FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1997
 

FDIC
 

NEW YORK
 

REGION
 

DIVISION OF
 

INSURANCE
 

SUZANNAH L. SUSSER,
 

SENIOR REGIONAL

 ANALYST
 

NORMAN GERTNER,
 

REGIONAL ECONOMIST
 

KAREN A. DENU,
 

FINANCIAL ANALYST
 

In Focus This Quaitei

• Will Credit Scoring Transform the Market for SmallBusiness Lending? - In an effort to reduce the cost of small-business lending,

some institutions are using credit scoring technology to reduce underwriting costs and

to grow their small-business lending portfolios, in some cases venturing into markets

well beyond their local economies. The ramifications could be significant. An

overreliance on credit scoring models could expose lenders to increased credit risks.

Over time, the traditional niche enjoyed by small banks in small-business lending

could come under considerable pressure. See page 3.

• Banking on the Internet: New Technologies, New

Opportunities, New Risks - Internet banking promises a wide range of new

benefits. It also offers a host of new problems and some new twists on old ones. The

tradeoff is one that depository institutions and regulators alike must grapple with as

they stake out their positions in cyberspace. See page 7.

Regu[ai Featuies

+Regional Economy +Financial Markets +Regional Banking

· Economic Recovery · Asset-Backed Securities · Industry Consolidation

· Job Growth · Bond Values · Mergers

· Upstate New York · Price/Earnings Ratios · Syndicated Lending

 See page 11 See page 14 See page 19

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

Insurance Corporation for the following eight geographic regions:

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

found on the back cover to the FDIC Public Information Center. Contact the Public Information

Center for current pricing on bulk orders.

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

more information or to provide comments or suggestions about the New York Region's Regional

Outlook, please call Suzannah Susser at (212) 704-1482 or send an e-mail to ssusser@fdic.gov.

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

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

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

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

the Federal Deposit Insurance Corporation.

Chairman Ricki Helfer

Director, Division of Insurance Arthur J. Murton

Editor George E. French

Managing Editor Stephen Linehan

Associate Editor Maureen E. Sweeney

Assistant Editors Paul C. Bishop

Steven K. Burton

Richard A. Brown

Diane Ellis

Kathy R. Kalser

Ronald L. Spieker

Publications Managers Nancy Maginn

Diane Ellis

Publication Date: April 24, 1997
 
In Focus This Quarter
 

WillfCreditfScoringfTransformfthefMarketffor
 

Small-BusinessfLending?
 

• 	 Small-business lending, traditionally a segment in

which small banks have enjoyed comparative

advantages, is receiving greater focus from

larger banks and nonbank financial companies.

• 	 Some insured institutions are beginning to rethink traditional approaches to small-business

loan underwriting to include the use of credit

scoring models.

• 	 The use of small-business lending credit scoring

models, while providing banks opportunities for

underwriting and servicing efficiencies, carries

with it a number of potential risks.

Background

As of 1994, there were more than 22 million small

businesses in the U.S., making this a very attractive

potential market for lenders. Small-business lending

has been a line of business in which small banks have

been very successful given their traditional strong niche

in relationship banking. Small-business lending traditionally has been a relatively cost-intensive lending

segment, since origination costs are spread over smaller

loan balances. Some institutions are now beginning to

TABLE 1

use credit scoring technology to reduce underwriting

costs and to grow their small-business lending portfolios. A number of larger banks, especially, appear to be

looking to the efficiencies of credit scoring to help

provide quick loan approvals and more competitive

loan rates. With the aid of this technology, some

institutions are rapidly expanding their loan portfolios,

in some cases venturing into markets well beyond their

local economies.

Commercial bank small-business lending exposures in

the New York Region considerable. (For purposes of

this article, small-business lending refers to loans categorized as commercial and industrial loans with original

amounts of $1 million or less reported on the June Call

Reports.) At midyear 1996, commercial banks in this

Region reported $29 billion of small-business loans,

amounting to 13 percent of all commercial and industrial

loans. As shown in Table 1, there are 103 banks in the

Region with small-business loan exposure exceeding

100 percent of equity and 23 banks with exposure

exceeding 200 percent of equity. Given the level of

lending exposures, increased usage of new credit scoring technology could have a significant effect on smallbusiness lending in the Region.

In the New York Region, as well as the nation, many

large banking companies have announced nationwide

BANKS WITH CONCENTRATIONS IN SMALL•BUSINESS LOANS

ExPOSURE GREATER THAN 100

PERCENT OF EQUITY

ExPOSURE GREATER THAN 200

PERCENT OF EQUITY

NUMBER

OF BANKS

COMBINED TOTAL

ASSETS ($MILLIONS)

NUMBER

OF BANKS

COMBINED TOTAL

 ASSETS ($ MILLIONS)

WASHINGTON, D.C.

DELAWARE

MARYLAND

NEW JERSEY

NEW YORK

PENNSYLVANIA

PUERTO RICO

5

1

16

21

30

25

5

$660

59

1,925

3,124

6,494

4,763

1,884

2

0

7

2

6

5

1

$447

0

605

283

565

668

199

TOTALS 103 $18,809 23 $2,768

SOURCE: BANK CALL REPORTS

Regional Outlook	 3 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

programs to increase their share of small-business lending. These programs may have been prompted by the

new credit scoring technology. Several of these companies reportedly are offering pre-qualified and preapproved lines of credit to small businesses through the

use of credit scoring technology.

ThefGrowingfImportancefoffCreditfScoring

While credit scoring technology

is not new, until recently it typically has been associated with

consumer lending, particularly

with credit card lending. Primarily using credit bureau information, credit scoring provides lenders with a tool to rank

risks or probabilities of default, assigning statistically

derived numerical ratings or scores based upon a borrower's past experience with paying debt. Based upon

the enormous volume of historical information on consumers contained in credit bureaus, model developers

link incidences of good and bad credit performance with

borrower characteristics. Applicants then are compared to these credit performance indicators in order to

make credit extension decisions. While credit scoring

has helped consumer lenders reduce origination costs

and to grow receivables at rapid rates, the recent rise in

credit card charge-offs has raised concerns about the

effectiveness of such models, or at least about how the

models are being used.

Small-business credit scoring is a relatively new concept in scoring technology, but is gaining more attention

from lenders. Small-business credit scoring models

are similar to consumer credit scoring models in one

significant aspect -- the most important indicator of

credit performance is the credit profile of the principals of the business derived from consumer credit

bureau information. Other business information from

companies such as Dun and Bradstreet Corporation and

Experian (formerly TRW) also is used in the scoring

process.

A primary vendor of these scoring models has cited

analysis purporting to show that business financial statement information did not prove a useful indicator of

credit performance for small-business loans. The reasons for this result may be due to inconsistency in

financial statement quality and the difficulty in separating business entity cashflow information from the business owners' activities. Also, the relative importance

of principals' credit history and financial statement

information in predicting credit performance was found

to change somewhat with the size of the business -- the

larger the business the more important financial statements become in assessing performance.

Many institutions cite the potential cost savings involved in the underwriting process as one of the most

significant characteristics of credit scoring. In many

cases, with scoring technology, loan application processes have been streamlined to one page forms for

loans up to $50,000, not dissimilar to that of consumer

loan applications. In some cases, financial statements

are not required at all. Reducing paperwork helps to

reduce both processing time and costs. Table 2 illustrates how scoring has changed underwriting practices,

as reported by one large bank at a recent conference on

credit scoring. While it is impossible to know whether

the information presented in Table 2 is representative of

the way most institutions are using credit scoring models, it is clear that credit scoring may represent a

significant departure from traditional underwriting

methods.

