Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1998 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Gary C. Zimmerman,
 

Regional Economist
 

Millen L. Simpson,
 

Financial Analyst
 

In Focus This Quarter 

◆ The Asian Economic Crisis: Implications for the U.S. Economy—The 

economic crisis in Asia is now more than one year old, yet its consequences are still 

reverberating throughout the global economy. There are growing indications that 

some sectors of the U.S. economy are beginning to experience slower growth directly attributable to problems in Asia. Consequently, lenders should be cognizant of 

their customers’ exposure to global markets. Lending and strategic decisions predicated on an assumption of continued robust economic growth should be carefully 

scrutinized. See page 3. 

By Paul C. Bishop 

◆ CLOs Lure Another Major Bank Asset off the Balance Sheet— 

Securitization of corporate loans and bonds is in full swing, with 1997 issuance 

exceeding that of securities backed by credit card loans. Collateralized loan obligations (CLOs) and collateralized bond obligations, securities with deal- and issuerspecific risks, are potential bank investments that may grow in popularity if a 

current proposal to lower the risk weights for AAA-rated securities is enacted. 

Banks with an ample supply of low-margin commercial loans are expected to issue 

more CLOs to an increasingly demanding secondary commercial loan market. An 

institution’s CLO strategy may have implications that should be considered when 

evaluating its capital adequacy trends. See page 8. 

By Kathy Kalser and Allen Puwalski 

◆ The Payment System: Emerging Issues—The payment system is the 

heart of the U.S. economic infrastructure, moving value at the rate of 90 times the 

U.S. gross domestic product each year. The banking industry, although historically 

central to this movement, now faces a tangle of new technologies, new exposures, 

and new competitors that challenges its hold on the payments business. Its regulators face a different dilemma—that of how much intervention, if any, these changes 

warrant and how best to prevent the systemic exposures that increasingly large and 

rapid flows of money can create. Together, the issues they face frame a payment system that is fast becoming a technical and political contest. See page 14. 

By Gary Ternullo 

Regular Features 

◆ Regional Economy—Housing permits were weak in 1997 in most states, but 

permit activity has rebounded in 1998...Oregon and Utah are reporting declines in 

permit activity and softening housing indicators...in Oregon and Nevada, the number of new permits issued has substantially exceeded the number of new households 

over the past few years. See page 20. 

By Gary C. Zimmerman 

◆ Regional Banking—Banks and thrifts in the San Francisco Region continue 

to report strong earnings and solid asset quality...recent growth and high concentrations in construction lending in some states pose risks to community banks... 

residential lending standards have come under pressure from large bank and nonbank competitors. See page 24. 

By Millen L. Simpson and Catherine I. Phillips-Olsen 

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)
 

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

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

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

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

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

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

publish/regout. For more information or to provide comments or suggestions about the San 

Francisco Region’s Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 974-4247 or 

send an e-mail to cphillips-olsen@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Assistant Editors Gary L. Beasley 

Robert L. Burns 

Norman Gertner 

David T. Griffiths 

Suzannah L. Susser 

Karen A. Wigder 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

The Asian Economic Crisis:
 

Implications for the U.S. Economy
 

•	 The impact of the Asian economic crisis on the 

U.S. economy has been increasingly evident, with 

some sectors experiencing slower growth as conditions in Asia continue to deteriorate. 

•	 U.S. exports to Asia have decreased in recent 

months owing to falling demand for commodities, 

manufactured goods, and agricultural products. 

•	 Slower U.S. growth resulting from reduced export 

sales and lower corporate profits could affect 

institutions throughout the nation. 

The economic crisis in Asia is now more than one year 

old, yet the consequences of the unprecedented slide in 

currency values are still reverberating throughout the 

global economy. There are growing indications that 

some sectors of the U.S. economy are beginning to 

experience slower growth directly attributable to problems in the Asian economies. It is difficult to assess 

how significant and long-lasting the effects of the crisis 

will be, but it is clear that earlier views that the crisis 

would pass quickly and be followed by renewed growth 

were too optimistic. The consensus among economists 

and analysts now is that the recovery will be measured 

in years, not months. 

Causes of the Crisis 

Most economists agree that the Asian economies1 are in 

the midst of a steep and severe recession. For example, 

Indonesia’s gross domestic product fell by more than 12 

percent in the first half of 1998, a decline second only 

to the drop in economic activity in the Soviet Union following its collapse in the early 1990s. While Indonesia 

may be the most startling example of economic deterioration in Asia, the other Asian nations also have experienced weakened stock markets, falling real estate 

values, rising corporate bankruptcies, and growing 

problem loan portfolios among financial institutions. It 

is generally agreed (with the benefit of hindsight) that 

the conditions that precipitated these events included 

the following2

: 

1 Unless otherwise noted, “Asia” refers to the economies of China, 

Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, 

South Korea, Taiwan, and Thailand. 

•	 Reduced Export Competitiveness: Most of the 

Asian economies had effectively pegged their currencies to the U.S. dollar. Between mid-1995 and 

early 1997, the U.S. dollar increased in value by 

more than 42 percent against the Japanese yen and 

by 23 percent against the German mark. This 

increase significantly worsened the international 

competitiveness of many Asian firms relative to 

Japanese or European competitors in export markets, 

since the value of their currencies and the price of 

their exports rose along with the U.S. dollar. By late 

1995, export growth among the Southeast Asia 

economies was slowing, and by mid-1996 it was near 

zero. 

•	 Excess Production Capacity: Although Asian savings rates were among the highest in the world, 

domestic saving was not sufficient to fund the 

desired levels of investment in factories, roads, housing, and telecommunications. The resulting inflow of 

foreign capital funded rapid capacity expansion in 

key sectors such as autos, chemicals, and microchips. For example, capital inflows to Thailand 

totaled $1.9 billion in 1980 but rose to $15.2 billion 

by 1996. The increase in production capacity put 

downward pressure on prices and reduced earnings 

growth in key export sectors.3 

•	 Rapid Asset Price Appreciation: Real estate, land, 

and share prices on the region’s stock markets soared 

during the 1980s and early 1990s. In Indonesia, for 

example, the Jakarta Composite stock index 

2 A comprehensive survey of recent events and links to other information sources is available at the Asia Crisis Home Page, 

www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html. 3 A case in point is the growth of the auto industry. During the past 

several years, Korea invested heavily in new auto plants to satisfy 

both domestic and export demand. By 1999, Korean capacity is 

expected to reach 4.66 million light vehicles annually—2 million 

more than domestic demand. In Japan, excess capacity of 2.8 million 

vehicles is expected through 2002. Worldwide excess capacity in light 

vehicles is expected to reach more than 20 million units by 2002— 

more than the total 1997 production of General Motors, Ford, and 

Chrysler combined (Wall Street Journal, March 2, 1998). The result 

has been downward pressure on prices of domestically produced 

autos—down by 1.9 percent on the basis of the first-quarter 1998 producer price index—and imports, which have experienced price 

increases of less than 1 percent since mid-1996. 

San Francisco Regional Outlook 3	 Third Quarter 1998 
In Focus This Quarter
 

increased by nearly 53 percent in the two-year period ending in the first quarter of 1997. 

•	 Deteriorating Credit Quality: Slower export 

growth and eroding competitiveness hampered Asian 

firms’ ability to repay debt incurred to finance the 

growing levels of investment. Some Korean conglomerates were burdened with a debt load equal to 

300 to 400 percent of equity. As much as two-thirds 

of this debt was short-term, with a maturity of less 

than 12 months. Additionally, the debt denominated 

in foreign currencies, such as the U.S. dollar, ballooned as local currency values dropped. With some 

firms struggling to repay mounting debt, banks 

began to experience a further deterioration in credit 

quality. 

Some of the uncertainty about the strength and speed 

of the recovery in Asia is attributable to concerns 

about the faltering Japanese economy. As the second 

largest economy in the world and the engine of 

growth in the region, Japan must have a healthy economy if sustainable growth is to occur in the rest of 

Asia. With Japan currently in a deep recession and the 

outlook for its economy clouded by the halting pace 

of financial reform efforts, there is considerable 

uncertainty about how quickly economic and financial weaknesses throughout the rest of Asia can be 

repaired. 

Impact on the U.S Economy 

The Asian financial crisis could affect the U.S. economy through several avenues. Some firms and industries 

may be directly exposed, especially if they have operations in Asia. 

Banks may be exposed through 

changes in the financial condition 

of Asian borrowers. Other firms 

may be less directly exposed to 

economic conditions but will be 

affected by changes in relative 

prices and trade flows between the United States and 

Asia. The drop in Asian purchases of U.S. exports has 

hit agricultural products, commodities, and manufactured goods. As some recent corporate earnings 

announcements have shown, the crisis has been associated with profit growth that has failed to meet the market’s expectations. 

Banking 

The U.S. banking industry has a smaller direct lending 

exposure to the Asian economies than either European 

or Japanese banks. As shown in Table 1, U.S. banks had 

outstanding loans of $22 billion at the end of 1997, 

which accounted for 8.5 percent of all international 

lending to Indonesia, Malaysia, the Philippines, South 

Korea, and Thailand. To the extent that exposures exist, 

however, large banks and not smaller regional or community banks account for most of the lending. While the 

overall direct lending exposure of the U.S. banking 

industry may be relatively small, the indirect exposure 

resulting from changing economic conditions in the 

United States as a result of the crisis could potentially 

affect small and large institutions in all areas of the 

country. 

Agriculture 

Key to understanding the impact on agriculture is the 

fact that in world markets, agricultural commodities are 

priced and traded in terms of U.S. dollars. The steep 

decline in value of Asia’s currencies means that the 

price of imported agricultural commodities has rapidly 

risen. Over a longer period, higher import prices tend to 

stimulate production in the importing countries that can 

displace demand for imports. Thailand, for example, is 

positioned to increase production of poultry and sugar. 

Other world producers, such as Australia, whose currency also has fallen in value, are now more competitive 

suppliers of some agricultural products to the Asian 

market than the United States. 

On the basis of analysis performed by the U.S. Department of Agriculture’s (USDA’s) Economic Research 

Services,4 U.S. exports of red meat and poultry are 

expected to drop by 5 to 6 percent in fiscal 1998 and 

1999 as a result of the Asian crisis. Exports of grains are 

projected to fall by at least 2 percent in fiscal 1999 as 

other world producers increase production in response to 

changing relative prices among major grain exporters. 

Overall, USDA expects agricultural exports to fall by 3 

to 6 percent in fiscal 1998 and 1999, compared with the 

level of exports had the Asian crisis not occurred. 

Commodities 

Asian countries have become increasingly important 

commodity consumers in recent years. As a result, com4 “World Agriculture and Trade,” Agricultural Outlook, pp. 10–11. 

