Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 2002 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

and Research
 

John M. Anderlik,
 

Regional Manager
 

Jeff W. Walser,
 

Regional Economist 


Richard D. Cofer, Jr.,
 

Senior Financial
 

Analyst
 

Regional Perspectives 

◆ Some observers have viewed the Internet as an important means of improving the economic condition of rural areas—The rapidly diffusing technology 

allows rural consumers faster and cheaper access to a wider variety of information, 

goods, and services, and provides rural businesses with the means to operate more 

efficiently and reach wider markets. 

◆ At the same time, the Internet may enhance the ability of non-local businesses 

to compete in isolated rural areas—Evidence suggests that an increasing number 

of farmers are purchasing inputs online from suppliers outside their areas. 

◆ Internet technology may also be a double-edged sword for rural banks— 

On one hand, it may allow them to provide a broad range of services over wider 

areas, but it may also expose these institutions to competition from large banks that 

could not previously afford to deliver services to rural areas. See page 3. 

By Jeffrey Walser 

In Focus This Quarter 

◆ The Road to Recovery for Commercial Credit Quality: Not without a Few 

Hurdles Ahead—The recession that began in March 2001 has been especially 

hard on the corporate sector. Banks that made loans to affected firms felt the 

immediate effects of the recession through rising problem commercial loans. 

Large banks took the brunt of this commercial credit deterioration, as indicated 

by a somewhat larger uptick in problem commercial loans among large banks 

compared with smaller banks. This credit deterioration was more apparent 

at banks that participated in loan syndications, one of the financing vehicles 

available primarily to large corporate customers. Various indicators pointing 

toward economic recovery, as well as an apparent decline in rating downgrades 

and default rates among corporate bond issuers in recent weeks, suggest that 

improvement in commercial credit quality may be just ahead. This recovery, however, faces a few hurdles, including continued high leverage, weak earnings, and 

prospects for a more difficult funding environment, particularly for speculativegrade corporations with maturing debt. See page 10. 

By Cecilia Lee Barry, Senior Financial Analyst 

A Publication of the Division of Insurance and Research 
The Regional Outlook is published quarterly by the Division of Insurance and Research of the 

Federal Deposit Insurance Corporation as an information source on banking and economic issues 

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

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

The first and third quarter issues of the Regional Outlook feature in-depth coverage of the economy and the banking industry in each Region and consist of a national edition and eight regional editions. The second and fourth quarter issues are a single national edition that provides an overview 

of economic and banking risks and discusses how these risks relate to insured institutions in each 

FDIC Region. These issues tell the national story and, at the same time, alert the reader to specific 

trends and developments at the regional level. 

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 Kansas City Region’s Regional 

Outlook, please call John Anderlik at (816) 234-8198 or send an e-mail to janderlik@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 Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

and Research 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives 

The Information Superhighway: Panacea or Threat for Rural America? 

In the second half of the 1990s, Internet technology 

dawned, bringing with it the promise of “abolishing distance” and creating a truly global marketplace. Many 

observers believe emerging telecommunications technology may provide the means of maintaining or restoring the vitality of many of America’s rural areas. 

According to this line of thinking, improved telecommunications will improve the quality of life in sparsely 

populated areas and will allow rural businesses to compete more effectively over wider areas. 

Closer analysis suggests, however, that while there is 

some truth to these beliefs, Internet technology may 

prove to be less than the “magic bullet” hoped for by 

those who are searching for means to revitalize rural 

economies. This article explores potential effects of 

recent advances in telecommunications on rural 

economies, with special attention to the experience of 

community banks as these institutions adopt Internet 

technology. 

Many Rural Areas Face 

Continuing Economic Decline 

As discussed in the Kansas City Regional Outlook, 

first quarter 2002, a majority of the Region’s counties 

have declined in population since the 1970s, with a significant fraction declining at an increasing rate during 

the 1990s.1 

Analysis of recently released data from the 2000 Census 

shows that these trends are continuing. The United 

States, along with all industrialized countries, has experienced rural-to-urban migration throughout its history, 

as technological advances in agriculture have reduced 

the demand for farm labor. The relative importance of 

agriculture in the Kansas City Region has heightened 

the visibility of this phenomenon in recent decades. 

As rural populations decline, the economic viability of 

many small towns and rural areas becomes increasingly 

threatened. Low and declining population densities 

make it more difficult for rural businesses to grow or 

even survive. It also becomes increasingly expensive to 

provide roads, schools, and health care. The decline in 

rural populations has not gone unnoticed, however, as 

individuals from the rural business community, academia, and state, federal, and county governments 

search for ways to maintain the economic viability of 

rural areas. 

Some observers have viewed recent advances in 

telecommunications as a means of improving the economic condition of rural areas. The instantaneous transfer of information allowed by the Internet reduces 

historic pressures on firms to locate in urban areas, 

increases the competitiveness and efficiency of rural 

businesses, facilitates telecommuting, and provides 

opportunities for distance learning. 

The Internet in Rural America— 

A Reason for Optimism? 

Access to the Internet has diffused rapidly in rural 

America, closely tracking national trends. According to 

surveys conducted by the United States Census Bureau 

in September 2001 (see Chart 1) access to the Internet 

in rural households is only slightly less than that in 

urban households. 

CHART 1 

Percentage of U.S. Households with 

Internet Access, by U.S., Rural, Urban, 

and Central Cities, 1998, 2000, 2001 

Percent 1998 2000 2001 60 

50 

40 

30 

20 

10 

0 

26.2 

41.5 

50.5 

22.2 

38.9 

48.7 

27.5 

42.3 

51.1 

24.5 

37.7 

45.7 

U.S. Rural Urban Central Cities 

Note: Central Cities are the largest cities in the MSA.
 

Source: U.S. Department of Commerce, National Telecommunications and
 

Information Administration, and Economics and Statistics Administration, using
 

Census Bureau Current Population Survey Supplements. A Nation Online:
 

How Americans Are Expanding Their Use of the Internet. February 2002.
 

1 Depopulation Threatens the Viability of Many of the Region’s Rural 

Counties. Kansas City Regional Outlook, first quarter 2000, 20–28. 

Kansas City Regional Outlook 3 Third Quarter 2002 
Regional Perspectives
 

As of September 2001, 48.7 percent of rural households 

had access to the Internet, compared with a national 

rate of 50.5 percent. From 1998 to 2001, growth in 

Internet use in rural households was particularly 

strong—24 percent at an average annual rate.2 Adoption 

of the Internet in rural areas has closely tracked the rate 

in the nation as a whole, suggesting, at least at first 

glance, that the countryside is fully participating in the 

so-called “Internet Revolution.” 

