FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1997
 

FDIC ATLANTA
 

REGION
 

DIVISION OF
 

INSURANCE
 

JACK M.W. PHELPS,
 

SENIOR REGIONAL

 ANALYST
 

SCOTT C. HUGHES,
 

REGIONAL ECONOMIST
 

PAMELA R. STALLINGS,
 

FINANCIAL ANALYST
 

In Focus This Quaitei
 

• Will Credit Scoring Transform the Market for SmallBusiness Lending? - In an effort to reduce the cost of small-business

lending, some institutions are using credit scoring technology to reduce underwriting

costs and to grow their small-business lending portfolios, in some cases venturing into

markets well beyond their local economies. The ramifications could be significant.

An overreliance on credit scoring models could expose lenders to increased credit

risks. Over time, the traditional niche enjoyed by small banks in small-business

lending could come under considerable pressure. See page 3.

• Banking on the Internet: New Technologies, New

Opportunities, New Risks - Internet banking promises a wide range of new

benefits. It also offers a host of new problems and some new twists on old ones. The

tradeoff is one that depository institutions and regulators alike must grapple with as

they stake out their positions in cyberspace. See page 7.

Regu[ai Featuies
 

+Regional Economy +Financial Markets +Regional Banking

 · Economic Overview · Asset-Backed Securities · Recent Profitability

 · Office Market · Bond Values · Commercial Real Estate

 · Retail Market · Price/Earnings Ratios · Structure Changes

 · Multifamily Market

See page 11 See page 15 See page 20

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

Insurance Corporation for the following eight geographic regions:

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

found on the back cover to the FDIC Public Information Center. Contact the Public Information

Center for current pricing on bulk orders.

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

more information or to provide comments or suggestions about the Atlanta Region's Regional

Outlook, please call Jack Phelps at (404) 817-2590 or send an e-mail to phelps@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 Ricki Helfer

Director, Division of Insurance Arthur J. Murton

Editor George E. French

Managing Editor Stephen Linehan

Associate Editor Maureen E. Sweeney

Assistant Editors Paul C. Bishop

Steven K. Burton

Richard A. Brown

Diane Ellis

Kathy R. Kalser

Ronald L. Spieker

Publications Managers Nancy Maginn

Diane Ellis

Publication Date: April 24, 1997
 
In Focus This Quarter
 

WillfCreditfScoringfTransformfthefMarketffor
 

Small-BusinessfLending?
 

• 	 Small-business lending, traditionally a segment in

which small banks have enjoyed comparative

advantages, is receiving greater focus from

larger banks and nonbank financial companies.

• 	 Some insured institutions are beginning to rethink traditional approaches to small-business

loan underwriting to include the use of credit

scoring models.

• 	 The use of small-business lending credit scoring

models, while providing banks opportunities for

underwriting and servicing efficiencies, carries

with it a number of potential risks.

Background

As of 1994, there were more than 22

million small businesses in the U.S.,

making this a very attractive potential market for lenders. Smallbusiness lending has been a line of

business in which small banks have

been very successful given their traditional strong niche in relationship banking. Smallbusiness lending traditionally has been a relatively costintensive lending segment, since origination costs are

spread over smaller loan balances. Some institutions

are now beginning to use credit scoring technology to

reduce underwriting costs and to grow their smallbusiness lending portfolios. A number of larger banks,

especially, appear to be looking to the efficiencies of

credit scoring to help provide quick loan approvals and

more competitive loan rates. With the aid of this

technology, some institutions are rapidly expanding their

loan portfolios, in some cases venturing into markets

well beyond their local economies.

Commercial bank small business lending exposures in

the Atlanta Region are considerable. (For purposes of

this article, small business lending refers to loans categorized as commercial and industrial loans with original

amounts of $1 million or less reported on the June Call

Reports.) At midyear 1996, commercial banks in this

Region reported $29 billion of small business loans,

amounting to 32 percent of all commercial and industrial

loans. This is an increase of $1.3 billion or 5 percent

from a year ago. There are 388 banks in the Region with

small business loan exposures exceeding equity, and 82

banks with exposure exceeding 200 percent of equity.

Small banks with assets under $1 billion have a substantial 39 percent share of the Regions' small business

loans (see Chart 1 next page). However, the market

share held by the Region's small banks may come under

pressure as several large banking companies have announced nationwide programs to increase their share of

small business lending. These nationwide programs

may have been prompted by new credit scoring technologies that have reportedly allowed some companies

to offer pre­approved and pre­qualified lines of credit.

ThefGrowingfImportancefoffCreditfScoring

While credit scoring technology is not new, until recently it typically has been associated with consumer

lending, particularly with credit

card lending. Primarily using

credit bureau information, credit

scoring provides lenders with a

tool to rank risks or probabilities of

default, assigning statistically derived numerical ratings or scores

based upon a borrower's past experience with paying debt. Based upon the enormous

volume of historical information on consumers contained in credit bureaus, model developers link incidences of good and bad credit performance with borrower characteristics. Applicants then are compared to

these credit performance indicators in order to make

credit extension decisions. While credit scoring has

helped consumer lenders reduce origination costs and to

grow receivables at rapid rates, the recent rise in credit

card charge­offs has raised concerns about the effectiveness of such models, or at least about how the models

are being used.

Small­business credit scoring is a relatively new concept in scoring technology, but is gaining more attention

from lenders. Small-business credit scoring models

are similar to consumer credit scoring models in one

significant aspect -- the most important indicator of

credit performance is the credit profile of the principals of the business derived from consumer credit

bureau information. Other business information from

Regional Outlook	 3 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

CHART 1
 0ercent of Loans

Asset Size of Small-Business Lenders Varies by State

(Shown by Bank Asset Size)

100%

80%

60%

40%

20%

0%

Alabama Florida Georgia North South

Carolina Carolina

Source: June 30, 1996 Bank Call Reports

companies such as Dun and Bradstreet Corporation and

Experian (formerly TRW) also is used in the scoring

process.

A primary vendor of these scoring models has cited

analysis purporting to show that business financial statement information did not prove a useful indicator of

credit performance for small­business loans. The reasons for this result may be due to inconsistency in

financial statement quality and the difficulty in separating business entity cashflow information from the business owners' activities. Also, the relative importance

of principals' credit history and financial statement

information in predicting credit performance was found

to change somewhat with the size of the business ­­ the

larger the business the more important financial statements become in assessing performance.

Many institutions cite the potential cost savings involved in the underwriting process as one of the most

significant characteristics of credit scoring. In many

cases, with scoring technology, loan application processes have been streamlined to one page forms for

loans up to $50,000, not dissimilar to that of consumer

loan applications. In some cases, financial statements

are not required at all. Reducing paperwork helps to

reduce both processing time and costs. Table 1 illustrates how scoring has changed underwriting practices,

as reported by one large bank at a recent conference on

credit scoring. While it is impossible to know whether

the information presented inTable 1 is representative of

the way most institutions are using credit scoring models, it is clear that credit scoring may represent a

significant departure from traditional underwriting

methods.

