FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1997
 

FDIC
 

MEMPHIS
 

REGION
 

DIVISION OF

INSURANCE

GARY L. BEASLEY,
 

SENIOR REGIONAL
 

ANALYST
 

WALLACE D.
 

PEDDICORD
 

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

 · Current Conditions · Asset-Backed Securities · Recent Bank Results

 · Industrial Sector · Bond Values · Recent Thrift Results

 · Residential Real Estate · Price/Earnings Ratios · Residential Lending

 · Retail Real Estate · Agriculture Lending

 · Gaming

See page 11 See page 15 See page 20

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

Insurance Corporation for the following eight geographic regions:

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Center for current pricing on bulk orders.

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

more information or to provide comments or suggestions about the 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 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 Memphis 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 $15 billion of small-business loans,

amounting to 56 percent of all commercial and industrial

loans. This level is an increase of $1.1 billion or 8

percent from one year ago. There are 254 banks in the

Region with small-business loan exposures exceeding

100 percent of equity, and 34 banks with exposure

exceeding 200 percent of equity.

Small banks with assets under $1 billion have a substantial 57 percent share of the Region's small-business

loans. Chart 1 (next page) provides a state-by-state

summary of small-business market share. However, the

market share held by the Region's small banks may

come under fire as several large banking companies

have announced nationwide programs to increase their

share of small-business lending. These nationwide

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

companies to offer pre-approved and pre-qualified lines

of credit.

ThefGrowingfImportancefoffCreditfScoring

While credit scoring technology is

not new, until recently it typically

has been associated with consumer

lending, particularly with credit

card lending. Primarily using

credit bureau information, credit

scoring provides lenders with a

tool to rank risks or probabilities of

default, assigning statistically derived numerical ratings

or scores based upon a borrower's past experience with

paying debt. Based upon the enormous volume of

historical information on consumers contained in credit

bureaus, model developers link incidences of good and

bad credit performance with borrower characteristics.

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

decisions. While credit scoring has helped consumer

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

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. Small-business credit scoring models

are similar to consumer credit scoring models in one

significant aspect -- the most important indicator of

Regional Outlook	 3 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

CHART 1
 0ercent o0 Loans

Banks Under $1 Billion Hold a Substantial Small-Business Market Share

(Shown by Asset Bank Size)

100%

80%

60%

40%

20%

0%

Arkansas Kentucky Louisiana

Source: June 30, 1996, Bank Call Reports

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 inTable 1 is representative of

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

Over $3 Billion

$1 - $3 Billion

Under $1 Billion

Mississippi Tennessee Region

significant departure from traditional underwriting

methods.

Part of the reduction in underwriting costs may come

from improvements in the allocation of underwriting

resources. It has been argued that credit scoring allows

banks to more easily identify those applicants which are

clearly either approvals or denials. This process would

enable banks to reallocate their underwriting resources

more efficiently to those loans which pose intermediate

risks and require closer attention. Other advantages of

credit scoring systems that often are cited are greater

consistency in underwriting, better measures for pricing

strategies, and the potential to enhance the ability to

securitize small-business loans.

WhatfArefthefRisks?

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
 

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 commercial and

industrial loan delinquency ratios near historical lows.

How well these models perform during an economic

downturn remains to be seen.

Depending on the manner in which it is implemented,

credit scoring for small-business lending may represent

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

consumer loan and, thus, granting credit more on the

strength of the principals' personal credit history and

less on the financial strength of the business itself.

While this may be appropriate in some cases, it is

CHART 2
 

Business Dissolution Rate Shows Early Risk

100%

80%

60%

40%

20%

0%

Years

Source: Small Business Administration

53%

Cumulative Dissolution Rates

24%

62%

71%

80%

123 4 5 6 7 8 9 10

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

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 accepRegional Outlook 5 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

tance 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 Memphis 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

Division o Compliance and

Consumer A airs

Regional O ice Contacts

O ice o Policy Development

Related Web Sites

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

DCA is reviewing new banking technologies from a consumer protection, fair lending 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

Mark Kearns, Review Examiner

Division or Supervision

Memphis Regional Orrice

(901) 821-5212

Christine Stammen, Review Examiner

Division or Compliance and Consumer Arrairs

Memphis Regional Orrice

(901) 821-5224

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

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
 

The Shifting Economic Structure of the Memphis
 

Region
 

• 	 Growth in the Memphis Region appears to be slowing as the nation's economy continues to move away

from its cyclical peak in 1994.

