Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 2000 

FDIC
 

Memphis
 

Region
 

Division of
 

Insurance
 

Gary L. Beasley,
 

Regional Manager
 

Harry W. John,
 

Regional Economist
 

Robert L. Burns,
 

Senior Financial
 

Analyst
 

F. Miguel Hasty,
 

Financial Analyst
 

Regional Perspectives 

◆ Earnings Pressures Lead to Heightened Levels of Credit Risk—With 

increasing competition compressing net interest margins, many of the Region’s 

banks are accepting greater levels of credit risk to improve asset yields, potentially 

heightening their vulnerability to any deterioration in economic conditions. Risk 

management is becoming increasingly important, particularly as capital levels are 

declining. See page 3. 

◆ Perspectives from the FDIC Regional Director—The senior regulator 

for the FDIC in the Memphis Region, Division of Supervision Regional Director 

Cottrell Webster, hopes that bank management will review strategies and policies 

and take any needed steps to strengthen risk management procedures. See page 11. 

By the Memphis Region Staff 

In Focus This Quarter 

◆ Emerging Risks in an Aging Economic Expansion—This article 

focuses on the potential risks of current economic conditions to insured depository 

institutions. Although the current conditions may appear to be ideal, some imbalances are emerging: rising energy prices, tight labor markets, a less robust stock 

market, a large trade deficit and strong U.S. dollar, rising household debt burdens, 

increased corporate leverage and rising potential default risk, and, in some metropolitan areas, overheated housing and commercial real estate markets. At the same 

time, aggregate risk within the banking industry appears to have risen, as evidenced 

by softening profitability, growing reliance on noncore funding, heightened levels of 

interest rate risk, and increasing concentrations in traditionally higher-risk loan 

categories. A confluence of these trends could heighten the vulnerability of some 

insured institutions. See page 13. 

By the Division of Insurance Staff 

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

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

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

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX) 

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

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

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

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

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

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

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

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

Outlook, please call Gary Beasley at (901) 821-5234 or send an e-mail to gbeasley@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 

REVISION: 

The article “Ranking Metropolitan Areas at Risk for Commercial Real Estate Overbuilding” in 

the Third Quarter 2000 issue of the Regional Outlook has been revised to correct a data-related 

error. The revision affects Chart 4 and Chart 11 of the report. Please see www.fdic.gov/bank/ 

analytical/regional/ro20003q/correction.html for revised versions of Chart 4 and Chart 11, along 

with an additional explanation of how the revision affects the article. 
Regional Perspectives
 

Regional Perspectives
 

•	 With increasing competition compressing net interest margins, many banks are accepting greater credit risk 

to improve asset yields. Rising loan levels contributed to higher net interest margins in the first half of 2000 

but may be difficult to sustain. 

•	 High and growing credit exposure may increase the vulnerability of the Region’s banks to any deterioration 

in economic conditions. It also increases the importance of risk management, particularly as capital levels 

are declining. 

Late Cycle Behavior: Earnings Pressures Lead to Increased Credit Risk 

The duration and continuing strength of the economic 

expansion have provided a positive environment for 

banks and other financial institutions. This positive 

environment, however, has led to the emergence of considerable competition from a growing number of newly 

established banks and the entrance of nonbanks into traditional banking lines of business. Resulting pricing 

pressures for both loans and funding have affected 

banks’ net interest margins (NIMs) adversely. Many 

banks have responded to declining margins by steadily 

increasing loan-to-asset (LTA) ratios, accommodated by 

strong loan demand. The first half of this article discusses the emphasis many banks have placed on loan 

growth to combat margin pressures. 

The second half of this article focuses on the potential 

negative consequences associated with higher credit 

exposure should economic conditions deteriorate. Experiences during the banking crises of the 1980s and early 

1990s suggest that increases in LTA ratios heighten 

banks’ vulnerability to changing economic conditions. 

During the previous expansion, the Region’s economy 

and banks’ credit exposure grew slowly and were less 

affected by the subsequent recession in 1990–1991 than 

those of other areas of the nation. During the current 

expansion, however, the Region’s economy and bank 

credit exposure have grown rapidly. Recent growth has 

been fueled by migration into higher-risk loan types, 

such as construction and development (C&D) lending. 

Some banks currently report higher capital and 

allowance levels in line with risk selections. Many other 

banks, however, are emphasizing short-term profitability while relying on continuing economic strength to 

minimize potential long-term credit concerns. The title 

“Late Cycle Behavior” is less a reflection of the maturity of the current economic expansion than a description 

of the changing risk tolerances at many financial institutions, which is consistent with behaviors exhibited in the 

later stages of previous economic cycles. 

Earnings Pressures Are Driving Bank 

Risk Selections 

Although the current banking environment remains 

favorable, some concerns have emerged, as evidenced 

by the performance of bank stocks in public markets. 

Bank stocks outperformed broader stock indices 

throughout much of the 1990s but have underperformed 

broader market trends since late 1998 (see Chart 1). 

Bank share prices have been held down by a decline in 

merger and acquisition activity, worries about possible 

credit quality deterioration, and concerns over earnings 

performance given rising interest rates and questions 

regarding revenue growth potential.1 

Although the stock of many smaller banks and bank 

holding companies is not publicly traded, management at 

these institutions also faces pressure from stockholders 

CHART 1 

Source: Standard & Poor's 

Bank Stocks Underperformed Broader 

Markets in the Late 1990s 

Index = 100 in 1992

S&P Bank Stock 

S&P 500 Stock Index 

May 

’97 

Jan 

’92 

May 

’93 

Sep 

’94 

Jan 

’96 

Sep 

’98 

Jan 

’00 

Sep 

’92 

Jan 

’94 

Sep 

’96 

Jan 

’98 

May 

’99 

0 

50 

100 

150 

200 

250 

300 

350 

400 

450 

May 

’95 

1 Standard & Poor’s. July 1999 to July 2000. Monthly Investment 

Review Industry Survey. 

Memphis Regional Outlook 3	 Fourth Quarter 2000 
Regional Perspectives
 

to improve earnings performance. Return on assets 

(ROA) and NIMs contracted at most community banks2 

in the Memphis Region in the late 1990s (see Chart 2). 

In fact, during 1998 and 1999, NIMs were below the 

average reported over the past 15 years. This decline followed a period of exceptionally strong earnings early in 

the expansion and is consistent with banks’ performance 

nationwide. 

However, during the first half of 2000, NIMs and ROAs 

were no longer declining. Banks in the Region and 

nation reported improved or stable earnings during this 

period (see Table 1). Increased credit exposure appears 

to be a primary contributor to the improvement in 

NIMs, as community banks reported higher LTA levels 

and a shift in loan portfolio composition. 

Loan-to-Asset Levels Have Risen Sharply 

In the absence of other changes, NIMs typically 

increase as assets are shifted from securities to loans, 

which usually offer higher yields. Although LTA levels 

have climbed steadily since the early 1990s (with a brief 

pause in 1998 because of capital markets-driven credit 

concerns), recent increases have been particularly large. 

Memphis Region community bank aggregate LTA 

TABLE 1 

Community Bank NIMs Improved 

in the First Half of 2000 

SIX MONTHS ENDING 

JUNE 30, 

1999 

JUNE 30, 

2000 

NATION 

REGION 

MEDIAN ROA 

MEDIAN NIM 

MEDIAN ROA 

MEDIAN NIM 

1.15 

4.32 

1.22 

4.32 

1.21 

4.45 

1.22 

4.40 

Note: Includes banks with less than $1 billion in total 

assets that have been in operation for three years or 

longer. 

ROA = return on assets; NIM = net interest margin 

Source: Bank Call Reports 

2 We define community banks as commercial banks (not savings and 

loan institutions) with less than $1 billion in total assets that have 

been in operation three years or longer, unless otherwise noted. 

3 The data shown in Table 2 are for banks headquartered in the Memphis Region. Expanded analysis of approximately 7,400 banks nationally reveals a similar positive relationship between improvement in 

NIMs and increases in LTA ratios. 

CHART 2 

Note: Includes banks with less than $1 billion in total assets in operation for three 

years or more. 

NIM = net interest margin; ROA = return on assets 

Source: Bank Call Reports 

NIMs and ROAs at Memphis Region Banks 

Declined in the Late 1990s 

Median ROA 

3.8 

4.0 

4.2 

4.4 

4.6 

4.8 

5.0 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 ROA NIM 

19851987 198919911993199519971999 

Median NIM 

ratios rose from 60.9 percent at the beginning of 1999 

to 65.3 percent by midyear 2000. The sharp increase 

over the past 18 months, mirrored by community banks 

nationally, equaled the cumulative growth in LTA levels 

over the preceding six years. As shown in Chart 3, LTA 

ratios are at historically high levels. 