San Francisco Regional Outlook 4	 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

International Claims by Nationality of Reporting Bank 

End December 1997 

TOTAL INTERNATIONAL 

CLAIMS (MILLION U.S. $) 

U.S. 

CLAIMS PERCENT 

JAPAN 

CLAIMS PERCENT 

EUROPE* 

CLAIMS PERCENT 

OTHER 

CLAIMS PERCENT 

Indonesia 58,388 4,898 8.4 22,018 37.7 15,044 25.8 16,428 28.1 

Malaysia 

Philippines 

South Korea 

27,528 

19,732 

94,180 

1,786 

3,224 

9,533 

6.5 

16.3 

10.1 

8,551 

2,624 

20,278 

31.1 

13.3 

21.5 

12,997 

9,317 

29,614 

47.2 

47.2 

31.4 

4,194 

4,567 

34,755 

15.2 

23.1 

36.9 

Thailand 58,835 2,533 4.3 33,180 56.4 14,782 25.1 8,340 14.2 

Total 258,663 21,974 8.5 86,651 33.5 81,754 31.6 68,284 26.4 

* Includes France, Germany, Netherlands, and United Kingdom 

Source: Bank for International Settlements 

modity markets have been affected by falling demand for 

basic materials and fuels in Asia. The abrupt halt of construction activity in the region has reduced Asian imports 

of metals and metal products. Consequently, world copper and nickel prices fell more than 36 percent during the 

year ending June 1998. Asian developing countries also 

had stepped up their demand for petroleum products, 

accounting for two-thirds of the increase in world petroleum consumption between 1992 and 1996. As economic activity in Asia slowed, oil demand softened and world 

inventories expanded, causing prices to tumble from $20 

per barrel in July 1997 to less than $14 per barrel in June 

1998. To the benefit of U.S. consumers, the drop in oil 

prices has reduced the prices of gasoline and other 

refined petroleum products, but it has cut into profits of 

oil producers. While there are few indications of widespread financial problems in the industry, smaller and 

less geographically diversified producers may be exposed to adverse price and inventory changes. 

Manufacturing 

Asia accounts for a large and growing share of U.S. 

trade in manufactured goods. Between 1990 and 1996, 

U.S. exports of manufactured goods to Asia increased 

from $75 billion to more than $140 billion, accounting 

for nearly one-third of the increase in total U.S. exports 

of manufactured goods. For the U.S. economy as a 

whole, machinery, food products, and chemicals are the 

most exposed to a drop in Asia’s demand for U.S. 

exports. Together, these industries account for nearly 70 

percent of U.S. exports to Asia. 

Between 1990 and 1996, U.S. imports of manufactured 

goods from Asia rose from $176 billion to more than 

$285 billion. Increased imports from China accounted 

for about one-third of the gain. U.S. imports from Asia 

are dominated by machinery and manufactured goods, 

including electronics and semiconductors, which 

together account for 93 percent of imports. 

Asia’s demand for U.S. exports will continue to weaken 

following the dramatic increase in import prices resulting from the drop in currency values. The latest trade 

data show that the dollar volume of U.S. goods exports 

to Asia (including both manufactured goods and other 

commodities) fell by 22.5 percent in May 1998 compared with one year earlier (Chart 1). 

Changes in the volume of exports at the national level 

do not adequately describe the variation in the export 

exposure of different regions of the country. Chart 2 

(next page) shows the percentage of state-level exports 

CHART 1 

U.S. Exports to Asia Drop While Imports 

Continue Modest Growth 

Source: Bureau of the Census 

–25 

–20 

–15 

–10 

–5 

0 

5 

10 

15 

20 

Jan-96

Mar-96

May-96

Jul-96

Sep-96

Nov-96

Jan-97

Mar-97

May-97

Jul-97

Sep-97

Nov-97

Jan-98

Mar-98

May-98 

Percent Change - Year Ago

Imports Exports 

San Francisco Regional Outlook 5 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Western and Midwestern State Exports Are
 

Vulnerable to Changes in Asian Demand
 

Percentage of Total 

State Exports Destined 

for Asia (1997) 

More than 30% (14) 

21% to 30% (16) 

10% to 20% (17) 

Less than 10% (4) 

Source: Bureau of the Census, International Trade Administration 

that are destined for Asia.5 Clearly, Western states are 

most exposed to changes in the demand for U.S. 

exports, especially electronics, transportation equipment, and industrial machinery. A significant share of 

exports from the Midwest also is destined for Asia, 

including chemicals and machinery such as construction equipment.6 

In the initial stages of the crisis, the consensus view 

suggested that the United States would be overwhelmed 

by cheap imports from Asia, as Asian countries exported their way to economic recovery. Although there has 

been an increase in U.S. imports from Asia, the growth 

has been well below expectations. In May 1998, goods 

imports were up by just 4.8 percent over the previous 

year. The reason that U.S. imports of Asian goods have 

not been greater is due in part to the severity of the economic downturn and the weakness of Asia’s financial 

institutions. Many Asian manufacturers are dependent 

5 The state-level export data are from the Export Locator series published by the Bureau of the Census. These data tabulate the value of 

exports as determined by the location of the exporter, which may differ from the location of the producer. Although these data are an 

imperfect measure of state-level export performance, they are still of 

value in assessing regional exposures and remain the most complete 

data available. 

6 A state-by-state analysis has been prepared by the U.S. Treasury and 

the U.S. Department of Commerce. 

on components imported from neighboring countries or 

purchased on world markets. With the drop in currency 

values, all imported goods, including finished goods 

and intermediate goods that are used in the manufacturing sector, have become more costly. At the same time, 

Asia’s weak financial systems have come under increasing pressure as the economic slump deepens. Many 

banks cannot, or will not, lend. Consequently, Asian 

firms cannot secure the capital to acquire imported 

inputs or to finance the sale of exports abroad. As the 

“credit crunch” abates, imports from Asia should 

rebound, placing greater pressure on U.S. manufacturers. 

Corporate Profits 

Profits of U.S. producers also will be affected by falling 

prices for import-competing goods and plummeting 

Asian demand for some U.S. exports. Although U.S. 

producers of import-competing goods will be under 

increasing competitive pressure, firms that use imported components from Asia will benefit from an effective 

reduction in costs. U.S. exporters may see disappointing 

Asian market profits offset by continuing strong sales in 

the U.S. and European markets. For these reasons, the 

impact of the crisis on corporate profits must be viewed 

in the context of gains and losses caused by changing 

relative prices of a firm’s products and inputs. 

A number of recent earnings announcements have 

failed to meet analysts’ expectations. According to 

IBES International,7 the crisis has contributed to a 

reduction of profit growth, although most of the slowdown is attributable to both falling prices and weak 

demand for semiconductors and oil. Operating profits 

of all companies tracked in the Standard & Poor’s 500 

stock index increased by 4.4 percent in the first quarter 

of 1998, the smallest increase since 1991. Excluding the 

energy and technology sectors, profits of the S&P 500 

firms increased by 8.6 percent in the first quarter. On 

the basis of these results, the impact of the crisis on corporate profits appears to be highly concentrated among 

firms in a few industries. 

Summary and Implications 

The consequences of the Asian economic crisis continue to unfold. The slowdown in growth in most Asian 

economies has already reduced U.S. export shipments 

and put downward pressure on prices of commodities 

and agricultural products. How long this trend will con7 As quoted in the Wall Street Journal, June 22, 1998, p. C1. 

San Francisco Regional Outlook 6 Third Quarter 1998 
In Focus This Quarter
 

tinue is uncertain, but most analysts have dismissed the 

chances of a speedy recovery in Asia. Although most 

economists are not anticipating a recession in the 

United States in the foreseeable future, the indirect 

impact of the Asian crisis will be felt to some extent 

across most regions of the country. 

Lenders should be cognizant of their customers’ exposure to a continued drop in demand for exports or to further deterioration in the pricing environment. More 

generally, slower U.S. growth could affect even those 

borrowers that have little or no 

direct exposure to export markets. What is clear for insured 

institutions is that at this stage of 

the economic expansion and with 

a number of uncertainties about 

the global economic outlook, 

lending and strategic decisions 

predicated on an assumption of 

TABLE 2 

continued robust economic growth should be carefully 

scrutinized. 

References 

Asia Crisis Home Page. New York University. www. 

stern.nyu.edu/~nroubini/asia/AsiaHomepage.html. 

“Automobile Glut Worries Analysts Even as Some Cut 

Back on Output.” The Wall Street Journal. March 2, 

1998. 

The Importance of Asia to the State Economies. 1998. 

U.S. Treasury and U.S. Department of Commerce. 

www.treas.gov/press/releases/pr2317.htm. 

“World Agriculture and Trade.” Agricultural Outlook. 

United States Department of Agriculture, Economic 

Research Service. February 1998. 

Paul C. Bishop, Economist 

San Francisco Region: Merchandise Exports to Asia—1997 

Includes China, Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and Thailand 

PERCENT 

EXPORT OF EXPORTS EXPORT 

VOLUME GROWTH TO ASIA BY EXPOSURE 

INDUSTRY SECTOR ($ MILLIONS) 1993–97 INDUSTRY* TO ASIA** 

TOTAL EXPORTS TO ASIA 78,663.9 41% 100% 48% 

TOP FIVE EXPORT INDUSTRIES 

ELECTRIC & ELECTRONIC EQUIPMENT 21,661.6 94% 28% 57% 

TRANSPORTATION EQUIPMENT 14,841.6 –1% 19% 44% 

INDUSTRIAL MACHINERY & COMPUTERS 14,299.6 107% 18% 42% 

AGRICULTURAL & LIVESTOCK PRODUCTS 4,862.5 40% 6% 65% 

SCIENTIFIC & MEASURING INSTRUMENTS 4,484.5 86% 6% 43% 

TOTAL OF TOP FIVE EXPORT INDUSTRIES 60,149.8 55% 76% 48% 

* Percent of Region’s total exports to Asia from each of the top five export industries. 

** Percent of Region’s total world exports for each industry destined for Asia. 

Source: International Trade Administration 

San Francisco Regional Outlook 7 Third Quarter 1998 
In Focus This Quarter
 

CLOs Lure Another Major Bank Asset
 

off the Balance Sheet
 

•	 Securitization of corporate loans and bonds is in 

full swing, with 1997 issuance exceeding that of 

securities backed by credit card loans. 

•	 Collateralized loan obligation (CLO) and collateralized bond obligation (CBO) issuance has grown 

dramatically since 1996. Both CLOs and CBOs 

are potential bank investments that may grow in 

popularity if a current proposal to lower the risk 

weights for AAA-rated securities is enacted. 

