Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1999 

FDIC
 

National
 

Edition
 

Boston 

Chicago 

New 

York 

Atlanta 

Memphis 

Kansas 

City 

San 

Francisco 

Dallas 

Division of
 

Insurance
 

In Focus This Quarter 

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

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

depository institutions. 

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

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

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

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

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

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

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

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

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

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

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

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

market. See page 11. 

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

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

remain low. See page 12. 

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

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

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

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

Regional Perspectives 

◆ Atlanta—Increased reliance on more volatile noncore funding by banks in the Region may require higher levels of asset-side 

liquidity. See page 18. 

◆ Boston—Commercial lending levels have increased. Smallbusiness lending has grown faster than in previous years at the 

Region’s small institutions. See page 19. 

◆ Chicago—Despite some weakness in the manufacturing 

sector, economic and banking conditions remained healthy. 

Recently chartered banks may need to be particularly vigilant 

about the potential for a reversal of strong economic conditions. 

See page 20. 

◆ Dallas—Insured financial institutions hold a higher percentage of securities than do institutions in other areas of the country. This asset mix may reduce credit risk, but it could expose 

institutions to higher levels of interest rate and market risks. See 

page 21. 

◆ Kansas City—Low agricultural commodity prices remain 

a concern. Entry by large commercial companies with existing 

thrift charters or financial services conglomerates could increase 

the level of competition for small, rural community banks. See 

page 22. 

◆ Memphis—Favorable banking and economic conditions 

have led to considerable new bank activity, but the performance of 

these institutions is declining. See page 23. 

◆ New York—The Region has experienced an increase in new 

bank activity over the past three years, particularly in New Jersey 

and Pennsylvania. See page 24. 

◆ San Francisco—Weakness was evident in the aerospace, 

manufacturing, energy, and agricultural sectors. Depressed commodity prices for some products and declining farm income in certain states caused deterioration in the Region’s agricultural banks. 

See page 25. 

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

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

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

For more information or to provide comments or suggestions about the National Edition of Regional Outlook, please call Lynn Nejezchleb at (202) 898-3898 or send an e-mail to lnejezchleb@ 

fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 

Writer/Editor Kim E. Lowry 
In Focus This Quarter
 

Economic Conditions and 


Emerging Risks in Banking
 

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

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

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

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

this assessment: 

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

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

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

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

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

more difficult for borrowers. 

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

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

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

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

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

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

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

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

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

Indicators of Industry Performance 

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

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

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

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

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

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

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

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

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

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

Regional Outlook—National Edition 3	 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 1 

Overview 

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

Projected Earnings Growth 

Analysts expect continued earnings growth for banks 

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

Institutions Has Been Stable Recently 

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

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

–1.0 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

6.0 

’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

Net Loan Loss Ratio (percent)* 

95th Percentile 

Mean 5th Percentile 

licly traded banks and 19.4 percent for publicly traded 

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

ratings issued by Moody’s Investors Service improved 

in the second quarter, with nine companies receiving 

upgrades versus four receiving downgrades. 

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

1999. The SNL Securities Bank Stock Index, which 

tracks more than 450 publicly traded commercial banks, 

declined 6.7 percent between January 1 and September 

30, 1999. The SNL Securities Thrift Stock Index, 

which tracks the performance of about 350 publicly 

traded thrifts, fell 13.7 percent during the same period. 

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

gained 4.6 percent. Analysts cite rising interest rates, 

concerns about problems with corporate credit quality, 

and a decline in bank merger activity as reasons for the 

recent performance of bank and thrift stocks. 

Economic Conditions
 

The U.S. economy has remained generally strong during 

1999, the ninth year of the current economic expansion. 

If growth continues through February 2000—as most 

analysts expect—this expansion will become the 

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

this business cycle expansion is the fact that the highest 

rates of growth have occurred during the past two years, 

1997 and 1998. Even as growth has accelerated with 

unemployment declining to 4.2 percent, wage and price 

inflation has remained unusually subdued. While low 

inflation has helped prolong the expansion, it has 

imposed intense price competition on a wide range of 

industries. The currently positive economic outlook is 

subject to possible sudden deterioration in the event of 

financial market shocks that could raise financing costs, 

reduce the availability of financing, or destroy investor 

wealth. 

Commodity Industries Have 

Faced Pricing Pressures 

One disadvantage of low inflation during this expansion 

has been that firms in certain commodity industries 

have suffered from falling prices. Profit margins have 

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

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

margins. Nonetheless, profit growth has been flat or 

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

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

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

industries have chosen to consolidate through mergers. 

According to Mergerstat, the dollar volume of merger 

and acquisition transactions involving U.S. firms was a 

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

1997 levels. 

Business Investment Is Outpacing Cash Flow 

Analysts recently have become concerned about 

increasing levels of debt on corporate balance sheets. 

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

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

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

and Manufacturing Pose Continuing Risks to Credit Quality,” 

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

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

Regional Outlook—National Edition 4 Fourth Quarter 1999 
In Focus This Quarter
 

Chart 2 tracks the steady growth of fixed investment by 

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

shows, however, that growth in cash flow available to 

finance investment has slowed in recent years. This 

“financing gap” has grown steadily, reaching a record 

$86 billion in 1998. 

As a result, corporations must finance an increasing 

portion of investment spending by issuing either net 

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

overwhelmingly chosen debt financing. Net issuance of 

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

straight year. Corporate borrowing has also continued 

at a brisk pace; domestic commercial and industrial 

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

June 1999. 

A widening financing gap and increasing debt levels 

could pose future problems if there are adverse 

changes in the financial environment. For example, a 

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

their creditworthiness. Under such a scenario, firms 

might decide to curtail their capital expenditures, 

which would tend to reduce the rate of growth in the 

rest of the economy. 

Consumer Spending 

Continues to Grow 

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

in recent quarters, in contrast to previous expansions 

when the strongest growth in consumer spending 

occurred early in the recovery. One factor supporting 

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

more than 1.3 million units in fourth quarter 1998 and 

have remained near that level through third quarter 

1999. Existing home sales also have maintained a 

record pace of 5.3 million units on an annualized basis 

during the second and third quarters. Low mortgage 

interest rates and real income gains have combined to 

push housing affordability to its highest level in many 

years.3 

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

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

was 127.1. 

CHART 2 

The Financing Gap Has Widened 

for Nonfinancial Corporations 

Source: Federal Reserve Board (Haver Analytics) 

100 

200 

300 

400 

500 

600 

700 

800 

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

Billions of Dollars 

Capital Expenditures 

“Financing Gap” 

Cash Flow 

Rapid growth in consumer spending also warrants 

attention. Despite the highest rates of real income 

growth in nine years, consumer spending has grown 

more quickly than disposable personal income. The 

divergence in growth has resulted in a falling personal 

savings rate, which reached a record low in 1999.4 The 

recent decline in the personal savings rate continues a 

trend that has been under way for more than a decade 

(see Chart 3, next page).5 

Analysts cannot fully explain the reasons for the falling 

savings rate, although the “wealth effect” associated 

with the accumulation of capital gains by households is 

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

value of equities, mutual funds, and pension funds 

owned by households has risen by $6.8 trillion, while 

the value of owner-occupied housing net of mortgage 

debt has increased by $812 billion. This accumulation 

of wealth apparently has emboldened consumers to 

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

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

expenditures. The personal savings rate is equal to personal savings 

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

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

down the personal savings rate. 

5 The Bureau of Economic Analysis, which tabulates the personal 

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

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

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

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

quarter of 1999 was 2.1 percent. Although higher than previously 

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

downward trend similar to earlier savings rate estimates. 

