Outlook
 

FALL 2004 

In Focus This Quarter: 


Commercial Lending at FDIC-Insured Institutions
 

Total commercial and industrial (C&I) loans held by FDIC-insured banks and savings institutions have declined for 13 consecutive quarters, beginning in the first quarter of 2001. This issue of FDIC Outlook assesses recent trends in the business sector and 

bank commercial lending activity and suggests where and when a turnaround in C&I loan growth is likely to occur. 

Emerging Signs of a Recovery in Commercial and Industrial The Recent Recovery in Inventory Building Lending Should Boost C&I Loan Demand Commercial and industrial (C&I) loan volume among U.S. insured 

Commercial and Industrial Loans Combined Manufacturing, Retail and institutions declined for 13 consecutive quarters through March 31, Percent Change from a Year Ago Wholesale Inventories Percent 

2004. However, the near-term outlook for C&I borrowing is improv- Change from a Year Ago 

20 8 ing. Overall, the U.S. business sector is again experiencing stronger 

investment, increased inventory building, and greater merger activ- 15 6 

4 

This article looks at why this recovery was delayed two years after 5 

ity. As a result, signs of a recovery in C&I lending are emerging. 10 

2 

the end of the 2001 recession, identifies the indicators of a rebound 0 0 

in this lending segment, and analyzes some of the competitive chal­ –5 –2 

lenges facing community banks as these institutions try to expand –10 –4 C&I portfolios. See page 3. 

Note: C&I = commercial and industrial. 

Source: FDIC; U.S. Census Bureau. Where Should Banks Look for C&I Loan Demand? 

A recovery in commercial and industrial (C&I) lending will help 

commercial banks’ earnings growth. However, a broad-based recovery in C&I loan demand can occur only if the business sector’s 

need for external funding expands. This article identifies those industries that show the greatest external funding need for and, in 

turn, likely will drive a rebound in C&I lending among insured institutions. See page 9. 

The U.S. Manufacturing Sector: A Strong Past and an Uncertain Future 

The manufacturing sector continues to contribute to the strength of the U.S. economy, despite reductions in employment. Technological advances are expected to provide new opportunities, but key challenges remain. See page 14. 

Have Chicago Region Community Banks Been Adversely Affected by Auto Sector Job Losses? 

Despite significant employment losses in the motor vehicle industry, community banks located in Chicago Region counties with 

high exposure to this industry are performing as well as banks elsewhere in the Region. See page 19. 

The U.S. Agricultural Sector: Recent Events Highlight Ongoing Systemic Risks 

Although healthy, the nation’s agricultural sector faces long-term risks, including changing consumer attitudes toward food safety, 

evolving water allocation policies, and the ongoing agricultural trade policy debate. See page 25. 

95 96 97 98 99 00 01 02 03 04 

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

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

institutions and financial institution regulators. It is produced for the following six geographic regions: 

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

Jack M. Phelps, Regional Manager, 678-916-2295 

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

David Van Vickle, Regional Manager, 312-382-7551 

Dallas Region (AR, CO, LA, MS, NM, OK, TN, TX) 

Midsouth: Gary Beasley, Regional Manager, 901-821-5234 

Southwest: Alan Bush, Regional Manager, 972-761-2072 

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

John Anderlik, Regional Manager, 816-234-8198 

New York Region (CT, DC, DE, MA, MD, ME, NH, NJ, NY, PA, PR, RI, VI, VT) 

Mid-Atlantic: Kathy Kalser, Regional Manager, 917-320-2650 

New England: Paul Driscoll, Regional Manager, 781-794-5502 

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

Catherine Phillips-Olsen, Regional Manager, 415-808-8158 

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

to insured institutions nationally and in each FDIC region. 

Single copy subscriptions of the FDIC 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 FDIC 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 FDIC Outlook, please call Richard A. Brown at 202-898-3927 

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

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

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

of this publication was obtained from publicly available sources that are considered reliable. However, the 

use of this information does not constitute an endorsement of its accuracy by the Federal Deposit Insurance 

Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance 

and Research 

Arthur J. Murton 

Executive Editor Maureen E. Sweeney 

Managing Editor Kim E. Lowry 

Editors Jack M. Phelps 

Kathy Kalser 

Ronald L. Spieker 

Richard A. Brown 

Norman Williams 

Publications Managers Elena Johnson 

Geri Bonebrake 

FDIC OUTLOOK 2 FALL 2004 
In Focus This Quarter 

Emerging Signs of a Recovery in

Commercial and Industrial Lending 

Commercial and industrial (C&I) loan volume among 

U.S. insured institutions declined for 13 consecutive 

quarters through March 31, 2004. The reasons for this 

decline have been well documented.1 However, the 

near-term outlook for C&I loan demand among businesses is improving. Overall, the U.S. business sector 

is again experiencing stronger investment, increased 

inventory building, and greater merger activity. As a 

result of more robust loan demand and greater willingness by banks to extend C&I credits, insured institution C&I lending is beginning to recover. This article 

looks briefly at why this recovery was delayed for two 

years after the 2001 recession ended, identifies some 

indicators of a rebound in this lending segment, and 

analyzes some of the competitive challenges facing 

community banks as these institutions try to expand 

their C&I portfolios. 

Several Factors Kept C&I Loan Growth in Check 

despite More than Two Years of Economic 

Expansion 

From a fourth quarter 2000 peak of roughly $1.1 trillion, the overall level of C&I loans outstanding at 

insured institutions steadily declined 16 percent to just 

over $910 billion by the end of first quarter 2004. 

Almost two-thirds of that decline occurred after the 

recent recession ended in late 2001. Now, two and a 

half years later, the banking industry is seeing signs of a 

recovery in C&I lending. The delay in C&I loan 

growth resulted in part from normal cyclical lags but 

also involved unique elements that are explored in 

more detail below. 

Borrowers and Lenders Became More Risk Averse 

in 2002 and Early 2003 

Just as the economy was beginning to expand following 

the recession and recovery in 2001, two shocks 

occurred that raised business uncertainty. The first was 

the corporate accounting scandals that unfolded in 

mid-2002, and the second was the buildup to the war 

in Iraq during late 2002 and early 2003. These events 

raised concerns about the economy’s fledgling expansion and the growing geopolitical tensions related to 

the situation in Iraq—concerns that in turn weighed 

heavily on financial markets and business risk taking. 

In its Monetary Policy Report to Congress in early 

2003, the Federal Reserve Board noted the adverse 

effects of these developments on business sentiment.2 

Lenders and borrowers became more cautious during 

this period, especially in areas that involve risk taking 

and confidence in future demand, such as investment 

spending and inventory accumulation. This caution 

likely slowed growth in both the supply of and demand 

for corporate lending. 

Robust Profits Reduced the Need for Outside 

Funding 

With U.S. corporations taking a conservative approach 

to the evolving economic expansion in 2002, cost 

controls and a reluctance to hire and invest helped 

firms to build profits and cash flow. According to the 

Bureau of Economic Analysis, U.S. corporate operating profits, after dropping $84 billion during 2000 and 

2001, rose $107 billion in 2002 and $146 billion in 

2003. These gains, on the order of 14 percent to 17 

percent per year, represented the strongest two-year 

1 For information on the effect of the 2001 recession on C&I loan 

trends, see the FDIC FYI article “Loan Weakness Spreads; Banks’ 

Defenses Hold,” February 27, 2002, www.fdic.gov/bank/analytical/fyi/ 

2002/fyi022702.html; and the FDIC Regional Outlook articles “In Focus 

This Quarter: The Road to Recovery for Commercial Credit Quality: 

Not Without a Few Hurdles Ahead,” third quarter 2002, 

www.fdic.gov/bank/analytical/regional/ 

ro20023q/na/Infocus.html, and “In Focus: Economic Conditions and 

Emerging Risks in Banking,” fourth quarter 2002, www.fdic.gov/bank/ 

analytical/regional/ro20024q/na/index.html. 

2 Monetary Policy Report submitted to Congress on February 11, 2003, 

by the Federal Reserve Board. 

FDIC OUTLOOK 3 FALL 2004 
In Focus This Quarter 

Chart 1	 Chart 2 

U.S. Corporate Profits Turned Down Well before The Recent Recovery in Inventory Building 

the 2001 Recession Began, but Recently Have	 Should Boost C&I Loan Demand 

Posted Very Strong Growth Commercial and Industrial Loans Combined Manufacturing, Retail and

U.S. Corporate Operating Profits 

Percent Change from Year Earlier
 

40
 

30 

20 

10 

0 

–10 

–20 

90 92 94 96 98 00 02 04 

Source: Bureau of Economic Analysis. 

growth in corporate profits since the mid-1990s (see 

Chart 1). Strong profit gains pushed the amount of net 

cash flow at U.S. corporations to almost $1.2 trillion in 

2003, a record high of 10.8 percent of gross domestic 

product. As businesses accumulated cash over the past 

few years, many firms self-funded their working capital 

needs and incremental business expansion. 

Access to Cheaper Funding Sources Further 

Hampered C&I Demand 

Large public corporations also took significant advantage of low-cost alternative funding sources during the 

past few years, thereby diminishing their need for C&I 

loans. Through 2003 and the first half of 2004, Moody’s 

high-quality corporate bond yields, as reported by the 

Federal Reserve, averaged at or below 5.7 percent—the 

lowest yields in more than 30 years. As a result, according to Thomson Financial, corporate bond and 

convertible securities sales rose to a record $899 billion 

in 2003 from $668 billion in 2002, a 35 percent 

increase.3 Had this debt not been so affordable to 

corporate issuers, some of those funding needs may 

have been met through commercial lenders. 

Emerging Signs of a Recovery in 

C&I Lending Activity 

As the factors that delayed demand for C&I loans 

during the past two years abate, U.S. corporations 

should turn increasingly to bank funding. In fact, 

3 Reuters, “U.S. Corporate Bond Issuance Rises in 2003–Thomson,” 

December 31, 2003. 

Percent Change from a Year Ago Wholesale Inventories Percent 

Change from a Year Ago 

20 8 

15 6 

10 4 

5 2 

0 0 

–5 –2 

–10 –4 

95 96 97 98 99 00 01 02 03 04 

Note: C&I = commercial and industrial.
 

Source: FDIC; U.S. Census Bureau.
 

several signs are pointing toward stronger C&I loan 

demand, as well as a greater availability of credit 

moving forward. Some of these signs are discussed 

below. 

Business Investment Growth Has Accelerated 

The recent acceleration in business investment growth 

is a sign of renewed strength in the U.S. corporate 

sector. Outlays for equipment and software grew at a 

double-digit annualized pace in the last three quarters 

of 2003. Although this growth pace moderated in the 

first half of 2004, it remained at a solid 9 percent. Forecasts from Macroeconomic Advisers and Blue Chip 

Economic Indicators expect strong double-digit business investment gains through year-end 2004. 

Inventory Building Has Resumed 

Historically, C&I lending has tracked the U.S. inventory cycle. Business inventory growth has been on the 

rise for a little over one year (see Chart 2). Even so, 

recent growth has been weak, especially given the 

protracted declines in 2001 and 2002. The slow buildup 

in inventory to date suggests that inventories have 

more room to grow as the economy expands. For many 

industries, inventory needs will drive their demand for 

C&I loans.4 

4 See “Where Should Banks Look for Emerging C&I Loan Demand?” 

by Steven C. Gabriel in this issue. 

FDIC OUTLOOK 4	 FALL 2004 
In Focus This Quarter 

Chart 3 

A Higher Percentage of Banks Are Easing C&I Lending
 

Standards Now than in the Past 15 Years
 

Net Percentage of Domestic Banks Tightening 

Standards for C&I Loans 

Percent, by Customer Size 

Standards for Large 

and Medium Firms 

Standards for Small Firms 

91 92 93 94 95 96 97 98 99 00 01 02 03 04 

30 

20 

10 

0 

10 

20 

30 

40 

50 

60 

70 

_ 

_ 

_ 

Source: Federal Reserve. 

