FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1997
 

FDIC

 KANSAS CITY
 

REGION
 

DIVISION OF
 

INSURANCE
 

CRAIG A. RICE,
 

SENIOR REGIONAL
 

ANALYST
 

JOHN M. ANDERLIK,
 

FINANCIAL ANALYST
 

In Focus This Quaitei
 

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

some institutions are using credit scoring technology to reduce underwriting costs and

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

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

overreliance on credit scoring models could expose lenders to increased credit risks.

Over time, the traditional niche enjoyed by small banks in small-business lending could

come under considerable pressure. See page 3.

• Banking on the Internet: New Technologies, New

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

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

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

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

Regu[ai Featuies
 

+Regional Economy +Financial Markets +Regional Banking

 · Job Growth · Asset-Backed Securities · Overall Conditions

 · Tight Labor Markets · Bond Values · Credit Card Losses

 · Growth in Kansas City · Price/Earnings Ratios · Cattle Sector

 · Cattle · Farm Bank Challenges

 · Grains

 · Pork

See page 17 See page 17 See page 21

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

Insurance Corporation for the following eight geographic regions:

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Center for current pricing on bulk orders.

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

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

Outlook, please call Craig Rice at (816) 234-8034 or send an e-mail to crice@fdic.gov.

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

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

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

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

the Federal Deposit Insurance Corporation.

Chairman Ricki Helfer

Director, Division of Insurance Arthur J. Murton

Editor George E. French

Managing Editor Stephen Linehan

Associate Editor Maureen E. Sweeney

Assistant Editors Paul C. Bishop

Steven K. Burton

Richard A. Brown

Diane Ellis

Kathy R. Kalser

Ronald L. Spieker

Publications Managers Nancy Maginn

Diane Ellis

Publication Date: April 24, 1997
 
In Focus This Quarter
 

WillfCreditfScoringfTransformfthefMarketffor
 

Small-BusinessfLending?
 

• 	 Small-business lending, traditionally a segment in

which small banks have enjoyed comparative

advantages, is receiving greater focus from

larger banks and nonbank financial companies.

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

loan underwriting to include the use of credit

scoring models.

• 	 The use of small-business lending credit scoring

models, while providing banks opportunities for

underwriting and servicing efficiencies, carries

with it a number of potential risks.

Background

As of 1994, there were more than 22

million small businesses in the U.S.,

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

business in which small banks have

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

spread over smaller loan balances. Some institutions

are now beginning to use credit scoring technology to

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

especially, appear to be looking to the efficiencies of

credit scoring to help provide quick loan approvals and

more competitive loan rates. With the aid of this

technology, some institutions are rapidly expanding their

loan portfolios, in some cases venturing into markets

well beyond their local economies.

Commercial bank small-business lending exposures in

the Kansas City Region are considerable. (For purposes

of this article, small-business lending refers to loans

categorized as commercial and industrial loans with

original amounts of $1 million or less reported on the

June Call Reports.) At midyear 1996, commercial

banks in this Region reported $21 billion in smallbusiness loans, amounting to 55 percent of all commercial and industrial loans. This level is an increase of

$1.2 billion, or 6 percent, from one year ago. There are

722 banks in the Region with small-business loan exposures exceeding 100 percent of equity, and 124 of those

have exposures exceeding 200 percent of equity.

In the Region, small-business loans are fairly evenly

distributed among large banks (those with over $1

billion in assets), small banks (those with under $100

million in assets), and midsized banks. However, as

illustrated by Chart 1 (next page), the Region's large

banks dominate the market for small-business loans over

$250 thousand, while the Region's small banks control

the market for business loans under $100 thousand.

Clearly, the Region's large banks and small banks have

historically concentrated their lending efforts toward

different segments of the small-business sector.

However, recent trends indicate that large banks are

increasing their efforts to compete with small banks

for smaller business credits. While mid-1996 data do

not indicate that the Region's small banks are losing

market share, the Region's large banks do appear to be

making inroads in the market for business loans under

$100 thousand. Large banks grew such credits by

almost 6 percent in 1996, while small banks posted 4

percent growth. This trend is likely to become more

pronounced as some of the Region's largest banking

companies have recently announced nationwide programs to increase their market share of small-business

lending. These programs may have been prompted by

the new credit scoring.

ThefGrowingfImportancefoffCreditfScoring

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

Primarily using credit bureau information, credit scoring provides

lenders with a tool to rank risks or

probabilities of default, assigning

statistically derived numerical ratings or scores based upon a borrower's past experience

with paying debt. Based upon the enormous volume of

historical information on consumers contained in credit

bureaus, model developers link incidences of good and

bad credit performance with borrower characteristics.

Regional Outlook	 3 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

CHART 1
 

The Region's Large and Small Banks Have Well-Defined Small-Business Loan (SBL) Niches
 

0%

10%

20%

30%

40%

50%

Small Banks

Mid-si e Banks

Market Share 

of Category

47%

Large Banks

49%

All SBLs SBLs Under SBLs Between SBLs Between

in the Region $100,000 $100,000 - $250,000 $250,000 - $1,000,000

Source: June 30, 1996, Bank Call Reports

Applicants then are compared to these credit performance indicators in order to make credit extension

decisions. While credit scoring has helped consumer

lenders reduce origination costs and to grow receivables at rapid rates, the recent rise in credit card

charge-offs has raised concerns about the effectiveness

of such models, or at least about how the models are

being used.

Small-business credit scoring is a relatively new concept in scoring technology, but is gaining more attention

from lenders. Small­business credit scoring models

are similar to consumer credit scoring models in one

significant aspect ­­ the most important indicator of

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

bureau information. Other business information from

companies such as Dun and Bradstreet Corporation and

Experian (formerly TRW) also is used in the scoring

process.