Over $10 Billion

$1 - $10 Billion

Under $1 Billion

Virginia West Region

Virginia

Part of the reduction in underwriting costs may come

from improvements in the allocation of underwriting

resources. It has been argued that credit scoring allows

banks to more easily identify those applicants which are

clearly either approvals or denials. This process would

enable banks to reallocate their underwriting resources

more efficiently to those loans which pose intermediate

risks and require closer attention. Other advantages of

credit scoring systems that often are cited are greater

consistency in underwriting, better measures for pricing

strategies, and the potential to enhance the ability to

securitize small­business loans.

WhatfArefthefRisks?

Small­business lending has historically been a profTABLE 1

SMALL-BUSINESS LENDING: CREDIT SCORING

VERSUS TRADITIONAL LOAN UNDERW RITING

1993 1996 1997

PERCENT OF LOANS

REQUIRING ANNUAL 100% 20% - -

FINANCIAL STATEMENTS

PERCENT OF LINES

REVIEWED ANNUALLY 100% 0 - 5% - -

PROCESSING TIME FOR LOANS 3 1 1

OF $50,000 - $250,000 DAYS DAY HOUR

SOURCE: REPORTED BY A LARGE BANK AT A RECENT CONFERENCE ON

CREDIT SCORING.

Regional Outlook 4 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

itable area of bank lending. This situation is most likely

attributable to lenders thoroughly analyzing potential

customers, persistently monitoring their performance,

and building solid lending relationships. Credit scoring

for small­business lending raises the possibility that

some banks will forgo the traditional underwriting concepts of relationship lending in favor of a more massmarketing approach, in a manner similar to credit card

lending. To the extent that credit scoring is used to

rapidly gain new customers by either targeting out­ofterritory customers, or customers with less business

experience, the risk profile of an institution's smallbusiness lending portfolio may change. Any such

change in profile may be significant due to the risks

associated with newer borrowers. For example, new

firms tend to fail at an extremely high rate, with 53

percent of new businesses failing within the first four

years of inception (see Chart 2). Larger, more established commercial businesses tend not to exhibit such

volatile characteristics.

There are potential dangers associated with placing

undue reliance on credit scoring models. The predictive

value of any credit scoring system may be substantially diminished if the model is

used for unintended purposes or

customer types. Therefore, misuse

of a scoring system could expose an

institution to considerable losses.

Since only the largest banks have

small­business loan portfolios

large enough to create statistically

valid scoring models customized for their own customer

base, smaller companies should be especially aware of

potential misuse. This risk takes on added meaning

when one considers that a $1 million small­business

loan represents substantially more capital to a $100

million bank than to a $10 billion bank. Adding further

uncertainty, small­business credit scoring has been implemented during a period of relatively strong performance by businesses, with commercial and industrial

loan delinquency ratios near historical lows. How well

these models perform during an economic downturn

remains to be seen.

Depending on the manner in which it is implemented,

credit scoring for small­business lending may represent

a fundamental shift in underwriting philosophy ­­ viewing a small-business loan as more of a high-end

consumer loan and, thus, granting credit more on the

strength of the principals' personal credit history and

less on the financial strength of the business itself.

While this may be appropriate in some cases, it is

important to remember that the income from small businesses remains the primary source of repayment of most

CHART 2
 

Business Dissolution Rate Shows Early Risk

100%

53%

Cumulative Dissolution Rates

24%

62%

71%

80%

123 4 5 6 7 8 9 10

80%

60%

40%

20%

0%

Years

Source: Small Business Administration

loans. Banks that do not analyze business financial

statements or periodically review their lines of credit

may lose an opportunity for early detection of credit

problems.

Competitive pressures in small­business lending are

increasing not only because of large banks' efforts to

expand their lending but also because of greater participation in the market by nonbank financial companies.

Several large firms, such as American Express, AT&T,

the Money Store, and GE Capital Services, are expanding their business lines to service the needs of small

businesses. These companies are offering smallbusiness credit cards, innovative new types of credit,

and other services such as consulting, accounting and

investment services. Some observers have suggested

that the cost advantages of credit scoring may cause

small­business lending in the future to be dominated by

12 to 15 large banks or financial firms. Faced with stiff

competition, there may be strong motivation for some

banks to increase the dollar threshold on low documentation loans, streamline the process for larger loans, or

lower credit scoring thresholds for loan approvals.

The most recent FDICfSurveyfoffUnderwritingfPractices and the FederalfReserve'sfSeniorf LoanfOfficer

OpinionfSurveyfonfBankfLendingfPractices both indicate that only a small percentage of banks reported an

easing of standards on small­business loans. Aggressive competitive pressures and loan growth goals were

seen as the main reasons for easing in these cases. With

regard to small­business credit scoring techniques, the

Federal Reserve survey pointed out that banks were

most commonly using creditscores for automatic acceptance or rejection of loans up to $50,000.

Regional Outlook 5 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

Summary

Credit scoring has the potential to transform the market

for small­business lending. The traditional niche enjoyed by small banks in this area may come under

tremendous pressure from larger banks and nonbank

companies employing this new technology. Credit scoring at a number of institutions is driving dramatic

changes in underwriting methods for small­business

lending. These changes may facilitate short­term revenue generation as business can be expanded rapidly

and underwriting costs can be slashed. It is extremely

important, however, that banks understand and control

the potential risks inherent in such a strategy. The

application of credit scoring to small­business lending

merits the close attention of both bankers and their

supervisors.

Andrea W. Bazemore, Banking Analyst

Regional Outlook 6 Second Quarter 1997
 
In Focus This Quarter
 

Banking on the Internet
 New Technologies, New Opportunities, New Risks

• 	 Despite the potential for lower transaction costs,

increased efficiency, and greater asset diversification, few banks do business through the Internet.

• 	 Although competitive risks are pushing banks to

create an Internet presence, operational risks

remain an obstacle to actually using those sites

for moving information or money.

• 	 The FDIC's Division of Supervision recently released examiner guidance on Internet banking

and is developing training programs for its examiners.

The Allure o Cyberbanking

On-line Banking is a comprehensive term for transactions conducted

over wires or from remote locations. It includes banking by telephone, banking by personal computer through a dial-up connection

and, more recently, banking over the

Internet. Internet banking, frequently

referred to as cyberbanking, is of particular interest to

banks because it exploits an existing and geographically

extensive public network infrastructure and promises a

range of new operating and marketing benefits. One

such benefit is the ability for an institution to expand its

trade area to include other cities, states, regions -- or

even countries -- without a commensurate expansion of

its branch structure. This greater geographic reach can

CHART 1

do more than simply increase volume. It also can offer

institutions -- particularly smaller ones -- the potential

to diversify their asset portfolios across multiple regions, leaving them less exposed to the economic

volatility of any single one. Another benefit is the lower

cost of Internet delivery. A March 1996, study by Booz,

Allen & Hamilton Inc. estimated an average Internet

transaction cost of $0.01 compared to $0.27 for an

ATM, $0.54 for a telephone, and $1.07 for a fullservice branch.

Slow Migration to the Future

Another 1996 study, this one by Grant Thornton in July

(see Chart 1), found that despite these potential benefits,

most banks established an Internet presence for appearance's sake -- being perceived as a leader, advertising

bank services or staying abreast of competitors -- rather

than with an intent to grow deposits or capture the

transaction economies that cyberbanking could provide.

