Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1998 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

Craig A. Rice,
 

Regional Manager
 

Jeffrey W. Walser,
 

Regional Economist
 

John M. Anderlik,
 

Financial Analyst
 

In Focus This Quarter 

◆ The Asian Economic Crisis: Implications for the U.S. Economy—The 

economic crisis in Asia is now more than one year old, yet its consequences are still 

reverberating throughout the global economy. There are growing indications that 

some sectors of the U.S. economy are beginning to experience slower growth directly attributable to problems in Asia. Consequently, lenders should be cognizant of 

their customers’ exposure to global markets. Lending and strategic decisions predicated on an assumption of continued robust economic growth should be carefully 

scrutinized. See page 3. 

By Paul C. Bishop 

◆ CLOs Lure Another Major Bank Asset off the Balance Sheet— 

Securitization of corporate loans and bonds is in full swing, with 1997 issuance 

exceeding that of securities backed by credit card loans. Collateralized loan obligations (CLOs) and collateralized bond obligations, securities with deal- and issuerspecific risks, are potential bank investments that may grow in popularity if a 

current proposal to lower the risk weights for AAA-rated securities is enacted. 

Banks with an ample supply of low-margin commercial loans are expected to issue 

more CLOs to an increasingly demanding secondary commercial loan market. An 

institution’s CLO strategy may have implications that should be considered when 

evaluating its capital adequacy trends. See page 8. 

By Kathy Kalser and Allen Puwalski 

◆ The Payment System: Emerging Issues—The payment system is the 

heart of the U.S. economic infrastructure, moving value at the rate of 90 times the 

U.S. gross domestic product each year. The banking industry, although historically 

central to this movement, now faces a tangle of new technologies, new exposures, 

and new competitors that challenges its hold on the payments business. Its regulators face a different dilemma—that of how much intervention, if any, these changes 

warrant and how best to prevent the systemic exposures that increasingly large and 

rapid flows of money can create. Together, the issues they face frame a payment system that is fast becoming a technical and political contest. See page 14. 

By Gary Ternullo 

Regular Features 

◆ Regional Economy—The Federal Agriculture Improvement and Reform 

Act of 1996 (FAIR Act) has had immediate effects on farmers in the Region... 

wheat-growing states such as North Dakota and Kansas have the most to lose...the 

direction for farm policy after 2002 will depend on how well the FAIR Act has performed and economic and political conditions prevailing at the time. See page 20. 

By Jeffrey W. Walser, Regional Economist 

◆ Regional Banking—Farm banks in the Kansas City Region, in aggregate, 

continue to perform well...but the FAIR Act will raise farmers’ income volatility, 

increasing the importance of risk-management practices for farmers and their 

lenders. See page 25. 

By John M. Anderlik, Financial Analyst 

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)
 

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

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

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

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

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

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Assistant Editors Gary L. Beasley 

Robert L. Burns 

Norman Gertner 

David T. Griffiths 

Suzannah L. Susser 

Karen A. Wigder 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

The Asian Economic Crisis:
 

Implications for the U.S. Economy
 

•	 The impact of the Asian economic crisis on the 

U.S. economy has been increasingly evident, with 

some sectors experiencing slower growth as conditions in Asia continue to deteriorate. 

•	 U.S. exports to Asia have decreased in recent 

months owing to falling demand for commodities, 

manufactured goods, and agricultural products. 

•	 Slower U.S. growth resulting from reduced export 

sales and lower corporate profits could affect 

institutions throughout the nation. 

The economic crisis in Asia is now more than one year 

old, yet the consequences of the unprecedented slide in 

currency values are still reverberating throughout the 

global economy. There are growing indications that 

some sectors of the U.S. economy are beginning to 

experience slower growth directly attributable to problems in the Asian economies. It is difficult to assess 

how significant and long-lasting the effects of the crisis 

will be, but it is clear that earlier views that the crisis 

would pass quickly and be followed by renewed growth 

were too optimistic. The consensus among economists 

and analysts now is that the recovery will be measured 

in years, not months. 

Causes of the Crisis 

Most economists agree that the Asian economies1 are in 

the midst of a steep and severe recession. For example, 

Indonesia’s gross domestic product fell by more than 12 

percent in the first half of 1998, a decline second only 

to the drop in economic activity in the Soviet Union following its collapse in the early 1990s. While Indonesia 

may be the most startling example of economic deterioration in Asia, the other Asian nations also have experienced weakened stock markets, falling real estate 

values, rising corporate bankruptcies, and growing 

problem loan portfolios among financial institutions. It 

is generally agreed (with the benefit of hindsight) that 

the conditions that precipitated these events included 

the following2

: 

1 Unless otherwise noted, “Asia” refers to the economies of China, 

Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, 

South Korea, Taiwan, and Thailand. 

•	 Reduced Export Competitiveness: Most of the 

Asian economies had effectively pegged their currencies to the U.S. dollar. Between mid-1995 and 

early 1997, the U.S. dollar increased in value by 

more than 42 percent against the Japanese yen and 

by 23 percent against the German mark. This 

increase significantly worsened the international 

competitiveness of many Asian firms relative to 

Japanese or European competitors in export markets, 

since the value of their currencies and the price of 

their exports rose along with the U.S. dollar. By late 

1995, export growth among the Southeast Asia 

economies was slowing, and by mid-1996 it was near 

zero. 

•	 Excess Production Capacity: Although Asian savings rates were among the highest in the world, 

domestic saving was not sufficient to fund the 

desired levels of investment in factories, roads, housing, and telecommunications. The resulting inflow of 

foreign capital funded rapid capacity expansion in 

key sectors such as autos, chemicals, and microchips. For example, capital inflows to Thailand 

totaled $1.9 billion in 1980 but rose to $15.2 billion 

by 1996. The increase in production capacity put 

downward pressure on prices and reduced earnings 

growth in key export sectors.3 

•	 Rapid Asset Price Appreciation: Real estate, land, 

and share prices on the region’s stock markets soared 

during the 1980s and early 1990s. In Indonesia, for 

example, the Jakarta Composite stock index 

2 A comprehensive survey of recent events and links to other information sources is available at the Asia Crisis Home Page, 

www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html. 3 A case in point is the growth of the auto industry. During the past 

several years, Korea invested heavily in new auto plants to satisfy 

both domestic and export demand. By 1999, Korean capacity is 

expected to reach 4.66 million light vehicles annually—2 million 

more than domestic demand. In Japan, excess capacity of 2.8 million 

vehicles is expected through 2002. Worldwide excess capacity in light 

vehicles is expected to reach more than 20 million units by 2002— 

more than the total 1997 production of General Motors, Ford, and 

Chrysler combined (Wall Street Journal, March 2, 1998). The result 

has been downward pressure on prices of domestically produced 

autos—down by 1.9 percent on the basis of the first-quarter 1998 producer price index—and imports, which have experienced price 

increases of less than 1 percent since mid-1996. 

Kansas City Regional Outlook 3	 Third Quarter 1998 
In Focus This Quarter
 

increased by nearly 53 percent in the two-year period ending in the first quarter of 1997. 

•	 Deteriorating Credit Quality: Slower export 

growth and eroding competitiveness hampered Asian 

firms’ ability to repay debt incurred to finance the 

growing levels of investment. Some Korean conglomerates were burdened with a debt load equal to 

300 to 400 percent of equity. As much as two-thirds 

of this debt was short-term, with a maturity of less 

than 12 months. Additionally, the debt denominated 

in foreign currencies, such as the U.S. dollar, ballooned as local currency values dropped. With some 

firms struggling to repay mounting debt, banks 

began to experience a further deterioration in credit 

quality. 

Some of the uncertainty about the strength and speed 

of the recovery in Asia is attributable to concerns 

about the faltering Japanese economy. As the second 

largest economy in the world and the engine of 

growth in the region, Japan must have a healthy economy if sustainable growth is to occur in the rest of 

Asia. With Japan currently in a deep recession and the 

outlook for its economy clouded by the halting pace 

of financial reform efforts, there is considerable 

uncertainty about how quickly economic and financial weaknesses throughout the rest of Asia can be 

repaired. 

Impact on the U.S Economy 

The Asian financial crisis could affect the U.S. economy through several avenues. Some firms and industries 

may be directly exposed, especially if they have operations in Asia. 

Banks may be exposed through 

changes in the financial condition 

of Asian borrowers. Other firms 

may be less directly exposed to 

economic conditions but will be 

affected by changes in relative 

prices and trade flows between the United States and 

Asia. The drop in Asian purchases of U.S. exports has 

hit agricultural products, commodities, and manufactured goods. As some recent corporate earnings 

announcements have shown, the crisis has been associated with profit growth that has failed to meet the market’s expectations. 

Banking 

The U.S. banking industry has a smaller direct lending 

exposure to the Asian economies than either European 

or Japanese banks. As shown in Table 1, U.S. banks had 

outstanding loans of $22 billion at the end of 1997, 

which accounted for 8.5 percent of all international 

lending to Indonesia, Malaysia, the Philippines, South 

Korea, and Thailand. To the extent that exposures exist, 

however, large banks and not smaller regional or community banks account for most of the lending. While the 

overall direct lending exposure of the U.S. banking 

industry may be relatively small, the indirect exposure 

resulting from changing economic conditions in the 

United States as a result of the crisis could potentially 

affect small and large institutions in all areas of the 

country. 

Agriculture 

Key to understanding the impact on agriculture is the 

fact that in world markets, agricultural commodities are 

priced and traded in terms of U.S. dollars. The steep 

decline in value of Asia’s currencies means that the 

price of imported agricultural commodities has rapidly 

risen. Over a longer period, higher import prices tend to 

stimulate production in the importing countries that can 

displace demand for imports. Thailand, for example, is 

positioned to increase production of poultry and sugar. 

Other world producers, such as Australia, whose currency also has fallen in value, are now more competitive 

suppliers of some agricultural products to the Asian 

market than the United States. 

On the basis of analysis performed by the U.S. Department of Agriculture’s (USDA’s) Economic Research 

Services,4 U.S. exports of red meat and poultry are 

expected to drop by 5 to 6 percent in fiscal 1998 and 

1999 as a result of the Asian crisis. Exports of grains are 

projected to fall by at least 2 percent in fiscal 1999 as 

other world producers increase production in response to 

changing relative prices among major grain exporters. 

Overall, USDA expects agricultural exports to fall by 3 

to 6 percent in fiscal 1998 and 1999, compared with the 

level of exports had the Asian crisis not occurred. 

Commodities 

Asian countries have become increasingly important 

commodity consumers in recent years. As a result, com4 “World Agriculture and Trade,” Agricultural Outlook, pp. 10–11. 

Kansas City Regional Outlook 4	 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

International Claims by Nationality of Reporting Bank 

End December 1997 

TOTAL INTERNATIONAL 

CLAIMS (MILLION U.S. $) 

U.S. 