Part of the reduction in underwriting costs may come

from improvements in the allocation of underwriting

resources. It has been argued that credit scoring allows

banks to more easily identify those applicants which are

clearly either approvals or denials. This process would

enable banks to reallocate their underwriting resources

more efficiently to those loans which pose intermediate

risks and require closer attention. Other advantages of

credit scoring systems that often are cited are greater

consistency in underwriting, better measures for pricing

strategies, and the potential to enhance the ability to

securitize small-business loans.

WhatfArefthefRisks?

TABLE 2

SMALL BUSINESS LENDING: CREDIT SCORING

VERSUS TRADITIONAL LOAN UNDERWRITING

1993 1996 1997

PERCENT OF LOANS

REQUIRING ANNUAL 100% 20% • •

FINANCIAL STATEMENTS

PERCENT OF LINES

REVIEWED ANNUALLY 100% 0 • 5% • •

PROCESSING TIME FOR LOANS 3 1 1

OF $50,000 • $250,000 DAYS DAY HOUR

SOURCE: REPORTED BY A LARGE BANK AT A RECENT CONFERENCE ON

CREDIT SCORING.

Regional Outlook 4 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

Small-business lending has historically been a profitable area of bank lending. This situation is most likely

attributable to lenders thoroughly analyzing potential

customers, persistently monitoring their performance,

and building solid lending relationships. Credit scoring

for small-business lending raises the possibility that

some banks will forgo the traditional underwriting concepts of relationship lending in favor of a more massmarketing approach, in a manner similar to credit card

lending. To the extent that credit scoring is used to

rapidly gain new customers by either targeting out-ofterritory customers, or customers with less business

experience, the risk profile of an institution's smallbusiness lending portfolio may change. Any such

change in profile may be significant due to the risks

associated with newer borrowers. For example, new

firms tend to fail at an extremely high rate, with 53

percent of new businesses failing within the first four

years of inception (see Chart 1). Larger, more established commercial businesses tend not to exhibit such

volatile characteristics.

There are potential dangers associated with placing

undue reliance on credit scoring models. The predictive

value of any credit scoring system may be substantially diminished if the model is used

for unintended purposes or customer types. Therefore, misuse of a

scoring system could expose an institution to considerable losses. Since

only the largest banks have smallbusiness loan portfolios large enough

to create statistically valid scoring

models customized for their own customer base, smaller

companies should be especially aware of potential misuse. This risk takes on added meaning when one

considers that a $1 million small-business loan represents substantially more capital to a $100 million bank

than to a $10 billion bank. Adding further uncertainty,

small-business credit scoring has been implemented

during a period of relatively strong performance by

businesses, with commercial and industrial loan delinquency ratios near historical lows. How well these

models perform during an economic downturn remains

to be seen.

Depending on the manner in which it is implemented,

credit scoring for small-business lending may represent

a fundamental shift in underwriting philosophy -- viewing a small-business loan as more of a high-end

consumer loan and, thus, granting credit more on the

strength of the principals' personal credit history and

less on the financial strength of the business itself.

While this may be appropriate in some cases, it is

important to remember that the income from small busiCHART 1
 

Business Dissolution Rate Shows Early Risk

100%

53%

 umulati e Dissolution Rates

24%

62%

71%

80%

1 2 3 4 5 6 7 8 9 10

80%

60%

40%

20%

0%

Years

Source: Small Business Administration 

nesses remains the primary source of repayment of most

loans. Banks that do not analyze business financial

statements or periodically review their lines of credit

may lose an opportunity for early detection of credit

problems.

Competitive pressures in small-business lending are

increasing not only because of large banks' efforts to

expand their lending but also because of greater participation in the market by nonbank financial companies.

Several large firms, such as American Express, AT&T,

the Money Store, and GE Capital Services, are expanding their business lines to service the needs of small

businesses. These companies are offering smallbusiness credit cards, innovative new types of credit,

and other services such as consulting, accounting and

investment services. Some observers have suggested

that the cost advantages of credit scoring may cause

small-business lending in the future to be dominated by

12 to 15 large banks or financial firms. Faced with stiff

competition, there may be strong motivation for some

banks to increase the dollar threshold on low documentation loans, streamline the process for larger loans, or

lower credit scoring thresholds for loan approvals.

The most recent FDICfSurveyfoffUnderwritingfPractices and the FederalfReserve'sf Seniorf LoanfOfficer

OpinionfSurveyfonfBankfLendingfPractices both indicate that only a small percentage of banks reported an

easing of standards on small-business loans. Aggressive competitive pressures and loan growth goals were

seen as the main reasons for easing in these cases. With

regard to small-business credit scoring techniques, the

Federal Reserve survey pointed out that banks were

most commonly using creditscores for automatic acceptance or rejection of loans up to $50,000.

Regional Outlook 5 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

Summary

Credit scoring has the potential to transform the market

for small-business lending. The traditional niche enjoyed by small banks in this area may come under

tremendous pressure from larger banks and nonbank

companies employing this new technology. Credit scoring at a number of institutions is driving dramatic

changes in underwriting methods for small-business

lending. These changes may facilitate short-term revenue generation as business can be expanded rapidly

and underwriting costs can be slashed. It is extremely

important, however, that banks understand and control

the potential risks inherent in such a strategy. The

application of credit scoring to small-business lending

merits the close attention of both bankers and their

supervisors.

Andrea W. Bazemore, Banking Analyst

Regional Outlook 6 Second Quarter 1997
 
In Focus This Quarter
 

Banking on the Internet
 New Technologies, New Opportunities, New Risks

• 	 Despite the potential for lower transaction costs,

increased efficiency, and greater asset diversification, few banks do business through the Internet.

• 	 Although competitive risks are pushing banks to

create an Internet presence, operational risks

remain an obstacle to actually using those sites

for moving information or money.

• 	 The FDIC's Division of Supervision recently released examiner guidance on Internet banking

and is developing training programs for its examiners.

The Allure o Cyberbanking

On-line Banking is a comprehensive term for transactions conducted

over wires or from remote locations. It includes banking by telephone, banking by personal computer through a dial-up connection

and, more recently, banking over the

Internet. Internet banking, frequently

referred to as cyberbanking, is of particular interest to

banks because it exploits an existing and geographically

extensive public network infrastructure and promises a

range of new operating and marketing benefits. One

such benefit is the ability for an institution to expand its

trade area to include other cities, states, regions -- or

even countries -- without a commensurate expansion of

its branch structure. This greater geographic reach can

CHART 1

do more than simply increase volume. It also can offer

institutions -- particularly smaller ones -- the potential

to diversify their asset portfolios across multiple regions, leaving them less exposed to the economic

volatility of any single one. Another benefit is the lower

cost of Internet delivery. A March 1996, study by Booz,

Allen & Hamilton Inc. estimated an average Internet

transaction cost of $0.01 compared to $0.27 for an

ATM, $0.54 for a telephone, and $1.07 for a fullservice branch.

Slow Migration to the Future

Another 1996 study, this one by Grant Thornton in July

(see Chart 1), found that despite these potential benefits,

most banks established an Internet presence for appearance's sake -- being perceived as a leader, advertising

bank services or staying abreast of competitors -- rather

than with an intent to grow deposits or capture the

transaction economies that cyberbanking could provide.

