Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1999 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael Anas,
 

Senior Financial
 

Analyst
 

Ronald W. Sims, II,
 

Financial Analyst
 

In Focus This Quarter 

◆ Economic Conditions and Emerging Risks in Banking—This article provides an overview of 

economic conditions and banking industry trends, with a primary focus on potential risks to insured 

depository institutions. 

● Indicators of Industry Performance—The reported financial condition of insured banks and 

thrifts is strong. However, despite projected growth in earnings, bank and thrift stocks underperformed the broader market through October 1999. See page 3. 

● Economic Conditions—The economy remains generally strong, and the outlook calls for continued growth. Growth is likely to slow, however, in order to correct financial imbalances that have 

developed as a result of a rapid creation of household and commercial credit and borrowing from 

abroad. There is a threat that the adjustment process could be a volatile one. See page 4. 

● Emerging Risks in Banking—Rising indebtedness on the part of businesses and households 

raises concerns about future loan performance. Industry responses to intense competition have 

created greater credit, market, and operational risks. See page 8. 

Consumer Lending—Banks and thrifts are becoming increasingly involved in subprime consumer lending, which has raised some supervisory concerns. See page 8. 

Commercial and Industrial Lending—Signs of deterioration in corporate credit quality can be 

found in rising loss rates, slower profit growth, and rising corporate bond defaults. At the same 

time, banks are expanding their lending to heavily indebted companies in the syndicated loan 

market. See page 11. 

Commercial Real Estate and Construction Lending—Loans for real estate construction and 

development are growing rapidly. Despite an uptick in commercial vacancy rates, loan losses 

remain low. See page 12. 

Agricultural Lending—Low commodity prices are hurting farm operating incomes, but widespread effects on farm banks have yet to materialize. See page 13. 

Funding and Interest Rate Risk—Lagging deposit growth has led to a greater reliance on more 

volatile, market-based funding, and some institutions are taking on greater interest rate risk to 

maintain loan growth. See page 14. By the Analysis Branch Staff 

Regional Perspectives 

◆ Economic and Banking Conditions—Although the economy remains healthy, tight labor 

markets and weak demand have led to a slowdown in industrial output growth. Factors continuing to 

support the expansion include high levels of new construction, low inflation, and rapidly appreciating 

consumers’ net worth. A sudden drop in the value of consumer assets, should one occur, could trigger 

a sharp and swift decline in households’ discretionary spending. Sharply lower stock prices also could 

limit businesses’ access to capital markets. The growing use of noninterest income and a changing asset 

mix during the first half of 1999 contributed to solid profitability levels and earnings performance at 

insured institutions. See page 18. 

◆ Depressed Crop Prices Lead to a Decline in Farm Cash Receipts and Farmland Values— 

As farm cash receipts and farmland values decline, agricultural banks’ asset quality measures are 

beginning to show signs of deterioration. A decline in the reserve coverage ratio could suggest that 

commercial banks have not made sufficient provisions for loan losses, which may affect the quality of 

future earnings. See page 22. 

◆ Heightened Levels of New Bank Formation This Late in an Expansion Could Be Cause for 

Concern—The banking industry’s record profitability during the 1990s has led to an increase in new 

bank charters. However, risky lending practices combined with declining earnings and growing use of 

noncore funding could be problematic for new institutions during an economic downturn. See page 23. 

By the Chicago Region Staff 

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

Insurance Corporation institutions and financial institution regulators. It is produced for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

more information or to provide comments or suggestions about the Chicago Region’s Regional 

Outlook, please call Suzannah Susser at (312) 382-6543 or send an e-mail to ssusser@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 

Writer/Editor Kim E. Lowry 
In Focus This Quarter
 

Economic Conditions and 


Emerging Risks in Banking
 

The Division of Insurance periodically assesses conditions in the economy and the banking industry to identify and 

evaluate trends that could adversely affect the performance of insured depository institutions. Overall, conditions in 

the economy and banking industry are favorable at this time. However, signs point to vulnerability in the economy 

and in the banking industry that may make the years ahead much more challenging. Three broad themes emerge from 

this assessment: 

•	 Households’ and businesses’ debt levels are on the rise. Spending by households and businesses is growing faster 

than cash income, resulting in rapidly increasing indebtedness. Consumer spending has been driven, in part, by 

large increases in the net worth associated with stock holdings and home equity. Businesses are restructuring and 

investing in new technologies to raise productivity and cut costs. Both consumer and business spending has been 

assisted by ready access to financing. Rising interest rates or slower economic growth could make debt service 

more difficult for borrowers. 

•	 Intense competition in banking is driving business strategies. Competitive pressures have affected nearly every 

facet of the banking business. These pressures are evident in net interest margins, which have suffered from tighter 

loan pricing and higher funding costs. To maintain profits, some institutions are lending to less creditworthy borrowers, expanding into new or higher-yielding activities, creating more complex balance sheet structures, or cutting costs. These strategies may lead to greater credit, market, and operational risks. 

•	 The currently benign economic environment is vulnerable to rapid deterioration in the event of financial market 

instability. During the 1990s, we have witnessed recurring, and perhaps more frequent, episodes of financial market turbulence. Recent episodes have arisen mainly overseas and have had little adverse effect on U.S. economic 

activity. However, the current economic expansion is closely tied to the ready availability of market-based financing for households and businesses and to wealth generated with the help of rising stock prices and falling interest 

rates. For this reason, the currently strong economic outlook may be subject to sudden deterioration in the event 

of market shocks that sharply raise interest rates or lower stock prices. 

The analysis that follows explores these themes in more detail in the following sections: 1) indicators of industry performance, 2) economic conditions, and 3) emerging risks in banking. 

Indicators of Industry Performance 

Industry Financial Performance Is Strong and a decline in provision expense. However, the majority of the decline in net earnings resulted from a $1.5 

According to reported financial information, the bank- billion loss posted by one large bank. 

ing and thrift industries are performing well. As summarized in the FDIC Quarterly Banking Profile, The low overall level of net loan losses has been a key 

second quarter 1999, both the commercial banking and contributor to strong industry performance. Chart 1 

thrift industries report near-record earnings, strong cap- (next page) shows that the average net loan loss ratio for 

ital levels, and manageable volumes of problem assets the industry has been low and stable in recent years. 

and loan losses. Return on assets (ROA) for all insured Similarly, the range between the worst and best 5 perinstitutions in the second quarter was 1.21 percent and cent of net loan loss ratios has narrowed considerably 

return on equity (ROE) was 14.07 percent. ROA and since the early 1990s. More than 95 percent of insured 

ROE were down slightly from the first quarter despite institutions reported a net loan loss ratio of less than 1 

improvement in the industry net interest margin (NIM) percent in 1998, continuing a five-year trend. 

Chicago Regional Outlook 3	 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 1 

Overview 

ings per share is projected to be 16.9 percent for pubBank Stocks Underperform Despite 

Projected Earnings Growth 

Analysts expect continued earnings growth for banks 

and thrifts in 1999 and 2000. Median growth in earnThe Range of Loan Losses for FDIC-Insured 

Institutions Has Been Stable Recently 

* For institutions with at least 10 percent of assets invested in loans. 

Source: FDIC Bank and Thrift Call Reports (Research Information System) 

–1.0 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

6.0 

’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

Net Loan Loss Ratio (percent)* 

95th Percentile 

Mean 5th Percentile 

licly traded banks and 19.4 percent for publicly traded 

thrifts for 1999.1 Ratings agencies also view the industry positively. The ratio of upgrades to downgrades for 

ratings issued by Moody’s Investors Service improved 

in the second quarter, with nine companies receiving 

upgrades versus four receiving downgrades. 

Nonetheless, bank and thrift stocks have underperformed the broader market in the first three quarters of 

1999. The SNL Securities Bank Stock Index, which 

tracks more than 450 publicly traded commercial banks, 

declined 6.7 percent between January 1 and September 

30, 1999. The SNL Securities Thrift Stock Index, 

which tracks the performance of about 350 publicly 

traded thrifts, fell 13.7 percent during the same period. 

By contrast, the Standard & Poor’s (S&P) 500 index 

gained 4.6 percent. Analysts cite rising interest rates, 

concerns about problems with corporate credit quality, 

and a decline in bank merger activity as reasons for the 

recent performance of bank and thrift stocks. 

Economic Conditions
 

The U.S. economy has remained generally strong during 

1999, the ninth year of the current economic expansion. 

If growth continues through February 2000—as most 

analysts expect—this expansion will become the 

longest in U.S. history. What is also remarkable about 

this business cycle expansion is the fact that the highest 

rates of growth have occurred during the past two years, 

1997 and 1998. Even as growth has accelerated with 

unemployment declining to 4.2 percent, wage and price 

inflation has remained unusually subdued. While low 

inflation has helped prolong the expansion, it has 

imposed intense price competition on a wide range of 

industries. The currently positive economic outlook is 

subject to possible sudden deterioration in the event of 

financial market shocks that could raise financing costs, 

reduce the availability of financing, or destroy investor 

wealth. 

Commodity Industries Have 

Faced Pricing Pressures 

One disadvantage of low inflation during this expansion 

has been that firms in certain commodity industries 

have suffered from falling prices. Profit margins have 

declined in agriculture, mining, and some manufacturing sectors because of weak or negative revenue growth 

during 1997 and 1998.2 Firms operating in these industries have aggressively cut costs to preserve profit 

margins. Nonetheless, profit growth has been flat or 

negative for a large proportion of S&P 500 firms in the 

mining, textiles, chemicals, iron and steel, and oil and 

gas sectors since 1997. In response, some firms in these 

industries have chosen to consolidate through mergers. 

According to Mergerstat, the dollar volume of merger 

and acquisition transactions involving U.S. firms was a 

record $1.2 trillion in 1998, more than 80 percent above 

1997 levels. 

Business Investment Is Outpacing Cash Flow 

Analysts recently have become concerned about 

increasing levels of debt on corporate balance sheets. 

1 Based on estimates as of November 4, 1999, for 98 commercial 

banks and 33 thrifts that have at least five analyst estimates. 

2 Richard A. Brown and Alan Deaton, “Falling Prices in Commodities 

and Manufacturing Pose Continuing Risks to Credit Quality,” 

Regional Outlook, Third Quarter 1999 (http://www.fdic.gov/bank/ 

analytical/regional/ro19993q/na/t3q1999.pdf). 