Independent research conducted by the United States 

Department of Agriculture’s Economic Research 

Service in June 2001 indicates that Internet use by farmers is comparable to that by small manufacturers. The 

survey found that 43 percent of farmers use the Internet 

in their business, compared with 47 percent of manufacturers with fewer than five employees.3 The results of 

this research confirm earlier studies that found the rate 

of adoption of computers by farm households to be 

similar to that of U.S. households in general.4 

What are the possible benefits of this significant 

presence of Internet technology in the rural sector? 

Clearly, the defining characteristics of rural areas are 

low population densities and distances from urban 

areas. Historically, these characteristics have increased 

costs for farmers and rural businesses. While it may be 

an overstatement to claim that the Internet will “abolish 

distance,” it clearly has the potential to reduce the costs 

of doing business in geographically isolated areas. The 

Internet’s ability to transfer large volumes of information nearly instantaneously can mitigate some of the 

disadvantages inherent in geographical isolation. 

For farmers, the Internet has already increased access to 

business-related information. According to the USDA 

survey cited above, 82 percent of the farmers using the 

Internet in 2001 used it to track prices of the commodities 

they were producing, 56 percent used it to access commercial agricultural information services, and 33 percent 

used it to access USDA information.5 These statistics sug2 U.S. Department of Commerce, Economics and Statistics Administration and National Telecommunications and Information Administration. February 2002. “A Nation Online: How Americans Are 

Expanding Their Use of the Internet,” 20. 

3 Economic Research Service. November 2001. Farms, the Internet, and 

E-Commerce: Adoption and Implications. Agricultural Outlook, 19. 4 Abbott, Eric A., J. Paul Yarbrough, and Allan G. Schmidt. 2000. Farmers, Computers, and the Internet: How Structures and Roles Shape the 

Information Society. In Having All the Right Connections—Telecommunications and Rural Viability. Eds. Peter F. Korsching, Patricia C. 

Hipple, and Eric A. Abbott. Westport, CT: Praeger Publishers, 220. 

5 Economic Research Service, 17. 

gest that the Internet can provide farmers with more 

information sources in a more timely fashion. Potentially, 

the Internet will give farmers the means to purchase 

inputs from a greater variety of sources. Many in the 

farming sector have embraced the new communications 

technology enthusiastically. As of early 2002, thousands 

of Internet sites offer agriculture-related information and 

access to products such as fertilizer, chemicals, seed, farm 

equipment, and livestock. The Federal Reserve Bank of 

Kansas City estimates that the value of online agriculturerelated purchases will be in the range of $70 billion by 

2003, with significant growth in subsequent years.6 

Improvements in communications technology will also 

enhance the feasibility of locating businesses in rural 

areas: 

The growth of the Internet, ubiquitous computing, 

and instantaneous communication from anywhere to 

anyplace have made geographic locations and distances less relevant....Markets that were closed due 

to geographic constraints have become accessible 

and global dissemination of information from the 

most remote corners of the world has become feasible. Rural businesses can compete with their urban 

counterparts in the same market.7 

All these communications-related improvements substantially reduce historical incentives to locate firms in 

urban areas. The advantages traditionally associated 

with rural areas—lower labor and land costs and less 

stringent environmental regulations—will loom larger 

in the decision about where to locate a business.8 

Additionally, the Internet enhances the ability of rural 

firms to participate in supply chain networks, a business 

model of increasing importance in the U.S. economy. 

Over the past five years, an increasing number of manufacturing and wholesale firms have adopted Internet 

technology to organize and coordinate the flow of 

inputs and products, the process known as the “supply 

chain” from raw materials to finished products. As more 

businesses have embraced this technology, business-tobusiness (B2B) communication has resulted in the 

development of business networks. B2B communication 

is important in several industries traditionally located in 

6 Staihr, Brian. May 2000. Rural America’s Stake in the Digital Economy. The Main Street Economist. Center for the Study of Rural America.
 

Federal Reserve Bank of Kansas City, 3.
 

7 Premkumar, G. 2000. Rural Businesses and Telecommunications
 

Technologies. In Having All the Right Connections, 83.
 8 Korsching, Peter F., and Sami El-Gharini. 2000. Telephone Companies:
 

Providing All the Right Connections for Viable Rural Communities.
 

In Having All the Right Connections, 40.
 

Kansas City Regional Outlook 4 Third Quarter 2002 
22 

Regional Perspectives
 

rural areas, including food processing, agricultural 

machinery, and agricultural chemicals.9 The Internet 

is also being used to facilitate the management of 

vertically integrated livestock production industries, 

such as pork and poultry. By helping rural businesses 

participate in supply chain networks, the Internet 

increased the probability that these businesses would 

achieve sustained economic success. 

Thus, the argument that the Internet has the potential to 

improve the economic climate in rural areas has considerable merit, but it is also useful to consider some issues 

on the other side of the ledger. 

Rural Areas Face Important Impediments 

to Comparable Internet Access 

While Chart 1 suggests that access to the Internet in rural 

areas is comparable to that in urban areas, these statistics 

do not address differences in quality. Rural areas have 

traditionally lagged cities in the adoption of new technologies, and the Internet is no exception.10 Additional 

data from the Department of Commerce suggest that 

rural areas lag the rest of the nation in availability of 

broadband and other high-speed access to the Internet 

(see Chart 2). 

The Federal Communications Commission defines 

“broadband” as an Internet connection that delivers 

data at speeds more than four times faster than 56 kilobits per second, the maximum speed achievable through 

conventional phone lines. Today, broadband connection 

is available over a digital subscriber line (DSL) provided by telephone companies or through a cable modem.11 

Communities require a minimum size or “critical mass” 

to justify expenditures for the infrastructure necessary 

to support the most modern, high-quality technologies. 

Businesses and institutions in rural areas often lack this 

critical mass, and insufficient scale may discourage 

telecommunications providers from bringing services to 

some rural areas. Many rural communities may not have 

9 Henderson, Jason R. September 2001. Networking with E-commerce 

in Rural America. The Main Street Economist. Center for the Study of 

Rural America, Federal Reserve Bank of Kansas City, 3. 

10 Dilman, Don A. February 2000. Some Thoughts About the Impact 

of E-commerce on Rural America. Presentation at the Iowa Farm 

Forum. Iowa State University. 11 Staihr, Brian. August 2000. The Broadband Quandary in Rural 

America. The Main Street Economist. Center for the Study of Rural 

America, Federal Reserve Bank of Kansas City, 2. 

CHART 2 

High-Speed Internet Connection by Geographic 

Area as a Percentage of Total U.S. 