The correlation between rising LTA ratios and recent 

improvement in NIMs at many banks is shown in 

Table 2. This analysis segregates community banks in 

the Memphis Region3 into five equal groups (quintiles) 

on the basis of each institution’s reported change in 

NIMs from June 30, 1999, to June 30, 2000. The top 

quintile represents the 20 percent of banks reporting the 

largest increase in NIMs during the period. The changes 

in LTA ratios between year-end 1998 and year-end 1999 

were then calculated for each group.4 Bank groups that 

reported progressively stronger improvement in NIMs 

(moving up the table) also reported progressively larger 

increases in LTA ratios during 1999. The banks reporting the greatest improvement in NIMs, for example, 

reported an increase in LTA ratios of almost 400 basis 

points. The bottom quintile of banks reported a decline 

in NIMs despite an increase in LTA ratios. For this 

group, the increased earnings potential resulting from 

slightly higher LTA ratios was more than offset by competitive pressures and other factors discussed in the box 

on page 6. 

4 The built-in lag between changes in LTA ratios and NIMs is necessary, as balance sheet composition changes do not occur instantaneously; rather, they take place throughout the reporting period. 

Changes in LTAs in the first reporting period, the first half of 1999, 

for example, would have only a limited effect on NIMs during the 

period but would be fully incorporated into NIM performance in the 

following period. 

Memphis Regional Outlook 4 Fourth Quarter 2000 
Regional Perspectives
 

CHART 3 TABLE 2 

Note: Includes banks with less than $1 billion in total assets in operation for three 

years or longer and with at least 10 percent of total assets in loans. 

Source: Bank Call Reports 

Community Bank Aggregate Loan-to-Asset 

Levels Have Climbed Sharply during 

This Expansion 

Loans as a Percentage

of Total Assets 

1972197419781980198419881992199419961998 

40 

45 

50 

55 

60 

65 

70 

Banks in the Region 

Banks in the Nation 

19761982 19861990

Memphis Region NIM Improvement 

Appears Linked to Rising 

Loan-to-Asset Ratios 

MEDIAN 

CHANGE 

BANKS GROUPED RANGE OF IN LTA BY CHANGE NIM CHANGE RATIO 

IN NIMS (BPS) (BPS) 

TOP QUINTILE MORE THAN 37 398 

SECOND QUINTILE 18 TO 37 295 

THIRD QUINTILE 2 TO 18 251 

FOURTH QUINTILE –18 TO 2 137 

BOTTOM QUINTILE LESS THAN –18 45 

Notes: This analysis included 805 Memphis Region 

banks that reported less than $1 billion in total 

assets, had been in operation for three years or 

longer, and reported at least 10 percent of total 

assets in loans. 

Source: Bank Call Reports 

Commercial Real Estate Loan Growth 

Has Driven Overall Portfolio Growth in 

Recent Periods 

Credit risk among Memphis Region banks increased not 

only as a result of higher LTA ratios but also because 

recent growth has been concentrated in higher-yielding, 

and traditionally higher-risk, loan types. Commercial 

real estate (CRE) loans and commercial and industrial 

(C&I) loans represent a disproportionate share of overall loan growth since the beginning of 1999 (see 

Chart 4). C&D loans, a component of CRE lending and 

potentially the most complex and highest-risk type of 

lending performed by most community banks, constiCHART 4 

tuted the fastest-growing segment of loan portfolios at 

community banks during the period. 

CRE loans typically generate considerable loan fees and 

are often characterized by higher contractual interest 

rates than many other forms of lending. Therefore, 

some banks may be targeting these loan types in an 

effort to improve overall loan yields. Strong demand for 

CRE loans offered banks this opportunity to shift loan 

portfolio composition. 

Commercial Real Estate and Commercial and Industrial Lending Represent 

a Disproportionate Share of Recent Loan Growth in the Region 

Loan Portfolio Composition as of Share of Net Loan Growth from 

December 31, 1998 December 31, 1998, to June 30, 2000 

Agricultural & 

Residential &

Consumer

55.8% 

CRE

 23.3% 

Agricultural &
 

Other
 Other


 7.7%
 5.5% 

C & I

 13.2% 

C & I

CRE

Residential & 41.7%

Consumer 

30.2% 

Note: Includes banks with total assets of less than $1 billion that have been in operation for three years or longer. 

CRE = commercial real estate; C&I = commercial and industrial 22.6% 

Source: Bank Call Reports 

Memphis Regional Outlook 5 Fourth Quarter 2000 
Regional Perspectives
 

Other Factors May Have	 Inelastic Nature of Core Deposit Rates: Although 

bank core deposits such as savings accounts, nego- Affected NIMs tiable order of withdrawal accounts, and money market deposits are potentially subject to daily repricing, 

Factors other than increasing competition and rising banks historically have been able to lag changing 

loan exposure undoubtedly influenced NIMs during rates paid on such deposits behind changes in market 

the first half of 2000. interest rates. As a result, banks were often able to 

improve NIMs in the short run during periods of risRising Interest Rates: From June 30, 1999, to June ing rates even though the longer-term effects of ris30, 2000, the Federal Reserve Board increased short- ing rates are often negative for liability-sensitive 

term interest rates 175 basis points. NIMs may have banks. The inelastic nature of core deposits may have 

been affected adversely by rising interest rates as most waned in recent years, however, as consumers have 

banks, at least on the surface, remain liability sensi- become increasingly savvy money managers and 

tive (i.e., bank liabilities can be repriced more quick- competition among financial institutions for funding 

ly than assets). As discussed below, however, the has intensified. 

inelastic repricing nature of core deposits likely offsets some of the otherwise negative effects of rising Asset Maturity Extension: After averaging just over 

interest rates on bank earnings. 14 percent of total assets during the first five years of 

this expansion (1992–1996), long-term assets (those 

Yield Curve Changes: Changes in the shape of the maturing or repricing in more than five years) at comyield curve have considerable influence on NIMs, as munity banks in the Region rose to 18.4 percent of 

banks tend to “fund short and lend long.” Most bank assets by year-end 1999. Assets with longer maturities 

funding is priced from the short end of the yield or repricing frequencies typically provide incremencurve, while many loans and securities are priced fur- tally higher rates of return in exchange for the opporther out on the yield curve. A comparison of short- tunity costs of longer holding or repricing periods. 

term interest rates (three-month U.S. Treasury bill) However, with interest rates increasing from June 

and longer-term rates (10-year U.S. Treasury note) 1999 to June 2000, the extension of asset maturities in 

reveals a narrow spread between these rates from late the late 1990s likely had an adverse affect on NIMs. 

1997 to early 1999. This spread increased somewhat Perhaps in response to rising interest rates, banks 

from midyear 1999 through first quarter 2000 and began to move away from long-term assets; the ratio 

likely contributed to the improvement in NIMs dis- of long-term assets to total assets as of June 30, 2000, 

cussed in this article. In March 2000, the yield curve declined slightly from year-ago levels. 

flattened again. 

Recent Improvement in NIMs May Be 

Difficult to Sustain without a Steepening 

of the Yield Curve 

Additional pricing pressures on loans could constrain 

banks’ ability to improve NIMs by increasing loan 

exposure. Greater competition could lead to reductions 

in interest rates charged on loans (relative to other interest rates) and lower loan fees, particularly if loan 

demand softens. Moderating economic conditions in the 

Region seem unlikely to sustain recent levels of loan 

growth indefinitely. 

The cost of funding loan growth also could continue to 

escalate. In the early and mid-1990s, loan growth was 

funded largely through a combination of core deposit 

growth and the liquidation of securities portfolios. As 

core deposit growth at many banks remained anemic 

and securities portfolios approached minimum levels5 in 

the late 1990s, institutions began to rely on higher-cost 

noncore funding sources to support loan growth. Going 

forward, NIMs likely will be pressured further as the 

cost of funding new loans continues to rise. 

Increased Credit Exposure Equates to Higher 

Levels of Risk during Economic Downturns 

The positive economic environment in recent years has 

not only allowed financial institutions to grow loan 

portfolios but also contributed to exceptionally strong 

5 Community banks typically require minimum levels of securities for 

pledging against public funds and as a source of liquidity. 

Memphis Regional Outlook 6	 Fourth Quarter 2000 
Regional Perspectives
 

credit quality. Reported past-due loan ratios and loan 

loss rates remain favorable by historical standards. 

Annual aggregate loan losses at the Region’s banks, for 

example, ranged from 0.38 percent to 0.43 percent of 

total loans from 1994 to 1999. These traditional measures of asset quality, however, are of limited predictive 

value for loan portfolio performance because by definition they are lagging indicators of credit quality deterioration.6 Repayment difficulties for most loans are 

unlikely to surface until economic conditions erode. 

The severity of credit quality deterioration at such a 

time likely would be influenced heavily by current bank 

risk selections. 

