Outlook
 

FALL 2006 

In Focus This Quarter: 


Accessing Capital Markets and Managing Market Risk
 

During the past two decades, FDIC-insured institutions have 

increasingly turned to the capital markets to finance their 

activities. Business models have gravitated from traditional 

balance sheet sources of financing—debt and equity—to 

project financing, where assets are financed off balance sheet 

through securitization. These innovations have not only 

refined the methods by which risk can be partitioned and 

distributed, but they have also contributed to the depth and 

breadth of the financial markets themselves. Innovation also 

is changing the way in which financial managers must evaluate balance sheets as well as the risks associated with securitized instruments. This issue of FDIC Outlook provides 

an overview of trends in the securitization market and a closer 

look at two elements of risk management in which funding 

decisions play a critical role. 

A New Plateau for the U.S. Securitization Market 

Article01Chart01

$0

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$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

Total Securitization Issuance Approximated 

$2.7 Trillion in 2005

Note: Nonmortgage ABS excludes collateralized debt obligations (CDOs). 

ABS = asset-backed securities, CMOs = collateralized mortgage obligations, 

REMICs = rea estate mortgage investment conduits MBS= mortgage-backed securities. 

Sources: Ginnie Mae, Freddie Mac, Fannie Mae, Inside MBS & ABS.

(dollars in billions)

Nonmortgage ABS

CMOs/REMICs

MBS

985 1987 1 989 1991 1993 1995 1997 1999 2 001 2003 2005

The traditional practice of holding bank loans on the balance 

sheet until maturity increasingly is giving way to off-balance sheet securitization. Improved technology and innovative, complex 

financial structures have made it possible to securitize a wide range of loan types, from mortgages to credit card receivables and 

beyond. This article provides a brief history of securitization and summarizes the factors that continue to drive growth and innovation in the securitization of bank loans. See page 3. 

An Assessment of Traditional Liquidity Ratios 

Banks have long relied on key balance sheet ratios to assess their funding and liquidity positions. However, the shift from traditional balance sheet funding to off-balance-sheet funding through securitization has changed the structure of many balance sheets 

and made it more complex to assess liquidity risk. This article explores the relevance of traditional balance sheet measures of 

liquidity and discusses a dynamic cash flow method that may provide a more accurate assessment of liquidity risk. See page 11. 

Managing Net Interest Margins Under a Shifting Yield Curve 

The shape of the Treasury yield curve influences how banks manage net interest margins. To enhance earnings, managers may be 

tempted to select investment or funding strategies that involve a considerable degree of market risk. This article identifies strategies used by community banks and large banks to manage net interest margins in the normal, flat, and inverted yield curve environments observed since 2000, and it summarizes the relative performance of these strategies. See page 17. 

FEDERAL DEPOSIT INSURANCE CORPORATION 
FDIC Outlook is published quarterly by the Division of Insurance and Research of the Federal Deposit 

Insurance Corporation as an information source on banking and economic issues for insured financial 

institutions and financial institution regulators. 

FDIC Outlook provides an overview of economic and banking risks and discusses how these risks relate to 

insured institutions nationally and in each FDIC region. 

Single-copy subscriptions of FDIC Outlook can be obtained by sending the subscription form found on the 

back cover to the FDIC Public Information Center. 

FDIC Outlook is available online by visiting the FDIC’s Web site at www.fdic.gov. For more information or to 

provide comments or suggestions about FDIC Outlook, please call Richard A. Brown at 202-898-3927 or 

send an e-mail to rbrown@fdic.gov. 

The views expressed in FDIC 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 Sheila C. Bair 

Director, Division of Insurance 

and Research 

Arthur J. Murton 

Executive Editor Maureen E. Sweeney 

Managing Editors Kim E. Lowry 

Kathy Zeidler 

Editors Richard A. Brown 

Philip Shively 

Christopher J. Newbury 

Ronald L. Spieker 

Publications Managers Lynne Montgomery 

Elena Johnson 

Contact information for the FDIC’s six geographic regions: 

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

Marlon G. Cook, Acting Regional Manager, 678-916-2171 

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

Richard M. Gilloffo, Regional Manager, 312-382-7543 

Dallas Region 

Midsouth (AR, LA, MS, TN): Gary Beasley, Regional Manager, 901-821-5234 

Southwest (CO, NM, OK, TX): Alan Bush, Regional Manager, 972-761-2072 

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

John Anderlik, Regional Manager, 816-234-8198 

New York Region 

Mid-Atlantic (DC, DE, MD, NJ, NY, PA, PR, VI): Kathy Kalser, Regional Manager, 917-320-2650 

New England (CT, MA, ME, NH, RI, VT): Paul Driscoll, Regional Manager, 781-794-5502 

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

Shayna Olesiuk, Regional Manager, 415-808-7962 

FDIC OUTLOOK 2 FALL 2006 
A New Plateau for the U.S. Securitization Market
 

Banks exist to provide credit to household and business 

borrowers. But the traditional practice of holding bank 

loans on the balance sheet until maturity is increasingly 

giving way to off-balance-sheet securitization. During 

the past 30 years, new information technologies and 

new financial practices have made it possible to securitize a wide range of loan types, from mortgages to credit 

card receivables and beyond. Recently, these changes 

have brought about “synthetic” securitizations in which 

only certain types of risk move off the balance sheet.1 

These new structures are intended to improve the 

ability of individual institutions—and the system as a 

whole—to bear the risks of providing credit. But as the 

complexity of securitization structures has increased, so 

too have concerns about their transparency and how 

they might perform in periods of financial market 

turmoil. This article provides a brief summary of the 

factors that continue to drive growth and innovation 

in the securitization of bank loans. 

Look How Far Securitization Has Come 

What Is Securitization? 

Securitization is a method of funding in which illiquid, 

balance sheet assets are converted into marketable securities. The process starts when assets are transferred from 

the balance sheet of the originator to a special-purpose 

entity (SPE). The SPE is a bankruptcy remote trust that 

is set up by the originator to hold the assets.2 The SPE is 

financed by issuing tradable, capital market securities 

against the pool of assets. Then the SPE uses cash flows 

generated by the assets to make principal and interest 

payments to the investors. 

SPEs typically issue multiple classes of securities, 

which are referred to as tranches. Tranches are classified as senior, mezzanine, or junior, depending on their 

priority in receiving cash flows and sustaining losses 

from the underlying pool of assets in the SPE. Principal and interest payments generally “cascade” first to 

the senior tranche, then the mezzanine tranche, and 

last to the junior tranche, with all of the payments 

1 Synthetic securitizations use credit derivatives to construct an asset 

pool with characteristics similar to a traditional securitization. 

2 Some SPEs purchase loans from the originators to securitize. 

satisfied in the higher tranche before any payments 

are made to the next tranche. Conversely, losses are 

generally sustained from the bottom up, with the 

junior tranche absorbing all of the losses before the 

mezzanine tranche sustains any losses. 

The securities in each tranche have their own 

risk/return profile. Senior tranches typically carry 

AAA credit ratings and yields. The most junior 

tranche is referred to as the residual or equity tranche. 

It is unrated, has a higher expected return, and typically has been carried on the balance sheet of the 

originator to enhance the credit quality of higher 

tranches. Other credit enhancements, such as thirdparty insurance purchased by the originator, can be 

incorporated into the securities to protect investors in 

the event that cash flows from the underlying assets are 

insufficient to pay principal and interest in a timely 

manner. Credit enhancements improve the credit 

rating, and therefore the pricing and marketability, of 

the securities. 

Securitization has thrived during the past 25 years 

because it is highly efficient at redistributing risk from 

illiquid, balance sheet assets of the originator to the 

capital securities markets. Instead of issuing securities 

based on its overall credit rating, the originator can 

stratify the risk in the underlying assets and issue securities based on the stratified risk. This efficient redistribution of risk enables the originator to access capital 

market funds at more favorable rates, and it enables 

investors to purchase capital market securities tailored 

to their specific risk/return profile. 

A Brief History of Securitization 

Securitization dates back to the early 1970s, when the 

Government National Mortgage Association (Ginnie 

Mae) pooled mortgage loans and sold single-class, 

mortgage-backed securities (MBS) against the pool. 

MBS enabled Ginnie Mae to access national credit 

markets to fund local mortgage lending. The Federal 

Home Loan Mortgage Corporation (Freddie Mac) and 

the Federal National Mortgage Association (Fannie 

Mae) followed Ginnie Mae in securitizing mortgages 

in the early 1980s. These government-sponsored entities (GSEs) realized that they could access capital 

market investors more efficiently by issuing multiple 

classes of securities against the pooled mortgages, 

FDIC OUTLOOK 3 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

which led to multiple-class collateralized mortgage 

obligations (CMOs). 

Mortgage securitizations were followed by asset-backed 

securities (ABS) and collateralized debt obligations 

(CDOs). ABS is a general term that denotes the securitization of any balance sheet asset. In the narrower 

sense, however, ABS typically refers to the securitization of a large pool of homogeneous assets, such as 

receivables, and they generally have simple structures. 

CDOs are securitizations against a pool of heterogeneous loans (collateralized loan obligations, CLOs) or 

bonds (collateralized bond obligations, CBOs).3 CDOs 

can have a variety of complex structures depending on 

their purpose, exposure to the underlying assets, and 

credit structure. 

CDOs first appeared in the market in the late 1980s.4 

In the 1990s, CDOs were issued against a much broader 

universe of underlying collateral, including corporate 

bonds, corporate loans, trust preferred stocks, high-yield 

loans, middle-market loans, asset-backed consumer 

debt, and a combination of these asset classes. In 1997, 

the development of the credit derivatives market led 

to the construction of synthetic CDO structures in 

which credit derivatives are used to transfer risk to 

the SPE instead of actually transferring the underlying assets. Synthetic CDOs allow banks to maintain 

their loan portfolio on their balance sheet while 

simultaneously securitizing the credit risk in their 

loan portfolio. Synthetic CDOs have played a critical 

role in the growth of CDO issuance and the emergence of a market for traded credit securitizations. 