Of the 44 Internet institutions surveyed, only one in three

expressed intentions to begin offering bill payment or

funds transfer over the Internet by the end of the second

quarter of this year. Even this subdued enthusiasm now

appears optimistic. Despite the perceived benefits and

the scarcity of competition, few banks have to date

ventured into this area in a meaningful way. According

to the Bankweb world- wide web site, only 800 or so

banks -- less than 1 percent of the industry -- have an

Internet site and only 18 of those permit transactions. In

the Atlanta Region, 120 institutions have an Internet

presence but only five allow customers to pay bills or

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

Banking on Cybercommerce: A Survey of Internet Bank Product Plans

Source: Grant Thornton "Banking on Cybercommerce: A Survey of Internet Bank Product Plans"

Mid 199 

(Projected)

Mid 1996 (Actual)

Regional Outlook	 7 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

transfer funds. A major question, then, is why so few

institutions have chosen to exploit this medium? Some Concerns or the CyberBanker
 

Risk
 

The reason is risk. Banks are familiar with the control

of exposures found in proprietary or private payment

channels, but they are less comfortable with the new

risks attendant to a public network. On one hand, there

are operational exposures that convincingly argue

against rushing headlong into cyberspace. On the other

hand, there are competitive risks. Nonbank competitors

with strong foundations in cybertechnology pose a budding threat to the banks' historical payment-services

monopoly and argue with equal authority for an immediate Internet presence to gain or preserve market share.

These opposing forces help explain the large numbers of

banks establishing web sites that stop short of actually

moving information or money.

Of these two types, operational risks are the most

immediate and command the most attention. They derive from the formative state of both the technology

supporting on-line commerce, and the legal and regulatory structure governing its use. These risks include

theft or misappropriation of internal data or external

transmissions, transaction fraud, errors in underwriting

virtual transactions, liquidity shortfalls, changing technical standards, inadequate or geographically inconsistent

regulatory and legal infrastructure, noncompliance with

existing laws or regulations that were not designed for

an on-line world, and damage to an institution's reputation from the realization of any or all of these risks (see

Some Concerns or the CyberBanker,right).

Systemic Threats and a New Payments Model

In addition to bank-specific risks there are the systemic

threats that a public domain payments model could

bring. One of the key features of the Internet is redundancy. Any one of a large number of possible paths can

be used for a given transaction and therefore the failure

of any one path or node will not affect the functionality

of the network as a whole. This feature presents a

multitude of new and -- from a banker's perspective --

previously unconsidered points of vulnerability to

technologically-sophisticated miscreants. In a cyberworld of small value transactions, the effects of an

attack may not be much more severe than those which

accompany credit card crime. However, there is good

reason to expect that Internet transaction sizes will

continue to grow. According to one software vendor,

Internal Data Security. The Internet cannot distinguish

between customers and criminals. Invasive attacks can range

from simple vandalism to theft or destruction of proprietary

operating or customer data. Firewall software, data encryption, specialized hardware configurations and commercial

insurance can limit such exposures.

External Transmission Security. Because the Internet is an

open network, transaction messages are completely exposed,

rendering them vulnerable to theft or tampering. Message

encryption is a common response, but hardware or implementation flaws can circumvent it. This threat will increase

greatly if large value or interbank transactions migrate to the

Internet.

Transaction Fraud. Fraud takes two forms:misrepresentation during a transaction or repudiation following it. This

problem takes new dimensions in cyberspace because no

physical relationship with a customer exists. Encryption

protocols which include digital signatures are one response.

Biometric authentication schemes, the most commonly proposed being fingerprint or retinal verification, are another.

Difficulties with Virtual Underwriting. Even if your cyberborrowers are who they claim to be, there remain difficulties

in establishing their creditworthiness. The lack of a personal

relationship is one factor. The limited knowledge of local

employers and credit grantors that appear on applications is

another. Such difficulties could hasten and heighten dependency upon credit scoring models.

Liquidity Risks. Internet transaction volume and velocity

are expected to increase rapidly, potentially creatingtransactions which occur so rapidly as to exceed immediate bank

liquidity. Denial of service attacks, where a site isintentionally deluged with transactions in order to shut it down, also

can affect liquidity if affected customers decide to close their

accounts.

Lack of Technical Standards. An institution building an

early presence on the Internet is making a financial bet as to

which standards will endure.

Lack of Regulatory and Legal Infrastructure. Regulators

are waiting and observing. Future promulgated "bestpractices" may not be those which an institution has already

adopted. Similarly, a lack of legal precedent hinders criminal

and civil prosecution of cybercriminals. Even where precedent exists, it is frequently inconsistent across jurisdictions.

Reputation Risk. An image of solidity is a cornerstone of

banking. Internet banking confronts banks with more exposure and potentially greater publicity about losses.

Competitive Risks. Unlike the operational risks discussed

above, competitive risks accrue to institutions not securing an

Internet foothold. They involve the threat of lost market

share or payment system position to more aggressive peers

and nonbank competitors.

Regional Outlook 8 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

interbranch payments on the Internet are likely to begin

in 1997 with interbank activity to follow a year or so

later. This development would be a significant evolution because wholesale transactions are generally large

relative to bank liquidity. An attack or disruption of the

Internet payments mechanism for a single large transaction could conceivably pass liquidity shocks to other

banks in the same way that bad weather at a major

airport can disrupt air traffic throughout the country.

New Technologies, Old Reporting

The advent of fully transactional web sites also could

heat up bank competition for low cost deposits and

frustrate regulatory oversight in the process. One possibility is a "deposit arbitrageur," a hybrid of brokered

deposits and program trading in which a computer

program could search the Internet for the highest deposit

rates and immediately reallocate deposits accordingly.

In the long run, such activities could harmonize local

interest rates. In the short run, however, this rapid

turnover could mean substantial liquidity drains on institutions accustomed to local deposit monopolies. From

the regulatory perspective, this transaction velocity --

and its potential to rapidly alter bank balance sheets --

could present new challenges in a world of quarterly

Call Reports and examination intervals that can exceed

one year.

FDIC -- the CyberRegulator

New risks demand new supervision techniques and the

FDIC's Division of Supervision (DOS) has responded

with their recently-released electronic banking safety

and soundness examination guidance. Under that guidance, institutions having Internet sites are placed into

TABLE 1

one of three tiers based upon the "maturity" of their site.

Safety and soundness examination procedures focus on

bank policies, procedures and planning. The examination procedures are cumulative -- meaning that each

successive tier adds an additional level of scrutiny to

the tiers below -- and do not require a technical knowledge of Internet systems. "Information Specialist" involvement also varies by tier (see Table 1). A DOS

training program for all safety and soundness examiners

already has begun, and technical training for information

systems specialists is being developed. A new specialty, the electronic banking Subject Matter Expert,

also is being established.

Measured Steps in a New Environment

Banks increasingly are becoming distributors of

commodity-like products. As such, profitability may

become dependent upon both cost efficiencies and high

volume -- a combination sometimes argued as inconsistent with high-cost branch structures. Internet banking

offers institutions a means to compete in this new environment. It also offers new risks. Recognizing this

tradeoff, many banks have entered this realm with measured steps. Those who have not face risk of a different

sort. They face instead the risk that their competitive

position will pass to more innovative competitors --

competitors with new technologies and the drive to

accomplish old business in thoroughly new ways.

