Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1998 

FDIC
 

Memphis
 

Region
 

Division of
 

Insurance
 

Gary L. Beasley,
 

Regional Manager
 

David T. Griffiths,
 

Regional Economist
 

Robert L. Burns,
 

Financial Analyst
 

In Focus This Quarter 

◆ The Asian Economic Crisis: Implications for the U.S. Economy—The 

economic crisis in Asia is now more than one year old, yet its consequences are still 

reverberating throughout the global economy. There are growing indications that 

some sectors of the U.S. economy are beginning to experience slower growth directly attributable to problems in Asia. Consequently, lenders should be cognizant of 

their customers’ exposure to global markets. Lending and strategic decisions predicated on an assumption of continued robust economic growth should be carefully 

scrutinized. See page 3. 

By Paul C. Bishop 

◆ CLOs Lure Another Major Bank Asset off the Balance Sheet— 

Securitization of corporate loans and bonds is in full swing, with 1997 issuance 

exceeding that of securities backed by credit card loans. Collateralized loan obligations (CLOs) and collateralized bond obligations, securities with deal- and issuerspecific risks, are potential bank investments that may grow in popularity if a 

current proposal to lower the risk weights for AAA-rated securities is enacted. 

Banks with an ample supply of low-margin commercial loans are expected to issue 

more CLOs to an increasingly demanding secondary commercial loan market. An 

institution’s CLO strategy may have implications that should be considered when 

evaluating its capital adequacy trends. See page 8. 

By Kathy Kalser and Allen Puwalski 

◆ The Payment System: Emerging Issues—The payment system is the 

heart of the U.S. economic infrastructure, moving value at the rate of 90 times the 

U.S. gross domestic product each year. The banking industry, although historically 

central to this movement, now faces a tangle of new technologies, new exposures, 

and new competitors that challenges its hold on the payments business. Its regulators face a different dilemma—that of how much intervention, if any, these changes 

warrant and how best to prevent the systemic exposures that increasingly large and 

rapid flows of money can create. Together, the issues they face frame a payment system that is fast becoming a technical and political contest. See page 14. 

By Gary Ternullo 

Regular Features 

◆ Regional Economy—The Region continues to grow at a slower pace than the 

nation...limited moisture during the crucial midsummer growing period coupled 

with low agricultural prices suggest farming results will lag those of recent years... 

low oil prices have significantly reduced drilling activity in Louisiana...household 

debt relative to income is at a historic high. See page 20. 

By David T. Griffiths, Robert L. Burns, Gary L. Beasley 

◆ Regional Banking—Banks and thrifts experienced a continuation of many 

favorable trends...consumers are using home equity lines of credit with increasing 

frequency, while traditional consumer loans account for a declining share of portfolios but the majority of charge-offs...some institutions are offering consumers 

high loan-to-value mortgages...others are providing credit to customers with subprime credit. See page 24. 

By Robert L. Burns 

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)
 

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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 Memphis 

Region’s Regional Outlook, please call Gary Beasley at (901) 821-5234 or send an e-mail to 

gbeasley@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Assistant Editors Gary L. Beasley 

Robert L. Burns 

Norman Gertner 

David T. Griffiths 

Suzannah L. Susser 

Karen A. Wigder 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

The Asian Economic Crisis:
 

Implications for the U.S. Economy
 

•	 The impact of the Asian economic crisis on the 

U.S. economy has been increasingly evident, with 

some sectors experiencing slower growth as conditions in Asia continue to deteriorate. 

•	 U.S. exports to Asia have decreased in recent 

months owing to falling demand for commodities, 

manufactured goods, and agricultural products. 

•	 Slower U.S. growth resulting from reduced export 

sales and lower corporate profits could affect 

institutions throughout the nation. 

The economic crisis in Asia is now more than one year 

old, yet the consequences of the unprecedented slide in 

currency values are still reverberating throughout the 

global economy. There are growing indications that 

some sectors of the U.S. economy are beginning to 

experience slower growth directly attributable to problems in the Asian economies. It is difficult to assess 

how significant and long-lasting the effects of the crisis 

will be, but it is clear that earlier views that the crisis 

would pass quickly and be followed by renewed growth 

were too optimistic. The consensus among economists 

and analysts now is that the recovery will be measured 

in years, not months. 

Causes of the Crisis 

Most economists agree that the Asian economies1 are in 

the midst of a steep and severe recession. For example, 

Indonesia’s gross domestic product fell by more than 12 

percent in the first half of 1998, a decline second only 

to the drop in economic activity in the Soviet Union following its collapse in the early 1990s. While Indonesia 

may be the most startling example of economic deterioration in Asia, the other Asian nations also have experienced weakened stock markets, falling real estate 

values, rising corporate bankruptcies, and growing 

problem loan portfolios among financial institutions. It 

is generally agreed (with the benefit of hindsight) that 

the conditions that precipitated these events included 

the following2

: 

1 Unless otherwise noted, “Asia” refers to the economies of China, 

Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, 

South Korea, Taiwan, and Thailand. 

•	 Reduced Export Competitiveness: Most of the 

Asian economies had effectively pegged their currencies to the U.S. dollar. Between mid-1995 and 

early 1997, the U.S. dollar increased in value by 

more than 42 percent against the Japanese yen and 

by 23 percent against the German mark. This 

increase significantly worsened the international 

competitiveness of many Asian firms relative to 

Japanese or European competitors in export markets, 

since the value of their currencies and the price of 

their exports rose along with the U.S. dollar. By late 

1995, export growth among the Southeast Asia 

economies was slowing, and by mid-1996 it was near 

zero. 

•	 Excess Production Capacity: Although Asian savings rates were among the highest in the world, 

domestic saving was not sufficient to fund the 

desired levels of investment in factories, roads, housing, and telecommunications. The resulting inflow of 

foreign capital funded rapid capacity expansion in 

key sectors such as autos, chemicals, and microchips. For example, capital inflows to Thailand 

totaled $1.9 billion in 1980 but rose to $15.2 billion 

by 1996. The increase in production capacity put 

downward pressure on prices and reduced earnings 

growth in key export sectors.3 

•	 Rapid Asset Price Appreciation: Real estate, land, 

and share prices on the region’s stock markets soared 

during the 1980s and early 1990s. In Indonesia, for 

example, the Jakarta Composite stock index 

2 A comprehensive survey of recent events and links to other information sources is available at the Asia Crisis Home Page, 

www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html. 3 A case in point is the growth of the auto industry. During the past 

several years, Korea invested heavily in new auto plants to satisfy 

both domestic and export demand. By 1999, Korean capacity is 

expected to reach 4.66 million light vehicles annually—2 million 

more than domestic demand. In Japan, excess capacity of 2.8 million 

vehicles is expected through 2002. Worldwide excess capacity in light 

vehicles is expected to reach more than 20 million units by 2002— 

more than the total 1997 production of General Motors, Ford, and 

Chrysler combined (Wall Street Journal, March 2, 1998). The result 

has been downward pressure on prices of domestically produced 

autos—down by 1.9 percent on the basis of the first-quarter 1998 producer price index—and imports, which have experienced price 

increases of less than 1 percent since mid-1996. 

Memphis Regional Outlook 3	 Third Quarter 1998 
In Focus This Quarter
 

increased by nearly 53 percent in the two-year period ending in the first quarter of 1997. 

•	 Deteriorating Credit Quality: Slower export 

growth and eroding competitiveness hampered Asian 

firms’ ability to repay debt incurred to finance the 

growing levels of investment. Some Korean conglomerates were burdened with a debt load equal to 

300 to 400 percent of equity. As much as two-thirds 

of this debt was short-term, with a maturity of less 

than 12 months. Additionally, the debt denominated 

in foreign currencies, such as the U.S. dollar, ballooned as local currency values dropped. With some 

firms struggling to repay mounting debt, banks 

began to experience a further deterioration in credit 

quality. 

Some of the uncertainty about the strength and speed 

of the recovery in Asia is attributable to concerns 

about the faltering Japanese economy. As the second 

largest economy in the world and the engine of 

growth in the region, Japan must have a healthy economy if sustainable growth is to occur in the rest of 

Asia. With Japan currently in a deep recession and the 

outlook for its economy clouded by the halting pace 

of financial reform efforts, there is considerable 

uncertainty about how quickly economic and financial weaknesses throughout the rest of Asia can be 

repaired. 

Impact on the U.S Economy 

The Asian financial crisis could affect the U.S. economy through several avenues. Some firms and industries 

may be directly exposed, especially if they have operations in Asia. 

Banks may be exposed through 

changes in the financial condition 

of Asian borrowers. Other firms 

may be less directly exposed to 

economic conditions but will be 

affected by changes in relative 

prices and trade flows between the United States and 

Asia. The drop in Asian purchases of U.S. exports has 

hit agricultural products, commodities, and manufactured goods. As some recent corporate earnings 

announcements have shown, the crisis has been associated with profit growth that has failed to meet the market’s expectations. 

Banking 

The U.S. banking industry has a smaller direct lending 

exposure to the Asian economies than either European 

or Japanese banks. As shown in Table 1, U.S. banks had 

outstanding loans of $22 billion at the end of 1997, 

which accounted for 8.5 percent of all international 

lending to Indonesia, Malaysia, the Philippines, South 

Korea, and Thailand. To the extent that exposures exist, 

however, large banks and not smaller regional or community banks account for most of the lending. While the 

overall direct lending exposure of the U.S. banking 

industry may be relatively small, the indirect exposure 

resulting from changing economic conditions in the 

United States as a result of the crisis could potentially 

affect small and large institutions in all areas of the 

country. 

Agriculture 

Key to understanding the impact on agriculture is the 

fact that in world markets, agricultural commodities are 

priced and traded in terms of U.S. dollars. The steep 

decline in value of Asia’s currencies means that the 

price of imported agricultural commodities has rapidly 

risen. Over a longer period, higher import prices tend to 

stimulate production in the importing countries that can 

displace demand for imports. Thailand, for example, is 

positioned to increase production of poultry and sugar. 

Other world producers, such as Australia, whose currency also has fallen in value, are now more competitive 

suppliers of some agricultural products to the Asian 

market than the United States. 

On the basis of analysis performed by the U.S. Department of Agriculture’s (USDA’s) Economic Research 

Services,4 U.S. exports of red meat and poultry are 

expected to drop by 5 to 6 percent in fiscal 1998 and 

1999 as a result of the Asian crisis. Exports of grains are 

projected to fall by at least 2 percent in fiscal 1999 as 

other world producers increase production in response to 

changing relative prices among major grain exporters. 

Overall, USDA expects agricultural exports to fall by 3 

to 6 percent in fiscal 1998 and 1999, compared with the 

level of exports had the Asian crisis not occurred. 

Commodities 

Asian countries have become increasingly important 

commodity consumers in recent years. As a result, com4 “World Agriculture and Trade,” Agricultural Outlook, pp. 10–11. 