CLAIMS PERCENT 

JAPAN 

CLAIMS PERCENT 

EUROPE* 

CLAIMS PERCENT 

OTHER 

CLAIMS PERCENT 

Indonesia 58,388 4,898 8.4 22,018 37.7 15,044 25.8 16,428 28.1 

Malaysia 

Philippines 

South Korea 

27,528 

19,732 

94,180 

1,786 

3,224 

9,533 

6.5 

16.3 

10.1 

8,551 

2,624 

20,278 

31.1 

13.3 

21.5 

12,997 

9,317 

29,614 

47.2 

47.2 

31.4 

4,194 

4,567 

34,755 

15.2 

23.1 

36.9 

Thailand 58,835 2,533 4.3 33,180 56.4 14,782 25.1 8,340 14.2 

Total 258,663 21,974 8.5 86,651 33.5 81,754 31.6 68,284 26.4 

* Includes France, Germany, Netherlands, and United Kingdom 

Source: Bank for International Settlements 

modity markets have been affected by falling demand for 

basic materials and fuels in Asia. The abrupt halt of construction activity in the region has reduced Asian imports 

of metals and metal products. Consequently, world copper and nickel prices fell more than 36 percent during the 

year ending June 1998. Asian developing countries also 

had stepped up their demand for petroleum products, 

accounting for two-thirds of the increase in world petroleum consumption between 1992 and 1996. As economic activity in Asia slowed, oil demand softened and world 

inventories expanded, causing prices to tumble from $20 

per barrel in July 1997 to less than $14 per barrel in June 

1998. To the benefit of U.S. consumers, the drop in oil 

prices has reduced the prices of gasoline and other 

refined petroleum products, but it has cut into profits of 

oil producers. While there are few indications of widespread financial problems in the industry, smaller and 

less geographically diversified producers may be exposed to adverse price and inventory changes. 

Manufacturing 

Asia accounts for a large and growing share of U.S. 

trade in manufactured goods. Between 1990 and 1996, 

U.S. exports of manufactured goods to Asia increased 

from $75 billion to more than $140 billion, accounting 

for nearly one-third of the increase in total U.S. exports 

of manufactured goods. For the U.S. economy as a 

whole, machinery, food products, and chemicals are the 

most exposed to a drop in Asia’s demand for U.S. 

exports. Together, these industries account for nearly 70 

percent of U.S. exports to Asia. 

Between 1990 and 1996, U.S. imports of manufactured 

goods from Asia rose from $176 billion to more than 

$285 billion. Increased imports from China accounted 

for about one-third of the gain. U.S. imports from Asia 

are dominated by machinery and manufactured goods, 

including electronics and semiconductors, which 

together account for 93 percent of imports. 

Asia’s demand for U.S. exports will continue to weaken 

following the dramatic increase in import prices resulting from the drop in currency values. The latest trade 

data show that the dollar volume of U.S. goods exports 

to Asia (including both manufactured goods and other 

commodities) fell by 22.5 percent in May 1998 compared with one year earlier (Chart 1). 

Changes in the volume of exports at the national level 

do not adequately describe the variation in the export 

exposure of different regions of the country. Chart 2 

(next page) shows the percentage of state-level exports 

CHART 1 

U.S. Exports to Asia Drop While Imports 

Continue Modest Growth 

Source: Bureau of the Census 

–25 

–20 

–15 

–10 

–5 

0 

5 

10 

15 

20 

Jan-96

Mar-96

May-96

Jul-96

Sep-96

Nov-96

Jan-97

Mar-97

May-97

Jul-97

Sep-97

Nov-97

Jan-98

Mar-98

May-98 

Percent Change - Year Ago

Imports Exports 

Kansas City Regional Outlook 5 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Western and Midwestern State Exports Are
 

Vulnerable to Changes in Asian Demand
 

Percentage of Total 

State Exports Destined 

for Asia (1997) 

More than 30% (14) 

21% to 30% (16) 

10% to 20% (17) 

Less than 10% (4) 

Source: Bureau of the Census, International Trade Administration 

that are destined for Asia.5 Clearly, Western states are 

most exposed to changes in the demand for U.S. 

exports, especially electronics, transportation equipment, and industrial machinery. A significant share of 

exports from the Midwest also is destined for Asia, 

including chemicals and machinery such as construction equipment.6 

In the initial stages of the crisis, the consensus view 

suggested that the United States would be overwhelmed 

by cheap imports from Asia, as Asian countries exported their way to economic recovery. Although there has 

been an increase in U.S. imports from Asia, the growth 

has been well below expectations. In May 1998, goods 

imports were up by just 4.8 percent over the previous 

year. The reason that U.S. imports of Asian goods have 

not been greater is due in part to the severity of the economic downturn and the weakness of Asia’s financial 

institutions. Many Asian manufacturers are dependent 

5 The state-level export data are from the Export Locator series published by the Bureau of the Census. These data tabulate the value of 

exports as determined by the location of the exporter, which may differ from the location of the producer. Although these data are an 

imperfect measure of state-level export performance, they are still of 

value in assessing regional exposures and remain the most complete 

data available. 

6 A state-by-state analysis has been prepared by the U.S. Treasury and 

the U.S. Department of Commerce. 

on components imported from neighboring countries or 

purchased on world markets. With the drop in currency 

values, all imported goods, including finished goods 

and intermediate goods that are used in the manufacturing sector, have become more costly. At the same time, 

Asia’s weak financial systems have come under increasing pressure as the economic slump deepens. Many 

banks cannot, or will not, lend. Consequently, Asian 

firms cannot secure the capital to acquire imported 

inputs or to finance the sale of exports abroad. As the 

“credit crunch” abates, imports from Asia should 

rebound, placing greater pressure on U.S. manufacturers. 

Corporate Profits 

Profits of U.S. producers also will be affected by falling 

prices for import-competing goods and plummeting 

Asian demand for some U.S. exports. Although U.S. 

producers of import-competing goods will be under 

increasing competitive pressure, firms that use imported components from Asia will benefit from an effective 

reduction in costs. U.S. exporters may see disappointing 

Asian market profits offset by continuing strong sales in 

the U.S. and European markets. For these reasons, the 

impact of the crisis on corporate profits must be viewed 

in the context of gains and losses caused by changing 

relative prices of a firm’s products and inputs. 

A number of recent earnings announcements have 

failed to meet analysts’ expectations. According to 

IBES International,7 the crisis has contributed to a 

reduction of profit growth, although most of the slowdown is attributable to both falling prices and weak 

demand for semiconductors and oil. Operating profits 

of all companies tracked in the Standard & Poor’s 500 

stock index increased by 4.4 percent in the first quarter 

of 1998, the smallest increase since 1991. Excluding the 

energy and technology sectors, profits of the S&P 500 

firms increased by 8.6 percent in the first quarter. On 

the basis of these results, the impact of the crisis on corporate profits appears to be highly concentrated among 

firms in a few industries. 

Summary and Implications 

The consequences of the Asian economic crisis continue to unfold. The slowdown in growth in most Asian 

economies has already reduced U.S. export shipments 

and put downward pressure on prices of commodities 

and agricultural products. How long this trend will con7 As quoted in the Wall Street Journal, June 22, 1998, p. C1. 

Kansas City Regional Outlook 6 Third Quarter 1998 
In Focus This Quarter
 

tinue is uncertain, but most analysts have dismissed the 

chances of a speedy recovery in Asia. Although most 

economists are not anticipating a recession in the 

United States in the foreseeable future, the indirect 

impact of the Asian crisis will be felt to some extent 

across most regions of the country. 

Lenders should be cognizant of their customers’ exposure to a continued drop in demand for exports or to further deterioration in the pricing environment. More 

generally, slower U.S. growth could affect even those 

borrowers that have little or no 

direct exposure to export markets. What is clear for insured 

institutions is that at this stage of 

the economic expansion and with 

a number of uncertainties about 

the global economic outlook, 

lending and strategic decisions 

predicated on an assumption of 

TABLE 2 

continued robust economic growth should be carefully 

scrutinized. 

References 

Asia Crisis Home Page. New York University. www. 

stern.nyu.edu/~nroubini/asia/AsiaHomepage.html. 

“Automobile Glut Worries Analysts Even as Some Cut 

Back on Output.” The Wall Street Journal. March 2, 

1998. 

The Importance of Asia to the State Economies. 1998. 

U.S. Treasury and U.S. Department of Commerce. 

www.treas.gov/press/releases/pr2317.htm. 

“World Agriculture and Trade.” Agricultural Outlook. 

United States Department of Agriculture, Economic 

Research Service. February 1998. 

Paul C. Bishop, Economist 

Kansas City Region: Merchandise Exports to Asia—1997 

Includes China, Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and Thailand 

PERCENT 

EXPORT OF EXPORTS EXPORT 

VOLUME GROWTH TO ASIA BY EXPOSURE 

INDUSTRY SECTOR ($ MILLIONS) 1993-97 INDUSTRY* TO ASIA** 

TOTAL EXPORTS TO ASIA 7,539.9 38% 100% 23% 

TOP FIVE EXPORT INDUSTRIES 

FOOD PRODUCTS 2,065.5 33% 27% 41% 

AGRICULTURAL & LIVESTOCK PRODUCTS 1,556.7 43% 21% 23% 

INDUSTRIAL MACHINERY & COMPUTERS 993.9 51% 13% 20% 

ELECTRIC & ELECTRONIC EQUIPMENT 697.0 39% 9% 28% 

SCIENTIFIC & MEASURING INSTRUMENTS 602.3 64% 8% 28% 

TOTAL OF TOP FIVE EXPORT INDUSTRIES 5,915.3 42% 78% 27% 

* Percent of Region’s total exports to Asia from each of the top five export industries. 

** Percent of Region’s total world exports for each industry destined for Asia. 

Source: International Trade Administration 

Kansas City Regional Outlook 7 Third Quarter 1998 
In Focus This Quarter
 

CLOs Lure Another Major Bank Asset
 

off the Balance Sheet
 

•	 Securitization of corporate loans and bonds is in 

full swing, with 1997 issuance exceeding that of 

securities backed by credit card loans. 

•	 Collateralized loan obligation (CLO) and collateralized bond obligation (CBO) issuance has grown 

dramatically since 1996. Both CLOs and CBOs 

are potential bank investments that may grow in 

popularity if a current proposal to lower the risk 

weights for AAA-rated securities is enacted. 

•	 These bonds may offer a higher yield than other 

AAA-rated securities, but they also may carry 

both deal- and issuer-specific risks that warrant 

closer scrutiny. 

•	 Banks with an ample supply of low-margin commercial loans are expected to issue more CLOs to 

an increasingly demanding secondary commercial loan market. 

•	 Securitizing investment-grade commercial loans 

has implications for capital adequacy. 

CBOs and CLOs are fixed-income securities that share 

many similarities with other asset-backed securities. In 

a CLO or CBO, commercial loans or bonds are pooled 

and securitized, and participation certificates in the 

underlying assets are sold to investors. The first CLO 

and CBO transactions occurred in the late 1980s, but 

issuance was slow until last year. During 1997, the estimated volume of corporate bonds and commercial loans 

securitized was $54 billion, more than double the 

amount securitized in 1996. In fact, the combined 

issuance of CBOs and CLOs in 1997 was more than the 

amount of credit card loans securitized during the year. 

The amount of securitized commercial loans and corporate bonds is expected to continue to grow this year, 

with an increasing number of deals backed by commercial loans1 (see Chart 1). 

1 CBOs/CLOs: An Expanding Securitization Product, p. 1, 

JP Morgan, September 1997. 

