Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 1998 

FDIC
 

New York
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Norman Gertner,
 

Regional Economist
 

Karen A. Wigder,
 

Financial Analyst
 

In Focus This Quarter 

◆ Y2K—Preventing the Year 2000 (Y2K) computer problem is becoming ever more 

costly as the time and resources left to do so disappear. Equally costly, according to 

some estimates, will be the litigation that follows in the problem’s wake. A failure to 

address Y2K exposures immediately and successfully may amount to a gamble backed 

by the value of the bank franchise and the officers and directors who run it. See page 3. 

By Gary Ternullo 

◆ Trends in Commercial Real Estate Loan Pricing and 

Underwriting—An abundant supply of financing is placing pressure on commercial real estate loan pricing and underwriting standards. Underwriting standards are being increasingly influenced by the rapid growth in commercial 

mortgage-backed securities and real estate investment trusts. While many within the 

industry believe that broader public funding of commercial real estate projects will 

lead to greater market transparency and improved underwriting discipline, there 

are a number of unique risk considerations related to the rapid growth and continuing development of these alternative funding sources. See page 7. 

By Steven Burton 

◆ Total Return:A Useful Tool for Monitoring Investment Portfolio 

Risk—The Federal Financial Institutions Examination Council is rescinding the 

1991 policy that required “high-risk” testing for mortgage derivative products and 

has released for comment a policy encouraging risk management across all types of 

instruments on an investment portfolio basis. Total return, a concept that includes 

fluctuations in market value, is a useful tool for measuring the performance of an 

investment portfolio and providing information about market risk at the portfolio 

level. See page 14. 

By Allen Puwalski 

Regular Features 

◆ Regional Economy—The New York Region is continuing its job expansion, 

although growth slowed during the third quarter of 1997...the largest cities in the 

Region, including Baltimore, New York City, Philadelphia, and Washington, D.C., 

continue to lag behind in job growth...after two decades of economic growth, 

Puerto Rico’s employment growth appears to be leveling off. See page 17. 

By Norman Gertner 

◆ Regional Banking—Favorable banking conditions continue, despite higher 

credit card charge-offs...merger and acquisition activity heats up as the regulatory 

environment changes, competition intensifies, and banks focus on efficiency...new 

banks spring up in the Region, hoping to fill a niche in small communities. 

See page 21. 

By Suzannah L. Susser, Karen A. Wigder 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

form found on the back cover to the FDIC Public Information Center. Contact the Public 

Information Center for current pricing on bulk orders. 

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

publish/regout. For more information or to provide comments or suggestions about the New York 

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

ssusser@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Daniel Frye 

Craig A. Rice 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Y2K: Banking in the twenty-first century may provide
 

grand new opportunities—but you have to get there first
 

•	 As a result of a three-decades-old programming 

convention, January 1, 2000, may find some computer systems unable to function correctly, if at 

all. Links within and between systems and organizations make the problem a complex one. 

•	 Cures are expected to be difficult and costly. If 

those cures fail, litigation could be equally costly, 

and much of it may be aimed at directors and 

officers. 

•	 Accordingly, senior bank management should be 

actively involved in making sure the cure takes 

place. A failure to do so amounts to a gamble 

backed by the value of the bank franchise and 

those who run it. 

Complex Problem, Complex Cure 

By now the story is well known. At midnight on 

December 31, 1999, computer systems that process 

dates using only the last two digits of a year will cease 

to function correctly, if at all. Equipment that contains 

embedded systems—chips or circuitry designed to perform specific functions—also may fail. And the problem is pervasive. It lies within systems and between 

systems, in both software and hardware. The large number of ways dates are used, the number of places they 

can occur, and the number of creative ways for naming 

them confounds an accurate assessment. 

Fixing the Year 2000 (Y2K) problem will require considerable time and effort. Computers and applications 

must be inventoried, examined for date usage, corrected 

where necessary, and then tested—not just by themselves but in combination with every other system with 

which they interact. This includes not only a bank’s own 

systems but also those of its servicers, correspondents, 

customers, vendors, and trading counterparties. 

Moreover, there are a variety of ways to address the 

problem, ranging from expanding date fields to four 

digits to simply subtracting 28 years from every date 

before processing—any of which could introduce new 

incompatibility problems when systems that have been 

fixed in different ways attempt to interact.1 And because 

not all systems can be corrected at once, interfaces or 

bridges between corrected and uncorrected systems also 

must be developed to maintain business system continuity. Most important, it must all be done before the 

non-negotiable deadline of December 31, 1999. 

For bank management, there are two ways to find out 

how serious the problem will be. The first is to commit 

resources to determining just how exposed the bank’s 

systems are—the first concrete step in actually solving 

the problem. The second is to gamble the franchise by 

doing little or nothing and letting the century date 

change provide the ultimate stress test. 

Costs 

The costs of a cure are many. First, there are the costs of 

actually finding and fixing the problem. Estimates of 

this cost have ranged widely, although the Gartner 

Group’s estimate of $300 to $600 billion worldwide is 

the most widely quoted. Using a different approach, 

Software Productivity Research (SPR) places the global number at over $1.3 trillion, including a $176 billion 

slice for the United States alone. Then there are the estimated costs of litigation. At the low end, SPR places 

them at $300 billion globally and projects that fully onethird of that amount will be generated in the United 

States. At the high end, the Giga Information Group 

sees a much more litigious future—estimating that 

Y2K-related legal costs could exceed $1 trillion. 

Significant opportunity costs may accrue as well, and 

the degree to which Y2K-related outlays fail to provide 

1 Every 28 years the same combination of dates and days recurs. 

Subtracting 28 years from a date before processing and then adding 

them back upon output has been suggested as a temporary but partial 

remedy because it permits applications to continue measuring time by 

subtracting two-digit years from each other. Windowing is another 

partial correction whereby some two-digit years—say those less than 

“50,” for example—are assumed to be preceded by “20” (thus “49” 

becomes “2049” in date calculations) while the remainder are 

assumed to be preceded by a “19” (thus “50” becomes “1950”). Both 

approaches only delay the need for permanent corrections. 

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

more efficient or functional systems will serve as a 

starting point for measuring the value of technology 

investments forgone. These forgone improvements will 

be especially costly for institutions that have started 

their repairs too late. They may find not only that the 

time for system improvements and upgrades has slipped 

away, but that they have insufficient time for anything 

beyond a patchwork solution that will continue to cost 

them beyond the year 2000. 

At the macro level, the tally of potential Y2K costs 

includes declining stock values, business failures, and 

recession. J.P. Morgan has estimated that as much as 40 

percent of organizations’ remediation costs have not 

been accounted for in their information technology budgets, presumably indicating that many firms will see 

their share value erode as the costs of Y2K fixes and 

related losses are priced into their future earnings. The 

cost of not being Y2K compliant might be substantial as 

well. According to the Gartner Group, as many as one 

in two firms may discover just how substantial as they 

head into 1999 with even their most mission-critical 

systems unfixed. The potential for these firms to fail 

looms large among the factors that have led Edward 

Yardeni, chief economist at Deutsche Morgan Grenfell, 

to assign a 40 percent chance of recession in the year 

2000. Peter de Jager, a consultant who also has commented extensively on Y2K issues, went even further, 

suggesting that 1 percent of all businesses would fail 

because of Y2K problems. Whatever the eventual 

number, many of these businesses will also be bank 

borrowers. 

Systems and Systemic Risks 

More immediate than the risk of borrower failures is the 

risk that a bank’s own systems may fail. Banks are heavily dependent on software applications that employ 

dates. Among other things, they use them for calculating interest paid or due and for managing the horizons 

of their assets and liabilities. If these applications begin 

returning erroneous calculations, bank operations could 

be seriously disrupted.2 If they fail altogether, the bank’s 

2 For example, interest due from borrowers for a one-year period 

beginning in 1999 and ending in 2000 might be calculated not as one 

year’s interest due but rather as nearly one century of interest payable 

(00 − 99 = − 99) if only the last two digits of the year are used in the 

calculation. Similarly, any other time calculation that straddles the 

century date change might return answers wrong in both size and 

sign. 

credibility—and hence its franchise value—can be substantially damaged or even irrevocably lost. 

The solution is often described in software terms, but 

executable software is not the only problem. Correcting 

software to process four-digit years does little good if 

bank databases that store the critical information about 

who owes what to whom and when still store them in 

two-digit form. Hardware is another critical area. 

Nearly all electronic devices have embedded, permanently programmed chips that can be difficult to find 

because the functions they perform are not always 

apparent. This situation could lead to a host of nuisances, with automated teller machines, point-of-sale 

terminals, bank vaults, check and credit card processing 

equipment, and even building systems succumbing to 

the Y2K problem. 

This dependence on external components and services 

creates a systemic exposure as well. The substantial 

efficiencies that now exist in transmitting payments 

among and between banks and borrowers are a direct 

result of technology. Servicers and 

clearinghouses fulfill computerintensive intermediary roles in this 

high-velocity business—pooling 

payments from those who owe and 

redistributing them among those 

to whom they are due. Anything 

that interrupts these flows can 

have a substantial impact on the ability of banks to settle with their customers and with each other. 

Accordingly, both the Bank for International 

Settlements and the U.S. Federal Reserve are concerned 

about the Y2K threat for two reasons—first because it 

can interrupt the operations of systems dedicated to 

making interbank payments and second because it can 

interrupt the operations of the individual participants 

and generate a liquidity shock that could cause other 

institutions to fail. 

Unfortunately for banks, even a fully successful, 

industry-wide Y2K fix will not completely mitigate 

their risk. The year 2000 story is simply too dramatic 

and lends itself too well to sensationalism. Therefore, 

in addition to managing the cure, bankers will have to 

manage the perceptions of their customers and of the 

public at large—a considerable challenge given that a 

loss of confidence by a small number of customers 

could precipitate liquidity problems for institutions 

even in the absence of a genuine threat. 