• 	 Future volatility may increase as industrial production shifts toward durable goods.

• 	 Slowing growth may be cause for concern given the substantial market space remaining in the retail real

estate pipeline.

Current Conditions

The current business cycle appears to be showing its age

as illustrated by the continued weakening of the Memphis Region's economic performance (see Chart 1). At

1.7 percent, annual job growth in the Region in 1996

was below the national average (2 percent) for the first

time in nearly a decade. The deceleration in growth has

been most dramatic in Tennessee where employment

rose by 1.4 percent in 1996, less than one­half its rate of

expansion in 1995. This was Tennessee's weakest

performance since the 1991 recession. Most of the

Region's slowdown in growth can be traced to its

manufacturing industries. Louisiana was the Region's

fastest growing state with 2.2 percent employment

growth in 1996. Analysts expect this Region's growth

to remain subdued throughout 1997 as the nation's economy continues its move away from the cyclical peak in

1994. Reductions in automobile purchases nationwide

should exert a dampening influence in Tennessee and

Kentucky, further reducing growth. In February 1997,

total sales of passenger cars in the U.S. were down 2.2

CHART 1

-2

-1

0

1

2

3

4

87 88 89 90 91 92 93 94 95 96

 S erage

Memphis Region

Source: Bureau of Labor Statistics

Job Growth

No Escaping the Business Cycle

percent from one year earlier.

Pockets of healthy growth in the Region still remain,

however. Even in some rural areas, labor markets

remain exceptionally tight. Tennessee's Shelbyville

(Bedford county) is an interesting case in point where

growth is causing some local conflict in the economy.

At issue is the proposed construction of a major new

industrial park. Promoters argue the site would attract

new manufacturers and high paying jobs to the Region.

Major employers in the area oppose construction, contending that they already are unable to attract new

workers given the county's tight labor market.

Implications: The deceleration in economic growth in

recent quarters poses a number of challenges for the

Region's banking industry. Slower job growth or concerns about job security could have an impact on consumers' spending activity, particularly for big ticket

items such as automobiles, home furnishings, and appliances. Consequently, loan volumes may experience

some weakening. Moreover, newly started and expanded small businesses spawned during the current

expansion may suffer, if economic growth fails to generate sufficient revenues to compensate for debts incurred,

adversely affecting banks' profit margins and credit

quality.

Shifting Gears in Industry

The textile and apparel industry traditionally has been a

source of wealth for the Memphis Region, providing

thousands of manufacturing jobs. This industry has

suffered a steady slide in payroll numbers with the

strengthening in the last decade of competitors located

overseas (see Chart 2 next page). The recent strength in

the dollar versus other currencies could provide foreign

competitors with an even greater cost advantage over

Regional Outlook	 11 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

domestic producers.

Fortunately, during the

last decade another industry has emerged as

an important force in

the Region's manufacturing sector. Low levels of

unionization, state and local government incentives, and

low costs of doing business became a magnet to automobile assembly and parts manufacturers. Trade barriers

also benefited the Region as foreign manufacturers,

including Toyota and Nissan, spent hundreds of millions

of dollars to enter the Region, particularly in Tennessee

and Kentucky. Saturn Motor Company also set up new

facilities in the Region, creating jobs for thousands of

factory workers. Emerging growth industries have had

a multiplier effect on the economy. New jobs have

attracted in­migration and have fostered increases in

local demand for goods and services. This, in turn, has

spurred the Region's construction industry as commercial and residential developments have been rapidly

spawned. In a decade, transportation equipment's share

of total manufacturing employment in the Region doubled to over 10 percent, rivaling the textile industry's

claim as the largest industrial employer. Tennessee

now accounts for 10 percent of national automobile

production.

The new jobs brought by the automotive manufacturers

pay a higher wage than those in textiles and apparel. In

the Memphis Region, the average hourly wage for transportation equipment workers ranges from $10.42

(Arkansas) to $17.12 (Kentucky), compared to a range

of $6.76 (Louisiana) to $9.69 (Tennessee) in the textile

and apparel industries.

The current contraction in manufacturing is the product

of this shift to greater cyclicality in the economy. Since

1992, the erosion in textiles and apparel has been

successfully offset by gains in durable goods production. This counterbalance was further accentuated by

the influx of new automotive manufacturers. This occurred at a time when the nation was emerging from a

recession in 1991 and car sales were booming, further

fueling production. However, as the demand for new

automobiles is tempered by cooling economic growth,

jobs generated by the durable goods sector have become

insufficient to offset losses in the textile industry.

