Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 1998 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Gary C. Zimmerman,
 

Regional Economist
 

Roger Stephens,
 

Financial Analyst
 

In Focus This Quarter 

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

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

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

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

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

By Gary Ternullo 

◆ Trends in Commercial Real Estate Loan Pricing and 

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

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

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

lead to greater market transparency and improved underwriting discipline, there 

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

By Steven Burton 

◆ Total Return:A Useful Tool for Monitoring Investment Portfolio 

Risk—The Federal Financial Institutions Examination Council is rescinding the 

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

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

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

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

investment portfolio and providing information about market risk at the portfolio 

level. See page 13. 

By Allen Puwalski 

Regular Features 

◆ Regional Economy—The San Francisco Region continues to lead the 

nation in job growth...the diverse economies of Arizona, California, Oregon, Utah, 

and Washington have been propelled by the national economic expansion...states 

dependent on natural resources have lagged recently...fast-growing Nevada’s heavy 

dependence on gaming, tourism, and construction warrants close monitoring. 

See page 16. 

By Gary C. Zimmerman 

◆ Regional Banking—Banks report improved asset quality throughout most 

of the Region...but many banks have reduced the level of reserves set aside for 

future loan losses and increased their concentrations in traditionally riskier lending 

categories...faced with declining levels of core deposits, some institutions are shifting to more potentially volatile funding sources. See page 21. 

By Catherine I. Phillips-Olsen, Roger Stephens 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Information Center for current pricing on bulk orders. 

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

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

Francisco Region’s Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 974-4247 or 

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

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Daniel Frye 

Craig A. Rice 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Y2K: Banking in the twenty-first century may provide
 

grand new opportunities—but you have to get there first
 

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

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

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

•	 Cures are expected to be difficult and costly. If 

those cures fail, litigation could be equally costly, 

and much of it may be aimed at directors and 

officers. 

•	 Accordingly, senior bank management should be 

actively involved in making sure the cure takes 

place. A failure to do so amounts to a gamble 

backed by the value of the bank franchise and 

those who run it. 

Complex Problem, Complex Cure 

By now the story is well known. At midnight on 

December 31, 1999, computer systems that process 

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

to function correctly, if at all. Equipment that contains 

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

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

can occur, and the number of creative ways for naming 

them confounds an accurate assessment. 

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

must be inventoried, examined for date usage, corrected 

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

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

systems but also those of its servicers, correspondents, 

customers, vendors, and trading counterparties. 

Moreover, there are a variety of ways to address the 

problem, ranging from expanding date fields to four 

digits to simply subtracting 28 years from every date 

before processing—any of which could introduce new 

incompatibility problems when systems that have been 

fixed in different ways attempt to interact.1 And because 

not all systems can be corrected at once, interfaces or 

bridges between corrected and uncorrected systems also 

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

non-negotiable deadline of December 31, 1999. 

For bank management, there are two ways to find out 

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

resources to determining just how exposed the bank’s 

systems are—the first concrete step in actually solving 

the problem. The second is to gamble the franchise by 

doing little or nothing and letting the century date 

change provide the ultimate stress test. 

Costs 

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

actually finding and fixing the problem. Estimates of 

this cost have ranged widely, although the Gartner 

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

the most widely quoted. Using a different approach, 

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

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

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

States. At the high end, the Giga Information Group 

sees a much more litigious future—estimating that 

Y2K-related legal costs could exceed $1 trillion. 

Significant opportunity costs may accrue as well, and 

the degree to which Y2K-related outlays fail to provide 

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

Subtracting 28 years from a date before processing and then adding 

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

remedy because it permits applications to continue measuring time by 

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

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

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

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

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

approaches only delay the need for permanent corrections. 

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

more efficient or functional systems will serve as a 

starting point for measuring the value of technology 

investments forgone. These forgone improvements will 

be especially costly for institutions that have started 

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

time for system improvements and upgrades has slipped 

away, but that they have insufficient time for anything 

beyond a patchwork solution that will continue to cost 

them beyond the year 2000. 

At the macro level, the tally of potential Y2K costs 

includes declining stock values, business failures, and 

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

percent of organizations’ remediation costs have not 

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

their share value erode as the costs of Y2K fixes and 

related losses are priced into their future earnings. The 

cost of not being Y2K compliant might be substantial as 

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

in two firms may discover just how substantial as they 

head into 1999 with even their most mission-critical 

systems unfixed. The potential for these firms to fail 

looms large among the factors that have led Edward 

Yardeni, chief economist at Deutsche Morgan Grenfell, 

to assign a 40 percent chance of recession in the year 

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

suggesting that 1 percent of all businesses would fail 

because of Y2K problems. Whatever the eventual 

number, many of these businesses will also be bank 

borrowers. 

Systems and Systemic Risks 

More immediate than the risk of borrower failures is the 

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

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

of their assets and liabilities. If these applications begin 

returning erroneous calculations, bank operations could 

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

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

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

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

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

calculation. Similarly, any other time calculation that straddles the 

century date change might return answers wrong in both size and 

sign. 

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

The solution is often described in software terms, but 

executable software is not the only problem. Correcting 

software to process four-digit years does little good if 

bank databases that store the critical information about 

who owes what to whom and when still store them in 

two-digit form. Hardware is another critical area. 

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

because the functions they perform are not always 

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

terminals, bank vaults, check and credit card processing 

equipment, and even building systems succumbing to 

the Y2K problem. 

This dependence on external components and services 

creates a systemic exposure as well. The substantial 

efficiencies that now exist in transmitting payments 

among and between banks and borrowers are a direct 

result of technology. Servicers and 

clearinghouses fulfill computerintensive intermediary roles in this 

high-velocity business—pooling 

payments from those who owe and 

redistributing them among those 

to whom they are due. Anything 

that interrupts these flows can 

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

Accordingly, both the Bank for International 

Settlements and the U.S. Federal Reserve are concerned 

about the Y2K threat for two reasons—first because it 

can interrupt the operations of systems dedicated to 

making interbank payments and second because it can 

interrupt the operations of the individual participants 

and generate a liquidity shock that could cause other 

institutions to fail. 

Unfortunately for banks, even a fully successful, 

industry-wide Y2K fix will not completely mitigate 

their risk. The year 2000 story is simply too dramatic 

and lends itself too well to sensationalism. Therefore, 

in addition to managing the cure, bankers will have to 

manage the perceptions of their customers and of the 

public at large—a considerable challenge given that a 

loss of confidence by a small number of customers 

could precipitate liquidity problems for institutions 

even in the absence of a genuine threat. 

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

Liability in the Executive Suite 

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

beyond those of the systems themselves and extend into 

the labyrinth of business relationships and fiduciary 

obligations that bind directors and officers—and the 

assorted attorneys, auditors, consultants, and service 

providers who assist them—to their banks. Through this 

network could pass liability and litigation that could be 

several times the cost of fixing the problem itself. And 

although the problem may have had a technical origin, 

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

should have corrected or disclosed the institution’s Y2K 

exposures. 

While the bank failures of the late 1980s and early 

1990s are often attributed to unforeseen economic 

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

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

be taken seriously. Moreover, placing the blame, no 

matter how well deserved, at the feet of vendors and 

consultants may offer little protection. The Federal 

Financial Institutions Examination Council (FFIEC) 

has indicated that senior bank management should be 

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

actions in such a way as to make imperative the active 

involvement of top bank management in both solving 

3 Safety and Soundness Guidelines Concerning the Year 2000 Business 

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

at www.ffiec.gov. 