CBOs and CLOs: A Natural Development in the 

Asset-Backed Securities (ABS) Market 

The growth of the CLO market can be explained by several supply and demand factors. On the demand side, 

strong investor appetite for ABS has produced tremendous growth in the securitization of consumer loan segments such as credit card, auto, and home equity loans. 

The increasing comfort level of the capital markets with 

these asset classes and the various structures used to 

securitize them has facilitated the ABS market’s expansion into nonconsumer loans, including corporate debt 

obligations and bank commercial loans. CBO and CLO 

structures represent a natural progression from the securitization of a pool of consumer loans to the securitization of a diversified package of corporate bonds or bank 

loans. 

Increased standardization of terms among commercial 

lenders and more information flow on returns, defaults, 

and recoveries also have made commercial loans and 

corporate debt more desirable to institutional investors 

and an asset class viable for securitization. In addition, 

CLOs provide a way for investors, including banks, to 

own a credit-enhanced interest in a diversified pool of 

loans without directly owning the individual loans. 

Investors are increasingly considering collateralized 

bond and loan products as higher yielding alternatives 

to other ABS. 

CHART 1 

CBO and CLO Issuance Is Growing 

Source: JP Morgan 

0 

10 

20 

30 

40 

50 

60 

1990 1991 1992 1993 1994 1995 1996 1997 

($ Billions)

CBO CLO 

Kansas City Regional Outlook 8	 Third Quarter 1998 
In Focus This Quarter
 

Foreign and, to a lesser extent, domestic banks have 

been large purchasers of CLOs and CBOs. Bank investment in CLOs and CBOs primarily has been in the most 

senior, highest investment-rated tranches. Together, foreign and domestic banks are estimated to have purchased almost one-half of the highest rated classes of 

CLO and CBO securities issued in 1997. Insurance 

companies dominated the purchase of the middle or 

mezzanine class of CLOs and CBOs.2 

Last year the Federal Financial Institutions Examination 

Council proposed lowering the risk weighting for AAArated ABS from 100 percent to 20 percent. Bank investment in AAA-rated ABS products, including CLOs and 

CBOs, could increase substantially if the proposal is 

approved. 

Lower Capital Requirements, Higher Return 

Ratios Attract Banks to CLO Market 

On the supply side, issuers of CLOs backed by investment-grade loans are motivated by regulatory capital 

treatment, return on capital, and relationship management. While the CLOs originated in the late 1980s were 

designed to purge the lender’s balance sheet of lower 

quality commercial loans, the recent bank-issued CLOs 

have been secured by higher credit quality, lower margin commercial and industrial loans. 

A bank that is capital constrained may view the CLO 

structure as an alternative to issuing additional equity. 

But more often, banks are motivated to securitize 

investment-grade commercial loans because by doing 

so they effectively subject themselves to the market’s 

capital requirements for such loans instead of their regulator’s. Tight competition has compressed the margin 

that banks earn on investment-grade loans to the point 

that more institutions are considering investment-grade 

lending to be an inefficient use of capital. As margins 

have declined, the CLO market has helped relationship 

managers rationalize lower pricing from the perspective 

of return on capital. Since investment-grade and non2 CBOs & CLOs—An Attractive Investment Class, p. 5, Merrill Lynch 

& Co., Inc., December 1997. 

investment-grade-performing commercial loans have 

the same risk weightings for regulatory capital purposes, removing the higher quality, lower yielding assets 

from the balance sheet tends to leave existing bank capital supporting higher return activities.3 In this way, a 

bank can improve certain profitability measures, but 

possibly with a higher risk profile. 

Table 1 (next page) illustrates the effects of a CLO on a 

bank’s capital and return ratios. In order to compare the 

on- and off-balance sheet transactions, the costs of the 

CLO and the associated reserve requirement are analogized to the on-balance sheet funding costs and capital 

requirement if the assets remained on the balance sheet. 

The assumptions reflect the spreads and reserve 

requirement of a typical transaction. While the execution of the CLO costs more than the on-balance sheet 

financing of the loans, the risk-adjusted return on capital (RAROC) is greater with the CLO. The reserve 

requirement is minimized by the tiering of tranches in 

the securitization, which provides credit enhancement 

to the senior classes. The reserve fund, if retained by the 

issuing bank, represents recourse to the bank from the 

sold assets and requires capital at 100 percent under 

“low-level” recourse. 

CLOs also may be used to facilitate corporate borrowing relationships. For example, banks that want to maintain relationships with corporate borrowers but are 

restrained by concentration limitations, either by borrower or by industry, may use CLOs to alleviate concentrations without disrupting borrower relationships. 

Large commercial banks with significant holdings of 

investment-quality commercial loans are likely candidates to issue CLOs. CLO issuance by investment banks 

could grow as these institutions secure a stronger foothold in the commercial loan market. In 1997, foreign 

banks were the primary issuers of CLOs, but more U.S. 

banks are expected to issue CLOs in the future. Japanese and Asian banks may increase their CLO activity as 

they come under pressure to improve capital ratios and 

remove distressed loans from their balance sheets. 

3 Pursuant to the Basle Accord, commercial loans generally receive a 

100 percent risk weighting regardless of the credit rating of the loan. 

Proponents of CLOs have argued that banks can improve their riskadjusted return on capital by removing the higher quality, lower earning commercial loans from the balance sheet. 

Kansas City Regional Outlook 9 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

CLOs Can Facilitate a Higher RAROC on Investment-Grade Assets 

ASSUMPTIONS: 

AMOUNT OF LOANS IN CLO: $1 BILLION 

LOAN PORTFOLIO YIELD: LIBOR + 50 BPTS 

BANK FUNDING COSTS: LIBOR − 10 BPTS 

CLO FUNDING COSTS: LIBOR + 24 BPTS 

BANK RETAINS 1% RESERVE FUND: $10 MILLION 

BEFORE CLO 

YIELD LESS FUNDING COST (L+50) LESS (L− 10) = 60 BASIS POINTS 

NET SPREAD EARNED .006 × $1 BILLION = $6 MILLION 

RISK-BASED CAPITAL REQUIREMENT (8% ON $1 BILLION) = $80 MILLION 

RAROC $6 MILLION/$80 MILLION = 7.5% 

AFTER CLO 

YIELD LESS FUNDING COST (L+50) LESS (L+24) = 26 BASIS POINTS 

NET SPREAD EARNED .0026 × $1 BILLION = $2.6 MILLION 

RISK-BASED CAPITAL REQUIREMENT (100% OF RESERVE FUND) = $10 MILLION 

RAROC $2.6 million/$10 million = 26% 

Source: Bear, Stearns & Co. Inc. 

Arbitrage Opportunities Motivate Most 

Securitization of Subinvestment-Grade Debt 

Issuance of CLOs backed by subinvestment-grade loans 

and most CBOs, which commonly are backed by a mixture of bonds with a subinvestment-grade weighted average, typically is motivated by the potential to capitalize 

on wide spreads between investment and subinvestmentgrade debt. The securities backed by subinvestmentgrade collateral, often referred to as “arbitrage” CLOs 

and CBOs, contain higher yielding, riskier securities 

such as high-yield debt, distressed bonds, highly leveraged loans, and emerging market debt. By assembling a 

diversified pool of higher yielding investments, asset 

managers can limit aggregate event risk and create a 

security with a lower required yield than the underlying 

collateral. Securitizations can include a combination of 

loans and bonds and are sometimes referred to as collateralized debt obligations or CDOs. 

A Closer Look at CLO Structures 

While the structures of CLOs and CBOs are similar, 

banks’ involvement as issuers of CLOs, and the forces 

driving this issuance, elevate the importance of considering CLO structures. Chart 2 presents the basic structure of a CLO. Although specifics may vary, most CLOs 

use a stand-alone special purpose vehicle (SPV) or trust 

to purchase a diversified pool of assets from a bank 

originator or issuer. The purchase of the assets by the 

SPV is funded through the sale of debt securities to 

investors. The structure of the SPV may include one or 

more tranches of debt that are secured by the pool of 

assets owned by the SPV. The classes of debt are distinguished by their priority of claims on the cash flow from 

the collateral, with the most subordinated pieces functioning as an equity investment in the pool. 

The senior tranche is usually the largest, has the greatest amount of credit protection, and earns the highest 

credit ratings in the CLO structure. The rating of the 

senior class typically is higher than the average rating 

of the underlying pool of assets due to the tiering of 

claims among the debt classes and credit enhancement 

in the CLO. The junior tranches of debt may be below 

investment grade or not rated. The reserve or “equity” 

portion may be retained by the issuing entity as a form 

of credit enhancement or sold to third-party investors 

who want a potentially higher return investment. 

CLO collateral has included both funded and unfunded 

loan commitments, loan participations, and different 

types of credit default swaps. Loan assignments also 

may be transferred through a CLO but are less commonly included because of bank issuers’ desire to mainKansas City Regional Outlook 10 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Simplified Collateralized Loan Obligation Structure 

Originating Bank 

Special Purpose Vehicle 

(Purchases assets from originator and 

sells debt and equity to investors) 

Senior Class A Notes 

(90% of debt) 

(Investment Grade) 

Mezzanine Class B Notes 

(9% of debt) 

Reserve 

(1%) 

(May be retained by bank) 

Proceeds 

Sale, assignment, or 

participation of loans or credit 

linked notes to special purpose 

vehicle (SPV) 

Assets purchased from 

originator are collateral for debt 

and equity issued by the SPV 

Relative size 

varies by deal 

Proceeds 

tain borrower relationships. The issuer may transfer the 

actual loan, the cash flow from the loan, or the default 

risk to investors. 

CLOs typically rely on an asset manager or servicer 

to “manage” or protect the investors’ interest in the 

collateral. The investment style or role of the asset 

manager may change depending on the purpose of the 

CLO. Securitizations that use an asset manager to 

actively manage the performance and market value of 

the collateral are referred to as “market arbitrage” or 

“market value” transactions. In these deals, the asset 

manager can trade assets into and out of the securitized 

pool in order to maximize the market value of the 

securitized portfolio. In contrast, most bank-issued 

CLOs are designed as “cash flow” transactions, in 

which the asset manager’s role is more as a servicer than 

as a portfolio trader. These structures rely primarily on 

the ability of the collateral to make stable cash flow payments over a predetermined period and emphasize 

the credit quality of the collateral and the predictability of interest and principal payments rather than liquidity and market performance, as in market value 

transactions. 

Kansas City Regional Outlook 11 Third Quarter 1998 
In Focus This Quarter
 

An Introduction to Delinked 

and Linked CLO Structures 

The variables in structuring a CLO are many. The relative size of the senior and subordinated tranches, the 

form of credit enhancement, the ability of the asset 

manager or servicer to adjust the asset pool, and the 

method and degree to which ownership of the underlying loans is conveyed to investors vary among CLOs. 

Despite the variations, two basic structures have 

emerged: “delinked” structures and “linked” structures. 

The primary difference between these two is the extent 

to which the SPV “owns” the securitized assets. An 

issuer may consider many factors when determining the 

type of structure to use, including the ability or desire of 

the issuer to transfer the loans without notifying the borrower, the credit quality of the loans, the investment rating of the bank issuer, and the desired capital treatment 

of the securitized loan. 