Measuring Risk in the Pool of Assets 

All securitized products share three key characteristics: (1) the pooling of assets into a common asset 

pool, (2) the issuance (tranching) of securities backed 

by the asset pool, with each tranche having a distinct 

risk/return profile, and (3) the delinking of credit risk 

in the underlying pool of assets from the credit risk of 

the originator through the creation of an SPE.5 Securitized products can differ in the types of underlying 

3 The first rated CLOs backed by U.S. bank loans were brought to 

market in 1990, and the first CBO backed by high-yield bonds was 

brought to market in 1988. Janet M. Tavakoli, Collateralized Debt 

Obligations and Structured Finance: New Developments in Cash and 

Synthetic Securitization (New York: John Wiley & Sons, 2003). 4 Merrill Lynch, “U.S. Cash Flow CDOs and Their Assets,” Fixed 

Income Strategy, no. 6 (February 9, 2005): 5. 5 Committee on the Global Financial System, Bank for International 

Settlements, The Role of Ratings in Structured Finance: Issues and 

Implications, January 2005: 5. 

assets they securitize, the degree of diversification of 

the underlying asset pool, and the complexity of their 

capital structure. 

MBS, CMOs, and ABS typically bundle together a 

fairly homogeneous pool of assets such as mortgages or 

some type of receivable. Idiosyncratic risk from individual assets in the asset pool typically is well diversified. 

Consequently, the asset pool can be valued based on 

default probabilities that draw on the historical experience of similar asset pools. In contrast, CDOs often are 

collateralized by a relatively heterogeneous pool of 

assets, such as different types of bank loans, corporate 

debt, emerging market debt, other CDOs, ABS, and 

many different types of derivative instruments. Both 

systematic and idiosyncratic risks remain critical factors 

in pool performance. Consequently, valuing CDO asset 

pools on the basis of historical default probabilities is 

a useful, but inadequate valuation method because of 

the idiosyncratic risk that remains in the asset pool. 

The CDO market gradually is moving toward valuation 

models that are based on statistical techniques, but this 

area remains a challenge. 

Innovation Continues to Accelerate Growth 

The U.S. securitization market has experienced tremendous growth over the past 20 years. Total securities 

issuance has grown from $126 billion in 1985 to more 

than $2.7 trillion in 2005 (see Chart 1). The industry’s 

ability to innovate and adapt to changing circumstances 

and demands of the market has fueled this growth. 

Several trends have emerged in the securitization 

market. Four examples are discussed here: (1) the 

Chart 1 

Article01Chart01

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Total Securitization Issuance Approximated 

$2.7 Trillion in 2005

Note: Nonmortgage ABS excludes collateralized debt obligations (CDOs). 

ABS = asset-backed securities, CMOs = collateralized mortgage obligations, 

REMICs = rea estate mortgage investment conduits MBS= mortgage-backed securities. 

Sources: Ginnie Mae, Freddie Mac, Fannie Mae, Inside MBS & ABS.

(dollars in billions)

Nonmortgage ABS

CMOs/REMICs

MBS

985 1987 1 989 1991 1993 1995 1997 1999 2 001 2003 2005

FDIC OUTLOOK 4 FALL 2006 
A New Plateau for the U.S. Securitization Market 

growth in nonagency MBS, (2) the growth of nonmortgage ABS, (3) the growth in cash funded CDOs, 

and (4) the issuance of new securitized products. 

MBS Growth Has Shifted from Agency to 

Nonagency Issuers 

The market for securitized mortgages appears vastly 

different in many respects than just a few years ago. 

Until recently, GSEs dominated the market for 

MBS issues. However, nonagency (or private-label) 

MBS issuance more than doubled between 2003 

($586 billion) and 2005 ($1.191 trillion), and for 

the first time surpassed agency MBS issuance in 2005 

Chart 2 

Nonagency MBS

Agency MBS

Article01Chart02

NonagencyMBS Issuance Surpassed 

Agency MBS Issuance for the First Timein2005 

(dollars in billions)

Note: Mortgaged-backed securities (MBS)are backed by one-to-four family mortgage 

loans. Nonagency MBS include private-label jumbo and Alternative A transactions, plus 

mortgage-related asset-backed securities (ABS), including subprime second liens, home 

equitylines of credit, high loan-to-value loans, scratch-and-dent, and resecuritizations

Source: GNMA, FHLMC, FNMA, InsideMBS & ABS.

19851987 1991 1989 19951993 1997 1999 2001 2003 2005

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Chart 4 

($966 billion) (see Chart 2). The most important of 

the many factors driving this transformation are high 

housing valuations, a heightened appetite for yield, 

a reduction in agency issues, and better technology. 

As home prices increased and mortgage rates fell to 

generational lows since 2000, more homeowners have 

opted for jumbo loans or nontraditional affordability 

loan products such as interest-only loans, option 

adjustable-rate mortgages (ARMs), and 40-year loans 

to finance their home purchases. Standard & Poor’s 

(S&P) has stated that affordability loan products 

represented 45 percent of S&P-rated originations in 

Chart 3 

Article01Chart03

Note:ABS =asset-backed securities. Source:Data obtained from Moody’s.

RisingHousing Prices Have Led to Significant Growth

inHome Equity Loans 

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1998 1999 2000 2001 2002 2003 2004 2005

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20

30

40

50

60

70

Home Equity Loans

Percentageof ABS Issuance

Collateralized by Home Equity Loans (dollarsin bi lions)

rticle01Chart04

Subprime

36%

Prime

53%

Alt A

1%

e-MBS

2%

Other

0%

Seconds

4%

S&D

4%

rim

4% ubprime 

9%

&D

2% econds 

5%

Other

1%

e-MBS

1%

Alt A 

8%

NonagencyMBS Issuance Is Increasingly Becoming Dominatedby Subprimeand Al ALoans

1995 Issuance 2005 Issuance

Notes: Scratch-and-dent (S&D) transactions include reperforming FHA/VA and conventional loans resecuritized loansfrom existing MBS, and conduit fallout loans S& an second-lien 

transactions backed by subprime loans are not included in th subprime category MBS=mortgage-backe securities.

Source: Inside MBS & ABS, based on SEC filings and industry surveys.

FDIC OUTLOOK 5 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

2005, with option ARMs representing 27 percent of the 

affordability product originations. Moody’s reported that 

more than 35 percent of the securitized collateral (rated 

by Moody’s) consisted of option ARMs, up from approximately 12 percent in 2004.6 Origination volumes in 

these products have been sufficient to permit securitization structures wholly backed by option ARMs. 

Homeowners have increasingly used home equity loans 

to extract their home equity. Many of these home 

equity loans (of which the vast majority are deemed 

subprime) were subsequently securitized (see Chart 3, 

page 5). Despite their subprime status, high yields 

propelled nonagency lenders to underwrite and securitize jumbo and affordability loan products (see Chart 4, 

page 5). Investor demand for higher-yielding MBS and 

improved technology in structuring deals ensured a 

readily available market for these securitized loan products. Last, there was a reduction in agency issuance 

over this period, which was likely the result of the 

accounting scandal facing agency MBS issuers. 

ABS Growth Has Shifted from Mortgage to 

Nonmortgage Assets 

The market for securitized assets other than mortgages 

has undergone its own transformation. As illustrated 

Chart 5 

Article01Chart05

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Nonmortgage ABS Issuance Continues

toIncrease Steadily

Note: ABS = asset-backed securities. Nonmortgage ABS excludes collateralized debt

obligations (CDOs).

Sources: Ginnie Mae, Freddie Mac, Fannie Mae, Inside MBS & ABS.

(dollars in billions)

Nonmortgage ABS

1990 1992 1994 199619982000 2002 2004

6 Data taken from a presentation at the Federal Financial Institutions 

Examination Council’s Capital Markets Conference, June 12, 2006, by 

Brian D. Grow and Martin C. Kennedy, Directors, Residential Mortgage-Backed Securities (RMBS) S&P’s Rating Services, New York, 

N.Y.; and “2005 Review” and “2006 Outlook: Alternative – A RMBS,” 

Moody’s Investor Service. Included in the category of affordability 

RMBS are interest-only loans, 40-year amortization loans, and option 

ARMs. There is research indicating that the pace of origination of 

option ARM loans has slowed in 2006. 

in Chart 5, nonmortgage ABS issuance continues to 

grow at a steady pace, achieving a record issuance of 

$292 billion for 2005. However, it is interesting to 

note from where most of this growth is coming. In 

1995, credit card and vehicle financing made up 

approximately 81 percent of ABS issuance, while 

student and business financing made up just 6 percent. 

In 2005, credit card and vehicle financing represented 

only 56 percent of ABS issuance, whereas student 

and business financing increased their portion to 

40 percent (see Chart 6 on page 7). 

ABS backed by student loans experienced the most 

significant growth over this period, increasing from 

$3.1 billion (3 percent of total ABS issuance) to 

$77.5 billion (25 percent of total ABS issuance). 

However, much of the growth in student loan ABS 

issuance occurred since 2001, when total issuance 

stood at $13.4 billion. Historically low interest rates 

and increased issuance from nonagency issuers were 

the primary drivers of growth in student loan issuance 

since 2001. Last, increases in 2005 issuance volumes 

were driven in large part by consolidations, whereby 

borrowers consolidated their student loans before 

interest rates increased. 

The Cash-Funded CDO Market Has Grown 

Dramatically 

In recent years, CDOs have become a dominant vehicle for funding, hedging, and trading virtually all types 

of debt instruments. There are a variety of structures 

that CDOs can adopt, depending on their purpose, 

credit structure, and underlying assets.7 Consequently, 

there are a variety of ways to report CDO issuance 

data. One important way of reporting CDO data is 

based on whether the underlying debt is sold to the 

SPE for cash (cash-funded CDO) or synthetically 

transferred to the SPE using credit derivatives 

(synthetic CDO). This section focuses on trends in 

the cash-funded CDO market. 

