Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1999 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

John M. Anderlik,
 

Acting Regional
 

Manager
 

Jeffrey W. Walser,
 

Regional Economist
 

Christopher
 

J. Sesler
 

Economic Analyst
 

Troy D. Osborne
 

Financial Analyst
 

In Focus This Quarter 

◆ Falling Prices in Commodities and Manufacturing Pose Continuing 

Risks to Credit Quality—Falling prices are causing problems for a wide range 

of commodity industries—a collection of agricultural, mining, and manufacturing 

industries that produce standardized products and face global competition, mostly 

on the basis of price. Firms in these industries have experienced slow or negative 

profit growth even as they reduce payrolls to cut costs. There are signs that these 

trends are contributing to higher credit risk for insured institutions. The effects of 

these problems on local economies and community banks could grow if low prices 

persist. See page 3. 

By Richard A. Brown and Alan Deaton 

◆ Shifting Funding Trends Pose Challenges for Community Banks— 

Several long-term trends are making it more difficult for some institutions to economically fund asset growth with deposits in today’s marketplace. As a result, 

traditional measures of liquidity and liability composition for commercial banks 

reflected record-low levels of deposit funding at year-end 1998. The need to augment lagging deposit growth to meet loan demand has led many community banks 

to seek more wholesale funding sources, particularly borrowings. If the trend 

toward greater reliance on nondeposit funding continues, liability management 

may become more important and more challenging for community banks that have 

historically relied upon deposits for funding and net interest revenues for profitability. See page 11. 

By Allen Puwalski and Brian Kenner 

Regional Perspectives 

◆ Agricultural Sector under Stress: The 1980s and Today—With prices 

for wheat, corn, soybeans, hogs, and cattle depressed again in 1999, many people are 

beginning to ask if the agricultural crisis of the 1980s is about to recur. However, 

today’s economic environment differs from the one that led to the agricultural crisis of the 1980s. Interest rates are low and stable, farm debt levels are moderate, and 

real farmland values have been relatively stable throughout the 1990s. In addition, 

the Region’s farm banks are reporting higher capital and loan loss reserve levels 

than in the 1980s, indicating that institutions today can better absorb an increase in 

loan losses. Although the Region does not appear to be entering a crisis period like 

that of the 1980s, several factors may pose significant risks to farm banks, including continuing low commodity prices, higher loan levels, and uncertainty regarding 

the future of federal farm programs. See page 18. 

By John M. Anderlik and Jeffrey W. Walser 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

San Francisco Region (AK, AZ, CA, 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 Kansas City 

Region’s Regional Outlook, please call John Anderlik at (816) 234-8198 or send an e-mail to 

janderlik@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Falling Prices in Commodities and Manufacturing 


Pose Continuing Risks to Credit Quality
 

•	 Prices have fallen sharply across a wide range of 

commodities and manufactured goods. 

•	 Signs of stress are apparent in some industry 

sectors. 

•	 These trends are contributing to rising credit risk 

for insured institutions. 

•	 Effects on local economies and community banks 

could grow if low prices persist. 

The performance of the U.S. economy during the midto late-1990s has been generally positive for banking. 

Economic activity grew in 1998 at an inflation-adjusted 

rate of 3.9 percent for the second consecutive year. Continued low inflation has helped to hold interest rates low 

and extend the expansion into its ninth consecutive year. 

However, one downside of low inflation has been that 

firms in certain commodity industries have encountered 

slow or negative growth in revenues because of the low 

prices they receive for their products. 

Commodity industries are defined in this article as a 

collection of agricultural, mining, and manufacturing 

industries that produce standardized products and face 

global competition, mostly on the basis of price. Since 

the beginning of 1997, price weakness has extended 

across a wide range of commodity industries, from agricultural products to oil, chemicals, textiles, paper, semiconductors, steel, and even some segments of the auto 

industry. While many firms have retooled and restructured to cut costs, clear signs of financial stress have 

become apparent. 

The potential importance of problems in commodity 

industries to the FDIC was illustrated by the banking 

problems related to oil and agriculture during the 1980s 

and early 1990s. As documented in a 1997 study by the 

FDIC Division of Research and Statistics, regional 

economic dislocations related to declining farmland 

values and declining oil prices contributed to large 

increases in credit losses and the eventual failure of 

hundreds of federally insured banks and thrifts. The 

analogy to the 1980s is far from perfect—for example, 

oil and agriculture have not experienced booms comparable to those that preceded their collapse in the 

1980s—but exposures to commodity industries remain 

important for many insured institutions. 

This article summarizes recent adverse trends in commodity and manufacturing sectors and discusses why 

industry-sector problems are important in banking. It 

takes a high-level approach, emphasizing the economic 

fundamentals that are driving prices across the economy 

while ignoring many of the industry-specific factors 

that are also driving the performance of individual sectors. The goal is to evaluate the effects of these trends 

on bank credit quality if they persist through 1999 and 

beyond. 

Prices Have Been Declining across a Range 

of Commodities and Manufactured Goods 

Low inflation has been a boon for consumer spending 

and business investment during the economic expansion 

of the 1990s. As of March 1999, the Consumer Price 

Index had risen at an annualized rate of less than 2.0 

percent for 8 consecutive quarters and at an annualized 

rate of less than 4.0 percent for 

33 consecutive quarters. The 

prices of many popular and 

essential consumer goods— 

from computers to gasoline— 

have generally fallen throughout 

the decade, even as the prices of 

most services continue to rise 

steadily. Businesses, too, have 

benefited from the ability to 

purchase goods cheaply, as well as from the generally 

low interest rates that have accompanied low inflation. 

The declining average wholesale price of goods is 

reflected in Chart 1 (next page), which shows changes 

in the producer price index (PPI) and some of its key 

components since the beginning of 1997. The PPI 

focuses on goods, omitting changes in the price of services. The decline of nearly 5 percent in the PPI since 

the beginning of 1997 has been led by falling prices for 

mining products, petroleum, and steel. Moreover, economy-wide price declines for wholesale goods have been 

steady over time, with the PPI registering year-over-year 

declines for 26 consecutive months through May 1999. 

Kansas City Regional Outlook 3	 Third Quarter 1999 
In Focus This Quarter
 

CHART 1	 CHART 2 

Widespread Pricing Pressures Are Evident in the 

Components of the Producer Price Index 

Percent Change in Selected Components of the Producer Price 

Index, January 1997 to May 1999 

–45 

–40 

–35 

–30 

–25 

–20 

–15 

–10 

–5 

0 

Agricultural Prices Are Down Sharply Since 1997 

Percent Change in Reported Price Between 

January 1997 and May 1999 

Source: Wall Street Journal (Haver Analytics) 

Cotton 

Corn 

Hogs 

Wheat 

10 

5 

0 

–5 

–10 

–15 

–20 

–25 

–30 

–35 

–40 

Source: Bureau of Labor Statistics (Haver Analytics) All Commodities Lumber & Wood Chemicals Textiles Automobiles Electrical Machinery 

Iron & SteelPetroleumProductsMining 

3.3 

–4.0 

0.6 –1.9 –2.5 –2.5 

–10.0 

–19.8 

–33.2 

Although they are only indirectly included in the PPI 

numbers, the prices of several important agricultural 

commodities have also fallen substantially. Chart 2 

shows that the price of wheat has fallen by more than 35 

percent since January 1997, with the price of corn, 

hogs, and cotton also registering double-digit rates of 

decline. While the price of hogs has rebounded significantly since the end of 1998—more than doubling from 

its low of less than 15 cents per pound—prices for corn, 

wheat, and cotton continued to decline through May 

1999. 

Reasons for Broad-Based Commodity 

Price Weakness 

Pricing trends in disparate industries such as electronics 

and agriculture, or oil and steel, are driven in part by 

industry-specific factors. For example, weather patterns 

heavily influence agricultural prices, while global politics tends to drive world oil price levels. In manufacturing, technological developments can significantly alter 

the demand for a product or its cost of production, 

thereby influencing its market price. For example, 

improvements in semiconductor manufacturing techniques—from shrinking the size of chips to using larger 

silicon wafers—have significantly increased production 

yields in that industry during the 1990s.1 

However, the pervasiveness of recent price declines 

across a wide range of commodities and manufactured 

1 See “Semiconductor Industry Trends,” Standard and Poor’s Industry 

Surveys, May 27, 1999, p. 4. 

goods suggests that a number of common factors are 

driving prices lower: 

•	 Low inflationary expectations. Since 1980, inflation rates have gradually declined worldwide as central banks shifted their focus toward price stability. 

Disinflation has profoundly altered the expectations 

of investors, consumers, and businesses, and in the 

process has altered the course of events in individual markets and in the economy as a whole. As a 

result, commodities have lost much of their appeal 

as a hedge against inflation. This has contributed to 

a decline of more than 50 percent in the price of 

gold since 1980. The expectations of many businesses have also changed, because with less pricing 

power they must continually cut costs to remain 

competitive. 

•	 Overcapacity because of large-scale investment. 

Global investment in productive capacity accelerated 

during the early to mid-1990s in a number of commodity and manufacturing industries. Many U.S. 

firms have implemented new technologies and 

moved their operations closer to their markets or to 

areas where low-cost labor is available. For example, 

major U.S. and foreign automakers have invested billions of dollars in recent years in new production 

facilities in the emerging markets of Asia and Latin 

America as part of a “build-where-you-sell” strategy.2 Because these additions to capacity largely have 

not been offset by the closure of existing plants, analysts say that global productive capacity in autos 

2 Barbara McClellan, “Asia Woes Worsen,” Ward’s Auto World, 

November 1998, pp. 28–31. 

Kansas City Regional Outlook 4	 Third Quarter 1999 
In Focus This Quarter
 

could exceed demand by more than 20 million units 

annually by 2000.3 A similar situation has developed 

in the semiconductor industry, where capital investment in chipmaking equipment tripled between 1993 

and 1996, contributing to a glut of memory chips and 

plunging prices.4 

•	 Curtailed global demand in the wake of emerging 

market crises. The economic crises that have developed in Asia, Russia, and parts of Latin America 

since 1997 have crimped global demand for commodities and manufactured goods. For example, 

demand for new cars in Korea fell by 50 percent in 

1998.5 Asia received approximately 30 percent of 

U.S. feed grain exports in 1996, but declining Asian 

demand since then has contributed to a sharp decline 

in global grain prices. The slowdown of economic 

activity in crisis countries and the resulting decline 

in their demand for imports is only one factor that 

has hurt the pricing power of U.S. producers. Another problem is the pricing advantage conferred on 

countries that have experienced currency devaluation. Firms operating in a country that has devalued 

its currency experience a reduction in the price of 

their exports in U.S. dollar terms. This process further depresses the pricing power of U.S. farmers and 

businesses that sell their goods in global markets. 

Recently, there have been signs that some hard-hit Asian 

economies may soon begin to recover. However, the 

other factors cited above—low inflationary expectations and rapid investment in productive capacity—may 

well be longer-term trends. In any event, U.S. farmers 

and businesses that participate in commodity industries 

must be prepared for the possibility that pricing pressures will not dissipate in the near term. 

