Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1997 

FDIC
 

New York
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Norman Gertner,
 

Regional Economist
 

Karen A. Wigder,
 

Financial Analyst
 

In Focus This Quarter 

◆ Bank Earnings: Competitive Pressures and Cyclical 

Risks—Intense competition to preserve or attract business can lead to relaxed 

underwriting standards and other changes to risk management practices that can 

reduce banks’ ability to weather a downturn. As this economic expansion reaches 

an advanced age, prudent bankers will evaluate their lending standards and reserve 

adequacy with an eye to possible adverse changes in economic conditions. 

See page 3. 

By Ronald Spieker, Steve Linehan, George French 

◆ Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets—Commercial real 

estate markets in many parts of the United States have rebounded, and commercial 

banks are once again actively pursuing lending opportunities. Banks are not alone, 

however, as a broader and more competitive financing market has emerged. 

Securitization vehicles such as commercial mortgage-backed securities and real 

estate investment trusts are changing how real estate is owned and paid for. 

See page 9. 

By Steven Burton, Gary Ternullo 

Regular Features 

◆ Regional Economy—The New York Region continues to experience a 

modest job and labor force expansion...prices for single-family homes are rising, 

but demand remains uneven...tourism has become a major source of the Region’s 

economic growth. See page 15. 

By Norman Gertner 

◆ Financial Markets—Bank holding companies of all sizes have issued 

trust preferred stock following the Federal Reserve’s decision in October 1996 to 

count these tax-advantaged, capital securities toward Tier 1 capital...rating agencies and investment analysts have argued that trust preferred stock is a weaker 

form of Tier 1 capital. See page 21. 

By Kathy R. Kalser 

◆ Regional Banking—Because of increasing competition for consumers’ 

financial assets, banks are finding alternatives to core deposits for funding 

growth...a look at foreign banking operations in New York State...new auditing 

regulations for foreign branches and agencies established by the New York State 

Banking Department are meant to improve controls. See page 25. 

By Kevin P. Hemhauser, Suzannah L. Susser, Karen A. Wigder 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Information Center for current pricing on bulk orders. 

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

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

Outlook, please call Suzannah Susser at (212) 704-1482 or send an e-mail to ssusser@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 Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Managing Editor Stephen Linehan 

Associate Editor Maureen E. Sweeney 

Assistant Editors Suzannah L. Susser 

John D. Weier 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Bank Earnings: Competitive Pressures
 

and Cyclical Risks
 

•	 Rapid loan growth, record low credit losses, 

vigorous expansion of income sources, and costcutting continue to propel bank earnings to 

record levels. 

•	 Intense competition to preserve and attract 

business can lead to aggressive loan pricing, 

relaxed loan underwriting standards, increased 

portfolio concentrations, and other changes to 

risk-management practices that can reduce 

banks’ ability to sustain earnings and capital 

through a downturn. 

•	 As this economic expansion approaches an 

advanced age, prudent bankers will allow for the 

possibility of an adverse change in economic 

conditions. 

As the U.S. economic expansion continues through its 

seventh year, the banking industry continues to run at 

full throttle. Earnings climb to ever-higher levels, driven by rapid loan growth, record low credit losses, 

aggressive expansion of income sources, and vigorous 

cost-cutting. Some analysts argue that banking has 

entered a new era in which the development of noninterest income sources and new risk-management techniques will insulate banks from swings in the business 

cycle. 

Yet banks face risks that should not be overlooked. 

Assertions that bank earnings will be less sensitive to 

business cycles remain untested. Meanwhile, competition to attract and maintain business can result in 

relaxed underwriting standards and easing of loan 

terms, or increased focus on business lines whose risks 

are difficult to manage. Policies that boost short-term 

shareholder returns, including high dividends and stock 

repurchase programs, can reduce banks’ capacity to 

weather a future downturn. There is evidence that these 

things are occurring to varying degrees in banking 

today. Accordingly, as this expansion reaches an 

advanced age, prudent bankers will give careful regard 

to the quality and sustainability of the earnings generated by today’s strategic decisions. 

