Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1999 

FDIC
 

Kansas City
 

Region
 

Division of 

Insurance 

John M. Anderlik, 

Regional Manager 

Jeffrey W. Walser,
 

Regional Economist
 

Christopher
 

J. Sesler,
 

Economic Analyst
 

Troy D. Osborne,
 

Financial Analyst
 

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 

◆ Economic and Banking Conditions—The creation of new jobs and a low rate of unemployment continued through the summer in the Region. Banks reported strong financial conditions through midyear, but continuing low agricultural commodity prices could adversely 

affect future performance. Entry by existing unitary thrifts and large financial services conglomerates, formed as a result of pending financial reform legislation, could increase the level 

of competition experienced by the Region’s small rural banks. See page 18. 

By the Kansas City Region Staff 

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 Kansas City Region’s Regional Outlook, please call John Anderlik at (816) 234-8198 or send an e-mail to janderlik@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman 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. 

Kansas City Regional Outlook 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). 

Kansas City Regional Outlook 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. 

Kansas City Regional Outlook 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 

Kansas City Regional Outlook 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. 

Kansas City Regional Outlook 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. 

Kansas City Regional Outlook 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.
 

Kansas City Regional Outlook 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. 

Kansas City Regional Outlook 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).
 

Kansas City Regional Outlook 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). 

Kansas City Regional Outlook 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. 

Kansas City Regional Outlook 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). 

Kansas City Regional Outlook 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)
 

Kansas City Regional Outlook 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. 

Kansas City Regional Outlook 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 

Kansas City Regional Outlook 17 Fourth Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

•	 The Region’s economy continues to perform well overall; however, low agricultural commodity prices and 

tight labor markets are causes for concern. 

•	 Community banks in the Region are performing well despite increasing nonbank competition. 

•	 Existing unitary thrifts and other new nonbank entrants with a significant presence in the Region could 

intensify the level of competition faced by community banks, particularly in rural areas. 

Economic and Banking Conditions 

The Region’s economy remained strong through the 

summer months, with average nonfarm employment 

through July increasing 1.7 percent from a year ago. 

This performance compares with a 2.1 percent increase 

at the national level. Employment in the Region’s manufacturing sector increased for the first time since 

March, while the nation’s employment rate in this sector 

has declined each month in 1999. The Region’s unemployment rate remained at 3.0 percent in July, compared 

with the national rate of 4.3 percent. Employers 

throughout the Region, especially in the construction 

and service sectors, continue to report difficulty recruiting workers. 

The monthly survey of purchasing managers’ expectations in the Kansas City Region showed a modest 

decline for the second consecutive month, moving from 

57.4 in July 1999 to 53.6 in August 1999 (see Chart 1). 

The most notable trend identified in the survey was the 

CHART 1 

Purchasing Managers’ Expectations Decline 

for Second Consecutive Month 

65 

Sources: National Association of Purchasing Managers; Creighton 

45 

50 

55 

60 

Kansas City Region 

United States 

Value < 50 Indicates Expected

 Contraction 

Jan 

’97 

Apr 

’97 

Jul 

’97 

Oct 

’97 

Jan 

’98 

Apr 

’98 

Jul 

’98 

Oct 

’98 

Jan 

’99 

Apr 

’99 

Jul 

’99 

eighth monthly increase in the prices paid for manufacturing inputs. Low unemployment rates continue to 

exert upward pressure on wages throughout the Region. 

In addition to pressure on wages, a drop in manufacturing volume and export orders in August contributed to a 

modest decline in expectations. Despite the conflicting 

signals reported in August, the purchasing managers 

have expected continuing expansion during every 

month in 1999. 

The Region’s agricultural sector experienced stress 

throughout the summer of 1999, as illustrated by continuing pessimistic forecasts for commodity prices 

shown in Table 1. Consecutive years of high production 

worldwide have led to significant accumulations of 

inventories of grains and oilseeds. Current U.S. Department of Agriculture (USDA) forecasts call for large 

harvests of corn and soybeans in the United States in 

1999, with little chance of drawing down the stocks that 

have kept prices depressed. U.S. wheat production will 

TABLE 1 

Prices Are Expected to Remain 

Depressed through 2000 

PRICE ($) 

1996 1997 1998 

OCTOBER PRO­ EST. JECTED 

1999 2000 

CORN 3.24 2.71 2.43 1.95 1.85 

WHEAT 4.55 4.30 3.38 2.65 2.55 

SOYBEANS 6.72 7.35 6.47 5.05 5.00 

HOGS 53.39 51.36 34.72 37.00 35.50 

CATTLE 65.06 66.32 61.48 64.50 69.00 

Note: Grain prices are for marketing year of each crop.
 

