Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1998 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

John D. Weier,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael J. Feeney,
 

Financial Analyst
 

In Focus This Quarter 

◆ Merger and Acquisition Activity in the U.S. Banking Industry: 

Trends and Rationale—The size and value of recent mergers and acquisitions 

(M&A) in the banking industry have received much attention, yet the activity is a 

continuation of a longer-term trend and is one aspect of a broader national and global wave of business mergers. For banks, deregulation, competitive pressures, market 

valuations, synergistic opportunities, technology, globalization, and managerial 

incentives are among important drivers of the trend. By identifying the rationale and 

incentives for bank M&A activity, industry participants can better understand and 

evaluate the risks and challenges facing merged institutions. See page 5. 

By Steven E. Cunningham, John F. Sherman 

◆ Risks and Challenges for Consolidating Institutions—M&A activity 

creates significant challenges for bank managers, including combining management 

teams, integrating technology, realizing the benefits of diversification, and maximizing operating economies. As premiums paid in bank M&A deals have escalated, 

some industry observers have questioned whether the promised benefits of the transactions can be realized. Institutions in the process of integrating an acquired entity 

may be especially vulnerable to a downturn in the economy. See page 11. 

By John F. Sherman 

◆ Industry Consolidation Presents Unique Risks and Challenges for 

Community Banks—Industry consolidation has created competitive challenges 

for small banks and highlights traditional obstacles related to operating scale and 

scope. Aside from merging with or selling to competitors, some small banks are 

addressing consolidation challenges by outsourcing business functions, expanding the 

use of nondeposit funding sources, partnering with other banks and nonbanks, capitalizing on personalized service, and focusing on niche markets. While these adaptive 

strategies may help community banks meet the challenges of industry consolidation, 

they potentially complicate these institutions’ operations and risk profiles. See page 14. 

By Steven E. Cunningham 

Regional Perspectives 

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

and banking sectors remain healthy but face various challenges amidst an aging 

cyclical expansion...current events suggest that some recently favorable trends 

may have limited upside potential and greater downside risks. See page 19. 

◆ Household Sector’s Behavior Affects Credit and Interest-Rate Risk 

Profiles of Insured Institutions—Households’ recent spending spree has 

depended on income growth, debt restructuring, the assumption of additional debt, 

and appreciating asset values...despite favorable economic conditions, consumer 

credits dominate charge-offs in the Region...thus, underwriting standards for consumer loans and their credit quality may deserve more attention in light of households’ elevated debt relative to income...household behavior also is affecting the 

composition and maturity structure of loan portfolios, which may increase institutions’ exposure to interest rate risk. See page 21. 

By the Chicago 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 for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

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

Region’s Regional Outlook, please call John Weier at (312) 382-7512 or send an e-mail to 

jweier@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Publications Manager Teresa J. Franks 
To the Reader:
 

The Regional Outlook is intended to enhance readers’ understanding of risks and trends affecting FDIC-insured
 

institutions. The editorial staff welcomes the comments of any reader who is willing to take a few minutes to
 

complete the attached survey. Return the survey in the enclosed envelope or fax to (202) 898-8636.
 

You may also access the survey through the FDIC Internet site at www.fdic.gov. FDIC employees may take the
 

survey via the DOI homepage on the FDICnet.
 

All feedback is confidential. Thank you for your time and thought.
 

Sincerely,
 

George French 

Executive Editor 

The Regional Outlook has three In Focus articles that address national issues and a Regional Perspectives article 

that analyzes the economic and banking conditions in each of the eight FDIC supervisory regions. 

0 

No 

Opinion 

1 

Strongly 

Disagree 

2 

Disagree 

3 

Agree 

4 

Strongly 

Agree 

1 The In Focus articles improve my understanding of risks 

affecting the financial institutions of interest to me. 

2 The Regional Perspectives article improves my understanding 

of risks affecting the financial institutions of interest to me. 

3 The Regional Perspectives article is relevant to my geographic 

area of interest. 

4 How would you prefer the geographic boundaries be delineated? 

by the FDIC’s eight supervisory regions—Atlanta, Boston, Chicago, Dallas, Kansas City, Memphis, 

New York, and San Francisco (current format) 

by a smaller geographic location, such as ______________________________________________________ 

by a larger geographic boundary, such as ______________________________________________________ 

5 The length of the In Focus section is 

just right too long too short 

6 The length of the Regional Perspectives article is 

just right too long too short 

7 What other topics would you like to see in future editions? 

8 Additional comments and suggestions 

9 I am affiliated with: 

FDIC Financial institution 

Federal regulatory agency (non-FDIC) State banking department 

Other __________________________________________________________________________________ 
In Focus This Quarter
 

Merger and Acquisition Activity in the U.S. Banking
 

Industry: Trends and Rationale
 

•	 The size and value of recent mergers and acquisitions in the banking industry have received much 

attention, yet the activity is a continuation of a 

longer-term trend and is one aspect of a broader 

national and global wave of business mergers. 

•	 Deregulation, competitive pressures, market valuations, synergistic opportunities, technology, globalization, and managerial incentives are among 

the important drivers of bank merger and acquisition activity. 

•	 By identifying the rationale and incentives 

for bank merger and acquisition activity, industry participants can better understand and evaluate the risks and challenges facing merged 

institutions. 

Merger and acquisition (M&A) activity among banking 

companies is changing the industry’s structure. The 

number of insured commercial banks in the United 

States, which held relatively steady during the FDIC’s 

first 51 years of existence, has declined by one-third 

since year-end 1984, resulting in just under 9,000 commercial banks at the end of the second quarter of 1998. 

The number of banking organizations (bank holding 

companies, independent banks, and thrifts) also has 

declined precipitously since the mid-1980s. 

The recent flurry in M&A activity by banking companies has attracted significant attention as the magnitude 

of transactions has escalated. As shown in Chart 1, the 

announced values of bank mergers have increased 

sharply in recent years. However, increased consolidation activity is not unique to the banking industry: The 

United States is now experiencing the fifth major wave 

of business M&A in this century, which is in turn part 

of an unprecedented level of worldwide M&A activity. 

According to data from Mergerstat, the value of M&A 

deals announced for all U.S. industries during the first 

half of 1998, measured both absolutely and as a percentage of nominal gross domestic product, exceeded 

the value of announced transactions for any full calendar year on record. 

The factors that have contributed to this activity, including the availability of capital, technological change, and 

CHART 1 

Values of Announced Bank Mergers 

Increased Sharply during 1998 

450 $250 

400 

350 $200 

300 

250 $150 

200 

$100 

150 

100 $50 

50 

0 

Number of Announced

 Deals (left axis) 

Total Announced 

Deal Values (right axis) 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 

($ Billions) 

Year 

Source: SNL Securities 

globalization, are particularly important to the banking 

industry. Indeed, according to data from SNL Securities, the announced values of banking M&A have 

accounted for roughly one-third of all U.S. merger 

activity for the first half of 1998, exceeding any full calendar year percentage since the data have been collected (1989). This article will briefly describe the factors 

that are driving M&A activity in banking. 

Why Are Banks Merging? 

Deregulation 

Historically, state regulations and boundaries dictated 

the structure of commercial banking in the United 

States. Not until the 1980s did most states remove or 

substantially relax intrastate branching restrictions. 

Subsequently, the Riegle-Neal Interstate Banking and 

Branching Act removed most remaining restrictions to 

interstate expansion—restrictions that had been significantly liberalized by a 1985 U.S. Supreme Court decision (Northeast Bancorp v. The Board of Governors of 

the Federal Reserve System) that upheld the ability of 

states to reduce restrictions on entry by out-of-state 

holding companies.1 As recently as January 1994 only 

10 commercial banks owning 30 branches operated 

across state lines. By early 1998, 165 institutions owned 

12,694 interstate branches.2 

1 “Interstate Banking—The Past, Present and Future,” FDIC Banking
 

Review, Fall 1996.
 2 Figures provided by the FDIC’s Division of Research and Statistics.
 

Chicago Regional Outlook 5	 Fourth Quarter 1998 
In Focus This Quarter
 

There is some evidence that the recent increase in 

expansion and branching opportunities arising from 

deregulation has led to improved efficiencies and profitability, both from M&A activity and from intracompany consolidation of bank subsidiaries by 

multibank holding companies. In addition, the recent 

easing of Federal Reserve Board restrictions governing 

Section 20 securities underwriting subsidiaries of bank 

holding companies and favorable bank operating subCHART 2 

Commercial Bank Profitabilty Has Improved 

While Revenue Growth Rates Are Declining 

14 

12 

10 

Percent 

8 

6 

1940s 1950s 1960s 1970s 1980s 1990s 

sidiary rule interpretations by the Office of the Comptroller of the Currency have made expansions into new 

lines of business and mergers across financial sectors 

more feasible. For example, according to data provided 

by SNL Securities, since the beginning of 1997, 47 

banking companies have purchased investment banking 

units, investment advisors, or broker-dealers. 

Increasing Competition 

Significant changes in the competitive environment also 

have contributed to the trend in bank M&A activity. 

One way to consider competition in an industry is 

through the “industry life cycle” framework. In this 

framework, an industry is generally categorized into 

one of four stages—start-up, rapid growth, mature, or 

decline. In each stage, firms are likely to take certain 

actions in response to the competitive environment. As 

discussed below, banking best fits the criteria for an 

industry in the mature stage. These criteria include 

declining revenue growth, improving profitability, 

increasing competition, and a shortage of investment 

opportunities relative to the amount of capital being 

generated. 

