Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 2000 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Paul R. Agosti,
 

Regional Economist
 

Millen L. Simpson,
 

Financial Analyst
 

Shayna M. Olesiuk,
 

Economic Analyst
 

Regional Perspectives 

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

economy continues to outperform the nation’s because of strong growth in the construction, trade, and services sectors, particularly in Arizona, California, Idaho, 

Nevada, and Utah. Continuing contraction in the manufacturing sector slowed 

employment growth in Oregon and Washington. Despite strong reported earnings, 

profitability levels of mortgage and large commercial lenders may be increasingly 

vulnerable to rising interest rates. Commercial lenders in many of the Region’s 

states reported rapid growth and increased concentrations in construction, commercial real estate, and commercial and industrial loans during 1999. See page 3. 

By the San Francisco Region Staff 

In Focus This Quarter 

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

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

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

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

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

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

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

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

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

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

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

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

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

other risks to watch in banking. See page 11. 

By the Analysis Branch Staff 

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

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

financial institutions and financial institution regulators. It is produced for the following eight 

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

For more information or to provide comments or suggestions about the San Francisco Region’s 

Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 808-8158 or send an e-mail to 

cphillips-olsen@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 The Region’s economy continues to outperform the nation’s because of robust growth in the trade, services, 

and construction sectors, offsetting weakness in the agricultural, manufacturing, and mining sectors. 

•	 Despite robust reported earnings, profits of the Region’s mortgage and large commercial lenders may be 

increasingly vulnerable should interest rates continue to rise. 

•	 Commercial lenders in many of the Region’s states reported rapid growth and increased concentrations in 

construction, commercial real estate, and commercial and industrial loans during 1999. 

•	 Some of the Region’s commercial lenders maintained relatively low allowances for loan and lease losses compared with national peers. 

Economic and Banking Conditions 

The San Francisco Region’s Economy 

Continues to Grow 

The San Francisco Region’s economy remains strong 

compared with the nation’s, as measured by nonfarm 

payroll employment growth. The Region’s employment 

expanded through year-end 1999, driven primarily by 

strength in the services, trade, and construction sectors. 

However, while the Region’s employment growth rate 

surpassed the nation’s, manufacturing sector employment contracted, which contributed to the slower 

employment growth seen in Oregon and Washington 

(see Chart 1). Also, persistent weakness in the agricultural and mining sectors continued to negatively affect 

some of the Region’s more rural areas. Per capita personal income growth and housing price appreciation 

were robust for most of the Region during 1999. 

CHART 1 

States Performing Ahead of the National Curve 

Nevada led the Region and the nation during 1999 in 

total nonfarm employment growth. Expansion in the 

services, trade, and construction sectors was attributed 

to continued strength in the gaming and tourism industries. Services sector employment, which represents 

over 40 percent of total employment, expanded more 

than 8 percent. 

Arizona’s economy remained robust. Manufacturing 

employment contracted in 1999, undoubtedly from lingering weaknesses in overseas economies, primarily in 

Asian countries. However, a December 1999 report prepared by Regional Financial Associates (RFA) states 

that the rising value of electrical equipment exports 

bodes well for chip manufacturing. Aerospace continues to account for a significant percentage of manufacThe San Francisco Region Economy Continues 

to Grow, but at a Slower Rate 

–1 

0 

1 

2 

3 

4 

5 

6 

7 

NV AZ ID CA UT MT WY WA OR AK HI 

Employment Growth Rate

 (Percent) 

U.S. 

1999 

1997 

1998 

1999 

Source: Haver Analytics 

SF Region 

1999 

turing employment: roughly 13 percent. 

Idaho’s economy performed well during 1999, driven by 

growth in the construction and services industries. Per 

capita personal income and house prices appreciated 

(see Chart 2, next page), and nonfarm employment grew 

3.4 percent, exceeding the 1998 rate of 2.3 percent. 

Export levels are rebounding in the electrical equipment 

sector but declining in the agricultural sector. 

California’s economy performed well, with employment expanding in all major industries except mining 

and manufacturing. Many large cities are experiencing 

tight labor markets. For example, the San Francisco, 

Orange County, and San Diego metropolitan statistical 

San Francisco Regional Outlook 3	 Second Quarter 2000 
Regional Perspectives
 

CHART 2

 San Francisco Region Housing Prices and Per Capita Income Remain Strong 

–1 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

Growth Rate (Percent) 

State House Price Index 

Growth Rate 1998–99 

State Estimated 1999 

Per Capita Personal 

Income Growth Rate 

National Estimated 1999 

Per Capita Personal 

Income Growth Rate 

National House Price Index 

Growth Rate 1998–99 

MT CA WY WA AZ NV UT OR ID HI AK 

Note: 1Q80 =100 

Source: Haver Analytics 

areas (MSA) reported unemployment rates below 2.5 

percent during December 1999, much lower than the 

state and national rates. However, the unemployment 

rate in Los Angeles-Long Beach MSA exceeds the 

national and state averages, primarily because of weakness in the manufacturing industry. In particular, the 

city’s aerospace and apparel sectors continue to lose 

jobs. 

Utah remained an above-average performer. Although 

total nonfarm employment growth slowed in 1999, the 

state’s construction sector posted solid employment 

gains. 

States Tracking the Nation 

but Showing Weakness 

Montana’s nonfarm employment grew 2.2 percent in 

1999, unchanged from a year ago. Growth in the state’s 

services and trade sectors was a key economic driver 

during 1999; however, the state’s mining and agricultural industries continued to be adversely affected by low 

commodity prices. 

Wyoming’s economy benefited from job growth in the 

trade and government sectors, which make up roughly 

half of nonfarm employment. However, the state lagged 

the nation in nonfarm employment growth. The mining 

industry continues to be adversely affected by softness 

in the oil and gas industries. While oil prices have 

firmed, drilling activity remains depressed. 

Washington’s economy has slowed, experiencing weakness in the manufacturing industry. The state ended 

1999 with nonfarm employment growth of 1.8 percent, 

less than half what it was at year-end 1998. Washington’s manufacturing employment contracted over 4 percent during the year, the greatest regional decline for 

that sector. Job losses at Boeing, one of the state’s 

largest employers, and lingering weakness in overseas 

economies have hurt export-manufacturing employment growth. A robust construction industry and 

increased growth in the transportation and public utiliSan Francisco Regional Outlook 4 Second Quarter 2000 
Regional Perspectives
 

ties industries have absorbed some of the excess labor, 

resulting in a slight decline in the state’s unemployment 

rate. 

