Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 2000 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael Anas,
 

Senior Financial
 

Analyst
 

Ronald W. Sims, II,
 

Financial Analyst
 

Regional Perspectives 

◆ The Region’s Banking and Economic Conditions—The Region’s banks 

and thrifts reported record earnings and generally healthy conditions at year-end 

1999. However, the range of profitability as measured by return on assets has 

widened over the past two years and is trending downward for the more poorly performing institutions. See page 3. 

◆ Labor Market Conditions Illustrate Region’s Economic Health and 

Constraints—Labor market conditions reflect the Region’s economic health and 

constraints. The unemployment rate continues to edge downward, and labor market 

tightness is building. Job growth remains positive but modest. See page 4. 

◆ Capital Levels Remain High, but a Recent Downward Trend Is Not Consistent with a Rising Risk Profile—Although the median Tier 1 leverage ratio among 

the Region’s community institutions remains near the decade high, it has recently 

begun to decline modestly. This decline is occurring even as some measurements 

suggest that risk levels are increasing. See page 5. 

◆ Agricultural Bankers Share Views on Current Conditions and Outlook— 

The FDIC hosted a meeting of Illinois agricultural bankers on March 30, 2000, to 

discuss the effects of prolonged, depressed commodity prices on small farmers and 

rural agricultural banks and the long-term structural changes occurring in the 

industry and in rural communities. See page 6. 

By the Chicago Region Staff 

In Focus This Quarter 

◆ Banking Risk in the New Economy—This article summarizes current economic conditions, with a primary focus on potential risks to insured depository 

institutions. It explores the implications of long-term trends that have led to the 

New Economy. Recent high rates of economic growth with low inflation have been 

made possible by increases in productivity arising from new technologies, higher 

investment spending by businesses, and large-scale industrial restructuring. Underlying these trends has been a financial environment that has largely accommodated 

the growing borrowing needs of consumers and businesses. Market-based financing, 

provided in large part through securitizations and mutual funds, has made capital 

readily available to start-up “new economy” firms as well as mature companies that 

seek to merge or restructure. Despite the clear benefits of market-based financing 

in supporting economic activity, there are also concerns. A recurrence of financial 

market turmoil, such as that experienced in fall 1998, has the potential to quickly 

change the currently positive economic outlook to one that is far more challenging. 

Detail is provided on commercial credit quality, market sources of revenue, and 

other risks to watch in banking. See page 11. 

By the Analysis Branch Staff 

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

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

financial institutions and financial institution regulators. It is produced for the following 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. For 

more information or to provide comments or suggestions about the Chicago Region’s Regional 

Outlook, please call Suzannah Susser at (312) 382-6543 or send an e-mail to ssusser@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 The Region’s banks and thrifts reported record earnings and generally healthy conditions at year-end 1999. 

However, the range of profitability as measured by return on assets has widened over the past two years and 

is trending downward for the more poorly performing institutions. 

•	 High employment in the Region is supporting moderate income growth among households. However, 

the accompanying low unemployment rate is constraining the ability of the Region’s economy to expand 

rapidly. 

•	 Although the median Tier 1 leverage ratio of the Region’s insured institutions remains high, it has declined 

modestly recently. This decline has occurred even as evidence suggests that risk levels among the Region’s 

insured financial institutions are rising. 

•	 The FDIC hosted a meeting during which Illinois agricultural bankers discussed issues affecting small 

farmers, rural agricultural banks, the agricultural industry, and rural communities. 

The Region’s Banking and Economic Conditions 

Insured Financial Institutions Report 

Record Earnings 

The Region’s banks and thrifts reported record earnings 

performance for the 12-month period ending December 

31, 1999, with net income increasing by roughly 12 percent to $12.8 billion from the year-earlier period. On the 

basis of median values for year-end 1999, 

•	 the net interest margin (NIM) declined to 3.94 percent, falling slightly from a year ago; 

•	 the return on assets (ROA) also declined slightly to 

1.01 percent over the same period; 

•	 the Tier 1 leverage ratio fell to 9.21 percent from 

9.27 percent a year ago; and 

•	 the total past-due and nonaccrual loan ratio improved 

to 1.65 percent from 1.87 percent a year ago. 

Despite some moderating, these measures reflect generally healthy conditions and performance. However, rising interest rates and the age of the current economic 

expansion may hinder insured institutions’ ability to 

sustain this level of performance. Despite generally 

favorable economic conditions, median adverse classifications have increased to 8.19 percent of capital compared with 6.14 percent two years ago. In addition, the 

range of profitability as measured by ROA has widened 

over the past two years and is trending downward for 

the bottom fifth percentile of insured institutions (see 

Chart 1). The number of established1 banks and thrifts 

that were unprofitable increased to 59, or 3 percent, of 

the Region’s institutions as of December 31, 1999, compared with 35, or 1.7 percent, a year earlier. 

Two groups of the Region’s insured institutions exhibit 

trends that warrant continued attention. The median 

CHART 1 

1 The universe of established banks and thrifts excludes any institution 

that is less than three years old. 

The Variability of Return on Assets Increases 

among Community Institutions* 

–0.5 

0 

0.5 

1 

1.5 

2 

2.5 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

* Community institutions have less than $1 billion in assets. 

Source: Bank and Thrift Call Reports, December 31 

95th Percentile 

5th Percentile 

Median

Return on Assets (%) 

Chicago Regional Outlook 3	 Second Quarter 2000 
Regional Perspectives
 

ROA for commercial and industrial lenders2 remained CHART 2 

solid at 1.14 percent, but declined from 1.20 percent a Region’s Unemployment Rate Reflects year earlier. This group continued to report strong loan Tight Labor Market growth over the past 12 months, recording a median net 

loan growth rate of 14 percent. This growth has 

occurred amid signs of deteriorating commercial credit 

quality, including escalating corporate indebtedness, 

rising levels of stress in some industries, and increasing 

corporate bond defaults (see “Recent Trends Raise 

Concerns about the Future of Business Credit Quality,” Regional Outlook, first quarter 2000). While 

3 

4 

5 

6 

7 

8 

United States 

Chicago Region

Percentage of Labor Force 

reported asset quality remains satisfactory, strong loan 

growth may make it more difficult to identify potential 

asset quality problems, as newly originated loans are 

unlikely to fail to perform initially. 

The Region’s residential real estate (RRE) lenders3 

reported strong capital and asset quality, but profitability has declined. This group of 317 insured institutions 

reported a median ROA of only 0.67 percent at the end 

of fourth quarter 1999 compared to 0.84 percent two 

years earlier. Recent interest rate hikes pose particular 

risks for the Region’s RRE institutions. Increases in 

mortgage rates may suppress loan demand and fees 

associated with mortgage originations and refinancings. 

In addition, the negative convexity4 inherent in many 

mortgage-backed securities has led to more significant 

depreciation in RRE bank securities portfolios. Finally, 

these banks and thrifts may be exposed to higher levels 

of interest rate risk, given that they typically hold assets 

with longer maturities. 

Labor Market Conditions Illustrate Region’s 

Economic Health and Constraints 

The cyclical expansion started its ninth year in March 

2000, when it also set a record for longevity. At a point 

when many prior expansions had expired or were in 

their last days, the Region is experiencing about 1 percent job growth (at an annual rate). The first quarter 

unemployment rate of 3.6 percent reflected increased 

labor-market tightness relative to both a year earlier and 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

Source: Bureau of Labor Statistics/Haver Analytics 

High employment, in turn, is supporting moderate 

income growth among households and other conditions 

that promote a healthy economy. Housing permits early 

in 2000 continued to post gains from year-earlier levels, 

for example. Meanwhile, consumer confidence in the 

Region reached an all-time high in the first quarter of 

2000 and bankruptcy filings eased modestly, although 

the level remains near historical highs. 

The buoyancy of domestic demand from households, 

businesses, and other sectors is supplemented by a 

revival in demand from abroad. Exports of goods to 

Japan and newly industrialized Asian countries are 

increasing, for example, following a double-digit drop 

in 1998. Together, domestic and foreign demand have 

triggered more robust production gains in the Region, 

as illustrated in Chart 3. 

CHART 3 

Region’s Manufacturing Output Growth Perks Up 

Midwest 

12 Manufacturing 

Index 

Percentage Change

from Year Ago 

8 

4 

0 

–4 

the nation as a whole (see Chart 2). 

2 Defined as institutions with less than $1 billion in assets and commercial and industrial plus commercial real estate loans greater than 

25 percent of total assets. 