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

Liability in the Executive Suite 

It bears frequent repeating that Y2K is a business problem and not just a technical one. Its intricacies go 

beyond those of the systems themselves and extend into 

the labyrinth of business relationships and fiduciary 

obligations that bind directors and officers—and the 

assorted attorneys, auditors, consultants, and service 

providers who assist them—to their banks. Through this 

network could pass liability and litigation that could be 

several times the cost of fixing the problem itself. And 

although the problem may have had a technical origin, 

claims would likely be directed against those with deeper pockets who jointly and severally, it will be argued, 

should have corrected or disclosed the institution’s Y2K 

exposures. 

While the bank failures of the late 1980s and early 

1990s are often attributed to unforeseen economic 

events, it will be difficult to assert such a defense for a 

failure to address the Y2K problem. It is simply too visible and offers too much advance notice. This is one reason why the potential potency of Y2K litigation should 

be taken seriously. Moreover, placing the blame, no 

matter how well deserved, at the feet of vendors and 

consultants may offer little protection. The Federal 

Financial Institutions Examination Council (FFIEC) 

has indicated that senior bank management should be 

fully aware of their vendors’ progress and develop contingency plans should those vendors fail.3 This pronouncement has elevated the standard for prudent Y2K 

actions in such a way as to make imperative the active 

involvement of top bank management in both solving 

3 Safety and Soundness Guidelines Concerning the Year 2000 Business 

Risk, December 1997. The full text is available on the FFIEC website 

at www.ffiec.gov. 

Managing the Y2K Process 

On May 5, 1997, the Federal Financial Institutions Renovation. Renovation includes not only fixing the 

Examination Council—an interagency group com- problem internally but monitoring the efforts of cusposed of the Federal Deposit Insurance Corporation, tomers, counterparties, vendors, and service 

Federal Reserve, Office of the Comptroller of the providers. The prudent execution of due diligence and 

Currency, Office of Thrift Supervision, and National best practices at this stage will provide a measure of 

Credit Union Administration—released a statement confidence that exposures have been addressed. It 

on Year 2000 project management awareness that will also provide a measure of protection from liabilincluded an outline of the Y2K management process. ity claims should problems nevertheless emerge. 

That outline identified five phases that each financial 

institution would have to navigate in identifying and Validation. Validation means testing how a bank’s 

fixing its Y2K exposures: systems will respond on their own as well as when 

connected with those outside the bank. The FFIEC 

Awareness. Before Y2K exposures can be fixed, they believes that one full year should be available for testmust be seen as problems. Creating awareness, how- ing and correcting problems that either remain or are 

ever, is not easy because the pervasiveness of compo- introduced by the renovation process. Accordingly, 

nents and intersystem links that can harbor or pass the institutions should plan on completing the previous 

problem create complexities that are neither intuitive three phases by the end of 1998. 

nor easily quantified. However, it is critical that senior 

managers understand the problem and fully support Implementation. Testing corrected systems to ensure 

the commitment of resources to fixing it. their compliance does not complete the process. The 

final step is to gain acceptance by the users as to the 

Assessment. In this phase, all information systems, ability of the system to satisfy business requirements. 

electronic equipment, and building systems must be A failure at this stage will require further correction 

evaluated for specific Y2K exposures. Remediation or the implementation of contingency plans. 

plans must then be devised. In addition to plans for 

fixing the problem, contingency plans will be needed For the full text of this and other FFIEC guidance, see
 

as a precaution against unforeseen Y2K failures orig- the FFIEC website at www.ffiec.gov.
 

inating from both within and outside the bank.
 

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

the problem and ensuring that the franchise will be protected if one or more of those solutions fail. 

Betting the Franchise 

The FFIEC has divided Y2K remediation into five 

phases—awareness, assessment, renovation, validation, 

and implementation (see Inset 1, page 5). As a benchmark for progress, the FFIEC has indicated that the validation phase—the phase in which testing of Y2K fixes 

is conducted—should be well under way for all banks 

by the end of 1998. This leaves less than a year for laggards to complete the first three phases. Banks that are 

not devoting adequate resources to identify and address 

their exposures need to be aware that the consequences 

of delay or inaction could be severe. The bank supervisory agencies, Congress, and the financial markets are 

taking the risk to heart. So too are attorneys intent on 

sharing in what has been described as potentially the 

most expensive litigation in history. 

Insurance companies are concerned as well, as evidenced by extremely high Y2K policy premiums or outright refusal to write Y2K coverage. Thus, any business 

interruptions and liability that emerge may have to be 

financed from the bank income statement and balance 

sheet. As such, a bet that Y2K will not be a problem 

might well amount to a gamble backed by the bank franchise and those who run it. (See Inset 2 below for additional sources of information.) 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

For Further Information 

Further information on the Y2K problem can be obtained from banking regulatory agencies at the websites shown 

below. 

Federal Deposit Insurance Corporation (FDIC) www.fdic.gov 

Federal Financial Institutions Examination Council (FFIEC) www.ffiec.gov 

U.S. Federal Reserve Board of Governors www.bog.frb.fed.us 

National Credit Union Administration (NCUA) www.ncua.gov 

Office of the Comptroller of the Currency (OCC) www.occ.treas.gov 

Office of Thrift Supervision (OTS) www.ots.treas.gov 

The following websites contain additional information concerning the Y2K problem. Their inclusion here does 

not serve as an endorsement by the FDIC of any information contained therein. 

Market Partners Inc.—Year 2000 Resources for Banks www.marketpartners.com 

Gartner Group—Technology Consultant www.gartner.com 

Software Productivity Research (SPR)—Technology Consultant www.spr.com 

De Jager LLC (Peter de Jager)—Technology Consultant www.year2000.com 

Giga Information Group—Technology Consultant www.gigaweb.com 

Y2K LLC (Williams, Mullen, Christian & Dobbins)—Attorneys www.Y2K.com 

Economics Network (Dr. Edward Yardeni)—Economist www.webcom.com/yardeni 

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

Trends in Commercial Real Estate 

Loan Pricing and Underwriting 

•	 An abundant supply of capital is placing signifi- CHART 1 

cant pressure on commercial real estate loan Banks’ Commercial Real Estate and pricing. Construction Lending Rebounds 

• Considerable evidence suggests that a large per- Construction Loans 

centage of insured institutions are easing commercial real estate and construction lending 

underwriting standards. 

• The rapid rise in commercial mortgage-backed 

securities and real estate investment trust funding 

could change the way banks underwrite commercial real estate loans and have important effects 

on their competitive position in the lending 

Year-over-Year (%) Growth

20 Commercial Real Estate Loans 

10 

0 

–10 

–20 

–30 

YE90 YE91 YE92 YE93 YE94 YE95 YE96 3Q97 

markets. 

As reported in last quarter’s Regional Outlook, banks 

provided the largest share of funding for commercial 

real estate during 1995 and 1996 compared with all 

other financing sources (see Strong Demand and 

Financial Innovation Fuel Rebounding Commercial 

Real Estate Markets). Chart 1 shows that banks’ commercial real estate and construction lending continues 

to increase and that year-over-year growth rates in these 

two loan categories are accelerating. At the same time, 

however, alternative funding sources in the form of 

commercial mortgage-backed securities (CMBS) and 

real estate investment trusts (REITs) are also experiencing significant growth. Commercial Mortgage Alert 

reports that $26 billion in CMBS was issued through 

September 1997, up from $17 billion for the same period in 1996. The same publication projects that CMBS 

issuance will top $40 billion during 1997, compared 

with last year’s record issuance of $29.8 billion. 

Measures of REIT activity also indicate impressive 

growth. According to the National Association of Real 

Estate Investment Trusts, REITs issued $26.3 billion in 

equity through October, compared with $12.3 billion 

for all of 1996. In addition, REIT market capitalization 

rose $50 billion (64 percent) through the first nine 

months of 1997. 

While it is good news to borrowers, the abundance of 

capital for commercial real estate projects raises the 

often-quoted concern that “too much money is chasing 

too few deals.” Market observers worry that fierce competition and an excessive supply of financing are leadSource: Commercial Bank Call Reports 

ing to both inadequate loan pricing relative to risks 

borne by lenders and looser loan underwriting standards. This article examines current trends in commercial real estate loan pricing and loan underwriting. It 

also explores the possible influences of CMBS and 

REITs on loan underwriting practices and commercial 

real estate markets. 

An Abundance of Capital Has Placed 

Significant Pressure on Commercial Real 

Estate Loan Pricing 

Chart 2 (next page) shows that prime-graded commercial mortgage spreads have steadily declined since 1992 

and are now at levels not seen since the real estate boom 

years of 1988 and 1989. At 113 basis points above tenyear treasuries, current spreads on ten-year commercial 

mortgages are only slightly higher than A-rated ten-year 

industrial corporate bonds, which traded at spreads of 

66 basis points over comparable-term treasuries as of 

September 1997. Some property sectors have experienced more narrowing of spreads than others. 

American Council of Life Insurance (ACLI) data show 

that mortgage spreads relative to treasuries compressed 

31 basis points for industrial, 22 basis points for hotel, 

21 basis points for retail, 11 basis points for multifamily, and 10 basis points for office real estate from March 

1996 to March 1997. Moreover, because of continuing 

downward pressure, current pricing varies little across 

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

CHART 2 CHART 3 

Commercial Mortgage Spreads Are Pricing Narrows between High- and 

Tightening 

Basis Point Spread over

Ten-Year Treasuries 

Source: Barron’s/John B. Levy 

0 

50 

100 

150 

200 

250 

Jan ’87Jan ’89Jan ’91Jan ’93Jan ’95Jan ’97 

Spread between AAA and BBB


Grades (Ten-Year Average Life)
 

Medium-Grade CMBS 

Basis Points 

140 

120 

100 

80 

60
 

40
 

20
 

0 

Q1 ’95Q3 ’95Q1 ’96Q3 ’96Q1 ’97Q3 ’97 

Source: Nomura Securities International 

the quality spectrum. For instance, Chart 3 indicates 

that spreads between AAA- and BBB-rated CMBS have 

narrowed considerably since year-end 1995, from 110 

basis points to a scant 28 basis points. 