Gary Ternullo, Senior Financial Analyst

gternullo@rdic.gov

THE DIVISION OF SUPERVISION CLASSIFICATIONS FOR INTERNET BANKS

LEvEL 1 LEvEL 2 LEvEL 3

DESCRIPTION AN INFORMATION-ONLY

SITE

A SITE PERMITTING

ELECTRONIC

SUBMISSION OF LOAN

OR DEPOSIT

APPLICATIONS

TRANSACTIONAL SITE

OFFERING ELECTRONIC

BILL PAYMENT OR FUNDS

TRANSFER SERVICES

SPECIALIST

EXAMINATION

REQUIREMENT

(IN ADDITION TO

SAFETY AND

SOUNDNESS EXAM)

INFORMATION

SPECIALIST REVIEW

REQUIRED ONLY IF SITE

IS TIED INTO INTERNAL

BANK SYSTEMS.

CONSULTATION WITH

INFORMATION

SPECIALIST REQUIRED

TO DETERMINE IF

FURTHER REVIEW IS

WARRANTED.

CONCURRENT

INFORMATION

SPECIALIST EXAMINATION

REQUIRED.

Regional Outlook 9 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

For More In ormation:

Division o Supervision	 DOS currently is implementing examination guidance for safety and soundness examiners and developing training for technical specialists.

Cynthia Bonnette, Examiner

Chairman, New Banking Technologies Task Force

(202) 898-6583

Stephen White, Inrormation Systems Review Examiner

Chairman, Inrormation Systems Subcommittee

Federal Financial Institutions Examination Council Task Force on Supervision

(202) 898-6923

Division o Compliance and DCA is reviewing new banking technologies from a consumer protection, fair lendConsumer A airs ing and CRA perspective to provide guidance on compliance matters. DCA also is

coordinating outreach efforts with consumer community groups.

John Jackwood, Special Assistant to the Director

(202) 942-3854

Regional O ice Contacts	 Frederick Barnes, Review Examiner (EDP)

Division or Supervision

Atlanta Regional Orrice

(404) 817-2570

Christina Quinlan, Review Examiner

Division or Compliance and Consumer Arrairs

Atlanta Regional Orrice

(404) 817-2551

O ice o Policy Development	 OPD provides leadership in developing FDIC policies, including those addressing

new banking technologies. The office coordinates several interdivisional electronic banking efforts and represents the FDIC on the interagency U. S. Treasury

Consumer Electronic Payments Task Force.

Sharon Powers Sivertsen, Director

(202) 898-8710

Related Web Sites	 FDIC http://www.fdic.gov

FFIEC http://www.ffiec.gov

NETBanker http://www.netbanker.com

Bankweb http://www.bankweb.com

National Computer Security Assoc. http://www.ncsa.com

RSA Data Security Inc. http://www.rsa.com

Smart Card Resource Center http://www.smart-card.com

American Bankers Association http://www.aba.com

Regional Outlook	 10 Second Quarter 1997
 
Regular Features	 Regional Economy
 

Slower Growth in the Atlanta Region
 

• 	 Growth in the Atlanta Region may slow in 1997 as the economy moves further away from its 1994 cyclical

peak. The Region, however, should continue to grow at a pace that exceeds the national average.

• 	 The metropolitan Atlanta retail real estate market appears to be at overcapacity. The multifamily and

office segments may not be far behind.

• 	 Years of fast-paced economic growth have created the possibility that as Atlanta's growth cools, new net

A Downshift in the Economy?	 CHART 1

The economic performance of the Atlanta Region continues to cool, though numerous pockets of growth remain. The Region's cyclical peak occurred in 1994,

when job growth reached a robust 3.6 percent, compared to a more modest 2.6 percent increase in 1996

(see Chart 1). Still, the smaller increase in employment

in 1996 continued to surpass the national average of 2

percent. Indeed, the Atlanta Region boasts three of the

five states east of the Mississippi ranked in the top

quartile of U.S. job growth (Georgia, Florida, and

North Carolina).

In many respects, the Region's performance parallels

that of the nation, which also has seen a deceleration in

growth. This similar performance is the result of increased diversification and financial interdependence

with the rest of the nation and global markets. Nonetheless, the Region is host to some industries that do not

necessarily move in tandem with the nation, such as its

large and structurally declining textiles and

apparel industries, which are heavily concentrated in the Carolinas, Georgia, and

Alabama. Tobacco, though not as large an

employer as textiles and apparel, still generates substantial levels of income for the

Region. Federal fiscal austerity also has

been a drag on the Region's growth, especially in Virginia.

Some analysts expect that growth in the

Region will continue to slow in 1997 as

the economy moves further away from its

-2 0

-1 0

0 0

1 0

2 0

3 0

4 0

5 0

87 88 89 90 91 92 93 94 95 96

The Atlanta Region Economy: Beyond the Peak

 S 

Atlanta Region

Source: Bureau of Labor Statistics

Job Growth (%)

omy, nonetheless, will face a challenge in the postOlympic era. Even with the Games, job growth in 
 

Georgia averaged less than 4 percent in 1996 and
 

...analysts expect

that growth in the

Region will

continue to slow in

1997 as the economy moves further

away from its 1994

cyclical peak.

1994 cyclical peak. Growth, however, should continue

to exceed national averages. Above­average population

growth in the Region should lend considerable support

to continued demand for local goods and services.

Geographically, the most robust gains should continue

to occur in Georgia and Florida, which have the

Region's most dynamic economies. Georgia's econemployment gains this year should be substantially lower.

North Carolina, though still hampered by

the persistent erosion of its older industrial base (tobacco and textiles and apparel), should benefit from high­tech

growth and corporate relocation. Business

in­migration slackened in 1996 due to legal challenges, which have since been put

to rest, and the state foresees a year of

aggressive corporate courting in 1997.

Virginia and West Virginia also are encouraging corporate relocation. Virginia is pursuing

high­tech industries, and West Virginia is attempting to

attract automobile parts manufacturers. Job growth in

Alabama is expected to remain sluggish even with the

start up of the much anticipated Mercedes­Benz plant in

Tuscaloosa. Weak population growth and shortages of

Regional Outlook	 11 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

skilled labor have continued to constrain Alabama's

economic performance.

Corporate relocation fuels economic activity and bank

lending. As businesses move into an area, population

and other commercial growth soon follow. Subsequently, infrastructure development also is required.

Nonetheless, the 'relocation game' is a double­edged

sword, as it may be risky and competitive. Government

incentives to migrating business can prove costly, and

areas of concentrated relocation have the potential to

attract commercial development away from neighboring

areas, thus adversely affecting adjacent local

economies. Nonetheless, the Wall Street Journal notes

that four of the Atlanta Region's seven states (Florida,

Georgia, North Carolina, and South Carolina) anticipate increasing incentive programs over the next five

years. Alabama, Virginia, and West Virginia plan to

stabilize their business­incentive programs.

Implications: Slowing growth ultimately translates into

weaker loan demand. There is an additional risk that

consumers and businesses may not recognize the

changing economic conditions and become over-

...consumers and extended. Longer term,

businesses may growing economic linkages

not recognize the may make the Atlanta Region

changing eco- more sensitive to national

nomic conditions conditions.

and become overextended.

Trends in Commercial

Real Estate in Atlanta

The Atlanta metropolitan area faces a number of risks to

its economic well­being that could potentially affect its

banking sector. Years of fast­paced economic growth

have created the possibility that as the city's growth

cools, new net supply may fail to slow commensurately,

which could potentially lead to the emergence of real

estate "bubbles" (see Current Regional Banking Conditions).