A primary vendor of these scoring models has cited

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

credit performance for small-business loans. The reasons for this result may be due to inconsistency in

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

of principals' credit history and financial statement

information in predicting credit performance was found

to change somewhat with the size of the business -- the

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

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

significant characteristics of credit scoring. In many

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

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

loan applications. In some cases, financial statements

are not required at all. Reducing paperwork helps to

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

as reported by one large bank at a recent conference on

credit scoring. While it is impossible to know whether

the information presented in Table 1 is representative of

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

significant departure from traditional underwriting

methods.

Part of the reduction in underwriting costs may come

from improvements in the allocation of underwriting

TABLE 1

SMALL-BUSINESS LENDING: CREDIT SCORING

VERSUS TRADITIONAL LOAN UNDERW RITING

1993 1996 1997

PERCENT OF LOANS

REQUIRING ANNUAL 100% 20% - -

FINANCIAL STATEMENTS

PERCENT OF LINES

REVIEWED ANNUALLY 100% 0 - 5% - -

PROCESSING TIME FOR LOANS 3 1 1

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

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

CREDIT SCORING.

Regional Outlook 4 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

resources. It has been argued that credit scoring allows

banks to more easily identify those applicants which are

clearly either approvals or denials. This process would

enable banks to reallocate their underwriting resources

more efficiently to those loans which pose intermediate

risks and require closer attention. Other advantages of

credit scoring systems that often are cited are greater

consistency in underwriting, better measures for pricing

strategies, and the potential to enhance the ability to

securitize small-business loans.

WhatfArefthefRisks?

Small-business lending has historically been a profitable area of bank lending. This situation is most likely

attributable to lenders thoroughly analyzing potential

customers, persistently monitoring their performance,

and building solid lending relationships. Credit scoring

for small-business lending raises the possibility that

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

lending. To the extent that credit scoring is used to

rapidly gain new customers by either targeting out-ofterritory customers, or customers with less business

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

change in profile may be significant due to the risks

associated with newer borrowers. For example, new

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

percent of new businesses failing within the first four

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

volatile characteristics.

There are potential dangers associated with placing

undue reliance on credit scoring models. The predictive

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

used for unintended purposes or

customer types. Therefore, misuse

of a scoring system could expose an

institution to considerable losses.

Since only the largest banks have

small-business loan portfolios

large enough to create statistically valid scoring models

customized for their own customer base, smaller companies should be especially aware of potential misuse.

This risk takes on added meaning when one considers

that a $1 million small-business loan represents substantially more capital to a $100 million bank than to a $10

billion bank. Adding further uncertainty, small-business

credit scoring has been implemented during a period of

relatively strong performance by businesses, with comCHART 2
 

Business Dissolution Rate Shows Early Risk

100%

53%

Cumulative Dissolution Rates

24%

62%

71%

80%

123456 7 8 9 10

80%

60%

40%

20%

0%

Years

Source: Small Business Administration

mercial and industrial loan delinquency ratios near

historical lows. How well these models perform during

an economic downturn remains to be seen.

Depending on the manner in which it is implemented,

credit scoring for small-business lending may represent

a fundamental shift in underwriting philosophy -- viewing a small­business loan as more of a high­end

consumer loan and, thus, granting credit more on the

strength of the principals' personal credit history and

less on the financial strength of the business itself.

While this may be appropriate in some cases, it is

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

loans. Banks that do not analyze business financial

statements or periodically review their lines of credit

may lose an opportunity for early detection of credit

problems.

Competitive pressures in small-business lending are

increasing not only because of large banks' efforts to

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

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

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

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

and other services such as consulting, accounting and

investment services. Some observers have suggested

that the cost advantages of credit scoring may cause

small-business lending in the future to be dominated by

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

competition, there may be strong motivation for some

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

Regional Outlook 5 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

lower credit scoring thresholds for loan approvals.

The most recent FDICfSurveyfoffUnderwritingfPractices and the FederalfReserve'sfSeniorf LoanfOfficer

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

easing of standards on small-business loans. Aggressive competitive pressures and loan growth goals were

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

regard to small-business credit scoring techniques, the

Federal Reserve survey pointed out that banks were

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

Summary

Credit scoring has the potential to transform the market

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

tremendous pressure from larger banks and nonbank

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

changes in underwriting methods for small-business

lending. These changes may facilitate short-term revenue generation as business can be expanded rapidly

and underwriting costs can be slashed. It is extremely

important, however, that banks understand and control

the potential risks inherent in such a strategy. The

application of credit scoring to small-business lending

merits the close attention of both bankers and their

supervisors.

Andrea W. Bazemore, Banking Analyst

Regional Outlook 6 Second Quarter 1997
 
In Focus This Quarter
 

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

• 	 Despite the potential for lower transaction costs,

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

• 	 Although competitive risks are pushing banks to

create an Internet presence, operational risks

remain an obstacle to actually using those sites

for moving information or money.

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

and is developing training programs for its examiners.

The Allure o Cyberbanking

On-line Banking is a comprehensive term for transactions conducted

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

and, more recently, banking over the

Internet. Internet banking, frequently

referred to as cyberbanking, is of particular interest to

banks because it exploits an existing and geographically

extensive public network infrastructure and promises a

range of new operating and marketing benefits. One

such benefit is the ability for an institution to expand its

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

even countries -- without a commensurate expansion of

its branch structure. This greater geographic reach can

CHART 1

do more than simply increase volume. It also can offer

institutions -- particularly smaller ones -- the potential

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

volatility of any single one. Another benefit is the lower

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

Allen & Hamilton Inc. estimated an average Internet

transaction cost of $0.01 compared to $0.27 for an

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

Slow Migration to the Future

Another 1996 study, this one by Grant Thornton in July

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

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

bank services or staying abreast of competitors -- rather

than with an intent to grow deposits or capture the

transaction economies that cyberbanking could provide.