Banks most adversely affected in regional or sectoral 

downturns during the previous economic cycle exhibited some common characteristics important in evaluating the risk of rising credit exposure at institutions 

today. A 1997 study of banking crises in the 1980s and 

early 1990s described two such characteristics:7 

•	 During periods of economic expansion preceding 

regional or sectoral downturns, many banks pursued 

a strategy of aggressive loan growth in response to 

strong credit demand, leading to rising LTA ratios at 

these institutions. 

•	 Banks that failed during the economic downturns 

were found to have higher LTA ratios and CRE loan 

exposure than banks that survived. In fact, the probability of failure for the group of institutions reporting the highest LTA ratios (the top quintile) was 

more than double the probability of failure for all 

banks. 

Before the current expansion, community banks in the 

Region consistently reported LTA levels at or below 

national levels; this gap gradually widened to more than 

400 basis points by year-end 1989 (see Chart 3). From 

December 31, 1991, through December 31, 1999, however, loan growth at established community banks in the 

Memphis Region averaged 9.7 percent annually, compared with 7.9 percent annual growth at community 

banks nationwide. With strong loan growth, aggregate 

6 Examination ratings trends, which include an evaluation of underwriting standards and credit administration practices in the assessment of potential future credit quality performance, suggest rising 

levels of credit risk in recent periods. 

7 Federal Deposit Insurance Corporation. 1997. History of the Eighties—Lessons for the Future, Volume I: An Examination of the Banking Crises of the 1980s and Early 1990s. 

Excerpt from History of the Eighties—Lessons for 

the Future, Volume I: An Examination of the Banking Crises of the 1980s and Early 1990s, p. 27. 

Although the interplay of broad economic, legislative, and regulatory forces helped make the environment for banking increasingly demanding, the 

more immediate cause of bank failures was a series 

of regional and sectoral recessions. Because most 

U.S. banks served relatively narrow geographic 

markets, these regional and sectoral recessions had 

a severe impact on local banks. It should be noted, 

however, that not all regional recessions of the magnitude experienced during the 1980–94 period 

resulted in a major increase in the number of bank 

failures. Rather, bank failures were generally associated with regional recessions that had been preceded by rapid regional expansions—that is, they 

were associated with “boom-and-bust” patterns of 

economic activity. 

LTA levels among established community banks in the 

Memphis Region are now slightly above national levels. 

The strong growth in the economy and the banking 

industry in the Memphis Region throughout much of 

the past decade is reminiscent of growth experienced by 

several states in the early 1980s that later fell victim to 

regional or sectoral downturns. The repercussions of 

economic strength and aggressive loan growth may be 

best illustrated by comparing banks headquartered in 

metropolitan areas in the Memphis Region with those in 

a “boom” area, New England,8 where both economic 

and banking conditions differed greatly in the previous 

economic cycle. 

During the mid-1980s, New England states had rapidly 

expanding economies that helped fuel considerable 

commercial and residential real estate activity. Banks in 

the area responded with growing loan portfolios and 

significant involvement in financing ballooning CRE 

markets (see Chart 5, next page). 

8 New England states considered in this analysis are Connecticut, 

Maine, Massachusetts, New Hampshire, Rhode Island, and Vermont. 

Only metropolitan community banks are included in this analysis. 

Any comparison of all banks operating in both Regions would lack 

validity, as a majority of banks in New England are headquartered in 

metropolitan areas, unlike in the Memphis Region. Also, savings 

banks, prevalent in New England but absent from the Memphis 

Region, are excluded from this analysis. 

Memphis Regional Outlook 7	 Fourth Quarter 2000 
Regional Perspectives
 

CHART 5 

Comparison of Inherent Credit Risk in the 1980s and 1990s: Memphis Region
 

Community Banks in Metropolitan Statistical Areas Report Higher Risk This Cycle
 

80
 

70
 

60
 

50
 

40
 

30
 

20
 

10
 

0
 

New England Memphis New England Memphis 

Region Region Region Region 

Loan/Assets Loan/Assets CRE/Assets CRE/Assets 

Note: Includes commercial banks with total assets less than $1 billion, in operation for three years or more, with 10 percent of total assets in loans, and headquartered in 

metropolitan statistical areas. 

CRE = commercial real estate 

Source: Bank Call Reports Percent of Assets

1989 

1982 

1991 

1999 

New England

 Region 

Loan/Assets 

Memphis

 Region 

Loan/Assets 

New England 

Region 

CRE/Assets 

Memphis

 Region 

CRE/Assets 

1982 54.4 52.5 7.2 7.2 

1989 74.6 55.0 19.9 10.4 

1991 69.4 54.1 19.2 10.8 

1999 57.0 66.3 18.5 19.6 

By contrast, the Memphis Region recovered slowly 

from the 1980–1982 recessions. Depressed commodity 

prices for both energy and agriculture dampened the 

Region’s recovery. Louisiana, heavily influenced by the 

oil and gas industry, did not emerge from its economic 

downturn until 1987. LTA levels and CRE loan exposure at metropolitan-headquartered community banks in 

the Memphis Region rose only modestly from 1982 

through 1989. 

Because the Memphis Region did not share fully in the 

expansion from 1982 to 1990, it was less affected by the 

national recession that followed. During the 1990–1991 

recession, economic growth9 in the Region slowed 

appreciably but remained positive, unlike many areas, 

such as the northeast and west coast, where economies 

contracted. With slow economic growth and moderate 

loan exposure levels entering the recession, Memphis 

Region banks generally weathered the downturn better 

than banks in some other parts of the country. Only 16 

banks in the Memphis Region failed from 1990 to 1993, 

equivalent to 1.3 percent of commercial banks in operation in the Region at year-end 1989. This failure rate 

compares favorably with the 3.2 percent national failure 

rate during this period. New England suffered an extraordinarily high 16.3 percent failure rate, underscoring 

the potential risk associated with rapid economic 

growth and high loan exposure levels. 

Extending the comparison into the current expansion 

shows a reversal from the previous economic cycle. 

Memphis Region states recovered quickly in the 1990s. 

Average annual personal income growth of 5.8 percent 

from 1991 to 1997 exceeded the national average of 5.4 

percent. Gross state products in the Region also grew 

faster than national production. The Region shifted 

from its commodity and nondurable manufacturing 

bases, with economic growth led by strong growth in 

the service and retail sectors. The construction sector 

also has been strong, with active real estate markets 

reported Regionwide. Commercial and residential real 

estate construction activity expanded rapidly in the late 

1990s and only recently began to slow in response to 

higher interest rates.10 Credit exposure in the Memphis 

Region also has grown considerably in the current 

expansion (see Chart 5). Conversely, credit exposure in 

New England subsided somewhat, influenced by the 

Region’s more gradual recovery and perhaps also by a 

more cautious strategy toward credit risk selection 

among the Region’s banks. 

More recently, the Memphis Region’s economy has 

begun to slow. Employment growth has trailed the 

nation’s since 1996, after leading during the first four 

years of the expansion. Likewise, personal income 

growth has trailed the national rate in recent years, with 

all five states in the Region reporting personal income 

growth below the national rate in 1999 for the first time 

during this expansion. The moderating of the Region’s 

economy seems somewhat inconsistent with the continued strong loan growth at the Region’s insured financial 

institutions. 

9 As measured by personal income growth adjusted by the gross 10 Recent construction activity and related lending issues are disdomestic product deflator. cussed in Regional Perspectives, third quarter 2000. 

Memphis Regional Outlook 8 Fourth Quarter 2000 
Regional Perspectives
 

The comparison between New England in the 1980s and 

the Memphis Region in the 1990s is not intended to suggest that New England’s banking crisis is on the verge of 

recurring in the Memphis Region. New England in the 

1980s was very different from the Memphis Region 

today: New England’s economic growth was stronger 

prior to the downturn, CRE markets were more active, 

and banks’ credit exposure levels were higher. Furthermore, credit underwriting is generally perceived to be 

considerably stronger today. The comparison does, however, demonstrate the relatively low exposure levels of the 

Memphis Region during the previous economic cycle 

compared with those of a “boom” Region, and it highlights growing credit exposure during the current cycle. 

Banks with High Credit Exposure 

Report Lower Capital Levels 

Banks willing to operate with high loan exposure also 

report other characteristics that demonstrate a high risk 

tolerance. These characteristics, described below, could 

expose the banks to greater performance variability in 

the event of economic deterioration. 

Metropolitan Areas 


May Be More at Risk
 

The Memphis Region’s economic growth in the current expansion is bifurcated; strong growth in urban 

areas contrasts with slow growth (or no growth) in 

many rural areas. Both job growth and personal 

income growth have been consistently higher in metropolitan areas than in rural areas in the 1990s. Many 

rural areas continue to report double-digit unemployment rates because of declining nondurable manufacturing, such as in the textile and apparel sector. With 

relatively low-skilled labor forces, many rural areas 

have difficulty attracting service or durable goods 

manufacturing firms to compensate for these job 

losses. Weaknesses in the agricultural sector since 

1997 also contributed to depressed conditions in 

many rural areas. Metropolitan areas, by contrast, 

have benefited from strong service, retail, and durable 

goods manufacturing employment gains. 

