Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2000 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Paul R. Agosti,
 

Regional Economist
 

Millen L. Simpson,
 

Financial Analyst
 

Shayna M. Olesiuk,
 

Economic Analyst
 

In Focus This Quarter 

◆ Recent Trends Raise Concerns about the Future of Business Credit 

Quality—Commercial and industrial (C&I) lending is one of the largest and 

fastest-growing lending lines at insured institutions. Recent growth in C&I lending 

can be attributed to a strong U.S. economy, increased industrial merger activity, and 

a willingness of lenders to extend credit. While C&I credit quality remains relatively strong, signs of deterioration have recently begun appearing in C&I portfolios 

and in corporate bond defaults. These signs of weakness in commercial credit quality raise concerns because they are appearing during a period of economic strength. 

Business credit quality could deteriorate further in the event of an economic slowdown, higher interest rates, or a loosening of underwriting practices. See page 3. 

By Arlinda Sothoron, Alan Deaton 

◆ Local Industries in the Global Economy—The contribution of international trade to overall U.S. economic activity has been increasing for a number of 

years. Although the United States trades with many nations, most activity is concentrated in a few markets—Canada, Japan, and Mexico. Across a collection of 

industries, there is, however, considerable variation in both the level of exposure to 

export markets and the intensity of import competition.A number of industries are 

highly exposed to international markets, suggesting that economic conditions 

abroad are particularly important in any assessment of future revenue growth or 

profitability. See page 11. 

By Paul C. Bishop 

Regional Perspectives 

◆ Although the San Francisco Region experienced tight labor markets in many 

urban areas and economic weakness in some states, the Region’s nonfarm employment growth through October 1999 continued to outpace the nation’s growth. See 

page 18. 

◆ The Region’s insured financial institutions reported strong earnings, credit 

quality, and capitalization during third-quarter 1999, although earnings growth 

slowed. See page 20. 

◆ Insured financial institutions have entered the Region’s higher-growth urban 

areas at an increasing rate through mergers and acquisitions and de novo chartering. Currently, the number of institutions in the Region that have not weathered an 

economic downturn is at the highest point in the past decade. See page 21. 

By the San Francisco Region 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, AS, AZ, CA, 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 San Francisco Region’s 

Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 808-8158 or send an e-mail to 

cphillips-olsen@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Steven E. Cunningham 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Recent Trends Raise Concerns about the Future of
 

Business Credit Quality
 

•	 C&I loan portfolios have been growing rapidly 

during this economic expansion. 

•	 Indicators of weakening corporate credit quality 

have begun to appear, including higher C&I loan 

losses and rising corporate bond defaults. 

•	 The future of business credit quality will depend 

on the economy and on underwriting practices. 

Commercial and industrial (C&I) lending is one of the 

largest and fastest-growing segments of lending at 

insured institutions. As of the third quarter of 1999, 

C&I loans comprised 24 percent of total loans and 

leases held by FDIC-insured institutions, up from 21 

percent at the end of 1995. C&I loan portfolios have 

grown primarily because of strong loan demand driven 

by a long economic expansion during which the indebtedness on corporate balance sheets has expanded rapidly. Even as the economic expansion continues, C&I loan 

charge-offs have begun to trend upward, albeit from historically low levels. By some measures, banks and the 

financial markets appear to be assuming increased levels of risk that could lead to greater C&I loan losses 

when the economy eventually weakens. 

High rates of growth in commercial lending and weakening indicators of C&I credit quality raise concerns 

about the future of credit quality at insured institutions. 

This article examines the factors that have contributed 

to high C&I loan growth rates and discusses the drivers 

that will determine the direction of C&I credit quality in 

the future. While loan performance at insured institutions is relatively good at the present time, signs of deterioration and stress have begun to appear despite the 

continued strength of the domestic economy. The future 

of C&I credit quality will ultimately be determined by 

trends in underwriting and corporate debt levels, along 

with the performance of the U.S. economy. 

C&I Loan Growth Has Accelerated 

C&I loans held by FDIC-insured banks and thrifts grew 

by almost 9 percent during the 12 months ending in 

September 1999, down somewhat from a 13.4 percent 

rate of growth in 1998 (see Chart 1). By contrast, total 

CHART 1 

Commercial and Industrial (C&I) 

Loans Are Growing at a Faster Rate 

than Total Loans and Leases 

Loan Growth 

Rate (%) C&I Loans 

15 

10 

5 

0 

–5 

–10 

Note: 1999 data are annualized based on 3Q99 data. 

Source: FDIC Research Information System 

Total Loans 

and Leases 

’86 ’88 ’90 ’92 ’94 ’96 ’98 

loans and leases at insured institutions grew by only 7 

percent in the 12 months ending in September 1999. 

C&I loans accounted for approximately 29 percent of 

all net new loans booked during the 12 months ending 

in September 1999, while unfunded C&I loan commitments grew by approximately 17 percent to $1.6 trillion. 

Syndicated lending played a major role in C&I loan 

growth during the 1990s. As intense competition and a 

narrowing of financial institutions’ net interest margins 

have encouraged lenders to seek additional sources of 

revenue, larger institutions have become increasingly 

active as loan syndicators and as purchasers of syndicated credits. Syndicated loan volume reached its peak 

in 1997, when originations totaled some $1.1 trillion 

(see Chart 2, next page).1 After falling off in 1998, originations of syndicated loans rose by 17 percent in 1999 

to just over $1.0 trillion. Leveraged loans, in which the 

borrower’s debt-to-equity ratio is significantly higher 

than the industry average, served as a catalyst for syndicated lending growth in 1999, accounting for 32 percent of total syndicated loan originations. Leveraged 

lending is very attractive to lending institutions because 

of the generous fee income associated with leveraged 

originations. Leveraged loan originations grew to $320 

billion in 1999, partly because of the continued rapid 

pace of corporate mergers in 1999.2 

1 LPC Gold Sheets, Vol. XIV, No. 1. Loan Pricing Corporation.
 

January 10, 2000.
 

2 According to Houlihan Lokey’s Mergerstat, total M&A activity set
 

a new record of $1.4 trillion in merger deal value in 1999.
 

San Francisco Regional Outlook 3	 First Quarter 2000 
In Focus This Quarter
 

Most of the C&I loan growth among insured institutions 

since 1997 has been concentrated in loans to domestic 

borrowers. C&I loans held in foreign offices declined 

following the Asian economic crisis and the Russian 

government bond default in 1997 and 1998, respectively, while domestic C&I lending was growing at doubledigit rates. During the 12 months ending in September 

1999, C&I loans held in domestic offices grew 12.2 

percent while C&I loans held in foreign offices 

declined by almost 6 percent. 

Is This Rapid Loan Growth a Cause 

for Concern? 

The effect of rapid loan growth on subsequent credit 

quality has been the subject of a number of articles. A 

recent study by the Federal Reserve Bank of Kansas 

City found that high rates of loan growth in the early 

1980s and early 1990s appeared to be positively correlated with future higher loss rates.3 The study also noted, 

however, that relatively high loan growth rates in the 

late 1980s did not result in sharply higher loss rates. 

Another study by the Federal Deposit Insurance Corporation found that banks that failed during the banking 

crisis of the 1980s were generally more likely to have 

grown their loan portfolios aggressively than banks that 

did not fail.4 But it remains to be seen whether the high 

C&I loan growth rates of today will necessarily contribute to higher losses for insured institutions in the 

future. The future course of industry loan losses 

depends on many factors, including the condition of the 

economy, the interest rate environment, and underwriting standards used in originating C&I credits. 

The Condition of the Economy 

Is an Important Driver of C&I Loan Growth 

Recent economic conditions have been particularly 

conducive to rapid growth in domestic C&I lending. 

Business investment has expanded at double-digit 

annual rates as firms have invested in new technologies 

to raise productivity and keep costs down. These productivity gains have been instrumental in allowing the 

3 William R. Keeton. “Does Faster Loan Growth Lead to Higher Loan
 

Losses?” Economic Review. Federal Reserve Bank of Kansas City.
 

Second quarter 1999. 


4 Federal Deposit Insurance Corporation, Division of Research and
 

Statistics. History of the Eighties: Lessons for the Future. Vol. 1, An
 

Examination of the Banking Crises of the 1980s and Early 1990s.
 

1997. http://www.fdic.gov/bank/historical/history/contents.html.
 

CHART 2 

Syndicated Loan Originations Rebounded 

in 1999 after Falling from Record Levels 

Source: Loan Pricing Corporation 

Syndicated Loan Originations

 ($ Billions) 

0 

200 

400 

600 

800 

1,000 

1,200 

’95 ’96 ’97 ’98 ’99 

economy to grow at a relatively rapid pace with low 

inflation. Strong growth in real wages has helped boost 

the consumer confidence index to an all-time high of 

144 in January 2000. Robust consumer demand for 

goods and services has kept business profits growing, 

further spurring business borrowing to finance inventories, new construction, and fixed assets such as computer networks. Amid all of these favorable trends, C&I 

loan charge-off rates have remained at record lows of 

less than 0.5 percent since 1994. Recently, however, 

despite a continuation of generally favorable conditions 

in the economy and the financial markets, signs of credit quality deterioration have begun to appear in C&I 

loan portfolios. 

Evidence from Financial Institutions Points 

to a Weakening in Business Credit Quality 

Despite strong business conditions and generally good 

asset quality, signs of deterioration in C&I credit quality have begun to appear in bank portfolios. While problem C&I loan levels remain low by historical standards, 

net C&I loan charge-offs during the 12 months ending 

in September 1999 were 63 percent higher than during 

the previous 12-month period. The net C&I loan chargeoff rate rose in the 12 months ending in September 1999 

to 0.5 percent, up from 0.3 percent one year earlier. 

Similarly, noncurrent C&I loans as of September 1999 

rose to $11.2 billion, or 1.2 percent of total C&I loans.5 

In dollar terms, this level of noncurrent loans is 30 percent higher than one year earlier. 

5 Noncurrent C&I loans include C&I loans past-due over 90 days and 

all C&I loans in nonaccrual status. 

San Francisco Regional Outlook 4 First Quarter 2000 
In Focus This Quarter
 

Despite these increases in C&I charge-offs and noncurrent C&I loans, the current industry ratios for these measures remain well below the 1.9 percent and 4.5 percent 

ratios reported during the recession in 1991 for net C&I 

charge-offs and noncurrent C&I loans, respectively. 