Crop quantities are per bushel; livestock are per 


hundredweight.
 

Source: USDA
 

Kansas City Regional Outlook 18	 Fourth Quarter 1999 
Regional Perspectives
 

be down slightly but not enough to have much influence 

on the price of this most export-dependent grain. The 

increased importance of large entities with significant 

fixed costs has prevented the hog market from adjusting 

supplies in response to the low prices experienced in 

1998. The cattle market is one bright spot in the 2000 

forecasts, although the USDA has revised its price forecast downward significantly since this summer. 

Actual income from farming has declined substantially 

in 1998 and 1999, but government payments have 

helped mitigate the effects of the decline. In early October the House passed a bill providing an additional $8.7 

billion for 1999, and the Senate is expected to pass similar legislation. This appropriation would result in a near 

record $52 billion of net farm income, of which a record 

$25 billion would be government payments. Such 

appropriations may slow the ongoing exodus of small 

farmers from the industry but will not reverse the trend 

of consolidation in agriculture and the subsequent ruralto-urban migration occurring through much of the 

Region. 

This quarter’s Banking Scorecard (on the next page) 

highlights the Region’s farm banks, which continue to 

report sound aggregate conditions but remain vulnerable to continued stress in the agricultural sector. 

New Banking Entrants Could Soon Alter the Region’s
 

Competitive Landscape
 

Although community banks1 in the Region’s rural counties have faced increasing competition from nonbank 

entities such as Farm Credit System institutions and 

mutual fund companies, competition from large banks 

remains minimal in many areas. Low population bases, 

past restrictions on interstate branching, and the need to 

maintain personal relationships with rural customers 

may have made entering some rural markets unattractive to large banks. As a result, competition for community banks has come largely from other community 

banks, which typically do not have the pricing power or 

product offerings of larger institutions. 

However, many commercial and financial services companies have entered the banking business through the 

purchase or creation of unitary thrifts. In addition, 

pending financial modernization legislation would 

allow securities firms and insurance companies to affiliate with commercial banks, forming large financial 

services conglomerates. Certain existing unitary thrifts 

and insurance 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. 

1 Community banks are defined in this article as FDIC-insured commercial or savings institutions with assets of less than $250 million. 

The term “banks” includes both commercial and savings institutions. 

This article begins with a discussion of how increasing 

nonbank competition has affected community bank performance in recent years. The next section assesses 

banking competition, showing specifically how community banks in rural areas face less direct competition 

from large banks than their metropolitan counterparts. 

The final section describes how the entry of new, large 

banking organizations, through ownership of existing 

unitary thrift charters or affiliation with commercial 

banks, could accelerate competition in the Region’s 

rural banking markets. 

Community Banks Are Performing Well 

despite Increasing Nonbank Competition 

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. Pretax earnings,2 although down 

slightly in 1999, remain high by historical standards. 

Community banks’ performance has been strong in 

spite of steadily growing competition from nonbanks on 

both sides of the balance sheet in recent years. For 

example, on the asset side, the Farm Credit System 

2 Earnings are shown pretax because many community banks have 

elected Subchapter S status for federal income tax purposes. Because 

these banks pay no federal income taxes, their financial statements 

are comparable to those of other institutions only on a pretax basis. 

Kansas City Regional Outlook 19 Fourth Quarter 1999 
Regional Perspectives
 

Banking Scorecard—Farm Banks 

In aggregate, as of June 30, 1999, the Region’s farm banks1 continued to report strong earnings with a 1.22 percent aggregate return-on-assets ratio, contributing to adequate reported capital levels. 