Memphis Regional Outlook 4	 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

International Claims by Nationality of Reporting Bank 

End December 1997 

TOTAL INTERNATIONAL 

CLAIMS (MILLION U.S. $) 

U.S. 

CLAIMS PERCENT 

JAPAN 

CLAIMS PERCENT 

EUROPE* 

CLAIMS PERCENT 

OTHER 

CLAIMS PERCENT 

Indonesia 58,388 4,898 8.4 22,018 37.7 15,044 25.8 16,428 28.1 

Malaysia 

Philippines 

South Korea 

27,528 

19,732 

94,180 

1,786 

3,224 

9,533 

6.5 

16.3 

10.1 

8,551 

2,624 

20,278 

31.1 

13.3 

21.5 

12,997 

9,317 

29,614 

47.2 

47.2 

31.4 

4,194 

4,567 

34,755 

15.2 

23.1 

36.9 

Thailand 58,835 2,533 4.3 33,180 56.4 14,782 25.1 8,340 14.2 

Total 258,663 21,974 8.5 86,651 33.5 81,754 31.6 68,284 26.4 

* Includes France, Germany, Netherlands, and United Kingdom 

Source: Bank for International Settlements 

modity markets have been affected by falling demand for 

basic materials and fuels in Asia. The abrupt halt of construction activity in the region has reduced Asian imports 

of metals and metal products. Consequently, world copper and nickel prices fell more than 36 percent during the 

year ending June 1998. Asian developing countries also 

had stepped up their demand for petroleum products, 

accounting for two-thirds of the increase in world petroleum consumption between 1992 and 1996. As economic activity in Asia slowed, oil demand softened and world 

inventories expanded, causing prices to tumble from $20 

per barrel in July 1997 to less than $14 per barrel in June 

1998. To the benefit of U.S. consumers, the drop in oil 

prices has reduced the prices of gasoline and other 

refined petroleum products, but it has cut into profits of 

oil producers. While there are few indications of widespread financial problems in the industry, smaller and 

less geographically diversified producers may be exposed to adverse price and inventory changes. 

Manufacturing 

Asia accounts for a large and growing share of U.S. 

trade in manufactured goods. Between 1990 and 1996, 

U.S. exports of manufactured goods to Asia increased 

from $75 billion to more than $140 billion, accounting 

for nearly one-third of the increase in total U.S. exports 

of manufactured goods. For the U.S. economy as a 

whole, machinery, food products, and chemicals are the 

most exposed to a drop in Asia’s demand for U.S. 

exports. Together, these industries account for nearly 70 

percent of U.S. exports to Asia. 

Between 1990 and 1996, U.S. imports of manufactured 

goods from Asia rose from $176 billion to more than 

$285 billion. Increased imports from China accounted 

for about one-third of the gain. U.S. imports from Asia 

are dominated by machinery and manufactured goods, 

including electronics and semiconductors, which 

together account for 93 percent of imports. 

Asia’s demand for U.S. exports will continue to weaken 

following the dramatic increase in import prices resulting from the drop in currency values. The latest trade 

data show that the dollar volume of U.S. goods exports 

to Asia (including both manufactured goods and other 

commodities) fell by 22.5 percent in May 1998 compared with one year earlier (Chart 1). 

Changes in the volume of exports at the national level 

do not adequately describe the variation in the export 

exposure of different regions of the country. Chart 2 

(next page) shows the percentage of state-level exports 

CHART 1 

U.S. Exports to Asia Drop While Imports 

Continue Modest Growth 

Source: Bureau of the Census 

–25 

–20 

–15 

–10 

–5 

0 

5 

10 

15 

20 

Jan-96

Mar-96

May-96

Jul-96

Sep-96

Nov-96

Jan-97

Mar-97

May-97

Jul-97

Sep-97

Nov-97

Jan-98

Mar-98

May-98 

Percent Change - Year Ago

Imports Exports 

Memphis Regional Outlook 5 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Western and Midwestern State Exports Are
 

Vulnerable to Changes in Asian Demand
 

Percentage of Total 

State Exports Destined 

for Asia (1997) 

More than 30% (14) 

21% to 30% (16) 

10% to 20% (17) 

Less than 10% (4) 

Source: Bureau of the Census, International Trade Administration 

that are destined for Asia.5 Clearly, Western states are 

most exposed to changes in the demand for U.S. 

exports, especially electronics, transportation equipment, and industrial machinery. A significant share of 

exports from the Midwest also is destined for Asia, 

including chemicals and machinery such as construction equipment.6 

In the initial stages of the crisis, the consensus view 

suggested that the United States would be overwhelmed 

by cheap imports from Asia, as Asian countries exported their way to economic recovery. Although there has 

been an increase in U.S. imports from Asia, the growth 

has been well below expectations. In May 1998, goods 

imports were up by just 4.8 percent over the previous 

year. The reason that U.S. imports of Asian goods have 

not been greater is due in part to the severity of the economic downturn and the weakness of Asia’s financial 

institutions. Many Asian manufacturers are dependent 

5 The state-level export data are from the Export Locator series published by the Bureau of the Census. These data tabulate the value of 

exports as determined by the location of the exporter, which may differ from the location of the producer. Although these data are an 

imperfect measure of state-level export performance, they are still of 

value in assessing regional exposures and remain the most complete 

data available. 

6 A state-by-state analysis has been prepared by the U.S. Treasury and 

the U.S. Department of Commerce. 

on components imported from neighboring countries or 

purchased on world markets. With the drop in currency 

values, all imported goods, including finished goods 

and intermediate goods that are used in the manufacturing sector, have become more costly. At the same time, 

Asia’s weak financial systems have come under increasing pressure as the economic slump deepens. Many 

banks cannot, or will not, lend. Consequently, Asian 

firms cannot secure the capital to acquire imported 

inputs or to finance the sale of exports abroad. As the 

“credit crunch” abates, imports from Asia should 

rebound, placing greater pressure on U.S. manufacturers. 

Corporate Profits 

Profits of U.S. producers also will be affected by falling 

prices for import-competing goods and plummeting 

Asian demand for some U.S. exports. Although U.S. 

producers of import-competing goods will be under 

increasing competitive pressure, firms that use imported components from Asia will benefit from an effective 

reduction in costs. U.S. exporters may see disappointing 

Asian market profits offset by continuing strong sales in 

the U.S. and European markets. For these reasons, the 

impact of the crisis on corporate profits must be viewed 

in the context of gains and losses caused by changing 

relative prices of a firm’s products and inputs. 

A number of recent earnings announcements have 

failed to meet analysts’ expectations. According to 

IBES International,7 the crisis has contributed to a 

reduction of profit growth, although most of the slowdown is attributable to both falling prices and weak 

demand for semiconductors and oil. Operating profits 

of all companies tracked in the Standard & Poor’s 500 

stock index increased by 4.4 percent in the first quarter 

of 1998, the smallest increase since 1991. Excluding the 

energy and technology sectors, profits of the S&P 500 

firms increased by 8.6 percent in the first quarter. On 

the basis of these results, the impact of the crisis on corporate profits appears to be highly concentrated among 

firms in a few industries. 

Summary and Implications 

The consequences of the Asian economic crisis continue to unfold. The slowdown in growth in most Asian 

economies has already reduced U.S. export shipments 

and put downward pressure on prices of commodities 

and agricultural products. How long this trend will con7 As quoted in the Wall Street Journal, June 22, 1998, p. C1. 

Memphis Regional Outlook 6 Third Quarter 1998 
In Focus This Quarter
 

tinue is uncertain, but most analysts have dismissed the 

chances of a speedy recovery in Asia. Although most 

economists are not anticipating a recession in the 

United States in the foreseeable future, the indirect 

impact of the Asian crisis will be felt to some extent 

across most regions of the country. 

Lenders should be cognizant of their customers’ exposure to a continued drop in demand for exports or to further deterioration in the pricing environment. More 

generally, slower U.S. growth could affect even those 

borrowers that have little or no 

direct exposure to export markets. What is clear for insured 

institutions is that at this stage of 

the economic expansion and with 

a number of uncertainties about 

the global economic outlook, 

lending and strategic decisions 

predicated on an assumption of 

TABLE 2 

continued robust economic growth should be carefully 

scrutinized. 

References 

Asia Crisis Home Page. New York University. www. 

stern.nyu.edu/~nroubini/asia/AsiaHomepage.html. 

“Automobile Glut Worries Analysts Even as Some Cut 

Back on Output.” The Wall Street Journal. March 2, 

1998. 

The Importance of Asia to the State Economies. 1998. 

U.S. Treasury and U.S. Department of Commerce. 

www.treas.gov/press/releases/pr2317.htm. 

“World Agriculture and Trade.” Agricultural Outlook. 

United States Department of Agriculture, Economic 

Research Service. February 1998. 

Paul C. Bishop, Economist 

Memphis Region: Merchandise Exports to Asia—1997 

Includes China, Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and Thailand 

PERCENT 

EXPORT OF EXPORTS EXPORT 

VOLUME GROWTH TO ASIA BY EXPOSURE 

INDUSTRY SECTOR ($ MILLIONS) 1993-97 INDUSTRY* TO ASIA** 

TOTAL EXPORTS TO ASIA 6,189.6 65% 100% 25% 

TOP FIVE EXPORT INDUSTRIES 

AGRICULTURAL & LIVESTOCK PRODUCTS 1,742.8 77% 28% 58% 

CHEMICAL PRODUCTS 722.8 30% 12% 24% 

TRANSPORTATION EQUIPMENT 680.5 171% 11% 20% 

TOBACCO PRODUCTS 638.9 25% 10% 73% 

INDUSTRIAL MACHINERY & COMPUTERS 456.8 70% 7% 14% 

TOTAL OF TOP FIVE EXPORT INDUSTRIES 4,241.8 65% 69% 32% 

* Percent of Region’s total exports to Asia from each of the top five export industries. 

** Percent of Region’s total world exports for each industry destined for Asia. 

Source: International Trade Administration 

Memphis Regional Outlook 7 Third Quarter 1998 
In Focus This Quarter
 

CLOs Lure Another Major Bank Asset
 

off the Balance Sheet
 

•	 Securitization of corporate loans and bonds is in 

full swing, with 1997 issuance exceeding that of 

securities backed by credit card loans. 

•	 Collateralized loan obligation (CLO) and collateralized bond obligation (CBO) issuance has grown 

dramatically since 1996. Both CLOs and CBOs 

are potential bank investments that may grow in 

popularity if a current proposal to lower the risk 

weights for AAA-rated securities is enacted. 

•	 These bonds may offer a higher yield than other 

AAA-rated securities, but they also may carry 

both deal- and issuer-specific risks that warrant 

closer scrutiny. 

•	 Banks with an ample supply of low-margin commercial loans are expected to issue more CLOs to 

an increasingly demanding secondary commercial loan market. 

•	 Securitizing investment-grade commercial loans 

has implications for capital adequacy. 