The cash-funded CDO market has grown dramatically 

over the past ten years (see Chart 7 on page 7). One 

estimate puts global cash-funded CDO issuance at 

$224 billion in 2005, up 196 percent since 2000. Prior 

to 1995, global cash-funded CDO issuance never 

exceeded $4 billion annually. The U.S. cash-funded 

CDO market experienced similar growth during this 

period. U.S. cash-funded CDO issuance was $165 

billion in 2005, up 198 percent since 2000. Recent 

7 JPMorgan, CDO Handbook, May 29, 2001. 

FDIC OUTLOOK 6 FALL 2006 
A New Plateau for the U.S. Securitization Market 

Chart 6 

rticle01Chart06

1995 Issuance

Notes: Vehicle asset-backed securities (ABS) include car loans and leases and financingfor buyersof motorcycles, trucks, and othervehicles. Business loan includ dealer floorplan financing, 

franchise loans, SBA loans, and other financing for business borrowers. Other ABS includes toba co settlement and stranded asset utility securitizations Subprime mortgages, home equit loans, 

HELOCs, home improvement loans, and other mortgage collateral are not included. Due t rounding,the percentages ma add up to greater than 100 percent.

Source: Inside MBS & ABS. 

Growthin Nonmortgage ABS Issuance Has Come from Studentand Business Loans 

2005 Issuance

Business

15%

Credit Card

21%

Other

4%

ehicle

5%

Student

25%

ehicle

33%

Credit Card

48%

Business

3%

Other

Manufactured 6%

Housing

7%

Student

3%

Manufactured

Housing

.5%

issuance data suggest that 2006 will be another strong 

year. Through July 20, 2006, global cash-funded CDO 

issuance has been $174 billion, and U.S. cash-funded 

CDO issuance has been $138 billion.8 Many market 

participants expect cash-funded CDO growth to 

continue for the remainder of 2006. Originators 

continue to supply new issues, investors continued 

to demand new issues, and the market continues to 

innovate with novel securitization structures and 

new classes of underlying collateral. 

Much of the growth in U.S. cash-funded CDO issuance 

since 1997 was driven by a general increased demand 

for CDO products. However, there was clearly a shift 

in preference away from CDOs collateralized with 

high-yield bonds and investment-grade debt to CDOs 

collateralized with structured finance products (both 

mezzanine and high grade; see Chart 8, page 8). Structured finance CDOs typically invest in MBS, ABS, and 

other CDOs, whereas high-yield loan CDOs typically 

invest in sub-investment-grade loans. U.S. cash-funded 

CDOs collateralized with structured finance products 

have grown from approximately $250 million in 1997 

to more than $76 billion in 2005. U.S. cash-funded 

CDOs collateralized with high-yield loans also grew 

significantly during this period, increasing from 

$4.8 billion to more than $60 billion. 

8 Data obtained through conversation with JPMorgan analyst. 

Chart 7 

Article01Chart07

Note: Global cash-funded collateralized debt obligation (CDO) issuanceincludes 

U.S. cash-funded CDO issuance.

Source: JPMorgan.

Global and U.S. Cash-Funded CDO Issuance

Has Grown Tremendously Since 1996

Issuance of Cash-FundedCDOs

(dollars inbillions)

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$50

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U.S.

Global

1996 1997 1998 1999 2000 2001 2002 20032004 2005 Through

7 /20/2006

Strong global demand for high-yield CDOs, a robust 

housing market, and innovations in capital structures, 

technology, and underlying mortgage products have 

helped drive CDOs to the forefront of structured 

capital market securities. The concentration of residential mortgage products, in particular subprime 

home equity loans, increased significantly in the 2005 

vintage. On average, 81 percent of collateral pools in 

the 2005 vintage were composed of residential mortgage products, with home equity loans accounting for 

66 percent of all pools. This compares with a 65 percent residential mortgage concentration in the 2004 

FDIC OUTLOOK 7 FALL 2006 
 

Accessing Capital Markets and Managing Market Risk 

vintage, of which home equity loans represented 

46 percent of all pools.9 According to Credit Suisse 

First Boston, many structured finance CDOs contain 

as much as 50 to 60 percent subprime mortgages (also 

called residential B&C mortgages) and home equity 

loan bonds.10 An increase in private-label MBS 

issuance collateralized by subprime mortgages and an 

increase in ABS collateralized by home equity loans 

(most of which are deemed subprime) soon followed 

(see Chart 8). 

High yields have made these new CDO structures very 

attractive relative to other fixed-income instruments. 

However, the increasing use of subprime debt in the 

collateral pools is of growing concern, particularly in 

a rising interest rate environment. According to 

JPMorgan, “With clear deterioration in U.S. home 

price appreciation (HPA), the full downside [risk] is 

still unclear for SF [structured finance] CDO tranches, 

and potential interest rate increases are likely to be far 

more penalizing compared to the benefit from one or 

even two (interest rate) cuts.”11 

Chart 8 

New Structured Finance Products: Net Interest 

Margin Securities (NIMS) 

Many new structured products are introduced in the 

capital markets every year, but many either do not 

succeed or take years to gain acceptance in the market. 

There are a variety of reasons for this, such as lack of 

credit enhancements, poor transparency, or difficulty 

in modeling cash flows. This section discusses net 

interest margin securities (NIMS), which were introduced in the mid-1990s but did not gain wide market 

acceptance until recently. 

NIMS are structured finance products collateralized by 

the residual cash flows from one or more securitizations 

(underlying deals). They may be structured within a 

securitization, but more frequently they are structured 

as a separate issuance after the inception of the underlying securitization.12 NIMS are a popular option for 

subprime residential mortgage securitizations because 

they allow the issuer to securitize the excess spread, 

which is the difference between the income on the 

underlying pooled assets and the financing cost, as 

12 Yogesh Gupta, “Understanding Net Interest Margin Securities 

(NIMS),” Structured Finance Group publication, Pricewaterhouse 

Coopers Web site. 

rticle01Chart08

U.S. Cash-Funded CDOs Increasingly Being Collateralized byStructured Finance Products 

Note: CDO = collateralized debt obligation, CDO^2 = CDO squared,CMBS =commercial mortgage-backe ecurities, EM emergin markets, H SF = high grade structured finance, 

HY=high yield, IG = investment grade, Mezz SF = mezzanine structured finance.

Source: JPMorgan. 

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CDO^2 CMBS EM

HGSF CDO HYBonds HY oans

IGDebt Mezz SF CDO Other

Issuance of U.S. Cash-Funded CDOs by Collateral Type

(dollars in billions)

1997 1998 1999 2000 2001 2002 2003 2004 2005

9 Credit Suisse, “U.S. CDO Strategy, Insight & Market Recap,” The
 

CDO Strategist, June 29, 2006. 
 10 Credit Suisse First Boston, “Classification Conundrum: Residential
 

Mortgage Classifications in SF CDOs,” Fixed Income Research publication, December 23, 2004.
 

11 JPMorgan, CDO Monitor, October 30, 2006: 3.
 

FDIC OUTLOOK 8 FALL 2006 
A New Plateau for the U.S. Securitization Market 

well as prepayment penalties. If not securitized, the 

excess spread would remain on the issuers’ balance 

sheet as a form of credit enhancement used primarily to 

absorb credit losses on the senior tranches of the deal. 

NIMS are either sold in the secondary market, which 

provides regulatory capital relief to the issuer, or maintained on the issuer’s balance sheets. The recent 

growth in NIMS issuances is the result of growth in 

the subprime mortgage market, new structures, and 

attractive yields that have increased investor demand. 

Although issuance statistics on NIMS are not widely 

published, S&P experienced significant growth in its 

rated NIMS deals. According to S&P, the par value 

of rated NIMS in 2003 increased more than sevenfold 

to $3.4 billion, and growth in 2004 was more than 

fourfold to $14.97 billion.13 

The Future of Securitization 

Securitization has continued to thrive because it is 

highly efficient at converting illiquid balance sheet 

assets into capital market securities. We are likely to 

see continued advances in technology, more accurate 

modeling of future cash flows, more complex securitization structures, and increased participation by 

institutional investors. Continued refinement in stratifying and managing the risk/return profile of securities 

through tranching will enable originators to reduce 

funding costs and investors to increase value through 

investments that meet their specific risk/return profiles. 

Advances in Technology 

Technological advances in cash flow modeling, data 

processing, and data availability will continue to play 

an integral role in the highly innovative market for 

securitizations. Advances in computer processing speeds 

and improvements in modeling irregular cash flows— 

such as late payments, partial payments, defaults, recoveries, prepayments, and payment triggers—will enable 

issuers and investors to model the timing and amount 

of cash flows from the underlying asset pool in a securitization more accurately. Both issuers and investors will 

benefit from technological advances. 

Data availability will continue to have a significant 

impact on growth in the securitization market. Long 

13 National Mortgage News, “S&P Tracks and Forecasts U.S. NIM 

Trends,” Nonprime News 30, no. 8 (November 14, 2005): 26. 

periods of historical data are needed to model cash 

flows and default probabilities in the underlying asset 

pool so that the securities issued in each tranche can be 

priced accurately. As more historical data become available, originators will be able to securitize new assets 

such as hybrid loan products, ABS structures, and 

derivatives. Data available to investors also have 

improved significantly. Information on loan pools that 

was once available only to issuers is now available to 

investors. This information has added a new level of 

transparency that will continue to increase demand for 

securitized products. 

Increasing Capital Structure Complexity 

Much of the complexity of today’s securitizations stems 

from the introduction of new types of collateral used in 

the underlying asset pools. There is less homogeneity 

in the underlying collateral than in the past, which 

makes it more difficult to value and price the deal. For 

example, CDOs now pool a number of different types 

of assets, including corporate loans, high-yield bonds, 

emerging market debt, other CDOs, ABS, and many 

different types of derivative instruments. Because innovation in the securitization market tends to coincide 

with advances in technology, structuring and pricing 

many of these more complex deals was improbable 

only a few years ago. 

Refined Risk/Return Profiles of New Securitization 

Structures 

One of the major factors driving new securitization 

structures is the desire of issuers to reduce funding 

costs and of investors to purchase securities that 

increasingly meet their risk/return profile. For example, 

banks, pension funds, and insurance companies will 

continue to invest in AAA-rated securities in the 

senior securitized tranches, while hedge fund and 

money managers seeking yield will invest in securities 

in the mezzanine and equity tranches.14 The combination of historically low interest rates and the explosion 

of hedge funds over the past several years has increased 

the demand for yield, which has increased demand for 

securities in the mezzanine and junior structures. 