TABLE 3 

Bank loan growth also has been strongest in metropolitan areas. As shown in Table 3, credit exposure at 

community banks headquartered in metropolitan 

areas, particularly CRE loan exposure, rose sharply in 

recent years. These banks reported annual aggregate 

CRE loan growth of 21.0 percent in 1998 and 23.6 

percent in 1999, following average annual growth of 

15.9 percent over 1993 to 1997. Year-over-year CRE 

loan growth as of June 30, 2000, slowed modestly to 

21.1 percent but remained well above the average for 

the preceding five years. 

The first quarter 2001 Memphis Regional Perspectives article will describe specific metropolitan markets that may be most vulnerable to any deterioration 

in economic conditions. The article will focus on markets where competitive pressures have been or are 

becoming particularly strong. The emphasis will be 

on how banks operating in these markets have 

responded to these competitive pressures. 

Loan Exposure Has Grown Rapidly at Memphis Region Community Banks 

Headquartered in Metropolitan Areas 

MSAS NATIONWIDE LTA CRE/ASSETS C&D/ASSETS 

JUNE 30, 2000 65.9 20.1 3.2 

MSAS REGIONWIDE 

JUNE 30, 2000 68.9 20.1 4.8 

JUNE 30, 1999 64.8 18.9 4.1 

JUNE 30, 1998 63.7 15.8 3.7 

Note: Includes banks headquartered in metropolitan areas with less than $1 billion in total assets in operation 

for three years or longer and with at least 10 percent of total assets in loans. 

MSA = metropolitan statistical area; LTA = loan to asset; CRE = commercial real estate; C&D = construction and 

development 

Source: Bank Call Reports 

Memphis Regional Outlook 9 Fourth Quarter 2000 
Regional Perspectives
 

TABLE 4 

Memphis Region Banks with High Loan-to-Asset Ratios 

Report Additional Risk Factors and Lower Capital 

RISK FACTORS PROTECTION FACTORS 

BANKS GROUPED RANGE OF LOAN CRE/ RISK-BASED TIER 1 ALLOWANCE/ 

BY LTA RATIOS LTA RATIOS GROWTH1 TOTAL CAPITAL CAPITAL TOTAL 

LOANS2 RATIO RATIO LOANS 

TOP QUINTILE GREATER 15.8 26.2 12.3 8.5 1.22 

THAN 74.1 

SECOND QUINTILE 67.3 TO 74.1 10.9 22.5 13.3 8.7 1.23 

THIRD QUINTILE 60.8 TO 67.3 9.0 20.7 15.8 9.8 1.25 

FOURTH QUINTILE 52.4 TO 60.8 7.0 18.7 18.7 10.8 1.30 

BOTTOM QUINTILE LESS THAN 3.0 16.0 23.7 11.7 1.56 

52.4 

Notes: Includes banks with total assets of less than $1 billion in operation for three years or more and with 10
 

percent of total assets in loans.
 

1Merger-adjusted loan growth from year-end 1998 to year-end 1999.
 

2CRE is shown relative to total loans in this table rather than total assets because banks with high loan-to-asset
 

ratios could be expected to report high levels of CRE to assets without necessarily reflecting increased emphasis
 

on this loan type.
 

LTA = loan to asset; CRE = commercial real estate
 

Source: Bank Call Reports
 

Other potential risks associated with banks reporting 

high LTA ratios are shown in Table 4. This analysis segregates community banks in the Region into five equal 

groups based on reported LTA ratios as of June 30, 2000, 

with the top quintile representing banks with the highest 

LTA ratios. This analysis is distinct from the analysis 

performed earlier in this article that grouped the 

Region’s banks on the basis of changes in NIMs and then 

focused on changes in LTA ratios. The current analysis 

groups banks on the basis of level of LTA ratios and then 

focuses on other risk factors and capital levels. 

In addition to reporting the highest LTA ratios, the top 

quintile of banks reported considerably faster loan 

growth in 1999 and significantly greater exposure to 

CRE loans as of midyear 2000 than typical community banks in the Region (represented by the third quintile of banks, which are clustered around the median 

ratio reported by all banks in the sample). Although 

not shown in the table, banks with the highest LTA levels also are relying more heavily on alternative sources 

to fund loan portfolios. As noncore funding sources 

may represent a more volatile and more costly source 

of funding, liquidity risk could be higher at these 

institutions. 

Despite the higher credit exposure of banks in the top 

quintile, this group reported lower capital and allowance 

for loan and lease losses levels at midyear 2000. Tier 1 

capital ratios for this group, as with most community 

banks, declined in recent years. The median Tier 1 capital ratio for banks with the highest LTA ratios declined 

12 basis points from June 30, 1999, to June 30, 2000. 

Risk Analysis and Management Are Vital Today 

There is nothing inherently inappropriate in a strategy 

of accepting additional credit exposure; banks are in the 

business of accepting and managing credit risk. In fact, 

such a strategy may be even more necessary in today’s 

banking environment in order to preserve earnings. But 

with credit exposure rising and capital levels declining, 

strong risk management becomes increasingly critical. 

While economic conditions remain favorable, bank management may want to evaluate acceptable risk tolerance 

levels in reviewing overall credit exposure and take steps 

to correct any specific underwriting laxity. The Comptroller of the Currency, in a recent letter to board members and chief executive officers of all national banks, 

Memphis Regional Outlook 10 Fourth Quarter 2000 
Regional Perspectives
 

asked bankers to prepare for the eventuality of rising 

delinquencies and collection problems by “shoring up 

collateral values and guarantor support, and, where possible, correcting overly generous repayment terms.”11 The 

senior regulator for the FDIC in the Memphis Region, 

Division of Supervision Regional Director Cottrell L. 

Webster, also hopes to see banks take this opportunity to 

review their strategies and policies and take any needed 

steps to strengthen their risk management procedures as 

discussed in the box that follows. 

Memphis Region Staff 

Perspectives from the FDIC Our examiners sympathize with the balance chief 

executive officers must maintain between an elusive Regional Director net interest margin and financial prudence. My concern, quite frankly, is that chief executive officers and 

the boards of directors will become numb to the incre- Every chief executive officer can relate to earnings mental risk they have assumed in recent periods. pressure described in the article entitled “Late Cycle 

Behavior: Earnings Pressures Lead to Increased Credit Risk.” This article could not be more timely. Many The best way to counteract complacency with risk is 

banks have squeezed the last ounce of efficiency from to establish risk parameters beyond which the bank 

operations and must look to increasing asset yields to will not operate. Managers who exceed those paramemaintain revenue growth.	 ters, by either design or default, should be held 

accountable. 

As you have read, FDIC analysts (and some bankers) In 1998, four of the bank regulatory agencies com- contend that the economic expansion begun in the piled a list of “best practices” regarding residential 1990s is the first in which the Midsouth has fully par- real estate lending in the greater Atlanta area. The ticipated. If this is so, our banks may also fully par- techniques were not new or particularly sophisticated, ticipate in the subsequent contraction. The FDIC is but they could be applied to virtually any type of com- not in the business of predicting business cycles and munity lending. They are not intended to replace has no interest in seeing the nation’s economic expan­ sound underwriting, but they serve to diversify credit sion end. However, both the FDIC and the banking risk if conscientiously implemented. Here is a partial industry would be careless if we did not anticipate and list of those best practices that FDIC examiners may plan for a contracting economy. suggest during your next examination: 

But how does a chief executive officer do that? Where 

• Establish portfolio limits by lending category (e.g., does competition for credit end and disregard for pru­ commercial real estate, residential, consumer, and dent lending standards begin? The question does not agricultural). Depending on the degree of risk, spe­ have an easy answer. Subtle growth in the loan port­ cialized lending within these broad categories may folio adds slow, increasing pressure on capital, liquid- benefit from volume limitations. ity, and portfolio risk from marginal credits that might 

have been rejected in less aggressive times. • Incorporate location criteria into your real estate 

lending portfolio to encourage diversity and limit 

Rapid loan growth has been verified in our current overexposure in a particular market. 

examination cycle. Loan-to-asset ratios in excess of 75 

percent, once rare, are increasingly common. Commer­ • Be mindful of indirect loans and commitments to 

cial real estate and commercial and industrial loans borrowers who are reliant on the successful comhave fueled the growth, but all lending categories are pletion of commercial projects when evaluating 

expanding. The shift from securities investments to individual lines of credit and total portfolio 

loans has increased banks’ risk exposure. Asset deteri­ exposure. 

oration, though hardly a regional pattern, is appearing 

in isolated segments of the Memphis Region. (continued on page 12) 

11 Letter to Board Members and Chief Executive Officers of National Banks, September 2000, which discusses the results of the Office of the 

Comptroller of the Currency’s 2000 Survey of Credit Underwriting Practices. 