Credit Quality 

Variations in credit quality have been and are likely to 

remain for some time the primary source of large 

swings in bank earnings (see Chart 1). Banks manage 

the risks of large swings in credit quality by adjusting 

underwriting standards and loan terms, by diversifying 

loan portfolio exposures, and by supplying adequate 

amounts to the allowance for loan losses. In large part, 

the degree to which bank earnings can be sustained during a downturn will depend on decisions made about 

these factors during the expansion. 

Some perspective on the cyclical nature of credit quality can be gleaned from Charts 2 and 3 (next page). As 

shown in Chart 2, bank loan growth has exceeded 

growth in gross domestic product (GDP) for ten of the 

past twelve quarters, even without considering the substantial volume of loans originated and sold in securitized pools. Moreover, Chart 3 shows that growth in 

loan losses has tended to follow episodes of rapid loan 

growth. 

Credit standards are important tools for individual 

banks to manage these cyclical fluctuations in credit 

quality. According to the Federal Reserve’s August 1997 

CHART 1 

Earnings Results Are Largely Driven by 

Provision Expenses 

-1.0% 

0.0% 

1.0% 

2.0% 

3.0% 

Return on Avg Assets 

Provision Exp/Avg Assets 

Source: Commercial Bank Call Reports 

-2.0% 

6-’85

12-’86

6-’88

12-’89

6-’91

12-’92

6-’94

6-’97

12-’95 

New York Regional Outlook 3	 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 2 CHART 3 

-15% 

-10% 

-5% 

0% 

5% 

10% 

15% 

20% 

1980 

GDP Growth 

Loan Growth 

Average Loan Growth Has Recently 

Outpaced Nominal GDP Growth 

Source: Commercial Bank Call Reports, Haver Analytics 1982 1984 1986 1988 1990

199219941996 

Source: Commercial Bank Call Reports Loan, GDP Growth (%)

Net Loan Loss Growth (%)

Loan Losses and Loan Growth Are Correlated 

-15 

-10 

-5 

0 

5 

10 

15 

-90 

-60 

-30 

0 

30 

60 

90 

Loan Growth 

Net Loan Loss Growth 

198019831986198919921995 

Senior Loan Officer Survey, during the preceding three 

months, a large percentage of banks had eased terms on 

commercial and commercial real estate loans, including 

reducing loan interest rates, increasing credit lines, and 

easing loan covenants and collateralization requirements. A “small but significant” share reported willingness to accept increased levels of risk on commercial 

real estate loans. In a similar vein, the Federal Deposit 

Insurance Corporation’s (FDIC) Report on Underwriting Practices (second quarter 1997) did not note 

any widespread problems with underwriting practices 

but reported that about 24 percent of institutions examined that were actively involved in construction lending 

were “frequently or commonly” funding speculative 

construction projects. About 18 percent of institutions 

examined that were actively involved in business lending “frequently or commonly” made unsecured business 

loans that lack documentation of financial strength. 

Maintaining an adequate allowance for loan losses is 

another important way for banks to sustain earnings and 

capital during downturns. The aggregate allowance held 

by commercial banks has decreased from 2.74 percent 

of total loans in the first quarter of 1992 to 1.90 percent 

in the second quarter of 1997; 166 banks reported negative loan loss provisions in the second quarter. 

Although in the aggregate these reserve numbers 

remain high relative to the early to mid-1980s, when 

reserve levels ranged from 1.20 percent to 1.74 percent, 

the Office of the Comptroller of the Currency (OCC) 

recently issued an advisory letter expressing concern 

about declining reserve levels and the need to maintain 

an adequate allowance. This letter was a response to 

weakness in the credit card sector and to trends in the 

market for syndicated commercial loans, including 

increasing leverage, declining spreads, and a weakening 

in other underwriting terms, all stemming from increasing competitive pressures. 