Interagency Loan Review Reveals Increases 

in Problem Credits from Previously Low Levels 

The results of the 1999 Shared National Credit (SNC) 

review provide another indication of slipping credit 

quality at large commercial banks.6 According to the 

Federal Reserve Board of Governors, adversely classified syndicated loans rose to $37.4 billion in the 1999 

review, a level approximately 70 percent higher than that 

reported in 1998. This figure represents 2 percent of the 

$1.8 trillion in drawn and undrawn loan commitments 

reviewed in 1999. By contrast, adversely classified 

assets identified in the 1998 SNC review totaled only 

$22 billion, or 1.3 percent of loans reviewed in 1998.7 

While the level of adversely classified syndicated loans 

remains low, 14 percent of the loans adversely classified 

during the 1999 review were loans made to new borrowers since the 1998 SNC review. In reference to this 

finding, Office of the Comptroller of the Currency 

(OCC) First Senior Deputy Comptroller and Chief 

Counsel Julie Williams has noted that “Banks are booking new loans that are weak at their inception.”8 The 

high rate of adversely classified new loans could be 

attributable to the continued effects of loan originations 

made toward the end of a period of loosened underwriting standards in 1997 and early 1998. Alternatively, it 

could indicate a higher-risk credit mix in current C&I 

loan portfolios. 

Signs of corporate stress that may weaken credit quality at insured institutions are also reflected in recent 

Banc of America Securities analysis of publicly available bank loan amendments.9 This study shows a significant increase in the number of loan amendments 

6 The annual interagency process reviews commercial loans over 

$20 million that are shared by three or more participants. 

7 Federal Reserve Board Press Release. November 10, 1999. 

8 “OCC’s Williams Warns of Credit Risk in the Banking System; Calls 

for Bankers to Scrutinize Loan Portfolios More Closely.” OCC Press 

Release. October 5, 1999. 

9 “Leveraged Loans: The Plot Thickens.” Banc of America Securities 

Syndicated Finance Research. November 15, 1999. This loan amendment analysis was completed using only publicly available information 

from Loan Pricing Corporation and Banc of America Securities LLC. 

generated because of covenant relief requests, from 22 

percent of all loan amendments during the last six 

months of 1998 to 45 percent during the first ten 

months of 1999. 

Corporate Bond Defaults Soared in 1999 

Trends in corporate bond defaults also indicate increasing levels of stress in the corporate sector. During 1999, 

147 issuers defaulted on $44.6 billion in long-term debt. 

Default rates as a percentage of volumes outstanding (or 

dollar default rates) have trended upward each year 

since 1996, reaching 2.2 percent for all corporate issues 

at year-end 1999. Much of the increase can be attributed 

to a rising dollar default rate for speculative-grade 

issues, which peaked in November 1999 at 8.2 percent. 

Measured as a percentage of all issuers, the default rate 

for speculative-grade issues rose to a post-1991 high of 

6 percent in September 1999 (see Chart 3). According 

to Moody’s, year-end 1999 default rates improved marginally but are expected to remain high through mid2000.10 In addition, domestic speculative-grade issuers 

reported twice as many issuer downgrades as upgrades 

during the fourth quarter of 1999, although the dollar 

volume of upgrades exceeded the dollar volume of 

downgrades by 55 percent.11 

10 “Corporate Bond Default Rates Highest Since 1991.” Moody’s
 

Investors Service. October 13, 1999.
 

11 “Moody’s Default Rate Pendulum.” Moody’s October 1999 Commentary. Moody’s Investors Service. October 18, 1999.
 

CHART 3 

The Default Rate on Corporate Bonds Has
 

Been Driven by Defaults on Speculative Issues
 

Issuer-Weighted 

Default Rate (%) 

15 All Corporate Issues 

10 

5 

0 

Speculative Issues 

Dec ’89 Dec ’91 Dec ’93 Dec ’95 Dec ’97 Dec ’99 

Source: Moody’s Investors Service 

San Francisco Regional Outlook 5 First Quarter 2000 
In Focus This Quarter
 

Why Are C&I Loan Losses Increasing 

Amid Strong Economic Growth? 

Several factors have contributed to the current signs of 

deterioration of C&I credit quality in an environment of 

favorable business conditions. These factors include 

global competition and deflationary pressures, an 

increase in corporate debt levels, loosened underwriting 

standards, and a greater appetite for risk. 

Global competition and deflationary pressures 

have squeezed revenues. An era of low inflation and 

intense global price competition has contributed to low 

or negative revenue growth in a number of domestic 

industry sectors, particularly commodities and manufacturing.12 The result has been an increase in loan 

losses and corporate bond defaults in these sectors. 

Moody’s noted that the industrial sector, weakened by 

low commodity prices, accounted for 64 percent of all 

defaults in 1999, with the oil and gas, steel, and shipping industries being especially hard-hit.13 For example, 

Standard & Poor’s (S&P) reports that third-quarter 

1999 earnings for the iron and steel sector declined 80 

percent from one year earlier after five consecutive 

quarters of negative year-over-year earnings growth. 

Initially, commodity price declines and the international economic turmoil in 1997 and 1998 resulted in 

slowed foreign C&I lending and increased net losses of 

C&I loans held in foreign offices. These losses accounted for the majority of net C&I loan losses in 1997 and 

1998. However, this adverse trend reversed itself in 

1999, when C&I loans held in domestic offices 

accounted for the majority of losses. 

Corporations are increasingly reliant on debt markets. Increasing levels of debt on corporate balance 

sheets have helped to foster C&I loan growth. The 

growth in corporate debt is partially a result of actions 

taken by firms to improve operating efficiency, including increasing merger and acquisition (M&A) activity 

and rising spending on fixed investments. Capital 

expenditures on fixed investments by businesses have 

increased at a steady rate since the 1990–91 recession, 

as evidenced by Chart 4. Cash flow has also been 

increasing, but at a slower rate, resulting in a growing 

“financing gap” that reached an annualized level of 

12 See also Richard A. Brown and Alan Deaton. “Falling Prices in
 

Commodities and Manufacturing Pose Continuing Risks to Credit
 

Quality.” Regional Outlook, third quarter 1999. http://www.fdic.gov/
 

bank/analytical/regional/ro19993q/na/t3q1999.pdf.
 

13 “Historical Default Rates of Corporate Bond Issuers, 1920–1999.”
 

Moody’s Investors Service, January 2000.
 

CHART 4 

The Financing Gap Has Widened

 for Nonfinancial Corporations 

$ Billions “Financing Gap” 

900 

700 

500 

300 

100 

Capital Expenditures Cash Flow 

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

Note: 1999 data are annualized based on 3Q99 data. 

Source: Federal Reserve Board (Haver Analytics) 

$142 billion in the third quarter of 1999. Where cash 

flow has not been available to finance investment, firms 

have turned primarily to debt financing as opposed to 

equity financing. Net new corporate equity issues by 

nonfarm nonfinancial corporations have been negative 

in each year since 1993, while net new corporate bond 

issuance has increased from $75 billion in 1993 to $219 

billion in 1998. 

Loosened underwriting standards in 1997 and early 

1998 are contributing to current losses. Signs of 

stress in C&I loan portfolios can be partially attributed 

to loosened underwriting standards in 1997 and early 

1998. During 1997 and early 1998, loan underwriting 

standards loosened, accompanied by reduced spreads 

and pricing. In May 1998, the Federal Reserve Board 

Senior Loan Officer Opinion Survey on Bank Lending Practices reported that domestic banks were “generally eager to make loans to businesses” and that 

during early 1998 “a large percentage cut their spreads 

on such loans.” Moody’s describes the second half of the 

1990s as a “mini credit cycle.” The cycle began in 1995, 

when the strong economy, accompanied by falling interest rates and low loan losses and default rates, encouraged investor demand for high-yield bonds and loans.14 

A record number of first-time speculative-grade deals 

were also brought to market during 1997 and early 

1998. The increase in the volume of issuance was itself 

enough to push the default rate lower, which in turn may 

have fueled investor demand for additional high-risk 

bonds. However, the Asian crisis during 1997 and the 

Russian debt default during the second half of 1998 

14 “Default Rate Pendulum.” October 18, 1999. 

San Francisco Regional Outlook 6 First Quarter 2000 
In Focus This Quarter
 

caused new issuance of speculative-grade bonds to slow 

significantly while defaults rose sharply, to a rate of 6 

percent by issuer in September 1999. While speculativegrade bond issuance declined, banks stepped in to fill 

the void by raising originations of highly leveraged 

loans between second-quarter 1998 and fourth-quarter 

1999.15 

Financial markets have evidenced greater risk 

appetite. While the ratio of speculative-grade bond 

issues to total corporate bond issues has remained fairly stable at approximately 40 percent during the past 

decade, the composition of borrowings has shifted substantially. Moody’s reports a shift in the distribution of 

bond issue ratings within the speculative-grade category toward the lower end of the ratings scale (see Chart 

5).16 Evidence of this shift is demonstrated by the fact 

that bonds rated B3 or lower currently comprise approximately 35 percent of all speculative-grade issues, a 

record high and up from 24 percent in 1995.17 Furthermore, almost 50 percent of the issuers that defaulted 

during the year ending September 1999 were rated for 

three years or less.18 This change in the composition of 

ratings has contributed to the current increase in speculative-grade defaults and could affect the future volatility and liquidity of the market. The current high volume 

of corporate bond defaults reflects the looser standards 

in 1997 and 1998 for corporate debt issued by low-rated 

first-time issuers, who accounted for 40 percent of rated 

15 LPC Gold Sheets. January 10, 2000.
 16 Moody’s January 2000 Commentary. January 18, 2000.
 

17 “Refunding Risk for Speculative Grade Borrowers.” Moody’s Special Comment. Moody’s Investors Service. December 15, 1999.
 

18 “Default Rate Pendulum.” October 18, 1999.
 

CHART 5 

bond defaults in 1999.19 This relationship is analogous 

to the current increase in net C&I charge-offs partially 

attributable to weakened underwriting standards in 

1997 and early 1998. 