Memphis Regional Outlook 11	 Fourth Quarter 2000 
Regional Perspectives
 

•	 Reevaluate appraisals as appropriate and required 

by regulation. Market information should be part 

of an ongoing appraisal review program. 

•	 Keep apprised of economic conditions that affect 

your institution’s market area. 

Just as important are events that will trigger a review 

of lending policies. Most banks operate with policies 

adopted during strong economic conditions, which 

may not protect the bank from undue risk in a less 

favorable economy. Prudence suggests that key measures of strength for main business lines be identified, 

along with thresholds that, if passed, lead to a review 

of policy. For example, higher minimum equity in a 

speculative home, or minimum capitalization for the 

builder, might be appropriate when unsold inventory 

levels begin to rise. Simple or sophisticated, our 

examiners will be looking for written boundaries and 

sufficient board oversight for specialized lending. 

The FDIC has specific regulations that provide greater 

detail regarding real estate lending and portfolio management. Refer to Parts 323 and 365 of the FDIC 

Rules and Regulations. National and state member 

banks should consult 12 CFR 34 for the Comptroller 

of the Currency guidelines and Regulation H Appendix C of the Federal Reserve Board Regulations. State 

law also establishes lending limitations. For additional 

guidance, contact your primary regulator. 

Federal Reserve Chairman Alan Greenspan recently 

remarked to a meeting of the American Bankers 

Association, “Today’s products and rapidly changing 

structures of finance mean that supervisors are backing off from detail-oriented supervision, which no 

longer can be implemented effectively.” I contend 

that the FDIC is concentrating on those aspects of 

banking that pose the greatest risk to the deposit 

insurance fund. Community banks of all sizes within 

the Memphis Region are experiencing rapid loan 

growth and engaging in specialized activity, such as 

subprime lending. To the extent that sufficient oversight and operating policies are in place, financially 

sound banks are free to offer the products their customers demand. The depth and degree of the FDIC’s 

supervisory role is entirely dependent on how well 

banks balance financial reward with economic risk. 

Cottrell L. Webster, Regional Director 

Memphis, Tennessee 

Memphis Regional Outlook 12	 Fourth Quarter 2000 
In Focus This Quarter
 

Emerging Risks in an Aging Economic Expansion
 

•	 The economy and the banking and thrift industries are reporting generally healthy conditions. 

However, the economic expansion is aging, and it 

is unlikely that the vigor experienced during the 

first half of 2000 can be sustained. 

•	 Likewise, record banking and thrift industry 

profits, healthy capital cushions, and good asset 

quality of recent years may not be sustainable. 

Declining net interest margins, rising commercial 

loan losses, tighter liquidity, and riskier asset 

composition are among the warning signs that 

industry performance may have peaked for this 

business cycle. 

•	 Specific areas of concern include growing reliance 

on noncore funding; heightened interest rate risk; 

increased exposure to market-sensitive revenues; 

deteriorating credit quality; rising leverage 

among businesses and households; and signs of 

imbalance in some residential and commercial 

real estate markets. 

Although no readily apparent situations or imbalances 

suggest that a recession or widespread banking problems will develop in the near term, warning signs are 

present. A highly competitive banking industry shapes 

the environment in which pressures on insured institutions are unfolding. The presence of a large share of 

newly chartered banks in some areas appears to be raising the risk profile among all institutions in certain markets. Publicly owned companies remain under intense 

pressure to grow earnings and increase shareholder 

value. In addition, local banking environments exist in 

which a confluence of risks is generating heightened 

vulnerability for all participants, even during healthy 

economic times. Complacency in these environments 

may have negative repercussions for many insured institutions going forward. 

Imbalances Are Appearing amid a Healthy 

Macroeconomic Environment 

The performance of the U.S. economy contributes to the 

opportunities and risks financial institutions face. The 

current cyclical expansion, now nine and one-half years 

old, is displaying signs of aging while setting a record 

for longevity. A consensus forecast calls for moderate 

real gross domestic product (GDP) growth through 

2001, following robust gains in the first half of 2000. 

Current conditions might be called a “soft landing,” in 

which real GDP growth slows to a sustainable noninflationary rate of 2.5 to 3.5 percent, and unemployment 

hovers around recent rates. 

Although the current macroeconomic environment 

might appear to be the best of all possible worlds, areas 

of concern exist. One is that sustained prosperity tends 

to foster higher levels of risk taking, overconfidence, 

and complacency. For example, the turmoil in world 

foreign exchange and financial markets during 1997 

and 1998 illustrates how dramatic imbalances can 

develop and trigger disruptive adjustments even during 

healthy economic times. 

Currently, no specific situation or imbalance seems to 

threaten the viability of the expansion. However, as 

detailed below, several likely will contribute to slower 

economic growth. Situations that warrant monitoring 

include the following: 

•	 The repercussions from higher energy prices are 

unfolding. Historically, oil price shocks have weakened several other long-lived economic expansions. 

•	 Short-term interest rates rose over the past year while 

longer-term rates declined, resulting in a modest 

inversion of the yield curve. This relationship may 

inhibit the profitability of some lenders’ practice of 

borrowing short term and lending longer term and 

also complicate the interest rate risk management 

process for some insured institutions. 

•	 Continuing low unemployment suggests that demand 

for additional workers will go unfilled, thus limiting 

economic growth or triggering bidding wars that 

increase workers’ compensation and, potentially, 

inflation. 

•	 Stock market sentiment is no longer strongly bullish. 

A pullback from high valuations and optimism could 

trigger negative repercussions on consumers’ net 

worth and spending as well as on the level of business investment. 

•	 A large international trade deficit and strong U.S. 

dollar may be an unsustainable combination over the 

Memphis Regional Outlook 13	 Fourth Quarter 2000 
In Focus This Quarter
 

long run. Meanwhile, repatriated profits of U.S. corporations are being trimmed by the dollar’s strength 

relative to the euro and other currencies. 

•	 Household debt burdens are historically high, with 

leverage rising the most in recent years among lowand middle-income households. These households’ 

access to credit has increased as lenders competed 

more fiercely for customers. 

•	 Corporations are more highly leveraged, and potential default risk rose in the past year across a range of 

industries. Meanwhile, downgrades of publicly traded corporate debt issues are exceeding upgrades by a 

2 to 1 ratio. 

•	 In some metropolitan areas, overheated housing markets are developing, in which home prices are rising 

dramatically and exceeding gains in median 

incomes. 

•	 Potential signs of excess commercial real estate construction are appearing in several urban areas where 

banks’ construction loan growth also is strong. 

Economic indicators of what lies ahead are not clearcut, and each possible scenario contains a set of potential challenges for insured institutions and regulators. 

Should economic growth slow considerably, current 

vulnerabilities, such as highly leveraged borrowers’ 

debt loads and overheated housing markets, could worsen significantly. As evidenced by the rash of bank failures during the 1980s, it doesn’t always take a national 

recession for problems to develop. Alternatively, sustained rapid growth might foster new vulnerabilities and 

allow current imbalances to intensify or build up. For 

example, speculative construction could accelerate, 

stock market volatility could increase, or ballooning 

trade deficits could generate turmoil in foreign 

exchange markets. 

Signs of Strain Are Also Appearing 

amid Healthy Banking and Thrift Industries 

With the long economic expansion as a backdrop, 

insured institutions in the aggregate are performing 

very well. However, the record profits attained in recent 

years may not be sustainable. The losses posted recently by several large institutions are striking examples of 

increased appetite for risk resulting in significant financial loss during a period of strong economic growth. 

While these are isolated instances, they are indicative of 

the increasingly competitive environment facing the 

financial services industry. 

Overall industry profitability is beginning to soften, led 

primarily by rising commercial loan losses at large institutions and declining net interest margins in institutions 

of all sizes. Credit card loss rates, which had been 

steadily falling since late 1997, have stalled in recent 

quarters, suggesting that recent increases in interest 

rates and energy costs not only are affecting businesses 

but also are taking a toll on some consumers. Other 

signs suggesting that aggregate risk within the system 

has risen include the growing reliance on noncore funding to support asset growth, heightened interest rate risk 

at many institutions, growing concentrations in traditionally higher-risk loan classes, and a shift in institutions’ overall asset mix toward higher-risk categories. A 

brief discussion of these risks follows. 