Managing the Y2K Process 

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

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

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

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

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

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

That outline identified five phases that each financial 

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

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

connected with those outside the bank. The FFIEC 

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

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

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

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

nor easily quantified. However, it is critical that senior 

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

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

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

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

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

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

plans must then be devised. In addition to plans for 

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

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

inating from both within and outside the bank.
 

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

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

Betting the Franchise 

The FFIEC has divided Y2K remediation into five 

phases—awareness, assessment, renovation, validation, 

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

is conducted—should be well under way for all banks 

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

not devoting adequate resources to identify and address 

their exposures need to be aware that the consequences 

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

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

sharing in what has been described as potentially the 

most expensive litigation in history. 

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

interruptions and liability that emerge may have to be 

financed from the bank income statement and balance 

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

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

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

For Further Information 

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

below. 

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

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

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

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

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

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

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

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

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

Gartner Group—Technology Consultant www.gartner.com 

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

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

Giga Information Group—Technology Consultant www.gigaweb.com 

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

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

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

Trends in Commercial Real Estate 

Loan Pricing and Underwriting 

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

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

• Considerable evidence suggests that a large per- Construction Loans 

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

underwriting standards. 

• The rapid rise in commercial mortgage-backed 

securities and real estate investment trust funding 

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

on their competitive position in the lending 

Year-over-Year (%) Growth

20 Commercial Real Estate Loans 

10 

0 

–10 

–20 

–30 

YE90 YE91 YE92 YE93 YE94 YE95 YE96 3Q97 

markets. 

As reported in last quarter’s Regional Outlook, banks 

provided the largest share of funding for commercial 

real estate during 1995 and 1996 compared with all 

other financing sources (see Strong Demand and 

Financial Innovation Fuel Rebounding Commercial 

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

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

two loan categories are accelerating. At the same time, 

however, alternative funding sources in the form of 

commercial mortgage-backed securities (CMBS) and 

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

reports that $26 billion in CMBS was issued through 

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

issuance will top $40 billion during 1997, compared 

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

Measures of REIT activity also indicate impressive 

growth. According to the National Association of Real 

Estate Investment Trusts, REITs issued $26.3 billion in 

equity through October, compared with $12.3 billion 

for all of 1996. In addition, REIT market capitalization 

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

months of 1997. 

While it is good news to borrowers, the abundance of 

capital for commercial real estate projects raises the 

often-quoted concern that “too much money is chasing 

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

ing to both inadequate loan pricing relative to risks 

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

also explores the possible influences of CMBS and 

REITs on loan underwriting practices and commercial 

real estate markets. 

An Abundance of Capital Has Placed 

Significant Pressure on Commercial Real 

Estate Loan Pricing 

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

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

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

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

industrial corporate bonds, which traded at spreads of 

66 basis points over comparable-term treasuries as of 

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

American Council of Life Insurance (ACLI) data show 

that mortgage spreads relative to treasuries compressed 

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

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

1996 to March 1997. Moreover, because of continuing 

downward pressure, current pricing varies little across 

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

CHART 2 CHART 3 

Commercial Mortgage Spreads Are Pricing Narrows between High- and 

Tightening 

Basis Point Spread over

Ten-Year Treasuries 

Source: Barron’s/John B. Levy 

0 

50 

100 

150 

200 

250 

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

Spread between AAA and BBB


Grades (Ten-Year Average Life)
 

Medium-Grade CMBS 

Basis Points 

140 

120 

100 

80 

60
 

40
 

20
 

0 

Q1 ’95Q3 ’95Q1 ’96Q3 ’96Q1 ’97Q3 ’97 

Source: Nomura Securities International 

the quality spectrum. For instance, Chart 3 indicates 

that spreads between AAA- and BBB-rated CMBS have 

narrowed considerably since year-end 1995, from 110 

basis points to a scant 28 basis points. 

It seems likely that competitive factors will continue to 

place pricing pressure on lenders. The relatively recent 

entrance of Wall Street firms into the financing arena 

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

become.1 Conduits are rapidly becoming the dominant 

issuer of CMBS and underlie much of the rapid growth 

in CMBS noted above. Through the first nine months of 

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

compared with 30 percent during the same period in 

1996. 

Many industry participants see conduits and REITs as 

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

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

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

aggressively pursue higher quality loans in order to 

strengthen pools that contain weaker credits. Such 

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

incentive to pursue lower quality credits. Given their 

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

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

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

would in turn increase competition at the regional or 

local community level. While their influence is less 

direct, the growing use of REITs to finance commercial 

real estate projects also places pressure on loan pricing 

spreads, since lenders must compete for a smaller pool 

of customers. With their access to a seemingly limitless 

source of public funding, REITs could pose a particular 

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

Narrowing pricing spreads raise concerns over whether 

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

originating, servicing, and holding commercial real 

estate loans. More important, tightening spreads raise 

prospects that lenders will ease other loan terms and 

relax loan standards to the extent that they are unable to 

differentiate their product based solely on price. While 

such easing may enable lenders to retain business in the 

face of stiff competition, imprudent underwriting could 

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

Are Commercial Real Estate Loan Underwriting 

Standards Becoming Looser? 

Most industry experts have argued that the memory of 

the real estate downturn of the late 1980s and early 

1990s keeps lenders from becoming overly aggressive 

in making commercial real estate loans despite the 

abundance of funding alternatives currently available to 

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

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

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

and that lenders are requiring borrowers to bring more 

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

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

real estate lending policies. Rating agencies impose 

additional guidelines and standards as lenders originate 

loans for possible sale into the secondary markets. 

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

commercial banks is not readily available, some sense 

of industry trends may be gleaned from competitors’ 

practices. For example, the ACLI performs a quarterly 

survey of underwriting criteria for commercial real 

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

indicated that new commitments (total volume of $4.1 

billion) had a weighted average LTV for all property 

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

favorably to an LTV ratio in late 1989 approaching 75 

percent and a DCR just under 1.3 times. 

ACLI data suggest that recent commercial mortgage 

originations are better supported by borrower equity 

and property cash flows than they were in the late 

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

and DCR ratios are driven largely by market conditions 

and expectations. Property valuations take into account 

recent sales and expected cash flows, and cash flows 

available to service debt are based on projected net 

operating revenues, which often incorporate projected 

increases in rents and other revenue sources. In other 

words, the overwhelmingly favorable conditions in 

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

improved LTV and DCR ratios. Keeping in mind the 

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

shift from today’s positive outlook to a more pessimistic 

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

Notwithstanding these quantitative considerations, 

there are indications that banks are easing commercial 

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

due on the underlying loan. 

real estate underwriting standards. This evidence, 

derived from industry and examiner surveys conducted 

by the three banking agencies, includes the following 

observations: 

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

(OCC’s) 1997 Survey of Credit Underwriting 

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

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

16 percent of banking companies surveyed. Among 

institutions with eased lending standards in the 1997 

survey, examiners noted a 75 percent incidence of 

reductions in loan fees or rate spreads, a 43 percent 

incidence of eased guarantor requirements, and a 29 

percent incidence of lower collateral requirements. 

Examiners cited competitive factors and a change in 

economic outlook as the main reasons for changes in 

underwriting standards. 