Declines in corn, soybean, wheat, and hog prices that began in 1998 are beginning to affect farm banks’ delinquent loan levels in 1999. In aggregate, problem loans are increasing but still remain manageable, at 2.57 percent of total loans as of June 30, 1999, up 8 basis points from June 30, 1998. Farm banks reported 2.80 percent 

of farm operating loans and 2.29 percent of farm real estate loans as past-due at June 30, 1999, a 41-basis-point 

increase in each loan category from a year earlier. Significant increases in past-due loan ratios generally lag 

falling prices by at least two harvests because farm banks typically “carry over” unpaid loans from poor years 

into subsequent years,2 which masks the reported loan delinquency in down years. As such, the Region’s aggregate past-due ratios largely reflect farmers’ strong earnings in 1996 and 1997. However, continued low commodity prices forecast by the U.S. Department of Agriculture through 2000 signal much higher levels of 

problem loans in the near future. 

Source: Bank Call Reports 

1.4 

Return on Assets (%)

0.6 

0.8 

1.0 

1.2 

June 

KC Region 

U.S. 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

The Region’s Farm Banks 

Continue to Post Strong Earnings 

Capital Levels Remain High 

Compared to Historical Levels 

June 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

8.5 

9.0 

9.5 

10.0 

10.5 

11.0 

11.5 

Leverage Ratio (%)

KC Region 

U.S. 

Total Past Due Loans Are Creeping Up 

Slowly; Reserves Remain Strong 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

June 

Percent of Total Loans 

’99’98’97’96’95’94’93’92’91’90’89’88 

Loan Loss Reserves 

Noncurrent 

Loans 

Loans Past-Due 

30–89 Days 

Both Operating and Real Estate Farm Loans 

Are Showing Increased Delinquency Levels 

Percent of Total Farm Loans 

’96 ’97 ’98 ’99

June 

0.0 

1.0 

2.0 

3.0 

4.0 

Farm 

Operating 

Loans 

Farm Real Estate Loans 

Composition of Total Past-Due Farm Loans 

1 Farm banks are defined as FDIC-insured financial institutions whose agricultural operating loans and agricultural real estate loans make
 

up at least 25 percent of their total loans. There were 1,340 farm banks in the Kansas City Region as of June 30, 1999.
 

2 For a detailed discussion regarding how carryover debt masks farm loan delinquency levels, refer to “Agricultural Sector under Stress: The
 

1980s and Today” in the Kansas City Regional Outlook, third quarter 1999.
 

Kansas City Regional Outlook 20 Fourth Quarter 1999 
Regional Perspectives
 

again is an active originator of farm loans in competition with the Region’s farm banks, placing downward 

pressure on loan pricing strategies. For more information on the resurgence of the Farm Credit System and 

implications for the Region’s farm banks, refer to 

“Commercial Banks Faced with Formidable Competition from Farm Credit System Institutions” in the 

Kansas City Regional Outlook, first quarter 1998. 

On the funding side, increases in household investment 

in mutual funds and other nonbank investments, as well 

as greater rate competition from Internet banking alternatives, are reducing community banks’ ability to attract 

and retain deposits. For a detailed discussion on community bank funding trends, refer to “Shifting Funding 

Trends Pose Challenges for Community Banks” in the 

FDIC’s Regional Outlook, third quarter 1999. In addition, credit unions, despite a relatively small market 

share in the Region, have successfully added depositors 

while FDIC-insured institutions have struggled in this 

area. Refer to “Credit Unions Have Advantages over 

Community Banks, but Currently Have a Small Market 

Share in the Region” in the Kansas City Regional Outlook, fourth quarter 1998. These developments suggest 

increased upward pressure on community banks’ cost of 

funds. 

One would expect increased competitive pressures to 

have had an adverse effect on community banks’ net 

interest margins (NIMs). However, community banks’ 

NIMs showed no compression until the past 12 months, 

when the aggregate NIM declined by 14 basis points. 

The stability of NIMs is attributed largely to community banks shifting assets from 

lower-yielding securities to 

higher-yielding assets during 

this economic expansion. For 

example, the Region’s community banks’ aggregate 

loans-to-assets ratio increased 

from 52.8 percent at June 30, 

1992, to 63.5 percent at June 

30, 1998, while the aggregate securities-to-assets ratio 

declined from 36.0 percent to 26.2 percent during that 

same time. This shift increased interest income and 

effectively masked the impact of increased competition 

on aggregate NIMs. Results as of June 30, 1999, compared with a year earlier, show the first indication that 

this trend may be reversing; the aggregate loans-toassets ratio declined by 33 basis points and the securities-to-assets ratio increased by 103 basis points. 

