 

$1,915 

$202 

$120 

$120 

2.14 

1.63 

4.21 

1.26 

1.53 

2.25 

1.71 

3.48 

1.45 

1.66 

2.55 

1.90 

3.21 

1.45 

1.69 

2.83 

2.16 

2.89 

1.69 

1.75 

3.10 

2.37 

3.35 

1.87 

1.83 

Definitions for lender types by order of priority: Multinational—assets >$10 billion and foreign assets >25% of 

assets; Commercial—C&I plus CRE loans >50% of assets; Credit Card—credit card loans >50% of assets; Mortgage— 

1- to 4-family mortgages and mortgage-backed securities >50% of assets; Agricultural—agricultural production and 

agricultural real-estate loans >25% of total loans. 

Source: Bank Call Reports 

ALLL levels. Asset quality indicators such as nonperforming loans and loan loss rates are at historically 

favorable levels. At year-end 1997, the banking industry’s nonperforming loans were just under 1 percent of 

total loans, the lowest in 13 years. The industry’s loan 

charge-off rates (with the exception of consumer loans) 

are also at historical lows. (See the Regional Outlook, 

first quarter 1997, for a detailed discussion of consumer 

loan losses.) However, even with the problems in consumer lending, the banking industry’s aggregate loan 

loss rate is down significantly from levels in the early 

1990s (see Chart 2). 

As the economic expansion reaches an advanced age, 

an important question for insured institutions is 

whether their ALLLs adequately reflect the risks assoCHART 2 

Source: Bank Call Reports 

Asset Quality Indicators Are at Historically 

Favorable Levels 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1985 1987 1989 1991 1993 1995 1997

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

Charge-off 

Rates 

Nonperforming 

Loan Rates 

% of Total Loans 

ciated with changing industry practices. Insured institutions could experience strains on profitability and capital if allowance levels are inadequate. Given changing 

underwriting trends and loan delinquency patterns, a 

related question is whether reliance on past loss experience in setting the allowance will be an adequate measure for current losses. 

Trends in Underwriting Prompt 

Regulatory Cautions 

Over the past year, various underwriting and lending 

practices surveys by the FDIC, the Office of the Comptroller of the Currency (OCC), and the Federal Reserve 

have noted easing of terms and weakening underwriting 

standards on loans, especially in commercial loan portfolios. It is important to note that, in 1997, nearly twothirds of the commercial banking industry’s loan growth 

was centered in the commercial real estate (CRE) and 

commercial and industrial (C&I) loan categories 

(Chart 3). 

In the FDIC’s Report on Underwriting Practices for 

April 1997 through September 1997, examiners noted 

“above-average” risk in current underwriting practices 

for new loans at almost 10 percent of the 1,233 FDICsupervised institutions examined. Of the institutions 

with above-average risk, 12 percent did not adjust pricing for loan risk. Examiners noted that several of the 

852 institutions examined that were making business 

loans had poor underwriting standards, including lack 

of documentation of the borrower’s financial strength 

San Francisco Regional Outlook 12 Second Quarter 1998 
In Focus This Quarter
 

(21 percent) and poor and unpredictable loan repayment 

sources (14 percent). Also, of the 571 institutions 

specifically involved in asset-based business lending, 

20 percent often failed to monitor collateral. Furthermore, 20 percent of the 398 institutions examined that 

were actively engaged in construction lending repeatedly failed to consider alternative repayment sources, and 

29 percent often funded speculative projects. In contrast, just one year earlier, in the Report on Underwriting Practices for April 1996 through September 1996, 

examiners reported that only 11 percent of the institutions examined that were actively engaged in construction lending often funded speculative projects. 

The Federal Reserve’s Senior Loan Officer Opinion 

Survey for November 1997 and February 1998 both 

indicated some easing of commercial business lending 

terms and standards. Also, the OCC’s 1997 Survey of 

Credit Underwriting Practices stated that the level of 

inherent credit risk continues to increase for components of both commercial and consumer loan portfolios. 

These underwriting trends have resulted in increased 

risk profiles for some insured institutions, while ALLL 

ratios at some institutions continue to decline. 

In August 1997, the OCC issued an Advisory Letter 

voicing its concern about declining allowance levels in 

commercial banks. The OCC cited as primary concerns 

the apparent increases in credit risk reported by examiners, such as weakening underwriting trends in the syndicated loan market, easing of other commercial 

underwriting standards, and consumer lending delinquency and charge-off trends. Moreover, the OCC 

found that some banks were using flawed reserve 

CHART 3 

Loan Growth in 1997 Centered in
 

Commercial Loans
 

% of Total Loan Growth 

–30 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

70 

80 

Commercial

Consumer

Residential

Mortgages

CRE 

C&I 

Other 

Note: Percent of all loan growth for commercial banks in 1997 

Source: Bank Call Reports 

methodologies for estimating loan loss rates, including 

an overreliance on historical loss rates. 

Factors Affecting Adequacy 

of the ALLL 

In using offsite data to assess allowance adequacy, analysts consider financial ratios such as the allowance to 

total loans, reserve coverage (allowance to nonperforming loans), loan loss provisions to charge-offs, and loan 

delinquency levels. These ratios are evaluated against 

historical benchmarks. At the same time, however, analysts supplement the analysis with consideration of the 

potential effects of current industry trends. For example, the banking industry is currently witnessing higher 

than normal losses in consumer lending spurred by 

increased bankruptcy filings and the migration of loans 

from current to charged off without intervening delinquencies. An institution that has a sizable consumer 

loan portfolio may therefore need to attach more weight 

to recent loan loss data in setting the allowance, since 

historical trends may not adequately reflect reserving 

needs. 

Insured institutions exhibit different management and 

portfolio characteristics that significantly influence the 

level of the allowance. These characteristics include the 

diversification of a loan portfolio (diversification by 

borrower, loan type, geography, or industry), the history and recent trends of credit losses, management’s 

practices in the recognition of losses, trends in past-due 

and nonperforming loans, underwriting practices, and 

economic conditions. 

New techniques continue to be developed to improve 

the reliability of allowance estimates. Management 

information systems, which enable the collection of 

more refined historical data, coupled with the application of statistical techniques, are helping some institutions formulate more statistically reasoned allowance 

estimates. Loan management tools such as credit scoring systems, risk rating systems, and consideration of 

economic cycles in the review of historical loss and 

delinquency data all are aiding bankers in the reserving 

process. While these new techniques provide more analytically defensible estimates, they do not diminish the 

role of judgment in assessing ALLL adequacy. 