As shown in Chart 2, over the long term, commercial 

banks have experienced the declining trend in revenue 

growth and the improving trend in profitability that 

characterize a mature industry. The average annual revenue growth rate by decade, adjusted for inflation, has 

declined since the 1960s. Profitability, as measured by 

the average annual return on equity by decade, has 

steadily improved since the 1940s, with the exception of 

the crisis period of the 1980s. 

Competition in a mature industry often intensifies as 

competitors focus on sustaining market share as revenue growth rates slow. In banking, recent changes in 

the operating environment have stimulated a dramatic 

increase in competition. Specifically, barriers to entry 

into the industry have fallen: Capital is plentiful, experienced managerial talent is available (as a result of the 

many mergers), and regulatory restrictions have been 

relaxed. Technological and financial innovations also 

4
 

2
 

0
 

Return on Equity Revenue Growth (Inflation Adjusted) 

Source: FDIC Historical Statistics on Banking 

are influencing how banks compete by enabling them to 

manage disparate operations with broader product 

arrays more efficiently. Moreover, as a result of intensifying nonbank competition and continuing evolution in 

distribution systems, some banking services have come 

to resemble commodities. Consequently, brand loyalty 

appears to be declining and banks are experiencing 

reduced influence over pricing. 

The final criterion for a mature industry, a shortage of 

investment opportunities relative to the level of capital 

being generated (“excess capital”), as discussed below, 

has become an obstacle for banks. Although generating 

and retaining capital increase the level of protection 

from insolvency risk for depositors and the FDIC, rising capital levels without a corresponding increase in 

profitability reduce returns on equity and, thus, returns 

to shareholders. Attempts to increase assets relative to 

equity capital in an industry with excess capital also 

can be undesirable because competition drives the yield 

on available investments to levels that either dilute current earnings or fail to compensate adequately for the 

amount of risk taken. (See “Bank Earnings: Competitive Pressures and Risks,” Regional Outlook, Fourth 

Quarter 1997.) Alternatives for managing capital in 

such an environment include dividends, share repurchases, and M&A transactions; banks have pursued all 

three. 

Commercial bank cash dividend payments have reached 

record levels in the 1990s. In fact, the level of earnings 

retained over the past two years (26 percent in 1996 and 

28 percent in 1997) was the lowest during a noncrisis 

period since the FDIC’s inception (see Chart 3). A large 

percentage of these dividend payments is made to bank 

Chicago Regional Outlook 6 Fourth Quarter 1998 
In Focus This Quarter
 

CHART 3 

Commercial Banks Are Retaining a Smaller Share 

of Earnings than during Any Other Profitable Period 

35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 

Year 

Note: Negative 285 percent rate in 1987 shown as zero. 

Source: FDIC Historical Statistics on Banking 

$ Billions

Percent 

Percent of Earnings Retained (left axis) 

Cash Dividends Declared (right axis) 

80 

70 

60 

50 

40 

30 

20 

10 

0 

45 

40 

35 

30 

25 

20 

15 

10 

5 

0 

holding companies, which, in turn, use the funds to 

repurchase common stock—another means of reducing 

book capital, increasing financial leverage, and improving return on equity. According to data compiled by 

Keefe, Bruyette & Woods, Inc., share repurchases by the 

top 25 banking organizations increased in each quarter 

during 1995 and 1996 and reached an all-time high of 

$11.5 billion in the first quarter of 1997, but have 

declined steadily since then. There are at least two likely reasons for this trend. First, the continued escalation 

in share prices through the first half of 1998 made 

repurchases more expensive. Second, as share prices 

increase, the “pooling of interests” method of accounting for a merger becomes more attractive; however, it 

carries certain Securities and Exchange Commission 

restrictions on share repurchases both before and after 

the transaction. Therefore, as values rise, institutions 

considering future mergers are less likely to initiate 

repurchase programs. 

The third capital management alternative, M&A, offers 

potential benefits to both parties to the transaction. 

M&A may permit acquirers to deploy excess capital 

while improving earnings through operating and financial economies, diversification of revenues and 

geographic exposures, and greater management 

expertise. M&A also can provide 

access to new products—a common objective of competitors in 

mature industries. For institutions 

acquired through a purchase transaction in which ownership rights 

are relinquished, mergers provide 

a means of returning capital to 

shareholders rather than attempting to remain independent in an increasingly competitive environment. 

Market Valuations 

The increased market values commercial banking companies have experienced through the first half of 1998 

played a major role in recent M&A activity, as common 

stock increasingly has been used as “currency” in transactions, especially the largest mergers. More valuable 

stock allows banks to issue fewer shares to execute 

mergers, which reduces the potential dilutive effects to 

shareholders. Through mid-April 1998, the amount of 

cash used to fund all U.S. business mergers (13.4 percent) had reached the lowest point in ten years.3 Similarly, the aggregate cash amount of announced bank 

deal values through the first half of 1998 was less than 

1 percent and reflects a steady decline since 1994. There 

appears to be a strong relationship between bank stock 

valuations and the level of cash committed in bank 

M&A activity since 1991 (see Chart 4), although this 

relationship is obviously influenced by large, stockbased mergers. 

Record earnings, positive market assessments of earnings quality and stability, and continued consolidation 

expectations sparked the upward trend in bank stocks 

through June 1998. The value of the SNL Bank Index, 

which is composed of publicly traded banking companies, quadrupled between January 1990 and June 1998 

and far outstripped gains in the broader S&P 500 over 

the same period. The result was a rise in bank stock 

prices as a multiple of earnings per share (the price3 As reported by the Wall Street Journal, April 16, 1998, p. C1. 

CHART 4 

5 

10 

15 

20 

25 

30 

’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 

SNL Bank Index 

Price-Earnings Ratio* Percentage of 

Cash Used in 

All Bank M&A 

* Price-Earnings Ratio = stock price of index members to previous 12 months’ 

earnings weighted by market capitalization. 

Source: SNL Securities 

As Market Valuations Have Increased, 

Cash Usage in Bank Mergers Has Declined 

Price-Earnings Ratio,

% Cash 

0 

Year 

Chicago Regional Outlook 7 Fourth Quarter 1998 
In Focus This Quarter
 

earnings ratio) both absolutely and relative to the S&P 

500. For example, according to the price-earnings ratio 

for the SNL Bank Index, at year-end 1994, investors 

paid $9.76 per dollar of bank earnings; on June 30, 

1998, investors paid $22.88 per dollar of earnings. Over 

the same period, the price-earnings ratio of the SNL 

Bank Index relative to the S&P 500 increased from 65 

percent to 79 percent. 

From a corporate finance perspective, firms create 

wealth for shareholders by generating returns on invested long-term debt and equity capital that exceed their 

combined cost. Since long-term debt is used less in 

banking than in other industries, Credit Suisse/First 

Boston uses return on equity less the cost of equity capital as a proxy for measuring wealth generation by 

banks.4 As shown in Chart 5, over the long term, 

increases in the price-earnings ratio for banks relative to 

that for the S&P 500 tends to track with the banking 

industry’s ability to generate returns on equity in excess 

of the cost of equity capital. Through 1997, high levels 

of industry profitability, low market interest rates, and 

market expectations of more stable long-term industry 

earnings had driven the spread between the return on 

and cost of equity capital to unprecedented levels. 

Following the strong performance through the first half 

of 1998, the SNL Bank Index lost 21 percent of its value 

during the third quarter of 1998 (all during the month of 

August) because of concerns about corporate earnings, 

international exposures, the flat yield curve, and the ability of banking companies to expand market-sensitive 

4 “Value-Based Analysis of Banks,” Credit Suisse/First Boston, Equity Research—Americas, June 4, 1998. 

CHART 5 

revenues. Over the same period, the S&P 500 declined 

only 10 percent. Likely in response to relatively poor 

stock market conditions, only 75 bank mergers were 

announced during the third quarter of 1998— a 30 percent decline from the second quarter—with over half 

announced during July. According to SNL Securities, 

only 32 bank mergers were announced in August and 

September 1998, the lowest number for any two-month 

period since March and April 1997, when 31 mergers 

were announced. The August 1998 decline in the SNL 

Bank Index was the largest monthly decline since a 7 

percent drop in March 1997. In addition, the average 

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

during third-quarter 1998 was the lowest in eight quarters. Consistent with the aforementioned relationship 

between bank stock valuations and the level of cash committed to bank M&A activity, the amount of cash committed to mergers in September increased significantly. 

Synergistic Opportunities 

A primary motive for M&A activity is to increase the 

value of the combined company by creating synergies. 

In other words, through some combination of cost cutting and revenue growth, M&A can produce additional 

wealth for shareholders of the combined company 

beyond what the companies operating independently 

could generate. Although each transaction has unique 

characteristics, most bank M&A generate additional 

value from some combination of operating economies, 

diversification of revenues and geographic exposures, 

financial economies, and transfer of management 

expertise. 

Operating economies are achieved by eliminating overlapping administrative functions and infrastructure as 

Chicago Regional Outlook 8 Fourth Quarter 1998 

Bank Stock Values Relative to the Broader Market 

Reflect Ability to Generate Equity Returns in Excess of Costs 

0 

20 

40 

100 

120 

–14.0 

–12.0 

–10.0 

–8.0 

–6.0 

–4.0 

–2.0 

0.0 

2.0 

4.0 

80 

60 

Year 

’55 ’58 ’61 ’64 ’67 ’70 ’73 ’76 ’79 ’82 ’85 ’88 ’91 ’94 ’97 

Return on Equity Less Estimated Cost of Equity (right axis) 

Bank Price-Earnings Ratio Relative to S&P 500 (left axis) 

Source: Credit Suisse/First Boston Percent

Percent 
In Focus This Quarter
 

well as by using existing distribution networks to crosssell products and services to generate revenue gains. 