The Increase in Leveraged Lending Could 

Result in a Riskier Mix in C&I Loan Portfolios 

Leveraged lending comprises an important part of the 

syndicated lending market and generates considerable 

fee income for financial institutions. Leveraged loans 

have grown from 12 percent of total syndicated loan 

originations in 1995 to 32 percent in 1999 (see Chart 6, 

next page). Leveraged syndicated loan originations grew 

19 percent to $320 billion in 1999, as investors were 

seeking higher risk-adjusted returns and lenders were 

seeking higher fees. Paine Webber analysts estimate that 

leveraged lending accounts for over 80 percent of syndicated loan fees and profits earned by loan underwriters.20 

Highly leveraged lending increased to a new record of 

$190 billion in 1999.21 This growth in loan originations 

reflects the current high corporate demand for loans, and 

by definition these loans are being made to borrowers 

with higher-than-normal levels of financial leverage and 

risk. In return for their higher risk profile, leveraged borrowers must compensate financial institutions through 

higher pricing and higher fees. 

19 Moody’s January 2000 Commentary. January 18, 2000.
 

20 “The Biggest Secret of Wall Street.” Paine Webber Equity Research.
 

May 14, 1999.
 

21 Loan Pricing Corporation defines highly leveraged loans as those
 

for which pricing exceeds 250 basis points over LIBOR and generally involves sub-investment-grade credits.
 

The Composition of the Rated Bond Market Has Shifted

 toward the Lower Part of the Speculative-Grade Issues 

Distribution of Issuer Ratings 

as a Percentage of Total Issuers 

Note: Unrated issues of corporate debt fall below the speculative-grade “C” rating. 

Source: Moody's Investors Service 

Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca C 

Moody’s Bond Ratings 

January 1998 January 2000 

Investment-Grade Ratings Speculative-Grade Ratings 

0 

2 

4 

6 

8 

10 

12 

San Francisco Regional Outlook 7 First Quarter 2000 
In Focus This Quarter
 

CHART 6 

$ Billions As a Percentage of 

Total Syndicated Loans 

Loans to Leveraged Companies Represent 

a Greater Portion of Syndicated Loans 

Originations of Syndicated Loans to Leveraged Companies 

Note: 1999 data are annualized based on 3Q99 data. 

Source: Loan Pricing Corporation 

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

400 

0 

100 

200 

300 

40 

0 

10 

20 

30 

Leveraged lending volumes have recently been partially 

driven by M&A lending, which comprised over 30 percent of the total syndicated loan market in 1999. M&A 

activity approached $1.4 trillion in total volume during 

1999, increasing the demand for capital and driving corporations to the loan market.22 Approximately 22 percent of leveraged loans originated in 1998 were to the 

media and telecommunications industries, which have 

experienced significant levels of M&A activity.23 Leveraged buyout activity contributed an additional 15 percent to leveraged lending volumes, surpassing 1998 

levels in quantity. 

Where Is Business Credit Quality Heading? 

The future direction of business credit quality will be 

influenced by several factors, including the condition of 

the economy, growth in the indebtedness of corporate 

borrowers, exposure to vulnerable industry sectors, the 

interest rate environment, the development of emerging 

markets, and underwriting standards. 

Economic growth will remain an important determinant of credit quality. Should economic growth slow 

and corporate profits decline, the demand for C&I loans 

is likely to fall, and problem asset levels are likely to 

rise. A recent S&P survey of global credit conditions 

noted that excessive credit, attributable to unsustainable 

corporate indebtedness and falling asset values, has 

weakened the financial systems of 20 nations. As for 

credit expansion in the United States, the survey noted 

22 Houlihan Lokey’s Mergerstat. www.mergerstat.com. 23 “The Biggest Secret of Wall Street.” May 14, 1999. 

that the ratio of private sector loans outstanding to gross 

domestic product rose from 101 percent in 1995 to 142 

percent in 1999. S&P also noted evidence that banks’ 

C&I loan portfolios may be relying too heavily on loan 

repayments based on projections that are realizable only 

if the current economic expansion continues. S&P estimates that 5 to 15 percent of bank loans could default 

should the United States experience a significant downturn in the stock market leading to a hard landing for the 

domestic economy.24 

Continued growth in corporate indebtedness could 

contribute to increased losses and defaults. The 

growth rate of corporate debt has surpassed the growth 

rate of the economy in each year since 1994. A widening financing gap and increasing debt levels could pose 

problems if there are adverse changes in the interest rate 

environment or if corporate revenue growth slows. Rising rates will increase the costs of servicing debt, while 

a slowdown in revenue growth would reduce the cash 

flow available to service outstanding debt. Under such a 

scenario, business bankruptcies and failures are likely 

to rise, causing increased loan losses and bond defaults. 

Lending to some industries involves high-risk exposures. Despite the strength of the U.S. economy, some 

domestic industries are continuing to experience stress. 

Exposures to weakened industry sectors, such as health 

care and oil and gas, could negatively affect C&I credit 

quality at insured institutions. One way to evaluate the 

relative riskiness of firms operating in a given industry 

is through KMV Corporation’s® Expected Default FrequencyTM (EDFTM) analysis. KMV Corporation® has 

developed a proprietary method of measuring the 

degree of credit risk inherent in corporate borrowers by 

calculating an EDFTM score to estimate the probability 

that a firm will default on its obligations within one 

year.25 Chart 7 diagrams syndicated loan exposures 

along with December 1999 EDFTM scores and the direction of change since December 1998. This chart illustrates one measure of the risk associated with the 10 

industry sectors having the highest expected default 

24 “Global Financial System Stress: The Weak, the Vulnerable, and 

Those Limping Toward Recovery.” Standard & Poor’s. December 17, 

1999. 

25 KMV’s® proprietary calculation for EDFTM 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. Multiplying industry originations by median industry 

EDFTM scores provides an estimate of expected default volumes. This 

figure provides a more meaningful measure of aggregate lending risk 

exposure than pure origination volumes alone and can be used to rank 

industry exposures. 

San Francisco Regional Outlook 8 First Quarter 2000 
 

In Focus This Quarter
 

volume based on the volume of 1999 syndicated loan 

originations. In 1999, loans originated to mortgage 

lenders (including subprime lenders), communications 

firms, oil and gas firms, health care firms, and retail 

trade organizations generated the five highest expected 

default volumes among 50 broad industry sector classifications. 

The interest rate environment and refunding risk 

affect the demand for and availability of credit. 

Declining interest yield spreads from 1996 to 1998 

benefited borrowers. As spreads declined, the rate of 

syndicated loan growth increased and refinancing 

activity was high. Increases in spreads since 1998, 

along with higher interest rates, have caused refinancing activity to slow significantly. However, rising rates 

have not significantly affected origination volumes, as 

new debt continues to come into the market. Rising 

interest rates and refunding risk particularly affect 

speculative-grade borrowers. Higher interest rates 

would raise businesses’ cost of borrowing, potentially 

decreasing the demand for business credit and impairing borrowers’ ability to repay their debts. Once a corporation’s debt service ability is compromised, access 

to new capital markets can become limited. A sharp 

rise in interest rates would particularly impair the ability of highly leveraged firms to repay floating-rate debt 

obligations. 

Refunding risk continues to be a concern for speculative-grade borrowers as they face potential problems 

refinancing the maturing portions of long-term debt. 

The current tightening of terms in the C&I market and 

increasing default rates heighten refunding risk to borrowers. Rising interest rates or limited access to secondary markets could also increase refunding risk. This 

situation could continue to be problematic, since a rising volume of speculative-grade borrowings, consisting 

largely of unsecured bank debt, matures in 2001 and 

2002. Specifically, $64 billion in speculative-grade debt 

matures in 2001 and 2002, and approximately 63 percent of the debt is unsecured.26 

Potential growth in new markets presents both 

opportunities and challenges. The Internet and European syndicated loan markets represent both future 

potential growth areas and possible sources of credit 

risk for C&I lenders. The Internet has introduced large 

new markets to the loan and bond markets and has 

26 “Refunding Risk for Speculative Grade Borrowers.” December 15, 

1999. 

CHART 7 

Lending to Some Industries May 

Involve Higher Risk Exposures 

Change in Expected Default FrequencyTM (EDFTM) 

for the 12 Months Ending in December 1999 

6 

8 

–2 0 2 4 6 8 10 12 14 16 18 20

 EDFTM as of December 1999 

1 

2 4 5

3 

6 

7 

9 

10 

4 

2 

0 

–2 

Industry Name and Origination Dollars in Billions:

 1. Communication Services - $234.6

 2. Motor Vehicles and Parts - $133.1

 3. Chemicals and Drugs - $96.1

 4. Retail Trade - $92.1

 5. Wholesale Trade - $46.5

 6. Health Care Services - $42.3

 7. Oil & Gas Extraction - $41.8

 8. Entertainment - $33.5

 9. Mortgage Lenders and Mortage-Backed Securities - $20.2 

10. Hotels & Lodging Services - $20.2 

Note: Data and bubble size represent total syndicated loan originations
 

for the year ending 1999.
 

Sources: Securities Data Corporation; KMV Credit Monitor®
 

increased market efficiency. The “Internet economy” 

grew 68 percent from the first quarter of 1998 to the 

first quarter of 1999, with annual revenue expected to 

exceed $500 billion in 1999.27 Internet technology has 

improved the efficiency of the syndicated loan markets, 

with recent changes including the development of public price reporting, credit ratings, and Internet sites for 

online trading.28 Increased levels of credit risk could 

result from the volatility of Internet stock prices and the 

competitive disadvantage faced by firms that do not 

have an Internet presence but must compete against 

firms that do. 

While the majority of syndicated loan financing currently occurs in the United States, analysts predict that 

syndicated lending activity in Europe will accelerate 

significantly because of increased cross-border competition generated by the introduction of the euro and new 

financing needs. In addition, the European high-yield 

bond market is still developing but produced $6.8 billion of volume in the third quarter of 1999, or 61 per27 “Internet Indicators.” The Center for Research in Electronic Commerce at the University of Texas Graduate School of Business. October 27, 1999. 

28 “Syndicated Loan Market Soars as Efficiency Increases.” The Wall 

Street Journal. December 6, 1999. 

San Francisco Regional Outlook 9 First Quarter 2000 
In Focus This Quarter
 

cent of the total market.29 Domestic lenders have begun 

to compete for this market but face credit risks because 

the European markets also pose sovereign and foreign 

exchange risk. 