The role of judgment in setting the ALLL is underscored by the volatility of loan losses over time. 

San Francisco Regional Outlook 13 Second Quarter 1998 
In Focus This Quarter
 

CHART 4 

Historically, Commercial Loan Loss Rates Have Been Higher and More Volatile 

than Mortgage Loss Rates 

Source: Bank Call Reports 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1991 1992 1993 1994 1995 1996 1997 

Loan Loss Rates (%)

Commercial Real Estate Loans 

Commercial & Industrial Loans 

Residential Mortgages 

“Volatility” in this context refers to the degree to which 

loan losses have diverged or might diverge from the 

long-run averages. Volatility in loan losses can result 

from changes in the business cycle, local economic 

events, and major one-time events. For example, a bank 

relying on a historic average loan loss calculation to 

derive its reserve level could find itself underreserved if 

it does not adjust its historical loss rates for deteriorating economic conditions and suddenly incurs greater 

loan losses than it had anticipated simply on the basis of 

past performance. 

Generally, different types of loans experience varying 

loan loss rates because of the inherently different risks 

and varying levels of volatility within each type. Chart 

4 shows that commercial loans, such as commercial and 

industrial loans and commercial real estate, historically 

have had greater losses than residential loans. Furthermore, the loss rates on commercial loans have not only 

been higher, they have been more volatile over the 

years, while average losses on mortgage loans have varied little. 

Volatility in loan losses is determined not only by economic events but also by banks’ willingness to take risk. 

Banks that adopt more liberal underwriting policies and 

high loan growth objectives may experience greater 

loan default risk and greater volatility in loan loss rates 

than suggested by their own past experience. For example, Chart 4 shows that mortgage lending has had low 

and stable loss rates on average. The recent growth in 

subprime and high loan-to-value mortgage lending, 

however, may result in increased volatility and losses 

for some lenders going forward. 

All of these factors suggest that ALLLs would be 

expected to vary considerably both over time and across 

loan types. Table 2 shows that this has been the case. 

The ALLL is reported as a single line item on the Call 

Report. This makes it difficult to estimate how much of 

the ALLL is attributable to a particular loan type or to 

compare allowance levels for banks with significantly 

different loan portfolios. Table 2 shows the results of a 

statistical regression estimation of commercial bank 

allowance allocations across the various loan types for 

TABLE 2 

ALLL Allocations Have Varied over Time and by Loan Type 

(Commercial Banks under $1 Billion)* 

LOAN TYPE 1997 (%) 1996 (%) 1995 (%) 1994 (%) 1993 (%) 1992 (%) 1991 (%) 

C&I 

CRE 

MORTGAGES 

CREDIT CARDS 

1.71 

1.44 

0.92 

4.47 

1.85 

1.54 

1.00 

4.42 

1.87 

1.77 

1.05 

3.32 

2.06 

1.83 

1.19 

3.11 

2.14 

1.97 

1.22 

3.20 

2.29 

2.02 

1.07 

3.29 

2.45 

1.99 

0.91 

3.59 

* Estimated regression results 

Source: Bank Call Reports 

San Francisco Regional Outlook 14 Second Quarter 1998 
In Focus This Quarter
 

1991 through 1997 for commercial banks with under $1 

billion in assets. Not surprisingly, CRE and C&I loans 

received relatively higher allowance allocations than 

residential mortgage loans, indicating that banks saw 

greater risk in these loan types. Also, credit card loans 

consistently received higher allocations than the other 

loan categories, and the allocations have increased in 

recent years owing to the increased delinquencies and 

charge-offs in this area. 

Conclusions 

The adequacy of the ALLL is measured not only relative to historical loan loss experience but also relative to 

current conditions that may cause losses to differ from 

past experience. Increased losses could result from 

adverse economic developments, from changes in 

banks’ appetite for taking risk, or 

both. In this regard, reported weakening in underwriting standards is 

increasing some banks’ risk exposure to an economic downturn. 

Institutions with high concentrations in riskier loans, significant 

growth in riskier loans, or weaknesses in underwriting may be most at risk. Especially 

for such institutions, the adequacy of the ALLL and its 

methodologies merits close scrutiny. 

Andrea Bazemore, Banking Analyst 

San Francisco Regional Outlook 15 Second Quarter 1998 
Regular Features	 Regional Economy
 

Strong Economic Growth Is Expected to Continue 

in the San Francisco Region despite Potential 

Fallout from the Asian Crisis 

•	 The San Francisco Region added jobs at a rapid 3.6 percent pace in 1997, much faster than the nation’s 

2.7 percent growth rate. 

•	 The Asian crisis is likely to have a more significant effect on the San Francisco Region than on most other 

parts of the nation; still, most forecasters do not expect it to be a major stumbling block in 1998. Its impact 

on the various states and industries will not be uniform; effects on high tech, aerospace, and tourism could 

be sizable for some states. 

•	 The 1998 outlook for most of the Region’s states remains positive, with another year of robust expansion 

projected, although at somewhat reduced growth rates. 

San Francisco Region Continued to Lead 

the Nation in Growth 

The San Francisco Region’s economic performance, 

driven by a surging California economy and generally 

rapid growth throughout much of the Region, was robust 

in 1997. The Region led the nation in job growth rates 

for the third consecutive year in 1997, adding 815,000 

jobs (seasonally adjusted) between December 1996 and 

December 1997, a 3.6 percent rate of increase. Arizona, 

Nevada, Utah, California, Oregon, and Washington 

were among the nation’s 13 fastest growing states; all 

exceeded the nation’s 2.7 percent job growth rate, as 

shown in Chart 1. The Region’s economic expansion was 

generally reflected in strong banking industry performance as well. The Region posted a return on assets 

(ROA) of 1.19 percent in 1997, the highest in at least a 

CHART 1 

Job Growth Accelerated in California in 1997 

but Slowed in Much of the Region 

Source: Nonfarm Payroll Employment, Bureau of Labor Statistics 

− 2 

0 

2 

4 

6 

8 

10 

% of Job Growth

1997 

1996 

AZ

NV

UT

CA

OR

WA

ID

MT

AK

WY

HI

Region

U.S. 

decade, and matched the performance for the nation (see 

Current Regional Banking Conditions). 