•	 Chart 4 summarizes current and historical results of 

the Federal Reserve Board Senior Loan Officer 

Opinion Survey for responses to the question of 

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

tightened, or remained unchanged. These survey 

results show that banks have had a tendency to ease 

underwriting standards since the fourth quarter of 

1996. This tendency appears to have become 

stronger through the third quarter 1997 survey but 

moderated somewhat in the most recent survey. The 

most recent survey showed that large banks (over 

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

CHART 4 

Survey Shows Tendency to Ease Commercial 

Real Estate Underwriting Standards 

Percentage 

Source: FRB Senior Loan Officer Opinion Surveys 

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

–15 

–10 

–5 

0 

5 

10 

15 

20 

25

 % Respondents Tightening

 % Respondents Easing

 Net % Tightening (Easing) 

San Francisco Regional Outlook 9	 First Quarter 1998 
In Focus This Quarter
 

smaller banks. Specifically, 21 percent of large 

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

only 9 percent of smaller banks reported easing 

standards, while 13 percent reported tightening 

standards. 

•	 Results from the FDIC Report on Underwriting 

Practices indicate possible easing of standards for 

construction and development (C&D) loans at 

FDIC-supervised banks. A comparison of examiner 

responses for the third quarter 1997 survey (covering 

examination reports filed from April through 

September 1997) with responses for the third quarter 

1996 survey leads to the following observations3

: 

•	 The percentage of banks frequently or commonly 

originating C&D loans tied to speculative projects 

(that is, projects lacking meaningful preleasing or 

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

of construction) rose markedly, from 11 percent to 

29 percent. 

•	 The percentage of banks frequently or commonly 

granting C&D loans without considering alternative 

repayment sources other than income generated by 

the project being financed rose significantly, from 8 

percent to 20 percent. 

•	 The percentage of banks frequently or commonly 

basing C&D loans on unrealistic appraisals rose 

from 5 percent to 11 percent. 

•	 The percentage of banks frequently or commonly 

funding or deferring interest payments during the 

term of construction loans rose from 7 percent to 15 

percent. 

Much of the commentary in recent issues of various 

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

higher incidence of (1) banks funding construction loans 

without preleasing commitments on major portions of 

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

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

across time periods must be interpreted with caution since the survey 

samples are dictated principally by examination scheduling factors. 

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

period to another. 

lenders curtailing reserve requirements for such items as 

tenant improvements and insurance, and (4) nonrecourse 

lending. Some industry participants have also noted the 

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

extrapolated several years into the future. Of course, 

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

an assumption that may not be reasonable given 

the cyclical nature of real estate coupled with 

the advanced age of the current economic 

expansion. 

With a combination of relatively low 

interest rates, rising real estate prices, 

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

lenders have eased commercial real 

estate underwriting standards. Such 

easing may be a natural response to 

improved confidence in the real estate 

markets. However, indicators that show 

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

and competitive pressures. To avoid losses like those 

sustained by banks during the last real estate downturn, 

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

CMBS Could Change the Way 

Lenders Underwrite Loans 

Much as residential mortgage lending standards were 

shaped by the advent of mortgage-backed securities, 

CMBS promise to change the way banks underwrite and 

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

marketability of their commercial mortgage portfolios. 

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

manage portfolio risks and respond rapidly to liquidity 

demands. 

The ability to securitize commercial real estate loans 

also may fundamentally alter the way lending decisions 

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

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

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

Commercial Property News, “Michelson, Greenland Seize Low 

CMBS Spreads” (1 May 1997). 

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

are made. Before the development of CMBS markets, 

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

accept-or-reject decision whose primary focus was on 

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

most important elements in CMBS are deal structure, 

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

making credit decisions: That is, how will this loan 

enhance the expected return and risk diversification of 

the overall pool? 

External rating agencies will become increasingly 

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

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

and loan performance disclosure, there are several 

potential risks to consider as the CMBS markets evolve: 

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

by quantitative factors, namely debt service coverage 

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

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

example, lack of alternative repayment sources or 

minimal borrower equity in the project) applied to 

individual loans within the pool may receive only 

secondary consideration. A quantitative perspective 

also ignores such immeasurable factors as borrower 

“character” and the existence of long-standing 

lender-borrower relationships. 

•	 Rating agencies cannot be relied upon as a backstop 

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

are not practically able to review every credit in the 

securitization. Some within the industry have even 

suggested that investment bankers commonly move 

one problem property, discovered through one 

agency’s sample, into pools reviewed by another 

agency in the hope that it will not be sampled. 

•	 Competition among the rating agencies could 

become a factor in the underwriting process. This 

“shopping of the agencies” could result in continual 

pressure for rating agencies to ease their underwriting guidelines. 

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

underlying credit risk associated with commercial 

real estate lending to investors. However, like other 

types of asset securitization, CMBS raise concerns 

over the degree to which banks will voluntarily 

absorb investor losses. Bank issuers may be more 

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

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

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

resources than nonbanks with which to support securitization activities. 

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

applied by the rating agencies to CMBS have not been 

tested during a cyclical downturn in real estate prices. It 

remains to be seen how the market will react to rising 

loan losses that result in investor losses. 

Will Increased Public Funding through CMBS 

and REITs Improve Market Discipline? 

Many contend that the increased transparency brought 

to the market by CMBS will temper cyclical swings in 

real estate values. This viewpoint argues that investors 

will serve as a constraint against the natural tendency to 

overbuild commercial real estate during boom periods, 

since less funding will be allocated to segments of the 

market where excess capacity exists. This viewpoint 

presupposes that the investing public is sophisticated 

enough to recognize when markets are out of balance 

and when projects are economically infeasible. In this 

sense, CMBS shift much of the burden of monitoring 

credit quality standards and credit performance from 

lenders to public investors. 

In contrast, others have argued that lenders are much 

better suited than investors to make judgments about 

credit quality standards and project feasibility. This line 

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

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

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

lead to differentiation in pricing based on investors’ 

San Francisco Regional Outlook 11	 First Quarter 1998 
In Focus This Quarter
 

perceptions of the quality of underwriting applied by 

specific issuers.5 

Putting market efficiency arguments aside, the sheer 

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

property valuations. With such an abundance of capital 

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

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

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

most recent real estate downturn provided a ready 

example of how tighter credit availability compounded 

the effects of declining commercial property values by 

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

CMBS and REITs will temper cyclical price swings, the 

underwriting standards and practices evolving in 

response to these financing vehicles will likely play a 

crucial role in determining the magnitude of losses 

experienced by investors and banks during the next 

downturn in commercial property values. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Selected Articles
 

for Further Reading
 

Bloomfield, Craig. “Michelson, Greenland Seize 

Low CMBS Spreads.” Commercial Property News. 

1 May 1997. p. 33. 

“CMBS Issuance Seen Topping $40 Billion.” 

Commercial Mortgage Alert. 10 November 1997. 

p. 1. 

Fitch Investor Services, Inc. “Commercial 

Mortgage Stress Test.” Fitch Research: Structured 

Finance Special Report. 8 June 1992. 

Office of the Comptroller of the Currency. Advisory 

Letter 97-3: Credit Underwriting Standards and 

Portfolio Credit Risk Management. 3 March 1997. 

Sinderman, Martin. “Public Markets Fuel 

Financing Glut.” Commercial Real Estate South. 

October 1997. p. 1. 

Wolf, Barney. “Wall Street and Main Street 

Squeeze Lenders.” Midwest Real Estate News. 

October 1997. p. 1. 

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

pricing. 