It seems likely that competitive factors will continue to 

place pricing pressure on lenders. The relatively recent 

entrance of Wall Street firms into the financing arena 

via conduits is a striking example of just how competitive the market for commercial real estate financing has 

become.1 Conduits are rapidly becoming the dominant 

issuer of CMBS and underlie much of the rapid growth 

in CMBS noted above. Through the first nine months of 

1997, Commercial Mortgage Alert reported that conduits accounted for 50 percent of total CMBS issuance, 

compared with 30 percent during the same period in 

1996. 

Many industry participants see conduits and REITs as 

significant and increasing competitive threats to traditional lenders. For example, a recent issue of 

Commercial Real Estate South discussed the continuing expansion of conduit business into a much wider 

range of property and credit quality types. This publication noted that conduits have a particular incentive to 

aggressively pursue higher quality loans in order to 

strengthen pools that contain weaker credits. Such 

aggressiveness threatens to squeeze banks’ profit margins on low-risk deals, which might give banks an 

incentive to pursue lower quality credits. Given their 

focus on larger credits, conduits presently pose a competitive threat primarily to larger lenders. However, the 

1 Conduits are entities created to originate mortgage loans for distribution to investors in the secondary market. 

rapid growth of capital within the industry may eventually force larger lenders to target smaller markets, which 

would in turn increase competition at the regional or 

local community level. While their influence is less 

direct, the growing use of REITs to finance commercial 

real estate projects also places pressure on loan pricing 

spreads, since lenders must compete for a smaller pool 

of customers. With their access to a seemingly limitless 

source of public funding, REITs could pose a particular 

threat to community bankers by dominating certain geographic markets or property sectors. 

Narrowing pricing spreads raise concerns over whether 

lenders are being adequately compensated for the operational, funding, credit, and market risk inherent in 

originating, servicing, and holding commercial real 

estate loans. More important, tightening spreads raise 

prospects that lenders will ease other loan terms and 

relax loan standards to the extent that they are unable to 

differentiate their product based solely on price. While 

such easing may enable lenders to retain business in the 

face of stiff competition, imprudent underwriting could 

ultimately lead to higher loan losses than would otherwise be the case in the event of a downturn in commercial property markets. 

Are Commercial Real Estate Loan Underwriting 

Standards Becoming Looser? 

Most industry experts have argued that the memory of 

the real estate downturn of the late 1980s and early 

1990s keeps lenders from becoming overly aggressive 

in making commercial real estate loans despite the 

abundance of funding alternatives currently available to 

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

borrowers. These experts point out that today’s loan-tovalue (LTV) ratios are lower than they were at the peak 

of the last real estate boom, that lenders are concentrating more on obtaining adequate debt-coverage ratios, 

and that lenders are requiring borrowers to bring more 

cash equity to the table. One might also argue that practices have improved and become much more uniform 

with the implementation of regulatory appraisal standards and the adoption of interagency guidelines for 

real estate lending policies. Rating agencies impose 

additional guidelines and standards as lenders originate 

loans for possible sale into the secondary markets. 

While information about specific quantitative underwriting criteria applied to new loan originations by 

commercial banks is not readily available, some sense 

of industry trends may be gleaned from competitors’ 

practices. For example, the ACLI performs a quarterly 

survey of underwriting criteria for commercial real 

estate loan commitments originated by major life insurance lenders. The ACLI’s second quarter 1997 survey 

indicated that new commitments (total volume of $4.1 

billion) had a weighted average LTV for all property 

types of 66 percent and a weighted average debt-coverage ratio (DCR)2 of 1.6 times. These figures compare 

favorably to an LTV ratio in late 1989 approaching 75 

percent and a DCR just under 1.3 times. 

ACLI data suggest that recent commercial mortgage 

originations are better supported by borrower equity 

and property cash flows than they were in the late 

1980s. It is important to recognize, however, that LTV 

and DCR ratios are driven largely by market conditions 

and expectations. Property valuations take into account 

recent sales and expected cash flows, and cash flows 

available to service debt are based on projected net 

operating revenues, which often incorporate projected 

increases in rents and other revenue sources. In other 

words, the overwhelmingly favorable conditions in 

today’s real estate markets may also be a factor in the 

improved LTV and DCR ratios. Keeping in mind the 

cyclical nature of real estate, one can easily see how a 

shift from today’s positive outlook to a more pessimistic 

outlook might result in a sharp reversal in these commonly cited ratios. 

Notwithstanding these quantitative considerations, 

there are indications that banks are easing commercial 

2 The debt-coverage ratio measures annual net operating income generated by a property relative to annual principal and interest payments 

due on the underlying loan. 

real estate underwriting standards. This evidence, 

derived from industry and examiner surveys conducted 

by the three banking agencies, includes the following 

observations: 

•	 In the Office of the Comptroller of the Currency’s 

(OCC’s) 1997 Survey of Credit Underwriting 

Practices, OCC examiners reported eased commercial real estate lending standards in 38 percent of 

banking companies surveyed. For comparison purposes, the 1996 survey reported eased standards in 

16 percent of banking companies surveyed. Among 

institutions with eased lending standards in the 1997 

survey, examiners noted a 75 percent incidence of 

reductions in loan fees or rate spreads, a 43 percent 

incidence of eased guarantor requirements, and a 29 

percent incidence of lower collateral requirements. 

Examiners cited competitive factors and a change in 

economic outlook as the main reasons for changes in 

underwriting standards. 

•	 Chart 4 summarizes current and historical results of 

the Federal Reserve Board Senior Loan Officer 

Opinion Survey for responses to the question of 

whether bank credit standards for approving applications for commercial real estate loans have eased, 

tightened, or remained unchanged. These survey 

results show that banks have had a tendency to ease 

underwriting standards since the fourth quarter of 

1996. This tendency appears to have become 

stronger through the third quarter 1997 survey but 

moderated somewhat in the most recent survey. The 

most recent survey showed that large banks (over 

$15 billion in assets) were much more likely to indicate easing commercial real estate standards than 

CHART 4 

Survey Shows Tendency to Ease Commercial 

Real Estate Underwriting Standards 

Percentage 

Source: FRB Senior Loan Officer Opinion Surveys 

2Q96 3Q96 4Q96 1Q97 2Q97 3Q97 4Q97 

–15 

–10 

–5 

0 

5 

10 

15 

20 

25

 % Respondents Tightening

 % Respondents Easing

 Net % Tightening (Easing) 

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

smaller banks. Specifically, 21 percent of large 

banks reported easing standards, while only 3 percent reported tightening standards. In comparison, 

only 9 percent of smaller banks reported easing 

standards, while 13 percent reported tightening 

standards. 

•	 Results from the FDIC Report on Underwriting 

Practices indicate possible easing of standards for 

construction and development (C&D) loans at 

FDIC-supervised banks. A comparison of examiner 

responses for the third quarter 1997 survey (covering 

examination reports filed from April through 

September 1997) with responses for the third quarter 

1996 survey leads to the following observations3

: 

•	 The percentage of banks frequently or commonly 

originating C&D loans tied to speculative projects 

(that is, projects lacking meaningful preleasing or 

presales, or loans without a formal take-out commitment for permanent financing following completion 

of construction) rose markedly, from 11 percent to 

29 percent. 

•	 The percentage of banks frequently or commonly 

granting C&D loans without considering alternative 

repayment sources other than income generated by 

the project being financed rose significantly, from 8 

percent to 20 percent. 

•	 The percentage of banks frequently or commonly 

basing C&D loans on unrealistic appraisals rose 

from 5 percent to 11 percent. 

•	 The percentage of banks frequently or commonly 

funding or deferring interest payments during the 

term of construction loans rose from 7 percent to 15 

percent. 

Much of the commentary in recent issues of various 

trade journals echoes the results of these regulatory surveys.4 In brief, many industry participants are seeing a 

higher incidence of (1) banks funding construction loans 

without preleasing commitments on major portions of 

rentable space, (2) banks easing LTV ceilings, (3) 

3 The authors of this survey note that comparisons of survey results 

across time periods must be interpreted with caution since the survey 

samples are dictated principally by examination scheduling factors. 

As a result, sample populations may be materially different from one 

period to another. 

lenders curtailing reserve requirements for such items as 

tenant improvements and insurance, and (4) nonrecourse 

lending. Some industry participants have also noted the 

increasing acceptance of “trended rents,” whereby property valuations are based on positive rent projections 

extrapolated several years into the future. Of course, 

these trended rents will hold true only if economic circumstances remain favorable for extended periods— 

an assumption that may not be reasonable given 

the cyclical nature of real estate coupled with 

the advanced age of the current economic 

expansion. 

With a combination of relatively low 

interest rates, rising real estate prices, 

and an expanding economy, it is perhaps not too surprising that some 

lenders have eased commercial real 

estate underwriting standards. Such 

easing may be a natural response to 

improved confidence in the real estate 

markets. However, indicators that show 

loosening standards may also be warning flags that lenders have succumbed to tighter pricing 

and competitive pressures. To avoid losses like those 

sustained by banks during the last real estate downturn, 

prudent lenders will refrain from incorporating unrealistic expectations into their lending practices. 

CMBS Could Change the Way 

Lenders Underwrite Loans 

Much as residential mortgage lending standards were 

shaped by the advent of mortgage-backed securities, 

CMBS promise to change the way banks underwrite and 

service commercial real estate loans. For instance, lending terms and practices could become increasingly standardized as lenders attempt to improve the liquidity and 

marketability of their commercial mortgage portfolios. 