14 It is believed that the main participants in the market for equity and 

mezzanine tranches are the hedge funds and dealers, whereas the 

insurers and pension funds are more focused on the mezzanine and 

senior tranches. Banks are also buyers of senior and super senior 

tranches. See Global Financial Stability Report, The Influence of 

Credit Derivative and Structured Credit Markets on Financial Stability 

(April 2006), 51. 

FDIC OUTLOOK 9 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

Chart 9 

Article01Chart09

$0

$50

$100

$150

$200

$250

$300

$350

Hedgefundcredit-oriented assets

(dollars in billions)

Credit-Oriented Hedge Fund Assets

under Management GrewTremendously

over thePast Few Years

Source: Global Financial Stability Report, TheInfluence of Credit Derivative and Structured

Credit Markets on FinancialStability (April 2006) 56.

199719981999 2000 20012002 2003 2004 2005

What Does the Reemergence of Risk Aversion Mean 

for the Market? 

Risk aversion in the financial markets can reemerge 

gradually or quickly. Should the reemergence of risk 

aversion happen quickly as a result of a major market 

disruption, the subsequent flight to quality may cause 

significant losses for investors in securitized products, 

especially investors in the higher risk mezzanine and 

equity tranches. For example, many hedge funds, 

traders, and other market participants experienced 

sizeable losses in securitized products resulting from 

the flight to quality that took place following the 

Russian debt default in 1998. Material losses also 

were noted at hedge funds in spring 2005, when 

default risk at General Motors and Ford increased. 

Currently about 8,500 hedge funds are operating 

worldwide, managing more than $1 trillion in assets, 

compared with about 2,800 hedge funds managing 

$2.8 billion in 1995.15 Credit-oriented hedge funds, 

which are the most likely to hold securitized products, 

have also grown significantly in recent years, from 

about $30 billion in 1997 to about $340 billion in 

2005 (see Chart 9). Consequently, given the significant increase in assets under management at hedge 

funds in recent years, the potential for losses among 

investors (especially in mezzanine and equity tranches) 

should a major market disruption occur is even greater 

today than in the past. 

Mitigating the Risk Associated with New 

Securitization Structures 

As the securitization market continues to innovate 

and offer new structured products, issuers and 

investors need to perform proper due diligence before 

taking positions. Market participants should have a 

thorough understanding of the risks associated with 

each structure, such as market, credit, and liquidity 

risks, and how these risks fit in with their overall 

market strategy. More historical data, advances in 

technology, improved modeling techniques, and 

more experience will help issuers and investors understand the risk/return profile of increasingly complex 

securitized products. 

David E. Vallee, Senior Financial Analyst, 

FDIC Division of Insurance and Research 

dvallee@fdic.gov 

15 Angel Ubide, “Demystifying Hedge Funds,” Finance and Development 43, no. 2 (June 2006). 

FDIC OUTLOOK 10 FALL 2006 
An Assessment of Traditional Liquidity Ratios
 

Liquidity refers to an institution’s ability to meet its 

short-term financial obligations. Liquidity risk is inherent in the banking industry. It arises from the maturity 

mismatch between long-term loan portfolios on the 

asset side of the balance sheet and short-term deposit 

funding on the liability side, as well as market 

constraints in converting loan portfolios into cash. 

How banks measure and manage liquidity risk depends 

to a great extent on the complexity of their operations 

and the funding mechanisms they use. Historically, 

many banks, particularly smaller community banks 

holding less than $1 billion in assets, have relied on 

balance sheet ratios to assess their funding and liquidity positions and, by extension, their liquidity risk. 

However, during the past decade, there has been a 

fundamental shift away from traditional balance sheet 

sources of funding to alternative off-balance-sheet 

funding sources through securitization and alternative 

borrowings. Consequently, the structure of many bank 

balance sheets has changed, and assessing liquidity risk 

has become more challenging. 

As funding mechanisms evolve, so too must the tools 

that banks use to measure and manage liquidity risk. 

The first section of this article shows that the traditional balance sheet measures of liquidity may have 

become less relevant for many banks, and that more 

sophisticated methods may be needed to monitor and 

manage liquidity risk. The second section discusses 

more dynamic cash flow methods of measuring liquidity 

that potentially can provide a more accurate assessment 

of liquidity risk. 

The Traditional Approach to Liquidity Measurement 

Traditionally, banks have used core deposits to fund 

loan growth and have held marketable securities to 

meet short-term liquidity needs.1 While core deposits 

remain the primary source of funds for many banks, the 

ability to generate deposits locally depends a great deal 

on local economic conditions and demographic trends. 

For the past generation, bankers have seen household 

savings rates decline, while household investments in 

1 Core deposits include savings and transactions accounts, and 

domestic certificates of deposit up to $100,000. 

money market accounts and mutual funds have 

increased, making it harder to generate core deposit 

growth at many institutions.2 During the same period, 

banks have remained important sources of credit to 

both household and business borrowers. Consequently, 

banks increasingly have turned to alternative funding 

sources to meet loan demand and fund growth. 

One important trend in alternative funding at insured 

institutions has been the increased use of borrowings 

such as wholesale deposits, Federal Home Loan Bank 

(FHLB) advances, and Federal funds.3 However, these 

are balance sheet activities that allow traditional forms 

of liquidity measurement and management. Another 

trend in bank funding is the increasing use of capital 

market funding through securitizing loan portfolios.4 

The shift to new off-balance-sheet funding sources has 

complicated liquidity measurement. Traditionally, bank 

managers measured liquidity using balance sheet ratios 

that consider an institution’s asset and liability structure at a particular point in time. The relative simplicity of such ratios and the ease by which they can be 

compared with historical trends at peer institutions 

increased their attractiveness. However, in today’s more 

complex funding environment, these ratios, while still 

useful, may not adequately reflect an institution’s 

liquidity position. In fact, ratio-based analysis can hide 

potential problems and leave a bank unknowingly 

exposed to considerable liquidity risk. For example, 

balance sheet ratios do not consider off-balance-sheet 

financing, nor do they adequately address fundamental 

aspects of liquidity management such as projected cash 

flow, borrowing capacity, and the potential impact of 

contingent liabilities. 

2 According to recent FDIC research, the percentage of U.S. banks 

that were able to fund at least two-thirds of their assets with core 

deposits fell from nearly 91 percent in 1978 to 59 percent in 2005. 

Christine M. Bradley and Lynn Shibut, “The Liability Structure of 

FDIC Insured Institutions,” 2006 FDIC Banking Review, Vol. 18 No. 2. 3 For an historical overview of the events that led up to the banks’ 

decreased reliance on deposits and an explanation of different 

wholesale funding options available to banks, see Christine M. 

Bradley and Lynn Shibut, “The Liability Structure of FDIC Insured 

Institutions,” FDIC Banking Review 18, no.2 (2006). 4 Securitization is a process where balance sheet assets are transferred to a special-purpose entity, and then capital market securities 

are issued against the pooled assets. 

FDIC OUTLOOK 11 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

Possible Limitations of Traditional Balance Sheet Ratios 

To assess the accuracy of ratio-based liquidity analysis, 

FDIC analysts reviewed all Reports of Examination 

generated during FDIC supervisory exams conducted 

between November 2002 and December 2005. Of 

these, some 93 institutions had a CAMELS (Capital, 

Asset quality, Management, Earnings, Liquidity, and 

Sensitivity to market risk) liquidity component rating 

of 3, 4, or 5. For the purposes of this analysis, these 

ratings indicate institutions with liquidity concerns. 

(See CAMELS Liquidity Rating Components inset 

box.) For each institution identified as having liquidity concerns, subsequent analysis surveyed the 

frequency and range of four traditional balance sheet 

liquidity ratios: net noncore funding dependency, 

pledged securities to total securities, large deposits to 

total deposits, and loans to deposits. (See inset box 

“Traditional Balance Sheet Ratios” on page 13 for a 

description of the liquidity ratios.) 

Of the institutions with liquidity component ratings of 

3, 4, or 5, the analysis found 

• The noncore funding dependence ratio appeared in 

75 percent of exam reports. It ranged from negative 

43.9 percent to 95.0 percent, with the majority of 

ratios distributed evenly between 0 percent and 

70 percent. 

• The pledged securities-to-total securities ratio 

appeared in 45 percent of exam reports and ranged 

from 0 percent to 100 percent. 

• The ratio of large deposits to total deposits appeared 

in 40 percent of exam reports and ranged from 0 

percent to 43 percent. 

• The loans-to-deposits ratio ranged from 51 percent 

to 148 percent.5 

These results show that balance sheet ratios can vary 

widely among institutions with identified liquidity 

concerns. Consequently, some traditional ratios may 

not be the most accurate indicators of an institution’s 

true liquidity position, and may be misleading when 

considered in isolation. In the past, the assumption was 

that banks with liquidity concerns would have poor 

ratios and thus would be easily distinguishable from 

institutions with a more favorable liquidity position. 

5 Not all ratios appeared in each individual exam report. 

CAMELS Liquidity Rating Components 

The Uniform Financial Institutions Rating System 

rates liquidity based upon, but not limited to, an assessment of the following evaluation factors: 

•	 The adequacy of liquidity sources compared to present and future needs and the ability of the institution to meet liquidity needs without adversely 

affecting its operations or condition. 

•	 The availability of assets readily convertible to cash 

without undue loss. 

•	 Access to money markets and other sources of funding. 

•	 The level of diversification of funding sources, both 

on- and off-balance sheet. 

•	 The degree of reliance on short-term, volatile 

sources of funds, including borrowings and brokered 

deposits, to fund longer term assets. 

•	 The trend and stability of deposits. 

•	 The ability to securitize and sell certain pools of assets. 

•	 The capability of management to properly identify, 

measure, monitor, and control the institution’s liquidity position, including the effectiveness of funds 

management strategies, liquidity policies, management 

information systems, and contingency funding plans. 