Office Markets Tightening

Over the last four years, the Atlanta metro office vacancy rate has shown dramatic improvement from 19.9

percent in 1992 to a current estimated 6.5 percent.

However, office vacancy rates vary widely through the

city. Buckhead, the Central Perimeter, and North Fulton

are well below the metro­wide average.

Near Hartsfield International Airport,

the office vacancy rate is near 20 percent. Midtown and downtown vacancy

rates are in the double­digits. Moreover, the construction of the new Federal Center is expected to raise the

downtown class A and B vacancy levels up to 22 percent.

A lack of new construction from 1991 to 1995 has

contributed to the occupancy of Atlanta's vacant office

space and has led to a rapid rise in rental rates (see

Chart 2). The sharp rise in rental rates has spurred a

resurgence in speculative office construction in Atlanta

which has more than doubled over the past year from

about 1.1 million square feet in 1996 to about 2.4

million square feet scheduled for construction this year.

Atlanta currently is the most active speculative office

construction market in the country. In total, four

million square feet of new

office space is expected to

come on line in both 1997 Atlanta currently

and 1998. Following the is the most acOlympics, most construction tive speculative

has shifted to the suburbs and office construc- away from the downtown tion market in

area. For example, the At­ the country.

lanta North Fulton submarket, has over 1.8 million

square feet of office space

currently under construction ­­ more than all the rest of

the Atlanta market combined.

The rise in rental rates also is being driven by record

lease expirations of over 30.8 million square feet from

1995 through 1998. Office job growth is expected to

CHART 2

Office Rental Rates Soar as Vacancy
 

Rates Decline
 

Avg Lease Rate $ Vacancy Rate (%)
 

18 5 20

18 0 15

17 5 10

17 0 5

16 5 0

1993 1994 1995 1996 1997

Source: Grubb & Ellis

Regional Outlook 12 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

drive demand for new office space to record highs for at

least the next two years. Over the last three years, office

employment growth has escalated by over 11 percent,

but growth is expected to slow to 4 percent in 1997 and

to 3 percent in 1998, according to Donald Ratajczak,

Director of the Economic Forecasting Center at Georgia

State University. Atlanta's office vacancy rate is expected to reach an estimated 6.8 percent rate for 1997,

well below the projected 11 percent national average.

While fundamentals appear strong over the next two

years, the office market may experience a correction if

the pace of new construction continues and the forecasted slowdown in office employment growth materializes over the longer term.

Retail Markets Oversupplied?

The Atlanta metropolitan area's retail market has enjoyed several years of expansion. Prompted by strong

levels of absorption following the recession early in the

decade, net new supply of retail space has consistently

trended upward. Strong growth, exemplified by rapid

gains in retail trade employment, has steadily reduced a

vacancy rate that stood above 13 percent in 1990. By

1994, the peak of the recovery, the Atlanta retail vacancy rate was close to 6 percent. Since then, absorption has slowed, except for a brief surge in 1996 associated with the Olympic Games. In contrast, net new

supply has continued its upward trend (see Chart 3), and

consequently, the vacancy rate has started to inch upward.

Net new supply of retail space in the third quarter of

1996 was estimated by F. W. Dodge to be 9 million

square feet (annual rate). This amount is a remarkable

1O percent of the total new retail space for 58 major

CHART 3

markets reporting nationally.

Considerable space also remains in the construction

pipeline at a time when absorption is weakening. These conditions are exacerbated by the

approval for construction of the

Mall of Georgia in northern Gwinnett County scheduled

to open in August 1999. The new mall will add 1.8

million square feet of mall space and another 1.8 million

square feet in other retail space to an already competitive market. Property owners in Gwinnett county are

beginning to convert retail properties into office space

because of a shortage of tenants, which is further evidence that the retail market is becoming overbuilt. As

Atlanta's overall economy continues to cool, so will

growth in retail trade and consumer spending. As

such, the potential exists for a shakeout in the retail

real estate market.

Multifamily Construction ­­ Where Will the

Renters Come From?

Recently, there have been concerns about overbuilding

of multifamily dwellings in the Atlanta metropolitan

area. As noted in the Wall Street Journal, the pursuit

of renters by landlords has included the use of "bobbing

balloons" outside apartment complexes. In one case, an

employee dressed up in a rabbit suit to lure potential

renters.

Over the past three years, the Atlanta apartment market

has been quite strong. During 1994 and 1995, the

occupancy rate held steady at 96 percent, then declined

to 94 percent in 1996 as 12,000 new units were added

to the market, according to the Atlanta Business ChroniCHART 4

2 0

2 2

2 4

2 6

2 8

3 0

3 2

1994 1995 1996 1997 1998

6,500

7,500

8,500

9,500

10,500

11,500

Source: Permit Issuance - Georgia State niversity, Forecasting Center

 Population Growth - WEFA Group

Multifamily Construction Expected to Slow

Population 

Growth

Multifamily Permit

Issuance

-4

-2

0

2

4

6

8

10

88 89 90 91 92 93 94 95 96*

0

1000

2000

3000

4000

5000

6000

7000

Net New Supply Is on the Rise While Retail

Trade Growth Slows

Net New

Supply (SF)

* Based on Estimates through 301996

Source: FDIC Real Estate Report, January 1997

Retail Job

Growth %

Regional Outlook 13 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

cle. The metro area's occupancy rate

is expected to decline again in 1997

to 92 percent occupancy as an additional 10,000 units will be constructed. At the same time, analysts

expect a slowdown in corporate relocation and in­migration to Atlanta

from other parts of the nation. Hence,

it appears that the Atlanta metro area

population will not continue to grow

at the rapid pace experienced over the past three years

(see Chart 4 previous page). Given that apartment

construction is expected to remain strong and population growth appears to be leveling off, the Atlanta

multifamily housing market may be in the early stages

of overbuilding.

Implications: Atlanta's economy appears to be in a

state of transition, posing a number of challenges to the

metro area's commercial real estate developers that

have a presence in possibly overbuilt markets. As a

result, cautionmay be warranted for lenders anticipating

continued strong demand for commercial and multifamily real estate.

Jack M.W. Phelps, Senior Regional Analyst

Scott C. Hughes, Regional Economist

Pamela R. Stallings, Financial Analyst

Regional Outlook 14 Second Quarter 1997
 
Regular Features	 Financial Markets
 

Financial Markets
 

• 	 While demand for asset-backed securities continues to be strong, further deterioration in consumer credit

quality could have adverse effects on both investors and issuers.

• 	 Although there has been little net change in the Treasury yield curve between September 30, 1996, and

early March 1997, rates in the 5-year to 30-year segment of the yield curve did fluctuate modestly during

this time period.

• 	 During the fourth quarter 1996, the Atlanta Region's Bank Index outperformed both the S&P Composite

Bank Index and S&P 500, gaining almost 15 percent, compared to a 12 percent gain for the S&P Composite Bank Index and an almost 8 percent gain for the S&P 500.

• 	 Banks' price/earnings ratios relative to the broader market have been trending upward since 1994,

perhaps signaling an improved perception of the quality of bank earnings.