Chicago Regional Outlook 4 Fourth Quarter 1999 
In Focus This Quarter
 

Chart 2 tracks the steady growth of fixed investment by 

U.S. corporations during the current expansion. It also 

shows, however, that growth in cash flow available to 

finance investment has slowed in recent years. This 

“financing gap” has grown steadily, reaching a record 

$86 billion in 1998. 

As a result, corporations must finance an increasing 

portion of investment spending by issuing either net 

new equity or net new debt. In recent years, firms have 

overwhelmingly chosen debt financing. Net issuance of 

corporate debt was $219 billion in 1998, while corporations repurchased equity shares on net for the sixth 

straight year. Corporate borrowing has also continued 

at a brisk pace; domestic commercial and industrial 

(C&I) lending rose by 12.5 percent in the year ending 

June 1999. 

A widening financing gap and increasing debt levels 

could pose future problems if there are adverse 

changes in the financial environment. For example, a 

sharp rise in interest rates would increase the debt burden of businesses, hurt their profitability, and impair 

their creditworthiness. Under such a scenario, firms 

might decide to curtail their capital expenditures, 

which would tend to reduce the rate of growth in the 

rest of the economy. 

Consumer Spending 

Continues to Grow 

Strong growth in consumer spending continues to propel the economic expansion. Spending has accelerated 

in recent quarters, in contrast to previous expansions 

when the strongest growth in consumer spending 

occurred early in the recovery. One factor supporting 

the robust pace of spending is housing activity. Singlefamily housing starts rose to an annualized rate of 

more than 1.3 million units in fourth quarter 1998 and 

have remained near that level through third quarter 

1999. Existing home sales also have maintained a 

record pace of 5.3 million units on an annualized basis 

during the second and third quarters. Low mortgage 

interest rates and real income gains have combined to 

push housing affordability to its highest level in many 

years.3 

3 The housing affordability index published by the National Association of Realtors equals 100 when the median family income qualifies 

for an 80 percent mortgage on a median-priced existing singlefamily home. The value of the index as of the third quarter of 1999 

was 127.1. 

CHART 2 

The Financing Gap Has Widened 

for Nonfinancial Corporations 

Source: Federal Reserve Board (Haver Analytics) 

100 

200 

300 

400 

500 

600 

700 

800 

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

Billions of Dollars 

Capital Expenditures 

“Financing Gap” 

Cash Flow 

Rapid growth in consumer spending also warrants 

attention. Despite the highest rates of real income 

growth in nine years, consumer spending has grown 

more quickly than disposable personal income. The 

divergence in growth has resulted in a falling personal 

savings rate, which reached a record low in 1999.4 The 

recent decline in the personal savings rate continues a 

trend that has been under way for more than a decade 

(see Chart 3, next page).5 

Analysts cannot fully explain the reasons for the falling 

savings rate, although the “wealth effect” associated 

with the accumulation of capital gains by households is 

believed to be a significant factor. Since 1995, the total 

value of equities, mutual funds, and pension funds 

owned by households has risen by $6.8 trillion, while 

the value of owner-occupied housing net of mortgage 

debt has increased by $812 billion. This accumulation 

of wealth apparently has emboldened consumers to 

spend, as evidenced by data that show aggregate spend4 Personal savings is calculated as the difference between disposable 

personal income (DPI, or total income net of taxes) and consumption 

expenditures. The personal savings rate is equal to personal savings 

divided by DPI. It should be noted that capital gains, even when realized, are not included as income in this calculation, although taxes 

paid on capital gains are deducted from DPI. Consequently, largescale realization of capital gains by households will tend to push 

down the personal savings rate. 

5 The Bureau of Economic Analysis, which tabulates the personal 

savings rate, has recently revised its methodology, leading to a large 

revision in the savings rate data. Earlier estimates reported the personal savings rate to be around negative 1 percent, suggesting that 

households were spending more than their disposable (after-tax) 

income. Revised estimates show that the savings rate for the third 

quarter of 1999 was 2.1 percent. Although higher than previously 

reported, the revised personal savings rate data continue to show a 

downward trend similar to earlier savings rate estimates. 

Chicago Regional Outlook 5 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 3 

Strong Consumer Spending Has Been 

Accompanied by a Falling Personal Savings Rate 

Source: Bureau of Economic Analysis (Haver Analytics) 

0.0 

2.0 

4.0 

6.0 

8.0 

1Q92 1Q93 1Q94 1Q95 1Q96 1Q97 1Q98 

0.0 

2.0 

4.0 

6.0 

8.0 

10.0 

Personal Savings Rate 

(Percent) 

Personal Consumption Spending 

(Percent change from year ago) 

1Q99 

ing growth exceeding income growth. For the most part, 

when consumers have chosen to convert capital gains to 

spendable cash, they have done so by borrowing—often 

against the equity in their homes or their 401(k) 

accounts. 

The increasing indebtedness of consumers could substantially raise the costs of debt service relative to 

income, especially if interest rates rise or income 

growth slows. Moreover, analysts express concerns 

about a reversal of the wealth effect if there is a significant and sustained decline in equity prices. Any resulting decline in consumer confidence could substantially 

slow the pace of consumer spending, leading to a 

reduced pace of economic growth. 

CHART 4 

The Growing Private Deficit Raises Concerns 

Taken together, the sum of annual net borrowing by 

businesses and households has been referred to as the 

“private deficit.” During the late 1990s, as the combined 

budget of federal, state, and local governments moved 

from deficit to surplus, the private deficit rose sharply; 

between 1996 and 1998, it nearly doubled from $550 

billion to $1.02 trillion (see Chart 4). 

The private deficit was financed from three sources in 

1998. One source was the $73 billion surplus in the 

government sector, the first surplus in 28 years. The 

largest portion of the 1998 private deficit was financed 

by the creation of credit by the domestic financial sector and by an inflow of foreign capital. The rapid creation of credit raises concerns about credit quality, an 

issue that is explored in more detail under Emerging 

Risks in Banking, below. Dependence on foreign capital 

raises questions about what might happen if the foreign 

sector becomes less willing to export capital to the 

United States. 

Recovery Abroad Is Changing 

the Terms of Trade 

During the past three years, the U.S. economy has experienced consistently strong growth with low inflation, 

while the economies of some of its major trading partners have grown more slowly or not at all. Japan was 

mired in its worst recession in decades, while a number 

of countries in Asia, Latin America, and Eastern Europe 

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

Flow of Net Sectoral Lending (lending less borrowing), 

in Billions of Dollars 

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

Source: Federal Reserve Board (Haver Analytics) 

–1200 

–600 

0 

600 

1200 

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

Foreign Sector 

Domestic Financial Sector 

Nonfinancial Business 

Households 

Government 

Chicago Regional Outlook 6 Fourth Quarter 1999 
In Focus This Quarter
 

have experienced the harsh fallout resulting from financial market and exchange rate crises. The euro-zone 

economies, Germany and France in particular, have 

grown slowly following the imposition of tight fiscal 

and monetary policies in advance of the introduction of 

the euro on January 1, 1999. 

The net effect of this disparity in growth rates has been 

a growing U.S. trade deficit. The deficit rose by 57 percent in 1998 to $164.3 billion, reflecting a small decline 

in exports and a 5 percent increase in imports. The 

adverse effects of the trade deficit on the U.S. economy 

have been felt primarily by the commodity industries— 

farming, mining, and basic manufacturing. In addition, 

the large trade deficit has resulted in the transfer of billions of dollars to foreign investors. During 1997 and 

1998, many foreign investors used their excess dollars 

to purchase dollar-denominated stocks and bonds. This 

inflow of capital helped keep U.S. equity and bond 

prices high, while pushing up the value of the dollar. 

A global economic recovery during the first three quarters of 1999 has led to higher demand for investment 

capital outside the United States. The International 

Monetary Fund estimates that growth in the global 

economy will increase from 2.5 percent in 1998 to 3.0 

percent in 1999 and 3.5 percent in 2000.6 Foreign 

investors, in anticipation of stronger growth and greater 

investment opportunities abroad, have started to convert 

excess dollar holdings to other currencies, including the 

yen and euro. This change in investment strategy has put 

downward pressure on the value of the dollar. Between 

July and September 1999, the dollar lost approximately 

10 percent of its value against the yen. 

A falling dollar will likely contribute to a recovery of 

U.S. exports in coming months. The index of export 

orders compiled by the National Association of Purchasing Managers points to future growth in shipments 

abroad. The index has signaled growing export orders 

for nine months through October 1999. As Chart 5 

shows, increasing export orders tend to lead the actual 

rise in exports by several months. 

A lower dollar could also place upward pressure on U.S. 

inflation and interest rates. A steady decline in the dollar would make foreign goods more expensive, while 

higher export demand would raise manufacturing output at a time when U.S. labor markets are very tight. The 

prices of several important industrial commodities have 

6 International Monetary Fund, World Economic Outlook, October 

1999. 

CHART 5 

U.S. Exports Fell in 1998, but Rising 

Orders Point to Growth in 1999 

Source: Bureau of the Census; National Association of Purchasing Managers 

(NAPM) (Haver Analytics) 

–10 

–5 

0 

5 

10 

15 

20 

’93 ’94 ’95 ’96 ’97 ’98 ’99 

40 

45 

50 

55 

60 

65 

70 

U.S. Export Growth 

(Percent change from year ago) 

NAPM Export Orders Diffusion Index 

(Greater than 50 signals expansion) 

risen in dollar terms during 1999, led by a doubling in 

the price of oil during the first nine months of 1999. 

Domestically, the producer price index has risen by 

approximately 4 percent since the beginning of the year 

following a two-year decline, reflecting an increase in 

oil and intermediate goods prices. 

Interest rates have risen in step with renewed concerns 

about inflation. The constant maturity yield on 10-year 

Treasury bonds increased by approximately 140 basis 

points in the year ending October 1999, while the Federal Reserve instituted two 25-basis point increases in 

short-term rates during the summer of 1999. 

The Economic Outlook Calls 

for Continued Growth 

One scenario for the year ahead is that the U.S. economy will continue to grow at much the same rate as it 

has during the past few years. As discussed above, 

however, continued rapid growth would lead to even 

greater imbalances in the domestic economy and in the 

foreign sector. For this reason, most economists do not 

believe that rapid growth can continue indefinitely. 

Instead, analysts suggest two possible scenarios for the 

economy. 

The Blue Chip Economic Indicators consensus outlook for the U.S. economy calls for a “soft landing.” 

Gross domestic product is projected to grow at a rate of 

3.8 percent in 1999 with somewhat slower growth of 2.8 

percent in 2000.7 Rising wage pressures, reflecting tight 

7 Blue Chip Economic Indicators, Aspen Publishing, October 10, 

1999. 