Funding Patterns Heighten Liquidity Concerns 

Lackluster core deposit growth is placing pressure on 

bank earnings and contributing to rising liquidity risk in 

the banking system. During the past five years, the compounded annual rate of core deposit growth for all 

insured institutions was just 2.8 percent. Assets over this 

time grew at a 6.6 percent rate. Accordingly, a significant portion of the industry’s growth has been funded by 

noncore sources (see Chart 1). The higher cost and rate 

sensitivity of these funds put downward pressure on net 

interest margins, particularly in a rising rate environment. 

CHART 1 

Most of $2 Trillion of Asset Growth since 1995
 

Was Funded with Noncore Funds
 

Subordinated Debt 

and Other Liabilities

 5% 

9% 

Equity 

22%
 

Core Deposits
 

64%
 

Noncore Funding
 

Source: Bank and Thrift Call Reports, June 2000 and June 1995 

Memphis Regional Outlook 14	 Fourth Quarter 2000 
In Focus This Quarter
 

To compensate for higher funding costs, the industry 

has pursued growth in higher-yielding asset classes that 

are traditionally both riskier and less liquid. For example, almost 37 percent of the asset growth in the past 

five years has come from nonresidential real estate and 

commercial and industrial loans. 

For institutions that fund illiquid assets with wholesale 

sources, any adverse events that trigger a lack of confidence in the institution may result in higher funding 

costs, thus placing further pressure on margins. In 

efforts to obtain funding, an institution also may pledge 

a greater portion of its best quality assets as collateral, 

further reducing liquidity. Finally, in instances where 

funding needs have exceeded available liquidity, the 

forced sale of illiquid assets to meet funding outflows 

could result in losses if market conditions are unfavorable. Presumably, the FDIC, as insurer, would suffer 

greater losses if such an institution failed, because it 

would be relying on proceeds from the liquidation of 

less liquid, and potentially lower-quality, assets to satisfy 

the claims of insured depositors. 

Subprime lenders, in particular, tend to rely heavily on 

noncore funding to pursue aggressive growth strategies. 

Chart 2 illustrates the extent to which noncore funding 

exceeds the level of liquid assets for this group. The 

chart suggests the difficulty these institutions may 

encounter if forced to convert assets to meet funding 

outflows. Although subprime lenders may use noncore 

sources to fund riskier assets to a greater extent than the 

industry at large, this illustration exemplifies a systemic 

trend that is raising liquidity risk industrywide and is 

increasing risk to the insurance funds. 

Increasing Levels of Interest Rate Risk 

Challenge Some Institutions 

The refinancing boom of the late 1990s spurred a significant shift into longer-maturity assets for many 

insured institutions. During this period, a vast majority 

of mortgage borrowers opted for longer-term, fixed-rate 

loans, which they obtained at historically low rates. A 

great deal of the higher-rate or adjustable-rate loans that 

borrowers refinanced were held in the portfolios of 

insured institutions, which contributed to a general 

lengthening of the maturity of assets held at insured 

institutions. 

The trend toward longer-term, fixed-rate assets has been 

particularly pronounced among mortgage lenders. For 

example, state-chartered savings banks, which are traditionally mortgage lenders, have experienced a dramatic 

increase in long-term assets. As of June 30, 2000, 

almost 45 percent of the median savings bank’s earning 

assets were not scheduled to reprice for five years or 

longer (see Chart 3). 

Fixed-rate mortgage-related assets at federally chartered thrifts have risen similarly. From year-end 1995 

through first quarter 2000, the percentage of fixed-rate 

mortgage-related assets at thrifts with assets less than 

$1 billion rose from 49 percent to 60 percent of 

mortgage-related assets. Some thrifts and savings 

banks, therefore, have significant exposure to rising 

rates from low-yielding long-term assets. 

CHART 2 $ Billions 

Source: FDIC Division of Supervision and Bank and Thrift Call Reports (data are 

merger adjusted) 

Subprime Lenders’ Growing Dependence

 on Noncore Funding Strains Liquidity 

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

0 

30 

60 

90 

All other loans 

Residential real estate loans 

Securities and shortterm investments 

Columns: Noncore funding 

CHART 3 

Growing Concentration in Long-Term 

Assets Elevates Interest Rate Risk 

Source: Bank Call Reports, excluding Thrift Financial Report filers 

Share of Assets Maturing or Repricing in Five Years or Longer 

Relative to Total Earning Assets (median percentage) 

Percent 

Savings Banks 

Commercial Banks 

50 

0 

10 

20 

30 

40 

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

Memphis Regional Outlook 15 Fourth Quarter 2000 
In Focus This Quarter
 

While most commercial banks do not have as high 

exposure to rising rates as savings banks, some may 

have taken on significant risk. The median savings bank 

has a ratio of long-term assets to earning assets that corresponds to the ratio level for the 93rd percentile of 

commercial banks. Although the 93rd percentile is in 

the tail of the commercial bank distribution, almost 600 

commercial banks have a concentration in long-term 

assets that exceeds that of the median savings bank. 

These institutions may be exposed to significant interest rate risk as well. 

While assets have lengthened considerably for many 

institutions, there has not been a corresponding extension of liabilities. To the contrary, funding pressures are 

tending to make bank liabilities more rate sensitive. 

These diverging trends generate concern, especially in a 

rising interest rate environment. That is, rate increases 

drive up the cost of funds more rapidly than earning 

asset yields at institutions with liability-sensitive interest rate risk postures. In a significantly higher interest 

rate environment, many institutions’ current postures 

likely would cause heavy margin erosion. 

Most institutions that have high concentrations in longterm assets also have strong capital and an asset mix 

that contains lower credit risk than that of many other 

institutions. Among savings banks, interest rate risk primarily arises from significant concentrations in residential mortgage loans, whereas the typical commercial 

bank’s exposure is more likely to arise from large holdings of long-term securities. However, some institutions 

with concentrations in long-term assets also may have 

lower capital levels, a higher-risk asset mix, or poor 

earnings. Rising rates could weaken these institutions 

and make it more difficult for them to weather adverse 

economic or other developments. 

Dependence on Market-Sensitive Revenues 

Increases Earnings Volatility for Some 

Institutions 

During the recent generally favorable conditions in financial markets, the share of revenue earned from business 

lines susceptible to financial market volatility has 

increased substantially for some of the industry’s largest 

institutions. Among these revenue sources are fees and 

gains from asset management, brokerage, investment 

banking, venture capital, and trading activities. The 19 

institutions most active in these lines of business earned 

over 26 percent of their net operating income from such 

sources in the second quarter of 2000. Other large institutions also have reported a growing dependence on these 

volatile sources of revenue. 

Turbulence in the financial markets has led to greater 

earnings volatility for some of these institutions. Stress 

in the financial markets could weaken the demand for 

underwriting services or significantly reduce trading 

revenues or venture capital gains. Furthermore, the 

same factors that are causing volatility in the financial 

markets could hamper loan growth and lead to slower 

revenue growth from core business lines. Should 

increased earnings volatility from exposure to marketsensitive revenues combine with slower revenue growth 

from core business lines, some institutions could face 

significant earnings challenges. 

The Rising Level of Problem Business Loans 

Is Centered in Large Banks 

Second quarter 2000 commercial and industrial (C&I) 

credit quality indicators at banks deteriorated for the 

eighth consecutive quarter. Noncurrent C&I loans— 

those on nonaccrual status plus those 90 days or more 

past-due—rose 13 percent over first quarter 2000 levels 

to $14.5 billion, or 1.4 percent of total C&I loans. Noncurrent loan levels for the period ending June 2000 were 

40 percent higher than the year-earlier level. Net C&I 

loan loss rates also continue to edge higher but remain 

well below those experienced by banks in the late 1980s 

and early 1990s.1 

Large banks, particularly those active in syndicated 

lending, are bearing the brunt of deteriorating C&I loan 

quality. Recent increases in criticized and classified 

shared national credits (SNCs), which are loans exceeding $20 million that are shared among three or more 

lending institutions, are illustrated in Chart 4. In the 

2000 SNC review, criticized and classified credits 

increased 44 percent over 1999 levels to 5.1 percent of 

total SNC commitments. Furthermore, the bulk of the 

increase was in the more severe classified categories, 

which now comprise 64 percent of total criticized and 

classified credits, compared with 54 percent at the yearearlier review. 

11

During second quarter 2000, banks posted an annualized net C&I 

loss rate of 0.67 percent, up from 0.55 percent for second quarter 

1999. For comparison purposes, net quarterly annualized C&I loss 

rates averaged 1.11 percent from fourth quarter 1991 to fourth quarter 

1993. 