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

Total Return: A Useful Tool for
 

Monitoring Investment Portfolio Risk
 

•	 The Federal Financial Institutions Examination 

Council (FFIEC) is replacing the 1991 policy that 

contained a specific “high-risk test” for mortgage 

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

investment portfolio basis. 

•	 A good way to start measuring portfolio risk is by 

monitoring an appropriate measure of return. 

•	 Total return, a concept that includes fluctuations 

in market value, is a more appropriate tool than 

simple yield for measuring the performance of an 

investment portfolio, especially one that contains 

bonds with embedded options. 

The Federal Financial Institutions Examination Council 

(FFIEC) has released for comment a new Joint Agency 

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

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

the former statement has been retained, the section 

requiring specific “high-risk” testing for mortgage 

derivative products (MDPs) has been eliminated. The 

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

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

The goal of the original policy statement was to deter 

banks from investing in products that presented risks 

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

growth, nontraditional and potentially risky nature, and 

common use by insured financial institutions. The new 

policy states that, as a sound management practice, 

institutions should conduct prepurchase and ongoing 

analysis of all their investments at a level appropriate to 

the size and complexity of those holdings. 

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

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

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

point parallel shift in rates. 

The policy change is in part a response to increasing 

bank investment in securities that have complex cash 

flows analogous to MDPs but that escaped the analysis 

requirement of the previous policy. Mortgage index 

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

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

bonds are popular bank investments because they offer 

a slightly larger spread to Treasury than noncallable 

agency securities, and they were not subject to the 

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

Appropriately measuring portfolio return can enhance 

the ability to monitor the extent to which these kinds of 

securities put future earnings at risk. 

Total Return Analysis Is a Useful Tool for 

Analyzing Risk at the Portfolio Level 

Total return analysis is a basic but useful tool that can 

alert management to the level of certain risks in an 

investment portfolio. It can also provide information 

that is useful for validating the assumptions used in 

more sophisticated models. Total return is calculated 

from three components: beginning price, income and 

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

a horizon date. Total return incorporates the change in 

the market value of the investment, resulting in a more 

comprehensive measure of performance than other 

measures that ignore such changes. Monitoring total 

return on a portfolio basis can provide institutions with 

important information about the risks inherent in the 

portfolio and how these risks may be changing over 

time. 

In two articles in the ABA Banking Journal,

2 Nicholas 

Betzold and Richard Berg convincingly dispute the 

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

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

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

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

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

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

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

1993, interest rates fell almost 300 basis points. Bank 

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

reinvest at a significantly lower rate for the remaining 

four years of the seven-year investment horizon. Over 

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

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

From the yield perspective, 

Bank A enjoyed three years of 

superior performance. However, during those three years, 

monitoring total return might 

have revealed a less favorable 

but more accurate picture of 

Bank A’s performance relative 

to Bank B’s. Here is why: As 

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

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

security would have gained incrementally less than the 

noncallable bond because each downward tick in rates 

increased the expectation that the bond would be called, 

and the higher coupon would be earned over a shorter 

period. In contrast, the noncallable security’s market 

value would have enjoyed the full benefit of the falling 

rate environment because its maturity and cash flows 

are fixed. 

The disparate change in the market value of the two 

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

call option to the bond issuer. The issuer bought the 

right to repurchase the debt at par after three years. 

Bank A was compensated for selling this right to the 

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

option to call the bond would have gained value as rates 

fell. The increasing positive value of the call option to 

the issuer represents an increasing negative value to the 

bondholder and erodes the value of the bond. 

Step-up bonds present reinvestment risk similar to that 

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

are not called. Total return analysis would similarly 

reveal adverse changes in the value of the embedded 

call options and the extent to which the additional 

coupon is compensating for call risk. 

UBPR Yield 

Bank management often uses the portfolio yield that is 

calculated in the Uniform Bank Performance Report 

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

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

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

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

because implicit options have been sold, the latter has 

been put at risk for the sake of the former. 

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

changes in reinvestment risk over time. Ultimately, a 

portfolio manager who earns total returns consistently 

higher than average will earn more in terms of simple 

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

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

The popularity of using yield to gauge the performance 

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

UBPR. Some managers may be reticent to evaluate 

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

Betzold and Berg have devised an investment portfolio 

index (introduced in the April 1997 ABA Banking 

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

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

portfolio on which the index is based is rebalanced 

monthly as principal pays down, and it is rebalanced 

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

September 30, 1996, Call Report data. 

According to Betzold and Berg, this index produced 

total returns that closely approximated those of the actuSan Francisco Regional Outlook 14 First Quarter 1998 
In Focus This Quarter
 

al median bank total portfolio measured by Call Report 

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

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

Chart 1 shows the performance of the index so far this 

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

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

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

Calculate the bond equivalent semiannual yield 

and express the semiannual bond equivalent yield 

as an effective annual yield. 

4

: 105.00 3

6.72% = 100 [(:) − 1

100.00 ]

The performance of the index for 1997 suggests that 

banks’ total investment portfolio returns were highly 

negatively correlated with changes in the five-year 

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

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

interest rate sensitivity. As emphasized above, these 

changes in total return over time include the effects of 

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

investment securities and hence provide information 

about the degree to which future income is at risk. 

Given the increasing level of optionality embedded in 

the average bank securities portfolio—even if it arises 

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

overall portfolio performance. Total return analysis is an 

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

implicit options. 

Allen Puwalski, Senior Financial Analyst 

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

compute total return precisely, the authors computed an estimate
 

using the reported yield and market value data.
 

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

TABLE 1 

Composition of Betzold Berg Index 

December 31, 1996 

PERCENT 

SECURITY TYPE OF INDEX 

TREASURIES 24.52 

AGENCIES 24.38 

MUNICIPAL BONDS 12.26 

FIXED-RATE MORTGAGE OR 

MORTGAGE-RELATED PRODUCTS 19.93 

OTHER SECURITIES 6.09 

ADJUSTABLE-RATE SECURITIES 13.00 

Source: Bank and Thrift Call Reports, September 30, 

1996 

CHART 1 Index Value 

Index Tracks the Total Return of an 

“Average” Bank Portfolio 

Source: ABA Banking Journal 

100.84 

104.31 

Dec Jan Feb Mar Apr 

100 

101 

102 

103 

104 

105 

106 

May Jun Jul Aug Sep 

100.51 100.71 

101.49 

102.23 

103.06 

104.03 

105.00 

100.00 

CHART 2 

Total Return Index Is Correlated 

to Changes in Interest Rates 

Source: ABA Banking Journal, Bloomberg 

5-year Treasury 

(right scale) 

Betzold Berg Index 

(left scale) 

Percent Change Percent Change 

–10 

–5 

0 

5 

10 

Jan-97

Feb-97

Mar-97

Apr-97

May-97

Jun-97

Jul-97

Aug-97

Sep-97 

–0.20 

0.00 

0.20 

0.40 

0.60 

0.80 

1.00 

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

The San Francisco Region’s Larger
 

and More Diverse State Economies
 

Tend to Closely Follow the National Economy
 

•	 Over the past year, the San Francisco Region recorded the fastest employment growth of the eight FDIC 

Regions. 

•	 Nevada, Utah, Washington, Arizona, Oregon, and California, states that generally expand when the national economy does, are all growing much faster than the nation as a whole. 

•	 States in the Region with more diverse economies tend to be expanding more rapidly than states that have 

less diverse economies, especially those that are more dependent on natural resource-based industries. 