Chicago Regional Outlook 7 Fourth Quarter 1999 
In Focus This Quarter
 

labor markets across the nation, and economic recovery 

abroad are expected to increase the risks of higher U.S. 

inflation. Improving growth prospects in the global 

economy may also lead to a stabilization of commodity 

prices, reversing a trend of falling prices that has until 

recently contributed to lower U.S. inflation. In response 

to expectations of higher inflation, medium-term interest rates are also expected to rise modestly. Slower U.S. 

growth and faster expansion abroad would result in a 

rebalancing of global growth that should narrow the 

U.S. trade deficit and reduce downward pressure on the 

dollar. 

Although the consensus forecast calls for continued 

expansion, an alternative scenario suggests the possibility of a steep decline in economic growth leading to a 

“hard landing.” Sharply higher interest rates, in 

response to a weak dollar and an unexpected acceleration of U.S. inflation, could lead to declining capital 

investment and reduced consumer spending. Rising 

interest rates would increase the debt burden for households and businesses even as measures of indebtedness 

are rising. A significant and sustained decline in equity 

prices may occur if investors become pessimistic as the 

economy slows. The response of the world economy to 

a U.S. recession is difficult to assess. As the past several months have shown, growth in the U.S. economy has 

been an important factor in supporting growth abroad. 

If the U.S. economy were to enter a recession, overall 

global growth could also slow, depending on the extent 

to which recoveries in Europe, Asia, and Latin America 

offset any shortfall in U.S. growth. 

Emerging Risks in Banking
 

Overview 

Favorable economic conditions continue to support 

strong loan growth and healthy loan performance 

among insured institutions. Net loss rates remain low 

relative to the early 1990s for almost every major loan 

category except consumer loans. Loss rates in domestic 

commercial loans, previously at low levels, rose modestly during the first half of 1999. Agricultural loan loss 

rates appear likely to rise in the future due to the effects 

of weak commodity prices on farm incomes. Strong 

loan growth and low loan losses have helped banks 

achieve record and near-record high quarterly profits. 

However, rising indebtedness on the part of businesses 

and households raises concerns about future loan performance, particularly if economic conditions were to 

deteriorate or if interest rates were to rise. 

Strategic responses to competitive pressures point to 

greater credit, market, and operational risks for the 

industry. Intense competition has pressured NIMs and 

has encouraged many lenders to seek higher returns by 

lending to less creditworthy borrowers. In order to 

maintain and grow profits, some insured institutions are 

expanding into activities such as subprime consumer 

lending, high loan-to-value mortgage lending, and lending with minimal or no documentation requirements. 

Rapid growth in syndicated lending to leveraged companies also indicates that large commercial lenders have 

increased their tolerance for risk. Competition has made 

funding with deposits more difficult. As a result, some 

institutions are relying increasingly on securitizations 

and more expensive, market-based sources of funds, 

which can alter an institution’s liquidity position, interest rate risk profile, and operational needs. Institutions 

have also responded to competitive pressures by cutting 

costs or merging in an attempt to achieve greater efficiencies. In some cases, deep reductions in operating 

costs support profits at the expense of less effective 

operational controls. 

Consumer Lending 

Household Borrowing Is on the Rise 

Household borrowing is growing rapidly, consistent 

with high reported levels of consumer confidence and 

strong consumer spending. Mortgage debt, which grew 

by 10.4 percent in the second quarter from year-ago 

levels, is the fastest-growing segment of household 

debt (see Chart 6). Mortgage loan growth has been particularly strong, in part because of rising homeownership, the availability of more low-down-payment loans, 

and the use of mortgage loans to consolidate revolving 

debt balances. Nonrevolving debt grew by 7.3 percent 

in the year ending June 1999, largely because of strong 

sales of new cars. In contrast, credit card and other 

revolving debt increased by only 5.7 percent during the 

same period—a much slower rate of growth than during the mid-1990s. 

Chicago Regional Outlook 8 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 6 

Household Borrowing Is on the Rise, 

Led by Increases in Mortgage Debt 

Source: Federal Reserve Board (Haver Analytics) 

–10 

–5 

0 

5 

10 

15 

20 

25 

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

Percent Change from Year Ago 

Nonrevolving 

Home 

Mortgages Revolving 

A Mortgage Refinancing Boom Has Helped 

Consumers Consolidate Debt 

A key component of the recent shift by consumers from 

credit card debt to mortgage debt has been a surge in 

mortgage refinancing in 1998 and early 1999. The 

Mortgage Bankers Association’s Refinancing Index 

peaked at over 4,300 in October 1998, compared with 

an average monthly index value of 527 during 1997.8 

Many households have refinanced their mortgages to 

obtain cash to pay down credit card and other high-cost 

consumer debt, thereby lowering their monthly financial obligations. According to a Freddie Mac survey of 

1998 refinancing transactions, more than 3 million 

homeowners, or 51 percent of all mortgage-refinance 

borrowers, generated net cash proceeds when they refinanced their loans.9 On average, these borrowers cashed 

out 11 percent of the equity in their homes. On the basis 

of this survey, Bank One Corporation estimated that 

cash out refinancing added about $60 billion in cash 

flow to consumer pocketbooks last year. This extra cash 

flow could help explain recent quarterly declines in personal bankruptcy filings, mortgage delinquencies, and 

consumer credit charge-offs.10 Rising interest rates 

appear to have ended this mortgage refinancing boom. 

The lower volume of mortgage refinancings raises ques8 Index is seasonally adjusted where the week of March 16, 1990 =
 

100.
 

9 Survey cited in a study by the Joint Center for Housing Studies at
 

Harvard University, “The State of the Nation’s Housing: 1999.”
 

10 Tristan Mabry, “This Boom, Some Say, Is on the House,” The Wall
 

Street Journal, July 6, 1999.
 

tions about whether consumers again will increase their 

use of credit cards to finance purchases. If so, there may 

be negative consequences for future consumer debt service burdens and consumer credit quality. 

Credit Card Lenders Face Declining Returns 

After several years of rapid growth in the mid-1990s, 

the credit card industry has become characterized by 

overcapacity and declining margins. At the same time, 

the high level of mortgage refinancings and rising 

household incomes have reduced the dependence of 

consumers on credit card debt. Consequently, credit 

card lenders are struggling to maintain volume as consumers pay off their credit card balances more quickly. 

Overcapacity and declining margins have led lenders to 

search aggressively for new ways to increase revenues. 

One method they have adopted is to charge new fees 

that are triggered by cardholder behavior. Lenders are 

now charging fees for inactive accounts, fees to close 

accounts, and even customer service fees. In addition, 

they are reducing grace periods, curtailing leniency 

periods, and imposing higher penalty interest rates. 

According to RAM Research, banks’ income from 

credit card fees has grown 79 percent over the past two 

years, while card interest income rose only 10 percent.11 

Shrinking margins have also prompted consolidation in 

the credit card industry. Today, the top five issuers control about 60 percent of the total managed assets in the 

credit card sector, up from just 35 percent in 1990.12 

Amid this changing competitive 

landscape, credit quality has 

improved. Credit card charge-off 

levels at insured commercial banks 

hit an all-time high of 5.5 percent 

in the third quarter of 1997 but 

have declined steadily to a level of 

4.1 percent in the second quarter of 

1999. This decline has been attributed to tighter underwriting standards, more aggressive collection efforts, 

and extra household cash flow generated through mortgage refinancings. 

11 Miriam Kreinan Souccar, “Consumer Groups Up in Arms Over
 

Card Penalties,” American Banker, February 26, 1999.
 12 James C. Allen, “Tarnished Platinum,” SNL Securities Bank Mergers & Acquisitions, June 1999.
 

Chicago Regional Outlook 9 Fourth Quarter 1999 
In Focus This Quarter
 

Subprime Lenders Have Riskier 

Characteristics than the Industry 

Subprime lending to consumers has grown dramatically in recent years. Subprime mortgage originations 

have grown from 5 percent of the total mortgage market in 1994 to 15 percent in 1997.13 The percentage of 

originations fell somewhat in 1998 to 10 percent—not 

because the volume of subprime mortgage originations 

fell but because the volume of prime mortgage originations was at a record high. In fact, in terms of dollars, 

subprime originations grew by 20 percent from 1997 to 

1998, to $150 billion. That figure is up significantly 

from the $35 billion in subprime originations in 1994. 

Estimates of the size of the subprime automobile loan 

market vary somewhere between $50 billion and $75 

billion, but one source estimates that subprime automobile originations jumped 

from about 8 percent of all 

automobile loan originations 

in 1990 to over 18 percent in 

1998.14 Analysts also have indicated that the subprime 

credit card market is the fastest-growing segment of 

credit card lending today. According to RAM 

Research, subprime receivables are growing 45 percent 

annually, compared with 16 percent or less for other 

segments of credit card lending.15 

Intense competitive pressure has contributed to the 

expansion of bank and thrift participation in subprime 

consumer lending. These loan programs offer higher 

margins than prime consumer lending products and 

have become an attractive alternative for banks and 

thrifts that have experienced shrinking margins in credit cards, mortgage lending, and other consumer product 

types. Moreover, the shakeout in the subprime specialty 

finance industry has provided new opportunities for 

insured depository institutions seeking to enter the subprime lending market. In 1999, several insured depository institutions acquired, or announced plans to 

acquire, a subprime specialty finance company. Bank 

and thrift involvement in subprime lending is expected 

to increase. In fact, some industry analysts predict that 

insured depository institutions with subprime affiliates 

13 The Mortgage Market Statistical Annual for 1999, Inside Mortgage Finance Publications, 1999. 

14 Ron Feldman, An Introduction to Subprime Auto Lending for 

Examiners, Federal Reserve Bank of Minneapolis, April 1998, and 

data supplied by CNW Marketing and Research. 

15 Lisa Fickenscher, “Credit Card Issuers Panning for Gold Among 

Tarnished Credit Histories,” American Banker, October 22, 1998. 

will overtake finance companies as leaders in the subprime industry. 

Subprime lending poses entirely new challenges in risk 

management for insured institutions. Not only are 

expected credit losses higher than for prime consumer 

lending, but a number of factors suggest that losses are 

also less predictable: 

•	 Subprime borrowers are more likely to default than 

prime borrowers and may be more vulnerable to 

economic shocks, such as a recession. Borrowers’ 

previous credit problems suggest that they have 

limited financial resources to withstand economic 

difficulties. 

•	 Credit-scoring and pricing models used to underwrite subprime loans are untested in a recession. 