Asian Crisis Creates a Risk 

Despite the strong performance of the Region and the 

banking industry as a group, there are still risks ahead. 

The greatest risk on the horizon in 1998 is the crisis in 

Asia, which has the potential to weaken the entire San 

Francisco Region. The initial effects of the Asian crisis 

likely will be felt in key sectors—manufacturing, export 

services, and agriculture—and may be concentrated in 

several states. The Asian crisis is not the only risk facing the Region. Alaska, for example, faces the risk that 

low oil prices will slow its economy. 

The major currency devaluations suffered by a number 

of the Asian Tiger economies in 1997 force them to 

make serious economic adjustments that will dramatically slow their economies. The crisis is most often 

associated with the “Asian 10” group, henceforth 

referred to as “Asia”: China, Hong Kong, Indonesia, 

Japan, Malaysia, the Philippines, Singapore, South 

Korea, Taiwan, and Thailand. Asia’s economic turmoil 

could affect the Region’s economy in 1998 in many 

ways, including: 

•	 reduced Asian demand for U.S. exports; 

•	 lower prices on Asian goods, which may weaken the 

market share of U.S. manufacturers in both domestic 

and international markets; 

San Francisco Regional Outlook 16	 Second Quarter 1998 
Regular Features	 Regional Economy
 

•	 reduced spending in the United States by Asian visitors; and 

•	 lower prices in Asia, which may attract more U.S. 

visitors and slow tourism in the United States and 

Hawaii. 

Crisis May Have a Proportionately Larger 

Impact on the San Francisco Region 

The ill effects of the Asian crisis have particular relevance for the San Francisco Region. International 

Trade Administration Exporter Location data for 1996 

indicate that about 52 percent of the Region’s merchandise exports were shipped to Asia; elsewhere in the 

nation the comparable figure was 22 percent. The 

Region’s largest export markets are shown in Chart 2. 

The Region also may have a higher share of service 

exports, including business, personal, and transportation and trade services; however, the following analysis 

focuses on merchandise export exposure, which for 

most states is much larger and for which statistics are 

available. 

A disproportionate number of metropolitan areas in this 

Region are heavily dependent on merchandise exports; 

San Jose leads the nation in exports for metropolitan 

areas. Los Angeles, Seattle, Portland, San Francisco, 

Orange County, Phoenix, Oakland, and San Diego 

are among the top 20 metropolitan export centers. Ports 

in these areas may be affected by changes in both export 

and import volumes. 

CHART 2 

Not only are the Region’s exports heavily weighted 

toward Asia, but in 1996 over three-quarters of the dollar volume of all exports fell in three categories of 

goods—high technology, aerospace, and agriculture. 

All three of these export categories are vulnerable to 

cutbacks in Asian sales. The Region’s merchandise 

export composition is shown in Chart 3. 

Finally, as illustrated in Chart 4 (next page), the ill 

effects will not be evenly distributed across the states in 

the Region. Four states rank among the top five nationally in merchandise exports relative to gross state product (GSP): Washington, Oregon, California, and 

Arizona. Nationally, 1996 exports to Asia represented 

about 2.5 percent of gross domestic product; as a percentage of the total economy this may appear small. 

However, the share of exports to GSP in these four 

states and in selected industries is much higher than for 

the nation and may represent a significant share of economic activity. Some key areas of exposure for the 

Region, by state and industrial sector, are as follows: 

•	 High-tech exports to Asia are about 3.5 percent of 

GSP in Arizona and California, and about 2 percent 

in Idaho and Oregon. 

•	 Aerospace exports to Asia are over 4 percent of 

Washington’s GSP but have slipped to under 1 percent of California’s GSP. 

•	 Agricultural exports to Asia from Oregon and Washington are about 3.5 and 1.5 percent of state GSP, 

respectively. 

•	 Tourism is the major industry in both Nevada and 

Hawaii; Hawaii is especially dependent on Asian 

travelers. 

CHART 3 

Canada 11% 

Mexico 7% 

Japan 20% 

South Korea 7% 

Taiwan 6% Singapore 5% 

Other Asia* 14% 

Rest of World 30% 

Japan and Asia Are Key Destinations for 

San Francisco Region Exports 

* China, Hong Kong, Indonesia, Malaysia, Thailand, and the Philippines. 

Source: International Trade Administration, 1996, Exporter Location, $ volume. 

High Technology 50% 

Aerospace 18% 

Lumber & Paper 5% Agriculture 10%

Petrochemical 4% 

Other 13% 

Region’s Top Exports Include High Technology, 

Aerospace, and Agriculture 

Source: International Trade Administration, 1996, Exporter Location, $ volume. 

San Francisco Regional Outlook 17	 Second Quarter 1998 
Regular Features Regional Economy
 

CHART 4 

* China, Hong Kong, Indonesia, Japan, Malaysia, Philippines, Singapore, 

S. Korea, Taiwan, and Thailand as a percent of gross state product. 

Sources: International Trade Administration and Bureau of Economic Analysis 

Several of the Region’s States Are Relatively 

Heavily Dependent on Exports to Asia* 

0 

2 

4 

6 

8 

10

% of Gross State Product

WA

OR

CA

AZ

ID

UT

AK

HI

NV

MT

WY

Region

U.S. 

Are There Mitigating Circumstances? 

Several factors, including the strong national economy, 

moderate interest rates, and low prices for oil and Asian 

imports, are expected to help sustain the Region’s 

expansion. Consequently, most forecasters believe that 

the Asian crisis will lower the Region’s growth rate but 

will not cause a significant downturn. Still, considerable uncertainty remains about the ultimate size of the 

impact and when will it be felt. At the industry level, the 

crisis may dampen the growth of the Region’s booming 

high-tech and commercial aircraft industries. Some 

agricultural exports, like Alaskan seafood, Idaho potatoes, and fruits and vegetables, also may be hurt (see 

Current Regional Banking Conditions). 

Implications: Banks should be aware of the uncertainties created by the Asian crisis when evaluating the 

financial health of their market area and their borrowers. Because the Asian crisis, at least initially, will hit 

selected states and key industries, the paragraphs that 

follow briefly examine each state’s vulnerability to the 

crisis and its outlook for 1998. States are presented in 

order of their projected exposure to the Asian crisis. 