CBOs and CLOs are fixed-income securities that share 

many similarities with other asset-backed securities. In 

a CLO or CBO, commercial loans or bonds are pooled 

and securitized, and participation certificates in the 

underlying assets are sold to investors. The first CLO 

and CBO transactions occurred in the late 1980s, but 

issuance was slow until last year. During 1997, the estimated volume of corporate bonds and commercial loans 

securitized was $54 billion, more than double the 

amount securitized in 1996. In fact, the combined 

issuance of CBOs and CLOs in 1997 was more than the 

amount of credit card loans securitized during the year. 

The amount of securitized commercial loans and corporate bonds is expected to continue to grow this year, 

with an increasing number of deals backed by commercial loans1 (see Chart 1). 

1 CBOs/CLOs: An Expanding Securitization Product, p. 1, 

JP Morgan, September 1997. 

CBOs and CLOs: A Natural Development in the 

Asset-Backed Securities (ABS) Market 

The growth of the CLO market can be explained by several supply and demand factors. On the demand side, 

strong investor appetite for ABS has produced tremendous growth in the securitization of consumer loan segments such as credit card, auto, and home equity loans. 

The increasing comfort level of the capital markets with 

these asset classes and the various structures used to 

securitize them has facilitated the ABS market’s expansion into nonconsumer loans, including corporate debt 

obligations and bank commercial loans. CBO and CLO 

structures represent a natural progression from the securitization of a pool of consumer loans to the securitization of a diversified package of corporate bonds or bank 

loans. 

Increased standardization of terms among commercial 

lenders and more information flow on returns, defaults, 

and recoveries also have made commercial loans and 

corporate debt more desirable to institutional investors 

and an asset class viable for securitization. In addition, 

CLOs provide a way for investors, including banks, to 

own a credit-enhanced interest in a diversified pool of 

loans without directly owning the individual loans. 

Investors are increasingly considering collateralized 

bond and loan products as higher yielding alternatives 

to other ABS. 

CHART 1 

CBO and CLO Issuance Is Growing 

Source: JP Morgan 

0 

10 

20 

30 

40 

50 

60 

1990 1991 1992 1993 1994 1995 1996 1997 

($ Billions)

CBO CLO 

Memphis Regional Outlook 8	 Third Quarter 1998 
In Focus This Quarter
 

Foreign and, to a lesser extent, domestic banks have 

been large purchasers of CLOs and CBOs. Bank investment in CLOs and CBOs primarily has been in the most 

senior, highest investment-rated tranches. Together, foreign and domestic banks are estimated to have purchased almost one-half of the highest rated classes of 

CLO and CBO securities issued in 1997. Insurance 

companies dominated the purchase of the middle or 

mezzanine class of CLOs and CBOs.2 

Last year the Federal Financial Institutions Examination 

Council proposed lowering the risk weighting for AAArated ABS from 100 percent to 20 percent. Bank investment in AAA-rated ABS products, including CLOs and 

CBOs, could increase substantially if the proposal is 

approved. 

Lower Capital Requirements, Higher Return 

Ratios Attract Banks to CLO Market 

On the supply side, issuers of CLOs backed by investment-grade loans are motivated by regulatory capital 

treatment, return on capital, and relationship management. While the CLOs originated in the late 1980s were 

designed to purge the lender’s balance sheet of lower 

quality commercial loans, the recent bank-issued CLOs 

have been secured by higher credit quality, lower margin commercial and industrial loans. 

A bank that is capital constrained may view the CLO 

structure as an alternative to issuing additional equity. 

But more often, banks are motivated to securitize 

investment-grade commercial loans because by doing 

so they effectively subject themselves to the market’s 

capital requirements for such loans instead of their regulator’s. Tight competition has compressed the margin 

that banks earn on investment-grade loans to the point 

that more institutions are considering investment-grade 

lending to be an inefficient use of capital. As margins 

have declined, the CLO market has helped relationship 

managers rationalize lower pricing from the perspective 

of return on capital. Since investment-grade and non2 CBOs & CLOs—An Attractive Investment Class, p. 5, Merrill Lynch 

& Co., Inc., December 1997. 

investment-grade-performing commercial loans have 

the same risk weightings for regulatory capital purposes, removing the higher quality, lower yielding assets 

from the balance sheet tends to leave existing bank capital supporting higher return activities.3 In this way, a 

bank can improve certain profitability measures, but 

possibly with a higher risk profile. 

Table 1 (next page) illustrates the effects of a CLO on a 

bank’s capital and return ratios. In order to compare the 

on- and off-balance sheet transactions, the costs of the 

CLO and the associated reserve requirement are analogized to the on-balance sheet funding costs and capital 

requirement if the assets remained on the balance sheet. 

The assumptions reflect the spreads and reserve 

requirement of a typical transaction. While the execution of the CLO costs more than the on-balance sheet 

financing of the loans, the risk-adjusted return on capital (RAROC) is greater with the CLO. The reserve 

requirement is minimized by the tiering of tranches in 

the securitization, which provides credit enhancement 

to the senior classes. The reserve fund, if retained by the 

issuing bank, represents recourse to the bank from the 

sold assets and requires capital at 100 percent under 

“low-level” recourse. 

CLOs also may be used to facilitate corporate borrowing relationships. For example, banks that want to maintain relationships with corporate borrowers but are 

restrained by concentration limitations, either by borrower or by industry, may use CLOs to alleviate concentrations without disrupting borrower relationships. 

Large commercial banks with significant holdings of 

investment-quality commercial loans are likely candidates to issue CLOs. CLO issuance by investment banks 

could grow as these institutions secure a stronger foothold in the commercial loan market. In 1997, foreign 

banks were the primary issuers of CLOs, but more U.S. 

banks are expected to issue CLOs in the future. Japanese and Asian banks may increase their CLO activity as 

they come under pressure to improve capital ratios and 

remove distressed loans from their balance sheets. 

3 Pursuant to the Basle Accord, commercial loans generally receive a 

100 percent risk weighting regardless of the credit rating of the loan. 

Proponents of CLOs have argued that banks can improve their riskadjusted return on capital by removing the higher quality, lower earning commercial loans from the balance sheet. 

Memphis Regional Outlook 9 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

CLOs Can Facilitate a Higher RAROC on Investment-Grade Assets 

ASSUMPTIONS: 

AMOUNT OF LOANS IN CLO: $1 BILLION 

LOAN PORTFOLIO YIELD: LIBOR + 50 BPTS 

BANK FUNDING COSTS: LIBOR − 10 BPTS 

CLO FUNDING COSTS: LIBOR + 24 BPTS 

BANK RETAINS 1% RESERVE FUND: $10 MILLION 

BEFORE CLO 

YIELD LESS FUNDING COST (L+50) LESS (L− 10) = 60 BASIS POINTS 

NET SPREAD EARNED .006 × $1 BILLION = $6 MILLION 

RISK-BASED CAPITAL REQUIREMENT (8% ON $1 BILLION) = $80 MILLION 

RAROC $6 MILLION/$80 MILLION = 7.5% 

AFTER CLO 

YIELD LESS FUNDING COST (L+50) LESS (L+24) = 26 BASIS POINTS 

NET SPREAD EARNED .0026 × $1 BILLION = $2.6 MILLION 

RISK-BASED CAPITAL REQUIREMENT (100% OF RESERVE FUND) = $10 MILLION 

RAROC $2.6 million/$10 million = 26% 

Source: Bear, Stearns & Co. Inc. 

Arbitrage Opportunities Motivate Most 

Securitization of Subinvestment-Grade Debt 

Issuance of CLOs backed by subinvestment-grade loans 

and most CBOs, which commonly are backed by a mixture of bonds with a subinvestment-grade weighted average, typically is motivated by the potential to capitalize 

on wide spreads between investment and subinvestmentgrade debt. The securities backed by subinvestmentgrade collateral, often referred to as “arbitrage” CLOs 

and CBOs, contain higher yielding, riskier securities 

such as high-yield debt, distressed bonds, highly leveraged loans, and emerging market debt. By assembling a 

diversified pool of higher yielding investments, asset 

managers can limit aggregate event risk and create a 

security with a lower required yield than the underlying 

collateral. Securitizations can include a combination of 

loans and bonds and are sometimes referred to as collateralized debt obligations or CDOs. 

A Closer Look at CLO Structures 

While the structures of CLOs and CBOs are similar, 

banks’ involvement as issuers of CLOs, and the forces 

driving this issuance, elevate the importance of considering CLO structures. Chart 2 presents the basic structure of a CLO. Although specifics may vary, most CLOs 

use a stand-alone special purpose vehicle (SPV) or trust 

to purchase a diversified pool of assets from a bank 

originator or issuer. The purchase of the assets by the 

SPV is funded through the sale of debt securities to 

investors. The structure of the SPV may include one or 

more tranches of debt that are secured by the pool of 

assets owned by the SPV. The classes of debt are distinguished by their priority of claims on the cash flow from 

the collateral, with the most subordinated pieces functioning as an equity investment in the pool. 

The senior tranche is usually the largest, has the greatest amount of credit protection, and earns the highest 

credit ratings in the CLO structure. The rating of the 

senior class typically is higher than the average rating 

of the underlying pool of assets due to the tiering of 

claims among the debt classes and credit enhancement 

in the CLO. The junior tranches of debt may be below 

investment grade or not rated. The reserve or “equity” 

portion may be retained by the issuing entity as a form 

of credit enhancement or sold to third-party investors 

who want a potentially higher return investment. 

CLO collateral has included both funded and unfunded 

loan commitments, loan participations, and different 

types of credit default swaps. Loan assignments also 

may be transferred through a CLO but are less commonly included because of bank issuers’ desire to mainMemphis Regional Outlook 10 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Simplified Collateralized Loan Obligation Structure 

Originating Bank 

Special Purpose Vehicle 

(Purchases assets from originator and 

sells debt and equity to investors) 

Senior Class A Notes 

(90% of debt) 

(Investment Grade) 

Mezzanine Class B Notes 

(9% of debt) 

Reserve 

(1%) 

(May be retained by bank) 

Proceeds 

Sale, assignment, or 

participation of loans or credit 

linked notes to special purpose 

vehicle (SPV) 

Assets purchased from 

originator are collateral for debt 

and equity issued by the SPV 

Relative size 

varies by deal 

Proceeds 

tain borrower relationships. The issuer may transfer the 

actual loan, the cash flow from the loan, or the default 

risk to investors. 

CLOs typically rely on an asset manager or servicer 

to “manage” or protect the investors’ interest in the 

collateral. The investment style or role of the asset 

manager may change depending on the purpose of the 

CLO. Securitizations that use an asset manager to 

actively manage the performance and market value of 

the collateral are referred to as “market arbitrage” or 

“market value” transactions. In these deals, the asset 

manager can trade assets into and out of the securitized 

pool in order to maximize the market value of the 

securitized portfolio. In contrast, most bank-issued 

CLOs are designed as “cash flow” transactions, in 

which the asset manager’s role is more as a servicer than 

as a portfolio trader. These structures rely primarily on 

the ability of the collateral to make stable cash flow payments over a predetermined period and emphasize 

the credit quality of the collateral and the predictability of interest and principal payments rather than liquidity and market performance, as in market value 

transactions. 