However, the degree to which these benefits materialize 

will depend on the specific characteristics of the merger partners and their markets. For example, a review of 

48 banking company mergers from 1995 through the 

first half of 1998, where the seller held more than $1 

billion in assets, revealed estimated cost savings that 

increased with the degree of market overlap (see Chart 

6). Expected cost savings should translate into an 

increase in a firm’s value. This appears to be the case in 

this sample, as the median price paid by acquirers as a 

multiple of the target’s previous 12 months’ earnings 

increased with the level of expected cost savings. 

Although perceived cost savings have contributed to 

bank M&A activity, whether the gains actually materialize hinges on execution, as discussed in “Risks and 

Challenges for Consolidating Institutions” in this 

issue. 

Whereas mergers in overlapping markets provide 

opportunities for cost cutting, value creation from revenue enhancements is more likely to materialize in 

M&A transactions across markets and industries. Such 

mergers can be expected to lead to increased diversification of revenues and geographic exposures. These 

expectations may be driving the recent trend in acquisitions of investment banking units and brokerage houses 

by banking companies. As traditional interest-spread 

income has stagnated, many institutions have focused 

on expanding noninterest sources of revenue. At June 

30, 1998, noninterest income made up 40 percent of net 

operating revenue (net interest income plus noninterest 

income) for all commercial banks, compared with only 

25 percent in 1984. Similarly, geographic expansion can 

CHART 6 

In-Market Overlapping Out-of-Market 

Median Estimated 

Cost Savings (left axis) 

Estimated Cost Savings and Pricing for Bank 

Mergers Are Tied to the Degree of Market Overlap 

Source: SNL Securities 

Multiple of Median Price Paid by 

Acquirer to Seller’s Previous 

12 Months Earnings (right axis) 

0% 

5% 

10% 

15% 

20% 

25% 

30% 

35% 

40% 

16 

17 

18 

19 

20 

21 

22 

reduce a firm’s dependency on local, undiversified 

economies. Supporting this notion, a May 1998 working paper by the Federal Reserve Bank of Philadelphia 

found that economic benefits are strongest for banks 

engaged in interstate expansion, especially for mergers 

that diversify macroeconomic exposures.5 

As an institution’s size increases through M&A activity, 

financial economies may result from greater access to 

nondeposit funding alternatives as well as traded and 

over-the-counter off-balance-sheet financial instruments. As of June 30, 1998, commercial banks with 

assets less than $1 billion funded approximately 80 percent of assets with domestic deposits, compared with 

roughly 50 percent for commercial banks with assets 

greater than $1 billion—reflecting how funding flexibility and accessibility increase with scale. Access to 

money and capital markets is enhanced for larger institutions through potentially lower transaction costs and 

increased coverage by securities analysts and rating 

agencies. For the same reasons, large banks are also the 

primary users of off-balance-sheet financial derivatives. 

Differences in the ability of managers to operate institutions efficiently may also provide impetus for acquisitions. As Federal Reserve Board Chairman Alan 

Greenspan noted in recent testimony, “there are considerable differences in the cost efficiencies of banks 

within all bank classes, implying that there is substantial potential for many banks to improve efficiency of 

their operations, perhaps through mergers.”6 Thus, 

managers of more efficient banks may acquire less 

efficient competitors in an attempt to increase the latters’ value through improved management. As shown in 

Chart 7 (next page), the efficiency ratios7 of bank holding companies improved significantly from 1987 to 

1997. However, continued disparities in efficiency 

among companies, as reflected by the upward slope of 

the lines in Chart 7, may offer additional opportunities 

for M&A activity. 

Technology and Globalization 

The application of technology to nearly every aspect 

of banking offers the potential for more streamlined 

oversight, management, and evaluation of far-flung 

5 The Dollars and Sense of Bank Consolidation, Working Paper No.
 

98-10,The Federal Reserve Bank of Philadelphia.
 

6 Testimony before the Committee on the Judiciary, U.S. Senate, June
 

16, 1998.
 

7 The efficiency ratio is calculated by dividing noninterest expense by
 

the sum of net interest income and noninterest income. The ratio can
 

be interpreted as the cost to generate each dollar of revenue.
 

Chicago Regional Outlook 9 Fourth Quarter 1998 
In Focus This Quarter
 

CHART 7 

100% 

80% 

60% 

40% 

20% 

Efficiency Ratios* 

Most Efficient 

Institution 

* The efficiency ratio is noninterest expense divided by the sum of net interest 

income and noninterest income. 

Bank Efficiency Has Improved, but Differences 

among Institutions May Provide Merger Incentives 

Bank Holding Companies Continuously Operating from 1987 to 1997 

Least Efficient 

Institution 

Source: Federal Reserve Board Y-9 Reports, adapted from an analysis 

by McKinsey & Company. 

1987 

1997 

operations both domestically and internationally. 

Consequently, technology can facilitate merger activity. 

Moreover, some insured institutions may turn to mergers with compliant partners as a solution to Year 2000 

computer problems. 

In a June 1997 speech to the Institute for International 

Economics, Deputy Treasury Secretary Lawrence Summers credited information and communication technologies as a contributing factor to the trilliondollar-a-day volume of cross-border capital flows.8 

Although the number of insured branches of foreign 

banks and the number of foreign offices of insured 

domestic banks have both declined in recent years, 

increasingly interconnected financial markets, firms, 

and customers have heightened the potential for competition across borders and continents. 

The scale, scope, and structure of many foreign competitors may promote combinations by U.S. institutions 

looking to enhance competitiveness in the global arena. 

Approval of proposed large mergers announced in early 

1998 will elevate several U.S. banking companies to 

banking’s global elite in terms of assets and market capitalization. Mergers among large European financial 

institutions in anticipation of the European economic 

and monetary union may spur U.S. multinational banks 

to consider strategic mergers across financial sectors. 

8 “Promoting Global Financial Stability: The G-7 Agenda,” delivered 

to the Institute for International Economics, June 12, 1997. 

Management Incentives 

Other factors that may drive M&A activity are related to 

managers’ compensation, special reward structures, and 

job security. Industry observers have noted that executive salaries are highly correlated with company size 

and revenues. Some analysts have noted that compensation of bank executives rises as assets expand, regardless of the source of the expansion. Bear, Stearns & 

Company opined in June 1998 that bank mergers would 

continue partly because “executive compensation in 

banking is correlating more with asset size than with 

any other financial performance measure.” 

Special reward structures also may influence acquisition programs. Large salary increases and special merger bonuses have been observed recently for executives 

of large acquiring banking companies. Amassed stock 

holdings and options may offer significant wealth for managers who 

decide to sell. Additionally, managers may take actions to lessen the 

likelihood of takeover and the corresponding probability of job loss. 

Such defensive managers may 

undertake acquisitions to avoid having their own banks targeted for 

purchase. 

Summary and Conclusions 

By identifying the rationale and incentives for bank 

M&A activity, regulators and industry participants can 

better understand and evaluate the risks and challenges 

facing merged institutions. The recent wave of banking 

industry M&A activity has been stimulated by a number 

of factors, including deregulation, increasing competition, market valuations, synergistic opportunities, technology and globalization, and management incentives. 

Although the pace of M&A activity may slow in the 

short term due to such factors as a stock market downturn or concern about Year 2000 implementation issues, 

the presence of multiple drivers will likely extend the 

consolidation trend well into the future. 

Steven E. Cunningham, CFA, Senior Financial Analyst 

scunningham@fdic.gov 

John F. Sherman, CFA, Senior Financial Analyst 

jsherman@fdic.gov 

Chicago Regional Outlook 10 Fourth Quarter 1998 
In Focus This Quarter
 

Risks and Challenges for Consolidating Institutions
 

•	 Bank merger and acquisition (M&A) activity creates significant challenges for bank managers, 

including combining management teams, integrating technology, realizing the benefits of diversification, and maximizing operating economies. 

•	 As premiums paid in M&A transactions have 

escalated, some industry observers have raised 

concerns over whether the assumptions concerning potential earnings and strategic benefits can 

be realized. 

•	 Institutions in the process of integrating an 

acquired entity are likely to be especially vulnerable to a downturn in the economy. 

Merging institutions are under great pressure to execute 

the combination smoothly and realize its anticipated 

benefits. On the basis of anticipated earnings improvement and other strategic benefits, M&A deals are often 

executed at premiums substantially above recent market 

prices. As a result, financial market participants closely 

scrutinize post-merger results. Senior management of 

the merged entities, who typically are instrumental in 

convincing shareholders to agree to the transaction, are 

responsible for ensuring that expectations are realized. 

Entities that have demonstrated a proficiency at executing mergers have been regarded favorably by the capital 

markets. For some organizations, merging has effectively become a line of business. Alternatively, those that 

struggle after a merger may experience poor financial 

performance and could potentially become targets for 

acquisition themselves. 

Execution Risk 

The term “execution risk” often is applied to potential 

obstacles to integrating merging institutions. According 

to some analysts, execution risks are the primary risk in 

these combinations. These risks stem from a variety of 

uncertainties that arise following a merger: Can the new 

institution combine its management teams, integrate 

technological systems, realize the benefits of diversification, and maximize operating economies, all without 

interrupting services? Each of these uncertainties, summarized below, presents significant challenges to bank 

managers. 