In a delinked structure, the collateral is transferred from 

the issuer to the SPV. Delinked structures are generally 

treated as “true sales” for accounting purposes, and the 

loans in the CLO are removed from the issuer’s balance 

sheet. Delinked CLOs are structured to insulate the 

investor from the credit quality problems or insolvency 

of the issuer. Ratings on delinked CLOs are predicated 

on the projected performance of the collateral and the 

credit enhancement structure rather than the credit quality of the issuer. Some delinked CLOs are similar to 

structures used in credit card securitizations that capitalize on the flexibility of a revolving master trust. The 

master trust structure is advantageous because it allows 

for the securitization of different types of assets, such as 

fixed or floating rate or revolving or term loans. 

In linked transactions, also known as credit linked 

notes, the issuer retains ownership of the underlying 

collateral, and the cash flow generated by the collateral 

pool is conveyed or sold to the SPV. All or part of the 

credit risk from the underlying assets is transferred to 

the CLO investor using credit derivatives. As in 

delinked CLO structures, credit protection is provided 

through the layering or tranching of the debt sold and 

other credit enhancements. 

Investors in linked CLOs are not completely insulated 

from the credit risk of the issuer. Because the issuer 

retains ownership of the underlying loans, a default or 

bankruptcy by the issuer could affect the transmission 

of cash flow to the CLO investors. As a result, investors 

in linked CLOs bear both the credit risk of the securitized loan pool and, to some degree, the risk that the 

issuer may become insolvent. Because of this dual 

exposure, ratings on linked structures are typically 

capped by the credit rating of the issuer. 

The accounting and regulatory capital treatments of 

delinked and linked CLOs also differ. Linked structures 

generally do not qualify for sale treatment under generally accepted accounting principles because the assets 

remain under the control of the issuer. Issuers of linked 

CLOs may be granted some regulatory capital relief 

under the Basle Accord if the cash received from the 

securitization is assigned as collateral for the underlying 

loans. The Basle Accord, which governs capital adequacy requirements for Bank for International Settlements 

member countries, reduces the risk weighting on commercial loans that are secured by cash or certain types 

of risk-free marketable securities such as Treasury 

bills.4 While linked CLOs may provide some form of 

capital incentive for foreign banks under the Basle 

Accord, linked structures offer 

little relief to U.S. banks 

because U.S. banks must maintain minimum leverage capital 

ratios in addition to risk-based 

capital ratios. Since the securitized loans count as assets of 

the bank issuer in a linked 

structure, the leverage ratio 

(roughly, book equity to book assets) is not reduced. 

Consequently, the linked CLO structure has been more 

popular among foreign banks. 

The Role of Investment Rating Agencies 

Although the approach may vary among rating agencies, the criteria used to determine the investment rating 

for CLOs are similar. Rating agencies evaluate the ability of the securitization vehicle to make interest and 

principal payments to holders of the debt. This analysis 

requires an evaluation of the credit quality of the underlying collateral pool, including the projected cash flow 

4 Under the Basle Accord and the U.S. risked-based capital guidelines, 

assets collateralized by cash or Treasury securities generally receive a 

preferential risk-weighting that may range from 0 to 20 percent. For 

background information regarding the risk weightings for collateralized transactions applicable to federally regulated institutions, see 

Federal Deposit Insurance Corporation Financial Institution Letter 

number 64–96 dated August 22, 1996. 

Kansas City Regional Outlook 12 Third Quarter 1998 
In Focus This Quarter
 

generated by the pool, the credit enhancement, and any 

additional protection provided to the investors based on 

the structure of the securitization. The rating agencies 

set limits on the amount of industry and borrower concentration in a pool and statistically evaluate the effect 

of diversification among loans when estimating potential defaults and losses from the securitized assets over 

the life of the transaction. If the underlying collateral is 

not already rated—most commercial loans are not—the 

rating agency will grade the underlying loans and assign 

a rating to the security on the basis of the credit quality 

of the loans and the underwriting criteria used by the 

lender. Estimates of default probabilities, timing of 

default, and recoveries in the event of default are 

assigned to the loans and vary by collateral type and 

credit grade. These estimates are generally based on historical default studies authored by the various rating 

agencies. 

Implications for Insured Institutions 

The advent of CLOs poses new opportunities and risks 

to banks. The ability to transfer all or part of a commercial loan’s credit risk to investors may have several consequences. When issuers of CLOs securitize their 

highest grade assets, they are effectively lowering the 

weighted average credit quality of their retained assets. 

An institution’s loan loss reserving policies and capital 

adequacy should take into account the implications of 

its CLO strategy. 

While the issuance of CLOs may be confined to larger 

banks that have considerable commercial loan portfolios, smaller banks or other types of institutions that 

desire a greater exposure to this type of lending may 

consider investing in CLOs. These instruments offer 

banks the opportunity to invest in a diversified pool of 

commercial loans. Because of credit enhancement features and diversification advantages, the most senior 

debt issued by the CLOs can earn a higher investment 

rating than the average rating on individual loans in the 

pool. Despite the investment rating, banks that invest in 

CLOs should be aware that CLO structures are less 

standardized than other ABS investments, and therefore, performance and underlying risk will be both 

issuer and deal specific. 

Kathy Kalser, Chief, Financial Sector Analysis Section 

Allen Puwalski, Senior Financial Analyst 

Kansas City Regional Outlook 13 Third Quarter 1998 
In Focus This Quarter
 

The Payment System: Emerging Issues
 

•	 Essential to the transfer of value in the U.S. economy, the once-arcane and bank-centered payment 

system is undergoing considerable change as new 

technologies bring new opportunities, new exposures, and new competitors into the payments 

business. 

•	 For most banks, the major issues lie in smallvalue payments, where they struggle for advantage in adapting new technologies into new 

products and services while protecting their traditional payments business from technologically 

adept nonbank competitors. 

•	 For regulators and a handful of the largest banks, 

large-value payments present the most serious 

challenges, as technology has enabled increasing 

payment velocity and volume but also has created 

the potential for systemic failures. 

The payment system is the heart of the U.S. economic 

infrastructure, moving an estimated $670 trillion annually among consumers, businesses, financial institutions, and governments.1 Despite this volume—an 

amount equal to roughly 90 times the U.S. gross domestic product—the payment system remains transparent to 

most users because of its dependability in moving value 

safely. Historically, banks have been essential to this 

movement, reaping, according to the Bank Administration Institute, an estimated $117 billion each year in 

revenues both as payment agents and as the holders of 

the funds from which those payments are made. 

Broadly speaking, the payment system encompasses the 

numerous payment products, players, and the infrastructure that together transmit value throughout the 

economy. More specifically, it can be defined as a collection of individual systems constructed around specific payment products. Credit cards, for example, 

represent a payment system. So do debit cards, checks, 

foreign exchange, and even cash. This product-based 

definition is a relevant one for many bankers, since it 

centers on the products and services that generate revenue rather than on the less glamorous “back office” 

functions that are measured instead by their cost. A 

1 Estimate for 1996 from the National Automated Clearing House 

Association; www.nacha.org/resources/marketing/direct-payment/uspayments-96.gif. 

second definition segments the payment system by payment size. Using this definition, the payments world is 

divided into systems that carry small-value or retail 

payments and those that carry large-value or interbank 

payments. This latter classification is oriented more 

toward infrastructure than product but is convenient 

from a regulatory perspective because the seriousness 

of the risk posed varies considerably by payment size. 

However defined, the payment system today is a source 

of new opportunities and exposures—a result of a host 

of new technologies that the “information revolution” 

has spawned. These technologies create different issues 

for banks and regulators. For banks, the issues involve 

adapting the technologies into new products and services while protecting their payments business from 

nontraditional competitors that specialize in its creation 

and use. For regulators, the issues involve managing the 

risks—principally systemic risk—that accompany the 

large increases in payment volume and velocity enabled 

by technology. Taken together, these issues frame a payment system that can be both a political and a technological battleground, with significant incentives for 

participants to shape payment products and channels in 

a way that favors their own objectives. 

Small-Value Payments: 

A Technological Brawl 

Nowhere has the battle to shape the payment system 

been more contentious than in the small-value segment, 

where emerging information technology can best be 

leveraged into new fee-based retail products. There are 

two battles here. The first involves maintaining the 

monopoly over the payments infrastructure that connects each bank with the Federal Reserve and, by extension, with every other depository institution in the 

United States.2 While this infrastructure is interbank— 

that is, it is dedicated to settling accounts between institutions and does not directly extend to their 

customers—the ability to aggregate and settle individual retail payments through it has enabled the banking 

industry to maintain its centrality to the nation’s monetary flows. 

2 Depository institutions were granted exclusive access to this infrastructure upon its creation by the Federal Reserve Act of 1913. 

Kansas City Regional Outlook 14	 Third Quarter 1998 
In Focus This Quarter
 

The second battle involves exploiting new technologies 

either to attract new customers or to serve existing ones 

more profitably. This battle is both highly visible and 

highly technical and underscores the potential of the 

passing of information to eclipse the passing of value as 

the most critical profit opportunity in payments. The 

best example of this potential is bill presentment, the 

process of posting vendor invoices—such as credit card 

or utility statements—on the Internet to facilitate electronic payment. The crucial question concerns where 

the customer transaction data will lie. If they lie on vendors’ sites or on the sites of nonbanks that concentrate 

such data, those entities will effectively “own” the customer by owning the information needed to cross-sell or 

otherwise add value during the billing process. Owners 

of customer-specific data also can tailor new services— 

a process that can develop loyalty as well as related 

sales. Losing this battle would be doubly costly for 

banks because, regardless of where the data reside, electronic payments will eliminate most of the float in the 

payment process, to the benefit of vendors and largely 

at the expense of banks. 

Another battle is building between banks and nonbanks 

with respect to digital cash and stored value applications. These applications are directed at the micropayment sector—that is, payments that are normally 

considered too small for credit cards. Whether they 

reside on a computer or a smart card, these applications 

substitute electronic data for actual cash, with the 

amount stored on each card covered dollar for dollar by 

balances on account with an issuer. The struggle is for 

the right to issue this value, and the American Bankers 

Association has contended that regulated depository 

institutions alone should be permitted to do so.3 The battle here is for more than just fees, for the interest on the 

balances that back this electronic value could provide 

issuers with substantial new sources of income. 

With some new payment technologies, the distinction 

between opportunity and risk can blur. As the Internet 

enables the distance between shopper and shopkeeper to 

increase, the need to authenticate unseen customers, 

merchants, and banks increases as well. At the same 

time, the open nature of the Internet requires that the 

privacy and integrity of transaction information be protected. The building blocks to accomplish this are neither simple nor easily interwoven—successfully 

combining cryptographic protocols, specialized security hardware, and existing information systems is a dif3 The Role of Banks in the Payments System of the Future, www. 

aba.com. 

Emerging Issues in 


Small-Value Payments
 

Maintaining the payment system monopoly. Access 

to Federal Reserve payment services has historically 

been limited to depository institutions. Maintaining 

that monopoly—and thus maintaining its centrality to 

current and future payment products and services—is 

an important issue to the banking industry. 