Washington Has the Highest Exposure 

but a Positive Outlook 

Washington’s economy depends heavily on exports of 

aerospace, timber and wood products, and agricultural 

goods to Asia. As shown in Chart 4, exports to these 

countries represented about 9 percent of Washington’s 

GSP, compared with about 2.5 percent for the nation. As 

a share of GSP, Washington’s exposure is the highest in 

the nation. Thus, there is potential for considerable disruption to Washington’s export-based economy, especially if Asian airlines cancel a significant number of 

orders for commercial aircraft. Fortunately, Boeing has 

a huge backlog of orders, and these long-term purchases often may just be postponed. 

The state of Washington’s 1997 Labor Market and Economic Report projects “modestly slower growth in 

1998 but basically a continuation of present trends.” Job 

growth is expected to increase about 3.5 percent in 

1998, keeping the state among the fastest growing in the 

nation. 

Oregon Looks for Continued Growth 

but Needs to Watch the Exports 

State analysts issued a warning about Oregon’s vulnerability to the crisis in Asia, noting that it “will almost 

certainly have a disproportionate impact on the state 

because of the region’s importance as an export market 

and as a source of foreign direct investment.” Exports to 

Asia represent nearly 7 percent of GSP, the secondhighest share in the nation. Risk is concentrated in agriculture, high technology, and lumber and wood 

products. 

Like Washington, Oregon’s economy is expected to 

grow more slowly in 1998. The 1998 Oregon Economic and Revenue Forecast projects that employment will 

grow 2.5 percent in 1998, down from 3.4 percent in 

1997 when the state ranked tenth nationally in job 

growth. Manufacturing, as well as construction, showed 

signs of slowing in the second half of 1997, which is 

consistent with this outlook. 

California’s 1998 Outlook Is Upbeat, 

but High Tech Needs Watching 

The Asian crisis is expected to have an impact on California’s high-tech sector and to a lesser extent the state’s 

agricultural industry, but the crisis probably will not 

affect the state’s four-year-old expansion. Still, California, especially the Silicon Valley, is much more vulnerable to the crisis than the nation as a whole. High-tech 

exports to Asia accounted for about one-third of California’s $99 billion in merchandise export sales in 1996. 

Asian exports are about 5.5 percent of GSP, third highest in the nation. Analysts will be watching for signs of 

declining sales of computers and electronic equipment 

San Francisco Regional Outlook 18 Second Quarter 1998 
Regular Features Regional Economy
 

or reduced profitability at high-tech firms. Analysts 

also will want to monitor changes in the farm sector 

(see Current Regional Banking Conditions). 

Despite the Asian situation, California’s employment 

growth in 1998 is expected to exceed the national 

growth rate while slowing to a 2.5 to 3 percent growth 

range. The strong national economy and a booming service sector in California are expected to continue to 

help boost the California recovery, much as they did in 

1997 when the state added jobs at a 3.8 percent rate. 

Arizona Is the Fastest Growing State 

Arizona’s dependence on exports to Asia as a share of 

GSP ranks fifth nationally, at over 4 percent. Moreover, 

exposure is highly concentrated: over 80 percent of the 

state’s exports to Asia are high-tech products, which 

increases the state’s risk from a high-tech slowdown. 

Arizona’s economy has been growing rapidly; in 1997 it 

overtook Nevada as the nation’s fastest growing state in 

terms of job growth. Moreover, employment growth 

was well balanced across the economy as it added 4.5 

percent more jobs in 1997. The Arizona Department of 

Commerce estimates that 1998 employment growth will 

be 3.3 percent, the slowest rate of growth since 1992. 

Nonetheless, Arizona would remain among the fastest 

growing states in the nation. 

Asian Situation Clouds the Outlook for 

Hawaii and the Pacific Islands 

Hawaii’s primary exposure to the Asian crisis lies in its 

main industry, tourism, rather than in exports to Asia. 

Asian tourists make up a large share of the state’s visitors, and Japan accounts for nearly one-third of all visitors and more than one-third of all spending. The yen’s 

depreciation has reduced Japanese spending in Hawaii. 

While the other Asian Ten nations account for only 

about 5 percent of visitors, their numbers and spending 

are expected to be sharply curtailed as a result of the 

severe devaluation of their currencies in 1997, which 

further contributes to the weak outlook for tourism. 

Most analysts expect the state’s economy to remain 

stagnant in 1998. In the 1990s, the Hawaiian economy 

appears to have been driven more by the weak performance of Japan than by the expanding U.S. economy. In 

1998, international forces and the continued weak 

Japanese economy should again curtail tourism, as well 

as foreign investment, especially in real estate. Furthermore, banking industry performance in the state likely 

will continue to reflect the stagnant economy. 

In recent years the Pacific Island Territories of American Samoa, the Federated States of Micronesia, and 

Guam have benefited from the rapid growth in Asia and 

have focused much of their economic development and 

export strategies on their links with Asia. While that 

may be a sound long-term strategy, it will create challenges in 1998 since the devaluations have made these 

three areas less competitive in attracting tourists from 

Asia and in generating export sales to Asia. Banks in 

these three territories reported increases in problem 

loan ratios in 1997; at year-end, ratios for all three areas 

were 6.50 percent or more of total loans. 

Alaska’s Guarded Outlook Hinges on Oil 

Although Alaska’s exports are modest, according to the 

Export Location data series, other series suggest that the 

state’s exposure may be significantly larger. In both 

cases exports are heavily weighted toward natural 

resources—oil, lumber and wood products, and 

seafood—destined for Asia, especially Japan and South 

Korea. State economists expect Japan and South Korea 

to continue to demand sizable quantities of oil and timber, minimizing the potential 

impact on export sales. By 

contrast, Alaskan seafood 

exporters should face additional downward pressure on prices 

in 1998 as Asian consumers 

find prices for Asian fish products much more attractive than 

for Alaskan fish. 

A larger concern for the Alaskan economy is oil prices, 

which fell to a nine-year low in March. Alaska’s economy is unusual in that its economic performance depends 

more on conditions in the energy markets than on 

national economic conditions. Its 1997 performance 

reflected the weakness in energy prices; the state added 

jobs at a very slow pace—only 1.3 percent in 1997. On 

the positive side, state economists now expect that oil 

production will be “flat rather than plummeting” over 

the next four or five years. The improved forecast also 

should benefit the state government, which depends 

heavily on oil tax revenues. 