Percent Internet Households 

25 

20 

15 

10 

5 

0 

19.1 

10.7 

2000 

12.2 

7.3 

2001 21.2 

11.8 12.1 

U.S. Rural Urban Central Cities 

Source: U.S. Department of Commerce, National Telecommunications and 

Information Administration, and Economics and Statistics Administration, using 

Census Bureau Current Population Survey Supplements. A Nation Online: How 

Americans Are Expanding Their Use of the Internet. February 2002. 

enough customers to allow providers to recoup the fixed 

costs associated with providing up-to-date services.12 

It seems, then, that while improved telecommunications 

have the potential of bringing significant benefits to 

rural areas, the technology will not completely erase the 

disadvantages of isolation and distance. 

History Suggests that Technological Advances 

Have Not Prevented Rural Depopulation 

While some observers believe that advances in 

telecommunications technology hold the promise of 

revitalizing rural economies, the history of earlier technological innovations suggests otherwise. When the 

telephone began to be widely adopted in rural areas 

early in the 20th century, many observers saw it as a 

means of keeping people “down on the farm.” According to an advertisement run by a telephone equipment 

manufacturer in Wallaces’ Farmer in 1905, “The former isolation, which drove many of the young men and 

women from the farm to the city, has been banished by 

the many telephone lines now in use all over this country.”13 Similarly, the 1909 Cyclopedia of Agriculture 

stated that the “striking contrast between city and country life is perhaps today the greatest single cause of that 

so-called rural depopulation which is attracting the 

attention of statesmen and reformers the world over. It 

12 Korsching, Peter F., Patricia C. Hipple, and Eric A. Abbott. 2000.
 

On-Ramps and Roadblocks to the Information Superhighway. In
 

Having All the Right Connections, 287.
 13 Quoted in Kline, Ronald R. 2000. Consumers in the Country:
 

Technology and Social Change in Rural America. Baltimore, MD.
 

Johns Hopkins University Press, 24.
 

Kansas City Regional Outlook 5 Third Quarter 2002 
Regional Perspectives
 

is reasonable to suppose that it can be done away with 

by perfecting the agencies of rural communication.”14 

Similar claims were made when the automobile 

became available in rural areas in the 1920s and when 

rural electrification became widely available after 

World War II. According to this line of thinking, such 

technological advances narrowed the gap between the 

perceived quality of life in rural areas and that in the 

cities and would, as a consequence, halt or slow the 

pace of rural-to-urban migration. 

These hopes were not to be realized, however, as rural-tourban migration proceeded steadily throughout the 20th 

century. More than 40 percent of the country’s population 

lived on farms at the beginning of the century; that proportion had declined to less than 3 percent by its end.15 

Perhaps the technological improvements embedded in the 

telephone, automobile, and rural electrification were not 

enough to overcome the strong economic incentives drawing people from the countryside to the cities. Others have 

argued that these innovations actually increased the pace 

of rural-to-urban migration. The automobile allowed 

farmers to visit cities more often and more conveniently; 

the telephone allowed them to maintain commercial and 

personal relationships with a wider circle of urban people; 

and rural electrification allowed them to experience the 

conveniences already common to city-dwellers.16 While 

each of these advances improved the quality of life in 

the country, they also increased the flow of information 

between the two sectors, perhaps motivating more country people to seek their fortunes in the cities. 

Similar to their counterparts earlier in the century, 

present-day proponents of technological solutions see 

the new communications technologies as a “bridge 

from” rural communities to the wider world. According 

to this line of the thinking, the Internet will enhance the 

ability of farmers, rural consumers, and rural businesses 

to access information, goods, and services from faraway 

sources, increasing the economic viability of rural areas. 

While this argument may have some merit, the historical 

examples cited above suggest that technology alone may 

not be sufficient to reverse the decline of rural areas. 

Those who are more dubious of the benefits of modern 

telecommunications to rural areas see the technology 

as a “bridge to” rural areas, opening businesses in these 

areas to competition. In many ways, the economic 

14 Ibid.
 

15 Garkovich, Lorraine. 1989. Population and Community in Rural
 

America. Westport, CT: Greenwood Press, 98.
 16 Kline. 25.
 

effects of the interstate highway system are an apt 

analogy for the effects of bringing the information 

superhighway to rural areas. Many rural communities 

received no direct benefits from the interstate highway 

system and lost business because the highways opened 

access to larger trade and service areas.17 Similarly, the 

Internet may enhance urban firms’ access to rural 

consumers, as “telecommunications are more likely to 

be used to reach into the rural community customer 

base from outside.”18 When the Internet provides rural 

customers with more choices, they may be less likely to 

bring their business to local merchants.19 

Researchers who have studied the use of the Internet by 

Iowa farmers confirm that larger-scale farmers are 

already using the technology to shop for inputs outside 

their traditional market areas: 

Commercial farmers are actively seeking ways to use 

their computers and the Internet to link beyond their 

communities to access favorable credit [emphasis 

added], lower-cost inputs, better market prices, and 

contacts with agricultural experts. As agricultural 

enterprises increase electronic links for marketing 

and regulatory purposes, farmers who are large 

enough to negotiate favorable terms and sophisticated 

enough to know where to look for the best deals 

will benefit most. These...large commercial farms... 

are using their computers to negotiate with bankers, 

suppliers, and marketers.20 

In the opinion of these researchers, not only will the 

Internet weaken the economic ties between large farmers and the local economy, it is also likely to enhance 

the advantages of larger, more technologically sophisticated farmers relative to smaller farmers, accelerating 

the consolidation of agriculture.21 

It seems likely that not all of rural America will benefit 

equally from advances in telecommunications technology. 

Clearly, farmers and businesses that perceive and embrace 

the advantages provided by the new technologies have the 

17 Korsching, Peter F., Patricia C. Hipple, and Eric A. Abbott. 2000.
 

Rural America and the Information and Communications Revolution.
 

In Having All the Right Connections, 4.
 18 Korsching, Hipple, and Abbott. On-Ramps and Roadblocks to the
 

Information Superhighway, In Having All the Right Connections, 283.
 19 Korsching and El-Gharini. Telephone Companies: Providing All the
 

Right Connections for Viable Rural Communities. In Having All the
 

Right Connections, 40.
 20 Abbott, Yarbrough, and Schmidt. Farmers, Computers, and the
 

Internet: How Structures and Roles Shape the Information Society. In
 

Having All the Right Connections, 223.
 21 Ibid.
 

Kansas City Regional Outlook 6 Third Quarter 2002 
Regional Perspectives
 

potential to improve their profitability and long-term 

viability. However, the technologies could exacerbate the 

risks faced by farmers and rural businesses that are slow 

to embrace the new methods. Those who do not adopt 

new communications technologies, or come late to the 

game, could fall behind their more savvy competitors. 