Electronic bill presentment is the process of presenting bills and receiving payments electronically. Internet 

bill presentment may be one of the most hotly contested services, because the owner of the site where invoices are posted could cross-sell to customers as well. 

Digital cash and stored value are applications in 

which electronic data substitute for cash. Such applications can run on either smart cards or personal computers. An important issue is who holds the balances that 

back electronic value, because, unlike with paper cash, 

issuers may be able to earn interest on the digital balances held by consumers. 

Securing online transactions. Ensuring the integrity, 

privacy, and authenticity of electronic transactions is 

widely desired by those engaged in electronic commerce. With larger payments, desirability will become 

necessity. Current implementations use combinations 

of encryption algorithms and specialized hardware. 

Banks as certificate authorities (CAs). Authenticating Internet payers and payees may require a complex 

public key infrastructure in which trusted organizations 

supply decryption keys to authenticate the counterparties to a transaction. Some banks are already acting as 

CAs. Others are weighing the benefits and largely 

uncertain exposures of providing such a service. 

Electronic Funds Transfer ’99 (EFT 99). On January 

2, 1999, the U.S. government will be required to make 

benefit and vendor payments electronically. This mandate raises issues of how to provide service to the “unbanked,” how to provide service internationally, and for 

vendors, how to integrate remittance data with the payment itself. 

Development of financial electronic data interchange (EDI) standards. For bank commercial customers to benefit from electronic payments, banks must 

be able to handle remittance information—information 

that accompanies payments and identifies sender and 

transaction detail. Standardizing such data is an important step in enabling banks to receive them and pass 

them on to their customers. 

Point of sale check truncation. Checks are costly to 

handle and time-consuming to collect. Check truncation reduces cost and eliminates float by converting the 

check into an electronic transaction at the point of sale. 

Although banks will have fewer checks to handle under 

check truncation, they will lose float and the return on 

investment in check-handling equipment. 

Kansas City Regional Outlook 15 Third Quarter 1998 
In Focus This Quarter
 

ficult matter in itself if the whole is not to be weaker 

than the individual parts. 

The VISA and MasterCard Secure Electronic Transaction (SET) protocols, designed to protect Internet credit card transactions, illustrate the complexity that banks 

and their customers will need to navigate in securing 

online transactions. Under SET, all banks and merchants will use digital certificates to authenticate themselves to consumers and each other for each Internet 

transaction.4 These certificates are electronic messages 

that contain a decryption key for the sender that is itself 

authenticated by a trusted third party. The infrastructure 

for storing, distributing, and vouching for these keys, 

known as a Public Key Infrastructure (PKI), will contain several tiers of certificate authorities (CAs) and 

will be difficult and costly to implement. Banks not 

only will use these certificates, but many are considering becoming—or have already become—CAs themselves. While banks acting as certificate authorities 

may represent a logical progression in banking services, 

there is little evidence of a homogeneous legal infrastructure or legal precedent sufficient to guide digital 

signature disputes. These voids leave unanswerable the 

question of whether the expected gains from providing 

such services will compensate for the potentially longtailed liability from doing so. 

A major stimulus for electronic payments could come 

on January 2, 1999, when the U.S. government is 

required by law to convert its vendor and benefit payments from paper checks to electronic transfers—the 

so-called Electronic Funds Transfer ’99 (EFT 99) program. Three separate challenges arise from this mandate. The first is that the “unbanked”—those segments 

of the population that are socially, economically, or geographically distanced from a financially bank-centric 

world—must eventually be provided with a cost-effective means to receive, store, and spend their electronic 

value.5 The second challenge is that the EFT mandate 

applies internationally as well as domestically. Given 

the need for each international payment to settle in two 

currencies and countries, the ability to provide efficient 

cross-border EFT will vary considerably from country 

to country.6 

4 Depending upon card brand and SET version, consumer certificates 

may be required as well. 5 Because of resistance from bankers and benefit recipients, compliance waivers are envisioned that will make the program largely voluntary until the details of the special electronic transfer accounts 

(ETA) are worked out. 6 www.fms.treas.gov/eft. 

Perhaps more challenging to many financial institutions 

is that electronic payments to vendors, unlike those to 

individuals, will require electronic remittance data to 

accompany the payment itself. This information goes 

beyond simple routing instructions and includes the 

information—such as purchase order or invoice numbers—necessary for the vendor to apply the payment 

correctly. According to a study by Booz-Allen & 

Hamilton, only slightly more than 5 percent of financial 

institutions were able to receive and forward such remittance information as of early 1997.7 Developing this 

capacity will therefore be an industrywide challenge. 

Once again, there is an opportunity disguised as a cost. 

The development and implementation of financial electronic data interchange (financial EDI) standards will 

enable financial institutions to retain control of—and 

add value to—business-to-business transactions when 

commercial payments migrate to the Internet. 

The U.S. government is not alone in seeking an end to 

costly paper-based payments. Vendors too are pressing 

for the elimination of the slow check presentment 

process wherein checks must physically be moved 

from vendor to vendor bank to issuer bank before 

funds can be transferred. Point of sale check truncation 

shortens this process by converting the check into an 

electronic payment at the point of sale, leaving the customer with an executed check and the vendor with a 

transaction that will settle like a debit card—and in 

doing so eliminates much of the potential for check 

fraud. While this process is beginning to displace physical presentment, the outlook for banks is mixed. As 

the volume of checks that must be physically handled 

decreases, so too will the income from float and the 

returns from past investments in check-handling 

capacity. 

Large-Value Payments: Making the 

World a ‘Good and Final’ Place 

Unlike small-value payments, the issues surrounding 

large-value payments are not strategic ones for banks, 

and less technological wizardry pervades them. Instead, 

the common factor is the systemic risk posed by payment failures. For this reason, regulators—particularly 

the Federal Reserve and the world’s other central 

banks—take very seriously the payments “plumbing” 

that is otherwise obscure even to many bankers. In an 

7 Remittance Data Study, Booz-Allen & Hamilton; www.fms.treas. 

gov/eft/remit.html. 

Kansas City Regional Outlook 16 Third Quarter 1998 
In Focus This Quarter
 

electronic and intangible world where a bank’s accumulated exposures can routinely exceed its equity, the overriding objective for payment system designers, users, 

and regulators is “good and final” payment—a term 

referring to funds that are both irreversible and fully 

collected. 

Recognition is building concerning the payment system’s vulnerability and just how critical it is to the 

U.S. economy. An October 1997 report issued by the 

President’s Commission on Critical Infrastructure 

Protection (PCCIP) warned that “the nation’s core payment systems...seem to present a serious physical vulnerability within the financial system.”8 The source of 

that vulnerability, in the eyes of the commission, 

stemmed not so much from a lack of security as from 

the critical importance of those systems to settling 

financial transactions throughout the economy and the 

lack of available alternatives if they failed. As such, it 

was feared that the payment infrastructure provides an 

enticing target for cyber-terrorists and information warriors and that such threats will only grow in the future. 

Concentration refers to the fact that while banks are 

central to payments and all enjoy equal access to Federal Reserve payment services, some banks are clearly 

more central than others. According to March 1998 Call 

Report data, a mere 25 banks hold nearly two-thirds of 

the U.S. banking industry’s transaction accounts.9 

Should one of these large banks suddenly fail, its inability to fund settlements could result in a loss of payment 

system liquidity and disruption of domestic and foreign 

financial systems alike. While this concentration is not 

new, what is new is the considerable increase in concentration that the new megamergers promise.10 How 

and whether to inoculate the payment system from the 

weight of these super-institutions will become an issue 

for the regulatory community. 

The criticality of a nation’s payment system is not confined within its own borders. Because of globalization 

and the increasing velocity of payments, threats to one 

8 www.pccip.gov/report_index.html, p. A39. 9 Transaction accounts, in essence, are those accounts from which 

third-party payments can be made. The data used here are based only 

on transaction accounts held on behalf of other public and private 

financial institutions here and abroad—accounts from which interbank transfers are made. 

10 As of March 31, 1998, the top three U.S. bank holding companies 

held approximately 25 percent of all reported interbank transaction 

deposits. The mergers announced through June 30, 1998, would 

increase that concentration to over 34 percent. 

Emerging Issues in 


Large-Value Payments
 

Payment system vulnerability. According to the 

PCCIP, the nation’s core payment systems may present 

a serious physical vulnerability within the financial 

system. 

Payments concentration. Payment services are concentrated in a relatively few large banks, and that concentration is growing as megamergers are creating a 

smaller number of superbanks. 

Y2K. The Year 2000 problem threatens to disrupt payments by transmitting computer problems via the payment system from banks that have not fixed the 

problem to banks that have. 

The Euro. Bank and interbank systems in Europe 

and abroad must be modified to accept the Euro. In 

addition, the resources required to implement the 

Euro must be diverted from resolving Y2K problems. 

Foreign exchange settlement risk. Foreign exchange 

transaction exposures can be many times a bank’s capital. The failure of a major creditor to pay could drain 

essential liquidity from international markets. 

Achieving finality in gross payment systems. Making a given country’s domestic payments irrevocable 

and immediate is a major step in avoiding the international spillover of internal financial crises. 

Collateralizing net payment systems. According to 

the BIS, systems that do not permit immediate final 

settlement must be collateralized to ensure the eventual satisfaction of member positions in the event of a 

participant’s failure. Like finality, collateralizing helps 

prevent the internationalization of a domestic failure. 

country’s system become threats to those of other countries as well. There are a number of these emerging 

cross-border concerns. The most immediate and visible 

is the Year 2000 or Y2K problem. Because banks and the 

payment networks that join them are heavily computerized, the latent points of vulnerability to software and 

hardware failures have grown factorially with the number of interconnected internal and external systems. In 

this context, the concern is that any banks that have 

failed to correct their Y2K exposures will transmit that 

failure via the payment system to other institutions 

throughout the world, delaying or even arresting settlements in the process. This concern is heightened 

because, in both Asia and Europe, bank resources needed to fix Y2K are being consumed instead by more 

immediate problems. In Asia, it is surviving the decay in 

currencies and credits. In Europe, it is the Euro, which 

rates as an issue in itself—demanding the modification 

Kansas City Regional Outlook 17 Third Quarter 1998 
In Focus This Quarter
 

of bank and interbank payment systems throughout the 

world in anticipation of that currency’s January 1, 1999, 

launch. 

Although less well known to the general public, foreign 

exchange settlement risk remains of considerable concern to the Bank for International Settlements (BIS) and 

its member central banks. This exposure arises because 

cross-border payments, unlike domestic payments, have 

no single central bank to guarantee settlement, leaving 

U.S. banks exposed to their foreign counterparties and 

correspondents—sometimes for several days—for more 

than $244 billion in daily trades.11 Potential solutions to 

this problem include netting—offsetting risks so that 

only the differences are due—and simultaneous settlement. An ongoing effort by several of the world’s largest 

banks to provide simultaneous cross-border settlement, 

a project known as the Continuous Linked Settlement 

Bank, will require considerable international cooperation since it will effectively span the central banks in 

each country whose currency it settles. 