Analysts have noted that credit-scoring models 

are less effective in predicting the likelihood of 

default for subprime borrowers than they are for 

prime borrowers. 

•	 Operational risks are greater in subprime lending. 

Because defaults occur sooner and more often than 

in prime lending, subprime portfolios require a 

greater investment in servicing and collections 

resources. Subprime lenders run a greater risk that 

these resources could become severely strained if the 

level of defaults is not correctly anticipated. 

•	 Liquidity risks are greater in subprime lending. 

Some large-volume subprime lenders heavily depend 

on the ability to securitize and sell loans to the secondary market. But investor demand for paper 

backed by subprime loans may be volatile, as was 

demonstrated during the financial market turmoil of 

late 1998. A number of nonbank subprime lenders 

experienced a liquidity crunch as a result of that market turmoil, and several opted for—or were forced 

into—bankruptcy.16 

•	 Reputation, legal, and compliance risks also are 

important for subprime lenders. Subprime lenders 

generally run a greater risk of violating, or being 

accused of violating, consumer protection laws or 

regulations. The public perception of subprime 

16 Dominic DiNapoli and Ron Greenspan, “The Next Industry Crisis 

Could Be Even Bigger,” American Banker, June 15, 1999. 

Chicago Regional Outlook 10	 Fourth Quarter 1999 
In Focus This Quarter
 

lenders could be tarnished if a recession were to 

result in substantially higher default rates. 

The growing involvement by insured depository institutions in subprime lending has raised significant concerns for bank and thrift supervisors. To address those 

concerns, FDIC Chairman Donna Tanoue recently 

announced that the FDIC will propose to the other federal financial institution regulators that insured depository institutions with concentrations in subprime 

lending be held to higher minimum capital requirements than the current rules dictate.17 The FDIC proposal includes a common supervisory definition of 

subprime lending and ties capital adequacy to the types 

and levels of risks that individual subprime lenders have 

in their portfolios. This proposal will be shared with 

other federal regulators to refine a final approach. 

Commercial and Industrial Lending 

Commercial and Industrial Loan 

Losses Have Been on the Rise 

Insured institutions continue to accommodate the credit needs of business borrowers. Domestic C&I loans 

grew almost 12.5 percent during the year ending in June 

1999 and accounted for 40 percent of all net new loans 

booked during that period. 

Although commercial loan losses are low, there are 

signs that credit quality in C&I portfolios is deteriorating. Net domestic C&I charge-offs during the first half 

of 1999 more than doubled from 1998 levels, while 

noncurrent domestic C&I loans rose by 26 percent. 

Examiners also have reported increasing problems in 

commercial portfolios. The Office of the Comptroller 

of the Currency recently reported that the dollar volume of classified and special-mention Shared National 

Credits rose 70 percent during a recent annual review.18 

Slower profit growth and rising corporate bond defaults 

also point toward somewhat weaker business credit 

17 FDIC Chairman Donna Tanoue in a speech before America’s Community Bankers, Orlando, Florida, November 2, 1999 (http://www. 

fdic.gov/news/news/speeches/chairman/sp02Nov99.html). 

18 “OCC Says Big Commercial Loans Suffering from Lax Underwriting,” American Banker, October 6, 1999, p. 1. The shared national 

credit program is a cooperative interagency program to review large 

credits held at several institutions. Loans subject to review include 

commitments in excess of $20 million that are shared among three or 

more participating lenders. 

quality. While corporate profits grew by an average of 

15 percent per year between 1993 and 1996, economists 

polled by Blue Chip Economic Indicators project 

growth of 6.7 percent for all of 1999, followed by 

growth of only 3.5 percent in 2000.19 Standard & Poor’s 

reported that 55 rated issuers defaulted on $20.5 billion 

in debt during the first six months of 1999.20 This pace 

of defaults is already nearly double levels experienced 

in the first half of 1998 and does not include more 

recent large defaults such as Iridium and Daewoo 

Group. Approximately 85 percent of the defaults that 

occurred during the first half of 1999 were among 

speculative-grade issuers. According to Moody’s, junk 

bond defaults rose to 5.8 percent of issues outstanding 

during the 12 months ending in September 1999, the 

highest level since 1991. 

Rising Losses May Be Attributable 

to Loose Underwriting 

Analysts attribute the recent deterioration in commercial credit quality to weak underwriting standards in 

the corporate debt markets during 1997 and early 

1998.21 Bank underwriting was reported to be particularly accommodating at that time. The Federal Reserve 

Board reported in its May 1998 Senior Loan Officer 

Opinion Survey on Bank Lending Practices that 

domestic banks were “generally eager to make loans to 

businesses” and that during early 1998 “a large percentage cut their spreads on such loans.” Subsequently, the November 1998 Survey reported a “broad 

tightening of business lending practices” associated 

with the financial market turmoil in progress at that 

time. However, regulators have continued to express 

concern about the assumptions underlying bank lending decisions. A Supervision and Regulation Letter 

sent by the Federal Reserve Board of Governors to its 

examiners in September 1999 noted the recent tightening of standards, but stated that “certain deeper issues 

remain,” which relate mainly to overoptimistic 

assumptions about the future repayment capacity of 

business borrowers.22 

19 Blue Chip Economic Indicators, Aspen Publishing, October 10,
 

1999.
 

20 “Defaults Soar in First Half 1999,” Standard & Poor’s, August 12,
 

1999.
 

21 See, for example, “Under Boom Economy, Strain Over Debt,” The
 

Wall Street Journal, August 18, 1999, Section C, p. 1. 
 22 SR 99-23, September 28, 1999. “Recent Trends in Bank Lending
 

Standards for Commercial Loans” (http://www.federalreserve.gov/
 

boarddocs/SRLETTERS/1999/SR9923.HTM).
 

Chicago Regional Outlook 11 Fourth Quarter 1999 
In Focus This Quarter
 

Leveraged Lending Has Been the Predominant 

Type of Syndicated Lending 

Banks appear to be taking on more risk in the syndicated loan market by expanding their lending to heavily indebted companies. During the first half of 1999, 

leveraged lending was the fastest-growing segment of 

syndicated commercial lending.23 While overall syndicated loan volume was down slightly compared with 

the first half of 1998, syndicated lending to leveraged 

companies rose $7 billion, or 5 percent, on the strength 

of a record volume of “highly leveraged loans.”24 As 

shown in Chart 7, loans to leveraged companies are 

making up a growing proportion of syndicated loan 

originations. 

Factors driving growth in leveraged lending include a 

high volume of corporate mergers and acquisitions, 

increasing investor demand for higher-yielding loans, 

and a shift in preference for loans over bonds by highyield issuers.25 While bank syndicators pass a large volume of these loans along to nonbank investors, a 

23 Syndicated loans are credits extended to large or medium-sized corporate borrowers that are originated by a group, or syndicate, of 

lenders. One type of syndicated lending is leveraged lending, in 

which the borrower’s debt-to-equity ratio is significantly higher than 

the industry average. Loan Pricing Corporation defines “leveraged 

loans” as those for which pricing exceeds 125 basis points over 

LIBOR. 

24 Loan Pricing Corporation defines “highly leveraged loans” as those 

for which pricing exceeds 225 basis points over LIBOR. 

25 According to Mergerstat, the value of mergers and acquisitions 

(M&A) was almost $400 billion during second-quarter 1999. According to Loan Pricing Corporation, syndicated loans originated in the 

second quarter to finance M&A activity totaled some $69 billion—a 

43 percent increase over issuance in the first quarter. 

CHART 7 

Loans to Leveraged Companies
 

Are Making Up A Greater Proportion of
 

Syndicated Loan Originations
 

Originations of Syndicated Loans to Leveraged Companies
 

As a Percentage of Total Syndicated Loans Dollars in Billions 

32% 

350 

300 

60 

50 

250 40 

200 

30 150 

20 100 

10 50 

0 

’90 ’92 ’94 ’96 ’98 ’99:1H* 

0 

* First half, annualized 

Source: Loan Pricing Corporation 

substantial portion of these credits remains on bank balance sheets. Loan Pricing Corporation has reported 

that as much as 64 percent of the value of “highly leveraged” loans originated in the first half of 1999 was 

retained by banks.26 

Commercial Real Estate 

and Construction Lending 

Construction Loan Volume Continues to Rise 

Loans for real estate construction and development 

(C&D) represent one of the fastest-growing segments of 

bank balance sheets, increasing 24 percent during the 

year ending June 1999. Compared with construction 

activity in the mid-1990s, spending on new commercial 

construction has shifted somewhat away from the industrial and retail markets and toward office and hotel construction. Residential construction growth was also 

strong during the first half of 1999, with single-family 

completions increasing 17 percent from a year ago. In 

the midst of this growth in loan volume, loss rates and 

past-due ratios for construction and development loans 

remain very low by historical standards, as indicated in 

Chart 8. 

Office Vacancy Rates Are Rising 

in Many Top Markets 

In previously published reports, Division of Insurance 

analysts identified nine metropolitan real estate markets 

where rapid development threatened to produce nearterm oversupply conditions.27 These cities were identified based on the pace of current construction activity, 

commercial space demand indicators, and independent 

market analysts’ projections. Six of the metropolitan 

areas identified—Atlanta, Phoenix, Orlando, Portland, 

Dallas, and Nashville—subsequently experienced large 

increases in office vacancy rates during the first half of 

1999. These areas have also experienced reduced 

employment growth and slowing net in-migration. 

Higher vacancy rates are often accompanied by slower 

26 “Junk Loan Market Is Feeling the Pinch of Oversupply and Rising 

Interest Rates,” The Wall Street Journal, September 13, 1999. 27 Steven K. Burton, “Commercial Developments Still Hot in Many 

Major Markets, but Slower Growth May Be Ahead,” Regional 

Outlook, First Quarter 1999 (http://www.fdic.gov/bank/analytical/ 

regional/ro19991q/na/infocus2.html) and “Ranking the Risk of 

Overbuilding in Commercial Real Estate Markets,” Bank Trends, 

FDIC Division of Insurance, October 1998 (http://www.fdic.gov/ 

bank/analytical/bank/bt9807.html). 