•	 These bonds may offer a higher yield than other 

AAA-rated securities, but they also may carry 

both deal- and issuer-specific risks that warrant 

closer scrutiny. 

•	 Banks with an ample supply of low-margin commercial loans are expected to issue more CLOs to 

an increasingly demanding secondary commercial loan market. 

•	 Securitizing investment-grade commercial loans 

has implications for capital adequacy. 

CBOs and CLOs are fixed-income securities that share 

many similarities with other asset-backed securities. In 

a CLO or CBO, commercial loans or bonds are pooled 

and securitized, and participation certificates in the 

underlying assets are sold to investors. The first CLO 

and CBO transactions occurred in the late 1980s, but 

issuance was slow until last year. During 1997, the estimated volume of corporate bonds and commercial loans 

securitized was $54 billion, more than double the 

amount securitized in 1996. In fact, the combined 

issuance of CBOs and CLOs in 1997 was more than the 

amount of credit card loans securitized during the year. 

The amount of securitized commercial loans and corporate bonds is expected to continue to grow this year, 

with an increasing number of deals backed by commercial loans1 (see Chart 1). 

1 CBOs/CLOs: An Expanding Securitization Product, p. 1, 

JP Morgan, September 1997. 

CBOs and CLOs: A Natural Development in the 

Asset-Backed Securities (ABS) Market 

The growth of the CLO market can be explained by several supply and demand factors. On the demand side, 

strong investor appetite for ABS has produced tremendous growth in the securitization of consumer loan segments such as credit card, auto, and home equity loans. 

The increasing comfort level of the capital markets with 

these asset classes and the various structures used to 

securitize them has facilitated the ABS market’s expansion into nonconsumer loans, including corporate debt 

obligations and bank commercial loans. CBO and CLO 

structures represent a natural progression from the securitization of a pool of consumer loans to the securitization of a diversified package of corporate bonds or bank 

loans. 

Increased standardization of terms among commercial 

lenders and more information flow on returns, defaults, 

and recoveries also have made commercial loans and 

corporate debt more desirable to institutional investors 

and an asset class viable for securitization. In addition, 

CLOs provide a way for investors, including banks, to 

own a credit-enhanced interest in a diversified pool of 

loans without directly owning the individual loans. 

Investors are increasingly considering collateralized 

bond and loan products as higher yielding alternatives 

to other ABS. 

CHART 1 

CBO and CLO Issuance Is Growing 

Source: JP Morgan 

0 

10 

20 

30 

40 

50 

60 

1990 1991 1992 1993 1994 1995 1996 1997 

($ Billions)

CBO CLO 

San Francisco Regional Outlook 8	 Third Quarter 1998 
In Focus This Quarter
 

Foreign and, to a lesser extent, domestic banks have 

been large purchasers of CLOs and CBOs. Bank investment in CLOs and CBOs primarily has been in the most 

senior, highest investment-rated tranches. Together, foreign and domestic banks are estimated to have purchased almost one-half of the highest rated classes of 

CLO and CBO securities issued in 1997. Insurance 

companies dominated the purchase of the middle or 

mezzanine class of CLOs and CBOs.2 

Last year the Federal Financial Institutions Examination 

Council proposed lowering the risk weighting for AAArated ABS from 100 percent to 20 percent. Bank investment in AAA-rated ABS products, including CLOs and 

CBOs, could increase substantially if the proposal is 

approved. 

Lower Capital Requirements, Higher Return 

Ratios Attract Banks to CLO Market 

On the supply side, issuers of CLOs backed by investment-grade loans are motivated by regulatory capital 

treatment, return on capital, and relationship management. While the CLOs originated in the late 1980s were 

designed to purge the lender’s balance sheet of lower 

quality commercial loans, the recent bank-issued CLOs 

have been secured by higher credit quality, lower margin commercial and industrial loans. 

A bank that is capital constrained may view the CLO 

structure as an alternative to issuing additional equity. 

But more often, banks are motivated to securitize 

investment-grade commercial loans because by doing 

so they effectively subject themselves to the market’s 

capital requirements for such loans instead of their regulator’s. Tight competition has compressed the margin 

that banks earn on investment-grade loans to the point 

that more institutions are considering investment-grade 

lending to be an inefficient use of capital. As margins 

have declined, the CLO market has helped relationship 

managers rationalize lower pricing from the perspective 

of return on capital. Since investment-grade and non2 CBOs & CLOs—An Attractive Investment Class, p. 5, Merrill Lynch 

& Co., Inc., December 1997. 

investment-grade-performing commercial loans have 

the same risk weightings for regulatory capital purposes, removing the higher quality, lower yielding assets 

from the balance sheet tends to leave existing bank capital supporting higher return activities.3 In this way, a 

bank can improve certain profitability measures, but 

possibly with a higher risk profile. 

Table 1 (next page) illustrates the effects of a CLO on a 

bank’s capital and return ratios. In order to compare the 

on- and off-balance sheet transactions, the costs of the 

CLO and the associated reserve requirement are analogized to the on-balance sheet funding costs and capital 

requirement if the assets remained on the balance sheet. 

The assumptions reflect the spreads and reserve 

requirement of a typical transaction. While the execution of the CLO costs more than the on-balance sheet 

financing of the loans, the risk-adjusted return on capital (RAROC) is greater with the CLO. The reserve 

requirement is minimized by the tiering of tranches in 

the securitization, which provides credit enhancement 

to the senior classes. The reserve fund, if retained by the 

issuing bank, represents recourse to the bank from the 

sold assets and requires capital at 100 percent under 

“low-level” recourse. 

CLOs also may be used to facilitate corporate borrowing relationships. For example, banks that want to maintain relationships with corporate borrowers but are 

restrained by concentration limitations, either by borrower or by industry, may use CLOs to alleviate concentrations without disrupting borrower relationships. 

Large commercial banks with significant holdings of 

investment-quality commercial loans are likely candidates to issue CLOs. CLO issuance by investment banks 

could grow as these institutions secure a stronger foothold in the commercial loan market. In 1997, foreign 

banks were the primary issuers of CLOs, but more U.S. 

banks are expected to issue CLOs in the future. Japanese and Asian banks may increase their CLO activity as 

they come under pressure to improve capital ratios and 

remove distressed loans from their balance sheets. 

3 Pursuant to the Basle Accord, commercial loans generally receive a 

100 percent risk weighting regardless of the credit rating of the loan. 

Proponents of CLOs have argued that banks can improve their riskadjusted return on capital by removing the higher quality, lower earning commercial loans from the balance sheet. 

San Francisco Regional Outlook 9 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

CLOs Can Facilitate a Higher RAROC on Investment-Grade Assets 

ASSUMPTIONS: 

AMOUNT OF LOANS IN CLO: $1 BILLION 

LOAN PORTFOLIO YIELD: LIBOR + 50 BPTS 

BANK FUNDING COSTS: LIBOR − 10 BPTS 

CLO FUNDING COSTS: LIBOR + 24 BPTS 

BANK RETAINS 1% RESERVE FUND: $10 MILLION 

BEFORE CLO 

YIELD LESS FUNDING COST (L+50) LESS (L− 10) = 60 BASIS POINTS 

NET SPREAD EARNED .006 × $1 BILLION = $6 MILLION 

RISK-BASED CAPITAL REQUIREMENT (8% ON $1 BILLION) = $80 MILLION 

RAROC $6 MILLION/$80 MILLION = 7.5% 

AFTER CLO 

YIELD LESS FUNDING COST (L+50) LESS (L+24) = 26 BASIS POINTS 

NET SPREAD EARNED .0026 × $1 BILLION = $2.6 MILLION 

RISK-BASED CAPITAL REQUIREMENT (100% OF RESERVE FUND) = $10 MILLION 

RAROC $2.6 million/$10 million = 26% 

Source: Bear, Stearns & Co. Inc. 

Arbitrage Opportunities Motivate Most 

Securitization of Subinvestment-Grade Debt 

Issuance of CLOs backed by subinvestment-grade loans 

and most CBOs, which commonly are backed by a mixture of bonds with a subinvestment-grade weighted average, typically is motivated by the potential to capitalize 

on wide spreads between investment and subinvestmentgrade debt. The securities backed by subinvestmentgrade collateral, often referred to as “arbitrage” CLOs 

and CBOs, contain higher yielding, riskier securities 

such as high-yield debt, distressed bonds, highly leveraged loans, and emerging market debt. By assembling a 

diversified pool of higher yielding investments, asset 

managers can limit aggregate event risk and create a 

security with a lower required yield than the underlying 

collateral. Securitizations can include a combination of 

loans and bonds and are sometimes referred to as collateralized debt obligations or CDOs. 

A Closer Look at CLO Structures 

While the structures of CLOs and CBOs are similar, 

banks’ involvement as issuers of CLOs, and the forces 

driving this issuance, elevate the importance of considering CLO structures. Chart 2 presents the basic structure of a CLO. Although specifics may vary, most CLOs 

use a stand-alone special purpose vehicle (SPV) or trust 

to purchase a diversified pool of assets from a bank 

originator or issuer. The purchase of the assets by the 

SPV is funded through the sale of debt securities to 

investors. The structure of the SPV may include one or 

more tranches of debt that are secured by the pool of 

assets owned by the SPV. The classes of debt are distinguished by their priority of claims on the cash flow from 

the collateral, with the most subordinated pieces functioning as an equity investment in the pool. 

The senior tranche is usually the largest, has the greatest amount of credit protection, and earns the highest 

credit ratings in the CLO structure. The rating of the 

senior class typically is higher than the average rating 

of the underlying pool of assets due to the tiering of 

claims among the debt classes and credit enhancement 

in the CLO. The junior tranches of debt may be below 

investment grade or not rated. The reserve or “equity” 

portion may be retained by the issuing entity as a form 

of credit enhancement or sold to third-party investors 

who want a potentially higher return investment. 

CLO collateral has included both funded and unfunded 

loan commitments, loan participations, and different 

types of credit default swaps. Loan assignments also 

may be transferred through a CLO but are less commonly included because of bank issuers’ desire to mainSan Francisco Regional Outlook 10 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Simplified Collateralized Loan Obligation Structure 

Originating Bank 

Special Purpose Vehicle 

(Purchases assets from originator and 

sells debt and equity to investors) 

Senior Class A Notes 

(90% of debt) 

(Investment Grade) 

Mezzanine Class B Notes 

(9% of debt) 

Reserve 

(1%) 

(May be retained by bank) 

Proceeds 

Sale, assignment, or 

participation of loans or credit 

linked notes to special purpose 

vehicle (SPV) 

Assets purchased from 

originator are collateral for debt 

and equity issued by the SPV 

Relative size 

varies by deal 

Proceeds 

tain borrower relationships. The issuer may transfer the 

actual loan, the cash flow from the loan, or the default 

risk to investors. 