Implications: As the economy's industrial make­up in

the Memphis Region shifts increasingly toward durable

goods production (e.g., transportation equipment) and

away from nondurable goods manufacturing, economic

growth is likely to become more volatile. In Chart 3,

national job growth for the nation in durable and nondurable goods production is tracked since the early

1960s. The business cycle for durable goods production is far more volatile than that for nondurable goods

production. As a result, the Region's banking industry

may see greater variation in credit quality over time and

across lending sectors.

Residential Real Estate Markets: Strong Growth

in 1996

Residential real estate markets in the Memphis Region

were vigorous in 1996, as permit issuance jumped by

nearly 9 percent after slipping the previous year. The

strongest growth was in multifamily construction. Two

factors, however, may dampen future growth in residential construction in the Region. First, slower growth

could cool homebuyer enthusiasm. Arkansas and Mississippi already have started to see construction activity

abate. Over the longer term, the Region's real estate

CHART 2 CHART 3
 

Tale of Two Industries

Employment Index

1988=100

135 Transportation Equipment

125

115 Textiles

105

95

85 pparel

75

1988 1989 1990 1991 1992 1993 1994 1995 1996

Source: Bureau of Labor Statistics

S Industrial Employment Volatility

Job Growth (%) urable Goods

8

3

-2

-7 Nondurable Goods

-12

61 64 67 70 73 76 79 82 85 88 91 94

Source: Bureau of Labor Statistics

Regional Outlook 12 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

market potential may be limited by slow population

growth. With an annual growth rate of 0.8 percent in

1996, the Region's population is rising more slowly

than the nation's. Louisiana, moreover, may face even

tighter constraints on housing demand as annual population growth was just 0.3 percent in 1996. If growth in

residential construction were to outpace the limits on

demand imposed by these market fundamentals, the

potential for a downward correction exists.

Retail Real Estate Markets Are Expanding

At the same time that the Region's growth appears to be

cooling, substantial retail space is in the pipeline in a

number of areas. For example, the Region will be home

to two of the largest shopping malls opening in the

nation this year. In Baton

Rouge, where growth remained solid last year,

planned construction remains at high levels. Over

1.4 million square feet of

retail space is under construction, more than any other major metro area in the

Memphis Region. The bulk of Baton Rouge's space is

to be in the Mall of Louisiana, a 1.2 million square foot

mall scheduled to open in late October. Large amounts

of retail space also have come on­line in the Memphis

metro area with the opening of the 1.1 million square

foot Wolfchase Galleria in Shelby county. Completion

is near for another one million square feet of retail

space adjacent to the Wolfchase mall. Nashville's

retail market also is seeing a large amount of space in

the retail pipeline, with 1.2 million square feet in the

planning stages. Conditions in Nashville's retail market

have improved tremendously over the past five years. In

1991, the metro area's retail vacancy rate was in excess

of 20 percent but now stands at 8.5 percent.

Implications: Construction is a notoriously volatile

industry and thus presents a risk to banks that finance

development activities. Growth in the Memphis Region

will likely continue its deceleration this year and consequently absorption rates could retreat at a time when

substantial market space remains in the pipeline. Metro

areas, such as Baton Rouge, Memphis, and Nashville,

that have seen large amounts of retail space injected into

local markets could face varying degrees of retail dislocation due to new competition. As new malls open their

doors, consumption patterns, geographically, have

started to shift. Consequently, existing retail operations

may see earnings slip as customers are wooed away by

new malls. Overall retail sales in the metro areas, in

contrast, may remain the same or increase only

marginally.

Rolling the Dice in Gaming

Gaming has been a key source of growth in portions of

the Memphis Region since legalized casinos opened in

1992. The industry now seems to be reaching a mature

stage, with the last casino license available in Louisiana

having been awarded in March (not including the unopened Harrah's

casino in New Orleans) and a lack of

new entrants in the

Mississippi market.

However, casinos

should continue to

boost local markets,

as they expend large amounts in 1997 for amenities, such

as hotels and golf courses. In Mississippi for example,

2,000 new hotel rooms are under construction and multimillion dollar infrastructure improvements are expected

to expand northwestern Mississippi's ability to draw

tourists.

