Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1997 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

John D. Weier,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael J. Feeney,
 

Financial Analyst
 

In Focus This Quarter 

◆ Bank Earnings: Competitive Pressures and Cyclical 

Risks—Intense competition to preserve or attract business can lead to relaxed 

underwriting standards and other changes to risk management practices that can 

reduce banks’ ability to weather a downturn. As this economic expansion reaches 

an advanced age, prudent bankers will evaluate their lending standards and reserve 

adequacy with an eye to possible adverse changes in economic conditions. 

See page 3. 

By Ronald Spieker, Steve Linehan, George French 

◆ Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets—Commercial real 

estate markets in many parts of the United States have rebounded, and commercial 

banks are once again actively pursuing lending opportunities. Banks are not alone, 

however, as a broader and more competitive financing market has emerged. 

Securitization vehicles such as commercial mortgage-backed securities and real 

estate investment trusts are changing how real estate is owned and paid for. 

See page 9. 

By Steven Burton, Gary Ternullo 

Regular Features 

◆ Regional Economy—In the seventh year of cyclical expansion, the 

Region’s labor markets are tight...but pockets of high unemployment also persist...sales of existing single-family homes in the Midwest are high but expanding 

only slightly...appreciation of farmland values continues, as does price volatility for 

crops and products. See page 14. 

By Joan D. Schneider 

◆ Financial Markets—Bank holding companies of all sizes have issued 

trust preferred stock following the Federal Reserve’s decision in October 1996 to 

count these tax-advantaged, capital securities toward Tier 1 capital...rating agencies and investment analysts have argued that trust preferred stock is a weaker 

form of Tier 1 capital. See page 19. 

By Kathy R. Kalser 

◆ Regional Banking—Interested parties indicate that now is an ideal time 

to review and strengthen lending practices...charge-off rates pinpoint consumer 

lending as an area of continuing concern...past-due rates confirm consumer problems and identify other areas of interest...loan surveys show some weakness in types 

of lending where growth has been strong. See page 23. 

By James D. Eisfeller, Michael J. Feeney, John D. Weier 

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 Chicago Region’s Regional 

Outlook, please call John Weier at (312) 382-7512 or send an e-mail to jweier@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 Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Managing Editor Stephen Linehan 

Associate Editor Maureen E. Sweeney 

Assistant Editors Suzannah L. Susser 

John D. Weier 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Bank Earnings: Competitive Pressures
 

and Cyclical Risks
 

•	 Rapid loan growth, record low credit losses, 

vigorous expansion of income sources, and costcutting continue to propel bank earnings to 

record levels. 

•	 Intense competition to preserve and attract 

business can lead to aggressive loan pricing, 

relaxed loan underwriting standards, increased 

portfolio concentrations, and other changes to 

risk-management practices that can reduce 

banks’ ability to sustain earnings and capital 

through a downturn. 

•	 As this economic expansion approaches an 

advanced age, prudent bankers will allow for the 

possibility of an adverse change in economic 

conditions. 

As the U.S. economic expansion continues through its 

seventh year, the banking industry continues to run at 

full throttle. Earnings climb to ever-higher levels, driven by rapid loan growth, record low credit losses, 

aggressive expansion of income sources, and vigorous 

cost-cutting. Some analysts argue that banking has 

entered a new era in which the development of noninterest income sources and new risk-management techniques will insulate banks from swings in the business 

cycle. 

Yet banks face risks that should not be overlooked. 

Assertions that bank earnings will be less sensitive to 

business cycles remain untested. Meanwhile, competition to attract and maintain business can result in 

relaxed underwriting standards and easing of loan 

terms, or increased focus on business lines whose risks 

are difficult to manage. Policies that boost short-term 

shareholder returns, including high dividends and stock 

repurchase programs, can reduce banks’ capacity to 

weather a future downturn. There is evidence that these 

things are occurring to varying degrees in banking 

today. Accordingly, as this expansion reaches an 

advanced age, prudent bankers will give careful regard 

to the quality and sustainability of the earnings generated by today’s strategic decisions. 

Credit Quality 

Variations in credit quality have been and are likely to 

remain for some time the primary source of large 

swings in bank earnings (see Chart 1). Banks manage 

the risks of large swings in credit quality by adjusting 

underwriting standards and loan terms, by diversifying 

loan portfolio exposures, and by supplying adequate 

amounts to the allowance for loan losses. In large part, 

the degree to which bank earnings can be sustained during a downturn will depend on decisions made about 

these factors during the expansion. 

Some perspective on the cyclical nature of credit quality can be gleaned from Charts 2 and 3 (next page). As 

shown in Chart 2, bank loan growth has exceeded 

growth in gross domestic product (GDP) for ten of the 

past twelve quarters, even without considering the substantial volume of loans originated and sold in securitized pools. Moreover, Chart 3 shows that growth in 

loan losses has tended to follow episodes of rapid loan 

growth. 

Credit standards are important tools for individual 

banks to manage these cyclical fluctuations in credit 

quality. According to the Federal Reserve’s August 1997 

CHART 1 

Earnings Results Are Largely Driven by 

Provision Expenses 

-1.0% 

0.0% 

1.0% 

2.0% 

3.0% 

Return on Avg Assets 

Provision Exp/Avg Assets 

Source: Commercial Bank Call Reports 

-2.0% 

6-’85

12-’86

6-’88

12-’89

6-’91

12-’92

6-’94

6-’97

12-’95 

Chicago Regional Outlook 3	 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 2 CHART 3 

-15% 

-10% 

-5% 

0% 

5% 

10% 

15% 

20% 

1980 

GDP Growth 

Loan Growth 

Average Loan Growth Has Recently 

Outpaced Nominal GDP Growth 

Source: Commercial Bank Call Reports, Haver Analytics 1982 1984 1986 1988 1990

199219941996 

Source: Commercial Bank Call Reports Loan, GDP Growth (%)

Net Loan Loss Growth (%)

Loan Losses and Loan Growth Are Correlated 

-15 

-10 

-5 

0 

5 

10 

15 

-90 

-60 

-30 

0 

30 

60 

90 

Loan Growth 

Net Loan Loss Growth 

198019831986198919921995 

Senior Loan Officer Survey, during the preceding three 

months, a large percentage of banks had eased terms on 

commercial and commercial real estate loans, including 

reducing loan interest rates, increasing credit lines, and 

easing loan covenants and collateralization requirements. A “small but significant” share reported willingness to accept increased levels of risk on commercial 

real estate loans. In a similar vein, the Federal Deposit 

Insurance Corporation’s (FDIC) Report on Underwriting Practices (second quarter 1997) did not note 

any widespread problems with underwriting practices 

but reported that about 24 percent of institutions examined that were actively involved in construction lending 

were “frequently or commonly” funding speculative 

construction projects. About 18 percent of institutions 

examined that were actively involved in business lending “frequently or commonly” made unsecured business 

loans that lack documentation of financial strength. 

Maintaining an adequate allowance for loan losses is 

another important way for banks to sustain earnings and 

capital during downturns. The aggregate allowance held 

by commercial banks has decreased from 2.74 percent 

of total loans in the first quarter of 1992 to 1.90 percent 

in the second quarter of 1997; 166 banks reported negative loan loss provisions in the second quarter. 

Although in the aggregate these reserve numbers 

remain high relative to the early to mid-1980s, when 

reserve levels ranged from 1.20 percent to 1.74 percent, 

the Office of the Comptroller of the Currency (OCC) 

recently issued an advisory letter expressing concern 

about declining reserve levels and the need to maintain 

an adequate allowance. This letter was a response to 

weakness in the credit card sector and to trends in the 

market for syndicated commercial loans, including 

increasing leverage, declining spreads, and a weakening 

in other underwriting terms, all stemming from increasing competitive pressures. 

Diversifying loan portfolios is another way for banks to 

help reduce susceptibility to economic downturns. It 

has often been noted that the trend toward interstate 

banking and branching may improve loan diversification. It should also be noted, however, that many banks 

retain high concentrations of credit exposure to specific 

economic sectors. For example, commercial real estate 

lending and construction lending has been a source of 

volatility in bank earnings since the real estate investment trust (REIT) crisis of the 1970s. As discussed in 

Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets, banks 

are leading a resurgence in commercial real-estate lending. As Table 1 shows, 28 percent of FDIC-insured institutions grew their total commercial real estate and 

construction portfolios more than 30 percent from mid1996 to mid-1997, and 16 percent had total commercial 

real estate and construction exposures1 exceeding 200 

percent of equity and reserves. Concentrations and 

rapid growth do not necessarily portend difficulties, but 

the greater the concentration of credit to a specific sector, the greater the importance of strict adherence to 

sound underwriting policies and standards and the 

maintenance of adequate loss reserves. 

The most immediate concerns about credit quality have 

been expressed regarding credit cards and some other 

1 Includes loans secured by multifamily dwellings and nonfarm nonresidential structures, as well as construction loans. 

Chicago Regional Outlook 4 Fourth Quarter 1997 
In Focus This Quarter
 

consumer debt. Despite seven years of economic expansion, commercial banks’ net credit card charge-offs at 

mid-1997 were running at 5.22 percent of average outstanding balances, matching levels not seen since the 

aftermath of a 56 percent run-up in charge-offs that 

accompanied the recession of 1990 to 1991. Noncurrent 

rates on these loans are at near-historic highs of 1.94 

percent, and some examiners are commenting that these 

rates would be even higher were it not for some of these 

balances being rolled over into home equity debt consolidation loans with loan-to-value ratios as high as 135 

percent. Home equity lines are a rapidly growing business for some banks; 25 percent of banks and thrifts 

grew their home equity lines by more than 30 percent 

during the year ending mid-1997 (see Table 1). 