3 Defined as institutions with less than $1 billion in assets and one- to –8

four-family mortgage loans plus mortgage-backed securities greater ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

than 50 percent of total assets. Note: Q1 2000 is an estimate. 4 Prices of securities with negative convexity fall at an increasing rate Source: Federal Reserve Bank of Chicago/Haver Analytics 

as interest rates rise and rise at a decreasing rate as interest rates fall. 

Chicago Regional Outlook 4 Second Quarter 2000 
Regional Perspectives
 

The recent upswing in factory output growth, however, 

has not been accompanied by corresponding increases 

in manufacturers’ payrolls. This discrepancy suggests 

that output gains are being achieved via productivity 

growth, longer workweeks, increased use of contract 

workers, or a combination of these factors. In some 

cases, employers are unable to find workers with the 

required skills. Although the Region’s manufacturing 

sector is performing better than the nation’s, this situation does not reflect strong job gains. Rather, the 0.7 

percent rate of contraction in manufacturing employment is slightly less than the nation’s. 

Among the Region’s manufacturers, payrolls were 

32,000 lower in the fourth quarter of 1999 than a year 

earlier, with only Indiana posting an increase (see Chart 

4). Much of that state’s better performance reflects the 

growing role of motor vehicle production. The state is 

home to assembly plants for some very popular models 

and also is adding capacity. These factors contributed to 

the addition of 4,300 jobs in Indiana’s transportationequipment sector last year. Without this development, 

job gains in the state’s manufacturing sector would have 

tracked more closely with the Region’s other states. 

In addition to the recent weaknesses in manufacturing 

employment, tight labor markets and the lack of available workers are constraining the ability of the Region’s 

economy to expand rapidly. Favorable interest rates and 

energy prices, which helped boost activity during 1999, 

are no longer low and stable. The affordability of purchasing a home has been reduced by higher interest 

rates (see Chart 5), and growth in business spending for 

plant and equipment also is being dampened. Considerable stock market volatility and net losses also may trim 

some net worth valuations, negatively affect highly 

leveraged investors, and dampen consumer optimism. 

Although the cyclical expansion may continue for some 

CHART 4 

Manufacturing Job Growth Lags in Chicago Region 

Source: Bureau of Labor Statistics/Haver Analytics 

Percent Change between 1Q99 and 1Q00 

Manufacturing Employment Total Employment 

–2.0 –1.0 0.0 1.0 2.0 

Illinois 

Michigan 

Ohio 

Wisconsin 

Indiana 

CHART 5 

time, current conditions suggest that the Region’s vulnerabilities at mid-year 2000 are greater than in the 

recent past. 

100 

110 

120 

130 

140 

150 

’89 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

6.75 

7.50 

8.25 

9.00 

9.75 

10.50 

11.25 

Mortgage Rate 

(right scale) 

Affordability Index 

(left scale) 

Housing Affordability Is Dampened 

as Mortgage Rates Rise 

* A rising index indicates that a home purchase is more affordable. 

Source: National Association of Realtors/Haver Analytics 

’90 

Index*

Percent per Annum 

Capital Levels Remain High, but a Recent Downward Trend
 

Is Not Consistent with a Rising Risk Profile
 

Although the median Tier 1 leverage ratio remains asset ratio is rising and profitability is declining (see 

high, the recent downward trend is not consistent with Chart 7, page 7). 

the increased risk shown in some measurements. After 

rising dramatically in the early nineties, the median Strong growth in commercial and commercial real 

Tier 1 leverage ratio has declined modestly during the estate loan portfolios primarily has driven the increase 

past few years (see Chart 6, page 7). This decline has in the loan-to-asset ratio. Traditionally, these two segoccurred even as recent evidence suggests that risk lev- ments have been the higher-yielding, higher-risk porels are increasing. For example, the median loan-to- tions of the loan portfolio. Yet, profitability levels have 

Chicago Regional Outlook 5 Second Quarter 2000 
Regional Perspectives
 

Agricultural Bankers Share Views on Current Conditions and Outlook
 

On March 30, 2000, the FDIC hosted an agricultural 

bankers’ roundtable in Springfield, Illinois, to discuss 

the effects of prolonged, depressed commodity prices on 

small farmers and rural agricultural banks. The roundtable participants also addressed the long-term structural changes occurring in the agricultural industry and in 

rural communities. 

In general, strong yields in most areas and significant 

government payments have helped farmers withstand 

depressed commodity prices. Particularly strong corn 

and soybean yields last year in the state’s northwest, central, and eastern counties helped offset lower prices. 

Bankers indicated that the majority of farmers in these 

areas had positive income or reached a breakeven point 

before government payments. However, yields in most 

southern counties were well below the Illinois average. 

Government payments were critical in these areas, where 

they were the only factor that enabled some farmers to 

break even. In addition, many bankers noted the significant and growing importance of off-farm income in supplementing farm operation income. 

Several bankers indicated that they had restructured 

some farm debt over the past two years. The lack of significant leverage among farmers and relatively stable 

land prices have enabled bankers to work effectively 

with farm borrowers who had encountered problems. 

Bankers noted little demand for equipment loans. 

Farmers and bankers actively use a variety of risk management techniques. Farmers enter contracts for the sale 

of grain crops and hogs. Many are purchasing crop insurance during this growing season. Some have formed 

cooperatives to purchase seed and chemicals. Others 

share equipment to cut costs. Bankers now more routinely obtain and analyze detailed cash flow statements, 

income tax returns, and credit bureau reports during the 

underwriting process. They also review operating lines 

throughout the season. Many bankers participate in a 

variety of guaranteed loan programs. 

Funding strategies were of particular interest to the 

group. The aggregate loan-to-deposit ratio among 

Illinois agricultural banks was 67 percent as of December 31, 1999. This ratio has increased from 51 percent 

a decade ago. Bankers commented that deposits have 

declined as the local population has aged. As a result, 

bankers increasingly seek noncore funding alternatives, 

including Federal Home Loan Bank (FHLB) advances. 

A provision of the Gramm-Leach-Bliley Act allowing 

the FHLB to offer small banks greater access to FHLB 

advances was discussed at the roundtable. The law 

permits FHLB member banks with less than $500 million in assets to use small-business and agricultural 

loans as collateral for advances. While it is too soon to 

know the extent to which banks will use FHLB borrowings, many community banks, including agricultural banks, likely will see the FHLB as an important 

means of supporting future growth. Regulators stressed 

that a solid business plan should always be the foundation for any funding strategy, including one using 

FHLB borrowings. 

Participants also discussed several structural changes 

occurring in agricultural and rural communities: 

•	 Bankers noted the trend toward the integration of the 

small farmer into production, processing, and marketing networks. 

•	 The global acceptance of genetically modified grains 

was considered vital to area farmers, who increasingly take advantage of advances in biotechnology. 

•	 Individuals entering farming without a family tradition in the industry are rare. As a result, the population of many rural communities is declining and 

aging. 

•	 Several bankers noted that their communities had 

formed development corporations to encourage and 

support business formation. 

Going into the 2000 planting season, bankers voiced 

some concerns. First, dry soil conditions have increased 

the potential for drought this summer. As of March 27, 

the topsoil moisture condition in Illinois was rated 14 

percent very short, 51 percent short, 31 percent adequate, and 4 percent surplus. Though topsoil moisture 

conditions have improved, low subsoil moisture is still a 

concern. In addition, rising fuel costs and interest rates 

will increase farm expenditures. Bankers also indicated 

that operating lines are increasing, an indication that 

cash reserves may be declining. Younger farmers with 

higher leverage and lower cash reserves appear the most 

vulnerable to the consequences of sustained low commodity prices. 

Chicago Regional Outlook 6	 Second Quarter 2000 
Regional Perspectives
 

CHARTS 6 AND 7 

7.0 

7.5 

8.0 

8.5 

9.0 

9.5 

10.0 

0 

10 

20 

30 

40 

50 

60 

Capital Ratios Have Declined Recently... 