M&A Activity Has Increased 

A return of merger activity may also boost C&I loan 

demand. After a long period of dormancy, merger and 

acquisition (M&A) activity has recently increased. 

According to Mergerstat, total M&A activity for 2003 

was $528 billion, compared with $462 billion in 2002; 

moreover, the year-to-date value of mergers and acquisitions through second quarter 2004 was $354 billion, 

up from $168 billion in the first half of 2003.5 

Although this was a significant increase, about onethird of 2004 year-to-date activity was in banking and 

finance. Further, current levels of M&A activity are 

less than half their peak 1999 level. A robust economic 

expansion and historically low interest rates for the 

remainder of 2004 are likely to support further M&A 

gains over the near term. 

Banks Are More Willing to Lend 

In addition to rising demand for commercial loans, 

some data suggest that C&I lending standards have 

begun to ease as the economy recovers. For example, in 

July 2004, the Loan Pricing Corporation reported that 

the ratio of debt-to-cash flow on syndicated loans 

5 Mergerstat, “FactSet Mergerstat’s M&A Roundup in 2003,” news 

release, January 7, 2004, www.mergerstat.com/new/press/ 

release23.htm, and “FactSet Mergerstat’s M&A Roundup: Second 

Quarter, 2004,” news release, June 30, 2004, 

www.mergerstat.com/new/press/release25.htm. 

increased to 4.3 compared with 4.0 in 2003.6 In addition, the Federal Reserve’s April 2004 Senior Loan 

Officer Survey indicates that, after three years of significant tightening in C&I loan underwriting standards, a 

higher percentage of respondents, on net, reported 

easing C&I underwriting standards than at any other 

time in the past 15 years (see Chart 3).7 

Survey Suggests More Interest in C&I Loans 

The Federal Reserve’s Loan Officer Survey also shows 

that a net 29 percent of banks saw increasing demand 

for C&I loans from large- and middle-market borrowers 

in early 2004, while a net 38 percent of banks reported 

that small business C&I demand was increasing. These 

levels were the highest readings in six to ten years. 

Furthermore, about 50 percent of domestic respondents 

indicated that they had received an increasing number 

of inquiries from potential business borrowers. Among 

those banks reporting more C&I inquiries, most attributed this activity to increased customer financing needs 

for inventories and accounts receivable, as well as for 

investment in plant and equipment. Finally, the Federal 

Reserve Board indicated in its July 2004 Beige Book 

that, in 9 of 12 districts, commercial loan demand was 

rising in recent weeks.8 

The Competitive Landscape for C&I Lending Is 

Changing 

C&I lending is recovering across the industry; however, 

competition between large and small institutions may 

intensify. Large banks, despite renewed strength in the 

syndicated loan market, may diversify their commercial 

lending by targeting mid-sized and small businesses. 

This strategy will intensify competition for commercial 

loans at community banks that have traditionally dominated this market. 

6 Sadaf Khan, “No Holds Barred in 2Q04! Leverage Caps Loosen
 

across the Market,” Loan Pricing Corporation,
 

www.loanconnector.com, July 19, 2004.
 7 Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank
 

Lending Practices, April 2004.
 8 Federal Reserve Board, The Beige Book, July 28, 2004, www.federalreserve.gov/FOMC/BeigeBook/2004/20040728/default.htm. 


FDIC OUTLOOK 5 FALL 2004 
In Focus This Quarter 

Community Banks Will Face Increased Competition 

for Their Core Business Customer 

As mentioned earlier, demand for C&I lending by midsized and small firms appears to be recovering. A 

sustained increase in demand for C&I loans among 

community banks has traditionally depended, at least 

in part, on small business owners’ views of business 

conditions and their plans for future expansion.9 

According to the National Federation of Independent 

Business (NFIB) Optimism Index, small business 

owners have become increasingly optimistic in recent 

quarters about future operating conditions (see Chart 

4).10 Factors that have contributed to greater optimism 

for economic and business conditions include an 

increase in the number of small businesses reporting 

higher earnings, a greater need for labor, and expectations for higher sales during the next quarter. In addition, according to the NFIB, a larger share of small 

business owners reported that they intend to increase 

inventory levels in the next three to six months.11 As 

small businesses tend to rely on community banks for 

external financing, optimism about business conditions 

and plans to build inventories should contribute to 

stronger demand for C&I loans at community banks. 

Evidence suggests that some of the nation’s small banks 

have already experienced a pickup in C&I loan 

demand. In fact, the NFIB survey results are supported 

by the Federal Reserve Loan Officer Survey: almost 

one-third of the small banks surveyed reported 

increased loan demand from the small business sector 

during the previous three months—a sharp contrast 

from the previous year, when no respondents reported 

evidence of greater demand for small business loans.12 

9 According to the Small Business Administration (SBA), small businesses in the United States make up over 99 percent of all business 

enterprises, employ 50 percent of all private-sector workers and 

create more than half of private gross domestic product. Small businesses are defined by the SBA as firms employing fewer than 500 

individuals. 

10 The NFIB Optimism Index is an index based on survey responses by 

small business owners to questions about plans to increase employment and expenditures as well as expectations of future economic 

conditions and earnings performance. 

11 NFIB, NFIB Small Business Economic Trends: Based on a Survey of 

Small and Independent Business Owners, July 2004. 12 Federal Reserve Board, Senior Loan Officer Opinion Survey on 

Bank Lending Practices, April 2003 and April 2004, Table 1, Question 

4B. Response data under the heading “Other Banks” are cited as a 

proxy for small bank responses. “Other Banks” are defined in the 

surveys as banks with total domestic assets of less than $20 billion 

as of December 31, 2002, and December 31, 2003, respectively. 

Chart 4 

Optimism Is Growing among Small Businesses, Which 

Should Encourage Greater C&I Loan Activity 

NFIB Small Business Optimism Index
 

Quarterly Average, 1986 = 100
 

110
 

105 

100 

95 

Note: C&I = commercial and industrial
 

Source: National Federation of Independent Business.
 

One of the advantages that community banks have in 

competing for small business banking services is that 

they are near, and familiar with, local firms. Nonetheless, competition for small business banking is intense. 

According to one survey, when banks were asked why 

they might consider easing credit standards or loan 

terms, aggressive competition from other banks and 

nonbank lenders was the most frequently cited factor.13 

So, although C&I loan demand for community banks is 

showing early signs of improvement, these smaller institutions may face more intense competition going 

forward. 

Larger Banks Increase Efforts to Target Smaller 

Business Borrowers 

The largest institutions have seen increasing interest 

from C&I borrowers, and stronger growth may be on 

the horizon. Syndicated lending has traditionally been 

a principal lending market for large banks. According 

to the Loan Pricing Corporation, syndicated loan 

originations surged in the first half of 2004 to Recession 

94 95 96 97 98 99 00 01 02 03 04 

13 Federal Reserve Board Senior Loan Officer Opinion Survey on Bank 

Lending Practices, January 2003–April 2004, Table 1, Question 3B. 

FDIC OUTLOOK 6 FALL 2004 
In Focus This Quarter 

$643 billion, up 38 percent from the same period a year 

earlier.14 

Even though the syndicated loan market is beginning 

to recover, large banks also may seek to increase their 

C&I marketing efforts in the mid-sized and small business arenas. According to a 2003 survey by the American Bankers Association, almost three-fourths of large 

banks surveyed have increased or are planning to 

increase marketing expenditures to small businesses in 

2004.15 The larger banks that may be more successful at 

taking market share from smaller banks are those with 

more distribution channels, extensive technological 

capabilities, and greater marketing resources. Many 

large banks, in an effort to gain a greater share of the 

small business banking market, are marketing a suite of 

small business services, such as credit cards, Web bill 

payment, cash management, and payroll administration. The number of credit cards used by small businesses in the United States increased from 4 million in 

2000 to more than 10 million last year and is estimated 

to reach 12.1 million at the end of 2004.16 Furthermore, 

many large institutions are promoting strong customer 

service as part of their marketing strategy. Historically, 

local customer service has been the calling card of 

community banks. 

14 Loan Pricing Corporation, GoldStats, July 14, 2004.
 15 American Bankers Association, Bank Marketing Planning Survey
 

Report, September 2003. The report defines large banks as those with
 

total assets of at least $1 billion.
 

16 “More Firms Make Credit Cards Their Financing Tool of Choice,”
 

Wall Street Journal, July 6, 2004.
 

Conclusion 

Increasing evidence suggests that C&I loan demand is 

finally picking up after three and a half years of weakness. Conditions typically associated with expansion in 

C&I lending have turned positive in recent quarters, 

including renewed inventory building, rebounding capital expenditures, an improved view of business conditions on the part of business owners, and increased 

M&A activity. 

Insured institutions also are becoming more receptive 

to C&I borrowers. Data suggest that following several 

years of significant tightening, lenders, on net, have 

begun to ease C&I underwriting standards to some 

degree and have taken other steps to increase the 

supply of C&I loans. Nonetheless, the competitive 

landscape for business lending may be changing. 

Competition, particularly in the small business market, 

will likely intensify, especially as larger banks court the 

same customer base that has been the stronghold of 

smaller financial institutions. 

Mary Ledwin Bean, Technical Writer Editor 

Robert M. DiChiara, Senior Financial Analyst, 

New York Region 

FDIC OUTLOOK 7 FALL 2004 
In Focus This Quarter 

Where Should Banks Look for C&I Loan Demand?
 

Recent underwriting surveys indicate that bankers are 

eager to grow commercial and industrial (C&I) credit. 

With the expectation of slowing consumer lending 

growth, particularly residential real estate lending, C&I 

loan growth will factor prominently in sustaining earnings growth for commercial banks. Demand for credit, 

however, will not improve substantially until corporations are no longer able to meet their financing needs 

from internal cash flows. The need for many companies 

to tap external funding sources may remain lackluster 

for several more quarters. Indeed, when viewed across 

all industries, corporate cash flows appear more than 

sufficient to meet near-term funding needs. 

The need for external funding is often measured by the 

corporate financing gap (capital expenditures plus the 

change in inventories less internal cash flow). When 

summed across all nonfinancial U.S. corporations, the 

four-quarter moving average of this metric has been 

declining since second quarter 2000. The corporate 

financing gap is watched carefully by forecasters of C&I 

loan demand because it correlates historically with C&I 

loans outstanding (see Chart 1).1 

Strong corporate profits, scaled-back capital expenditures, and declining inventories across many industries 

have driven the total corporate financing gap into 

negative territory, where it has remained since second 

quarter 2003. Nevertheless, this national trend does not 

reflect the current need by many companies for exterChart 1 

The Corporate Financing Gap and C&I Lending 

Are Correlated 

Sources: FDIC; Federal Reserve Board. 

Four-Quarter Moving Average 

Financing Gap ($ Millions) 

C & I Loans 

($ Billions) 

(20,000) 

0 

20,000 

40,000 

60,000 

80,000 

100,000 

0 

200 

400 

600 

800 

1000 

1200 

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 

1 Applebaum, Lori, et al., The Next Leg of Growth: Middle-Market 

Banking, Goldman Sachs Global Investment Research, May 13, 2004. 

nal funding. This article identifies the industries that 

evidence the greatest need for external funding and, 

therefore, are more likely to drive a turnaround in C&I 

loan demand. The article further stratifies industries by 

corporate credit quality to identify industry sectors that 

need funding but that may find an unfavorable reception in the public debt markets. 