Except for credit cards and some other consumer loans, 

loan losses are at historically low levels. Nevertheless, 

lending decisions that assume a continuation of favorable economic conditions should be closely examined 

this far into the expansion. Institutions that maintain 

strong underwriting standards, an adequate allowance 

for losses, and prudent diversification of the loan portfolio will be best positioned to sustain earnings and capital during a downturn in credit quality. 

Net Interest Margin 

Net interest margin (NIM) is another primary driver of 

bank earnings. Indeed, a sharp improvement in NIM 

TABLE 1 

CHART 4 

Rebound in ROA Since 1990 Fueled 

by Improved NIM and Asset Quality 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1984 1986 1988 1990 1992 1994 1996 

2.5% 

3.0% 

3.5% 

4.0% 

4.5% 

5.0% 

ROA 

Net charge-off ratio 

NIM 

Source: Commercial Bank Call Reports ROA, Net Charge-Off Ratio

NIM (%) 

helped lead the banking industry’s dramatic recovery 

from the last recession (see Chart 4). Commercial 

banks’ NIM has declined slightly in recent years, but at 

4.23 percent still remains near the top of the range 

within which it has fluctuated since 1984 (see Table 2, 

next page). 

The banking industry’s rapid loan growth in recent 

years has been one of the factors supporting the current 

high NIM. (Since loans generally yield more than 

securities, a higher proportion of loans generally 

results in a higher yield on the total portfolio of earning assets.) Economic fundamentals cannot sustain 

rapid loan growth indefinitely, however. Accordingly, a 

Rapid Loan Growth Is 

Occurring at a Significant 

Number of Institutions 

(4 qtrs growth ending 6/97) 

TOTAL LOANS AND LEASES 

CONSTRUCTION LOANS 

COMMERCIAL REAL ESTATE LOANS 

TOTAL CRE 

1-4 FAMILY RESIDENTIAL LOANS 

HOME EQUITY LINES 

TOTAL RESIDENTIAL 

CREDIT CARD LOANS AND RELATED PLANS 

OTHER CONSUMER LOANS 

TOTAL CONSUMER LOANS 

COMMERCIAL LOANS 

Source: Bank & Thrift Call Reports 

Chicago Regional Outlook 

Percentage of Institutions with Loan 

Category Growth Approximating 

20% to 30% 30% or Total 

More Over 20% 

11 13 24 

4 36 40 

9 27 37 

10 28 38 

11 17 29 

4 25 29 

12 18 29 

4 17 21 

9 18 27 

9 18 27 

9 26 35 

5 Fourth Quarter 1997 
In Focus This Quarter
 

TABLE 2 

1997 Commercial Bank Performance Compared with Historical Averages 

INDUSTRY AVERAGES 

6/30/97 1984-1996 

ANNUALIZED LOW HIGH 

(%) (%) (%) 

NET INTEREST INCOME/AVERAGE EARNING ASSETS 4.23 3.89 4.36 

X AVERAGE EARNING ASSETS/AVERAGE ASSETS 86.50 86.21 88.42 

= NET INTEREST INCOME/AVERAGE ASSETS 3.66 3.36 3.89 

+ NONINTEREST INCOME/AVERAGE ASSETS 2.13 1.10 2.13 

− NONINTEREST EXPENSE/AVERAGE ASSETS 3.50 3.05 3.90 

− PROVISION EXPENSE/AVERAGE ASSETS 0.40 0.28 1.28 

+ OTHER ITEMS/AVERAGE ASSETS 0.03 − 0.02 0.15 

− TAXES/AVERAGE ASSETS 0.68 0.18 0.64 

= NET INCOME/AVERAGE ASSETS (ROA) 1.25 0.10 1.20 

Source: Bank & Thrift Call Reports 

risk in the current environment is that in the effort to 

support their NIM by generating new lending, banks 

may make compromises in loan underwriting, pricing, 

and portfolio diversification. 

Recent pricing trends have tended to weaken NIM, offsetting to a degree the effects of rapid loan growth. On 

the liability side, over the past six years, commercial 

banks’ average annual deposit growth rate of 3.2 percent 

has been outpaced by the 4.9 percent average annual 

growth rate of earning assets. As a result, nondeposit 

borrowings have increased significantly in importance, 

rising from about 12.6 percent of earning assets in 1991 

to 19.1 percent at mid-1997. Since the average cost of 

nondeposit borrowings has exceeded the average cost of 

deposits over the period by an average of 135 basis 

points, the greater use of relatively higher cost borrowings to fund earning asset growth has been an obstacle 

to wider margins. The slower deposit growth can perhaps be attributed to the increasing array of choices 

available to small savers; its effect is that bank funding 

is becoming more expensive and more interest-rate 

sensitive. 

On the asset side, pricing pressures also are frequently 

cited as contributing to sluggish NIM. For example, in 

the aforementioned syndicated lending market, average 

interest spreads charged to noninvestment-grade large 

customers have dropped more than 63 basis points 

between 1992 and 1996, while spreads on investmentgrade debt are at all-time lows. Reportedly, some deals 

are being done at minimal or no risk-adjusted spreads 

simply to preserve lending relationships. Increased 

securitization of various asset types has also had effects 

on pricing. By increasing the depth and liquidity of the 

market for the underlying loans, securitization has tended to lower spreads on these assets, thereby increasing 

competitive pressures on institutions not able to achieve 

the volumes necessary to efficiently utilize this new 

funding vehicle. 

The thin spreads available from high-quality lending 

may tempt some institutions to finance higher yielding, 

riskier credits in an effort to preserve or boost profit 

margins. For example, recent forays by some banks into 

subprime lending (see Subprime Lending: A Time for 

Caution, Third Quarter 1997) may be one indication of 

how competitive pressures on NIMs are affecting bank 

behavior. Over the long term, institutions that manage 

their NIMs with a prudent regard for how their newly 

booked business may fare during a cyclical downturn 

will have a better chance of sustaining earnings performance through the business cycle. 

Growth in Noninterest Income 

Industry analysts often cite the increasing contribution 

of fees and other sources of noninterest income as 

evidence of the evolution of the banking industry. As 

Chart 5 (next page) illustrates, for commercial banks 

with over $1 billion in assets, noninterest income now 

averages over 40 percent of net revenue (net interest 

income plus noninterest income). In contrast, banks 

Chicago Regional Outlook 6 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 5 Other measures of productivity have shown similar 

Noninterest Revenue to Net Revenue* 

Banks Over $1 Billion 

Banks Under $1 Billion 

Source: Commercial Bank Call Reports 

* Net Revenue = Net interest income plus noninterest income 

10 

20 

30 

40 

50 

6-’85 

Net Revenue (%) 

6-’876-’896-’916-’936-’956-’97 

improvement. For example, commercial banking assets 

per employee doubled, from $1.5 million to $3 million, 

between 1984 and 1997. 

Growth in overhead expense has been contained largely 

through consolidation, technological advances, and low 

levels of problem assets. Mergers have resulted in the 

wringing out of redundant expenses. Information technology (IT) has been deployed to trim underwriting 

expense, manage customer relationships, speed backoffice processing, and facilitate the creation of new 

products and services. Favorable economic conditions 

have reduced costs associated with loan collection and 

asset workouts. 

Whether the downward trend in overhead expenses will 

with under $1 billion show a profile of reliance on more 

traditional banking activities, with only 25 percent of 

revenue from these noninterest sources. 

Noninterest income growth is being driven both by new 

business lines and higher deposit-related fees. 

Examples include fees from sales of mutual funds and 

other nondeposit products, investment banking activities such as securities underwriting and asset management, and increases in traditional fee sources such as 

from automated teller machines. Increasing securitization of assets, in which the accounting conventions convert interest income to noninterest income, has also 

affected the growth in reported noninterest income. 

With the exception of trading revenue, noninterest 

income has historically shown a growth trend that has 

not been especially sensitive to economic cycles. 

However, newer fee-based businesses such as mortgage 

banking, mutual funds, and securities underwriting may 

ultimately share the same cyclical characteristics as traditional bank lines of business, and therefore may not 

reduce banks’ historical exposure to economic cycles. 

The Effect of Expense Control 

on Earnings Performance 

Cost-cutting efforts in banking continue to show their 

effects. Since 1991, commercial banks’ efficiency 

ratio,2 a measure of an institution’s effectiveness in generating revenue, has steadily improved (see Chart 6). 

continue is an open question. Should problem loans 

increase from their cyclical lows, collection and workout costs will increase (evidence of this effect can be 

discerned for the late 1980s in Chart 6). The rapid 

change in information technology may prompt increasing expenditures. The 1996 Atlantic Data Services/ 

Tower Group Survey of Information Technology 

Services in Banking noted that the banking industry is 

“faced with an aging IT infrastructure.” The survey 

suggests that most technology-related expenses could 

increase at a 5.6 percent compounded growth rate until 

the year 2000 and that expenses for outside services 

could increase 11 percent over the same period. The 

ability to generate future revenue gains may depend on 

additional bank investment not only in technology but 

also in the development of new products and services. 

CHART 6 

Commercial Banks’ Efficiency Ratio*
 

Is Steadily Improving
 

70% 

68% 

66% 

64% 

62% 

60% 

58% 

56% 

1984198619881990199219941996 

The efficiency ratio is normally defined as noninterest expense * Noninterest expense/(net interest income + noninterest income) 

Source: Commercial Bank Call Reports divided by the sum of net interest revenue and noninterest revenue.
 