Ratings 

1.	 A rating of 1 indicates strong liquidity levels and 

well-developed funds management practices. The 

institution has reliable access to sufficient sources of 

funds on favorable terms to meet present and anticipated liquidity needs. 

2.	 A rating of 2 indicates satisfactory liquidity levels 

and funds management practices. The institution 

has access to sufficient sources of funds on acceptable terms to meet present and anticipated liquidity 

needs. Modest weaknesses may be evident in funds 

management practices. 

3.	 A rating of 3 indicates liquidity levels or funds 

management practices in need of improvement. 

Institutions rated 3 may lack ready access to funds 

on reasonable terms or may evidence significant 

weaknesses in funds management practices. 

4. A rating of 4 indicates deficient liquidity levels or 

inadequate funds management practices. Institutions rated 4 may not have or be able to obtain a 

sufficient volume of funds on reasonable terms to 

meet liquidity needs. 

5.	 A rating of 5 indicates liquidity levels or funds 

management practices so critically deficient that the 

continued viability of the institution is threatened. 

Institutions rated 5 require immediate external 

financial assistance to meet maturing obligations or 

other liquidity needs. 

FDIC OUTLOOK 12	 FALL 2006 
An Assessment of Traditional Liquidity Ratios 

Traditional Balance Sheet Ratios
 

Non-Core Funding Dependence 

Non-core funding dependencea is the difference between 

non-core liabilities and short-term investments, divided 

by long-term assets. This ratio is based on the premise 

that non-core liabilities are better suited to fund shortterm investments rather than long-term assets. In theory, 

a lower ratio implies that an institution is better able to 

meet its’ liquidity needs. Today there are many concerns 

with the original premise of this dependency ratio. Highly 

stable funding items, such as long-term borrowings and 

long-standing large deposits, are considered non-core, 

while most highly volatile internet deposits are considered core deposits. Additionally, all loans regardless of 

time to expected repayment are considered long-term. 

Pledged Securities to Total Securities 

Pledged securities to total securities is the book value of 

all securities pledged to secure deposits, repurchase transactions, or other borrowing (regardless of the balance of 

the deposits or other liabilities against which the securities are pledged), as performance bonds under futures or 

forward contracts, or for any other purpose, divided by 

total securities.b In theory, this ratio measures an institution’s borrowing capacity, with a high ratio indicating a 

diminished ability to borrow.

c For institutions with 

stressed liquidity positions, this ratio could be as high as 

a Non-core liabilities are defined in the UBPR Users Guide as the 

sum of total time deposits of $100M or more and include: 

+ Other borrowed money (all maturities) 

+ Foreign office deposits 

+ Securities sold under agreements to repurchase and federal
 

funds purchased
 

+ Insured brokered deposits issued in denominations of less than 

$100,000 

+ Demand notes issued to the U.S. Treasury (Not available from
 

March 31, 2001, forward).
 b UBPR Users Guide 

c Banks use Treasury and other securities as collateral for certain 

transactions such as repo agreements and FHLB advances. 

However, given the changing balance sheet structure 

and uniqueness of individual bank funding strategies, 

poor ratios do not necessarily mean banks are under 

liquidity pressures, and favorable ratios do not always 

depict a strong liquidity position. 

Old Assumptions May Not Capture New Risks 

As funding strategies and mechanisms have changed, the 

assumptions behind traditional liquidity ratios (that 

100 percent. Other institutions may have no liabilities 

requiring collateral. This ratio does not consider other 

assets, such as loans, that can be pledged as collateral. As 

such, the pledged securities-to-total securities ratio could 

have minimal application under the liquidity management strategies used by some insured institutions. 

Large Deposits to Total Deposits 

The ratio of large deposits to total deposits has been used 

to evaluate the stability of a bank’s funding.d By virtue of 

size alone, a high percentage of large deposits could 

represent a liquidity concern because a single large 

depositor leaving the institution will cause a significant 

drain on liquidity. However, anecdotal evidence suggests 

that certain large deposits remain relatively stable for 

long periods. A single point-in-time ratio may not be 

sufficient to evaluate the intricacies of most large deposit 

relationships. Factors such as the depositor’s relationship 

to the bank and the community, balance fluctuation, the 

borrower’s willingness to place the funds out for bid, and 

seasonality also must be understood. 

Loans to Deposits 

The loans-to-deposits ratio is total loans divided by total 

deposits. The idea behind this ratio is that loans are illiquid, and any deposit runoff likely would be funded 

through the sale of securities. The higher the ratio, the 

more illiquid an institution is considered. Today, loan 

portfolios have become a more important factor in 

liquidity management. Banks can use loans as collateral 

for secured borrowings, enter into loan participation 

agreements, and sell the loans on the secondary market. 

Moreover, the loans-to-deposits ratio does not consider 

some widely used alternative sources of funding, such as 

FHLB advances and fed funds. 

d For examination purposes, large deposits are defined as those 

concentrations of funds under the control of or payable to one 

entity, which aggregate 2 percent or more of the bank’s total 

deposits. 

investments are the only liquid assets and deposits are the 

only stable and acceptable funding source) may no longer 

apply to many institutions. In fact, these ratios may hide 

underlying risks, given that liquidity pressure may arise 

from a number of factors, including heightened credit or 

reputational risk. For example, examiners noted liquidity 

concerns as a result of negative publicity in 4 percent of 

exams surveyed, and examiners noted liquidity concerns 

as a result of holding company concerns, such as a rating 

FDIC OUTLOOK 13 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

downgrade, in 5 percent of exams. In addition, the review 

found that some banks underestimate the difficulty of 

obtaining or retaining credit-sensitive borrowing lines 

during times of financial stress. Eleven percent of the 

exam reports noted that a bank was unable to maintain 

or establish desired borrowing lines. 

Asset quality often is prominent in determining an institution’s liquidity position. However, the survey found that 

poor asset quality is not necessarily a precursor to the 

development of liquidity concerns. Liquidity concerns 

often emerged among institutions with no asset quality 

problems, as indicated by the institution’s CAMELS asset 

quality rating. In fact, 45 percent of banks with a liquidity 

rating of 3, 4, or 5 were rated 1 or 2 for asset quality. 

Traditional balance sheet ratios may not accurately 

address risks essential to understanding and planning for 

liquidity risk. Furthermore, today’s complex funding mix 

may require more formal procedures, not only to measure 

liquidity, but also to address liquidity concerns in extenuating circumstances. The next section explores cash flow 

analysis as a dynamic alternative to evaluate an institution’s liquidity risk profile. It also discusses contingency 

funding analysis and places liquidity measurement in the 

broader context of liquidity risk management. 

New Ways to Measure and Mitigate Liquidity Risk 

Strategies for measuring liquidity continue to evolve 

and must be commensurate with the complexity of 

funding strategies used by banking institutions. Given 

the diverse funding options now available to banks, the 

most effective liquidity measurement tools are dynamic, 

forward looking, and sensitive to potential future 

concerns. For most institutions, the quantitative assessment of liquidity is only one component of sound 

liquidity risk management. The broader framework for 

liquidity management identifies, measures, monitors, 

and controls exposure to liquidity risk. Not only should 

an institution be capable of assessing current and 

expected future funding sources and uses, it should also 

maintain strong internal controls and governance practices to create and promote comprehensive liquidity 

management strategies, policies, procedures, and limits.6 

6 This discussion is based on the principles of sound liquidity management as described by the Basel Committee in “Sound Practices for 

Managing Liquidity Risk in Banking Organizations” (February 2000), 

the Comptrollers Handbook on Liquidity, the Federal Reserve’s 

Commercial Bank Examination Manual (Section 4020), and the FDIC’s 

Revised Examination Guidance for Liquidity and Funds Management. 

Cash Flow Analysis 

Cash flow analysis can help banks of all sizes and levels 

of complexity identify the sources and uses of funds, 

both now and in the future. Unlike traditional balance 

sheet ratios, cash flow analysis captures liquidity implications arising from all asset, liability, and off-balancesheet positions, including a bank’s borrowing capacity. 

Given the heightened complexity of funding sources 

used by most institutions, as well as the credit- and ratesensitive nature of popular funding sources, an institution’s liquidity profile can be significantly affected by 

external factors. For example, a low interest rate environment may increase the demand for longer-maturity 

loans while increasing retail deposit customers’ demand 

for shorter-term liabilities. Conversely, a higher interest 

rate environment might have the opposite affect— 

customers may opt for higher-yielding products, such as 

money market accounts and mutual funds, over bank 

deposits. In addition to identifying these risks, cash flow 

analysis also may be used to determine the effect of 

operational risks, such as the introduction of a new 

deposit product on an institution’s liquidity position. 

Unlike ratio-based analysis, cash flow analysis is a 

dynamic tool that enables banks to assess their funding 

structure, liquidity needs, and alternative sources of 

funds, while considering a variety of economic and 

financial risk factors, including: 

• Current and future economic and financial market 

conditions, 

• Current asset quality trends, 

• Changes in credit ratings, 

• Earnings projections, 

• Asset growth and new product development, 

• Current and future interest rate expectations and 

funding costs, 

• The market’s perception of the institution and the 

potential effect on its liquidity risk profile, and 

• Contingent events, including the inability to fund 

asset growth, the inability to renew/replace maturing 

liabilities, the exercise of options by customers, and 

use of off-balance-sheet commitments. 

FDIC OUTLOOK 14 FALL 2006 
An Assessment of Traditional Liquidity Ratios 

Cash flow analysis can be the basis for a more targeted 

examination, allowing an institution to consider funding gaps, funding concentration, and asset/liability 

mismatches. It also can be helpful in determining 

liquidity risk tolerance under both normal and adverse 

conditions. For example, an institution may use a cash 

flow analysis to set target amounts of liquid assets or set 

ceilings for wholesale funding and brokered deposits. 

Contingency Funding Planning 

Cash flow analysis can be the basis for a contingency 

funding plan, which is a predetermined course of action 

should a bank face a liquidity event. In the past, contingency funding plans often were limited to informal 

discussions about the type of assets that could be sold 

or borrowing lines of credit that would be available. 

Considering the diverse funding alternatives available 

to most banks, which expose institutions to a variety of 

risks and may increase the speed of a liquidity event, 

contingency planning takes on heightened importance. 