Of the 44 Internet institutions surveyed, only one in three

expressed intentions to begin offering bill payment or

funds transfer over the Internet by the end of the second

quarter of this year. Even this subdued enthusiasm now

appears optimistic. Despite the perceived benefits and

the scarcity of competition, few banks have to date

ventured into this area in a meaningful way. According

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

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

Internet site and only 18 of those permit transactions. In

the Kansas City Region, 75 institutions have an Internet

presence but only one allows customers to pay bills or

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

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

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

Banking on Cybercommerce: A Survey of Internet Bank Product Plans

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

Mid 199 

(Projected)

Mid 1996 (Actual)

Regional Outlook	 7 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

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

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

Risk
 

The reason is risk. Banks are familiar with the control

of exposures found in proprietary or private payment

channels, but they are less comfortable with the new

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

are operational exposures that convincingly argue

against rushing headlong into cyberspace. On the other

hand, there are competitive risks. Nonbank competitors

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

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

These opposing forces help explain the large numbers of

banks establishing web sites that stop short of actually

moving information or money.

Of these two types, operational risks are the most

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

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

theft or misappropriation of internal data or external

transmissions, transaction fraud, errors in underwriting

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

regulatory and legal infrastructure, noncompliance with

existing laws or regulations that were not designed for

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

Some Concerns or the CyberBanker,right).

Systemic Threats and a New Payments Model

In addition to bank-specific risks there are the systemic

threats that a public domain payments model could

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

be used for a given transaction and therefore the failure

of any one path or node will not affect the functionality

of the network as a whole. This feature presents a

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

previously unconsidered points of vulnerability to

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

attack may not be much more severe than those which

accompany credit card crime. However, there is good

reason to expect that Internet transaction sizes will

continue to grow. According to one software vendor,

Internal Data Security. The Internet cannot distinguish

between customers and criminals. Invasive attacks can range

from simple vandalism to theft or destruction of proprietary

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

insurance can limit such exposures.

External Transmission Security. Because the Internet is an

open network, transaction messages are completely exposed,

rendering them vulnerable to theft or tampering. Message

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

greatly if large value or interbank transactions migrate to the

Internet.

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

problem takes new dimensions in cyberspace because no

physical relationship with a customer exists. Encryption

protocols which include digital signatures are one response.

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

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

in establishing their creditworthiness. The lack of a personal

relationship is one factor. The limited knowledge of local

employers and credit grantors that appear on applications is

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

Liquidity Risks. Internet transaction volume and velocity

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

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

can affect liquidity if affected customers decide to close their

accounts.

Lack of Technical Standards. An institution building an

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

which standards will endure.

Lack of Regulatory and Legal Infrastructure. Regulators

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

adopted. Similarly, a lack of legal precedent hinders criminal

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

Reputation Risk. An image of solidity is a cornerstone of

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

Competitive Risks. Unlike the operational risks discussed

above, competitive risks accrue to institutions not securing an

Internet foothold. They involve the threat of lost market

share or payment system position to more aggressive peers

and nonbank competitors.

Regional Outlook 8 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

interbranch payments on the Internet are likely to begin

in 1997 with interbank activity to follow a year or so

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

relative to bank liquidity. An attack or disruption of the

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

banks in the same way that bad weather at a major

airport can disrupt air traffic throughout the country.

New Technologies, Old Reporting

The advent of fully transactional web sites also could

heat up bank competition for low cost deposits and

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

deposits and program trading in which a computer

program could search the Internet for the highest deposit

rates and immediately reallocate deposits accordingly.

In the long run, such activities could harmonize local

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

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

the regulatory perspective, this transaction velocity --

and its potential to rapidly alter bank balance sheets --

could present new challenges in a world of quarterly

Call Reports and examination intervals that can exceed

one year.

FDIC -- the CyberRegulator

New risks demand new supervision techniques and the

FDIC's Division of Supervision (DOS) has responded

with their recently-released electronic banking safety

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

TABLE 1

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

Safety and soundness examination procedures focus on

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

successive tier adds an additional level of scrutiny to

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

training program for all safety and soundness examiners

already has begun, and technical training for information

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

also is being established.

Measured Steps in a New Environment

Banks increasingly are becoming distributors of

commodity-like products. As such, profitability may

become dependent upon both cost efficiencies and high

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

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

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

sort. They face instead the risk that their competitive

position will pass to more innovative competitors --

competitors with new technologies and the drive to

accomplish old business in thoroughly new ways.

Gary Ternullo, Senior Financial Analyst

gternullo@rdic.gov

THE DIVISION OF SUPERVISION CLASSIFICATIONS FOR INTERNET BANKS

LEvEL 1 LEvEL 2 LEvEL 3

DESCRIPTION AN INFORMATION-ONLY

SITE

A SITE PERMITTING

ELECTRONIC

SUBMISSION OF LOAN

OR DEPOSIT

APPLICATIONS

TRANSACTIONAL SITE

OFFERING ELECTRONIC

BILL PAYMENT OR FUNDS

TRANSFER SERVICES

SPECIALIST

EXAMINATION

REQUIREMENT

(IN ADDITION TO

SAFETY AND

SOUNDNESS EXAM)

INFORMATION

SPECIALIST REVIEW

REQUIRED ONLY IF SITE

IS TIED INTO INTERNAL

BANK SYSTEMS.

CONSULTATION WITH

INFORMATION

SPECIALIST REQUIRED

TO DETERMINE IF

FURTHER REVIEW IS

WARRANTED.

CONCURRENT

INFORMATION

SPECIALIST EXAMINATION

REQUIRED.

Regional Outlook 9 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

For More In ormation:

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

Cynthia Bonnette, Examiner

Chairman, New Banking Technologies Task Force

(202) 898-6583

Stephen White, Inrormation Systems Review Examiner

Chairman, Inrormation Systems Subcommittee

Federal Financial Institutions Examination Council Task Force on Supervision

(202) 898-6923

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

coordinating outreach efforts with consumer community groups.

John Jackwood, Special Assistant to the Director

(202) 942-3854

Regional O ice Contacts	 Eugene Murphy, Review Examiner (EDP)

Division or Supervision

Kansas City Regional Orrice

(816) 234-9028

Allison Davis, Review Examiner

Division or Compliance and Consumer Arrairs

Kansas City Regional Orrice

(816) 234-8152

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

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

Consumer Electronic Payments Task Force.