States Lagging the Nation 

Oregon’s economy continued to slow in 1999, ending 

the year with nonfarm employment growth of 1.3 percent. Construction and services employment growth 

expanded during 1999, but the manufacturing industry 

lost jobs, largely as a result of lingering weakness in 

Asian economies. 

Alaska experienced nominal nonfarm employment 

growth in 1999. Furthermore, continued consolidation 

in the oil and gas industry, notably the BP-ARCO merger currently under federal government review, could 

adversely affect the Alaskan economy because of the 

potential for job losses. The state’s mining industry lost 

jobs during 1999. 

Hawaii’s economy appears to be recovering. Total nonfarm employment grew slightly in 1999. Strong westbound arrivals supported the tourism industry, while an 

increase in eastbound arrivals also was noted. An 

upswing in visitor arrivals has contributed to additional 

hiring in the services and trade sectors, helping to lower 

the state’s unemployment rate. 

Banking Conditions Remain Sound, but 

Profitability Levels May Be Susceptible to 

Increasing Interest Rate Sensitivity 

The majority of the Region’s insured financial institutions reported sound conditions as of year-end 1999, the 

third consecutive year of increasing profits. Aggregate 

return on average assets (ROA) for year-end 1999 

improved to 1.37 percent from 1.30 percent a year ago, 

on a merger-adjusted basis. Strong growth in fee 

income and declining provision expenses offset declining net interest margins (NIMs). A lower level of provision expenses is attributed to continued improvements 

in reported asset quality. The Region’s year-end 1.69 

percent past-due loan ratio was the lowest year-end level 

in the decade. 

However, rising interest rates during the latter half of 

1999 could pose problems for industry profitability levels going forward. For example, banking analysts have 

become more concerned about how rising interest rates 

could affect insured institutions’ profitability levels, 

while regulatory agency examiners have noted increasing levels of interest rate risk among the nation’s insured 

financial institutions. Banking analysts are concerned 

that rising interest rates could continue to compress 

NIMs while constraining noninterest income sources, 

such as mutual fund sales, mortgage banking revenue, 

venture capital gains, and securities underwriting fees. 

These concerns were in part responsible for the decline 

in market valuations experienced by the Region’s publicly traded institutions during 1999. Examiners also 

have identified increasing interest rate sensitivity in the 

Region’s insured financial institutions. In fact, during 

1999, downgrades of the market sensitivity or “S” component of the CAMELS rating1 exceeded upgrades. This 

was in contrast to 1998, when “S” component upgrades 

exceeded downgrades. 

Increasing interest rate sensitivity is most pronounced 

among the Region’s mortgage lenders,2 which account 

for only 7 percent of the Region’s institutions but hold a 

disproportionately high 40 percent of total assets. The 

Office of Thrift Supervision (OTS), the federal regulator for the majority of the Region’s mortgage lenders,3 

has stated that median interest rate sensitivity is at its 

highest level since 1993. Further, as of December 31, 

1999, the OTS reported five consecutive quarters of 

increasing median interest rate sensitivity nationwide. 

Not surprisingly, the Region’s mortgage lenders also 

posted five consecutive quarters of declining NIMs, on 

a merger-adjusted basis. Only reductions in overhead 

and provision expenses have kept reported ROA from 

declining significantly. 

Rising interest rate sensitivity is not confined to the 

Region’s mortgage lenders. Larger commercial lenders4 

1 The “S” component of the CAMELS [Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity] rating methodology 

measures the sensitivity of an institution’s earnings and economic 

value of equity to changes in interest rates, equity prices, commodity 

prices, and foreign exchange rates. Management’s ability to assess, 

measure, monitor, and control these risks is also considered in the “S” 

component rating. 

2 Mortgage lenders hold single-family mortgage loans and mortgagebacked securities greater than 50 percent of total assets. 

3 The OTS is the primary regulator for federally chartered savings 

banks. Because of the requirements of the qualified thrift lender test, 

many of these institutions hold relatively high concentrations in 

single-family mortgage loans and securities. 

4 Commercial lenders hold construction, multifamily, nonfarm, commercial real estate, and commercial and industrial loans greater than 

25 percent of total assets. 

San Francisco Regional Outlook 5 Second Quarter 2000 
Regional Perspectives
 

(total assets greater than $1 billion) have also shown 

vulnerability to rising interest rates. These lenders have 

increasingly funded long-term assets with interestsensitive liabilities. In addition, available-for-sale securities losses have grown steadily over the past year. 

These trends have resulted in stagnant NIMs, despite 

robust loan growth. Compressed NIMs have not hurt 

these lenders’ profitability, however, because of growth 

in noninterest income. Some increases in fee income— 

from such sources as mutual fund sales, venture capital 

gains, and underwriting revenues—could be characterized as “market sensitive” and may decline if interest 

rate increases slow capital markets activity. 

In the short term, rising interest rates have benefited the 

Region’s smaller commercial lenders (total assets of 

less than $1 billion). As of December 31, 1999, these 

lenders reported NIM increases for three consecutive 

quarters, on a merger-adjusted basis. Smaller commercial lenders primarily originate variable-rate loans, 

whose interest rates rise with increases in the federal 

funds rate. While this is beneficial in the short run, large 

increases in interest rates pose a longer-term risk to 

these lenders: asset quality deterioration. Since rising 

interest rates can increase debt service requirements for 

variable-rate loan debtors, cash flow for these debtors 

can become strained. While reported asset quality 

across the Region remained strong, the “A” (asset quality) component5 of the CAMELS rating was downgraded more frequently in 1999 than in 1998. Upgrades 

Region-wide continued to exceed downgrades by a slim 

margin; however, excluding southern California, downgrades in asset quality did exceed upgrades during 1999 

in the Region. Should interest rates continue to rise, 

resulting in less robust economic growth, the Region’s 

commercial lenders could face heightened risk of asset 

quality deterioration. 

Some of the Region’s Commercial Lenders 

Report Increased Concentrations in 

Traditionally Higher Risk Loan Types 

The Region’s 574 commercial lenders,6 which account 

for 68 percent of the Region’s insured institutions and 

5 The “A” component in the CAMELS rating methodology measures
 

the credit risk associated with an institution’s asset portfolio. This
 

component also measures management’s ability to assess, measure,
 

monitor, and control asset quality.
 