Regional Outlook—National Edition 5 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 3 

Strong Consumer Spending Has Been 

Accompanied by a Falling Personal Savings Rate 

Source: Bureau of Economic Analysis (Haver Analytics) 

0.0 

2.0 

4.0 

6.0 

8.0 

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

0.0 

2.0 

4.0 

6.0 

8.0 

10.0 

Personal Savings Rate 

(Percent) 

Personal Consumption Spending 

(Percent change from year ago) 

1Q99 

ing growth exceeding income growth. For the most part, 

when consumers have chosen to convert capital gains to 

spendable cash, they have done so by borrowing—often 

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

accounts. 

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

income, especially if interest rates rise or income 

growth slows. Moreover, analysts express concerns 

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

slow the pace of consumer spending, leading to a 

reduced pace of economic growth. 

CHART 4 

The Growing Private Deficit Raises Concerns 

Taken together, the sum of annual net borrowing by 

businesses and households has been referred to as the 

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

budget of federal, state, and local governments moved 

from deficit to surplus, the private deficit rose sharply; 

between 1996 and 1998, it nearly doubled from $550 

billion to $1.02 trillion (see Chart 4). 

The private deficit was financed from three sources in 

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

government sector, the first surplus in 28 years. The 

largest portion of the 1998 private deficit was financed 

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

issue that is explored in more detail under Emerging 

Risks in Banking, below. Dependence on foreign capital 

raises questions about what might happen if the foreign 

sector becomes less willing to export capital to the 

United States. 

Recovery Abroad Is Changing 

the Terms of Trade 

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

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

mired in its worst recession in decades, while a number 

of countries in Asia, Latin America, and Eastern Europe 

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

Flow of Net Sectoral Lending (lending less borrowing), 

in Billions of Dollars 

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

Source: Federal Reserve Board (Haver Analytics) 

–1200 

–600 

0 

600 

1200 

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

Foreign Sector 

Domestic Financial Sector 

Nonfinancial Business 

Households 

Government 

Regional Outlook—National Edition 6 Fourth Quarter 1999 
In Focus This Quarter
 

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

economies, Germany and France in particular, have 

grown slowly following the imposition of tight fiscal 

and monetary policies in advance of the introduction of 

the euro on January 1, 1999. 

The net effect of this disparity in growth rates has been 

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

in exports and a 5 percent increase in imports. The 

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

have been felt primarily by the commodity industries— 

farming, mining, and basic manufacturing. In addition, 

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

1998, many foreign investors used their excess dollars 

to purchase dollar-denominated stocks and bonds. This 

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

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

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

capital outside the United States. The International 

Monetary Fund estimates that growth in the global 

economy will increase from 2.5 percent in 1998 to 3.0 

percent in 1999 and 3.5 percent in 2000.6 Foreign 

investors, in anticipation of stronger growth and greater 

investment opportunities abroad, have started to convert 

excess dollar holdings to other currencies, including the 

yen and euro. This change in investment strategy has put 

downward pressure on the value of the dollar. Between 

July and September 1999, the dollar lost approximately 

10 percent of its value against the yen. 

A falling dollar will likely contribute to a recovery of 

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

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

abroad. The index has signaled growing export orders 

for nine months through October 1999. As Chart 5 

shows, increasing export orders tend to lead the actual 

rise in exports by several months. 

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

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

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

prices of several important industrial commodities have 

6 International Monetary Fund, World Economic Outlook, October 

1999. 

CHART 5 

U.S. Exports Fell in 1998, but Rising 

Orders Point to Growth in 1999 

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

(NAPM) (Haver Analytics) 

–10 

–5 

0 

5 

10 

15 

20 

’93 ’94 ’95 ’96 ’97 ’98 ’99 

40 

45 

50 

55 

60 

65 

70 

U.S. Export Growth 

(Percent change from year ago) 

NAPM Export Orders Diffusion Index 

(Greater than 50 signals expansion) 

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

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

Domestically, the producer price index has risen by 

approximately 4 percent since the beginning of the year 

following a two-year decline, reflecting an increase in 

oil and intermediate goods prices. 

Interest rates have risen in step with renewed concerns 

about inflation. The constant maturity yield on 10-year 

Treasury bonds increased by approximately 140 basis 

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

short-term rates during the summer of 1999. 

The Economic Outlook Calls 

for Continued Growth 

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

has during the past few years. As discussed above, 

however, continued rapid growth would lead to even 

greater imbalances in the domestic economy and in the 

foreign sector. For this reason, most economists do not 

believe that rapid growth can continue indefinitely. 

Instead, analysts suggest two possible scenarios for the 

economy. 

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

Gross domestic product is projected to grow at a rate of 

3.8 percent in 1999 with somewhat slower growth of 2.8 

percent in 2000.7 Rising wage pressures, reflecting tight 

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

1999. 

Regional Outlook—National Edition 7 Fourth Quarter 1999 
In Focus This Quarter
 

labor markets across the nation, and economic recovery 

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

inflation. Improving growth prospects in the global 

economy may also lead to a stabilization of commodity 

prices, reversing a trend of falling prices that has until 

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

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

growth and faster expansion abroad would result in a 

rebalancing of global growth that should narrow the 

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

dollar. 

Although the consensus forecast calls for continued 

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

“hard landing.” Sharply higher interest rates, in 

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

investment and reduced consumer spending. Rising 

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

are rising. A significant and sustained decline in equity 

prices may occur if investors become pessimistic as the 

economy slows. The response of the world economy to 

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

been an important factor in supporting growth abroad. 

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

global growth could also slow, depending on the extent 

to which recoveries in Europe, Asia, and Latin America 

offset any shortfall in U.S. growth. 

Emerging Risks in Banking
 

Overview 

Favorable economic conditions continue to support 

strong loan growth and healthy loan performance 

among insured institutions. Net loss rates remain low 

relative to the early 1990s for almost every major loan 

category except consumer loans. Loss rates in domestic 

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

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

of weak commodity prices on farm incomes. Strong 

loan growth and low loan losses have helped banks 

achieve record and near-record high quarterly profits. 

However, rising indebtedness on the part of businesses 

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

deteriorate or if interest rates were to rise. 

Strategic responses to competitive pressures point to 

greater credit, market, and operational risks for the 

industry. Intense competition has pressured NIMs and 

has encouraged many lenders to seek higher returns by 

lending to less creditworthy borrowers. In order to 

maintain and grow profits, some insured institutions are 

expanding into activities such as subprime consumer 

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

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

increased their tolerance for risk. Competition has made 

funding with deposits more difficult. As a result, some 

institutions are relying increasingly on securitizations 

and more expensive, market-based sources of funds, 

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

have also responded to competitive pressures by cutting 

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

costs support profits at the expense of less effective 

operational controls. 

Consumer Lending 

Household Borrowing Is on the Rise 

Household borrowing is growing rapidly, consistent 

with high reported levels of consumer confidence and 

strong consumer spending. Mortgage debt, which grew 

by 10.4 percent in the second quarter from year-ago 

levels, is the fastest-growing segment of household 

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

and the use of mortgage loans to consolidate revolving 

debt balances. Nonrevolving debt grew by 7.3 percent 

in the year ending June 1999, largely because of strong 

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

revolving debt increased by only 5.7 percent during the 

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

Regional Outlook—National Edition 8 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 6 

Household Borrowing Is on the Rise, 

Led by Increases in Mortgage Debt 

Source: Federal Reserve Board (Haver Analytics) 

–10 

–5 

0 

5 

10 

15 

20 

25 

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

Percent Change from Year Ago 

Nonrevolving 

Home 

Mortgages Revolving 

A Mortgage Refinancing Boom Has Helped 

Consumers Consolidate Debt 

A key component of the recent shift by consumers from 

credit card debt to mortgage debt has been a surge in 

mortgage refinancing in 1998 and early 1999. The 

Mortgage Bankers Association’s Refinancing Index 

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

an average monthly index value of 527 during 1997.8 

Many households have refinanced their mortgages to 

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

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

1998 refinancing transactions, more than 3 million 

homeowners, or 51 percent of all mortgage-refinance 

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

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

of this survey, Bank One Corporation estimated that 

cash out refinancing added about $60 billion in cash 

flow to consumer pocketbooks last year. This extra cash 

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

consumer credit charge-offs.10 Rising interest rates 

appear to have ended this mortgage refinancing boom. 