The Asset-Backed Securities Market: The

Effects of Weakened Consumer Loan Quality

Asset­backed securities (ABS) are debt securities that

are backed by loans such as credit cards, car loans, and

home equity loans. Over the past ten years, the ABS

market has grown dramatically. In 1996, the issuance of

ABS was $167 billion, up from $65 billion issued in

1993 as illustrated in Chart 1. Commercial banks and

credit card companies accounted for approximately 35

percent of total ABS issuance last year. Major buyers

of ABS were mutual funds, insurance companies, corporations, and foreign and domestic banks. Although it is

difficult to quantify the amount of bank investment in the

ABS market, market participants have observed that

small and midsized banks have recently increased their

holdings of ABS.

Monoline credit card banks and large banks with significant credit card operations have been particularly active ABS issuers. Issuing banks generally structure

ABS transactions as nonrecourse sales (loans that cannot be "put back" to issuers upon default), which results

in the removal of the assets from the bank's balance

sheet and lowers capital requirements. In order to

receive investment grade ratings on their ABS, issuers

must provide credit support either in the form of overcollateralization, reserve accounts, or third party credit

enhancement from bond insurers.

Bank issuers benefit from the sales treatment of assets

into the security without completely severing their economic interest in the income generated by the assets.

The economic interest results when the revenue generated by the sold assets after charge­offs, servicing fees,

CHART 1
 

0

25

50

75

100

125

150

175

1993 1994 1995 1996

ABS Issuance Is on the Rise

Sou ce: Bloombe g, nside MBS and ABS

$ Billion

 e it a 

Auto 

Home Equity

 the 

and interest coupon payment is recognized as income by

the issuer. This surplus is referred to as excess spread.

Banks that issue ABS usually continue to service the

underlying assets, which not only generates servicing

income but also permits customer relationships to continue.

Delinquency and charge­off rates rose in 1996 on consumer loans, particularly in credit cards and auto loans.

Despite this rise, the difference between ABS and Treasury yields of similar maturity did not increase. As

Chart 2 (next page) shows, the average spread to the

two­year Treasury note on selected ABS products continued to tighten during 1996. The lack of widening

spreads despite the overall weakening in consumer

credit quality reflects strong demand from an expanding

investor base, which increasingly includes overseas

Regional Outlook	 15 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

buyers. Spreads on selected credit card and auto ABS

products began to increase during the first quarter of

1997, however, as investors reacted to higher than

expected charge­offs reported by some of the larger

issuers.

The increasing frequency of rating agencies' reviews for

possible downgrades of credit card transactions, as

well as problems in the auto finance sector, have raised

some concerns in the ABS market. How would a further

deterioration in consumer credit affect the ABS market?

For the issuer, higher charge­offs, absent a corresponding increase in fees or rates, reduces the excess spread

from the ABS. If deterioration worsens, the ABS face

potential rating downgrades. This situation may compel

the issuer to improve the overall loan quality in the ABS

or face what is termed an "early amortization" event.

An early amortization event may result in the termination

of the ABS issue prior to the maturity date. Once an

early amortization occurs, new receivables associated

with the accounts in the asset­backed security no longer

move into the security but must be funded by the bank on

their balance sheet and accounted for in determining

capital requirements. In addition, an issuer's access to

the ABS market may become more costly after an early

amortization if investors demand higher yields on subsequent issues.

For the investor, the threat of a ratings downgrade

usually impairs the market value of the security. Investors also may forfeit some interest income in an early

amortization because principal may be paid prior to the

scheduled maturity date. ABS investors would lose

principal, however, only if the deterioration in the

quality of the underlying loans is severe enough to

deplete the entire credit support. The high level of

credit support demanded by rating agencies on existing

CHART 2

ABS deals minimizes the risk of principal loss by

investors.

During 1996, some bankcard issuers took steps to prevent a ratings downgrade or a possible early amortization. Methods used by bank issuers to support deteriorating ABS have included the sale of new receivables at

a discount, the repurchase of low quality receivables

from the issue, and the infusion of additional cash into a

reserve account of the ABS. However these strategies

were specifically cited by the Office of the Comptroller

of the Currency (OCC) as actions that could be considered recourse and require full risk­based capital treatment for the assets in the particular ABS issue. The

FDIC is working with other regulatory agencies through

the Federal Financial Institutions Examination Council

(FFIEC) on new Risk­Based Capital Guidelines that are

expected to address limitations on post­sale actions and

capital requirements for direct credit substitutes or

credit enhancements for ABS.

Given the continuing trend of higher charge­offs and

delinquencies for credit card loans, investors consider

the ABS market less homogeneous in terms of issuer

quality and therefore are scrutinizing the securitizations

of issuers more closely. Although the risks vary by ABS

issuer, banks that issue or invest in the ABS market

should be cognizant of the changing market conditions

and potential risks associated with ABS.

Changes in Interest Rates and Bond Values

Chart 3 (next page) shows little change in the Treasury

yield curve between September 30, 1996, and early

March 1997. What this chart does not show, however,

is how rates in the 5­year to 30­year segment of the yield

0

25

50

75

100

125

150

175

3§20§97

12§16§96

6§3§969§9§96

2§26§96

11§20§95

 §14§95

5§ §95

1§30§95

10§24§94

4§11§947§1 §94

1§3§94

2§17§925§25§92 §31§9212§7§923§15§936§21§939§27§93

11§11§91

 §5§91

1§21§914§29§91

ompa ison of Sp ea s to T easu ies fo Asset-Backe Secu ities -- 2-Yea Matu ity

Auto

 a

Sou ce: P u ential Secu ities

Basis Points

Home Equity

Regional Outlook 16 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

CHART 3 CHART 4
 

-4%

-2%

0%

2%

4%

4- ct

1 - ct

1-zo6

15-zo629-zo6

13-0ec27-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

-0.5%

-0.3%

-0.1%

0.1%

0.3%

0.5%

Mo el

Po tfolio

Sou ce: Bloombe g

5-yea 

T easu y

Mo el Po tfolio's Value Relati6e to 5-Yea 

T easu y Yiel (Pe cent hange) T easu y Yiel u 6e Shows Little

hange Since Septembe 30, 1996

5.0%

5.2%

5.4%

5.6%

5. %

6.0%

6.2%

6.4%

6.6%

6. %

7.0%

3-mo. 2-y . 7-y . 30-y .

3§12§97

12§31§96

9§30§96

Sou ce: Bloombe g

curve fluctuated during this time period. The path of

yields on Treasury bonds with 5­year through 30­year

maturities changed directions four times, rising or

falling by more than 30 basis points. Movements in the

shorter segment of the yield curve have been less pronounced.

In order to consider the effect that these rate swings may

have had on banks' fixed income portfolios, Chart 4

shows the percent change in the yield on the 5­year

Treasury and the percent change in the market value of a

model bank portfolio created by the Division of Insurance. The presentation of this model portfolio extends

an analysis that was introduced in the first quarter 1997

edition of the Regional Outlook, which looked at the

market values of several common fixed income instruments relative to interest rate movements.

TABLE 1

In order to enhance the model portfolio's applicability

to bank portfolios, the type and amount of the securities

chosen for the portfolio are based on an aggregation of

securities­related Call Report data. The limitations of

Call Report data concerning the maturity distribution of

securities required that assumptions be made when

choosing the maturity of the securities for the model

portfolio. An effort was made, however, to construct a

model portfolio that approximates, in the aggregate, the

maturity distribution of the aggregate commercial bank

portfolio. The model portfolio is shown in Table 1.