6 See footnote 4.
 

hold 44 percent of the Region’s assets, could face the 

greatest challenge in maintaining asset quality in the 

event of an economic slowdown. Commercial lenders in 

most of the Region’s states have increased concentrations in traditionally higher-risk loan types—construction, commercial real estate (CRE), and commercial 

and industrial (C&I) loans—through rapid loan growth 

during the current economic expansion. The increase in 

traditionally riskier assets can be problematic in the 

event of an economic slowdown, because commercial 

lenders’ net charge-off rates, one measure of overall 

asset quality, can change significantly when economic 

conditions weaken. Chart 3 shows commercial lenders’ 

median net charge-off rates in three areas of the Region 

that experienced economic downturns during the past 

15 years: Alaska, Arizona, and Southern California. The 

chart shows that changes in local economic conditions 

can result in volatility in commercial lenders’ net 

charge-off rates. 

Favorable economic conditions throughout the 1990s 

have fostered rapid loan growth rates among the 

Region’s commercial lenders. Table 1 shows that 59 percent of the Region’s commercial lenders exceeded the 

nation’s median loan growth rate during 1999.7 However, only 13 commercial lenders achieved this rapid 

growth through an acquisition; the vast majority of the 

Region’s commercial lenders have generated rapid loan 

growth internally. In fact, the median loan growth rate 

for the Region has exceeded the nation’s during each of 

the past four years. Further, the Region’s construction, 

CRE, and C&I median loan growth rates exceeded the 

nation’s during 1998 and 1999. 

Commercial lenders in some states have outpaced the 

nation’s loan growth rate for an even longer period 

because of robust economic conditions. For example, 

commercial lenders in Arizona, Nevada, Utah, and 

Washington, states that have led the Region in economic growth throughout much of the decade, have exceeded the nation’s median loan growth rates since 1992. 

Oregon, until its recent economic slowdown, surpassed 

the nation’s median loan growth rate from 1992 through 

1998. In addition, commercial lenders in these states 

have generally experienced a more rapid median loan 

growth rate than the nation’s in construction, CRE, and 

C&I loans since 1992. Moreover, in several states, rapid 

loan growth was widespread. Over 70 percent of the 

7 When determining median growth rates for commercial lenders, de 

novo institutions were excluded. 

San Francisco Regional Outlook 6 Second Quarter 2000 
Regional Perspectives
 

CHART 3 

Changes in Economic Conditions Result in Volatility in Commercial Lender Net Charge-off Rates 

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

Median Net Charge-off Rates 

Source: Bank and Thrift Call Reports 

Alaska 

Arizona 

Southern 

California 

commercial lenders in Arizona, Nevada, and Washington topped the nation’s 1999 median loan growth rate. 

The strong economic growth in these states during the 

1990s is reflected in the rapid loan growth figures. 

In addition to rapid loan growth, examiner surveys indicate that the Region’s insured financial institutions may 

TABLE 1 

be engaging in potentially higher-risk underwriting 

practices than institutions in other parts of the country. 

Likely due to the robust real estate markets in the majority of the Region’s metropolitan areas, the FDIC San 

Francisco Region Underwriting Survey has consistently 

shown that the Region’s state nonmember banks are 

more likely than nonmember banks nationwide to 

High Percentages of Commercial Lenders in Some States Report Rapid Loan
 

Growth, High Concentrations in Riskier Assets, and Relatively Low ALLL Levels
 

CONSTRUCTION, ALLOWANCE FOR 

CRE, AND C&I LOAN AND LEASE 

LOAN GROWTH 

LOAN 

CONCENTRATIONS 

LOSSES 

(ALLL) % OF COM­ TIER 1 LEVERAGE CAPITAL RATIO* MERCIAL 

LENDERS MEDIAN 

MEDIAN MEDIAN WITH ALL (AS A 

% ABOVE (AS A % % ABOVE (AS A % % BELOW THREE % OF % BELOW 

MEDIAN* NATIONAL OF TOTAL NATIONAL OF TOTAL NATIONAL CHARACTER- AVERAGE NATIONAL 

STATE (%) MEDIAN ASSETS) MEDIAN LOANS) MEDIAN ISTICS** ASSETS) MEDIAN 

ARIZONA 28.56 84 52.39 87 1.19 58 45 8.02 58 

WASHINGTON 19.47 70 41.60 75 1.13 58 39 9.93 23 

OREGON 13.24 48 45.06 68 1.18 56 22 8.68 39 

NEVADA 37.24 92 49.35 78 1.26 33 22 8.58 50 

SOUTHERN CA 18.69 63 49.56 86 1.34 39 22 8.47 49 

NORTHERN CA 14.70 54 45.75 79 1.42 35 21 8.29 50 

UTAH 15.79 54 45.46 77 1.64 13 10 11.06 19 

REGION 17.73 59 45.78 75 1.33 40 23 8.68 42 

NATION 14.51 50 35.95 50 1.23 50 16 8.38 50 

* Median loan growth rates and capital ratios exclude de novo institutions.
 

** % of Commercial Lenders with All Three Characteristics refers to the percentage of institutions that report loan
 

growth rates and portfolio concentrations above the national median and ALLL levels below the national median.
 

Sources: Year-End 1999 Bank and Thrift Call Reports
 

San Francisco Regional Outlook 7 Second Quarter 2000 
Regional Perspectives
 

originate speculative construction loans8 and minipermanent CRE loans.9 Also, San Francisco nonmember banks are more likely to originate loans to 

businesses without demonstrated ability to repay, likely 

due to strong growth in technology, Internet, and other 

start-up companies. While this cannot be interpreted as 

a sign that all or even most of the San Francisco Region 

commercial lenders engage in potentially more risky 

underwriting practices, these practices were found to 

occur more frequently in state nonmember banks in this 

Region than in the nation. 

The percentage of San Francisco Region commercial 

lenders experiencing rapid loan growth has shifted loan 

portfolios toward higher concentrations in construction, 

CRE, and C&I loans than those held by commercial 

lenders nationwide (see Table 1). Table 1 also shows 

that several states’ median concentrations in combined 

construction, CRE, and C&I loans are much higher than 

the Region’s median levels. In addition, commercial 

lenders in Nevada, Oregon, Utah, and Washington have 

developed these concentrations only recently. Chart 4 

shows that median exposure in each state remained relatively constant and close to the national median from 

1984 through 1992, then steadily increased. Exposures 

in Arizona and California (not shown in Chart 4) have 

generally remained higher than those in the nation 

throughout the past 15 years, despite the 1990 through 

CHART 4 

1993 California recession and the 1988 through 1992 

Arizona slowdown. 