•	 Nevada, the Region’s least diverse economy, is the fastest-growing state in the nation because of strong 

growth in gaming, tourism, and construction. However, the state’s heavy dependence on these industries 

continues to warrant close monitoring. 

The San Francisco Region’s Expansion 

Keeps on Rolling 

The San Francisco Region, fueled by strong job growth 

in the Region’s larger states, continues to outpace the 

nation and the other seven FDIC Regions. Total nonfarm payroll employment for the Region grew by 

669,000, an increase of 3.0 percent over the 12-month 

period ending October 1997. Over the same period, the 

nation’s employment grew at a 2.1 percent annual rate. 

Performance across the Region’s states is as follows: 

•	 Outperforming—The Region’s six fastest-growing 

states are Nevada, Arizona, Utah, Washington, 

Oregon, and California (listed in order of employment growth rates). These states, which are the most 

populous states in the Region, added jobs at a very 

fast pace, 2.7 percent or better, over the past year. 

•	 Lagging—Idaho, Montana, and Alaska (ranked by 

growth rates) all grew more slowly than the nation 

over the 12 months ending October 1997. Just two 

years ago, Idaho and Montana were among the 

nation’s fastest-growing states. 

•	 Weak—Wyoming and Hawaii ranked forty-ninth 

and fiftieth, respectively, in job growth over the past 

year. While Wyoming reported a small increase in 

employment, Hawaii reported a slight loss. 

Key Relationships between State and National 

Employment Growth 

This article examines several factors that may help to 

explain why the Region’s six most populous states tended to outperform the least populous states over the past 

year. The analysis focuses on three factors: 

•	 The historical correlation between a state’s employment growth rate and the national employment 

growth rate; 

•	 The diversity of state economies compared with the 

national economy; and 

•	 The health of key industrial sectors in a state. 

Understanding these three factors may provide insights 

into both current and future state-level economic performance. Consequently, it is important to review these 

indicators because of their potential relationship to 

state-level economic conditions, which in turn play an 

important role in state-level banking industry performance, especially for community banks. In addition, 

these three factors may be useful for analyzing state 

economic trends in the event of a downturn in the 

national economy. 

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

While few economists are predicting a downturn in the CHART 1 

U.S. economy in the near future, the recent disturbances 

in the financial markets both at home and abroad have 

given rise to concerns about the path the national economy will take over the next several years. Within the 

Region, which has a large share of U.S. high-technology manufacturing, the slowdown in high-tech exports to 

Asia in 1997, combined with the weakened economic 

conditions of key trading partners like South Korea, 

already has resulted in slightly lower estimates of 

growth for California’s economy in 1998. States like 

Hawaii and Nevada, with a heavy dependence on 

tourism, also could be susceptible to reduced travel and 

spending by Asian tourists. 

San Francisco Region and U.S. Payroll 

Employment Growth Rates Move Together 

Source: Bureau of Labor Statistics. Annual data, not seasonally adjusted. 

–4 

–2 

0 

2 

4 

6 

8 

1971 1975 1979 1983 1987 1991 1995 

San Francisco Region 

U.S. 

Percent of Growth 

Measuring the Linkage between State and 

National Employment Growth 

Clues to state-level economic behavior can be found by 

correlating past state economic performance with 

national economic trends. One way to quantify this relationship is to compare the correlation, or comovement, 

over time between the employment growth rates for the 

nation and for the Region (or a state). This measure, or 

correlation coefficient, for a series like nonfarm payroll 

employment growth rates, can be used to evaluate the 

strength of the relationship. The measure also shows 

whether the relationship is positive or negative. A cor­ –0.50

relation coefficient of 1 indicates that a Region’s 

employment growth rate is perfectly positively correlatCHART 2 

Most San Francisco Region States Show a Strong 

Correlation with U.S. Employment Growth (US=1) 

1.00 

0.75 

0.50 

0.25 

0.00 

–0.25 

Region

AZ

NV

OR

CA

UT

WA

ID

MT

HI

WY

AK 

Source: Bureau of Labor Statistics. Annual Growth Rates, 1972–1996. 

ed with that of the nation, meaning that when the 

nation’s economy moves up (or down) the Region follows that movement. Conversely, a correlation coefficient of –1 indicates perfect negative correlation, such 

that when the nation’s economy improves, the Region’s 

economy worsens. A correlation coefficient of zero 

indicates that there is no statistical relationship between 

movements in employment in the nation and the 

Region. 

Over the past 25 years the San Francisco Region’s 

employment growth rate has been fairly closely correlated with that of the nation, as shown in Chart 1. The 

correlation coefficient for the Region’s and the nation’s 

employment growth rates over the 25-year period was 

0.91. Moreover, as shown in Chart 2, the Region’s 

employment growth rate correlated more closely with 

the national employment growth rate than did that of 

any individual state in the Region. 

Larger States in the Region Generally Follow the 

National Economy More Closely than Smaller States 

Employment growth rates in Arizona, Nevada, Oregon, 

California, Utah, and Washington (ranked from highest 

to lowest) all exhibited a high degree of correlation 

(above .70) with the national employment growth rates 

over the 25-year period. These states also are the most 

populous in the Region; in 1996 their populations 

ranged from 1.6 million in Nevada to 31.9 million in 

California. As indicated in Chart 2, these more populous states show a much closer relationship to the 

nation’s employment growth pattern than do the five 

least populous states (populations ranging from 500,000 

to nearly 1.2 million). 

The employment growth rates in three of the least populous states, Idaho, Montana, and Hawaii, do show a 

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

modest positive relationship to employment growth 

rates for the nation. However, movements in Alaska and 

Wyoming show only a weak correlation with national 

employment growth rates. These two states are heavily 

dependent on natural resource-based employment, and 

they both have a large share of government jobs. 

Employment growth rates in these two sectors typically 

do not show a close correlation with national rates. 

Alaska’s relationship to national employment growth 

after the oil crisis of the early 1970s is especially unusual. Alaska is the only state in the Region that exhibited a negative correlation with national employment 

growth over the past 25 years. 

This means that as the nation’s 

economy lost jobs, Alaska’s 

economy tended to add jobs. 

Alaska is a major oil producer; 

consequently, it benefits from 

high or rising oil prices, conditions that dampen economic 

performance in most of the 

nation. 

Implications: The six most populous states tend to 

move in tandem with the national economy, and they are 

currently among the six fastest-growing states in the 

nation. Their strong relationship to the national economy suggests that the economies of Arizona, Nevada, 

Oregon, California, Utah, and Washington (ranked by 

their correlation to the national economy) are likely to 

continue to follow national conditions. Despite this tendency, it is clear that state economies do not always follow the national economy. Within the Region, even the 

states with a high correlation to the national economy 

occasionally follow their own economic cycles, such as 

Arizona’s real estate-induced slump in the late 1980s or 

California’s extended recession in the early 1990s. 

The five least populous states (ranked by their correlation to the national economy), Idaho, Montana, Hawaii, 

Wyoming, and Alaska, are not as closely linked to the 

national economy as more populous states. These states 

are more likely to experience their own upturns and 

downturns. Present conditions in these states do not 

reflect the strong national economy; rather, their 

employment growth ranges from weak compared with 

the nation (Idaho, Montana, and Alaska) to little or no 

growth (Wyoming and Hawaii). These five states are 

not closely linked to the national economy, so we should 

examine other factors, like economic diversity and the 

health of key industries, to understand their current 

economic performance and their future prospects. 