The acceptance of gaming has stemmed from the seemingly successful experiences in some areas of the Region. In Tunica, Mississippi, alone a $1 billion per

year gaming industry has emerged, providing thousands

of jobs to an impoverished area. Income growth in

Tunica county has been in the double­digits and per

capita incomes have increased from 55 percent of the

U.S. average to more than 70 percent in a few years.

Elsewhere in the Region, gaming has helped offset job

losses in key industries such as oil and gas and textiles

and apparel. There are now 30 large­scale gaming

operations in the state of Mississippi employing 30,000

workers, with another 20,000 jobs supported indirectly.

Despite the apparent success and subsequent enthusiasm

for gaming as a source of jobs and income for local

economies, gaming does not guarantee continued prosperity. For example, although Tunica has made seemingly enormous strides in the past few years, a large

portion of the development that has occurred has been

limited to the support of the gaming industry. Moreover,

many jobs and contracts for support services have accrued to the Memphis metro area rather than to Tunica.

As such, poverty is still widespread in some areas of

Tunica county. Also, earlier growth rates may not

persist in Tunica unless the gaming industry continues its

rapid rate of expansion. After the casino market has

Regional Outlook 13 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

been fully tapped, the gaming industry may be more a

source of stability in some parts of Louisiana and Mississippi, rather than a major growth factor.

Implications: As gaming becomes increasingly

widespread, casino earnings may soften, prompting a

local shake­out in the industry. Lenders located in the

casino markets should remain alert to the possibility that

borrowers may fail to guard against a potential softening

of the local casino industry and become overextended.

The risk of excess capacity in areas such as lodging also

should receive continued monitoring by those lending to

this segment.

Gary L. Beasley, Senior Regional Analyst

Scott C. Hughes, Atlanta Regional Economist

Regional Outlook 14 Second Quarter 1997
 
Regular Features	 Financial Markets
 

Financial Markets
 

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

quality could have adverse effects on both investors and issuers.

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

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

this time period.

• 	 During the fourth quarter 1996, the Memphis Region's Bank Index outperformed both the S&P Composite Bank Index and S&P 500, gaining 15 percent, compared to a 12 percent gain for the S&P Composite

Bank Index and an almost 8 percent gain for the S&P 500.

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

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

The Asset-Backed Securities Market: The

Effects of Weakened Consumer Loan Quality

Asset­backed securities (ABS) are debt securities that

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

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

market has grown dramatically. In 1996, the issuance of

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

1993 as illustrated in Chart 1. Commercial banks and

credit card companies accounted for approximately 35

percent of total ABS issuance last year. Major buyers

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

difficult to quantify the amount of bank investment in the

ABS market, market participants have observed that

small and midsized banks have recently increased their

holdings of ABS.

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

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

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

sheet and lowers capital requirements. In order to

receive investment grade ratings on their ABS, issuers

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

enhancement from bond insurers.

Bank issuers benefit from the sales treatment of assets

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

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

CHART 1
 

0

25

50

75

100

125

150

175

1993 1994 1995 1996

ABS Issuance Is on the Rise

Sou ce: Bloombe g, nside MBS and ABS

$ Billion

 e it a 

Auto 

Home Equity

 the 

and interest coupon payment is recognized as income by

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

Banks that issue ABS usually continue to service the

underlying assets, which not only generates servicing

income but also permits customer relationships to continue.

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

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

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

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

spreads despite the overall weakening in consumer

credit quality reflects strong demand from an expanding

investor base, which increasingly includes overseas

Regional Outlook	 15 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

buyers. Spreads on selected credit card and auto ABS

products began to increase during the first quarter of

1997, however, as investors reacted to higher than

expected charge­offs reported by some of the larger

issuers.

The increasing frequency of rating agencies' reviews for

possible downgrades of credit card transactions, as

well as problems in the auto finance sector, have raised

some concerns in the ABS market. How would a further

deterioration in consumer credit affect the ABS market?

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

from the ABS. If deterioration worsens, the ABS face

potential rating downgrades. This situation may compel

the issuer to improve the overall loan quality in the ABS

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

An early amortization event may result in the termination

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

early amortization occurs, new receivables associated

with the accounts in the asset­backed security no longer

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

their balance sheet and accounted for in determining

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

the ABS market may become more costly after an early

amortization if investors demand higher yields on subsequent issues.

For the investor, the threat of a ratings downgrade

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

amortization because principal may be paid prior to the

scheduled maturity date. ABS investors would lose

principal, however, only if the deterioration in the

quality of the underlying loans is severe enough to

deplete the entire credit support. The high level of

credit support demanded by rating agencies on existing

CHART 2

ABS deals minimizes the risk of principal loss by

investors.