Chicago Regional Outlook 7 Fourth Quarter 1997
 

2 
In Focus This Quarter
 

In any event, cost-cutting is not without its risks. For 

example, reductions in personnel, or excessive reliance 

on automated underwriting procedures (see Will Credit 

Scoring Transform the Market for Small-Business 

Lending? Second Quarter 1997), may raise concerns 

about the effectiveness of internal administration and 

control processes. Cost-cutting that cuts too deeply into 

customer service can erode franchise value. Mergers 

can reduce redundant expense, but at some point there 

may be diseconomies to managing a large organization. 

The Role of Capital in the Management 

of Earnings 

Management, shareholders, and analysts often evaluate 

earnings in relation to the level of capital using measures such as return on equity (ROE) and earnings per 

share (EPS). One result has been pressure on banks to 

continue to grow ROE and EPS; these objectives have 

been made progressively more difficult to attain by the 

significant level of capital that has built up over the past 

five years. 

Finding effective ways to deploy historically high capital levels appears to be one driving force behind the 

recent rash of mergers and acquisitions, high dividend 

payout ratios, increased stock repurchases, and the 

development of alternative types of hybrid capital such 

as trust preferred stock (see Financial Markets). For 

example, during 1995 and 1996, major merger and 

acquisition deals included some $835 billion in bank 

and thrift assets. During 1996, commercial banks with 

over $1 billion in assets had an average dividend payout 

ratio over 89 percent, up significantly from the 67 percent payout rate of 1994. Banks with under $1 billion in 

assets averaged 55 percent for 1996 and 52 percent for 

1994. In addition, banks and bank holding companies 

have issued some $21 billion in trust preferred stock 

during the last nine months, some of which has been 

used to fund the almost $42 billion in share repurchase 

programs announced by large banks during 1996 and 

early 1997.3 

While the book value of equity and other capital ratios 

has increased at the aggregate industry level, a number 

of banks are reporting declines in equity capital and 

leverage capital ratios despite positive earnings (see 

Chart 7). For all institutions, the ability to actively man3 Salomon Brothers. 

CHART 7 

An Increasing Number of Profitable Banks Are
 

Reducing Tier 1 Capital*
 

Number of Banks 

800 

600 

400 

200 

0 

1992 1993 1994 1995 1996 

* Both Tier 1 dollar amount and ratio 

Source: Commercial Bank Call Reports 

age capital accounts going forward will depend largely 

on having earnings available above the levels needed to 

fund dividends and growth, after assuming capital protection adequate for the level of business risk. Bankers 

and examiners will need to carefully review strategies 

that increase bank leverage or increase business risk 

without considering the potential effects of a downturn 

in credit quality or other weakening in the economy. 

Summary 

The most profitable period for U.S. banks in the postWorld War II era is paradoxically occurring during a 

time when banks’ traditional business lines are coming 

under greater competitive pressure than ever. While the 

industry as a whole is adapting well to these competitive 

pressures, there may be a tendency for some insured 

institutions to respond by accepting greater risks to preserve or gain business. 

The nature of banking is to profit by taking calculated 

risks, and naturally more profits will be made during the 

expansionary phase of a cycle than during a downturn. 

Nevertheless, the institutions that are best able to sustain their earnings and capital over the complete cycle 

will be those that allow for the possibility of an adverse 

change in business conditions, and prudently balance 

the levels of risk taken with the expected returns. 

Ronald Spieker, Chief, Depository Institutions Section 

Steve Linehan, Assistant Director, Analysis Branch 

George French, Deputy Director 

Chicago Regional Outlook 8 Fourth Quarter 1997 
In Focus This Quarter
 

Strong Demand and Financial Innovation Fuel
 

Rebounding Commercial Real Estate Markets
 

•	 Commercial banks are leading a resurgence in 

commercial real estate financing; many metropolitan markets are experiencing rapidly rising rents 

and single-digit vacancy rates, suggesting the likelihood of further development. 

•	 New funds directed toward commercial real estate 

are being increasingly supported by commercial 

mortgage-backed securities and real estate investment trusts. 

•	 Some analysts have expressed concern that these 

financing vehicles may serve to heighten competitive pressures that will lead to more aggressive 

loan pricing. 

In the wake of declining values and the large losses of 

the late 1980s and early 1990s, commercial real estate is 

making a comeback. There are two stories here of interest to lenders. The first entails the remarkable resurgence in commercial real estate demand. The second 

involves the major changes taking place in how real 

estate is owned and paid for and—of greater interest to 

banks—who is financing this expanding activity. 

Commercial Banks Show Renewed Interest 

in Commercial Real Estate 

Strong evidence of commercial real estate’s rebound 

can be seen in its renewed attractiveness to lenders. 

TABLE 1 

Federal Reserve figures show that nearly $58 billion of 

new commercial mortgage debt was added to the market in 1995 and 1996 (see Table 1). While this new net 

lending pales in comparison with that of the late 

1980s—when nearly $74 billion in net new debt was 

added in 1987 alone—it positively shines when compared with the $89 billion shrinkage of commercial real 

estate loans from 1991 to 1994. Table 1 shows that commercial banks are leading this resurgence with a $37 

billion net increase in mortgage lending during 1995 

and 1996. 

Perhaps the most convincing evidence of commercial 

real estate’s recovery comes from the market itself. 

Rising prices and tightening supplies of space in most 

major markets and for most property types suggest a 

growing demand for new commercial property stock. 

Numerous indices and market studies support this 

notion: 

•	 As measured by Koll/NREI national composites, 

prices and rents turned up sharply after 1993, with 

rents surpassing their 1988 to 1989 levels by 1995 

(see Chart 1, next page). For office properties in particular, the ten fastest-growing cities in terms of rental 

rates saw increases exceeding 20 percent in 1996.1 

1 Those cities are, in order, Minneapolis, Columbus, Dallas, Portland, 

Salt Lake City, Atlanta, San Jose, Phoenix, San Francisco, and San 

Diego. 

Banks Are Increasing Their Flow of Funds into Commercial Real Estate ($ Billions) 

1991 1992 1993 1994 1995 1996 

NET NEW BORROWING, ALL SOURCES $ − 15.6 $ − 47.1 $ − 21.5 $ − 4.4 $ 22.6 $ 35.1 

COMMERCIAL BANKS 3.1 − 8.4 − 4.3 7.5 18.0 18.7 

CMBSS 1.3 8.7 10.3 11.3 10.6 16.1 

SAVINGS INSTITUTIONS − 22.4 − 18.5 − 7.5 − 6.8 − 1.8 0.8 

LIFE INSURANCE COMPANIES − 5.6 − 15.1 − 13.4 − 10.5 − 3.3 − 2.5 

ALL OTHER SOURCES 8.0 − 13.5 − 6.6 − 5.9 − 0.9 2.3 

EQUITY CAPITAL FLOW, ALL SOURCES $ 4.9 $ 3.1 $ 17.4 $ 21.6 $ 21.5 $ 30.3 

REIT EQUITY OFFERINGS 1.6 2.0 13.2 11.1 8.2 13.0 

PENSION FUNDS − 4.8 − 4.3 − 0.7 9.6 13.8 14.3 

ALL OTHER SOURCES 8.1 5.4 5.0 0.9 − 0.5 3.0 

Sources: Federal Reserve, National Association of Real Estate Investment Trusts (NAREIT), LaSalle Advisors 

Investment Research 

Chicago Regional Outlook 9	 Fourth Quarter 1997 
In Focus This Quarter
 

•	 Property capitalization rates, which measure the 

annual income generated by a property as a percentage of its purchase price, are falling (see Chart 2). 

These falling rates indicate that investors are paying 

higher prices for each dollar of current income generated by the property. Overall, however, prices have 

not yet caught up with rents, which now exceed their 

previous highs in some markets, suggesting that the 

current recovery is not yet peaking. 

•	 Declining vacancy rates reflect strong demand for 

office properties, which Grubb & Ellis cast as the 

hottest sector in its 1997 forecast. Nationwide, office 

vacancies have fallen dramatically, by 5 to 10 percentage points during the last four years (see Chart 

3). Moreover, Torto-Wheaton Research estimates 

that 21 of the 56 metropolitan areas it tracks had 

single-digit vacancy rates at the end of first quarter 

1997. Not surprisingly, many of the tightest markets 

are those with the greatest rent inflation. 

While the unrestrained commercial development of the 

1980s continues to cast a shadow over the industry, that 

shadow is fading as declining vacancy rates and rising 

rental rates for existing properties fuel optimism 

among lenders and investors and strengthen the case 

for new development. Lenders, examiners, and analysts, however, must be diligent in monitoring commercial real estate markets to identify possible imbalances 

between supply and demand. It is particularly important that lending decisions be made on the basis of economic feasibility and realistic property cash flow 

projections rather than solely on the basis of competitive pressures. 

Borrowers’ Financing Options Expanding 

Although banks are clearly the largest source of financing for resurgent commercial real estate markets, a 

broader and more competitive financing market has 

emerged. In this market, financing often bypasses 

banks, being funneled instead through entities that purchase and securitize commercial real-estate-secured 

debt or the properties themselves, parceling them into 

smaller, more standardized, and thus more liquid pieces 

that are attractive to institutional and individual 

investors alike. This trend is illustrated in Table 1, which 

shows the increasing roles commercial mortgagebacked securities (CMBSs) and real estate investment 

trusts (REITs) have played in funding commercial real 

estate over the past five years. This increase in public 

CHART 1 

Prices and Rents on Upswing Nationwide 

Index (1986 = 1.00)
 

1.30
 

1.20
 Rents
 

1.10
 

1.00
 Prices
 

0.90
 

0.80
 

1990 1991 1992 1993 1994 1995 1996 

Source: Koll National Real Estate Index 

CHART 2 

Property Capitalization Rates Dropping 

8.0 

8.5 

9.0 

9.5 

10.0 

10.5 

11.0 

11.5 

1990 1991 1992 1993 1994 1995 1996 1997 

Overall Cap Rates (%)

Office 

Retail 

Apartment 

Source: Donaldson, Lufkin & Jenrette 

CHART 3 

National Downtown and Suburban
 

Class A Vacancy Rates Falling
 

8 

13 

18 

23 

Downtown 

Suburban 

Vacancy Rates (%) 

1988 1989 1990 1991 1992 1993 1994 1995 1996 

Source: CB Commercial / Torto-Wheaton Research 

Chicago Regional Outlook 10	 Fourth Quarter 1997 
In Focus This Quarter
 

financing left financial institutions in 1996 with 

approximately a one-third share of all new net commercial real estate financing, down from well over half just 

a decade before. 