Of the 44 Internet institutions surveyed, only one in three

expressed intentions to begin offering bill payment or

funds transfer over the Internet by the end of the second

quarter of this year. Even this subdued enthusiasm now

appears optimistic. Despite the perceived benefits and

the scarcity of competition, few banks have to date

ventured into this area in a meaningful way. According

to the Bankweb world-wide web site, only 800 or so

banks -- less than 1 percent of the industry -- have an

Internet site and only 18 of those permit transactions. In

the New York Region, 114 institutions have an Internet

presence but only three allow customers to pay bills or

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

Banking on Cybercommerce: A Survey of Internet Bank Product Plans

Source: Grant Thornton "Banking on Cybercommerce: A Survey of Internet Bank Product Plans"

Mid 199 

(Projected)

Mid 1996 (Actual)

Regional Outlook	 7 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

transfer funds. A major question, then, is why so few

institutions have chosen to exploit this medium? Some Concerns or the CyberBanker
 

Risk
 

The reason is risk. Banks are familiar with the control

of exposures found in proprietary or private payment

channels, but they are less comfortable with the new

risks attendant to a public network. On one hand, there

are operational exposures that convincingly argue

against rushing headlong into cyberspace. On the other

hand, there are competitive risks. Nonbank competitors

with strong foundations in cybertechnology pose a budding threat to the banks' historical payment-services

monopoly and argue with equal authority for an immediate Internet presence to gain or preserve market share.

These opposing forces help explain the large numbers of

banks establishing web sites that stop short of actually

moving information or money.

Of these two types, operational risks are the most

immediate and command the most attention. They derive from the formative state of both the technology

supporting on-line commerce, and the legal and regulatory structure governing its use. These risks include

theft or misappropriation of internal data or external

transmissions, transaction fraud, errors in underwriting

virtual transactions, liquidity shortfalls, changing technical standards, inadequate or geographically inconsistent

regulatory and legal infrastructure, noncompliance with

existing laws or regulations that were not designed for

an on-line world, and damage to an institution's reputation from the realization of any or all of these risks (see

Some Concerns or the CyberBanker,right).

Systemic Threats and a New Payments Model

In addition to bank-specific risks there are the systemic

threats that a public domain payments model could

bring. One of the key features of the Internet is redundancy. Any one of a large number of possible paths can

be used for a given transaction and therefore the failure

of any one path or node will not affect the functionality

of the network as a whole. This feature presents a

multitude of new and -- from a banker's perspective --

previously unconsidered points of vulnerability to

technologically-sophisticated miscreants. In a cyberworld of small value transactions, the effects of an

attack may not be much more severe than those which

accompany credit card crime. However, there is good

reason to expect that Internet transaction sizes will

continue to grow. According to one software vendor,

Internal Data Security. The Internet cannot distinguish

between customers and criminals. Invasive attacks can range

from simple vandalism to theft or destruction of proprietary

operating or customer data. Firewall software, data encryption, specialized hardware configurations and commercial

insurance can limit such exposures.

External Transmission Security. Because the Internet is an

open network, transaction messages are completely exposed,

rendering them vulnerable to theft or tampering. Message

encryption is a common response, but hardware or implementation flaws can circumvent it. This threat will increase

greatly if large value or interbank transactions migrate to the

Internet.

Transaction Fraud. Fraud takes two forms:misrepresentation during a transaction or repudiation following it. This

problem takes new dimensions in cyberspace because no

physical relationship with a customer exists. Encryption

protocols which include digital signatures are one response.

Biometric authentication schemes, the most commonly proposed being fingerprint or retinal verification, are another.

Difficulties with Virtual Underwriting. Even if your cyberborrowers are who they claim to be, there remain difficulties

in establishing their creditworthiness. The lack of a personal

relationship is one factor. The limited knowledge of local

employers and credit grantors that appear on applications is

another. Such difficulties could hasten and heighten dependency upon credit scoring models.

Liquidity Risks. Internet transaction volume and velocity

are expected to increase rapidly, potentially creatingtransactions which occur so rapidly as to exceed immediate bank

liquidity. Denial of service attacks, where a site isintentionally deluged with transactions in order to shut it down, also

can affect liquidity if affected customers decide to close their

accounts.

Lack of Technical Standards. An institution building an

early presence on the Internet is making a financial bet as to

which standards will endure.

Lack of Regulatory and Legal Infrastructure. Regulators

are waiting and observing. Future promulgated "bestpractices" may not be those which an institution has already

adopted. Similarly, a lack of legal precedent hinders criminal

and civil prosecution of cybercriminals. Even where precedent exists, it is frequently inconsistent across jurisdictions.

Reputation Risk. An image of solidity is a cornerstone of

banking. Internet banking confronts banks with more exposure and potentially greater publicity about losses.

Competitive Risks. Unlike the operational risks discussed

above, competitive risks accrue to institutions not securing an

Internet foothold. They involve the threat of lost market

share or payment system position to more aggressive peers

and nonbank competitors.

Regional Outlook 8 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

interbranch payments on the Internet are likely to begin

in 1997 with interbank activity to follow a year or so

later. This development would be a significant evolution because wholesale transactions are generally large

relative to bank liquidity. An attack or disruption of the

Internet payments mechanism for a single large transaction could conceivably pass liquidity shocks to other

banks in the same way that bad weather at a major

airport can disrupt air traffic throughout the country.

New Technologies, Old Reporting

The advent of fully transactional web sites also could

heat up bank competition for low cost deposits and

frustrate regulatory oversight in the process. One possibility is a "deposit arbitrageur," a hybrid of brokered

deposits and program trading in which a computer

program could search the Internet for the highest deposit

rates and immediately reallocate deposits accordingly.

In the long run, such activities could harmonize local

interest rates. In the short run, however, this rapid

turnover could mean substantial liquidity drains on institutions accustomed to local deposit monopolies. From

the regulatory perspective, this transaction velocity --

and its potential to rapidly alter bank balance sheets --

could present new challenges in a world of quarterly

Call Reports and examination intervals that can exceed

one year.

FDIC -- the CyberRegulator

New risks demand new supervision techniques and the

FDIC's Division of Supervision (DOS) has responded

with their recently-released electronic banking safety

and soundness examination guidance. Under that guidance, institutions having Internet sites are placed into

TABLE 1

one of three tiers based upon the "maturity" of their site.

Safety and soundness examination procedures focus on

bank policies, procedures and planning. The examination procedures are cumulative -- meaning that each

successive tier adds an additional level of scrutiny to

the tiers below -- and do not require a technical knowledge of Internet systems. "Information Specialist" involvement also varies by tier (see Table 1). A DOS

training program for all safety and soundness examiners

already has begun, and technical training for information

systems specialists is being developed. A new specialty, the electronic banking Subject Matter Expert,

also is being established.

Measured Steps in a New Environment

Banks increasingly are becoming distributors of

commodity-like products. As such, profitability may

become dependent upon both cost efficiencies and high

volume -- a combination sometimes argued as inconsistent with high-cost branch structures. Internet banking

offers institutions a means to compete in this new environment. It also offers new risks. Recognizing this

tradeoff, many banks have entered this realm with measured steps. Those who have not face risk of a different

sort. They face instead the risk that their competitive

position will pass to more innovative competitors --

competitors with new technologies and the drive to

accomplish old business in thoroughly new ways.