Sharon Powers Sivertsen, Director

(202) 898-8710

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

FFIEC http://www.ffiec.gov

NETBanker http://www.netbanker.com

Bankweb http://www.bankweb.com

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

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

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

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

Regional Outlook	 10 Second Quarter 1997
 
Regular Features	 Regional Economy
 

Kansas City Region --

The Cattle Sector Remains a Concern
 

• 	 The Kansas City Region's nonfarm job growth has kept pace with the national average since 1994.

However, tight labor markets could lead to increasing wage costs and slower economic growth.

• 	 The cattle sector shows some distress from continued low cattle prices.

• 	 Strong demand for soybeans, both domestic and foreign, coupled with low stocks, have raised soybean

prices to levels not seen since 1988.

Region's Non/arm Job Growth Pacing U.S.

The Kansas City Region continues to keep pace with the

broader national economy. Although the rest of the

nation experienced a decline in nonfarm employment

during the last recession, the Kansas City Region continued to add jobs at a very slow rate. As a result, nonfarm

job gains between 1990 and 1996 totaled almost 13

percent in the Kansas City Region, while the nation

grew by just under 9 percent. Since the end of 1994, the

Region's pace of job growth has matched the nation's.

Chart 1 highlights these trends.

The Region's manufacturing sector (about 16 percent of

total jobs) also has outperformed the national trend

during the last five years. The factory job count grew an

average of 1.3 percent per year between 1991 and 1996

for the Region, while it was essentially unchanged for

the nation.

Tight Labor Markets Have Not Yet Resulted in

Wage In/lation

Relatively modest population growth, together with

steady employment gains, have resulted in a declining

unemployment rate during the last several years (see

Chart 2). Some of the Region's states saw annual

average unemployment drop below 3 percent last year

(Nebraska's average rate has been at or below 3 percent

since 1990).

Concerns have been raised that tight labor markets,

particularly in highly skilled manufacturing, will lead to

increased wage inflation and a consequent slowing of

growth in the Region. Rising manufacturing wage rates

would affect Minnesota and Missouri more than other

states given their higher concentrations of industrial

employment.

Thus far, however, increases in the Region's manufacturing wages (average hourly earnings) remain subdued.

CHART 1	 CHART 2
 

-2

-1

0

1

2

3

4

88 89 90 91 92 93 94 95 96

U.S.

Source: Bureau of Labor Statistics

Region

Region's Nonfarm Job Growth Keeps Pace 

with the Nation Change in 

Employment (%)

3

4

5

6

87 88 89 90 91 92 93 94 95 96

0.0

0.2

0.4

0.6

0.8

1.0

Population 

Change (%)

Source: Bureau of Labor Statistics and Bureau of Economic Analysis

Unemployment 

Rate (%)

Region's Slow Population Growth May Lead to 

Upward Pressure on Wages

Regional Outlook	 11 First Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

During this decade, average manufacturing earnings in

the Kansas City Region have moved up at a slightly

slower pace than that seen for the nation as a whole.

For example, in 1996 the Region experienced an average increase in hourly earnings of 2.9 percent ­­ somewhat below the nation's average increase of 3.3 percent.

Kansas City Metropolitan Area Showing Signs o/

Strong Growth

During the last several quarters, Kansas City has witnessed a series of new hotel and motel additions aimed
 

at increasing the city's appeal as a convention destination (the city doubled the size of its
 

convention center three years ago).
 

Current plans call for a 22 percent
 

increase in room inventory by the end
 

of 1997 (an additional 4,000 rooms
 

added to the existing stock of about
 

18,500). About 40 percent of the proposed room additions would arise from four casino projects and two
 

downtown renovations. The boom in construction primarily has been funded by Real Estate Investment Trusts
 

(REITs) and other investment sources (to a lesser extent
 

banks). Lower­end properties, which can be readily
 

built and start generating cash flow quickly, have been a
 

favorite of investors. However, there have been concerns over the potential for an overbuilt market ­­

particularly in the lower­end properties around the
 

city's outskirts, the fastest growing segment of the
 

market.
 

Retail space also has been added at a steady pace, as

national chains expand in the area. Construction activity

has spread south of Kansas City; recently rezoned wheat

fields in the southern suburbs have provided an excellent site on which to build "power centers" and other

CHART 3
 

large retail facilities. Most of the growth has been in the

Overland Park, KS area. Retail vacancy rates in the

greater Kansas City metro area are just under 8 percent,

according to research by a local firm, Cohen-Esrey

Real Estate Services.

The market for industrial space is extremely tight in

Kansas City. CB Commercial reported an average

industrial vacancy rate of only 1.7 percent during the

fourth quarter of last year. In fact, industrial vacancy

rates hit an all­time low for the Kansas City metro area

last year, averaging 2.9 percent.

Outlook /or Cattle Remains Uncertain

The cattle industry has long been important to the

Kansas City Region. The large semi­arid open spaces

in Kansas, Nebraska and South Dakota, coupled with

close proximity to feed supplies, make it ideally suited

for cow­calf operations and feedlots. Table 1 (next

page) shows the cattle sector's

importance in terms of cash

receipts. In three of the seven

states in the Region, cattle are

the number one commodity.

Chart 3 shows the comparison
 

of the gross value of production to total cash expenses (break­even costs) for U.S.
 

cow­calf producers. The U.S. Department o/Agriculture (USDA) data show than since 1993 cow­calf operations have been unprofitable. Moreover, the losses
 

experienced during the latest downturn are more pronounced than during the early 1980s, the last episode of
 

unprofitability.
 