What Does Internet Technology Imply 

for Community Banks? 

Community banks have embraced Internet technology 

rapidly. According to a series of annual surveys of community bank presidents by a major accounting firm, the 

proportion of banks with a website increased from 29 percent in 1998 to 75 percent in November 2001. More significantly, 43 percent of the community banks surveyed 

had some transactional capabilities in 2001, with 77 percent expecting such capability by 2003. Table 1 provides 

a more detailed presentation of current and projected 

online capabilities reported by the survey’s respondents.22 

Why has the community bank sector adopted this new 

technology so rapidly? In autumn 2000, the Federal 

TABLE 1 

Deposit Insurance Corporation interviewed several 

community banks that were early adopters of Internet 

technology and concluded that “Community banks view 

Internet banking primarily as a retail customer retention 

strategy—a ‘must-have’ service much like automated 

teller machines. Banks that are seeking to achieve a 

competitive edge or are responding to customer demand 

generally institute Internet banking.” Although the 

banks interviewed hoped to earn revenue or achieve 

cost advantages from adopting the Internet, none of 

them had achieved these goals in the early stages.23 

Certainly, the Internet provides rural banks with many of 

the advantages ascribed to other rural businesses, including the ability to employ telecommuters, use outsourcing 

services more efficiently, and buy inputs, including 

deposits, more competitively. Some rural bankers have 

said that they might use Internet technology to retain the 

deposits of young people who migrate away from their 

hometowns. Table 1 indicates that community bankers 

plan to use the technology to increase the menu of services that they offer their customers. Community banks 

may be able to use the Internet to reduce unit costs of 

delivering many services while continuing to provide the 

From Cash to Clicks 

PERCENTAGE OF COMMUNITY BANKS WITH INTERNET BANKING SERVICES THAT OFFER THE FOLLOWING 

FEATURES TODAY AND PLAN TO OFFER THEM IN THREE YEARS 

OFFER TODAY 

PLAN TO OFFER 

IN THREE YEARS 

TRACK ACCOUNT BALANCES 65 91 

TRANSFER FUNDS AMONG ACCOUNTS 63 89 

BILL PAYMENT 49 81 

E-MAIL–BASED CUSTOMER SERVICE 35 58 

CASH MANAGEMENT AND OTHER SMALL BUSINESS SERVICES 32 65 

PERSON-TO-PERSON ELECTRONIC PAYMENTS 26 54 

LOAN APPLICATIONS 21 70 

NEW DEMAND DEPOSIT ACCOUNT APPLICATIONS 18 61 

NEW CDS, IRAS, ETC. 17 59 

BILL PRESENTMENT 16 54 

BUSINESS-TO-CUSTOMER PORTAL FOR NONBANK PRODUCTS 11 39 

E-MORTGAGES 9 37 

BROKERAGE TRADES 9 33 

BUSINESS-TO-BUSINESS PORTAL FOR NONBANK PRODUCTS 5 28 

SELL INSURANCE 5 27 

AGGREGATION SERVICES 4 37 

Notes: CD = certificate of deposit, IRA = individual retirement account 

Source: Grant Thornton. Ninth Annual Survey of Community Bank Executives. March 2002. 

22 Grant Thornton. March 2002. Ninth Annual Survey of Community 23 FDIC Bank Technology Group. 2001. Report on Internet Banking 

Bank Executives. March 2002. Experiences Interviews. 

Kansas City Regional Outlook 7 Third Quarter 2002 
Regional Perspectives
 

personalized attention to many of their customers that is 

their comparative advantage over larger institutions.24 

Many early proponents of Internet technology for 

smaller banks argued that the Internet could “level the 

playing field” between large banks and community 

banks by enabling the smaller players to reach more customers and remain competitive with the services they 

offer. However, some observers, including a leading 

European banker, hold a contrary view: 

Technology is an even greater source of opportunity 

for the large banks, which already have an immense 

client base and brand image the new competitors do 

not possess and could take years to acquire. [From 

an operational and cost perspective, of course,] 

e-business is a volume, not margins business, and 

volume is determined by the number of clients. The 

Internet is a classic example of a technology that is 

ideally suited to mass market applications. Firms 

applying this technology that already have a wide 

client base can win an almost unassailable competitive advantage. So technology, far from representing 

a threat to the leading banks, is an instrument 

that, if exploited well, can boost their efficiency and 

competitivity [sic] even more.25 

According to this line of argument, the Internet will 

allow the largest banks to deliver commoditized services 

over a wider area without incurring the costs of building 

branches.26 

If this line of thinking is correct, it could have significant implications in the Kansas City Region, where 

geographic isolation protects many community banks 

from competition by large banks. Table 2 provides 

some striking evidence of the phenomenon. 

According to the FDIC’s Summary of Deposits data, 

only 8.1 percent of the branches in counties nonadjacent 

to urban areas belong to large banks with more than 

$10 billion in assets. Large banks have not found it economically prudent to acquire or build branches in the 

most rural areas, so the community banks in these areas 

have not been subject to competition from them. As is 

apparent in the bottom half of the table, the relative 

24 DeYoung, Robert, and William C. Hunter. 2002. Deregulation, the 

Internet and the Competitive Viability of Large Banks and Community 

Banks. Federal Reserve Bank of Chicago working paper, 15. 25Corcostegui, Angel, chief executive of Banco Santander Central 

Hispano. 2000. Quoted in The Future of Banking. Ed. Henry Engler 

and James Essinger. London. Reuters, 29. 

26 DeYoung and Hunter. 15. 

presence of large bank branches declines substantially 

as counties become more rural. 

But the development of Internet methods may allow the 

largest banks to pursue a “less than a branch” strategy in 

rural areas. Some large insurance companies that acquired 

bank charters are using a combination of local insurance 

agents and Internet technology to provide banking services in some of the nation’s most rural areas. As more 

rural customers become conversant with using the Internet for commercial transactions, large banks may have 

increasing opportunities to gain business in rural areas. 

The results of a 2002 Grant Thornton survey provide 

some evidence of how community bankers currently 

perceive their competition.27 (See Table 3.) 

The community bankers surveyed consider other community banks their most significant competition. The 

decline from 2001 to 2002 in the perceived threat from 

Internet-only banks reflects the lack of success of that 

business model. In 2000, many industry observers 

argued that Internet-only banks would quickly render the 

bricks and mortar versions obsolete; however, a consensus has evolved that the Internet is an additional, rather 

than an alternative, distribution channel and that “bricks 

and clicks”—a combination of traditional methods and 

the Internet—will be the preferred method of delivering 

services in the foreseeable future. In this evolving competitive environment, rural banks will be challenged to 

assess their strengths, identify competitive advantages, 

and carefully assess how advances in communications 

technology will affect the competitive landscape. 