Underwriting Remains the Key to Assessing 

C&I Credit Quality 

The August 1999 OCC Survey of Credit Underwriting 

Practices reported some tightening of commercial loan 

underwriting standards. However, loan officers also 

reported increased embedded risks in commercial loan 

portfolios for the fifth consecutive year. Survey respondents attributed the increased risks to weakened underwriting standards in previous years. The November 

1999 Federal Reserve Board Senior Loan Officer 

Opinion Survey on Bank Lending Practices found that 

30 percent of domestic banks reported increasing risk 

premiums, credit line costs, and loan spreads during the 

preceding three months. Loan 

officers cited an uncertain or 

unfavorable economic outlook, 

an expected worsening of industry-specific problems, and a 

reduced tolerance for risk as reasons for tightening C&I lending 

standards. 

Despite signs of tightening underwriting standards, the 

mix of credits appears to be riskier than in recent times. 

The OCC issued an advisory to banks in May 1999 

warning of potential problems with leveraged lending. 

The OCC stated that highly leveraged corporations 

could be particularly vulnerable to economic weakness 

and may not be able to compete effectively in a rising 

29 LPC Gold Sheets, Vol. XII, No. 44. Loan Pricing Corporation. 

November 15, 1999. 

interest rate environment. The OCC also addressed 

reliance on enterprise value loans, which are often used 

to support leveraged lending. Enterprise values are calculations based on projections of the future income of a 

firm. If such estimates are overly optimistic, or if the 

company fails to meet the assumptions underlying these 

estimates, the lender may be subject to considerable 

credit risk. The last interagency SNC review also noted 

instances of inadequate documentation and support for 

enterprise loans.30 

Summary 

C&I lending is one of the largest and fastest growing 

lending lines at insured institutions. Recent growth in 

C&I lending can be attributed to a number of factors, 

including a favorable economy, merger and acquisition 

activity, and other sources of high loan demand, strong 

asset quality, aggressive pricing, and attractive fee 

income. While indicators of C&I loan performance 

remain generally strong, signs of deterioration in commercial credit quality have begun to surface. These 

signs are cause for some concern because they are surfacing during a period of remarkable economic 

strength. Increasing corporate indebtedness, signs of 

corporate stress, and adverse trends in corporate bond 

defaults suggest that an economic downturn could result 

in a much more challenging environment for business 

credit quality. 

By Arlinda Sothoron, Senior Financial Analyst 

Alan Deaton, Economic Analyst 

30 Remarks by OCC First Senior Deputy Comptroller and Chief Counsel Julie L. Williams before the Robert Morris Associates Conference 

on Lending and Credit Risk Management, October 5, 1999. 

San Francisco Regional Outlook 10 First Quarter 2000 
In Focus This Quarter
 

Local Industries in the Global Economy
 

•	 The contribution of international trade to U.S. 

economic activity has risen rapidly during the 

past decade. The U.S. economy has been increasingly influenced by conditions abroad, such as the 

recent financial market turmoil in several emerging markets. 

•	 Canada, Japan, and Mexico are the largest U.S. 

trading partners, accounting for approximately 

40 percent of U.S. trade. Western Europe and Asia 

(excluding Japan) also account for a large share 

of U.S. trade. 

•	 The importance of trade at the industry level 

varies widely. The industries most dependent on 

trade, including machinery and transportation 

equipment, also account for a large share of U.S. 

trade. 

The value of goods and services traded on international 

markets has more than doubled during the past decade. 

More goods and services than ever are being shipped 

abroad and imported from all parts of the globe. Consequently, U.S. economic activity is increasingly influenced by the flow of goods, services, and capital across 

national borders. 

The increasing importance of international trade is 

reflected in different types and levels of exposure to 

international markets. First, total exports and imports 

compared with overall economic activity confirm the 

increasing contribution of trade to the economy as a 

whole. Second, the amount of U.S. trade with foreign 

markets, although widely varied, is concentrated in a 

small number of countries, namely Canada, Japan, and 

Mexico. Consequently, economic conditions in these 

countries are particularly important in assessing the 

influence of global economic conditions on U.S. trade. 

Third, the level of exposure to international trade across 

industry sectors varies considerably. Some industries are 

not influenced greatly by activity in international markets, while for other, more trade-dependent industries, 

conditions in the world economy are an important factor 

in determining the level of sales and profit. The exposure 

to international markets, either through reliance on trade 

with particular countries or via industries with a significant exposure to international markets, is an important 

consideration for lenders seeking to determine a firm’s 

future profitability and financial condition. 

International Trade Is of Growing Importance 

Over the past 30 years, international trade has grown 

more quickly than the economy as a whole. Exports, 

which include both merchandise and services, have 

risen from less than 5 percent of U.S. gross domestic 

product (GDP) in 1970 to approximately 12 percent 

today. The merchandise component accounts for about 

73 percent of exports and includes manufactured goods, 

agricultural products, and raw materials such as metals 

and oil. The services component of exports, accounting 

for about 28 percent of total exports, includes travel services, passenger fares, royalties, freight and port services, and a number of smaller sectors such as financial 

and educational services. 

Imports also account for a growing share of U.S. consumption of goods and services, exceeding 15 percent 

of U.S. GDP in 1999, up from 6 percent in 1970. Merchandise is the largest component of imports, accounting for 83 percent, while services account for 17 percent 

(see Table 1, next page). 

Although trade in services has grown quickly for many 

years, merchandise still accounts for the majority of all 

trade. The dominance of merchandise is attributable, in 

part, to the difficulty of trading many types of services. 

With few exceptions, services are generally produced 

and consumed within a local market because they cannot be transported easily and are subject to language 

and cultural barriers. Hospitals, dry cleaners, and movie 

theaters, for example, serve well-defined local markets 

and produce products that cannot be traded competitively on international markets. Although trade in services such as travel continues to grow, the remainder of 

this article focuses primarily on the dominant merchandise component. 

U.S. Trade Activity Has Reflected Recent 

Global Economic Turmoil 

Over time, conditions in the international economy have 

become an increasingly important influence on U.S. 

growth, since a rising share of all domestically produced goods and services is sold abroad. Similarly, an 

increasing volume of imported goods and services 

implies a higher level of competition for domestic producers that compete directly with imports. 

San Francisco Regional Outlook 11	 First Quarter 2000 
In Focus This Quarter
 

TABLE 1 

Merchandise Is the Largest Component of Trade 

DOLLAR VALUE* PERCENT 1999 

(1998, $ MILLIONS) OF TOTAL GROWTH** 

Exports $ 933,910 100.0% 1.8% 

MERCHANDISE 682,138 73.0% 0.8% 

AGRICULTURE AND 

RELATED COMMODITIES 26,603 2.8% –1.8% 

MINERAL COMMODITIES 6,644 0.7% –17.4% 

MANUFACTURED GOODS 593,297 63.5% –0.1% 

OTHER MERCHANDISE 55,593 6.0% 39.5% 

SERVICES 263,662 28.2% 4.3% 

TRAVEL 71,250 7.6% 3.0% 

PASSENGER FARES 19,996 2.1% 2.7% 

ROYALTIES AND LICENSE FEES 36,807 3.9% 4.1% 

FREIGHT AND PORT SERVICES 25,520 2.7% 6.4% 

OTHER SERVICES 110,089 11.8% 5.0% 

ADJUSTMENTS*** (11,890) 

Imports $ 1,098,193 100.0% 10.3% 

MERCHANDISE 907,647 82.6% 10.4% 

AGRICULTURE AND 

RELATED COMMODITIES 22,859 2.1% –2.2% 

MINERAL COMMODITIES 38,619 3.5% 5.6% 

MANUFACTURED GOODS 803,384 73.2% 11.6% 

OTHER MERCHANDISE 42,786 3.9% –0.6% 

SERVICES 181,015 16.5% 9.6% 

TRAVEL 56,105 5.1% 7.2% 

PASSENGER FARES 19,797 1.8% 8.3% 

ROYALTIES AND LICENSE FEES 11,293 1.0% 11.0% 

FREIGHT AND PORT SERVICES 30,460 2.8% 11.4% 

OTHER SERVICES 63,360 5.8% 10.9% 

ADJUSTMENTS*** 9,531 

* Sum of components may not equal total due to rounding.
 

** First three quarters of 1999 versus first three quarters of 1998.
 

*** Because of different methods of estimating the merchandise and services components of trade, an adjustment
 

term is necessary. Consequently, percentages may not sum to 100.
 

Sources: Bureau of Economic Analysis; Bureau of Census
 

San Francisco Regional Outlook 12 First Quarter 2000 
In Focus This Quarter
 

During the past two and a half years, for example, the 

international economy has been buffeted by a series of 

crises that resulted in steep exchange rate depreciations 

for a number of countries and a marked slowdown in 

economic growth in many emerging markets. Although 

the U.S. economy remained surprisingly strong during 

the worst of the emerging markets crises, the fallout 

was evident in the diverging performance of U.S. 

exports and imports over the period. 

From mid-1997 through mid-1999, U.S. exports were 

generally flat, reflecting the sluggish pace of growth in 

several important U.S. export markets. Export prices 

fell by 4 percent over the period in response to weak 

demand for U.S. exports. In particular, exporters of 

agricultural products, basic manufactured goods, and 

commodities faced rapidly deteriorating conditions in 

several important overseas markets. For example, the 

value of merchandise exports to the Pacific Rim fell by 

15 percent during the first six months of 1999 compared with the same period in 1997 because of the 

recent financial market turmoil in the region. 

U.S. imports continued to grow during the period, 

however, reflecting both strong demand for imported 

goods and falling prices. In fact, average import prices 

fell by 5 percent between 1997 and 1999. At the same 

time, competition from imports limited the pricing 

power of domestic producers that compete with goods 

produced abroad. Although producers that compete 

with cheaper imports experienced adverse effects on 

profitability, consumers and firms that purchased 

goods from abroad generally benefited from falling 

import prices.1 

The slowdown in U.S. export activity and the acceleration of import growth have resulted in an increasing 

trade imbalance (see Chart 1). The U.S. trade deficit, 

which reached a record $26.5 billion in November, has 

raised concerns among analysts about the vulnerability 

of the dollar. Faster growth abroad or a slowdown in 

U.S. growth could convince foreign investors to 

increase purchases of assets outside the United States, 

resulting in a sell-off of the dollar. Depending on the 

severity and speed of a sell-off, heightened financial 

market volatility and rising U.S. import prices could 

result. Although potentially many forces are at work in 

1 Weak import prices are a factor cited by analysts to explain the 

benign performance of U.S. inflation during the past few years. 