CLOs typically rely on an asset manager or servicer 

to “manage” or protect the investors’ interest in the 

collateral. The investment style or role of the asset 

manager may change depending on the purpose of the 

CLO. Securitizations that use an asset manager to 

actively manage the performance and market value of 

the collateral are referred to as “market arbitrage” or 

“market value” transactions. In these deals, the asset 

manager can trade assets into and out of the securitized 

pool in order to maximize the market value of the 

securitized portfolio. In contrast, most bank-issued 

CLOs are designed as “cash flow” transactions, in 

which the asset manager’s role is more as a servicer than 

as a portfolio trader. These structures rely primarily on 

the ability of the collateral to make stable cash flow payments over a predetermined period and emphasize 

the credit quality of the collateral and the predictability of interest and principal payments rather than liquidity and market performance, as in market value 

transactions. 

San Francisco Regional Outlook 11 Third Quarter 1998 
In Focus This Quarter
 

An Introduction to Delinked 

and Linked CLO Structures 

The variables in structuring a CLO are many. The relative size of the senior and subordinated tranches, the 

form of credit enhancement, the ability of the asset 

manager or servicer to adjust the asset pool, and the 

method and degree to which ownership of the underlying loans is conveyed to investors vary among CLOs. 

Despite the variations, two basic structures have 

emerged: “delinked” structures and “linked” structures. 

The primary difference between these two is the extent 

to which the SPV “owns” the securitized assets. An 

issuer may consider many factors when determining the 

type of structure to use, including the ability or desire of 

the issuer to transfer the loans without notifying the borrower, the credit quality of the loans, the investment rating of the bank issuer, and the desired capital treatment 

of the securitized loan. 

In a delinked structure, the collateral is transferred from 

the issuer to the SPV. Delinked structures are generally 

treated as “true sales” for accounting purposes, and the 

loans in the CLO are removed from the issuer’s balance 

sheet. Delinked CLOs are structured to insulate the 

investor from the credit quality problems or insolvency 

of the issuer. Ratings on delinked CLOs are predicated 

on the projected performance of the collateral and the 

credit enhancement structure rather than the credit quality of the issuer. Some delinked CLOs are similar to 

structures used in credit card securitizations that capitalize on the flexibility of a revolving master trust. The 

master trust structure is advantageous because it allows 

for the securitization of different types of assets, such as 

fixed or floating rate or revolving or term loans. 

In linked transactions, also known as credit linked 

notes, the issuer retains ownership of the underlying 

collateral, and the cash flow generated by the collateral 

pool is conveyed or sold to the SPV. All or part of the 

credit risk from the underlying assets is transferred to 

the CLO investor using credit derivatives. As in 

delinked CLO structures, credit protection is provided 

through the layering or tranching of the debt sold and 

other credit enhancements. 

Investors in linked CLOs are not completely insulated 

from the credit risk of the issuer. Because the issuer 

retains ownership of the underlying loans, a default or 

bankruptcy by the issuer could affect the transmission 

of cash flow to the CLO investors. As a result, investors 

in linked CLOs bear both the credit risk of the securitized loan pool and, to some degree, the risk that the 

issuer may become insolvent. Because of this dual 

exposure, ratings on linked structures are typically 

capped by the credit rating of the issuer. 

The accounting and regulatory capital treatments of 

delinked and linked CLOs also differ. Linked structures 

generally do not qualify for sale treatment under generally accepted accounting principles because the assets 

remain under the control of the issuer. Issuers of linked 

CLOs may be granted some regulatory capital relief 

under the Basle Accord if the cash received from the 

securitization is assigned as collateral for the underlying 

loans. The Basle Accord, which governs capital adequacy requirements for Bank for International Settlements 

member countries, reduces the risk weighting on commercial loans that are secured by cash or certain types 

of risk-free marketable securities such as Treasury 

bills.4 While linked CLOs may provide some form of 

capital incentive for foreign banks under the Basle 

Accord, linked structures offer 

little relief to U.S. banks 

because U.S. banks must maintain minimum leverage capital 

ratios in addition to risk-based 

capital ratios. Since the securitized loans count as assets of 

the bank issuer in a linked 

structure, the leverage ratio 

(roughly, book equity to book assets) is not reduced. 

Consequently, the linked CLO structure has been more 

popular among foreign banks. 

The Role of Investment Rating Agencies 

Although the approach may vary among rating agencies, the criteria used to determine the investment rating 

for CLOs are similar. Rating agencies evaluate the ability of the securitization vehicle to make interest and 

principal payments to holders of the debt. This analysis 

requires an evaluation of the credit quality of the underlying collateral pool, including the projected cash flow 

4 Under the Basle Accord and the U.S. risked-based capital guidelines, 

assets collateralized by cash or Treasury securities generally receive a 

preferential risk-weighting that may range from 0 to 20 percent. For 

background information regarding the risk weightings for collateralized transactions applicable to federally regulated institutions, see 

Federal Deposit Insurance Corporation Financial Institution Letter 

number 64–96 dated August 22, 1996. 

San Francisco Regional Outlook 12 Third Quarter 1998 
In Focus This Quarter
 

generated by the pool, the credit enhancement, and any 

additional protection provided to the investors based on 

the structure of the securitization. The rating agencies 

set limits on the amount of industry and borrower concentration in a pool and statistically evaluate the effect 

of diversification among loans when estimating potential defaults and losses from the securitized assets over 

the life of the transaction. If the underlying collateral is 

not already rated—most commercial loans are not—the 

rating agency will grade the underlying loans and assign 

a rating to the security on the basis of the credit quality 

of the loans and the underwriting criteria used by the 

lender. Estimates of default probabilities, timing of 

default, and recoveries in the event of default are 

assigned to the loans and vary by collateral type and 

credit grade. These estimates are generally based on historical default studies authored by the various rating 

agencies. 

Implications for Insured Institutions 

The advent of CLOs poses new opportunities and risks 

to banks. The ability to transfer all or part of a commercial loan’s credit risk to investors may have several consequences. When issuers of CLOs securitize their 

highest grade assets, they are effectively lowering the 

weighted average credit quality of their retained assets. 

An institution’s loan loss reserving policies and capital 

adequacy should take into account the implications of 

its CLO strategy. 

While the issuance of CLOs may be confined to larger 

banks that have considerable commercial loan portfolios, smaller banks or other types of institutions that 

desire a greater exposure to this type of lending may 

consider investing in CLOs. These instruments offer 

banks the opportunity to invest in a diversified pool of 

commercial loans. Because of credit enhancement features and diversification advantages, the most senior 

debt issued by the CLOs can earn a higher investment 

rating than the average rating on individual loans in the 

pool. Despite the investment rating, banks that invest in 

CLOs should be aware that CLO structures are less 

standardized than other ABS investments, and therefore, performance and underlying risk will be both 

issuer and deal specific. 

Kathy Kalser, Chief, Financial Sector Analysis Section 

Allen Puwalski, Senior Financial Analyst 

San Francisco Regional Outlook 13 Third Quarter 1998 
In Focus This Quarter
 

The Payment System: Emerging Issues
 

•	 Essential to the transfer of value in the U.S. economy, the once-arcane and bank-centered payment 

system is undergoing considerable change as new 

technologies bring new opportunities, new exposures, and new competitors into the payments 

business. 

•	 For most banks, the major issues lie in smallvalue payments, where they struggle for advantage in adapting new technologies into new 

products and services while protecting their traditional payments business from technologically 

adept nonbank competitors. 

•	 For regulators and a handful of the largest banks, 

large-value payments present the most serious 

challenges, as technology has enabled increasing 

payment velocity and volume but also has created 

the potential for systemic failures. 

The payment system is the heart of the U.S. economic 

infrastructure, moving an estimated $670 trillion annually among consumers, businesses, financial institutions, and governments.1 Despite this volume—an 

amount equal to roughly 90 times the U.S. gross domestic product—the payment system remains transparent to 

most users because of its dependability in moving value 

safely. Historically, banks have been essential to this 

movement, reaping, according to the Bank Administration Institute, an estimated $117 billion each year in 

revenues both as payment agents and as the holders of 

the funds from which those payments are made. 

Broadly speaking, the payment system encompasses the 

numerous payment products, players, and the infrastructure that together transmit value throughout the 

economy. More specifically, it can be defined as a collection of individual systems constructed around specific payment products. Credit cards, for example, 

represent a payment system. So do debit cards, checks, 

foreign exchange, and even cash. This product-based 

definition is a relevant one for many bankers, since it 

centers on the products and services that generate revenue rather than on the less glamorous “back office” 

functions that are measured instead by their cost. A 

1 Estimate for 1996 from the National Automated Clearing House 

Association; www.nacha.org/resources/marketing/direct-payment/uspayments-96.gif. 

second definition segments the payment system by payment size. Using this definition, the payments world is 

divided into systems that carry small-value or retail 

payments and those that carry large-value or interbank 

payments. This latter classification is oriented more 

toward infrastructure than product but is convenient 

from a regulatory perspective because the seriousness 

of the risk posed varies considerably by payment size. 

However defined, the payment system today is a source 

of new opportunities and exposures—a result of a host 

of new technologies that the “information revolution” 

has spawned. These technologies create different issues 

for banks and regulators. For banks, the issues involve 

adapting the technologies into new products and services while protecting their payments business from 

nontraditional competitors that specialize in its creation 

and use. For regulators, the issues involve managing the 

risks—principally systemic risk—that accompany the 

large increases in payment volume and velocity enabled 

by technology. Taken together, these issues frame a payment system that can be both a political and a technological battleground, with significant incentives for 

participants to shape payment products and channels in 

a way that favors their own objectives. 

Small-Value Payments: 

A Technological Brawl 

Nowhere has the battle to shape the payment system 

been more contentious than in the small-value segment, 

where emerging information technology can best be 

leveraged into new fee-based retail products. There are 

two battles here. The first involves maintaining the 

monopoly over the payments infrastructure that connects each bank with the Federal Reserve and, by extension, with every other depository institution in the 

United States.2 While this infrastructure is interbank— 

that is, it is dedicated to settling accounts between institutions and does not directly extend to their 

customers—the ability to aggregate and settle individual retail payments through it has enabled the banking 

industry to maintain its centrality to the nation’s monetary flows. 

2 Depository institutions were granted exclusive access to this infrastructure upon its creation by the Federal Reserve Act of 1913. 