Banks that choose to deviate from these emerging standards will sacrifice flexibility in terms of their ability to 

manage portfolio risks and respond rapidly to liquidity 

demands. 

The ability to securitize commercial real estate loans 

also may fundamentally alter the way lending decisions 

4 See, for example, Commercial Real Estate South, “Public Markets 

Fuel Financing Glut” (October 1997); Midwest Real Estate News, 

“Wall Street and Main Street Squeeze Lenders” (October 1997); and 

Commercial Property News, “Michelson, Greenland Seize Low 

CMBS Spreads” (1 May 1997). 

New York Regional Outlook 10	 First Quarter 1998 
In Focus This Quarter
 

are made. Before the development of CMBS markets, 

loan approval was essentially a binary, good-or-bad, 

accept-or-reject decision whose primary focus was on 

the credit risk inherent in a single asset. In contrast, the 

most important elements in CMBS are deal structure, 

price execution for multiple tranches, credit enhancements, and portfolio composition. Here, the loan originator is more likely to use a portfolio approach in 

making credit decisions: That is, how will this loan 

enhance the expected return and risk diversification of 

the overall pool? 

External rating agencies will become increasingly 

important as CMBS markets expand, since these agencies’ guidelines will effectively dictate the underwriting 

standards applied to securitized loans. While such standardization could arguably improve market discipline 

and loan performance disclosure, there are several 

potential risks to consider as the CMBS markets evolve: 

•	 While rating agencies do incorporate qualitative considerations into their analysis, issue ratings and credit enhancement level decisions are driven primarily 

by quantitative factors, namely debt service coverage 

and expected loss levels. Moreover, most of the qualitative factors the agencies consider involve an 

analysis of portfolio balance and pool diversification. Hence, weak or poor qualitative standards (for 

example, lack of alternative repayment sources or 

minimal borrower equity in the project) applied to 

individual loans within the pool may receive only 

secondary consideration. A quantitative perspective 

also ignores such immeasurable factors as borrower 

“character” and the existence of long-standing 

lender-borrower relationships. 

•	 Rating agencies cannot be relied upon as a backstop 

to unsound underwriting practices. While they generally review a substantial volume of the loans within a pool, typically the largest individual credits, they 

are not practically able to review every credit in the 

securitization. Some within the industry have even 

suggested that investment bankers commonly move 

one problem property, discovered through one 

agency’s sample, into pools reviewed by another 

agency in the hope that it will not be sampled. 

•	 Competition among the rating agencies could 

become a factor in the underwriting process. This 

“shopping of the agencies” could result in continual 

pressure for rating agencies to ease their underwriting guidelines. 

•	 In theory, bank-issued CMBS transfer much of the 

underlying credit risk associated with commercial 

real estate lending to investors. However, like other 

types of asset securitization, CMBS raise concerns 

over the degree to which banks will voluntarily 

absorb investor losses. Bank issuers may be more 

likely than nonbank issuers to provide voluntary support to poorly performing CMBS for at least two reasons: A tarnished reputation in one aspect of a bank’s 

operations could carry over to other business activities like deposit taking and borrowing due to a bank’s 

broad brand name association within the marketplace; and banks often have greater financial 

resources than nonbanks with which to support securitization activities. 

Because the rapid growth in CMBS has been a relatively recent phenomenon, current underwriting guidelines 

applied by the rating agencies to CMBS have not been 

tested during a cyclical downturn in real estate prices. It 

remains to be seen how the market will react to rising 

loan losses that result in investor losses. 

Will Increased Public Funding through CMBS 

and REITs Improve Market Discipline? 

Many contend that the increased transparency brought 

to the market by CMBS will temper cyclical swings in 

real estate values. This viewpoint argues that investors 

will serve as a constraint against the natural tendency to 

overbuild commercial real estate during boom periods, 

since less funding will be allocated to segments of the 

market where excess capacity exists. This viewpoint 

presupposes that the investing public is sophisticated 

enough to recognize when markets are out of balance 

and when projects are economically infeasible. In this 

sense, CMBS shift much of the burden of monitoring 

credit quality standards and credit performance from 

lenders to public investors. 

In contrast, others have argued that lenders are much 

better suited than investors to make judgments about 

credit quality standards and project feasibility. This line 

of reasoning suggests that the increase in public ownership of property through CMBS and REITs could actually reduce market discipline, since the most 

sophisticated participants with access to the best information (that is, lenders) may come to have less at stake 

in making prudent credit decisions. Of course, excessive losses attributable to any one CMBS issuer might 

lead to differentiation in pricing based on investors’ 

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

perceptions of the quality of underwriting applied by 

specific issuers.5 

Putting market efficiency arguments aside, the sheer 

volume of REIT and CMBS activity causes some concern over the extent to which such financing is driving 

property valuations. With such an abundance of capital 

flowing into the commercial real estate market, it is perhaps easy to see why lenders might opt to ease standards 

rather than lose business. However, to the extent securitization activities are driving decisions in today’s commercial real estate markets, lenders might wish to 

consider how property values would react if the availability of such financing were sharply diminished. The 

most recent real estate downturn provided a ready 

example of how tighter credit availability compounded 

the effects of declining commercial property values by 

limiting the ability of lenders to sell distressed properties. While there may not be consensus on whether 

CMBS and REITs will temper cyclical price swings, the 

underwriting standards and practices evolving in 

response to these financing vehicles will likely play a 

crucial role in determining the magnitude of losses 

experienced by investors and banks during the next 

downturn in commercial property values. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Selected Articles
 

for Further Reading
 

Bloomfield, Craig. “Michelson, Greenland Seize 

Low CMBS Spreads.” Commercial Property News. 

1 May 1997. p. 33. 

“CMBS Issuance Seen Topping $40 Billion.” 

Commercial Mortgage Alert. 10 November 1997. 

p. 1. 

Fitch Investor Services, Inc. “Commercial 

Mortgage Stress Test.” Fitch Research: Structured 

Finance Special Report. 8 June 1992. 

Office of the Comptroller of the Currency. Advisory 

Letter 97-3: Credit Underwriting Standards and 

Portfolio Credit Risk Management. 3 March 1997. 

Sinderman, Martin. “Public Markets Fuel 

Financing Glut.” Commercial Real Estate South. 

October 1997. p. 1. 

Wolf, Barney. “Wall Street and Main Street 

Squeeze Lenders.” Midwest Real Estate News. 

October 1997. p. 1. 

5 The evolution of the credit card securitization markets is one example of how investors now differentiate between issuers in terms of 

pricing. 

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

Regional Results: General
 

Underwriting Trends
 

Regional responses to the Report on Underwriting 

Practices during the reporting period indicated that an 

equal proportion of banks examined had either tightened or loosened underwriting standards since the last 

examination (see Chart 5). Of the 72 banks examined 

in the New York Region during the reporting period, 

3 percent had tightened underwriting practices while 

3 percent had loosened them. 

Highlights in construction lending underwriting 

trends in the New York Region include the following: 

•	 Just over 6 percent of banks examined were funding construction projects on a speculative basis 

without meaningful pre-sale, pre-lease, or take-out 

commitments “frequently enough to warrant 

notice.” 

•	 An equal percentage of banks examined were 

making construction loans without consideration 

of repayment sources other than that the project 

was being funded “commonly or as standard 

procedure.” 

•	 Nearly 8 percent of banks examined were funding 

or deferring interest payment during the term of 

construction loans “commonly or as a standard 

procedure.” 

CHART 5 

Tighter 3% 

Looser 3% 

Unchanged 94% 

Source: Report of Underwriting Practices 

Have the Institution’s Underwriting Practices

 Materially Changed since the Last Exam? 

(Percent of Responses Received: 4/97–9/97) 

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

Total Return: A Useful Tool for
 

Monitoring Investment Portfolio Risk
 

•	 The Federal Financial Institutions Examination 

Council (FFIEC) is replacing the 1991 policy that 

contained a specific “high-risk test” for mortgage 

derivative products (MDPs) held by insured institutions with a policy that encourages risk management across all types of instruments on an 

investment portfolio basis. 

•	 A good way to start measuring portfolio risk is by 

monitoring an appropriate measure of return. 

•	 Total return, a concept that includes fluctuations 

in market value, is a more appropriate tool than 

simple yield for measuring the performance of an 

investment portfolio, especially one that contains 

bonds with embedded options. 

The Federal Financial Institutions Examination Council 

(FFIEC) has released for comment a new Joint Agency 

Policy Statement on Investment Securities and EndUser Derivatives Activities that will replace a statement 

issued February 3, 1992. While much of the content of 

the former statement has been retained, the section 

requiring specific “high-risk” testing for mortgage 

derivative products (MDPs) has been eliminated. The 

“high-risk” test applied specifically to bonds collateralized by residential mortgage pass-through certificates 

or whole loans but that distributed cash flows to bondholders on a basis other than pro rata.1 

The goal of the original policy statement was to deter 

banks from investing in products that presented risks 

that they were not able to adequately monitor and control. MDPs were singled out because of their rapid 

growth, nontraditional and potentially risky nature, and 

common use by insured financial institutions. The new 

policy states that, as a sound management practice, 

institutions should conduct prepurchase and ongoing 

analysis of all their investments at a level appropriate to 

the size and complexity of those holdings. 

1 A security was deemed “high risk” if it exhibited any of the following characteristics: (1) it had a weighted average life of more than ten 

years; (2) its average life extended by more than four years or shortened by more than six years from a 300 basis point parallel shift in 

rates; (3) its price changed by more than 17 percent given a 300 basis 

point parallel shift in rates. 