Gary Ternullo, Senior Financial Analyst

gternullo@rdic.gov

THE DIVISION OF SUPERVISION CLASSIFICATIONS FOR INTERNET BANKS

LEvEL 1 LEvEL 2 LEvEL 3

DESCRIPTION AN INFORMATION-ONLY

SITE

A SITE PERMITTING

ELECTRONIC

SUBMISSION OF LOAN

OR DEPOSIT

APPLICATIONS

TRANSACTIONAL SITE

OFFERING ELECTRONIC

BILL PAYMENT OR FUNDS

TRANSFER SERVICES

SPECIALIST

EXAMINATION

REQUIREMENT

(IN ADDITION TO

SAFETY AND

SOUNDNESS EXAM)

INFORMATION

SPECIALIST REVIEW

REQUIRED ONLY IF SITE

IS TIED INTO INTERNAL

BANK SYSTEMS.

CONSULTATION WITH

INFORMATION

SPECIALIST REQUIRED

TO DETERMINE IF

FURTHER REVIEW IS

WARRANTED.

CONCURRENT

INFORMATION

SPECIALIST EXAMINATION

REQUIRED.

Regional Outlook 9 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

For More In ormation:

Division o Supervision	 DOS currently is implementing examination guidance for safety and soundness examiners and developing training for technical specialists.

Cynthia Bonnette, Examiner

Chairman, New Banking Technologies Task Force

(202) 898-6583

Stephen White, Inrormation Systems Review Examiner

Chairman, Inrormation Systems Subcommittee

Federal Financial Institutions Examination Council Task Force on Supervision

(202) 898-6923

Division o Compliance and DCA is reviewing new banking technologies from a consumer protection, fair lendConsumer A airs ing and CRA perspective to provide guidance on compliance matters. DCA also is

coordinating outreach efforts with consumer community groups.

John Jackwood, Special Assistant to the Director

(202) 942-3854

Regional O ice Contacts	 Albert Bennett, Examiner

Division or Supervision

New York Regional Orrice (Talleyville Field Orrice)

(302) 478-4954

John Sorrronorr, Review Examiner

Division or Compliance and Consumer Arrairs

New York Regional Orrice

(212) 704-1405

O ice o Policy Development	 OPD provides leadership in developing FDIC policies, including those addressing

new banking technologies. The office coordinates several interdivisional electronic banking efforts and represents the FDIC on the interagency U. S. Treasury

Consumer Electronic Payments Task Force.

Sharon Powers Sivertsen, Director

(202) 898-8710

Related Web Sites	 FDIC http://www.fdic.gov

FFIEC http://www.ffiec.gov

NETBanker http://www.netbanker.com

Bankweb http://www.bankweb.com

National Computer Security Assoc. http://www.ncsa.com

RSA Data Security Inc. http://www.rsa.com

Smart Card Resource Center http://www.smart-card.com

American Bankers Association http://www.aba.com

Regional Outlook	 10 Second Quarter 1997
 
Regular Features	 Regional Economy
 

Economic Recovery Continues in the New York Region
 

• 	 The New York Region is slowly recovering from the early 1990s recession, although growth rates

throughout the Region are uneven.

• 	 The Region has added a large number of jobs since the last recession. Despite the employment growth, the

New York Region continues to lag the nation in job creation.

Economic trends indicate that the New York Region has CHART 1
 

recovered from the last recession and is expanding

moderately. Commercial and industrial (C&I) loan

growth in insured institutions in the Region also has

rebounded modestly, signaling that the climate for banks

has improved somewhat. However, while certain areas

of the Region are strengthening, other parts are growing

less rapidly. Upstate New York, in particular, is showing signs of weakness.

Region Continues Along Road to Recovery

Since the end of the 1990­1991

recession, the New York Region

has added over 830,000 new jobs

to its employment base, representing growth of 4.2 percent. After

four consecutive years of negative

growth, aggregate C&I loan growth

has bounced back into the positive.

Chart 1 relates aggregate growth in

Region's C&I loans to employment growth in the Region. Both measures show a recovery and expansion

from the early 1990s recession.

However, job growth within the Region has been uneven. The smaller states and jurisdictions such as

Delaware and Puerto Rico have performed the best.

Both have added more than 10 percent to their employment bases over the period 1991 to 1996. For example,

employment in the Wilmington area has risen by over

11 percent. Delaware has benefited from favorable tax

policies that have attracted out­of­state banks and financial corporations. Puerto Rico's economy has been

helped by a 23 percent increase in service jobs and a 19

percent increase in trade jobs. However, despite the

improved employment growth, Puerto Rico's economic

performance remains inconsistent. A large percentage

of the population still receives some form of public

assistance.

-3

-2

-1

0

1

2

89 90 91 92 93 94 95 96

-10

-5

0

5

10

Source: Bureau of Labor Statistics, Bank and Thrift Call Reports

The Region's Employment and Aggregate Loan 

Growth Have Recovered

Employment

 C & I Loans

Employment

(Annual Percentage Change) Loans

The larger states have lagged in job creation, with

employment rising only 2 percent in New York and 4.4

percent in Pennsylvania over the same five year period.

New Jersey and Maryland did slightly better and

recorded about 5.5 percent growth. Much of the slower

growth in jobs can be traced to the severity of the last

recession in the major East Coast urban centers of New

York City, Baltimore, Philadelphia and Newark. In

Baltimore, employment rose just 3 percent, while New

York City, after suffering the sharpest job loss in more

than two decades, added only about 2 percent to its

workforce. In Newark, employment has been essentially flat, while in Philadelphia, employment has declined by over 4 percent since 1991.

Retail sales are another indicator of a Region's economic health. Rising retail sales point to a generally

strengthening business climate. Again, growth has been

uneven. In Pennsylvania, retail sales were up 5.4

percent in December 1996 compared to a year earlier.

In comparison, retail sales throughout the nation rose 4.8

percent over the same period. In New York, retail sales

nearly matched the national rate of growth with an

increase of 4.4 percent over the prior year end. HowRegional Outlook	 11 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features	 Regional Economy
 

ever, retail sales growth in New Jersey, Maryland and Delaware were

mostly flat.

A more recent and interesting development regarding growth in consumer

prices is taking place in New York

City and Baltimore. Although consumer prices remain generally higher in the Region than
 

elsewhere, growth rates are moderating in those cities.
 

For example, between December 1995 and December
 

1996, the U.S. consumer price index rose 3.3 percent.
 

In New York City, the change in prices was just 2.9
 

percent. In Baltimore, consumer prices rose only 2.6
 

percent. If the trend continues, lower consumer prices
 

will help make the Region more competitive for business development and jobs.
 

Implications: The Region continues along the long
 

road to recovery from the national recession of the early
 

1990s. The strengthening economy in the New York
 

Region has promoted growth in existing businesses and
 

stimulated new business formation. For the banking
 

industry, this development has been good news for
 

loan demand and profitability.
 

Compared to the Nation, Jobs Growth Still Remains Slow

Despite these economic gains, the Region continues to

lag the nation in employment growth. The nation's payrolls have grown three times faster than the Region's

since the last recession. This lagging relationship is

consistent with long­term trends. Chart 2 shows that the

Region's slower job growth relative to the nation has

existed for about 15 years. The reasons for these lags

are complex and reflect a number of factors which

discourage job creation. These factors include:

• 	 In general, the Region's population has been growing more slowly than other parts of the nation, such

as the southwestern or southeastern parts of the U.S.

• 	 Most of the Region is a "mature economy." Industries and infrastructure are already in place. Land

is expensive and the potential for physical expansion is limited compared to other regions of the

U.S.

• 	 In general, the Region has higher taxes, energy and

living costs than other parts of the nation.