Most industry sources believe that profitability will
 

-100

0

100

200

300

400

500

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Gross Expenses

Gross Revenue

Source: U.S. Department of Agriculture

Dollars Per Cow

Cow - Calf Operations Have Been Unprofitable Since 1993

Net Income Per Cow

Regional Outlook 12 First Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

begin to improve for cattle producers in 1997. Importantly, the big corn crop of 1996 has lowered corn

prices by about 25 percent compared to March 1996

levels, drastically reducing cattle ranchers' feed costs.

In addition, cattle numbers are expected to decline

during the next several years, setting the stage for increases in average feeder cattle and calf prices.

However, the severe winter experienced in North

Dakota and South Dakota has negative implications for

cattlemen in those states. The numerous blizzards

caused tens of thousands of cattle deaths in the northern

half of South Dakota and in the south­central portion of

North Dakota. Although cattlemen typically do not carry

insurance to cover weather­related losses, federal disaster aid may mitigate damages.

Compounding cattle ranchers' problems, the persistent

cold weather has caused increased consumption of feed

by the surviving cattle, increasing costs for producers.

In addition, complications with calving are expected

due to the stress placed on cows and unborn calves by

the cold temperatures and heavy snow accumulation.

Implications: Since most cattle operations in North

Dakota and South Dakota are small (100 head or less),

there are concerns that some cattlemen may not have the

necessary resources to manage financially through this

difficult time. In addition, these small operations may

be affected further by saturated fields and flooding when

record snow levels melt this spring. While increased

field moisture should not affect larger cattle operations,

many small cattle farmers may be affected because they

TABLE 1

typically raise crops as well as cattle.

Grains: 1997 - The Year o/ the Soybean?

Strong demand for soybeans, both domestic and foreign,

coupled with low stocks, have raised soybean prices to

levels not seen since 1988. The USDA expects that the

U.S. will see an all­time high soybean crush of 1,420

million bushels in the 1996­1997 crop year. Cash

prices for soybeans, currently in excess of $8.00 a

bushel, are pushing the USDA average market­year

price range to $6.90 to $7.30 per bushel.

The current high soybean price levels may be influencing farmers' planting decisions. The USDA projects

that total U.S. soybean plantings will be 7 percent higher

in 1997 than in 1996. In the Region, farmers are

expected to plant 12 percent more soybeans than last

year. Whether the current price levels are sustainable

will depend in part on the volume of foreign supplies

from sources such as Brazil, as well as the response in

demand to the current high price level. For example,

last year at this time, early supply concerns coupled

with strong demand resulted in high wheat prices during

the spring. However, these early high price levels had

a dampening effect on demand for wheat later in 1996,

resulting in a subsequent sharp decline in wheat prices

to more normal levels. This year, watching for similar

changes in supply and demand forces for soybeans also

will be important.

Winter Wheat Update: The winter wheat crop in

CATTLE ARE BIG BUSINESS IN THE KANSAS CITY REGION

STATE

NATIONAL CASH RECEIPTS

RANKING (IN MILLIONS)

% OF TOTAL

U.S. CATTLE

RECEIPTS

% OF TOTAL

STATE

COMMODITY

RECEIPTS

COMMODITY

RANKING

WITHIN THE

STATE

KANSAS

NEBRASKA

IOWA

S. DAKOTA

MINNESOTA

MISSOURI

N. DAKOTA

2 $4,235

3 4,158

6 1,705

8 1,046

9 835

11 660

20 366

12.5

12.2

5.0

3.1

2.5

1.9

1.1

56.3

47.8

15.5

30.9

11.9

15.0

11.6

1

1

4

1

5

2

2

REGION $13,005 38.3

SOURCE: U.S. DEPARTMENT OF AGRICULTURE

Regional Outlook 13 First Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

Kansas was rated 82 percent "good to excellent" in

USDA's March crop report. This rating is good news

for wheat growers in Kansas, where last year at nearly

the same time the crop was rated only 12 percent good

to excellent. While yields are projected to improve,

many analysts are less than bullish on wheat in the

coming months. At the USDA's annual Agricultural

Outlook Forum in February, a senior USDA economist

stated that prices for wheat could bottom out sometime

between July and September in a range as low as $3.25

to $3.35 per bushel. Demand concerns are apparently

the driving force. Not surprisingly, farmers who can

rotate between wheat and other crops, such as corn and

soybeans, are expected to do so this spring.

Implications: The planting flexibility granted in the

1996 Farm Bill perhaps makes planning a more challenging exercise. Farmers must now more carefully

evaluate crop pricing dynamics to assess whether price

levels early in the crop year can be sustained. Similarly, hedging techniques may take on a relatively

greater role in the management of farmoperations. The

enhanced ability to respond to changes in the market,

especially in areas where crop rotations are more feasible, provides positive opportunities for those farmers

that make the right decisions but can be detrimental for

those that do not. Lenders in areas where crop rotations

have been less common must be cognizant of the level of

experience farmers have with crops that they are not

accustomed to growing.

Pork Producers Expected to Enjoy a Pro/itable

Year

Lower feed costs and continued strong prices should

benefit the Region's pork producers in 1997, according

to industry experts. The most recent Hogs and Pigs

Report from the USDA indicated that the breeding herd

increased slightly from the last year's level. Iowa,

Minnesota and Nebraska registered increases on a yearover­year basis for the first time in two years. An

industry analyst suggests that until the expansion progresses further, tight supply should allow for prices

well above $50 per cwt. into the autumn.

The recent suspension of exports of pork from Taiwan

due to an outbreak of foot­and­mouth disease in their pig

herd may have positive implications for U.S. pork producers. Taiwan is currently the largest provider of

imported pork to Japan. According to current World

Health Organization rules, all exports must be suspended for at least one year. The suspension may be

an opportunity for U.S. suppliers to gain additional

market share in the large Japanese market. The

length of the suspension most likely will determine the

amount of the improvement in market share.

Craig A. Rice, Senior Regional Analyst

Norman Williams, Boston Regional Economist

Regional Outlook 14 First Quarter 1997
 
Regular Features	 Financial Markets
 

Financial Markets
 

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

quality could have adverse effects on both investors and issuers.