San Francisco Regional Outlook 14	 Third Quarter 1998 
In Focus This Quarter
 

The second battle involves exploiting new technologies 

either to attract new customers or to serve existing ones 

more profitably. This battle is both highly visible and 

highly technical and underscores the potential of the 

passing of information to eclipse the passing of value as 

the most critical profit opportunity in payments. The 

best example of this potential is bill presentment, the 

process of posting vendor invoices—such as credit card 

or utility statements—on the Internet to facilitate electronic payment. The crucial question concerns where 

the customer transaction data will lie. If they lie on vendors’ sites or on the sites of nonbanks that concentrate 

such data, those entities will effectively “own” the customer by owning the information needed to cross-sell or 

otherwise add value during the billing process. Owners 

of customer-specific data also can tailor new services— 

a process that can develop loyalty as well as related 

sales. Losing this battle would be doubly costly for 

banks because, regardless of where the data reside, electronic payments will eliminate most of the float in the 

payment process, to the benefit of vendors and largely 

at the expense of banks. 

Another battle is building between banks and nonbanks 

with respect to digital cash and stored value applications. These applications are directed at the micropayment sector—that is, payments that are normally 

considered too small for credit cards. Whether they 

reside on a computer or a smart card, these applications 

substitute electronic data for actual cash, with the 

amount stored on each card covered dollar for dollar by 

balances on account with an issuer. The struggle is for 

the right to issue this value, and the American Bankers 

Association has contended that regulated depository 

institutions alone should be permitted to do so.3 The battle here is for more than just fees, for the interest on the 

balances that back this electronic value could provide 

issuers with substantial new sources of income. 

With some new payment technologies, the distinction 

between opportunity and risk can blur. As the Internet 

enables the distance between shopper and shopkeeper to 

increase, the need to authenticate unseen customers, 

merchants, and banks increases as well. At the same 

time, the open nature of the Internet requires that the 

privacy and integrity of transaction information be protected. The building blocks to accomplish this are neither simple nor easily interwoven—successfully 

combining cryptographic protocols, specialized security hardware, and existing information systems is a dif3 The Role of Banks in the Payments System of the Future, www. 

aba.com. 

Emerging Issues in 


Small-Value Payments
 

Maintaining the payment system monopoly. Access 

to Federal Reserve payment services has historically 

been limited to depository institutions. Maintaining 

that monopoly—and thus maintaining its centrality to 

current and future payment products and services—is 

an important issue to the banking industry. 

Electronic bill presentment is the process of presenting bills and receiving payments electronically. Internet 

bill presentment may be one of the most hotly contested services, because the owner of the site where invoices are posted could cross-sell to customers as well. 

Digital cash and stored value are applications in 

which electronic data substitute for cash. Such applications can run on either smart cards or personal computers. An important issue is who holds the balances that 

back electronic value, because, unlike with paper cash, 

issuers may be able to earn interest on the digital balances held by consumers. 

Securing online transactions. Ensuring the integrity, 

privacy, and authenticity of electronic transactions is 

widely desired by those engaged in electronic commerce. With larger payments, desirability will become 

necessity. Current implementations use combinations 

of encryption algorithms and specialized hardware. 

Banks as certificate authorities (CAs). Authenticating Internet payers and payees may require a complex 

public key infrastructure in which trusted organizations 

supply decryption keys to authenticate the counterparties to a transaction. Some banks are already acting as 

CAs. Others are weighing the benefits and largely 

uncertain exposures of providing such a service. 

Electronic Funds Transfer ’99 (EFT 99). On January 

2, 1999, the U.S. government will be required to make 

benefit and vendor payments electronically. This mandate raises issues of how to provide service to the “unbanked,” how to provide service internationally, and for 

vendors, how to integrate remittance data with the payment itself. 

Development of financial electronic data interchange (EDI) standards. For bank commercial customers to benefit from electronic payments, banks must 

be able to handle remittance information—information 

that accompanies payments and identifies sender and 

transaction detail. Standardizing such data is an important step in enabling banks to receive them and pass 

them on to their customers. 

Point of sale check truncation. Checks are costly to 

handle and time-consuming to collect. Check truncation reduces cost and eliminates float by converting the 

check into an electronic transaction at the point of sale. 

Although banks will have fewer checks to handle under 

check truncation, they will lose float and the return on 

investment in check-handling equipment. 

San Francisco Regional Outlook 15 Third Quarter 1998 
In Focus This Quarter
 

ficult matter in itself if the whole is not to be weaker 

than the individual parts. 

The VISA and MasterCard Secure Electronic Transaction (SET) protocols, designed to protect Internet credit card transactions, illustrate the complexity that banks 

and their customers will need to navigate in securing 

online transactions. Under SET, all banks and merchants will use digital certificates to authenticate themselves to consumers and each other for each Internet 

transaction.4 These certificates are electronic messages 

that contain a decryption key for the sender that is itself 

authenticated by a trusted third party. The infrastructure 

for storing, distributing, and vouching for these keys, 

known as a Public Key Infrastructure (PKI), will contain several tiers of certificate authorities (CAs) and 

will be difficult and costly to implement. Banks not 

only will use these certificates, but many are considering becoming—or have already become—CAs themselves. While banks acting as certificate authorities 

may represent a logical progression in banking services, 

there is little evidence of a homogeneous legal infrastructure or legal precedent sufficient to guide digital 

signature disputes. These voids leave unanswerable the 

question of whether the expected gains from providing 

such services will compensate for the potentially longtailed liability from doing so. 

A major stimulus for electronic payments could come 

on January 2, 1999, when the U.S. government is 

required by law to convert its vendor and benefit payments from paper checks to electronic transfers—the 

so-called Electronic Funds Transfer ’99 (EFT 99) program. Three separate challenges arise from this mandate. The first is that the “unbanked”—those segments 

of the population that are socially, economically, or geographically distanced from a financially bank-centric 

world—must eventually be provided with a cost-effective means to receive, store, and spend their electronic 

value.5 The second challenge is that the EFT mandate 

applies internationally as well as domestically. Given 

the need for each international payment to settle in two 

currencies and countries, the ability to provide efficient 

cross-border EFT will vary considerably from country 

to country.6 

4 Depending upon card brand and SET version, consumer certificates 

may be required as well. 5 Because of resistance from bankers and benefit recipients, compliance waivers are envisioned that will make the program largely voluntary until the details of the special electronic transfer accounts 

(ETA) are worked out. 6 www.fms.treas.gov/eft. 

Perhaps more challenging to many financial institutions 

is that electronic payments to vendors, unlike those to 

individuals, will require electronic remittance data to 

accompany the payment itself. This information goes 

beyond simple routing instructions and includes the 

information—such as purchase order or invoice numbers—necessary for the vendor to apply the payment 

correctly. According to a study by Booz-Allen & 

Hamilton, only slightly more than 5 percent of financial 

institutions were able to receive and forward such remittance information as of early 1997.7 Developing this 

capacity will therefore be an industrywide challenge. 

Once again, there is an opportunity disguised as a cost. 

The development and implementation of financial electronic data interchange (financial EDI) standards will 

enable financial institutions to retain control of—and 

add value to—business-to-business transactions when 

commercial payments migrate to the Internet. 

The U.S. government is not alone in seeking an end to 

costly paper-based payments. Vendors too are pressing 

for the elimination of the slow check presentment 

process wherein checks must physically be moved 

from vendor to vendor bank to issuer bank before 

funds can be transferred. Point of sale check truncation 

shortens this process by converting the check into an 

electronic payment at the point of sale, leaving the customer with an executed check and the vendor with a 

transaction that will settle like a debit card—and in 

doing so eliminates much of the potential for check 

fraud. While this process is beginning to displace physical presentment, the outlook for banks is mixed. As 

the volume of checks that must be physically handled 

decreases, so too will the income from float and the 

returns from past investments in check-handling 

capacity. 

Large-Value Payments: Making the 

World a ‘Good and Final’ Place 

Unlike small-value payments, the issues surrounding 

large-value payments are not strategic ones for banks, 

and less technological wizardry pervades them. Instead, 

the common factor is the systemic risk posed by payment failures. For this reason, regulators—particularly 

the Federal Reserve and the world’s other central 

banks—take very seriously the payments “plumbing” 

that is otherwise obscure even to many bankers. In an 

7 Remittance Data Study, Booz-Allen & Hamilton; www.fms.treas. 

gov/eft/remit.html. 

San Francisco Regional Outlook 16 Third Quarter 1998 
In Focus This Quarter
 

electronic and intangible world where a bank’s accumulated exposures can routinely exceed its equity, the overriding objective for payment system designers, users, 

and regulators is “good and final” payment—a term 

referring to funds that are both irreversible and fully 

collected. 

Recognition is building concerning the payment system’s vulnerability and just how critical it is to the 

U.S. economy. An October 1997 report issued by the 

President’s Commission on Critical Infrastructure 

Protection (PCCIP) warned that “the nation’s core payment systems...seem to present a serious physical vulnerability within the financial system.”8 The source of 

that vulnerability, in the eyes of the commission, 

stemmed not so much from a lack of security as from 

the critical importance of those systems to settling 

financial transactions throughout the economy and the 

lack of available alternatives if they failed. As such, it 

was feared that the payment infrastructure provides an 

enticing target for cyber-terrorists and information warriors and that such threats will only grow in the future. 

Concentration refers to the fact that while banks are 

central to payments and all enjoy equal access to Federal Reserve payment services, some banks are clearly 

more central than others. According to March 1998 Call 

Report data, a mere 25 banks hold nearly two-thirds of 

the U.S. banking industry’s transaction accounts.9 

Should one of these large banks suddenly fail, its inability to fund settlements could result in a loss of payment 

system liquidity and disruption of domestic and foreign 

financial systems alike. While this concentration is not 

new, what is new is the considerable increase in concentration that the new megamergers promise.10 How 

and whether to inoculate the payment system from the 

weight of these super-institutions will become an issue 

for the regulatory community. 

The criticality of a nation’s payment system is not confined within its own borders. Because of globalization 

and the increasing velocity of payments, threats to one 

8 www.pccip.gov/report_index.html, p. A39. 9 Transaction accounts, in essence, are those accounts from which 

third-party payments can be made. The data used here are based only 

on transaction accounts held on behalf of other public and private 

financial institutions here and abroad—accounts from which interbank transfers are made. 

10 As of March 31, 1998, the top three U.S. bank holding companies 

held approximately 25 percent of all reported interbank transaction 

deposits. The mergers announced through June 30, 1998, would 

increase that concentration to over 34 percent. 

Emerging Issues in 


Large-Value Payments
 

Payment system vulnerability. According to the 

PCCIP, the nation’s core payment systems may present 

a serious physical vulnerability within the financial 

system. 

Payments concentration. Payment services are concentrated in a relatively few large banks, and that concentration is growing as megamergers are creating a 

smaller number of superbanks. 