• There is a perception that some parts of the Region,

particularly the heavily populated urban areas, offer a lower quality of life compared to other parts

of the nation.

Upstate New York Remains an Area to Watch

Upstate New York is generally defined as the area north

of the New York City metropolitan area. This area

essentially mirrors the territory encompassed by the

FDIC's Syracuse field office. Originally, upstate New

York was a leader in the manufacture of electrical

equipment, photographic equipment, paper products and

machinery. However, beginning in the 1970s, large

numbers of manufacturing jobs were shed to other parts

of the nation and the world. More recently, large

numbers of service and trade jobs, as well as additional

manufacturing jobs, were lost during

the last recession. These job losses

were caused by a wave of corporate

restructurings and downsizings.

Upstate New York continues to exhibit very little economic growth.

Since the end of the last recession, the economy of the

Region has not benefited from the national economic

expansion. For example, housing prices, which are

already among the lowest in the Region, are either

falling or are flat. In the Rochester area, housing prices

have risen about 4 percent, but remain well below the

average 19 percent rise in the U.S. over the five­year

period.

Since 1991, housing prices in the Albany area have

dropped 5 percent. In the Syracuse and Buffalo areas,

housing prices have moved very little. To the extent

that this continues, mortgage loan demand can be

CHART 2

-3

-2

-1

0

1

2

3

4

5

198119831985198r1989199119931995

Source: Bureau of Labor Statistics

The Region's Employment Has Historically

Ann. % Lagged the Nation

Change

N Region

Nation

Regional Outlook	 12 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

expected to remain flat and banks' collateral positions

may weaken.

Employment in the upstate New York area also has

shown little growth. In the Albany­Schenectady­Troy

area, job growth has declined as a result of layoffs in

state government. In 1996, Albany lost 4,000 jobs, a

loss of about 1 percent of its job base. Economic

growth in the Albany area has been weakened by a

nominal population growth. With the New York State

government continuing to seek reductions in its workforce over the next few years, the outlook for faster

employment growth appears limited.

The Syracuse area has been hurt by a slowly eroding

manufacturing base. The area also has seen slowdowns

in trade and construction. Its high utility and corporate

tax rates further limit economic growth. Although Syracuse posted a small 3,000 job gain in

1996, less than 1 percent of its employment base, there has been practically no employment growth since the

last recession.

Despite a gain of 2,000 jobs in 1996,

less than 1 percent of its employment

base, the Rochester area has a poor

record for job creation. Rochester

was particularly hard hit by the last recession with large

job losses in manufacturing, including extensive downsizing by Xerox and Eastman Kodak. Restructuring in

manufacturing industries will limit near term growth.

Rochester's dependence on only a few companies for

employment and income also is a source of instability.

The Buffalo area also has exhibited a decline in its

employment base. In 1996, Buffalo lost 2,000 jobs,

representing less than 1 percent of its jobs base. Its

nonseasonally adjusted unemployment rate as of December 1996 stood at 7.1 percent, compared to a U.S. rate of

5.0 percent for the same month. Comments from Data

Resources, Inc. characterize the slowdown as broad

based and trace the decline to weakness in the Canadian

economy. Trade with Canada is a major component of

the Buffalo economy. Overall, Buffalo is dependent on

a declining automotive and heavy­machinery manufacturing base that may limit its future economic growth.

Implications: The upstate New York area has benefited

less from the national economic expansion than the

rest of the Region. The area's anemic economic

performance apparently has affected the demand for

banking services. For example, aggregate C&I loans in

the Syracuse field office declined 3.6 percent in 1996.

Aggregate real estate loans rose only 1.8 percent. If

weakening housing and employment trends persist, loan

growth can be expected to remain weak.

Norman Gertner, Regional Economist

Regional Outlook 13 Second Quarter 1997
 
Regular Features	 Financial Markets
 

Financial Markets
 

• 	 While demand for asset-backed securities continues to be strong, further deterioration in consumer credit

quality could have adverse effects on both investors and issuers.

• 	 Although there has been little net change in the Treasury yield curve between September 30, 1996, and

early March 1997, rates in the 5-year to 30-year segment of the yield curve did fluctuate modestly during

this time period.

• 	 During the fourth quarter 1996, the S&P Composite Bank Index and the New York Region's Bank Index

both outperformed the S&P 500, gaining 12 percent and 13 percent, respectively, compared to an almost 8

percent gain for the S&P 500.

• 	 Banks' price/earnings ratios relative to the broader market have been trending upward since 1994,

perhaps signaling an improved perception of the quality of bank earnings.

The Asset-Backed Securities Market: The

Effects of Weakened Consumer Loan Quality

Asset­backed securities (ABS) are debt securities that

are backed by loans such as credit cards, car loans, and

home equity loans. Over the past ten years, the ABS

market has grown dramatically. In 1996, the issuance of

ABS was $167 billion, up from $65 billion issued in

1993 as illustrated in Chart 1. Commercial banks and

credit card companies accounted for approximately 35

percent of total ABS issuance last year. Major buyers

of ABS were mutual funds, insurance companies, corporations, and foreign and domestic banks. Although it is

difficult to quantify the amount of bank investment in the

ABS market, market participants have observed that

small and midsized banks have recently increased their

holdings of ABS.

Monoline credit card banks and large banks with significant credit card operations have been particularly active ABS issuers. Issuing banks generally structure

ABS transactions as nonrecourse sales (loans that cannot be "put back" to issuers upon default), which results

in the removal of the assets from the bank's balance

sheet and lowers capital requirements. In order to

receive investment grade ratings on their ABS, issuers

must provide credit support either in the form of overcollateralization, reserve accounts, or third party credit

enhancement from bond insurers.

Bank issuers benefit from the sales treatment of assets

into the security without completely severing their economic interest in the income generated by the assets.

The economic interest results when the revenue generated by the sold assets after charge­offs, servicing fees,

CHART 1
 

0

25

50

75

100

125

150

175

1993 1994 1995 1996

ABS Issuance Is on the Rise

Sou ce: Bloombe g, nside MBS and ABS

$ Billion

 e it a 

Auto 

Home Equity

 the 

and interest coupon payment is recognized as income by

the issuer. This surplus is referred to as excess spread.

Banks that issue ABS usually continue to service the

underlying assets, which not only generates servicing

income but also permits customer relationships to continue.

Delinquency and charge­off rates rose in 1996 on consumer loans, particularly in credit cards and auto loans.

Despite this rise, the difference between ABS and Treasury yields of similar maturity did not increase. As

Chart 2 (next page) shows, the average spread to the

two­year Treasury note on selected ABS products continued to tighten during 1996. The lack of widening

spreads despite the overall weakening in consumer

credit quality reflects strong demand from an expanding

investor base, which increasingly includes overseas

Regional Outlook	 14 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

buyers. Spreads on selected credit card and auto ABS

products began to increase during the first quarter of

1997, however, as investors reacted to higher than

expected charge­offs reported by some of the larger

issuers.

The increasing frequency of rating agencies' reviews for

possible downgrades of credit card transactions, as

well as problems in the auto finance sector, have raised

some concerns in the ABS market. How would a further

deterioration in consumer credit affect the ABS market?

For the issuer, higher charge­offs, absent a corresponding increase in fees or rates, reduces the excess spread

from the ABS. If deterioration worsens, the ABS face

potential rating downgrades. This situation may compel

the issuer to improve the overall loan quality in the ABS

or face what is termed an "early amortization" event.