Conclusion 

The diffusion of the Internet may be a double-edged 

sword for the rural economy: it can be expected to 

increase the efficiency and market reach of many rural 

businesses, but it may also expose these businesses to 

competitors who can now more easily reach into the rural 

community, perhaps providing more services more 

cheaply than rural businesses can. Rural banks may find 

the Internet to be a similarly mixed blessing: while many 

may use the Internet to improve operational efficiency 

and extend market reach, the technology also may provide a means for large banks and other financial services 

providers to compete more aggressively in rural areas. 

27 Grant Thornton. 

Kansas City Regional Outlook 8 Third Quarter 2002 
Regional Perspectives
 

TABLE 2 

Competition from Large Bank

COUNTY TYPE (ENTIRE NATION) 

s Declines a

COUNTIES 

s Counties 

TOTAL 

BRANCHES LBBS 

Become More Rural 

% OF 

BRANCHES 

THAT ARE 

LBBS 

METROPOLITAN 

RURAL ADJACENT 

RURAL NONADJACENT 

836 

1,001 

1,303 

60,955 

12,429 

11,511 

30,151 

2,746 

1,970 

49.5 

22.1 

17.1 

REGION TOTALS 3,140 84,895 34,867 41.1 

RURAL NONADJACENT BREAKOUT 

URBAN POPULATION OVER 20,000 

URBAN POPULATION 2,500–20,000 

URBAN POPULATION UNDER 2,500 

114 

656 

533 

2,746 

6,572 

2,193 

727 

1,066 

177 

26.5 

16.2 

8.1 

1,303 11,511 1,970 17.1 

Notes: LBB = large bank branch; LBBs are branches of FDIC-insured institutions with over $10 billion in assets. 

Rural adjacent counties are rural counties that are adjacent to a metropolitan county. 

Rural nonadjacent counties are rural counties that are not adjacent to a metropolitan county. 

Source: FDIC Summary of Deposits; Bank and Thrift Call Reports; USDA (for county codes) 

TABLE 3 

Sources of Competition 

PERCENTAGE OF COMMUNITY BANKS THAT SAY THE FOLLOWING SOURCES OF COMPETITION ARE 

A MAJOR CONCERN 

2002 2001 2000 

OTHER COMMUNITY BANKS 70 57 66 

CREDIT UNIONS 63 63 60 

BROKERAGE FIRMS 56 66 65 

REGIONAL OR MEGA-BANKS 47 45 47 

MORTGAGE COMPANIES 42 36 45 

MUTUAL FUND COMPANIES 37 49 51 

FARM CREDIT BANKS 23 17 22 

INSURANCE COMPANIES 21 31 * 

GOVERNMENT-SPONSORED ENTITIES (E.G., FREDDIE MAC, 

FANNIE MAE, FHLB) 18 16 

FINANCE COMPANIES 8 7 32 

INTERNET BANKS (E.G., NETBANK, ETRADE BANK) 19 30 * 

INTERNET PORTAL SITES (E.G., YAHOO, MSNBC) 13 22 * 

U.S. POSTAL SERVICE (E.G., EBILLPAY) 11 13 * 

TELECOM COMPANIES (VIA PURCHASES ADDED TO TELEPHONE BILL) 6 10 * 

OTHER NONFINANCIAL COMPANIES (E.G., MOBIL SPEED PASS, 

FREQUENT SHOPPER/FREQUENT FLYER PROGRAMS, 

WAREHOUSE/DISCOUNT STORES) 6 10 * 

* Question not asked in 2000 

Source: Grant Thornton. Ninth Annual Survey of Community Bank Executives. March 2002. 

Jeffrey Walser 

Regional Economist 

Kansas City Regional Outlook 9 Third Quarter 2002 
In Focus This Quarter
 

The Road to Recovery for Commercial Credit Quality:
 

Not without a Few Hurdles Ahead
 

Introduction 

The banking industry as a whole has performed well in 

recent years, despite increasing loan delinquencies, 

notably in commercial credits. Although the extent of 

commercial loan deterioration has not reached levels 

experienced in the early 1990s, it nonetheless warrants 

scrutiny. With a variety of economic indicators pointing 

toward recovery, the volume of problem commercial 

loans held by insured institutions could plateau during 

2002. Many banks tightened business loan underwriting 

standards beginning in early 2000, a trend that should 

contribute to an eventual turnaround in commercial loan 

quality. Nevertheless, several factors could delay this 

improvement. Corporate profitability has yet to recover 

fully, and many firms continue to operate with significant financial leverage. Highly leveraged firms are 

especially vulnerable to declining revenues, which 

reduce the cash flow available to service debt obligations. More significantly, lower investor tolerance for 

risk has created a far less hospitable financing market 

for speculative-grade firms, possibly straining liquidity 

and increasing the likelihood that these companies 

could default as debts mature. 

Commercial Credit Deterioration Should 

Subside with the Economic Recovery 

While the banking industry has fared well through the 

latest recession, it did not escape the effects of the troubled corporate sector. Large banks (those with assets 

greater than $1 billion), in particular, have seen a significant rise in noncurrent commercial and industrial 

(C&I) loan and loss rates.1 While total C&I loans represented 25 percent of all outstanding loans held by all 

insured commercial banks as of March 31, 2002, net 

C&I loan losses comprised 32 percent of all loan 

losses. In first quarter 2002, noncurrent C&I loans 

reached 2.6 percent of outstanding loans (2.8 percent 

for large banks), the highest level since fourth quarter 

1993. The four-quarter moving average C&I loss rate 

also rose among small and large banks; however, the 

rate of increase for large banks was significantly higher, 

as shown in Chart 1. 

1 Noncurrent loans are defined as loans 90 or more days past due or 

on nonaccrual status. 