Source: Bank and Thrift Call Reports and Examination Reports for community 

institutions (<$1 billion in total assets), excluding new banks 

Institutions with Less 

than an 8% 

Tier 1 Leverage Ratio 

(right axis) 

Median Tier 1 

Leverage Ratio 

(left axis) 

Mar 1990

Sept 1990

Mar 1991

Sept 1991

Mar 1992

Sept 1992

Mar 1993

Sept 1993

Mar 1994

Sept 1994

Mar 1995

Sept 1995

Mar 1996

Sept 1996

Mar 1997

Sept 1997

Mar 1998

Sept 1998

Mar 1999

Sept 1999 

Institutions with Capital 

Ratings of 3, 4, or 5 

(right axis) 

0.7 

0.8 

0.9 

1.0 

1.1 

1.2 

1.3 

0.54 

0.56 

0.58 

0.60 

0.62 

0.64 

0.66 

0.68 

Source: Bank and Thrift Call Reports for community institutions (<$1 billion in 

total assets), excluding new banks 

...While Some Measures of Risk Are Rising 

Median Return on Assets 

(left axis) 

Median Loan-to-Asset Ratio 

(right axis) 

Mar 1990

Sept 1990

Mar 1991

Sept 1991

Mar 1992

Sept 1992

Mar 1993

Sept 1993

Mar 1994

Sept 1994

Mar 1995

Sept 1995

Mar 1996

Sept 1996

Mar 1997

Sept 1997

Mar 1998

Sept 1998

Mar 1999

Sept 1999 

Percentage

Percentage 

Percentage 

not improved as a result of this loan growth. Other factors, such as increased competition, which may suppress loan yields, and growth in noncore funding, which 

raises funding costs, are dampening profitability. These 

factors constrain the Region’s institutions’ ability to 

strengthen capital positions. In addition, the financial 

flexibility afforded by some noncore funding sources 

may be tempting more institutions to operate at lower 

capital levels. 

Several other dynamics also are affecting capital levels. 

The strength and duration of the current economic 

expansion has sustained strong loan growth over several years. Some institutions may be extrapolating strong 

economic performance well into the future and as a 

result have become more comfortable operating with 

lower capital levels. Off-balance-sheet items, such as 

loan commitments, have increased at many institutions. 

These commitments carry risk as well by potentially 

leading to rising loan exposure. The trend toward asset 

securitization has implications for the Region’s insured 

financial institutions. Banks may be selling the highestquality loans in the portfolio in the secondary market, 

resulting in a higher proportion of lower-quality or nonconforming loans on the balance sheet. Furthermore, 

investors may expect higher returns on investment given 

the strong stock market performance over the past several years. In response, some banks may manage returns 

on equity more aggressively through increased risk tolerance or lower capital levels to compete with nonbank 

investment alternatives. 

Some groups of banks have experienced a more substantial decline in capital levels or have reported stable 

capital levels despite rising risk levels. The median Tier 

1 leverage ratio for the Region’s farm banks, excluding 

new banks, was 10.34 percent as of December 31, 1999, 

a high level relative to other bank groupings. However, 

agricultural bank capital levels have been declining 

since 1995. During this period, loan-to-asset ratios have 

risen steadily and the Region’s agricultural sector has 

come under increasing pressure (see “Agricultural 

Bankers Share Views on Current Conditions and Outlook,” page 6). 

A study of farm bank failures in the 1980s5 found that 

many healthy agricultural banks continued to operate in 

counties where other farm banks failed. Therefore, 

attributing agricultural bank failures at that time solely 

to weakness in the agricultural sector appeared too simplistic. The study found that vulnerability to failure was 

most influenced by bankers’ risk management decisions. For example, high loan-to-asset ratios were associated with a higher likelihood of failure. Given these 

findings and the current stress in the Region’s agricultural sector, high loan-to-asset ratios may be viewed as 

a potential warning sign for farm banks. In this Region, 

agricultural banks operating with relatively high loanto-asset ratios are in fact maintaining significantly 

lower capital ratios than are other agricultural banks 

(see Table 1, next page). 

Agricultural banks with high loan levels do report 

slightly higher profitability levels; however, profitability has declined because of NIM compression driven, in 

part, by increased use of noncore funding. Coverage of 

nonperforming loans among all agricultural banks has 

dropped from two years ago. In addition, adversely clas5 Belongiz, Michael T., and R. Alton Gilbert. November 1990. The 

Effects of Management Decisions on Agricultural Bank Failures. 

American Journal of Agricultural Economics, 901–10. 

Chicago Regional Outlook 7 Second Quarter 2000 
Regional Perspectives
 

TABLE 1 TABLE 2 

Agricultural Banks with Significant 

Loan Exposure Maintain Lower 

Capital Levels 

Commercial Lenders’ Risk Profile Has 

Increased, but Capital Remains Stable 

LOAN-TO-ASSET 

LEVEL 

MEDIAN 

TIER 1 

LEVERAGE 

RATIO (%) 

MEDIAN 

RETURN ON 

ASSETS (%) 

TOP 20% 

(62 BANKS) 9.64 1.09 

ALL OTHER BANKS 

(250 BANKS) 10.65 1.04 

Source: Bank and Thrift Call Reports, excluding new 

banks 

sified items as a percentage of Tier 1 capital have 

increased during the past two years. Although the current level of adversely classified assets remains low, 

these trends and continued weakness in the agricultural 

sector warrant monitoring. 

Capital levels among the Region’s commercial lenders 

(includes only insured institutions with assets less than 

$1 billion) have plateaued despite several indicators of 

rising risk, such as an increasing level of commercial 

real estate loans and a growing use of noncore funding 

(see Table 2). The Region’s commercial lenders have 

reported exceptionally strong commercial loan growth 

during the past two years (18 percent in 1999 and 22 

percent in 19986). This sector has historically been a 

riskier segment of the loan portfolio. Beginning in 

1995, the median Tier 1 leverage ratio of this group of 

lenders leveled out while the loan-to-asset ratio continued to climb. And like many other types of institutions 

in the Region, this group has reported declining profitability because of NIM compression. During the past 

two years, the number of troubled institutions7 in this 

group, while still low, has increased significantly. This 

fact indicates that some of the group’s marginal performers are beginning to experience some strain. 

6 Commercial loan growth figures represent growth in aggregate commercial loans and exclude new banks.
 

7 Troubled institutions are those that received a composite CAMELS
 

rating of 3, 4, or 5 at the conclusion of the most recent examination.
 

DEC-95 DEC-99 

(%) (%) 

ASSETS 

COMMERCIAL REAL 

ESTATE LOANS/ASSETS 20.3 23.2 

LOANS/ASSETS 66.1 70.7 

PROFITABILITY 

RETURN ON ASSETS 1.17 1.10 

NET INTEREST MARGIN 4.61 4.27 

FUNDING 

NONCORE FUNDING/ 

ASSETS 13.3 20.3 

CAPITAL 

TIER 1 LEVERAGE RATIO 9.09 9.06 

Source: Bank and Thrift Call Reports for community 

institutions (<$1 billion in total assets), excluding 

new banks 

Lower Equity Returns May Prompt 

More Aggressive Strategy 

Although maintaining or increasing capital levels often 

mitigates the risk of failure, it often does so at the 

expense of equity returns. Some banks with low equity 

returns may feel compelled to compete with alternative 

investments to keep shareholders satisfied in light of 

the strong overall market returns of the past several 

years. As a result, some banks may begin to manage 

return on equity more aggressively and choose to operate at lower capital levels. Consumer lenders8 and mortgage lenders9 have experienced particularly large 

declines in equity returns over the past several years 

and may consider adopting this strategy (see Chart 8). 

Such trends warrant continued monitoring to ensure 

that higher equity returns are not achieved solely 

8 Consumer lenders are typically defined as institutions in which the 

sum of one- to four-family mortgage loans and loans to individuals is 

greater than 50 percent of assets. 

9 Mortgage lenders are typically defined as institutions in which the 

sum of one- to four-family mortgage loans and mortgage-backed 

securities is greater than 50 percent of assets. 

Chicago Regional Outlook 8 Second Quarter 2000 
Regional Perspectives
 

CHART 8 

2 

4 

6 

8 

10 

12 

14 

16 

Source: Bank and Thrift Call Reports for community institutions (<$1 billion in 

total assets), excluding new banks 

Consumer Lenders 

Mortgage Lenders 

Consumer and Mortgage Lenders Experience 

Significant Declines in Equity Returns 

Mar 1990

Sept 1990

Mar 1991

Sept 1991

Mar 1992

Sept 1992

Mar 1993

Sept 1993

Mar 1994

Sept 1994

Mar 1995

Sept 1995

Mar 1996

Sept 1996

Mar 1997

Sept 1997

Mar 1998

Sept 1998

Mar 1999

Sept 1999 

Equity Return (%) 

through reduced capital levels. Recent interest rate 

increases, which may restrain the demand for mortgage 

and consumer loans, may make profitability improvements difficult in the near term. Returns on equity for 

mortgage lenders have been highly erratic and currently are below levels during the last recession. (For further discussion about mortgage lenders and their recent 

decline in profitability, see the Chicago Regional Outlook, first quarter 2000.) 