An early amortization event may result in the termination

of the ABS issue prior to the maturity date. Once an

early amortization occurs, new receivables associated

with the accounts in the asset­backed security no longer

move into the security but must be funded by the bank on

their balance sheet and accounted for in determining

capital requirements. In addition, an issuer's access to

the ABS market may become more costly after an early

amortization if investors demand higher yields on subsequent issues.

For the investor, the threat of a ratings downgrade

usually impairs the market value of the security. Investors also may forfeit some interest income in an early

amortization because principal may be paid prior to the

scheduled maturity date. ABS investors would lose

principal, however, only if the deterioration in the

quality of the underlying loans is severe enough to

deplete the entire credit support. The high level of

credit support demanded by rating agencies on existing

CHART 2

ABS deals minimizes the risk of principal loss by

investors.

During 1996, some bankcard issuers took steps to prevent a ratings downgrade or a possible early amortization. Methods used by bank issuers to support deteriorating ABS have included the sale of new receivables at

a discount, the repurchase of low quality receivables

from the issue, and the infusion of additional cash into a

reserve account of the ABS. However these strategies

were specifically cited by the Office of the Comptroller

of the Currency (OCC) as actions that could be considered recourse and require full risk­based capital treatment for the assets in the particular ABS issue. The

FDIC is working with other regulatory agencies through

the Federal Financial Institutions Examination Council

(FFIEC) on new Risk­Based Capital Guidelines that are

expected to address limitations on post­sale actions and

capital requirements for direct credit substitutes or

credit enhancements for ABS.

Given the continuing trend of higher charge­offs and

delinquencies for credit card loans, investors consider

the ABS market less homogeneous in terms of issuer

quality and therefore are scrutinizing the securitizations

of issuers more closely. Although the risks vary by ABS

issuer, banks that issue or invest in the ABS market

should be cognizant of the changing market conditions

and potential risks associated with ABS.

Changes in Interest Rates and Bond Values

Chart 3 (next page) shows little change in the Treasury

yield curve between September 30, 1996, and early

March 1997. What this chart does not show, however,

is how rates in the 5­year to 30­year segment of the yield

0

25

50

75

100

125

150

175

3§20§97

12§16§96

6§3§969§9§96

2§26§96

11§20§95

 §14§95

5§ §95

1§30§95

10§24§94

4§11§947§1 §94

1§3§94

2§17§925§25§92 §31§9212§7§923§15§936§21§939§27§93

11§11§91

 §5§91

1§21§914§29§91

ompa ison of Sp ea s to T easu ies fo Asset-Backe Secu ities -- 2-Yea Matu ity

Auto

 a

Sou ce: P u ential Secu ities

Basis Points

Home Equity

Regional Outlook 15 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

CHART 3 CHART 4
 

-4%

-2%

0%

2%

4%

4- ct

1 - ct

1-zo6

15-zo629-zo6

13-0ec27-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

-0.5%

-0.3%

-0.1%

0.1%

0.3%

0.5%

Mo el

Po tfolio

Sou ce: Bloombe g

5-yea 

T easu y

Mo el Po tfolio's Value Relati6e to 5-Yea 

T easu y Yiel (Pe cent hange) T easu y Yiel u 6e Shows Little

hange Since Septembe 30, 1996

5.0%

5.2%

5.4%

5.6%

5. %

6.0%

6.2%

6.4%

6.6%

6. %

7.0%

3-mo. 2-y . 7-y . 30-y .

3§12§97

12§31§96

9§30§96

Sou ce: Bloombe g

curve fluctuated during this time period. The path of

yields on Treasury bonds with 5­year through 30­year

maturities changed directions four times, rising or

falling by more than 30 basis points. Movements in the

shorter segment of the yield curve have been less pronounced.

In order to consider the effect that these rate swings may

have had on banks' fixed income portfolios, Chart 4

shows the percent change in the yield on the 5­year

Treasury and the percent change in the market value of a

model bank portfolio created by the Division of Insurance. The presentation of this model portfolio extends

an analysis that was introduced in the first quarter 1997

edition of the Regional Outlook, which looked at the

market values of several common fixed income instruments relative to interest rate movements.

TABLE 1

In order to enhance the model portfolio's applicability

to bank portfolios, the type and amount of the securities

chosen for the portfolio are based on an aggregation of

securities­related Call Report data. The limitations of

Call Report data concerning the maturity distribution of

securities required that assumptions be made when

choosing the maturity of the securities for the model

portfolio. An effort was made, however, to construct a

model portfolio that approximates, in the aggregate, the

maturity distribution of the aggregate commercial bank

portfolio. The model portfolio is shown in Table 1.

As shown in Table 1, the total market value of the

portfolio changed less than one­half of 1 percent since

September 30, 1996. The portfolio's period­high value,

representing a 1.51 percent increase from September 30,

1996, occurred on November 29, 1996, when the 5­year

TYPE OF SECURITY PAR

VALUE

PERCENT

OF

PORTFOLIO

MATURITY

OR

WAL

PERCENT

CHANGE

FROM

9/30/96

TO

12/31/96

PERCENT

CHANGE

FROM

12/31/9

6 TO

3/12/97

PERCENT

CHANGE

FROM

9/30/96

TO

3/12/97

U.S. TREASURY 5.6% 2,000 20% 1YR 0.35% •0.05% 0.30%

FNMA AGENCY 5.8% CALLABLE 1,200 12% 2YR 0.59% •0.25% 0.34%

STATE COUNTY MUNICIPAL GO 4.8% 800 8% 11YR 1.95% •0.64% 1.95%

FNMA MORTGAGE PASSTHROUGH 7.5% 3,000 30% 8YR 1.08% •0.30% 0.78%

FNMA (REMIC) 8.0% PAC 2,000 20% 2.5YR 0.58% •0.68% •0.10%

CREDIT CARD ASSET•BACKED SECURITY 1,000 10% 5YR 0.10% 0.00% 0.10%

TOTAL 10,000 100% 4.85YR 0.77% •0.29% 0.48%

Regional Outlook 16 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

Treasury rate fell to its period­low

of 5.83 percent. Observe that,

while longer term rates fluctuated

modestly over the reporting period,

the reasonably short weighted average life (WAL) of the portfolio

further moderated the value

changes sustained by the portfolio.

Changes in the value of the model portfolio demonstrate

a higher correlation to changes in the 5­year Treasury

yield than to other maturities along the yield curve

because the 5­year bond's maturity better matches the

WAL of the model portfolio. Even though the 30­year

Treasury rate is often cited as a benchmark for daily rate

changes, it may not be the most significant rate in

assessing exposures of bank securities portfolios to

changes in interest rates.

On March 25, 1997, the Federal Reserve Open Market

Committee met and raised the target federal funds rate

25 basis points to 5.50 percent. By the following day,

the 5­year Treasury yield had risen to 6.66 percent, 23

basis points higher than the 5­year Treasury yield dated

March 12, 1997, displayed in Chart 3 (previous page).

The rise in rates from March 12 to March 26 caused the

model portfolio's market value to fall 0.56 percent to

$9,965.

This model portfolio will be used regularly to show the

effects on bond values of interest rates movements from

quarter to quarter. It also will be used from time to time

to illustrate how investment choices that portfolio managers make concerning duration, optionality, and other

risk factors affect a portfolio's relative volatility.

Banks' Stock Prices and Price/Earnings Ratios

Continued to Rise in 1996. Is the Market ImCHART 5

proving its Perception of the Quality of Bank

Earnings?