A formal contingency funding plan should identify and 

test all potential funding sources. It should: 

• Be customized for the liquidity situation of the 

financial institution, 

• Identify alternative stress events and scenarios, 

• Evaluate stress events under different levels of severity and duration, and 

• Assess funding needs and sources under different 

stress events. 

A contingency funding plan should define policies and 

procedures for managing potential liquidity events. 

Much like cash flow analysis, contingency funding 

should be stress tested for potential changes in 

economic and financial conditions. For example, credit 

quality may deteriorate in weaker economic environments, directly affecting the cash flow and funding 

sources available to the institution through the 

marketability and use of collateral.7 The potential duration of a liquidity event may also be a factor in determining strategies for using various sources of contingent 

7 Nonperforming loans directly reduce otherwise expected cash 

inflows, and the reduced credit quality of problem assets impairs their 

marketability and potential use as a source of liquidity through either 

sale or their use as collateral. 

funding. Used in combination, cash flow analysis and 

contingency funding planning should alert a bank to 

events that may result in a liquidity crisis, giving the 

institution time to strengthen its liquidity position 

before a major liquidity event occurs. 

Effective Liquidity Risk Management 

An institution’s liquidity risk management process 

should be an extension of its overall corporate governance structure and internal controls. Strong corporate governance, as it applies to liquidity, means that 

the board of directors should guide the strategic 

management of liquidity risk and establish the institution’s tolerance for this type of risk. The priorities 

approved by the board should articulate the liquidity 

risk management objectives and strategies for the 

institution, and provide clear guidance on the level of 

acceptable liquidity risk. In addition, the board should 

identify executive-level lines of authority and responsibility for managing liquidity, thus ensuring that 

senior management has a full understanding of the 

institution’s risks. Should an adverse liquidity event 

occur, such as a run on bank deposits, the contingency 

funding plan is there to guide the bank through the 

troubled period. 

Internal controls are an important aspect of robust 

corporate governance. In general, they are a set of 

procedures, approval processes, and reviews designed 

to provide a reasonable degree of assurance that the 

institution’s risk management objectives are achieved. 

It is important to review and update the risk measurement and management systems periodically to ensure 

that the assumptions, parameters, and methodologies 

are still useful and relevant. Appropriate internal 

controls should address all the elements of risk 

management, including adherence to polices and 

procedures, and the adequacy of risk identification, 

measurement, and reporting. 

Conclusion 

Funding strategies for banks of all sizes have evolved 

during the past two decades and now incorporate a 

wide variety of balance sheet and off-balance-sheet 

funding sources. Liquidity measurement and risk 

management should be tailored to fit an individual 

institution’s complexity and liquidity risk profile. For 

some institutions, traditional balance sheet ratios that 

describe funding mix, deposit retention, or asset 

composition adequately assess their liquidity positions. 

FDIC OUTLOOK 15 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

However, the funding alternatives and liquidity risk 

profile of many institutions have become too complex 

for traditional balance sheet ratios to measure. A more 

dynamic, cash-flow-based approach is necessary for 

banks to manage liquidity in a changing financial 

environment. 

Kyle L. Hadley, Senior Capital Markets Specialist 

FDIC Division of Supervision and Consumer Protection 

khadley@fdic.gov 

Alison T. Touhey, Economic Analyst 

FDIC Division of Insurance and Research 

atouhey@fdic.gov 

FDIC OUTLOOK 16 FALL 2006 
Managing Net Interest Margins Under a 

Shifting Yield Curve 

FDIC-insured institutions have operated in normal 

(upward sloping), flat, and inverted yield curve environments since 2000. The shape of the yield curve 

influences investment and funding strategies as well as 

net interest margins (NIMs).1 With every decision, 

financial managers face a risk/return trade-off. To 

enhance earnings, managers may be tempted to “chase 

yields” by selecting traditionally higher yielding investments without considering the impact on longer-term 

risks, such as credit, market, and liquidity risks. Institutions face similar risks on the funding side. Banks have 

a variety of short-term funding alternatives available 

with which to fund growth in higher-yielding, longerduration asset portfolios. However, banks not only face 

risk from duration mismatches between investment 

and funding alternatives; managers may try to manage 

NIMs using funding sources without fully understanding the risks involved. (See inset box, “The Yield 

Curve Defined,” for a description of the yield curve 

and the risks it embodies.) 

This article explores the performance of FDIC-insured 

institutions in the normal, flat, and inverted yield curve 

environments observed since 2000. It identifies strategies used by community banks (banks with less than 

$1 billion in assets) and large banks (banks with more 

than $1 billion in assets) to manage NIMs, as well as 

strategies that may have raised institutional risk profiles 

in the recent flat yield curve environment. 

The Changing Yield Curve Since 2000 

The yield spread between one-year Treasury bills and 

ten-year Treasury notes since 2000 has ranged from 

–40 to 320 basis points. Consequently, FDIC-insured 

institutions have operated in normal, flat, and inverted 

yield curve environments (see Chart 1, page 18). In 

2000, yields on ten-year Treasuries lagged yields on 

one-year Treasuries, and the yield curve went from flat 

to inverted. In 2001, yield spreads increased and the 

1 Other factors—including credit shocks, interest rate shocks, term 

shocks, asset quality, and balance sheet composition—can affect 

NIM performance. See Gerald Hanweck and Lisa Ryu, “The Sensitivity of Bank Net Interest Margins to Credit, Interest Rate, and Term 

Structure Shocks,” FDIC Working Paper, September 3, 2004. 

The Yield Curve Defined 

The term structure of interest rates refers to the relationship between interest rates and the time to maturity. The yield curve is a graph of the term structure. 

The yield curve typically is presented using Treasury 

securities to eliminate the impact of credit risk on the 

term structure. Interest rates generally go up with the 

time to maturity, and the yield curve normally is 

upward sloping. However, yield curves can be flat or 

inverted in unusual economic environments. The slope 

of the yield curve is measured by the yield spread, 

which is the difference between a short-term and 

long-term interest rate, such as a one-year and ten-year 

Treasury rate. 

A variety of risks affect the level and slope of the yield 

curve. Liquidity risk is the possibility that an instrument cannot be obtained, closed out, or disposed of 

rapidly at, or very close to, its economic value. Market 

risk is the possibility that an instrument will lose value 

as a result of a change in the price of an underlying 

instrument, an index of financial instruments, changes 

in various interest rates, or other factors. The principal 

types of market risk are price risk, interest rate risk, and 

basis risk. 

•	 Price risk is the possibility that an instrument’s 

value will fluctuate and unfavorably affect a bank’s 

income, capital, or market risk reduction strategy. 

•	 Interest rate risk is the possibility that an instrument’s value will fluctuate in response to current or 

expected market interest rate changes. 

•	 Basis risk is the possibility that an instrument’s value 

will fluctuate at a rate that differs from a related 

instrument (for example, three-month LIBOR and 

three-month Treasury bills). 

Yield curve risk is a manifestation of interest rate risk. 

Specifically, it is the risk that changes in the shape of 

the yield curve (such as a nonparallel shift where shortterm rates change relative to long-term rates) may 

affect an institution’s financial condition (such as earnings, asset values, or nature of funding).a 

a

Definitions appear in the FDIC Division of Supervision and 

Consumer Protection Capital Markets Handbook, January 1999. 

FDIC OUTLOOK 17	 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

Chart 1 

350

300

250

200

150

100

50

0

–50

–100

Source: Federal Reserve Board.

FDIC-Insured Institutions Have Operated in 

Different YieldCurve EnvironmentsSince 2000 Spread between the one-year and ten-year 

Treasury securities (basis points)

Inverted

Normal

Flat

1Q003Q001Q013Q011Q023Q021Q033Q031Q043Q041Q053Q051Q063Q06

Article03Chart01

yield curve steepened. From late 2001 to mid 2004, the 

spread between one-year and ten-year Treasuries 

exceeded 200 basis points, and institutions operated in 

a normal, upward-sloping yield curve environment. In 

the second half of 2004, yield spreads fell and the yield 

curve flattened. From early 2005 through mid 2006, 

one-year and ten-year Treasury yield spreads averaged 

less than 30 basis points, and institutions operated in a 

relatively flat yield curve environment. 

How FDIC-Insured Institutions Fared in Each 

Yield Curve Environment 

During the normal yield curve environment in effect 

from late 2001 to mid 2004, NIMs fluctuated at both 

community and large institutions. (See Chart 2 for an 

example of a normal upward-sloping yield curve.) 

Chart 2 

However, the two types of institutions followed different strategies to enhance NIMs. Community institutions invested in longer-term securities and expanded 

their commercial real estate portfolios on the investment side, and they grew deposits and Federal Home 

Loan Bank (FHLB) advances on the funding side. 

Large institutions expanded their residential loan and 

home equity loan portfolios on the investment side as 

demand for commercial and industrial (C&I) loans 

continued to decline. On the funding side, large institutions saw rapid growth in interest-bearing deposits 

and other borrowings. 

During the flat yield curve environment in effect from 

early 2005 through mid 2006, NIMs diverged at 

community institutions and large institutions, with 

large institutions experiencing greater NIM compression. (See Chart 3 for an example of a flat yield curve 

during this period.) To enhance NIMs, community 

institutions grew their commercial real estate portfolios 

and home equity lines on the investment side, and 

reported a rise in short-term FHLB advances on the 

funding side of the balance sheet. Large institutions had 

a rebound in C&I lending and strong commercial real 

estate loan growth on the investment side, and they 

continued to report record levels of interest-bearing 

deposits on the funding side. Community institutions 

experienced shrinkage in their securities portfolios, 

while large institutions saw a shift toward longer maturities in their portfolios. 

In the inverted yield curve environment of 2000, 

community institutions experienced greater NIM 

compression than larger institutions. (See Chart 4 for 

an example of an inverted yield curve.) In response, 

Chart 3 

Monthsto maturity

TheYield Curve Was Upward Sloping (Normal)

atthe End of the ThirdQuarter 2003

Source: Federal Reserve Board.