Rural Community Banks Face Less Large Bank 

Competition than Their Metropolitan 

Counterparts 

In addition to increased competition from nonbank entities, some community banks, particularly those in metropolitan areas, face considerable competition from 

other banks. Community banks headquartered in rural 

counties generally face less direct banking competition 

than those headquartered in metropolitan counties. 

Because of smaller population bases, rural counties typically headquarter a small number of institutions, which 

tend to be community banks. By contrast, metropolitan 

areas typically headquarter a large number of institutions, many of which are bigger than community banks. 

However, the number of headquarters locations does not 

tell the whole story of competition, because many banks 

establish branches outside their home counties. The 

only branch-specific data available are deposit balances 

by branch that banks report at midyear. As of June 30, 

1998 (midyear 1999 data are not yet available), 8,021 

bank branches were located in the Region. Community 

banks operated 4,790 branches, or 60 percent of all the 

Region’s branches. Large banks—those with more than 

$10 billion in assets—operated 1,005 branches (termed 

large bank branches, or LLBs, in this article), or 13 percent of all branches. Institutions with assets between 

$250 million and $10 billion operated the remaining 

2,226 branches. 

It is important to understand where large banks compete 

because such institutions, through enhanced market 

power, can offer a greater array of product offerings and 

have pricing advantages driven by economies of scale 

that make them formidable competitors for smaller 

banks. As shown in Table 2 (next page), LBBs tend to 

be located in heavily populated areas. For example, 

LBBs make up 20.9 percent of all bank branches in the 

Region’s metropolitan counties, but only 6.5 percent of 

branches in rural counties. Furthermore, 80.6 percent of 

metropolitan counties have at least one LBB, while 

most rural counties have none. In the most rural counties,3 11 LBBs comprise just 1.1 percent of branches, 

and 95.9 percent of such counties have no LBBs. 

3 Refers to rural counties that are not adjacent to metropolitan counties and have an urban population of less than 2,500. Such counties 

make up 217 of the Region’s 618 counties, and they headquartered 

412 community banks as of June 30, 1999. 

Kansas City Regional Outlook 21 Fourth Quarter 1999 
Regional Perspectives
 

TABLE 2 

Competition from Large Banks Declines as Counties Become More Rural 

TOTAL % OF BRANCHES 

COUNTY TYPE COUNTIES BRANCHES LBBS THAT ARE LBBS 

METROPOLITAN 72 3,344 699 20.9 

RURAL ADJACENT 144 1,557 100 6.4 

RURAL NONADJACENT 402 3,120 206 6.6 

REGION TOTALS 618 8,021 1,005 12.5 

RURAL NONADJACENT BREAKOUT: 

URBAN POPULATION OVER 20,000 25 490 85 17.3 

URBAN POPULATION 2,500–20,000 160 1,651 110 6.7 

URBAN POPULATION UNDER 2,500 217 979 11 1.1 

402 3,120 206 6.6 

Notes: LBBs (large bank branches) are branches of FDIC-insured institutions with over $10 billion in assets.
 

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

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

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


These statistics illustrate that many of the Region’s rural 

community banks have 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, which may 

not be as desirable to large banks as more populous metropolitan areas; the vast geography of the Region, which 

could make large rural branch structures unworkable; 

past restrictions on interstate banking and branching,4 

which may have prevented large banks from entering 

rural markets; and rural banks’ strong personal relationships with their clientele, which large banks may perceive as difficult to penetrate. 

The small number of LBBs in rural counties benefits 

rural community banks in important ways. Foremost, 

less competition for loans and deposits helps permit 

more discretion for setting loan and deposit interest 

rates, benefiting rural community banks’ NIMs. Despite 

the lower level of competition, rural community banks 

tend to have lower NIMs than their metropolitan counterparts because of their different loan compositions 

and greater dependence on high-cost large time deposits 

for funding. For more information on the operating differences between rural and metropolitan community 

banks, refer to “Rural and Metropolitan Banking Are 

Different” in the Kansas City Regional Outlook, second quarter 1998. 