The Region’s Commercial Lenders’ALLL 

Levels Exceed the Nation’s... 

An assessment of the allowance for loan and lease loss 

(ALLL) levels is difficult and can be influenced by 

many variables. Loan growth levels, portfolio mix, 

problem loan levels and net charge-off volatility, underwriting, and credit administration practices are some of 

the factors that make this task a challenging one. In 

addition, management practices can heighten or reduce 

risk for any given portfolio relative to other institutions. 

Examiners, accountants, and bank managers are better 

able, at the individual institution level, to determine the 

appropriate ALLL level because of their access to institution-specific, nonpublic information. Therefore, the 

following analysis of aggregate ALLL levels reported 

by the Region’s commercial lenders is based on reported data and does not consider all factors that could 

affect statements about the adequacy of the allowance. 

An analysis of ALLL levels for the Region highlights 

certain positive trends. First, San Francisco Region 

commercial lenders report higher median ALLL levels 

Commercial Lenders Headquartered in Nevada, Oregon, Utah, and Washington Have Increased 

Concentrations in Traditionally Higher-Risk Loan Types 

0 

10 

20 

30 

40 

50 

60 

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

Construction, CRE, and C&I as a

Percentage of Total Assets

Oregon 

Nevada Washington 

Nation Utah 

Source: Bank and Thrift Call Reports 

8 Speculative construction loans are for commercial buildings or 

homes under construction that are not preleased or presold. 

9 A mini-permanent CRE loan is one with payments based on a longer 

amortization schedule than the maturity of the loan. This type of loan 

generally has a large “bullet” or balloon payment due at maturity 

because of the extended amortization schedule. 

San Francisco Regional Outlook 8 Second Quarter 2000 
Regional Perspectives
 

than commercial lenders nationwide. Second, ALLL 

levels have fallen more slowly than reductions in net 

charge-off rates in recent years (see Chart 5). Third, 

despite the downward trend in ALLL levels, the ALLL 

coverage of nonperforming loans is at its highest point 

in 15 years. Finally, commercial lenders in most 

states—including Alaska, Arizona, Northern and Southern California, Idaho, Montana, and Wyoming—report 

median ALLL levels above those that preceded each 

state’s last economic downturn or banking crisis. 

...But Reported ALLL Levels in Certain States 

Lag the Nation; High Concentrations and Rapid 

Loan Growth Rates Are Also Reported 

Commercial lenders in some states, however, maintain 

ALLL levels at or below the national level despite rapid 

loan growth and high portfolio concentrations in potentially higher risk loan types. Table 1 shows that the 

median ALLL level for commercial lenders in Arizona, 

Washington, Oregon, and Nevada are similar to or lower 

than the nation’s; yet median concentrations in riskier 

loan types reported by commercial lenders in these 

states are relatively high compared with the nation. 

Additionally, Arizona, Washington, and Nevada commercial lenders continue to experience loan growth 

rates well in excess of the nation’s. Conversely, California and Utah commercial lenders report median growth 

CHART 5 

rate and portfolio concentration levels above the nation, 

but exceed the nation’s median ALLL levels. 

Table 1 also shows that Arizona and Washington are 

home to a disproportionate number of commercial 

lenders that report above-median loan growth rates and 

concentrations in riskier construction, CRE, and C&I 

loans, while maintaining below-median ALLL levels. 

Nevada, Oregon, and California also have a fairly high 

percentage of institutions that exhibit a combination of 

these characteristics. 

Geographic diversification at the level of the bank holding company may mitigate some of the risk from high 

concentrations and rapid growth noted in Arizona and 

Nevada commercial lenders. Over half of the commercial lenders in these two states, including almost twothirds of the de novo institutions, are subsidiaries of 

multibank holding companies headquartered elsewhere. 

Many of the commercial lenders in Arizona and Nevada 

have been chartered or acquired by bank holding 

companies headquartered in slower growing midwestern states, and the banking subsidiaries in Arizona 

and Nevada may represent only a small portion of the 

holding companies’ assets. Thus, even if institutions in 

these states have relatively low ALLL levels relative to 

high growth and portfolio concentrations, the bank 

holding companies could provide them with financial 

support and management expertise. On the other hand, 

Commercial Lender ALLL Levels Track Net Charge-off Rates
 

2.00
 0.70 

1.80 

0.60 

1.60 

0.50 1.40
 

1.20
 0.40 

1.00 

0.30 0.80
 

0.60
 0.20 

0.40 

0.10 0.20
 

0.00
 0.00 

Note: ALLL = allowance for loan and lease losses 

Source: Bank and Thrift Call Reports Median ALLL to Total Loans Ratio 

Median ALLL to Total 

Loans Ratio 

Median Net 

Charge-off Rate 

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

Median Net Charge-off Rate 

San Francisco Regional Outlook 9 Second Quarter 2000 
Regional Perspectives
 

institutions that have entered these markets through 

acquisitions or de novo chartering may not be familiar 

with the Arizona or Nevada economies. 

Although ALLL levels maintained by commercial 

lenders headquartered in the Pacific Northwest states 

appear relatively low, this may be the result of low historical net charge-off experience and relatively strong 

capital levels. As Chart 6 shows, median net charge-off 

rates for commercial lenders in Oregon and Washington 

have generally remained below those of the Region and 

the nation since 1987. Further, Table 1 shows that the 

majority of commercial lenders in the Pacific Northwest maintain stronger Tier 1 Leverage Capital ratios 

than that of the nation. Net charge-off rates have likely 

been low relative to those in the rest of the Region 

because these states have not experienced an economic 

slowdown such as that in Alaska (oil, 1986 through 

1987); Idaho, Montana, and Wyoming (agriculture, 

1986 through 1987); Arizona (real estate, 1988 through 

1992); or California (real estate and defense/aerospace 

spending cutbacks, 1990 through 1993).10 Neither Oregon nor Washington has experienced an annual contracCHART 6 

tion in employment growth or gross state product since 

1984. 

While economic growth in the Pacific Northwest has 

been generally strong for the past 15 years, signs of 

slowing have emerged recently. As a result of the Asian 

economic slowdown, Oregon posted annual employment growth well below its 15-year average during 1998 

and 1999. Washington’s economic growth rate for 1999 

lagged its 15-year average, primarily because of the 

aerospace employment layoffs at Boeing. Commercial 

lenders in the Pacific Northwest should remain cognizant of slowing in these two states’ economies, 

because rapid loan growth and increased concentrations 

in riskier loan types have developed during a period of 

sustained economic growth. Further, the majority of 

Oregon and Washington commercial lenders, unlike 

those in Arizona and Nevada, are not subsidiaries of 

multistate bank holding companies and therefore cannot 

draw on the geographic diversification and support 

those entities may offer. 