CHART 1 

Large Banks Experience a Rapid Rise in 

Commercial and Industrial Loan Loss Rates 

Source: Bank Call Reports, FDIC Research Information System 

Large banks 

(> $1 billion in assets)

Four-Quarter Moving Average Commercial

and Industrial Loss Rates (%)

Small banks 

(< $1 billion in assets) 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

2.2 

1Q90 3Q91 1Q93 3Q94 1Q96 3Q97 1Q99 3Q00 1Q02 

Improving economic conditions and tighter underwriting standards suggest that commercial credit quality 

should improve. A range of indicators suggests that economic recovery is under way, albeit more slowly than 

some expected earlier this year. The housing sector 

remains robust, job conditions have stabilized, and real 

gross domestic product (GDP) grew 5.0 percent in first 

quarter 2002. Although GDP grew at a slower pace of 

1.1 percent in second quarter 2002, business equipment 

spending increased 2.9 percent, in contrast to a decrease 

of 2.7 percent in first quarter 2002. Also, the manufacturing sector began to show signs of recovery with the 

Institute for Supply Management (ISM) index for 

manufacturing reaching 56.2 and 50.5 in June and July 

2002, respectively. The ISM index has remained above 

50, which signals an economic expansion, for the six 

consecutive months since February 2002. Also, the 

index of coincident indicators, a gauge of current economic activity, rose 0.3 percent in June 2002. Furthermore, a survey of 50 leading corporate economists by 

Blue Chip Economic Indicators shows that analysts 

expect the U.S. economy to grow at a rate of 3.3 percent 

in third quarter 2002.2 

Recent changes in underwriting standards also bode 

well for credit quality at commercial banks. The Federal 

2 Blue Chip Economic Indicators, July 2002. Also see Regional 

Outlook, Second Quarter 2002, “Back to the Future: How This 

Downturn Compares to Past Recessions.” See http://www.fdic.gov/ 

bank/analytical/regional/ro20022q/na/index.html. 

Kansas City Regional Outlook 10 Third Quarter 2002 
In Focus This Quarter
 

Reserve Board’s Senior Loan Officer Opinion Survey 

on Bank Lending Practices, which focuses on 

changes in the supply of and demand for bank loans to 

businesses and households over the previous three 

months, has shown consistent tightening of business 

loan standards during the past two years. The April 

2002 survey indicated some further tightening of standards, but the percentage of banks reporting this tightening has declined since the January survey, consistent 

with the anticipation of a continued economic 

rebound.3 Since credit quality typically lags the business cycle, near-term recovery appears more likely, 

provided the economy continues to improve. This 

recovery in commercial credit quality, however, is not 

without a few hurdles ahead. 

High Default Rates, Rating Downgrades, 

and Bankruptcies Persist 

While the U.S. economy is showing signs of recovery 

and underwriting standards have tightened, corporate 

credit quality could continue to be affected by several 

adverse trends. The number of bankruptcies filed by 

public companies this year is on pace to challenge 

the record set in 2001.4 Furthermore, default rates for 

CHART 2 

Current U.S. Corporate Credit Deterioration Is 

U.S. speculative-grade corporate bond issuers remained 

high at 10.3 percent in June 2002, and the high ratio of 

corporate rating downgrades to upgrades indicates continuing weakness in the corporate sector (see Chart 2).5 

The main reasons for rating downgrades have been poor 

profitability and high leverage. 

Corporate Profitability Remains Fragile 

Corporate profitability has been depressed since first 

quarter 2001 (see Chart 3). However, this trend is improving slowly in 2002. U.S. corporate profits rose during 

second quarter 2002 for the first time in five quarters.6 

However, the rate of recovery is not expected to be strong 

in 2002, as some 93 companies in the Standard & Poor’s 

500 have announced that third quarter earnings will be 

less than expected, more than twice the number of companies that have announced they will beat estimates.7 In 

fact, earnings forecasts have been revised downward 

consistently for the past several months, and analysts 

have warned recently that earnings estimates for the 

second half of 2002 are likely to be reduced. The bright 

spot in earnings continues to be the consumer sector, 

with automobile manufacturers and certain retail areas 

posting strong sales. The worst-performing sectors on a 

CHART 3 

Corporate Profits Remained Depressed 

Approaching Early 1990s Levels 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

4.5 

5.0 

Percent Ratio 

Bank commercial and 

industrial noncurrent 

rate (left scale) 

U.S. speculative-grade bond 

issuer default rate (left scale) 

U.S. Corporate bond ratings downgrades 

to upgrades (right scale) 

1988 1990 1992 1994 1996 1998 2000 1Q02 

Year-over-year growth in net income from

continuing operations for all S&P 500 firms (%)

35 

25 

15 

5 

–5 

–15 

–25 

through the First Quarter of 2002 

1997 1998 1999 2000 2001 2002 

Sources: Moody’s, Bank Call Reports, FDIC Research Information System 

3 Senior Loan Officer Opinion Survey on Bank Lending Practices, 

The Federal Reserve Board, April 2002. The survey reported that the 

percentage of domestic banks that reported tightened standards on 

C&I loans to large and middle-market firms (annual sales of at least 

$50 million) since the January survey declined to 25 percent from 

45 percent. The percentage of domestic banks that report tightened 

standards on business loans to small firms declined more, from 42 

percent in January to 15 percent in April. 

4 Bankruptcydata.com reports that 257 publicly traded companies 

filed for bankruptcy in 2001, while 114 companies had filed by 

June 30, 2002. 

Source: Standard & Poor’s 

5 In the first half of 2002, Moody’s downgraded 262 companies and 

upgraded 59, producing a downgrades to upgrades ratio of 4.4:1. 

6 On a year-over-year basis, 371 companies in the Standard & Poor’s 

500 Index that reported earnings through July 26, 2002, posted 

profits. 

7 Danielle Sessa, “U.S. Stocks Slide as Johnson & Johnson, Pepsi 

Shares Tumble,” Bloomberg.com, July 19, 2002. 

Kansas City Regional Outlook 11 Third Quarter 2002 
In Focus This Quarter
 

year-over-year basis appear to be energy, transportation, 

utilities, capital goods, and communications services.8 

The latest recession was driven primarily by the sharp 

decline in the demand for capital goods. With the slow 

economic recovery, businesses have continued to limit 

capital spending. The rate of recovery for corporate profitability will depend in large part on how soon and to 

what extent businesses resume spending. 

The prospect of slow earnings growth could be particularly problematic for many highly leveraged corporations. Debt levels relative to cash flow have been 

rising because of anemic earnings (see Chart 4). Negative earnings news also comes at a time when several 

well-publicized accounting irregularities have shaken 

investors’ confidence in corporate earnings reports. A 

Huron Consulting Group study of financial restatements indicates that during the past five calendar 

years, the number of restated financial statements filed 

by public companies has grown from approximately 

120 in 1997 to 270 in 2001.9 The number of restatements continued to grow in 2001, despite a reduction in 

the number of public companies. That study found that 

CHART 4 

the largest source of restatements relates to how companies recognize revenue. With depressed corporate 

profits and diminishing investor confidence, some 

firms with debts maturing in the near term may have 

difficulty refinancing. 