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

100.
 

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

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

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

Street Journal, July 6, 1999.
 

tions about whether consumers again will increase their 

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

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

Credit Card Lenders Face Declining Returns 

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

the credit card industry has become characterized by 

overcapacity and declining margins. At the same time, 

the high level of mortgage refinancings and rising 

household incomes have reduced the dependence of 

consumers on credit card debt. Consequently, credit 

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

Overcapacity and declining margins have led lenders to 

search aggressively for new ways to increase revenues. 

One method they have adopted is to charge new fees 

that are triggered by cardholder behavior. Lenders are 

now charging fees for inactive accounts, fees to close 

accounts, and even customer service fees. In addition, 

they are reducing grace periods, curtailing leniency 

periods, and imposing higher penalty interest rates. 

According to RAM Research, banks’ income from 

credit card fees has grown 79 percent over the past two 

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

Shrinking margins have also prompted consolidation in 

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

credit card sector, up from just 35 percent in 1990.12 

Amid this changing competitive 

landscape, credit quality has 

improved. Credit card charge-off 

levels at insured commercial banks 

hit an all-time high of 5.5 percent 

in the third quarter of 1997 but 

have declined steadily to a level of 

4.1 percent in the second quarter of 

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

and extra household cash flow generated through mortgage refinancings. 

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

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

Regional Outlook—National Edition 9 Fourth Quarter 1999 
In Focus This Quarter
 

Subprime Lenders Have Riskier 

Characteristics than the Industry 

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

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

originations fell somewhat in 1998 to 10 percent—not 

because the volume of subprime mortgage originations 

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

subprime originations grew by 20 percent from 1997 to 

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

from the $35 billion in subprime originations in 1994. 

Estimates of the size of the subprime automobile loan 

market vary somewhere between $50 billion and $75 

billion, but one source estimates that subprime automobile originations jumped 

from about 8 percent of all 

automobile loan originations 

in 1990 to over 18 percent in 

1998.14 Analysts also have indicated that the subprime 

credit card market is the fastest-growing segment of 

credit card lending today. According to RAM 

Research, subprime receivables are growing 45 percent 

annually, compared with 16 percent or less for other 

segments of credit card lending.15 

Intense competitive pressure has contributed to the 

expansion of bank and thrift participation in subprime 

consumer lending. These loan programs offer higher 

margins than prime consumer lending products and 

have become an attractive alternative for banks and 

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

types. Moreover, the shakeout in the subprime specialty 

finance industry has provided new opportunities for 

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

acquire, a subprime specialty finance company. Bank 

and thrift involvement in subprime lending is expected 

to increase. In fact, some industry analysts predict that 

insured depository institutions with subprime affiliates 

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

14 Ron Feldman, An Introduction to Subprime Auto Lending for 

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

data supplied by CNW Marketing and Research. 

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

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

will overtake finance companies as leaders in the subprime industry. 

Subprime lending poses entirely new challenges in risk 

management for insured institutions. Not only are 

expected credit losses higher than for prime consumer 

lending, but a number of factors suggest that losses are 

also less predictable: 

•	 Subprime borrowers are more likely to default than 

prime borrowers and may be more vulnerable to 

economic shocks, such as a recession. Borrowers’ 

previous credit problems suggest that they have 

limited financial resources to withstand economic 

difficulties. 

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

Analysts have noted that credit-scoring models 

are less effective in predicting the likelihood of 

default for subprime borrowers than they are for 

prime borrowers. 

•	 Operational risks are greater in subprime lending. 

Because defaults occur sooner and more often than 

in prime lending, subprime portfolios require a 

greater investment in servicing and collections 

resources. Subprime lenders run a greater risk that 

these resources could become severely strained if the 

level of defaults is not correctly anticipated. 

•	 Liquidity risks are greater in subprime lending. 

Some large-volume subprime lenders heavily depend 

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

backed by subprime loans may be volatile, as was 

demonstrated during the financial market turmoil of 

late 1998. A number of nonbank subprime lenders 

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

into—bankruptcy.16 

•	 Reputation, legal, and compliance risks also are 

important for subprime lenders. Subprime lenders 

generally run a greater risk of violating, or being 

accused of violating, consumer protection laws or 

regulations. The public perception of subprime 

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

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

Regional Outlook—National Edition 10	 Fourth Quarter 1999 
In Focus This Quarter
 

lenders could be tarnished if a recession were to 

result in substantially higher default rates. 

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

concerns, FDIC Chairman Donna Tanoue recently 

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

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

subprime lending and ties capital adequacy to the types 

and levels of risks that individual subprime lenders have 

in their portfolios. This proposal will be shared with 

other federal regulators to refine a final approach. 

Commercial and Industrial Lending 

Commercial and Industrial Loan 

Losses Have Been on the Rise 

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

grew almost 12.5 percent during the year ending in June 

1999 and accounted for 40 percent of all net new loans 

booked during that period. 

Although commercial loan losses are low, there are 

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

of 1999 more than doubled from 1998 levels, while 

noncurrent domestic C&I loans rose by 26 percent. 

Examiners also have reported increasing problems in 

commercial portfolios. The Office of the Comptroller 

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

Credits rose 70 percent during a recent annual review.18 

Slower profit growth and rising corporate bond defaults 

also point toward somewhat weaker business credit 

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

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

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

credit program is a cooperative interagency program to review large 

credits held at several institutions. Loans subject to review include 

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

more participating lenders. 

quality. While corporate profits grew by an average of 

15 percent per year between 1993 and 1996, economists 

polled by Blue Chip Economic Indicators project 

growth of 6.7 percent for all of 1999, followed by 

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

reported that 55 rated issuers defaulted on $20.5 billion 

in debt during the first six months of 1999.20 This pace 

of defaults is already nearly double levels experienced 

in the first half of 1998 and does not include more 

recent large defaults such as Iridium and Daewoo 

Group. Approximately 85 percent of the defaults that 

occurred during the first half of 1999 were among 

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

bond defaults rose to 5.8 percent of issues outstanding 

during the 12 months ending in September 1999, the 

highest level since 1991. 

Rising Losses May Be Attributable 

to Loose Underwriting 

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

the corporate debt markets during 1997 and early 

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

Board reported in its May 1998 Senior Loan Officer 

Opinion Survey on Bank Lending Practices that 

domestic banks were “generally eager to make loans to 

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

tightening of business lending practices” associated 

with the financial market turmoil in progress at that 

time. However, regulators have continued to express 

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

sent by the Federal Reserve Board of Governors to its 

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

remain,” which relate mainly to overoptimistic 

assumptions about the future repayment capacity of 

business borrowers.22 

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

1999.
 

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

1999.
 

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

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

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

boarddocs/SRLETTERS/1999/SR9923.HTM).
 

Regional Outlook—National Edition 11 Fourth Quarter 1999 
In Focus This Quarter
 

Leveraged Lending Has Been the Predominant 

Type of Syndicated Lending 

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

leveraged lending was the fastest-growing segment of 

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

the first half of 1998, syndicated lending to leveraged 

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

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

shown in Chart 7, loans to leveraged companies are 

making up a growing proportion of syndicated loan 

originations. 

Factors driving growth in leveraged lending include a 

high volume of corporate mergers and acquisitions, 

increasing investor demand for higher-yielding loans, 

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

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

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

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

the industry average. Loan Pricing Corporation defines “leveraged 

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

LIBOR. 

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

for which pricing exceeds 225 basis points over LIBOR. 

25 According to Mergerstat, the value of mergers and acquisitions 

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

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

43 percent increase over issuance in the first quarter. 