Y2K. The Year 2000 problem threatens to disrupt payments by transmitting computer problems via the payment system from banks that have not fixed the 

problem to banks that have. 

The Euro. Bank and interbank systems in Europe 

and abroad must be modified to accept the Euro. In 

addition, the resources required to implement the 

Euro must be diverted from resolving Y2K problems. 

Foreign exchange settlement risk. Foreign exchange 

transaction exposures can be many times a bank’s capital. The failure of a major creditor to pay could drain 

essential liquidity from international markets. 

Achieving finality in gross payment systems. Making a given country’s domestic payments irrevocable 

and immediate is a major step in avoiding the international spillover of internal financial crises. 

Collateralizing net payment systems. According to 

the BIS, systems that do not permit immediate final 

settlement must be collateralized to ensure the eventual satisfaction of member positions in the event of a 

participant’s failure. Like finality, collateralizing helps 

prevent the internationalization of a domestic failure. 

country’s system become threats to those of other countries as well. There are a number of these emerging 

cross-border concerns. The most immediate and visible 

is the Year 2000 or Y2K problem. Because banks and the 

payment networks that join them are heavily computerized, the latent points of vulnerability to software and 

hardware failures have grown factorially with the number of interconnected internal and external systems. In 

this context, the concern is that any banks that have 

failed to correct their Y2K exposures will transmit that 

failure via the payment system to other institutions 

throughout the world, delaying or even arresting settlements in the process. This concern is heightened 

because, in both Asia and Europe, bank resources needed to fix Y2K are being consumed instead by more 

immediate problems. In Asia, it is surviving the decay in 

currencies and credits. In Europe, it is the Euro, which 

rates as an issue in itself—demanding the modification 

San Francisco Regional Outlook 17 Third Quarter 1998 
In Focus This Quarter
 

of bank and interbank payment systems throughout the 

world in anticipation of that currency’s January 1, 1999, 

launch. 

Although less well known to the general public, foreign 

exchange settlement risk remains of considerable concern to the Bank for International Settlements (BIS) and 

its member central banks. This exposure arises because 

cross-border payments, unlike domestic payments, have 

no single central bank to guarantee settlement, leaving 

U.S. banks exposed to their foreign counterparties and 

correspondents—sometimes for several days—for more 

than $244 billion in daily trades.11 Potential solutions to 

this problem include netting—offsetting risks so that 

only the differences are due—and simultaneous settlement. An ongoing effort by several of the world’s largest 

banks to provide simultaneous cross-border settlement, 

a project known as the Continuous Linked Settlement 

Bank, will require considerable international cooperation since it will effectively span the central banks in 

each country whose currency it settles. 

Efforts by individual countries to solidify their payments infrastructure are ongoing as well. Achieving 

finality in payments—a term meaning that a completed 

payment is irrevocable—is the most prevalent, and recognizes that payments must be irreversible to establish 

the liquidity for those that follow. One way of speeding 

up finality is with real time gross settlement (RTGS) 

systems. “Real time” means that there is no delay in settlement. “Gross settlement” means that transactions are 

settled in the full amount for which the original payment 

instructions were entered. FedWire, the U.S. Federal 

Reserve’s large-value payment system, is an RTGS system. Many other countries also have them, and still 

more are developing or planning them. Complementary 

to RTGS systems are net or provisional settlement systems, which total up the accumulated debits and credits 

for each participant over the course of some period— 

usually one day, offset them against each other, and settle at the end of the period. The New York Clearing 

House’s Clearing House Interbank Payment System is 

one such system. Although their use leads to smaller, or 

netted, settlement amounts for each participant and substantially lower liquidity demands on the payment system as a whole, payments in such systems are not final 

until the last creditor pays. Thus, there is a daily threat 

of recalculation and a potentially fatal change in mem11 Settlement Risk in Foreign Exchange Transactions, March 1996, 

and Central Bank Survey of Foreign Exchange and Derivatives Market Activity, May 1996; Bank for International Settlements; 

www.bis.org/publ. 

Sources of Additional Payment
 

System Information
 

Electronic Bill Presentment 

Checkfree . . . . . . . . . . . . .www.checkfree.com/ebill 

Microsoft-First Data 

Corp . . . . . . . . . . . . . .www.msfdc.com 

Digital Cash and Stored Value 

Cybercash . . . . . . . . . . . .www.cybercash.com 

Digicash . . . . . . . . . . . . .www.digicash.com 

Mondex . . . . . . . . . . . . . .www.mondex.com 

VISACash . . . . . . . . . . . .www.visa.com 

Securing Online Transactions 

Certicom . . . . . . . . . . . . .www.certicom.com 

Entrust . . . . . . . . . . . . . .www.entrust.com 

RSA . . . . . . . . . . . . . . . .www.rsa.com 

SETCO . . . . . . . . . . . . . .www.setco.org 

Certificate Authorities 

Certco . . . . . . . . . . . . . . .www.certco.com 

Digital Signature Trust . . .www.digsigtrust.com 

GTE Cybertrust . . . . . . . .www.cybertrust.gte.com 

Verisign . . . . . . . . . . . . . .www.verisign.com 

Electronic Funds Transfer ’99, Financial 

EDI, and POS Check Truncation 

National Automated 

Clearing House 

Association . . . . . . . . .www.nacha.org 

U.S. Treasury Financial 

Management Service . .www.fms.treas.gov/eft 

Payment System Vulnerability 

President’s Commission on 

Critical Infrastructure 

Protection . . . . . . . . . .www.pccip.gov 

The Euro, Foreign Exchange 

Settlement Risk, Payments Finality, 

and Collateralization 

Bank for International 

Settlements (BIS) . . . .www.bis.org/publ 

Federal Reserve Board 

of Governors . . . . . . . .www.ny.frb.org 

New York Clearing 

House Association . . .www.chips.org 

U.S. Federal Reserve . . . .www.bog.frb.fed.us 

San Francisco Regional Outlook 18 Third Quarter 1998 
In Focus This Quarter
 

bers’ liquidity positions if a major creditor bank fails. 

For such systems, the BIS is encouraging member collateralization levels sufficient to cover at least one, and 

preferably two, of each system’s largest net creditor 

banks at any one time.12 While these are not new issues 

in developed nations, the increasing extent to which 

financially underdeveloped and underregulated countries are involved in global payments confers new 

importance on the development of finality and collateralization in payment systems worldwide. 

Differing Perceptions, Common Threat 

Banks are united neither in their perceptions of these 

issues nor in their desire for regulation to address them. 

With respect to small-value payments, large and small 

banks have disagreed over whether the Federal Reserve 

should withdraw from providing retail payment services—a debate that ended in favor of the small bank 

faction earlier this year when the Fed announced that it 

would remain an active and, according to some large 

banks at least, a subsidized competitor in clearing and 

12 Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy report), 

November 1990; BIS; www.bis.org/publ. 

settlement. There also has been disagreement, again 

along lines of size, over whether the issuance of new 

products such as stored value cards should be limited to 

regulated depository institutions. In large-value payments, the differences are due more to relevancy than 

competition. Few small banks will feel compelled to 

address foreign exchange exposures or the vulnerabilities of the national and international payments infrastructure. 

Whatever their individual perceptions of the issues surrounding the payment system, all banks are susceptible 

to its interruption. Likewise, they are strategically vulnerable—individually and as an industry—if they fail to 

preserve their role as a trusted gateway for the settlement of their customers’ obligations. This is perhaps the 

most critical of all payments issues facing banks, for 

while their daily operations may depend on their continued success in maintaining the payment system’s 

dependability, nothing short of their payments franchise 

may rest on their ability to market this success to their 

customers as a feature essential to the entire range of 

current—and future—payment services. 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

San Francisco Regional Outlook 19 Third Quarter 1998 
Regular Features	 Regional Economy
 

Signs of a Pause in the Prolonged Residential 


Housing Boom Raise Concerns about Banks’
 

Exposure to Construction Lending
 

•	 The highly cyclical residential construction sector has experienced a long period of prosperity; however, a 

few warning signs are emerging. 

•	 In spite of the 1998 rebound in permit activity for the Region, permits continued to fall in Oregon and Utah, 

two states where other housing indicators were softening and economic growth has been tapering off. 

•	 Residential building activity is outpacing new household formation (a situation that can lead to overbuilding) in Oregon and Nevada, the two states where community banks have the highest concentration in construction lending in the nation. 

Residential housing markets have enjoyed a long period 

of prosperity in many states in the San Francisco 

Region; however, recent trends in building permit activity may signal emerging weakness or overbuilding, or 

both, in a few states. In Oregon and Utah, softening in 

housing permits over a period of months, an indicator of 

a slowdown in future housing activity, suggests that the 

boom may be coming to an end. While the weakness 

may reflect the cyclical nature of construction activity, 

it is occurring at a time when the Region’s financial 

institutions are recording rapid increases in construction 

lending. 

Slower job growth, the Asian crisis, and changing 

demographics all contribute to concerns about housing 

indicators and increased construction lending. The 

Region, with a 3.2 percent job growth rate over the 

12-month period ending in June 1998, continues to add 

jobs at a faster pace than the nation (2.5 percent). However, over the past year, job growth rates in most states 

in the Region have fallen moderately. Moreover, in part 

because of the Asian crisis, most state-by-state economic forecasts for 1998 project slower growth rates than in 

1997. In addition, aside from California, population 

growth in the Region has slowed slightly but noticeably 

over the past two years. Slower population growth outside of California has translated into fewer new households formed and likely has reduced housing demand. 

The Construction Sector Is Highly Cyclical 

Lenders’ assumptions about the outlook for the housing 

sector are very important, because construction is one 

of the most highly cyclical sectors of the economy. 

Construction projects are very sensitive to both the cost 

and availability of financing. Thus, changes in mortgage interest rates and overall economic activity tend to 

result in much larger swings in construction employment than in most other types of jobs. For example, over 

the past 25 years in the San Francisco Region, the annual percent changes in construction employment varied 

about four times more than changes in nonconstruction 

payroll jobs. Changing inflation expectations and consumer confidence, as well as wealth effects associated 

with stock market valuation, also can affect housing 

activity. 

Not only does the construction sector experience large 

cyclical movements, but the timing of the peaks and 

troughs is significant. Nationally, declines in housing 

permits occur months or quarters in advance of changes 

in the overall economy; hence the sector is designated a 

leading economic indicator. At the 

state level, permits may occasionally move independently of national business conditions, but 8 of the 

Region’s 11 states recorded downturns in permits prior to the 

1990–91 recession. 