San Francisco Regional Outlook 19 Second Quarter 1998 
Regular Features Regional Economy
 

Moderate Expansion Continues in Idaho 

The Idaho economy is not heavily dependent on exports 

to Asia. However, almost 36 percent of that state’s small 

volume of exports are high-tech goods destined for 

Asia. Agricultural products, many of which are tied to 

the state’s large potato crop, also are exported to Asia. 

Nonetheless, total farm exports to Asia account for less 

than 11 percent of the state’s exports. State forecasters 

expect both high-tech and food product demand to soften in 1998 as a result of the Asian situation. 

Idaho’s Department of Financial Management (January 1998) forecasts a 2.5 percent employment growth in 

1998, similar to that of 1997 when the state added jobs 

at a 2.6 percent rate. The department foresees weakness 

in lumber and wood products, as well as federal government employment. The state’s construction boom 

also appears to be over. 

Strong Growth Is Expected in Utah in 1998 

As is the case in Idaho, exports are less important to 

Utah’s economy than they are to the Region as a whole. 

Moreover, exposure is not concentrated in any one 

industry or sector. High-tech goods are the state’s leading export, but only 15 percent of them are high-tech 

products destined for Asia. 

State forecasters expect that Utah will continue to 

expand in 1998; they also expect the slowing trend of 

recent years to continue. Utah added jobs at a 4 percent 

rate in 1997, the fifth fastest rate in the nation, but the 

slowest growth rate for the state since 1991. The 1998 

Economic Report of the Governor projects robust 

growth for employment, at 3.6 percent. Still, the report 

cites several factors that justify the prediction of slower 

growth: lower net in-migration, reduced housing affordability and residential construction, improved conditions in other state economies, slower export growth, 

tight labor market conditions, and expected higher 

downtown office vacancy rates. 

Nevada Will Have Rapid Growth 

but Higher Risks 

Nevada’s exposure to the Asian crisis arises mostly 

through its heavy dependence on gaming and tourism, 

which account for about one-third of the state’s employment. While Asia may not be a major issue for Nevada 

(except through its impact on gaming and tourism), 

other risks are of concern to the banking industry. 

Nevada’s booming economy is slowing; it added jobs at 

a 4.3 percent annual rate in 1997, only about half as fast 

as in 1996 when it added jobs at an extraordinary 7.7 

percent rate. Nevada’s huge gaming and tourism industry appears to have weakened 

somewhat in 1997, while construction job growth slowed 

dramatically. Construction of 

new hotel rooms is outpacing 

the number of visitors, and 

commercial office vacancy 

rates have climbed well above 

the national average. Finally, 

Nevada’s new banks and community banks both have a 

high exposure to construction and commercial real 

estate loans, as discussed in previous issues of this 

publication. 

Despite this high-risk profile, most forecasters expect 

the state’s economy to continue to add jobs at a 4 to 6 

percent rate in 1998; the consensus published by the 

Western Blue Chip Economic Forecast (January/ 

February 1998) was a 5.4 percent rate of job growth for 

the year. 

Montana and Wyoming Should Have 

Moderate to Weak Growth 

Neither Montana nor Wyoming is likely to be significantly affected by a decline in exports to Asia. Both 

states’ export sectors are only a tiny share of GSP, and 

exports to Asia are below the national average. The only 

major difference between the two is in the type of 

exports destined for Asia. Montana’s exports to Asia are 

mainly high-tech goods, while Wyoming’s are primarily 

agricultural. 

Montana’s economy likely will continue to record moderate to slow growth during 1998. The economy clearly 

has slowed over the past several years; its 1997 employment growth rate, 2.1 percent, was the slowest since 

before the 1990–1991 recession. Weak personal income 

growth, a rising unemployment rate, and softness in 

housing all contribute to the weak prognosis. 

Likewise, Wyoming’s outlook for 1998 is for continued 

weakness, especially in its large natural resources sector. The state has been hurt by falling energy prices and 

San Francisco Regional Outlook 20 Second Quarter 1998 
Regular Features Regional Economy
 

declining energy production; its construction sector also 

contracted in 1997 as the building boom faded. 

Implications: A review of the exposure of the individual states in the Region to Asia, their current performance, and their outlook for 1998 suggests that the 

Region in aggregate likely will be only moderately 

affected by the Asian situation. In general, states with 

large manufacturing sectors are growing rapidly and are 

expected to continue to expand faster than the nation in 

1998; however, most are expected to slow somewhat as 

a result of a mix of factors, including weaker exports to 

Asia. Despite this concern, strong economic growth in 

these states may give the Region’s banking institutions 

the opportunity for another good year in 1998, although 

insured institutions in these states should carefully monitor the health of borrowers that depend on high technology, aerospace, farm products, or other trade that 

may be affected by the Asian crisis. 

Unlike Hawaii, most of the states with weaker 

economies will not be affected directly by the Asian 

crisis. Still, any additional softening could expose 

lenders to potential asset quality problems. Furthermore, continued weak economic conditions in Hawaii 

and the Pacific Island Territories could result in additional deterioration in the performance of some community banks and thrifts (see Current Regional 

Banking Conditions). 

Gary C. Zimmerman, Regional Economist 

San Francisco Regional Outlook 21 Second Quarter 1998 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

•	 The Region’s commercial banks and thrifts posted their strongest results in more than a decade at year-end 

1997. 

•	 Agricultural lending, which is prevalent in almost 60 percent of the Region’s banks, may become more 

volatile as government payments decline and some export markets react negatively to the Asian crisis. 

•	 Higher risk real estate concentrations in some of the Region’s newly chartered banks warrant attention, 

especially in Nevada, where some real estate indicators are showing signs of a slowdown. 

Region’s Insured Institutions 

Report Strong Profits 

Banks and thrifts in the San Francisco Region finished 

1997 with the strongest earnings, lowest nonperforming 

loan ratios, and highest capital levels in over a decade. 

Despite the Region’s above-average exposure to the 

financial turmoil in Asia, the slowdown there thus far 

has had only a minor impact on the health of the 

Region’s economy and financial institutions (see Strong 

Growth Is Expected to Continue in the San Francisco 

Region despite Potential Fallout from the Asian 

Crisis). 