Identifying Sources of C&I Loan Demand 

Historical trends and industry research confirm that the 

financing gap is a key indicator of potential C&I loan 

demand. William Bassett and Egon Zakrajsek of the 

Federal Reserve Board offered the sharply rising 

financing gap in the 1997 to 2000 period as an explanation for the increase in C&I loan growth at that 

time.2 This sharp rise in the financing gap was most 

pronounced in the telecommunications sector. Shortly 

after, telecommunications dominated the shared 

national credits in the banking system. More recently, 

Richard Berner of Morgan Stanley has pointed to a 

projected increase in the corporate financing gap as 

evidence of an impending rise in business funding 

needs in late 2004.3 

Although the analysis presented here relies on the 

strong historical relationship between a firm’s or an 

industry’s financing gap and its demand for C&I loans, 

this relationship should not be overstated. Companies 

have access to sources of funds other than cash flow, 

including sale of investments and issuance of long-term 

debt and equity. Also, capital expenditures and 

purchases of inventory are not the only potential uses 

of funds. Companies use available funds to increase 

investments, make acquisitions, reduce long-term debt, 

and pay cash dividends (see Box 1 for details).4 

Because of these factors, a company’s or an industry’s 

financing gap should be viewed as a necessary, if not 

2 Bassett, William, and Egon Zakrajsek, “Recent Developments in
 

Business Lending by Commercial Banks,” Federal Reserve Bulletin,
 

December 2003. 


3 Berner, Richard, “Business Borrowing—On the Way,” Global
 

Economic Forum, Morgan Stanley, April 30, 2004.
 4 Mergers and acquisitions are also considered sources of C&I loan
 

demand. Mergerstat ranked the top industries as of June 20, 2004, in
 

terms of base equity price offered. The top six industries were banking and finance, leisure and entertainment, communications,
 

computer software, supplies and services, and retail.
 

FDIC OUTLOOK 9 FALL 2004 
In Focus This Quarter 

Box 1 

Analytical Approach
 

Corporate financial data from the Standard & Poor’s 

Compustat database were used to calculate the 2003 

financing gap and first quarter 2004 financing gap of more 

than 4,000 public companies. (Firms not reporting inventories, cash flow, or capital expenditures separately were 

excluded from the analysis.) Industries were initially categorized according to the 24 Global Industry Classification 

Standard (GICS) codes, which were developed by Standard & Poor’s and Morgan Stanley Capital International. 

Firms were further categorized by standard industrial classification (SIC) for a more detailed industry breakdown. 

sufficient, predicate to bank borrowing. Analyzing 

financing gaps provides insights into which industries 

have the greatest demand for financing purchases of 

inventories and capital equipment. Other conditions 

being equal, these industries will be more likely to need 

bank-provided financing.5 

The 2003 Financing Gap Suggests Which Industries 

Had the Strongest C&I Loan Demand Last Year 

Table 1 presents industries with the largest financing 

gaps at year-end 2003. Industry financing gaps are further 

divided on the basis of credit quality. Credit quality is 

proxied with the Expected Default FrequencyTM 

(EDFTM) bands calculated by Moody’s KMV Company 

(see Box 2 for details). Unfavorable pricing in the public 

Chart 2 

The analysis identifies industries that likely had the 

strongest C&I loan demand in 2003 by calculating the 

total 2003 financing gap for those firms with a positive 

financing gap. The results are presented by credit quality category (see Box 2). Similar analysis using first quarter 2004 data indicates emerging C&I loan demand in 

2004. We also look at the composition of each industry’s 

C&I loan demand in 2003 and first quarter 2004 by 

considering the relative importance of capital expenditures and changes in inventories. 

debt markets might further increase the likelihood that a 

company needing funds would turn to bank financing. 

Firm credit quality affects the relative cost of accessing 

the capital markets for funding when compared with the 

cost of bank financing. Therefore, the highest-creditquality firms may be most successful finding accommodative pricing in the public debt markets, allowing them to 

defer bank borrowing longer. 

First Quarter Data Suggest Different Industries 

May Lead C&I Loan Demand in 2004 

Retailing, capital goods, and consumer durables and 

apparel exhibited far more demand for external financing relative to other industries in first quarter 2004 

compared with 2003 (see Table 2 and Chart 2). 

Financing Gap Data Suggest Different Industries May Lead C&I Loan Demand in 2004 

Note: Universe of firms includes only those with a positive financing gap. 

Source: FDIC, Standard & Poor’s Compustat. 

2003 

6,000 

First quarter 2004 

2,000 4,000 6,000 8,000 10,000 12,000 

Million Dollars 

1,000 2,000 3,000 4,000 5,000 

Million Dollars 

Household & Personal Products Real Estate Food & Staples Retailing

Health Care Equip & Services

Commercial Services/Supplies

Capital Goods Insurance Telecommunication Services 

Hotels Restaurants & Leisure Software & Services Consumer Durables & Apparel

Food Beverage & Tobacco Semiconductors Media Retailing

Energy Materials 

Utilities Transportation Pharmaceuticals & Biotech

Automobiles & Components

Technology Hardware & Equipment 

Household & Personal Products Utilities Real Estate Health Care Equip & Services Food Beverage & Tobacco

Automobiles & Components 

Telecommunication Services Insurance Semiconductors Media Software & Services Hotels Restaurants & Leisure Food & Staples Retailing Commercial Services/Supplies Materials Energy Pharmaceuticals & Biotech Transportation

Consumer Durables & Apparel Technology Hardware

Capital Goods Retailing 

5 Not all C&I loan demand will be met by commercial banks and savings institutions. Nonbank financial institutions compete with banks for C&I 

loan business. 

FDIC OUTLOOK 10 FALL 2004 
In Focus This Quarter 

Table 1 

Industries with the Highest 2003 Financing Gap* 

Expected Default FrequencyTM (EDFTM) Category** 

Investment-Grade Non-Investment-Grade All Firms 

.02 – .56 .56 – 20 .02 – 20 

Autos & Components Technology Hardware Technology Hardware 

Energy Computers Computers 

Crude petroleum/natural gas Printed circuit boards Printed circuit boards 

Petroleum refining Telecom equipment Telecom equipment 

Utilities Materials Autos and Components 

Electric Utilities Steelworks/blast furnaces Pharmaceuticals and Biotech 

Pharmaceuticals & Biotech Chemicals Transportation 

Transportation Plastics Airlines 

Auto rentals Pharmaceuticals and Biotech Auto rentals 

Transportation Utilities 

Airlines Electric utilities 

Food, Beverage, and Tobacco 

Cigarettes 

* Industries are listed in descending order of magnitude. The indented industries are the industries contributing the most to the broader sector’s financing gap. 

** Based on firms’ March 2003 Expected Default FrequencyTM. The lowest EDFTM assigned is .02 and the highest is 20. 

Note: The universe of companies includes only those with a positive financing gap in 2003. 

Sources: FDIC; Standard & Poor’s Compustat; Moody’s KMV Company. 

Table 2 

Industries with the Highest First Quarter 2004 Financing Gap* 

Expected Default FrequencyTM (EDFTM) Category** 

Investment-Grade Non-Investment-Grade All Firms 

.02 – .56 .56 – 20 .02 – 20 

Retailing Technology Hardware Retailing 

Building supply retailers Computers Building supply retailers 

Department stores Systems integrators Auto dealers 

Variety stores Printed circuit boards Department stores 

Auto dealers Telecom equipment Capital goods 

Capital Goods Retailing Industrial systems/instruments 

Industrial systems/instruments Auto dealers Farm/construction machinery 

Construction machinery Department stores Technology Hardware 

Consumer Durables/Apparel Variety stores Computers 

Home builders Transportation Printed circuit boards 

Energy Airlines Telecom equipment 

Petroleum refining Pharmaceuticals & Biotech Systems integrators 

Crude petroleum/natural gas Materials Consumer Durables/Apparel 

Transportation Chemicals Home builders 

Auto rentals Transportation 

Airlines 

Auto rentals 

* Industries are listed in descending order of magnitude. The indented industries are the industries contributing the most to the broader sector’s financing gap. 

** Based on firms’ March 2004 Expected Default FrequencyTM. The lowest EDFTM assigned is .02 and the highest is 20. May 2004 EDF was used for 88 firms with no assigned March 2004 EDF. 

Note: The universe of companies includes only those with a positive financing gap in 2003. 

Sources: FDIC; Standard & Poor’s Compustat; Moody’s KMV Company. 

FDIC OUTLOOK 11 FALL 2004 
In Focus This Quarter 

Although seasonal factors may influence the quarterly 

financing gap of some industries, historical data suggest 

that retail companies tend to experience peak external 

financing needs in the third quarter. Capital goods 

firms generally face peak financing requirements in the 

fourth quarter. 

The Importance of Inventory Financing Will Likely 

Grow in 2004 

Capital spending finance was the primary source of 

external funding needs overall in 2003, accounting for 

more than 82 percent of the total.6 In some industries, 

however, inventory finance was a far more important 

need. For example, the change in inventories in 

consumer durables and apparel accounted for 88 

percent of the total. Change in inventories accounted 

for a large part of financing needs in the household and 

personal products and food, beverage, and tobacco 

sectors as well. 

These industries aside, businesses generally have 

allowed inventories to decline to very low levels since 

the economic slump that began in the middle of 2001. 

However, both business and consumer confidence have 

largely recovered and economic activity has become 

brisk, requiring businesses to begin investing in inventories to meet product demand. 

First quarter 2004 data bear this out. Inventories’ share 

of external funding needs rose from 18 percent in 2003 

to 43 percent in first quarter 2004. Higher inventories 

were significantly more important relative to capital 

spending in the consumer durables and apparel, capital 

goods, household and personal products, and retail 

sectors (see Chart 3). For some industries, the change 

in the source of external funding needs was stark. For 

example, the change in inventories at retail firms 

increased from 31 percent of funding needs in 2003 to 

66 percent in the first quarter of 2004. For the capital 

goods sector the change in inventories increased from 

41 percent to 77 percent from 2003 to first quarter 

2004. 

6 Total C&I loan demand is assumed to be the sum of capital expenditures and the change in inventories during the period for firms with a 

positive financing gap. 

Box 2 

Expected Default FrequencyTM 

Provides Insights into Firms’ Credit 

Quality 

Moody’s KMV Company calculates its Expected 

Default FrequencyTM (EDFTM) for thousands of public 

companies on a monthly basis using information from 

each firm’s financial statements and market value of 

assets. A firm’s EDFTM is the probability of default 

within one year.7 Although Moody’s KMV does not 

specify investment-grade EDFsTM as the rating agencies’ rating systems do, it is possible to make some 

inferences based on the distribution of firms’ EDFsTM 

by rating category. 

There is considerable overlap of EDFTM scores across 

Standard & Poor’s rating categories. However, for the 

purposes of this analysis, we used the EDFTM at the 

90th percentile of all BBB rated firms to define the 

highest EDFTM for what we refer to as investmentgrade firms. Hence, we refer to firms with EDFsTM 

greater than .56 as non-investment-grade, understanding that some non-investment-grade firms have 

EDFsTM lower than .56. On the basis of this criterion, 

industries with the greatest potential commercial and 

industrial loan demand among investment-grade and 

non-investment-grade firms are identified. 

Chart 3 

The Need to Finance Inventories Grew 

in the First Quarter 2004 

Capital Expenditures Change in Inventories 

Contribution to Total Need for Funding (%), First Quarter 2004 

Consumer Durables/Apparel

Capital Goods Household & Personal Products Retailing Real Estate Technology Hardware Materials 

Insurance Food Beverage & Tobacco 

Automobiles & Components

Food & Staples Retailing Energy

Health Care Equip & Services

Pharmaceuticals & Biotech Semiconductors Media Commercial Hotels Restaurants & Leisure Software & Services Telecommunication Services Transportation Utilities

0 10 20 30 40 50 60 70 80 90 100 

Source: Standard & Poor’s Compustat 

7 The Moody’s KMV Credit Monitor® EDFTM estimates the probability 

of default within one year. Moody’s KMV Company’s calculation for 

EDFTM is based on (1) the current market value of the firm, (2) the 

structure of the firm’s current obligations, and (3) the vulnerability of 

the firm to large changes in market value measured in terms of asset 

volatility. 

FDIC OUTLOOK 12 FALL 2004 
In Focus This Quarter 

Conclusion 

When C&I loan growth resumes, the industries with 

the strongest demand will be those with the greatest 

need for financing purchases of capital equipment and 

inventories. This demand will likely come from the 

retailing, consumer durables, transportation, technology 

hardware, and capital goods sectors. 