Signs of Stress Are Showing 

for Affected Industry Sectors 

As commodity prices continue to stagnate, signs of 

stress are emerging among firms in the commodity 

industries. A long-term trend toward reduced levels of 

employment in manufacturing has accelerated in the 

midst of the current economic expansion. Chart 3 shows 

that employment levels declined in a wide range of 

commodity industries in the 24 months ending in May 

3 “1997 Automotive Outlook,” Automotive Industries. This report is
 

available at http://www.ai-online.com.
 4 “Semiconductor Industry Trends” (1999), p. 3.
 

5 Barbara McClellan (1998).
 

CHART 3 

Total Percent Change in Payroll Employment, May 1997 to May 1999 

Employment Levels Have Declined across a Wide 

Range of Commodity and Manufacturing Sectors 

* Percent change between 1997 and 1998 based on county-level estimates 

of payroll employment in agriculture and agricultural services 

Sources: Bureau of Labor Statistics (Haver Analytics); WEFA 

Electronics and Semiconductors 

Textiles 

Autos 

Primary Metals/Iron and Steel 

Chemicals 

Oil and Gas 

Mining 

Lumber and Paper 

Agriculture* 

–20 –15 –10 –5 0 

1999. The total manufacturing sector lost more than 

420,000 jobs during that period, while another 64,000 

jobs were lost in the mining sector, which includes oil 

and gas extraction. The trend toward lower levels of 

employment in mining and manufacturing not only 

reflects pricing pressures but also attempts by firms in 

these sectors to maintain profitability by investing in 

labor-saving technologies. 

The profit picture has begun to deteriorate as well for 

firms operating in commodity industries. Four-quarter 

trailing earnings through March 1999 for oil-sector 

firms in the Standard & Poor’s 500 dropped by more 

than 44 percent from a year ago (see Chart 4), while the 

earnings of steel firms fell by almost 32 percent. The 

losses experienced by firms in some of these industrial 

sectors extended to the farm sector as well, where net 

CHART 4 

–50 –40 –30 –20 –10 0 10 20 

Agriculture* 

Year-over-Year Percent Change in Earnings from Continuing Operations 

for S&P 500 Companies, by Sector, for the Year Ending in March 1999 

Earnings Have Declined across a Wide Range 

of Commodity and Manufacturing Sectors 

Oil and Gas 

* 1998 percent change in net farm income 

Sources: Standard and Poor’s (Bloomberg); U.S. Department of Agriculture 

Lumber and Paper 

Mining 

Chemicals 

Primary Metals/Iron and Steel 

Autos 

Textiles 

Electronics and Semiconductors 

Kansas City Regional Outlook 5	 Third Quarter 1999 
In Focus This Quarter
 

incomes fell by more than 7 percent in 1998, according 

to the U.S. Department of Agriculture. 

Affected Industries Have Found Ways to Cope 

with Pricing Pressures Thus Far 

Despite the signs of stress in industries where prices are 

weak or declining, U.S. farmers and industrial firms 

have shown themselves to be fairly resilient thus far in 

their ability to cope with the situation. Agricultural producers have been making greater use of carryover debt 

to keep their operations running even if they were not 

able to fully retire their operating loans during the previous crop year. The FDIC Report on Underwriting 

Practices shows that 29 percent of FDIC-supervised 

agricultural lenders reported at least a moderate 

increase in carryover debt during the six-month period 

ending in March 1999, compared with only 10 percent 

in March 1998. Although the use of carryover debt is 

not an uncommon practice in agriculture, it indicates 

that low prices and declining subsidies have contributed 

to financial stress for farmers. 

Many industrial firms have found ways to increase productivity and cut costs to offset declining revenues. 

Chart 5 follows trends in annual total revenue and costs 

for U.S. corporations operating in a selected group of 

commodity industries. It shows that growth in revenue 

and costs slowed noticeably in 1997. Both revenue and 

costs in these sectors declined in 1998, illustrating that 

firms in these sectors have needed to cut costs to preserve profit margins. Cost cutting in the manufacturing 

sector is further illustrated by a steady decline in the 

index of unit labor costs for manufacturing, which started from a value of 100 in 1992 and fell to less than 96 

CHART 5 

U.S. Corporations Operating in 

Commodity Industries Have Trimmed 

Costs to Offset Falling Revenue* 

* Totals represent a summation of revenues and costs for the following industry 

sectors, as reported by the Bureau of the Census: textile mill products, paper and 

allied products, chemicals and allied products, industrial chemicals and synthetics, 

petroleum and coal products, lumber and wood products, iron and steel, electrical 

and electronic equipment, motor vehicles and equipment, and mining. 

Source: Bureau of the Census (Haver Analytics) 

1992 1993 1994 1995 1996 1997 1998 

Billions of Dollars 

Costs 

Revenues 

1,250 

1,450 

1,650 

1,850 

2,050 

2,250 

by the first quarter of 1999. Falling unit labor costs 

means that the productivity of manufacturing workers is 

rising faster than the cost of their services. This trend 

demonstrates that manufacturing firms have been successful at implementing new technologies and new capital equipment to cut production costs. 

Cost savings and industry consolidation have been 

accomplished in part through mergers. According to 

Merger Stat, the dollar volume of merger and acquisition transactions involving U.S. firms exceeded $1.2 

trillion in 1998, an increase of more than 80 percent 

from 1997 levels. Both the number and dollar volume of 

mergers announced in 1998 far exceeded the volumes 

recorded during the “merger mania” of the 1980s. Some 

of the largest mergers announced in 1998 involved 

firms looking for ways to increase market share and cut 

costs in markets characterized by overcapacity. Examples include the $39 billion Daimler-Chrysler transaction announced in May 1998 and the $80 billion 

Exxon-Mobil transaction announced in December 

1998. Furthermore, merger activity recorded in early 

1999 suggests that total merger volume for the year 

could exceed the record pace of a year ago. 

Industries plagued by oversupply and weak prices 

require consolidation to reduce capacity and improve 

profit margins. Mergers and acquisitions represent a 

fairly orderly way for firms operating in a troubled 

industry to consolidate on their own terms. Bankruptcy 

filings are an alternative means for severely troubled 

firms to reduce capacity and achieve consolidation 

within an industry. Regardless of how industry consolidation is achieved, it often results in reductions in 

employment (such as those documented in Chart 3). 

However, from a lender’s perspective, an orderly consolidation process through mergers and acquisitions is 

preferable to a disorderly shakeout of firms through 

bankruptcies. 

Recent favorable capital market conditions have 

allowed firms in troubled industries to consolidate 

through mergers. Acquisitions are sometimes financed 

through corporate borrowings or, more commonly, by 

swapping equity shares that have been rising in value 

during the bull market of the 1990s.6 Recent consolidation in commodity industries could be depicted as an 

6 According to Loan Pricing Corporation’s Gold Sheets, syndicated 

and leveraged lending related to mergers and acquisitions reached a 

record high of $80 billion in the second quarter of 1998, which represents about 30 percent of the total syndicated and leveraged lending 

market for that period. 

Kansas City Regional Outlook 6 Third Quarter 1999 
In Focus This Quarter
 

orderly process, associated with record-high merger and 

acquisition activity, near-record-low business bankruptcy filings, and low credit losses on commercial and 

industrial (C&I) loans. However, a sudden change in 

financial market conditions characterized by sharply 

higher interest rates, lower stock values, or both could 

inhibit the ability of businesses to restructure and retool 

on their own. This could lead to a much more disorderly shakeout of firms accompanied by a rise in business 

bankruptcies and losses to lenders. 

Signs Point to Rising Credit Risk 

in the Commodity Industries 

In dollar terms, the largest commercial bank exposures 

to the commodity industries are in the portfolios of 

large banks. Chart 6 provides an estimated breakdown 

of the aggregate exposure of insured institutions to 

commodity industries based on corporate balance sheet 

information collected by the Bureau of the Census.7 The 

chart shows that the aggregate exposure of the bank and 

thrift industries to these sectors is approximately $206 

billion, or 26 percent of the total industry C&I portfolio. The largest single industry exposure is to the chemical industry, which represents approximately 9.5 

7 Because of the limitations of the data, bank exposures to corporations engaged in agriculture are not broken out in Chart 6. 

CHART 6 

Commodity Industries Make Up
 

Over One-Quarter of Bank C&I Loans
 

to Corporate Borrowers
 

Mining Total Loans Lumber & Paper* 3.2% 4.4% Outstanding

as of 12/31/98= Petroleum & Coal $778.3 Billion** 1.2% 

Electronics 

4.2% 

Chemicals* 

9.5% All Other 

73.5% Textiles
 

1.2%
 

Iron & Steel 

1.1% 

Automobiles 

1.7% 

* “Lumber & Paper” includes lumber and wood products and paper and allied 

products as reported by the Bureau of the Census; "Chemicals" includes chemical 

and allied products and industrial chemicals and synthetics as reported by the 

Bureau of the Census. 

** Total includes bank loans not elsewhere classified to the nonfarm nonfinancial 

corporate business sector as reported in the Flow of Funds. Component loan 

amounts represent short-term and long-term bank loans on corporate balance 

sheets, by sector, as reported by the Bureau of the Census. 

Sources: Bureau of the Census (Haver Analytics); Federal Reserve Board 

percent of bank C&I loans. In the syndicated loan market, where large U.S. banks dominate in terms of originations, about 25 percent of all loans made in 1998 were 

to firms operating in the manufacturing sector. 

A rough indicator of recent trends in the credit risk 

associated with bank loans to commodity industries can 

be found in expected default frequencies (EDFs) calculated by KMV Corporation. The EDF is an estimate of 

the probability that a firm will default on its bond obligations within one year.8 Chart 7 tracks the median EDF 

for firms operating in commodity industries compared 

with the median for all other firms rated by KMV. This 

chart shows that while the median EDF for commodity 

industries has consistently exceeded the median for all 

other firms in the recent past, this difference has 

widened appreciably since the middle of 1998. Over the 

past year, the median EDF for commodity industries has 

more than doubled, rising from 0.8 percent to 1.9 percent, while the median EDF for all other firms has doubled as well, from 0.6 percent to 1.2 percent. These data 

indicate that the level of credit risk associated with corporate borrowers has been increasing, led by an 

increased probability of default among firms operating 

in commodity industries. 

8 KMV’s proprietary calculation for EDF is based on 1) the current 

market value of the firm, 2) the structure of the firm’s current obligations, and 3) the vulnerability of the firm to large changes in market 

value. 

CHART 7 

The Default Risk of Firms Operating 

in Commodity Industries Has 

Risen over the Past Year 

Median Expected Default Frequency (EDF)* 

(Probability that a Firm Will Default on Bond 

Obligations within One Year) 

KMV’s proprietary calculation for EDF is based on 1) the current market value of the firm, 

2) the structure of the firm’s current obligations, and 3) the vulnerability of the firm to large 

changes in market value. 

* Sectors included in the calculation of EDF for commodity industries include 

the following KMV aggregates: agriculture; automotive; chemicals; electrical 

equipment; electronic equipment; lumber and forestry; mining; oil refining; oil, 

gas, and coal exploration and production; paper; semiconductors; steel and metal 

products; and textiles. 