The Chicago Region Staff 

Chicago Regional Outlook 9 Second Quarter 2000 
In Focus This Quarter
 

Banking Risk in the New Economy
 

The Division of Insurance periodically assesses conditions in the economy and the banking industry to identify and evaluate trends that could adversely affect the 

performance of insured depository institutions. At this 

time, the banking industry as a whole continues to 

enjoy record profits and solid financial ratios.1 Much of 

the industry’s strength derives from the remarkable performance of the U.S. economy, which has been expanding for the past nine years. This article explores factors 

that have shaped this unusually robust economic environment and discusses how changes in the economy 

may create new types of risks for insured depository 

institutions. 

During 1999, the FDIC reported the first annual loss for 

the Bank Insurance Fund since 1991. This loss primarily resulted from an uptick in unanticipated and highcost bank failures. Some of these failures were 

associated with high-risk activities such as subprime 

lending, and some were related to operational weaknesses and fraud. The emergence of these problems in 

the midst of a strong economic environment raises concerns about how the condition of the banking industry 

might change if economic conditions deteriorate. 

The Longest U.S. Expansion 

In February 2000, the U.S. economy entered its 108th 

month of expansion, making this the longest period of 

uninterrupted growth in U.S. history.2 This recordsetting performance has also been marked by a recent 

acceleration in the rate of real gross domestic product 

(GDP) growth, which has exceeded 4 percent in each 

year since 1997. Meanwhile, price inflation has 

remained relatively subdued. The core inflation rate, 

which excludes the volatile food and energy components, was just 2.1 percent in 1999, the lowest core rate 

since 1965. 

Recent economic conditions have been highly conducive to strong loan growth, low credit losses, and 

record earnings for the banking industry. The important 

1 For a recent summary of financial performance and condition of the 

banking and thrift industries, see the FDIC Quarterly Banking Profile, fourth quarter 1999, http://www2.fdic.gov/qbp/. 2 The chronology of U.S. business cycles is available from the National Bureau of Economic Research, http://www.nber.org/cycles.html. 

question going forward is how long these favorable conditions might last. Is this remarkable economic performance the result of some long-term upward shift in the 

pace of economic activity, or is it the temporary result 

of a few transitory factors? More important, are there 

new and unfamiliar dangers that, at some point, could 

significantly impair banking industry performance? To 

evaluate these questions, we must assess the factors that 

have contributed to recent economic performance and 

think ahead to possible developments that could end this 

expansion. 

What Is the New Economy? 

The term used most often to describe the recent period 

of economic performance has been somewhat controversial: the New Economy. Much of the controversy has 

arisen because people interpret the term in different 

ways. Wall Street analysts use the term to refer to the 

high-technology sectors of the economy, such as computers and software, biotechnology, and especially the 

Internet. Some of these New 

Economy firms have been able to 

raise large amounts of capital and 

command market valuations in 

the tens of billions of dollars well 

in advance of earning a profit or 

even booking significant cash 

revenues. 

Economists tend to employ the term New Economy in a 

slightly different way. To them, it refers to evidence that 

some of the traditional economic relationships have 

changed. For example, intangible assets now appear to 

play a much larger role in the valuation of investments 

than they have in the past.3 Firms in some industries 

now may exhibit increasing returns to scale (rather than 

diminishing returns), reflecting the fact that the value of 

their product rises as it becomes a de facto industry 

standard.4 Individual decision making, too, may be 

changing. Some believe that investors have reduced the 

risk premium they demand to hold equity positions 

3 Nakamura, Leonard. Federal Reserve Bank of Philadelphia. 

July/August 1999. Intangibles: What Put the New in the New Economy? Business Review. http://www.phil.frb.org/files/br/brja99ln.pdf. 4 Brown, William S. March 2000. Market Failure in the New Economy. Journal of Economic Issues, 219–27. 

Chicago Regional Outlook 11 Second Quarter 2000 
In Focus This Quarter
 

because of their perception that holding equity is not, 

after all, substantially riskier than holding debt.5 Such a 

shift in investor attitudes could help explain why the 

price-to-earnings ratio for the S&P 500 index has 

recently approached all-time highs.6 

Perhaps the most important underlying change in the 

economy is the relationship between high rates of economic growth and changes in inflation. Economists have 

long maintained that rapid growth in economic activity 

has a tendency to lead to excess demand for goods (thereby raising consumer and producer prices) and excess 

demand for labor (thereby raising wage rates). But during 

the late 1990s, as growth accelerated and inflation 

remained low, economists began to reevaluate their 

notions of these trade-offs. Some argued that the low rate 

of inflation during this expansion was the fortunate result 

of temporary factors, such as a strong dollar and low 

energy prices, both of which could diminish or reverse 

direction over time.7 Only a few analysts were so bold as 

to suggest that the fundamental workings of the economy 

had changed in such a way as to allow a sustained period 

of high economic growth with low inflation. 

An early Wall Street description of the New Economy 

appeared in an article released by Goldman Sachs in 

January 1997.8 It describes a number of fundamental 

changes in the economy—driven by global competition 

and advancing technology—that may permit business 

cycle expansions to last longer than they have in the 

past. At the same time, it warned that longer economic 

expansions might have a tendency to contribute to 

greater financial excess and the possibility of more 

severe recessions and more sluggish recoveries. 

If this hypothesis is correct, and an emerging New 

Economy would contribute to longer expansions and 

more severe recessions, there may be implications for 

how banks manage risks. Since the Great Depression, 

U.S. business cycle recessions have not necessarily been 

catalysts for large numbers of bank and thrift failures. 

5 January 24, 2000. Has the Market Gone Mad? Fortune.
 6 September 1999. Earnings: Why They Matter. Money.
 7 Brown, Lynn Elaine. Federal Reserve Bank of New England.
 

May/June 1999. U.S. Economic Performance: Good Fortune, Bubble,
 

or New Era? New England Economic Review. http://www.bos.frb.org/
 

economic/pdf/neer399a.pdf, and Brinner, Roger E. Federal Reserve
 

Bank of New England. January/February 1999. Is Inflation Dead?
 

New England Economic Review. http://www.bos.frb.org/economic/
 

pdf/neer199c.pdf.
 

8 Dudley, William C., and Edward F. McKelvey. January 1997. The
 

Brave New Business Cycle: No Recession in Sight. U.S. Economic
 

Research, Goldman Sachs.
 

During the period from 1983 to 1989, when the U.S. 

economy was in the midst of a long expansion, some 

1,855 insured banks and thrifts failed. This wave of 

failures has been attributed to a variety of factors, 

including severe regional economic downturns, realestate-related problems, stress in the agricultural sector, 

an influx of newly chartered banks and banks that converted charters, and high nominal interest rates.9 However, the potential for significantly more severe national 

recessions would represent largely uncharted territory 

that could cause losses and loss correlations to depart 

from historical norms, posing a new set of risk management challenges for the industry going forward. 

The Productivity Revolution 

As the essential element that links faster economic 

growth and low inflation, productivity growth is the cornerstone of the New Economy. Productivity refers generally to the amount of output that can be obtained from 

a fixed amount of input. Labor productivity is usually 

measured in terms of output per hour. Chart 1 shows 

that output per hour in manufacturing has risen at an 

average annual rate of 4.5 percent during the current 

expansion, compared with rates of just over 2.5 percent 

in the three previous long economic expansions. Moreover, productivity growth accelerated in 1999 to a rate 

of 6.3 percent. Why is productivity growing so fast now 

compared with previous expansions? Even economists 

who believe that economic relationships have fundaCHART 1 

Productivity Has Grown at a Faster Rate in This 

Expansion than in Previous Long Expansions 

Average Year-over-Year Growth 

in Manufacturing Output per Hour 

5.0% 

4.0% 

3.0% 

2.0% 

1.0% 

0.0% 

1961–69 1975–79 1983–90 1991–2000 

Source: Bureau of Labor Statistics (Haver Analytics) 

9 FDIC 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, 16–17. http://www. 

fdic.gov/bank/historical/history/contents.html. 

Chicago Regional Outlook 12 Second Quarter 2000 
In Focus This Quarter
 

mentally changed are hard-pressed to explain why all of 

the factors came together in the late 1990s and not 

before.10 Still, explanations for the increase in productivity tend to focus on three main factors. 