Finally, since these states often do not closely follow 

national economic trends, we might expect that the performance of their community banks may not closely follow U.S. banking industry performance either (see 

Regional Banking Conditions). 

The San Francisco Region Has a 

Diverse Economic Base 

A second key factor in explaining economic trends at 

the state level is economic diversity. Diversity can be 

measured and used to compare a state or region’s industrial structure with that of the nation. Diversity may help 

explain why some states are more likely than others to 

follow national economic trends. Generally, we expect 

states that are more diverse, or that have an industrial 

composition more like the nation’s, to move more closely with the national economy. 

A diversity index (Index) developed by the FDIC’s 

Division of Insurance is a useful tool for evaluating the 

diversity of a state or region’s economy compared with 

the nation. The Index is derived from sectoral earnings 

data published by the Bureau of Economic Analysis. It 

measures the differences between the share of statelevel earnings for key sectors of a state economy and the 

share of earnings for those sectors at the national level. 

The Index also takes into account the relative sizes of 

the various sectors. Higher index values show greater 

diversity relative to the national economy. A state or 

region that has the same share of earnings for each sector of the economy as the nation will have the maximum 

diversity rating, 100. A state with large differences in 

industrial sectors from the national economy will have a 

low diversity rating. 

The diversity of the San Francisco Region’s economy as 

a whole is quite high. It ranked highest among all eight 

FDIC Regions in diversity with a rating of 92, well 

above the average of 87 for all the Regions. Even the 

Chicago Region, which has the lowest rating (82), is relatively diverse compared with most states. 

States Are Much Less Diverse than the Regions 

State diversity index values or ratings vary much more 

widely than do the ratings for the much larger FDIC 

Regions. The average index value for all 50 states and 

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

the District of Columbia was just under 70 for 1996. 

Individual state diversity ratings ranged from 16 for the 

District of Columbia, the least diverse area, to 93 for 

Illinois, the most diverse. In the San Francisco Region, 

shown in Chart 3, the range ran from 21 in Nevada to 90 

in Utah, the fifth most diverse state economy in the 

nation. 

Utah, California, and Arizona, with diversity index values ranging between 86 and 90, are among the most 

diverse economies in the nation. Furthermore, over the 

past 25 years both Utah’s and Arizona’s economies have 

become significantly more diverse as these states have 

expanded their service sector, increased their manufacturing base, and reduced their dependence on natural 

resource-based industries. In contrast, California’s 

diversity rating has not changed significantly in the past 

decade, despite the ongoing restructuring in the state 

from defense-related manufacturing toward services. 

Three other states in the Region, Oregon, Washington, 

and Montana, have diversity ratings around 70, close to 

the average rating for all the states. The economies of 

these three states also have become more diverse since 

the early 1970s, when all three were much more dependent on natural resource-based industries. Of the three, 

only Montana remains heavily dependent on natural 

resources. More than 6 percent of Montana’s 1996 earnings were generated from agriculture, forestry, and 

extractive industries, more than double the share for the 

nation. 

Idaho, with a diversity rating of 60, and Hawaii, with a 

rating of 50, are less diverse than the typical state. 

Idaho’s diversity rating has improved in recent decades 

as the state has expanded its manufacturing base and 

reduced its reliance on natural resources and agriculture. Unlike Idaho, Hawaii’s diversity rating has not 

changed significantly from 25 years earlier. The lack of 

diversity in Hawaii’s economy results from the state’s 

heavy dependence on the tourist trade, which by some 

estimates accounts for approximately one of every four 

jobs in the state. 

The economies of Alaska and Wyoming, with Index ratings of 35 and 25, respectively, are among the least 

diverse of all the states. These states rely heavily on natural resource-based industries like oil and mining, and 

both have large governmental sectors (accounting for 

over 25 percent of state employment, versus 16 percent 

for the nation). Furthermore, both states were less 

CHART 3 

Economic Diversity Varies Widely across 

the San Francisco Region (US=100) 

100 More Diverse
 

90
 

80
 

70
 

60
 

50
 Less 40 Diverse
 

30
 

20
 

10
 

0
 

Source: Division of Insurance Diversity Index for 1996, based on Bureau of 

Economic Analysis earnings data. NV
 WY
 AK
 HI
 ID


MT

WA

OR

AZ

CA

UT

Region 

diverse in 1996 than they were in the early 1970s. This 

trend runs counter to the national trend toward greater 

diversity among states. 

While Nevada’s population doubled from 1979 to 1995, 

its economic base has not become more diverse, and it 

continues to be the least diverse of any state in the 

Region or the nation. Nevada is very dependent on 

tourism, defined here to include gaming, lodging, eating and drinking, air transport, and recreational employment. These industries account for over one-third of all 

jobs in Nevada, far above the national average. In addition, construction accounts for almost 10 percent of all 

jobs, about twice the national average. 

Industrial Health Also Matters 

The health of key industries is a third factor in a state’s 

economic well-being. Similar levels of economic diversity do not necessarily translate into similar economic 

performance, because the health of key industries or 

industrial sectors may vary from state to state. For 

example, in 1997 two states with similar diversity ratings, Washington and Montana, experienced vastly different economic conditions. Fueled by an upswing in 

aerospace manufacturing employment, Washington’s 

economy is accelerating; it is now one of the fastestgrowing states in the nation. In comparison, Montana’s 

economy is slowing and lags behind the nation in job 

growth. Montana has only a small manufacturing sector, 

and its large mining sector is weak. The contrast 

between these two states illustrates the important role 

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

the composition of a state’s economy can play in its 

health. 

A comparison of Montana and Nevada further illustrates the importance of key industries to a state’s performance. They are the only states in the Region where 

diversity was not consistent with economic performance over the past year. Among the group of diverse 

states, only Montana is lagging behind the nation in job 

growth. As was noted earlier, it is heavily dependent on 

both the natural resources sector and government jobs, 

two areas that have been weak relative to the overall 

economy. In contrast, Nevada’s economy is the least 

diverse of all 50 states, yet it is booming. Nevada has a 

heavy concentration in tourism and construction, industries that have been expanding. Nevada’s lack of diversity is presently a factor in its rapid growth, again 

illustrating the importance of the health of key industries at the state level. 

Unlike larger interstate banks, community banks operating in state or local markets will find their performance closely linked to state or local market conditions. 

Thus, in states that are not closely linked to the national economy, community bank performance likely will 

reflect state and local economic conditions. The situation in Hawaii illustrates this point. In spite of the 

national recovery, Hawaii has been in a recession for 

several years. Through the third quarter of 1997, 

Hawaii’s community banks (assets under $1 billion) 

recorded a year-to-date return on assets (ROA) of only 

0.81, well below the 1.35 ROA the Region’s community banks posted over the same period. 

Implications: Correlation with the national economy, 

the diversity of the industrial base, and the health of key 

industry sectors provide useful information about this 

Region’s state economies. The economies of California, 

Washington, Arizona, Oregon, Utah, and Nevada correlate much more closely with national economic conditions than do those of the Region’s less populous states. 

Aside from Nevada, the Region’s most populous states 

have more diverse economies than the less populous 

states. In the event of a national downturn, the historical 

record suggests that these states likely would follow the 

national economy. 