Diversifying loan portfolios is another way for banks to 

help reduce susceptibility to economic downturns. It 

has often been noted that the trend toward interstate 

banking and branching may improve loan diversification. It should also be noted, however, that many banks 

retain high concentrations of credit exposure to specific 

economic sectors. For example, commercial real estate 

lending and construction lending has been a source of 

volatility in bank earnings since the real estate investment trust (REIT) crisis of the 1970s. As discussed in 

Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets, banks 

are leading a resurgence in commercial real-estate lending. As Table 1 shows, 28 percent of FDIC-insured institutions grew their total commercial real estate and 

construction portfolios more than 30 percent from mid1996 to mid-1997, and 16 percent had total commercial 

real estate and construction exposures1 exceeding 200 

percent of equity and reserves. Concentrations and 

rapid growth do not necessarily portend difficulties, but 

the greater the concentration of credit to a specific sector, the greater the importance of strict adherence to 

sound underwriting policies and standards and the 

maintenance of adequate loss reserves. 

The most immediate concerns about credit quality have 

been expressed regarding credit cards and some other 

1 Includes loans secured by multifamily dwellings and nonfarm nonresidential structures, as well as construction loans. 

New York Regional Outlook 4 Fourth Quarter 1997 
In Focus This Quarter
 

consumer debt. Despite seven years of economic expansion, commercial banks’ net credit card charge-offs at 

mid-1997 were running at 5.22 percent of average outstanding balances, matching levels not seen since the 

aftermath of a 56 percent run-up in charge-offs that 

accompanied the recession of 1990 to 1991. Noncurrent 

rates on these loans are at near-historic highs of 1.94 

percent, and some examiners are commenting that these 

rates would be even higher were it not for some of these 

balances being rolled over into home equity debt consolidation loans with loan-to-value ratios as high as 135 

percent. Home equity lines are a rapidly growing business for some banks; 25 percent of banks and thrifts 

grew their home equity lines by more than 30 percent 

during the year ending mid-1997 (see Table 1). 

Except for credit cards and some other consumer loans, 

loan losses are at historically low levels. Nevertheless, 

lending decisions that assume a continuation of favorable economic conditions should be closely examined 

this far into the expansion. Institutions that maintain 

strong underwriting standards, an adequate allowance 

for losses, and prudent diversification of the loan portfolio will be best positioned to sustain earnings and capital during a downturn in credit quality. 

Net Interest Margin 

Net interest margin (NIM) is another primary driver of 

bank earnings. Indeed, a sharp improvement in NIM 

TABLE 1 

CHART 4 

Rebound in ROA Since 1990 Fueled 

by Improved NIM and Asset Quality 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1984 1986 1988 1990 1992 1994 1996 

2.5% 

3.0% 

3.5% 

4.0% 

4.5% 

5.0% 

ROA 

Net charge-off ratio 

NIM 

Source: Commercial Bank Call Reports ROA, Net Charge-Off Ratio

NIM (%) 

helped lead the banking industry’s dramatic recovery 

from the last recession (see Chart 4). Commercial 

banks’ NIM has declined slightly in recent years, but at 

4.23 percent still remains near the top of the range 

within which it has fluctuated since 1984 (see Table 2, 

next page). 