Increased Competition. Expanding global trade during 

the 1980s and 1990s has subjected U.S. firms to new 

competition from around the world. Annual U.S. 

exports of goods and services grew by over 230 percent 

(after inflation) between 1982 and 1999, while imports 

grew by 315 percent. The construction of new production facilities around the world in industries such as 

autos and chemicals has led to excess manufacturing 

capacity that has kept prices low. In other industries, 

including air travel, trucking, telecommunications, and 

banking, competition has been intensified through 

domestic deregulation. Facing intense competitive pressures and a low rate of general price inflation, firms 

cannot rely on annual price increases to help expand 

top-line revenue. Instead, there is pressure to continually cut costs in order to increase earnings. For many 

firms, this means adopting new technologies and new 

ways of organizing operations. 

Expanded Investment. U.S. firms of all sizes have 

invested in new technologies at a rapid pace during this 

expansion. Chart 2 shows that business investment in 

equipment and software represents almost one-quarter 

of total net GDP growth during this expansion, comCHART 2 

Business Investment in Equipment and Software
 

Has Been Robust during This Expansion
 

Average Percent Contribution of Real Investment 

in Durable Equipment and Software 

to Net GDP Growth by Expansion 

25 

20 

15 

10 

5 

0 

1961–69 1975–79 1983–90 1991–99 

Note: GDP = gross domestic product
 

Source: Bureau of Economic Analysis (Haver Analytics)
 

10 One possible explanation is that there is a learning curve for adopting new technologies and that technology diffusion is an inherently 

slow process. David, Paul A. Organization for Economic Cooperation 

and Development. 1991. Computer and Dynamo: The Modern Productivity Paradox in a Not-Too-Distant Mirror. In Technology and 

Productivity: The Challenge for Economic Policy, 315–47. 

pared with around 15 percent or less during previous 

long expansions. While this investment has been motivated by the need to cut costs, it has also been fueled by 

the availability of new computer technologies that have 

fallen in cost over time and by the ready availability of 

financial capital on favorable terms. 

Industrial Restructuring. The third aspect of the productivity revolution is large-scale restructuring in the 

U.S. corporate sector. Chart 3 shows that both the annual number and dollar volume of mergers in the late 

1990s far exceeded the pace of the so-called merger 

mania of the late 1980s. Two classes of firms are leading the new wave of mergers. First, companies in 

mature industries such as oil, autos, and banking are 

faced with excess productive capacity and intense price 

competition. For these firms, mergers are useful in 

expanding market share and removing redundant operations. Second, the largest dollar volume of mergers is in 

some of the most volatile emerging industries, including telecom, media, and the Internet. It is in these sectors of the economy, in particular, where the business 

models are evolving rapidly and where technological 

standards are still being determined. Firms in these 

industries that can grow rapidly through mergers have 

the chance to achieve long-term market dominance in 

what appear to be some of the fastest growing industries 

of the new century. 

The implications of the productivity revolution for the 

banking industry have been decidedly positive. Higher 

productivity has allowed a long expansion and faster 

economic growth with low inflation, all of which are 

conducive to robust financial performance by depository institutions. Higher rates of business investment 

CHART 3 

Note: M&A = merger and acquisition 

Source: Houlihan Lokey’s Mergerstat 

The Volume of Corporate Mergers Set 

Another New Record in 1999 

Number of M&A Deals M&A Deal Value, Billions of Dollars 

’70 ’72 ’74’76’78’80 ’82 ’84’86 ’88 ’90’92’94’96 ’98 

0 

2,000 

4,000 

6,000 

8,000 

10,000 

1,000 

1,200 

1,400 

1,600 

0 

200 

400 

600 

800 

Chicago Regional Outlook 13 Second Quarter 2000 
In Focus This Quarter
 

have generated demand for credit that is supplied, in 

part, by banks and thrifts. Perhaps most important, the 

recent large-scale industrial restructuring has been 

highly supportive of strong business credit quality. This 

process has moved economic resources to more productive uses in an orderly fashion, without the high levels 

of bankruptcies and defaults that often accompany 

industrial restructuring. Given the volumes of corporate 

assets that have changed hands in recent years (more 

than $1.4 trillion in 1999 alone), it is fortunate indeed 

that this restructuring has proceeded in this fashion. 

The Role of the Capital Markets 

A critical factor in heightened business investment and 

restructuring during this expansion has been the 

remarkably favorable conditions in the financial markets. Financial capital has generally been readily available to business borrowers, usually on favorable terms. 

One factor that has held down the cost of capital for 

publicly traded corporations has been sharply rising 

stock prices. Many of these firms have been able to use 

equity shares as a currency with which to finance mergers. Furthermore, existing accounting rules do not 

always require the amortization of good will that comes 

onto the balance sheet as a result of a merger.11 

By far the largest amount of external business financing 

has been debt financing. U.S. nonfinancial corporations 

issued net debt in the amount of $535 billion in 1999 

and repurchased equity shares, on net, for the sixth consecutive year. Businesses have used this debt to purchase capital equipment, finance mergers, and buy back 

equity shares. This increase in debt issuance has not 

been limited to highly rated corporations. Venture capital financing amounted to almost $15 billion in the 

fourth quarter of 1999 alone, with over 60 percent of 

that amount going to Internet firms.12 

Banks have been active participants in nearly every 

facet of this financing activity. Syndicated loan origination volumes rose by 17 percent in 1999 to just over 

$1 trillion, despite relatively high credit costs and facility fees, factors that helped keep total volume below 

1997’s record $1.1 trillion in issuance. Syndicated loans 

to leveraged companies also rose 17 percent in 1999 to 

a record $320 billion. More impressive still was the 

growth in high-yield transactions, which rose nearly 50 

11 April 17, 2000. Techdom’s New Bean-Counting Battle. Business 

Week. 

12 May 2000. Venture financing data are derived from a PriceWaterhouseCoopers/Money Tree survey, as cited in Upside, 43. 

percent in 1999 to $190 billion. It is difficult to determine precisely how much syndicated loan exposure 

resides on the books of insured institutions or, more 

important, how much high-yield exposure is retained by 

commercial banks. Loan Pricing Corporation estimates that 64 percent of high-yield volume in the first 

half of 1999 was retained by banks.13 Insured commercial banks are the dominant originators of syndicated 

loans, with a 79 percent market share of investmentgrade originations and a 56 percent market share of 

non-investment-grade originations in 1999. Commercial banks have also expanded their presence in the venture capital market. For some of the largest banks, 

profits from venture capital operations account for a 

large portion of total earnings. Chase Manhattan reported venture capital investment earnings of $2.3 billion in 

1999, accounting for 22 percent of total net income.14 

Innovation in the capital markets continues to provide 

new and more efficient vehicles for business financing. 

For example, issuance of asset-backed securities totaled 

$346 billion in 1999, up from only $50 billion in 1990. 

In this ongoing revolution in finance, market-based 

intermediaries, such as mutual funds and asset pools, 

have assumed an increasing role in the credit markets. 

Chart 4 shows that net holdings of credit market instruments by mutual funds, government-sponsored enterprises, and asset pools exceeded the debt held by 

depository institutions for the first time in 1997. 

CHART 4 

Market-based Lending Is Becoming More 

Important as a Source of Business Financing 

Share of Total Net 

Credit Market Lending1 

Market-based Lenders3 

Depository Institutions2 

0% 

10% 

20% 

30% 

40% 

50% 

60% 

70% 

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

1 Total net credit market lending is defined as net holdings of open-market paper,
 

government and municipal securities, corporate and foreign bonds, mortgages,
 

and other loans.
 

2 Depository institutions include commercial banks, savings institutions, and credit
 

unions.
 

3 Market-based lenders include mutual funds, closed-end funds, government-


sponsored enterprises, and asset pools.
 

Sources: Federal Reserve Board (Haver Analytics); Regional Financial Associates
 

13 September 13, 1999. Junk Loan Market Is Feeling the Pinch of 

Oversupply and Rising Interest Rates. The Wall Street Journal. 14 April 3, 2000.What’s Really Driving Banks’ Profits. Business Week. 

Chicago Regional Outlook 14 Second Quarter 2000 
In Focus This Quarter
 

While the expansion in market-based financing has 

made credit more available to business and consumer 

borrowers, it also creates some concerns. One issue is 

the susceptibility of the financial markets to periodic 

bouts of turmoil. These episodes, such as the one triggered by the Russian government bond default and the 

near-failure of the Long Term Capital Management 

hedge fund in the fall of 1998, can result in the interruption of capital flows even to creditworthy borrowers. 