Chicago Regional Outlook 12 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 8 

Construction Loan Volume Continues to Rise, 

but Problem Loans Remain Low 

* First half 

Source: FDIC Bank and Thrift Call Reports (Research Information System) 

Construction and Development Loans 

0 

75 

150 

225 

’84 ’87 ’90 ’93 ’96 ’99:1H* 

0 

2 

4 

6 

8 

10 

12 

14 

Percent Nonaccrual Rate 

(Right Scale) 

Loss Rate 

(Right Scale) 

Volume in billions of dollars 

(Left Scale) 

rental-rate growth, which may lead to lower real estate 

values. For example, Atlanta’s vacancy rate rose 1.5 percentage points to 10.3 percent, while growth in rental 

rates slowed noticeably from the pace of the previous 

three years.28 

Surveys Suggest Tighter Standards 

in Commercial Real Estate Lending 

Evaluations of bank loan underwriting suggest a recent 

tightening of lending standards for commercial real 

estate loans. The August 1999 Federal Reserve Board 

Senior Loan Officer Opinion Survey reported a net 

tightening of commercial real estate underwriting standards, continuing a trend begun in late 1998. The 

FDIC’s March 1999 Report on Underwriting Practices 

also found fewer instances of risky lending practices 

with respect to commercial real estate and construction 

lending than in prior reports. The FDIC’s September 

Report showed no significant changes in lending 

standards. 

The FDIC also recently published the findings of a targeted evaluation of the underwriting practices of banks 

operating in three of the fastest-growing metropolitan 

areas in the country—Atlanta, Dallas, and Las Vegas.29 

Results indicated that competition was generally driving 

pricing margins down to very low levels, particularly 

28 Vacancy rates and rental growth rates were obtained from REIS 

Reports. 

29 Steven K. Burton, “Recent Trends in Construction Lending Practices,” Bank Trends, FDIC Division of Insurance, July 1999 (http:// 

www.fdic.gov/bank/analytical/bank/bt9901.pdf). 

compared with the 1980s. In some instances, lenders 

have responded to competitive pressures by making 

structural concessions on loan-to-value, cash equity, 

and recourse terms, particularly for large borrowers. 

However, underwriting standards generally have not 

been as aggressive as practices observed in the 1980s. 

Agricultural Lending 

Low Commodity Prices Stress 

the Agriculture Industry 

Low prices for wheat, corn, hogs, cotton, and oilseeds 

are creating financial difficulties for farmers in the 

nation’s midsection. Several consecutive years of high 

worldwide production have resulted in large inventories 

of grains and oilseeds, which have depressed prices. 

Prices not only have fallen from mid-1990s levels, but 

are also low by historical standards. The United States 

Department of Agriculture (USDA) forecasts for 2000 

show little likelihood of improvement in prices.30 

The financial outlook for significant portions of the 

farm sector has deteriorated. The USDA projects that 

farm income from operations will decline by around 15 

percent in 1999 from year-ago levels. However, total net 

farm income is projected to decline less 

than 1 percent. A projected $16.6 billion in government payments is expected to make up most of the difference 

between operating income and total net 

income.31 Legislation passed in October 

1998 provides for $8.7 billion in emergency aid to affected farmers. 

Farm Banks Continue 

to Perform Well Overall 

Despite the difficulties created by low farm prices, the 

overall financial condition of the 2,250 FDIC-insured 

farm banks continues to be strong.32 Farm banks reported an annualized ROA of 1.21 percent and an equity 

capital-to-assets ratio of 10.5 percent at mid-year 

30 “World Agricultural Supply and Demand Estimates,” USDA, October 10, 1999. 

31 “Potential Impacts of an Agricultural Aid Package,” Agricultural 

Outlook, USDA, September 1999. 32 Farm banks are defined by the FDIC as those with over 25 percent 

of their loans in agricultural production or secured by agricultural real 

estate. 

Chicago Regional Outlook 13 Fourth Quarter 1999 
In Focus This Quarter
 

1999.33 Loan loss reserves, which stood at 1.58 percent 

of total loans in June, remain high compared to historical levels. Loan performance at farm banks also appears 

to be strong at this time. Total past-due loans made up 

just 2.66 percent of total loans at farm banks in June, a 

level that is only 9 basis points higher than a year ago. 

Moreover, this increase in past-due loans is attributable 

entirely to nonagricultural loans; the level of past-due 

farm loans has not risen over the past 12 months. At the 

same time, higher-than-average nonperforming loan 

levels have been reported by farm banks in the upper 

Midwest and the South. 

There are reasons to believe, however, that it will take 

time for financial distress among farm producers to 

significantly affect loan performance at farm banks. 

One such reason is the increasing use of carryover debt 

to restructure and extend operating loans that cannot 

be fully retired by borrowers during the current crop 

year. The most recent Survey of Agricultural Credit 

Conditions conducted by the Federal Reserve Bank of 

Kansas City indicated an increase in the use of agricultural carryover debt by Tenth District banks.34 

An increase in carryover debt was also noted in 

the FDIC’s March 1999 Report on Underwriting 

Practices, which indicated that almost one-third 

of FDIC-supervised farm banks experienced at least 

a “moderate” increase in agricultural carryover debt 

during the preceding six-month period.35 Although the 

use of carryover debt is not an uncommon practice in 

agricultural lending, it can be a leading indicator of 

declining loan performance. Chart 9 shows that 

increases in carryover debt by Tenth District farm 

banks in 1995 preceded increased loan losses during 

1996. 

33 Twenty-three percent of insured farm banks have adopted a Subchapter S designation since 1997, when banks were first allowed to 

take advantage of the favorable tax treatment available under this section of the Internal Revenue Service code. Because of the effects of 

this tax treatment on reported profitability, farm bank ROA levels 

may not be comparable with ratios from prior periods. 

34 Survey of Agricultural Credit Conditions, Federal Reserve Bank of 

Kansas City, June 29, 1999 (http://www.kc.frb.org/PUBLICAT/ 

RED/PDF/2q99AgCrPress.pdf). The Tenth District comprises significant agricultural areas in Colorado, Kansas, Nebraska, Oklahoma, 

Wyoming, northern New Mexico, and western Missouri. 

35 John M. Anderlik and Jeffrey W. Walser, “Agricultural Sector 

Under Stress: The 1980s and Today,” Kansas City Regional Outlook, 

Third Quarter 1999 (http://www.fdic.gov/bank/analytical/regional/ 

ro19993q/kc/k3q1999.pdf). 

CHART 9 

Rising Levels of Carryover Debt Suggest Future 

Increases in Loan Losses at Farm Banks 

Reports (Research Information System) 

Source: Federal Reserve Bank of Kansas City; FDIC Bank and Thrift Call 

–30% 

–10% 

10% 

30% 

50% 

1Q89 2Q90 3Q91 4Q92 1Q94 2Q95 3Q96 4Q97 1Q99 

–1.0% 

–0.5% 

0.0% 

0.5% 

1.0% 

1.5% 

Net Percentage Reporting 

Higher Agricultural Loan 

Renewals and Extensions 

Moving 4-quarter 

Charge-Off Rate

 (percent) 

Agricultural Production Loans 

(right scale) 

Funding and Interest Rate Risk 

Lagging Deposit Growth Has Led to Greater 

Reliance on Market-Based Funding 

For most of the 1990s, banking industry asset growth 

has outstripped growth in deposits, creating greater 

reliance on more expensive and less stable marketbased sources of funding. The trend in the loan-todeposit ratio for commercial banks, which reached a 

record high of almost 90 percent at June 30, 1999, 

reflects this shift. Deposit growth has not kept pace with 

asset growth, in part because of a low rate of personal 

savings by households and competition for depositor 

funds from higher-yielding investment alternatives and 

nonbanks. Lagging deposit growth is particularly 

important for community banks because these institutions traditionally rely more heavily on deposits to fund 

assets than do larger banks.36 Greater dependence on 

market-based funding can alter the liquidity and interest 

rate risk positions of institutions and may require 

heightened attention to, and expertise regarding, assetliability policies and procedures. 

Growth in Securitization Affects Underwriting 

and the Structure of Bank Balance Sheets 

Banks, and nonbanks in particular, continue to employ 

the securitization market to fund lending activities. 

36 Allen Puwalski and Brian Kenner, “Shifting Funding Trends Pose 

Challenges for Community Banks,” Regional Outlook, Third Quarter 

1999 (http://www.fdic.gov/bank/analytical/regional/ro19993q/na/ 

t3q1999.pdf). 

Chicago Regional Outlook 14 Fourth Quarter 1999 
In Focus This Quarter
 

Issuance of asset-backed securities and commercial 

mortgage-backed securities (CMBS) totaled $223 billion through the first six months of 1999, and is on pace 

for another record year. Including participation through 

credit card companies and CMBS conduit programs, 

bank-related issuance amounted to about 25 percent of 

total issuance in 1998, a decline from 1997 levels. 

Although insured institutions are not dominant players, 

growth in the securitization market can influence loan 

underwriting practices and the structure of bank balance 

sheets. 

The securitization market competes to originate loans 

that could be made by insured institutions. This competition may tend to erode underwriting standards if securitizers ease terms to maintain sufficient volume to 

support lending pipelines. Recent trends indicate that 

this competition has intensified. For example, market 

observers note that the subordination levels in the 

CMBS market have been declining, which allows securitizers to increase lending volume for a given level of 

capital.37 

When banks do securitize, it is not always clear how 

much risk is transferred. The issue of credit risk transference by commonly used securitization structures 

continues to receive attention from the markets and rating agencies. For example, many analysts agree that 

revolving structures, such as those used to securitize 

credit cards, eliminate only the most catastrophic credit 

risks for issuers.38 In addition, assets created by gain-onsale accounting rules when loans are securitized can be 

37 Securitizations are often structured in tranches such that a subordinated security bears the credit risk for a senior piece. The relative 

size of the subordinated piece affects not only funding costs for the 

issuer, but also the amount of effective leverage achievable through 

securitization. 

38 A common feature of a revolving securitization structure is the provision for an “early amortization.” When a triggering event occurs, 

such as a negative three-month average excess spread, all available 

cash flows are used to pay off bondholder principal. This event causes receivables related to the deteriorating accounts to remain on the 

balance sheet of the issuer. Unless the deterioration in account credit 

quality is very rapid and severe, the bondholders will be repaid completely, and the credit risk will be borne by the issuer. 

volatile and can lead to unstable earnings and capital if 

not properly controlled and administered. 

Banks and Thrifts Appear Increasingly 

Vulnerable to Rising Interest Rates 

Potentially volatile liabilities and long-term assets 

have been growing as a percentage of banking assets. 

Consistent with reduced deposit funding by insured 

institutions, more market-based and potentially volatile 

liabilities have been supporting an increasing proportion of banking assets in recent years (see Chart 10).39 

At the same time, the lengthening maturity of insured 

institution mortgage portfolios has increased the percentage of total bank assets with maturities or repricing 

frequencies of greater than five years. This trend in 

mortgage portfolios is primarily responsible for the 

thrift industry’s increasing interest rate sensitivity. 