Management 

Combining the management teams of consolidating 

companies is a critical first step in the transition 

process. Lines of reporting and authority must be delineated, and compensation arrangements coordinated and 

aligned with corporate goals. All of this must be accomplished without alienating critical personnel. The most 

difficult aspect may involve intangible cultural differences. A recent poll by Hewitt Associates1 of human 

resource managers of 218 large U.S. companies identified integrating organizational cultures as the “top challenge” in mergers. While some level of turnover must be 

expected, losses of key personnel and interruptions in 

service can result in dissatisfied customers, which in 

turn can lead to poor financial performance. 

Technology 

Technological advances often are 

identified as the single greatest 

enabler of the wave of bank consolidation; however, smoothly 

integrating existing systems and 

maximizing potential benefits of 

technology can be difficult. A 

Federal Reserve Board2 study of 

nine recent mergers concluded that the most frequent 

and serious problem merging institutions encountered 

was unexpected difficulty in integrating data processing 

systems and operations. The faster systems can be consolidated, the sooner cost savings can be realized; however, disruptions in service or breakdowns in control 

mechanisms may be less likely with a more measured 

integration timetable. Rather than attempting to integrate existing, sometimes incompatible systems, many 

merger partners have chosen to maintain parallel operations while integrating data processing systems over 

time. Year 2000 compliance efforts add yet another layer 

of complexity to these endeavors. 

Diversification 

M&A transactions provide an opportunity to diversify 

risk exposures, thereby potentially decreasing earnings 

volatility and moderating the effect of economic down1 “Career Tracks: Personnel Execs: Toughest Job in Mergers Is Blending.” American Banker, August 10, 1998, p. 6. 2 “The Efficiency Effects of Bank Mergers: An Overview of Case 

Studies of Nine Mergers.” Journal of Banking & Finance, March 

1998, vol. 22, no. 3, pp. 273–291. 

Chicago Regional Outlook 11	 Fourth Quarter 1998 
In Focus This Quarter
 

turns on an institution’s performance. However, diversification creates added complexity for bank managers. 

They may have little practical experience with new 

product lines or new geographic markets and as a result 

they may not fully understand the risks involved in these 

new areas. 

CHART 1 

Many of the Most Acquisitive Banking Companies 

Have Underperformed the Universe of Bank Stocks 

(March 31, 1993–March 31, 1998) 

550 ◆ Total Assets Greater Than $20B 

Total Return (Percent) 

Total Assets between $5B and $20B 

450 Total Assets Less Than $5B 

Operating Economies 

The degree to which anticipated operating economies 

are realized hinges on management’s ability to carry out 

multiple objectives. To achieve anticipated revenue 

enhancements, managers of consolidating institutions 

350 

250 SNL All Bank Index = 249.4% 

150 

have attempted to promote a culture of cross-selling 50 

20 30 40 50 60 70 80 90 

new and existing products to a broader customer base in 

new markets, often through new distribution networks. 

At the same time, they have sought to reduce expenses 

by eliminating redundant administrative functions. 

Underlying these efforts is the need to establish strong 

internal controls and develop appropriate risk management systems. 

Are Expectations Unreasonable? 

As premiums paid to carry out M&A transactions have 

escalated, some industry analysts have viewed the 

assumptions regarding the expected earnings and strategic benefits as aggressive, raising uncertainty as to 

whether these benefits can be realized. Shares of banking organizations that have been active acquirers have 

not necessarily outperformed the universe of bank 

stocks, even before the recent market volatility. According to BankINVESTOR, for the five-year period ending March 31, 1998, most of the returns of the most 

acquisitive banking organizations across three separate 

size categories lagged the SNL Bank Index (Chart 1). 

This lag may be due to investor concerns about whether 

and to what extent the anticipated benefits of merger 

activity will be realized. For example, the assumed benefits related to economies of scale and diversification 

may be overoptimistic. 

Benefits of Scale 

Economies of scale associated with greater size and 

capacity are commonly identified as a potential benefit 

of consolidation. Large banks make substantial capital 

investment in areas such as technology and deliverysystem infrastructures; spreading these costs across a 

larger customer base may lead to greater efficiency. 

However, some observers question whether there is a 

limit to benefits of scale. Federal Reserve Board ChairPercentage of Current Assets Purchased 

over Past Five Years 

Source: BankINVESTOR 

man Alan Greenspan testified before the Senate Judiciary Committee in June 1998 that “there are no clearcut findings that suggest bank mergers uniformly lead 

to efficiency gains. Returns could be muted by large 

company inefficiencies, and their customers may face 

bureaucratic inflexibility.” Perhaps the increased complexity of larger institutions combined with their 

involvement in more nontraditional activities offset the 

advantages of larger scale. 

Benefits of Diversification 

Another common goal of M&A activity is to promote 

diversification of revenue streams. The relaxation of 

regulatory restrictions on geographic expansion and 

permissible activities has made possible new combinations of revenue sources. However, the extent to which 

combining traditional banking with a broader range of 

activities will yield a diversified income stream is not 

yet clear. Industry analysts often point to the declining 

share of total revenues from net interest income as an 

example of improved diversification and potentially less 

volatile earnings. However, others argue that, like 

margin-related income, fee income from activities such 

as mutual fund sales, investment management, and brokerage operations is sensitive to both increasing interest 

rates and deteriorating economic conditions. 

Cost of Capital 

Failure to meet performance expectations following a 

merger can lead to negative market assessments of earnings quality and stability. As creditors and investors 

view an institution’s performance less favorably, they 

Chicago Regional Outlook 12 Fourth Quarter 1998 
In Focus This Quarter
 

require a higher rate of return on capital markets instruments. While cost of capital always has been important 

for institutions that rely significantly on capital markets 

as a funding source, changes in the competitive environment have made it a critical issue for all banking 

organizations. Technological advances and deregulation 

now permit low-cost competitors to enter previously 

insulated markets. (See “Merger and Acquisition Activity in the U.S. Banking Industry: Trends and Rationale” for a discussion of changes in the competitive 

environment.) Competitors with a lower cost of capital 

often can provide services at a lower price, or they can 

accept similar risks in exchange for a lower expected 

return. Such competition may lead higher-cost competitors to pursue higher-yielding but riskier investment 

alternatives. 

Economic Conditions 

The M&A activity of the past few years has occurred in 

an environment of nearly ideal economic conditions. As 

a result, many of the new business combinations have 

yet to be tested by a downturn in the economy. Until 

these new entities experience a full business (and credit) cycle, the results of the M&A activity cannot be fully 

assessed. 

Regardless of whether the long-term objectives of 

M&A activity are achievable, institutions that are transitioning to a new structure following a merger are likely to be especially vulnerable to deteriorating economic 

conditions. The experience of newly chartered institutions during the 1980s banking crisis is an example of 

deteriorating economic conditions interrupting this 

transition period. According to the FDIC’s recent study, 

History of the Eighties—Lessons for the Future, more 

than 16 percent of institutions chartered during the 

1980s failed by 1994, compared with just 7.6 percent of 

preexisting institutions. The study attributed the high 

failure rate to a combination of “powerful competitive 

pressures to assume greater risk with relative inexperience in a demanding new environment.” The competitive pressures included incentives to “leverage high 

initial capital positions, increase earnings per share, and 

meet stockholder expectations.” Although recently 

merged institutions and newly chartered institutions are 

not identical, today’s merger participants face many of 

the same pressures. 

The percentage of institutions that have recently experienced a structural change is higher today than at any 

other time since the consolidation trend began. Institutions that were chartered or involved in a merger over 

the past three years represent nearly 13 percent of all 

commercial banks and 65 percent of commercial bank 

assets. (See “Industry Consolidation Presents Unique 

Risks and Challenges for Community Banks” for a 

discussion of the trend in newly chartered institutions.) 

As shown in Chart 2, these percentages have increased 

substantially in recent years. Much of the consolidation 

activity is occurring between institutions that have been 

part of the same holding company for extended periods; 

however, even these transactions present integration 

challenges that would be complicated by an economic 

downturn. 

Summary and Conclusions 

While substantial benefits may be derived from bank 

M&A activity, mergers impose heavy demands on bank 

managers and present potential risks to banking organizations, bank investors, and the insurance funds. Bank 

managers face significant challenges associated with 

executing the merger, including combining management teams, integrating technology, realizing the benefits of diversification, and maximizing operating 

economies. Additionally, uncertainty remains as to 

whether merger-related expectations can be fully realized. Finally, the process of integrating two institutions 

is complex and time-consuming. Should this process be 

interrupted by an economic downturn, these institutions 

may be especially vulnerable. 

John F. Sherman, CFA, Senior Financial Analyst 

jsherman@fdic.gov 

CHART 2 

The Share of Institutions That Were Newly
 

Chartered* or Involved in a Merger within the
 

Previous Three Years Is Increasing
 70 14 

60 13 

50 12 

40 

30 

11 

10

 9 

20 8 

10 7 

0 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 6 

Percent of Commercial Banks 

(right axis) 

Percent of Commercial Bank Assets 

(left axis) 

Year * Includes all de novo institutions 

Source: Bank Call Reports 

Chicago Regional Outlook 13 Fourth Quarter 1998 
In Focus This Quarter
 

Industry Consolidation Presents Unique Risks and
 

Challenges for Community Banks
 

•	 Industry consolidation has created competitive 

challenges for small banks and highlights traditional obstacles related to operating scale and 

scope. 