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

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

this time period.

• 	 During the fourth quarter 1996, the S&P Composite Bank Index outperformed S&P 500, gaining 12 percent, compared to an almost 8 percent gain for the S&P 500. The Kansas City Region's Bank Index outperformed the S&P 500 also but by a slim margin of only 22 basis points.

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

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

The Asset-Backed Securities Market: The

Effects of Weakened Consumer Loan Quality

Asset­backed securities (ABS) are debt securities that

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

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

market has grown dramatically. In 1996, the issuance of

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

1993 as illustrated in Chart 1. Commercial banks and

credit card companies accounted for approximately 35

percent of total ABS issuance last year. Major buyers

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

difficult to quantify the amount of bank investment in the

ABS market, market participants have observed that

small and midsized banks have recently increased their

holdings of ABS.

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

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

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

sheet and lowers capital requirements. In order to

receive investment grade ratings on their ABS, issuers

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

enhancement from bond insurers.

Bank issuers benefit from the sales treatment of assets

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

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

CHART 1
 

0

25

50

75

100

125

150

175

1993 1994 1995 1996

ABS Issuance Is on the Rise

Sou ce: Bloombe g, nside MBS and ABS

$ Billion

 e it a 

Auto 

Home Equity

 the 

and interest coupon payment is recognized as income by

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

Banks that issue ABS usually continue to service the

underlying assets, which not only generates servicing

income but also permits customer relationships to continue.

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

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

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

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

spreads despite the overall weakening in consumer

credit quality reflects strong demand from an expanding

investor base, which increasingly includes overseas

Regional Outlook	 15 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

buyers. Spreads on selected credit card and auto ABS

products began to increase during the first quarter of

1997, however, as investors reacted to higher than

expected charge­offs reported by some of the larger

issuers.

The increasing frequency of rating agencies' reviews for

possible downgrades of credit card transactions, as

well as problems in the auto finance sector, have raised

some concerns in the ABS market. How would a further

deterioration in consumer credit affect the ABS market?

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

from the ABS. If deterioration worsens, the ABS face

potential rating downgrades. This situation may compel

the issuer to improve the overall loan quality in the ABS

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

An early amortization event may result in the termination

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

early amortization occurs, new receivables associated

with the accounts in the asset­backed security no longer

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

their balance sheet and accounted for in determining

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

the ABS market may become more costly after an early

amortization if investors demand higher yields on subsequent issues.

For the investor, the threat of a ratings downgrade

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

amortization because principal may be paid prior to the

scheduled maturity date. ABS investors would lose

principal, however, only if the deterioration in the

quality of the underlying loans is severe enough to

deplete the entire credit support. The high level of

credit support demanded by rating agencies on existing

CHART 2

ABS deals minimizes the risk of principal loss by

investors.

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

a discount, the repurchase of low quality receivables

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

reserve account of the ABS. However these strategies

were specifically cited by the Office of the Comptroller

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

FDIC is working with other regulatory agencies through

the Federal Financial Institutions Examination Council

(FFIEC) on new Risk­Based Capital Guidelines that are

expected to address limitations on post­sale actions and

capital requirements for direct credit substitutes or

credit enhancements for ABS.

Given the continuing trend of higher charge­offs and

delinquencies for credit card loans, investors consider

the ABS market less homogeneous in terms of issuer

quality and therefore are scrutinizing the securitizations

of issuers more closely. Although the risks vary by ABS

issuer, banks that issue or invest in the ABS market

should be cognizant of the changing market conditions

and potential risks associated with ABS.

Changes in Interest Rates and Bond Values

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

yield curve between September 30, 1996, and early

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

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

0

25

50

75

100

125

150

175

3§20§97

12§16§96

6§3§969§9§96

2§26§96

11§20§95

 §14§95

5§ §95

1§30§95

10§24§94

4§11§947§1 §94

1§3§94

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

11§11§91

 §5§91

1§21§914§29§91

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

Auto

 a

Sou ce: P u ential Secu ities

Basis Points

Home Equity

Regional Outlook 16 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

CHART 3 CHART 4
 

-4%

-2%

0%

2%

4%

4- ct

1 - ct

1-zo6

15-zo629-zo6

13-0ec27-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

-0.5%

-0.3%

-0.1%

0.1%

0.3%

0.5%

Mo el

Po tfolio

Sou ce: Bloombe g

5-yea 

T easu y

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

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

hange Since Septembe 30, 1996

5.0%

5.2%

5.4%

5.6%

5. %

6.0%

6.2%

6.4%

6.6%

6. %

7.0%

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

3§12§97

12§31§96

9§30§96

Sou ce: Bloombe g

curve fluctuated during this time period. The path of

yields on Treasury bonds with 5­year through 30­year

maturities changed directions four times, rising or

falling by more than 30 basis points. Movements in the

shorter segment of the yield curve have been less pronounced.

In order to consider the effect that these rate swings may

have had on banks' fixed income portfolios, Chart 4

shows the percent change in the yield on the 5­year

Treasury and the percent change in the market value of a

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

an analysis that was introduced in the first quarter 1997

edition of the Regional Outlook, which looked at the

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

TABLE 1

In order to enhance the model portfolio's applicability

to bank portfolios, the type and amount of the securities

chosen for the portfolio are based on an aggregation of

securities­related Call Report data. The limitations of

Call Report data concerning the maturity distribution of

securities required that assumptions be made when

choosing the maturity of the securities for the model

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

model portfolio that approximates, in the aggregate, the

maturity distribution of the aggregate commercial bank

portfolio. The model portfolio is shown in Table 1.