CHART 7 

Loans to Leveraged Companies
 

Are Making Up A Greater Proportion of
 

Syndicated Loan Originations
 

Originations of Syndicated Loans to Leveraged Companies
 

As a Percentage of Total Syndicated Loans Dollars in Billions 

32% 

350 

300 

60 

50 

250 40 

200 

30 150 

20 100 

10 50 

0 

’90 ’92 ’94 ’96 ’98 ’99:1H* 

0 

* First half, annualized 

Source: Loan Pricing Corporation 

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

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

retained by banks.26 

Commercial Real Estate 

and Construction Lending 

Construction Loan Volume Continues to Rise 

Loans for real estate construction and development 

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

bank balance sheets, increasing 24 percent during the 

year ending June 1999. Compared with construction 

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

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

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

completions increasing 17 percent from a year ago. In 

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

past-due ratios for construction and development loans 

remain very low by historical standards, as indicated in 

Chart 8. 

Office Vacancy Rates Are Rising 

in Many Top Markets 

In previously published reports, Division of Insurance 

analysts identified nine metropolitan real estate markets 

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

commercial space demand indicators, and independent 

market analysts’ projections. Six of the metropolitan 

areas identified—Atlanta, Phoenix, Orlando, Portland, 

Dallas, and Nashville—subsequently experienced large 

increases in office vacancy rates during the first half of 

1999. These areas have also experienced reduced 

employment growth and slowing net in-migration. 

Higher vacancy rates are often accompanied by slower 

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

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

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

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

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

Overbuilding in Commercial Real Estate Markets,” Bank Trends, 

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

bank/analytical/bank/bt9807.html). 

Regional Outlook—National Edition 12 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 8 

Construction Loan Volume Continues to Rise, 

but Problem Loans Remain Low 

* First half 

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

Construction and Development Loans 

0 

75 

150 

225 

’84 ’87 ’90 ’93 ’96 ’99:1H* 

0 

2 

4 

6 

8 

10 

12 

14 

Percent Nonaccrual Rate 

(Right Scale) 

Loss Rate 

(Right Scale) 

Volume in billions of dollars 

(Left Scale) 

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

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

rates slowed noticeably from the pace of the previous 

three years.28 

Surveys Suggest Tighter Standards 

in Commercial Real Estate Lending 

Evaluations of bank loan underwriting suggest a recent 

tightening of lending standards for commercial real 

estate loans. The August 1999 Federal Reserve Board 

Senior Loan Officer Opinion Survey reported a net 

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

FDIC’s March 1999 Report on Underwriting Practices 

also found fewer instances of risky lending practices 

with respect to commercial real estate and construction 

lending than in prior reports. The FDIC’s September 

Report showed no significant changes in lending 

standards. 

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

operating in three of the fastest-growing metropolitan 

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

Results indicated that competition was generally driving 

pricing margins down to very low levels, particularly 

28 Vacancy rates and rental growth rates were obtained from REIS 

Reports. 

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

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

compared with the 1980s. In some instances, lenders 

have responded to competitive pressures by making 

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

and recourse terms, particularly for large borrowers. 

However, underwriting standards generally have not 

been as aggressive as practices observed in the 1980s. 

Agricultural Lending 

Low Commodity Prices Stress 

the Agriculture Industry 

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

are creating financial difficulties for farmers in the 

nation’s midsection. Several consecutive years of high 

worldwide production have resulted in large inventories 

of grains and oilseeds, which have depressed prices. 

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

are also low by historical standards. The United States 

Department of Agriculture (USDA) forecasts for 2000 

show little likelihood of improvement in prices.30 

The financial outlook for significant portions of the 

farm sector has deteriorated. The USDA projects that 

farm income from operations will decline by around 15 

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

farm income is projected to decline less 

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

between operating income and total net 

income.31 Legislation passed in October 

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

Farm Banks Continue 

to Perform Well Overall 

Despite the difficulties created by low farm prices, the 

overall financial condition of the 2,250 FDIC-insured 

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

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

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

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

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

of their loans in agricultural production or secured by agricultural real 

estate. 

Regional Outlook—National Edition 13 Fourth Quarter 1999 
In Focus This Quarter
 

1999.33 Loan loss reserves, which stood at 1.58 percent 

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

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

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

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

Moreover, this increase in past-due loans is attributable 

entirely to nonagricultural loans; the level of past-due 

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

same time, higher-than-average nonperforming loan 

levels have been reported by farm banks in the upper 

Midwest and the South. 

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

time for financial distress among farm producers to 

significantly affect loan performance at farm banks. 

One such reason is the increasing use of carryover debt 

to restructure and extend operating loans that cannot 

be fully retired by borrowers during the current crop 

year. The most recent Survey of Agricultural Credit 

Conditions conducted by the Federal Reserve Bank of 

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

An increase in carryover debt was also noted in 

the FDIC’s March 1999 Report on Underwriting 

Practices, which indicated that almost one-third 

of FDIC-supervised farm banks experienced at least 

a “moderate” increase in agricultural carryover debt 

during the preceding six-month period.35 Although the 

use of carryover debt is not an uncommon practice in 

agricultural lending, it can be a leading indicator of 

declining loan performance. Chart 9 shows that 

increases in carryover debt by Tenth District farm 

banks in 1995 preceded increased loan losses during 

1996. 

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

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

this tax treatment on reported profitability, farm bank ROA levels 

may not be comparable with ratios from prior periods. 

34 Survey of Agricultural Credit Conditions, Federal Reserve Bank of 

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

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

Wyoming, northern New Mexico, and western Missouri. 

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

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

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

ro19993q/kc/k3q1999.pdf). 

CHART 9 

Rising Levels of Carryover Debt Suggest Future 

Increases in Loan Losses at Farm Banks 

Reports (Research Information System) 

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

–30% 

–10% 

10% 

30% 

50% 

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

–1.0% 

–0.5% 

0.0% 

0.5% 

1.0% 

1.5% 

Net Percentage Reporting 

Higher Agricultural Loan 

Renewals and Extensions 

Moving 4-quarter 

Charge-Off Rate

 (percent) 

Agricultural Production Loans 

(right scale) 

Funding and Interest Rate Risk 

Lagging Deposit Growth Has Led to Greater 

Reliance on Market-Based Funding 

For most of the 1990s, banking industry asset growth 

has outstripped growth in deposits, creating greater 

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

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

reflects this shift. Deposit growth has not kept pace with 

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

savings by households and competition for depositor 

funds from higher-yielding investment alternatives and 

nonbanks. Lagging deposit growth is particularly 

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

assets than do larger banks.36 Greater dependence on 

market-based funding can alter the liquidity and interest 

rate risk positions of institutions and may require 

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

Growth in Securitization Affects Underwriting 

and the Structure of Bank Balance Sheets 

Banks, and nonbanks in particular, continue to employ 

the securitization market to fund lending activities. 

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

Challenges for Community Banks,” Regional Outlook, Third Quarter 

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

t3q1999.pdf). 

Regional Outlook—National Edition 14 Fourth Quarter 1999 
In Focus This Quarter
 

Issuance of asset-backed securities and commercial 

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

for another record year. Including participation through 

credit card companies and CMBS conduit programs, 

bank-related issuance amounted to about 25 percent of 

total issuance in 1998, a decline from 1997 levels. 

Although insured institutions are not dominant players, 

growth in the securitization market can influence loan 

underwriting practices and the structure of bank balance 

sheets. 

The securitization market competes to originate loans 

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

support lending pipelines. Recent trends indicate that 

this competition has intensified. For example, market 

observers note that the subordination levels in the 

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

capital.37 

When banks do securitize, it is not always clear how 

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

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

revolving structures, such as those used to securitize 

credit cards, eliminate only the most catastrophic credit 

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

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

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

issuer, but also the amount of effective leverage achievable through 

securitization. 