The Region’s Banks Are Highly 

Exposed to Construction Lending 

The cyclical nature of the construction sector is important to the Region’s financial institutions because sharp 

declines in construction activity are usually followed by 

San Francisco Regional Outlook 20	 Third Quarter 1998 
Regular Features Regional Economy
 

deterioration in the quality of banks’ construction loan 

portfolios. This importance has grown as institutions 

have increased their exposure to construction lending. 

In the San Francisco Region, real estate lending is the 

largest single loan category at community banks (noncredit card banks with assets of less than $1 billion), 

accounting for 39.6 percent of total assets as of March 

31, 1998. Construction loans, which include both residential and nonresidential construction and land development lending, account for about 5.2 percent of total 

assets. As a result, changes in real estate markets may 

have a significant impact on the health of banks in the 

Region (see Increased Construction Lending and 

Changing Residential Lending Practices Pose Risks to 

San Francisco Region Banks). 

The analysis that follows examines several state-level 

housing markets. In Oregon and Utah, housing permits 

have shown unusual weakness in 1997 and 1998. Comparing the number of housing permits to new households focuses attention on the potential for overbuilding 

in Nevada and Oregon. 

Continuing Weakness in Housing 

Permit Activity in Oregon and Utah 

Is a Concern 

The Region as a whole reported moderate growth in 

total housing permit activity throughout 1997 (4.9 percent) and strong growth in permit activity in the first 

five months of 1998 (10.6 percent annual rate). However, the performance was not uniform across the Region’s 

states. For example, in 1997 California registered a 

rapid increase in permits (nearly 20 percent) that 

masked declines in seven other states. 

Unlike the other states that experienced declines in 

housing permit activity in 1997, Oregon and Utah continued to experience declines in the first five months of 

1998 (see Chart 1). Moreover, this weakness is consistent with other housing and construction indicators for 

these two states; housing price appreciation has slowed 

and sales activity remains below mid-1990s peaks. The 

weakness in permits, as well as slower rates of job 

growth in both states over the past year, is a significant 

indication that the extended housing booms in these 

states may be coming to an end. 

CHART 1 

Single-Family Housing Permits Remain
 

Weak in Oregon and Utah despite 1998
 

Strength Elsewhere in the Region
 

Year-to-date growth rates (in percent), through May 

U.S. 

Region 

Utah 

Oregon 

Montana 

Washington 

Nevada 

Hawaii 

Idaho 

1997 

1998 

–20% –15% –10% –5% 0% 5% 10% 15% 20% 

Source: Bureau of the Census 

Shifting Demographics May Be a Factor in 

Future Permit Activity outside of California 

Shifting demographics may be having an effect on 

housing activity across the Region. California experienced significant out-migration during the early 1990s 

when the state suffered a prolonged recession. However, as the state’s economy began to accelerate in the latter half of the 1990s, its population growth rate also has 

increased, and many of its housing markets have registered strong improvements. While still low by historic 

standards, California’s population growth rate for 1997 

had doubled from its 1995 low of 0.6 percent. 

However, California’s increased population growth rate 

has been accompanied by slower growth rates elsewhere 

in the Region. Most states in the Region began reporting slower population growth rates and new household 

formation rates after 1995. Although the Region, 

excluding California, still is adding residents at a rapid 

pace of about 2 percent per year, the growth rate is down 

from about 2.5 percent earlier in the 1990s (see Chart 2, 

next page). In Arizona, Idaho, Montana, and 

Wyoming, population growth rates for 1997 were at 

least 1 percentage point below 1994 rates, according to 

Census Bureau figures. Hawaii, Nevada, and Utah 

reported nearly 1 percentage point declines in their 

population growth rates over the same period. Furthermore, most states also are reporting declines or slower 

growth in the 25- to 34-year-old population cohort, 

which typically accounts for a large share of first-time 

home buyers. 

San Francisco Regional Outlook 21 Third Quarter 1998 
Regular Features	 Regional Economy
 

CHART 2 

As California’s Population Growth Rate 

Accelerates, Population Growth Elsewhere 

in the Region Is Slowing 

3.0
 

2.5
 

2.0
 

1.5
 

1.0
 

0.5
 

0.0
 

1994 

1995 

1996 

1997 

U.S.	 SF Region California 

except California 

Source: Bureau of the Census Annual Percent Change 

An Excess of Housing Permits Relative 

to New Households Formed May Be an 

Issue in Oregon and Nevada 

A comparison of the number of housing permits and net 

new household formation is an indicator of the potential 

housing supply in the pipeline and the potential demand 

from households. Over a long period of years, these 

indicators tend to roughly balance out, but on a year-toyear basis they may vary widely, depending on the point 

in the business cycle. During and after recessions, when 

housing demand softens, the growth in the number of 

housing permits tends to fall below the rate of new 

household formation, creating a negative gap, which 

may indicate a shortage of housing units. During periods of expansion, the number of new housing permits 

often is larger than the number of new households 

formed, creating a positive gap. However, a large and 

persistent gap also may suggest that an excess inventory 

of housing units is building. 

In 1997, the most recent period for which data are available, the Region reported 51,000 more housing permits 

issued than the number of net new households formed. 

Oregon and Nevada, which have been among the 

Region’s fastest growing states for several years, reported large excesses of permits over new households relative to their populations. However, the positive gaps for 

Oregon and Nevada may be occurring for different 

reasons. 

Oregon’s 10,400-unit gap between housing permits and 

new households, shown in Chart 3, is of note because 

of its size and the recent softening in both the state’s 

economy and housing markets. Employment growth 

CHART 3 

Housing Permits Remain High in Oregon 

despite a Drop in New Household Formation 

40,000 

35,000 

30,000 

25,000 

20,000 

15,000 

10,000 

5,000 

New Building Permits 

New Households 

1991 1992 1993 1994 1995 1996 1997 

Year 

Source: Bureau of the Census 

over the 12 months ending in June 1998 slipped to 2.3 

percent, near the national average. Fewer sales of existing houses, slower home price appreciation, and weak 

construction job growth in 1998 all are consistent with 

slowing in housing permit activity. The slowdown also 

may be linked to slower net in-migration, which is 

reflected in the lower number of new households 

formed in 1997 (see Chart 3). Oregon’s sizable positive 

gap and other indications of slowing are significant 

because community banks hold 9.2 percent of their 

assets in construction loans, the second highest share in 

the nation. 

In contrast to Oregon’s softening, Nevada’s residential 

real estate markets continued to boom at mid-year 1998. 

The state reported nearly a 24 percent increase in housing permits for the first five months of 1998 compared 

with the same period in 1997. Although Nevada’s 

5,000-unit gap in 1997 is less than the 1996 gap, shown 

in Chart 4, it is still fairly large relative to the state’s 

small population. Despite this gap, the market remains 

healthy. Existing housing sales in the first quarter of 

1998 were at their highest level in ten years, while housing price appreciation remained moderate. 

Still, the potential exists for residential overbuilding in 

Nevada. Although the state’s employment growth rate 

remains high at 4.2 percent for the 12 months ending in 

June 1998, it is the slowest job growth since 1992. Furthermore, with population growth moderating slightly 

and permit activity soaring, the housing gap could 

widen significantly in 1998. Overbuilding is a concern 

in Nevada because the state’s community bank exposure 

to construction lending as of March 1998 was 15 percent of assets, the highest in the nation. 

San Francisco Regional Outlook 22	 Third Quarter 1998 
Regular Features Regional Economy
 

CHART 4 

Implications: Most states in the San Francisco Region 

have experienced prolonged residential housing booms 

in the 1990s; however, recent economic and housing 

conditions may be an indication of change. In this situation, lenders should not assume that the boom in conHousing Permits in Nevada Exceed 

New Household Formation 

for the Fifth Consecutive Year 

Source: Bureau of the Census 

40,000 

35,000 

30,000 

25,000 

20,000 

15,000 

10,000 

5,000 

1991 1992 1993 1994 1995 1996 1997 

Year 

New Building Permits 

New Households 

struction will go on indefinitely, especially given the 

highly cyclical nature of the residential construction 

sector. 

Changing conditions may be especially relevant to the 

Region’s community banks, because as a group they 

have heavy exposure to construction lending and they 

have been recording rapid increases in construction and 

land development loans. The maturity of the nation’s 

economic recovery, the inherent volatility in construction activity, and increased construction lending by 

banks all indicate that lenders should carefully monitor 

housing conditions in their markets for signs of weakness. Such action may be especially timely in states like 

Oregon and Utah, where banks are heavily exposed to 

construction lending and housing indicators are showing signs of weakness, or in states like Nevada, where 

residential construction continues to grow faster than 

household formation. 

Gary C. Zimmerman, Regional Economist 

San Francisco Regional Outlook 23 Third Quarter 1998 
Regular Features	 Regional Banking
 

Increased Construction Lending and
 

Changing Residential Lending Practices Pose
 

Risks to San Francisco Region Banks
 

•	 The Region’s insured financial institutions continue to report strong earnings, solid asset quality, and 

increased leverage capital ratios. 

•	 Amid reports of loosening underwriting standards, the recent growth and high concentrations in construction lending at banks in faster growing states warrant attention. 

•	 Residential lending standards have come under pressure from nontraditional lending practices at large 

banks and nonbank competitors. 

Overview 

Most of the insured institutions in the San Francisco 

Region performed admirably in the first quarter of 

1998. 

•	 Strong asset quality and noninterest income growth, 

coupled with ongoing gains in operating efficiency, 

continue to drive earnings to record levels. The 873 

insured institutions in the Region posted a collective 

return on assets (ROA) of 1.27 percent and a return 

on equity of 14.00 percent. Both of these profitability measures compare favorably with the national 

averages of 1.2 percent and 14.42 percent, respectively, and represent solid increases over prior-year 

performance. 

•	 Favorable economic conditions also translated into 

improvement in reported asset quality. As of March 

31, 1998, loans that were reported 30 days or more 

past due plus nonaccrual loans as a percentage of 

total loans fell to 1.96 percent, well below the national average of 2.23 percent. 

•	 Excellent earnings and minimal asset growth boosted the Region’s leverage capital ratio to 7.73 percent, 

the highest level in over a decade, despite a 73 percent dividend payout ratio. 

Although the Region as a whole performed well, the 

following states are showing signs of deterioration: 

Hawaii’s prolonged recession continues to have a negative effect on the state’s insured financial institutions. 

As a group, these institutions are the weakest in the 

Region. During the first quarter of 1998, ROA declined 

to 0.94 percent from 0.99 percent a year earlier. These 

returns are well below both the Region’s and the nation’s 

ROAs of 1.27 percent and 1.22 percent, respectively. 