•	 Some small banks that are not merging with or 

selling to competitors are addressing consolidation challenges by outsourcing business functions, 

expanding the use of nondeposit funding sources, 

partnering with other banks and nonbanks, capitalizing on personalized service, and focusing on 

niche markets. 

•	 While these adaptive strategies may help community banks meet the challenges of industry consolidation, they potentially complicate the 

operations and risk profiles of these institutions. 

Historically, commercial banking has been characterized by a large number of small institutions operating at 

the community level. Although the number of small, or 

community, banks (defined as those with total assets of 

$500 million or less) has declined significantly since 

consolidation began in the 1980s, they continue to dominate the industry’s demographics. At June 30, 1998, 92 

percent (8,306) of FDIC-insured commercial banks 

held assets of $500 million or less. Approximately 73 

percent of these banks had no holding company or were 

subsidiaries of one-bank holding companies, and more 

than one-third operated only one office. The June 30, 

1997, Summary of Deposits data present more evidence 

of the extent of community banking. On that date, twothirds of all commercial banks operated offices exclusively within a one-county area. 

In terms of demographics, the structure of commercial 

banking continues to reflect the time when state and 

interstate banking and branching restrictions tended to 

limit rivalry in many local markets. However, recent 

changes in the structure, regulation, and operating environment of the financial services sector have affected 

commercial banks, especially smaller community 

banks. Specifically, industry consolidation has created 

new challenges for small banks arising from heightened 

competition and accentuates traditional small bank 

obstacles related to size and scope of operations. 

Competitive Pressures 

In addition to intensifying competitive pressures from 

nonbanks, industry consolidation has heightened competition among commercial banks. According to the 

Federal Reserve Board’s Flow of Funds data, for the 

seven-year period ending on March 31, 1998, commercial banks’ share of total financial assets in the U.S. 

economy declined nearly 6 percentage points to just 

over 20 percent. At the same time that banks are capturing a smaller slice of the financial services pie, mergers, 

acquisitions, and consolidation have set the stage for 

increased competition within the industry. Larger banks 

operating across state lines and in multiple markets via 

branches, mailings, or technology now vie for community bank customers. Moreover, the rebound in new 

bank charters over the past four years, an outgrowth of 

the consolidation trend, has increased the number of 

small bank competitors in many markets. The inaugural 

ABA Community Bank Competitiveness Survey1 in 

1997 reported that small bankers considered other community banks their chief competitors for deposit gathering and all types of lending, and considered large banks 

formidable competitors in commercial and consumer 

lending and deposit gathering. While competition 

among small banks in common markets has existed for 

some time, the emergence of larger institutions as challengers results largely from many of the merger motivators and drivers discussed in “Merger and Acquisition 

Activity in the U.S. Banking Industry: Trends and 

Rationale” in this issue. 

New Chartering Activity 

A secondary effect of industry consolidation, and a 

potential source of increased competition for preexisting community banks, is the recent trend in new bank 

charters. From June 1994 to June 1998, more than 500 

commercial banks were established in 48 states. 

Although rebounding, the annual level of new chartering activity remains well below the peaks of the previous three decades. Industry observers attribute the 

recent increase in new charters to many factors, including the availability of displaced banking talent, strong 

economic growth, potential niche opportunities in mar1 As presented in the ABA Banking Journal, April 1997, p. 55. 

Chicago Regional Outlook 14	 Fourth Quarter 1998 
Small Banks in Business 4 Years or Less

18%

21%

29%

40%

24%

38% 20%

27%

In Focus This Quarter
 

ket segments underserved by larger banks, and the loss CHART 1 

of local decision making and perceived service gaps as New Chartering Activity Appears to Be Related local banks are acquired by larger banks or are consoli­ to the Number of Banks Sold or Consolidated dated into far-flung multibank companies. in Merger Transactions 

New bank activity is not concentrated in one region of 

the country. However, at the state level there appears to 

be a relationship between new chartering activity and 

the number of institutions sold or consolidated in merger and acquisition transactions (see Chart 1). Forty percent of all banks sold or consolidated and 27 percent of 

new charters from June 1994 to June 1998 were in 

Texas, California, Florida, Illinois, and Georgia. 

Number of New Commercial Banks 

TX 

IL 

GA 

FL CA 

(June 1994–June 1998) 40 

35 

30 

25 

20 

15 

10 

5 

0 

As shown in Map 1, ten states currently host a high per0 50 100 150 200 250 

Number of Banks Sold or Consolidated 

Sources: Bank Call Reports, FDIC Division of Research and Statistics centage of recently established community banks. Many 

of these states have experienced strong economic MAP 1

growth during this expansion and have a large number 

of banking offices owned by out-of-state institutions. 

These concentrations are especially noteworthy since 

newly chartered institutions often pursue aggressive 

growth to improve profitability, which may influence 

pricing and terms for competitors within their markets. 

Reflecting the recent surge in new banks, 57 percent of 

the 402 unprofitable commercial banks through the first 

half of 1998 had been in business less than four years, 

up from 17 percent at year-end 1994 (see Chart 2). As 

would be expected, the ten states highlighted in Map 1 

rank among the top in terms of the percentage of small 

banks that were unprofitable during the first half of 

1998. 

Challenges of Scale and Scope 

A by-product of industry consolidation is the emerSome States Host a High Percentage of Banks 

Established in the Past Four Years 

Greater than 15% (10) 

5% to 15% (19) 

Less than 5% (22) 

New Banks as a Percentage of Total 

June 30, 1998 

24% 

16% 

gence of larger institutions. By definition, community CHART 2 

banks operate with relatively less scale than their 

regional, super-regional, and money-center counter- Recently Chartered Small Banks Comprise a 

Higher Proportion of Unprofitable Institutions parts. As a result, small banks have limited ability to 

spread the costs of new investments or operating 

expenses across a broad asset base. This characteristic 

has traditionally forced community banks to spend 

more to generate each dollar of revenue than the rest of 

the industry, as measured by efficiency ratios.2 The 

inability of many community banks to fund large expenditures, such as investments in technology, alternative 

delivery systems, or new business lines, may cause 

Percentage of All Unprofitable Banks 100 

80 

60 

40 

20 

0 

Small Banks in Business More Than 4 Years 

Small Banks in Business 4 Years or Less 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 2 The efficiency ratio is calculated by dividing noninterest expense by Year the sum of net interest income and noninterest income. The ratio can 

Source: Bank Call Reports be interpreted as the cost to generate each dollar of revenue.
 

Chicago Regional Outlook 15 Fourth Quarter 1998
 
In Focus This Quarter
 

CHART 3 

Small Banks Remain Highly Dependent 

on Spread Income 

55% 

60% 

65% 

70% 

75% 

80% 

85%

Net Interest Income to Net Operating Revenue 

Total Assets Greater 

Than $500M 

Total Assets Less 

Than $500M 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 1H98 

Year 

Source: Bank Call Reports 

long-term competitive disadvantages. For example, The 

Tower Group estimates that 70 percent of 1997 information technology (IT) spending by banks was by the 

top 15 institutions.3 Smaller institutions competing with 

larger banks that are investing in technology to improve 

operational efficiency, increase customer convenience, 

or to better identify customer profitability, pricing 

strategies, or cross-selling opportunities may find a 

diminished presence in the marketplace. Consequently, 

small banks may face increasing competition for customers who are attracted to sophisticated pricing, wider 

product arrays, and multiple delivery channels offered 

by competitors. 

Closely related to scale is the issue of scope of operations, both business line and geographic. Community 

banks’ scale may limit their ability to expand into new 

business lines or activities, thereby reducing the degree 

of revenue diversification and resulting in dependence 

on spread income. Since many noninterest sources of 

revenue require scale to economically justify investment, small banks tend to derive a greater percentage 

of net operating revenue from spread income, as shown 

in Chart 3. Also, the limited geographic scope of many 

community banks may result in less loan portfolio 

diversification and greater exposures to local economic downturns. From a portfolio management perspective, lenders with more diverse loan portfolios that can 

spread risks over a broader customer and economic 

base may gain pricing advantages over less diversified 

competitors. 

3 “How Much Do US Banks Spend On Information Technology?,” 

The Tower Group Research Notes, www.towergroup.com. 

How Are Community Banks Addressing 

Consolidation Challenges? 

In response to competitive pressures arising from industry consolidation, community banks, new and old, 

appear to be adapting to meet strategic challenges to 

their long-term viability. Indeed, this summer, Federal 

Reserve Board Chairman Alan Greenspan told the 

Charlotte, North Carolina, Chamber of Commerce that 

“well-managed smaller banks have little to fear from 

technology, deregulation, or consolidation.” Recent surveys and anecdotes reveal that small banks that are not 

selling to or merging with competitors are adjusting 

business practices to cope with the aforementioned 

pressures and challenges. Their strategies include outsourcing business functions, expanding the use of nondeposit funding sources, partnering with other banks 

and nonbanks, emphasizing personalized service, and 

developing niches or specialties. However, as described 

below, while these approaches may help small banks 

meet the challenges of consolidation, they potentially 

complicate the operations and risk profiles of these 

institutions. 

Outsourcing 

A recent survey by Electronic Data Systems Corporation and Bank Earnings International LLP4 found that 

community bankers are more concerned with controlling operating expenses than any other issue. This finding is not surprising given the cost savings expected 

from many recent mergers. The study also revealed that 

banks view IT as the most valuable tool for improving 

day-to-day performance—from controlling expenses to 

increasing fee income. Yet, according to The Tower 

Group, IT budgets as a percentage of total noninterest 

expenses for small banks are typically half of those for 

larger banks.5 As a result, some small banks are turning 

to outside parties to maximize the utility of expenditures, IT and others. 