Diversity and industrial composition also are important 

for analyzing a state’s economic condition and potential 

risks. Nevada’s economy is the least diverse in the 

Region, yet it tends to move closely in line with the 

national business cycle. Still, Nevada faces an additional downside risk because its economy is heavily concentrated in tourism and construction, two cyclical 

sectors. A slowdown in the national economy, the state’s 

huge gaming industry, or its large gaming-dependent 

construction sector probably would weaken Nevada’s 

economy more than it would that of other states. 

Moreover, this is an area of concern because Nevada’s 

booming economy has led to the formation of a number 

of new banks, the rapid expansion of many smaller 

banks, and an increase in community banks’exposure to 

construction and commercial real estate lending. 

Finally, Hawaii’s ongoing recession illustrates the 

potential for the Region’s less populous states to follow 

their own business cycles in spite of a strong national 

economy. Hawaii, Idaho, Montana, Alaska, and 

Wyoming are less likely than the more populous states 

to closely follow the national economy. These states 

either rank low on diversity (Hawaii, Idaho, Alaska, and 

Wyoming) or are relatively heavily dependent on natural resource-based industries or agriculture, or both 

(Idaho, Alaska, Wyoming, and Montana). An added risk 

in these states is that downturns are less likely to coincide with a national recession than they are in the 

Region’s larger states. This fact may have implications 

for the banks in these states, because a weak state economy normally will be reflected in the performance of 

community banking institutions, as currently is the case 

in Hawaii. 

Gary C. Zimmerman 

Regional Economist 

San Francisco Regional Outlook 20 First Quarter 1998 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

•	 Reported earnings, asset quality, and capital remained strong for most banks and thrifts in the San 

Francisco Region during the third quarter of 1997. 

•	 Declining loan loss reserve levels for community banks in certain states and metropolitan statistical areas 

raise concerns because of increasing concentrations of risky assets held by these institutions. 

•	 Increasing reliance on volatile funding sources underscores the importance of sound liquidity management 

practices. 

Supported by a strong economy in most of the San 

Francisco Region, insured financial institutions reported solid performance in the third quarter of 1997. 

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

continues to trend upward, as shown in Chart 1. During 

the past 12 months, the asset-weighted Tier 1 capital 

ratio climbed from 7.44 percent to 7.65 percent. 

Reported asset quality is characterized by a low and 

declining ratio of past-due and nonaccrual loans, which 

now approximates only 2 percent of total loans. 

Although overall trends for the Region’s insured institutions appear favorable, performance within each of the 

11 states varies, particularly among community banks 

(defined here as non-credit-card banks with total assets 

of less than $1 billion). In the aggregate, community 

banks in some of the Region’s fastest growing states— 

Arizona, Nevada, Oregon, Utah, and Washington— 

report ROAs above 1.30 percent. ROAs at community 

banks in Alaska, Idaho, and Wyoming also exceed 1 

percent, and operating income has improved despite a 

slowdown in employment growth rates in these states. 

CHART 1 

Profitability Continues to Rise at Region’s
 

Banks and Thrifts
 

2.0 

1.5 Banks 1.3%

1.0 

0.7% 

0.5 

0.0

% Return on Assets (ROA) 

–0.5 

–1.0 

1987 1989 1991 

Source: Bank and Thrift Call Reports 

Thrifts 

1993 1995 3Q97* 

* Third quarter annualized ROA 

Conversely, community banks in some states and metropolitan statistical areas (MSAs) whose economies are 

less diverse or whose major industries have slowed 

down performed less well during the third quarter of 

1997 (see The San Francisco Region’s Larger and 

More Diverse State Economies Tend to Closely Follow 

the National Economy): 

•	 Community banks in Hawaii, one of the Region’s 

less populous states, continue to underperform both 

the Region and the nation as a result of the state’s lingering recession. ROA for these banks is the lowest 

in the Region at 0.81 percent, and the ratio of pastdue and nonaccrual loans to total loans is the highest 

in the Region at 6.28 percent. Although profits at 

these institutions are up slightly, reserve coverage of 

noncurrent loans (loans 90 days or more past due 

plus nonaccrual loans) remains extremely low at 41 

percent. If provisions were made to bring the loan 

loss reserves more in line with the Region and 

nation, profits and Tier 1 capital would decline. 

Prospects for a near-term economic recovery in 

Hawaii remain tenuous, in part owing to the recent 

events in Asia (see The San Francisco Region’s 

Larger and More Diverse State Economies Tend to 

Closely Follow the National Economy). 

•	 Year-to-date ROA for community banks in 

California was 1.07 percent through September; 

however, performance varied throughout the state. 

While, in aggregate, ROAs for the community banks 

in the Los Angeles MSA remained above 1 percent 

for the third consecutive quarter after almost a decade 

of low and negative returns, banks in some other 

MSAs are showing signs of weakness. For example, 

community banks as a whole are underperforming, 

with ROAs of 0.85 percent or less in the following 

large California MSAs: Vallejo-Fairfield-Napa, 

Stockton-Lodi, and Riverside-San Bernardino. 

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

More than 50 percent of the institutions in these 

MSAs reported subpar ROAs, typically caused by 

higher provisions for loan losses. Most of these institutions had higher levels of past-due loans, and many 

also had above-average exposure to higher risk assets 

relative to their peers. 

•	 Although reported profits at community banks in 

Montana are healthy, some asset quality deterioration is becoming evident. Past-due and nonaccrual 

loans have hovered above 3 percent of total loans for 

the past four quarters. In addition, reserve coverage 

of noncurrent loans dipped to 95 percent from 139 

percent during the same period. Higher levels of 

problem assets may be a reflection of the state’s slow 

employment growth and weak natural resources 

sector. 

Reserves for Loan Losses Slip at 

Some Institutions 

While profits are generally strong at the Region’s banks, 

their first line of defense against loan losses—the 

allowance for loan and lease losses (ALLL)—has 

declined as a percentage of total loans in every year 

since its 1992 peak. This decline took place during a 

period of strong postrecession economic growth in 

much of the Region. Although, as shown in Chart 2, the 

ALLL decline of 80 basis points for the Region’s banks 

parallels the national decline, the relative adequacy of 

ALLL levels for some of the Region’s banks warrants 

closer review. In particular, the ALLL levels and trends 

vary significantly among community banks in different 

locations around the Region. The differences in ALLL 

CHART 2 

Regional Banks’ Reserve for Loan Losses
 

Declines with the Nation
 

3.0 

Reserve to Total Loans (%) 2.5 

2.0 Nation 

Region 

1.5 

1990 1991 1992 1993 1994 1995 3Q96 3Q97 

Source: Bank Call Reports 

levels are a reflection of differing economic growth patterns, market conditions, and bank portfolios. 

Community Banks Exhibit Risky Trends in 

Certain States and MSAs 

The ALLL for community banks in the Region is generally in line with national averages. However, community banks in some states in the Region are raising 

concerns because of rapid loan growth and an assumption of greater lending risks in recent years. Oregon, 

Washington, and Nevada, for example, have recorded 

strong loan growth in recent years and have some of the 

highest concentrations of construction and commercial 

real estate lending, measured as a percentage of total 

assets, in the Region. Despite the increase in risk profiles, the overall level of reserves to loans in all three 

states has declined below the Region’s average of 1.68 

percent for similar-size banks with lower risk profiles 

(see Table 1). 