Source: KMV Corporation 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

Firms in Other Industry Sectors 

Firms in Commodity Industries 

05/96 12/96 07/97 02/98 09/98 04/99 

Kansas City Regional Outlook 7 Third Quarter 1999 
In Focus This Quarter
 

Effects on Local Economies and 

the Banks That Operate in Them 

The economic effects of adversity in commodity industries tend to be most severe in local areas that depend 

heavily on these sectors for employment and income. In 

the 1980s, problems in the agricultural and oil sectors 

kicked off a “rolling recession” that spread through the 

Plains states and oil-producing regions of the southcentral and western states. In agricultural regions, farmland values began to decline around 1981, contributing 

to the failure of hundreds of FDIC-insured banks 

between 1984 and 1990.9 Similarly, declining oil prices 

in the mid-1980s contributed to the failure of federally 

insured banks and thrifts in Texas, Oklahoma, 

Louisiana, and other states, while the attempts of some 

institutions to diversify into risky real estate investments resulted in still more failures. The FDIC’s analysis of these episodes emphasizes how industry-sector 

problems can affect local economies and bank credit 

quality.10 Moreover, the study shows that there can be a 

significant lag between the onset of industry-sector 

problems and the emergence of performance problems 

9 Federal Deposit Insurance Corporation, Division of Research and
 

Statistics (1997). History of the Eighties: Lessons for the Future,
 

Vol. 1, An Examination of the Banking Crises of the 1980s and 


Early 1990s. pp. 275–276, http://www.fdic.gov/databank/hist80/
 

index.html.
 

10 Federal Deposit Insurance Corporation (1997). See Chapters 8 


and 9.
 

TABLE 1 

in the banking industry. Although banks with direct 

credit exposures to a troubled industry are likely to be 

affected first, virtually all banks that operate in areas 

that are heavily dependent on a troubled sector will 

eventually have to contend with the indirect effects on 

the local economy. 

To evaluate the extent of local economic effects that 

might have resulted from the recent adverse trends in 

the commodity industries, we have conducted analysis 

on 1,027 U.S. counties identified as particularly dependent on at least one commodity industry (see Table 1 for 

a list of the commodity industries studied).11 The purpose of this analysis is not to identify every county that 

might be affected by these trends; instead, this analysis 

focuses on the U.S. counties most concentrated in the 

commodity industries and determines if these counties 

and banks that operate in them are showing any symptoms of widespread distress. 

Table 2 compares 1998 average job growth and unemployment rates in these “most concentrated counties” 

against the average for all U.S. counties. This comparison shows that the concentrated counties tended to have 

moderately lower job growth and higher unemployment 

than the U.S. average. However, further analysis shows 

11 Counties identified as being highly dependent on one or more commodity industries had an average population of 36,250 in 1998 versus 

86,055 for all U.S. counties. 

U.S. Counties Most Concentrated in Commodity Industries 

by 1998 Payroll Employment 

NUMBER OF 

PERCENT OF COUNTIES WITH 

1998 COUNTY EMPLOYMENT 

EMPLOYMENT IN CONCENTRATION STATES WITH THE MOST 

THE INDUSTRY IN 1998 DESIGNATED COUNTIES 

AGRICULTURE >30 295 TX, NE, SD, KS, MO 

LUMBER AND PAPER >5 305 GA, AL, MS, AR 

OIL AND GAS >5 83 TX, OK, LA 

CHEMICALS >5 46 TN, IL, NC, TX 

STEEL >5 70 KY, OH, AR, IN 

AUTOS >5 118 MI, IN, OH, KY, TN 

TEXTILES >5 156 GA, NC, SC, VA, AL 

ELECTRONICS AND SEMICONDUCTORS >5 33 TX, NY, IN, IA 

Any Commodity Industry N/A 1,027 TX, GA, NC, TN, AL 

All U.S. Counties N/A 3,142 N/A 

Source: WEFA, based on data from the Bureau of Labor Statistics 

Kansas City Regional Outlook 8 Third Quarter 1999 
In Focus This Quarter
 

TABLE 2 

Relative Economic Performance of Counties 

Most Concentrated in Commodity Industries 

1998 AVERAGE 1998 AVERAGE 

EMPLOYMENT GROWTH (%) UNEMPLOYMENT RATE (%) 

AGRICULTURE 1.1 4.8 

LUMBER AND PAPER 1.3 6.9 

OIL AND GAS 1.4 5.6 

CHEMICALS 1.3 6.0 

STEEL 1.7 5.6 

AUTOS 1.8 4.4 

TEXTILES 0.9 5.1 

ELECTRONICS AND SEMICONDUCTORS 1.9 3.7 

Any Commodity Industry 1.3 5.5 

All U.S. Counties 1.6 5.1 

Source: Bureau of Labor Statistics, Household Survey (Haver Analytics) 

that the current situation is not unusual in that job markets in concentrated counties have tended to consistently underperform other U.S. counties over the past two 

decades. On the whole, the economic picture did not 

noticeably deteriorate in 1998 for the concentrated 

counties. Average unemployment declined in 1998 for 

every group of concentrated counties except oil counties, and average job growth increased in every group of 

counties except textile counties. These data indicate that 

while recent problems in the commodity industries 

might be having severe effects in specific areas, these 

problems had not translated into a broader weakening of 

economic performance through the end of 1998. 

The financial performance of insured institutions operating in concentrated counties is evaluated in Table 3 

(next page). The table provides average C&I loan performance and profitability ratios for 1,915 banks and 

thrifts identified as having at least 25 percent of their 

deposits in at least one of the concentrated counties as 

of June 1998.12 The average C&I loan charge-off ratio 

for concentrated counties overall was higher than the 

U.S. average, driven largely by higher average charge12 This analysis identifies the location of deposits by county through 

the Summary of Deposits report for June 1998, the most recent report 

available. The analysis is limited to institutions reporting at least $1 

million in C&I loans as of December 31, 1998. Institutions operating 

in one or more concentrated counties and meeting all the selection 

criteria averaged $195 million in total assets as of December 31, 

1998, compared with an average of $733 million in assets for institutions operating in any U.S. county. 

offs in both agricultural and oil and gas counties. Comparisons of past-due and noncurrent C&I loans also 

indicate that institutions operating in agricultural and 

oil and gas counties tend to have more problem credits 

than the U.S. average.13 During the 12 months ending in 

December 1998, the average noncurrent loan ratio 

jumped from 4.8 percent to 6.1 percent for institutions 

operating in agricultural counties, while the average 

ratio rose from 2.7 percent to 3.8 percent for institutions 

operating in oil and gas counties. 

These results indicate that while profitability in 1998 

remained solid for the average bank operating in concentrated counties, credit losses appeared to be on the 

rise in agricultural and oil and gas counties. However, 

because this analysis relies on annual data that extend 

only through 1998, it is by design a backward-looking 

test for the local effects of problems in the commodity 

industries. There is every reason to expect these credit 

problems to intensify over time if commodity prices 

remain low.14 These considerations suggest that bankers 

in commodity-dependent counties should continually 

13 Past-due loans are defined as loans that have been past due for 30 

to 89 days. Noncurrent loans are defined as loans that have been past 

due for 90 or more days plus loans placed in nonaccrual status. 

14 For more information on how the agricultural outlook could affect 

FDIC-insured institutions, see the statement of FDIC Chairman 

Donna Tanoue to the Committee on Agriculture, U.S. House of 

Representatives, February 12, 1999, http://www.fdic.gov/publish/ 

speeches/99spchs/spc13apr.html. 

Kansas City Regional Outlook 9 Third Quarter 1999 
In Focus This Quarter
 

TABLE 3 

Relative Financial Performance of Insured Institutions Operating in Counties 

Most Concentrated in Commodity Industries 

NUMBER OF AVERAGE C&I AVERAGE AVERAGE NET 

BANKS WITH AT LOANS PAST DUE NONCURRENT C&I LOAN 

INCLUDES ONLY INSURED LEAST 25% OF 30 TO 89 DAYS, C&I LOANS, CHARGE-OFFS, AVERAGE 

INSTITUTIONS WITH DEPOSITS IN A AS PERCENT AS PERCENT AS PERCENT OF RETURN ON 

AT LEAST $1 MILLION DESIGNATED OF LOANS, OF LOANS, AVERAGE LOANS, ASSETS, 

IN C&I LOANS COUNTY 12/31/98 12/31/98 1998 1998 

AGRICULTURE 416 5.08 6.12 1.58 1.16 

LUMBER AND PAPER 465 3.38 1.89 0.78 1.21 

OIL AND GAS 163 3.44 3.78 1.18 1.29 

CHEMICALS 81 2.47 2.97 0.79 1.18 

STEEL 186 2.53 2.06 0.59 1.08 

AUTOS 341 2.64 2.05 0.66 1.12 

TEXTILES 264 2.91 1.92 0.70 1.10 

ELECTRONICS AND 

SEMICONDUCTORS 107 2.71 2.36 0.68 0.87 

Any Commodity 

Industry 1,915 3.39 3.03 0.93 1.13 

All U.S. Counties 8,485 2.91 2.50 0.76 1.05 

Noncurrent loans include loans past due 90 or more days plus loans placed on nonaccrual status. 


C&I = Commercial and industrial.
 

Sources: Summary of Deposits, Division of Research and Statistics, FDIC; Bank and Thrift Call Reports (Research
 

Information System)
 

monitor their local economy for signs of stress related 

to problems in the commodity industries. 

Conclusion 

Businesses operating in a range of commodity and manufacturing industries continue to grapple with weak or 

declining prices. This problem is not solely the result of 

industry-specific factors; it is part of long-term economic trends that may continue for some time. Signs of 

stress among firms in these industries are apparent in 

the form of declining levels of employment and slow or 

negative profit growth. However, there are few signs to 

date of any disorderly industry shakeouts involving 

widespread business bankruptcies and losses to lenders. 

Thus far, most firms have managed to cope with 

the situation by cutting costs and consolidating operations through mergers. At the same time, more forwardlooking indicators show that the level of credit risk 

associated with commodity industries may be on the 

rise. An analysis of the U.S. counties most heavily 

dependent on these industries showed few signs of a 

widespread deterioration in the performance of their 

economies or in the profitability of their local depository institutions through the end of 1998. However, there 

are signs of rising credit losses among local depository 

institutions in counties with the highest concentrations 

of agriculture and oil and gas extraction. A continuation 

of today’s weak pricing picture in these industries has 

the potential to result in higher credit losses for insured 

institutions during the next few years. 

Richard A. Brown, Chief, 

Economic and Market Trends Section 

Alan Deaton, Economic Analyst 

Kansas City Regional Outlook 10 Third Quarter 1999 
In Focus This Quarter
 

Shifting Funding Trends Pose Challenges 


for Community Banks 


•	 Several long-term trends are making it more difficult for some institutions to economically fund 

asset growth with deposits in today’s marketplace. 

•	 Lagging deposit growth in recent years has resulted in greater reliance on alternative funding 

sources to meet loan demand. 

•	 Liability management may become more important and more challenging for community banks 

that have historically relied upon deposits for 

funding and net interest revenues for profitability. 

For the past few years, assets have been expanding 

faster than deposits at many commercial banks. The 

result is an increased reliance on equity and borrowings 

for funding. Since 1992, commercial bank assets have 

grown at an average annual rate of 6.3 percent compared with a 3.9 percent average annual growth rate for 

deposits. Traditional measures of liquidity and funding 

for commercial banks reflected record-low levels of 

deposit funding at year-end 1998. Large commercial 

banks have traditionally made greater use of nondeposit 

funding alternatives. However, many community 

banks,1 which have typically relied more on deposit 

funding, may face liability management challenges as a 

result of shifting funding trends. This article surveys the 

factors influencing the ability of banks to fund loan 

growth with deposits, discusses community bank funding trends, and considers the implications of these 

trends for community banks. 