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

a discount, the repurchase of low quality receivables

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

reserve account of the ABS. However these strategies

were specifically cited by the Office of the Comptroller

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

FDIC is working with other regulatory agencies through

the Federal Financial Institutions Examination Council

(FFIEC) on new Risk­Based Capital Guidelines that are

expected to address limitations on post­sale actions and

capital requirements for direct credit substitutes or

credit enhancements for ABS.

Given the continuing trend of higher charge­offs and

delinquencies for credit card loans, investors consider

the ABS market less homogeneous in terms of issuer

quality and therefore are scrutinizing the securitizations

of issuers more closely. Although the risks vary by ABS

issuer, banks that issue or invest in the ABS market

should be cognizant of the changing market conditions

and potential risks associated with ABS.

Changes in Interest Rates and Bond Values

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

yield curve between September 30, 1996, and early

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

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

0

25

50

75

100

125

150

175

3§20§97

12§16§96

6§3§969§9§96

2§26§96

11§20§95

 §14§95

5§ §95

1§30§95

10§24§94

4§11§947§1 §94

1§3§94

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

11§11§91

 §5§91

1§21§914§29§91

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

Auto

 a

Sou ce: P u ential Secu ities

Basis Points

Home Equity

Regional Outlook 16 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

CHART 3 CHART 4
 

-4%

-2%

0%

2%

4%

4- ct

1 - ct

1-zo6

15-zo629-zo6

13-0ec27-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

-0.5%

-0.3%

-0.1%

0.1%

0.3%

0.5%

Mo el

Po tfolio

Sou ce: Bloombe g

5-yea 

T easu y

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

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

hange Since Septembe 30, 1996

5.0%

5.2%

5.4%

5.6%

5. %

6.0%

6.2%

6.4%

6.6%

6. %

7.0%

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

3§12§97

12§31§96

9§30§96

Sou ce: Bloombe g

curve fluctuated during this time period. The path of

yields on Treasury bonds with 5­year through 30­year

maturities changed directions four times, rising or

falling by more than 30 basis points. Movements in the

shorter segment of the yield curve have been less pronounced.

In order to consider the effect that these rate swings may

have had on banks' fixed income portfolios, Chart 4

shows the percent change in the yield on the 5­year

Treasury and the percent change in the market value of a

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

an analysis that was introduced in the first quarter 1997

edition of the Regional Outlook, which looked at the

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

TABLE 1

In order to enhance the model portfolio's applicability

to bank portfolios, the type and amount of the securities

chosen for the portfolio are based on an aggregation of

securities­related Call Report data. The limitations of

Call Report data concerning the maturity distribution of

securities required that assumptions be made when

choosing the maturity of the securities for the model

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

model portfolio that approximates, in the aggregate, the

maturity distribution of the aggregate commercial bank

portfolio. The model portfolio is shown in Table 1.

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

portfolio changed less than one­half of 1 percent since

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

representing a 1.51 percent increase from September 30,

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

TYPE OF SECURITY PAR

VALUE

PERCENT

OF

PORTFOLIO

MATURITY

OR

WAL

PERCENT

CHANGE

FROM

9/30/96

TO

12/31/96

PERCENT

CHANGE

FROM

12/31/9

6 TO

3/12/97

PERCENT

CHANGE

FROM

9/30/96

TO

3/12/97

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

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

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

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

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

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

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

Regional Outlook 17 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

Treasury rate fell to its period­low

of 5.83 percent. Observe that,

while longer term rates fluctuated

modestly over the reporting period,

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

further moderated the value

changes sustained by the portfolio.

Changes in the value of the model portfolio demonstrate

a higher correlation to changes in the 5­year Treasury

yield than to other maturities along the yield curve

because the 5­year bond's maturity better matches the

WAL of the model portfolio. Even though the 30­year

Treasury rate is often cited as a benchmark for daily rate

changes, it may not be the most significant rate in

assessing exposures of bank securities portfolios to

changes in interest rates.

On March 25, 1997, the Federal Reserve Open Market

Committee met and raised the target federal funds rate

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

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

basis points higher than the 5­year Treasury yield dated

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

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

model portfolio's market value to fall 0.56 percent to

$9,965.

This model portfolio will be used regularly to show the

effects on bond values of interest rates movements from

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

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

risk factors affect a portfolio's relative volatility.