Efforts by individual countries to solidify their payments infrastructure are ongoing as well. Achieving 

finality in payments—a term meaning that a completed 

payment is irrevocable—is the most prevalent, and recognizes that payments must be irreversible to establish 

the liquidity for those that follow. One way of speeding 

up finality is with real time gross settlement (RTGS) 

systems. “Real time” means that there is no delay in settlement. “Gross settlement” means that transactions are 

settled in the full amount for which the original payment 

instructions were entered. FedWire, the U.S. Federal 

Reserve’s large-value payment system, is an RTGS system. Many other countries also have them, and still 

more are developing or planning them. Complementary 

to RTGS systems are net or provisional settlement systems, which total up the accumulated debits and credits 

for each participant over the course of some period— 

usually one day, offset them against each other, and settle at the end of the period. The New York Clearing 

House’s Clearing House Interbank Payment System is 

one such system. Although their use leads to smaller, or 

netted, settlement amounts for each participant and substantially lower liquidity demands on the payment system as a whole, payments in such systems are not final 

until the last creditor pays. Thus, there is a daily threat 

of recalculation and a potentially fatal change in mem11 Settlement Risk in Foreign Exchange Transactions, March 1996, 

and Central Bank Survey of Foreign Exchange and Derivatives Market Activity, May 1996; Bank for International Settlements; 

www.bis.org/publ. 

Sources of Additional Payment
 

System Information
 

Electronic Bill Presentment 

Checkfree . . . . . . . . . . . . .www.checkfree.com/ebill 

Microsoft-First Data 

Corp . . . . . . . . . . . . . .www.msfdc.com 

Digital Cash and Stored Value 

Cybercash . . . . . . . . . . . .www.cybercash.com 

Digicash . . . . . . . . . . . . .www.digicash.com 

Mondex . . . . . . . . . . . . . .www.mondex.com 

VISACash . . . . . . . . . . . .www.visa.com 

Securing Online Transactions 

Certicom . . . . . . . . . . . . .www.certicom.com 

Entrust . . . . . . . . . . . . . .www.entrust.com 

RSA . . . . . . . . . . . . . . . .www.rsa.com 

SETCO . . . . . . . . . . . . . .www.setco.org 

Certificate Authorities 

Certco . . . . . . . . . . . . . . .www.certco.com 

Digital Signature Trust . . .www.digsigtrust.com 

GTE Cybertrust . . . . . . . .www.cybertrust.gte.com 

Verisign . . . . . . . . . . . . . .www.verisign.com 

Electronic Funds Transfer ’99, Financial 

EDI, and POS Check Truncation 

National Automated 

Clearing House 

Association . . . . . . . . .www.nacha.org 

U.S. Treasury Financial 

Management Service . .www.fms.treas.gov/eft 

Payment System Vulnerability 

President’s Commission on 

Critical Infrastructure 

Protection . . . . . . . . . .www.pccip.gov 

The Euro, Foreign Exchange 

Settlement Risk, Payments Finality, 

and Collateralization 

Bank for International 

Settlements (BIS) . . . .www.bis.org/publ 

Federal Reserve Board 

of Governors . . . . . . . .www.ny.frb.org 

New York Clearing 

House Association . . .www.chips.org 

U.S. Federal Reserve . . . .www.bog.frb.fed.us 

Kansas City Regional Outlook 18 Third Quarter 1998 
In Focus This Quarter
 

bers’ liquidity positions if a major creditor bank fails. 

For such systems, the BIS is encouraging member collateralization levels sufficient to cover at least one, and 

preferably two, of each system’s largest net creditor 

banks at any one time.12 While these are not new issues 

in developed nations, the increasing extent to which 

financially underdeveloped and underregulated countries are involved in global payments confers new 

importance on the development of finality and collateralization in payment systems worldwide. 

Differing Perceptions, Common Threat 

Banks are united neither in their perceptions of these 

issues nor in their desire for regulation to address them. 

With respect to small-value payments, large and small 

banks have disagreed over whether the Federal Reserve 

should withdraw from providing retail payment services—a debate that ended in favor of the small bank 

faction earlier this year when the Fed announced that it 

would remain an active and, according to some large 

banks at least, a subsidized competitor in clearing and 

12 Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy report), 

November 1990; BIS; www.bis.org/publ. 

settlement. There also has been disagreement, again 

along lines of size, over whether the issuance of new 

products such as stored value cards should be limited to 

regulated depository institutions. In large-value payments, the differences are due more to relevancy than 

competition. Few small banks will feel compelled to 

address foreign exchange exposures or the vulnerabilities of the national and international payments infrastructure. 

Whatever their individual perceptions of the issues surrounding the payment system, all banks are susceptible 

to its interruption. Likewise, they are strategically vulnerable—individually and as an industry—if they fail to 

preserve their role as a trusted gateway for the settlement of their customers’ obligations. This is perhaps the 

most critical of all payments issues facing banks, for 

while their daily operations may depend on their continued success in maintaining the payment system’s 

dependability, nothing short of their payments franchise 

may rest on their ability to market this success to their 

customers as a feature essential to the entire range of 

current—and future—payment services. 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

Kansas City Regional Outlook 19 Third Quarter 1998 
Regular Features	 Regional Economy
 

The Federal Agriculture Improvement and Reform Act
 

of 1996 Increases Risks and Opportunities
 

•	 The Federal Agriculture Improvement and Reform Act of 1996 (FAIR Act) has had immediate effects on 

farmers in the Region, giving them choices in planting and ensuring fixed transition payments, but increasing their financial risks. 

•	 The FAIR Act will have long-term effects on the Region as well; wheat-growing states such as the Dakotas 

and Kansas that have few planting choices and high dependence on government assistance have the most to 

lose. 

• The direction for farm policy in 2003 will depend on how the FAIR Act has performed and the economic 

and political conditions prevailing at the time. 

The Federal Agriculture Improvement and Reform Act 

of 1996 (FAIR Act) will have significant ramifications 

for many farmers in the Region and the bankers who 

lend to them. The FAIR Act took a major step toward 

greater market orientation in agricultural policy by 

removing most restrictions on farmers’ planting decisions for major crops and eliminating the system of 

deficiency payments that protected farmers from low 

crop prices. In the seven states of the Kansas City 

Region, 1,381 of the 2,447 financial institutions are 

farm banks.1 These institutions face greater risk under 

the FAIR Act because of increased volatility of farmers’ incomes and potential negative effects on farmland 

values. 

The farms of the Kansas City 

Region had the most profitable 

year of the decade in 1996, as short 

supplies led to unusually high 

prices for grains, soybeans, and 

hogs. Export demand in each of 

these sectors helped support producers’ incomes. Production flexibility payments of $1.9 billion, as provided for in the 

FAIR Act, brought them additional income that would 

not have been paid under the previous system of deficiency payments because of the high grain prices prevailing in 1996. Grain prices moderated in 1997, and 

net farm income declined in all of the states but 

remained above the average for the 1990s. North Dakota experienced the poorest performance in 1997, mainly because of low yields in the disease-ravaged wheat 

crop. The United States Department of Agriculture 

1 Farm banks are defined as those with more than 25 percent of their 

loan portfolios in agriculture or agriculture real estate lending. 

(USDA) currently forecasts a 7 percent decline in 

national net farm income for 1998. The historical experience of the 1990s indicates that the Region may experience a slightly greater decline for 1998, but it still 

would be above the average for the 1990s. Prices for 

wheat, corn, and soybeans will likely average below 

1997 prices because of high levels of crops in storage, 

large planted acreage, competition from other 

exporters, and weakened demand from the Asian countries. In recent years, Asian countries have accounted 

for 40 percent of U.S. agricultural exports. 

While highly variable weather conditions in 1998 have 

introduced a large element of uncertainty into forecasts 

of the harvests of corn and soybeans for the Region, the 

USDA projects corn and soybean harvests larger than 

those in 1997. The Region seems to have been spared 

the severe drought conditions that have affected the 

Southeast and Southwest. 

Background: FAIR Act Represents a 

New Direction for U.S. Farm Policy 

Since the Agricultural Adjustment Act of 1933, the federal government has employed various strategies of 

price support and supply restriction to boost farm 

income. Prior to the 1996 reforms, the farm program 

included a system of deficiency payments for major 

crops. Commodities covered by the program were corn, 

sorghum, wheat, barley, oats, rice, and cotton. Under 

this system, the secretary of agriculture announced a 

target price at the beginning of the year, and farmers 

were paid the difference between it and the market price 

of the commodity at the end of the year. The deficiency 

Kansas City Regional Outlook 20	 Third Quarter 1998 
1990 

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003 

Regular Features	 Regional Economy
 

payments served as a risk-reducing mechanism, offsetting fluctuations in commodity prices. 

In the 1980s, the system of deficiency payments came 

under increasing criticism. Federal agricultural programs were no longer perceived as an efficient and 

equitable means of providing income support for farmers. In addition, because deficiency payments were 

based on market prices, the largest producers received 

the largest benefits from the program, belying its justification as an income support program. Deficiency payments began to be seen as a drain on the U.S. Treasury. 

Farm program payments peaked at $11.7 billion in 

1988, as an appreciating dollar choked off export 

demand for grains and depressed prices. By 1995, a 

consensus had grown in Congress in favor of a substantial reform of U.S. farm policy, resulting in the passage 

of the FAIR Act of 1996. 

The FAIR Act introduced a number of changes in farm 

policy that will likely have important effects on the agricultural economy of the Region. The FAIR Act: 

•	 Decoupled program payments from most production 

decisions. It ended the practice of paying farmers 

deficiency payments when prices of program commodities fell below target prices. During the first 

part of the 1990s, more than 90 percent of the crops 

grown in the Region, measured by value, qualified 

for the deficiency payment program. Following the 

passage of the FAIR Act, the farmers’ effective price 

became equal to the market price. 

•	 Eliminated federal authority to control the supply of 

program commodities by limiting planted acreage. 

Under previous farm bills, farmers were required to 

“set aside” a portion of their production acreage to 

qualify for deficiency payments. Set-aside requirements could be as high as 15 percent of base acreage. 

•	 Established a schedule of fixed income support payments known as “production flexibility payments,” 

based on farmers’ historical pattern of production. 

Farmers receive these payments without regard to 

their present production decisions. These payments 

will decline over the life of the FAIR Act until its 

expiration in 2002. 

•	 Included other provisions, such as phasing out dairy 

price supports and reauthorizing the Conservation 

Reserve Program, which pays farmers to withhold 36 

million acres of environmentally fragile land from 

production. 

Chart 1 shows the value of deficiency payments 

received by farmers in the Region in the 1990s and the 

schedule of production flexibility payments for the life 

of the FAIR Act. 

In the 1990s, deficiency payments to the farmers of the 

Region averaged $2.39 billion annually; the production 

flexibility payments will average $1.89 billion annually. 

In 1996, the first year of the FAIR Act, farmers in the 

Region and the nation attained record levels of farm 

income, thanks to high commodity prices and fixed 

government transition payments. 

The FAIR Act Has Had Immediate Effects 

on Farmers’ Economic Decisions 

Early in 1997, the USDA funded a study2 of the effects 

of the FAIR Act, based on discussion panels of farm 

operators and professional farm managers. More than 

half of the panelists identified the “elimination of planting restrictions” as a factor in their 1997 management 

decisions, and nearly half expected the policies to affect 

their decisions in 2000 to 2002. Panelists also identified 

the predictability of production flexibility payments as 

a factor supporting rising demand for and prices of 

farmland. 