The composition of C&I loan demand is likely to shift 

in 2004. First quarter 2004 data suggest that inventory 

financing will grow in importance this year as the economy continues to strengthen and the business sector 

invests in inventory to meet emerging demand. However, there should also be significant demand for capital 

equipment financing. 

Stephen C. Gabriel, Senior Financial Economist 

FDIC OUTLOOK 13 FALL 2004 
In Focus This Quarter 

The U.S. Manufacturing Sector: A Strong Past
 

and an Uncertain Future 

Manufacturing has played a major role in the U.S. 

economy since before the Civil War. This article 

reviews the sector’s more recent contribution to 

employment and output, explores key technological 

improvements, and concludes with a discussion of 

future prospects for the manufacturing industry. 

This issue of FDIC Outlook also features an article 

that looks at how community bank performance was 

affected in counties of the Chicago Region that are 

characterized by relatively high employment exposures 

to a subsector of manufacturing, the motor vehicle and 

parts industry (see “Have Chicago Region Community 

Banks Been Adversely Affected by Auto Sector Job 

Losses?”). 

Good-bye to the Industrial Revolution 

Manufacturing output grew rapidly through the 20th 

century. Even during the past ten years, manufacturing 

production expanded at an average rate of 3.6 percent 

per year.1 

National income and product account data confirm 

the continuing importance of manufacturing. In 1939, 

just before World War II, manufacturing represented 

almost 30 percent of gross domestic product when 

measured in inflation-adjusted dollars. The comparable 

amount in 2003 was even higher—almost 35 percent 

(see Chart 1).2 

World War II. As of World War II, 1 in 3 production 

workers not in agriculture was employed in manufacturing; 60 years later, fewer than 1 in 12 were employed in 

manufacturing.3 

Technology, Not Hiring, Drives the Productivity 

Miracle 

Maintaining significant growth in output with small, or 

no, gains in labor input implies substantial increases in 

productivity. Manufacturing overall has enjoyed higher 

productivity over time. Increases in productivity often 

have resulted in profound changes in products as well 

as in production techniques—changes that have been 

driven in large part by technological advances. 

The measure of productivity most commonly cited 

defines productivity as output per hours worked. This 

definition implicitly attributes any increases in productivity to workers. However, other factors, such as 

changes in technologies, physical capital, nonlabor 

inputs, and organizational characteristics, also affect 

output. When measured as output per hour worked, 

increases in manufacturing productivity appear quite 

Chart 1 

Despite a Rapid Decline in the Share of Total
 

Employment, Manufacturing Output Grew as
 

Fast — or Faster than — the U.S. Economy.
 

40 Manufacturing's Real Dollar Output

as a Percentage of Real GDP 

Manufacturing's Employment 

as a Percentage of Total 

Nonfarm Employment 

Such growth, of course, suggests increasing manufacturing employment. In broad terms, as the U.S. economy 35 

advanced during the 19th and much of the 20th 

century, workers relocated from farms to factories. That 

migration, however, became less and less effective at 

Percentage30 

25 

20 

generating manufacturing employment, as capital was 15 

substituted for labor and technology progressed. Indeed, 10 

maximum employment of manufacturing workers 

occurred 25 years ago in 1979, when employment 

slightly exceeded the previous peak reached during 

1 G.17, Industrial Production and Capacity Utilization, Federal Reserve 

Board. Current estimates for manufacturing production, 1993–2003. 

2 Department of Commerce, Bureau of Economic Analysis, National 

Income and Product Accounts, Real Gross Product by Major Type of 

Product, Chained 2000 Dollars, Table 1.2.6. 

39 47 55 63 71 79 87 95 03 

Note: GDP = gross domestic product.
 

Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Haver Analytics.
 

3 Bureau of Labor Statistics of the Department of Labor, The Employment Situation, Employees on Nonfarm Payrolls by Industry Sector, 

Table B-1, distributed by Haver Analytics. 

FDIC OUTLOOK 14 FALL 2004 
In Focus This Quarter 

Chart 2 Chart 3 

Manufacturing Productivity Grew More After Accounting for Capital and Technological 

Rapidly than Other Areas Inputs, Measures of Productivity in 

Manufacturing Are Less Impressive In Manufacturing 

160 (NAIC-Based 

Measure) 

In Private Nonfarm 

Business (SIC-Based 

Measure) 

In Private 

Nonfarm Business 

(NAIC-Based 

In Manufacturing Measure) 

(SIC-Based Measure) 

120 

Index Basis, Output per Hour,

1996 = 100 

140 

120 

100 

80 

60 

40 

20 

Multi-Factor Productivity,


Index Basis, 1996 = 100
 110 

100 

90 

80 

70 

60 

50 

In Private Nonfarm 

Business (SIC-Based 

Measure) 

In Manufacturing

 (SIC-Based Measure) 

49 55 61 67 73 79 85 91 97 03 

Note: NAICS = North American Industry Classification System, SIC = Standard Industrial
 

Classification.
 

Sources: Bureau of Labor Statistics, Haver Analytics.
 

sizable. From 1949 through 2001 (the years for which 

data are available), annual productivity increases averaged 2.7 percent in the manufacturing sector compared 

with 2.1 percent in the larger private nonfarm business 

sector, which includes service industries (see Chart 2). 

However, if variations in capital inputs (including 

embedded new technologies) also are considered, 

the direct output gains attributed to labor diminish 

considerably. 

When this more advanced multifactor approach is used, 

increases in manufacturing productivity slip to only 1.2 

percent per year, very close to the 1.1 percent gain for 

the private nonfarm business sector (see Chart 3). 

Thus, factors other than labor accounted for slightly 

more than half the total productivity gains during this 

period. In addition, changes in capital (including technology)—not labor directly—appear responsible for the 

high rate of increase in productivity that characterizes 

the manufacturing sector.4 

On an annual basis, changes in productivity have been 

highly variable, sometimes affected by cyclical developments and other times by secular events. Such events 

range from advances in technology to changing demographics, and also encompass economic shocks. From 

the end of World War II to 1973, the date of the first 

oil shock, productivity in manufacturing trended 

upward. However, higher oil prices, changing demographics, policy responses to high inflation, and other 

4 Bureau of Labor Statistics, Monthly Labor Review, 

November/December 2003, pp. 80–82. See also Bureau of Labor 

Statistics press release, “Multifactor Productivity Trends in Manufacturing, 2001,” February 10, 2004, for data on output per hour of all 

persons and multifactor productivity from 1949 to 2001. 

49 53 57 61 65 69 73 77 81 85 89 93 97 01 

Note: SIC = Standard Industrial Classification.
 

Sources: Bureau of Labor Statistics, Haver Analytics.
 

global factors led to a loss of competitiveness in key 

industries. As a result, productivity increases during the 

ensuing years slowed considerably. Later, during the 

1980s and particularly during the 1990s, new technologies associated with the development of personal 

computers, the Internet, and wireless communications 

drove productivity increases to levels that matched or 

even exceeded previous performances.5 

U.S. Manufacturing Competitiveness Has Been 

Challenged Worldwide 

Manufacturing output has varied with changes in 

productivity. Beginning in 1973, hours worked in 

manufacturing showed cyclical variations but little 

sustained change on a secular basis. 

In large part, this lack of growth in manufacturing 

employment reflected changing global economic conditions. The rise of Asian economies, in particular, introduced new economic powers on the world stage. In 

some cases, these rapidly developing economies 

competed directly with U.S. manufacturers. In other 

cases, U.S. manufacturers moved production facilities 

offshore, either through direct investment or by 

contracting out to reduce labor costs. International 

competition also was enhanced by the relaxation and 

removal of trade barriers under agreements forged 

through the World Trade Organization and by the 

5 Bureau of Labor Statistics, Monthly Labor Review, “Labor Productivity in Manufacturing,” June 2002, pp. 51–65. 

FDIC OUTLOOK 15 FALL 2004 
In Focus This Quarter 

development of free-trade areas, such as that created Chart 4 

by the North American Free Trade Agreement. The 

combination of these diverse developments presented Imports Have Far Outpaced Export 

both new opportunities and challenges for U.S. manu­ for Motor Vehicles and Parts* 

facturers. 

The U.S. automotive industry is a case in point, as 

global competition and consolidation have enabled 

foreign manufacturers to make significant inroads. The 

U.S. market has been transformed by growing imports 

of product and parts, along with manufacturing facilities and production techniques introduced into the 

United States by foreign producers. In the mid-1960s, 

Percentages Relative to U.S.


Motor Vehicle Output


60 

50 

40 

30 

20 

10 Exports 

Imports 

exports and imports of motor vehicles and parts in this 0 

67 70 73 76 79 82 85 88 91 94 97 00 03 

country were about equal, each representing less than 

10 percent of domestic output. Since that time, the 

export share has more than doubled, while imports 

have grown more than fivefold (see Chart 4).6 

Textile Manufacturing Suffers while 

Pharmaceuticals Expand 

The outlook for traditional manufacturing is not 

expected to change greatly. In its employment outlook 

for 2002 through 2012, the Bureau of Labor Statistics 

projects that the manufacturing sector will realize 

continuing significant output gains without increases 

in labor usage. These projections anticipate that real 

growth in the manufacturing sector will match that of 

the overall economy. As a result, manufacturing’s 

output share will change little during this ten-year 

period. By contrast, the employment share will 

continue its steady decline.7 

Specifically, over this ten-year period, manufacturing is 

projected to lose about 200,000 production workers. 

Retirements of existing workers, however, will soften 

this impact, implying a minor, but positive, level of new 

hiring.8 The textile and apparel industries and related 

occupations are expected to experience the greatest 

6 Bureau of Economic Analysis, Tables 4.2.5 and 7.2.5B. Globalization 

also works to the advantage—as well as disadvantage—of U.S. 

producers. See “GM to Invest $3 Billion to Grow China Output,” The 

Washington Post, June 7, 2004. Cost comparisons associated with 

motor vehicle parts manufacturing can be found in “Big Three’s 

Outsourcing Plan: Make Parts Suppliers Do It,” The Wall Street Journal, June 10, 2004. 7 Monthly Labor Review, “Employment Outlook, 2002–2012,” February 

2004, pp. 3–105. 

8 Employment projection materials provided to Business Research 

Advisory Council, Bureau of Labor Statistics, April 2004. 

*Motor Vehicles Include Automobiles.
 

Sources: Bureau of Labor Statistics, Haver Analytics.
 

percentage declines, in large part because of global 

competition and easing of import quotas. 

Although the outlook for manufacturing is mixed, with 

good-sized output gains coinciding with an essentially 

unchanged number of workers, conditions across industries are expected to differ widely (see Table 1). For 

example, employment in the chemicals industry is 

expected to decline by 38,000, or 4 percent, during 

the ten years ending in 2012.9 By contrast, the plastics 

manufacturing industry is expected to expand 20 

percent—a considerable acceleration in the rate of 

growth for this sector. 

Perhaps most significantly, pharmaceutical production 

is also expected to expand by at least 20 percent. A 

large share of this increase will be based in medical 

areas characterized by an extended development period. 

The approval of new drugs is expected to contribute to 

some significant increases in employment. 

Avant Immunotherapeutics, a Massachusetts-based 

pharmaceutical company, provides an example. At a 

point of transition from start-up to a mature operating 

company, Avant has achieved sufficient size and 

progress to support research facilities in Needham, 

Massachusetts, and St. Louis, Missouri. It also has 

occupied a new production facility in Fall River, 

Massachusetts.10 

9 Bureau of Labor Statistics, Monthly Labor Review, “Industry Output 

and Employment Projections to 2012,” February 2004, p. 63. 

10 Presentation by Dr. Una Ryan, CEO of Avant Immunotherapeutics, to 

“South Coast Economic Outlook Briefing—Spring 2004,” by Mass 

Insight and Mass Development, May 12, 2004. 