Yields onTreasury Securities (%)

6.0

5.5

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0 612 24 36 60 120

Article03Chart02

Monthsto maturity Source: Federal Reserve Board.

612 24 36 60 120

5.25

5.20

5.15

5.10

5.05

5.00

4.95

4.90

4.85

TheYield Curve Was RelativelyFlat

atthe End ofthe Second Quarter 2006

Article03Chart03

Yields on Treasury Securities (%)

FDIC OUTLOOK 18 FALL 2006 
Managing Net Interest Margins Under a Shifting Yield Curve 

Chart 4 

Monthsto maturity Source: Federal Reserve Board.

612 24 36 60 120

Article03Chart04

Yields onTreasury Securities (%)

TheYield Curve Was Inverted at the 

Endofthe Third Quarter 2000 

6.6

6.5

6.4

6.3

6.2

6.1

6.0

5.9

5.8

5.7

5.6

community institutions shifted assets from longer-term 

securities to higher-yielding loans. Large institutions 

took advantage of loans that matured or repriced 

within 12 months at higher interest rates to maintain 

more stable NIMs. Both community and large institutions experienced higher funding costs, with depositors 

looking to lock in higher short-term interest rates. 

The appendix contains a more detailed analysis of how 

large and community institutions performed in each 

yield curve environment, including the effects on 

NIMs, operating challenges, investments, funding allocations, and risk/return trade-offs. 

Risk/Return Trade-offs When Operating in a 

Flat Yield Curve Environment 

While it is important to understand the risk/return 

trade-offs of operating in a range of yield curve environments, FDIC-insured institutions have operated in 

a relatively flat yield curve environment from 2005 

through mid 2006. In June 2004, the Federal Reserve 

began 17 straight quarter-point increases in the federal 

funds rate. Consequently, the short end of the U.S. 

Treasury curve (one-year T-bill) increased almost 350 

basis points from 2004 to 2006, while the long end 

(ten-year T-note) shifted up only 100 basis points. The 

net effect has been a dramatic shift from a normal, 

upward-sloping yield curve to a flat yield curve. 

The shape of the yield curve affects investment and 

funding decisions, and ultimately the performance of 

FDIC-insured institutions. In a flat yield curve environment with compressed NIMs, managers may be 

tempted to chase yields through investment or funding 

strategies that initially offer attractive yields, but most 

likely also carry higher credit, market, or liquidity risks. 

For example, investing in government-sponsored 

agency securities or FHLB notes, which appear to have 

very little risk, may in fact increase investors’ exposure 

to changes in financial markets, interest rates, or the 

shape of the yield curve. 

Investment and funding strategies should be considered 

in the context of an institution’s overall strategic goals. 

The investment process should be based on an understanding of the nature and characteristics of a security, 

how the security may perform in different yield curve 

environments, and the overall risk/return profile of 

the security.2 On the funding side, managers should 

consider how an institution’s funding is obtained, the 

risk/return trade-offs of alternative funding decisions, 

and the longer-term implications of liabilities repricing 

under alternative yield curve scenarios. 

Structured Products and Yield Curve Risk 

It is important for managers to understand the longerterm risk/return trade-offs on the investment side of the 

balance sheet when operating in a flat yield curve environment. This section uses two examples to illustrate 

the point. The first example uses an investment in U.S. 

Government Agency Collateralized Mortgage Obligation (CMO) securities, and the second example uses an 

investment in an FHLB note. 

Example 1 

In this example, an institution purchased U.S. Government Agency CMO securities in early 2005. These 

securities are considered to have virtually no credit risk 

because they are issued by a government-sponsored 

2 The Office of the Comptroller of Currency (OCC) issued guidance in 

2002 entitled “Unsafe and Unsound Portfolio Practices for National 

Banks.” The OCC bulletin discussed the ramifications of poor investment selection on future earnings and capital. Further, it emphasized 

the importance of maintaining prudent credit risk, interest rate risk, 

and liquidity risk management practices to control risk in the investment portfolio. In April 1998, the Federal Financial Institutions Examination Council (FFIEC) issued a document adopting a new “Supervisory 

Policy Statement on Investment Securities and End-User Derivatives 

Activities” (1998 Statement). The 1998 Statement provides guidance 

on sound practices for managing the risks of investment activities, 

with a particular emphasis on market risk (primarily interest rate risk) 

and can be accessed at www.fdic.gov/news/news/financial/1998/ 

fil9845.html. 

FDIC OUTLOOK 19 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

enterprise (GSE).3 When these securities were 

purchased, yields on GSE CMOs were attractive at 

about 350 basis points above the risk-free rate of return. 

However, the coupon on this CMO series is based on 

a complex floating rate formula that moves inversely 

with the one-month London Interbank Offered Rate 

(LIBOR).4 As short-term interest rates increased 

throughout 2005 and early 2006 and the yield curve 

flattened, the price of these CMOs began to fall and 

the coupon payments dropped to zero. 

This example shows that risks can appear later as the 

interest rate and yield curve environment changes, 

particularly for financial instruments with complex 

structures. Although initial yields may appear attractive, 

the risk/return trade-off inherent in each investment 

should be evaluated under a variety of market and interest rate scenarios. Other investments may be susceptible 

to the same yield curve risk. For example, structured 

notes, such as dual-index floating-rate notes, stepped 

inverse notes, and range accrual notes, may also react 

unfavorably to yield curve shifts.5 (See inset box, “Structured Notes,” for a description of these instruments.) 

Example 2 

This example is based on an FHLB note that matures 

in 2015 and has a floating-rate coupon of three-month 

LIBOR plus 200 basis points, contingent on LIBOR 

not exceeding a certain rate based on a complex 

formula. In the case of the 2006 accrual formula, if 

three-month LIBOR is less than or equal to 4.75 

percent, then the investor receives the stated coupon 

rate (which is attractive, given the AAA rating). If 

three-month LIBOR exceeds 4.75 percent, then the 

investor receives a floor rate of 3 percent. Given that 

the three-month LIBOR rate was well above 5 percent 

at the end of third quarter 2006, the investor received 

the 3 percent floor instead of the more attractive 

floating-rate formula. Consequently, this investor held 

an underperforming, relatively low-yielding asset with 

3 GSEs are chartered by Congress to serve a public policy purpose 

(such as housing and availability of credit). GSEs are rated AAA by 

the Nationally Recognized Statistical Rating Organization (NRSRO)— 

the highest credit grade and lowest risk of default. The capital 

markets view GSEs as having the implied backing of the U.S. government during times of financial stress. 

4 In this example, interest rates were increasing rapidly, so yields on 

these inverse-floating securities decreased. 

5 The FDIC has issued several Financial Institution Letters (FILs) 

addressing structured notes: “Structured Note Holdings Reported at 

FDIC-Supervised Banking Institutions” FIL-59-2004 issued May 18, 

2004, and “Examination Treatment for Certain Types of Credit-Linked 

Notes” FIL-88-2000 issued December 13, 2000. 

Structured Notes 

Structured notes are hybrid securities that combine 

standard fixed or variable rate instruments with derivative products, such as embedded call options, and interest rate caps and floors. Examples of structured notes 

are dual-index floating rate notes, single and multiple 

step-up notes, stepped inverse notes, and range notes 

(or accrual notes). 

A dual-index structured note is a security whose 

coupon is tied to the spread between two market rate 

indices. It can be structured in any manner and is 

designed to allow the investor to take advantage of the 

spread between two indices. Common interest rate 

indices used include LIBOR (London Interbank Offer 

Rate) and CMT (Constant Maturity Treasury index). 

However, these notes can be tied to indices other than 

interest rates, such as foreign exchange rates, commodity prices, or stock indices. 

Single step-up notes are bonds with one coupon 

increase (if not called) according to a predetermined 

coupon schedule. Typically, coupon payments are semiannual. Principal is repaid at par at maturity or, if 

callable, on the call date, as determined by the issuer. If 

the coupon has more than one adjustment period, the 

bond is a multiple step-up note. Multiple step-up notes 

generally have coupons that increase annually or semiannually until maturity. A stepped inverse note is a 

variant of the step-up note. It also contains a coupon 

formula that moves in the opposite direction of the 

referenced index (inverse moves in interest rate). 

Range notes (or accrual notes) accrue interest periodically at a fixed or floating coupon rate tied to a specified index. Most range notes have two accrual rates 

that allow interest payments to vary according to the 

number of days the designated index falls within or 

outside an established range of interest rates. If the 

index remains within the designated range, interest 

will accrue at the coupon rate. During periods that the 

index is outside the designated range, interest will 

accrue at a lower rate. In some structures, the lower 

accrual rate may be zero. 

an extended duration, high market risk, and poor 

liquidity in the secondary market. 

Borrowings—Caveats in a Flat Yield Curve 

Environment 

There has been growing use of FHLB advances on the 

funding side of bank balance sheets. FHLB advances 

are particularly relevant in the context of a changing 

FDIC OUTLOOK 20 FALL 2006 
Managing Net Interest Margins Under a Shifting Yield Curve 

Chart 5 

Article03Chart05

Source: Bloomberg.

InterestRate 

6%

5%

4%

3%

2%

1%

0%

TheFederal Home Loan Bank (FHLB)

Rate on Advances Has Been Rising

Along with Short-Term Interest Rates 

Mar JulNov M a Jul Nov Mar Jul Nov Mar

0 3 0 3 0 3 0 4 0 4 0 4 0 5 0 5 0 5 0 6

FHLB One-Year Index

Federal Funds Rate

yield curve environment. As short-term rates have 

risen over the past three years, so too have rates on 

FHLB advances. Chart 5 shows that fixed rate oneyear advances began trending upward well in advance 

of the Federal Reserve’s decision to raise the federal 

funds rate, rising from 1.5 percent in first quarter 2004 

to 5.5 percent in June 2006. 