American Banker recently reported on a trend among 

small banks to outsource the origination of consumer 

loans. The Tower Group noted that third parties handled 

2.7 million noncard, nonmortgage loan applications 

(mostly from small institutions) in 1997, and annual 

outsourced volume growth is projected to average 40 

percent through 2002.6 Vendor networks designed to 

4 American Banker, July 22, 1998, p. 16.
 5 Computerworld, May 25, 1998, p. 20.
 6 “More Banks Handing Off Nitty-Gritty of Consumer Lending,”
 

American Banker, June 12, 1998, p. 1.
 

Chicago Regional Outlook 16 Fourth Quarter 1998 
In Focus This Quarter
 

enable small banks to reduce hardware and personnel CHART 4 

needs also have emerged and allow for more cost- Small Bank FHLB Membership and efficient processing and cheaper access to customer Borrowing Are Rising information. Many small banks planning Internet-based 

or home banking also are turning to outside experts. 60 Nonborrowing members 

Outsourcing certain business functions may allow for 

greater focus on profitable business lines, less risky 

access to state-of-the-art technology, cost savings, and 

more options for customers. However, these arrangements are not without risk. Indeed, FDIC-insured institutions have experienced difficulties in the past with 

indirect consumer lending, such as auto lending. Moreover, banks that outsource business functions may have 

Percentage of Small Banks


Belonging to the FHLBs


Borrowing members 50 

’93 ’94 ’95 ’96 ’97 2Q98 

40 

30 

20 

10 

less control over those functions and may become overreliant on third-party providers. 

Nondeposit Funding Sources 

As noted above, increasing competition for deposits has 

left some small banks searching for alternative funding 

sources to meet loan demand. On average each year 

from 1993 to 1997, 64 percent of small commercial 

banks experienced loan growth in excess of deposit 

growth. Similarly, six in ten banks responding to the 

1998 ABA Community Bank Competitiveness Survey7 

reported that deposit levels were not keeping pace with 

loan demand. In response, small banks are increasingly 

turning to nondeposit funding sources. From 1993 

through the second quarter of 1998, the percentage of 

small banks using borrowings of any type increased 

from 48 to 56 percent. Over the same period, the percentage of small banks funding with borrowings other 

than overnight funds (Federal funds and repurchase 

agreements) increased from 20 percent to 35 percent, 

and the percentage reporting brokered deposits rose 

from 7 percent to 12 percent. 

The rising number of commercial banks joining the 

Federal Home Loan Bank (FHLB) System in recent 

years, as reflected in Chart 4, is likely a symptom of the 

aforementioned funding trend. At June 30, 1998, nearly 

half of all small banks were FHLB members, compared 

with 21 percent at year-end 1993. On the same date, 90 

percent of FHLB commercial bank members and 87 

percent of FHLB commercial bank borrowers were 

small banks. In addition to providing a backup source of 

liquidity, the FHLB is essentially acting as an intermediary to the capital markets for banks with limited 

access. The relatively limited nondeposit funding 

options available to many small banks may explain their 

7 ABA Banking Journal, February 1998, p. 47. 

0 

Year 

Sources: Bank Call Reports, Federal Housing Finance Board 

increasing reliance on FHLB advances. At June 30, 

1998, approximately 80 percent of small banks’ 

nonovernight borrowings were FHLB advances. 

The increasing liquidity of loan portfolios is becoming 

another funding alternative. Many small banks have 

used participation arrangements to sell off portions of 

loans to correspondent banks or have turned to Fannie 

Mae or Freddie Mac to sell mortgages. The securitization of other loan types also may become increasingly 

appealing as funding shortages persist and market 

opportunities for small banks increase. For example, in 

July 1998, American Banker highlighted the creation 

of a new commercial mortgage conduit established 

specifically to buy loans originated by community 

banks.8 The secondary market for the guaranteed portion of Small Business Administration loans also has 

been cited as a potential source of liquidity. 

Although identifying and expanding the use of 

nondeposit funds may increase the flexibility of small 

banks, their use complicates asset-liability management. While net interest margins for small banks have 

yet to reveal significant compression, recent evidence 

suggests future declines. For example, a recent survey 

conducted by the Federal Reserve Bank of Minneapolis found that 57 percent of small bankers in the upper 

Midwest expect a shift away from deposit funding to 

decrease profitability.9 

8 “Commercial Real Estate: New Conduit Plans to Help Small Banks
 

Enter,” American Banker, July 21, 1998, p. 29.
 9 “Location Influences Community Bank Challenges,” Fedgazzette,
 

Federal Reserve Bank of Minneapolis, July 1998, p. 2.
 

Chicago Regional Outlook 17 Fourth Quarter 1998 
In Focus This Quarter
 

Partnering 

In an effort to expand revenue sources and attract and 

retain customers, smaller banks are expanding their 

spectrum of products and services through partnerships 

with other entities. The 1998 ABA Community Bank 

Competitiveness Survey found that 10 percent of community banks partnered with other banks in 1997, while 

nearly twice as many have teamed up with nonbanks. 

Over two-thirds of the survey’s respondents considered 

their partnering approach profitable. The leading types 

of arrangements with other banks include loan participations, title insurance, data processing, credit card programs, and mortgage lending. Nonbank partnering has 

been used to expand offerings to customers such as brokerage, insurance, and travel agency services. However, 

like outsourcing, partnering could result in less control 

and overreliance on third parties. 

Service Orientation 

Small banks have long touted personalized service and 

local decision making as a competitive advantage. 

Influenced by the recent wave of merger and acquisition 

activity in the industry, community bankers cited service as an area 

with great opportunity in the 1998 

ABA Community Bank Competitiveness Survey. Indeed, many 

community bankers have publicly 

welcomed consolidation as a 

chance to establish new relationships and attract customers affected by integration problems and personnel shifting at larger acquiring or 

merging banks. 

Establishing prudent relationships with smaller, underserved customers may present opportunities and profits 

for small banks. This may be especially true for small 

business customers, which may not fit more standardized lending models of larger banks yet remain acceptable credit risks. According to the Federal Reserve 

Board’s second-quarter 1998 Survey of Terms of Business Lending, rates on small commercial and industrial 

loans earn the greatest spread of any size business 

loans. Further, a recent survey by PSI Global of small 

business owners in south Florida, which has seen a great 

deal of merger and acquisition activity in recent years, 

found that nearly one-quarter of respondents would 

move their business if their bank was purchased, exemplifying the extent to which small banks may be able to 

use service to capitalize on consolidation activity.10 

Developing Niches or Specialties 

Anecdotal evidence suggests that some small banks are 

specializing in narrow markets and niches. Some analysts and consultants have emphasized that community 

banks should not try to be what they are not, but should 

instead focus on a particular market segment or niche. 

By default, many small banks depend on their customers’ local businesses and, through local expertise, 

may be better at serving specific industries than their 

larger competitors. However, a narrow focus may 

reduce portfolio diversification and could lead to 

greater exposures during an economic downturn. 

Summary and Conclusions 

Small banks are facing heightened competitive pressures from larger, merged institutions and from new 

banks. Their ability to respond to these pressures is 

restricted by traditional scale and scope limitations. 

Community banks are addressing these challenges by 

outsourcing business functions, utilizing nondeposit 

funding sources, partnering with other banks and nonbanks to diversify revenues and widen customer 

options, capitalizing on personalized service, and developing niches or specialties. While these strategies may 

help community banks meet the challenges of industry 

consolidation, they potentially complicate the operations and risk profiles of these institutions. 

Steven E. Cunningham, CFA, Senior Financial Analyst 

scunningham@fdic.gov 

10 South Florida Business Journal, May 22, 1998, p. 6. 

Chicago Regional Outlook 18 Fourth Quarter 1998 
Regular Feature
 

Regional Perspectives
 

•	 The Region’s economic and banking sectors remain healthy but face various challenges amidst an aging 

cyclical expansion. 

•	 Households’ recent spending spree and strong demand for homes have depended on income growth, the 

restructuring of existing debt, the assumption of additional debt, and appreciating asset values. Recent 

events suggest that at least some of these trends may have limited upside potential and greater downside 

vulnerabilities. 

•	 Despite favorable economic conditions, consumer credits dominate net charge-offs in the Region. Underwriting standards for loans and the credit quality of those loans may deserve more attention in light of 

households’ elevated debt relative to income. 

•	 Consumers’ recent behavior also is affecting the composition and maturity structure of loan portfolios of 

institutions in the Region, which may increase their exposure to interest rate risk. 

Region’s Economic and Banking Conditions 

Regional Update: Economy 

The Region’s economy is healthy but remains vulnerable to repercussions from a recent deceleration in job 

and output growth in the five-state area. The slowdown 

is the result of both short- and longer-term developments. They include an inventory correction, disruptions from strikes against General Motors (GM), 

economic and financial turmoil abroad, and farm sector 

challenges, all of which are playing out in an aging 

cyclical expansion. In addition, stock market volatility 

could dampen confidence levels and the financial 

health of businesses and households. 

Labor markets remained tight in the third quarter, 

when the Region’s unemployment rate averaged 3.9 percent. This rate, more than half a percentage point below 

the national average, was slightly higher than the second 

quarter’s historic low of 3.7 percent. Low unemployment partly explains why the Region’s moderate 1.1 

percent rate of job growth so far this year is running 

about a percentage point slower than nationally. This 

gap persists even though hiring by the Region’s manufacturing sector resumed in late 

1997 (see Chart 1, next page). 