During the fourth quarter of 1996, the S&P Composite

Bank Index outperformed the S&P 500, gaining over

12 percent compared to an almost 8 percent gain for

the S&P 500. The fourth quarter results topped off a

year during which the S&P Composite Bank Index

gained 37 percent compared to a 20 percent gain for the

S&P 500. As shown inChart 5, the New York Region's

Bank Index (NYRBI) gained a little more than 13 percent in the fourth quarter 1996. Moreover, the NYRBI

returned 38 percent for the year with performance that

tracked closely to the S&P Composite Bank Index. The

year's moderate economic growth, contained inflation,

and favorable interest rates are credited for providing a

friendly environment for bank stocks. As 1997 began

with much the same economic conditions, bank equities

have continued to do well. Year­to­date, the NYRBI is

up over 17 percent compared to an almost 20 percent

gain for the S&P Bank Index and a 9 percent gain for the

S&P 500 through March 7, 1997.

While appreciating stock prices provide an obvious

positive signal about the health of the industry, the

market provides other information about the prospects

for the industry through the price/earnings (P/E) ratio.

The P/E ratio presents the price of a company's stock as

a multiple of its earnings per share and is derived by

dividing the stock's market value by the company's

earnings per share. Typically investors are willing to

pay a higher price for a company with earnings that are

expected to be consistent and growing. However, firms

with more volatile earnings are generally penalized by

investors in terms of stock price and lower P/E ratios.

Generally, a higher P/E ratio can be interpreted to mean

that investors have more confidence in the outlook for

0%

10%

20%

30%

40%

30-Sep

11- ct25- ct

-zo6

22-zo6

6-0ec

20-0ec31-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

S&P 500

zew Yo k Region's

Bank In ex

S&P Bank In ex

Sou ce: Bloombe g,Ameriian Banker

The zew Yo k Region's Bank In ex Has T acke the S&P Bank

In ex losely, an Both Ha6e utpe fo me the S&P 500 

hange f om 9§30§96

Regional Outlook 17 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

future earnings performance.

The relationship between bank P/E ratios and the P/E

ratios for the broader market provides further insight

into the market's perception of the quality of bank

earnings compared to other firms. Historically, bank

P/E ratios have been lower in the aggregate as compared to the rest of the market. The rationale posed for

this discounted bank P/E ratio relative to the broader

market has been that the primary sources of bank revenue, deposit taking and lending activities, traditionally

have been viewed as being more volatile because they

are prone to rising and falling with changes in the

business cycle. For example, despite recording some of

the highest quarterly return on equity averages ever at

the end of 1993, the P/E ratio of the major regional bank

index was at a level that was still only about 50 percent

of the broader market P/E.

Over the past two years the magnitude of the banking

sector's P/E discount has declined. As seen in Chart 6,

the P/E discount has gone from 50 percent to only 24

percent (a relative P/E ratio of 76 percent). The higher

P/E ratio may represent a view by market participants

that bank earnings are becoming less sensitive to the

business cycle, perhaps as a result of geographic or

product­related diversification and more efficient management of overhead expenses. Another factor contributing to higher bank P/E ratios could include speculation on bank stocks as investors anticipate potential

CHART 6
 

45%

55%

65%

75%

 5%

0ec-93

Ma -94

-un-94

Sep-940ec-94

Ma -95

-un-95

Sep-950ec-95

Ma -96

-un-96

Sep-960ec-96

Ma -97

S&P Majo Regional Bank In ex's

Relati6e P§E Ratio Is Rising

P§E Majo Regional Banks § P§E S&P 500

Source: Bloomberg 

acquisitions.

Allen Puwalski, Banking Analyst

Kathy R. Kalser, Chief,

Financial Sector Analysis Section

Regional Outlook 18 Second Quarter 1997
 
Regular Features	 Regional Banking
 

Current Banking Trends in the New York Region
 

• 	 Even as bank consolidation in the New York Region slowed, aggregate transaction value soared, reflecting

the number of large transactions completed in the Region during 1996.

• 	 Bank mergers with nonbanks, thrifts, and monolines are changing the nature of consolidation in the

financial services industry while potentially creating unique risks.

• 	 Fueled by merger and acquisition activity, increased investor demand, and greater attention by rating

agencies, the banking industry set new syndicated lending records. Banks in the New York Region led the

nation in syndicated loan activity in 1996.

• 	 The increased volume of syndicated lending activity has resulted in the narrowing of loan pricing spreads.

Analysts are watching this market closely for signs that lenders are continuing to be adequately compensated for risk.

Despite four fewer transactions in 1996, the aggregate

value of bank and thrift mergers and acquisitions in the

Region increased nearly five times compared to 1995.

This statistic reflects the number of large bank and thrift

transactions involving banking companies headquartered in the Region (see Table 1). The largest was the

Chemical Banking Corporation acquisition of Chase

Manhattan Corporation, which closed on

March 31, 1996 and had a final value of $13.3 billion.

In the year ending December 31, 1996, 46 transactions,

with an aggregate value of $30 billion, were completed

involving New York Region banks and thrifts. In 1995,

50 transactions, with an aggregate value of $6 billion,

were completed.

TABLE 1

Consolidation May Change the Face of the

Financial Services Industry

The merger between Morgan Stanley and Dean Witter

Discover & Co. was a watershed event for the financial

services industry. By combining investment banking,

funds management, securities, and credit card businesses, Morgan Stanley has laid the groundwork for a

one­stop financial services supermarket. Many analysts

speculate that the merger of these firms, which have such

different strategies and customer bases, presages the

future of the financial services industry.

Marketp dynamicsp arep compellingp banksp top become

betterpproviderspofpfinancialpproductspandpservices. At

���� �� T�� T�� ������T ���������������T���� �������� ��� ���� �

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DATE DATE

BUYER NAME SELLER NAME ANNOUNCED COMPLETED

VALUE

($B)

1 WELLS FARGO & CO., CA FIRST INTERSTATE BANCORP, CA 01/24/96 04/01/96 $ 13.708

2 CHEMICAL BANKING CORP., NY CHASE MANHATTAN CORP., NY 08/28/95 03/31/96 $ 13.286

3 FIRST UNION CORP., NC FIRST FIDELITY BANCORP., NJ 06/19/95 01/02/96 $ 6.130

4 CORESTATES FINANCIAL CORP.,PA MERIDIAN BANCORP, PA 10/10/95 04/09/96 $ 3.434

5 FLEET FINANCIAL GROUP INC., RI NATWEST BANK NA, NJ 12/19/95 05/01/96 $ 2.700

6 NATIONAL CITY CORP., OH INTEGRA FINANCIAL CORP.,PA 08/28/95 05/03/96 $ 2.414

7

8

9

1

0

BANK OF BOSTON CORP., MA BAYBANKS INC., MA 12/12/95 07/29/96

WASHINGTON MUTUAL INC., WA AMERICAN SAVINGS BANK, FA, CA 07/22/96 12/20/96

CITIZENS FINANCIAL GROUP, RI FIRST NH BANKS, NH 11/30/95 04/20/96

NATIONSBANK CORP., NC BANK SOUTH CORP., GA 09/05/95 01/09/96

 $ 2.308

$ 2.045

$ 1.850

$ 1.739

SCURCES: SHESHUNCFF INFCRMATICN SERVICES, INC.; SNL SECURITIES

RegionalpOutlook	 19 SecondpQuarterp1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features	 Regional Banking
 

a minimum, this means that banks must study and learn

from nonbanks and other corporations that excel in

financial and other service industries. Ultimately,

market forces may drive banks to partner with, merge

with, or acquire dissimilar entities to capture new

market opportunities.