Firms with Maturing Debts Could Face 

a Critical Period in the Near Term 

Moody’s estimates that $141 billion worth of U.S. 

speculative-grade corporate bonds and rated bank debt 

will come due over the next three years: $27 billion 

(19 percent) in 2002, $54 billion (38 percent) in 2003, 

and $60 billion (43 percent) in 2004.10 To put these 

numbers into perspective, total U.S. corporate bond 

defaults were $115 billion in all of 2001, of which 

95 percent of those defaulting were speculative-grade 

borrowers. Although Moody’s expects the bulk of 

high-yield debt maturing in 2002 to be refinanced 

despite unfavorable market conditions, concern exists 

about the large percentage of issues rated B1 or lower 

that will come due in 2003 and 2004 (see Chart 5).11 

CHART 5 

Corporate Debt Continues to Rise 

Relative to Cash Flows 

Source: Federal Reserve Board Ratio of nonfarm, nonfinancial debt to cash flow 

3.5 

4.0 

4.5 

5.0 

5.5 

6.0 

1975 1978 1981 1984 1987 1990 1993 1996 1999 1Q02 

Forty-Seven Percent of U.S. Speculative-Grade
 

Bonds and Bank Debt Maturing in 2003–2004
 

Are Rated B1 or Lower
 

Ba1 to Ba3 

53% 

B1 to B3 

36% 

Caa1 or lower 

11% 

Source: Moody’s 

8 Charles L. Hill, et al., This Week in Earnings, Thomson First Call, 

July 22, 2002. 

9 A Study of Restatement Matters, for the five years ended December 

31, 2001, Huron Consulting Group, June 2002. This study excluded 

restatements caused by changes in accounting principles and 

nonfinancial-related restatements. 

10 Tom Marshella, et al., “Refunding Risk for U.S. Speculative Grade 

Borrowers, 2002–2004,” Global Credit Research, Moody’s Investors 

Service, December 2001. Figures related to refunding risk presented 

throughout this article are taken from Moody’s refunding risk studies, 

conducted annually since November 1998. 

11 Speculative-grade debt ratings assigned by Moody’s in the order of 

declining credit quality are as follows: Ba, B, Caa, Ca, and C. 

Moody’s also applies numerical modifiers 1, 2, and 3 in each generic 

rating classification. The modifier 1 indicates that the obligation 

ranks in the higher end of its generic rating category, while the 

modifier 3 indicates a ranking in the lower end of that generic rating 

category. 

Kansas City Regional Outlook 12 Third Quarter 2002 
In Focus This Quarter
 

Credit deterioration of bank loans is similar to the cur- TABLE 1 

rent trend in corporate bonds. Migration of maturing 

loans into lower grade categories has accelerated in 

recent years (see Chart 6). This ratings decay reflects 

the borrowers’ deteriorated financial condition and the 

effects of liberal underwriting conditions from 1996 to 

1998, when speculative-grade originations were more 

common. For example, the 1999 and 2000 refunding 

risk studies conducted by Moody’s noted that 16 percent 

and 17 percent, respectively, of all rated bank loans 

maturing in 2002 were rated B1 or lower. The trend 

worsened significantly in 2001, when the study noted 

that 39 percent of bank loans maturing in 2002 were 

rated B1 or lower. When firms have to refinance lowgrade debts in today’s environment, they may face 

additional pressure on earnings and liquidity. 

Loss Severity Has Increased 

with Higher Default Rates 

Moody’s credit ratings reflect the likelihood of default 

and the severity of loss given default. As a result, the 

migration of maturing bonds and loans into lower 

grades implies a greater risk of default or increased loss 

severity upon default, or perhaps both. Moody’s notes, 

as part of its 15th annual study of global corporate 

defaults and ratings performance, that average recovery 

rates fell for the third straight year in 2001.12 The recovery rate has deteriorated for all levels of security and 

CHART 6 

The Proportion of Maturing Bank Loans Rated
 

B1 or Lower Is Increasing
 30 

Ba 25 

Average Speculative-Grade 

Recovery Rates in 2001 Show a 

Declining Trend in Nearly All Levels 

of Security and Subordination 

AVERAGE
 

RECOVERY
 

PER $100
 

1982– 

SENIORITY/SECURITY 2000 2001 

SENIOR SECURED BANK LOAN $67.06 $54.68 

EQUIPMENT TRUST $64.65 NA 

SENIOR SECURED BONDS $52.09 $58.00 

SENIOR UNSECURED BONDS $43.82 $36.20 

SENIOR SUBORDINATED BONDS $34.59 $19.90 

SUBORDINATED BONDS $31.83 $16.45 

JUNIOR SUBORDINATED BONDS $22.48 NA 

Note: NA=not available 

Source: Moody’s 

subordination except for senior secured bonds (see 

Table 1). 

Higher-Risk Borrowers Pay High Premiums 

A speculative-grade company refinancing debt today 

will face a much higher price, in terms of spreads over 

a cost of funds index or risk-free instruments, compared to several years ago. Yield spreads between 

investment-grade and speculative-grade bonds have 

widened significantly since early 2000 (see Chart 7), in 

part because of lower investor tolerance for risk, rising 

CHART 7 

$ Billions 

20 

15 

10 

5 

0 

B1 or Lower 

2002 2003 2004 

Credit Costs for Higher-Risk Borrowers Rose 

Dramatically in Recent Years 

Sources: Merrill Lynch Bond Global Bond Indices, Federal Reserve Board Basis point spread over ten-year constant-maturity Treasuries

Investment-grade bonds 

High-yield bonds 

0 

100 

200 

300 

400 

500 

600 

700 

800 

900 

1000 

Jun 

’98 

Dec 

’98 

Jun 

’99 

Dec 

’99 

Jun 

’00 

Dec 

’00 

Jun 

’01 

Dec 

’01 

Jun 

’02 

Source: Moody’s 

12 David Hamilton, et al., “Default & Recovery Rates of Corporate 

Bond Issuers: A Statistical Review of Moody’s Ratings Performance 

1970–2001,” Global Credit Research, Moody’s Investors Service, 

February 2002. The recovery rate is defined as the secondary market 

price of the defaulted instrument approximately one month after the 

time of default. 

Kansas City Regional Outlook 13 Third Quarter 2002 
In Focus This Quarter
 

defaults, and weakening corporate cash flows. After 

narrowing a bit in first quarter 2002, spreads have 

widened again on renewed concerns about accounting 

irregularities and the realization that the economic 

recovery may come at a slower pace than anticipated. 