Banks' Stock Prices and Price/Earnings Ratios

Continued to Rise in 1996. Is the Market ImCHART 5

proving its Perception of the Quality of Bank

Earnings?

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

Bank Index outperformed the S&P 500, gaining over

12 percent compared to an almost 8 percent gain for

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

year during which the S&P Composite Bank Index

gained 37 percent compared to a 20 percent gain for the

S&P 500. As shown in Chart 5, the Memphis Region's

Bank Index (MRBI) gained 15 percent in the fourth

quarter 1996. The ARBI gained more than 24 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 MRBI is up a more than

13 percent compared to an almost 20 percent gain for

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

500, through March 7, 1997.

While appreciating stock prices provide an obvious

positive signal about the health of the industry, the

market provides other information about the prospects

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

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

a multiple of its earnings per share and is derived by

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

earnings per share. Typically investors are willing to

pay a higher price for a company with earnings that are

expected to be consistent and growing. However, firms

with more volatile earnings are generally penalized by

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

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

that investors have more confidence in the outlook for

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

Memphis Region's Bank In ex

S&P Bank In ex

Sou ce: Bloombe g,American Banker

hange f om 9§30§96

The Memphis 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
 

future earnings performance.

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

ratios for the broader market provides further insight

into the market's perception of the quality of bank

earnings compared to other firms. Historically, bank

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

this discounted bank P/E ratio relative to the broader

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

have been viewed as being more volatile because they

are prone to rising and falling with changes in the

business cycle. For example, despite recording some of

the highest quarterly return on equity averages ever at

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

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

of the broader market P/E.

Over the past two years the magnitude of the banking

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

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

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

P/E ratio may represent a view by market participants

that bank earnings are becoming less sensitive to the

business cycle, perhaps as a result of geographic or

product­related diversification and more efficient management of overhead expenses. Another factor contributing to higher bank P/E ratios could include speculation on bank stocks as investors anticipate potential

CHART 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 

acquisitions.

Allen Puwalski, Banking Analyst

Kathy R. Kalser, Chief,

Financial Sector Analysis Section

Regional Outlook 19 Second Quarter 1997
 
Regular Features	 Regional Banking
 

CurrentfRegionalfBankingfConditions
 

• 	 Fourth quarter results for commercial banks in the Memphis Region were marked by stable earnings and

capital levels, a continued increase in loan-to-deposit ratios, and reliance on volatile funding sources.

• 	 Thrifts ended 1996 with improved earnings and solid capital levels.

• 	 Some commercial banks are joining a movement to grant higher loan-to-value residential mortgages.

• 	 Agricultural issues that arose in 1996 likely will affect more than just the 119 banks in the Region that are

significant direct lenders to this sector.

CommercialfBanksfAchievefGoodfResultsffor CHART 1
 

AnotherfYearffbutfContinueftofIncreasefUsefof

VolatilefFunding

The Region's commercial banks ended 1996 with an

aggregate return on assets (ROA) of 1.3 percent, identical to the 1995 level. Capital coverage, measured by

the leverage ratio, also was essentially unchanged from

the prior year, with Tennessee institutions (as a group)

having the lowest coverage at 8.4 percent and Mississippi banks with the highest coverage at 9.4 percent.

Banks in the Region continue to steadily increase loan

to deposit ratios, while using more volatile fund

sources for an increasing share of total funds. Growth

in loan-to-deposit ratios is not uncommon during good

economic times and is not necessarily a cause for

concern. However, when coupled with greater reliance

on volatile funding, this trend may warrant monitoring of

liquidity for some institutions. For the fourth quarter,

625 banks held large time deposits (those exceeding

$100,000) in excess of 10 percent of total assets, which

represents 124 more institutions in that category than

existed at the end of 1994. Total reliance on volatile

funding increased from 18.6 percent of total funding to

20 percent between year-end 1995 and year-end 1996.

Still, the Region's banks are much less reliant on

volatile funding than banks in the nation as a whole,

where an average of 30.7 percent of funding is from

volatile sources.

FourthfQuarterf1996fResultsfforfThriftsfAre

GenerallyfPositive

Earnings for the Region's thrifts recovered quickly

from the effect of the one-time SAIF special assessment that was charged to third quarter 1996 earnings.