According to the Office of Thrift Supervision’s Quarterly Review of Interest Rate Risk, interest rate sensitivity for the median thrift rose in the second quarter of 

1999 for the third consecutive quarter. 

39 Volatile liabilities include borrowings, federal funds purchased, 

repurchase agreements, jumbo certificates of deposit, foreign 

deposits, and trading liabilities. 

CHART 10 

Long-Term Assets and Volatile Liabilities
 

Have Been Growing as a Percentage
 

of Total Assets
 

Percentage of 

Total Assets 

35 

30 

25 

20 

15 

10 

Volatile Liabilities 

Long-Term Assets 

2Q92 2Q93 2Q94 2Q95 2Q96 2Q97 2Q98 2Q99 

Note: Long-term assets have a maturity or repricing frequency of greater than
 

five years.
 

Source: FDIC Bank and Thrift Call Reports (Research Information System)
 

Chicago Regional Outlook 15 Fourth Quarter 1999 
In Focus This Quarter
 

Operational Risks 

Insured banks and thrifts face numerous business- and 

process-oriented operational risks on a daily basis. At 

the same time, recent industry developments and bank 

failures have highlighted the importance of maintaining 

strong operations. The Basle Committee on Banking 

Supervision reported in late 1998 that “awareness of 

operational risk among bank boards and senior management is increasing.”40 

The competitive environment and shareholder expectations have led many insured institutions to search for 

greater efficiency by cutting costs. In some cases, deep 

cuts in overhead expenses may weaken the effectiveness 

of operating and monitoring systems as well as internal 

controls. Anecdotal evidence from banking regulators 

suggests that internal control and recordkeeping weaknesses are on the rise. Moreover, industry consolidation 

and new business activities are creating bigger, more 

complex, and more decentralized operating environments, especially for the largest institutions. These 

issues are important since operational weaknesses may 

leave institutions more vulnerable to adverse economic 

conditions, insider abuse, or fraud. 

Implications 

This article has summarized the generally favorable current condition of the U.S. economy and banking industry. The economy is in the ninth year of a remarkable 

economic expansion that has been conducive to a high 

level of financial performance on the part of the banking industry. There are, nonetheless, areas of vulnerability that could contribute to a less favorable economic 

environment and less robust financial performance for 

insured institutions in the future. 

One issue raised by this report is rising indebtedness on 

the part of households and businesses, which represents 

a growing private deficit. Rising interest rates could 

40 “Operational Risk Management,” Basle Committee on Banking 

Supervision, September 1998 (http://www.bis.org/publ/bcbs42.pdf). 

increase the debt service burden for consumers and 

businesses, making them more vulnerable to a slowing 

economy. An increasing private deficit is problematic 

also because the two major sources of financing—foreign capital inflows and domestic credit creation—have 

the potential to create problems for the economy and for 

lenders. Dependence on foreign capital makes U.S. 

inflation and interest rates highly subject to changes in 

the decisions of foreign investors and the value of the 

dollar. The rapid pace of credit creation by the financial 

sector threatens to impair credit quality. The intuition 

that loose underwriting standards can lead to credit 

quality problems is supported by recent signs of rising 

credit losses in a strong economy. 

The second issue that cuts across this report is the effect 

that competition is having on banking strategies and 

exposures to credit, market, and operational risks. There 

has been an increase in lending to less creditworthy borrowers, including subprime consumer borrowers and 

leveraged corporate borrowers. There is also evidence 

that institutions are pursuing asset-liability structures 

with higher levels of interest rate risk to maintain loan 

growth and meet funding needs. Finally, some of the 

innovations banks have used to counter competitive 

pressures may introduce new risks associated with complex accounting valuations, weakening internal controls, and the need for more intensive loan servicing. 

The third issue is the increasing potential for financial 

market instability, which leaves the economy and the 

banking system vulnerable to sudden shocks. Events 

from fall 1998 showed some of the more damaging 

aspects of these crises, as market-based financing went 

from abundance to scarcity virtually overnight. The 

financial imbalances associated with the rapid creation 

of credit and borrowing from abroad not only create the 

need for the economy to slow down eventually, but also 

threaten to make that adjustment process a 

volatile one. Financial market shocks 

could quickly alter the confidence of 

consumers and businesses and their 

access to financing. Such instability 

could end the current expansion and 

expose underlying weaknesses in 

bank risk-management practices. 

Chicago Regional Outlook 16 Fourth Quarter 1999 
In Focus This Quarter
 

This article was prepared and coordinated by the staff of the Analysis Branch of the Division of Insurance. Contributions and feedback from analysts across the Division were essential to its completion. 

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

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

Steven K. Burton, Senior Banking Analyst 

Steven E. Cunningham, Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Arlinda Sothoron, Senior Financial Analyst 

Jack Taylor, Senior Financial Analyst 

Chicago Regional Outlook 17 Fourth Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

•	 The Region’s aggregate economy remains healthy, reflecting some conditions typically experienced in a 

mature expansion as well as others unique to the current cycle. A slowdown in the manufacturing sector’s 

growth and developments in the agricultural sector, however, warrant monitoring. 

•	 The reported aggregate financial condition of the Region’s banks and thrifts was favorable in second quarter 1999 as higher noninterest income offset a decline in net interest margin. 

•	 An increasing number of new banks and thrifts, which often exhibit high-risk profiles, are being established 

in the Region. 

Regional Conditions Reflect Expansion’s Longevity
 

Many economic and banking conditions within the 

Region are in line with those typically experienced after 

an extended period of expansion. Some, however, differ. 

The combined effect of these developments is that generally healthy economic conditions in the Chicago 

Region likely will continue at least through March 

2000, the cyclical expansion’s ninth anniversary. 

Industrial Sector Growth Slows 

The Region’s sustained low unemployment rate—4.1 

percent or less since late 1997—reflects tight labor markets. In turn, the lack of readily available workers and 

the need to attract workers away from other employers 

are limiting the Region’s ability to expand rapidly and 

triggering higher personnel costs and profit pressures 

among some firms. 

Although demand continues to climb for motor vehicles and some other products important to the Region’s 

manufacturers, combined output growth of 16 of the 

Region’s major manufacturing industries has slowed to 

between 1 and 2 percent during the past year (see Chart 

1). The current pace is the slowest since immediately 

after the last recession, except for the weakness in 1995 

and early 1996, following a year of rising interest rates. 

Along with tight labor markets and slower domestic 

demand growth, weak demand from abroad and the 

loss of some customers to foreign producers are contributing to the slowdown in the Region’s industrial 

output growth. 

National capacity utilization rates late in the summer 

suggest that increased production could be realized 

from current factories if strong demand conditions 

warranted it. Manufacturers of both durable and nondurable goods were using between 79 and 80.5 percent 

of their production capacity recently, somewhat below 

their annual averages of recent years (see Chart 2). The 

slowdown in production growth and easing of factory 

utilization rates have contributed to a 0.5 percent (or 

22,000 workers) drop in employment among the 

Region’s manufacturing firms in the year ending 

August 1999. 

CHART 1 

Midwest’s Industrial Output Growth Slows 

Source: Federal Reserve Bank of Chicago, via Haver Analytics, Inc. Percent Change from Year Ago 

20 

15 

10 

5 

0 

–5 

–10 

–15 

’82’83’84’85’86’87’88’89’90’91’92’93’94’95’96’97’98’99 

Chicago Regional Outlook 18	 Fourth Quarter 1999 
Regional Perspectives
 

CHART 2 CHART 3 Percent of Capacity 

Capacity Utilization Rates 

Ease among Manufacturers 

3Q99 plot is the average of July and August figures. 

Source: Federal Reserve Board, via Haver Analytics, Inc. 

90 

85 

80 

75 

70 

65 

60 

’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

Utilization Rate: 

Producers of 

Durable Goods 

Utilization Rate: Producers 

of Nondurable Goods 

3Q99 

Office Vacancy Rates Climb in Columbus 

Source: CB Richard Ellis, via Haver Analytics, Inc. Percent 

’98 

5 

7 

9 

11 

13 

15 

17 

19 

21 

23 

25 

5 

7 

9 

11 

13 

15 

17 

19 

21 

23 

25 

Downtown area 

Suburban areas 

’86 ’88 ’90 ’92 ’94 ’96 

Commercial Real Estate Activity Is Rising 

High levels of new construction and rising valuations of 

existing properties are accompanying the continued 

expansion. Scattered pockets of “hot” construction 

activity are reported in a few of the Region’s metropolitan markets, typically in suburban areas. Among the 

Region’s largest metropolitan statistical areas (MSAs), 

only Columbus, Ohio, has posted consistent and sizable increases in vacant office space over the past year 

(see Chart 3), a trend deserving careful evaluation by 

lenders, builders, and owners in that market. 

Overall office vacancy rates in the Region’s other major 

MSAs (Chicago, Cincinnati, Cleveland, Detroit, and 

Indianapolis) have not been boosted noticeably by 

recent construction, at least to date. However, because 

these MSAs are quite large, favorable aggregate data 

may obscure submarkets where a number of new projects under way will add new space in coming quarters. 

Should excess supply develop, cash flows for both 

existing and new structures could be negatively affected. In addition, some market participants may have been 

lulled by the favorable levels and stability of financing 

terms of recent years, which may not hold in coming 

quarters. 

One quarter of the Region’s 2,019 insured institutions 

had 200 percent or more of their Tier One capital 

exposed to commercial real estate (CRE) loans as of 

June 30, 1999. Among these institutions, 190 experienced CRE loan growth of 30 percent or more in the 

past year (based on data adjusted for mergers), with a 

median percentage increase of 49 percent. Although 

some loans secured by commercial real estate may, in 

fact, function as commercial and industrial (C&I) loans 

because their proceeds are used to finance general business operations, this portfolio segment warrants attention because of concentration, growth, issues related to 

the proper valuation of collateral properties, and rising 

interest rates. 

C&I Loans Are Growing Faster 

than Aggregate Loan Portfolios 

Other developments at insured institutions also mirror 

those typically experienced in a mature expansion. For 

example, C&I loans are growing faster than total loan 

portfolios, an indication that businesses are relying 

more heavily on external sources of financing than earlier in the expansion. This rising reliance on external 

funding is reflected by increases in what is sometimes 

referred to as the “financing gap,” the difference 

between capital expenditures and internally generated 

funds.1 Among nonfarm corporations outside the financial sector, taken in the aggregate, the financing gap is 

currently at a record high (see Chart 4, next page). 