Memphis Regional Outlook 11 Third Quarter 1998 
In Focus This Quarter
 

An Introduction to Delinked 

and Linked CLO Structures 

The variables in structuring a CLO are many. The relative size of the senior and subordinated tranches, the 

form of credit enhancement, the ability of the asset 

manager or servicer to adjust the asset pool, and the 

method and degree to which ownership of the underlying loans is conveyed to investors vary among CLOs. 

Despite the variations, two basic structures have 

emerged: “delinked” structures and “linked” structures. 

The primary difference between these two is the extent 

to which the SPV “owns” the securitized assets. An 

issuer may consider many factors when determining the 

type of structure to use, including the ability or desire of 

the issuer to transfer the loans without notifying the borrower, the credit quality of the loans, the investment rating of the bank issuer, and the desired capital treatment 

of the securitized loan. 

In a delinked structure, the collateral is transferred from 

the issuer to the SPV. Delinked structures are generally 

treated as “true sales” for accounting purposes, and the 

loans in the CLO are removed from the issuer’s balance 

sheet. Delinked CLOs are structured to insulate the 

investor from the credit quality problems or insolvency 

of the issuer. Ratings on delinked CLOs are predicated 

on the projected performance of the collateral and the 

credit enhancement structure rather than the credit quality of the issuer. Some delinked CLOs are similar to 

structures used in credit card securitizations that capitalize on the flexibility of a revolving master trust. The 

master trust structure is advantageous because it allows 

for the securitization of different types of assets, such as 

fixed or floating rate or revolving or term loans. 

In linked transactions, also known as credit linked 

notes, the issuer retains ownership of the underlying 

collateral, and the cash flow generated by the collateral 

pool is conveyed or sold to the SPV. All or part of the 

credit risk from the underlying assets is transferred to 

the CLO investor using credit derivatives. As in 

delinked CLO structures, credit protection is provided 

through the layering or tranching of the debt sold and 

other credit enhancements. 

Investors in linked CLOs are not completely insulated 

from the credit risk of the issuer. Because the issuer 

retains ownership of the underlying loans, a default or 

bankruptcy by the issuer could affect the transmission 

of cash flow to the CLO investors. As a result, investors 

in linked CLOs bear both the credit risk of the securitized loan pool and, to some degree, the risk that the 

issuer may become insolvent. Because of this dual 

exposure, ratings on linked structures are typically 

capped by the credit rating of the issuer. 

The accounting and regulatory capital treatments of 

delinked and linked CLOs also differ. Linked structures 

generally do not qualify for sale treatment under generally accepted accounting principles because the assets 

remain under the control of the issuer. Issuers of linked 

CLOs may be granted some regulatory capital relief 

under the Basle Accord if the cash received from the 

securitization is assigned as collateral for the underlying 

loans. The Basle Accord, which governs capital adequacy requirements for Bank for International Settlements 

member countries, reduces the risk weighting on commercial loans that are secured by cash or certain types 

of risk-free marketable securities such as Treasury 

bills.4 While linked CLOs may provide some form of 

capital incentive for foreign banks under the Basle 

Accord, linked structures offer 

little relief to U.S. banks 

because U.S. banks must maintain minimum leverage capital 

ratios in addition to risk-based 

capital ratios. Since the securitized loans count as assets of 

the bank issuer in a linked 

structure, the leverage ratio 

(roughly, book equity to book assets) is not reduced. 

Consequently, the linked CLO structure has been more 

popular among foreign banks. 

The Role of Investment Rating Agencies 

Although the approach may vary among rating agencies, the criteria used to determine the investment rating 

for CLOs are similar. Rating agencies evaluate the ability of the securitization vehicle to make interest and 

principal payments to holders of the debt. This analysis 

requires an evaluation of the credit quality of the underlying collateral pool, including the projected cash flow 

4 Under the Basle Accord and the U.S. risked-based capital guidelines, 

assets collateralized by cash or Treasury securities generally receive a 

preferential risk-weighting that may range from 0 to 20 percent. For 

background information regarding the risk weightings for collateralized transactions applicable to federally regulated institutions, see 

Federal Deposit Insurance Corporation Financial Institution Letter 

number 64–96 dated August 22, 1996. 

Memphis Regional Outlook 12 Third Quarter 1998 
In Focus This Quarter
 

generated by the pool, the credit enhancement, and any 

additional protection provided to the investors based on 

the structure of the securitization. The rating agencies 

set limits on the amount of industry and borrower concentration in a pool and statistically evaluate the effect 

of diversification among loans when estimating potential defaults and losses from the securitized assets over 

the life of the transaction. If the underlying collateral is 

not already rated—most commercial loans are not—the 

rating agency will grade the underlying loans and assign 

a rating to the security on the basis of the credit quality 

of the loans and the underwriting criteria used by the 

lender. Estimates of default probabilities, timing of 

default, and recoveries in the event of default are 

assigned to the loans and vary by collateral type and 

credit grade. These estimates are generally based on historical default studies authored by the various rating 

agencies. 

Implications for Insured Institutions 

The advent of CLOs poses new opportunities and risks 

to banks. The ability to transfer all or part of a commercial loan’s credit risk to investors may have several consequences. When issuers of CLOs securitize their 

highest grade assets, they are effectively lowering the 

weighted average credit quality of their retained assets. 

An institution’s loan loss reserving policies and capital 

adequacy should take into account the implications of 

its CLO strategy. 

While the issuance of CLOs may be confined to larger 

banks that have considerable commercial loan portfolios, smaller banks or other types of institutions that 

desire a greater exposure to this type of lending may 

consider investing in CLOs. These instruments offer 

banks the opportunity to invest in a diversified pool of 

commercial loans. Because of credit enhancement features and diversification advantages, the most senior 

debt issued by the CLOs can earn a higher investment 

rating than the average rating on individual loans in the 

pool. Despite the investment rating, banks that invest in 

CLOs should be aware that CLO structures are less 

standardized than other ABS investments, and therefore, performance and underlying risk will be both 

issuer and deal specific. 

Kathy Kalser, Chief, Financial Sector Analysis Section 

Allen Puwalski, Senior Financial Analyst 

Memphis Regional Outlook 13 Third Quarter 1998 
In Focus This Quarter
 

The Payment System: Emerging Issues
 

•	 Essential to the transfer of value in the U.S. economy, the once-arcane and bank-centered payment 

system is undergoing considerable change as new 

technologies bring new opportunities, new exposures, and new competitors into the payments 

business. 

•	 For most banks, the major issues lie in smallvalue payments, where they struggle for advantage in adapting new technologies into new 

products and services while protecting their traditional payments business from technologically 

adept nonbank competitors. 

•	 For regulators and a handful of the largest banks, 

large-value payments present the most serious 

challenges, as technology has enabled increasing 

payment velocity and volume but also has created 

the potential for systemic failures. 

The payment system is the heart of the U.S. economic 

infrastructure, moving an estimated $670 trillion annually among consumers, businesses, financial institutions, and governments.1 Despite this volume—an 

amount equal to roughly 90 times the U.S. gross domestic product—the payment system remains transparent to 

most users because of its dependability in moving value 

safely. Historically, banks have been essential to this 

movement, reaping, according to the Bank Administration Institute, an estimated $117 billion each year in 

revenues both as payment agents and as the holders of 

the funds from which those payments are made. 

Broadly speaking, the payment system encompasses the 

numerous payment products, players, and the infrastructure that together transmit value throughout the 

economy. More specifically, it can be defined as a collection of individual systems constructed around specific payment products. Credit cards, for example, 

represent a payment system. So do debit cards, checks, 

foreign exchange, and even cash. This product-based 

definition is a relevant one for many bankers, since it 

centers on the products and services that generate revenue rather than on the less glamorous “back office” 

functions that are measured instead by their cost. A 

1 Estimate for 1996 from the National Automated Clearing House 

Association; www.nacha.org/resources/marketing/direct-payment/uspayments-96.gif. 

second definition segments the payment system by payment size. Using this definition, the payments world is 

divided into systems that carry small-value or retail 

payments and those that carry large-value or interbank 

payments. This latter classification is oriented more 

toward infrastructure than product but is convenient 

from a regulatory perspective because the seriousness 

of the risk posed varies considerably by payment size. 

However defined, the payment system today is a source 

of new opportunities and exposures—a result of a host 

of new technologies that the “information revolution” 

has spawned. These technologies create different issues 

for banks and regulators. For banks, the issues involve 

adapting the technologies into new products and services while protecting their payments business from 

nontraditional competitors that specialize in its creation 

and use. For regulators, the issues involve managing the 

risks—principally systemic risk—that accompany the 

large increases in payment volume and velocity enabled 

by technology. Taken together, these issues frame a payment system that can be both a political and a technological battleground, with significant incentives for 

participants to shape payment products and channels in 

a way that favors their own objectives. 

Small-Value Payments: 

A Technological Brawl 

Nowhere has the battle to shape the payment system 

been more contentious than in the small-value segment, 

where emerging information technology can best be 

leveraged into new fee-based retail products. There are 

two battles here. The first involves maintaining the 

monopoly over the payments infrastructure that connects each bank with the Federal Reserve and, by extension, with every other depository institution in the 

United States.2 While this infrastructure is interbank— 

that is, it is dedicated to settling accounts between institutions and does not directly extend to their 

customers—the ability to aggregate and settle individual retail payments through it has enabled the banking 

industry to maintain its centrality to the nation’s monetary flows. 

2 Depository institutions were granted exclusive access to this infrastructure upon its creation by the Federal Reserve Act of 1913. 

Memphis Regional Outlook 14	 Third Quarter 1998 
In Focus This Quarter
 

The second battle involves exploiting new technologies 

either to attract new customers or to serve existing ones 

more profitably. This battle is both highly visible and 

highly technical and underscores the potential of the 

passing of information to eclipse the passing of value as 

the most critical profit opportunity in payments. The 

best example of this potential is bill presentment, the 

process of posting vendor invoices—such as credit card 

or utility statements—on the Internet to facilitate electronic payment. The crucial question concerns where 

the customer transaction data will lie. If they lie on vendors’ sites or on the sites of nonbanks that concentrate 

such data, those entities will effectively “own” the customer by owning the information needed to cross-sell or 

otherwise add value during the billing process. Owners 

of customer-specific data also can tailor new services— 

a process that can develop loyalty as well as related 

sales. Losing this battle would be doubly costly for 

banks because, regardless of where the data reside, electronic payments will eliminate most of the float in the 

payment process, to the benefit of vendors and largely 

at the expense of banks. 

Another battle is building between banks and nonbanks 

with respect to digital cash and stored value applications. These applications are directed at the micropayment sector—that is, payments that are normally 

considered too small for credit cards. Whether they 

reside on a computer or a smart card, these applications 

substitute electronic data for actual cash, with the 

amount stored on each card covered dollar for dollar by 

balances on account with an issuer. The struggle is for 

the right to issue this value, and the American Bankers 

Association has contended that regulated depository 

institutions alone should be permitted to do so.3 The battle here is for more than just fees, for the interest on the 

balances that back this electronic value could provide 

issuers with substantial new sources of income. 