Memphis Regional Outlook 16 Fourth Quarter 2000 
In Focus This Quarter
 

CHART 4 

Note: C&I = commercial and industrial; SNC = shared national credit 

Source: Shared National Credit Program 

Syndicated Loan Problems Are on the Rise 

Percent

$ Billions 

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

Criticized and 

Classified SNC Loan 

Commitments (right 

scale) 

Percentage of SNC 

Commitments Criticized 

and Classified (left scale) 

0 

2 

4 

6 

8 

10 

12 

14 

16 

0 

20 

40 

60 

80 

100 

120 

140 

C&I loan quality indicators continue to deteriorate 

despite generally favorable economic conditions. Three 

factors explain much of this deterioration: certain weak 

industries, rising corporate debt burdens, and the seasoning of syndicated loans underwritten from 1997 to 

1998, when many banks significantly eased business 

lending standards. 

Industry Sector Weaknesses 

The financial stresses facing healthcare and entertainment companies (cinema operators in particular) have 

been well publicized. While the healthcare and entertainment sectors have contributed significantly to the 

decline in commercial credit quality, problems within 

these two sectors do not account for the full extent of 

the increase in noncurrent loans and problem SNC 

loans. Both of these sectors are within the broader services sector, which experienced a $4.6 billion increase 

in criticized and classified credits from the 1999 to the 

2000 SNC review. However, this increase accounts for 

only 15 percent of the $30.8 billion increase in criticized and classified SNCs overall.2 The expected 

default probabilities evident in market-based information can be used to identify other industry sectors experiencing financial stress. KMV LLC has developed a 

model that uses publicly available information to estimate the likelihood of default of individual firms.3 

2 See the interagency release of SNC results at www.occ.treas.gov/
 

ftp/release/2000-78a.pdf.
 

3 KMV Credit Monitor® uses information from a firm’s equity prices
 

and financial statements to derive KMV’s Expected Default Frequency (EDFTM), which is the probability of the firm defaulting within a
 

one-year period. The main determinants of a firm’s likelihood of
 

default: the firm’s asset value, the volatility of the firm’s asset value,
 

and the degree of financial leverage.
 

KMV’s model is used by many lenders to monitor and 

evaluate obligor risk and credit risk trends. Applied to 

the analysis of industries, the output of KMV’s model is 

just one of a number of indicators that suggest weaknesses in certain industry sectors. 

Sectors that include a high proportion of firms with 

high default probabilities (median one-year default 

probabilities exceeding 4 percent) are shown in Chart 5. 

Using entertainment as an example, the bars in the chart 

show that in September 2000, one-half of publicly held 

entertainment firms had greater than an 8 percent 

chance of defaulting on their obligations within one 

year. In September 1999, this same proportion of entertainment companies had a substantially smaller (6 percent) chance of defaulting within a 12-month period. 

The median likelihood of default for all the industries 

shown in the chart far exceeds that of Standard & 

Poor’s-rated, BB-grade (sub-investment-grade) obligors 

as of September 2000, as indicated by the dotted line in 

the chart. 

Rising Corporate Debt Burdens 

U.S. corporate debt burdens, as measured by the debtto-net-worth ratio for nonfarm, nonfinancial businesses, 

continue to increase. This ratio reached 83 percent in 

the second quarter of 2000, up from 72 percent as of 

year-end 1996. Although debt burdens remain below the 

1988–1992 average of almost 87 percent, U.S. businesses are nevertheless becoming increasingly vulnerable to rising credit costs and disruptions in credit 

availability. 

CHART 5 Median Expected Default Frequency (EDFTM) (percent) 

Various Industries Show High Levels 

of Expected Default Risk 

Comparative EDFTM

 of S&P Bonds Rated BB 

(as of September 2000) 

Source: Credit MonitorTM ©2000, KMV LLC, all rights reserved 

Entertainment 

HealthcareWholesale Trade 

Apparel &Textile

Misc. Manufac. LodgingMining 

AgricultureConstruction 

Retail

0 

1 

2 

3 

4 

5 

6 

7 

8 

9

 September 1999

 September 2000 

Memphis Regional Outlook 17 Fourth Quarter 2000 
In Focus This Quarter
 

Seasoning of 1997–1998 Vintage Loans 

Results of recent supervisory surveys suggest that 

banks are tightening terms and conditions on loans to 

small-, middle-, and large-market obligors. However, 

this tightening follows a relaxation of standards in prior 

years that has contributed to a heightened level of risk 

in banks’ loan portfolios.4 Not coincidentally, the period 

between 1995 and 1998 saw a sharp rise in the proportion of lower-graded, higher-risk credits categorized as 

leveraged transactions by Loan Pricing Corporation. 

Leveraged loan originations—those priced at 150 basis 

points or more over the London Inter-Bank Offer Rate 

(LIBOR)—rose from 12 percent of total syndicated 

loan originations in 1995 to 31 percent in 1999. According to a recent Standard and Poor’s commentary, many 

banks have acknowledged that 1997 and 1998 vintage 

credits are beginning to produce higher problem loan 

levels.5 

Household Sector’s Leverage Is High, 

and Imbalances Are Appearing 

Consumers are enjoying the benefits of the economic 

expansion, as jobs are plentiful, home ownership 

remains generally affordable, and credit seems to be 

readily available for financing motor vehicles and other 

major purchases. These conditions contributed to record 

high sales of cars and light trucks during the first nine 

months of 2000, helping sustain the consumer spending 

growth shown in Chart 6. One corollary of high vehicle 

sales, however, is softening prices for used vehicles. 

Consequently, some lessors—including banks—are 

realizing lower-than-expected residual values on leased 

vehicles, which, in turn, are triggering losses in their 

lease portfolios. This situation illustrates one problem 

that lenders can encounter even in good economic 

times. 

Spending growth remained robust in recent quarters 

even as gains in disposable income slowed. The gap 

between income and spending growth is “financed” as 

households draw down savings, tap capital gains, refinance mortgages, assume more debt, or undertake some 

combination of these measures. 

4 See Federal Reserve Board’s Senior Loan Officer Opinion Survey on 

Bank Lending Practices for May and August 2000 and Surveys of 

Credit Underwriting Practices for 1999 and 2000 from the Office of 

the Comptroller of the Currency. 

5 “U.S. Bank Loan Portfolios Reflect Rise in Corporate Bond 

Defaults.” July 20, 2000. Standard and Poor’s Commentary. 

CHART 6 

Household Spending Growth 

Exceeds Income Growth 

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

Real Consumption Spending 

Real Disposable Income 

7 

–1 

0 

1 

2 

3 

4 

5 

6

Annual Growth Rate (percent) 

’86 ’87 ’88 ’89 ’90 ’91’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99’00 

Quarter 3 

From 1995 through 1998, and likely since then, the 

increase in both leverage and debt servicing burdens has 

been concentrated among low- and middle-income 

households. Among families holding debt in 1998, debt 

payments exceeded 40 percent of disposable income for 

nearly 20 percent in the $10,000 to $24,999 income 

group and nearly 14 percent in the $25,000 to $49,999 

group.6 One concern is that these debt-laden families 

may have inadequate financial resources to make payments should adverse conditions or job loss occur. In 

such instances, lenders could be doubly affected if 

households draw on their credit card and home equity 

lines of credit, further compromising their repayment 

ability, in order to sustain spending in excess of income. 

The recent rise in credit card losses in banks’ card portfolios and rising losses in the portfolios of subprime 

lending specialists may indicate that strains among 

some households are spilling over to lenders. Moody’s 

Investors Service expects credit card losses to rise 

through 2001, according to a recent analysis of 

prospects for the U.S. credit card industry. 

Overheated residential real estate markets in several 

metropolitan statistical areas (MSAs) may be another 

warning of economic imbalances. Dramatic gains in 

home resale prices in San Francisco stand out (see Chart 

7), but this market is not alone in experiencing appreciation considerably higher than income growth. In 

some markets, where financial-services or informationtechnology workers are concentrated, bidding wars for 

properties may reflect the fact that affordability is 

6 Kennickell, Arthur B., Martha Starr-McCluer, and Brian J. Surette. 

January 2000. “Recent Changes in U.S. Family Finances: Results 

from the 1998 Survey of Consumer Finances.” Federal Reserve 

Bulletin. Vol. 86, 1–29. 

Memphis Regional Outlook 18 Fourth Quarter 2000 
In Focus This Quarter
 

enhanced by gains in wealth rather than in income. 

Even so, similar surges in home resale prices in the 

past often were not sustainable. The subsequent years 

of stagnant or falling collateral values caused financial 

stress among some homeowners and their lenders. 

Further concern about residential real estate lenders 

arises because pockets of speculative construction 

under way in some markets may produce units that 

become increasingly difficult to sell at anticipated asking prices. 

Construction and Development 

Loan Growth Is Accelerating 

Commercial real estate (CRE) construction across all 

property sectors has grown during this expansion, with 

office construction particularly active. The amount of 

office space completed in mid-2000 was the largest 

since 1989 and is projected by Torto Wheaton Research 

to continue rising. Not surprisingly, construction and 

development (C&D) loan volume, growth rates, and 

concentrations are trending upward rapidly. While total 

private real estate spending grew about 6.5 percent over 

the four quarters ending midyear 2000, C&D loans at 

insured institutions rose by 26 percent. C&D loan 

growth has remained above 20 percent since 1997, and 

the aggregate volume of C&D loans is the highest since 

1989. 