Call report data for banks and thrifts in the Chicago 

Region show that, in the year ended June 30, aggregate 

loans expanded by 8.4 percent and C&I loans grew by 

1 In technical terms, the financing gap equals capital expenditures less 

the sum of domestic (U.S.) internal funds and inventory valuation 

adjustment. 

Chicago Regional Outlook 19 Fourth Quarter 1999 
Regional Perspectives
 

CHART 4 

Source: Federal Reserve Board, via Haver Analytics, Inc. 

Financing Gap among Nonfinancial 

Corporations Is High and Rising 

’73 ’75 ’77 ’79 ’81 ’83 ’85

$ Billions 

–50 

–30 

–10 

10 

30 

50 

70 

90 

110 

130 

150 

’87 ’89 ’91 ’95 ’97 ’99 ’93

13.9 percent, with larger institutions participating more 

than smaller ones (see Table 1). Among institutions with 

assets of $500 million or less, C&I loan growth has 

been stronger among newly formed institutions than 

among more seasoned ones, as discussed in more detail 

later in this article. 

In addition, aggregate loans and leases relative to total 

assets have risen during the expansion, which is typical. 

The 67 percent share in the Region on June 30, 1999, 

was the highest midyear share in at least 15 years. 

Meanwhile, a decline in net interest margins (NIMs) 

also is occurring, which is discussed along with other 

performance measures in the next section of this article. 

TABLE 1 

Loan Growth among 

Chicago Region’s Institutions 

MEDIAN GROWTH RATE (%): 

INSTITUTIONS’ 1999:Q2 FROM 1998:Q2

ASSET SIZE NET LOANS C&I LOANS 

$500 MILLION 

OR LESS 7.2 9.2 

excluding 


institutions 


established 


since 1996:Q2
 6.9 8.8 

$500 MILLION TO 

$1 BILLION 12.8 14.2 

$1 TO $10 BILLION 9.9 13.2 

$10 BILLION AND 

HIGHER 7.9 16.1 

C&I = Commercial and industrial 

Source: Bank and Thrift Call Reports, June 30, 1999 

The Current Situation Has 

Distinguishing Features 

Although the economy tends to follow a “normal” pattern, each business cycle has its own special characteristics. The unusually low inflation rate of less than 2.5 

percent after many years of this expansion has surprised 

many analysts. This condition, in turn, is contributing to 

interest rates that, although rising, at midyear were still 

among the lowest levels of the cycle. 

Recent years’ conditions in world financial markets also 

have contributed to keeping interest rates on U.S. Treasury securities low for this stage of an expansion. In 

turn, favorable financing rates have supported unusually robust growth in consumer and business spending 

during the ninth year of an expansion. In the aggregate, 

the generally low interest rate environment benefited 

much of the Region’s manufacturing sector, as well as 

financial services, construction, and others. These benefits may have more than countered the negative impact 

of rising import levels or heightened foreign competition that trimmed—sometimes significantly—output of 

specific firms in the Region. 

Unusually rapid appreciation in asset values is another 

distinguishing feature of the current economic expansion. The significant appreciation in real estate, equity, 

and other household assets over the past four years is 

illustrated in Chart 5. Without the wealth effect generated by their rising net worth, households’ spending 

growth likely would have moderated noticeably by 

now, in line with their personal income gains (see Chart 

5). Had that happened, demand for vehicles, appliances, and other goods produced in the Region likely 

CHART 5 

Significant Asset Appreciation Buffers 

Slower Income Growth in the Region 

Sources: Bureau of Economic Analysis and Federal Reserve Board, 

via Haver Analytics, Inc. Percent Change from Year Ago

$ Trillions 

’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 

1 

2 

3 

4 

5 

6 

7 

8 

9 

–0.5 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

All Households’ Holding 4.0

Gains on Assets 

(right scale) 

Personal Income: 

Chicago Region 

(left scale) 

Chicago Regional Outlook 20 Fourth Quarter 1999 
Regional Perspectives
 

would have been lower and, in turn, the recent growth 

in jobs and manufacturing output would have slowed 

more than it has. Among businesses, recent years’ stock 

market conditions are providing an attractive source of 

financing for many firms, helping to support their capital modernization and expansion efforts. 

The risk ahead is that a sudden drop in real estate or 

stock values, should one occur, could trigger a sharp 

and swift decline in households’ discretionary spending, with depressing spillover effects on manufacturers 

and local communities. Business firms could face 

reduced access to capital. In such an environment, 

insured institutions could experience increased customer use of unsecured lines of credit, reduced collateral values, and deterioration in the performance of 

their loan portfolios. 

Bank and Thrift Overview:
 

Financial Performance Remains Solid despite Falling Margins
 

Chicago Region banks and thrifts reported overall 

healthy financial conditions during the first six months 

of 1999. 

Commercial Banks Report Stable Profitability 

Despite a significant decline in the aggregate NIM to 

3.86 percent, down 17 basis points from June 1998, 

profitability of the Region’s commercial banks 

remained fairly stable. On an aggregate basis, return on 

assets (ROA) was 1.32 percent for the quarter ended 

June 30, 1999, compared with 1.31 percent a year earlier. This ROA level was heavily dependent on increases 

in noninterest income (NONII). 

Competition from other financial intermediaries and a 

relatively flat yield curve during the first half of the year 

led to the continued decline in the NIM. However, the 

Region’s commercial banks are trying to bolster earnings performance through other forms of revenue. 

These institutions’ growing use of NONII has been critical in helping to sustain overall profitability in light of 

lower margins and rising noninterest expenses (see 

Chart 6). When taken as a percentage of average assets, 

NONII for the Region’s commercial banks was 2.08 

percent, up 26 basis points from June 1998. 

age ratio could suggest that commercial banks have not 

made sufficient provisions for loan losses, which may 

affect the quality of future earnings. While allowance 

coverage slipped, capital levels remained stable at 

approximately 7.9 percent. 

Savings Institutions’ Performance Strengthens 

Performance among the Region’s 394 savings institutions strengthened by June 1999. NIMs improved 10 

basis points to 3.15 percent, resulting in a 1.09 percent 

ROA, up from 0.97 percent a year earlier. The improved 

performance of the Region’s thrifts can be attributed 

largely to a shift in asset mix (see Chart 7, next page). 

The aggregate loan-to-assets ratio grew to roughly 73 

percent, its seventh consecutive year-over-year increase 

since June 1992. This loan growth represents a shift 

CHART 6 

Rising Noninterest Income Helps to Sustain
 

Profitability at Commercial Banks
 

Jun-97 Jun-98 Jun-99
 

5
 

4 

the year-earlier period, at 2.13 percent. However, these 

0 institutions reported lower reserve coverage of past-due Net Interest Return Noninterest Noninterest

and nonaccrual loans (coverage ratio) of 180 percent Margin on Assets Income Expense 

during the first six months of 1999 compared with 196 Source: Bank and Thrift Call Reports, June 30, 1999 percent in the prior year’s period. The declining cover- Percent of Assets 3 

Reported asset quality at the Region’s commercial insti2 tutions held steady during the first half of 1999 as pastdue and nonaccrual loans remained fairly stable from 1 

Chicago Regional Outlook 21 Fourth Quarter 1999 
Regional Perspectives
 

CHART 7 

1 to 4 Family 

Other 

1995 1999 

Source: Bank and Thrift Call Reports (as of June 30) 

Declining Interest Rates 

Lead to a Shift in Asset Mix 

C&I 

Consumer 

from lower-yielding securities and, at the same time, a 

change in loan mix. 

One- to four-family residential mortgages continue to 

comprise the bulk of assets of the Region’s savings 

institutions. However, the declining interest rate environment, which began early in 1995 and continued into 

the first quarter of 1999, has led to a migration away 

from lower yielding residential mortgages toward higher yielding consumer loans and C&I obligations. As a 

result, one- to four-family obligations now comprise 68 

percent of total loans, down 8.5 percent from June 1995. 

However, the Region’s thrifts have experienced an 

increase in the C&I and consumer loan portfolios to 2.5 

percent and 11.9 percent, respectively, up from 1.2 percent and 6.5 percent as of June 30, 1995. 

Currently, neither C&I nor consumer loans make up a 

significant portion of the aggregate assets of the 

Region’s thrifts, but the five-year growth trend has 

been significant. Given the newness of these loans, 

asset quality remains solid. As a result, total past-due 

and nonaccrual loans among the Region’s thrifts 

improved over the past three years to 1.70 percent by 

June 30, 1999. However, the changing loan composition of these institutions has not been tested during a 

recession. 

Weak Agricultural Conditions Persist
 

According to The Kiplinger Agriculture Letter,2 the 

overall farm economy will remain under stress well into 

2000. Abundant supply, sagging demand, and increased 

competition from abroad will continue to depress crop 

prices, particularly for the Region’s principal crops of 

soybeans and corn (see Table 2). 

Weakness in crop prices continues to affect farmland 

values. Agricultural bankers in Illinois, responding to 

the Federal Reserve Bank of Chicago’s AgLetter3 survey, reported that the value of “good” farmland was 

down 7 percent on July 1, 1999, from a year ago. In 

Indiana, agricultural bankers reported farmland values 

off by 4 percent over the same period. 

While agricultural loans represent less than 2 percent of 

the total loan portfolio held by the Region’s insured 

institutions, a significant portion of agricultural loans 

are held by small institutions that are highly concentrated in this loan type. The Region’s 336 agricultural 

2 The Kiplinger Washington Editors, Inc., The Kiplinger Agriculture
 

Letter, August 13, 1999.
 3 Federal Reserve Bank of Chicago, Farmland Values and Credit Conditions, AgLetter, Number 1905, August 1999.
 

banks4 held agricultural loans totaling $4 billion as of 

June 30, 1999, or 32 percent of all agricultural loans 

held by the Region’s insured institutions. Reported asset 

TABLE 2 

Regional Producers Concentrate

in Corn and Soybeans 

Percent of Total U.S. Production 

1994–1998 Average 

CORN SOYBEANS 

RANK STATE PERCENT STATE PERCENT 

1 

2 

3 

4 

5 

IOWA 18.5 IOWA 18.0 

ILLINOIS 16.0 ILLINOIS 16.8 

NEBRASKA 12.2 MINNESOTA 9.8 

MINNESOTA 9.6 INDIANA 8.6 

INDIANA 7.9 OHIO 6.9 

REGIONAL PRODUCTION
 

23.9 32.3
 

Source: United States Department of Agriculture 

4 An agricultural bank is defined as an insured institution in which the 

sum of agricultural production loans and loans secured by farmland 

exceeds 25 percent of total loans. 