With some new payment technologies, the distinction 

between opportunity and risk can blur. As the Internet 

enables the distance between shopper and shopkeeper to 

increase, the need to authenticate unseen customers, 

merchants, and banks increases as well. At the same 

time, the open nature of the Internet requires that the 

privacy and integrity of transaction information be protected. The building blocks to accomplish this are neither simple nor easily interwoven—successfully 

combining cryptographic protocols, specialized security hardware, and existing information systems is a dif3 The Role of Banks in the Payments System of the Future, www. 

aba.com. 

Emerging Issues in 


Small-Value Payments
 

Maintaining the payment system monopoly. Access 

to Federal Reserve payment services has historically 

been limited to depository institutions. Maintaining 

that monopoly—and thus maintaining its centrality to 

current and future payment products and services—is 

an important issue to the banking industry. 

Electronic bill presentment is the process of presenting bills and receiving payments electronically. Internet 

bill presentment may be one of the most hotly contested services, because the owner of the site where invoices are posted could cross-sell to customers as well. 

Digital cash and stored value are applications in 

which electronic data substitute for cash. Such applications can run on either smart cards or personal computers. An important issue is who holds the balances that 

back electronic value, because, unlike with paper cash, 

issuers may be able to earn interest on the digital balances held by consumers. 

Securing online transactions. Ensuring the integrity, 

privacy, and authenticity of electronic transactions is 

widely desired by those engaged in electronic commerce. With larger payments, desirability will become 

necessity. Current implementations use combinations 

of encryption algorithms and specialized hardware. 

Banks as certificate authorities (CAs). Authenticating Internet payers and payees may require a complex 

public key infrastructure in which trusted organizations 

supply decryption keys to authenticate the counterparties to a transaction. Some banks are already acting as 

CAs. Others are weighing the benefits and largely 

uncertain exposures of providing such a service. 

Electronic Funds Transfer ’99 (EFT 99). On January 

2, 1999, the U.S. government will be required to make 

benefit and vendor payments electronically. This mandate raises issues of how to provide service to the “unbanked,” how to provide service internationally, and for 

vendors, how to integrate remittance data with the payment itself. 

Development of financial electronic data interchange (EDI) standards. For bank commercial customers to benefit from electronic payments, banks must 

be able to handle remittance information—information 

that accompanies payments and identifies sender and 

transaction detail. Standardizing such data is an important step in enabling banks to receive them and pass 

them on to their customers. 

Point of sale check truncation. Checks are costly to 

handle and time-consuming to collect. Check truncation reduces cost and eliminates float by converting the 

check into an electronic transaction at the point of sale. 

Although banks will have fewer checks to handle under 

check truncation, they will lose float and the return on 

investment in check-handling equipment. 

Memphis Regional Outlook 15 Third Quarter 1998 
In Focus This Quarter
 

ficult matter in itself if the whole is not to be weaker 

than the individual parts. 

The VISA and MasterCard Secure Electronic Transaction (SET) protocols, designed to protect Internet credit card transactions, illustrate the complexity that banks 

and their customers will need to navigate in securing 

online transactions. Under SET, all banks and merchants will use digital certificates to authenticate themselves to consumers and each other for each Internet 

transaction.4 These certificates are electronic messages 

that contain a decryption key for the sender that is itself 

authenticated by a trusted third party. The infrastructure 

for storing, distributing, and vouching for these keys, 

known as a Public Key Infrastructure (PKI), will contain several tiers of certificate authorities (CAs) and 

will be difficult and costly to implement. Banks not 

only will use these certificates, but many are considering becoming—or have already become—CAs themselves. While banks acting as certificate authorities 

may represent a logical progression in banking services, 

there is little evidence of a homogeneous legal infrastructure or legal precedent sufficient to guide digital 

signature disputes. These voids leave unanswerable the 

question of whether the expected gains from providing 

such services will compensate for the potentially longtailed liability from doing so. 

A major stimulus for electronic payments could come 

on January 2, 1999, when the U.S. government is 

required by law to convert its vendor and benefit payments from paper checks to electronic transfers—the 

so-called Electronic Funds Transfer ’99 (EFT 99) program. Three separate challenges arise from this mandate. The first is that the “unbanked”—those segments 

of the population that are socially, economically, or geographically distanced from a financially bank-centric 

world—must eventually be provided with a cost-effective means to receive, store, and spend their electronic 

value.5 The second challenge is that the EFT mandate 

applies internationally as well as domestically. Given 

the need for each international payment to settle in two 

currencies and countries, the ability to provide efficient 

cross-border EFT will vary considerably from country 

to country.6 

4 Depending upon card brand and SET version, consumer certificates 

may be required as well. 5 Because of resistance from bankers and benefit recipients, compliance waivers are envisioned that will make the program largely voluntary until the details of the special electronic transfer accounts 

(ETA) are worked out. 6 www.fms.treas.gov/eft. 

Perhaps more challenging to many financial institutions 

is that electronic payments to vendors, unlike those to 

individuals, will require electronic remittance data to 

accompany the payment itself. This information goes 

beyond simple routing instructions and includes the 

information—such as purchase order or invoice numbers—necessary for the vendor to apply the payment 

correctly. According to a study by Booz-Allen & 

Hamilton, only slightly more than 5 percent of financial 

institutions were able to receive and forward such remittance information as of early 1997.7 Developing this 

capacity will therefore be an industrywide challenge. 

Once again, there is an opportunity disguised as a cost. 

The development and implementation of financial electronic data interchange (financial EDI) standards will 

enable financial institutions to retain control of—and 

add value to—business-to-business transactions when 

commercial payments migrate to the Internet. 

The U.S. government is not alone in seeking an end to 

costly paper-based payments. Vendors too are pressing 

for the elimination of the slow check presentment 

process wherein checks must physically be moved 

from vendor to vendor bank to issuer bank before 

funds can be transferred. Point of sale check truncation 

shortens this process by converting the check into an 

electronic payment at the point of sale, leaving the customer with an executed check and the vendor with a 

transaction that will settle like a debit card—and in 

doing so eliminates much of the potential for check 

fraud. While this process is beginning to displace physical presentment, the outlook for banks is mixed. As 

the volume of checks that must be physically handled 

decreases, so too will the income from float and the 

returns from past investments in check-handling 

capacity. 

Large-Value Payments: Making the 

World a ‘Good and Final’ Place 

Unlike small-value payments, the issues surrounding 

large-value payments are not strategic ones for banks, 

and less technological wizardry pervades them. Instead, 

the common factor is the systemic risk posed by payment failures. For this reason, regulators—particularly 

the Federal Reserve and the world’s other central 

banks—take very seriously the payments “plumbing” 

that is otherwise obscure even to many bankers. In an 

7 Remittance Data Study, Booz-Allen & Hamilton; www.fms.treas. 

gov/eft/remit.html. 

Memphis Regional Outlook 16 Third Quarter 1998 
In Focus This Quarter
 

electronic and intangible world where a bank’s accumulated exposures can routinely exceed its equity, the overriding objective for payment system designers, users, 

and regulators is “good and final” payment—a term 

referring to funds that are both irreversible and fully 

collected. 

Recognition is building concerning the payment system’s vulnerability and just how critical it is to the 

U.S. economy. An October 1997 report issued by the 

President’s Commission on Critical Infrastructure 

Protection (PCCIP) warned that “the nation’s core payment systems...seem to present a serious physical vulnerability within the financial system.”8 The source of 

that vulnerability, in the eyes of the commission, 

stemmed not so much from a lack of security as from 

the critical importance of those systems to settling 

financial transactions throughout the economy and the 

lack of available alternatives if they failed. As such, it 

was feared that the payment infrastructure provides an 

enticing target for cyber-terrorists and information warriors and that such threats will only grow in the future. 

Concentration refers to the fact that while banks are 

central to payments and all enjoy equal access to Federal Reserve payment services, some banks are clearly 

more central than others. According to March 1998 Call 

Report data, a mere 25 banks hold nearly two-thirds of 

the U.S. banking industry’s transaction accounts.9 

Should one of these large banks suddenly fail, its inability to fund settlements could result in a loss of payment 

system liquidity and disruption of domestic and foreign 

financial systems alike. While this concentration is not 

new, what is new is the considerable increase in concentration that the new megamergers promise.10 How 

and whether to inoculate the payment system from the 

weight of these super-institutions will become an issue 

for the regulatory community. 

The criticality of a nation’s payment system is not confined within its own borders. Because of globalization 

and the increasing velocity of payments, threats to one 

8 www.pccip.gov/report_index.html, p. A39. 9 Transaction accounts, in essence, are those accounts from which 

third-party payments can be made. The data used here are based only 

on transaction accounts held on behalf of other public and private 

financial institutions here and abroad—accounts from which interbank transfers are made. 

10 As of March 31, 1998, the top three U.S. bank holding companies 

held approximately 25 percent of all reported interbank transaction 

deposits. The mergers announced through June 30, 1998, would 

increase that concentration to over 34 percent. 

Emerging Issues in 


Large-Value Payments
 

Payment system vulnerability. According to the 

PCCIP, the nation’s core payment systems may present 

a serious physical vulnerability within the financial 

system. 

Payments concentration. Payment services are concentrated in a relatively few large banks, and that concentration is growing as megamergers are creating a 

smaller number of superbanks. 

Y2K. The Year 2000 problem threatens to disrupt payments by transmitting computer problems via the payment system from banks that have not fixed the 

problem to banks that have. 

The Euro. Bank and interbank systems in Europe 

and abroad must be modified to accept the Euro. In 

addition, the resources required to implement the 

Euro must be diverted from resolving Y2K problems. 

Foreign exchange settlement risk. Foreign exchange 

transaction exposures can be many times a bank’s capital. The failure of a major creditor to pay could drain 

essential liquidity from international markets. 

Achieving finality in gross payment systems. Making a given country’s domestic payments irrevocable 

and immediate is a major step in avoiding the international spillover of internal financial crises. 

Collateralizing net payment systems. According to 

the BIS, systems that do not permit immediate final 

settlement must be collateralized to ensure the eventual satisfaction of member positions in the event of a 

participant’s failure. Like finality, collateralizing helps 

prevent the internationalization of a domestic failure. 

country’s system become threats to those of other countries as well. There are a number of these emerging 

cross-border concerns. The most immediate and visible 

is the Year 2000 or Y2K problem. Because banks and the 

payment networks that join them are heavily computerized, the latent points of vulnerability to software and 

hardware failures have grown factorially with the number of interconnected internal and external systems. In 

this context, the concern is that any banks that have 

failed to correct their Y2K exposures will transmit that 

failure via the payment system to other institutions 

throughout the world, delaying or even arresting settlements in the process. This concern is heightened 

because, in both Asia and Europe, bank resources needed to fix Y2K are being consumed instead by more 

immediate problems. In Asia, it is surviving the decay in 

currencies and credits. In Europe, it is the Euro, which 

rates as an issue in itself—demanding the modification 

Memphis Regional Outlook 17 Third Quarter 1998 
In Focus This Quarter
 

of bank and interbank payment systems throughout the 

world in anticipation of that currency’s January 1, 1999, 

launch. 