As shown in Table 1, the total market value of the

portfolio changed less than one­half of 1 percent since

September 30, 1996. The portfolio's period­high value,

representing a 1.51 percent increase from September 30,

1996, occurred on November 29, 1996, when the 5­year

TYPE OF SECURITY PAR

VALUE

PERCENT

OF

PORTFOLIO

MATURITY

OR

WAL

PERCENT

CHANGE

FROM

9/30/96

TO

12/31/96

PERCENT

CHANGE

FROM

12/31/9

6 TO

3/12/97

PERCENT

CHANGE

FROM

9/30/96

TO

3/12/97

U.S. TREASURY 5.6% 2,000 20% 1YR 0.35% •0.05% 0.30%

FNMA AGENCY 5.8% CALLABLE 1,200 12% 2YR 0.59% •0.25% 0.34%

STATE COUNTY MUNICIPAL GO 4.8% 800 8% 11YR 1.95% •0.64% 1.95%

FNMA MORTGAGE PASSTHROUGH 7.5% 3,000 30% 8YR 1.08% •0.30% 0.78%

FNMA (REMIC) 8.0% PAC 2,000 20% 2.5YR 0.58% •0.68% •0.10%

CREDIT CARD ASSET•BACKED SECURITY 1,000 10% 5YR 0.10% 0.00% 0.10%

TOTAL 10,000 100% 4.85YR 0.77% •0.29% 0.48%

Regional Outlook 17 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

Treasury rate fell to its period­low

of 5.83 percent. Observe that, while

longer term rates fluctuated modestly over the reporting period, the

reasonably short weighted average

life (WAL) of the portfolio further

moderated the value changes sustained by the portfolio. Changes in

the value of the model portfolio demonstrate a higher

correlation to changes in the 5­year Treasury yield than

to other maturities along the yield curve because the

5­year bond's maturity better matches the WAL of the

model portfolio. Even though the 30­year Treasury rate

is often cited as a benchmark for daily rate changes, it

may not be the most significant rate in assessing exposures of bank securities portfolios to changes in interest

rates.

On March 25, 1997, the Federal Reserve Open Market

Committee met and raised the target federal funds rate

25 basis points to 5.50 percent. By the following day,

the 5­year Treasury yield had risen to 6.66 percent, 23

basis points higher than the 5­year Treasury yield dated

March 12, 1997, displayed in Chart 3 (previous page).

The rise in rates from March 12 to March 26 caused the

model portfolio's market value to fall 0.56 percent to

$9,965.

This model portfolio will be used regularly to show the

effects on bond values of interest rates movements from

quarter to quarter. It also will be used from time to time

to illustrate how investment choices that portfolio managers make concerning duration, optionality, and other

risk factors affect a portfolio's relative volatility.

Banks' Stock Prices and Price/Earnings Ratios

Continued to Rise in 1996. Is the Market ImCHART 5

proving its Perception of the Quality of Bank

Earnings?

During the fourth quarter of 1996, the S&P Composite

Bank Index outperformed the S&P 500, gaining over

12 percent compared to an almost 8 percent gain for

the S&P 500. The fourth quarter results topped off a

year during which the S&P Composite Bank Index

gained 37 percent compared to a 20 percent gain for

the S&P 500. As shown in Chart 5, the Atlanta

Region's Bank Index (ARBI) gained 14.6 percent in the

fourth quarter 1996. The ARBI gained almost 34

percent for the full year 1996: enough to outperform

the S&P 500, but not the S&P Composite Bank Index.

The year's moderate economic growth, contained inflation, and favorable interest rates are credited for

providing a friendly environment for bank stocks. As

1997 began with much the same economic conditions,

bank equities have continued to do well. The ARBI

was up a little more than 17 percent compared to an

almost 20 percent gain for the S&P Bank Index and a

9 percent gain for the S&P 500, through March 7,

1997.

While appreciating stock prices provide an obvious

positive signal about the health of the industry, the

market provides other information about the prospects

for the industry through the price/earnings (P/E) ratio.

The P/E ratio presents the price of a company's stock as

a multiple of its earnings per share and is derived by

dividing the stock's market value by the company's

earnings per share. Typically investors are willing to

pay a higher price for a company with earnings that are

expected to be consistent and growing. However, firms

with more volatile earnings are generally penalized by

investors in terms of stock price and lower P/E ratios.

Generally, a higher P/E ratio can be interpreted to mean

0%

10%

20%

30%

40%

30-Sep

11- ct25- ct

-zo6

22-zo6

6-0ec

20-0ec31-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

S&P 500

Atlanta Region's Bank In ex

S&P Bank In ex

Sou ce: Bloombe g,American Banker

hange f om 9§30§96

The Atlanta Region's Bank In ex utpe fo me the S&P 500 an the S&P Bank In ex

Regional Outlook 18 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

that investors have more confidence in the outlook for

future earnings performance.

The relationship between bank P/E ratios and the P/E

ratios for the broader market provides further insight

into the market's perception of the quality of bank

earnings compared to other firms. Historically, bank

P/E ratios have been lower in the aggregate as compared to the rest of the market. The rationale posed for

this discounted bank P/E ratio relative to the broader

market has been that the primary sources of bank revenue, deposit taking and lending activities, traditionally

have been viewed as being more volatile because they

are prone to rising and falling with changes in the

business cycle. For example, despite recording some of

the highest quarterly return on equity averages ever at

the end of 1993, the P/E ratio of the major regional bank

index was at a level that was still only about 50 percent

of the broader market P/E.

Over the past two years the magnitude of the banking

sector's P/E discount has declined. As seen in Chart 6,

the P/E discount has gone from 50 percent to only 24

percent (a relative P/E ratio of 76 percent). The higher

P/E ratio may represent a view by market participants

that bank earnings are becoming less sensitive to the

business cycle, perhaps as a result of geographic or

product­related diversification and more efficient management of overhead expenses. Another factor contributing to higher bank P/E ratios could include specuCHART 6
 

45%

55%

65%

75%

 5%

0ec-93

Ma -94

-un-94

Sep-940ec-94

Ma -95

-un-95

Sep-950ec-95

Ma -96

-un-96

Sep-960ec-96

Ma -97

S&P Ma�o Regional Bank In ex's

Relati6e P§E Ratio Is Rising

P§E Ma�o Regional Banks § P§E S&P 500

Source: Bloomberg 

lation on bank stocks as investors anticipate potential

acquisitions.

Allen Puwalski, Banking Analyst

�athy R. �alser, Chief,

Financial Sector Analysis Section

Regional Outlook 19 Second Quarter 1997
 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

• 	 In the Atlanta Region, bank profits slipped slightly during the quarter and thrift profitability bounced

back. However, the percentage of unprofitable thrifts is well above the national average.

• 	 Commercial banks in metropolitan Atlanta are increasing their commercial real estate lending activity.

• 	 Consolidation has reduced the number of banks, but institutions opened more offices during the year.

Fourth Quarter Profits Dip Slightly at Banks,

but Rebound at Thrifts

For the second consecutive quarter, the

quarterly return on assets (ROA) for

banks in the Atlanta Region declined.