San Francisco Region Staff 

Commercial Lenders Headquartered in Oregon and Washington Have Experienced 

Low Charge-offs over the Past 15 Years 

0.00 

0.10 

0.20 

0.30 

0.40 

0.50 

0.60 

0.70 

0.80 

0.90 

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 

Median Net Charge-off Rates 

Source: Bank and Thrift Call Reports 

San Francisco Region 

Nation 

Oregon 

Washington 

10 Oregon’s recession during 1990–91 was not as severe or as lengthy 

as the nation’s. 

San Francisco Regional Outlook 10 Second Quarter 2000 
In Focus This Quarter
 

Banking Risk in the New Economy
 

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

performance of insured depository institutions. At this 

time, the banking industry as a whole continues to 

enjoy record profits and solid financial ratios.1 Much of 

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

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

may create new types of risks for insured depository 

institutions. 

During 1999, the FDIC reported the first annual loss for 

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

associated with high-risk activities such as subprime 

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

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

might change if economic conditions deteriorate. 

The Longest U.S. Expansion 

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

month of expansion, making this the longest period of 

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

acceleration in the rate of real gross domestic product 

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

year since 1997. Meanwhile, price inflation has 

remained relatively subdued. The core inflation rate, 

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

since 1965. 

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

record earnings for the banking industry. The important 

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

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

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

pace of economic activity, or is it the temporary result 

of a few transitory factors? More important, are there 

new and unfamiliar dangers that, at some point, could 

significantly impair banking industry performance? To 

evaluate these questions, we must assess the factors that 

have contributed to recent economic performance and 

think ahead to possible developments that could end this 

expansion. 

What Is the New Economy? 

The term used most often to describe the recent period 

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

arisen because people interpret the term in different 

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

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

Internet. Some of these New 

Economy firms have been able to 

raise large amounts of capital and 

command market valuations in 

the tens of billions of dollars well 

in advance of earning a profit or 

even booking significant cash 

revenues. 

Economists tend to employ the term New Economy in a 

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

some of the traditional economic relationships have 

changed. For example, intangible assets now appear to 

play a much larger role in the valuation of investments 

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

now may exhibit increasing returns to scale (rather than 

diminishing returns), reflecting the fact that the value of 

their product rises as it becomes a de facto industry 

standard.4 Individual decision making, too, may be 

changing. Some believe that investors have reduced the 

risk premium they demand to hold equity positions 

3 Nakamura, Leonard. Federal Reserve Bank of Philadelphia. 

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

San Francisco Regional Outlook 11 Second Quarter 2000 
In Focus This Quarter
 

because of their perception that holding equity is not, 

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

shift in investor attitudes could help explain why the 

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

recently approached all-time highs.6 

Perhaps the most important underlying change in the 

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

long maintained that rapid growth in economic activity 

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

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

the late 1990s, as growth accelerated and inflation 

remained low, economists began to reevaluate their 

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

of inflation during this expansion was the fortunate result 

of temporary factors, such as a strong dollar and low 

energy prices, both of which could diminish or reverse 

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

to suggest that the fundamental workings of the economy 

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

of high economic growth with low inflation. 

An early Wall Street description of the New Economy 

appeared in an article released by Goldman Sachs in 

January 1997.8 It describes a number of fundamental 

changes in the economy—driven by global competition 

and advancing technology—that may permit business 

cycle expansions to last longer than they have in the 

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

expansions might have a tendency to contribute to 

greater financial excess and the possibility of more 

severe recessions and more sluggish recoveries. 

If this hypothesis is correct, and an emerging New 

Economy would contribute to longer expansions and 

more severe recessions, there may be implications for 

how banks manage risks. Since the Great Depression, 

U.S. business cycle recessions have not necessarily been 

catalysts for large numbers of bank and thrift failures. 

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

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

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

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

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

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

pdf/neer199c.pdf.
 

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

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

Research, Goldman Sachs.
 

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

economy was in the midst of a long expansion, some 

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

failures has been attributed to a variety of factors, 

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

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

recessions would represent largely uncharted territory 

that could cause losses and loss correlations to depart 

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

The Productivity Revolution 

As the essential element that links faster economic 

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

a fixed amount of input. Labor productivity is usually 

measured in terms of output per hour. Chart 1 shows 

that output per hour in manufacturing has risen at an 

average annual rate of 4.5 percent during the current 

expansion, compared with rates of just over 2.5 percent 

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

of 6.3 percent. Why is productivity growing so fast now 

compared with previous expansions? Even economists 

who believe that economic relationships have fundaCHART 1 

Productivity Has Grown at a Faster Rate in This 

Expansion than in Previous Long Expansions 

Average Year-over-Year Growth 

in Manufacturing Output per Hour 

5.0% 

4.0% 

3.0% 

2.0% 

1.0% 

0.0% 

1961–69 1975–79 1983–90 1991–2000 

Source: Bureau of Labor Statistics (Haver Analytics) 

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

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

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

San Francisco Regional Outlook 12 Second Quarter 2000 
In Focus This Quarter
 

mentally changed are hard-pressed to explain why all of 

the factors came together in the late 1990s and not 

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

Increased Competition. Expanding global trade during 

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

competition from around the world. Annual U.S. 

exports of goods and services grew by over 230 percent 

(after inflation) between 1982 and 1999, while imports 

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

autos and chemicals has led to excess manufacturing 

capacity that has kept prices low. In other industries, 

including air travel, trucking, telecommunications, and 

banking, competition has been intensified through 

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

cannot rely on annual price increases to help expand 

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

firms, this means adopting new technologies and new 

ways of organizing operations. 

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

invested in new technologies at a rapid pace during this 

expansion. Chart 2 shows that business investment in 

equipment and software represents almost one-quarter 

of total net GDP growth during this expansion, comCHART 2 

Business Investment in Equipment and Software
 

Has Been Robust during This Expansion
 

Average Percent Contribution of Real Investment 

in Durable Equipment and Software 

to Net GDP Growth by Expansion 

25 

20 

15 

10 

5 

0 

1961–69 1975–79 1983–90 1991–99 

Note: GDP = gross domestic product
 

Source: Bureau of Economic Analysis (Haver Analytics)
 

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

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

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

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

pared with around 15 percent or less during previous 

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

the availability of new computer technologies that have 

fallen in cost over time and by the ready availability of 

financial capital on favorable terms. 