Although less well known to the general public, foreign 

exchange settlement risk remains of considerable concern to the Bank for International Settlements (BIS) and 

its member central banks. This exposure arises because 

cross-border payments, unlike domestic payments, have 

no single central bank to guarantee settlement, leaving 

U.S. banks exposed to their foreign counterparties and 

correspondents—sometimes for several days—for more 

than $244 billion in daily trades.11 Potential solutions to 

this problem include netting—offsetting risks so that 

only the differences are due—and simultaneous settlement. An ongoing effort by several of the world’s largest 

banks to provide simultaneous cross-border settlement, 

a project known as the Continuous Linked Settlement 

Bank, will require considerable international cooperation since it will effectively span the central banks in 

each country whose currency it settles. 

Efforts by individual countries to solidify their payments infrastructure are ongoing as well. Achieving 

finality in payments—a term meaning that a completed 

payment is irrevocable—is the most prevalent, and recognizes that payments must be irreversible to establish 

the liquidity for those that follow. One way of speeding 

up finality is with real time gross settlement (RTGS) 

systems. “Real time” means that there is no delay in settlement. “Gross settlement” means that transactions are 

settled in the full amount for which the original payment 

instructions were entered. FedWire, the U.S. Federal 

Reserve’s large-value payment system, is an RTGS system. Many other countries also have them, and still 

more are developing or planning them. Complementary 

to RTGS systems are net or provisional settlement systems, which total up the accumulated debits and credits 

for each participant over the course of some period— 

usually one day, offset them against each other, and settle at the end of the period. The New York Clearing 

House’s Clearing House Interbank Payment System is 

one such system. Although their use leads to smaller, or 

netted, settlement amounts for each participant and substantially lower liquidity demands on the payment system as a whole, payments in such systems are not final 

until the last creditor pays. Thus, there is a daily threat 

of recalculation and a potentially fatal change in mem11 Settlement Risk in Foreign Exchange Transactions, March 1996, 

and Central Bank Survey of Foreign Exchange and Derivatives Market Activity, May 1996; Bank for International Settlements; 

www.bis.org/publ. 

Sources of Additional Payment
 

System Information
 

Electronic Bill Presentment 

Checkfree . . . . . . . . . . . . .www.checkfree.com/ebill 

Microsoft-First Data 

Corp . . . . . . . . . . . . . .www.msfdc.com 

Digital Cash and Stored Value 

Cybercash . . . . . . . . . . . .www.cybercash.com 

Digicash . . . . . . . . . . . . .www.digicash.com 

Mondex . . . . . . . . . . . . . .www.mondex.com 

VISACash . . . . . . . . . . . .www.visa.com 

Securing Online Transactions 

Certicom . . . . . . . . . . . . .www.certicom.com 

Entrust . . . . . . . . . . . . . .www.entrust.com 

RSA . . . . . . . . . . . . . . . .www.rsa.com 

SETCO . . . . . . . . . . . . . .www.setco.org 

Certificate Authorities 

Certco . . . . . . . . . . . . . . .www.certco.com 

Digital Signature Trust . . .www.digsigtrust.com 

GTE Cybertrust . . . . . . . .www.cybertrust.gte.com 

Verisign . . . . . . . . . . . . . .www.verisign.com 

Electronic Funds Transfer ’99, Financial 

EDI, and POS Check Truncation 

National Automated 

Clearing House 

Association . . . . . . . . .www.nacha.org 

U.S. Treasury Financial 

Management Service . .www.fms.treas.gov/eft 

Payment System Vulnerability 

President’s Commission on 

Critical Infrastructure 

Protection . . . . . . . . . .www.pccip.gov 

The Euro, Foreign Exchange 

Settlement Risk, Payments Finality, 

and Collateralization 

Bank for International 

Settlements (BIS) . . . .www.bis.org/publ 

Federal Reserve Board 

of Governors . . . . . . . .www.ny.frb.org 

New York Clearing 

House Association . . .www.chips.org 

U.S. Federal Reserve . . . .www.bog.frb.fed.us 

Memphis Regional Outlook 18 Third Quarter 1998 
In Focus This Quarter
 

bers’ liquidity positions if a major creditor bank fails. 

For such systems, the BIS is encouraging member collateralization levels sufficient to cover at least one, and 

preferably two, of each system’s largest net creditor 

banks at any one time.12 While these are not new issues 

in developed nations, the increasing extent to which 

financially underdeveloped and underregulated countries are involved in global payments confers new 

importance on the development of finality and collateralization in payment systems worldwide. 

Differing Perceptions, Common Threat 

Banks are united neither in their perceptions of these 

issues nor in their desire for regulation to address them. 

With respect to small-value payments, large and small 

banks have disagreed over whether the Federal Reserve 

should withdraw from providing retail payment services—a debate that ended in favor of the small bank 

faction earlier this year when the Fed announced that it 

would remain an active and, according to some large 

banks at least, a subsidized competitor in clearing and 

12 Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy report), 

November 1990; BIS; www.bis.org/publ. 

settlement. There also has been disagreement, again 

along lines of size, over whether the issuance of new 

products such as stored value cards should be limited to 

regulated depository institutions. In large-value payments, the differences are due more to relevancy than 

competition. Few small banks will feel compelled to 

address foreign exchange exposures or the vulnerabilities of the national and international payments infrastructure. 

Whatever their individual perceptions of the issues surrounding the payment system, all banks are susceptible 

to its interruption. Likewise, they are strategically vulnerable—individually and as an industry—if they fail to 

preserve their role as a trusted gateway for the settlement of their customers’ obligations. This is perhaps the 

most critical of all payments issues facing banks, for 

while their daily operations may depend on their continued success in maintaining the payment system’s 

dependability, nothing short of their payments franchise 

may rest on their ability to market this success to their 

customers as a feature essential to the entire range of 

current—and future—payment services. 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

Memphis Regional Outlook 19 Third Quarter 1998 
Regular Features	 Regional Economy
 

Current Regional Economic Conditions
 

•	 The Region continues to grow at a moderate rate. 

•	 Low oil prices and lack of adequate moisture for crop development are among the issues that may adversely 

affect the Arkansas and Louisiana economies. 

•	 Household debt relative to income is at a historic high. 

•	 Bankruptcy rates for Memphis Region states remain among the highest in the nation. 

Regional Roundup 

The Memphis Region continues its stable but moderate 

growth relative to the nation. The June release of the 

Federal Reserve Beige Book indicates modest labor 

shortages, continued low unemployment rates, and no 

significant wage or price pressures in the Region. 

In the agricultural sector, early summer surveys show 

that crops in portions of Louisiana and Arkansas were 

being stressed by lack of adequate moisture. The dry 

weather coupled with weak prices for many commodities do not bode well for a repeat of recent years’ favorable operating results. Low hog prices are reducing 

producers’ revenues, and there is some concern that the 

Russian economic crisis may limit Arkansas and Mississippi poultry exports. 

In Mississippi, last year’s gross gaming revenues broke 

records, despite a slowdown in the growth of national 

gaming revenues. In fact, revenues may rise more in 

1998 as some casinos finish new hotel construction. 

In Tennessee, the Memphis residential construction 

market is the only major metro area with permits below 

last year’s levels. Although overall job growth remains 

positive, some sectors of the metro economy—particularly the textiles segment of the goods manufacturing 

sector—have experienced job losses this year. 

Oil prices continue to be watched closely in Louisiana, 

where the demand for onshore drilling and production 

equipment is reported to be weak. The decline in oil 

prices is forcing independent companies to curtail operations. Evidence supporting these reports is found in the 

state’s rotary rig count, which in June 1998 was 200, 

well down from the November 1997 peak of 274. 

Because of sluggishness in the energy sector, manufacturing employment has slowed somewhat. Although 

local banks typically do not make loans to independent 

producers, lower prices affect individuals and businesses not directly associated with the oil industry. The situation could lower credit quality of loan portfolios held 

by banks in the area, particularly if oil prices remain low 

for an extended period. (See Regional Outlook, second 

quarter 1998, for a discussion of the oil industry in the 

state.) 

Expectations of future economic activity in the Region 

are generally optimistic. The Federal Reserve survey of 

employers’ hiring intentions indicates that half of the 

employers surveyed anticipate adding jobs. Only in 

Louisville, Kentucky, and Little Rock, Arkansas, were 

expectations less optimistic. In these areas, only 30 percent of employers anticipate adding jobs. One factor 

contributing to lower optimism in Louisville is the 

announcement that United HealthCare Corporation is 

buying Humana, Inc., and moving the business to its 

Minneapolis headquarters. There are 4,000 Humana 

employees in Louisville, and an undetermined number 

of these jobs will be lost. 

Economic Factors Are Influencing 

Household Borrowing 

Borrowing patterns of households in the Memphis 

Region during 1997 and early 1998 shifted from installment and credit card loans to mortgage-related debt. 

This change follows several years of significant growth 

in installment and credit card debt held by financial 

institutions serving the Region. The shift to mortgagerelated debt is attributable to economic factors, institutional factors, and tax considerations. The economic 

factors include substantial increases in residential property values, strong consumer confidence and increasing 

wealth, and changes in demographics. See Current 

Regional Banking Conditions for a discussion of instiMemphis Regional Outlook 20	 Third Quarter 1998 
Regular Features Regional Economy
 

tutional factors and trends in banks’ consumer lending 

and single-family mortgage portfolios. 

Growth in Household Wealth Is Based 

on Growth in Asset Values 

Total Household Wealth Has 

Increased Substantially 

Strong consumer confidence, increasing wealth, and 

income growth have increased consumers’ willingness 

and ability to take on debt. The Balance Sheet of 

Households and Non-Profit Organizations, published 

by the Bureau of Economic Analysis, reveals that 

wealth is growing faster than personal income.1 The statistics indicate that, nationally, household net worth 

increased 100.5 percent in the 10-year interval to 1997, 

while disposable personal income was up a much lower 

74.4 percent. The most significant contributors to asset 

gains were corporate equities and mutual fund shares, 

whose value rose 306.3 percent and 424.5 percent, 

respectively. Over the same 10-year period, the value of 

household real estate was up a comparatively modest 59 

percent, and homeowners’ equity in residential real 

estate was up an even more modest 35.1 percent. 