During the 1998 episode, private yield spreads widened 

sharply as investors sought the safety of U.S. Treasury 

securities. Some companies that had planned to issue 

debt to the markets during that period were unable to do 

so. For companies whose business models depend heavily on a continuous supply of liquidity from the financial markets, the effects of these episodes can be 

catastrophic. For example, the relatively short-lived 

episode of financial turmoil during late 1998 resulted in 

significant liquidity problems for a number of commercial mortgage firms. Nomura, Lehman Brothers, CS 

First Boston, and others incurred losses, while Criimi 

Mae, Inc., was forced to declare bankruptcy. 

Because market-based financing has played such a large 

role in facilitating the orderly restructuring of the U.S. 

economy through mergers and the formation of new 

businesses, a recurrence of financial market turmoil 

could contribute to the end of the current expansion. 

Moreover, such an event could have serious consequences for business credit quality. A prolonged interruption of market-based financing could, in this very 

competitive economic environment, prevent businesses 

from restructuring themselves through mergers and 

deprive them of capital needed to invest in cost-cutting 

technologies. The loss of financial flexibility would 

leave businesses much more vulnerable to the effects of 

CHART 5 

competition and could result in more firms seeking 

bankruptcy protection. Such a scenario has the potential 

to bring about a significant increase in charge-off rates 

for business lenders. 

Financial Imbalances 

Another concern that arises from increased dependence 

on market-based financing is that it may contribute to 

the emergence of financial imbalances in the economy. 

These imbalances could, in turn, increase the potential 

for financial market turmoil as a result of some unforeseen shock to the markets. 

As recently as 1993, the public deficit was near the top 

of the list of economists’ concerns about the U.S. economy. During that year, the combined deficit of the federal, state, and local government sectors exceeded $300 

billion. However, on the strength of a long economic 

expansion, lower interest rates, and lower federal spending on defense, the consolidated government sector 

posted its second consecutive surplus in 1999 (Chart 5). 

As the government has moved from deficit to surplus, 

households and businesses have continued to borrow 

hundreds of billions of dollars every year. Taken together, the annual net borrowing of businesses and households has been referred to as the “private deficit.” In 

1999, the private deficit narrowed to $913 billion from 

a record $1.02 trillion the year before. Although this private borrowing indicates confidence on the part of consumers and businesses about future prospects, it also 

raises concerns about the ability to service debt if interest costs rise or if incomes level off or decline. 

Chicago Regional Outlook 15 Second Quarter 2000 

Flow of Net Sectoral Lending 

(Lending Less Borrowing), 

in Billions of Dollars Domestic Financial Sector 

Note: “Nonfinancial business” includes farm and nonfarm, corporate and noncorporate businesses. 

Source: Federal Reserve Board (Haver Analytics) 

Net Borrowing by Businesses and Households Represents a Growing “Private Deficit” 

–1,200 

–900 

–600 

–300 

0 

300 

600 

900 

1,200 

Foreign Sector 

Nonfinancial Business 

Households 

Government 

’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 
In Focus This Quarter
 

The largest part of the private deficit was again 

financed in 1999 by domestic financial institutions 

($649 billion) and an inflow of capital from abroad 

($207 billion). Both of these sources of financing are 

potential causes for concern. The rapid expansion in 

credit created by the financial sector raises questions 

about credit quality. Financial institutions theoretically 

serve as the gatekeepers of the economy, financing only 

the most creditworthy projects and rejecting those that 

are not viable. The sheer volume of credit extended to 

businesses and households—almost $1.4 trillion in new 

net lending over the past two years—raises the possibility that underwriting has become more lax and that 

average credit quality is slipping. (See the inset box on 

page 17 for a discussion of recent trends in commercial 

credit quality.) 

Reliance on inflows of foreign capital raises a different 

set of issues. The fact that the U.S. economy has been 

growing significantly faster than the economies of its 

major trading partners has contributed to a U.S. trade 

deficit that reached $268 billion in 1999 and could 

exceed $300 billion in 2000. This deficit puts hundreds 

of billions of dollars annually in the hands of foreign 

investors. As long as foreign investors largely choose to 

reinvest their excess dollars in U.S. factories and financial instruments, as has been the case in recent years, 

the United States can continue to enjoy a strong dollar 

and relatively low inflation and low interest rates. However, if foreign investors should choose to invest elsewhere, they must sell their dollars in foreign exchange 

markets. Doing so would put downward pressure on the 

dollar and upward pressure on U.S. inflation and interest rates. 

Recent Shocks to the U.S. Economy 

Despite the potential for a declining dollar as a result of 

U.S. reliance on foreign capital, other adverse developments have confronted the U.S. economy over the past 

year. The two factors of most consequence to the macroeconomic outlook have been rising energy costs and rising interest rates. These trends have played a role in 

recent equity market volatility that may have implications for the future direction of the economy. 

Rising Energy Prices. After declining to a low of 

around $10 per barrel in December 1998, oil prices have 

risen dramatically over the past year and a half. The spot 

price per barrel of West Texas Intermediate crude 

peaked in March 2000 at just under $30 before declining slightly in April. The rapid increase in oil prices during 1999 was sparked by a cutback in output by oilproducing nations that was instituted just as global economic growth was recovering from the crisis of 1998. 

The OPEC nations and other major oil producers 

reached a new agreement in March 2000 that provides 

for a production increase of some 1.5 million barrels a 

day. But, because demand is rising and gasoline inventories remain lean, analysts do not look for a significant 

decline in gasoline prices in the near term.15 

The effects of higher oil prices on the U.S. economy at 

this time are uncertain. According to some estimates, 

the economy is only half as dependent on oil as it was 

25 years ago, when the United States was experiencing 

the effects of its first “oil shock.”16 Still, higher oil 

prices were responsible for nearly all the increase in 

consumer price inflation during 1999. While year-overyear growth in the Consumer Price Index rose from 1.6 

percent in December 1998 to 2.7 percent in December 

1999, the core rate of inflation (excluding food and 

energy items) actually fell. The question now is whether 

higher energy prices will be passed along to the rest of 

the economy through rising wage and price demands 

during the remainder of 2000. 

Rising Interest Rates. From low points at the end of 

1998, both short-term and long-term interest rates have 

risen substantially, contributing to a higher cost of debt 

service for businesses and households. At the short end 

of the yield curve, the Federal Reserve (the Fed) raised 

the Federal Funds rate six times between June 1999 and 

May 2000, for a total increase of 175 basis points. 

While part of this increase merely reversed the reduction in rates that took place in late 1998, the Fed also 

voiced concerns that inflationary pressures might be 

emerging because of continued rapid U.S. economic 

growth. Given the stated commitment of the Federal 

Reserve to price stability, most analysts expect the Fed 

to continue to push short-term rates higher until growth 

in the economy slows to a more sustainable pace.17 

Bond markets also pushed up long-term interest rates 

during this period. The yield on the ten-year Treasury 

15 Energy Information Agency (U.S. Department of Energy). April
 

2000. Short-Term Energy Outlook. http://www.eia.doe.gov/emeu/
 

steo/pub/contents.html.
 

16 March 11, 2000. Fueling Inflation? The Economist.
 17 See, for example, U.S. House of Representatives. February 17,
 

2000. Testimony of Chairman Alan Greenspan Before the Committee
 

on Banking and Financial Services. http://www.federalreserve.gov/
 

boarddocs/hh/2000/February/Testimony.htm.
 

Chicago Regional Outlook 16 Second Quarter 2000 
In Focus This Quarter
 

As Commercial Credit Quality 

Indicators Slip, Trends in Commercial 

Lending Come to the Forefront 

Commercial lending, which includes both commercial 

and industrial (C&I) and commercial real estate (CRE) 

loans, represents the greatest source of credit risk to 

insured institutions and the deposit insurance funds. C&I 

loan growth continued to be strong in 1999, although it 

did moderate from 1998 levels, and recent underwriting 

surveys have reported a slight tightening of terms.18 Nevertheless, there are signs that commercial credit quality is 

deteriorating.19 Most notably, as seen in Chart 6, C&I loan 

charge-off rates, corporate bond defaults, and corporate 

bond rating downgrades relative to upgrades have all 

been trending upward recently. For example, C&I loan 

loss rates rose to 0.56 percent of total loans in 1999, nearly double the rate of loss experienced in 1997. Although 

C&I loan loss levels are well below historical highs experienced throughout the 1980s and early 1990s, these signs 

of credit quality deterioration are occurring despite 

extremely favorable economic conditions. 

At least three factors have contributed to weakening in 

corporate credit quality. First, corporate indebtedness has 

been rising, as businesses have been spending to increase 

productivity, cut costs, repurchase equity, and finance 

mergers and acquisitions. The second factor relates to a 

greater risk appetite in the financial markets. For example, originations of leveraged syndicated loans—in particular, highly leveraged loans—have tripled over the past 

five years. Finally, stresses within industry sectors hard 

hit by structural changes, global competition, and deflationary pressures have resulted in challenges for 

borrowers. 