FDIC OUTLOOK 16 FALL 2004 
In Focus This Quarter 

Table 1 

Projection of Annual Change in Manufacturing Employment by Sectors, 2002–2012* 

Gainers Losers 

Annual Projected Annual Projected 

Sector Change Sector Change 

Plastics and Rubber +1.5% Apparel –11.0% 

Wood Products +1.3% Textile Mills –6.1% 

Nonmetallic Minerals +1.1% Leather –4.0% 

Furniture +1.0% Petroleum and Coal –1.6% 

Machinery +0.9% Paper –1.4% 

Fabricated Metal +0.6% Beverages and Tobacco –1.4% 

Food +0.5% Computers and Electronics –1.3% 

Printing +0.3% Nonapparel Textile Products –0.8% 

Miscellaneous +0.3% Chemicals –0.4% 

Primary Metals –0.3% 

Electrical Equipment –0.3% 

Transportation –0.2% 

Projected Annual Rate of Change in all Manufacturing Employment: –0.1%. 

Sources: Bureau of Labor Statistics, "Industry Output and Employment Projections to 2012," Monthly Labor Review, February 2004, Table 3, pp. 62–65. See related articles in this publication for 

additional detailed projections by industries and occupations. 

Large bio-tech firms, such as Biogen-Idec, Inc., and 

Amgen, Inc., are expected to build on their earlier 

successes. However, the value of these and other enterprises lies more with research and development than 

with manufacturing. As a result, high-tech and bio-tech 

manufacturing activity in the United States will 

continue to produce high-volume, high-dollar-value 

products with only a limited impact on overall employment levels. 

U.S. Manufacturing Faces an Uncertain Future 

Even where the outlook for manufacturing appears relatively bright, challenges loom. Investment in new technologies and new facilities is increasingly expensive, 

have regained some competitive advantages among 

developed economies. However, the rapid rise of new 

international competitors has continued to erode the 

position of U.S. manufacturers. As the sector’s ability to 

generate profits for future investment has deteriorated, 

the manufacturing sector today appears as much a 

potential source of economic weakness as a source of 

strength. 

Frederick S. Breimyer 

Regional Economist 

Chart 5 

Manufacturing’s Share of Total Corporate
 

Profits Has Declined over the Years*
 

Ten-Year Trailing 60% and the sector’s ability to generate funds for investment 

is being called into question. Before the Great Depression and through the 1960s, U.S. manufacturers represented about one-half of total U.S. corporate profits. 

This share has declined to only one-fifth during the 

past decade (see Chart 5).11 

As a result, the outlook for the U.S. manufacturing 

Percentages, from National


Income and Product Accounts


50% 

40% 

30% 

20% 

10% 

0% 

Averages of Profits

(SIC-Based Measures) 

Annual Estimates of 

Profits (SIC-Based

Measures) 

Annual Estimates 

of Profits (NAICSBased Measures) 

67 70 73 76 79 82 85 88 91 94 97 00 03 sector is mixed. In recent years, U.S. manufacturers 

* Profits Include Inventory Valuation Adjustment. 11 Department of Commerce, Bureau of Economic Analysis, National Note: NAICS = North American Industry Classification System, SIC = Standard 

Industrial Classification. Income and Product Accounts, Corporate Profits by Industry, Tables Sources: Bureau of Labor Statistics; Haver Analytics.

6.16A, B, C, and D. 

FDIC OUTLOOK 17 FALL 2004 
In Focus This Quarter 

Box 3 

Pension Burden Dampens Outlook for Older, Capital-Intensive Industries 

U.S. manufacturers face substantial logistical challenges On June 17, 2004, the Pension Benefit Guaranty 

as they plan future operations. Although many may Corporation (PBGC), the federal agency that guaransucceed in their efforts to source, produce, and distribute tees qualifying private-sector defined benefit pension 

in increasingly global markets, others will find it difficult plans, reported that companies with underfunded 

to do so given the weight of prior obligations. Such obli- pension plans had a total pension shortfall of $278.6 

gations in some cases are quite sizable, and may include billion, down slightly from 2003, but still substantially 

large amounts of fixed-term debt or previously higher than the $18.4 billion deficit reported in 1999. 

contracted, but underfunded, pension liabilities. In addi- The PBGC disclosed that a significant amount of 

tion to substantial ongoing costs to provide pension pension underfunding persists in the airline and steel 

benefits, these companies often provide retiree medical industries. More recently, United Airlines announced 

coverage. that it would no longer contribute to its employee 

pension plans while in bankruptcy.14 This implies that This legacy of prior financial obligations impinges on the PBGC could face another huge obligation to cover some manufacturers’ ability to compete with overseas these pensions in the future. Even now the PBGC faces firms. For example, in the automotive industry, the serious challenges in the years ahead, as it reported a results of a Prudential Financial study show that $9.7 billion deficit in its single-employer insurance plan pension and retiree benefits represent $631 of the cost of as of March 31, 2004. This is down from the $11.2 

every Chrysler vehicle, $734 of the cost of every Ford billion deficit as of September 30, 2003, but in sharp vehicle, and $1,360 of the cost of every General Motors contrast to the $9.7 billion surplus posted in 2000. vehicle.12 In contrast, an article in the Detroit Free 

Press reported that pension and retiree benefit costs per For additional discussion on pension plans, see Rae-Ann 

vehicle at the U.S. plants of Honda and Toyota are esti- Miller and Jeffrey Ayres, FYI: An Update on Emerging 

mated to be $107 and $108, respectively.13 Issues in Banking, “Could a Bull Market Be a Panacea for 

Defined Benefit Pension Plans?” January 13, 2004, at 

www.fdic.gov/bank/analytical/fyi/2004/011304fyi.html. 

12 “Analyzing the Big Three’s Pension and OPEB Costs,” Prudential
 

Financial Research, July 15, 2003.
 13 Butters, Jamie. “UAW to Target Chrysler for Talks, Analyst Says 14 Walsh, Mary Williams, and Micheline Maynard. “United Airlines
 

Improved Benefits May Come at the Cost of Jobs.” Detroit Free to Quit Paying into Pension Plans.” The New York Times, July 24,
 

Press, March 19, 2003. 2004.
 

FDIC OUTLOOK 18 FALL 2004 
90:Q1

91:Q1

92:Q1

93:Q1

94:Q1

95:Q1

96:Q1

97:Q1

98:Q1

99:Q1

00:Q1

01:Q1

02:Q1

03:Q1

04:Q1 

In Focus This Quarter 

Have Chicago Region Community Banks Been
 

Adversely Affected by Auto Sector Job Losses?
 

Manufacturing, particularly the production of motor 

vehicles and parts—typically referred to as “auto-manufacturing” in this article—has played an important role 

in the Chicago Region’s economy for decades. During 

2003, about 40 percent of the nation’s employment in 

transportation equipment manufacturing was located in 

the Region’s six states: Illinois, Indiana, Kentucky, 

Michigan, Ohio, and Wisconsin.1 

Many domestic auto manufacturing firms have faced 

financial challenges and thin profit margins for some 

time. Small supplier firms, in particular, have been 

disappearing because of mergers, acquisitions, or 

closures. Technology has facilitated expansion of autorelated output without parallel growth in employment.2 

Such factors contributed to the recent sharp drop in 

employment by transportation equipment firms in the 

Region (see Chart 1). 

Employment cutbacks by auto manufacturers in this 

sector may affect the financial health of community 

banks and thrifts headquartered in areas with high 

Chart 1 

Steep Job Losses among Transportation Equipment
 

Workers Have Occurred in the Chicago Region
 

850 

800 

750 

700 

650 

Source: Bureau of Labor Statistics. 

1 The transportation equipment industry includes motor vehicles and 

parts as well as airplanes, ships, and railroad equipment. 

2 See “The U.S. Manufacturing Sector: A Strong Past and an Uncertain Future” in this issue of FDIC Outlook. Employees (thousands) 

exposure to the this sector in a variety of ways.3 For 

example, loan growth and credit quality, deposit 

growth, and fee income opportunities could reflect the 

condition of auto manufacturers, households that 

derive their income from these firms, and small local 

businesses that rely on both. 

To evaluate potential effects on community lenders, we 

identified a group of insured institutions operating in 

counties with relatively high employment exposure to 

auto manufacturing. We compared several key performance measures between the institutions based in these 

counties and institutions operating in markets with less 

exposure. The results of the analysis suggest that any 

county-level relationship between high auto manufacturing employment exposure and community bank 

performance is tenuous. 

Employment by Auto Manufacturers Is 

Concentrated in the Chicago Region 

The Chicago Region economy represented 18 percent 

of national employment in 2003, about 24 percent of 

the nation’s manufacturing output, and 61 percent of 

the nation’s auto manufacturing output.4 

Production of motor vehicles and equipment generates 

more than 4 percent of the Region’s real gross product, 

nearly four times the national share. Only Illinois, with 

0.7 percent of its real gross state product (GSP) generated by this sector, has a smaller share than does the 

nation. At the other extreme, auto manufacturing 

generates about 9 percent of GSP in Kentucky and 

Michigan. 

Michigan’s dependence on auto manufacturing is about 

half what it was 15 years ago, reflecting growing 

economic diversification in the state and faster growth 

of industries other than vehicles and parts. In contrast, 

3 The performance of large banks likely is subject to economic conditions beyond those in headquarters locations. As a result, our study 

focused on insured community banks and thrifts (institutions that hold 

assets less than $1 billion, excluding de novo and specialty institutions). 

4 Data reflect 2001 output shares, the most recent available. 

FDIC OUTLOOK 19 FALL 2004 
In Focus This Quarter 

the sector’s role in the Kentucky economy more than 

doubled during the past decade, reflecting the development of a major transplant assembly plant, expansion 

of United States-owned plants, and the growth of 

supplier firms.5 

Many more workers are employed by firms that make 

parts and equipment than by vehicle producers.6 

Employment data with this level of detail are available 

from the Bureau of Labor Statistics for three states in 

the Chicago Region. Michigan is the site of many 

assembly plants and the “Big Three” corporate headquarters (GM, Ford, and DaimlerChrysler), along with 

design, research, and engineering staff. Even so, 

employment in the state’s parts and equipment sector 

was more than double that of vehicle producers in 

recent years. In Ohio, the ratio of workers making parts 

to those hired by producers was about three to one, 

while in Indiana it was almost six to one. 

Production of motor vehicles and parts occurs in about 

60 percent of the Region’s 557 counties, according to 

estimates for 2003 from Global Insight, Incorporated, 

an economic analysis firm. The industry’s share of 

employment in 182 counties was as high as 6 percent, 

but the actual number of workers was fairly low, at 550 

or fewer. These figures illustrate that some counties 

with a relatively high share of auto manufacturing 

employment have rather low employment levels overall, but one or two plants hire a significant share of 

local workers. 

Wayne County, Michigan, home to Detroit, has the 

highest (72,200) of auto manufacturing workers in the 

Region. Eleven counties in the Region have at least 

9,500 auto sector workers: six of these counties are in 

Michigan, two in Ohio, two in Indiana, and one in 

Kentucky. Many of these counties are in large, urban 

areas with diversified economies; as a result, only Scott 

County, Kentucky, and Howard County, Indiana, also 

rank in the top dozen when sorted by auto manufacturing share of employment. 

5 “Transplant” is a term used to describe a foreign-owned plant 

located in North America. Transplant facilities produced 25 percent of 

light-vehicle output in North America in 2002. Japanese producers 

other than Toyota, Honda, and Nissan are controlled by, or allied with, 

GM, Ford, or DaimlerChrysler. (Source: John McElroy, “Fight Fire with 

Fire,” Ward’s AutoWorld, March 1, 2004.) 6 Along with assembly line workers, employment by producers 

includes headquarters, research and development, design, and other 

professional staff. 

In an effort to gauge the employment exposure of counties to auto manufacturing, we developed an index with 

equal weights for the number of workers in that industry and their share of county employment. The 100 

Chicago Region counties with the highest employment 

exposure to auto manufacturing (and that are home to 

at least one community bank or thrift) are listed in the 

appendix. 

Structural and Cyclical Developments Affect 

the Motor Vehicle Sector 

For some time, a mix of cyclical and longer term structural elements has buffeted domestic auto manufacturers. Structural factors such as productivity growth, 

producers’ growing reliance on supplier firms for parts 

(outsourcing), and increased use of robotics tend to be 

relatively impervious to cyclical contractions and 

expansions. 