Chicago Regional Outlook 22 Fourth Quarter 1999 
Regional Perspectives
 

quality measures at these institutions are showing some 

deterioration. Total past-due and nonaccrual loans 

equaled 2.37 percent of total loans as of June 30, 1999, 

up from 2.12 percent a year ago. According to the 

AgLetter, loan repayments were most problematic in 

Illinois and Indiana. In addition, the reserve coverage of 

past-due and nonaccrual loans (coverage ratio) among 

the Region’s agricultural banks declined to 129 percent 

as of June 30, 1999, from 153 percent a year ago (see 

Chart 8). As a group, agricultural banks reported high 

capital levels and healthy earnings performance; however, the declining coverage ratio indicates that earnings 

are possibly beginning to be overstated as provision 

expenses have not kept pace with increasing levels of 

past-due and nonaccrual loans. 

CHART 8 

Source: Bank and Thrift Call Reports 

Reserve Coverage of Past-Due and Nonaccrual 

Loans Declines among Agricultural Banks 

Sep. ’96

Dec. ’96

Mar. ’97 

Jun. ’97

Sep. ’97

Dec. ’97

Mar. ’98 

Jun. ’98

Sep. ’98

Dec. ’98

Mar. ’99 

Jun. ’99 

3.0 

Percent Percent 

Past-Due and 

Nonaccrual Loan Ratio 

(Left Axis) 

Coverage 

Ratio 

(Right Axis) 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

0 

20 

40 

60 

80 

100 

120 

140 

160 

180 

200 

New Bank and Thrift Formation Has Accelerated in the Chicago Region
 

Nationally, new bank5 creation has steadily increased 

since 1993 but remains well below levels experienced in 

the early to mid-1980s. In the Region, however, the 

level of new bank formation exceeds 1980s levels. During that time, the Region averaged 13 new bank openings annually, compared with 17 annually during the 

1990s. Twenty-seven new banks were established in 

1998, and 28 more have been established through September 9, 1999, ensuring that 1999 will have the highest level of new bank activity during the past two 

decades. 

Illinois has reported the greatest number of new banks 

in the Region since 1980. Activity in the past five years 

has been concentrated in Illinois and Michigan, but the 

pace increased in all states in the Region (see Chart 9). 

Illinois may continue to lead, given that 19 applications 

for state charters were pending in that state as of early 

September. 

Most new banks have been established in urban areas; 

87 percent of institutions started since 1980 are located 

in MSAs (see Map 1, next page). In particular, the 

Chicago and Detroit metropolitan areas have had substantial new bank activity. Cook, Lake, and DuPage 

counties in Illinois—all part of the Chicago MSA— 

have experienced the highest level of new bank creation 

5 New banks include de novo commercial banks and savings institutions established since 1980. 

since 1990 totaling 28, 13, and 9 new banks, respectively. These large markets likely provide more opportunities to new bank organizers hoping to fill a niche. 

Several Factors Are Leading 

to More New Bank Formation 

The banking industry’s record profitability in the mid1990s and the strength and longevity of the current economic expansion have helped drive new bank creation. 

A strong stock market has improved access to capital. In 

addition, the prospect of gains through initial public 

CHART 9 

Data through September 9, 1999 

Source: FDIC’s Structure Database 

The Pace of New Bank Formation Is 

Increasing across the Region 

Number of New Banks Formed 

IL 

IN 

MI 

OH 

WI 

0 20 40 60 80 100 120 

1980 to 1984 

1985 to 1989 

1990 to 1994 

1995 and after 

Chicago Regional Outlook 23 Fourth Quarter 1999 
Regional Perspectives
 

MAP 1 

Source: Bank and Thrift Call Reports for institutions established 

since January 1980 

New Banks Concentrated in Larger Markets 

(since 1980) 

Numbers of New Banks
 

(Number of Counties
 

in Parentheses)
 

Ten or more (6) 

Four to nine (17) 

One to three (88) 

None (326) 

offerings or because of potential sales of new banks to 

other institutions attracts investors to bank start-ups. 

Selected research also points to consolidation in the 

industry as a primary driver of new bank formation. For 

example, purchases of small, locally owned institutions 

by larger entities may lead to customer dissatisfaction 

and create opportunities for displaced banking executives and other entrepreneurs to provide small-business 

financing and personal banking services. 

However, consolidation may not necessarily lead to 

new bank formation in the same market areas where the 

consolidation has occurred. A study by the FDIC’s 

Division of Research and Statistics6 found that consolidation may not typically lead to new banks, at least in 

the same market areas. This study reviewed new bank 

activity in metropolitan markets from 1995 through 

1997 and found that recent acquisitions tended to have 

a negative correlation with new bank formation. 

The relaxation of unit banking laws and the emergence 

of interstate banking have contributed to increased 

merger activity and also may be contributing to new 

bank formation, particularly in Illinois, which previously had very strict unit banking laws. In addition, Illinois 

recently enacted the Banking on Illinois Act, empower6 Steven Seelig and Timothy Critchfield, FDIC Division of Research 

and Statistics, “Determinants of De Novo Entry in Banking,” 1999. 

ing state-chartered banks and thrifts to sell virtually any 

product or service if the same function is allowed by at 

least one other state. This development may increase the 

appeal of an Illinois charter to new bank organizers over 

time; however, this legislation currently does not appear 

to have expanded the types of permissible banking 

activities in the state. 

New Banks Face a Higher Risk Profile 

Rapid asset growth and weak earnings levels are typical 

for new banks. They also traditionally report low profitability levels because of high overhead and interest 

expenses. The Region’s new banks are no exception (see 

Table 3). 

Profitability. New banks and thrifts take time to grow 

into their initial overhead and replace higher cost funding with more stable deposits. A recent study7 found that 

while new banks report rapid improvement in profitability during the first three years of operation, an 

average of nine years of operation is required before 

they reach established banks’ levels. New banks’ weak 

initial earnings performance is attributable in part to 

high start-up costs and overhead expenses relative to a 

smaller earning assets base. 

TABLE 3 

High Overhead and Funding Costs 

Hamper New Banks’ Profitability 

NEW ESTABLISHED 

PERFORMANCE BANKS** INSTITUTIONS 

MEASURES* (%) (%) 

INTEREST INCOME 7.90 7.53 

INTEREST EXPENSE 4.11 3.68 

NONINTEREST INCOME 0.44 0.53 

OVERHEAD 3.61 2.85 

RETURN ON ASSETS 0.40 1.03 

* Median values; ratios as a percent of average assets 

** Chicago Region institutions in operation for more 

than one year but less than three years as of June 

30, 1999 

Source: Bank and Thrift Call Reports, June 30, 1999 

7 Robert DeYoung and Iftekhar Hasan, “The Performance of De Novo 

Commercial Banks: A Profit Efficiency Approach,” Journal of Banking and Finance, 1998, Volume 22, Issue 5. 

Chicago Regional Outlook 24 Fourth Quarter 1999 
Regional Perspectives
 

Recently, the rate of new bank earnings improvement 

has moderated. Median earnings after the second year 

of operation have been declining slightly for the 

Region’s new banks. Banks established from 1984 to 

1990 achieved a median ROA of 0.34 percent after two 

years. This earnings level has declined to 0.31 percent 

for banks and thrifts established since 1991. This earnings trend may indicate a change in the conditions that 

in the past made opening new banks desirable. 

Increased competition and the aging economic expansion may be contributing to the decline in new bank 

earnings improvement. 

Concentrations. The relative lack of diversification, 

both geographically and in asset mix, typical in new 

banks also poses potential risks. Because new banks are 

generally well capitalized initially, the likelihood of failure is extremely low in early years. The rate of failure 

quickly increases after the first few years of operation 

when capital levels have reached those of established 

institutions, but profitability and growth rates have not. 

At that point, many new banks may be experiencing 

rapid asset growth, weak earnings, declining capital 

levels, and less diversified loan portfolios than other 

institutions.8 

High levels of C&I lending also evidence increased risk 

at new banks and may explain the higher interest yields 

shown in Table 3. The median share of C&I loans to 

total loans for institutions established after 1989 and 

open for at least one year is currently 22 percent, versus 

11 percent for older institutions in the Region. New 

banks’ reliance on commercial lending, which is highly 

cyclical and has historically represented a riskier loan 

category than other forms of lending, indicates that 

asset quality concerns could quickly arise in an economic downturn. 

Funding. Funding strategies used by new banks add an 

additional layer of risk. Core funding represents only 69 

percent of assets for institutions established in the 

1990s, versus 76 percent for older ones. The high interest expense experienced by new banks and thrifts has 

resulted from this greater reliance on noncore funding 

sources. 

8 For further details, refer to Robert DeYoung, Birth, Growth, and 

Life or Death of Newly Chartered Banks, Federal Reserve Bank of 

Chicago, 1999. 

While new banks typically rely on noncore funding, the 

composition of this funding has been changing. This 

development is illustrated by a greater number of the 

Region’s new banks using a fairly significant volume of 

brokered deposits, which are traditionally viewed as a 

highly volatile source of funds. Currently, 13 percent of 

institutions established in the 1990s are funding 3 percent or more of assets with brokered deposits, compared 

with only 7 percent of established banks and thrifts. The 

number of new banks with a significant amount of brokered funds has increased from five years ago, when 

only 8 percent of new banks relied on brokered deposits 

to the same extent. As a result, any disruptions in capital markets may disproportionately affect new banks’ 

funding capabilities and costs. 

An Economic Downturn May Pose 

a Serious Threat to New Banks 

The significant growth in new institution formation in 

the Region that is occurring late in an economic expansion is a concern. Although new bank failure rates have 

been low in the Region for institutions established since 

1980, certain developments could heighten risk levels 

for new banks. Combined with 

the significant volume of new 

banks’ commercial lending, 

higher noncore funding, and a 

declining pace of earnings 

improvement, an economic 

downturn in the next several 

years could excessively strain 

new banks. Many of these new banks have not experienced a recession, and their ability to adapt to weakening economic conditions is relatively untested. 

As previously discussed, the risk of failure for new 

banks is greatest after the first few years of operation, 

while earnings remain low, capital levels are approaching established bank levels, and asset growth is high. 

Many new banks will be entering this period in the next 

few years and will need to manage carefully the effects 

of any economic downturn. 

Chicago Region Staff 

Chicago Regional Outlook 25 Fourth Quarter 1999 
✁
 

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