FHLB convertible advances carry embedded options 

that may magnify their risk in a changing interest 

rate and yield curve environment.6 In a convertible 

advance, the FHLB has the option of (1) calling the 

advance and issuing a new floating-rate advance tied 

to market rates, or (2) raising the interest rate on the 

advance. In return for accepting this risk, financial 

institutions obtain slightly lower funding costs than 

would otherwise be available. If rates rise, then the 

FHLB could exercise its option and either convert the 

advance from a fixed-rate to a market-based floating 

rate or terminate the advance and reissue it at the 

prevailing higher interest rate. For a financial institution that uses this instrument, the higher rate on 

convertible advances may alter cash flows on the funding side of the balance sheet, and may increase interest 

rate risk and the cost of funds. This is why special risk 

disclaimers appear in FHLB product circulars.7 

6 The FDIC Division of Supervision and Consumer Protection Memorandum dated August 22, 2000, entitled “Federal Home Loan Bank 

Advances” addresses the risk/return trade-offs of using FHLB 

advances. 

7 Member Products and Services Guide, p. 52, Federal Home Loan Bank 

of Atlanta www.fhlbatl.com/misc/MPSG/MPSG_jan2006.pdf#page=1. 

Conclusion 

FDIC-insured institutions have operated in normal, 

flat, and inverted yield curve environments since 2000. 

The shape of the yield curve influences their investment and funding strategies, and how they manage 

NIMs. FDIC-insured institutions should continually 

evaluate the risk/return trade-offs of their investment 

and funding strategies in the context of the institution’s 

overall risk management strategies. Strategies that are 

appropriate in one yield curve environment may not be 

suitable in another. Institutions that assume complex 

risks are required to identify, measure, monitor, and 

control the risks they assume. Ultimately, each institution is unique, and the investment and funding strategies must be appropriate for the circumstances and 

needs of the institution. 

Albert Crego, Senior Financial Analyst 

FDIC Division of Supervision and Consumer Protection 

acrego@fdic.gov 

Mary L. Garner, Senior Financial Analyst 

FDIC Division of Insurance and Research 

mgarner@fdic.gov 

Appendix 

This appendix contains a detailed analysis of how community banks (banks with less than $1 billion in assets) 

and large banks (banks with more than $1 billion in 

assets) performed in each yield curve environment. It 

addresses the impact of the yield curve on NIMs, operating challenges, investments, funding allocations, and 

risk/return trade-offs. Table 1 evaluates bank performance in the normal yield curve environment from late 

2001 to mid 2004; Table 2 evaluates bank performance 

in the flat yield curve environment from 2005 to mid 

2006; and Table 3 evaluates bank performance during 

the inverted yield curve of 2000. (Tables begin on 

next page.) 

FDIC OUTLOOK 21 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

Table 1 

In the Normal Yield Curve Environment from Late 2001 to Mid 2004, 

Community Banks Grew Securities Balances and Maturities to Enhance NIMs, 

While Larger Banks Focused on Consumer Loan Demand 

Community Banks Large Banks 

Net Interest Margins The average quarterly annualized NIM The average quarterly annualized NIM for 

ranged from a high of 4.27 percent to slightly first quarter 2002 was 4.04 percent, but it 

less than 4.00 percent. declined to less than 3.70 percent by the 

second half of 2003. 

Operating Challenges The U.S. economy was rebounding from a Interest rates were low, and the demand for 

mild recession, so institutions were trying to residential mortgage loans and home equity 

attract higher-yielding assets. Portfolios of lines of credit was strong. At the same time, 

commercial real estate loans grew, particu­ the demand for C&I loans fell, and total C&I 

larly nonfarm, nonresidential properties. loans outstanding dropped below $800 billion 

for the first time since mid 1998. 

Investments Securities portfolios grew, reaching a peak of Investments in longer-maturity securities 

$331 billion in first quarter 2004. Institutions grew, with maturity and repricing dates in 

increased exposure to securities with maturi­ excess of five years. 

ties between 5 and 15 years to achieve 

higher, longer-term yields. 

Funding FHLB advances, non-interest-bearing Interest-bearing deposits grew to a new 

deposits, and interest-bearing deposits record, reaching more than $3 trillion in first 

all grew. quarter 2003. Other borrowings grew as well, 

particularly those with maturities of less than 

one year. 

Risk/Return Trade-off Institutions were taking advantage of longer- C&I loan demand was weak, but demand in 

term interest rates by investing in securities the residential real estate market was growwith longer maturities and repricing dates. ing. With excess funds, management relied 

Institutions were using nondeposit funding on a risk/return strategy of investing in 

sources, including FHLB advances, to fund longer-term securities to increase yields, fund 

growth. By shifting to longer-term securities, residential loan demand, and grow deposits. 

yields were higher, but market and interest 

rate risks increased. 

Community banks are FDIC-insured institutions with total assets less than $1 billion. 

Large banks are FDIC-insured institutions with total assets greater than $1 billion. 

FDIC OUTLOOK 22 FALL 2006 
Managing Net Interest Margins Under a Shifting Yield Curve 

Table 2 

In the Flat Yield Curve Environment from 2005 to Mid 2006, Community Banks 

Managed Interest Expenses to Offset Lower Interest Income, While Large Banks 

Had Significant NIM Compression Partly as a Result of Higher Funding Costs 

Community Banks Large Banks 

Net Interest Margins During this time of a relatively flat yield curve, The story was NIM compression. The quarsmaller institution NIMs averaged 4.11 terly annualized NIM dropped to 3.36 percent 

percent. by first quarter 2006, the lowest since yearend 1990. 

Operating Challenges Commercial real estate lending was very Commercial real estate loans grew, particustrong, particularly in the areas of construc­ larly construction and development loans, 

tion and development and nonfarm, nonresi­ one-to-four family residential mortgages, and 

dential properties. Home equity lines of credit home equity lines of credit. C&I loan growth 

were expanding, while consumer lending also rebounded, topping $1 trillion, a new 

volumes continued to decline. record. 

Investments Securities volumes began to drop, notably in Securities growth was moderate during this 

securities with longer maturity and repricing time, but maturity and repricing allocations 

dates, as institutions realized they could changed dramatically. Larger FDIC-insured 

obtain similar yields with shorter-term institutions reported a significant drop in 

securities. mortgage pass-through securities backed by 

one-to-four family residential properties with 

maturity or repricing dates of 3 to 15 years. 

However, securities with maturities and 

repricing dates greater than 15 years 

increased markedly. 

Funding The volume of FHLB advances less than one Interest-bearing deposits peaked at $4 trillion 

year grew, while longer-term advances at year-end 2005. Money market deposits and 

declined and federal funds purchased and time deposits in excess of $100,000 with a 

securities sold under agreements to repur­ maturity of less than one year accounted for 

chase (repos) remained at about the same the majority of growth. Repos grew approxilevel. Other longer-term borrowings mately one-third from year-end 2001 to late 

increased. Interest-bearing deposits also 2005. 

surged, with depositors taking advantage of 

higher short-term interest rates. 

Risk/Return Trade-off Smaller institutions focused on construction For larger institutions, the risk/return trade-off 

lending and short-term securities to take shifted to longer-term securities with maturiadvantage of higher short-term interest rates. ties or repricing dates over 15 years in an 

Smaller institution funding costs remained effort to hold longer-duration assets. As rates 

lower than those of larger institutions, reduc­ on interest-bearing deposits and short-term 

ing some margin pressure. liabilities continued to rise, compressing 

NIMs, large banks focused on real estate 

lending to achieve higher yields and to grow 

shorter-term assets. 

Community banks are FDIC-insured institutions with total assets less than $1 billion. 

Large banks are FDIC-insured institutions with total assets greater than $1 billion. 

FDIC OUTLOOK 23 FALL 2006 
Accessing Capital Markets and Managing Market Risk 

Table 3 

During the Inverted Yield Curve of 2000, Community Banks Experienced Greater 

NIM Pressure as Funding Costs Increased Faster Than Yields on Assets, and Large Banks 

Were Better Able to Manage Assets and Liabilities Repricing at Short-Term Rates 

Community Banks Large Banks 

Net Interest Margins Community banks had a relatively stable Large banks had a relatively stable NIM, 

quarterly annualized NIM of 4.30 percent for dropping only 11 basis points from 3.72 

the first nine months of 2000. By first quarter percent in first quarter 2000 to 3.61 percent a 

2001, NIM dropped considerably to 4.07 year later. 

percent. 

Operating Challenges Institutions shifted from consumer lending The more stable NIM reflected how larger 

and securities to commercial real estate institutions implemented different asset and 

loans to increase their share of traditionally liability management strategies to deal with 

higher-yielding assets. Institutions were different yield curve environments.a On the 

trying to increase NIMs. asset side, large institutions reported 61 

percent of loans, excluding closed-end oneto-four family loans, repriced or matured 

within 12 months. This allowed large institutions to reprice assets faster and at higher 

rates than smaller institutions. 

Investments The volume of total securities declined almost The volume of debt securities remained rela11 percent during the year ending first quar­ tively stable, but securities reallocation 

ter 2001. U. S. government, agency, and other occurred. Securities with repricing dates of 

securities with repricing dates greater than less than one year increased. The volume of 

three years reported a marked decline as mortgage pass-through securities backed by 

yields on longer-term securities lagged those one-to-four family residential properties with 

of shorter-term securities. maturities greater than 15 years grew rapidly 

at the beginning of 2001. 

Funding The volume of interest-bearing deposits grew, Brokered deposits and money market 

while non-interest-bearing accounts deposits grew rapidly because of attractive 

remained relatively stable as depositors short-term yields. 

searched for short-term higher yields. 

Risk/Return Trade-off Funding costs were rising more rapidly than Larger institutions managed higher interest 

yields on interest earning assets, squeezing expenses by holding shorter-term assets that 

NIMs. Institutions increased exposure to repriced upward. They shortened asset duracommercial real estate loans to hold higher­ tions and attracted higher-cost funds through 

yielding assets and reduced securities brokered deposits. 

exposure, which offered lower yields. 

Interest-bearing deposits were growing, 

resulting in higher funding costs. 

Community banks are FDIC-insured institutions with total assets less than $1 billion. 

Large banks are FDIC-insured institutions with total assets greater than $1 billion. 

a John M. Anderlik and Richard D. Cofer, “Does Net Interest Margin Matter to Banks?” FDIC Outlook, Second Quarter 2004. 

FDIC OUTLOOK 24 FALL 2006 
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