4 The Riegle-Neal Interstate Banking and Branching Act of 1994 

allowed holding companies to acquire banks outside their home 

states, regardless of state law, effective September 29, 1995, and 

allowed banks to merge across state lines, effective June 1, 1997. 

In addition, rural community banks generate noninterest income (fees, product sales, etc.) at a much lower 

rate than their metropolitan counterparts do. As of June 

30, 1999, community banks headquartered in metropolitan counties reported a median noninterest-income-toaverage-assets ratio of 0.65 percent, compared with a 

median ratio for rural community banks of 0.49 percent. 

However, many metropolitan community banks generate much higher levels of noninterest income than the 

median indicates. Even excluding four metropolitan 

community banks with extremely high ratios, the aggregate noninterest-income-to-average-assets ratio was 

1.16 percent, compared with 0.67 percent for rural community banks. Lower levels of competition may offer 

the potential to grow noninterest income levels in the 

future. 

Existing Unitary Thrifts and Pending 

Legislation Could Change 

the Competitive Landscape 

Although competition is increasing throughout the 

Region, large nonbanking firms entering the banking 

business could intensify that level of competition. A 

number of nonbanking firms with significant operations in the Region have received charters to create or 

purchase unitary thrifts. In addition, Congress is on the 

verge of passing financial modernization legislation 

that would pave the way for affiliations among commercial banks, insurance companies, and brokerage 

firms. The presence of existing unitary thrifts and the 

Kansas City Regional Outlook 22 Fourth Quarter 1999 
Regional Perspectives
 

potential for entry of newly formed financial services 

conglomerates have implications for the Region’s community banks, particularly in rural areas. 

Existing Unitary Thrifts 

A unitary thrift is a structure whereby a parent company owns a single savings association.5 To qualify as a 

thrift, and therefore not a bank, the subsidiary must pass 

a Qualified Thrift Lender (QTL) test, which requires the 

thrift to invest at least 65 percent of its portfolio assets 

in qualified investments, generally consisting of residential and consumer loans. Unitary thrift holding companies whose subsidiaries pass the QTL test are exempt 

from unrelated business activity restrictions that apply 

to bank holding companies and multiple-thrift holding 

companies. This nonbank bank exemption allows commercial companies not engaged in thrift-related activities to own a single savings association with interstate 

branching privileges. In the past there have been no 

restrictions on the ownership of unitary thrifts, and, as a 

result, the unitary thrift charter has been an attractive 

means for commercial companies to enter the financial 

services arena. 

Many nonbanking companies have applied to purchase 

or establish new thrift institutions in recent years. Since 

January 1, 1997, 81 nonbanking companies have filed 

applications with the Office of Thrift Supervision 

(OTS) to establish a new thrift charter or purchase an 

existing thrift. As of August 31, 1999, the OTS had 

approved 26 of those applications. Companies whose 

applications for a new thrift charter have been approved 

include State Farm Mutual Automobile Insurance Company, A.G. Edwards, Inc., Allstate Insurance Company, 

Shelter Mutual Insurance Company, and Merrill Lynch 

and Company. Companies awaiting approval from the 

OTS for a charter include American Express Company, 

Ford Motor Company, General Motors Acceptance Corporation, and Walton Enterprises, LP (Wal-Mart). 

Existing unitary thrifts could compete with community 

banks on both sides of the balance sheet, vying directly 

for residential and consumer loans and, to a lesser 

extent, because of statutory restrictions, for business 

loans. On the liability side of the balance sheet, unitary 

thrifts would compete for various types of deposit 

accounts. 

Proposed Financial Modernization Legislation 

The number of unitary thrift charters has been on the 

rise over the past several years. However, as this article 

is being prepared for publication, Congress is finalizing 

negotiations on legislation that would close the exemption in federal law that allows commercial companies to 

own or acquire unitary thrifts. Existing unitary thrifts 

and companies that applied for new charters before May 

4, 1999, would be grandfathered under the proposed 

legislation. The financial reform bill would eliminate 

Depression-era restrictions on affiliations among banks, 

insurance companies, and securities firms, potentially 

creating new financial services conglomerates. The legislation also would expand bank access to Federal 

Home Loan Bank System funds for insured depository 

institutions with assets less than $500 million, allow 

securities underwriting in direct bank subsidiaries, and 

provide some measure of regulatory relief from Community Reinvestment Act requirements. At this time, it 

appears likely that some form of financial modernization legislation will be enacted soon. 