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

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

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

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

mature industries such as oil, autos, and banking are 

faced with excess productive capacity and intense price 

competition. For these firms, mergers are useful in 

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

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

models are evolving rapidly and where technological 

standards are still being determined. Firms in these 

industries that can grow rapidly through mergers have 

the chance to achieve long-term market dominance in 

what appear to be some of the fastest growing industries 

of the new century. 

The implications of the productivity revolution for the 

banking industry have been decidedly positive. Higher 

productivity has allowed a long expansion and faster 

economic growth with low inflation, all of which are 

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

CHART 3 

Note: M&A = merger and acquisition 

Source: Houlihan Lokey’s Mergerstat 

The Volume of Corporate Mergers Set 

Another New Record in 1999 

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

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

0 

2,000 

4,000 

6,000 

8,000 

10,000 

1,000 

1,200 

1,400 

1,600 

0 

200 

400 

600 

800 

San Francisco Regional Outlook 13 Second Quarter 2000 
In Focus This Quarter
 

have generated demand for credit that is supplied, in 

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

recent large-scale industrial restructuring has been 

highly supportive of strong business credit quality. This 

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

of bankruptcies and defaults that often accompany 

industrial restructuring. Given the volumes of corporate 

assets that have changed hands in recent years (more 

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

that this restructuring has proceeded in this fashion. 

The Role of the Capital Markets 

A critical factor in heightened business investment and 

restructuring during this expansion has been the 

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

One factor that has held down the cost of capital for 

publicly traded corporations has been sharply rising 

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

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

always require the amortization of good will that comes 

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

By far the largest amount of external business financing 

has been debt financing. U.S. nonfinancial corporations 

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

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

equity shares. This increase in debt issuance has not 

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

fourth quarter of 1999 alone, with over 60 percent of 

that amount going to Internet firms.12 

Banks have been active participants in nearly every 

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

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

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

to leveraged companies also rose 17 percent in 1999 to 

a record $320 billion. More impressive still was the 

growth in high-yield transactions, which rose nearly 50 

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

Week. 

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

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

resides on the books of insured institutions or, more 

important, how much high-yield exposure is retained by 

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

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

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

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

profits from venture capital operations account for a 

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

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

Innovation in the capital markets continues to provide 

new and more efficient vehicles for business financing. 

For example, issuance of asset-backed securities totaled 

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

In this ongoing revolution in finance, market-based 

intermediaries, such as mutual funds and asset pools, 

have assumed an increasing role in the credit markets. 

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

depository institutions for the first time in 1997. 

CHART 4 

Market-based Lending Is Becoming More 

Important as a Source of Business Financing 

Share of Total Net 

Credit Market Lending1 

70% 

60% 

50% 

40% 

30% 

20% 

10% 

0% 

Market-based Lenders3 

Depository Institutions2 

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

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

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

and other loans.
 

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

unions.
 

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


sponsored enterprises, and asset pools.
 

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

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

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

San Francisco Regional Outlook 14 Second Quarter 2000 
In Focus This Quarter
 

While the expansion in market-based financing has 

made credit more available to business and consumer 

borrowers, it also creates some concerns. One issue is 

the susceptibility of the financial markets to periodic 

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

near-failure of the Long Term Capital Management 

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

During the 1998 episode, private yield spreads widened 

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

securities. Some companies that had planned to issue 

debt to the markets during that period were unable to do 

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

catastrophic. For example, the relatively short-lived 

episode of financial turmoil during late 1998 resulted in 

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

First Boston, and others incurred losses, while Criimi 

Mae, Inc., was forced to declare bankruptcy. 

Because market-based financing has played such a large 

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

economy through mergers and the formation of new 

businesses, a recurrence of financial market turmoil 

could contribute to the end of the current expansion. 

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

competitive economic environment, prevent businesses 

from restructuring themselves through mergers and 

deprive them of capital needed to invest in cost-cutting 

technologies. The loss of financial flexibility would 

leave businesses much more vulnerable to the effects of 

CHART 5 

competition and could result in more firms seeking 

bankruptcy protection. Such a scenario has the potential 

to bring about a significant increase in charge-off rates 

for business lenders. 

Financial Imbalances 

Another concern that arises from increased dependence 

on market-based financing is that it may contribute to 

the emergence of financial imbalances in the economy. 

These imbalances could, in turn, increase the potential 

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

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

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

billion. However, on the strength of a long economic 

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

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

As the government has moved from deficit to surplus, 

households and businesses have continued to borrow 

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

1999, the private deficit narrowed to $913 billion from 

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

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

San Francisco Regional Outlook 15 Second Quarter 2000 

Flow of Net Sectoral Lending 

(Lending Less Borrowing), 

in Billions of Dollars Domestic Financial Sector 

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

Source: Federal Reserve Board (Haver Analytics) 

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

–1,200 

–900 

–600 

–300 

0 

300 

600 

900 

1,200 

Foreign Sector 

Nonfinancial Business 

Households 

Government 

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

The largest part of the private deficit was again 

financed in 1999 by domestic financial institutions 

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

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

potential causes for concern. The rapid expansion in 

credit created by the financial sector raises questions 

about credit quality. Financial institutions theoretically 

serve as the gatekeepers of the economy, financing only 

the most creditworthy projects and rejecting those that 

are not viable. The sheer volume of credit extended to 

businesses and households—almost $1.4 trillion in new 

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

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

page 17 for a discussion of recent trends in commercial 

credit quality.) 

Reliance on inflows of foreign capital raises a different 

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

growing significantly faster than the economies of its 

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

deficit that reached $268 billion in 1999 and could 

exceed $300 billion in 2000. This deficit puts hundreds 

of billions of dollars annually in the hands of foreign 

investors. As long as foreign investors largely choose to 

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

the United States can continue to enjoy a strong dollar 

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

markets. Doing so would put downward pressure on the 

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

Recent Shocks to the U.S. Economy 

Despite the potential for a declining dollar as a result of 

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

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

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

Rising Energy Prices. After declining to a low of 

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

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

price per barrel of West Texas Intermediate crude 

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

The OPEC nations and other major oil producers 

reached a new agreement in March 2000 that provides 

for a production increase of some 1.5 million barrels a 

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

decline in gasoline prices in the near term.15 

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

this time are uncertain. According to some estimates, 

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

25 years ago, when the United States was experiencing 

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

prices were responsible for nearly all the increase in 

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

percent in December 1998 to 2.7 percent in December 

1999, the core rate of inflation (excluding food and 

energy items) actually fell. The question now is whether 

higher energy prices will be passed along to the rest of 

the economy through rising wage and price demands 

during the remainder of 2000. 