The banking industry’s rapid loan growth in recent 

years has been one of the factors supporting the current 

high NIM. (Since loans generally yield more than 

securities, a higher proportion of loans generally 

results in a higher yield on the total portfolio of earning assets.) Economic fundamentals cannot sustain 

rapid loan growth indefinitely, however. Accordingly, a 

Rapid Loan Growth Is 

Occurring at a Significant 

Number of Institutions 

(4 qtrs growth ending 6/97) 

TOTAL LOANS AND LEASES 

CONSTRUCTION LOANS 

COMMERCIAL REAL ESTATE LOANS 

TOTAL CRE 

1-4 FAMILY RESIDENTIAL LOANS 

HOME EQUITY LINES 

TOTAL RESIDENTIAL 

CREDIT CARD LOANS AND RELATED PLANS 

OTHER CONSUMER LOANS 

TOTAL CONSUMER LOANS 

COMMERCIAL LOANS 

Source: Bank & Thrift Call Reports 

New York Regional Outlook 

Percentage of Institutions with Loan 

Category Growth Approximating 

20% to 30% 30% or Total 

More Over 20% 

11 13 24 

4 36 40 

9 27 37 

10 28 38 

11 17 29 

4 25 29 

12 18 29 

4 17 21 

9 18 27 

9 18 27 

9 26 35 

5 Fourth Quarter 1997 
In Focus This Quarter
 

TABLE 2 

1997 Commercial Bank Performance Compared with Historical Averages 

INDUSTRY AVERAGES 

6/30/97 1984-1996 

ANNUALIZED LOW HIGH 

(%) (%) (%) 

NET INTEREST INCOME/AVERAGE EARNING ASSETS 4.23 3.89 4.36 

X AVERAGE EARNING ASSETS/AVERAGE ASSETS 86.50 86.21 88.42 

= NET INTEREST INCOME/AVERAGE ASSETS 3.66 3.36 3.89 

+ NONINTEREST INCOME/AVERAGE ASSETS 2.13 1.10 2.13 

− NONINTEREST EXPENSE/AVERAGE ASSETS 3.50 3.05 3.90 

− PROVISION EXPENSE/AVERAGE ASSETS 0.40 0.28 1.28 

+ OTHER ITEMS/AVERAGE ASSETS 0.03 − 0.02 0.15 

− TAXES/AVERAGE ASSETS 0.68 0.18 0.64 

= NET INCOME/AVERAGE ASSETS (ROA) 1.25 0.10 1.20 

Source: Bank & Thrift Call Reports 

risk in the current environment is that in the effort to 

support their NIM by generating new lending, banks 

may make compromises in loan underwriting, pricing, 

and portfolio diversification. 

Recent pricing trends have tended to weaken NIM, offsetting to a degree the effects of rapid loan growth. On 

the liability side, over the past six years, commercial 

banks’ average annual deposit growth rate of 3.2 percent 

has been outpaced by the 4.9 percent average annual 

growth rate of earning assets. As a result, nondeposit 

borrowings have increased significantly in importance, 

rising from about 12.6 percent of earning assets in 1991 

to 19.1 percent at mid-1997. Since the average cost of 

nondeposit borrowings has exceeded the average cost of 

deposits over the period by an average of 135 basis 

points, the greater use of relatively higher cost borrowings to fund earning asset growth has been an obstacle 

to wider margins. The slower deposit growth can perhaps be attributed to the increasing array of choices 

available to small savers; its effect is that bank funding 

is becoming more expensive and more interest-rate 

sensitive. 

On the asset side, pricing pressures also are frequently 

cited as contributing to sluggish NIM. For example, in 

the aforementioned syndicated lending market, average 

interest spreads charged to noninvestment-grade large 

customers have dropped more than 63 basis points 

between 1992 and 1996, while spreads on investmentgrade debt are at all-time lows. Reportedly, some deals 

are being done at minimal or no risk-adjusted spreads 

simply to preserve lending relationships. Increased 

securitization of various asset types has also had effects 

on pricing. By increasing the depth and liquidity of the 

market for the underlying loans, securitization has tended to lower spreads on these assets, thereby increasing 

competitive pressures on institutions not able to achieve 

the volumes necessary to efficiently utilize this new 

funding vehicle. 