Other structural changes affect individual states and 

Regions more than the nation as a whole. For example, 

a growing share of auto manufacturing facilities is now 

located in the southern half of the auto corridor as a 

result of site selection decisions by transplant producers 

and the associated growth of supplier plants.7 

Auto manufacturing also is highly cyclical in nature. 

When the 2001 cyclical downturn is measured by vehicle sales, its severity was quite muted (see Chart 2). 

Chart 2 

The Slump in Vehicle Sales Was Muted around the 

2001 Recession 

Source: Bureau of Economic Analysis. Millions of Vehicles (seasonally adjusted annual rate) 

8 

10 

12 

14 

16 

18 

20 

76:Q1

78:Q1

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82:Q1

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98:Q1

00:Q1

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7 The auto corridor is bordered approximately by interstate highways 

65 and 75, extending south from Michigan. 

FDIC OUTLOOK 20 FALL 2004 
93:Q1

94:Q1

95:Q1

96:Q1

97:Q1

98:Q1

99:Q1

00:Q1

01:Q1

02:Q1

03:Q1

04:Q1 

In Focus This Quarter 

However, vehicle manufacturers offered generous Chart 3 

rebates, low-interest financing, and other inducements Weak Operating Profits of Motor Vehicle Sector to sustain demand. Even though the annual sales pace Reflect Challenges for domestic cars and light trucks held at around 16.5 15 million units during and after the 2001 recession, Profits: $ Billions
 (seasonally adjusted annual rate)


employment among transportation equipment manufacturers fell sharply during the same period. 

To the extent that auto manufacturing output and job 

contractions are cyclical, they are likely to be followed 

by cyclical rebounds. In turn, small businesses and 

households that depend heavily on this industry need 

10 

5 

0 

-5 

-10 

financial cushions that will carry them through the 

slowdowns. 

In contrast, to the extent that the industry’s job 

contractions are structural and thus permanent, the 

economic challenges for workers and firms can be steep 

-15 

Note: Data are not entirely comparable before and after first quarter of 2001 due to change
 

in methodology at source agency. Data reflect before-tax profits with inventory valuation
 

adjustments.
 

Source: Bureau of Economic Analysis.
 

In this environment of low profitability per vehicle and long lasting. Many communities in the Chicago 

Region that are dependent on auto manufacturing are 

affected by these structural and cyclical conditions, 

albeit to varying degrees. 

The historical experience of many community banks 

and thrifts in Michigan, Ohio, and the upper Midwest 

guides how they plan for and manage the local impacts 

from cyclical swings in auto manufacturing. These 

banks and thrifts also are familiar with structural trends, 

such as the demise of small, independent supplier firms 

and the fact that rising productivity and other factors 

trim the potential for robust auto sector job growth. 

Structural Challenges Are Significant 

As a group, U.S. producers of motor vehicle and parts 

frequently reported losses from current production in 

recent years (see Chart 3) despite the strong sales pace 

and the fact that the industry’s capacity utilization rate 

remained relatively high. The use of record-level 

rebates and incentives contributed to some producers’ 

poor profitability record. Sales incentives offered by the 

Big Three more than doubled between 1999 and late 

2003, to $4,000 per vehicle, yet these companies lost 

market share.8 

8 Thomas Klier, “Challenges to the U.S. auto industry,” Chicago Fed 

Letter, March 2004, referring to comments by Iain Carson, industry 

editor of The Economist, at a conference sponsored by the Federal 

Reserve Bank of Chicago. The exact dollar amount of incentive differs 

by sources, but few question that it has risen. 

produced, several Big Three corporations recently 

generated more income from their financial arms than 

from their production operations.9 Without the financing side of each corporation to counter the marginal 

profitability from producing vehicles, the effects on the 

Chicago Region economy from downsizing of the lightvehicle industry might have been more severe. 

Motor vehicle producers assemble and deliver finished 

cars and lightweight trucks.10 These firms operate in an 

environment of substantial excess production capacity 

in North America and worldwide. Consequently, they 

face keen competition for potential customers and 

limited ability to raise profits through higher prices. 

Pensions and other liabilities to retirees are substantial 

for the Big Three firms and do not fluctuate with 

production volumes.11 Firms thus have a high proportion of fixed costs relative to variable costs, and reducing production runs does not reduce total operating 

costs dramatically. 

9 See, for example, Lee Hawkins, Jr., “Outside Audit: Guess Why GM 

Is More Bank Than Car Maker? Finance Arm GMAC Gives Firm Most 

of Its Earnings; 0% Car Loans Pay Off, Too,” The Wall Street Journal, 

May 5, 2004. 

10 Lightweight vehicles are automobiles plus Class I and Class II 

trucks, which have a gross vehicle weight of 10,000 pounds or less. 

Some producers also own “captive supplier” subsidiaries. 

11 The collective benefit expense of Detroit-based producers is estimated to rise 80 percent from 2002 to 2007, and the pressure on cash 

flow is likely to peak in 2008–2012. (Source: Kenneth N. Gilpin, “Cool 

on Cars, but Warm on Car Parts,” The New York Times, June 22, 2003, 

quoting Goldman Sachs & Company’s auto analyst Gary R. Lapidus.) 

FDIC OUTLOOK 21 FALL 2004 
In Focus This Quarter 

Because vehicle producers often lack an economic 

motive to curtail production, the number of trucks and 

cars available for sale often exceeds demand. This 

imbalance, in turn, leads to price and incentive “wars.” 

One result of this strategy is that producers can face 

difficulties in generating profits from their manufacturing operations. 

Transplant facilities have a cost advantage compared 

with the Big Three. In general, transplants operate relatively new and efficient plants, are located in states 

with lower wage rates, lack the pension and medical 

“legacy costs” for a large pool of retirees, and have 

greater flexibility in scheduling employee work hours 

and duties. Therefore, the economic impact of an 

assembly plant on a locality can vary considerably, 

depending on whether or not the plant is unionized 

and run by one of the Big Three.12 

The 2003 United Auto Workers contract with the Big 

Three allows the firms greater flexibility in closing 

plants than the previous contract. Indeed, Detroitbased automakers have announced plans to reduce 

capacity in the next three years. This strategy likely 

will trim production and employment in the Chicago 

Region, but it is unlikely to resolve the vehicle glut or 

production profitability problems. 

Foreign producers, meanwhile, have announced plans 

to increase their U.S. production capacity by 1.8 

million vehicles, about twice the capacity being 

trimmed by the Big Three.13 Thus, excess supply in the 

North American market, which was two million vehicles in 2003, may not shrink substantially in the next 

five years.14 In the coming years, therefore, economic 

conditions in communities with high exposure to the 

sector may remain in flux, as some firms and locations 

experience auto manufacturing payroll growth while 

others face shrinkage. 

Manufacturing of equipment and parts is less concentrated among a few firms than is vehicle production. 

Some analysts feel that domestic supplier firms’ profitability and viability are under severe pressure because 

the Big Three, in particular, impose cost-reduction 

12 The degree of income volatility among households and small businesses in a bank’s market area may vary considerably, depending on 

whether local auto manufacturing workers are employed in union or 

nonunion plants. 

13 Diane C. Swonk, “The Fairy Tale Economy—What’s Real, What’s 

Not,” in One View of the Economy, Bank One, February 2004. 

requirements on their suppliers, while production from 

abroad limits domestic suppliers’ pricing power. 

Although cost containment is one factor in producersupplier relationships, the mutual nature of the relationship plays out in a number of ways. Vehicle 

manufacturers, for example, are entering longer-term 

contracts with suppliers (often for the life of a vehicle 

model) to foster engineering and design improvements 

while lowering per-unit parts prices (via larger production runs). Consequently, suppliers can invest in new 

products or production techniques without losing a 

major customer when an annual contract is renewed. 

Some supplier firms diversify risks by developing relationships with the Big Three and transplant firms. 

Others spread risks by serving not only new vehicle 

producers but also the replacement part market, and 

some produce for nonvehicle markets. For example, a 

firm might make molded plastic parts for computers as 

well as for vehicles. 

Producers prefer to purchase systems or modules rather 

than individual pieces and parts, a trend that favors 

certain suppliers. This trend has pressured the viability 

of small firms that produced a limited variety of individual parts. Some of these firms responded by expanding sufficiently to produce the new systems; some 

merged or formed alliances with firms that made similar 

or complementary parts; and others closed. 

All of these conditions and changes might be expected 

to stress the economic vigor of communities with 

historically high auto employment exposure. In turn, 

lenders and providers of financial services could suffer. 

The extent to which declining auto manufacturing 

employment in a market hurts community banks and 

thrifts, however, would reflect these institutions’ skill in 

managing risks and observing prudent underwriting as 

well as other factors. 

How Are Community Banks and Thrifts Faring in 

Auto Manufacturing Counties? 

As challenges facing the auto manufacturers remain 

and job losses continue in the Chicago Region, 

concerns have arisen about the possible adverse effects 

on banks and thrifts headquartered in communities 

with high employment exposure to producers of vehicles and parts. 

14 Kenneth N. Gilpin, “Cool on Cars, but Warm on Car Parts.” 

FDIC OUTLOOK 22 FALL 2004 
In Focus This Quarter 

To evaluate the economic implications for the Region’s 

community banks, we compared the overall risk profile 

and financial performance of two groups: insured 

community institutions headquartered in counties with 

the greatest employment exposures to auto manufacturing and all other community institutions in the Region. 

The Chicago Region is home to 1,779 community 

institutions. Of these, 326 are located in counties with 

relatively high employment exposure to auto manufacturing. These institutions are primarily based in Michigan, Ohio, and Indiana (see Chart 4). The median 

asset size of these 326 institutions is $126 million, 

versus $105 million for other institutions, suggesting 

that both groups operate traditional types of local 

banking. 

Chart 4 

Institutions in Counties with High Exposure to Auto
 

Manufacturing Are Concentrated in Three States
 

WI IL 5% MI 10% 26% 

KY
 

14%
 

OH 

21% 

IN 

24% 

Source: FDIC, Data as of December 31, 2003. 

Despite stresses among auto manufacturers, overall 

credit quality among community institutions with relatively high auto manufacturing exposure relative to 

other community institutions has not changed significantly since the 2001 recession. Both groups reported 

improving asset quality, with similar delinquency ratios 

in recent years. This stability exists, in part, because 

these institutions rarely lend directly to large vehicle 

producers or supplier firms. Although institutions in 

counties with high auto manufacturing employment 

reported a slightly higher 30- to 90-day past-due ratio, 

their noncurrent ratio was lower than among other 

institutions. Though both groups have a similar loan 

portfolio mix, delinquency ratios for 1- to 4-family 

mortgages and consumer loans were slightly higher 

among institutions in counties more reliant on auto 

manufacturing. However, this relationship could reflect 

conditions other than falling employment among 

producers of motor vehicles and parts. 

Historically, profitability has declined during economic 

downturns with increasing credit costs. However, 

despite the recent recession, insured community institutions based in the Chicago Region have maintained 

solid earnings and, notably, the earnings performance 

of institutions in auto manufacturing counties has been 

comparable to that of other community institutions. 

Yet, about 6 percent of institutions in these counties 

were unprofitable in 2003, slightly higher than for 

other institutions in the Region. 

Conclusion 

As noted in the FDIC Manual of Examination Policies, economic downturns or local exposures to declining industries can affect borrower repayment potential 

adversely and reduce collateral protection. Reliance on 

previously existing conditions and overly optimistic 

expectations for economic improvement could 

contribute to loan and deposit portfolio deterioration.15 

The Chicago Region has been characterized by relatively high dependence on auto manufacturing for 

many years. As a result, households, businesses, and 

lenders likely have learned to manage and adjust to the 

inherent risks. Moreover, many who worked for dominant motor vehicle firms received relatively generous 

pay and benefits that carried over into retirement, 

regardless of the timing of that retirement. Union benefits also may have cushioned the financial shock of job 

loss for some workers. Thus, while the risk profile of 

banks and thrifts based in auto manufacturing communities may be expected to be higher than those based 

elsewhere, recent historical experience does not 

confirm this hypothesis. Rather, banks and thrifts in 

these areas appear to be managing the risks appropriately. 