Rising Interest Rates. From low points at the end of 

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

risen substantially, contributing to a higher cost of debt 

service for businesses and households. At the short end 

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

the Federal Funds rate six times between June 1999 and 

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

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

voiced concerns that inflationary pressures might be 

emerging because of continued rapid U.S. economic 

growth. Given the stated commitment of the Federal 

Reserve to price stability, most analysts expect the Fed 

to continue to push short-term rates higher until growth 

in the economy slows to a more sustainable pace.17 

Bond markets also pushed up long-term interest rates 

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

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

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

steo/pub/contents.html.
 

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

2000. Testimony of Chairman Alan Greenspan Before the Committee
 

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

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

San Francisco Regional Outlook 16 Second Quarter 2000 
In Focus This Quarter
 

As Commercial Credit Quality 

Indicators Slip, Trends in Commercial 

Lending Come to the Forefront 

Commercial lending, which includes both commercial 

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

loans, represents the greatest source of credit risk to 

insured institutions and the deposit insurance funds. C&I 

loan growth continued to be strong in 1999, although it 

did moderate from 1998 levels, and recent underwriting 

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

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

charge-off rates, corporate bond defaults, and corporate 

bond rating downgrades relative to upgrades have all 

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

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

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

of credit quality deterioration are occurring despite 

extremely favorable economic conditions. 

At least three factors have contributed to weakening in 

corporate credit quality. First, corporate indebtedness has 

been rising, as businesses have been spending to increase 

productivity, cut costs, repurchase equity, and finance 

mergers and acquisitions. The second factor relates to a 

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

five years. Finally, stresses within industry sectors hard 

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

borrowers. 

Construction and development (C&D) lending continues 

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

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

remain extremely low. However, there are indications 

that conditions could be worsening in some markets. In 

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

absorptions and are projected to continue to do so over 

the next several years. Moreover, these trends have 

implications for vacancy rates. The national office 

vacancy rate moved higher during 1999 for the first time 

since 1991 and is projected to climb higher. 

In addition, some local CRE markets continue to show 

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

Insurance identified nine markets in which the pace of 

construction activity threatened to outstrip demand for at 

least two property sectors.20 Seven of these nine markets 

reported an increase in office vacancy rates in 1999. 

CHART 6 

0.0 

1.0 

2.0 

3.0 

4.0 

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

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

Note: C&I = commercial and industrial 

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

Deteriorating Indicators Suggest Weakening 

Business Credit Quality 

Insured Institution C&I 

Charge-off Rate 

Corporate Bond 

Default Rate 

Bond Ratings 

Downgrades to 

Upgrades (columns) 

18 Both the 1999 Senior Loan Officer Opinion Survey (Federal 

Reserve Board) and 1999 Survey of Credit Underwriting Practices 

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

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

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

FDIC Division of Insurance. First quarter 2000. Recent Trends 

Raise Concerns about the Future of Business Credit Quality. 

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

ro20001q/na/Infocus1.html. 

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

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

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

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

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

CHART 7 

0 

20,000 

40,000 

60,000 

80,000 

100,000 

120,000 

140,000 

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

0% 

5% 

10% 

15% 

20% 

Source: CB Commercial/Torto Wheaton Research 

U.S. Office Vacancies Rose Last Year 

for the First Time since 1991 

Completions, Absorption 

(000 sq. ft.) Vacancy

 Rate 

Completions 

Absorption 

Projected

Actual 

San Francisco Regional Outlook 17 Second Quarter 2000
 
In Focus This Quarter
 

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

6.5 percent by May 2000. Analysts have cited renewed 

demand for credit by a recovering world economy as 

well as concerns about inflation arising from the 

increase in energy prices as factors behind the rise in 

long-term rates. 

Higher energy costs and higher interest rates do not 

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

economic activity during the first quarter of 2000. The 

preliminary estimate of real gross domestic product 

growth during the quarter was 5.4 percent—a slowdown 

from the 7.3 percent rate of the fourth quarter of 1999 

but still well above what is considered a sustainable 

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

rates, has remained surprisingly resilient. Still confident 

of their future prospects, homebuyers have increasingly 

turned to adjustable-rate mortgages to avoid some of the 

immediate costs of higher fixed mortgage rates. 

As for the business sector, higher costs for energy and 

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

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

continuing operations during the first quarter of 2000.21 

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

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

Equity Market Volatility. The notion that New Economy 

firms are less vulnerable to the effects of higher energy 

costs and higher interest rates may be one of the reasons 

that equity shares of firms in the technology sector 

began to dramatically outperform the broader market, 

beginning around the middle of 1999. Chart 8 shows 

that the technology-heavy NASDAQ index performed 

more or less in tandem with the Dow Jones Industrial 

Average between the end of 1996 and the middle of 

1999, but thereafter the NASDAQ soared far ahead of 

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

2000, the NASDAQ rose by 72 percent while the Dow 

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

Parallel trends were observed in Europe, Japan, Korea, 

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

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

CHART 8 

and Hong Kong. The similarity in performance of the 

high-tech sectors across three continents suggests a 

worldwide flow of liquidity from investors to the shares 

of technology firms. 

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

0 

50 

100 

150 

200 

250 

300 

350 

400 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

Tech Stocks Have, Until Recently, Far 

Outperformed “Old Economy” Stocks Worldwide 

January 1997 = 100 

United States 

NASDAQ 

DJIA 

May 12, 2000 

0 

200 

400 

600 

800 

1,000 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

January 1997 = 100 

EASDAQ 

Bloomberg European 500 

May 12, 2000 

Europe 

0 

50 

100 

150 

200 

250 

300 

January 1997 = 100 

Japan 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

JASDAQ 

Nikkei 225 

May 12, 2000 

San Francisco Regional Outlook 18 Second Quarter 2000 
In Focus This Quarter
 

shares during March and April 2000. The NASDAQ 

index lost 30 percent of its value between March 10 and 

May 12, 2000. Analysts cited the Justice Department 

finding against Microsoft and doubts about the ultimate 

profitability of business-to-consumer Internet firms as 

two factors in the sell-off. 