2 Lyle P. Schertz and Warren E. Johnston, “FAIR Act 1996: Managing 

Farm Resources in a New Policy Environment,” Agricultural Outlook, 

August 1997, pp. 18–21. 

CHART 1 

Production Flexibility Payments Replace 

Deficiency Payments under the FAIR Act 

$ Billions 

4.0 

3.5 3.5 

2.9 3.0 

2.5 2.5 2.5 2.2 2.2 2.1

2.0 1.9 2.0 2.0 

1.6 1.5 1.5 1.3
 

1.0
 

0.5
 ? 

0.0 

Source: USDA 

Kansas City Regional Outlook 21	 Third Quarter 1998 
Regular Features Regional Economy
 

Farmers’ uses of the flexibility payments suggest that 

they do not believe that government support will disappear in 2003. Most are not saving payments for use 

in times of lower commodity prices. While some panelists indicated that payments were being used for 

productivity-enhancing improvements such as land 

leveling or irrigation, others testified that the payments 

were being used to acquire more land. 

Finally, the panelists recognized the increased price 

risks and resultant importance of greater sophistication 

in marketing crops. Eighty-five percent of the panelists 

identified “increasing risks” as one of the “major 

changes that have occurred in the economic and financial setting for farming” on the survey administered in 

the study. Most observers believe that the FAIR Act will 

result in greater volatility for crop prices, as the absence 

of planting restrictions will lead to greater variation in 

acreage planted each year. Greater income volatility 

will also result, as deficiency payments based on price 

will no longer counteract changes in market prices. 

The FAIR Act Will Have Long-term Effects 

That Vary Across the Region 

In another study3 of the FAIR Act, USDA economists 

conclude that while the aggregate impact of the law will 

be relatively slight, it will affect the structure of the 

farm sector. The changes brought about by the law will 

not affect all farmers or all parts of the Region equally. 

“Freedom to Farm” Means More to the CornGrowing States than the Wheat-Growing States 

The long-term effects of the FAIR Act will be influenced by the differences in the farm economies of different areas of the Region. Chart 2 indicates the 

geographic variation in crop agriculture among the 

seven states. 

Regional production patterns reflect the agronomic 

characteristics of the land and other costs of production. 

The white areas in the map are counties in Iowa, Missouri, Nebraska, and southern Minnesota where corn 

or soybeans are the principal crop. The areas lightly 

3 C. Edwin Young and Paul C. Westcott, The 1996 FAIR Act Increases 

Market Orientation. Agriculture Information Bulletin No. 726, August 1996. Washington, D.C.: United States Department of Agriculture. 

CHART 2 

The Dakotas and Kansas Are Primarily Wheat-


Growing States; Others Have Choices
 

Principal Crops 

by County, 1997 

Corn or Soybeans 

Wheat 

Other or None 

Source: State Agricultural Statistics Offices 

shaded are wheat-growing counties whose limited rainfall prevents the successful cultivation of corn without 

irrigation. In Kansas the principal crop is winter wheat, 

which is planted in the autumn and harvested in the 

summer. The Dakotas and northern Minnesota are home 

to spring wheat, which is planted in the spring and harvested in the autumn. 

The idea of “freedom to farm” has the most value to 

farmers in the corn- and soybean-growing portions of 

the Region, who can freely alternate between those two 

crops, depending on weather conditions and market 

prices. In the states of the Corn Belt, including Iowa, 

Nebraska, and southern Minnesota, where land is suitable for growing either crop, many farmers grow both at 

the same time, or in alternating years. 

Before 1996, each farmer participating in the deficiency payment program had an established crop-specific 

base acreage for feedgrains or wheat. Government payments were based on a five-year average of acreage 

planted to program crops. Soybeans, a crop that was not 

planted in significant volume until the 1960s, was not 

among the crops for which farmers received payments. 

Farmers were often unwilling to risk future deficiency 

payments by taking advantage of temporarily high soybean prices. As a result, soybean prices did not always 

provide enough incentive for farmers to try to meet the 

demand for the product. Following implementation of 

the FAIR Act, soybean planting increased significantly. 

Farmers planted a record 70.9 million acres of soybeans 

in 1997, a 10 percent increase over 1996. Iowa farmers 

increased their planting by 10.5 percent and achieved a 

record harvest in 1997. 

Kansas City Regional Outlook 22 Third Quarter 1998 
Regular Features Regional Economy
 

The corn-producing states enjoy another important 

advantage over the wheat-producing states. Because 

much of the corn crop is fed on-farm to hogs, beef cattle, and dairy cattle, total farm receipts are less sensitive 

to volatility in crop price. Livestock production is significant in Iowa, Minnesota, and Nebraska. In many 

cases, the corn grown in these states is not a direct 

source of income to farmers but a factor of production 

in the livestock enterprise. One analyst estimates that 30 

to 40 percent of Iowa’s corn crop is fed on-farm. Wheat, 

by contrast, has value only as a cash crop, sold for 

human consumption. 

Farmers in the wheat-growing states face fewer alternatives under the new freedom of the FAIR Act than the 

corn and soybean farmers of the Region. Fewer crops 

can thrive in the dryer climate of the Great Plains. North 

Dakota appears to be especially vulnerable to reductions in government payments mandated by the FAIR 

Act, as its wheat sector has deteriorated over the past 

five years. After a record harvest of 473 million bushels 

in 1992, its wheat harvest declined to 268 million 

bushels in 1997. Persistent disease, especially wheat 

scab, has hurt yields and crop quality in the state. Scab 

disease has persisted despite the efforts of the USDA 

and state agricultural officials to eradicate it. According 

to USDA surveys, planted wheat acreage in North 

Dakota declined to 9.67 million acres in 1998, 16 percent less than in 1997. 

Farmers are planting crops such as soybeans and canola, 

but these crops are not as well suited to North Dakota as 

wheat. Limited rainfall works against soybeans in most 

parts of the state, and canola, a newly developed oilseed, 

requires a combination of near-perfect weather and 

intensive management to achieve a profitable yield. 

Further evidence of the state’s strong reliance on wheat 

is that more than 9 million acres were planted for 1998 

harvests, despite forecasts by North Dakota State University that farmers’ cost per bushel may exceed the 

price by more than $.50. 

Dependence on Deficiency Payments 

Varies Across States 

Table 1 shows the relative importance of deficiency 

payments in the net farm income of each of the Region’s 

seven states, and the proportion of farm banks in the 

state. The first column was calculated by dividing total 

deficiency payments in 1995 by net farm income for 

that year for each state. North Dakota appears to present 

the greatest risk to banks because of the policy change. 

USDA economists simulated the effects of the FAIR Act 

in the Great Plains, including the Dakotas, Nebraska, 

and Kansas.4 For the long-run, normal-price scenario 

with average demand growth and average production 

flexibility payments through 2002, short-run net cash 

incomes to farm operators declined 29 percent, while 

long-run residual returns to the sector declined 18 percent. The projected decline in returns results from the 

relatively high dependence on wheat farming in the 

Plains and the lack of profitable alternative crops in 

Kansas and the Dakotas. 

In a 1997 study5 of the effect of government programs 

on farmland value, a team of USDA economists estimated that cropland prices in North Dakota would 

decline as much as 69 percent if the programs were 

entirely abolished. This estimate is an upper bound, 

which could be tempered if relaxed planting restrictions 

let farmers find ways to gain productivity. As argued 

above, however, North Dakota is not well positioned to 

benefit from the new flexibility. 

4 David H. Harrington and Robert Dubman, “Agriculture and New 

Agricultural Policies in the Great Plains,” Rural Development Perspectives, Vol. 13, No. 1, Spring 1998. 5 Charles H. Barnard et al., “Evidence of Capitalization of Direct Government Payments into U.S. Cropland Values,” American Journal of 

Agricultural Economics, Vol. 79, No. 5, 1997. 

TABLE 1 

North Dakota Depended Most on 

Deficiency Payments and Also Has the 

Highest Proportion of Farm Banks 

DEFICIENCY FARM BANKS 

PAYMENTS TO NET TO TOTAL 

FARM INCOME INSTITUTIONS 

STATE 1995 (%) (%) 

NORTH DAKOTA 40 83 

MISSOURI 40 26 

MINNESOTA 28 45 

IOWA 27 71 

KANSAS 24 59 

NEBRASKA 22 79 

SOUTH DAKOTA 20 69 

Note: Refers to institutions headquartered in each 

state. 

Sources: USDA, Bank and Thrift Call Reports 

Kansas City Regional Outlook 23 Third Quarter 1998 
Regular Features Regional Economy
 

An analysis6 of the effect of the FAIR Act on Minnesota concludes, “Most farmers will receive less in transition payments than they have under the combination of 

target price, deficiency payment program, and disaster 

relief program.... Even if the periodic disaster payments 

are removed from the 1993–1995 payment calculations, 

production flexibility contract payments will fall 

short...even counties receiving the most under FAIR’s 

provisions will receive substantially less than in the 

recent past.” The estimates of the value of cropland in 

the absence of any government programs show a 20 percent decline in the northern part of the state and a 30 

percent decline in the southern part. Less concentration 

of crop types, the presence of soybeans, and the importance of livestock in the state result in a less serious 

impact than seen in North Dakota. 

Reduced government payments will have an important 

impact in Iowa, which received more than 23 percent of 

the Region’s total deficiency payments in the 1990s. 

6 Thomas Stinson and Barry Ryan, “The New Farm Payments: What’s 

in Store for Minnesota?” Minnesota Agricultural Economist, No. 687, 

Winter 1997. 

The study of land value estimated that Iowa’s cropland 

prices would decline by 30 percent without government 

payments. The true effect may be less significant, however, given Iowa’s ability to alternate between corn and 

soybean production. 

The path of farm policy after the Year 2002 is uncertain, 

and predictions reflect the divergent views of those who 

supported passage of the FAIR Act. Authors of the legislation saw the flexibility payments as compensation to 

farmers in exchange for giving up their dependence on 

deficiency payments. Darryl Ray of the University of 

Tennessee argues, “But many farmers and farm groups 

view the lucrative payments of FAIR as a windfall and 

not as transition payments. Those with that view believe 

FAIR was the best deal available at the time, and there 

will be opportunities to revisit the legislation and perhaps move it back more to their liking.” The direction 

for farm policy in 2003 will depend on how the FAIR 

Act has performed and on the economic and political 

conditions prevailing at the time. 

Jeffrey W. Walser, Regional Economist 

Kansas City Regional Outlook 24 Third Quarter 1998 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

•	 Financial results from the first quarter of 1998 show that, in aggregate, farm banks in the Kansas City 

Region continue to perform well. 

•	 However, in the intermediate term, the 1996 Federal Agriculture Improvement and Reform Act of 1996 will 

increase farmers’ income volatility and, in turn, could affect the Region’s farm banks. 

•	 In this environment, risk-management practices, both traditional and contemporary, have become much 

more important for farmers and the banks that lend to them. 