The policy change is in part a response to increasing 

bank investment in securities that have complex cash 

flows analogous to MDPs but that escaped the analysis 

requirement of the previous policy. Mortgage index 

amortizing notes are an example of popular bank investments that potentially exhibit all the risks of MDPs but 

were not subject to the testing requirement of the soonto-be rescinded policy because they are not collateralized by mortgages. Callable agency and “step-up” 

bonds are popular bank investments because they offer 

a slightly larger spread to Treasury than noncallable 

agency securities, and they were not subject to the 

“high-risk” test under the old policy. However, the additional yield offered on these kinds of securities compensates the investor for assuming additional risk. 

Appropriately measuring portfolio return can enhance 

the ability to monitor the extent to which these kinds of 

securities put future earnings at risk. 

Total Return Analysis Is a Useful Tool for 

Analyzing Risk at the Portfolio Level 

Total return analysis is a basic but useful tool that can 

alert management to the level of certain risks in an 

investment portfolio. It can also provide information 

that is useful for validating the assumptions used in 

more sophisticated models. Total return is calculated 

from three components: beginning price, income and 

reinvested cash flow, and ending price (market value) at 

a horizon date. Total return incorporates the change in 

the market value of the investment, resulting in a more 

comprehensive measure of performance than other 

measures that ignore such changes. Monitoring total 

return on a portfolio basis can provide institutions with 

important information about the risks inherent in the 

portfolio and how these risks may be changing over 

time. 

In two articles in the ABA Banking Journal,

2 Nicholas 

Betzold and Richard Berg convincingly dispute the 

2 The articles were published in December 1996 and April 1997. 

Reprints of the articles are available at the ABA Banking Journal website at http://www.banking.com.aba/backissues.htm. 

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

view that if the investment strategy is to buy and hold to 

maturity, total return is not relevant. Consider the following example. In 1990, Bank A purchases a sevenyear security yielding 8.83 percent that is callable after 

three years. At the same time, Bank B buys a noncallable seven-year agency security yielding 8.53 percent. For three years, Bank A’s bond yields 30 basis 

points more than Bank B’s. However, from 1990 to 

1993, interest rates fell almost 300 basis points. Bank 

A’s bond would likely be called, forcing the bank to 

reinvest at a significantly lower rate for the remaining 

four years of the seven-year investment horizon. Over 

the seven-year horizon, Bank A could expect an average 

yield that is about 150 basis points less than Bank B’s. 

From the yield perspective, 

Bank A enjoyed three years of 

superior performance. However, during those three years, 

monitoring total return might 

have revealed a less favorable 

but more accurate picture of 

Bank A’s performance relative 

to Bank B’s. Here is why: As 

rates fell from 1990 to 1993, bonds gained in value. 

However, as rates fell, the market value of the callable 

security would have gained incrementally less than the 

noncallable bond because each downward tick in rates 

increased the expectation that the bond would be called, 

and the higher coupon would be earned over a shorter 

period. In contrast, the noncallable security’s market 

value would have enjoyed the full benefit of the falling 

rate environment because its maturity and cash flows 

are fixed. 

The disparate change in the market value of the two 

bonds reflects the fact that Bank A, in essence, sold a 

call option to the bond issuer. The issuer bought the 

right to repurchase the debt at par after three years. 

Bank A was compensated for selling this right to the 

issuer with increased yield. In the example, the issuer’s 

option to call the bond would have gained value as rates 

fell. The increasing positive value of the call option to 

the issuer represents an increasing negative value to the 

bondholder and erodes the value of the bond. 

Step-up bonds present reinvestment risk similar to that 

of generic callable bonds, but with the added complexity of a coupon that rises, usually annually, if the bonds 

are not called. Total return analysis would similarly 

reveal adverse changes in the value of the embedded 

call options and the extent to which the additional 

coupon is compensating for call risk. 

UBPR Yield 

Bank management often uses the portfolio yield that is 

calculated in the Uniform Bank Performance Report 

(UBPR) to assess performance of the bank’s securities 

portfolio against its peers. This yield measure is calculated by dividing annualized book income on a tax 

equivalent basis (plus or minus amortization or accretion of any premium or discount) by the amortized cost 

of the securities. This measure of present yield says little about potential future yield and the extent to which, 

because implicit options have been sold, the latter has 

been put at risk for the sake of the former. 

Total return measures the risk-adjusted return of a portfolio more closely than yield because it incorporates 

changes in reinvestment risk over time. Ultimately, a 

portfolio manager who earns total returns consistently 

higher than average will earn more in terms of simple 

yield. Conversely, a manager who earns less in terms of 

total return will eventually find an unfavorable reinvestment environment that will erode reported yield. 

The popularity of using yield to gauge the performance 

of bank securities portfolios may be due to the convenient presentation of bank peer portfolio yields in the 

UBPR. Some managers may be reticent to evaluate 

portfolio performance using total return without a peerlike benchmark for calibrating total return expectations. 

Betzold and Berg have devised an investment portfolio 

index (introduced in the April 1997 ABA Banking 

Journal) that is designed to track the total return of a 

typical bank portfolio composed of the same percentages of investment sectors as the average bank. The 

portfolio on which the index is based is rebalanced 

monthly as principal pays down, and it is rebalanced 

quarterly to reflect the latest Call Report data on portfolio allocations. Table 1 depicts the investment weighting of the index as of December 31, 1996, based on 

September 30, 1996, Call Report data. 

According to Betzold and Berg, this index produced 

total returns that closely approximated those of the actuNew York Regional Outlook 15 First Quarter 1998 
In Focus This Quarter
 

al median bank total portfolio measured by Call Report 

data from 1993 through third quarter 1997.3 They concluded that their index seems to provide a reasonable 

proxy for the total return of the “average” bank investment portfolio. 

Chart 1 shows the performance of the index so far this 

year.4 Changes in the index value over time can be translated into total returns that approximate the median 

bank portfolio’s total return. For example, the annualized total return for the index from year-end 1996 

through third quarter 1997 was 6.72 percent and is calculated as follows: 

Calculate the bond equivalent semiannual yield 

and express the semiannual bond equivalent yield 

as an effective annual yield. 

4

: 105.00 3

6.72% = 100 [(:) − 1

100.00 ]

The performance of the index for 1997 suggests that 

banks’ total investment portfolio returns were highly 

negatively correlated with changes in the five-year 

Treasury rate (see Chart 2). This finding indicates that 

changes in total return from period to period can provide useful information about the level of a portfolio’s 

interest rate sensitivity. As emphasized above, these 

changes in total return over time include the effects of 

changes in market value of any call options on a bank’s 

investment securities and hence provide information 

about the degree to which future income is at risk. 

Given the increasing level of optionality embedded in 

the average bank securities portfolio—even if it arises 

solely from callable agency debt and “step-up” structured notes—yield should not be the sole measure of 

overall portfolio performance. Total return analysis is an 

appropriate supplement that gauges the risk-return characteristics of an investment strategy that involves selling 

implicit options. 

Allen Puwalski, Senior Financial Analyst 

3 While the Call Report does not contain the information necessary to
 

compute total return precisely, the authors computed an estimate
 

using the reported yield and market value data.
 

4 The index is published monthly in the ABA Banking Journal.
 

TABLE 1 

Composition of Betzold Berg Index 

December 31, 1996 

PERCENT 

SECURITY TYPE OF INDEX 

TREASURIES 24.52 

AGENCIES 24.38 

MUNICIPAL BONDS 12.26 

FIXED-RATE MORTGAGE OR 

MORTGAGE-RELATED PRODUCTS 19.93 

OTHER SECURITIES 6.09 

ADJUSTABLE-RATE SECURITIES 13.00 

Source: Bank and Thrift Call Reports, September 30, 

1996 

CHART 1 Index Value 

Index Tracks the Total Return of an 

“Average” Bank Portfolio 

Source: ABA Banking Journal 

100.84 

104.31 

Dec Jan Feb Mar Apr 

100 

101 

102 

103 

104 

105 

106 

May Jun Jul Aug Sep 

100.51 100.71 

101.49 

102.23 

103.06 

104.03 

105.00 

100.00 

CHART 2 

Total Return Index Is Correlated 

to Changes in Interest Rates 

Source: ABA Banking Journal, Bloomberg 

5-year Treasury 

(right scale) 

Betzold Berg Index 

(left scale) 

Percent Change Percent Change 

–10 

–5 

0 

5 

10 

Jan-97

Feb-97

Mar-97

Apr-97

May-97

Jun-97

Jul-97

Aug-97

Sep-97 

–0.20 

0.00 

0.20 

0.40 

0.60 

0.80 

1.00 

New York Regional Outlook 16 First Quarter 1998 
Regular Features	 Regional Economy
 

New York Region:
 

Expansion Continues, but Big Cities Lag
 

•	 The New York Region is continuing its job expansion, although growth slowed somewhat during the third 

quarter of 1997. 

•	 The largest cities in the Region, including Baltimore, New York City, Philadelphia, and Washington, D.C., 

continue to lag behind the Region in job growth. 

• After almost two decades of economic growth, Puerto Rico’s employment growth appears to be leveling off, 

especially in the business service and lodging sectors. 

Regional Employment Gains Continue, 

Although at a Slower Pace 

Employment expansion in the New York Region continued in the third quarter of 1997, with about 270,000 

new jobs added compared to the third quarter of 1996. 

This increase represents growth of about 1.3 percent, 

which is somewhat slower than the 1.7 percent Regional 

job growth recorded in the first half of 1997, compared 

to the first half of 1996. Employment growth in the 

Region still lags the nation despite the new jobs. In the 

third quarter of 1997, the nation’s job base grew 2.2 percent. 