Analysts predict that commercial banks will take a

closer look at thrifts as acquisition targets in 1997,

citing several reasons including:

• 	 a diminishing pool of

bank acquisition targets;

• 	 growing similarities

between bank and

thrift products and

balance sheets;

• 	 capitalization of the SAIF, which has eliminated a

lingering question;

• 	 a recent tax accounting provision allowing acquiring banks to retain deductions taken by thrifts for

bad debt reserves in excess of the deduction

allowed for banks; and

• 	 the well­developed deposit gathering branch

system of many thrifts that may be particularly

appealing to banks interested in supplementing

their existing branch network.

Mergerspbetweenpbankspandpmonolinepcompaniesphave

thep potentialp top changep consolidationp trendsp inp the

financialpservicespindustry. Monolines are companies

that have a singular focus on a specific line of business,

such as mortgages, credit cards, leasing, or auto finance.

These focused companies often have volume and cost

efficiencies in specific business lines which banks desire. Bank One Corporation's announcement of its

intention to acquire First USA Inc. may be reflective of

a new trend toward monoline acquisitions and consolidation of the credit card industry.

Risks in Newly Merged Institutions Are Unique

The continuing wave of merger and acquisition activity

among financial services companies creates a unique set

of risks. These risks include the blending of systems,

informal processes, and cultures. Those companies

most adept at mergers tend to blend cultural sensitivity

with clear integration strategies from the outset. KPMG

Peat Marwick LLP presented a framework for evaluating the newly merged institution at the Federal Financial Institutions Examination Council EmergingIssues Conference (Multinational). The framework

emphasizes the importance of :

• 	 the management of the control environment;

• 	 the ability of operations to process expanded volumes accurately and on a timely basis;

• 	 the ability of management to manage a much larger

and more complex institution; and

• 	 the infusion of a common corporate culture.

Failure to address these issues beforehand could derail

the benefits anticipated from a merger. Time and money

could be wasted on integrating incompatible systems.

An inability to smoothly blend informal processes and

cultures, due to poor planning or unanticipated resistance to change, could create inefficiencies and hurt

employee morale. Such scenarios have the potential to

cost a newly merged financial institution extra

headaches and extra dollars.

Syndicated Lending Activity Soars in 1996

Syndicated loan volume in 1996 totaled $888 billion,

nearly 9 percent more than the then­record $817 billion

logged during 1995 and easily eclipsing the lofty levels

set during the late 1980s. In the fourth quarter alone,

banks originated $265 billion in syndicated loans, the

most ever for a quarter.

Leveraged lending also has been increasing, though not

��ART 1

0

200

400

600

800

1000

91 92 93 94 95 96

$ Billion

Syndicated Loans

Leveraged Loans

Syndicated Lending Sets New Record

Source: LPC Gold Sheets

RegionalpOutlook	 20 SecondpQuarterp1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

at the record levels of the 1980s. During 1996, some

$134 billion in leveraged loans were originated, comprising about 15 percent of all syndicated loans. Leveraged loans are made to companies that have high levels

of debt and debt service compared to their cash flow.

Chart 1 (previous page) shows the growth of syndicated

and leveraged lending since 1991.

In 1996, New York Region banks led the nation in

syndicated lending activity. According to data compiled

by Loan Pricing Corporation, the top three New York

Region syndicated lenders alone held over 15 percent of

the combined agent and co­agent dollar volume of syndicated loan originations. Additionally, the top three

New York Region leveraged lenders held a substantial

32 percent of agent­only leveraged loan originations.

Several factors have contributed to syndicated lending

growth. First, and perhaps most important, is rising

merger and acquisition activity, which generated about

$159 billion of syndicated loans in 1996. Although

equity is still the preferred choice for financing merger

and acquisition transactions, syndicated lending, especially leveraged lending, also has played an important

role. As merger and acquisition activity has picked up,

syndicated lending to this segment has increased.

A second factor is an ever expanding demand for earning assets by U.S. banks, foreign banks, insurance companies, mutual funds and investment banks. According

to the Office of the Comptroller of the

Currency (OCC), 57 percent of syndicated loans generated were purchased

by foreign banks, 26 percent were

either retained by the syndicating

banks or purchased by nonbank investors, and 17 percent were purchased by other commercial banks,
 

so­called "downstream banks." Institutional interest in
 

higher yielding investments has been a driving force in
 

leveraged lending market activity.
 

Thepvolumepofplendingpactivitypalsophaspresultedpinpstiff

competitionp fromp marketp participantsp top originate

thesep loans,p puttingp pressurep onp pricingp andp fees.

These competitive pressures have provided an opportunity for borrowers to refinance previous debt at favorable rates. During the year, almost $300 billion of the

$888 billion in syndicated loans was for debt repayment.

Another factor is the greatly increased involvement of

third­party rating services. With expanded coverage by

third parties, these large loans are now viewed more

like securities. As a result, the secondary market has

��ART 2
 

0

50

100

150

2a934a932a944a942a954a952a964a96

Syndicated Loan Pricing Spreads Narrow

(Basis Points Over LIBOR)

Source: LPC Gold Sheets

BB Nonleveraged

BBB

A

expanded. The Commercial Lending Reviewindicates

that in 1990, secondary market volume totaled only $1

billion but by 1995 had increased to more than $25

billion.

According to Loan Pricing Corporation, most lenders

expect that merger and acquisition transactions, and the

resulting loan activity, will continue unabated through at

least the first half of 1997.p These bankers indicate that

it would probably take a combination of a weaker stock

market and higher interest rates to stall the syndication

market.

Syndicated Lending Trends Raise Concerns

The increase in syndicated lending has raised a number

of concerns. Of particular note is narrowing loan

pricing spreads due to increased competition.

As seen inChart 2, the spread over LIBOR, a commonly

used pricing index, has declined greatly since June 1993

for the best noninvestment quality syndicated loans (BB

nonleveraged). Similarly, the spread between one­year

tenors and five­year tenors also has declined, making it

cost­effective to borrow over longer periods. Market

analysts point to these indicators when questioning

whether lenders are being adequately compensated for

risk.

While loan structures have been weakening, they appear

to remain more sound than those of the 1980s. According to Loan Pricing Corporation, leveraged loans have

reached average multiples of debt to earnings before

taxes and depreciation of around 5.5 times

(nonleveraged loans range from 3 to 3.5 times). While

debt­to­earnings multiples at this level reflect a trend of

RegionalpOutlook 21 SecondpQuarterp1997
 
 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

increasing leverage, they are still below the six to seven

range of the 1980s. Also, cash flow coverage of

operating expenses is better.

Therep alsophasp beenp somep evidencepthatp downstream

participantsphavepbecomepmorepwillingptopacceptploans

withoutp fullp documentationp orp anp independentp credit

analysis.ppThe OCC attributes this situation to a desire

to increase loan volume, coupled with a sense of complacency about company prospects due to the strong

economy and strong corporate profits. As lenders generally agree that there will remain pressure to loosen

terms and conditions, continued adherence to prudent

screening policies by downstream banks remains important.

SuzannahpL.pSusser,pSeniorpRegionalpAnalyst

LouispM.pScalza,pExaminer,pDivisionpofpSupervision

RegionalpOutlook 22 SecondpQuarterp1997
 
Regular Features Regional Banking
 

RegionalpOutlook 23 SecondpQuarterp1997
 
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