Farm Banks Continue to Perform 

Well Except in North Dakota 

In the Kansas City Region, 1,381 of the 2,447 FDICinsured financial institutions are farm banks.1 In aggregate, these institutions continue to perform well, 

although well-known trouble spots exist in North 

Dakota. As of March 31, 1998, farm banks in the 

Region reported strong first-quarter earnings, healthy 

capital positions, and stable levels of past-due loans. 

Table 1 shows selected aggregate financial results for 

farm banks in the Region for the last three calendar first 

quarters. 

While North Dakota’s farm banks continue to earn less 

(return on assets of 1.12 percent) and have less capital 

(10.09 percent) than those of other states in the Region, 

their performance remains relatively strong. However, 

as illustrated in Chart 1, farmers’ continued troubles in 

North Dakota are reflected in farm banks’ elevated levels of loan delinquencies in the first quarter of 1998. 

1 Farm banks are defined as those with more than 25 percent of their 

loan portfolios in agriculture or agriculture real estate lending. 

TABLE 1 

First-Quarter Operating Results 

Have Been Consistently Strong for 

the Region’s Farm Banks 

FARM BANKS, QUARTER-END 

3/96 3/97 3/98 

RETURN ON ASSETS (%) 1.24 1.25 1.28 

LEVERAGE RATIO (%) 10.63 10.72 10.73 

DELINQUENCY RATIO (%) 3.19 3.12 3.11 

Note: Delinquency ratio is all loans past due 30 or 

more days and loans on nonaccrual status divided by 

total loans. 

Source: Bank and Thrift Call Reports 

Although farm banks in aggregate continue to perform 

well, in the intermediate term the Federal Agriculture 

Improvement and Reform Act of 1996 (FAIR Act) will 

have significant ramifications for many farmers in the 

Region and the bankers who lend to them. As discussed 

in The Federal Agriculture Improvement and Reform 

Act of 1996 Increases Risks and Opportunities, the 

FAIR Act eliminated the system of deficiency payments 

that historically has protected farmers from low crop 

prices. As a result, farmers’ incomes are likely to 

become more volatile, which could in turn affect their 

ability to repay their loans. Risk-management instruments are becoming very important tools for farmers to 

use to manage their income volatility. 

Under the FAIR Act, Risk-Management 

Tools Will Be More Important than Ever 

Increased income volatility caused by reduced government support and the elimination of planting restrictions makes effective risk management essential to 

CHART 1 

Except in North Dakota, Farm Banks Report
 

Moderate Levels of Past-Due Loans
 

Percent of Total Loans

Farm Bank Loan 

Delinquency, 3/31/98 

IA KS MO MN NE SD ND 

0 

1 

2 

3 

4 

5 

6 

7 

Note: Delinquency ratio is all loans past due 30 or more days or on
 

nonaccrual status divided by total loans.
 

Source: Bank and Thrift Call Reports.
 

Kansas City Regional Outlook 25	 Third Quarter 1998 
Regular Features Regional Banking
 

farmers and the banks that lend to them. Fortunately, 

farmers can employ many tools to help manage the 

increased risk. 

Traditional Risk-Management Tools 

Traditionally, farmers have relied on fairly simple tools 

to manage risk. For example, diversification through 

planting more than one crop has allowed farmers to 

manage or reduce both price and 

production risks. Farmers have 

stored crops during periods of 

low prices in expectation of higher prices in the future, which 

reduced revenue variability. Farmers also have relied on 

federal crop insurance, a simple risk-management tool 

that has been in widespread use since at least 1980. 

Crop insurance can help ensure a stable revenue stream; 

if farmers insure part of their expected production, they 

can forward price it with greater certainty. The FAIR 

Act created considerable demand for crop insurance. In 

1994, the Federal Crop Insurance Corporation (FCIC) 

serviced 800,263 policies nationwide; in 1996, the first 

year of the FAIR Act, the number rose to 2,254,599.2 

Other tools include forward and futures contracts. 

Farmers have been able to lock in prices for their products prior to harvest by forward contracting with their 

local elevators. Futures contracts allow farmers to offset 

their position in the cash market and lock in a guaranteed return for their products. 

Contemporary Risk-Reduction Tools 

In response to the increased risks farmers incur because 

of the FAIR Act, two new risk-reduction tools are available: crop revenue insurance and off-exchange (“trade”) 

options contracts. These tools have the potential to 

reduce risks to farmers dramatically. 

In 1996, a pilot program called Crop Revenue Coverage 

(CRC) was created by a private insurance company and 

reinsured by the FCIC to expand crop insurance to cover 

price declines in addition to yield shocks. CRC offers a 

revenue guarantee based on expectations of prices and 

farmers’ yields. In addition, CRC offers “replacement 

coverage,” whereby coverage increases if prices 

increase. For example, if the farmer has a short crop and 

prices at harvest are higher than projected, the farmer’s 

crop yield loss is indemnified at the higher price. This 

2 Ken Ackerman, “New Agricultural Risk Management Insurance 

Tools,” USDA Agricultural Outlook Forum, 1997. 

coverage allows the farmer to purchase replacement 

bushels in the marketplace at harvest time, enabling 

performance on forward contracts. CRC is currently 

offered for corn, soybeans, grain sorghum, cotton, and 

wheat, but it is not available in all areas of the Region.3 

Because CRC is relatively inexpensive and allows farmers to benefit from rising crop prices, it has been a success in the Region. In its first year, approximately 

90,000 CRC policies were sold in Iowa and Nebraska, 

the two states covered by the pilot program at that time. 

The policies covered about one-third of the corn and 

soybean acreage planted in those two states.4 

Another innovation is a pilot program in which trade 

options may be written on agricultural products. Until 

recently, farmers could use only standard options offered 

by an exchange. Trade options, on the other hand, are 

privately negotiated, customized contracts that have been 

used for decades by producers and processors of metals, 

energy, and financial products, but have been banned for 

agricultural products since 1936. In April 1998, the 

Commodity Futures Trading Commission (CFTC) 

adopted a pilot program to permit agricultural trade 

options. This program allows grain elevators that register with the CFTC to offer options contracts to local 

farmers. During the pilot program, the CFTC intends to 

study the arrangement to ensure that the fraud and abuse 

that caused these contracts to be banned does not recur. 

Trade options allow farmers to set a minimum price for 

their crops by giving them the right, but not the obligation, to deliver a certain quantity of crops within a particular time frame for a set price known as the “strike 

price.” Farmers will pay the elevator a premium for this 

right. If, throughout the duration of the option contract, 

the local cash price is higher than the strike price, the 

farmer will abandon the option and sell to the highest 

bidder. However, if the cash price is below the strike 

price, the farmer will deliver the crop to the elevator at 

the strike price. Therefore, farmers can use trade options 

to set a minimum price for their crops while retaining 

the ability to benefit from price increases. Unlike 

3 According to the U.S. Department of Agriculture’s (USDA’s) Risk 

Management Agency, in the 1998 crop year the CRC pilot program is 

available for wheat, corn, and soybeans in all of the Region’s states 

except North Dakota. Wheat coverage is available in selected North 

Dakota counties. Coverage for corn and soybeans is not available in 

North Dakota. 4 Joy Harwood, Dick Heifner, Keith Coble, and Janet Perry, “Alternatives for Producer Risk Management,” USDA Agricultural Outlook 

Forum, 1997. 

Kansas City Regional Outlook 26 Third Quarter 1998 
Regular Features Regional Banking
 

futures contracts, put options do not force buyers to 

raise cash should prices move down before the harvest. 

In May 1998, legislation was introduced in the Senate to 

end the CFTC’s ban on agricultural trade options, effectively making its pilot program permanent. The legislation also would allow financial institutions to offer such 

products. While the legislation appears unlikely to pass 

this year, the prospect is that banks could end up offering hedging products to their farm borrowers. On the 

upside, banks could ensure that their customers are 

appropriately hedging their farm commodities. Banks 

could then offset their resulting trade option positions 

by purchasing offsetting options on exchanges. On the 

downside, the ability to sell agricultural options could 

expose banks to lender liability problems. 

Contract Production 

Another possible risk-reduction strategy for farmers is 

contract production, a form of vertical integration in 

which an agribusiness company coordinates all segments of production, from planting to the consumer’s 

shopping cart. In a contact production setting, farmers 

are given inputs for production by the agribusiness and 

then guaranteed a price for their product. While such an 

arrangement limits farmers’ planting flexibility and 

income potential, it stabilizes their revenue streams, 

making them more attractive borrowers to financial 

institutions. Contract production is widespread in livestock and poultry farming, and it is increasingly being 

offered on a wide range of crops. 

Risk-Management Techniques Can 

Benefit Both Borrowers and Lenders 

Because income volatility may adversely affect borrowers, banks may find it necessary to ensure that 

farmers are employing risk-management tools effectively. It is especially important for the Region’s small 

banks to do so, since their typical borrowers—smaller 

farm operators—are less likely to employ such tools 

than larger operators.5 Small operators tend to rely on 

intuitive methods (such as keeping cash on hand and 

staying out of debt) rather than hedging techniques to 

reduce risk, even though more complex techniques 

result in higher incomes.6 In some instances, banks may 

5 The USDA Economic Research Service, using preliminary data 

from its 1996 Agriculture and Resource Management Study, found 

that small farm operators (under $50,000 in sales) use all strategies at 

a lower rate than larger farm operators. 

6 USDA Economic Research Service, using preliminary data from its 

1996 Agriculture and Resource Management Study. 

be the primary impetus for farmers to use risk-management tools. For example, in a recent panel discussion 

with farmers conducted by the USDA, many farmers 

stated that they would purchase unsubsidized crop 

insurance only if their lenders required them to do so.7 

Risk management is especially important for farmers 

who carry significant amounts of debt. Operating with 

less equity, they are more likely to face financial ruin 

during years of low prices or yields. For financial institutions, this description would apply to most of their 

agricultural borrowers. 

Many banks are requiring farmers to have business 

plans, which include risk-management strategies, 

before making loans to them. To help farmers understand the myriad of tools available 

in the marketplace, some rural 

bankers are offering risk-management seminars. In some cases, 

banks are allowing farmers to use 

part of their operating loans to 

cover risk-management expenses, 

such as option premiums or margin calls. In such situations, banks should ensure that 

the risk-management tools are used appropriately and 

do not increase overall risk. 

Implications: Prudent lenders will consider the immediate and long-term implications of the FAIR Act for 

their farm borrowers. Cash flow projections for operating loans must consider the absence of price supports 

for major commodities and the possibility that federal 

disaster relief may not be available should there be a 

crop failure. Highly leveraged borrowers especially 

should be encouraged to used risk-management tools. 

Repayment projections for intermediate and long-term 

loans must take into account the elimination of production flexibility payments in 2003. Additionally, consideration should be given to a potential drop in farmland 

values, and therefore collateral margins, when the FAIR 

Act expires. Political and economic conditions may 

cause Congress to alter the FAIR Act, but prudent 

bankers will be prepared to operate in a new environment in which government support for their farm clients 

may be greatly reduced. 

John M. Anderlik 

Financial Analyst 

7 Lyle P. Schertz and Warren E. Johnston, “FAIR Act 1996: Managing 

Farm Resources in a New Policy Environment,” Agricultural Outlook, 

August 1997, pp. 18–21. 

Kansas City Regional Outlook 27 Third Quarter 1998 
✁
 

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