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

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

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

households, plus their holdings of mutual funds, by 

some $5.7 trillion. This windfall is an important reason 

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

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

other consumer goods. Although it is uncertain what 

effect a prolonged stock market correction might have 

on consumer spending, the potential wealth effect has 

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

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

how financial market volatility could affect banks.) 

The Economic Outlook 

Despite the effects of rising energy costs, increasing 

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

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

the May 1999 Blue Chip Economic Indicators suggests 

that the economy will grow by 4.7 percent in 2000, 

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

levels. In short, the consensus forecast indicates that the 

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

result will likely be another year of generally low loan 

losses and solid earnings for much of the banking 

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

discussion of other risks to watch in banking.) 

Clearly, risks are associated with the economic outlook. 

Recently, higher oil prices and higher interest rates have 

been the most visible signs of trouble for the economy. 

New Economy companies may be less vulnerable to 

these effects, but even these firms have experienced a 

sharp decrease in equity valuations as investors reevalFinancial Market Volatility Could 

Pare Earnings for Banks Most 

Reliant on Market Sources of 

Revenue 

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

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

According to Deutsche Banc Alex. Brown, the 18 

most active generators of market-sensitive sources of 

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

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

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

for those 18 banks that generated the largest amounts 

of market-sensitive revenues during the third quarter 

of 1998, the share of total revenue derived from 

market-sensitive sources declined from 23 percent to 

13 percent. Thus, a more sustained downward trend in 

the financial markets could particularly affect the 

earnings of large banking companies that rely heavily 

on income from sources such as venture capital, asset 

management and brokerage services, and investment 

banking. 

CHART 9 

15 

30 

45 

60 

75 

90 

1970s 1980s 1990s 

Noninterest Revenues Account for a Growing 

Share of Bank Net Operating Revenue 

Percentage of Net Operating Revenue* 

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

noninterest income. 

Sources: FDIC Historical Statistics on Banking; FDIC Quarterly Banking 

Profile 

Net Interest Income Noninterest Income 

0 

22 Net operating revenue is the sum of interest income and 

noninterest income less interest expense. According to 

Deutsche Banc Alex. Brown, these companies are Bank of 

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

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

Chase Manhattan Corporation; Citigroup, Inc.; First Union 

Corporation; FleetBoston Financial; JP Morgan; KeyCorp; 

Mellon Financial Corporation; National City Corporation; 

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

Wachovia Corporation; and Wells Fargo & Company. 

San Francisco Regional Outlook 19 Second Quarter 2000 
In Focus This Quarter
 

Other Risks to Watch in Banking
 

Subprime Lending 

•	 Subprime consumer loan portfolios contributed to 

the large losses associated with recent high-cost 

bank failures. During 1999, the FDIC reported the 

first annual loss for the Bank Insurance Fund since 

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

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

capital in subprime loans accounted for 6 of the 13 

bank failures that occurred between January 1998 and 

March 2000. Fraud and inappropriate accounting for 

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

•	 Subprime lending remains an area of concern. 

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

problem institutions. Of the 79 banks and thrifts on 

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

were institutions with at least 20 percent of their Tier 

1 capital in subprime loans.24 

Agricultural Lending 

•	 While a majority of agricultural institutions remain 

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

well as weather- and disease-related problems. Strong 

global competition and high worldwide production 

over the past several years have resulted in increasing 

inventories of many crops and poor prospects for a 

price turnaround in the near term. Moreover, in spite 

of record government farm payments in 1999, the 

U.S. Department of Agriculture projects that in the 

year 2000 one in four farms will not cover cash 

expenses, up to 20 percent of farmers will experience 

repayment problems, and 5 percent of farmers will be 

“vulnerable.”25 

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

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

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

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

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

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

Economic Research Service, applies to institutions that have 

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

cannot meet current expenses or reduce existing indebtedness. 

•	 Some signs point to growing stress for agricultural 

institutions. Forty-two percent of FDIC-supervised 

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

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

loss rates for agricultural production loans increased 

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

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

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

Operational Risk 

•	 Operational risks are becoming more prominent in 

the banking industry. Driven by consolidation and 

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

complexity. Operational risk encompasses a host of 

factors not related to credit or market activities, 

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

internal control weaknesses. Operational risks tend to 

be more pronounced when institutions engage in 

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

•	 Greater attention is being paid to operational risks 

in the financial industry. Recently, analysts have 

noted that the pressure to meet ambitious postmerger 

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

integrity of risk-management systems. In addition, 

the role that fraud has played in recent bank problems 

and failures reinforces the importance of adequate 

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

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

a Greenwich, Connecticut, consulting firm, recently 

estimated that operational losses among financial 

institutions have exceeded $40 billion over the past 

five years. 

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

Insurance. Third quarter 1999. Agricultural Sector Under Stress: 

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

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

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

Next Frontier. RMA/PricewaterhouseCoopers Survey. April 6, 

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

American Banker. 

San Francisco Regional Outlook 20	 Second Quarter 2000 
In Focus This Quarter
 

uate the long-term prospects. Equity market volatility 

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

invest. 

The economy has become particularly dependent on 

financing delivered through the capital markets. In this 

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

emerged as financial imbalances that may contribute to 

future problems for the economy. Businesses and 

households with high levels of debt are more vulnerable 

to problems if interest rates continue to rise or income 

growth falters. Rapid credit creation by the domestic 

financial sector suggests the possibility of lax credit 

underwriting standards. Reliance on foreign capital 

raises concerns about what would happen to the value of 

the dollar and to domestic inflation if foreign investors 

decide to invest elsewhere. 

Some analysts suggest that the New Economy, driven by 

increased productivity, heightened competition, and 

robust investment, may be characterized by longer 

expansions. Financial market imbalances may, however, 

contribute to deeper recessions and more sluggish 

recoveries compared with earlier business cycles. 

For the banking industry, it is clear that a recession 

would mean slower loan growth, deteriorating credit 

quality, and impaired profitability. But the biggest 

threat to the banking industry is a recession that is tied 

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

The process by which businesses have invested and 

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

process should be disrupted, we could see a much more 

disorderly process, with more bankruptcies and higher 

losses to lenders. 

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

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

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

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

Steve Burton, Senior Banking Analyst 

Steven C. Cunningham, formerly Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, formerly Senior Financial Analyst 

Mary L. Garner, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Thomas A. Murray, Senior Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Arlinda Sothoron, Senior Financial Analyst 

Ronald Spieker, Chief, Regional Programs and Bank Analysis 

San Francisco Regional Outlook 21 Second Quarter 2000 
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