Two local United Auto Workers 

strikes against GM in June and 

July affected the Region’s households and small businesses more 

heavily than elsewhere. At its height, about 90,000 GM 

employees in the Region were out of work, and many 

workers in supplier industries also experienced layoffs 

or reduced hours. Some analysts estimate that one-third 

to one-half of wages lost during the strike will not be 

recouped. 

Commercial real estate markets are generally in good 

shape, but early warning signs—including more speculative projects—are appearing. Vacancy rates in most 

metropolitan statistical areas (MSAs) are low or moderate, but pockets of excess supply may be developing. 

Specifically, vacancy rates in industrial space in five of 

the Region’s six major MSAs—especially in Columbus—are noticeably higher than a few years ago. 

Residential real estate activity remains high. A 10.4 

percent rebound in single-family building permits 

through August reflects favorable financing terms, mild 

weather, and sustained demand. Potential overbuilding 

of niche products (e.g., loft conversions and new construction in downtown areas) may need monitoring in 

select cities. 

Agriculture sector developments suggest that farm 

income in the Region may fall by 10 percent or more 

this year, which could stall recent years’ appreciation in 

farmland values. In September, Central Illinois cash 

prices for soybeans and corn were, respectively, 23 and 

31 percent lower than a year earlier. U.S. Department of 

Chicago Regional Outlook 19	 Fourth Quarter 1998 
Regular Feature	 Regional Perspectives
 

Agriculture projections call for further declines. Hog 

prices have fallen by 40 percent over the same period. 

Farmers in several states also face lower crop yields, 

reduced demand from Asia, and declining government 

payments. 

CHART 1 

The Composition of the Region’s 

Job Growth Is Changing 

FIRE = Finance, insurance, and real estate 

Source: Bureau of Labor Statistics, via Haver Analytics, Inc. 

1997:Q2 1998:Q2

Percent Change from 4 Quarters Earlier

All Payrolls

Mining

Construction

Manufacturing

Transportation

and Utilities

Trade

FIRE

Services

Government 

6 

4 

2 

0 

–2 

–4 

CHART 2 

Chicago Region Institutions Continue to Show 

Financial Strength 

Source: Bank and Thrift Call Reports, June 30, 1998 

10 

8 

6 

4 

2 

0 

Percent of Assets 

Tier 1 

Leverage 

Return on 

Assets 

Net Interest 

Margin 

Past-Due 

Loans 

1996 

1997 

YTD 

1998 

Regional Update: Banking 

On an aggregate basis, the Region’s insured banks and 

thrifts continue to report favorable operating performance; the traditional benchmarks for capital, earnings, 

and asset quality remain strong (see Chart 2). Total 

leverage capital remained at 8 percent of average assets 

in the second quarter, return on assets edged up to 1.25 

percent, and overall asset quality remained good. 

Behind these aggregate numbers, however, a few of the 

Region’s institutions continue to experience problems 

with asset quality, earnings, or both: 

•	 Nearly 200 banks and thrifts in the Region (slightly 

over 9 percent) reported elevated delinquency levels 

of 5 percent or higher at midyear, marginally higher 

than a year earlier. Concern over these elevated rates 

is somewhat moderated by generally strong capital 

ratios reported by many of the affected institutions. 

•	 Sixty-seven institutions (roughly 3 percent) operated 

on an unprofitable basis in the second quarter, about 

the same as in mid-1997. Thirty-four are newly chartered (operating less than five years), two are specialized credit card banks, and the rest are 

institutions operating in both metropolitan and rural 

areas throughout the Region. 

This Region was not immune to the trend toward 

mergers and consolidation in the industry (see In 

Focus articles). As of June 30, there were 2,101 banks 

and thrifts in the Region, 46 fewer than at the start of 

the year and 111 fewer than at mid-1997. However, 

assets are expanding even as the number of institutions 

dwindles. Over the first six months of this year, for 

example, total assets increased by $39 billion, to $961 

billion. 

Chicago Regional Outlook 20	 Fourth Quarter 1998 
6 

Regular Feature	 Regional Perspectives
 

Household Sector’s Spending and Debt Behavior Affects Credit and Interest-


Rate Risk Profiles of Insured Institutions in the Region
 

Are Households Heading into 

Financial Trouble? 

Households have spent freely in the past year, widening 

the gap between spending and income growth (see 

Chart 3). To finance this gap, they have relied on debt 

restructuring, the assumption of more debt, and appreciating market value of real estate and other assets. Low 

unemployment, healthy income growth, favorable 

financing terms, and buoyant consumer confidence are 

supporting factors. 

The changes in households’ balance sheets and financing patterns have affected the loan portfolios and risk 

profiles of the Region’s banks and thrifts. Looking 

ahead, lenders should consider that the economic and 

financial market conditions that drove households’ 

recent behavior may have limited upside potential and 

greater downside risks. 

Robust Consumer Spending and Home Purchases: 

Households’ inflation-adjusted spending for goods and 

services rose rapidly in the first half of 1998, by 4.2 percent in the first quarter and 5.2 percent in the second 

quarter. These rates represent a noticeable acceleration 

from 1997’s already healthy 3.7 percent pace, as shown 

in Chart 3. 

Meanwhile, sales of both new and existing singlefamily homes in the Midwest posted record highs in the 

first half of the year (see Chart 4). Sustained strong 

CHART 3 

demand triggered almost an 8 percent rise in the median resale price of Midwestern homes over the past year. 

In turn, this increase contributed to the expanding net 

worth of households. Home purchases typically trigger 

higher household spending for furnishings in subsequent months, so (in the absence of a recession) consumption outlays may continue rising for some time. 

Factors behind Robust Spending: A number of conditions spurred household spending and home purchases 

in recent quarters. Among these conditions are high and 

rising levels of consumer confidence about the current 

economic situation (see darker line in Chart 5, next 

page) and the sense that “good deals” are available—on 

items ranging from computers to vehicles to travel in 

Asia. In turn, consumer confidence in the Region 

reflects that households are experiencing 

•	 the lowest unemployment rate in decades; 

•	 accelerating wage gains—the largest since 1991— 

and roughly 3 percent growth in inflation-adjusted, 

after-tax income; and 

•	 rising net worth associated with appreciation in stock 

market valuations and home resale prices. 

However, only by assuming more debt and restructuring 

existing debt have households been able to sustain 

spending growth in excess of income gains. As a result, 

CHART 4 

Gap between Growth in Consumer 

Spending and Income Is Growing 

Sources: Census Bureau and National Association of Realtors, via Haver Analytics 

Midwest’s New and Existing Home Sales Climb Home Resales (000s, Annual Rate) New Home Sales (000s, Annual Rate) 

400 

600 

800 

1,000 

1,200 

1,400 

25 

75 

125 

175 

225 

Resales 

New Homes 

Q1-’80

Q1-’82Q1-’84Q1-’86Q1-’88

Q1-’90

Q1-’92Q1-’94Q1-’96

Q1-’98

Percent Change from 4 Quarters Ago 

Real Consumption Spending 

Real After-Tax Income 

Q1-’90

Q1-’92Q1-’94Q1-’96Q1-’98 

4 

2 

0 

–2 

Source: Bureau of Economic Analysis, via Haver Analytics, Inc. 

Chicago Regional Outlook 21	 Fourth Quarter 1998 
Regular Feature	 Regional Perspectives
 

liabilities per household averaged near $74,500 at mid1998. This debt load compares with an average of 

$60,300 per household four years earlier and $54,600 at 

the end of the last recession. In addition, debt growth 

accelerated in the past five quarters despite the fact that 

income growth slowed over the same period. Consequently, households’ liabilities relative to disposable 

income have risen sharply (see lower line in Chart 6). 

These conditions raise questions about how well households are managing their finances and debt loads, not 

only during these prosperous times but also with an eye 

to the future. The growing gap between consumers’ 

extremely positive evaluation of present conditions and 

their expectation of future conditions, illustrated in 

Chart 5, may be a warning sign that the current pace of 

spending and borrowing is exceeding a sustainable 

level. 

Households’ Debt-Repayment Ability: Households 

have used various means to assume more debt relative 

to income in the past few years without boosting their 

monthly debt servicing payments (see Chart 6). In some 

cases, extending the maturity of debt allows households 

to qualify for a credit line or to manage the monthly 

repayments. An increasing number of households lease 

vehicles rather than buying them, thus avoiding debt 

financing. 

Debt burdens also have been eased by low and falling 

interest rates and a flattening yield curve. This combination helps households reduce the payment burden 

associated with a given amount of debt and triggers substantial debt restructuring. As households free up 

income from debt payments, their discretionary spendCHART 5 

ing power increases. Characteristics of households’ debt 

restructuring include 

•	 a shift away from traditional consumer installment 

credit (including credit cards and auto loans); 

•	 a surge in refinancing of mortgages, sometimes generating “cash-out” funds used to finance current 

spending; 

•	 a dramatic shift from variable-rate to fixed-rate 

mortgages; and 

•	 substantial use of home equity loans (HELs) for debt 

consolidation purposes (accounting for about 35 percent of HELs extended in 1996). 

Although these actions are helping households manage 

their current debt payment burdens, there has been no 

reduction in bankruptcy filings. In four of the Region’s 

states, filings increased by 5 to 10 percent in the first 

half of 1998. Illinois had the smallest increase: 2.6 percent. A related short-term concern is that pending federal legislation to tighten the bankruptcy codes could 

spur a flurry of filings in anticipation of the new law. 