From a lender’s perspective, CMBSs offer several 

advantages over traditional portfolio lending. Most significantly, lenders can generate fee income from loan 

production and servicing activities while avoiding the 

excessive concentrations of credit risk that plagued 

lenders during the last real estate downturn.2 According 

to Commercial Mortgage Alert, outstanding CMBSs 

reached $125 billion in 1996 on a record $30 billion of 

new issuance. While outstanding volume is still dwarfed 

by the $3 trillion market for residential mortgagebacked securities (MBSs), the growth in CMBS volume 

has been remarkable considering that such securities 

were virtually nonexistent prior to 1991. 

At present, most commercial banks are not active in 

issuing CMBSs, accounting for only $2.6 billion of 

CMBS issuance in 1996, according to E&Y Kenneth 

Leventhal Real Estate Group. Rather, the primary 

source of these securities is investment banks, which 

generate substantial fees by converting existing loans 

into securities. CMBS issues also are being increasingly underwritten by conduits, which are entities created 

to originate mortgage loans for distribution to investors 

in the secondary market. Nomura Securities 

International estimates that such conduits accounted 

for over one-third of CMBS issuance in 1996, nearly 

double the volume of 1995. Only a handful of the 

largest commercial banks have set up conduit programs—the five largest banks accounted for $3.3 billion of the $10.2 billion in conduit issuance during 

1996. Aside from this relatively small number of bank 

competitors, investment banks are among the largest 

and most active conduit issuers. 

There is no fundamental reason why banks cannot take 

greater part in the rapidly growing CMBS market. In 

fact, they possess many distinct advantages over investment banks. Their distribution networks, lending experience, and back-office capabilities are naturally suited 

to facilitating loan demand, evaluating repayment risk, 

servicing loans, and monitoring a project’s development. Obstacles of scale may preclude smaller institu2 While securitization of loans purports to shift credit risk to investors, 

many analysts and rating agencies have recently expressed concern 

over recourse arrangements, both contractual and voluntary, whereby 

the seller/servicer effectively assumes all or most of losses experienced by the security. 

tions from directly issuing CMBSs ($500 million in volume is often cited as a minimum for efficiently assembling a deal). However, if the CMBS market develops 

like that for MBSs, standardized underwriting may 

enable small institutions to remain competitive either by 

cooperatively forming their own conduits or by selling 

their loans to existing conduits. 

Whether or not banks take part, the continuing development of a market for securitized commercial real estate 

assets raises a number of efficiency issues for direct 

lenders. Securitization provides property developers and 

owners access to a much larger pool of potential funding 

sources and a wider array of funding options. Moreover, 

the costs of public financing reflect efficiencies born of 

standardization and liquidity. In short, investors, including banks, can price, enter, and exit their positions in 

securitized debt more easily than could be done with 

whole loans. While improved efficiencies are a positive 

aspect of the growth in securitized investments, these 

efficiencies threaten to dictate bank pricing, thereby 

potentially reducing margins or driving institutions to 

lend on less economically feasible projects in an effort to 

preserve margins and market share. 

REITs: An Alternative to Traditional 

Capital Sources 

Commercial real estate financing is evolving in other 

ways. REITs have become major players in the industry 

since 1993, accounting for fully one-fifth of funds flowing into real estate in 1996. REITs are much like mutual funds in that they allow indirect investment in real 

estate through purchases of equity in the REIT. The 

REIT itself holds title to the underlying properties and, 

provided it meets certain requirements, can directly pass 

through its earnings to investors without any intermediate tax. Although Moody’s estimates place REIT holdings at less than 3 percent of all U.S. commercial real 

estate, outstanding REIT shares have grown considerably, with market capitalization doubling nearly three 

times in just four years (see Chart 4, next page). 

Accompanying this rise in capitalization has been an 

equally dramatic rise in bank lending to REITs. 

According to Loan Pricing Corporation, bank lending 

to REITs surged to $12.8 billion in 1996, a 16 percent 

increase over 1995’s then-record volume and more than 

a tenfold increase over the period 1990 to 1992. 

The rise in REIT capitalization can be attributed in part 

to pent-up institutional demand for real estate. REITs 

Chicago Regional Outlook 11 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 4 

REIT Capitalization Soaring 

400 

350 

300 

250 

200 

150 

100 

50 

0 

1996

have a particular appeal to fund managers since they 

offer the benefits of investment diversification without 

the dual headaches of property management and asset 

illiquidity. Aside from the direct credit risk posed by 

lending to REITs, their rising popularity confronts banks 

with an indirect threat as well—the threat that banks 

could be crowded out of lending opportunities if 

investors find REIT funding structures more attractive 

from a cost and control standpoint. The degree to which 

this crowding out may occur is unclear, for according to 

Nomura Research, REITs historically have borrowed 40 

cents for each dollar of real estate held. However, well 

over half of this borrowing takes place through public 

offerings of secured and unsecured debt, leaving only a 

small portion to be financed by banks and other private 

lenders. Because REITs tend to focus on the highest 

quality projects, their increasing presence also creates 

concerns that banks may be driven to lend to less attractive or more risky properties to preserve market share. 

Many analysts have also expressed unease over the rapid 

rise in the valuations of REITs, some of whose shares 

are priced at a considerable premium to the properties 

themselves. Anecdotal evidence suggests that premiums 

as high as 40 percent over market value have been paid 

for some REIT shares in recent months. Such marketbased valuations create concern over the extent to which 

an REIT’s capital structure allows it to pay more for 

properties than an investor who employs greater financial leverage. Accordingly, while REITs may make up a 

fairly nominal amount of overall real estate holdings, 

they may be quite influential in determining how commercial properties are being valued or appraised. 

80

70 

60 

50 

40 

30 

20 

10 

0 

Market Capitalization (Left Scale) 

Number of REITs (Right Scale) 

$ Billions 

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 

Source: National Association of Real Estate Investment Trusts

Commercial Real Estate Securitization: 

Some Broader Implications 

Maturing CMBS markets could eventually improve the 

overall stability of commercial real estate markets not 

only by improving market liquidity but also by enabling 

investors to diversify and share their credit exposures 

among a greater number of participants. In addition, 

loan performance could become increasingly transparent to the general marketplace, thereby encouraging 

more uniform and prudent underwriting standards. 

However, concern naturally arises because CMBSs are 

a major source of commercial real estate market funding that has not been tested through a serious market 

downturn. This situation leads to questions concerning 

the impact they will have on property values and market 

liquidity and whether today’s underwriting terms, driven 

largely by competitive factors, will stand up to tomorrow’s market downturn. Another question is whether the 

standardized structures underlying these securities offer 

enough flexibility to borrowers to renegotiate loan 

terms—a critical workout tool during times of financial 

stress. The answers to these questions will ultimately 

determine the extent to which lenders and investors suffer as a result of the inevitable cyclical swings in commercial property values. 

There are also questions about how REITs will affect 

commercial real estate markets. One argument is that 

the appetite for REIT investments, combined with the 

premiums that the trusts can pay for properties, will 

push the price of commercial space beyond sustainable 

levels. Those who hold this view see REITs, and other 

Wall Street innovations that increase the supply of funding, as potentially amplifying cyclical swings in real 

estate values. The contrary view holds that REITs will 

improve market efficiency by providing continuous 

pricing benchmarks through daily share price movements and thus enforce discipline upon developers and 

lenders. This discipline, it is argued, will prevent excessive development and dampen the severity of real estate 

cycles. 

As an investment, commercial real estate is quickly 

regaining the broad favor it lost during the last market 

downturn. But the channels through which a lender or 

investor can participate in this market are expanding 

even more dramatically. Investment exposures to real 

estate are no longer effectively limited to private equity 

or debt. The choices are multiplying, with liquid public 

markets for both debt and equity providing the foundation for existing and future commercial real estateChicago Regional Outlook 12 Fourth Quarter 1997 
In Focus This Quarter
 

based instruments—instruments such as swaps, options, 

and property derivatives—that will permit the tailoring, 

hedging, and even creation of synthetic real estate 

investment positions. Although financial institutions are 

participating in this revival, it is clearly a different world 

from the old, and one in which they will have to choose 

how best to compete against—or participate in—these 

new real estate financing strategies. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

Chicago Region: Widespread and
 

Rapid Growth in Real Estate
 

Lending
 

Direct commercial real estate lending (construction 

and nonresidential) is important to many Chicago 

Region institutions. More than 40 percent of banks 

and thrifts in the Region reported aggregate exposures 

in this lending type exceeding Tier 1 capital at 

midyear 1997. In addition, some of these institutions, 

and others with less exposure, registered very strong 

commercial real estate (CRE) loan growth over the 

past year. About one-third of Chicago Region instituCHART 5 

tions had CRE loan growth of 20 percent or higher. 

These banks and thrifts are dispersed throughout the 

Region, in metropolitan and nonmetropolitan areas 

alike (see Chart 5). 