Construction and development (C&D) lending continues 

to be one of the fastest growing segments of banks’ loan 

portfolios, while loss rates among CRE and C&D loans 

remain extremely low. However, there are indications 

that conditions could be worsening in some markets. In 

particular, as shown in Chart 7, strong office completions and construction activity have begun to outpace 

absorptions and are projected to continue to do so over 

the next several years. Moreover, these trends have 

implications for vacancy rates. The national office 

vacancy rate moved higher during 1999 for the first time 

since 1991 and is projected to climb higher. 

In addition, some local CRE markets continue to show 

signs of overbuilding. Last year, the FDIC’s Division of 

Insurance identified nine markets in which the pace of 

construction activity threatened to outstrip demand for at 

least two property sectors.20 Seven of these nine markets 

reported an increase in office vacancy rates in 1999. 

CHART 6 

0.0 

1.0 

2.0 

3.0 

4.0 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

Note: C&I = commercial and industrial 

Source: Moody’s; Bank and Thrift Call Reports (Research Information System) 

Deteriorating Indicators Suggest Weakening 

Business Credit Quality 

Insured Institution C&I 

Charge-off Rate 

Corporate Bond 

Default Rate 

Bond Ratings 

Downgrades to 

Upgrades (columns) 

18 Both the 1999 Senior Loan Officer Opinion Survey (Federal 

Reserve Board) and 1999 Survey of Credit Underwriting Practices 

(Office of the Comptroller of the Currency) point to more stringent 

C&I loan terms since the latter part of 1998. This tightening follows a four-year period of easing C&I loan standards and predominantly reflects an increase in loan pricing. 

19 For additional detail, see Sothoron, Arlinda, and Alan Deaton. 

FDIC Division of Insurance. First quarter 2000. Recent Trends 

Raise Concerns about the Future of Business Credit Quality. 

Regional Outlook. http://www.fdic.gov/bank/analytical/regional/ 

ro20001q/na/Infocus1.html. 

20 These markets are Charlotte, Orlando, Salt Lake City, Dallas, Las 

Vegas, Phoenix, Nashville, Atlanta, and Portland. See Burton, 

Steve. FDIC Division of Insurance. First quarter 1999. Commercial Development Still Hot in Many Major Markets, But Slower 

Growth May Be Ahead. Regional Outlook. http://www.fdic.gov/ 

bank/analytical/regional/ro19991/na/Infocus2.html. 

CHART 7 

0 

20,000 

40,000 

60,000 

80,000 

100,000 

120,000 

140,000 

’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 

0% 

5% 

10% 

15% 

20% 

Source: CB Commercial/Torto Wheaton Research 

U.S. Office Vacancies Rose Last Year 

for the First Time since 1991 

Completions, Absorption 

(000 sq. ft.) Vacancy

 Rate 

Completions 

Absorption 

Projected

Actual 

Chicago Regional Outlook 17 Second Quarter 2000
 
In Focus This Quarter
 

note rose from a low of 4.5 percent in October 1998 to 

6.5 percent by May 2000. Analysts have cited renewed 

demand for credit by a recovering world economy as 

well as concerns about inflation arising from the 

increase in energy prices as factors behind the rise in 

long-term rates. 

Higher energy costs and higher interest rates do not 

appear to have significantly slowed the pace of U.S. 

economic activity during the first quarter of 2000. The 

preliminary estimate of real gross domestic product 

growth during the quarter was 5.4 percent—a slowdown 

from the 7.3 percent rate of the fourth quarter of 1999 

but still well above what is considered a sustainable 

pace. Home construction, usually a sector that is particularly sensitive to movements in long-term interest 

rates, has remained surprisingly resilient. Still confident 

of their future prospects, homebuyers have increasingly 

turned to adjustable-rate mortgages to avoid some of the 

immediate costs of higher fixed mortgage rates. 

As for the business sector, higher costs for energy and 

debt service are most significantly affecting “Old Economy” firms that purchase commodity inputs and carry 

significant debt on their balance sheets. Airline companies in the S&P 500, for example, posted a year-overyear decline of 27 percent in net income from 

continuing operations during the first quarter of 2000.21 

Analysts have argued that New Economy firms, by contrast, are less vulnerable to recent economic shocks 

because they tend to carry little debt and consume relatively little energy. 

Equity Market Volatility. The notion that New Economy 

firms are less vulnerable to the effects of higher energy 

costs and higher interest rates may be one of the reasons 

that equity shares of firms in the technology sector 

began to dramatically outperform the broader market, 

beginning around the middle of 1999. Chart 8 shows 

that the technology-heavy NASDAQ index performed 

more or less in tandem with the Dow Jones Industrial 

Average between the end of 1996 and the middle of 

1999, but thereafter the NASDAQ soared far ahead of 

the Dow. Between October 1, 1999, and February 29, 

2000, the NASDAQ rose by 72 percent while the Dow 

declined by 4 percent. Moreover, this striking divergence between the equity returns of Old and New Economy companies was not limited to the U.S. markets. 

Parallel trends were observed in Europe, Japan, Korea, 

21 Bloomberg. The S&P 500 airline industry is composed of AMR 

Corp., Delta Air Lines, Southwest Airlines, and U.S. Airways Group. 

CHART 8 

and Hong Kong. The similarity in performance of the 

high-tech sectors across three continents suggests a 

worldwide flow of liquidity from investors to the shares 

of technology firms. 

However, emerging concerns about the technology sector contributed to significant volatility in technology 

0 

50 

100 

150 

200 

250 

300 

350 

400 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

Tech Stocks Have, Until Recently, Far 

Outperformed “Old Economy” Stocks Worldwide 

January 1997 = 100 

United States 

NASDAQ 

DJIA 

May 12, 2000 

0 

200 

400 

600 

800 

1,000 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

January 1997 = 100 

EASDAQ 

Bloomberg European 500 

May 12, 2000 

Europe 

0 

50 

100 

150 

200 

250 

300 

January 1997 = 100 

Japan 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

JASDAQ 

Nikkei 225 

May 12, 2000 

Chicago Regional Outlook 18 Second Quarter 2000 
In Focus This Quarter
 

shares during March and April 2000. The NASDAQ 

index lost 30 percent of its value between March 10 and 

May 12, 2000. Analysts cited the Justice Department 

finding against Microsoft and doubts about the ultimate 

profitability of business-to-consumer Internet firms as 

two factors in the sell-off. 

Equity market volatility also poses a threat to the economic outlook. One concern is the so-called “wealth 

effect” that a declining stock market may have on consumer spending. Since 1995, rising stock prices have 

helped raise the market value of equities held by U.S. 

households, plus their holdings of mutual funds, by 

some $5.7 trillion. This windfall is an important reason 

that households have continued to reduce annual personal savings (to just 2.4 percent of disposable income 

in 1999) and increase spending on homes, autos, and 

other consumer goods. Although it is uncertain what 

effect a prolonged stock market correction might have 

on consumer spending, the potential wealth effect has 

surely grown as more households hold a higher percentage of wealth in corporate equities and mutual fund 

shares. (See the inset box at right for a discussion of 

how financial market volatility could affect banks.) 

The Economic Outlook 

Despite the effects of rising energy costs, increasing 

interest rates, and equity market volatility, the U.S. 

economy continues to grow at a robust pace. The consensus forecast of 50 corporate economists surveyed by 

the May 1999 Blue Chip Economic Indicators suggests 

that the economy will grow by 4.7 percent in 2000, 

while consumer prices are projected to rise by 3.0 percent from 1999 levels. Short-term interest rates are projected to rise only slightly by year-end from early May 

levels. In short, the consensus forecast indicates that the 

New Economy formula of rapid economic growth combined with low inflation will continue for the foreseeable future. If actual events conform to this forecast, the 

result will likely be another year of generally low loan 

losses and solid earnings for much of the banking 

industry. (See the inset box on the following page for a 

discussion of other risks to watch in banking.) 

Clearly, risks are associated with the economic outlook. 

Recently, higher oil prices and higher interest rates have 

been the most visible signs of trouble for the economy. 

New Economy companies may be less vulnerable to 

these effects, but even these firms have experienced a 

sharp decrease in equity valuations as investors reevalFinancial Market Volatility Could 

Pare Earnings for Banks Most 

Reliant on Market Sources of 

Revenue 

FDIC-insured banks are deriving an increasing proportion of earnings from noninterest sources (see 

Chart 9), particularly market-sensitive sources of revenue. This is especially true for larger institutions. 