Factors Influencing Deposit Funding Trends 

The percentage of commercial bank assets, particularly 

loans, funded with deposits has declined steadily in the 

1990s. As shown in Chart 1, the industry’s ratios of 

deposits to assets and loans to deposits reflect a longerterm shift away from deposit funding. Although the 

level of these industry ratios is heavily influenced by 

larger banks, the trend toward lower deposit funding 

exists for both large banks and community banks and 

points to secular factors that are affecting banks’ ability 

to raise deposits in step with asset growth. 

Trends in Household Wealth Accumulation 

One factor affecting the ability of banks to attract 

deposits is the recent trend in the way households are 

amassing wealth. While the total wealth of U.S. households has soared in recent years because of unrealized 

capital gains on housing and investments, annual net 

purchases of new financial assets2 by households as a 

percentage of disposable income have actually trended 

downward since the mid-1980s (see Chart 2, next page). 

A falling personal savings rate and fewer purchases of 

financial assets may suggest that households are more 

comfortable consuming a higher percentage of current 

income as long as capital gains are adding to their accumulated wealth. However, because households have 

been setting aside less of their current income for savings, the pool of new funds available to purchase bank 

deposits has been growing more slowly. 

Higher-Yielding Investment Alternatives 

At the same time that households have been setting 

aside less of their current income for savings, the share 

of total new household savings flowing into bank 

deposits has declined in the 1990s as competition from 

higher-yielding alternatives has increased. During the 

1980s, over 30 percent of the cumulative net increase in 

2 Financial assets are defined as deposits, money market and mutual 

fund shares, credit market instruments, corporate equities, life insurance reserves, pension fund reserves, and trust reserves. 

CHART 1 

The Deposit-to-Asset and Loan-to-Deposit
 

Ratios Reflect Reduced Deposit


 Funding for Commercial Banks
 

Recession 

Ratio (%) Deposit-to-Asset Ratio 

90 

85 

80
 

75
 

70
 

65
 

60
 

55
 

50
 

Loan-to-Deposit Ratio 

’70 ’74 ’78 ’82 ’86 ’90 ’94 ’98 

Sources: FDIC Historical Statistics on Banking; Research Information System 1 Defined here as banks with total assets of $1 billion or less. 

Kansas City Regional Outlook 11	 Third Quarter 1999 
In Focus This Quarter
 

CHART 2 

Total Annual Additions* to Financial Assets 

of Households and Nonprofit Organizations 

Have Declined with Personal Savings Rate 

Percentage of Disposable 

Personal Income 

Net Acquisition 

15 

10 

5 

0 

20 

of Financial Assets 

Personal Savings 

’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

* Excludes capital gains 

Sources: Federal Reserve Board; Flow of Funds 

financial assets by households and nonprofit organizations flowed into deposits. In contrast, less than 15 percent of the cumulative net increase in financial assets 

has flowed into deposits during the 1990s, although an 

increasing proportion has been allocated to deposits in 

recent years. 

Not only do banks face intensifying competition from 

other banks and thrifts, as indicated by 66 percent of the 

respondents in Grant Thornton’s 1999 Sixth Annual 

Survey of Community Bank Executives,3 but they also 

3 Grant Thornton’s 1999 Sixth Annual Survey of Community Bank 

Executives, “Community Banks: A Competitive Force,” http://www. 

grantthornton.com/resources/finance/banksurvey99/survey99w.html. 

CHART 3 

face increasing competition from mutual funds and 

other nonbank financial service providers, such as credit unions. 

Mutual Funds. Increasingly, consumers are pursuing 

higher yields by investing in mutual funds. Beyond 

yields, however, many mutual fund companies also are 

competing effectively with banks on the basis of convenience by offering money market accounts that allow 

check writing, automated teller machine cards, and 

check cards. Chart 3 shows the changes in the composition of household liquid assets during the 1990s. In 

1990, bank deposits constituted 38 percent of households’ liquid assets versus 11 percent for mutual funds 

and money market funds; at year-end 1998, the shares 

were nearly even. While some of the change in composition can be explained by rising mutual fund share 

prices, other measures indicate a shifting preference for 

mutual funds as a savings vehicle. For example, data 

from the Investment Company Institute show that net 

inflows into mutual funds have exceeded net increases 

in insured institution deposit accounts in all but three 

quarters during this economic expansion. Moreover, the 

first quarter of 1999 marked the seventeenth consecutive quarter that mutual fund inflows outstripped 

increases in deposits for all FDIC-insured institutions. 

Credit Unions. In addition to mutual funds, credit 

unions also are formidable competitors for consumer 

savings. Membership in credit unions has increased 

more than 20 percent over the past decade, while 

deposits and share accounts have risen by over 90 perHouseholds Are Holding a Greater Share of Liquid Assets in Mutual Funds 

1990 1998 

U.S. Government 

Securities
 

7%
 

Equities, Bonds, 

and 

Commercial 

Paper 44% 

Money Market 

Fund Shares 

5% 

Mutual Fund
 

Shares
 

6%
 

Bank Deposits 

(excl. Foreign) 

38% 

Money Market Mutual Fund 

Fund Shares Shares 

7% 22% 

Equities, Bonds, Bank Deposits 

and Commercial (excl. Foreign) 

Paper 35% 30% 

U.S. Government 

Securities
 

6%
 

Source: Federal Reserve Board 

Kansas City Regional Outlook 12 Third Quarter 1999 
In Focus This Quarter
 

cent.4 Credit unions also offer federal insurance on share 

accounts as well as competitive rates on comparable 

deposit-type vehicles relative to other types of financial 

institutions. For example, according to information from 

the National Credit Union Association, on average, 

credit unions have offered rates on one-year share certificates in excess of one-year bank certificates of 

deposit in nine of the past ten years. As shown in Chart 

4, average rates paid by credit unions on one-year share 

certificates over the 12 months ending May 1999 were 

consistently higher than rates offered by banks or thrifts 

and approached retail rates offered by brokerages. 

Demographic Shifts 

Some analysts maintain that rural community banks 

face additional funding challenges as a result of demographic shifts. According to the Federal Reserve Bank 

of Kansas City, rural bankers perceive that sluggish 

deposit growth is at least partially attributable to the 

migration of deposits to cities as urban-dwelling heirs 

of rural depositors relocate funds. While evidence for 

this deposit migration remains anecdotal, economists at 

the Federal Reserve Bank of Kansas City indicate that 

the demographic shift is still in process, and its full 

effect may not be felt for some time. Further challenging deposit growth for banks, additional evidence suggests that urban dwellers tend to place less of their 

4 Center for Credit Union Research, “Credit Union FAQ,” http:// 

wiscinfo.doit.wisc.edu/bschool/cu/cufaq.html. 

CHART 4 

Bank One-Year CD Rates Have Recently Lagged
 

Those Offered by Competitors
 

Average Retail Rates Offered for 

One-Year Certificates (%) 

6.0 

3.0 

3.5 

4.0 

4.5 

5.0 

5.5 

Thrifts 

Credit Unions 

Banks 

Brokerages 

Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 

’98 ’98 ’98 ’98 ’98 ’98 ’98 ’99 ’99 ’99 ’99 ’99 

Sources: BanxQuote and Bank Rate Monitor 

savings in banks than their rural counterparts do.5 This 

trend poses additional consequences for bank deposits 

as rural populations migrate to suburban areas. 

Community Bank Funding Trends 

Community banks traditionally rely more heavily upon 

core deposit funding than larger banks do. For example, 

Chart 5 (next page) shows that 72 percent of aggregate 

community bank assets were funded with core deposits 

at year-end 1998. In contrast, 43 percent of aggregate 

large bank assets at year-end 1998 were funded with core 

deposits. This difference in liability structures reflects 

large banks’ broader use of wholesale funding alternatives and greater access to capital markets instruments. 

While large banks have responded to factors influencing deposit 

growth by making greater use of 

alternative funding sources, 

funding options for community 

banks tend to be more limited. 

Because of high fixed costs, community banks may find 

it more difficult than larger institutions to make costeffective use of capital market instruments such as securitizations or public debt and equity offerings (see 

“Industry Consolidation Presents Unique Risks and 

Challenges for Community Banks,” Regional Outlook, 

Fourth Quarter 1998, for a discussion of additional nondeposit funding sources for community banks). 

The need to augment lagging deposit growth to meet 

loan demand has led many community banks to acquire 

more noncore funds. These funds include time deposits 

greater than $100,000, borrowings, foreign deposits, 

brokered deposits, and demand notes. At year-end 1998, 

nearly 75 percent of community banks held noncore liabilities representing 10 percent or more of total liabilities. As recently as 1993, only 42 percent of community 

banks exceeded that threshold. Moreover, over the same 

five-year period, the ratio of core deposits (defined here 

as total deposits less time deposits greater than 

$100,000 and brokered deposits) to total deposits for all 

community banks declined each quarter. 

5 William R. Keeton, Federal Reserve Bank of Kansas City. “Are 

Rural Banks Facing Increased Funding Pressures? Evidence from 

Tenth District States.” Economic Review, Second Quarter 1998, p. 56. 

Also see “Regional Banking,” Regional Outlook, Kansas City Edition, Second Quarter 1998, p. 24. 

Kansas City Regional Outlook 13 Third Quarter 1999 
In Focus This Quarter
 

CHART 5 

Community Banks Relied More Heavily than Large Banks on Core Deposits* at Year-End 1998 

Large Banks Community Banks 

(total assets over $1 billion) (total assets under $1 billion) 

* Core deposits include total domestic deposits less time deposits greater than $100,000 and brokered deposits issued in denominations of less than $100,000. 

Source: Bank Call Reports (Research Information System) 

Other 

Domestic 

Deposits 

7% 

Borrowings 

16% 

Other 

Liabilities 

12% 

Equity and 

Subordinated 

Debt 

9% 

Core 

Deposits 

43% 

Foreign 

Deposits 

13% 

Other Domestic 

Deposits 

11% 

Borrowings 

6% 

Other 

Liabilities 

1% 

Equity and 

Subordinated Debt 

10% 

Core 

Deposits 

72% 

As community banks’ use of noncore funds has 

increased, they are relying more on federal funds purchased, repurchase agreements, other borrowings, 

demand notes, and mortgages (collectively referred to 

as borrowings). After adjusting for mergers, borrowings 

funded 12 percent of new community bank asset growth 

from 1992 through 1998—three times more than the 

percentage of new asset growth funded by borrowings 

from 1985 to 1990. Possibly reflecting a shift toward 

greater acceptance of wholesale funding by community 

bankers, growth in borrowings has been largely driven 

by increased use of nonovernight borrowings,6 which 

have become the dominant form of borrowings at community banks. As shown in Chart 6, the proportion of 

community banks reporting nonovernight borrowings 

has doubled in the 1990s. This trend coincides with 

growing community bank membership in the Federal 

Home Loan Bank (FHLB) system and increasing use of 

FHLB borrowings. 