The Region’s largest cities, including Baltimore, New 

York City, Philadelphia, and Washington, D.C., continue to lag behind the rest of the Region in employment 

growth. The slower growth of these cities, in part, 

explains why the Region is growing more slowly than 

the nation. In 1996, these four cities combined had a 

population of more than ten million people, representing slightly more than one-fifth of the Region’s population. In that year, they had a combined nonfarm 

workforce of over five million workers, hosting nearly 

one-quarter of all the jobs in the Region. 

Continuous erosion of the employment bases in 

Baltimore, Philadelphia, and Washington, D.C., has 

taken place since 1990, as shown in Chart 1 (next page). 

Between 1989 and 1996, Baltimore lost 70,000 jobs or 

almost 15 percent of its workforce. During that same 

time frame, Philadelphia lost more than 85,000 jobs or 

11 percent of its workforce, and Washington, D.C., lost 

about 58,000 jobs or 8.5 percent of its workforce. In 

New York City, where the recession was the most 

severe, job losses totaled more than 250,000 or about 7 

percent of the city’s employment base. 

Recent job growth in these large cities remains modest 

despite the strong national economy. Between 1993 and 

1996, New York City regained more than 74,000 jobs, 

representing 1.3 percent average annual growth over the 

three-year period. Moreover, during the first three quarters of 1997, New York City added about 46,000 new 

jobs, representing a 1.4 percent growth rate compared to 

the same period in 1996. Baltimore and Philadelphia 

have experienced only minimal job growth during the 

first three quarters of 1997. Conversely, Washington, 

D.C., lost more than 8,000 jobs or 1.3 percent of its 

workforce over the first three quarters of 1997, compared to the same period in 1996. 

Unemployment Rates for the Cities Are Well 

above Those for the Surrounding Suburbs 

As a result of the slow job growth, the unemployment 

rates for the cities are well above those for the surrounding suburbs. For example, during the first three 

quarters of 1997, unemployment rates in suburban Anne 

Arundel, Carroll, Frederick, Howard, and Montgomery 

Counties in Maryland were four to five points below 

the 8.4 percent average rate in Baltimore. The same is 

true of Philadelphia, where the average unemployment 

rate of 6.7 percent is two to four points higher than in 

the surrounding Pennsylvania counties of Bucks, 

Delaware, Lancaster, Chester, and Montgomery. 

Furthermore, unemployment rates in Charles and Prince 

George’s Counties in Maryland are three to four points 

below Washington, D.C.’s, 7.7 percent unemployment 

rate. The largest discrepancy is in New York City, where 

the unemployment rate recently has approached double 

digits. Unemployment rates are five to six points lower 

in suburban Nassau, Suffolk, and Westchester Counties 

in New York State. In general, the suburban areas have 

New York Regional Outlook 17	 First Quarter 1998 
Regular Features Regional Economy
 

CHART 1 

Big Cities Have Yet to Regain Jobs Lost during
 

the Last Recession
 

(1990=100)
 Index Value 

110 

Washington, D.C. 

100 

Baltimore 

New York City 

90 

Philadelphia 

80 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 

Source: Bureau of Labor Statistics 

benefited more than the cities from job increases in 

business services, high-tech industries, and health care. 

The cities have not attracted these kinds of jobs to the 

same degree, and they continue to lose manufacturing 

positions. 

Population Loss Follows Job Decline 

Employment and population growth are often associated. Employment growth can stimulate population 

growth as more workers migrate into the area to take 

advantage of employment opportunities. Once living in 

the area, more people generate increased demand for 

goods and services, which may in turn create more local 

jobs. On the other hand, declining population is often 

associated with job losses. In three of the Region’s four 

largest cities, losses in jobs have paralleled losses in 

population (see Chart 2). Only in New York City did the 

population remain relatively steady. The relative stability of New York City’s population may be a factor in its 

recent modest turnaround. 

Personal Income Growth Also Is 

Stronger in the Suburbs 

Personal income growth generally tracks employment 

growth, and the big cities are lagging in that measure as 

well. For example, between 1990 and 1995, personal 

income in the United States rose 28 percent or about 5 

percent a year. However, in Philadelphia it rose less than 

half that amount, or 13.5 percent, while in Baltimore 

personal income rose only about 15 percent. In 

Washington, D.C., personal income rose 19 percent, and 

CHART 2 

Job Losses Usually Follow Population Declines 

(percent change: 1990–1996) 

Baltimore 

New York 

Philadelphia 

Washington, D.C. 

Jobs 

Population 

–15 –10 –5 0 5 

Percent Change 

Source: Census Bureau 

in New York City it rose 22 percent. New York City’s 

personal income growth has been boosted by the large 

bonuses Wall Street paid in recent years as the stock 

market surged. 

Personal income growth patterns are similar to employment growth patterns in that the surrounding suburban 

counties are outperforming the Region’s largest cities. 

Personal income growth in the surrounding counties of 

Baltimore ranged between 25 and 36 percent between 

1990 and 1995. In the counties surrounding 

Philadelphia, personal income growth ranged from 20 

to 37 percent, while in the surrounding counties of 

Washington, D.C., personal income rose between 26 

and 29 percent. Only New York City had comparable 

personal income growth rates with its surrounding 

counties. Personal income growth ranged from 16 percent in Nassau County to 23 percent in Westchester 

County. 

Why Are These Cities Underperforming? 

There are many explanations for the lagging performance of these cities, including the age of the cities, 

high taxes, costs of doing business, quality of life, and 

population changes. All of the Region’s four largest 

cities are older industrial cities, with aging infrastructure and transportation systems, a relative lack of space 

for business expansion, and an acute housing shortage. 

Quality of life issues—including personal safety, educational opportunities, housing stock, cultural attractions, restaurants and park facilities, and overall 

congestion—clearly affect location decisions for businesses and individuals. 

New York Regional Outlook 18 First Quarter 1998 
Regular Features Regional Economy
 

Another major factor is the cost of doing business. 

Although the degree to which businesses make location 

and expansion decisions based on local costs cannot be 

precisely measured, it is clear from numerous surveys 

that taxes, energy, labor, and telecommunication costs 

can help or hurt a company’s bottom line. In the aggregate, these factors may have an important effect on an 

area’s growth rate. The 1997 annual study of metropolitan area business costs for 100 metropolitan areas by 

Regional Financial Associates (RFA) indicates that the 

Region’s major cities score very high in cost components (see Table 1). The data used by RFA included four 

components: unit labor costs, office rents, energy costs, 

and taxes. All the Region’s largest cities scored in the 

top ten for the combined cost category, with New York 

City ranking number one in most of the categories. 

Puerto Rican Economy Expanded 

during the 1980s and 1990s 

Puerto Rico has experienced a wide-ranging expansion 

since fiscal year 1985, with growth in almost every sector of its economy and record levels of employment. 

Although increases in real gross national product 

slowed to less than 1 percent in fiscal year 1991, reflecting the effects of the recession in the U.S. economy, the 

more rapid growth pattern resumed after the U.S. recession. Gross national product increases of 3.4 percent 

and 3.1 percent for fiscal years 1995 and 1996 outperformed growth rates in the U.S. economy (see Chart 3). 

Factors contributing to Puerto Rico’s long-term expansion include government-sponsored economic development programs, relatively stable prices of oil imports, 

the continued growth in the U.S. economy, and the relatively low cost of borrowing from the mid-1980s to the 

present. 

According to the 1997 Commonwealth of Puerto Rico 

Official Statement, the economy in Puerto Rico is now 

more diversified than it was in earlier periods of its 

TABLE 1 

CHART 3 

Source: Commonwealth of Puerto Rico Official Statement Percent Change 

Puerto Rico 

U.S. 

Puerto Rico’s GNP Has Expanded 

since the Mid-1980s 

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

–1 

0 

1 

2 

3 

4 

5 

development. Over the past 20 years, industrial development, for example, has become more capital intensive and more dependent on skilled labor. This gradual 

shift in emphasis is best exemplified by the heavy 

investment in pharmaceutical, scientific instrument, 

computer, microprocessor, medical product, and electrical product industries over the past decade. The Puerto 

Rican economy also has become more service oriented, 

with growth in business, social, and health care services 

taking a greater share of the new jobs. One of the major 

factors aiding the development of the manufacturing 

sector has been tax incentives offered by the federal and 

Puerto Rican governments. However, federal legislation 

amending Internal Revenue Code Section 936 phases 

out the federal tax incentives over a ten-year period 

beginning last year (see Regional Outlook, First 

Quarter 1997.) 

The strong growth in the economy has been responsible 

for declining unemployment rates in all the metropolitan areas in Puerto Rico (see Table 2, next page). 

However, the 13.5 percent overall unemployment rate in 

Puerto Rico is still high compared to the U.S. unemployment rate, which averaged about 5 percent throughout 1997. 

Largest Regional Cities Rank High in Business Costs - 1997 (U.S. Index = 100) 

COMBINED RANK LABOR RANK ENERGY RANK TAXES RANK RENT RANK 

BALTIMORE 112.1 6 101.9 44 105.9 39 130.4 9 89.2 39 

NEW YORK 129.0 1 103.9 32 187.8 1 180.6 2 151.8 1 

PHILADELPHIA 110.0 10 103.8 33 148.9 4 105.1 44 96.5 27 

WASHINGTON, D.C. 112.4 5 104.8 27 94.7 53 186.0 1 151.1 4 

Source: Regional Financial Associates 

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

TABLE 2 CHART 4 

Puerto Rican Unemployment Rates 

Remain High in the 1990s 

1991 1993 1995 1996 1997 

PUERTO RICO 16.0 17.0 13.7 13.4 13.5 

AGUADILLA 

ARECIBO 

CAGUAS 

MAYAGUEZ 

PONCE 

SAN JUAN 

20.3 

18.3 

16.6 

18.6 

20.0 

13.3 

21.8 

19.2 

17.0 

18.2 

21.7 

14.1 

18.1 

16.6 

13.3 

14.8 

17.3 

11.8 

19.9 

16.2 

12.4 

15.7 

18.3 

10.6 

20.1 

16.1 

12.2 

16.7 

18.1 

10.7 

UNITED STATES 6.8 6.9 5.6 5.4 5.1 

Source: Bureau of Labor Statistics. 1997 Is Average of 

First Three Quarters. Source: Bureau of Labor Statistics. 