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

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

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

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

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

volatile and can lead to unstable earnings and capital if 

not properly controlled and administered. 

Banks and Thrifts Appear Increasingly 

Vulnerable to Rising Interest Rates 

Potentially volatile liabilities and long-term assets 

have been growing as a percentage of banking assets. 

Consistent with reduced deposit funding by insured 

institutions, more market-based and potentially volatile 

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

At the same time, the lengthening maturity of insured 

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

frequencies of greater than five years. This trend in 

mortgage portfolios is primarily responsible for the 

thrift industry’s increasing interest rate sensitivity. 

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

1999 for the third consecutive quarter. 

39 Volatile liabilities include borrowings, federal funds purchased, 

repurchase agreements, jumbo certificates of deposit, foreign 

deposits, and trading liabilities. 

CHART 10 

Long-Term Assets and Volatile Liabilities
 

Have Been Growing as a Percentage
 

of Total Assets
 

Percentage of 

Total Assets 

35 

30 

25 

20 

15 

10 

Volatile Liabilities 

Long-Term Assets 

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

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

five years.
 

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

Regional Outlook—National Edition 15 Fourth Quarter 1999 
In Focus This Quarter
 

Operational Risks 

Insured banks and thrifts face numerous business- and 

process-oriented operational risks on a daily basis. At 

the same time, recent industry developments and bank 

failures have highlighted the importance of maintaining 

strong operations. The Basle Committee on Banking 

Supervision reported in late 1998 that “awareness of 

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

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

greater efficiency by cutting costs. In some cases, deep 

cuts in overhead expenses may weaken the effectiveness 

of operating and monitoring systems as well as internal 

controls. Anecdotal evidence from banking regulators 

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

and new business activities are creating bigger, more 

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

issues are important since operational weaknesses may 

leave institutions more vulnerable to adverse economic 

conditions, insider abuse, or fraud. 

Implications 

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

economic expansion that has been conducive to a high 

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

environment and less robust financial performance for 

insured institutions in the future. 

One issue raised by this report is rising indebtedness on 

the part of households and businesses, which represents 

a growing private deficit. Rising interest rates could 

40 “Operational Risk Management,” Basle Committee on Banking 

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

increase the debt service burden for consumers and 

businesses, making them more vulnerable to a slowing 

economy. An increasing private deficit is problematic 

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

the potential to create problems for the economy and for 

lenders. Dependence on foreign capital makes U.S. 

inflation and interest rates highly subject to changes in 

the decisions of foreign investors and the value of the 

dollar. The rapid pace of credit creation by the financial 

sector threatens to impair credit quality. The intuition 

that loose underwriting standards can lead to credit 

quality problems is supported by recent signs of rising 

credit losses in a strong economy. 

The second issue that cuts across this report is the effect 

that competition is having on banking strategies and 

exposures to credit, market, and operational risks. There 

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

leveraged corporate borrowers. There is also evidence 

that institutions are pursuing asset-liability structures 

with higher levels of interest rate risk to maintain loan 

growth and meet funding needs. Finally, some of the 

innovations banks have used to counter competitive 

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

The third issue is the increasing potential for financial 

market instability, which leaves the economy and the 

banking system vulnerable to sudden shocks. Events 

from fall 1998 showed some of the more damaging 

aspects of these crises, as market-based financing went 

from abundance to scarcity virtually overnight. The 

financial imbalances associated with the rapid creation 

of credit and borrowing from abroad not only create the 

need for the economy to slow down eventually, but also 

threaten to make that adjustment process a 

volatile one. Financial market shocks 

could quickly alter the confidence of 

consumers and businesses and their 

access to financing. Such instability 

could end the current expansion and 

expose underlying weaknesses in 

bank risk-management practices. 

Regional Outlook—National Edition 16 Fourth Quarter 1999 
In Focus This Quarter
 

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

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

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

Steven K. Burton, Senior Banking Analyst 

Steven E. Cunningham, Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Arlinda Sothoron, Senior Financial Analyst 

Jack Taylor, Senior Financial Analyst 

Regional Outlook—National Edition 17 Fourth Quarter 1999 
Regional Perspectives
 

Atlanta Regional Perspectives
 

The Atlanta Region’s economic growth exceeded that 

of the nation, although job growth moderated during 

the first half of 1999. Recently, however, some rural 

areas have experienced declines in the mining, manufacturing, and agricultural sectors. 

Growth remains very strong in metropolitan markets, but could be constrained by tight labor markets. Urban areas have experienced exceptionally low 

levels of unemployment, high 

rates of in-migration and corporate expansion and relocation, 

and strong real estate construction activity. However, the strong 

growth has led to rising labor shortages, particularly among less-skilled 

workers. In addition, between 1995 

and 1998, total compensation 

growth has trended upward. Inability to pass on these higher costs in 

highly competitive markets could affect businesses’ 

profit margins. High levels of construction activity have 

resulted in above-average and increasing construction 

and development lending exposure in several metropolitan areas. 

Gains in rural counties have not been as pronounced 

as in urban areas. Declining agricultural commodity 

prices, widespread drought, and destruction caused by 

recent hurricanes have hurt many farmers, particularly 

those who began 1999 in a weakened financial state. 

Many rural areas also have seen losses in the textile and 

apparel and coal mining industries. Increasing economic stress in rural areas can adversely affect credit quality as struggling businesses and displaced workers 

encounter difficulties servicing their debt. 

Insured institution performance reflects the differences between the Region’s urban and rural areas. 

Favorable growth and earnings among institutions 

in metropolitan areas have resulted in heavy de novo 

activity in high-growth markets, while asset quality in 

some rural institutions has weakened because of pressures in the agriculture, textiles and apparel, steel, and 

coal industries. 

Geographically diverse financial institutions may be 

better positioned to weather economic slowdowns. In 

contrast, smaller financial institutions may be more at 

risk to local economic volatility. Already, small banks in 

Alabama and West Virginia, states experiencing 

declining manufacturing sectors, report loan delinquencies above the Atlanta Region average. 

An increase in noncore funding emphasizes the 

importance of asset-side liquidity. Atlanta Region 

banks are relying increasingly on borrowings and noncore deposits to fund asset growth. The potential volatility of these types of funds raises the question of whether 

liquidity needs, particularly on the asset side, have 

grown more acute. This question is particularly important because off-balance-sheet lending commitments 

are at the highest levels in a decade. The shift in funding composition also has earnings and interest rate risk 

implications, as the potentially higher interest cost of 

noncore funding might lead some banks to sacrifice 

liquidity, either by extending maturities or by assuming 

more credit risk, in search of higher asset yields. 

The mix within loan and investment portfolios at 

Atlanta Region banks has changed substantively 

over the past decade. However, allocations among 

broad asset categories, such as cash, securities, and 

loans, have not changed significantly. For example, 

banks have been moving out of U.S. Treasury securities 

and into agency- and mortgage-backed securities 

(MBS), thus extending portfolio maturities and increasing banks’ sensitivity to interest rate fluctuations. However, the typical loan portfolio maturity structure is 

longer now than a decade ago, as residential mortgages 

have increased relative to shorter-term consumer and 

commercial and industrial loans. The shift has allowed 

Atlanta Region banks to earn higher yields over Treasuries, however, and given the size and transaction volume of the MBS market, the liquidity trade-off likely 

has been modest. 

Balance sheet structures continue to evolve, and 

asset/liability management becomes more complex 

as new interest rate and market sensitivities are 

introduced. Liquidity sources have increased on both 

sides of the balance sheet with expanded secondary 

loan markets and expanded bank borrowing opportunities. However, the stability of these sources has not been 

tested in a protracted down market. The challenge for 

bank managers going forward is to maintain an asset 

allocation that balances liquidity needs with an acceptable and stable return. 