Banks in several MSAs in the fastest growing states in 

the Region are some of the most heavily exposed to construction and commercial real estate lending, yet have 

lower loan loss reserves than other community banks in 

either the nation or the Region. These MSAs are 

Eugene and Salem in Oregon; Olympia and Seattle in 

Washington; and Reno in Nevada. In aggregate, banks 

in each of these MSAs hold about 30 percent of their 

assets in commercial real estate and construction lending while the reserves to total loans ranged from 0.99 

percent to 1.30 percent. These reserve levels are significantly lower than for similar-size banks with lower risk 

profiles in both the Region and the nation (see Table 1). 

Hawaiian community banks also raise concerns because 

of their very low ratio of reserves to noncurrent loans. 

This ratio has moved down from 183 percent in 1990 to 

only 41 percent as of the third quarter of 1997, far 

below averages for the nation and the Region. The low 

coverage ratio is noteworthy because, while more than 

half the noncurrent loans are in one- to four-family residential mortgages, median residential home sale prices 

in Hawaii continue to decline and have dropped approximately 20 percent from their peak in the third quarter 

of 1990. 

Implications: Community banks in several rapidly 

growing states have reduced reserve coverage levels to 

well below averages for both the Region and nation. 

These lower levels of reserves raise concerns that loss 

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

TABLE 1 

Community Banks’1 ALLL Lags in Several High-Growth Areas 

% TOTAL ASSETS 

STATE MSAS2 ALLL COMMERCIAL REAL CONSTRUCTION TOTAL COMMERCIAL REAL 

ESTATE LOANS LOANS ESTATE AND CONSTRUCTION LOANS 

OREGON 1.14% 17 9 26 

EUGENE 0.99% 19 14 33 

SALEM 1.30% 21 9 30 

WASHINGTON 1.14% 16 8 24 

OLYMPIA 1.05% 19 10 29 

SEATTLE 1.26% 17 11 28 

NEVADA 1.60% 17 11 28 

RENO 1.23% 18 14 32 

REGION 1.68% 19 5 24 

OTHER REGION3 1.84% 19 4 23 

NATION 1.41% 11 3 14 

1 Non-credit-card banks with assets < $1.0 billion 

2 Fast-growing MSAs where community bank assets in the aggregate sum to more than $500 million, ALLL is below 

1.68 percent, and commercial real estate and construction loans to total assets are greater than 28 percent 

3 Region excluding Oregon, Washington, and Nevada 

Source: September 30, 1997, Bank Call Reports 

provisions may be inadequate, particularly at rapidly 

growing banks that appear to be assuming greater lending risks. Hawaii is another area of concern because the 

reserve coverage of noncurrent loans has been reduced 

to levels significantly below that of similar-size banks 

in both the nation and the Region. 

Funding Structure Shifts at Region’s Banks 

With the rebound in the Region’s economy, loan growth 

has accelerated. Historically, insured institutions— 

especially small community banks—have funded loan 

growth with core deposits (demand, regular savings, 

NOW, money market accounts, and certificates of 

deposit under $100,000) because of the stability and 

cost-effectiveness of these instruments compared with 

other funding sources. However, as shown in Chart 3, 

the Region’s loan growth has outpaced core deposit 

growth since 1993. To fund the increase in loan growth, 

banks and thrifts have used other, potentially more 

volatile funding sources. 

Weak growth in core deposits appears to be caused by 

several factors. Banks have faced stiff competition from 

other types of financial service companies, especially 

mutual funds that have been generating returns well 

above the interest rates banks have been paying on 

deposits. Credit unions also actively compete for consumer deposits and generally offer higher interest rates 

than banks or thrifts. 

As a result of these competitive forces, the Region’s 

institutions appear to have altered their funding strategies. To retain customer relationships, some larger 

banks have begun offering a wider array of investment 

products, including annuities and money market mutual 

funds. For example, Chart 4 (next page) shows that bank 

CHART 3 

Loan Growth Outpaces Core Deposit Growth 

during Region’s Economic Expansion 

Source: Bank and Thrift Call Reports $ in Billions 

200 

300 

400 

500 

600 

700 

800 

1991 1992 1993 1994 1995 1996 3Q97 

Loans 

Core Deposits 

$521B 

$405B 

$652B 

$414B 

San Francisco Regional Outlook 23 First Quarter 1998 
45 

Regular Features Regional Banking
 

CHART 4 

Bank Sales of Nondeposit Products Are at an 

All-Time High in the San Francisco Region 

Bank Sales of Nondeposit Products 

Sales (in Billions) 

40
 

35
 

30
 

25
 

20
 

15
 

10
 

5
 

0
 

Source: Bank Call Reports 

1994 1995 1996 3Q97 

sales of nondeposit products for the third quarter of 

1997 were more than four times those of the fourth 

quarter of 1994. Often these funds are placed under the 

bank’s own management. In addition, a number of 

banks are sweeping accounts that shift balances from 

NOW and other deposit accounts into the bank’s own 

money market accounts. Doing this eliminates the 

bank’s need to hold non-interest-bearing reserves with 

Federal Reserve Banks. 

In addition to their efforts to retain funds, banks and 

thrifts in the Region have increased their reliance on 

potentially more volatile funding sources to offset the 

slow growth of core deposits. They are relying more on 

noncore funding such as large-denomination time 

deposits, foreign deposits, and borrowings. These more 

volatile funding sources had climbed from less than 15 

percent of assets in 1992 to almost 25 percent of assets 

as of September 1997. Large institutions (those with 

over $1 billion in assets) have augmented their funding 

primarily through the use of foreign deposits and other 

borrowed money. However, at community banks, most 

of the increase in volatile funds has been in time 

deposits of $100,000 or more. These large time deposits 

now fund 13.1 percent of total community bank assets 

for the Region, up from 9.6 percent at year-end 1994 

(see Chart 5). 

The ongoing funding shift appears to be putting some 

strain on insured institutions’ net interest margins. 

Large banks in the Region have seen their net interest 

margins decline from a high of 5.1 percent in 1992 to 

CHART 5 

Community Banks* Replace Lost Core Deposits 

with Large Certificates of Deposit (CDs) 

% of Assets
 

100
 Large CDs Core Deposits Borrowings 

90
 

80
 

70
 

60
 

50 

1990 1991 1992 1993 1994 1995 1996 3Q97 

* Non-credit-card banks with assets < $1 billion 

Source: Bank Call Reports 

4.5 percent as of September 30, 1997. The squeeze on 

net interest margins at the Region’s community banks 

began in 1991. Net interest margins at these institutions 

edged down from 5.8 percent in December 1989 to 5.4 

percent in the third quarter of 1997. 

Implications: The sustained period of low interest rates 

over the past several years has caused both individuals 

and corporations to shift balances from core deposits 

into higher yielding investments and noninsured investment products. This trend is likely to continue as long as 

a wide differential exists between the yields on these 

investment alternatives and the rate banks are willing to 

pay for deposits. Some banks, mostly the larger ones, 

have been able to retain interest-sensitive funds by 

offering their own mutual fund and annuity products. 

The increased reliance on potentially more volatile 

funding sources, especially for community banks with 

limited access to the capital markets, may increase the 

risk profile of some institutions. In addition, the erosion 

of a core deposit base underscores the need for sound 

asset-liability management caused by increased interest 

rate sensitivity resulting from shorter maturities, 

increased potential for liquidity problems, and 

increased pressure on net interest margins. 

Catherine I. Phillips-Olsen, Regional Manager 

Roger Stephens, Financial Analyst 

Also contributing: Timothy Curry, Financial Economist 

San Francisco Regional Outlook 24 First Quarter 1998 
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