Banks generated an annualized ROA of

1.17 percent, which matched results

from a year ago. Current quarter results

slightly trailed the national ROA of 1.19

percent. The number of banks reporting

negative quarterly earnings rose for the third consecutive quarter to 111, or 9 percent of all banks in the

Region compared to 8.8 percent nationally.

A narrowing of banks' net interest margin and increased

loan loss provisions caused the drop in bank profitability. The higher provisions were mainly driven by

higher consumer loan losses, particularly credit

cards. The quarterly loan charge­off rate rose to 0.55

percent, up from 0.49 percent in the fourth quarter of

1995. In dollar terms, net credit card charge-offs rose

62 percent in 1996 to $1.16 billion, for a charge-off

rate of 4.21 percent, up from 3.15 percent last year

and surpassing the last cyclical peak of 3.58 percent

in 1991.

After the one­time SAlF assessment last quarter caused

a negative annualized ROA of 0.42 percent, the ROA for

the Region's thrifts rebounded smartly to 0.70 percent.

...the percentage

of unprofitable

thrifts in the Region is almost

twice as high as

the national average of 7.3 percent

While the quarterly return

matched last year's, it was 15

basis points below the national average for all thrifts.

Several factors, including

healthy net interest margins,

lower provision and noninterest expenses, and higher securities gains led to the rebound

in profitability. evertheless,

there are some areas of weakness. Overhead costs at 3.25

percent of assets for the Region's thrifts were 95 basis

points above the national average. Almost 14 percent

of the Region's thrifts had negative earnings in the

quarter, up from 9.8 percent last year. Moreover, the

percentage of unprofitable thrifts in the Region is

almost twice as high as the national average of 7.3

percent.

Commercial Real Estate Lending Exposure in

Metropolitan Atlanta is Growing

Most segments of the commercial real estate market in

metropolitan Atlanta have rebounded strongly from the last economic downturn. A cyclical high

already may have been reached in

the retail market, and highs may be

nearing in the office and multifamily segment (see Slower Growth in

the Atlanta Region). At this stage

of the cycle, an analysis of commercial real estate lending by Atlanta community banks is

appropriate.

For this analysis, an Atlanta community bank peer group

was developed. The group includes all commercial

banks in the Atlanta Metropolitan Statistical Area

(MSA), except four large banks that are controlled by

super­regional bank holding companies. These four

banks were excluded because a significant portion of

their lending is outside the Atlanta MSA. Also, the Call

Report does not provide lending data by geographic

area. Commercial real estate loans include construction

and development loans, loans secured by multifamily

properties, and loans secured by nonresidential real

estate.

As seen in Chart 1 (next page), Atlanta community banks

have expanded their commercial real estate lending in

recent years. Overall, commercial real estate loans

Regional Outlook	 20 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

CHART 1
 

0%

3%

6%

9%

12%

15%

1992 1993 1994 1995 1996

Atlanta Community Banks Have Increased Their 

Commercial Real Estate Lending

Multifamily

% of Assets

Construction 

Nonresidential 

Source: Bank Call Reports

have increased from 17.5 percent to 24.8 percent of

assets since year­end 1992. On average, commercial

real estate loans represent 271 percent of equity, up

from 202 percent at year­end 1992. Currently, 19 banks

or 26 percent of the peer group have a concentration of

commercial real estate loans to equity above 400

percent, compared with just ten banks and 11 percent of

the peer group in 1992. The increased concentration of

commercial real estate loans to equity is impressive

considering that equity has grown at a 10.1 percent

compound rate for the last five years.

The commercial real estate past­due ratio appears to be

bottoming out. After hitting a cyclical high of 3.52

percent in 1991, the ratio dropped 260 basis points by

1992 and has declined gradually by 22 basis points to

0.70 percent over the last three years. onperforming

construction and development loans increased 75 percent during 1996, but the past­due ratio is only 0.82

TABLE 1

percent. The multifamily and nonresidential segment
 

have shown a decline in the dollar volume of nonperformings and have a past­due ratio of close to 65 basis
 

points.

FDlC examination personnel,

however, report that most Atlanta community banks are

...most Atlanta

not actively involved in com­ community

mercial office construction banks are not

projects and that the majority actively inof their construction and de­ volved in comvelopment lending is for resi­ mercial office

dential real estate projects

located in bedroom commuconstruction

projects...

nities outside the perimeter

highway circling the city.

This would suggest that the

Atlanta community bank peer group would be minimally

affected if a downturn occurred in Atlanta's commercial

real estate markets. evertheless, the large and growing

concentration of commercial real estate does make the

peer group susceptible to any spillover effects from a

downturn. Finally, since the bulk of construction and

development lending is residential, the group is exposed

to changes in economic and demographic factors that

drive the Atlanta residential real estate market.

Bank Structure Changes in 1996: Fewer

Banks, but More Offices

Table 1 provides a summary of structure changes of

commercial banks in the Atlanta Region. Last year, the

number of banks declined by 81 or 6.2 percent while

the number of domestic banking offices rose by 346 or

OWNERSHIP STRUCTURE, ASSETS, AND DOME

OF ATLANTA REGION BANKS

STIC OFFICES

YEAR

MULTIBANK HOLDING

COMPANY

# ASSETS OFFICES

($ BILLIONS)

ONE•BANK HOLDING

COMPANY

# ASSETS OFFICES

($ BILLIONS)

INDEPENDENT BANKS

# ASSETS OFFICES

($ BILLIONS)

1995

1996

CHANGE

427 $489.9 8,408

390 542.2 8,887

(37) 53.3 479

486 $120.2 3,400

479 124.1 3,407

(7) 3.2 7

396 $34.9 1,128

359 34.7 988

(37) (0.2) (140)

SOURCE: BANK CALL REPORTS, BANK STRUCTURE DATA

Regional Outlook 21 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

2.7 percent. The majority of

changes occurred within multibank

holding companies (MBHCs) and

independent banks. Mostly through

internal reorganizations, MBHCs

reduced the number of banks they

control by 8.7 percent. Conversely,

MBHCs expanded the number of

their banking offices by 5.7 percent. Independent banks

saw reductions both in number (9.3 percent) and offices (12.4 percent); the opening of 19 de novo banks

during the year prevented larger declines.

Geographically, office expansion was concentrated in

Virginia (8.2 percent) and Alabama (4.7 percent); all

other states experienced growth rates below the 2.6

percent average. Although 18 percent of the increase in

offices occurred in Georgia, state officials were expecting much stronger growth due to a liberalization of

branching laws allowing limited de novo branching.

The growth in the number of banking offices seems

paradoxical given the cost-cutting fixation of many

banking organizations and the frequent brick-andmortar obituaries penned by industry observers.

Moreover, the expansion in offices is occurring despite the increased use of alternative delivery methods -- like ATMs, phone centers, closed personal

computer systems, and the Internet. The other major

structure trend is a greater concentration of assets and

offices held by MBHCs and a decline in the number of

banks with assets under $100 million. Since 1991, these

small banks have declined in number by 37 percent to

705 from 1,112.

Jack M. W. Phelps, Senior Regional Analyst

Pamela R. Stallings, Financial Analyst

Scott C. Hughes, Regional Economist

Regional Outlook 22 Second Quarter 1997
 
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