CHART 1 

U.S. Import Growth Has Accelerated 

while Exports Remain Flat 

$ Billions 

350 

300 

250 

200 

150 

100 

Imports 

Exports 

1992 1993 1994 1995 1996 1997 1998 1999 

Source: Bureau of Economic Analysis 

such a scenario, rising inflation or a falling dollar may 

ultimately result in higher interest rates and slower U.S. 

growth. The extent to which U.S. trade would be affected by such a scenario is difficult to assess, since 

changes in the prices of either imports or exports would 

result in both positive and negative effects on firms’ 

costs, revenue, and profitability.2 

Most U.S. Trade Is Concentrated 

in a Few Foreign Markets 

Because the United States trades with most nations, 

economic conditions abroad are one of the critical 

factors that determine the growth of U.S. trade. Foreign demand for U.S. goods and services depends on 

the strength of the markets to which exporters ship 

their goods. Consequently, economic weakness 

abroad often results in slower U.S. export growth. 

Economic conditions abroad also influence the level 

of import competition that U.S. firms experience. 

Foreign firms facing slack demand in their own 

domestic markets, much like manufacturers in Southeast Asia during the recent market turmoil, may 

2 During the early 1980s, the dollar rose by roughly 50 percent, as 

measured against a trade-weighted basket of currencies. The 

increase in the value of the dollar made U.S. exports much more 

costly on world markets and contributed to financial stress among 

export-dependent manufacturers and agriculture producers. Beginning in mid-1985 the dollar fell sharply, back to its pre-appreciation 

level. The resulting improvement in U.S. competitiveness contributed to robust growth in U.S. exports that lasted during the rest 

of the 1980s. 

San Francisco Regional Outlook 13 First Quarter 2000 
In Focus This Quarter
 

reduce prices of their U.S.-bound goods to compete 

more effectively with U.S. producers.3 

Although the U.S. trades with many nations, a large 

share of U.S. trade is concentrated among a small number of countries. Canada, Mexico, and Japan account 

for more than 40 percent of merchandise exports and 

imports. Asia (excluding Japan) and Western Europe 

each account for just over 20 percent of U.S. exports 

and a broadly similar share of imports. Central and 

South America, despite proximity to the United States, 

account for less than 10 percent of exports and only 

5 percent of imports (see Chart 2). 

The United States has routinely run a trade deficit with 

its largest trading partners. The trade deficit with 

Canada was $22.8 billion through the first three quarters of 1999. The trade deficit with Mexico topped 

$18.8 billion during the same period. The trade 

deficits with Japan and China, by far the two largest at 

$53.4 billion and $49.4 billion, respectively, accounted for approximately 40 percent of the total U.S. merchandise trade deficit through the first three quarters 

of 1999. 

The Importance of Trade Varies 

among Industries 

The level of export activity or the intensity of import 

competition also varies across industries. Besides the 

overall dollar volume of exports, industries differ in the 

proportion of total production that is exported. 

Although some industries, such as leather products, 

account for a relatively small share of total U.S. 

exports, exports from this industry make up a large 

share of all U.S. leather goods production. In cases 

such as this, conditions in export markets are important 

for producers even if total export sales from a particular industry are small. 

Industries also differ in the share of total spending 

devoted to imports. Imports account for a relatively 

3 From the perspective of a foreign exporter, increased sales of goods 

abroad, even at reduced prices, may be a preferred strategy to offset 

lower sales within its own weaker domestic market. A foreign steel 

mill facing weak sales in its home market may choose to sell its output below cost on the world market if it can still cover its fixed costs 

of operation. There also may be an incentive to maintain or even 

expand market share and recoup current losses in the future when 

prices rebound. 

CHART 2 

Canada Is the Largest U.S. Trading Partner 

(1Q99 through 3Q99, ranked by exports) 

Eastern Europe 

Africa 

Central/South America 

Japan 

Mexico 

Asia (excluding Japan) 

Western Europe 

Canada 

Source: Bureau of Census 

–250 

$ Billions 

–150 –50 50 150 250 

Imports Exports 

small portion of all domestic spending on farm products such as grains and livestock, for example, while 

imports account for a relatively large share of all U.S. 

oil consumption. These differences expose U.S. industries to varying levels of competition from abroad. In 

industries characterized by high levels of import competition, import prices may largely shape the domestic 

pricing environment and, by extension, the revenue and 

profit growth of domestic firms. 

For the purposes of this article, industries can be 

assigned to one of three broad categories depending on 

their exposure to international markets either through 

exports or through the intensity of import competition. 

Firms in Less Exposed Industries are not directly influenced by conditions in the global markets. Export markets are not a particularly important source of revenue, 

and imports are a negligible share of all domestic consumption of goods produced by these industries. In 

contrast, some industries are highly exposed through 

their reliance on export markets, through competition 

from imports, or in some cases, through both. For firms 

in these Highly Exposed Industries, conditions in international markets are clearly one of the important factors influencing current and prospective financial 

performance. Industries not part of either group, or 

Moderately Exposed Industries, face some competition 

from abroad and may earn a relatively small amount of 

revenue from export markets. 

To gauge these differences more fully, a measure 

of exposure to international markets was calculated for 

a set of 26 industries (20 manufacturing industries, 

4 mining industries, and 2 agriculture sectors). Table 2 

San Francisco Regional Outlook 14 First Quarter 2000 
In Focus This Quarter
 

TABLE 2 

Industry Exposure to International Trade 

IMPORT SHARE OF U.S. CONSUMPTION 

LOW MEDIUM HIGH 

EXPORT 

SHARE OF U.S. PRODUCTION 

LOW 

PRINTING AND PUBLISHING 

FOOD PRODUCTS 

LUMBER AND WOOD 

PRODUCTS 

PETROLEUM AND COAL 

PRODUCTS 

AGRICULTURAL SERVICES, 

FORESTRY, AND FISHING 

FURNITURE AND FIXTURES 

OIL AND GAS EXTRACTION 

MEDIUM 

COAL MINING 

TOBACCO PRODUCTS 

NONMETALLIC MINERALS, 

EXCEPT FUELS 

FABRICATED METAL 

PRODUCTS 

METAL MINING 

PAPER AND ALLIED 

PRODUCTS 

TEXTILE MILL PRODUCTS 

STONE, CLAY, AND 

GLASS PRODUCTS 

RUBBER AND PLASTIC 

PRODUCTS 

PRIMARY METAL INDUSTRIES 

MISCELLANEOUS MANUFACTURING INDUSTRIES 

APPAREL PRODUCTS 

HIGH 

FARM PRODUCTS CHEMICALS AND ALLIED 

PRODUCTS 

INSTRUMENTS AND 

RELATED PRODUCTS 

TRANSPORTATION 

EQUIPMENT 

INDUSTRIAL MACHINERY 

AND EQUIPMENT 

ELECTRONIC EQUIPMENT 

LEATHER AND LEATHER 

PRODUCTS 

Highly Exposed Industries 

Moderately Exposed Industries 

Less Exposed Industries 

summarizes the results of the assessment.4 Each row 

shows industries that have high, medium, or low 

reliance on export markets, defined as the share of U.S. 

production in a particular industry that is exported. 

Each industry was ranked by this measure, with the 7 

highest industries placed in the High category, the 7 

lowest in the Low category, and the remaining 12 in the 

4 Export share of production (rows in Table 2) was calculated as the 

ratio of inflation-adjusted exports at the industry level divided by 

inflation-adjusted production in that industry (Gross Output by Industry from the Bureau of Economic Analysis was used as a measure of 

industry production). The import share of consumption (columns in 

Table 2) was calculated as the share of inflation-adjusted industry 

imports divided by inflation-adjusted domestic production less 

exports plus imports. All calculations were based on 1997 data, the 

latest industry-level production data available. 

Medium category.5 Table 2 shows, for example, that a 

relatively low proportion of production in the printing 

and publishing, lumber and wood products, and oil and 

gas extraction industries is exported. In contrast, a relatively high percentage of production in the farm products sector, chemicals, and transportation equipment 

industries is exported. 

5 This allocation, while completely arbitrary, roughly corresponds to a 

distribution where 50 percent of the industries are assigned to the 

Medium category, with the remaining 50 percent evenly allocated 

between the High and Low categories. Breakpoints for the distribution of industries by export share of production were as follows: Low: 

less than 7 percent; High: greater than 13 percent. 

San Francisco Regional Outlook 15 First Quarter 2000 
In Focus This Quarter
 

The industries in each column are categorized by the 

share of U.S. consumption expenditures in a particular 

industry that are satisfied by imports. Again, the Low 

and High categories each include 7 industries, and the 

Medium category includes the remaining 12 industries.6 

On the basis of this analysis, for example, a relatively 

low share of U.S. consumption of food, fabricated metals, and farm products is imported. In contrast, a large 

share of U.S. consumption of oil, apparel, and electronic equipment is imported.7 

As shown in the lower right cell of the table, four industries are highly exposed to both export markets and 

import competition. These industries—transportation 

equipment, industrial machinery, electronic equipment, 

and leather products—account for slightly less than half 

of total U.S. exports and a similar percentage of total 

U.S. imports. Not only are these industries more closely tied to international markets than most other industries examined, but they also account for a large share of 

U.S. international trade. 

Using the terminology introduced above, Highly 

Exposed Industries are defined as those assigned to 

either of the High categories; industries in this group 

either are very reliant on export markets or face high 

levels of import competition. Less Exposed Industries 

are defined as those that have little exposure to either 

export markets or import competition; they are shown 

in the upper left cell in the Low classification. The 

remaining industries are defined as Moderately 

Exposed Industries. 

Chart 3 illustrates the distribution of establishments in 

each of the three categories by Region.8 Among the 

6 Breakpoints for the distribution of industries by import share of 

consumption were as follows: Low: less than 9 percent; High: greater 

than 25 percent. 

7 Although not directly included in the analysis, most domestically 

produced services also have minimal reliance on export markets and 

face little import competition. Retail trade, construction, local transportation services, and government, for example, all operate in relatively sheltered markets and are dependent on the health of the local 

economy. Particular firms may engage in high levels of international activity in tradable services such as travel, but manufacturing, 

mining, and agriculture account for the majority of imports and 

exports. 