Rapid growth rates are not necessarily precursors to 

future problems but can cause stress on insured institutions’ management and control systems. In addition, 

competitive pressures caused, in part, by the financial 

innovations described in this article may be resulting 

in a slight increase of reports of liberalized underwriting practices. (See Regional Banking: Credit 

Quality Risk Management Becomes Even More 

Important as Economic Expansion Ages.) 

CRE Loan Growth Is Widespread in the Chicago Region 

Percentage of
 

Institutions with
 

20% or Higher
 

CRE Growth
 

Over 50%
 

33% to 50%
 

Below 33%
 

None
 

(Headquarter location
 

by county)
 

Chicago Regional Outlook 13 Fourth Quarter 1997 
Regular Features	 Regional Economy
 

The Chicago Region’s Economy
 

in the Seventh Year of Expansion
 

•	 The past year’s slight decline in manufacturing employment within the Region reflects both moderating 

demand for some products and a tight labor market. 

•	 Although the number of unemployed workers in the Region is the lowest in two decades, some insured institutions continue to cope with pockets of persistently high unemployment. 

•	 The healthy market for single-family homes has spurred competition for residential lending, with some 

institutions liberalizing credit terms, especially on home equity lines. 

•	 Ten years of appreciation have returned farmland prices in the Region to about 95 percent of their 1980 

peak and thus improved the farm sector’s debt-to-assets ratio. Continuation of these trends depends on both 

product prices and how well farmers manage their operations as government subsidies are phased out. 

Tight Labor Markets Limit Growth 

Employment growth in the Chicago Region has been 

stalled at around a 1.5 percent pace since early 1996, 

when the Region’s rate of job expansion started lagging 

the national pace (see Chart 1). The deceleration in job 

growth is associated with both low unemployment in the 

Region and a long-lived cyclical expansion. This expansion, now 79 months old, exceeds the post-World War II 

average of 50 months by a considerable span. 

Another sign of the expansion’s aging is that demand 

for such durable goods as light motor vehicles is high 

but has stopped growing. In this environment, productivity efforts by manufacturers and scattered strikes 

have actually trimmed the Region’s employment among 

producers of vehicles and transportation equipment by 

about 2 percent (13,700 workers) over the past year. 

Overall, the only sectors with significant job gains 

recently are construction and services (see Table 1, next 

page). 

This Region’s low 4.1 percent unemployment rate 

highlights the lack of readily available workers for 

employers seeking to expand. In fact, the 941,000 

unemployed workers in the Region during the second 

quarter was the lowest level in the two decades for 

which data are available. Meanwhile, Midwestern 

employers’ ability to attract workers from other areas 

has weakened as economic conditions elsewhere, especially on the coasts, have improved. 

Implications: In the seventh year of cyclical expansion, 

many factories and industries are operating near full 

capacity and labor markets are tight. Possible repercussions of this situation include the following: 

•	 Firms lose business opportunities because of their 

inability to increase output in the short run. 

•	 Labor costs rise and thus squeeze profit margins 

because firms cannot fully pass along higher costs in 

the form of higher output prices. 

•	 Capacity constraints and inflationary pressures lead 

to rising interest rates, which affect the lending and 

earnings streams of financial institutions. 

CHART 1 Q2-87

Q2-88Q2-89Q2-90Q2-91Q2-92Q2-93Q2-94Q2-95Q2-96Q2-97 

Source: Bureau of Labor Statistics

 Job Growth in Region Lags the Nation 

-2 

-1 

0 

1 

2 

3 

Chicago 

Region 

United 

States 

Job Growth (%) 

4 

Chicago Regional Outlook 14	 Fourth Quarter 1997 
Regular Features	 Regional Economy
 

Pockets of High Unemployment Persist 

The healthy economic environment represented by these 

statewide unemployment and job growth statistics, 

unfortunately, is not universal throughout the Region. In 

fact, 12 percent (52) of the Region’s 437 counties experienced unemployment rates of 8 percent or higher in the 

second quarter of this year (see Chart 2). While current 

conditions represent an improvement relative to a year 

ago (see Table 2), the involved counties traditionally are 

rather insensitive to business cycles and thus have not 

actively participated in the expansion of recent years. 

Within the Chicago Region, only Indiana had no counties with unemployment rates in the higher range. The 

pockets of higher unemployment are clustered in southern Illinois, northern Michigan and its Upper 

Peninsula, northern Wisconsin, and southeastern Ohio. 

Many high-unemployment counties lack significant 

diversity in their economic bases or reflect specific circumstances. For example: 

•	 Seven counties in southern Illinois are heavily 

dependent on coal mining, which has been curbed in 

recent years by environmental regulations on the use 

of high-sulfur coal. 

•	 The recent unemployment rate of 15.7 percent in 

Jefferson County, Ohio, largely reflected the effects 

TABLE 1 

Slowing Employment Growth 

Widespread in Chicago Region 

% CHANGE FROM 

4 QUARTERS EARLIER 

Q2-95 (%) Q2-96 (%) Q2-97 (%) 

TOTAL PAYROLLS 3.0 1.5 1.4 

MINING − 5.4 − 5.6 − 1.3 

CONSTRUCTION 2.5 4.7 4.9 

MANUFACTURING 3.2 − 0.7 − 0.4 

TRANSPORTATION, 

PUBLIC UTILITIES 3.1 1.3 1.5 

WHOLESALE TRADE 3.2 0.5 0.7 

RETAIL TRADE 3.7 1.2 1.5 

FINANCE, 


REAL ESTATE, 


INSURANCE
 − 1.0 1.8 1.8 

SERVICES 4.0 3.6 2.8 

GOVERNMENT 1.6 0.9 0.2 

Source: Bureau of Labor Statistics 

CHART 2 

Chicago Region Shows Scattered Pockets of
 

High Unemployment
 

Unemployment Rates, Q2 

(and Number of Counties) 

3.5% or Lower (124) 

3.51% to 5.5% (179) 

5.51% to 7.5% (73) 

7.51% to 9.5% (44) 

9.51% and Higher (17) Source: Bureau of Labor Statistics 

of a lengthy steelworkers’ strike. An August settlement is returning steelworkers to payrolls, but some 

of the damage to local businesses likely will be 

reversed very slowly. 

•	 Employment in many Upper Peninsula communities 

is concentrated in such seasonal sectors as tourism or 

logging. Additionally, the closing of an Air Force 

base affected not only military employees but also 

service workers, retailers, and others who depended 

on business from the base. 

Implications: Banks and thrifts headquartered in counties with high unemployment rates do not show an elevated percentage of past-due loans relative to banks in 

the rest of the Region. For the Region as a whole, slightly more than 9 percent of institutions had 5 percent or 

more of their loan portfolios past due in the second 

quarter. In high-unemployment counties, 7 percent of 

institutions had past-due ratios of 5 percent or higher. 

This comparability presumably reflects the ability of 

lending institutions in the high-unemployment areas to 

TABLE 2 

Pockets of High Unemployment Remain 

Unemployment Number of Counties in

Rate of Region IL IN MI OH WI 

Q2-97: 

8% and up 52 14 0 24 11 3 

10% and up 14 5 0 5 3 1 

Q2-96: 

8% and up 73 25 5 30 11 2 

10% and up 30 10 1 13 5 1 

Source: Bureau of Labor Statistics 

Chicago Regional Outlook 15	 Fourth Quarter 1997 
Regular Features Regional Economy
 

plan for and adjust to unfavorable economic conditions, TABLE 3 

thus managing the quality of their credits at least as well 

as institutions in markets with more vibrant and diversified economies. 

Single-Family Housing: High Demand 

but Modest Expansion 

Relatively low interest rates and high employment levels are favorable for the housing market, but in the 

seventh year of cyclical expansion there is minimal 

pent-up demand. As a result, sales of single-family 

homes in the Midwest remain high but are expanding at 

a subdued pace. On the supply side, construction starts 

of single-family homes in the first half of this year 

were about 6.5 percent below the year-earlier pace, 

with some of the decline resulting from the lack of 

suitable building sites. 

Around mid-year, prices of both new and existing 

homes in the Midwest were about 5 percent higher than 

a year earlier. However, they got there along different 

paths. Median prices of new homes in the Midwest have 

been on a modest rising trend since 1995. In contrast, 

price gains for existing homes have cooled recently after 

four quarters of 9 to 10 percent appreciation (at an 

annual rate), the most rapid in 10 years. Recent price 

changes in various metropolitan areas in the Region are 

shown in Table 3. 

While the market for single-family homes is strong at 

present, some signs of vulnerability are appearing. For 

example, the rate of foreclosures started (on conventional loans) in the Midwest, as reported by the 

Mortgage Bankers Association, remains among the 

lowest in the nation but has risen over the past two 

years. The sustained increase in the foreclosure rate 

joins rising credit card delinquencies in this Region as 

a signal that households’ debt burdens are a concern at 

this stage of the business cycle, when job gains and 

income growth are slowing. 