•	 Return on assets (ROA) at the Region’s banks and 

thrifts mirrored national returns of 1.19 percent for 

the 12 months ending December 31, 1997, which is 

significantly above the 1996 ROA of 0.95 percent. 

Lower deposit insurance premiums1 coupled with 

slightly higher trust fee income and noninterest 

income from foreign operations offset a contraction 

of net interest margins and a slight uptick in loan 

loss provision expenses at the Region’s insured 

institutions. 

•	 The ratio of past-due loans (loans past due 30 or 

more days plus nonaccrual loans) to total loans at the 

Region’s insured institutions dropped to 1.97 percent 

1 A special assessment on SAIF-assessable deposits, including those 

held by Savings Association Insurance Fund members and Bank 

Insurance Fund-member Oakar institutions, was imposed in 1996 to 

capitalize the SAIF at its target Designated Reserve Ratio of 1.25 percent of insured deposits. The one-time special assessment of 65.7 

basis points was applied against SAIF-assessable deposits held by 

institutions as of March 31, 1995, and had a significant effect on 1996 

earnings for institutions that paid the special assessment. 

of total loans, well below the national average of 

2.27 percent. The decline reflected improvement in 

most loan categories throughout the Region. Consumer loan portfolios are, however, still showing 

signs of weakness (see Chart 1). Community banks 

and thrifts (defined here as non-credit-card banks 

and thrifts with total assets of less than $1 billion) in 

two of the Region’s underperforming states—Montana and Hawaii—and three territories—American 

Samoa, Guam, and Micronesia—did buck the 

Region’s trend by reporting increases in past-due 

ratios at year-end. 

•	 Excellent earnings continue to bolster capital levels, 

despite a 79 percent dividend payout ratio. The 

aggregate tier 1 leverage ratio for the Region’s 

insured institutions is now 7.71 percent; for institutions with assets under $1 billion, the ratio is 9.50 

percent. 

CHART 1 

Region’s Past-Due Credit Card Loan Ratio Edges 

Up despite Improving Economic Conditions 

Credit Cards 

0% 

1% 

2% 

3% 

4% 

5% 

6% 

Dec ’91 Dec ’92 Dec ’93 Dec ’94 Dec ’95 Dec ’96 Dec ’97 

Loans 

Past Due as 

% of Portfolio 

Source: Bank and Thrift Call Reports 

San Francisco Regional Outlook 22	 Second Quarter 1998 
Regular Features Regional Banking
 

Agricultural Lending Is Prevalent 

throughout the Region 

The health of the agriculture sector significantly influences the performance of agricultural loans in financial 

institutions throughout the Region. Although the 

Region has only 20 percent of the total U.S. population, 

it accounts for over 28 percent of the nation’s agricultural production. California leads the nation in agricultural production, but Arizona, Hawaii, Idaho, Oregon, 

Montana, and Washington also are among the nation’s 

top ten producers of several agricultural products. 

At year-end 1997, banks and thrifts in the Region had 

$7.4 billion in outstanding agricultural production loans 

and another $2.2 billion in loans secured by farm real 

estate. Almost 60 percent (461) of the banks in the 

Region were involved in farm lending, 133 of these 461 

banks had over 100 percent of tier 1 capital in agricultural loans. Of these agricultural or farm banks, 131 can 

be described as community farm banks, institutions 

with assets of less $1 billion dollars.2 The average assets 

of these 131 community farm banks was just under 

$100 million. The number of farm banks in the San 

2 For this article, the 131 agricultural (or farm) banks are defined as 

institutions with total assets under $1 billion (community banks) and 

with agricultural loans (agricultural production loans and real estate 

loans secured by farm properties) that constitute over 100 percent of 

tier 1 capital. Two banks with over $1 billion in assets also report agricultural loans that constitute over 100 percent of tier 1 capital, but 

they are typically analyzed with comparably larger peers. 

CHART 2 

Source: Bank Call Reports 12/31/97 

Percent of Banks with 

Agricultural Loans 

Exceeding 100% 

of Tier 1 Capital 

67 to 100% 

50 to 66% 

25 to 49% 

1 to 24% 

Agricultural Banks Are Concentrated in 

the Region’s Northern States 

Francisco Region declined 23 percent between 1991 

and 1997; over half of the reduction occurred in Montana, where a 1989 change in the state’s mergers and 

acquisition’s banking law spurred merger activity. 

Most of the farm community banks are in the northern 

part of the Region and in California’s Central Valley, as 

shown in Chart 2. The number of community banks 

with agricultural lending concentrations is significant in 

Montana, Idaho, and Wyoming, where farm banks 

account for 56 percent, 44 percent, and 42 percent of 

total banks in each state, respectively. 

In addition to agricultural lending by community banks 

with concentrations in farm lending, four of the nation’s 

top ten agricultural lenders, ranked by agricultural loans 

outstanding, are located in the San Francisco Region. 

These four large banks have assets ranging from $8 billion to over $200 billion. They have multiple branch 

offices in farming communities, and as a group they 

account for over one-half of the Region’s agricultural 

loans. Their dominance in this market contrasts sharply 

with the situation elsewhere in the nation, where the 

bulk of agricultural loans are provided mostly through 

farm community banks, which typically have average 

assets of less than $100 million. Two factors that contribute to the Region’s agricultural lending patterns are 

the average size of the farms and the value of the products sold per farm, both of which are about twice the 

national average. In Arizona and California, the value of 

the products sold per farm in 1996 was almost three 

times the national average. The borrowing needs of 

these larger farms can exceed the legal lending limits of 

the state’s smaller community banks. 

1997 Was a Good Year for the 

Region’s Farm Banks 

As a group, the Region’s farm banks recorded a strong 

performance in 1997. ROA for farm banks with less 

than $1 billion in assets edged up to 1.24 percent as an 

increase in overhead expenses was offset by higher net 

interest margins. Favorable asset quality also helped 

maintain farm bank performance. The past-due ratio (30 

days or more and nonaccrual loans) to total farm real 

estate loans fell from 3.01 percent at year-end 1996 to 

2.58 percent at year-end 1997 for farm banks with less 

than $1 billion in assets. The past-due ratio for loans to 

finance agricultural production also remained low for 

these banks, although the past-due ratio climbed from 

0.21 percent at year-end 1996 to 0.39 percent at yearSan Francisco Regional Outlook 23 Second Quarter 1998 
Regular Features Regional Banking
 

end 1997. Despite excellent earnings, tier 1 leverage 

capital ratios at farm community banks declined from 

9.68 percent at year-end 1996 to 9.50 percent of total 

assets on December 31, 1997, because of strong asset 

growth. The loan growth was almost evenly split 

between agricultural production loans and real estate 

loans secured by farm properties. 