Problem assets in Hawaii are also on the rise. Loans and 

leases past due 30 days or more plus nonaccrual loans 

inched up from 3.23 percent to 3.30 percent of total 

loans during the past 12 months. Problem assets are 

centered primarily in residential real estate loans and 

secondarily in commercial real estate loans. Hawaii’s 

recession has hit community banks (less than $1 billion 

in total assets) the hardest, since they lack the geographic diversity of larger institutions. Although profits 

at community banks improved during the past 12 

months, their ROA of 0.82 percent continues to lag 

large banks’ ROA of 1.01 percent. Furthermore, asset 

quality at community banks continues to deteriorate. 

The ratio of loans and leases past due 30 days or more 

plus nonaccrual loans to total loans at these institutions 

climbed from 6.64 percent to 7.28 percent during the 

past 12 months. 

The ripple effect of slower economic conditions in 

Montana is showing up in the financials of the state’s 

insured financial institutions, which reported slightly 

lower profits and an increase in nonperforming assets 

during the past 12 months. Residential real estate, commercial real estate, and construction loan portfolios 

accounted for the bulk of the deterioration. The dollar 

volume of foreclosed properties almost doubled, to 

$8,149 million. Community banks appear to be bearing 

the brunt of the state’s economic slowdown; their ratio 

of foreclosed assets plus noncurrent loans to total 

assets, at 1.12 percent, is the second highest in the 

Region, behind only Hawaii’s community banks. 

San Francisco Regional Outlook 24	 Third Quarter 1998 
Regular Features Regional Banking
 

Community Bank Construction 

Lending Soars in Some States 

Real estate markets in much of the San Francisco 

Region are experiencing a boom that is fueling a resurgence in construction lending. Although both banks and 

thrifts are actively involved in construction lending, 

banks hold the predominant share of construction loans 

in the San Francisco Region. Furthermore, Chart 1 

shows that the construction loan exposure at the 

Region’s community banks1 is well above the exposure 

for the Region’s large banks (non-credit-card banks with 

over $1 billion in assets). Among these community 

banks, those in the Region’s faster growing states have 

a higher level of construction loans than peer institutions in other states. The increased concentration of 

construction loans in some states raises some concerns, 

given the apparent loosening of construction loan 

underwriting standards noted by bank examiners 

nationwide and the traditionally higher risk of construction lending. 

Although the Region’s community banks are less heavily exposed to construction loans in aggregate than they 

were prior to the 1990–91 recession, Nevada and Oregon, two of the Region’s faster growing states, have 

much higher levels of exposure than they did during that 

period. Chart 2 shows that, while community banks as a 

whole in 1990 had about 8.3 percent of their assets 

invested in construction loans, community banks in 

Nevada and Oregon currently have 14.7 and 9.2 percent, 

respectively, of their total assets in construction loans. 

Chart 2 also reveals that community bank exposure in 

1 Community banks are defined here as non-credit-card banks with 

total assets less than $1 billion. 

CHART 1 

Nevada far exceeds the level that California’s community banks had prior to the 1990–91 recession. 

Not only are construction loans at record levels in some 

states, but growth in construction loans at the Region’s 

community banks increased a robust 28 percent from 

the first quarter of 1997 to the first quarter of 1998.2 

However, growth has not been uniform across the 

Region. Community banks in states showing strong 

economic growth—such as Nevada, Arizona, Oregon, 

Utah, and Washington—registered some of the largest 

increases in the percentage of assets held in construction loans. Nevada’s community banks, for example, 

registered an increase of almost 50 percent in construction loans since the first quarter of 1997, while community banks in Arizona, Oregon, and Washington all 

recorded growth in excess of 30 percent. By contrast, 

community banks in Hawaii recorded overall declines in 

construction loans. 

FDIC examiners throughout the nation have noted a 

steady deterioration in construction loan underwriting 

standards since September 1996, according to the 

FDIC’s Report on Underwriting Practices. Chart 3 

(next page) shows a growing share of banks making 

speculative construction loans, financing borrower 

interest payments during the loan term, and relying 

solely on the project for repayment. In particular, Chart 

3 shows that the percentage of banks frequently or 

commonly funding speculative construction loans 

increased from about 11 percent as of September 1996 

to almost 40 percent as of March 1998. Prudent underwriting standards are often an institution’s best means of 

2 A constant sample of banks during this period was utilized to minimize the effects of industry mergers, acquisitions, and consolidations. 

CHART 2 

Community Banks Have the Most 

Construction Loan Exposure 

Source: Bank Call Reports Construction Loans as a % of Total Assets 

10 

8 

6 

4 

2 

0 

Large Banks 

Dec-89

Dec-90

Dec-91

Dec-92

Dec-93

Dec-94

Dec-95

Dec-96

Dec-97 

Community Banks 

Nevada and Oregon Community Banks Increase 

Their Construction Loan Concentrations 

Source: Bank Call Reports Construction Loans as a % of Total Assets 

16 

14 

12 

10 

8 

6 

4 

2 

0 

March 1998 

Nation

Region

Nevada

Oregon

California 

December 1990 

San Francisco Regional Outlook 25 Third Quarter 1998 
Regular Features Regional Banking
 

CHART 3 

Examiners Observe Loosening Construction Loan 

Underwriting Practices 

Source: FDIC Report on Underwriting Practices Percent of Banks 

50 

40 

30 

20 

10 

0 

% of Banks 

Funding 

Speculative 

Projects 

Sep-96 Mar-97 Sep-97 Mar-98 

% of Banks 

Funding 

Interest 

Payments 

% of Banks 

Not Considering 

Other Sources 

of Repayment 

limiting the risk associated with a concentration in a 

particular category of assets. Looser underwriting standards can weaken a bank’s ability to withstand a downturn in the economy. 

Several factors make construction lending a risky line 

of business for a bank. First, the construction industry is 

one of the most highly cyclical sectors of the economy 

and is extremely dependent on favorable economic conditions and interest rates (see Signs of a Pause in the 

Prolonged Residential Housing Boom Raise Concerns 

about Banks’ Exposure to Construction Lending). 

Second, some key risks are inherent in all construction 

lending: cost overruns; the uncertainty of the value of 

the project upon completion; the lengthy lags between 

project planning, construction, and completion; and the 

fact that partially completed projects typically have substantially less value than completed projects. While 

some risks in construction lending (such as its dependence on interest rates and economic conditions) are 

beyond bank management’s control, management can 

somewhat mitigate these macroeconomic risks with 

concentration limitations, prudent underwriting practices, and increased capital and reserve levels. 

Implications: Community banks in some of the 

Region’s faster growing states have much higher levels 

of exposure to construction lending than they did before 

the 1990–91 recession, and recent growth in construction lending at these institutions has been especially 

strong. Furthermore, economic factors such as the slowdown in population growth and the gap between permits 

issued and new household formation in some of the 

faster growing states could negatively affect banks concentrated in construction lending in these states. Loosening underwriting standards and the traditionally higher risk of construction lending also pose risks in the 

event of an economic downturn. Managers of insured 

financial institutions with high concentrations in construction loans should closely monitor local economic 

and real estate market conditions. 

Residential Lending Standards 

Come under Pressure from Large 

Banks and Nonbank Lenders 

In addition to increasing their exposure to construction 

loans, it appears that some banks may be easing credit 

standards in an effort to compete for residential mortgages and other consumer loans. Throughout the nation, 

finance companies and other subprime lenders are 

offering loan packages that allow the consumer to consolidate all mortgage, home equity, and credit card 

debts into one loan secured by the borrower’s residence. 

Debt consolidation loans are not a new idea; however, 

some institutions have acknowledged increasing the 

maximum threshold amount financed in relation to the 

value of the collateral. Loan-to-value (LTV) ratios have 

increased from previous standards of 80 to 90 percent to 

as much as 125 percent of appraised value. 

Some banks in this Region are joining this trend toward 

high LTV residential lending: A number of institutions 

routinely offer 100 percent financing. Institutions 

extending this type of credit also are permitting extended periods of interest-only payments, in some cases as 

long as ten years. It appears that most small community banks are not actively seeking these types of loans. 

However, interest in participating in high LTV residential loan programs could increase if both consumer 

demand and competition from larger institutions continue to grow. 

Residential mortgage lending represents a significant 

business for insured financial institutions in the Region. 

A total of 272 institutions hold portfolios of residential 

mortgage loans that exceed 25 percent of total loans and 

100 percent of Tier 1 capital. By the first quarter of 

1998, insured institutions in the Region had over $281 

billion or about 41 percent of their total loans in 1- to 4­

family mortgages, making residential lending the 

largest single loan category for the Region’s institutions. 

The Region’s banks currently have approximately 37 

percent of the Region’s total outstanding 1- to 4-family 

mortgages, up from 25 percent as of year-end 1984. 

San Francisco Regional Outlook 26 Third Quarter 1998 
Regular Features	 Regional Banking
 

Underwriters of high LTV mortgages should be careful 

not to make credit and pricing decisions based on 

assumptions that the favorable 

economic conditions experienced 

over the past six years will continue indefinitely. Low interest rates, 

coupled with high employment 

and rising income levels, have 

contributed to consumers’ ability 

to service increasing debt loads. 

These circumstances also are 

major factors in the increasing value of residential properties in most of the Region’s major markets. Adverse 

changes in these key factors could increase potential 

credit losses from this type of lending. There are additional considerations that lenders should take into 

account: 

•	 Loans collateralized by 1- to 4-family dwellings with 

high LTVs generally will not meet secondary market 

standards set by government-sponsored enterprises, 

such as Fannie Mae and Freddie Mac, meaning the 

loans will likely be less liquid and will remain in the 

loan portfolio (at least initially). 

•	 Banks that engage in this type of lending may be 

more exposed to changing economic conditions that 

adversely affect consumer income levels and the 

value of residential properties. 

While consolidating unsecured debt into a secured loan 

structure may provide some comfort to the lender, the 

possibility remains that some consumers will simply 

increase credit card debt after the consolidation is completed, thereby increasing the likelihood of bankruptcy. 

Implications: Single-family residential mortgage lending is the most significant loan category for insured 

financial institutions in the San Francisco Region. 

Some institutions have loosened underwriting standards 

in response to increased competition from finance companies and subprime lenders. High LTV debt consolidation financing is more common now than in the past. 

The performance of these loans is at greater risk in the 

event of an economic downturn than traditional singlefamily mortgage loans. Consequently, management 

needs to ensure that changes in the credit risk profile of 

the loan portfolio caused by eased underwriting standards are incorporated into the bank’s allowance for 

loan and lease loss adequacy reviews. 

Millen L. Simpson, Financial Analyst 

Catherine I. Phillips-Olsen, Regional Manager 

San Francisco Regional Outlook 27	 Third Quarter 1998 
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