Federal Home Loan Bank Membership 

Over the past five years, community banks have substantially increased their membership and participation 

in the FHLB system. According to data from the Federal Housing Finance Board, for the five-year period 

ending in 1998, the percentage of FDIC-insured community banks that were members of the FHLB more 

than doubled to 50 percent. Over the same period, FHLB 

advances outstanding for community banks grew by 

more than 50 percent to $47 billion. At year-end 1998, 

6 Nonovernight borrowings are defined here as all borrowings other 

than federal funds purchased and repurchase agreements. 

FHLB advances represented approximately 80 percent 

of all nonovernight borrowings for community banks. 

Analysts have cited a number of reasons why community banks are joining the FHLB system. Community 

banks are using FHLB advances to meet contingent liquidity needs, manage interest rate risk, fund new asset 

growth, and leverage capital to maintain or boost 

returns on equity. Recent surveys indicate that FHLB 

advances will continue to have a role in community 

bank liability management. Almost one-half of respondents to Grant Thornton’s 1999 Annual Survey of 

Community Bank Executives considered FHLB borrowings an important funding source over the next three 

years, and 43 percent plan to increase the use of FHLB 

advances in 1999. Similarly, the American Bankers 

Association’s 1999 Community Bank Competitiveness 

CHART 6 

’97 

0 

10 

20 

30 

40 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’98 

The Percentage of Community Banks Reporting 

Nonovernight Borrowings* Is Rising 

Community Banks 

Reporting Nonovernight 

Borrowings (%) 

* Includes all borrowings other than federal funds purchased and repurchase 

agreements 

Source: Bank Call Reports (FDIC Research Information System) 

Kansas City Regional Outlook 14 Third Quarter 1999 
In Focus This Quarter
 

Survey7 reported that FHLB advances are the preferred 

nontraditional funding product. In addition, legislative 

changes enacted in third-quarter 1998 have eased membership requirements for banks with assets less than 

$500 million, significantly increasing access to FHLB 

advances for smaller banks in rural areas. 

Implications of Funding Trends 

for Community Banks 

According to community banker opinion surveys, the 

trend toward greater reliance on noncore or alternative 

funding sources appears likely to continue. Grant 

Thornton’s 1999 Annual Survey of Community Bank 

Executives found that 75 percent of community bankers 

expect funding with core deposits to be more difficult in 

three years than it is today. Moreover, more than 20 percent of community bankers responding to the American 

Bankers Association’s 1999 Community Bank Competitiveness Survey do not expect to derive the bulk of their 

funding from deposits five years from now. Liability 

management is an important aspect of a bank’s operations and a key driver of interest expense. Responses to 

funding challenges will likely influence strategic business decisions that shape the risk profiles of insured 

institutions, particularly community banks that historically have relied more heavily upon core deposits to fund 

asset growth and net interest income for profitability. 

A fundamental challenge that confronts bank management is the strategic response to the increased costs 

associated with wholesale funding sources. As shown in 

Chart 7, the reported interest costs of nondeposit funding alternatives, such as federal funds purchased and 

repurchase agreements, subordinated notes, and FHLB 

advances, have traditionally exceeded the interest cost 

of core deposits for commercial banks. Therefore, as 

institutions that have typically relied upon core deposits 

increase the use of nondeposit sources, funding costs 

will likely rise relative to asset yields. As a result, net 

interest margins (NIMs) may be pressured. 

To some extent bank managers may be able to offset the 

higher interest costs of wholesale funding strategy by 

improving efficiency through greater management of 

overhead expenses and increases in noninterest income. 

However, community banks face challenges to their 

ability to increase noninterest income (see “Industry 

Consolidation Presents Unique Risks and Challenges 

CHART 7 

Subordinated Debt 

FHLB Advances 

0 

1 

2 

3 

4 

5 

6 

7 

8 

’93 ’94 ’95 ’96 ’97 ’98 

Reported Interest Cost for Commercial Banks (%) 

Nondeposit Alternatives Have Typically Cost 

More than Core Deposits 

Federal Funds 

Core Deposits* 

* Core deposit costs equal interest expense on total deposits minus time deposits 

greater than $100,000 divided by average total deposits minus average time 

deposits greater than $100,000. 

Sources: Bank Call Reports (FDIC Research Information System) and Federal 

Home Loan Bank (FHLB) System Annual Reports 

’ 

for Community Banks,” Regional Outlook, Fourth 

Quarter 1998), and there are limits to cost cutting. If 

banks are unable to fully offset higher funding costs 

with increases in noninterest income or reductions in 

noninterest expenses, overall profitability could suffer. 

Community bankers in the upper Midwest expressed 

this concern in a 1998 survey conducted by The Federal Reserve Bank of Minneapolis, which found that 57 

percent of respondents expect the shift away from 

deposit funding to decrease bank profitability.8 As bank 

managers search for additional ways to offset the relative rise in funding costs, they may be tempted to 

increase asset yields by pursuing additional portfolio 

risk, in the form of credit or market risk, to generate 

higher asset yields. 

Funding challenges also could alter the liquidity and 

interest rate risk positions of community banks. The relative complexity and volatility of some nondeposit 

sources require greater expertise and attention to assetliability policies and practices to avoid unexpected 

liquidity strains or exposures to changing interest rate 

environments. Strategies that result in the pledging of 

liquid assets, overreliance on purchased funds, or concentrations in price-sensitive long-term assets could 

adversely affect a bank’s relative liquidity or interest 

rate risk position. Moreover, interest rate risk management can be further challenged by the complexity of 

nondeposit funding sources. For instance, some FHLB 

advances may contain embedded options that required 

greater expertise and attention to policies and practices 

that, if not managed properly, could lead to undesirable 

outcomes if interest rates change adversely. 

7 ABA Banking Journal, February 1999, p. 30. 8 Fedgazette, July 1998, p. 2. 

Kansas City Regional Outlook 15 Third Quarter 1999 
In Focus This Quarter
 

Differences between Community Banks with 

High and Low Levels of Core Deposit Funding 

To evaluate how a shift from a core deposit funding 

strategy might change the profile of a community bank, 

TABLE 1 

performance and condition measures for community 

banks that rely most heavily on core deposits were contrasted with those that are least reliant on core deposit 

funding. Table 1 compares 1998 funding, earnings, and 

asset performance measures for these community bank 

Comparison of Banks with High and Low Levels of Core Deposit Funding 

ALL COMMUNITY BANK COMMUNITY BANK 

COMMUNITY BANKS1 AGRICULTURAL LENDERS2 COMMERCIAL LENDERS3 

HIGH CORE LOW CORE HIGH CORE LOW CORE HIGH CORE LOW CORE 

DEPOSIT DEPOSIT DEPOSIT DEPOSIT DEPOSIT DEPOSIT 

FUNDING4 FUNDING4 FUNDING FUNDING FUNDING FUNDING 

Selected Aggregate Measures 

NUMBER OF BANKS IN GROUP 405 405 106 51 126 185 

MEDIAN TOTAL ASSETS ($000S) 46,244 118,358 23,274 58,223 69,479 130,923 

MEMBERS OF FHLB (%) 32.10 49.38 17.92 47.06 38.89 50.81 

HAVE OUTSTANDING FHLB ADVANCES (%) 7.65 40.25 6.60 45.10 7.14 38.38 

Selected Median Liquidity and Funding Measures (%) 

1998 GROWTH IN TOTAL ASSETS 9.02 11.16 5.96 6.42 12.75 18.50 

1998 GROWTH IN TOTAL DEPOSITS 9.74 8.79 6.40 5.31 13.56 11.93 

1998 GROWTH IN BORROWINGS (50.00) 28.62 (64.49) 31.85 (51.87) 42.87 

1998 GROWTH IN TOTAL EQUITY CAPITAL 5.93 7.53 3.46 5.39 9.94 8.85 

TOTAL DEPOSITS-TO-TOTAL ASSETS RATIO 91.04 75.68 90.35 80.22 91.23 77.94 

CORE DEPOSITS-TO-TOTAL ASSETS RATIO 87.29 53.87 87.10 55.81 87.21 54.03 

BORROWINGS TO TOTAL ASSETS RATIO 0 9.58 0 4.15 0 8.55 

TOTAL EQUITY CAPITAL TO TOTAL ASSETS RATIO 8.25 10.24 9.00 10.09 7.74 10.16 

Selected Median Performance Ratios (%) 

RETURN ON EQUITY 12.65 10.19 11.10 10.93 14.49 9.52 

RETURN ON ASSETS 1.07 1.04 1.01 1.19 1.10 0.92 

NET INTEREST MARGIN 4.76 4.03 4.51 3.98 5.25 4.22 

GROSS EARNING ASSET YIELD5 8.17 8.02 8.24 7.89 8.45 8.26 

COST OF FUNDING EARNING ASSETS6 3.33 4.07 3.74 4.05 3.21 4.05 

NONINTEREST INCOME TO AVERAGE ASSETS 0.76 0.61 0.59 0.44 1.01 0.64 

NONINTEREST EXPENSE TO AVERAGE ASSETS 3.49 2.90 3.23 2.40 3.99 3.12 

EFFICIENCY RATIO7 69.01 63.68 68.59 57.48 68.99 67.00 

Selected Median Credit Quality Measures (%) 

NONPERFORMING ASSETS TO TOTAL ASSETS RATIO 0.39 0.44 0.40 0.51 0.46 0.61 

NONCURRENT LOANS TO TOTAL LOANS RATIO 0.53 0.72 0.53 1.02 0.52 0.77 

NET LOAN CHARGE-OFF RATIO 0.11 0.12 0.04 0.15 0.14 0.11 

1998 GROWTH IN NONPERFORMING ASSETS (9.10) 7.50 10.57 11.79 (17.32) 23.97 

1998 GROWTH IN NET LOAN LOSSES 6.09 10.24 (3.90) 23.73 9.59 30.64 

1 Community banks are banks with $1 billion or less in total assets. 

2 Agricultural lenders are banks with 25 percent or more of assets in agricultural real estate loans or agricultural production loans.
 

3 Commercial lenders are banks with 25 percent or more of assets in commercial and commercial real estate loans.
 

4 High core deposit funding group is composed of community banks with core deposits-to-assets ratios in the top 5
 

percent of all community banks, excluding those with equity-to-assets ratios in excess of 25 percent. The low core
 

deposit funding group is composed of community banks with core deposits-to-assets ratios in the bottom 5 percent
 

of all community banks.
 

5 Gross earning asset yield equals interest income divided by average earning assets.
 

6 Cost of funding earning assets equals interest expense divided by average earning assets.
 

7 Efficiency ratio equals noninterest expense divided by the sum of net interest and noninterest income.
 

FHLB = Federal Home Loan Bank
 

Sources: Bank Call Reports (Research Information System); Federal Housing Finance Board 


Kansas City Regional Outlook 16 Third Quarter 1999 
In Focus This Quarter
 

groups. High core deposit funders are defined as those 

community banks with core deposit-to-asset ratios in 

the top 5 percent of all community banks at year-end 

1998. Low core deposit funders are those community 

banks with a core deposit-to-asset ratio in the bottom 5 

percent.9 A similar comparison is included for agricultural banks and commercial lending specialists, which 

combined make up roughly 60 percent of each of the 

total community bank funding groups. 

This comparison reveals several differences. First, a 

tradeoff between heavy reliance on core funding and 

asset growth is evident. Median measures for the groups 

indicate that the typical bank that relies less on core 

deposit funding is larger and growing faster than the 

typical bank in the high core funding group. Second, 

less core deposit funding appears to be associated with 

a lower NIM, primarily the result of higher funding 

costs. However, overall profitability 

is similar between the groups 

mainly because of a lower ratio 

of overhead expenses to average assets for the low core 

funders. These characteristics are also evident across 

the agricultural and commercial specialists groups. 