Further Improvement in Households’ Financial 

Flexibility Is Questionable: Looking ahead, additional 

reductions in repayment burdens may be difficult to 

achieve. Significant reductions in debt payments arising 

from a further flattening of the yield curve or substantial decline in long-term interest rates are unlikely as 

long as the expansion continues and world financial 

markets avoid total chaos. Moreover, lenders’ willingCHART 6 

Consumer Confidence about Present Conditions Soars 

above Expectations for the Future 

Sources: Bureau of Economic Analysis and Federal Reserve Board, via Haver Analytics, Inc. 

Debt Servicing Burden Is Stable Despite 

Rising Amount of Debt Relative to Income 

1.15 

1.20 

1.25 

1.30 

14 

15 

16 

17 

18 

Household Liabilities to Disposable Income (left axis) 

Payments for Consumer Debt 

and Mortgages (right axis) 

Ratio of Liabilities to Income

Payments as % of Disposable Income 

Q2-’88

Q2-’89

Q2-’90

Q2-’91

Q2-’92Q2-’93

Q2-’94

Q2-’95Q2-’96

Q2-’97

Q2-’98 

Indices of Consumer Confidence

(1985=100) 

150 

100 

50 

0 

200 Future	 Present 

Conditions Conditions

Q1-’81

Q1-’83Q1-’85Q1-’87Q1-’89Q1-’91

Q1-’93Q1-’95Q1-’97 

Source: The Conference Board, via Haver Analytics, Inc. 

Chicago Regional Outlook 22	 Fourth Quarter 1998 
Regular Feature Regional Perspectives
 

ness to lengthen loan maturities in order to make a given 

amount of debt more serviceable may be approaching 

an upper limit. Thus, the advantageous conditions and 

debt management actions discussed above may not be 

sustainable. 

Heightened stock market volatility and falling prices 

also cast a shadow on households’ financial health. The 

slump in U.S. stock price indices since mid-July has 

already trimmed away about one-quarter of households’ 

equity appreciation since 1994. A sustained slump 

could deflate consumer confidence, significantly curtailing households’ willingness to assume more debt or 

maintain current levels of discretionary spending. 

Uncertainty generated by economic and political conditions at home and abroad could further dampen consumer confidence. The fact that about half of 

households now own corporate stocks—either directly 

or through retirement plan accounts—may magnify any 

negative repercussions from stock market gyrations or 

declines. 

Should consumers sharply curb their spending, the 

retrenchment likely would be concentrated among bigticket, discretionary purchases. Such cutbacks would be 

felt quickly by the Region’s producers of vehicles, 

appliances, and furniture, for example, along with their 

supplier industries. In turn, slower growth in workers’ 

earnings could weaken their ability to service their current debt and cause them to draw more heavily on 

unused credit lines. 

Overall conditions in the household sector may be 

viewed positively. However, there may not be much 

room for improvement in households’ ability to repay 

debt, and even their current repayment ability is 

vulnerable to shifting economic and financial market 

conditions. 

Consumer Behavior Affects Banks’ 

and Thrifts’ Risk Profiles 

Households’ recent behavior has affected bank and 

thrift portfolios throughout the Region. Some lenders 

are facing credit quality issues in their consumer loan 

portfolios, while others may be more affected by 

changes in their interest rate risk profile. 

In the past year, institutions in the Region increased the 

number of loans secured by residential real estate—that 

is, one- to four-family mortgages and home equity 

loans—by nearly 8 percent. Such loans now make up 

about 35.5 percent of total loans and leases in the 

Region, up a percentage point from mid-1997. Loans to 

individuals not secured by real estate, which account for 

another 14.5 percent, declined slightly in the past year, 

when the credit card component fell by nearly 19 percent. Of concern is the fact that, despite recent shrinkage, consumer credits not secured by real estate account 

for nearly 70 percent of net charge-offs in the Region 

(see Chart 7). 

Credit Quality of Some Portfolios Is a Concern: 

Credit quality concerns are most evident in charge card 

portfolios. High charge-off levels and past-due rates on 

credit card portfolios have moderated in recent months 

but remain high at 4.89 percent and 3.89 percent, 

respectively. Outstanding credit card balances totaled 

$19.7 billion in the Region on June 30, 1998, and 

unfunded credit card lines are slightly over $149 billion. 

Reported efforts to strengthen underwriting standards 

have not yet fully offset the effects of high personal 

bankruptcy rates and past aggressive underwriting. 

While the Region’s volume of credit card loans has 

declined, this trend may not continue: Credit card solicitations nationally jumped by roughly 30 percent—to 

over 3.1 billion—in the past year. 

From a credit quality perspective, another area to watch 

in this Region is home equity lending. Consumers have 

taken advantage of the favorable rates and tax advantages offered in this type of borrowing: Outstanding 

home equity lines of credit in the Region have grown 

over 25 percent over the past 18 months and now total 

$27.1 billion. These traditionally small loan portfolios 

have increased at over a 20 percent annual rate in 534 

CHART 7 

0 

25 

50 

75 

100 

Dec Dec Dec Dec Dec Dec Dec Dec Jun 

All Other 

Credits 

Source: Bank and Thrift Call Reports 

Credit Cards 

Other 

Consumer 

(Excluding Real 

Estate Secured) 

Consumer Credits Dominate 

Region’s Charge-Offs 

Percentage of Net Charge-Offs 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Chicago Regional Outlook 23 Fourth Quarter 1998 
Regular Feature	 Regional Perspectives
 

institutions. In addition, banks’ and thrifts’ exposure in 

the form of unused home equity lines amounts to $24.9 

billion. 

The present level of home equity loan delinquencies is 

low (1.25 percent), but problems in credit card portfolios may migrate into this sector. For example: 

•	 Ten percent of respondents eased their standards for 

home equity lending over the past six months, 

according to the Federal Reserve Board’s latest 

Senior Loan Officer Opinion Survey. 

•	 In a recent speech, the acting Comptroller of the Currency cited an easing of underwriting standards in 

home equity lending and lines of credit, according to 

the Office of the Comptroller of the Currency’s 

upcoming 1998 Survey of Credit Underwriting 

Practices. 

•	 Fifteen percent of institutions surveyed in the Region 

are not verifying borrowers’ ability to repay on home 

equity lines of credit, according to the Federal 

Deposit Insurance Corporation’s Report of Underwriting Practices for the second quarter. 

Finally, pricing and underwriting standards in direct and 

indirect auto loan portfolios are becoming more aggressive, which may adversely affect the credit quality of the 

$24.7 billion in domestic lease paper held by the 

Region’s institutions. 

In response to the reported slippage in underwriting 

practices and concerns about home equity portfolios, 

financial institutions may need to continue monitoring 

loan policies, especially with respect to loan amortization programs, the sufficiency of collateral, and internal 

controls. 

Focus on Mortgage Lending May Increase Interest 

Rate Risk: Changes in household sector spending and 

borrowing patterns also may affect the interest rate risk 

of insured institutions. Fueled by a flattened Treasury 

yield curve, consumers have made a dramatic shift to 

fixed-rate mortgages. Nationally, 86 percent of all mortCHART 8 

0 

20 

40 

60 

80 

100 

120 

Maturities Lengthen for First Mortgages 

(1- to 4-Family) in Chicago Region’s Institutions 

Source: Bank and Thrift Call Reports 

Less than 

3 years 

15+ years 

3–5 years 

$ Billions 

Jun ’97 Sep ’97 Dec ’97 Mar ’98 Jun ’98 

5–10 years 

gages closed in the first half of this year were fixed rate, 

compared with 56 percent three years earlier. While 

customers are locking in long-term mortgages at low 

rates, banks face the task of maintaining liquidity and 

adequate rate sensitivity. 

Increased lending secured by liens on one- to fourfamily residences (i.e., first mortgages, second mortgages, home equity lines, and related credits) and 

investments in mortgage-backed securities have 

changed the loan and securities mix at many insured 

institutions. In fact, almost 64 percent of the Region’s 

banks now hold over 25 percent of their assets in mortgage products, up from 55 percent at year-end 1990. For 

all insured institutions in the Region, the past year’s 

growth in one- to four-family first mortgages has been 

concentrated in the 3- to 30-year tranche (see Chart 8). 

In particular, maturities of 15 years and longer 

increased by over 61 percent. 

The consequent longer maturity of real estate portfolios may increase institutions’ need to monitor and 

adjust the interest rate sensitivity of their portfolios, 

and some lenders who face an increasing number of 

prepayments may not be able to maintain yield without 

incurring inappropriate risks in the current interest rate 

environment. 

The Chicago Region Staff 

Chicago Regional Outlook 24	 Fourth Quarter 1998 
✁
 

Subscription Form
 

To obtain a subscription to the FDIC Regional Outlook, please print or type the following information: 

Institution Name ______________________________________________________________ 

Contact Person ______________________________________________________________ 

Telephone ______________________________________________________________ 

Street Address ______________________________________________________________ 

City, State, Zip Code ______________________________________________________________ 

Please fax or mail this order form to:	 FDIC Public Information Center 

801 17th Street, N.W., Room 100 

Washington, D.C. 20434 

Fax Number (202) 416-2076 

Please indicate below each Region’s issue you wish to receive: 

Atlanta Boston Chicago 

Dallas Kansas City Memphis 

New York San Francisco All 

FDIC 

Federal Deposit Insurance Corporation 

Washington, DC 20429-9990 

OFFICIAL BUSINESS 

PENALTY FOR PRIVATE USE, $300 

BULK RATE
 

MAIL
 

Postage &
 

Fees Paid
 

FDIC
 

Permit No. G-36