Implications: The market for single-family housing in 

the Midwest has experienced moderate price appreciation and apparently avoided the boom mentality that 

often precedes a sharp reversal of fortunes. Even so, 

various potential developments could undermine current conditions and thus weaken the value of collateral 

behind real estate loans. Job growth could slow further 

or interest rates could start climbing, either of which 

would further aggravate debt payment problems among 

Median Price of Existing SingleFamily Homes Climbs 

(Percent Change from a Year Earlier) 

Q4-95 Q4-96 Q2-97 Metro Area
 

12.9
 3.4 3.7 Akron
 

5.7
 − 0.4 3.6 AppletonOshkosh-Neenah 

6.0 2.3 0.5 Aurora-Elgin 

8.1 2.7 4.1 Canton-Massillon 

4.4 − 1.0 5.0 Champaign-Urbana 

3.8 0.9 4.9 Chicago
 

5.8
 3.4 3.8 Cincinnati
 

10.6
 3.6 3.9 ClevelandLorain-Elyria 

− 5.0 5.8 8.1 Columbus
 

10.8
 3.2 7.7 Davenport-MolineRock Island 

7.7 5.1 2.4 Dayton-


Springfield
 

14.6
 12.9 6.7 Detroit
 

6.8
 − 1.6 3.1 Gary
 

6.3
 5.6 7.8 Grand RapidsMuskegonHolland 

6.4 9.5 2.5 Green Bay
 

8.2
 2.4 3.2 Indianapolis
 

13.8
 7.4 10.5 Kalamazoo
 

10.2
 6.7 7.2 Lake County, IL 

6.4 4.4 10.7 LansingEast Lansing 

9.4 7.1 6.1 Louisville
 

9.9
 − 1.3 5.5 Madison
 

7.2
 1.8 3.6 Milwaukee-Racine 

6.8 4.7 − 0.2 MinneapolisSt. Paul 

6.0 5.2 7.0 Peoria-Pekin 

4.8 − 0.6 1.2 Rockford
 

15.1
 3.4 5.6 Saginaw-Bay CityMidland 

18.3 0.8 − 5.1 South Bend 

3.8 2.7 5.4 Springfield 

6.0 3.3 7.6 St. Louis
 

9.7
 8.2 2.9 Toledo
 

3.2
 5.5 3.3 YoungstownWarren 

Source: National Association of Realtors 

Chicago Regional Outlook 16 Fourth Quarter 1997 
Regular Features Regional Economy
 

some households. A downturn in the stock market could 

wipe out some of households’ net worth and dent their 

optimism about economic conditions. 

Over one-fourth of the Region’s insured institutions 

experienced 20 percent or faster growth in 1 to 4 family residential loans over the past year. Home equity 

loans rose rapidly at a larger share of the Region’s institutions, in part because some portfolios were fairly 

small initially. Nearly 40 percent of banks and thrifts in 

the Region expanded their home equity lines by 20 percent or more in the past year. Some of the home equity 

loans may be especially vulnerable to any softening in 

residential market values in light of anecdotal information that institutions’ attempts to gain market share 

have, in some cases, resulted in loan-to-value ratios of 

100 percent or more. 

Agriculture: Appreciating Land Values 

and Volatile Prices 

Ten years of appreciating land values have brought the 

current value of farm real estate in the Region to about 

95 percent of its peak in 1980 (see Chart 3). The appreciation, in turn, has contributed to relatively low measures of debt loads (e.g., debt-to-assets ratio) among 

Chicago Region farmers (see Chart 4). It also has boosted the value of farm real estate holdings as a percentage 

of total farm assets to the highest level since 1983. 

While farmland prices have trended upward, commodity prices have tended to fluctuate widely. For example, 

prices received by farmers for milk gyrated considerCHART 3 

ably in the past year. Prices broke out of the $12- to $14­

per-hundredweight (Cwt) range experienced since 

1992, first climbing to over $16 per Cwt and then 

plunging to around $12.50 per Cwt recently (see Chart 

5, next page). Such volatility adds pressure in a market 

already undergoing structural change. 

Many dairy farmers also are responding to challenges 

from lower cost producers, which have expanded 

noticeably in the West. California, where operations 

average 438 cows per herd, displaced Wisconsin, where 

the average is 52 cows per herd, as the leading milkproducing state in 1994. The challenge of lower cost 

competition from large operators is especially important 

in Wisconsin, where dairy goods account for 52 percent 

of the state’s receipts from farming. Dairy farming also 

is important to the agricultural sectors in Michigan and 

Ohio, where it generates 20 percent and 13 percent, 

respectively, of each state’s agricultural receipts. 

Other agricultural markets important to the Chicago 

Region also are experiencing volatile prices. Despite 

favorable production estimates, price movements for 

corn and soybeans may be more pronounced than usual 

this season because of very low reserves. The unpredictability of weather and growing conditions may 

cause these markets to remain jittery and subject to 

large price swings until the harvests are in. 

Implications: The value of farmland in the Region 

climbed by 61 percent from its 1986 low through 1995, 

thus contributing to the currently low debt-to-assets 

ratio. As land values approach previous peaks and 

farmers face potentially increased price volatility 

resulting from the 1996 Farm Bill, lenders must 

CHART 4 

196019631966196919721975197819811984198719901993

1996 est. 

$ Billions 

Sources: U.S. Department of Agriculture, Federal Reserve Bank of Chicago 

Value of Farmland Assets in Chicago 

Region Rises 

0 

10 

20 

30 

40 

50 

$60 

Illinois 

Michigan Ohio 

Indiana 

Wisconsin 

19601963

19661969

19721975

1978

19811984198719901993 

Debt-to-Asset Ratio for Region’s Farmers Is Low 

Source: U.S. Department of Agriculture 

10 

12 

14 

16 

18 

20 

22 

24 

26 

Debt-to-assets Ratio (%) 

Chicago Regional Outlook 17 Fourth Quarter 1997 
Regular Features Regional Economy
 

evaluate whether real estate values will hold or appre- CHART 5 

ciate further. Recent Volatility in Milk Prices 

In addition, the impacts of some industry-specific $17 

developments deserve watching. Modernization steps 

by some small dairy operators in the Midwest are an 

example. As they expand their herds and adopt more 

capital-intensive methods, these farmers’ traditional 

financial arrangements may also change considerably. 

They may place greater reliance on debt financing, for 

instance, to pay for new buildings or equipment to 

$ per Hundredweight 

$16 

$15 

$14 

$13 

$12 

$11 

mechanize tasks and realize production efficiencies. $10 

Larger operators, in turn, may rely more heavily on purchased inputs such as feed. All told, modernization by 

dairy farmers could cause both their capital and operatJan-89

Jan-90Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97

Source: U.S. Department of Agriculture ing needs to shift from those to which they and their 

bankers have become accustomed. 

Joan D. Schneider, Regional Economist 

Chicago Regional Outlook 18 Fourth Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

• Bank holding companies of all sizes have issued trust preferred stock following the Federal Reserve’s decision in October 1996 to count these tax-advantaged capital securities toward Tier 1 capital. 

•	 Although the tax-advantaged status of trust preferred stock was not eliminated in the federal budget this 

year, there still exists the possibility that the Internal Revenue Service may alter the tax treatment of trust 

preferred dividends. 

• Institutions contemplating issuing trust preferred stock should be aware of the concerns expressed by rating agencies and of the potential risks associated with excessive reliance on debt-like capital instruments. 

Bank holding company capital requirements were effectively relaxed in October 1996 when the Federal 

Reserve ruled that trust preferred stock may be included in the portion of cumulative preferred stock that can 

compose up to 25 percent of a bank holding company’s 

Tier 1 capital. In the wake of this decision, financial 

institutions moved quickly to issue trust preferred stock. 

Trust preferred stock can be a less expensive form of 

Tier 1 capital for bank holding companies because of 

the tax deductibility of the dividend payments paid on 

this type of preferred stock. 

Approximately 90 banking organizations issued an estimated $21 billion of trust preferred shares from October 

1996 through June 1997.1 The dollar amount of trust 

preferred stock issued represented almost 95 percent of 

the incremental amount of Tier 1 capital added by those 

institutions during the period. A number of these institutions used the proceeds of trust preferred stock issues 

to fund stock buyback programs. As an example of the 

relative importance of these stock buyback programs, 

one large bank holding company’s Tier 1 capital ratio 

would be 7.25 percent excluding the trust preferred 

shares, and 8.34 percent including the shares. 

Rating agencies and investment analysts have argued 

that trust preferred stock is a weaker form of Tier 1 capital because of its limited life and debt-like characteristics. These characteristics include the tax treatment of 

trust preferred dividends,2 the limited life of the shares, 

and the ability of investors to accelerate their claims 

against the bank holding company. Institutions contem1 The amount of trust preferred stock outstanding is not delineated in 

Call Reports. 

2 Trust preferred dividends, unlike dividends on traditional preferred 

stock, are treated as a tax-deductible expense at the bank holding 

company level and as taxable income by investors of the trust preferred shares. 

plating issuing trust preferred stock should be aware of 

the concerns expressed by rating agencies and of the 

possibility that excessive reliance on debt-like capital 

instruments could increase their financial fragility during times of economic stress. 

Trust Preferred Structure 

Provides a Tax-Advantaged 

Capital Funding Alternative 

Trust preferred shares, also 

known as capital securities, are 

traded under different names 

depending on the underwriter, payment terms, and 

maturity. Some of the more common acronyms include 

TOPRS (Trust Originated Preferred Shares), QUIPS 

(Quarterly Income Preferred Shares), and MIPS 

(Monthly Income Preferred Shares). 

Although trust preferreds are issued under different 

names, they share the same basic structure (see Chart 1, 

next page). A non-taxpaying subsidiary, or “trust,” of 

the bank holding company is formed. The trust issues 

two classes of stock: common and preferred shares. The 

common stock of the trust subsidiary is owned by the 

bank holding company, and the trust preferred stock is 

sold to investors. The trust upstreams the proceeds from 

the sale of the preferred shares to the bank holding company in exchange for a long-term, deeply subordinated 

note with terms identical to the trust preferred shares. 

(The subordinated note must be the sole asset of the 

trust and subordinated to all other debt of the bank holding company.) 

On a consolidated basis, the trust preferred stock is 

treated as a minority interest of the bank holding company, and the subordinated note is eliminated as interChicago Regional Outlook 19	 Fourth Quarter 1997 
Regular Features Financial Markets
 

CHART 1
 

How Is Trust Preferred Stock Structured 

to Count as Tier 1 Capital? 