The results of this study may not apply to other 

Regions, as conditions and industry stresses differ 

among geographic areas. As economic conditions 

change, bankers should monitor lending policies and 

portfolio credit quality carefully. 

Chicago Region Staff 

15 FDIC Manual of Examination Policies, Section 3.1 (Loans) and IV 

(Lack of Attention to Underlying Economic Conditions), February 2002, 

www.fdic.gov/regulations/safety/manual/Section3-1.html. 

FDIC OUTLOOK 23 FALL 2004 
In Focus This Quarter 

Appendix 

Chicago Region Counties That Are Characterized by Relatively High Employment Exposure 

to the Motor Vehicle and Parts Industry 

MV&P Employment MV&P Employment 

Weighted County State 2003 % of Total Weighted County State 2003 % of Total 

Ranking Level Employment Ranking Level Employment 

1 HOWARD IN 16,885 32.0 51 EATON MI 1,825 5.2 

2 SCOTT KY 9,582 35.6 52 KENOSHA WI 2,264 4.8 

3 TRUMBULL OH 12,602 13.1 53 MONTGOMERY IN 1,188 6.3 

4 SAGINAW MI 12,760 12.3 54 ST CLAIR MI 2,330 4.5 

5 UNION OH 4,752 17.9 55 CHAMPAIGN OH 1,014 7.5 

6 LOGAN OH 4,201 18.1 56 CASS MI 892 8.4 

7 MACOMB MI 33,051 9.3 57 CLARK IL 650 11.0 

8 WAYNE MI 72,203 8.4 58 LINCOLN KY 598 13.5 

9 MERCER KY 2,883 29.5 59 ALLEN OH 2,388 4.1 

10 CALHOUN MI 6,931 11.2 60 ROSS OH 1,512 5.0 

11 HILLSDALE MI 3,373 16.2 61 TUSCOLA MI 953 7.0 

12 ELKHART IN 11,701 9.4 62 ALLEN IN 5,454 2.8 

13 GENESEE MI 14,913 8.8 63 DARKE OH 1,147 5.1 

14 TIPPECANOE IN 6,795 10.4 64 BARREN KY 1,034 5.3 

15 NOBLE IN 3,171 14.0 65 JACKSON MI 2,488 3.5 

16 INGHAM MI 17,728 8.3 66 JEFFERSON IN 910 6.1 

17 BOONE IL 2,876 17.8 67 WAYNE IL 566 10.4 

18 CASS IN 3,032 13.8 68 WINNEBAGO WI 2,832 3.0 

19 ST JOSEPH MI 3,279 13.2 69 BRANCH MI 1,012 5.1 

20 EDWARDS IL 1,813 52.9 70 KOSCIUSKO IN 1,631 3.9 

21 LAWRENCE IN 2,403 13.5 71 JOHNSON IN 1,718 3.8 

22 IONIA MI 2,544 12.2 72 WYANDOT OH 741 6.9 

23 HANCOCK IL 1,758 23.9 73 MARSHALL IN 1,089 4.7 

24 SHELBY OH 2,704 10.8 74 JEFFERSON KY 8,746 1.9 

25 ROCK WI 5,546 7.7 75 PULASKI IN 532 9.4 

26 CLARK OH 4,428 7.8 76 WAYNE OH 1,825 3.3 

27 LORAIN OH 7,049 6.1 77 LAPEER MI 1,012 4.5 

28 HARDIN KY 3,484 7.4 78 FRANKLIN KY 1,412 3.6 

29 LIVINGSTON MI 3,682 7.2 79 POLK WI 750 5.3 

30 STEUBEN IN 2,348 9.4 80 WAYNE IN 1,310 3.6 

31 HUNTINGTON IN 2,011 10.3 81 WASHINGTON IL 592 7.1 

32 OTTAWA MI 6,212 5.3 82 HARDIN OH 620 6.0 

33 MONTGOMERY OH 15,180 4.9 83 MADISON KY 982 4.3 

34 NELSON KY 1,532 9.1 84 GRANT IN 1,202 3.5 

35 FOUNTAIN IN 944 13.6 85 JO DAVIESS IL 631 5.2 

36 ADAMS IN 1,373 8.4 86 NOBLE OH 325 13.6 

37 BERRIEN MI 2,938 5.1 87 ALLEN KY 459 7.9 

38 CLAY IN 983 13.0 88 HIGHLAND OH 636 4.2 

39 BARTHOLOMEW IN 2,400 5.4 89 HENDERSON KY 887 3.5 

40 HENRY IN 1,322 7.9 90 KENT MI 4,212 1.2 

41 WOOD OH 2,534 5.0 91 MONTCALM MI 622 4.1 

42 WASHTENAW MI 8,646 3.6 92 DE KALB IN 789 3.4 

43 BUTLER KY 709 15.0 93 HENRY OH 537 4.6 

44 OAKLAND MI 23,515 3.0 94 WARREN KY 1,142 2.1 

45 GRATIOT MI 1,117 8.4 95 MARION IN 5,511 0.9 

46 DUBOIS IN 1,721 5.7 96 MADISON OH 614 2.6 

47 DELAWARE IN 2,348 5.0 97 CHRISTIAN KY 944 2.6 

48 MC LEAN IL 3,400 4.0 98 CLERMONT OH 1,166 2.0 

49 VAN WERT OH 1,024 8.1 99 FAYETTE IN 523 4.4 

50 CLINTON OH 1,509 6.0 100 WILLIAMS OH 636 3.1 

Source: Employment estimates for 2003 on a U.S. Standard Industrial Classification (SIC) basis are from Global Insight, Inc. Only counties with at least one community institution headquartered 

there are listed. 

FDIC OUTLOOK 24 FALL 2004
 
In Focus This Quarter 

The U.S. Agricultural Sector: Recent Events 

Highlight Ongoing Systemic Risks 

Compared with the troubled 1980s, the U.S. agricultural sector has been profitable and stable in recent 

years. Crop and livestock production has been positive, 

prices have improved overall, and federal government 

payments have bolstered farmers’ incomes. Agricultural 

lenders, in general, are reporting stable financial conditions. In addition, change affecting the agricultural 

sector, in the form of technological progress and steady 

consolidation of the industry, has been gradual and 

largely predictable. However, several recent developments, such as the filing of international trade disputes, 

the incidence of “mad cow” disease at the end of last 

year, and continuing water shortages across the West, 

highlight long-term, systemic risks that may profoundly 

affect the agricultural industry. 

Farm Income Levels Continue to Be Positive and 

Bank Conditions Are Stable 

During 2003 the U.S. agricultural sector earned $54.9 

billion in net farm income, the best performance since 

1996. A record corn crop, high cattle prices for much 

of the year, and significant government payments 

contributed to this strong performance. 

Table 1 

Prices of most major commodities are forecast to be 

even higher in 2004 than in 2003 because of low 

worldwide crop inventories and declining supplies in 

the livestock sector (see Table 1). With normal 

weather, the revenues earned from crop production will 

likely increase in 2004. Revenue from livestock production is forecast to decline slightly but is still expected to 

be the third-highest level on record. 

In the first half of 2004, the U.S. Department of Agriculture (USDA) forecasted net farm income at $47.6 

billion for the current year, a level in line with the tenyear average but down somewhat from 2003. Much of 

the difference in net farm income between 2003 and 

2004 can be attributed to the fact that government 

payments are expected to decline about $7 billion in 

2004. During 2003, emergency assistance provided to 

farmers in response to the drought experienced in 

previous years resulted in large government payments. 

Higher prices throughout 2004 would likely result in 

lower levels of federal assistance. 

According to the USDA, the net worth of the farming 

sector is forecast to increase more than 3 percent in 

2004, supported by continued strength in the value of 

farmland, which accounts for more than 80 percent of 

total industry assets.1 

Prices of Most Commodities Are Projected to Be Strong through 2005 

Estimated 

2001 2002 2003 2004 

Projected 

2005 

Corn 1.85 1.97 2.32 2.50 

Soybeans 4.54 4.25 5.53 7.65 

Wheat 2.62 2.78 3.56 3.40 

Cattle 72.71 67.50 84.69 86.00 

Hogs 45.81 34.92 39.45 48.00 

Milk 14.97 12.10 12.52 16.40 

2.75 

6.20 

3.55 

86.00 

47.00 

13.55 

Notes: Grain prices are for marketing year of each crop. Crop quantities are per bushel; livestock and milk are per hundredweight. Commodities are listed in order of total cash receipts by 

product groupings: crops, meat, and milk. 

Sources: U.S. Department of Agriculture/World Agricultural Supply and Demand Estimates, June 10, 2004. 

1 USDA/Economic Research Service, Farm Income and Costs Briefing 

Room, www.ers.usda.gov/Briefing/FarmIncome. 

FDIC OUTLOOK 25 FALL 2004 
In Focus This Quarter 

Banking Industry Conditions Reflect Solid because of expectations of an adverse reaction by 

Performance of the Agricultural Sector consumers.4 However, the discovery actually had no 

Overall, the financial condition of the nation’s 1,730 

farm banks remains satisfactory.2 In aggregate, reported 

asset quality indicators, such as past-due loan levels and 

net charge-offs, remain low, and profitability and capital levels remain high. In first-quarter 2004, farm banks 

reported a median delinquency ratio of 2.27 percent 

and a net charge-off ratio of 0.12 percent, the lowest 

first-quarter figures during the past five years. However, 

farm banks located in drought-stricken areas of the 

West and Great Plains are reporting far higher delinquency ratios. The drought-induced stress also is 

evident in Safety and Soundness examination trends. 

The number of farm banks based in drought-affected 

areas that have been rated 3, 4, or 5 for asset quality is 

increasing but remains manageable.3 

Despite the stability currently experienced in the farm 

sector and by its lenders, several recent events suggest 

that significant systemic risks remain—specifically 

consumer attitudes about the safety of food, ongoing 

water shortages, and events regarding farm policy. 

Systemic Risks to the Agricultural Sector Are 

Emerging 

Consumer Attitudes: What Does the “Mad Cow” 

Incident Suggest about Consumer Attitudes Toward 

Food Safety? 

U.S. cattle prices in both the cash and futures markets 

declined sharply in the weeks following the announcement of the discovery of the first occurrence of mad 

cow disease in the United States in December 2003 

2 An FDIC-insured bank is considered a “farm bank” if total agricultural production loans and loans secured by farmland are at least 25 

percent of total loans. 

3 Using data from U.S. Drought Monitor maps 

(http://drought.unl.edu/dm) published the first week of June 2000 

through June 2004, we grouped the individual counties of all continental states west of the Missouri River according to whether they 

have been largely affected by persistent drought or not. We then 

examined the proportions of farm banks headquartered in each group 

that have a current Safety and Soundness Regulatory Examination 

asset quality rating of 3, 4, or 5. Such a rating indicates that the institution’s asset quality and/or credit administration is less than satisfactory. For farm banks in areas of persistent drought, the proportion 

with less than satisfactory asset quality has risen from 7.2 percent in 

March 1998 to 14.8 percent in March 2004. Comparatively, for farm 

banks in areas less affected by drought, the proportion has risen from 

8.0 percent to 11.7 percent in the same period. 

discernible effect on domestic beef consumption, and 

prices rebounded quickly. According to one prominent 

industry analyst, domestic retail demand for beef 

increased 6.2 percent on a year-over-year basis in firstquarter 2004, and cash cattle prices recovered by early 

May.5 This result was consistent with academic research 

that shows that demand for meat products by U.S. 

consumers is not significantly affected by adverse information about product safety. Researchers at North 

Carolina State University and Kansas State University found that price, seasonal factors, and precommitted levels of consumption override the effects of such 

adverse events. The effects that were observed were 

transitory and not cumulative over long periods.6 

Though U.S. consumers do not appear to have been 

significantly or permanently affected by the single case 

of mad cow disease, the incident may have wider ramifications for the long-term health of the country’s agricultural sector. 