* First three quarters only. 

Percent Change 

Job Growth in Puerto Rico 

Fell Off in 1997 

–2 

–1 

0 

1 

2 

3 

4 

5 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97* 

U.S. Puerto Rico 

Puerto Rico’s Employment Growth 

May Be Leveling Off 

Job growth in Puerto Rico in 1997 may be leveling off. 

After adding almost 32,000 jobs (3.5 percent) in 1995 

and 37,000 jobs (almost 4.0 percent) in 1996, growth 

during the first three quarters of 1997 dropped to 2,000 

jobs (less than 1 percent) compared to the same period 

in 1996 (see Chart 4). The slowdown contrasts with 

Puerto Rico’s rapid growth throughout the 1980s and 

1990s, when Puerto Rico added a substantial number of 

jobs to its workforce. Between 1990 and 1996, for 

example, Puerto Rico added more than 120,000 jobs, 

for an increase of about 2.2 percent on an annual average basis. The San Juan area, which represents almost 

65 percent of the island’s workforce, added more than 

84,000 jobs, or 2.5 percent annually. The other major 

metropolitan areas combined (Caguas, Mayaguez, and 

Ponce) added about 38,000 jobs, or 3.4 percent annually. These growth rates exceeded comparable U.S. rates, 

which were about 1.5 percent on an annual average 

basis. 

Some of the slowdown can be traced to a sharp decline 

in business service employment growth, which had 

risen at about 10 percent annually in 1995 and 1996. 

This sector grew less than 1 percent during the first 

three quarters of 1997 compared to the same period in 

1996. The erosion of manufacturing jobs is also hurting 

growth in the economy. Manufacturing employment 

was down 0.5 percent in 1996 and declined another 1.3 

percent through the first nine months of 1997 compared 

to the same period in 1996. In addition, during the first 

three quarters of 1997, employment in the hotel and 

lodging industries dropped 4.9 percent compared to the 

same period a year earlier. Ironically, these industry sectors are currently adding jobs throughout the Region 

and the United States, and they are partially responsible 

for the record job expansion in the nation. 

The slowdown also may be related to changes in Section 

936 implemented in 1996. However, a General 

Accounting Office study published in May 1997 was 

unable to conclude whether the loss of the tax provisions would have a detrimental effect on the Puerto 

Rican economy. At the time of the study, the economic 

indicators through 1996 looked positive. Nevertheless, 

some negative effects from the provision’s loss may now 

be taking place. In response to the loss of Section 936, 

the government recently passed several local tax incentive measures designed to stimulate business development. 

Implications: It is still uncertain whether the leveling 

off in employment growth in Puerto Rico is a result of 

the loss of Section 936 or is a short-term cyclical event. 

It is possible that employment growth will bounce back 

in 1998. However, after almost two decades of sustained 

economic expansion, the Puerto Rican economy may be 

entering a period of slower growth. If so, loan demand 

may slow and banks may have to adjust temporarily to 

a more slowly growing economy. If the slowdown is 

structural and due to the loss of Section 936, banks may 

have to adjust more permanently to a changed economic environment. 

Norman Gertner, Regional Economist 

New York Regional Outlook 20 First Quarter 1998 
Regular Features	 Regional Banking
 

Current Regional Banking Issues
 

•	 The New York Region’s financial institutions report solid performance. 

•	 Credit card banks’ charge-off rates and past due levels continue to rise. 

•	 The wave of mergers and acquisitions in the Region persists as the regulatory environment changes and 

competition intensifies. 

• New bank formation in the Region heats up, especially in New Jersey and Pennsylvania, as merger activity 

leaves fewer independent community banks. 

The Region’s Insured Institutions Remain 

Healthy, Despite Credit Card Problems 

The Region’s banks and thrifts reported relatively strong 

financial conditions for the nine months ended 

September 30, 1997 (see Table 1). Insured institutions 

in the New York Region reported a return on assets 

(ROA) slightly higher than one year earlier, despite a 

decline in net interest margin (NIM), primarily due to 

an increase in noninterest income. The Region’s average 

leverage capital ratio fell slightly over the same period 

but continues to be strong. Insured institutions showed 

a continued decline in nonperforming assets (NPA) in 

the third quarter of 1997, reflecting improvement in 

TABLE 1 

New York Region Institutions 

Continue to Show Strength 

9/30/97 9/30/96 9/30/95 

RETURN ON 

ASSETS 1.04 1.01 1.11 

NET INTEREST 

MARGIN 3.51 3.69 3.82 

RATE OF 

EXCHANGE 13.82 13.40 14.50 

TIER 1 

LEVERAGE 7.18 7.25 7.43 

NONPERFORMING 

ASSETS/TOTAL 

ASSETS 0.83 1.00 1.22 

PAST DUE 

LOANS (%) 2.58 2.72 3.07 

NONPERFORMING 

RESIDENTIAL 

REAL ESTATE 

LOANS (%) 2.88 2.00 2.15 

Source: Bank and Thrift Call Reports 

commercial real estate loan portfolios. Residential real 

estate portfolios, however, are showing signs of weakness as nonperforming residential real estate loans have 

increased to a weighted average of 2.82 percent from 

1.91 percent a year ago. This ratio, weighted based on 

one- to four-family first-lien residential real estate 

loans, is highest in northern New Jersey, Puerto Rico, 

and upstate New York.

1 Since residential loans make up 

about 25 percent of the Region’s total loans, any negative trend in that sector warrants attention. 

The Region’s 26 credit card banks continued to report 

higher charge-off rates in the third quarter. Their 

weighted average charge-off rate was 5.96 percent, 

compared to 5.67 percent as of June 30, 1997, and 3.72 

percent as of December 31, 1996. Past due and nonaccrual rates, which had been declining over the previous 

two quarters, rose to 4.86 percent in the third quarter, 

compared to 4.5 percent in the second quarter. 

Merger and Acquisition Activity Continues to 

Sweep through the Region 

In 1997, 46 merger and acquisition transactions involving New York Region banks and thrifts were announced. 

These deals had an aggregate value of $22.7 billion. 

Merger and acquisition activity was up compared to 

1996 in terms of aggregate value; in 1996, 46 transactions with an aggregate value of $4.5 billion were 

announced. Capping off merger and acquisition activity 

in 1997 was the November 19 announcement that First 

Union Corporation of Charlotte, North Carolina, will 

acquire CoreStates Financial Corp., a Philadelphia1 The weighted nonperforming residential real estate loan ratio was 

5.57 percent in the Wayne field office, 5.37 percent in the San Juan 

field office, and 3.18 percent in the Syracuse field office. 

New York Regional Outlook 21	 First Quarter 1998 
Regular Features Regional Banking
 

based banking company. Analysts are speculating about 

other potential “regional” bank targets and opine that 

banks operating independently in larger markets are 

likely acquisition targets. 

Regulatory and State Legislative Changes Spur 

Acquisitions as Financial Modernization Stalls 

Despite intense congressional debate on financial modernization over the past two years, it has been regulatory 

and state legislative changes that have altered the profile of the financial services industry and spurred acquisition activity. Financial services companies, including 

banks, are maneuvering through existing regulations 

and court rulings to enter into deals once forbidden by 

Depression-era laws separating the banking, insurance, 

and securities industries. 

One example is the number of acquisitions of investment banks and brokerages by banking companies since 

the Federal Reserve Board of Governors more than doubled the amount of revenue a so-called Section 20 company can derive from its underwriting and dealing in 

bank-ineligible securities.2 Effective March 6, 1997, this 

limitation (part of the regulations implementing Section 

20 of the Glass-Steagall Act prohibiting affiliations 

between banks that are members of the Federal Reserve 

and companies that are “principally engaged” in underwriting and dealing in bank-ineligible securities) was 

increased by the Federal Reserve from 10 to 25 percent. 

This change substantially increased the ability of a 

Section 20 company to engage in all types of underwriting and dealing activities. The change also provided 

the impetus for new players to enter these businesses. 

The opportunity to purchase an equity underwriting 

franchise may be an attractive alternative to banks compared to the slow, expensive, and uncertain process of 

internal building. Moody’s Investors Service believes 

that the strategic decision to speed the building process 

will continue to be a prime factor motivating future 

acquisitions. 

Twenty-one banking organizations headquartered in the 

Region have Section 20 powers. This group includes 

some of the largest bank holding companies in the 

Region and ten foreign banking organizations. While 

2 Bank-ineligible securities generally include all types of debt and 

equity securities other than obligations of the United States government, general obligations of states and political subdivisions, banker’s 

acceptances, and certificates of deposit. 

some banking organizations have committed to building 

new securities units, others have used acquisitions to 

build this business line. For example, Bankers Trust 

New York Corp. acquired an investment bank, and PNC 

Bank Corporation purchased a portion of an institutional brokerage firm. Mellon Bank Corp., with an eye 

toward technology in the investment business, acquired 

an on-line discount brokerage firm. Mellon’s acquisition strategy cited the time and costs that would be 

required to create the same capabilities internally versus 

the established presence of the target. 

States also are moving forward with legislative changes 

that allow banks to enter previously precluded businesses. Pennsylvania enacted legislation that liberalizes the 

regulation of insurance sales for state banks. 

Pennsylvania banks can now sell life as well as property and casualty insurance, in addition to annuities and 

credit life insurance. 