The largest contributor to liabilities was home mortgages, up 106.6 percent. Equity in residential real 

estate, calculated as a percentage of the value of household real estate, actually fell from 66.6 percent in 1987 

to 52 percent in 1997. This percentage has gradually 

declined throughout the 10-year period. The gains in 

wealth during this expansion, through rising equity 

prices and other non-real estate assets, may have helped 

1 While these data are national, the general observation applies to the 

Region. The only readily available local measures of wealth comparable with national trends are mutual fund data published by The 

Investment Company Institute. The industry figures provide a stateby-state distribution of mutual fund accounts and assets based on 

reports representing 63 percent of industry assets. The latest December 1996 report provides data for year-end 1995. The information 

compiled from 1987 to 1995 indicates that the value of mutual fund 

assets (equities, bonds, and income funds) grew 193 percent in the 

Memphis Region. Nationally, growth was 237 percent. This comparison shows that for this asset category, the Region’s growth was similar to but slightly less than the nation’s. Over the same period, income 

growth was 82 percent in the Memphis Region, while nationally it 

was 59 percent. This information provides some circumstantial evidence that changes in ratios of wealth to income for the nation are reasonable but inexact proxies for the Memphis Region. Using this 

narrow measure of mutual fund holdings, the Memphis Region’s 

wealth to income ratio grew more slowly than the nation’s over this 

period. However, the point that the wealth to income ratio in the 

Region has increased significantly remains valid. 

consumers feel more comfortable in diminishing their 

residential equity as a percentage of real estate value. 

Residential Property Values Have Increased 

Sizable increases in the values of residential property 

have provided resources to collateralize loans. The highest levels of home equity lending are at insured institutions in metropolitan areas of Kentucky and Tennessee. 

One factor that has enabled the growth in home equity 

lending in recent years has been the rise in median 

home prices in most areas of the nation, with the concomitant increase in homeowner equity. In the Memphis 

Region, price increases for metropolitan areas in Kentucky and Tennessee generally have been greater over 

the past four years than price increases for the nation 

(see Table 1). These increases have provided homeowners with greater equity to draw on through mortgage 

refinancing or home equity lines. 

Demographics Are Influencing Consumer 

Borrowing Trends 

Changing Demographic Characteristics 

Also Affect Demand for Home Equity 

The rapid in-migration to the Region that occurred from 

the early 1990s to 1997, particularly in the 25 to 34 age 

group, altered the characteristics of the population. A 

survey in the April 1998 Federal Reserve Bulletin indicates that the demographic characteristics of homeowners are a good indicator of the form of debt they will 

hold.2 Households with home equity lines of credit are 

more likely to own more expensive homes, have higher 

2 Canner, Durkin, and Luckett, “Recent Developments in Home Equity Lending.” 

TABLE 1 

Median Home Prices* Have Climbed in 

Kentucky and Tennessee Metro Areas 

(Percent Change from Prior Year) 

AREA 1994 1995 1996 1997 

KNOXVILLE 6.8 11.2 5.0 2.2 

LEXINGTON 6.1 3.8 5.4 5.1 

LOUISVILLE 8.5 7.3 5.7 6.0 

MEMPHIS − 0.8 0.2 11.1 7.9 

NASHVILLE 4.6 4.9 5.5 1.2 

U.S. 2.9 2.5 5.1 4.7 

*For existing single-family homes 

Source: National Association of Realtors 

Memphis Regional Outlook 21 Third Quarter 1998 
Regular Features Regional Economy
 

incomes, have higher equity in their homes, and be better educated. In-migrants during this period were more 

likely to have these characteristics, as they were attracted by new higher wage jobs in the Region. 

More recently, in-migration has slowed significantly as 

a result of national competition for labor and slower job 

growth in the Region. Therefore, continued increases in 

demand for home equity loans that are caused by shifts 

in the structure of the population are less likely in the 

near term, although normal changes through natural 

increase of the population can be anticipated. 

Tax Ramifications Are a Factor in 

Consumer Borrowing Decisions 

Consumer borrowing decisions have been influenced 

for many years by tax guidelines that generally permit 

deductions for interest paid on mortgages but not for 

interest paid on other forms of borrowings. Changes in 

tax laws in 1997 made such borrowings more attractive 

by, among other things, liberalizing the amount of gains 

from the sale of a home that may be excluded from taxable income. 

Household Debt Service to Income 

Is Unchanged, While Total Liabilities 

to Income Have Increased 

The burden of household debt service is the total interest and principal payments on all consumer and mortgage debt in the household sector compared with 

disposable personal income. After sharp increases from 

1994 to 1996, the household debt service burden was 

largely unchanged in 1997, as Chart 1 shows. 

There are several possible reasons for the recent stability in the household debt service burden. They include 

tightening of underwriting standards by lenders, 

increased concern among households over rising debt 

levels, and economic factors, such as higher personal 

income levels and lower interest rates. Another partial 

explanation for this stability is that mortgage-related 

debt is increasingly being substituted for credit card and 

other consumer debt. Mortgage-related debt, whether 

first-lien mortgages or home equity lines, typically 

involves lower interest rates and longer repayment 

terms than consumer installment debt and credit card 

lines. Consequently, to the extent this substitution 

occurred, annual principal and interest payments would 

be lower relative to disposable personal income, even 

though the proportion of consumer household liabilities 

to income continued to rise in 1997 (see Chart 2). 

A final factor contributing to the lower debt service 

burden is the increasing use of consumer leasing. Lease 

obligations are not included in the calculation of household debt service burden. Given the dramatic increases 

in automobile leasing in recent years (about one-third of 

new automobile transactions are now leases), current 

total household obligations, including lease payments, 

are believed to be well above the previous apparent peak 

in 1989 shown on Chart 1. The change in total household obligations to disposable personal income for 1997 

could likewise be higher than shown if lease obligations 

are considered. 

CHART 1 CHART 2 

The Household Debt Service 

Burden Was Unchanged in 1997... 

Source: Federal Reserve Board Percent of Disposable Income 

18.0 

17.5 

17.0 

16.5 

16.0 

15.5 

15.0 

14.5 

Debt Service 

87:Q188:Q189:Q190:Q191:Q192:Q193:Q194:Q195:Q196:Q197:Q1 

...while Household Liabilities to Personal Income 

Continued to Rise 

Source: Bureau of Economic Analysis, Flow of Funds Percent of Disposable Income 

100.0 

95.0 

90.0 

85.0 

80.0 

75.0 

Household Liabilities 

19871988198919901991199219931994199519961997 

Memphis Regional Outlook 22 Third Quarter 1998 
Regular Features 

Bankruptcy Rates Remain High 

Many financial institutions are concerned about consumer loan losses and the historically high levels of 

bankruptcy filings. Personal bankruptcy rates have 

dropped slightly from early 1997 levels but are higher 

than 1996 filings. Personal bankruptcy filing rates for 

states in the Memphis Region continue to be among the 

nation’s highest. The 1997 personal bankruptcy filing 

rates per 1,000 population together with the percentage 

changes from 1992 for each state were Arkansas 5.99 

(+79 percent), Kentucky 5.43 (+38 percent), Louisiana 

5.17 (+40 percent), Mississippi 6.95 (+48 percent), and 

Tennessee 9.63 (+22 percent).3 The national average 

bankruptcy rate was 5.04 per 1,000, up 42 percent since 

1992. 

The geographic distribution of bankruptcy rates is one 

indication of the comparative financial health of each 

community. Chart 3 shows that in Tennessee, high bankruptcy rates prevail in the metro areas, in most of the 

western urban and rural counties of the state, and in 

some of the counties in the southeast. The other Memphis Region states, with few exceptions, have high 

bankruptcy rates concentrated only in the metro areas. 

3 Administrative Office of the U.S. Court (Haver Analytics and 

CDB Infotek). Data include Chapter 7 and Chapter 13 filings by 

households. 

CHART 3 

Bankruptcy Is Not Uniformly Distributed 

in the Region... 

Regional Economy 

For a discussion of possible reasons for higher bankruptcy rates, see Regional Outlook, first quarter 1997. 

Chart 4 shows the change in bankruptcy rates from 

1996 to 1997 by county. In the Memphis Region, bankruptcy rates increased in 348 counties and decreased in 

only 88 counties. 

Implications: While income growth, lower borrowing 

costs, and changing borrowing patterns have led to 

improvements in households’ ability to service debt 

during 1997, total liabilities to income continue to rise. 

The high level of total liabilities could cause problems 

for borrowers if economic conditions change or if 

households reacquire substantial credit card and installment debt after adding to mortgage-related debt. 

Although the switch from unsecured consumer debt to 

mortgages is generally viewed as a reduction in the 

overall risk profile, lenders should consider the household’s total financial position when making underwriting decisions. A sharp increase in interest rates, 

particularly if coupled with an overall economic slowdown, could increase financial stress for consumers and 

have a significantly greater effect on mortgage-related 

debt than has been the case in the past. 

David T. Griffiths, Regional Economist 

Robert L. Burns, Financial Analyst 

Gary L. Beasley, Regional Manager 

CHART 4 

...and Rates Increased Last Year 

Rate per 1,000 Population 

2.49 or less (23) 

2.5 to 4.99 (170) Rate per 1,000 Population 

5.0 to 7.49 (165) (change from 1996–1997) 

7.5 and higher (78) Decline (88) 

U.S. average = 5.04 Increase (348) 

Numbers in parentheses 

denote number of counties 

Source: CDB Infotek Source: CDB Infotek 

Memphis Regional Outlook 23 Third Quarter 1998 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

• The Region’s financial institutions continue to report solid financial performance and adjust to industry 

trends. 

•	 Consumer loans are a declining segment of many bank and thrift portfolios but represent a majority of total 

loan losses. 

•	 Consumers are increasingly turning to home equity loans as a substitute for traditional consumer credit, 

and banks are including new market segments not previously thought to be candidates for home equity 

lines. 

First Quarter Performance 

Continues 1997 Trends 

The beginning of 1998 has seen a continuation of several trends discussed below that affect financial institutions in the Memphis Region. Banks and thrifts 

continue to adjust to these trends while posting solid 

performance. During the first quarter of 1998, Memphis 

Region institutions: 

•	 improved aggregate return on assets by 7 basis points 

over the first quarter of 1997 to 1.35 percent; 

•	 maintained low levels of nonperforming assets; and 

•	 held aggregate leverage capital ratios at 8.9 percent 

of average assets. 

Although the aggregate return on assets improved, the 

Region’s aggregate net interest margin (NIM) declined 

10 basis points from the fourth quarter of 1997 to 4.3 

percent. The average NIM, which does not have the 

large bank bias of aggregate performance measures, fell 

even more dramatically during the period, from 4.67 

percent to 4.51 percent. The flattening of the yield curve 

during late 1997 and early 1998 (discussed in the 

Regional Outlook, second quarter 1998) is one likely 

reason for declining margins. The yield curve has continued to flatten throughout the first half of 1998, and 

long-term rates have crept lower. Additional effects 

from the shape of the yield curve may emerge as institutions’ balance sheets adjust to the current interest rate 

environment. 

Institutions’ nonperforming asset levels benefited from 

a sharp seasonal decline in past-due and nonaccrual 

consumer loans. Despite this one-quarter decline and a 

longer term pattern of declining loan portfolio share, 

consumer loans remain an area of concern. While overall lending to this market segment has declined, household demand for mortgage products by households has 

climbed steadily. Recent trends in consumer debt and 

underwriting are discussed further in this article and in 

Regional Economy, with a particular emphasis on 

home equity lines of credit (HELOCs). 