Asset quality indicators suggest that the low core funding groups may exhibit greater credit risk. Although 

higher asset yields resulting from increased portfolio 

risk are not evident, median measures for each low core 

funding group reflect higher levels of noncurrent loans 

and higher growth in nonperforming assets and net loan 

losses relative to its high core funding group counter9 These groups exclude community banks with equity-to-asset ratios 

greater than 25 percent. 

part. For example, the median growth in nonperforming 

assets for commercial lending specialists with less 

reliance upon core deposits was nearly 24 percent in 

1998 versus a 17 percent decline for the high core funding group. 

Summary and Conclusions 

Commercial banks have been experiencing a long-term 

trend toward lower deposit funding of loans and assets. 

Increasing competition among banks and from thrifts, 

nonbanks, and higher-yielding investment alternatives 

has made it more difficult and expensive for some 

banks to attract deposits in step with asset growth. 

While some nondeposit funding alternatives may provide a stable source of funds for insured institutions 

(especially those located in areas characterized by 

aggressive competition and slow deposit growth), better 

matching of asset cash flows, and greater flexibility in 

asset-liability management, they also may pose certain 

risks. To some extent community banks may be able to 

manage noninterest expense and noninterest income to 

offset the relative increase in interest expense incurred 

to acquire nondeposit funding sources. However, if 

overall profitability suffers, banks may be tempted to 

pursue additional portfolio risk to generate higher offsetting asset yields. As a result, liability management 

may become more challenging for community banks 

that have historically relied upon deposits for funding 

and net interest revenues for profitability. In addition, 

the complexity of some nondeposit funding sources 

requires greater expertise and attention to policies and 

practices to avoid unexpected liquidity strains or exposures to changing interest rate environments. 

Allen Puwalski, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Kansas City Regional Outlook 17 Third Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

•	 Today’s economic environment differs from the one that led to the agricultural crisis of the 1980s. Interest 

rates are low and stable, farm debt levels are moderate, and real farmland values have been relatively stable 

throughout the 1990s. 

•	 The Region’s farm banks are reporting higher capital and loan loss reserve levels than in the 1980s, 

indicating that they can better absorb an increase in loan losses. 

•	 Many farm banks have apparently increased their tolerance for risk by increasing lending volume, yet some 

maintain lower-than-average capital levels. 

•	 Although conditions are different from those of the 1980s, several factors may pose significant risks to farm 

banks: continuing low commodity prices, higher loan levels, and uncertainty regarding the future of federal 

farm programs. 

Agricultural Sector under Stress: The 1980s and Today
 

The 1980s were marked by a turbulent agricultural 

economy that saw rapid declines in farm income and 

real estate values. This situation led to the failure of 

many farm banks,1 especially in the Kansas City 

Region. Map 1 shows the location of the 297 farm bank 

failures that occurred nationwide between 1977 and 

1993. As the map shows, the Region was disproportionately affected, with 182 failures, 61 percent of total farm 

bank failures. 

With prices for wheat, corn, soybeans, hogs, and cattle 

depressed again in 1999, many people are beginning to 

ask if the agricultural crisis of the 1980s is about to 

recur. This question has important ramifications for the 

Kansas City Region, because over half the Region’s 

institutions are farm banks, and over half the nation’s 

farm banks are located in the Region. This article compares the economic conditions that led to the farm crisis 

of the 1980s with those of today. While evidence indicates that the agricultural crisis is not about to recur, 

certain factors in the farm sector could cause serious 

problems for the Region’s farmers and farm banks. 

1 The Federal Deposit Insurance Corporation (FDIC) defines farm 

banks as FDIC-insured financial institutions that have at least 25 percent of their loans in agricultural production or secured by agricultural real estate. 

Agriculture Prospered in the 1970s 

To understand the 1980s farm crisis, it is necessary to 

review the conditions of the 1970s, a decade of unprecedented agricultural prosperity. Chart 1 shows the path of 

farm income in the Region, restated in 1998 dollars. 

From 1972 through 1975, real net farm income in the 

Region reached levels never seen before or since and 

remained high through 1979. 

Export demand for farm products grew rapidly in the 

first half of the 1970s, when a number of trends converged to boost U.S. agricultural exports to record levels. Strong income and population growth among 

importing countries increased demand for U.S. products. At the same time, these importers gained access to 

external sources of credit, which, together with a weak 

U.S. dollar, improved their ability to import food and 

feed from the United States. Finally, a 1972 drought in 

the Soviet Union led to the enormous 1973 grain deal.2 

The early 1970s also witnessed tremendous technological changes as many farmers adopted improved 

machinery, chemicals, and fertilizers that led to rapid 

2 Cochrane, W. The Development of Agriculture—A Historical Perspective. 1993. Minneapolis: University of Minnesota. p. 134. 

Kansas City Regional Outlook 18	 Third Quarter 1999 
Regional Perspectives
 

MAP 1 

Bank Failures in the 1980s Were Centered in the Kansas City Region 

1 

2 1 1 

4 

0 

0 

0 

0 0 

8 

36 

31 

6 

5 

39 

33 

48 22 

0 

0 0 1 

0 

4 

0 

0 

0 

0 

0 

0 

0 0 

0 

0 

0 

0 

3 

9 4

29 

1 

0 

5 

5 

0 0 

Number of Agricultural Bank Failures, 

1977–1993 

20 and up (7) 

5 to 19 (6) 

0 to 4 (36) 

Source: FDIC, History of the Eighties 

production increases. In addition, the federal government shared in the exuberance of the era, as the United 

States Department of Agriculture (USDA) encouraged 

farmers to produce as much as possible. It was during 

this period that Secretary of Agriculture Earl Butz made 

his famous appeal for farmers to “plant fencerow to 

fencerow.”3 And they did. Between 1972 and 1981, the 

nation’s wheat acreage increased from 55 million to 88 

3 Peoples, K., et al. Anatomy of an American Agricultural Credit 

Crisis. 1992. Lanham, Md.: Rowan and Littlefield Publishers. p. 20. 

CHART 1 

Agriculture Boomed in the 1970s 

but Struggled in the 1980s 

45 

Kansas City Region Farms 

Excluding Gov’t Payments 

Billions (1998 dollars)

Net Farm Income 

5 

15 

25 

35 

’60 ’63 ’66 ’69 ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 

–5 

Source: USDA 

million acres, corn acreage increased from 67 million to 

84 million acres, and soybean acreage increased from 

47 million to 67 million acres. By 1981, planted acreage 

of these crops reached levels that have never been 

matched. 

Inflation in the 1970s Led to a Negative 

Real Interest Rate 

Macroeconomic developments in the 1970s had farreaching effects on the agricultural sector. Inflation 

(measured by the annual change in the Consumer Price 

Index) had been low throughout the 1950s and 1960s 

but began to increase somewhat as the nation’s involvement in Vietnam and domestic spending for the Great 

Society programs led to budget deficits. Inflation 

spiked significantly in 1974, as the Federal Reserve 

Board attempted to soften the effects of increased energy prices caused by the Arab oil embargo. Inflation continued to escalate in the last half of the 1970s, reaching 

13.5 percent by 1980. 

Chart 2 (next page) shows that interest rates charged by 

agricultural lenders rose significantly and steadily during the 1970s, from an average of 6.7 percent in 1970 to 

more than 11 percent in 1981. However, nominal interest rates, which reflected bankers’ expected inflation 

rates, did not rise commensurately with actual increases 

in inflation. As a result, the “real” interest rate (calculated by subtracting the inflation rate from the nominal 

Kansas City Regional Outlook 19 Third Quarter 1999 
Regional Perspectives
 

CHART 2 

Real Interest Rate 

Percent 

’96 

–4 

0 

4 

8 

12 

16 

The Real Rate of Interest Was Negative 

in the 1970s but Increased in the 1980s 

Inflation Rate Nominal Interest Rate 

’60 ’63 ’66 ’69 ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 

Note: Nominal interest rate is average rate charged by farm lenders. 

Sources: USDA; Bureau of Labor Statistics 

interest rate) was negative for most of the 1970s. This 

unusual situation enabled farmers to borrow today and 

repay tomorrow with fewer real dollars. 

Historically high farm incomes and the negative real 

interest rate that prevailed in the 1970s led to a large 

increase in borrowing by farmers, who increased the 

scale of their operations by purchasing land and 

machinery. The Farm Credit System, commercial 

banks, and insurance companies increased their levels 

of farm lending in the Region from $14 billion in 1970 

to a peak of $57 billion by 1984 (see Chart 3, which 

shows farm debt adjusted for inflation to 1998 dollars). 

Farmland Values Rose to New Heights in the 1970s 

The 1970s also saw a significant escalation in farmland 

values (see Chart 4, which shows changes in farmland 

CHART 3 

values, adjusted for inflation to 1998 dollars). The gradual upswing in farmland prices is evident for 1960 to 

1972, reflecting long-run increases in economic returns 

to farming, largely because of technological improvements in the industry. Farmland prices then rose dramatically, by 2.4 times in the eastern states of the 

Region and 2.0 times in the western states between 

1970 and 1981 (in inflation-adjusted terms), stimulated 

by strong farm income and the increased availability 

of credit. Rapid increases in land values improved 

farmers’ equity positions, allowing them to continue 

borrowing and expanding. 

As Chart 5 shows, despite increasing debt, rapidly 

increasing land values allowed farmers to maintain 

low debt-to-equity ratios. For example, land prices in 

Iowa rose faster and to higher levels than in other 

states in the Region. As a result, the average debt-toequity ratio of Iowa’s farmers actually declined during 

the 1970s. In this environment, the level of lending 

seemed sustainable. 

Prosperity Unraveled in the 1980s 

The Region’s farm income declined appreciably by the 

late 1970s, as the demand for farm exports began to 

subside. A combination of factors led to the drop in 

export demand: improved worldwide production that 

increased global inventory levels; a strengthening U.S. 

dollar that diminished the global competitiveness of 

U.S. products; the emergence of the European Community as an aggressive competitor in world grain markets; 

and enactment of the 1981 Farm Bill, which increased 

U.S. grain price supports and made U.S. products more 

CHART 4 

0 

20 

40 

60 

80 

100 

KC Region Farm Debt 

Source: USDA 

Farm Debt Soared in the 1970s 

but Declined in the 1980s 

Billions (1998 dollars) 

’60 ’63 ’66 ’69 ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 

0 

500 

1,000 

1,500 

2,000 

2,500 

3,000 Minnesota, Iowa, and Missouri 

Dakotas, Nebraska, and Kansas 

Source: USDA 

Farmland Values Soared until 1981 

but Then Plummeted to 1960s’ Levels 

$ per Acre (1998 dollars) 

Jan 1: ’60 ’63 ’66 ’69 ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 ’99 

Kansas City Regional Outlook 20 Third Quarter 1999 
Regional Perspectives
 

CHART 5 

0 

10 

20 

30 

40 

50 

Iowa 

United States 

Kansas 

Source: USDA 

High Debt Levels and Falling Land Values 

Caused Debt-to-Equity Ratios to Spike 

Debt-Equity Ratio (percent) 

’60 ’63 ’66 ’69 ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 

expensive in foreign markets. As a result, in the first 

half of the 1980s the Region’s farm income (in 1998 

dollars) averaged only $6 billion annually, compared 

with $17 billion in the 1970s. Even these modest returns 

were possible only because of government payments 

(see Chart 1); excluding government payments, the 

Region’s agricultural sector lost money during droughtravaged 1983. 