This incident highlights fundamental differences 

between the attitudes of U.S. consumers and those of 

European and Japanese consumers about the role of 

scientific evidence in formulating regulatory policy. 

Some observers suggest that the relatively frequent food 

scares in Europe, such as the original bovine spongiform 

encephalopathy (BSE) crisis in England, E coli incidents, and dioxin-tainted animal feed, have made European consumers more wary of threats to the safety of 

their food. Political analysts also suggest that the 

decentralized nature of Europe’s regulatory system 

makes it more susceptible to political pressure than is 

the U.S. Food and Drug Administration. Also, European consumers are not as accustomed as Americans to 

a steady stream of novel food products.7 European regulatory agencies often feel that they have to heed the 

concerns of the general public, regardless of whether 

regulatory action is justified in the eyes of the scientific 

community.8 

4 Mad cow disease is technically referred to as bovine spongiform
 

encephalopathy, a degenerative disease of the nervous system.
 

5 Smith, Rod. May 10, 2004. “Cattle return to December levels; demand
 

exceeds all experience.” Feedstuffs 76(19). 
 6 Piggott, Nicholas E., and Thomas L. Marsh. “Does Food Safety Information Impact US Meat Demand?” North Carolina State University
 

Working Paper, pp. 32–33. www.ag-econ.ncsu.edu/faculty/
 

piggott/food_safety.pdf.
 

7 “Biotechnology’s Transatlantic Divide,” Council for Biotechnology
 

Information, www.whybiotech.com/index.asp?id=3638.
 8 Zavon, Juliet. February 27, 2004. “Food safety and the consumer:
 

What matters and whose requirements count?” Feedstuffs 76(9). 


FDIC OUTLOOK 26 FALL 2004 
In Focus This Quarter 

This relatively conservative attitude toward food safety 

was evident among countries that import beef from the 

United States, including Japan, South Korea, and 

Mexico. These countries reacted immediately to the 

news of the discovery of BSE by suspending all imports 

of U.S. beef. As of mid-July, these major destination 

countries have continued this policy. Japan, the most 

important destination for U.S. beef, has insisted that all 

cattle slaughtered for export be tested for BSE, while 

the United States continues to maintain that such 

extensive testing is neither necessary nor prudent.9 

Similarly, this divergence in attitude between U.S. 

and foreign consumers and regulators is evident in the 

ongoing controversy about genetically modified (GM) 

crops. In the United States, soybean seed that was 

genetically modified to be tolerant of herbicides was 

first introduced in 1996 and, in 2003, constituted 81 

percent of all soybeans planted in the nation. Similarly, 

59 percent of all U.S. cotton planted in 2003 was 

genetically modified, as was 29 percent of the corn 

crop.10 In the United States, labeling of biotech products is not mandatory, and consumer attitudes toward 

the products are not well-formulated, as some argue 

that the speed at which the technology has been 

adopted has outstripped the public’s ability to understand it.11 

The European Union (EU), on the other hand, instituted a ban on new GM products six years ago, and the 

EU and Japan require that GM foods be labeled. The 

United States has protested this policy before the 

World Trade Organization (WTO), arguing that no one 

has ever presented scientific evidence showing that 

GM crops pose a risk to humans, animals, or the environment, and that U.S. farmers have been denied $1.8 

billion in export opportunities.12 On a global scale, the 

future of GM crops remains uncertain. In early May, 

the Monsanto Corporation, the largest producer of GM 

seeds, announced it was delaying the introduction of an 

9 Schuff, Sally. April 5, 2004. “Japan appears to reject U.S. BSE testing 

proposal.” Feedstuffs 76(12). Howie, Michael. March 22, 2004. 

“Hueston: Testing all cattle for BSE not warranted.” Feedstuffs 76(12). 10 Agricultural Biotechnology: Adoption of Biotechnology and Its 

Production Impacts. USDA/Economic Research Service Briefing 

Room, http://www.ers.usda.gov/Briefing/Biotechnology/chapter1.htm. 11 “Consumers and the Future of Bio-Tech Foods in the United States.” 

USDA/Economic Research Service. November 2003. Amber Waves 

1(5): 35. 

12 Elliot, Ian. April 30, 2004. “EU moves closer to ending GM ban.” 

Feedstuffs 76(18). 

herbicide-resistant wheat variety because of uncertainties in the international market.13 

The international reaction to the “mad cow” incident 

and the ongoing resistance to GM crops suggest that 

the U.S. agricultural sector is facing a new set of challenges in the world marketplace, where the attitudes of 

consumers are profoundly different from those in the 

domestic market. As U.S. producers become more 

closely integrated into global markets, they may have 

to be more sensitive to the needs and wishes of foreign 

customers. In addition, they must be prepared for U.S. 

consumers to be influenced by foreign perceptions 

about food safety. 

Water Shortages: Are They a Precursor to Conflict 

in the West and Great Plains? 

The Kansas City Regional Perspectives article in the 

Spring 2004 FDIC Outlook described the effects of longterm or “hydrological” drought on the Kansas City 

Region.14 Long-term drought issues are causing water 

shortages that are prompting conflicts between farm 

users (those who irrigate with wells) and urban users and 

developers. Changes in water policies stemming from 

ongoing shortages could significantly affect farmers. 

The agricultural sector’s dependence on irrigation has 

grown considerably since 1949 (see Map 1, next page). 

The Great Plains and the Mississippi Delta have significantly increased the use of irrigation. 

The extended drought that has persisted for six years 

in some parts of the West and the Great Plains has 

prompted concerns about the long-term sustainability 

of irrigated agriculture. In the Southwest and West, 

particularly, sustained growth of cities has increased 

demands for drinking water, as well as water for industrial uses and recreation. Historically, increased 

demands were met by expanding available supplies, but 

future opportunities for expansion of water supplies are 

13 Schuff, Sally. May 14, 2004. “Monsanto shelves GM wheat after
 

industry resistance.” Feedstuffs 76(20). 
 14 “Hydrological Drought Conditions Are Expected to Affect Farmers
 

and Their Lenders,” FDIC Outlook, Spring 2004, p. 25.
 

FDIC OUTLOOK 27 FALL 2004 
In Focus This Quarter 

Map 1 

Irrigated Cropland Has Increased Dramatically in the Past Half-Century 

Irrigated Land in Farms, 1949 Irrigated Land in Farms, 1997 

Large, dark dot = 10,000 acres 

Medium dot = 1,000 acres 

Small, light dot = 100 acres 

Sources: U.S. Department of Agriculture (USDA). Economic Research Service based on Census of Agriculture; U.S. Department of Commerce, Bureau of the Census, 1949; 

and USDA, National Agricultural Statistics Service, 1997. 

more limited because of the shortage of suitable sites 

and environmental concerns. Instead, future water 

demands will likely be met by reallocating existing 

supplies; because agriculture is the largest user, reallocation will surely result in reduced supplies for that 

sector.15 

In fact, recent press coverage shows that this reallocation is already occurring in some markets. For example, 

in 2003 farmers in the Imperial Valley of Southern 

California sold some of their irrigation water to the San 

Diego urban water district. Though economists see such 

transactions as an efficient means of allocating the 

water to its most valuable use, agricultural sector advocates argue that they threaten the long-term viability of 

the growers.16 In another example, a number of cities in 

Northern Texas have been purchasing water rights from 

farmers and ranchers since the 1980s, and their demand 

for water continues to grow.17 

These examples in Southern California and the Great 

Plains suggest that soon farmers may not be able to 

consider water a free resource. If they are forced to pay 

the economic value of their water, many farmers will 

not be able to afford the massive irrigation that is 

15 Gollehon, Noel, et al. February 2003. “Water Use and Pricing in Agriculture.” Agricultural Resources and Environmental Indicators, 2003,
 

USDA/Economic Research Service. www.ers.usda.gov/publications/
 

arei/ah722/arei2_2/arei2_2irrigationwatermgmt.pdf.
 

16 Johnson, Kirk, and Dean Murphy. “Drought Settles In, Lake Shrinks,
 

and West’s Worries Grow.” May 2, 2004. The New York Times.
 17 David W. Yoskowitz. 2002. “Water for the Future: The Development
 

of Markets in the Texas Plains.” Water on the Great Plains–Issue and
 

Policies. Ed. Peter J. Longo and David W. Yoskowitz. Lubbock, TX:
 

Texas Tech University Press, p. 135.
 

currently practiced. Significant declines in agricultural 

revenue, net income, and, ultimately, the value of farmland could result. 

Potentially more troubling is new evidence that casts 

doubt on the ability of western states to sustain their 

present level of economic growth. Research by a 

hydrologist at the U.S. Geological Survey on the 

drought cycles of the American West suggests that the 

relatively wet weather enjoyed in the 20th century may 

have been an historical aberration, and not the norm 

on which land development decisions should be based. 

Studies of tree rings suggest that long periods of 

drought, such as the current one, are more likely the 

normal state of affairs over the long term.18 If this 

evidence is correct, the days of water-intensive agriculture in the western states may be numbered. 

World Trade Organization Ruling on Cotton 

Subsidies Is Worth Watching 

The U.S. farm program provides significant financial 

support to the agricultural sector. From 1990 through 

2003, government payments represented more than 26 

percent of total net farm income. Government 

payments are disproportionately important in those 

states that concentrate in commodities that are 

18 Johnson and Murphy. 

FDIC OUTLOOK 28 FALL 2004 
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002 

In Focus This Quarter 

Chart 1 

Farmers in the Corn Belt and Great Plains Depend
 

Significantly on Government Payments
 

$Billions 

25 

20 

15 

10 

5 

-

Values for Government 

Payments in the Ten Most 

Heavily Subsidized States 

Government 

Payments 

Net Farm Income 

Less Government 

Payments 

Source: Economic Research Service/U.S. Department of Agriculture. 

included in the farm program (see Chart 1). From 1990 

to 2002, the ten states that received the highest level of 

subsidies represented 34 percent of national net farm 

income, but 59 percent of total direct government 

aid.19 In these states, government aid accounted for 

more than 45 percent of total net farm income. 

The first advance in global trade discussions since 2001 

was made during WTO talks held at the end of July 

2004 in Geneva. The 147-member group agreed on a 

new trade framework that will “include outlines for 

formulas for reducing import barriers, export subsidies 

and domestic support programs.” This framework will 

guide discussions that will culminate in a WTO meeting in December 2005 in Hong Kong. Of particular 

interest to U.S. cotton producers, the July 2004 talks 

resulted in the creation of a new panel that is charged 

with recommending reforms for U.S. cotton subsidies. 

In addition, U.S. government subsidies to cotton 

producers were the focus of a June 2004 WTO dispute 

panel ruling that remains confidential. Some press 

reports have indicated that the result, at least in part, 

was not favorable to the U.S. position. Details of the 

ruling are not expected to be made public until late 

summer or early fall 2004, and the WTO appeals and 

related processes could continue for more than a year. 

Nevertheless, given the importance of subsidies to 

farm income, the outcome could affect U.S. cotton 

subsidies and is an area to watch for spillover into 

other subsidies. 

Conclusion 

Though the U.S. agricultural sector and the banks that 

support it are currently healthy and profitable, each of 

the large-scale risks discussed in this article has the 

potential to affect the industry. And though the issues 

are likely considered longer term, decisions about what 

to produce, where to produce, the number of farmers 

needed to supply our food, and the ultimate impact on 

farm banks hinge on the resolution of these issues. 

John Anderlik, Regional Manager 

Richard Cofer, Jr., Senior Financial Analyst 

Jeff Walser, Regional Economist 

19 In order of total aid received: Texas, Iowa, Illinois, Kansas, 

Nebraska, Minnesota, North Dakota, Arkansas, Missouri, and Indiana. 

FDIC OUTLOOK 29 FALL 2004 
FDIC OUTLOOK 31 FALL 2004

In Focus This Quarter

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