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

portfolio changed less than one­half of 1 percent since

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

representing a 1.51 percent increase from September 30,

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

TYPE OF SECURITY PAR

VALUE

PERCENT

OF

PORTFOLIO

MATURITY

OR

WAL

PERCENT

CHANGE

FROM

9/30/96

TO

12/31/96

PERCENT

CHANGE

FROM

12/31/9

6 TO

3/12/97

PERCENT

CHANGE

FROM

9/30/96

TO

3/12/97

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

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

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

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

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

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

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

Regional Outlook 17 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

Treasury rate fell to its period­low

of 5.83 percent. Observe that,

while longer term rates fluctuated

modestly over the reporting period,

the reasonably short weighted average life (WAL) of the portfolio

further moderated the value

changes sustained by the portfolio.

Changes in the value of the model portfolio demonstrate

a higher correlation to changes in the 5­year Treasury

yield than to other maturities along the yield curve

because the 5­year bond's maturity better matches the

WAL of the model portfolio. Even though the 30­year

Treasury rate is often cited as a benchmark for daily rate

changes, it may not be the most significant rate in

assessing exposures of bank securities portfolios to

changes in interest rates.

On March 25, 1997, the Federal Reserve Open Market

Committee met and raised the target federal funds rate

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

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

basis points higher than the 5­year Treasury yield dated

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

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

model portfolio's market value to fall 0.56 percent to

$9,965.

This model portfolio will be used regularly to show the

effects on bond values of interest rates movements from

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

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

risk factors affect a portfolio's relative volatility.

Banks' Stock Prices and Price/Earnings Ratios

Continued to Rise in 1996. Is the Market ImCHART 5

proving its Perception of the Quality of Bank

Earnings?

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

Bank Index outperformed the S&P 500, gaining 12.37

percent compared to a 7.77 percent gain for the S&P

500. The fourth quarter results topped off a year during

which the S&P Composite Bank Index gained 37 percent

compared to a 20 percent gain for the S&P 500. As

shown in Chart 5, the Kansas City Region's Bank Index

(KCRBI) gained 7.99 percent in the fourth quarter 1996.

This performance, which significantly lagged the S&P

Composite Bank Index, was due primarily to First Bank

System, Inc., the second largest bank holding company

in the index, which gained only 2 percent during the

quarter. The KCRBI gained almost 36 percent for the

full year 1996: enough to outperform the S&P 500, but

not the S&P Composite Bank Index. The year's moderate economic growth, contained inflation, and favorable

interest rates are credited for providing a friendly environment for bank stocks. As 1997 began with much the

same economic conditions, bank equities have continued

to do well. The KCRBI is up a more than 13 percent

compared to an almost 20 percent gain for the S&P

Composite Bank Index and a 9 percent gain for the S&P

500, through March 7, 1997.

While appreciating stock prices provide an obvious

positive signal about the health of the industry, the

market provides other information about the prospects

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

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

a multiple of its earnings per share and is derived by

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

earnings per share. Typically investors are willing to

pay a higher price for a company with earnings that are

expected to be consistent and growing. However, firms

0%

10%

20%

30%

40%

30-Sep

11- ct25- ct

-zo6

22-zo6

6-0ec

20-0ec31-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

S&P 500

Kansas ity Region's Bank In ex

S&P Bank In ex

Sou ce: Bloombe g,American Banker

hange f om 9§30§96

The Kansas ity Region's Bank In ex utpe fo me the S&P 500 but zot the S&P Bank In ex

Regional Outlook 18 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

with more volatile earnings are generally penalized by

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

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

that investors have more confidence in the outlook for

future earnings performance.

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

ratios for the broader market provides further insight

into the market's perception of the quality of bank

earnings compared to other firms. Historically, bank

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

this discounted bank P/E ratio relative to the broader

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

have been viewed as being more volatile because they

are prone to rising and falling with changes in the

business cycle. For example, despite recording some of

the highest quarterly return on equity averages ever at

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

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

of the broader market P/E.

Over the past two years the magnitude of the banking

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

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

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

P/E ratio may represent a view by market participants

that bank earnings are becoming less sensitive to the

business cycle, perhaps as a result of geographic or

product­related diversification and more efficient manCHART 6
 

45%

55%

65%

75%

 5%

0ec-93

Ma -94

-un-94

Sep-940ec-94

Ma -95

-un-95

Sep-950ec-95

Ma -96

-un-96

Sep-960ec-96

Ma -97

S&P Majo Regional Bank In ex's

Relati6e P§E Ratio Is Rising

P§E Majo Regional Banks § P§E S&P 500

Source: Bloomberg 

agement of overhead expenses. Another factor contributing to higher bank P/E ratios could include speculation on bank stocks as investors anticipate potential

acquisitions.

Allen Puwalski, Banking Analyst

Kathy R. Kalser, Chief,

Financial Sector Analysis Section

Regional Outlook 19 Second Quarter 1997
 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

• 	 Profitability in 1996 was down slightly from 1995, but overall earnings performance for banks in the Kansas

City Region remains favorable.

• 	 Credit card loans continue to show elevated levels of charge-offs.

• 	 Weaknesses in the cattle sector are affecting a number of small farm banks in the Region.

• 	 Farm banks are facing increased competition for borrowers.

Profitability and Asset Quality Measures Are

Mostly Stable

Insured institutions in the Kansas City

Region reported an average net interest

margin and return on assets of 4.3 percent and 1.3 percent, respectively, in

1996, a moderate decline from 4.4 percent and 1.4 percent, respectively, reported in 1995 (see Chart 1). Both indicators exceed

the national averages for 1996 of 4.1 percent and 1.1

percent, respectively.

Reported asset quality remains good. Nonperforming

asset levels have been stable for the past three years at

0.65 percent of total assets. Net charge-offs increased

from a year-end 1995 rate of 0.48 percent of loans to

0.65 percent in 1996. The increase is largely a result of

continued weaknesses in credit card loans.

CHART 1

Credit Card Charge-Offs Remain High

Banks in the Region charged-off 5.30 percent

(annualized) of their credit card loans during the fourth

quarter of 1996. This level represents a slight increase

from the third quarter figure of 5.24 percent. Institutions with assets of $500 million to $1 billion were

affected the most; they saw a 10 percent increase in their

charge-off ratio for the quarter, bringing their annualized

rate to 5.65 percent.