In addition to farm sector problems, macroeconomic 

events worked against highly leveraged farmers in the 

1980s. As seen in Chart 2, inflation declined dramatically in the 1980s, from over 13 percent in 1980 to less 

than 2 percent by 1986. In August 1979, the Federal 

Reserve Board instituted a fundamental change in monetary policy by targeting money supply growth rates 

rather than interest rates. This shift to a more restrictive 

monetary policy enabled the Federal Reserve Board to 

“wring out the demon” of inflation that had characterized the U.S. economy during the 1970s.4 

Nominal interest rates again lagged this relatively rapid 

change in the inflation rate. As a result, the relatively 

high nominal interest rates that had prevailed in the 

1970s persisted into the early 1980s, leading to a rapid 

increase in the real interest rate farm borrowers paid. 

Increases in federal borrowing in the first half of the 

1980s also contributed to the rise in the real interest 

rate. 

4 Mussa, Michael. “U.S. Monetary Policy in the 1980s,” in American 

Economic Policy in the 1980s. Edited by Martin Feldstein. 1994. 

Chicago: University of Chicago Press. p. 103. 

Declining farm incomes reduced farmers’ ability to service large debts accumulated in the 1970s. The supply 

of available credit declined in the early 1980s as bankers 

became more cautious about lending to farmers. During 

this period, many farmers sold out or went bankrupt, 

and collateral values were often less than underlying 

debt because of the decline in real estate values. As 

debts were charged off from lenders’ portfolios, the 

aggregate level of debt declined appreciably.5 As Chart 

3 shows, by 1987 the real value of farm debt in the 

Region had fallen to 1960s levels. 

As Chart 4 shows, by 1987 real farmland values fell to 

mid-1960s levels and returned to the historical trend of 

gradual increase. The rapid decline in land values led to 

a sharp increase in farmers’ debt-to-equity ratios (see 

Chart 5). As noted earlier, the effect was most pronounced in Iowa because that state’s land values registered the largest percentage decline. 

Financial stress was widespread in the Region’s agricultural sector during 1984 through 1986 (see Table 1). 

Iowa had the highest number of distressed farms (more 

than 12,000), while Minnesota and Missouri each had 

the highest percentage of stressed farms (24 percent). 

Missouri had the nation’s highest percentage of insolvent farms (12 percent). 

The aggregate financial ratios only suggest the magnitude of the problem. A USDA survey of Iowa farmers 

5 Peoples, et al., p. 38. 

TABLE 1 

Many Farms Were Stressed 

at the Height of the Farm Crisis 

FINANCIALLY STRESSED FARMS 

1984–1986 

PERCENT 

NUMBER PERCENT TECHNICALLY 

OF FARMS OF FARMS INSOLVENT 

IOWA 12,580 20 8 

MINNESOTA 11,510 24 10 

MISSOURI 5,740 24 12 

NEBRASKA 5,390 17 6 

KANSAS 5,230 18 8 

SOUTH DAKOTA 4,080 19 6 

NORTH DAKOTA 3,790 18 4 

Source: USDA 

Kansas City Regional Outlook 21 Third Quarter 1999 
Regional Perspectives
 

conducted in 1984 showed that farmers with debt-toasset ratios above 40 percent represented 28 percent of 

total operators in the state but held 65 percent of the 

outstanding debt. The most highly leveraged farmers 

(those with debt-to-asset ratios over 70 percent) represented 10 percent of operators but held 25 percent of the 

debt. Clearly, the most highly leveraged farmers were 

most at risk, as their equity positions declined with the 

fall in land prices. 

However, farmers’ fortunes improved considerably 

between 1987 and 1990. Aggregate debt levels declined 

significantly as a result of an increase in loan chargeoffs and farmers’ attempts to reduce debt levels. 

According to one estimate, the share of dollar sales 

devoted to interest expense by financially stressed farmers declined from 25 percent in 1984 to 13 percent in 

1990.6 

Farmers also benefited greatly from federal government 

payments during the last part of the 1980s. Payments to 

farmers averaged nearly $13 billion annually between 

1986 and 1990, compared with an average of less than 

$3 billion per year in the 1970s. 

Current Difficulties in Agriculture Differ 

from Those in the 1980s 

The Region’s agricultural sector is again experiencing 

financial distress. In June 1999, the USDA forecast 

1999 national farm net income at $45.1 billion, the third 

consecutive year of decline. According to the USDA, 

large stocks of corn, wheat, and soybeans in domestic 

and international inventories point to continued low 

prices for these commodities through the year 2000 (see 

Table 2). A slight improvement in hog prices is forecast 

for 2000, but not to the 1997 level. Although the USDA 

forecasts an increase in cattle prices, forecasters have 

significantly overestimated cattle prices in each of the 

past two years. 

In addition, farmland values in the Region have shown 

the first indication of decline since 1986. In fact, Iowa 

State University’s annual survey of land values showed a 

1.8 percent decline in farmland values in Iowa for 1998. 

The Federal Reserve Bank of Kansas City reported a 

second consecutive quarter of declining farmland values 

in Kansas, Nebraska, and Missouri for the fourth quarter of 1998. The Federal Reserve Bank of Minneapolis 

6 Peoples, et al., p. 63. 

TABLE 2 

Prices Are Expected to Remain 

Depressed through 2000 

1997 1998 

EST. 1999 

PROJ. 2000 

CORN 

WHEAT 

SOYBEANS 

HOGS 

CATTLE 

2.71 

4.30 

7.35 

51.36 

66.32 

2.43 

3.38 

6.47 

34.72 

61.48 

2.00 

2.65 

5.05 

37.00 

64.50 

2.00 

2.85 

4.35 

41.50 

73.50 

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

Crop quantities are per bushel; livestock are per 


hundredweight.
 

Source: USDA
 

survey of agricultural credit conditions reports a yearover-year decline in North Dakota land values. 

Low prices in the major commodity markets are expected to compound the financial distress of many farmers 

in the Region. Iowa State University economists simulated the financial effects on Iowa’s farms if commodity prices remained at the 1998 level through 2000. 

Using financial data from 1,153 farms in Iowa, the 

researchers classified the farms into four categories of 

financial health: strong, stable, weak, and severe. Chart 

6 shows the results of this study. 

Projected average net income declined approximately 

60 percent, from $68,000 in 1997 to slightly more than 

$29,000 in 1998. In particular, net cash flow was negative for the farms in the weak and severe categories. The 

economists concluded that if the 1998 price levels continue through 2000, more than one-third of Iowa’s comCHART 6 

37 

10 

3 

23 

44 

22 

11 

50 

Strong Stable Weak Severe 

Financial Condition of 1,153 Iowa Farms Studied 

1997 Condition, Actual 

Year-end 2000 Condition, 

Forecast if Prices 

Remain at 1998 Levels 

Source: Iowa State University 

Farm Conditions Are Expected to Deteriorate 

if Low Prices Persist through 2000 

Percent of Total Farms 

0 

10 

20 

30 

40 

50 

60 

Kansas City Regional Outlook 22 Third Quarter 1999 
Regional Perspectives
 

mercial farms will require restructuring or liquidation. 

The results of the Iowa State University study may also 

apply to other states in the Region, such as Minnesota, 

Nebraska, and Missouri, that depend on similar commodities. As in the 1980s, a significant subset of highly 

indebted farmers is at risk today. 

Despite these difficulties, the level of risk in the agricultural sector is considerably lower than in the 1980s. 

Current debt levels, in real terms, are similar to 1969 

levels, before the buildup of the 1970s. Similarly, land 

values have not increased as dramatically as they did in 

the 1970s, instead increasing with steady improvements 

in agricultural productivity. As a result, despite recent 

small declines, farmland values appear less vulnerable 

to the precipitous declines seen in the 1980s. Finally, 

low debt levels and stable farmland values have led to 

aggregate debt-to-equity ratios in line with those reported over most of the past 40 years. 

New Federal Farm Policy and New Problems 

The future of U.S. agricultural policy remains uncertain, 

and risks are very different from those that farmers 

faced in the 1980s. U.S. agricultural policy appeared to 

have shifted with the enactment of the Federal Agricultural Improvement and Reform Act of 1996, which dismantled the system of deficiency payments to farmers 

that had been in effect since the Great Depression. In 

return, farmers were promised a series of payments, 

unrelated to their production decisions, that would 

decline to zero by the end of 2002. “The Federal Agricultural Improvement and Reform Act of 1996 Increases Risks and Opportunities,” Regional Outlook, Third 

Quarter 1998, argued that this legislation likely will 

negatively affect states with limited crop alternatives, 

such as the wheat-growing areas of North Dakota and 

Kansas. 

Developments since 1996 have blunted the impact of 

the intended reform. In 1998, in response to low commodity prices, Congress approved a $6 billion emergency aid package for agriculture. Senators from farm 

states have discussed reversing the 1996 reforms, but 

the likelihood of this occurring is unclear. Additionally, 

this November, World Trade Organization negotiations 

resume, during which U.S. agricultural policy will be 

scrutinized. Negotiators are expected to attempt to 

reduce domestic agricultural supports as part of a free 

trade policy. 

Farm Banking—the “Lag Effect” 

Masks Problems 

Before comparing farm banking in the 1980s with the 

present, it is important to understand the “lag effect.” 

The “lag effect” describes the phenomenon whereby 

problems in the agricultural sector typically do not manifest themselves in farm bank performance measures for 

two to three years. For example, farm banks’ reported 

conditions in the 1980s did not deteriorate significantly 

until 1984, three years into the farm crisis. 

The primary cause of this lag is the carryover debt 

process, in which loans not repaid in one season are carried over into the next season. The reason this process is 

more prevalent in farm lending than in commercial 

lending is that farm income tends to be volatile. In 

farming, it is common for one or two bad years to be 

made up entirely by a third healthy year. Other industries are more cyclical, and lenders tend to be less optimistic that the coming year will be strong enough to 

cover borrowers’ current losses. The lag effect is heightened when farm equity levels are strong, because farmers will have more real estate equity to convert 

carryover debt to term loans. 

Farm Banking—the Crisis of the 1980s 

The 1980s farm crisis caused 

widespread problems for farm 

banks. Table 3 (next page) shows 

how certain financial performance ratios declined dramatically between year-end 1982 (the 

first year of depressed farm income) and 1985 (when 

farm bank financial performance bottomed out). 

Although 1982 farm income declined 22 percent from a 

year earlier and 43 percent from 1979, farm banks 

reported strong aggregate operating results in 1982. The 

lag effect masked the impact of the emerging farm crisis on farm banks. Equity capital ratios were relatively 

high, and loan loss reserves compared favorably with 

the 1 percent benchmark that existed at the time. The 

aggregate return on assets (ROA) ratio remained high at 

1.23 percent, and few banks were unprofitable. Past-due 

loans were low at 2.8 percent. 