Trust Preferred 

Proceeds 

Trust Preferred Shares 

Dividend Payments—funded by interest 

received on subordinated note 

Investors in Trust 

Preferred Shares 

Trust Subsidiary 

Issues trust preferred shares 

(structured as a non-taxpaying entity) 

Trust Preferred Proceeds 

(Trust preferred shares treated as 

minority interest by BHC and 

counted toward Tier 1 capital) 

Subordinated Note—same coupon 

and payment terms as trust preferred 

shares, booked as intercompany debt 

and eliminated upon consolidation 

Interest Payments—paid with 

before-tax dollars by the BHC 

Bank Holding Company 

(BHC) 

(BHC owns common stock of 

trust subsidiary) 

Chicago Regional Outlook 20 Fourth Quarter 1997
 
Regular Features Financial Markets
 

company debt. The interest paid by the bank holding 

company on the subordinated note, which is taxdeductible at the bank holding company level, is used to 

fund the dividends on the trust preferred shares. In 

short, the issuing trust serves as a conduit for exchanging cash flows between the bank holding company and 

the investors in the trust preferred shares. 

To be eligible for Tier 1 capital treatment, trust preferred dividends may be cumulative, but dividends must 

be deferrable for a minimum of five years. If the dividends are not paid for more than five years, the trust 

preferred shares could be exchanged for junior subordinated debt of the trust. After the exchange, the trust preferred holder could declare an event of default and 

accelerate the claim against the bank holding company. 

Trust preferred shareholders would then be treated similarly to deeply subordinated debt holders or preferred 

stockholders of the bank holding company. 

Trust preferred shares typically have maturities of 30 

years or more and contain call options and redemption 

provisions. The redemption provisions, which are subject to Federal Reserve approval, permit the issuer to 

redeem or buy back the preferred shares prior to maturity upon an adverse event such as the loss of Tier 1 capital treatment or the tax deductible status. 

Banks are not permitted to count trust preferred stock 

toward Tier 1 capital because of the cumulative feature 

of trust preferred dividends. While bank holding companies are permitted to include up to 25 percent of Tier 

1 capital as cumulative preferred stock, including trust 

preferred shares, banks must exclude cumulative preferred stock from Tier 1 capital ratios pursuant to the 

Risk-Based Capital Standards set by the Basle Accord. 

Bank Holding Companies of All Sizes 

Have Issued Trust Preferred Stock 

The flood of trust preferred stock issuance was prompted in part by the threat of extinction under the 1997 

federal budget. Bank holding companies rushed to take 

advantage of a potentially short-lived tax loophole, 

while investors were attracted by the opportunity to 

earn higher rates than on similarly rated bank debt. 

Bank holding companies have used proceeds from trust 

preferred stock to retire or call more expensive outstanding preferred issues, to provide capital to bank 

subsidiaries, to finance acquisitions, and to buy back 

common stock. 

As the tax advantage of the trust preferred stock 

remained intact through the budget negotiations, the 

pace of trust preferred issuance subsided from an estimated $4.3 billion in the first quarter of 1997 to just 

under $2.5 billion in the second quarter. Trust preferred 

issuance by larger banks declined as some approached 

their limit on Tier 1 trust preferred, while more smaller 

banks took advantage of the market for trust preferred 

stock. (See Chart 2 for a distribution of the number of 

banks in various size categories that have issued trust 

preferred stock in recent quarters.) Investment bankers 

are reportedly working on new structures that may make 

it easier and more cost effective for smaller institutions 

to issue these capital securities, perhaps through some 

pooling arrangement. 

REIT Preferred Stock—Another Type 

of Tax-Advantaged Tier 1 Capital 

Prior to the Federal Reserve’s announcement last 

October, the REIT (real estate investment trust) preferred stock structure was the chosen way for financial 

institutions to issue tax-advantaged preferred shares. 

Bank-issued REIT preferreds lost favor once trust preferreds debuted, because the trust structure is less costly and easier to administer than REIT preferreds. 

In an REIT preferred structure, the issuer establishes a 

corporation that elects REIT tax status. Proceeds from 

the preferred shares that are sold to investors are used to 

purchase qualifying real estate assets such as mortgagebacked securities or equity interests in real property. 

Cash flow from the real estate assets funds the REIT’s 

CHART 2 

More Small Institutions Issue Trust
 

Preferred Stock
 

Bank Size 

Number of < $10 billion Banks 

$10-100 billion 30 

$100+ billion 25 

20 

15 

10 

5 

0 4Q96 1Q97 2Q97 

Source: Keefe, Bruyette & Woods 

Chicago Regional Outlook 21 Fourth Quarter 1997 
Regular Features Financial Markets
 

operating costs and preferred dividends. As long as the 

subsidiary continues to qualify for REIT tax status,3 dividend payments on the common and preferred shares 

are tax deductible by the holding company. 

Will the Tax-Advantaged Status of Trust 

Preferred Stock Continue? 

Although the tax-advantaged status of trust preferred 

stock was not eliminated in the federal budget, the possibility still exists that the Internal Revenue Service 

(IRS) may alter the tax treatment of trust preferred dividends. (In the first half of 1997, the IRS issued a ruling 

that eliminated the tax-advantaged status of a specific 

type of preferred stock known as Step-Down preferred 

stock.) If the tax advantage is eliminated, REIT preferred shares might again become a more popular 

means of raising tax advantaged Tier 1 capital. 

Issues and Concerns 

A number of bank holding companies have embarked 

on stock buyback programs financed by trust preferred 

stock issuance, thereby boosting earnings per share by 

reducing the number of common shares outstanding, 

while maintaining Tier 1 regulatory capital ratios. 

Rating agencies and investment analysts, however, 

generally view trust preferreds as analogous to preferred stock or deeply subordinated debt of the issuer. 

In fact, Standard & Poor’s has announced that bank 

holding companies with trust preferred stock in excess 

of 10 percent of Tier 1 capital may be subject to a ratings review. This announcement reflects the view of 

some analysts that trust preferred stock is a weaker 

form of Tier 1 capital than other forms of capital such 

as common and perpetual preferred stock, because of 

its limited life and treatment upon a liquidation of the 

trust. 

A recent regulatory interpretation has underscored the 

debt-like nature of trust preferred stock. The Office of 

the Comptroller of the Currency (OCC) has determined 

that investments by banks in trust preferred stock 

should be treated as investments in debt securities.4 The 

OCC cited a number of similarities between trust preferred stock and debt securities, including the fact that 

an investment in trust preferred securities is functionally equivalent to an investment in the underlying subordinated debt issued by the bank holding company, and 

that the trading characteristics of trust preferred securities are similar to traditional debt securities. 

Banking organizations should be aware of the views of 

rating agencies and bank analysts toward trust preferred 

stock. In times of economic stress, excessive reliance on 

debt-like capital instruments could result in increased 

financial fragility of the overall organization, a higher 

cost of raising new capital, and potential ratings downgrades. In extreme scenarios, pressures on the bank to 

service the obligations (explicit or implicit) of the 

holding company could attract the attention of bank 

regulators. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

3 To qualify as an REIT, the subsidiary must comply with Section 856 

of the U.S. Federal Income Tax Code, which requires that 75 percent 

of the REIT’s income come from real property rents, interest income 

from mortgage debt on real property, and other related sources. In 

addition, the REIT must distribute at least 95 percent of its net income 

to shareholders. 

4 In a letter dated April 8, 1997, the OCC stated that subject to applicable rating and marketability requirements, bank investments in trust 

preferred stock would be treated as Type III investments under 12 

CFR Section 2 1.2 (k). 

Chicago Regional Outlook 22 Fourth Quarter 1997 
Regular Features	 Regional Banking
 

Credit Quality Risk Management Becomes Even More
 

Important as Economic Expansion Ages
 

•	 A prolonged economic expansion has helped maintain good credit quality at insured institutions in the 

Region. However, given the age of the expansion, a growing number of interested parties argue that now is 

an ideal time to review and strengthen lending practices. 

•	 Charge-off rates in the Region reflect changing economic activity and pinpoint consumer lending as an area 

of concern. 

•	 Past-due rates confirm consumer loan problems and identify other areas of interest. 

•	 While primarily favorable, loan surveys show some weaknesses in the types of lending where Regional 

growth has been strong, especially commercial and industrial and commercial real estate loans. 

Overview 

Insured institutions in the Chicago Region continue to 

adapt to a rapidly changing operating environment. For 

example, the trend toward fewer but larger institutions 

accelerated during the second quarter and was fueled by 

the recent changes in interstate branching laws. As a 

result, during the second quarter there were 49 fewer 

insured institutions operating in the five-state Region, 

but the Region’s total assets have increased by almost 

$67 billion to $911 billion. 

To date, banks and thrifts have generally been able to 

manage such changes and maintain relatively strong 

earnings and capital positions (see Chart 1). Thus far in 

1997, the Chicago Region’s institutions increased 

aggregate leverage capital to over 8 percent of average 

CHART 1 

Chicago Region Institutions Continue to Show
 

Financial Strength
 

9
 

8
 

7
 

1996 6
 

5
 1995 YTD 1997 

4 

3 

2 

1 

0 

Tier 1 Return on Net Interest 

Leverage Assets Margin 

Source: Bank and Thrift Call Reports Percent 

assets and recorded a solid aggregate return on assets of 

1.24 percent. 

Certainly, the prolonged economic expansion in the 

Region and a relatively stable interest rate environment 

have assisted bank performance, including credit quality. (See Regional Economy: The Chicago Region’s 

Economy in the Seventh Year of Expansion.) Recently, 

however, a number of industry observers have voiced 

varying degrees of concern over credit quality issues, 

particularly lending terms and underwriting standards. 