Such growth is contributing to higher concentrations of 

C&D loans relative to Tier 1 capital. At current levels, 

concentrations do not begin to approach those of the 

late 1980s. However, several metropolitan areas have a 

CHART 7 

Median Home Resale Prices Soar 

in San Francisco Bay Area 

Percent Change from

Four Quarters Earlier 

Quarter 1 

–10 

–5 

0 

5 

10 

15 

20 

25 

30 

35 

’80 

’82 

’84 

’86 

’88 

’90 

’92 

’94 

’96 

’98 

’00

large percentage of insured institutions reporting high 

and rising concentrations. Table 1 (next page) shows 

MSAs with at least 15 nonspecialized community 

banks7 and at least one-third of those institutions reporting concentrations in C&D loans equal to at least 100 

percent of Tier 1 capital. The Atlanta MSA stands out. 

Sixty-five percent of Atlanta’s 85 nonspecialized community institutions reported C&D loans exceeding 100 

percent of Tier 1 capital on June 30, 2000, and 35 percent reported a concentration exceeding 200 percent. 

The aggregate C&D concentration for all 85 institutions 

in the MSA was 156 percent, the highest among MSAs 

with at least 15 institutions of similar size and nature. 

Several other markets also include significant shares of 

institutions with high concentration levels. 

Nine of the 16 markets highlighted in Table 1 not only 

have a relatively high percentage of C&D loan exposure but also appear vulnerable to overbuilding in two 

or more property types.8 While these markets show no 

clear signs of emerging economic stress, lenders there 

clearly may be at greater risk should economic or real 

estate conditions sour. Other concerns regarding CRE 

lending arise from a recent Office of the Comptroller 

of the Currency survey, which reports heightened 

credit risk in CRE portfolios and predicts it will 

increase through 2001. In addition, respondents to a 

midyear 2000 FDIC survey of examiners reported 

more frequent comments about excess office and retail 

space. 

Increasing Share of De Novo Institutions 

Raises the Stakes in Some Markets 

A common element among the metropolitan markets 

listed in Table 1 (next page) is the presence of newer 

institutions. In 10 of the 16 markets, at least 20 percent 

of the nonspecialized community institutions are less 

than three years old. The drive to build market share 

among these institutions, particularly if they are publicly traded entities, is increasing the competitive pressure on banks and thrifts in these markets. In some 

instances, the aggregate cost of deposits within the 

MSAs has risen faster than in the nation as a whole, risk 

7 The term “nonspecialized community bank” refers to institutions 

with total assets under $1 billion that are not specialty institutions 

such as credit card or trust banks. 

8 See “Ranking Metropolitan Areas at Risk for Commercial Real 

Estate Overbuilding,” Regional Outlook, third quarter 2000, which 

identifies markets where new construction is high relative to existing 

stocks of space. 

Source: National Association of Realtors via Haver Analytics, Inc. 

Memphis Regional Outlook 19 Fourth Quarter 2000 
In Focus This Quarter
 

TABLE 1 

High C&D Loan Exposure Appears in Various MSAs 

SHARE (%) OF AGGREGATE C&D LOANS 

MSAS WITH 15 OR INSTITUTIONS* WITH C&D RELATIVE TO AGGREGATE 

MORE NONSPECIALIZED CONCENTRATIONS > OR = TIER 1 CAPITAL (AS %) 

COMMUNITY INSTITUTIONS* 100% OF TIER 1 CAPITAL IN THIS MSA* 

ATLANTA, GA 65 156 

PHOENIX–MESA, AZ 56 131 

MEMPHIS, TN–AR–MS 52 154 

PORTLAND–VANCOUVER, OR–WA 47 146 

OAKLAND, CA 47 163 

NASHVILLE, TN 44 103 

RIVERSIDE–SAN BERNARDINO, CA 42 110 

SAN DIEGO, CA 41 90 

GRAND RAPIDS–MUSKEGON–HOLLAND, MI 40 81 

SEATTLE–BELLEVUE–EVERETT, WA 39 98 

SALT LAKE CITY–OGDEN, UT 38 56 

FORT WORTH–ARLINGTON, TX 38 110 

DALLAS, TX 36 95 

LAS VEGAS, NV–AZ 35 119 

LEXINGTON, KY 34 80 

DENVER, CO 33 113 

*Sample includes institutions with total assets under $1 billion that are not specialty institutions such as credit 

card or trust banks. 

Note: Boldface indicates major MSAs identified at risk for excess commercial real estate construction in Regional 

Outlook, third quarter 2000. 

C&D = construction and development, MSA = metropolitan statistical area 

Source: Bank and Thrift Call Reports for June 30, 2000 

profiles are being elevated, and aggregate leverage ratios 

are falling, despite the influx of capital from the new 

institutions. Highly competitive environments have the 

potential to increase risk taking by negatively affecting 

underwriting standards and balance sheet composition. 

Farm Sector Challenges Continue 

Much of the agricultural industry is experiencing 

stress because of low commodity prices, compounded 

in some areas by low yields resulting from weather- or 

disease-related problems. Strong global competition 

and high worldwide production during the past several years have resulted in large crop inventories, 

depressed prices, and limited prospects for a price 

turnaround in the near term. In the aggregate, record 

levels of government payments have helped the 

nation’s farms maintain a generally stable financial 

condition but have not eliminated the stress in this sector. In fact, the U.S. Department of Agriculture projects that at least one in four farm businesses in several regions9 will not cover net cash expenses in 2000, 

suggesting that the viability of highly leveraged farmers may be in question. 

Fortunately, the aggregate condition of nearly 2,100 

insured agricultural banks—institutions with 25 percent 

or more of loan portfolios in agricultural credits— 

remains healthy. Generally, agricultural banks continue 

to report favorable asset quality, earnings, and capital 

positions. However, they are experiencing somewhat 

elevated levels of noncurrent loans compared with 

nonagricultural institutions. Agricultural banks are disproportionately represented among the weakest 25 percent of institutions nationwide in terms of noncurrent 

9 These are USDA’s Basin and Range, Mississippi Portal, Fruitful 

Rim, and Southern Seaboard regions. See www.ers.usda.gov/ 

briefing/farmincome/fore/regional/regional.htm. 

Memphis Regional Outlook 20 Fourth Quarter 2000 
In Focus This Quarter
 

loan levels. In addition, rising levels of carryover debt at 

farm banks may translate into higher losses in the future 

if commodity prices remain low. 

The strains in the farm sector also have implications for 

nonfarm banks in agricultural areas. In several agriculturedependent states, such as Montana and the Dakotas, for 

example, where farmers’ earnings are depressed and the 

economies not well diversified, nonagricultural banks 

are reporting higher noncurrent levels than insured 

institutions elsewhere in the nation. 

Summary 

The long-lived economic expansion has contributed to 

the banking and thrift industries’ record levels of profitability and asset quality. However, as the expansion has 

matured, both consumer and corporate leverage has risen 

considerably. Bank liquidity is becoming increasingly 

strained by lackluster core deposit growth, which has 

been insufficient to fund strong loan demand. This trend 

has resulted in a decided shift into higher-risk asset 

classes to mitigate margin pressures arising from the 

greater reliance on noncore-funding sources. Furthermore, interest rate risk has risen significantly for many 

institutions, and after nearly a decade of improving asset 

quality, the level of problem loans is increasing. 

Clearly, high levels of profitability in recent years have 

been achieved, in part, by an increased appetite for risk. 

Concern arises because insured institutions’ current 

profitability is being negatively affected by some recent 

trends, despite the sustained economic expansion. And, 

while capital levels have remained fairly stable, the 

amount of risk being leveraged on the industry’s capital 

base is on the rise. Just as a rising tide is said to float all 

boats, a strong economy can mask potential problems 

that will become evident should the economic tide turn, 

particularly in institutions or markets where aboveaverage risk is concentrated. Insured institutions’ safety 

and soundness may be most vulnerable in situations 

where banks and thrifts are exposed to multiple challenges, whether because of strategic decisions or 

because of repercussions from economic and banking 

forces beyond their control. 

Daniel Frye, Regional Manager 

Joan D. Schneider, Regional Economist 

Steve Burton, Senior Banking Analyst 

Allen Puwalski, Senior Financial Analyst 

Ronald Spieker, Chief, Regional Programs 

and Bank Analysis 

The authors would like to acknowledge 

the Washington and regional staff of 

both the Division of Insurance and 

the Division of Supervision for their 

analyses and comments, which were 

instrumental in writing this article. 

Memphis Regional Outlook 21 Fourth Quarter 2000 
✁
 

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