By 1985, the situation for farm banks had changed significantly. Their financial performance measures fully 

Kansas City Regional Outlook 23 Third Quarter 1999 
Regional Perspectives
 

TABLE 3 

Farm Banks in the Region Deteriorated 

Significantly between 1982 and 1985 

KANSAS CITY REGION FARM BANKS 

PERCENT 

1982 1985 

CAPITAL/ASSETS 8.65 8.78 

ALLL/TOTAL LOANS 0.98 1.91 

LOANS/ASSETS 51.08 47.05 

RETURN ON ASSETS 1.23 0.29 

% OF BANKS UNPROFITABLE 

PAST-DUE LOANS/ 

3.26 25.22 

TOTAL LOANS 2.80* 7.63 

FARM LOANS/TOTAL LOANS 49.90 49.58 

FARM LOANS/TOTAL ASSETS 25.49 23.33 

Note: Farm loans are for farm production or secured 

by farm real estate. 

* Estimated from data in FDIC, “History of the Eighties.” 

Sources: Bank Call Reports; “History of the Eighties” 

reflected the magnitude of the agricultural crisis. Pastdue loans were up to 7.6 percent, and loan loss reserve 

levels were much higher to compensate for the increase 

in problem loans. The aggregate ROA ratio was just 

0.29 percent, and more than a quarter of farm banks lost 

money. It is interesting to note that equity capital levels 

rose between 1982 and 1985 as farm banks with low 

levels of capital failed, increasing the aggregate ratio of 

the remaining institutions. 

Why Did Some Banks Fail, While Others Survived? 

Although aggregate farm bank financial performance 

declined dramatically between 1982 and 1985, all farm 

banks were not affected equally. As Map 1 shows, a significant number of farm banks in the Region failed in 

the 1980s. However, despite the agricultural crisis, 93 

percent of farm banks in the Region did not fail. 

What distinguished the failures from the survivors? A 

1990 study by the Federal Reserve Bank of St. Louis7 

attempted to answer this question. First, researchers 

noted that the majority of failures were in agricultural 

areas, but beyond that, the failures were not geographically clustered. This finding suggested that local eco7 Belongia, Michael T., and R. Alton Gilbert. “The Effects of Management Decisions on Agricultural Bank Failures.” American Journal 

of Agricultural Economics. November 1990. pp. 901–910. Note that 

the authors’ definition of farm banks (those with a ratio of agricultural loans to total loans greater than the national average) differs 

from the FDIC’s. 

nomic conditions were not the primary cause of farm 

bank failures. In fact, the researchers found that most 

counties in which a failed farm bank was headquartered 

also included headquarters of other farm banks that 

reported sound financial results throughout the crisis. 

Few counties in agricultural areas experienced more 

than one farm bank failure between 1984 and 1986. 

Many studies point to management decisions as the primary cause of farm bank failures. Commonly cited 

qualitative characteristics of failed banks include 

relaxed underwriting standards, misconduct by bank 

officers, high tolerance for risk, and low involvement by 

bank directors. However, the St. Louis Federal Reserve 

Bank researchers attempted to determine if there were 

quantitative factors relating to management decisions 

that explained why some farm banks failed and others 

did not. 

The researchers created a statistical model8 that 

explained how changes in certain variables affected the 

probability of farm bank failure. They included only 

failed farm banks from counties where banks also survived, and they tested only financial ratios that management directly controls. 

The results of the study were striking: 

•	 The loan-to-asset (LTA) ratio was the most significant indicator of bank failure. The study found that 

for every 1 percent increase in a bank’s LTA ratio, its 

chance of failure rose by 3.3 percent. Loans typically carry more risk than other bank investments; as a 

result, management that opted for increased loan volume may have had a higher tolerance for risk and followed more relaxed underwriting standards. 

FDIC researchers working on the History of the 

Eighties project also determined that the LTA ratio 

was the most significant indicator of farm bank failure in the 1980s.9 They found that farm banks with 

LTA ratios in the top 20 percent in 1980 failed at a 

rate of 6.2 percent, or five times the rate of other 

farm banks. Researchers conducted the test again in 

8 This model was a multiple regression analysis using 145 failed
 

banks and approximately 600 surviving banks. Results shown in this
 

article are for independent variables lagged three years prior to failure. This model best portrays the effect of management decisions
 

before problems surfaced at their institutions.
 

9 Federal Deposit Insurance Corporation, History of the Eighties—
 

Lessons for the Future, Volume I. 1997. Washington, D.C. pp.
 

280–282.
 

Kansas City Regional Outlook 24	 Third Quarter 1999 
Regional Perspectives
 

1982 and found that banks with the highest LTA 

ratios had a failure rate of 10.3 percent, more than 

six times that of the remaining farm banks. 

•	 Concentration in farm loans was also a factor, but 

not as significant as the LTA ratio. For each 1 percent 

increase in the ratio of farm loans to total loans, the 

probability of failure increased 0.9 percent. Because 

the depressed farm economy was a driver of farm 

bank problems, higher concentrations in farm lending led to higher rates of failure. However, management decisions about lending volume were more 

predictive than concentrations in farm loans. 

•	 Higher capital levels were the most significant factor 

preventing farm bank failures. For each 1 percent 

increase in a farm bank’s equity capital-to-assets 

ratio, the institution’s probability of failing declined 

by 13.4 percent. 

Although most farm banks would find it difficult to 

diversify their lending portfolios, management can control their institutions’ overall risk profile by adjusting 

their lending volume and equity capital levels. Thus, the 

study suggests that management prudence in the 1980s 

helped some farm banks survive. 

The Present Situation:
 

The 1980s All Over Again?
 

Just as 1982, 1998 could represent the first year of a 

period of depressed farm income. Comparing the 

Region’s farm banks at year-end 1982 and year-end 1998 

illustrates similarities but important differences as well. 

Despite 1998’s depressed farm income, farm banks 

reported good conditions at year-end. Table 4 shows that, 

in aggregate, equity capital levels were strong, earnings 

were high, and past-due loan levels remained low. 

Important differences are apparent between farm banks 

today and in 1982. The aggregate LTA ratio has 

increased significantly from 1982 levels. This fact could 

raise concern given the prospect for continued low commodity prices and the studies that identified the LTA 

ratio as a significant correlating factor with farm bank 

failures in the 1980s. However, farm banks are significantly better capitalized now than they were in 1982. 

Aggregate equity capital levels are up almost 2 percentage points compared with 1982. In addition, loan loss 

TABLE 4 

Region’s Farm Banks Reported 

Higher Capital and Loan Levels 

in 1998 versus 1982 

PERCENT 

1982 1998 

CAPITAL/ASSETS 8.65 10.42 

ALLL/TOTAL LOANS 0.98 1.57 

LOANS/ASSETS 51.08 60.08 

RETURN ON ASSETS 1.23 1.19 

% OF BANKS UNPROFITABLE 

PAST-DUE LOANS/ 

3.26 1.70 

TOTAL LOANS 2.80* 2.42 

FARM LOANS/TOTAL LOANS 49.90 47.30 

FARM LOANS/TOTAL ASSETS 25.49 28.41 

Note: Farm loans are for farm production or secured 

by farm real estate. 

* Estimated from data in FDIC, “History of the Eighties.” 

Sources: Bank Call Reports, “History of the Eighties” 

reserve levels are much higher, suggesting that today’s 

farm banks are better positioned to handle an increase 

in loan losses. 

Although farm banks’ aggregate ratio of farm loans to 

total loans has declined over the past 16 years, their 

aggregate ratio of farm loans to total assets has 

increased because they have a higher LTA ratio (see 

Table 4). This higher ratio indicates that farm banks are 

more concentrated in farm lending than they were in 

1982 and may be more susceptible to a continued weak 

farm economy. 

In aggregate, management decisions in the 1990s have 

led to farm banks comparing negatively in some 

respects and positively in others with their counterparts 

of the early 1980s. Farm banks have a much higher 

aggregate LTA ratio than they did before the farm crisis, 

suggesting higher risk levels. On the other hand, the 

increased level of risk appears to be offset in the aggregate by higher capital and loan loss reserve levels. 

However, some individual farm banks in the Region 

appear to be aggressively increasing their lending volume relative to capital. Of the 1,355 farm banks in the 

Kansas City Region at year-end 1998: 

•	 312 have an LTA ratio over 60 percent and equity 

capital of less than 9 percent. 

•	 77 have an LTA ratio over 70 percent and equity 

capital of less than 8 percent. 

Kansas City Regional Outlook 25	 Third Quarter 1999 
Regional Perspectives
 

If the St. Louis Federal Reserve Bank study results are 

assumed to be applicable to the next prolonged agricultural downturn, these banks may be more susceptible 

to failure than those with lower loan levels or higher 

capital levels. 

Not surprisingly, the latter 77 institutions are in states 

reporting relatively strong farm income during the 

1990s because bankers are more likely to manage their 

institutions aggressively in healthy economies. Iowa 

has 25 of the 77 and Nebraska has 18. South Dakota 

and North Dakota, which have had more troubled farm 

sectors, have a total of seven. 

These 77 banks’ potential vulnerability to an agricultural downturn can be seen in their financial statements, 

which are already beginning to reflect the weakening 

farm economy. For example, the Region’s 1,355 farm 

banks posted an aggregate ROA of 1.19 percent in 1998, 

just 5 basis points below 1997’s aggregate ROA. By 

contrast, the 77 banks posted an aggregate ROA of 0.85 

percent, down 28 basis points from their 1997 level. 

This reduction was caused largely by provision expenses necessary to cover increasing charge-offs in light of 

below-average loan loss reserve levels. 

Conclusion—No Recurrence of the Farm Crisis, 

but Problems Persist 

We do not expect to see a recurrence of the agricultural 

crisis of the 1980s, which led to the failure of many 

farm banks. Problems in the farm sector today appear 

different from those in the 1980s. The macroeconomy is 

more stable today, export growth has not led to overinvestment in the farm sector, and land values have not 

increased as dramatically as they did during the 1970s. 

On the banking side, farm banks are better capitalized 

and have higher levels of loan loss reserves than they 

did in the 1980s. Therefore, institutions are more capable of absorbing loan and operating losses. 

However, concerns persist. Most 

importantly, if commodity prices continue at their low level, highly leveraged farmers will be at risk of failure. 

As shown by the Iowa State University 

study, if low prices persist through 

2000, one-third of Iowa farms could be 

at risk. Farms in parts of North Dakota 

and Minnesota, plagued by poor wheat 

yields and low prices over the past few 

years, would likely be affected more dramatically than 

the study suggests, as they began 1998 in weaker financial condition than farms in Iowa. 

In addition, the strong U.S. economy that has continued 

through nearly all of the 1990s has apparently increased 

some farm bankers’ tolerance for risk, as shown by the 

aggregate increase in the LTA ratio. Farm banks that 

have relaxed their underwriting standards to achieve 

loan growth will likely be more vulnerable to continued 

low crop and livestock prices. 

Finally, the safety net for farmers is shrinking. While 

the political climate is uncertain, federal transition payments are scheduled to expire at year-end 2002. This 

event is likely to affect more seriously the Region’s 

wheat growers, who do not have the planting choices of 

corn and soybean growers. Without federal aid, many 

farms in the Region may not be viable, and banks in the 

hardest-hit areas could experience serious problems. 

John M. Anderlik, Senior Financial Analyst 

Jeffrey W. Walser, Regional Economist 

Kansas City Regional Outlook 26 Third Quarter 1999 
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