The thin spreads available from high-quality lending 

may tempt some institutions to finance higher yielding, 

riskier credits in an effort to preserve or boost profit 

margins. For example, recent forays by some banks into 

subprime lending (see Subprime Lending: A Time for 

Caution, Third Quarter 1997) may be one indication of 

how competitive pressures on NIMs are affecting bank 

behavior. Over the long term, institutions that manage 

their NIMs with a prudent regard for how their newly 

booked business may fare during a cyclical downturn 

will have a better chance of sustaining earnings performance through the business cycle. 

Growth in Noninterest Income 

Industry analysts often cite the increasing contribution 

of fees and other sources of noninterest income as 

evidence of the evolution of the banking industry. As 

Chart 5 (next page) illustrates, for commercial banks 

with over $1 billion in assets, noninterest income now 

averages over 40 percent of net revenue (net interest 

income plus noninterest income). In contrast, banks 

New York Regional Outlook 6 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 5 Other measures of productivity have shown similar 

Noninterest Revenue to Net Revenue* 

Banks Over $1 Billion 

Banks Under $1 Billion 

Source: Commercial Bank Call Reports 

* Net Revenue = Net interest income plus noninterest income 

10 

20 

30 

40 

50 

6-’85 

Net Revenue (%) 

6-’876-’896-’916-’936-’956-’97 

improvement. For example, commercial banking assets 

per employee doubled, from $1.5 million to $3 million, 

between 1984 and 1997. 

Growth in overhead expense has been contained largely 

through consolidation, technological advances, and low 

levels of problem assets. Mergers have resulted in the 

wringing out of redundant expenses. Information technology (IT) has been deployed to trim underwriting 

expense, manage customer relationships, speed backoffice processing, and facilitate the creation of new 

products and services. Favorable economic conditions 

have reduced costs associated with loan collection and 

asset workouts. 

Whether the downward trend in overhead expenses will 

with under $1 billion show a profile of reliance on more 

traditional banking activities, with only 25 percent of 

revenue from these noninterest sources. 

Noninterest income growth is being driven both by new 

business lines and higher deposit-related fees. 

Examples include fees from sales of mutual funds and 

other nondeposit products, investment banking activities such as securities underwriting and asset management, and increases in traditional fee sources such as 

from automated teller machines. Increasing securitization of assets, in which the accounting conventions convert interest income to noninterest income, has also 

affected the growth in reported noninterest income. 

With the exception of trading revenue, noninterest 

income has historically shown a growth trend that has 

not been especially sensitive to economic cycles. 

However, newer fee-based businesses such as mortgage 

banking, mutual funds, and securities underwriting may 

ultimately share the same cyclical characteristics as traditional bank lines of business, and therefore may not 

reduce banks’ historical exposure to economic cycles. 

The Effect of Expense Control 

on Earnings Performance 

Cost-cutting efforts in banking continue to show their 

effects. Since 1991, commercial banks’ efficiency 

ratio,2 a measure of an institution’s effectiveness in generating revenue, has steadily improved (see Chart 6). 

continue is an open question. Should problem loans 

increase from their cyclical lows, collection and workout costs will increase (evidence of this effect can be 

discerned for the late 1980s in Chart 6). The rapid 

change in information technology may prompt increasing expenditures. The 1996 Atlantic Data Services/ 

Tower Group Survey of Information Technology 

Services in Banking noted that the banking industry is 

“faced with an aging IT infrastructure.” The survey 

suggests that most technology-related expenses could 

increase at a 5.6 percent compounded growth rate until 

the year 2000 and that expenses for outside services 

could increase 11 percent over the same period. The 

ability to generate future revenue gains may depend on 

additional bank investment not only in technology but 

also in the development of new products and services. 

CHART 6 

Commercial Banks’ Efficiency Ratio*
 

Is Steadily Improving
 

70% 

68% 

66% 

64% 

62% 

60% 

58% 

56% 

1984198619881990199219941996 

The efficiency ratio is normally defined as noninterest expense * Noninterest expense/(net interest income + noninterest income) 

Source: Commercial Bank Call Reports divided by the sum of net interest revenue and noninterest revenue.
 