8 An establishment is defined as a single physical location at which 

business is conducted or services or industrial operations are performed. It is not necessarily identical with a company or enterprise, 

which may consist of one or more establishments. Data are from 

County Business Patterns (Bureau of Census, 1997). 

CHART 3 

Atlanta Boston Chicago Dallas Kansas Memphis New San 

City York Francisco 

Number of Establishments* Classified by 

International Trade Exposure by Region 

0 

10,000 

20,000 

30,000 

40,000 

50,000 

60,000 

FDIC Region 

Source: Bureau of Census, 1997 County Business Patterns Database 

*An establishment is a single physical location at which business is conducted. 

Highly Exposed Industries 

Moderately Exposed 

Industries 

Less Exposed Industries 

group of industries analyzed, most are in the Moderately Exposed Industries category. Of the FDIC Regions, 

Atlanta, Chicago, and San Francisco have the greatest 

number of establishments in this category. The Chicago 

and San Francisco Regions lead in the number of establishments in the Highly Exposed Industries group, followed by the New York and Dallas Regions.9 Less 

Exposed Industries account for a relatively small number of establishments. As suggested above, however, 

most service-sector, construction, and government 

enterprises, while not part of this analysis, could be 

classified as Less Exposed.10 

Although this analysis highlights the varying level of 

direct exposure to international markets, industries also 

may be exposed through a less direct secondary channel. 

Several industries, although not highly exposed themselves, are suppliers to Highly Exposed Industries. For 

example, the rubber and plastics industry produces 

goods that are used in the manufacture and assembly of 

transportation equipment, a Highly Exposed Industry. 

9 An alternative way of analyzing the establishment data is to calculate the percentage of all establishments across the 25 industries that 

are in Highly Exposed Industries. On the basis of this calculation, the 

Dallas Region ranks highest at 42 percent because of the large number of establishments engaged in oil and gas extraction. For the 

remaining Regions, the percentages vary between 25 percent and 35 

percent. Across all industries (including services and other sectors not 

part of this analysis), the percentage of Highly Exposed Industries in 

each Region ranges from 1.7 percent (Atlanta Region) to 3.4 percent 

(Boston Region) of total establishments. 

10 These data do not include a count of establishments in the farm 

products sector (Standard Industrial Code (SIC) 01 and SIC 02). 

Therefore, 25 industries are represented in the establishment data, and 

not 26 as in Table 2. 

San Francisco Regional Outlook 16 First Quarter 2000 
In Focus This Quarter
 

Consequently, conditions in export markets for transportation equipment are of particular interest for manufacturers of certain types of rubber and plastic products. 

These supplier industries are also vulnerable to import 

competition through this secondary exposure to international markets. A transportation equipment manufacturer, in response to heightened competition in international 

markets for its products, may switch from a domestic 

supplier of rubber products to a cheaper foreign supplier 

if a favorable price differential emerges. Therefore, 

assessing the exposure of industries to either exports or 

imports requires consideration of any secondary linkages 

between suppliers and purchasers of industry products. 

Summary 

The contribution of international trade to overall U.S. 

economic activity has been increasing for a number of 

years. The growing significance of trade has been highlighted by the recent series of economic and financial 

crises across the globe. One result of recent global economic turmoil has been a slowdown in U.S. export 

growth resulting from both slumping international 

demand for U.S. goods and services and weak prices. 

Import growth has continued unabated, largely because 

of strong U.S. growth, leading to a rapidly widening 

trade deficit. The effects of import and export growth 

on particular industries vary because of differing levels 

of reliance on export markets and the extent of import 

competition. This analysis suggests that several industries are highly exposed to changing global economic 

conditions. Lenders should be aware that for firms in 

these industries, changes in global economic conditions, including demand for U.S. exports and prices of 

both imports and exports, largely determine pricing, 

revenue growth, and profitability. 

Paul C. Bishop 

Senior Financial Economist 

San Francisco Regional Outlook 17 First Quarter 2000 
Regional Perspectives
 

Regional Perspectives
 

•	 Although the San Francisco Region experienced tight labor markets in many urban areas and economic 

weakness in some states, the Region’s nonfarm employment growth through October 1999 continued to outpace the nation’s growth. 

•	 The Region’s insured financial institutions reported strong earnings, credit quality, and capitalization during third-quarter 1999, although earnings growth slowed. 

•	 Insured financial institutions have entered the Region’s higher-growth urban areas at an increasing rate 

through mergers and acquisitions and de novo chartering. Currently, the number of institutions in the 

Region that have not weathered an economic downturn is at the highest point in the past decade. 

Economic and Banking Conditions 

The San Francisco Region’s 

Economy Remains Strong 

The San Francisco Region’s economy continues to outperform the nation’s economy; however, differences in 

economic and banking conditions between the Region’s 

rural and urban areas are evident. Per capita personal 

income levels and in-migration flows are strong in the 

Region’s urban areas, where high-tech1 growth has been 

robust. However, certain rural areas are lagging because 

of stagnating growth in the agricultural, mining, and 

logging sectors. Insured financial institutions have 

entered the Region’s higher-growth urban areas at an 

increasing rate through mergers and acquisitions and de 

novo2 chartering. Currently, the number of institutions 

in the Region that have not weathered an economic 

downturn is at the highest point in the past decade. 

Despite tight labor markets in many urban3 areas and 

weakness in some states, the San Francisco Region 

enjoyed strong economic conditions through October 

1999. Strength in the services sector resulted in robust 

employment growth in Nevada, Arizona, and California. However, softness was evident in the economies of 

Washington, Oregon, Alaska, parts of Montana, and 

Hawaii. Employment growth rates in Washington and 

Oregon declined because of slowing in the aerospace 

1 The high-tech sector is defined to include Standard Industrial Codes 

3570, 3600, and 3800. 

2 A de novo institution is one chartered within the previous three 

years. 

3 Urban counties are those areas designated by the Economic 

Research Service, U.S. Department of Agriculture, as metropolitan 

counties. 

industry and lingering weakness in the Asian export 

markets. Alaska continued to feel the effects of consolidation in the oil industry, and areas of eastern Montana 

also have suffered because of weak agricultural conditions—specifically, lower wheat prices. Although still 

lagging the Region and nation, Hawaii during third 

quarter 1999 benefited from improving tourism activity 

and retail sales. Overall, however, the Region continues 

to outperform the nation, primarily because of strength 

in its metropolitan areas. 

Urban Areas Outperform Rural Counterparts 

The Region’s economic expansion since 1995 has been 

driven largely by its urban areas, in part because of 

strong growth in high-tech employment. These urban 

areas also reported healthy growth in the supporting services and construction sectors. Chart 1 shows those 

metropolitan statistical areas (MSAs) with concentrations in high-tech manufacturing (San Jose, Sacramento, San Diego, Orange County, Portland, and 

Boise) that experienced particularly strong total nonfarm employment growth in recent years. In these markets, strong employment growth has been accompanied 

by high levels of per capita personal income and has 

attracted higher levels of in-migration.4 

Large urban centers5 in Washington, California, and 

Oregon with concentrations in high-tech employment 

4 In-migration is the total of domestic and international migration. 5 Large urban centers are central counties of metropolitan areas with 

population exceeding 1 million people, as reported by the Economic 

Research Service, U.S. Department of Agriculture (USDA). 

San Francisco Regional Outlook 18	 First Quarter 2000 
Region

Boise 

Portland

Orange

San Diego

amento

County

San Jose 

Sacr

Regional Perspectives
 

posted particularly high levels of per capita personal CHART 1 

income, as shown in Chart 2. For example, the presence High-Tech-Dependent MSAs Report of Boeing and Microsoft in and around Seattle likely Strong Employment Growth contributed to the highest average per capita personal 80 

Growth Rate (percent) Nonfarm Employment 

Concentration of High-Tech Employment 

(Left Axis) 

Average Total Nonfarm Employment 

Growth 1995–98 (Right Axis) 

0 

1 

2 

3 

4 

5 

6

income in the Region in 19976—over $30,000. Large 

urban centers with concentrations of high-tech employment in California and Oregon followed closely, reporting average per capita personal income just under 

$30,000. Although high tech has driven growth in the 

Region’s large urban areas, smaller urban centers in 

Alaska, Hawaii, and Nevada7 also reported relatively 

Share of Employment in High-
Tech Manufacturing (percent)
 70 

60 

50 

40 

30 

20 

10 

0

high levels of per capita personal income. While the relatively isolated locations and high costs of doing business in Alaska and Hawaii help explain these states’ * High-tech manufacturing is defined to include Standard Industrial Codes 3570, levels of urban (and rural) per capita personal income, 3600, and 3800. 

Alaska also benefits from oil revenues. In addition, Source: Bureau of Labor Statistics via Haver Analytics 

Nevada’s smaller urban centers have prospered because 

of the increased popularity of tourism and gaming 

attractions. CHART 2 

Robust employment opportunities resulted in rapid inmigration to many of the Region’s urban areas. For 

example, growth in the high-tech and tourism and gaming sectors drove in-migration in Nevada, California, 

Arizona, Washington, and Oregon (see Chart 3). 

Agricultural-Sector Weakness and Volatility in 

the Lumber, Mining, and Oil Industries Slowed 

the Region’s Rural Economies 

Many of the Region’s rural8 economies have not kept 

pace with the vigorous growth in urban areas, particularly those areas concentrated in the agricultural industry. Map 1 (next page) shows that employment in the 

Region’s rural areas is generally concentrated in one of 

four industries: agriculture, lumber, mining, or oil and 

gas. As explained in the San Francisco Regional Outlook, Fourth Quarter 1999, the agricultural sector has 

recently experienced declining commodity prices for 

some of the Region’s most important crops, resulting in 

lower levels of operating income and continued farm 

consolidation. The lumber, mining, and oil and gas 

industries have also experienced periods of weak commodity prices, though oil and gas prices have recovered. 

6 The most recent per capita personal income data available at a county level are for 1997. 

7 Smaller urban centers include fringe counties of large urban centers 

and metropolitan areas with population between 250 thousand and 1 

million, as reported by the Economic Research Service, USDA. 