Farm Bill and Asian Crisis Mean 

Challenges Ahead 

Notwithstanding the general good health of the farm 

banks, the Region’s agricultural lenders may face two 

key challenges in the coming year. The first is the 1996 

Farm Bill. Under this bill, price supports have been 

replaced by a series of income payments that are being 

phased out over a seven-year period ending in 2002. 

Now farmers will base expected crop returns on market 

prices rather than on a guaranteed target price, thus 

exposing agricultural producers and consequently their 

TABLE 1 

lenders to new price risks. The legislation likely will 

result in increased price volatility for commodities 

because most producers are now free to determine the 

type of crop they wish to grow and the amount of 

acreage they wish to allocate. The financial transition 

will be greatest for farmers with the most dependence 

on government payments—generally wheat, cotton, and 

mixed-grain farmers. In the San Francisco Region, 

Montana’s farmers may be most affected by the 1996 

Farm Bill, as they are currently the most reliant on government cash payments, as shown in Table 1. 

The Asian crisis is the second area that warrants additional monitoring in 1998 for its potential effects on the 

farm sector. Agricultural exports nationwide average 

about 30 percent of farm cash receipts. In 1997, $24 billion or approximately 41 percent of the total value of 

U.S. agricultural exports were shipped to Asia. The five 

most troubled Asian economies—Indonesia, Malaysia, 

the Philippines, South Korea, and Thailand—account 

for 12 percent of U.S. farm exports. Japan and Taiwan, 

Montana Farmers Rely Most on Government Subsidies 

for Their Agricultural Cash Receipts 

AK AZ CA HI ID MT NV OR UT WA WY REGION U.S. 

FARM FINANCIAL INDICATORS 

GOVERNMENT PAYMENTS AS 

% OF CASH RECEIPTSA 4.1% 2.63% 1.25% 0.12% 3.29% 10.62% 0.90% 2.43% 2.53% 2.67% 3.55% 2.31% 3.48% 

PERCENT OF AG CASH 

RECEIPTS FROM EXPORTSA 1% 20% 31% 23% 26% 42% 3% 23% 17% 36% 7% 30% 30% 

FARM DEBT-TO-EQUITY RATIOA 2.1% 9.1% 23.2% 4.7% 22.4% 14.8% 7.8% 13.7% 9.6% 19.0% 12.8% NA NA 

FARM DEBT-TO-ASSETS RATIOA 2.0% 8.3% 18.8% 4.5% 18.3% 12.9% 7.2% 12.0% 8.7% 15.9% 11.4% NA NA 

NET FARM INCOME CHANGE: 

’95 TO ’96A − 7.8% 9.2% 21.9% − 117.6% 27.7% − 18.9% 17.9% 72.4% 19.4% 71.4% − 26.1% 26.4% 42.1% 

PERCENT W/ FARMING AS 

PRINCIPAL OCCUPATIONA 53% 53% 52% 55% 59% 70% 57% 48% 46% 55% 64% NA NA 

STATISTICS ON BANK LENDING TO FARMERS 

# OF COMMUNITY AG BANKSB 0 1 19 0 7 53 0 7 3 19 22 131 2947 

COMMUNITY AG BANKS AS A 

% OF ALL BANKSB 0.0% 2.6% 5.7% 0.0% 43.8% 56.3% 0.0% 17.8% 7.0% 21.0% 42.3% 17.4% 31.8% 

AVERAGE COMMUNITY AG 

BANK SIZE ($ IN MILLIONS)B $0.0 $246.7 $214.1 $0.0 $133.9 $48.0 $0.0 $202.1 $43.8 $91.5 $81.1 $98.2 $71.4 

COMMUNITY AG BANKS—PASTDUE FARM LOAN RATIOB,C 0.00% 0.00% 0.65% 0.00% 0.26% 1.54% 0.00% 0.12% 1.37% 0.53% 1.64% 0.97% 0.89% 

LARGE BANKS—PAST-DUE 

FARM LOANS RATIOB,D 4.28% 2.42% 2.35% 14.78% 0.25% 2.00% 0.40% 0.62% 2.97% 0.90% 2.26% 2.69% 1.46% 

AG LOANS AS % OF TIER 1 

CAPITALB,E 0% 129% 150% 0% 234% 301% 0% 125% 160% 199% 196% 199% 216% 

Note: na=not applicable 

aSource: U.S. Department of Agriculture 

bSource: Bank Call Reports 12/31/97 

cCommunity Ag Banks are banks with total assets under $1 billion and all agricultural loans that constitute over 100 percent of tier 1 

capital. 

dLarge Banks have assets of $1 billion or more. 

eAgricultural loans here are defined to include both agricultural production loans and loans secured by farm real estate. 

San Francisco Regional Outlook 24 Second Quarter 1998 
Regular Features Regional Banking
 

which did not experience sharp devaluations in 1997, 

account for an additional 25 percent. The U.S. Department of Agriculture (USDA) is projecting that U.S. 

agricultural exports will fall 2 percent below 1997 levels and more than 6 percent below 1996 levels because 

of weaker Asian demand, increased competition, and 

lower prices. 

Farmers in the San Francisco Region are disproportionately exposed to the turmoil in Asia for two reasons: 

First, two of the top ten agricultural export states in the 

country—California and Washington—are in the San 

Francisco Region; California alone accounts for more 

than 20 percent of total U.S. agricultural exports. Second, a high percentage of the Region’s exports go to 

Asia. Over half of California’s agricultural exports go to 

Asia, and selected markets like the state’s Central Valley 

ship as much as 80 percent of their cattle and cotton 

production to Asia. Chart 3 summarizes the major commodities in the Region that are most vulnerable to the 

projected reduction in exports to Asia. 