Cattle Ranchers' Difficulties Are Affecting

Banks in Nebraska and South Dakota

Because of the heavy dependence

on the cattle sector in Nebraska and

South Dakota, cattle ranchers'

problems have a pronounced effect

on farm banks in those states. Over

the past several years, the Region's

cattle sector has come under a great

deal of stress (see Kansas City Region -- The Cattle

Sector Remains a Concern), as a result of persistently

depressed prices and severe winter storms. Recent

3.2

3.4

3.6

3.8

4.0

4.2

4.4

4.6

1990 1991 1992 1993 1994 1995 1996

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

S u c : B k C ll p 

 S 

 u C 

 

 

 

surveys by the Federal Reserve Banks of Minneapolis

and Kansas City reported an increase in forced liquidations of cattle operations. In addition, the FD/C's

fourth quarter 1996 Underwriting Survey of its examiners provided further evidence of weakness in the

cattle sector. In that survey, 60 percent of examiners in

Nebraska and 50 percent in South Dakota reported

moderate increases in carryover debt, compared to 19

percent for the U.S. as a whole.

A potential concern for bankers is that debt-to-equity

ratios for farmers in these states are among the highest in

the nation. Nebraska and South Dakota farmers have

average debt-to-equity ratios of 26 percent and 25

percent, respectively, compared to the U.S. average of

Regional Outlook	 20 First Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

18 percent. Moreover, in contrast to the U.S.average,

debt-to-equity ratios of farmers in Nebraska and South

Dakota have increased since 1991. Because of their

higher leverage, farmers in these states may be more

vulnerable to prolonged periods of operating losses.

South Dakota's small farm banks have elevated levels

of nonperforming loans, due in part

to the problems facing cattle ranchers. As illustrated in Chart 2, South

Dakota's 79 small farm banks

(defined in this article as banks with

less than $100 million in total assets

and more than 25 percent of their

loan portfolio invested in agriculture production and

real estate) have reported higher levels of nonperforming assets than the rest of the Region's banks over the

past several years. Year-end 1996 results show that

small farm banks in South Dakota had nonperforming

assets equal to 1.2 percent of total assets, up 24 percent

from year-end 1995. By comparison, nonfarm banks of

similar size in South Dakota reported a nonperforming

loan ratio of about 0.75 percent.

Concerns over rising nonperforming loans in small

South Dakota farm banks are mitigated to some extent by

their strong capital and earnings. Capital levels for

these banks compare favorably to their peers in the

Region with Tier 1 capital of 11.6 percent (see Chart 3).

Profitability also is good, with return on assets of 1.16

percent, down slightly from 1.22 percent at year-end

1995 (see Chart 4). Of course, any detrimental effects

on cattle operations resulting from the severe winter

weather would not yet be reflected in these numbers.

Farm Banks Face /ncreased Competition for

Borrowers

During the first half of the 1990s, banks in the Region

CHART 3

0

2

4

6

8

10

12

1990 1991 1992 1993 1994 1995 1996

F B k H v H L v l f C p l

 d...

(1) T l G $100 ll

(2) T l L $100 ll

F S ll

 f (2)

 L

 f (1)

T 1

C p l

S u c : B k C ll p 

CHART 2
 

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1990 1991 1992 1993 1994 1995 1996

S u D k ' S ll F B k S w

l v d L v l f p f

S u c : B k C ll p

p f

L /T l

S u D k

gradually increased their share of total farm debt. Chart

5 (next page) illustrates this trend. Recent information,

however, suggests that increased competition may challenge banks' market share.

Farm Credit banks, having finally put the farm crisis of

the mid-1980s behind them, are aggressively seeking to

recapture marketshare. Their size facilitates aggressive

marketing efforts, and they have instituted expedited

underwriting processes that enable them to compete

effectively with small local institutions. In addition,

Farm Credit banks reportedly have been aggressively

pricing farm loans, making it more difficult and

potentially costly for bankers to compete for borrowers who make decisions based strictly on interest

rates.

The market for farm operating loans, a niche traditionally served by small farm banks, is under pressure from

other nonbank competitors in addition to Farm Credit

banks. Large seed companies, equipment manufacturers

CHART 4

...T c l H v B L 

V l l L C u p .

u

S ll

2.0

1.5

L 

f (1)

f (2)

F 

1.0

0.5

0.0

1990 1991

S u c : B k C ll p

1992 1993

(1) T l

(2) T l

1994

G

L

1995 1996

$100 ll

$100 ll

Regional Outlook 21 First Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

and farm supply companies are actively seeking new

lending relationships.

These competitive pressures on banks are intensifying

during a period when the 1996 Farm Bill may create

additional risks for their borrowers in terms of increased price and income volatility. Interest rates on

farm operating loans may adjust to account for this

additional risk. Alternatively, the increased competition for borrowers may put pressure on banks to lower

interest rates on loans or relax underwriting standards to maintain loan portfolio volume. Under such a

scenario, farm banks' net interest margins could be

affected by the lower rates, or asset quality problems

could increase if banks compromise underwriting standards to maintain current loan yields.

On the positive side, small farm banks appear well

positioned to take on additional competition. They are

better capitalized and their earnings recently have been

less volatile than similar-sized nonfarm banks (see

Charts 3 and 4 previous page). They also have longstanding relationships with their customers. However,

the ability to retain these customers on both sides of the

balance sheet, without sacrificing credit quality or profitability, may be the farmbanks' biggest challenge in the

coming years.

CHART S
 

42%

43%

44%

45%

46%

47%

48%

49%

1991 1992 1993 1994 1995

B k ' k 

S

S u c : U.S. D p f cul u 

P c f

T l F D b

B k ' k S f F D b 

L v l Off

Craig A. Rice, Senior Regional Analyst

John M. Anderlik, Financial Analyst

Regional Outlook 22 First Quarter 1997
 
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