Interstate Banking and Branching Influences 

Acquisition Activity 

One piece of federal legislation that has changed the 

profile and acquisition strategies of the banking industry is the Riegle-Neal Interstate Banking and Branching 

Efficiency Act of 1994. This Act, which in many cases 

confirmed a push for interstate banking that began at 

the state level, provided further momentum for bank 

and thrift acquisitions. For example, the total number of 

interstate acquisitions in the country in 1996 was 146, 

or 34 percent of all acquisitions, compared to just 46 

transactions, or 24 percent, in 1990. Interstate branching has changed the profile of bank operations in the 

Region, with out-of-state banks holding a large share of 

deposits in most states in the Region (see Table 2). 

Mergers Emphasize Profitability, 

Efficiency, and Technology 

Market pressure on insured institutions has shifted from 

growth in the loan portfolio to the identification of new 

sources of revenue and cost savings. Many banks have 

succeeded in expanding their business lines and diversifying their income streams. Over 26 percent of total 

income for the Region’s banks and thrifts now comes 

from sources other than interest income, nearly double 

the proportion in 1990. Some analysts believe this figure could reach 50 percent by 2005. While the Region’s 

New York Regional Outlook 22 First Quarter 1998 
Regular Features Regional Banking
 

TABLE 2 CHART 1 

Out-of-State Branches Hold a Large 

Share of Insured Branch Deposits 

STATE % OF DEPOSITS HELD BY 

OUT-OF-STATE BRANCHES 

DELAWARE 24 

DISTRICT OF 

COLUMBIA 75 

MARYLAND 37 

NEW JERSEY 33 

NEW YORK 6 

PENNSYLVANIA 0 

PUERTO RICO 15 

Source: Summary of Deposits, FDIC/OTS Databook, 

June 30, 1997 

largest commercial banks generate the largest proportion of noninterest income to total income, commercial 

banks with assets between $100 million and $1 billion 

have made the largest shift toward a more diversified 

income stream in the 1990s. Commercial banks in this 

segment generated noninterest income equal to over 22 

percent of total income as of September 30, 1997, compared to 9 percent in 1990. The shift toward more diversification in the income stream may in part be driving 

higher price/earnings ratios for bank stocks (see Second 

Quarter 1997 Regional Outlook, Financial Markets). 

In turn, greater market capitalization has significantly 

enhanced the ability of buyers to make acquisitions, and 

higher price levels have made mergers more attractive 

for potential sellers. 

Merger and acquisition strategies have placed emphasis 

on increased efficiencies. Often, mergers allow banks to 

cut costs through shared staffing and technology costs. 

In the case of mergers in which a significant number of 

branch operations overlap, substantial cost savings may 

be realized by closing or consolidating bank branches. 

Measures of efficiency for insured institutions in the 

Region have generally improved since the beginning of 

the decade, when the high costs associated with the 

workout of problem loans elevated the efficiency ratio 

(calculated as noninterest expense divided by noninterest income plus net interest income). The aggregate 

efficiency ratio of the Region’s insured institutions as of 

September 30, 1997, was 62.3 percent compared to 65.3 

percent in December 1993 (see Chart 1). Segmentation 

of the Region’s commercial banks by size revealed that 

banks with assets between $1 billion and $10 billion 

were the most efficient, with an aggregate efficiency 

ratio approaching 56.4 percent as of September 30, 

Source: Bank and Thrift Call Reports 

New York Region Insured Institutions 

Improve Efficiency 

Note: Efficiency Ratio = 

55.0 

60.0 

65.0 

70.0 

75.0 

1990 1992 1994 1996 

Efficiency Ratio 

1991 1993 1995 Sep1997 

Noninterest Income + Net Interest Income 

Noninterest Expense 

1997. With many banks attaining efficiency ratios 

below 50 percent, analysts indicate that the industry can 

yet make considerable improvement with regard to efficiency, and mergers may enable banks to do so. Mergers 

also enable banks to market their products to an established base of existing customers at the target institution. To the extent that these customers can be retained, 

the acquirer has, in effect, purchased a market for its 

products. 

Technology will play a key role in merger and acquisition activity, especially as the year 2000 approaches. 

Many banks have invested heavily in technology, and 

those that have not may become merger targets. 

Analysts predict that problems associated with the year 

2000 have the potential to push banks not prepared for 

the millennium into the arms of an acquirer. 

Mergers Create New Risks 

Risks associated with mergers and acquisitions often 

include striking the appropriate balance between opposing goals. For example, in an effort to maintain or 

increase current shareholder value, a bank may reach 

for yield by increasing risk. Emphasis on strict cost controls may impede a bank’s capacity to maintain an 

appropriate control environment. This situation may be 

compounded when a bank acquires a company with a 

different business line or risk profile. For example, in 

attempting to transform into “financial services supermarkets,” bank acquirers face significant challenges in 

harmonizing acquired cultures with their own banking 

and capital markets activities. A Moody’s Investors 

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

Service report, Mergers and Acquisitions in the 

Securities Industry, identified the following risk 

factors: 

•	 management incompatibility resulting in turnover 

and loss of top producers; 

•	 management unfamiliarity with the acquired business; 

•	 inadequate due diligence that fails to identify the 

extent of legal, reputation, or asset quality problems; 

•	 risk tolerance levels at the acquired company that are 

dangerously high; and 

•	 incompatible technologies that undermine adequate 

controls and require costly upgrades. 

Failure to address these issues in any acquisition transaction could derail the anticipated benefits of a merger 

and could increase the risk profile of newly merged 

financial services companies, including insured institutions. 

New Bank Charters Are on the Increase 

The consolidation of the U.S. banking industry over the 

past decade has helped create a related trend—the rise 

of new bank charters. The turmoil that has accompanied 

industry consolidation seems to have opened up opportunities for new banks by spurring bank customers to 

reevaluate their banking relationships and by displacing 

bank employees. These new banks hope to provide competition in local markets where consolidation has resulted in limited choices for consumers and businesses. In 

the first three quarters of 1997, 141 new insured institutions opened nationwide, with particularly strong 

activity in the Atlanta and San Francisco Regions. 

Chartering of new banks in the New York Region picked 

up in 1997. Thirteen new banks opened in the Region in 

1997 (through November), the highest number since 

1990 (see Chart 2). Nine additional bank charters were 

approved through November 1997 but have not yet 

opened. The Division of Supervision in the New York 

Region also reported 14 pending applications for new 

charters, indicating that formation of new banks in 1998 

could be equally brisk, if not more so. New Jersey and 

CHART 2 

Source: Bank and Thrift Call Reports * Through November 30, 1997 

DC 

DE 

MD 

NJ 

NY 

PA 

VI 

New Bank Chartering Picks Up 

in the New York Region 

0 

3 

6 

9 

12 

15 

18 

19901991199219931994199519961997* 

Pennsylvania, states that have been particularly affected 

by significant numbers of consolidations, saw the most 

new banks chartered over the past year. The number of 

insured institutions chartered in New Jersey has 

declined from 275 to 156, or 43 percent, since the 

beginning of 1990. In Pennsylvania, the number of 

insured institutions has declined from 473 to 330, or 30 

percent, over the same period. 

New banks face many hurdles and risks. They must 

have the financial strength and managerial experience 

to survive beyond the initial period of losses (generally 

two to three years on average) encountered as a result of 

start-up organizational and operating costs. The same 

competitive forces that are influencing merger and 

acquisition activity in the banking industry can affect a 

new bank’s ability to attract customers profitably. 

Margins may be squeezed if new banks have to offer 

lower rates on loans or higher rates on deposits to bring 

in new accounts. With minimal sources of noninterest 

income, new banks tend to rely on the spread to make 

money. This makes operational efficiency of utmost 

importance. A February 1997 study, The Performance 

of De Novo Commercial Banks, issued by the 

Comptroller of the Currency, found operational efficiency to be a major factor in the success of new banks. 

The study found that the average newly chartered commercial bank’s efficiency improves rapidly over the first 

three years of operation but doesn’t match established 

banks’ efficiency levels until year nine. Management, 

therefore, must establish proper controls over all areas 

of operations from the beginning. Discipline is needed 

to contain costs as well as minimize the tendency to turn 

to riskier assets to grow and improve margins. 

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

For More Information
 The study further cited previous findings concluding 

that new banks’ performance was most directly associated with factors within the control of bank managers— 

such as containment of wage costs and the initial growth 

rate of the bank—and was less affected by external 

forces such as market concentration. This suggests that 

although competitive forces certainly play a part in the 

ability to generate income, a sound business plan and 

strong management are imperative to a new bank’s ability to compete effectively and profitably over the long 

run. 

As consolidation in the industry intensifies, formation 

of new banks may be expected to continue. As banking 

services are delivered increasingly through technology 

and less through brick-and-mortar branches, the question becomes whether the market will support many 

more such institutions. Nevertheless, many consumers 

in smaller communities appear to prefer the personal 

service associated with community banks. A surprising 

number of consumers have demonstrated a willingness 

to move accounts from a recently acquired bank to a 

local, independent bank. Small established banks, as 

well as new banks, are taking advantage of such situations with increasing assertiveness. 

Suzannah L. Susser, Regional Manager 

Karen A. Wigder, Financial Analyst 

Mergers and Acquisitions in the Securities Industry, 

Moody’s Investors Service Special Comment, 

October 1997. 

The Performance of De Novo Commercial Banks, 

Robert DeYoung (Office of the Comptroller of the 

Currency) and Iftekhar Hasan (New Jersey Institute 

of Technology), February 1997, issued by the 

Comptroller of the Currency. 

Revenue Limit on Bank-Ineligible Activities of 

Subsidiaries of Bank Holding Companies Engaged 

in Underwriting and Dealing in Securities, Federal 

Reserve System Docket No. R-0841. 

Riegle-Neal Scorecard, FDIC Division of Research 

and Statistics. 

New York Regional Outlook 25 First Quarter 1998 
✁
 

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