Relative Levels of Consumer Loans Have 

Declined, but Some Concerns Remain 

The Region’s banks have seen a slowdown in recent 

years in consumer loan1 growth rates and a decline in 

that segment’s relative share of loan portfolios. Since 

year-end 1995, consumer loans have declined from an 

average of 21.2 percent of bank loan portfolios to 19.1 

percent as of March 31, 1998. Although their share of 

total loans has declined, consumer loans represent a 

growing share of total loan losses. As Chart 1 shows, 

consumer loan losses comprised slightly more than 70 

percent of total charge-offs during the first quarter of 

1998. Also, the percentage of aggregate past-due consumer loans remains higher than past-due percentages 

for all loans. As shown in Chart 2, past-due levels for 

consumer loans were up slightly in 1997 but declined in 

the first quarter of 1998, consistent with seasonal patterns in recent years. As of March 31, 1998, 2.85 percent of consumer loans were past due or in nonaccrual 

status, compared with 2.3 percent of total loans. 

Consumer loan growth at the Region’s banks may have 

slowed because households were recognizing that they 

were reaching the limits of their debt-carrying capacity. 

1 For purposes of this article, consumer loans include credit card and 

installment loans but no form of mortgage debt. 

Memphis Regional Outlook 24	 Third Quarter 1998 
Regular Features Regional Banking
 

CHART 1 CHART 2 

Consumer Credits Are an Increasing 

Component of Total Loan Losses... 

Source: Bank & Thrift Call Reports Percent of Total Loan 

100 

90 

80 

70 

60 

50 

40 

30 

20 

10 

0 

All 

Other 

Consumer 

Credits 

1992

Mar-98

19931994199519961997 

...and Consumer Credit Concerns Remain 

High Compared with Other Loan Types 

Source: Bank Call Reports Past-Due and Nonaccrual Loans/Total Loans 

3.50 

3.30 

3.10 

2.90 

2.70 

2.50 

2.30 

2.10 

1.90 

1.70 

1.50 

All 

Consumer Loans 

Dec-92

Jun-93

Dec-93

Jun-94

Dec-94

Jun-95

Dec-95

Jun-96

Dec-96

Jun-97

Dec-97 

Loan officer surveys and anecdotal evidence, however, 

suggest that strong demand for consumer loans still 

exists. The slowdown in consumer loan growth more 

likely happened because lenders have selectively tightened credit standards and terms for most consumer debt 

and because consumer credit has been consolidated into 

mortgage products, as discussed later in this article. 

The January 1998 Senior Loan Officer Survey conducted by the Federal Reserve Board was the ninth in a 

row to find that the percentage of banks tightening standards on consumer loans was significantly greater than 

the percentage of banks loosening standards, although 

the number and percentage of banks tightening standards continued to decline. The net percentage of banks 

reporting tighter standards was down again in the May 

1998 Senior Loan Officer Survey. These results suggest that lenders may be reaching what banks view as 

appropriate underwriting standards for consumer loans 

in the current climate. 

However, concerns about consumer underwriting practices persist. As part of each examination, FDIC examiners complete a credit underwriting survey on the 

bank’s lending policies and practices. Surveys completed during the fourth quarter of 1997 and first quarter of 

1998 revealed continuing concerns about consumer 

loan underwriting. In particular, examiners in the Memphis Region noted that many banks were frequently or 

commonly originating loans when borrowers lacked a 

demonstrated ability to repay the debt. 

Average levels of credit card debt held by the Region’s 

banks were little changed in recent quarters and represent less than 1 percent of total loans. Although the 

Region’s banks reported little change, the credit card 

industry as a whole appears to be continuing its aggressive pursuit of customers. Credit card mailings, which 

had decreased in late 1996, rose to almost 800 million 

per quarter in 1997. 

Even as consumer loan portfolio levels have fallen in 

recent quarters at the Region’s banks, households have 

added to first-lien residential mortgage and HELOC 

balances. Although the reasons behind the growth in 

first-lien positions are closely linked to generally positive macroeconomic conditions such as high employment levels and low interest rates, the growth in 

HELOCs may also be attributable partly to the increasing use of such products as a substitute for more traditional forms of consumer debt. 

Home Equity Lending Activity Is Growing 

Home equity lending has taken on increased importance 

for the Region’s institutions (see also Regional Outlook, fourth quarter 1997). The total funded amount of 

HELOCs held by Memphis Region banks has increased 

from just under $2 billion as of the first quarter of 1994 

to over $3.8 billion as of the first quarter of 1998. The 

unfunded amount available on such loans has also 

increased, totaling $3.9 billion as of the first quarter of 

1998. Aggregate holdings of HELOCs2 reached 2.5 per2 For purposes of this article, home equity lending specifically refers 

to revolving, open-end loans secured by 1- to 4-family residential 

properties and extended under lines of credit. Traditional home equity loans (closed-end, fixed-amortization, second mortgages) are not 

included. 

Memphis Regional Outlook 25 Third Quarter 1998 
Regular Features Regional Banking
 

cent of total loans on December 31, 1997, before a 

slight seasonal drop to 2.47 percent as of March 31, 

1998. Home equity lending is growing among the 

Region’s thrifts as well. 

Somewhat surprisingly, the most recent growth in 

HELOCs has occurred during considerable mortgage 

refinancing activity. Often, borrowers refinancing firstlien positions roll other mortgage debt, such as home 

equity loans, into the new first-lien mortgage. Because 

mortgage refinancings result in faster repayments on 

outstanding HELOCs, the comparative financial statement analysis discussed above likely understates the 

growth in new HELOCs. 

As of March 31, 1998, 138 commercial banks in the 

Region held home equity lines of credit in excess of 

2 percent of total loans, down from a seasonal high of 

150 banks in December 1997. Some banks reported 

considerably higher levels of home equity lines; 34 

banks held home equity lines ranging from 5 to 19 percent of total loans. These 34 banks had total assets of 

$37 billion, or 15 percent of the Region’s total assets. 

While this group includes some of the larger banks in 

the Region, 24 of them reported total assets of less than 

$500 million. One common characteristic of these 

banks and the larger group of 138 banks is that most are 

in or near metropolitan areas. Additionally, most of 

these banks are in either Tennessee or Kentucky. Economic conditions contributing to these geographic concentrations are discussed in Current Regional 

Economic Conditions. 

A major factor in the growth of 

home equity lines is the substitution of this loan type for other 

forms of consumer credit, either 

to consolidate existing debt or 

to finance new expenditures. 

According to the Mortgage Bankers Association, approximately 40 percent of home 

equity loans are for debt consolidation. A research 

study by Brittain Associates, released June 9, 1998, 

estimated that 4 million households nationwide had 

used equity loans during the preceding two years to pay 

down revolving credit card debt totaling an estimated 

$26 billion. 

In theory, refinancing credit card and other consumer 

debt into single home equity loans should improve borrowers’ financial position and ability to withstand economic hardship. HELOCs generally carry lower interest 

rates and longer maturities than most other consumer 

debt. In addition, interest paid on HELOCs can be 

deductible for taxpayers who itemize deductions, 

assuming certain conditions are met. Lower rates, 

extended maturities, and tax deductibility lower monthly payments and improve borrower cash flow. In practice, however, the use of HELOCs may not improve 

borrowers’ financial positions. Home equity borrowers 

may pay off credit cards and other consumer debts by 

tapping into what represents a major source of household net worth, only to then “reload” on these other 

credit sources. 

Active mortgage refinancing in recent quarters also has 

allowed consumers ample opportunity to “cash out” 

equity in their homes and roll debt into first-lien mortgages. Like home equity lending, mortgage refinancing 

gives consumers the opportunity to then “reload” on 

these other forms of debt. This trend was noted in the 

May 1998 Senior Loan Officer Opinion Survey conducted by the Federal Reserve Board. 

Active Subprime and ‘125’ Home 

Equity Markets Have Developed 

Traditionally, HELOCs were used by households with 

relatively strong financial positions. This general observation and the blended nature of home equity debt 

(representing elements of both consumer loans and residential mortgages) have historically combined to hold 

delinquency rates on home equity loans at lower levels 

than other forms of consumer debt. As discussed above, 

changes in underwriting standards and HELOC use 

make past indicators of performance less meaningful. 

In more recent years, HELOC use has expanded to other 

consumer market segments. A subprime market has 

emerged as lenders have advertised debt consolidation 

to borrowers with low income levels, little or no equity 

in their homes, or poor credit histories. Also, financial 

institutions have targeted many high-income consumers 

for HELOCs, offering credit that often exceeds the 

value of the home. Loans to this market segment have 

been associated with loan-to-value limits of 125 percent 

or more and are often referred to as “125s.” While both 

these market segments have been served predominately 

by nonbank lenders, some banks and thrifts in the 

Region have changed underwriting standards to compete for these credits. 

Memphis Regional Outlook 26 Third Quarter 1998 
Regular Features Regional Banking
 

Loss expectations for 125s are difficult to predict 

because they are relatively new and there is little historical performance information about them. The bulk of 

such loans were originated during 1997, and 125s even 

two years old are rare. However, because these loans 

share characteristics of both mortgages and credit card 

debt, loss rates may be expected to fall somewhere 

between those of traditional home equity loans and 

credit card receivables. 

Anecdotal evidence suggests that, 

while some larger banks in the 

Region are offering 125s, few 

smaller banks are participating in 

this market. Banks of all asset 

sizes are experiencing increases in 

the volume of HELOCs and, in 

many cases, are offering loans with loan-to-value limits 

of 95 to 100 percent, waiving closing costs, providing 

favorable interest rates, or supplying incentives such as 

free travel to new HELOC customers. 

Implications: The trends discussed above point to the 

potential migration of consumer lending problems to 

home equity and first-lien mortgage loan segments. At 

the same time, some evidence indicates that underwriting standards for these loan types are being relaxed. The 

January 1998 Federal Reserve Board Senior Loan Officer Survey revealed evidence of eased standards and 

terms for home equity lending. Between 15 and 20 percent of respondents, on net, eased standards on these 

loans during 1997. Similar percentages made such loans 

more accessible to more consumers by various methods, 

such as reducing fees. The May Senior Loan Officer 

Survey did not have questions concerning home equity 

lending. 

But are risks to the Region’s lenders increasing? Foreclosure rates for recent vintage HELOC pools (originated in 1995 and 1996) have risen faster and much higher 

than rates on previously originated pools. While 

HELOCs retained in bank and thrift loan portfolios tend 

to exhibit lower delinquency and loss rates than those 

sold into the secondary market, the observation of elevated risk can be applied to these loans as well. As a 

result, both lenders and examiners have had to reconsider the attention required for this loan type. 

Robert L. Burns, Financial Analyst 

Memphis Regional Outlook 27 Third Quarter 1998 
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