Regional Outlook—National Edition 18 Fourth Quarter 1999 
Regional Perspectives
 

Boston Regional Perspectives
 

The Boston Region had a more marked deceleration 

in job growth than the nation during the first eight 

months of 1999. As in 1998, job growth was stronger in 

the northern three states than in Connecticut, Massachusetts, and Rhode Island. Across sectors, only manufacturing payrolls declined during the first eight 

months. Job growth trailed the nation’s rate in all sectors 

except construction, where the New England states generally experienced gains that exceeded the nation’s. 

Home prices rose, but sales and building activity slowed 

in 1999. 

The Boston Region’s insured institutions performed 

well through June 1999, but several key indicators 

show signs of deterioration. Asset quality remained 

favorable and net charge-offs, though still low, 

increased slightly. Noninterest income helped to support earnings as net interest income declined. Profitability measures compared favorably with national 

levels but were below prior-year averages. Aggregate 

earnings numbers were driven largely by subsidiaries of 

the Region’s three largest banking organizations, which 

accounted for 52 percent of the Region’s total assets. 

Commercial office markets remained healthy 

throughout the Region in the first half of 1999. 

Office markets performed well throughout the Region 

as vacancy rates continued to fall, especially in 

Boston’s central business district. Office vacancy rates 

also fell in Stamford, New Haven, and southern New 

Hampshire, while Hartford’s rates remained steady. 

Although office markets performed well, retail and 

industrial markets experienced mixed results. Construction and development and commercial real estate loan 

activity has been increasing in institutions with assets 

less than $1 billion over the past few years; however, 

concentration levels to Tier One capital remain low 

compared with peak levels reached in the late 1980s. 

Commercial lending has grown considerably in the 

Region’s insured institutions. Commercial loans 

increased about 14 percent per year for each of the past 

three years, the highest growth rate of any loan type 

except credit card loans. From a low in June 1993, commercial loan concentration levels have been rising 

steadily toward high levels reached in the mid-1980s. 

Should earnings soften or interest rates rise, borrowers 

with high levels of commercial debt will face higher 

debt service burdens, which may increase commercial 

loan delinquency levels. 

Small-business loans in Boston 

Region insured institutions have 

increased almost 3.5 percent per 

year since 1993. This type of lending does not appear to have 

kept pace with overall asset 

and loan growth. Institutions 

with assets over $1 billion 

have experienced the most 

rapid growth during the past 

year in this loan category, with a 

growth rate of 19 percent. However, accurately measuring small-business loan growth 

is difficult because borrowers obtain financing from a 

variety of sources. Community Reinvestment Act data 

provided by the Federal Financial Institutions Examination Council for 1998 show that 19 percent of the 

total small-business loans made by FDIC-insured institutions to borrowers in the Region were made by 

lenders headquartered elsewhere in the country. These 

out-of-Region lenders are most active in the category 

of loans less than $100,000 and generate 57 percent of 

the total number of loans of that size but only 30 percent of the total dollars. These statistics show that these 

lenders are pursuing the smaller dollar loans in this category more aggressively. 

Regional Outlook—National Edition 19 Fourth Quarter 1999 
Regional Perspectives
 

Chicago Regional Perspectives
 

Economic conditions are generally healthy; however, 

some sectors are beginning to show signs of a slowdown. The Region’s low unemployment rate—4.1 percent or less since late 1997—shows that labor markets 

are tight. Slower domestic demand growth, weak 

demand from abroad, and the loss of some customers to 

foreign producers are accompanying this labor shortage 

and contributing to the slowdown of the Region’s industrial output growth. 

High activity in commercial real estate 

markets is partially cushioning the 

impact of slower gains in the industrial sector. While scattered 

pockets of “hot” construction 

activity have been reported in 

a few metropolitan statistical 

areas (MSAs), overall vacancy 

rates in large MSAs have not 

risen noticeably, suggesting that 

supply and demand are balanced. 

Rapid appreciation in asset values is another distinguishing feature of this expansion. Without the wealth 

effect generated by their rising net worth, households’ 

spending growth likely would have moderated noticeably by now. The risk ahead is that a sudden drop in 

asset values, should one occur, could trigger a sharp, 

swift decline in households’ discretionary spending. A 

sharp drop in stock prices also could limit businesses’ 

access to capital markets. The potential impacts on 

insured institutions include reduced collateral values 

and increased use of unsecured lines of credit. 

An unusually low inflation rate is contributing to interest rates that, although rising, at midyear were still near 

the lowest levels of the expansion. Low interest rates 

have contributed to strong real estate markets and 

wealth creation. 

At insured institutions, growth in commercial and 

industrial loans is outpacing the growth in total loan 

portfolios, which is typical of a mature expansion. This 

trend partly reflects the fact that businesses are relying 

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

Profitability among banks and thrifts remained solid 

during the first half of 1999. The stability in earnings 

performance reported by commercial banks was heavily dependent on increases in noninterest income 

(NONII). The growing use of NONII by the Region’s 

commercial institutions has helped to sustain overall 

profitability despite lower margins and rising noninterest expenses. For thrifts, earnings performance 

remained stable, in part because of a shift in asset mix. 

The declining interest rate environment has led to a 

migration from lower-yielding residential mortgages 

toward higher-yielding consumer loans and commercial 

and industrial obligations. 

Agricultural weakness continues. Abundant supply, 

sagging demand, and increased competition from 

abroad led to depressed crop prices, and as a result, 

farm cash receipts and farmland values have declined. 

A significant portion of the Region’s agricultural loans 

is held by small institutions whose reported asset quality measures are showing some signs of deterioration. 

The declining coverage ratio suggests that commercial 

banks may not have made sufficient provisions for 

loan losses, which may affect the quality of future 

earnings. 

Several factors have contributed to an increase in 

new bank formation. The record profitability of the 

banking industry has led to an average of 17 new bank 

openings annually since 1990, with the majority in 

established urban areas. The strength and longevity of 

the current economic expansion and a strong stock market have also helped drive new bank creation in the 

Region. In addition, industry consolidation has contributed to the formation of new banks as displaced 

banking executives and other entrepreneurs look to provide small-business financing and personal banking to 

the local community. 

The significant growth in new institution formation taking place this late in an economic expansion may be 

cause for concern. Higher levels of commercial lending, 

increased use of noncore funding, and declining earnings could excessively strain new banks during an economic downturn. Many of these new banks are untested 

during a recession. 

Regional Outlook—National Edition 20 Fourth Quarter 1999 
Regional Perspectives
 

Dallas Regional Perspectives
 

The Dallas Region’s economy continued to moderate 

during the second quarter. The Region’s states, with 

the exception of New Mexico, experienced slower, 

more sustainable growth rates in the past year compared 

with robust levels in the mid-1990s. All states in the 

Region, however, experienced falling unemployment 

rates for the 12 months ending August 1999. Declines in 

unemployment continue to reflect tight labor markets. 

Despite mortgage interest rates rising to the highest 

level in two years, new and existing home sales as well 

as home building continued to post strong numbers 

through the summer. Issuance of single-family building 

permits for the first seven months of 1999 exceeded last 

year’s pace by 5 percent, reflecting the strong demand in 

the Dallas Region for new homes. The Region’s hot 

housing market, however, is expected to cool by yearend. Slower job growth and higher mortgage rates and 

home prices are expected to constrain home sales and 

home-building activity in 2000. 

Financial institutions continue to report healthy conditions. The Dallas Region’s average return on assets 

(ROA) was 1.34 percent for second-quarter 1999, 13 

basis points higher than the nation’s ROA and 23 basis 

points higher than the Region’s first-quarter ROA. The 

Region’s average charge-off and past-due rates showed 

improvement over the prior quarter and compare favorably with national averages. 