8 Rural counties are those designated by the Economic Research Service, USDA, as nonmetropolitan counties. 

The San Francisco Region’s Urban Areas 

Have Higher Per Capita Personal Income 

than Rural Areas 

WA CA OR AZ UT AK HI NV WY ID MT 

Per Capita Personal Income 

Source: Census Bureau; 1997 data 

$0 

$5,000 

$10,000 

$15,000 

$20,000 

$25,000 

$30,000 

$35,000 Large Urban Counties Small Urban Counties 

Rural Counties 

CHART 3 

In-Migration to Urban Areas Exceeded 

Rate in Rural Areas in Six States in 

Region between 1995 and 1998 

Source: Census Bureau (estimates released March 1999: sum of domestic 

and international migration) Number of People 

–50,000 

0 

50,000 

100,000 

150,000 

200,000 

250,000 

Urban 

Rural 

CA AZ NV WA OR ID UT WY MT AK HI 

San Francisco Regional Outlook 19 First Quarter 2000 
Regional Perspectives
 

MAP 1 

Most Rural Counties Have High
 

Exposures to Troubled Industries
 

Source: Bureau of Labor Statistics 

Rural Counties’
 

Industry Exposure
 

(counties with 5 percent or more
 

of payroll employment)
 

Metropolitan Counties 

Mining/Oil and Gas 

Agriculture 

Lumber and Wood 

The Region’s rural areas, particularly those that rely on 

agriculture, also report lower per capita personal 

income and in-migration levels. In the Region’s most 

important agricultural states (Montana, Idaho, Oregon, 

Washington, and California), rural areas reported per 

capita personal income below $20,000 in 1997. In each 

state, this income level was lower than in metropolitan 

areas; in fact, in Washington, California, and Oregon, 

the gap neared $10,000. In contrast, rural areas in Alaska, Nevada, and Wyoming that are not dependent on 

agriculture reported relatively higher levels of per capita personal income. These higher levels can be attributed in part to the concentration of higher-paying 

mining and oil and gas employment. Nevertheless, 

every state in the Region reported higher average per 

capita income in urban areas. Weakness in rural per 

capita personal income has also resulted in migration to 

urban areas from 1995 through 1998. 

Low agricultural commodity prices and farm consolidation in the Region, in addition to weakness in the lumber, mining, and oil industries, likely contributed to 

out-migration. For example, Chart 3 indicates that rural 

areas in Alaska and Wyoming have experienced net outmigration. 

Rural Institutions Report Weaker Asset Quality,
 

Less Robust Earnings than Institutions in Urban Areas
 

Weaknesses in the Region’s rural economies are evident 

in the asset quality measures reported by rural banks 

compared with urban banks.9 As of September 30, 1999, 

rural banks reported a much higher median past-due 

ratio—about 40 basis points—than their urban counterparts, primarily because rural banks have higher levels 

of agricultural loan exposures (see Table 1). For example, Montana’s rural agricultural banks report a high 

3.13 percent past-due ratio, while urban banks as a 

group are experiencing strong asset quality. 

The Region’s insured financial institutions report 

strong earnings, credit quality, and capitalization, 

despite weaker credit quality in some rural areas. 

Financial institutions reported a return on assets (ROA) 

of 1.38 percent as of third quarter 1999, higher than the 

nation’s 1.27 percent. Continued improvements in noninterest income and provision expenses drove earnings 

higher for the third consecutive quarter. In addition, net 

interest margins, which were gradually declining in the 

9 Rural banks are not headquartered in a metropolitan statistical area; 

urban banks are located in a metropolitan statistical area. 

Region from late 1997 until mid-1999, have stabilized. 

Improving credit quality, as evidenced by the third consecutive quarter of declines in the net charge-off rate 

and past-due loan ratio, has made reductions in provision expenses possible. Capital ratios also have 

remained strong but relatively stable despite robust 

earnings. This stability is likely due to increases in dividend payments and stock buyback programs. 

Although the Region’s insured financial institutions 

have been reporting excellent earnings, the growth in 

ROA has begun to slow in recent quarters. Fee income 

gains and overhead expense savings, which were major 

contributors to earnings growth from 1994 through 

1998, are declining. In addition, the increasing numbers 

of de novo institutions are beginning to adversely affect 

aggregate earnings performance in the Region. While 

the Region’s rate of earnings growth may be slowing, 

many insured institutions continue to find its metropolitan banking markets attractive and are entering these 

markets through either mergers and acquisitions 

(M&As) or de novo chartering. 

San Francisco Regional Outlook 20 First Quarter 2000 
Regional Perspectives
 

TABLE 1 

Median Ratios for Rural and Urban San Francisco Region Commercial Banks 

RURAL INSTITUTIONS URBAN INSTITUTIONS 

SEP 97 SEP 98 SEP 99 SEP 97 SEP 98 SEP 99 

AGRICULTURE LOANS/TA 

CRE/TA 

PAST-DUE RATIO 

RETURN ON ASSETS 

8.44 

11.17 

2.05 

1.41 

7.41 

11.98 

2.33 

1.38 

7.44 

13.04 

1.71 

1.22 

0.01 

25.00 

1.96 

1.15 

0.02 

25.58 

1.61 

1.16 

0.00 

29.06 

1.29 

1.12 

De novo, credit card, and subchapter S institutions were excluded from both groups. 

TA = Average Total Assets; CRE = Commercial Real Estate Loans 

Source: Bank Call Reports 

The San Francisco Region Recently Has Experienced 


Strong M&A and New Bank Activity
 

Heightened M&A activity as well as increasing numbers of de novo institutions have materially altered the 

San Francisco Region’s banking landscape over the past 

decade. The Region began 1991 with 1,254 charters, but 

as of September 30, 1999, this number had declined to 

847. This decline was attributed to institution failures 

and relocations, and 505 charters were eliminated 

through M&A and consolidation. New institutions, 

however, have partially offset this decline. For example, 

114 de novo institutions are currently operating in the 

San Francisco Region, the highest number since yearend 1990. In fact, de novo charters as a percentage of 

total charters are higher than at any time during the past 

decade. 

Despite the large number of de novo charters, the 

Region’s total banking assets declined by about 16 percent from September 1998 to September 1999, largely 

because of acquisitions of institutions headquartered 

within the Region by institutions headquartered outside 

the Region. The majority of the recent M&A activity 

has been out-of-market M&A,10 as opposed to in-market 

M&A (see Chart 4). An in-market M&A is characterized by significant deposit franchise overlap; these 

types of mergers generally are executed to contain costs 

and enhance revenues by eliminating a significant competitor in the marketplace. An out-of-market M&A 

exhibits little deposit franchise overlap; cost savings, 

10 SNL Datasource defines an out-of-market or market expansion 

acquisition as an acquisition in which the deposit franchise of the 

buyer and seller do not overlap. An in-market merger contains significant deposit franchise overlap. 

while important, are not as crucial as entering a new 

market, expanding revenues, and increasing market 

share. Although an out-of-market M&A is much like a 

de novo charter in that both are a means of entering a 

new banking market, the factors influencing the type of 

entry differ. 

Factors Contributing to High Levels of 

De Novo and Out-of-Market M&A Activity 

Increased out-of-market M&A and de novo bank chartering activity during the 1990s can be attributed to 

several factors, including liberalized branching laws, 

favorable interest rates, excellent bank earnings performance, and strong equity markets, as well as robust 

CHART 4 

Market Expansion Mergers Have Outpaced

 In-Market Mergers in the San Francisco Region 

* As of September 30. 

Source: SNL DataSource Number of Mergers and Acquisitions

In-Market 

Mergers and 

Acquisitions 

0 

5 

10 

15 

20 

25 

30 

35 

40 

45 

50 Market Expansion 

Mergers and 

Acquisitions 

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

San Francisco Regional Outlook 21 First Quarter 2000 
Regional Perspectives
 

economic conditions in the San Francisco Region (see CHART 5 

Chart 5). The 1994 Riegle-Neal Interstate Banking and 

Branching Act removed many barriers to interstate While Market Expansion Mergers 

Decline, De Novo Entry Remains banking. In addition, from 1994 through 1998, interest Strong in San Francisco Region rates remained fairly low, bank earnings grew, and bank 

stock prices increased. As a result, institutions’ cost of 100 

capital declined, helping to lower barriers to entry. 

Strong economic growth in the San Francisco Region 

also played an important role in promoting entry into 

the Region. 

The level of economic growth, particularly in urban 

areas, appears to be one of the most important factors 

influencing institutions’ decisions to enter the Region’s 

banking market. The 11 markets that have experienced 

the highest level of de novo entry or out-of-area M&A 

in the past three years also are characterized by robust 

employment growth. Los Angeles, where entry has 

been low relative to the number of institutions in the 

market, is the exception, reporting relatively low 

employment growth (see Table 2). Conversely, urban 

markets with no de novo or out-of-area M&As, shown 

in Table 3, have posted sluggish economic growth figures. The Region’s rural areas also have experienced 

TABLE 2 

De Novo 

Charters 

Market Expansion 

Mergers 

De Novo Applications 

Pending Approval 

Market Expansion Acquisitions 

Pending Approval 

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

Number of De Novos and


Market Expansion Mergers
 90 

80 

70 

60 

50 

40 

30 

20 

10 

0 

*As of September 30.
 

Sources: Bank and Thrift Call Reports; SNL DataSource
 

low levels of de novo and M&A activity, likely because 

of slower economic growth.11 

11 Also refer to Steven A. Seelig and Timothy Critchfield, “Determinants of De Novo Entry in Banking,” FDIC, Division of Research and 

Statistics, 1999. 