Lower investor tolerance for risk has affected not only 

speculative-grade borrowers but also some investmentgrade borrowers. For example, the commercial paper 

(CP) market, which many investment-grade borrowers 

have used as a cheap source of funding, is no longer 

readily available to all investment-grade borrowers.13 

Drawn-Down Commercial Paper Back-up Lines 

Heighten Commercial Bank Exposure14 

Since its peak at the end of 2000, the CP market for 

domestic nonfinancial companies has shrunk by almost 

50 percent (see Chart 8). A reduction in the need for 

working capital and heavy refinancing activity have 

contributed to this contraction. However, the record 

number of downgrades among issuers of CP in 2001 

also contributed to this decline. Money market funds 

cannot hold more than 5 percent of assets in CP graded 

less than A1/P1/F1.15 Thus, the recent flux of downgrades effectively squeezed some issuers out of this 

market and forced them to refinance with fixed-rate 

bonds.16 Also, fears of deteriorating credit quality have 

shut some investment-grade companies out of the CP 

market. Since the collapse of Enron, investors have been 

reluctant to hold the debt of certain companies. Some of 

these companies reported accounting irregularities, and 

the restatement of financial statements revealed previously hidden losses. In some cases, issuers that were not 

involved with accounting irregularities were forced to 

draw on bank credit lines when they were unable to roll 

over their CP because of the lack of demand or extreme13 Commercial paper is short-term promissory notes issued by large 

firms, generally maturing in nine months or less. It is an important 

source of short-term funding for corporations that need a steady 

stream of working capital. 

14 A CP back-up line is a commitment to provide a liquidity support 

for a company’s CP program. It is typically a revolving credit, a 

364-day facility. The rationale is that the borrower does not intend 

to use the back-up line, which generally costs more than issuing 

CP, unless the CP cannot be rolled over or repaid. 

15 The CP market can be divided into three tiers: Tier 1 (A1/P1/F1 or 

better), Tier 2 (A2/P2/F2), and Tier 3 (A3/P3/F3). The first two 

groups make up the bulk of the market. The first rating refers to a 

rating assigned by Standard & Poor’s, while the second and third 

reflect ratings assigned by Moody’s and Fitch, respectively. 

16 Moody’s Investors Service, Moody’s Credit Perspectives, December 

31, 2001. Moody’s downgraded 38 commercial paper programs from 

P1 in 2001. 

CHART 8 

Domestic Nonfinancial Commercial Paper 

Outstandings Have Declined amid Investors’ 

Jitters about Credit Quality 

Source: Federal Reserve Board (Haver Analytics) $ Billions 

100 

150 

200 

250 

300 

350 

2Q95 2Q96 2Q97 2Q98 2Q99 2Q00 2Q01 2Q02 

ly high rates demanded by investors. When a CP issuer 

draws down on the back-up line, rating agencies often 

view this as a weakness in the company’s liquidity, and 

a rating downgrade can occur. In turn, lower ratings lead 

to higher funding costs for the borrowers. 

The steepness of the current yield curve also results in 

significantly higher refinancing costs for investmentgrade corporations that no longer have access to shortterm funding through the CP market. As these 

companies are forced to borrow longer term, they face 

higher refinancing costs in the long-term end of the 

current yield curve.17 For example, if a Tier 1 corporation formerly issuing 90-day CP was forced to issue 

ten-year fixed-term debt in mid-July 2002, the cost 

would have been almost 350 basis points higher than 

issuing 90-day CP. 

Using back-up lines of credit when companies cannot 

roll over maturing CP has become expensive for some 

issuers. Bankers are realizing that initial pricing does 

not reflect the risk inherent in drawn-down lines. As a 

result, bankers have started to impose high utilization 

premiums on BBB-rated CP back-up lines. Also, borrowers recently have been seeking term-out options, 

another sign that refunding risk is a concern.18 Recent 

transactions reported by Loan Pricing Corporation 

show that some investment-grade companies are seek17Bloomberg Fair Market Sector Curves, July 5, 2002. The spread
 

between 60-day and five-year Treasury instruments was nearly 300
 

basis points. 


18 Once the back-up line has been drawn down, the borrower again has
 

to repay or roll over the debt. A revolving facility can be “termed out”
 

so that it becomes an installment loan with a much longer maturity,
 

such as three to five years. Such an option, however, can be costly.
 

Kansas City Regional Outlook 14 Third Quarter 2002 
In Focus This Quarter
 

ing term-out options even at a fee of 200 basis points. 

The higher premiums demanded reflect both the volatility in the market and deteriorating credit quality indicated by high default rates and rating downgrades in 

recent quarters. 

Conclusion 

During the boom times of the late 1990s, corporations 

enjoyed an abundance of liquidity sources and easy 

access to capital. Many corporations used debt to 

finance business expansions, and rolling over maturing 

debt was not a significant concern. Recently, however, 

stock prices have been declining and investors have 

been concerned about the possibility of more corporate 

financial restatements. In this environment, highly 

leveraged borrowers worry about maturing debts and 

refunding risk implications. Lenders are demanding 

higher spreads because of the volatile financial markets 

and the deteriorated financial condition and debt ratings 

of many borrowers. In general, firms seeking to roll 

over maturing debt clearly face a less hospitable financing market today. With corporate profitability not yet 

strong, highly leveraged companies may find it increasingly difficult to meet debt service requirements and 

loan covenants. Despite these hurdles, the economy 

appears to be improving, and more companies are 

beginning to report higher earnings. With an economic 

recovery and tighter underwriting standards, the deterioration in commercial credit quality should stabilize 

and turn around. 

Cecilia Lee Barry, Senior Financial Analyst 

Kansas City Regional Outlook 15 Third Quarter 2002 
✁
 

Subscription Form
 

To obtain a subscription to the FDIC Regional Outlook, please print or type the following information: 

Institution Name __________________________________________________________________________ 

Contact Person __________________________________________________________________________ 

Telephone __________________________________________________________________________ 

Street Address __________________________________________________________________________ 

City, State, Zip Code __________________________________________________________________________ 

Please fax or mail this order form to:	 FDIC Public Information Center 

801 17th Street, N.W., Room 100 

Washington, D.C. 20434 

Fax Number (202) 416-2076 

Please indicate below each Region’s issue you wish to receive: 

Atlanta _________ Dallas _________ New York _________ National _________ 

Boston _________ Kansas City _________ San Francisco _________ All _________ 

Chicago _________ Memphis _________ 

Federal Deposit Insurance Corporation 

Washington, DC 20429-9990 

OFFICIAL BUSINESS 

PENALTY FOR PRIVATE USE, $300 

PRESORTED
 

STANDARD
 

MAIL
 

Postage &
 

Fees Paid
 

FDIC
 

Permit No. G-36