According to Deutsche Banc Alex. Brown, the 18 

most active generators of market-sensitive sources of 

revenue earned over 25 percent of net operating revenue from these potentially volatile business lines.22 

While market-sensitive sources help to diversify revenue streams, they can also introduce increased 

income volatility in the event of financial market turbulence. Deutsche Banc Alex. Brown also reports that 

for those 18 banks that generated the largest amounts 

of market-sensitive revenues during the third quarter 

of 1998, the share of total revenue derived from 

market-sensitive sources declined from 23 percent to 

13 percent. Thus, a more sustained downward trend in 

the financial markets could particularly affect the 

earnings of large banking companies that rely heavily 

on income from sources such as venture capital, asset 

management and brokerage services, and investment 

banking. 

CHART 9 

15 

30 

45 

60 

75 

90 

1970s 1980s 1990s 

Noninterest Revenues Account for a Growing 

Share of Bank Net Operating Revenue 

Percentage of Net Operating Revenue* 

* Net operating revenue is the sum of net interest income and 

noninterest income. 

Sources: FDIC Historical Statistics on Banking; FDIC Quarterly Banking 

Profile 

Net Interest Income Noninterest Income 

0 

22 Net operating revenue is the sum of interest income and 

noninterest income less interest expense. According to 

Deutsche Banc Alex. Brown, these companies are Bank of 

America Corporation; Bank of New York Company, Inc.; 

Bank One Corporation; Bank Boston; BB&T Corporation; 

Chase Manhattan Corporation; Citigroup, Inc.; First Union 

Corporation; FleetBoston Financial; JP Morgan; KeyCorp; 

Mellon Financial Corporation; National City Corporation; 

PNC Bank Corp.; SunTrust Banks, Inc.; US Bancorp; 

Wachovia Corporation; and Wells Fargo & Company. 

Chicago Regional Outlook 19 Second Quarter 2000 
In Focus This Quarter
 

Other Risks to Watch in Banking
 

Subprime Lending 

•	 Subprime consumer loan portfolios contributed to 

the large losses associated with recent high-cost 

bank failures. During 1999, the FDIC reported the 

first annual loss for the Bank Insurance Fund since 

1991. The loss was primarily the result of an uptick in 

unanticipated and high-cost bank failures. FDICinsured institutions with at least 20 percent of Tier 1 

capital in subprime loans accounted for 6 of the 13 

bank failures that occurred between January 1998 and 

March 2000. Fraud and inappropriate accounting for 

residuals also played a role in some of these failures.23 

•	 Subprime lending remains an area of concern. 

Insured depository institutions that engage in subprime lending represent a disproportionate share of 

problem institutions. Of the 79 banks and thrifts on 

the problem bank list as of year-end 1999, 21 percent 

were institutions with at least 20 percent of their Tier 

1 capital in subprime loans.24 

Agricultural Lending 

•	 While a majority of agricultural institutions remain 

relatively strong, external conditions have put pressure on some agricultural producers. Many agricultural areas are experiencing low commodity prices as 

well as weather- and disease-related problems. Strong 

global competition and high worldwide production 

over the past several years have resulted in increasing 

inventories of many crops and poor prospects for a 

price turnaround in the near term. Moreover, in spite 

of record government farm payments in 1999, the 

U.S. Department of Agriculture projects that in the 

year 2000 one in four farms will not cover cash 

expenses, up to 20 percent of farmers will experience 

repayment problems, and 5 percent of farmers will be 

“vulnerable.”25 

23 See Puwalski, Allen. FDIC Division of Insurance. Second 

quarter 1998. Gain-on-Sale Accounting Can Result in Unstable 

Capital Ratios and Volatile Earnings. Regional Outlook. http:// 

fdic01/division/doi/outlook/2q1998/atlanta/infocus1.html. 

24 The problem bank list includes all insured depository institutions rated a composite “4” or “5.” 

25 “Vulnerable,” as defined by the U.S. Department of Agriculture 

Economic Research Service, applies to institutions that have 

debt/asset ratios above 0.40 and negative income such that they 

cannot meet current expenses or reduce existing indebtedness. 

•	 Some signs point to growing stress for agricultural 

institutions. Forty-two percent of FDIC-supervised 

banks active in agricultural lending showed a moderate or sharp increase in the level of carryover debt 

during third quarter 1999, compared with just 26 percent during third quarter 1998.26 In addition, net loan 

loss rates for agricultural production loans increased 

in 1999 to the highest level since 1991. However, at 

0.32 percent, the 1999 net loss rate is just one-tenth 

the rate experienced during the height of the agricultural crisis of the mid-1980s.27 

Operational Risk 

•	 Operational risks are becoming more prominent in 

the banking industry. Driven by consolidation and 

expansion into new product lines and markets, financial institutions are seeing an increase in operational 

complexity. Operational risk encompasses a host of 

factors not related to credit or market activities, 

including risks associated with processing transactions, legal liability, fraud, strategic missteps, and 

internal control weaknesses. Operational risks tend to 

be more pronounced when institutions engage in 

rapid growth, far-flung operations, and complex business processes. 

•	 Greater attention is being paid to operational risks 

in the financial industry. Recently, analysts have 

noted that the pressure to meet ambitious postmerger 

earnings predictions can result in cost-cutting measures that jeopardize the comprehensiveness and 

integrity of risk-management systems. In addition, 

the role that fraud has played in recent bank problems 

and failures reinforces the importance of adequate 

internal controls and audit procedures. The significance of operational risks to financial institutions has 

been noted in industry surveys and informationsharing efforts among financial firms.28 NetRisk Inc., 

a Greenwich, Connecticut, consulting firm, recently 

estimated that operational losses among financial 

institutions have exceeded $40 billion over the past 

five years. 

26 September 1999. FDIC Report on Underwriting Practices. 27 See Anderlik, John M., and Jeffrey W. Walser. FDIC Division of 

Insurance. Third quarter 1999. Agricultural Sector Under Stress: 

The 1980s and Today. Regional Outlook. http://www.fdic.gov/ 

bank/analytical/regional/ro19993q/kc/agricult.html. 

28 For additional detail, see March 2000. Operational Risk: The 

Next Frontier. RMA/PricewaterhouseCoopers Survey. April 6, 

2000. Tech Bytes: Banks Join Forces Against Operational Risk. 

American Banker. 

Chicago Regional Outlook 20	 Second Quarter 2000 
In Focus This Quarter
 

uate the long-term prospects. Equity market volatility 

threatens to dampen consumer confidence and the ability of businesses to continue to merge, restructure, and 

invest. 

The economy has become particularly dependent on 

financing delivered through the capital markets. In this 

more permissive financial environment, rising debt levels and greater dependence on foreign capital have 

emerged as financial imbalances that may contribute to 

future problems for the economy. Businesses and 

households with high levels of debt are more vulnerable 

to problems if interest rates continue to rise or income 

growth falters. Rapid credit creation by the domestic 

financial sector suggests the possibility of lax credit 

underwriting standards. Reliance on foreign capital 

raises concerns about what would happen to the value of 

the dollar and to domestic inflation if foreign investors 

decide to invest elsewhere. 

Some analysts suggest that the New Economy, driven by 

increased productivity, heightened competition, and 

robust investment, may be characterized by longer 

expansions. Financial market imbalances may, however, 

contribute to deeper recessions and more sluggish 

recoveries compared with earlier business cycles. 

For the banking industry, it is clear that a recession 

would mean slower loan growth, deteriorating credit 

quality, and impaired profitability. But the biggest 

threat to the banking industry is a recession that is tied 

to disruptions in the financial markets. The ready availability of financing to start new businesses and restructure old businesses has been key to the New Economy. 

The process by which businesses have invested and 

restructured in response to competition has been orderly from the perspective of bank creditors. If this 

process should be disrupted, we could see a much more 

disorderly process, with more bankruptcies and higher 

losses to lenders. 

This article was prepared and coordinated by the management and staff of the Analysis Branch of the Division of 

Insurance. Contributions and feedback from analysts across the Division were essential to its completion. 

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

Richard A. Brown, Chief, Economic and Market Trends Section 

Steve Burton, Senior Banking Analyst 

Steven C. Cunningham, formerly Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, formerly Senior Financial Analyst 

Mary L. Garner, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Thomas A. Murray, Senior Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Arlinda Sothoron, Senior Financial Analyst 

Ronald Spieker, Chief, Regional Programs and Bank Analysis 

Chicago Regional Outlook 21 Second Quarter 2000 
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