San Francisco Region Markets with the Most Entry in the Previous Three Years 

METRO AREA 

LOS ANGELES-LONG BEACH, CA 

PHOENIX-MESA, AZ 

SEATTLE-BELLEVUE-EVERETT, WA 

LAS VEGAS, NV-AZ 

SAN DIEGO, CA 

ORANGE COUNTY, CA 

SALT LAKE CITY-OGDEN, UT 

PORTLAND-VANCOUVER, OR-WA 

SAN FRANCISCO, CA 

RIVERSIDE-SAN BERNARDINO, CA 

SACRAMENTO, CA 

DE NOVO
 

CHARTERS
 

9 

14 

11 

8 

3 

3 

7 

3 

1 

2 

3 

MARKET
 

EXPANSION
 

ACQUISITIONS
 

19 

1 

3 

3 

7 

7 

2 

6 

7 

6 

4 

TOTAL
 

ENTRY
 

28 

15 

14 

11 

10 

10 

9 

9 

8 

8 

7 

MARKET
 

CONCENTRATION
 

RANK1
 

32 

7 

9 

17 

27 

30 

10 

8 

12 

31 

29 

AVERAGE 

EMPLOYMENT 

EMPLOYMENT GROWTH 

GROWTH2 RANK 

1.67 31 

6.09 2 

4.48 4 

6.49 1 

3.84 9 

3.96 7 

3.64 12 

3.40 14 

3.40 13 

3.89 8 

3.27 16 

4.01 

Ranks are based on data from 34 metropolitan areas in the San Francisco Region. 

1 The Market Concentration Rank is measured using the Herfindahl-Herschman Index. 

2 Employment Growth is an average of the employment growth rate for the three previous years lagged one year. 

Sources: FDIC Summary of Deposits (June 30, 1999); Bank and Thrift Call Reports (September 30, 1999); Bureau of 

Labor Statistics; SNL DataSource 

San Francisco Regional Outlook 22 First Quarter 2000 
Regional Perspectives
 

TABLE 3 

San Francisco Region Markets without Entry in the Previous Three Years 

MARKET MARKET 

DE NOVO EXPANSION TOTAL CONCENTRATION 

METRO AREA CHARTERS ACQUISITIONS ENTRY RANK1 

EMPLOYMENT 

GROWTH2 

EMPLOYMENT 

GROWTH 

RANK 

ANCHORAGE, AK 0 0 0 2 2.22 28 

CASPER, WY 0 0 0 1 0.99 33 

HONOLULU, HI 0 0 0 6 –0.35 34 

SPOKANE, WA 0 0 0 11 2.03 29 

AVERAGE 1.22 

Ranks are based on data from 34 metropolitan areas in the San Francisco Region. 

1 The Market Share Rank is measured using the Herfindahl-Herschman Index. 

2 Employment Growth is an average of the employment growth rate for the three previous years lagged one year. 

Sources: FDIC Summary of Deposits (June 30, 1999); Bank and Thrift Call Reports (September 30, 1999); Bureau of 

Labor Statistics; SNL Data Source 

Out-of-market M&A was a more popular form of entry 

than de novo chartering in several of the Region’s metropolitan markets, particularly those with strong 

employment growth and low market concentration. 

Examples include the Los Angeles-Long Beach, 

Orange County, Riverside-San Bernardino, San Francisco, Sacramento, and San Diego MSAs. Most of these 

markets are characterized by generally strong employment growth and relatively low market concentrations 

and are home to many institutions that have been 

operating for more than five years—“qualified statechartered institutions.”12 

Chart 6 shows that, except for the San Diego market, 

most of California’s banking markets with low market 

concentrations tend to have lower acquisition premiums. The San Diego market, which has had a disproportionate number of out-of-market M&A transactions 

given its size, has been characterized by low market 

concentration and high acquisition premiums. Four San 

Diego County institutions sold for an average of 3.75 

times book, well above premiums paid for other institutions in California and the nation.13 The strength of the 

Southern California economy, the lack of “attractively 

priced” targets in that market, and the desirability of the 

institutions acquired also have contributed to high 

acquisition prices.14 

12 A qualified state-chartered institution is a state-chartered insured 

financial institution that has been in operation for more than five 

years. This definition applies to institutions in California, Arizona, 

and Nevada, where interstate branching laws do not allow out-of-state 

headquartered financial institutions to acquire state-chartered banks 

headquartered in the state unless the target bank has been in operation 

for at least five years. 

13 Andrejczak, Matt, “Looking for a Cheap Bank? Might as Well Skip 

San Diego,” American Banker, October 18, 1999. 14 Ibid. 

From 1994 to 1998, de novo activity was a popular form 

of entering the Las Vegas, Phoenix-Mesa, Salt Lake 

City-Ogden, Seattle-Bellevue, and Portland-Vancouver MSAs. While each of these markets experienced 

relatively strong employment growth, they also tended 

to be more dominated by a few institutions compared 

with other MSAs in the Region (see Table 2). Market 

concentration is a key factor here because as the level of 

concentration increases, acquisition costs for out-ofmarket M&As also rise (see Chart 6). 

In addition to high market concentrations, state banking 

laws appear to have played an important role in the level 

of de novo activity in these MSAs. For example, a limited number of locally owned “qualified state-chartered 

banks” were available for acquisition in the Las Vegas 

and Phoenix MSAs (4 and 3, respectively); these low 

numbers may have skewed entry toward de novo charCHART 6 

Market Concentration and Acquisition 

Prices Correlate in the Region 

Sources: SNL DataSource; FDIC Summary of Deposits 

Average Price-to-Book Ratio 

Herfindahl-Herschman Index 

0 

500 

1,000 

1,500 

2,000 

2,500 

3,000 

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00 

San Diego 

Orange County 

Salt Lake City 

Phoenix 

Seattle 

Portland-Vancouver 

San Francisco Las Vegas 

Sacramento 

Los Angeles 

Riverside-San Bernardino 

San Francisco Regional Outlook 23 First Quarter 2000 
Regional Perspectives
 

tering in these markets. Similarly, Utah offers an industrial loan company (ILC) charter that is attractive to 

industrial corporations that want to offer consumer 

credit nationwide. This charter, which allows industrial 

corporations access to insured deposits, in addition to 

Utah’s liberal consumer credit laws, makes Salt Lake 

City an ideal location to headquarter these corporations’ 

consumer credit operations. As of September 30, 1999, 

more than 70 percent of Salt Lake City’s de novo institutions were ILCs. 

The Risks of Entering New Banking Markets 

Some of the risks posed by out-of-market M&A (noted 

in “Risks and Challenges for Consolidating Institutions,” Regional Outlook, Fourth Quarter 1998) include 

melding different corporate cultures, integrating technology, and meeting earnings estimates.15 For example, 

meeting earnings goals has been increasingly difficult 

for institutions involved in large mergers. A recent study 

noted that only 2 of 15 banking companies that made 

large acquisitions in 1997 or 1998 met 1999 earnings 

targets.16 Consequently, the majority of these 15 institutions have experienced declines in share price, which 

can increase an institution’s cost of capital and force it 

to adopt a more aggressive business plan to meet return 

goals. Compounding these risks in an out-of-market 

M&A is the fact that management may be unfamiliar 

with the nuances of new markets, making it difficult to 

meet expectations. 

The high level of out-of-market M&A and de novo 

chartering in the Region between 1994 and 1999 has 

left the Region with a greater percentage of newly organized institutions. The record numbers of de novo institutions entering urban markets have done so at one of 

the most favorable times in recent economic history, 

given the economy’s strong growth, low inflation, and 

low unemployment, as well as strong stock and real 

estate markets. In addition to de novo institutions, many 

other institutions in the Region have been in operation 

between 4 and 14 years; we refer to them as “unseasoned institutions.”17 In fact, the percentage of the 

15 Sherman, John F., “Risks and Challenges for Consolidating Institutions,” Regional Outlook, Fourth Quarter 1998.
 16 Padgett, Tania, “Big Mergers Yielding Profit Letdowns, Study
 

Finds,” American Banker, October 12, 1999.
 17 An unseasoned institution has been in operation between 4 and 14
 

years.
 

Region’s assets controlled by de novo and unseasoned 

institutions has reached the highest point in the decade. 

Of concern is how these institutions would perform 

should a recession occur. 

A study conducted by the Federal Reserve Bank of 

Chicago18 provides some insight into how de novo and 

unseasoned institutions may perform during an 

economic downturn. The study notes that unseasoned 

institutions failed at twice the rate of established institutions. De novos tend to grow rapidly during the first 

three years of existence, but earnings do not reach 

maturity until about year ten of operation. The study 

also found that problem assets begin to accelerate in the 

early years of growth. These factors tend to make unseasoned institutions more vulnerable to adverse economic 

conditions. 

The Region’s experience during the previous recession 

tracks with this study’s findings. During the past ten 

years, the San Francisco Region experienced 67 commercial bank failures; more than 76 percent of these 

failures were unseasoned institutions. In addition, most 

of these institutions were headquartered in Southern 

California and Arizona, areas that suffered a severe 

recession and devaluation in real estate. These institutions also reported significant concentrations of commercial real estate assets, particularly construction and 

land development loans. 

CHART 7 

De Novos Offset Higher Cost of Funds 

with More Higher-Yielding Assets 

Cost of Funds (COF) (percent)

Commercial Real Estate

(percent of total assets) [CRE/TA] 

Source: Bank and Thrift Call Reports 

Median CRE/TA 

De Novo Institutions 

Median CRE/TA 

Seasoned Institutions 

Median De Novo COF 

Median Seasoned COF 

0 

1 

2 

3 

4 

5 

6 

7 

8 

0 

5 

10 

15 

20 

25 

30 

35 

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

18 DeYoung, Robert, “Birth, Growth, and Life or Death of Newly 

Chartered Banks,” FRB Chicago Economic Perspectives, Third Quarter 1999. 

San Francisco Regional Outlook 24 First Quarter 2000 
Regional Perspectives
 

The group of recently chartered institutions in the 

Region appears less diversified than more established 

institutions. Chart 7 shows that the Region’s de novo 

institutions have greater exposure to commercial real 

estate loans and a higher cost of funds than established 

institutions.19 In addition, de novo institutions depend 

slightly more on volatile funding sources than do established institutions. Furthermore, the earnings performance of the Region’s de novo institutions has been 

trending downward: The median ROA for de novo institutions in the second year of existence has been falling 

over the past several years. These negative trends could 

heighten these institutions’ risk profiles should an economic downturn occur. 

19 Established institutions are those that have been in operation for 

more than 14 years. 

Conclusion 

De novo chartering and M&A activity have resulted in 

a higher concentration of assets held by de novo and 

unseasoned institutions in the Region than at any other 

time in the past decade. De novo and unseasoned institutions tend to be more vulnerable to adverse economic 

events than more seasoned institutions, and the fact that 

the majority of these institutions have not weathered an 

economic downturn is a concern. 

San Francisco Region Staff 

San Francisco Regional Outlook 25 First Quarter 2000 
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