Implications for Community Banks 

The trend toward larger and more diversified financial 

companies is likely to continue, with pending financial 

modernization legislation adding momentum. The 

implications for community banks could be profound, 

as these large companies may enjoy a number of operating advantages, including 

•	 large customer bases to which they can sell banking 

products; 

•	 the ability to cross-sell financial products and 

services; 

•	 significantly lower operating costs than traditional 

banks. With no cost to build brick-and-mortar bank 

branches, diversified financial services companies 

could enjoy significant economies of scale in offering banking products at competitive prices; 

•	 national brand-name recognition developed over 

decades. Through national and local advertising, 

these companies may be better positioned to reach 

existing and new customers; and 

•	 professional salespersons to market insurance or 5 For purposes of this article, the term “savings association” is syn- securities products. Community bank employees onymous with thrift, savings and loan association, federal savings typically do not receive the same level of formal bank, insured building and loan association, or insured state savings
 

and loan or homestead association. sales training.
 

Kansas City Regional Outlook 23	 Fourth Quarter 1999 
Regional Perspectives
 

First, competition from new banking entrants is particularly important in the Kansas City Region because 

these companies could introduce significant large bank 

competition in areas where little currently exists. Nonbanking companies entering the banking business 

through existing unitary thrifts or the formation of 

financial services conglomerates 

as a result of the enactment of 

financial services reform could 

eliminate barriers that have kept 

large banks from establishing 

large rural branch networks. For 

example, unlike most large banking institutions, a number of 

insurance and securities firms 

already have successfully established relationships in 

rural communities through sales of insurance and securities products. 

If nonbanking institutions successfully build banking 

operations to include a significant rural presence in the 

Region, rural community banks may face increased 

competition on both sides of their balance sheets. This 

competition could potentially affect NIMs and funding 

strategies. Increased competition for loans, in addition 

to pressure from the Farm Credit System, implement 

dealers, and others, could result in community banks 

accepting lower loan yields, negatively affecting NIMs. 

Increased competition for deposits from large thrifts 

could add to competition from mutual funds and credit 

unions and potentially cause community banks to raise 

interest rates paid on deposits, also affecting NIMs. 

Institutions that are unwilling or unable to compete with 

large entities on deposit pricing alone could face significant funding pressures. 

Second, increased competition could result in rural 

community banks increasing their level of credit risk. In 

the face of increased competition, rural community 

banks may decide to accept higher levels of credit risk 

to maintain loan yields. While this strategy could help 

maintain NIMs, it could also result in loan quality problems. Large nonbanking entities that have centralized 

operations supported by advanced credit-scoring tools 

may be able to target loan products to highly creditworthy borrowers and underprice community banks 

for such customers. Ultimately, this practice may shrink 

community banks’ pools of high-quality loan 

customers. 

Third, increased competition from new banking entrants 

could reduce opportunities for rural community banks 

to generate noninterest income. Rural community 

banks, which lag their metropolitan counterparts in 

noninterest income generation, may find it difficult to 

compete with large financial services conglomerates in 

this area. 

Fourth, increased competition could diminish loan portfolio diversification among the Region’s community 

banks. Most rural community banks’ loan portfolios are 

heavily concentrated in farm production or farm real 

estate loans, with portfolio diversification coming primarily from residential and consumer loans. By their 

nature, thrifts specialize in making residential and consumer loans and would likely pressure community banks 

most for this line of business. If existing unitary thrifts 

become strong competitors for such loans, community 

banks may replace these loans with additional farm or 

commercial loans or investment securities, thereby 

reducing the level of loan portfolio diversification. 

It is not certain that existing unitary thrifts or large 

financial services conglomerates will compete successfully in the Region’s rural communities. However, the 

potential exists for new industry entrants to increase the 

level of competition for the Region’s rural community 

banks. Already faced with stiff challenges from the 

Farm Credit System, mutual funds, and credit unions, 

the Region’s community bankers may soon face significantly increased levels of competition from new banking entrants as well. 

Kansas City Region Staff 

Kansas City Regional Outlook 24 Fourth Quarter 1999 
✁
 

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