Oklahoma agricultural banks, however, are beginning 

to show signs of stress. The overall past-due ratio for 

these institutions was 3.43 percent, as of June 30, 1999, 

significantly higher than the 2.63 percent for all other 

agricultural banks in the nation and the 1.98 percent for 

all banks in the nation. The deterioration in credit quality is attributable, in part, to weather-related problems 

and, more recently, low commodity prices. Continued 

low commodity prices will place additional pressure on 

agricultural producers, rural economies, and banks in 

agriculturally concentrated areas. 

The Small Business and Job Protection Act of 1996 

created the S corporation tax-advantaged status. 

Since enactment of this legislation, 313 banks and 

thrifts in the Dallas Region have elected sub S status. 

These institutions represent 24 percent of all sub 

S banks nationwide. An S corporation is treated as a 

pass-through entity similar to a partnership and is not 

subject to federal income tax at the corporate level. The 

overall tax burden is usually reduced for a bank and its 

shareholders. 

While sub S status offers tangible benefits to bank 

shareholders, there are downsides. Safety and soundness issues may arise if an institution needs additional 

capital or is prohibited from issuing dividends to pay 

shareholder tax liability. In addition, the conversion of a 

significant number of small institutions to sub S status 

makes performance comparisons over time more difficult and may mask earnings deterioration in non-sub S 

banks. 

The Dallas Region has a higher percentage of securities on its balance sheet than any other Region. As 

of June 30, 1999, financial institutions in the Dallas 

Region had invested 27 percent of total assets in securities, compared with 19 percent for the rest of the nation. 

A lower cost of funding and a 

conservative mind-set rooted in 

the 1980s real estate and oil 

crisis help explain why the 

Region’s commercial banks 

maintain competitive profitability levels despite a relatively low loan-to-asset ratio. 

The higher allocation of securities 

may indicate a conscious choice to reduce 

credit risk; however, the potential exists for 

increased levels of interest rate risk and market risk. 

Mortgage-backed securities (MBS) with lengthening 

maturities expose the Region’s balance sheet to 

rising interest rates. MBS represented over half the 

Region’s total securities portfolio as of June 30, 1999. 

While MBS maturities lengthened for the nation and the 

Region, 62 percent of the Region’s MBS have maturities 

in excess of 15 years, significantly longer than the 

national average. As emphasized in previous articles, 

the unique asset mix of financial institutions in the 

Dallas Region may reduce levels of credit risk; however, holding a greater percentage of securities may also 

expose many institutions to higher levels of interest rate 

risk and market risk. 

Regional Outlook—National Edition 21 Fourth Quarter 1999 
Regional Perspectives
 

Kansas City Regional Perspectives
 

The Region’s economy remained strong through the 

summer months. Average nonfarm employment 

through July increased from year-ago levels, and unemployment remained significantly below the national 

average. The agricultural sector continued to experience 

stress, as the U.S. Department of Agriculture forecasts 

low prices for major commodities through 2000. In the 

aggregate, as of June 30, 1999, the 

Region’s farm banks continued to 

report strong earnings, capital, and 

loan loss reserve levels, as well as 

moderate levels of delinquent loans. 

However, continued low commodity 

prices could signal higher levels of 

problem loans in the near term. 

Despite steadily increasing competition in recent 

years from nonbanks (such as mutual fund companies, credit unions, Internet banking alternatives, 

and the Farm Credit System), community banks 

have performed well in the 1990s. Reported capital 

levels are strong, delinquent loan levels have remained 

moderate, and loan loss reserve levels appear adequate. 

Many of the Region’s rural community banks, however, have experienced less direct competition from 

large institutions than from metropolitan community banks. This phenomenon is largely a result of four 

factors: rural areas’ smaller population bases; the vast 

geography of the Region, which could make large rural 

branch structures unworkable; past restrictions on interstate banking and branching; and rural banks’ strong 

personal relationships with their customers, which large 

banks may perceive as difficult to penetrate. This situation, however, may be changing. 

Existing unitary thrift holding companies, with a 

significant presence in the Region, could intensify 

competition in rural areas. An exemption in financial 

services law that allows commercial companies to purchase or charter thrifts has presented significant opportunities for nonbanking companies, such as insurance 

companies, securities firms, and commercial entities, to 

enter the financial services arena. Since January 1, 

1997, 81 nonbanking companies have filed applications 

with the Office of Thrift Supervision to establish a new 

thrift charter or purchase an existing thrift. However, 

provisions included in financial modernization legislation pending in Congress would eliminate this exemption and prohibit commercial companies from creating 

or purchasing unitary thrifts. 

Financial reform legislation also would allow insurance companies, securities firms, and banks to affiliate, potentially creating large financial services 

conglomerates that could become significant competitors in the Region. Certain existing unitary thrifts, 

insurance companies, and brokerage firms already have 

significant operations in the Region’s rural areas, and as 

these institutions expand their banking business, they 

could represent the first significant form of competition 

from large institutions for many of the Region’s rural 

community banks. 

The results of this increased competition could be 

seen on both sides of community banks’ balance 

sheets, affecting net interest margins and funding 

strategies. Furthermore, increased competition could 

increase rural banks’ level of credit risk, diminish loan 

portfolio diversification, and reduce opportunities to 

generate noninterest income. 

Regional Outlook—National Edition 22 Fourth Quarter 1999 
Regional Perspectives
 

Memphis Regional Perspectives
 

The Region’s economy continues to underperform 

that of the nation. Nonagricultural payroll employment 

growth dropped sharply since mid-1998 (see chart 

below) because of slowdowns in manufacturing and energy sector job losses. 

Regional Employment Growth Has Dropped 

Sharply since Midyear 1998 

Source: Bureau of Labor Statistics, Payroll Establishment Survey Year-over-Year Job Growth (%) 

0 

1 

2 

3 

4 

5 

1999 

Memphis Region 

Nation 

1993 1994 1995 1996 1997 1998 

The outlook is unfavorable for much of the agricultural sector. Several factors are pressuring an already 

stressed farm economy, including a second year of 

adverse growing conditions in some areas, and continued low crop prices. 

Earnings performance of the Region’s agricultural 

lenders is being adversely affected by conditions in the 

sector. During the first six months of 1999, provisions 

for loan losses were 14 basis points higher than in the 

same period in 1998. The higher provision expense contributed to an overall 19-basis-point decline in reported 

return on assets (ROA). Agricultural lenders and their 

communities likely will continue to be adversely affected as high existing stocks will keep prices low in the 

near term, absent any supply shocks. 

Overall banking conditions remain favorable, 

although earnings performance continues to decline. An 

average ROA of 0.99 was reported during the first six 

months of 1999, down 19 basis points from the same 

period in 1998. Increasing competition for loans and 

funding contributed to a sharp decline in net interest margins. Other financial ratios generally reflect improvement 

over the first six months of 1998, with higher leverage 

capital ratios and lower past-due loan ratios reported. 

Recently established banks represent a higher portion 

of the Region’s existing banks than at any other time 

in the previous 30 years. Almost 11 percent of all 

insured institutions in the Region have been established 

since 1991 and have not experienced an economic downturn. Several factors may be contributing to the rising 

level of new banks, including record industry profitability in the mid-1990s; strength and longevity of the current 

economic expansion; and significant industry consolidation in recent years. 

New banks typically report operating losses followed by 

gradual improvement in profitability. Weak initial earnings performance is attributable to start-up costs, high 

overhead expense relative to a smaller earning assets 

base, and an initially heavy reliance on higher-cost noncore funding sources. 

The rate of new institutions’ initial 

earnings improvement appears to be 

slowing, suggesting that the climate for 

new bank performance has worsened 

since the middle of this decade. Nationally, the median ROA for new banks during 

their third year of operation declined in 

recent years from levels reported earlier in 

the expansion. Consistent with this trend, new banks in 

the Memphis Region are taking slightly longer to reach 

initial profitability than in prior periods. 