These comments have become more numerous as the 

current economic expansion ages. 

A review of traditional credit quality indicators and various surveys on underwriting standards reveals that 

some of these concerns may be justified. In particular, 

consumer loan charge-off rates and delinquency levels 

have been trending upward. Additionally, recent Federal 

Reserve Board (FRB) and Federal Deposit Insurance 

Corporation (FDIC) underwriting surveys note some 

evidence of eased underwriting or credit administration 

standards in other portfolios. 

Charge-Off Rates Pinpoint Consumer Lending 

as an Area of Concern 

Not surprisingly, net charge-off rates in the Region 

reflect changing economic activity and pinpoint consumer lending as an area of concern. From late 1992 

through first quarter 1995, insured institutions in the 

Chicago Region were able to dramatically reduce net 

charge-offs (see Chart 2, next page). Most of the reducChicago Regional Outlook 23	 Fourth Quarter 1997 
Regular Features Regional Banking
 

tion was realized in the commercial and commercial 

real estate sectors—two areas of the Region’s economy 

that substantially improved during this period. 

Unfortunately, the overall net charge-off rate for the 

Region began to rise a couple of years ago despite the 

fact that commercial and commercial real estate chargeoffs remain relatively low. The recent rise has been due 

to a dramatic increase in charge-offs of consumer loans. 

This deterioration appears to be attributable to aggressive underwriting and solicitations, generally high consumer debt levels, and high rates of consumer 

bankruptcy during this period. 

Consumer loans comprised over 80 percent of all net 

charge-offs thus far in 1997, a significant increase from 

the 26 percent noted earlier in this decade (see Chart 3). 

The bulk of these charge-offs are occurring in credit 

card portfolios of larger institutions. Of additional concern is the continuing increase in the credit card chargeoff rate, with recognized net losses for the Region 

approximating a 6 percent annualized rate during the 

second quarter. 

Past-Due Rates Confirm Consumer Loan 

Problems and Identify Other Areas of Interest 

Like charge-off activity, the aggregate past-due loan 

rate (30 days or more past due or on nonaccrual) for 

Chicago Region institutions declined through the first 

half of the 1990s, then rose slightly over the past few 

years (see Chart 4). Though it remains fairly low by historical standards, at about 2.2 percent of total loans, cerCHART 2 

CHART 3 

Consumer Credits Now Dominate 

Chicago Region Net Charge-Offs 

Source: Bank & Thrift Call Reports *Not real estate secured 

Percentage of Net Charge-Offs 

0 

20 

40 

60 

80 

100 

Credit 

Cards 

All Other 

Credits 

Other 

Consumer* 

Dec-90Dec-91Dec-92Dec-93Dec-94Dec-95Dec-96Dec-97 

tain portfolios and a minority of individual institutions 

have weaknesses in this area. 

The slight increase in overall past-due loans is primarily the result of increases in problem consumer credit. 

On an aggregate basis, the consumer loans held by the 

Region’s institutions had a past-due rate of 3.3 percent 

as of June 30, 1997, up from about 2.4 percent two years 

earlier. Credit card portfolios remain weak and now 

reflect over a 5 percent past-due rate. Anecdotal comments from some analysts suggest that past-due levels 

on consumer lending would be even higher were it not 

for some of these credits migrating to home equity and 

residential real estate portfolios. Home equity loans in 

the Region continue to be aggressively marketed, as 

evidenced by a proliferation of radio and print advertisements for these plans, some of which feature high 

loan-to-value limits. 

CHART 4 

Chicago Region Net Loan Charge-Off 

Rates Hit Low Point in 1994 

Source: Bank & Thrift Call Reports 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

Year-to-Date 

Charge-Off Rate in

Basis Points 

Dec-87Dec-88Dec-89Dec-90Dec-91Dec-92Dec-93Dec-94Dec-95Dec-96

Jun-97 

Source: Bank & Thrift Call Reports 

Compared with All Loans 

* Not secured by real estate 

Consumer Loan Past-Dues Remain High 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

Consumer Loans* 

All Loans 

Past-Due Percentage 

Dec-90

Jun-91

Dec-91

Jun-92

Dec-92

Jun-93

Dec-93

Jun-94

Dec-94

Jun-95

Dec-95

Jun-96

Dec-96

Jun-97 

Chicago Regional Outlook 24 Fourth Quarter 1997 
Regular Features	 Regional Banking
 

Another note of caution is that the overall volume of 

past-due loans (consumer, commercial, and real estate 

loans combined) is on the rise at a significant number of 

institutions. Almost one-third of Chicago Region institutions have registered a 30 percent or higher growth 

rate in past-due loans over the past four quarters. In 

addition, about 200 institutions have elevated (over 5 

percent) past-due loan ratios. These institutions are geographically dispersed between metropolitan and nonmetropolitan areas and are centered in Illinois, Ohio, 

and Wisconsin (see Chart 5). 

To some degree, the concerns in this area are softened 

by the fact that delinquency levels still are considered 

low by historical standards at many of the institutions 

where past-due loan growth has been high. In addition, 

the majority of institutions reflecting elevated past-due 

rates appear to have considerable financial flexibility in 

the form of strong capital and earnings, which may 

compensate for this added risk. 

Loan Survey Results Show Some Weaknesses 

in Areas Where Regional Loan Growth 

Has Been Strong 

Traditional measures of credit quality, such as chargeoff and past-due rates, are intended to identify weaknesses in current conditions and may not be good 

predictors of future areas of concern. To take a more 

proactive approach to risk assessment in loan portfolios, 

bankers and regulators have focused on reviewing 

underwriting standards—especially in areas where there 

is significant growth. 

In that regard, the Federal Reserve recently released the 

results of its August 1997 Senior Loan Officer Opinion 

Survey on Bank Lending Practices. As part of this survey, the FRB elicits responses from large banking organizations nationwide concerning loan standards, terms, 

and demand. Among other things, the survey noted the 

following areas of potential concern: 

•	 Increased competition has apparently led a large percentage of banks in the survey to ease interest rates 

on commercial and commercial real estate loans during the previous three months. Other loan terms also 

were eased, although not to the same extent as interest rates. These terms include increasing the maximum size of credit lines, adjusting loan covenants, 

and relaxing collateralization requirements. 

CHART 5 

Location of Institutions with 5 Percent or
 

More Past-Due Loans
 

(Number of Institutions by County)
 

None
 (311)

One or Two (113)
 

More than Two (13)
 

Source: Bank and Thrift Call Reports
 

•	 A “small but significant” share of respondents eased 

standards on commercial real estate loans. Standards 

reflect the level of risk an institution is willing to 

accept. 

In addition, as part of every safety and soundness examination, FDIC examiners complete a credit underwriting 

survey on the institution’s policies and practices. For 

second quarter 1997, 120 surveys were completed in the 

Chicago Region. Although these surveys did not disclose widespread problems with underwriting practices, 

loan administration was viewed as having “greater than 

average” risk in about 17 percent of the surveys. In 

addition, examiners noted the following: 

•	 About 10 percent of institutions examined were 

“frequently or commonly” funding speculative construction projects. 

•	 About 21 percent of institutions examined have 

“frequently or commonly” made business loans that 

lack documentation of financial strength. 

Eased underwriting terms and standards for commercial 

and commercial real estate lending take on added significance in the Chicago Region because these remain 

areas of substantial growth for many insured institutions 

(see Table 1, next page). The growth of these portfolios 

appears to be broad-based both geographically and by 

size of institution. 

Chicago Regional Outlook 25	 Fourth Quarter 1997 
Regular Features	 Regional Banking
 

TABLE 1 

Commercial Real Estate, Residential, Percentage of Chicago Region Institutions 

and Commercial Loans Are Growing at with Loan Category Growth Approximating 

a Rapid Pace at Many Institutions 20% to 30% 30% or Total 

(4 qtrs growth ending 6/97) More over 20% 

TOTAL LOANS AND LEASES 10 11 21 

CONSTRUCTION LOANS 5 35 39 

COMMERCIAL REAL ESTATE LOANS 9 27 36 

TOTAL CRE 10 26 36 

1-4 FAMILY RESIDENTIAL LOANS 12 16 28 

HOME EQUITY LINES 7 33 40 

TOTAL RESIDENTIAL 12 16 29 

FARM LOANS SECURED BY REAL ESTATE 5 16 21 

OTHER FARM LOANS 4 12 16 

TOTAL FARM LOANS 4 13 17 

CREDIT CARD LOANS AND RELATED PLANS 4 16 20 

OTHER CONSUMER LOANS 8 17 25 

TOTAL CONSUMER LOANS 8 17 24 

COMMERCIAL LOANS 9 23 32 

Source: Bank & Thrift Call Reports 

Implications: To be prepared for the credit quality 

problems a general or localized economic downturn 

might cause, maintenance and, where needed, strengthening of credit risk management procedures is essential. 

Institutions in this Region may want to be especially 

cognizant of the following: 

•	 Continuing weaknesses in consumer loan portfolios; 

•	 Possible migration of consumer lending problems to 

home equity and residential real estate portfolios; 

•	 Effects of eased underwriting on commercial and 

commercial real estate loans—especially in cases 

where growth has been significant, past-due levels 

are already high, or portfolios have large volumes of 

loans to customers that were not operating during the 

last economic downturn and, therefore, may have little experience with such conditions; and 

•	 Adequacy and support of loan loss reserves. 

James D. Eisfeller, Bank Examiner 

Michael J. Feeney, Regional Analyst 

John D. Weier, Regional Manager 

Chicago Regional Outlook 26	 Fourth Quarter 1997 
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