The 138 thrifts in the Region posted an aggregate net

0%

10%

20%

30%

40%

50%

60%

 0%

 0%

1990 1991 1992 1993 1994 1995 1996

Source: Bank Call Reports

Loan-to-Asset and Loan-to-Deposit Ratios Rise 

Loan-to- Steadily in the Region

Asset

 

income figure of just over $43 million for the final

quarter of 1996, resulting in an ROA of 0.62 percent for

the year. Thrifts in Mississippi were the most profitable

and the only group on a state-by-state basis to achieve a

1 percent ROA for the year, while Kentucky thrifts

turned in the weakest performance with an aggregated

ROA of just under 0.50 percent.

For the quarter, assets held by thrifts declined in

every state except for Louisiana. The resulting decline

in assets of $3.7 billion, or 14.5 percent, was primarily

due to charter changes and mergers of thrifts with

banks. For example, the Region's largest thrift, Leader

Federal Bank for Savings, with total assets of approximately $3.3 billion, merged with the lead bank of the

Region's largest holding company, Union Planters Corporation. Lower thrift asset volumes had the expected

effect of improving capital coverage from 9.6 percent to

10.1 percent. Past-due loan percentages increased

slightly in every state except for Mississippi after adjusting for these mergers.

ResidentialfLendingfStandardsfComefUnder

Regional Outlook	 20 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features	 Regional Banking
 

PressurefFromfLargefBanksfandfNonBank

Lenders

It appears some banks may be easing credit standards

in an effort to compete for

residential mortgages and

other consumer loans. On a

nationwide basis, finance companies and other subprime

lenders are offering loan packages that allow the consumer to

consolidate all mortgage, home

equity, and credit card debts

into one loan secured by the

borrower's residence. Debt

consolidation loans are not a

new idea; however, some institutions have acknowledged increasing the maximum

threshold amount financed in relation to the value of the

collateral. Loan-to-value (LTV) ratios have increased

from previous standards of 80 to 90 percent to as much

as 125 percent of appraised value.

Some banks in this Region are joining this trend

toward high LTV residential lending: 100 percent

financing is now routinely offered by a number of

institutions. Institutions extending this type of credit

also are permitting extended periods of interest-only

payments, in some cases, up to as long as ten years. It

appears that most small community banks are not actively seeking these types of loans. However, interest in

participating in high LTV residential loan programs

could increase if both consumer demand and competition from larger institutions continue to grow.

Residential mortgage lending represents a significant

business for banks in the Region. A total of 124

institutions hold portfolios of residential mortgage loans

that exceed 25 percent of total loans and 100 percent of

Tier 1 capital. By the end of 1996, banks in the Region

had increased their holdings of 1-to-4 family mortgages

to $43.3 billion or approximately 29 percent of total

loans, making residential lending the largest single loan

category for the Region's banks. Residential loan

growth, adjusted for a major merger, has increased

slightly to a rate of 13 percent (annualized).

Underwriters of high LTV mortgages should be cautious not to make credit and pricing decisions based

on assumptions that the favorable economic conditions experienced over the past six years will continue

indefinitely. Low interest rates, coupled with high

employment and rising income levels, have contributed

to the ability of consumers to service increasing debt

loads. These circumstances also are major factors in

the increasing value of residential properties in all of

the Region's major markets, a trend which appears to

be moderating (see ThefShiftingfEconomicfStructure

off thef MemphisfRegion). Adverse changes in these

key factors could increase potential credit losses from

this type of lending. There are a number of additional

considerations that lenders should take into account.

For example:

• 	 Loans collateralized by 1-to-4 family dwellings

with high LTVs generally will not meet secondary

market standards set by government-sponsored enterprises, such as Fannie Mae and Freddie Mac,

meaning the loans will likely be less liquid and

will remain in the loan portfolio (at least initially).

• 	 Banks that engage in this type of lending may be

more exposed to changing economic conditions that

adversely affect consumer income levels and the

value of residential properties.

While consolidating unsecured debt into a secured loan

structure may provide some comfort to the lender, the

possibility remains that some consumers will simply

increase credit card debt after the consolidation is

completed, thereby increasing the likelihood of

bankruptcy.

AgriculturefIsfBigfBusinessfinfthefRegion

The performance of agricultural businesses is important to the health of the Region's banks. Agriculturalrelated lending totaled $5.7 billion at the end of 1996,

or about 4 percent of

total loans. While this

level may not seem

like a significant concentration, there are a

number of institutions

where agricultural

lending is a principal

business line. Table 1 (next page) provides information by state on 119 agriculture banks, defined in this

article as institutions with more than 25 percent of

their total loans extended for agricultural purposes.