New banks also are more susceptible to economic 

downturns, on the basis of a review of bank failures 

from 1980 to 1992, a period encompassing three recessions. Of Memphis Region banks established during or 

immediately before that time, 17.7 percent failed. This 

failure rate is more than double that of established 

banks during the period. Factors contributing to the 

higher failure rate include lower earnings levels that 

provide a more limited cushion to absorb credit losses; 

concentrations of higher risk assets; and loan portfolios 

encompassing disproportionately high numbers of 

unseasoned borrowers. 

The significant growth in new banks late in an economic 

expansion may be cause for concern. The risk of failure 

for new banks is highest after the first few years of operation, when earnings are still relatively low, capital levels 

have declined, and asset growth remains high. Many 

banks will be entering this higher risk stage during the 

next few years. With earning performance of new banks 

already weakening, these institutions may need to 

respond quickly to changes in economic conditions. 

Regional Outlook—National Edition 23 Fourth Quarter 1999 
Regional Perspectives
 

New York Regional Perspectives
 

Employment levels and incomes in the Region continue to rise, and joblessness remains low. In the second quarter of 1999, the Region’s employment level 

rose by 1.4 percent. Wage and salary levels in the 

Region have been increasing faster than the rate of 

inflation since 1995, implying real gains for the 

Region’s workforce. 

The Region’s commercial real estate markets continue to benefit from the healthy economy. Office market vacancy rates in many of the Region’s largest cities 

continue to tighten and are at their lowest levels in the 

1990s. Office vacancy rates have declined to about 5 

percent in New York City, Washington, D.C., and 

Wilmington, Delaware. New office building construction has been reported in the Albany, New York, and 

northern and central New Jersey office markets. Most 

real estate observers, however, believe that the buildup 

of space is temporary and will be filled if the economy 

continues to grow. 

The Region’s banks and thrifts reported generally 

healthy financial performance in second-quarter 

1999. The Region’s average return on assets (ROA) was 

0.89 percent, compared with 

1.03 percent a year ago, 

largely reflecting a decline in 

the average net interest 

margin. Aggregate past-due 

ratios continued to decline, 

reflecting an improvement in 

almost all loan categories, 

with the exception of commercial and industrial (C&I) 

loans, which experienced a modest rise. Past-dues on credit card 

loans were stable. Credit card charge-offs were 3.46 percent in the second quarter of 1999, significantly lower 

than the near 5.0 percent level reported during much of 

the past three years. The Region’s savings institutions 

continued to report lower average ROA numbers than 

commercial banks. In the second quarter of 1999, savings institutions reported an average ROA of 0.75 percent, compared with 0.97 percent for commercial banks. 

C&I loan portfolio concentrations have been increasing 

steadily over the past four years, even though the total 

loan-to-asset ratio has declined in the past two years. 

Small-business lending (C&I loans under $1 million), 

traditionally the main niche of smaller financial institutions, is becoming particularly competitive. Although 

reported C&I loan asset quality indicators remain favorable, aggregate past-due and charged-off C&I loan levels have risen since midyear 1997. 

The New York Region has experienced an increase in 

new bank activity over the past three years. Sixty 

banks opened in the New York Region between June 30, 

1996, and June 30, 1999. Indeed, 1999 is shaping up to 

be a record year as 19 banks opened in the first half of 

the year, compared with 21 banks in all of 1998. Pennsylvania and New Jersey have experienced the highest 

levels of new bank activity in the Region. Clusters of 

new bank formation seem to be associated with improving economic and demographic conditions as well as 

industry consolidation. 

Higher interest rates may curtail the Region’s economic expansion. In 1994, higher interest rates resulted in slower housing activity and reduced capital gains 

in the subsequent year. A higher volatility of capital 

gains in the Region underscored the strong link between 

the stock market and the Region’s economy relative to 

the rest of the nation. If interest rates continue to rise, 

however, it is uncertain whether the Region’s economy 

will react as it did in 1995. 

Regional Outlook—National Edition 24 Fourth Quarter 1999 
Regional Perspectives
 

San Francisco Regional Perspectives
 

The San Francisco Region’s economy is generally 

healthy, despite a slowing since last year. Jobs were 

added at a 2.9 percent year-over-year pace during the first 

seven months of 1999. Strength in the services and construction sectors offset softness in the manufacturing, 

aerospace, energy, and agricultural sectors. 

Job growth rates in the Region differed widely during 

the first seven months of 1999. The services and construction sectors drove growth in the Region’s best performing states — Nevada, Arizona, Idaho, California, 

and Utah. Washington and Oregon experienced some 

weakening as a result of dependence on the depressed 

manufacturing and agricultural sectors. Alaska, Montana, and Wyoming trailed the nation’s rate of job 

growth because of low commodity prices. Hawaii 

remained weak because of declining eastbound tourist 

volume. 

The Region’s insured financial institutions generally 

reported strong earnings as of June 30, 1999. Insured 

institutions posted 1.33 percent aggregate return on average assets (ROA) through second-quarter 1999, 

unchanged from the level reported one year ago. While 

net interest margins (NIMs) have continued to fall from a 

year ago, ongoing reductions in overhead and provision 

expenses have offset the effect of declining margins. 

Strong and improving asset quality in most of the 

Region’s institutions has reduced provision expenses. 

Reported past-due loans, currently at a low 1.59 percent 

of total loans for the Region’s insured institutions, 

remained below the 1.98 percent reported for the nation. 

Although the Region’s insured institutions performed 

well through midyear 1999, pockets of weakness were 

identified. Banks in Hawaii and Montana underperformed peer institutions in the Region and the nation, 

likely as a result of poor economic conditions in these 

states. Macroeconomic trends also have negatively affected the financial performance of some institutions concentrating in mortgages. The Region’s 57 mortgage 

lenders reported declines in NIMs and lower gains on 

securities and loan sales, attributed in part to the increase 

in interest rates and a steepening yield curve. The 

Region’s commercial lenders, which account for over 31 

percent of the Region’s assets, increased higher-yielding, 

traditionally higher-risk assets such as commercial real 

estate, construction, and multifamily residential loans. 

Finally, stress in the agricultural sector has weakened 

conditions for the Region’s 93 agricultural banks, primarily located in California, Montana, Washington, and 

Wyoming. 

Low commodity prices, which have persisted since 

1997 for some of the Region’s agricultural products, 

have adversely affected the Region’s farm sector. In 

addition, farm incomes from operations have declined, 

and conditions at agricultural banks have deteriorated. 

Distress in the agricultural industry is a concern because 

the Region’s agricultural cash receipts represent over 20 

percent of the nation’s total, and over 50 percent of the 

Region’s 852 insured institutions have agricultural loans 

in their portfolios. 

Although the San Francisco Region produces a 

variety of agricultural products, the commodity 

groups that have recently experienced price declines are wheat, 

cattle, and vegetables and fruits 

(primarily apples). Domestic 

overproduction as a result of 

improved technology, farmers’ 

response to enactment of the 1996 

Federal Agriculture Improvement 

and Reform Act, low incidence of 

crop diseases, and a strong U.S. 

dollar have contributed to low 

agricultural commodity prices. 

In 1998, low commodity prices resulted in declining 

farm incomes, particularly in California, Montana, 

and Washington. However, in many states, weakness in 

crop or livestock revenue has been masked by large 

increases in government payments to farmers, particularly in 1998. 

While earnings and capital levels declined slightly 

through the second quarter of 1999, asset quality at 

the Region’s 93 agricultural banks has noticeably 

deteriorated compared with previous years. Insured 

institutions in Montana experienced the most severe pastdue agricultural loan problems in the Region during the 

first half of 1999. As a result, the total past-due loan ratio 

for agricultural loans in the state was one of the highest 

in the nation. While government programs guarantee 

some loans, many loans are not guaranteed, leaving 

lenders at risk of default if commodity prices continue to 

fall. 

Regional Outlook—National Edition 25 Fourth Quarter 1999 
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