Furthermore, world markets affect the value of commodities consumed domestically. Consequently, some 

agricultural products that are not exported directly to 

Asia nevertheless are being affected by the financial 

turmoil. For example, cattle and calves are the leading 

products in Wyoming, accounting for 60 percent of the 

state’s agricultural cash receipts. However, beef exporting countries like Australia and Canada now are having 

difficulty selling beef in Asia, and the strong dollar has 

made the United States a very attractive market. While 

USDA economists believe that Japan will continue to 

import two-thirds of all U.S. beef exports, U.S. cattle 

production is expected to decline in 1998 because of risCHART 3 

The Region’s Important Fruit, Vegetable,
 

and Wheat Exports Are Vulnerable
 

to Asia’s Downturn
 

% Destined for Asia* 

Vegetables 

31% 

Wheat 

32% 

Fruit 

42% 

* Hong Kong, Indonesia, Japan, Malaysia, People’s Republic of China, 

Philippines, Singapore, S. Korea, Taiwan, Thailand 

ing imports and declining exports. The rising domestic 

supply may affect the cash receipts and the health of the 

ranching industry directly. 

Implications: In the coming year, both the 1996 Farm 

Bill and the emerging Asian crisis will affect agricultural products and prices in the San Francisco Region. 

Although the 1998 price outlook for major crops and 

livestock products—for example, beef, cotton, and 

wheat—are stable to slightly down, prices could be 

greatly undermined if economic conditions in Asia 

deteriorate any further. Clearly, conditions in the agricultural sector will affect the performance of farm 

lenders as well. 

Despite the consolidation that has already occurred in 

Montana, farm banks in that state still may have higher 

than normal risk exposures. Montana’s agricultural sector has a high dependence on government subsidies, as 

shown in Table 1. Reductions in those subsidies will 

increase the risk agricultural producers face from 

changing market conditions and may increase the 

importance of risk management for both farmers and 

farm lenders. This could be particularly important in 

Montana, because the farm banks in that state have an 

agricultural loan concentration ratio of over 300 percent 

of capital, the highest in the Region (see Table 1). 

USDA can provide additional information on farm sector conditions. Those interested in topics such as crop 

prices, stages of planning, special research papers, and 

production forecasts may go to the USDA homepage at 

http://www.usda.gov/ and the USDA Statistics Service 

homepage at http://www.usda.gov/nass/. 

Industry Consolidates amid Rising 

Chartering Activity 

In 1997, the arrival of nationwide interstate banking 

sparked merger activity throughout the Region, 

although many of these mergers represented consolidations of banks already operated by large multistate bank 

holding companies. By year-end 1997, the number of 

mergers and consolidations within the Region totaled 

80, well above the 1996 tally of 65. Noteworthy interstate acquisitions were led by the acquisition of Great 

Western Bank, which is a federal savings bank with $42 

billion in assets located in California, by Washington 

Mutual Savings Bank, which is headquartered in Seattle, Washington. Many of the 1997 mergers involved 

affiliated institutions, as large bank holding companies 

San Francisco Regional Outlook 25 Second Quarter 1998 
Regular Features Regional Banking
 

in the Region took advantage of the new interstate banking laws to merge some of their out-of-state, and in 

some cases out-of-Region, bank subsidiaries into their 

lead bank. The latter transactions shifted reported bank 

assets into the Region. By contrast, the acquisition of 

U.S. National Bank of Oregon by an out-of-Region 

bank shifted the reporting of over $30 billion in assets 

out of the San Francisco Region. More recently, the proposed interstate merger between BankAmerica, headquartered in San Francisco, and NationsBank, of 

Charlotte, North Carolina, would continue the consolidation trend by creating the largest commercial bank in 

the nation. 

Industry consolidation and healthy economic growth 

have been catalysts for new chartering activity in the 

San Francisco Region. In 1994, only two thrift charters 

and five commercial bank charters were issued, a record 

low. The number of insured financial institution charters 

tripled in 1995 to 21, edged up to 25 in 1996, and then 

accelerated to 37 in 1997. As a result of this increased 

chartering activity, financial institutions that are three 

years old or less now account for 20 percent or more of 

the banks and thrifts in Nevada, Arizona, Idaho, and 

Utah (see Chart 4). 

Newly chartered financial institutions face a variety of 

challenges, not the least of which is to establish a profitable, well-balanced loan portfolio. Loan officers of 

CHART 4 

High Percentage of All Insured Banks and 


Thrifts in Nevada, Arizona, Idaho, 


and Utah Are New*
 

* Institutions chartered in the past three years, as of 12/31/97 

12% 

15% 

25% 

32% 

20% 

30% 

4% 

4% 

8% 

Source: Call Reports 12/31/97 

CHART 5 

New Banks* in Nevada Have Most Exposure to 

Higher Risk Real Estate Loans 

* Non-credit-card banks less than three years old 

Source: Bank and Thrift Call Reports 12/31/97 

Real Estate Construction, 

Commercial Real Estate, 

and Multifamily Loans as 

a Percentage of Assets 

0% 10% 20% 30% 40% 

NV 

OR 

MT 

AZ 

ID 

WA 

CA 

WY 

UT 

Region 

US 

new institutions, especially those located in some of the 

Region’s faster growing states, are facing stiff competition not only from large well-established institutions, 

but also from other newly chartered banks. Because 

they are located in rapidly expanding markets, some of 

these new institutions may develop loan portfolios that 

are relatively concentrated in certain types of loans, 

rather than being well diversified across a variety of 

loan types. For example, as seen in Chart 5, higher risk 

real estate loans account for over 33 percent of total 

assets at Nevada’s new insured institutions, compared 

with just 19 percent and 11 percent for the Region and 

the nation’s new institutions, respectively. This heavy 

concentration may place these institutions at risk from 

the effects of an economic downturn. 

Implications: According to the FDIC’s History of the 

Eighties report on banking problems, “new banks failed 

more frequently than existing banks, and banks that 

subsequently failed had significantly more of their 

assets in higher risk real estate loans.” Although the San 

Francisco Region continues to enjoy robust economic 

conditions, newly chartered institutions, especially fastgrowing banks with concentrations in higher risk real 

estate loans, may be among those institutions that are 

most at risk from the effects of an economic downturn. 

Thus, these institutions may warrant close attention 

from bank management and regulators. 

Catherine I. Phillips-Olsen, Regional Manager 

Roger Stevens, Financial Analyst 

San Francisco Regional Outlook 26 Second Quarter 1998 
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