As indicated in Table 1, on average these institutions

appear to enjoy significant financial strength.

The full effect of agriculture in the Region is understated, however, if one considers only direct bank

lending in this area. For example, a recent study by the

Agriculturalf Economicsf Departmentf off Mississippi

Regional Outlook	 21 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features	 Regional Banking
 

TABLE 1
 

AGRICULTURE BANKS* DISPLAY STRONG BALANCE SHEETS

AND OVERALL PERFORMANCE

NUMBER OF RETURN ON LEVERAGE NONPERFORMING NET LOAN

AG BANKS * ASSETS CAPITAL TO TOTAL ASSETS CHARGE-OFFS

ARKANSAS 49 1.34% 11.10% 0.59% 0.16%

KENTUCKY 30 1.39% 11.03% 0.53% 0.19%

LOUISIANA 15 1.26% 11.22% 1.56% 0.33%

MISSISSIPPI 20 1.34% 11.18% 1.12% 0.49%

TENNESSEE 5 1.37% 11.21% 1.05% 0.30%

UNITED STATES 2,467 1.14% 11.07% 0.74% 0.26%

SOURCE: DECEMBER 31, 1996, BANK CALL REPORTS

* BANKS WITH 25 PERCENT OF THEIR TOTAL LOANS EXTENDED FOR AGRICULTURAL PURPOSES.

StatefUniversityf(MSU) provides a broad measure of

the effect that agriculture has on Mississippi. The MSU

study determined that approximately one in three Mississippians are employed directly or indirectly in agriculture, including forestry, accounting for 23 percent of

wages and salaries in the state. The study also estimated that agriculture accounts for one-third of the

state's total annual production. A second example is

provided in a study by the Louisvillef Chamberf of

Commerce, which estimates that agribusiness accounts

for more than 35,000 local jobs, $1 billion in personal

income, $6 billion in product value, and $100 million in

Kentucky and Louisville tax revenue. Considering such

information, it seems clear that the performance of most,

if not all insured institutions operating in markets heavily influenced by agriculture, including certain institutions in large metropolitan areas, will be affected by

this sector. Therefore, an awareness of significant

events that affect this sector is important for both banks

in the Region and their supervisors.

A number of issues arose in 1996 that warrant continued monitoring. A fourth quarter Federalf Reserve

survey of active agricultural lenders disclosed that 32

percent of the respondents have significant concerns

over the portfolio risks caused by reductions in federal

farm subsidies contained in the 1996 Farm Bill. The

changes implemented in the bill are expected to introduce more volatility in prices paid to farmers for crops,

because supply and demand factors will drive prices

rather than artificial price subsidies. Absent the artificially established price targets, farmers are more likely

now than in the past to determine what crops to plant by

watching futures prices. However, planting decisions

based on futures prices could result in excessive supplies of some crops, causing downward pressure on

prices and income for some farmers. The impact on

income could of course be mitigated by hedging activities or obtaining "revenue insurance."

Other agribusiness-related issues that came to the

forefront in 1996 and that may be important to some

lenders include:

• 	 The emergence of increased underwriting and

pricing pressures from competitors, such as

chemical suppliers, as recently cited by some

bankers in Louisiana;

• 	 The increasing competitiveness of foreign producers is becoming a bigger factor in the prices

for some domestic crops, such as soybeans,

which have encountered recent price fluctuations

attributed partially to weather conditions and labor unrest in Brazil;

• 	 Higher exports to foreign countries such as

China, which is the second largest purchaser of

poultry and therefore particularly important to

Arkansas businesses like Tyson's; and

• 	 Negative demand and price ramifications from

lawsuits and general attacks leveled against the

tobacco industry (in 1995 tobacco was a $637

Million crop in Kentucky).

The U.S.fDepartmentfoffAgriculturefprovides information on the Internet for those interested in

agricultural-related issues such as crop prices, stages

of planting, special research papers, and production

forecasts. The USDA homepage may be found on-line

at http://www.usda.gov/, and the USDA Statistics

Regional Outlook	 22 Second Quarter 1997
 
 

Regular Features Regional Banking
 

Service home page may be found at http://

www.usda.gov/nass/.

Gary L. Beasley, Senior Regional Analyst

Timothy J. Hubby, Bank Examiner,

Division of Supervision

Regional Outlook 23 Second Quarter 1997
 
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