New York Regional Outlook 7 Fourth Quarter 1997
 

2 
In Focus This Quarter
 

In any event, cost-cutting is not without its risks. For 

example, reductions in personnel, or excessive reliance 

on automated underwriting procedures (see Will Credit 

Scoring Transform the Market for Small-Business 

Lending? Second Quarter 1997), may raise concerns 

about the effectiveness of internal administration and 

control processes. Cost-cutting that cuts too deeply into 

customer service can erode franchise value. Mergers 

can reduce redundant expense, but at some point there 

may be diseconomies to managing a large organization. 

The Role of Capital in the Management 

of Earnings 

Management, shareholders, and analysts often evaluate 

earnings in relation to the level of capital using measures such as return on equity (ROE) and earnings per 

share (EPS). One result has been pressure on banks to 

continue to grow ROE and EPS; these objectives have 

been made progressively more difficult to attain by the 

significant level of capital that has built up over the past 

five years. 

Finding effective ways to deploy historically high capital levels appears to be one driving force behind the 

recent rash of mergers and acquisitions, high dividend 

payout ratios, increased stock repurchases, and the 

development of alternative types of hybrid capital such 

as trust preferred stock (see Financial Markets). For 

example, during 1995 and 1996, major merger and 

acquisition deals included some $835 billion in bank 

and thrift assets. During 1996, commercial banks with 

over $1 billion in assets had an average dividend payout 

ratio over 89 percent, up significantly from the 67 percent payout rate of 1994. Banks with under $1 billion in 

assets averaged 55 percent for 1996 and 52 percent for 

1994. In addition, banks and bank holding companies 

have issued some $21 billion in trust preferred stock 

during the last nine months, some of which has been 

used to fund the almost $42 billion in share repurchase 

programs announced by large banks during 1996 and 

early 1997.3 

While the book value of equity and other capital ratios 

has increased at the aggregate industry level, a number 

of banks are reporting declines in equity capital and 

leverage capital ratios despite positive earnings (see 

Chart 7). For all institutions, the ability to actively man3 Salomon Brothers. 

CHART 7 

An Increasing Number of Profitable Banks Are
 

Reducing Tier 1 Capital*
 

Number of Banks 

800 

600 

400 

200 

0 

1992 1993 1994 1995 1996 

* Both Tier 1 dollar amount and ratio 

Source: Commercial Bank Call Reports 

age capital accounts going forward will depend largely 

on having earnings available above the levels needed to 

fund dividends and growth, after assuming capital protection adequate for the level of business risk. Bankers 

and examiners will need to carefully review strategies 

that increase bank leverage or increase business risk 

without considering the potential effects of a downturn 

in credit quality or other weakening in the economy. 

Summary 

The most profitable period for U.S. banks in the postWorld War II era is paradoxically occurring during a 

time when banks’ traditional business lines are coming 

under greater competitive pressure than ever. While the 

industry as a whole is adapting well to these competitive 

pressures, there may be a tendency for some insured 

institutions to respond by accepting greater risks to preserve or gain business. 

The nature of banking is to profit by taking calculated 

risks, and naturally more profits will be made during the 

expansionary phase of a cycle than during a downturn. 

Nevertheless, the institutions that are best able to sustain their earnings and capital over the complete cycle 

will be those that allow for the possibility of an adverse 

change in business conditions, and prudently balance 

the levels of risk taken with the expected returns. 

Ronald Spieker, Chief, Depository Institutions Section 

Steve Linehan, Assistant Director, Analysis Branch 

George French, Deputy Director 

New York Regional Outlook 8 Fourth Quarter 1997 
In Focus This Quarter
 

Strong Demand and Financial Innovation Fuel
 

Rebounding Commercial Real Estate Markets
 

•	 Commercial banks are leading a resurgence in 

commercial real estate financing; many metropolitan markets are experiencing rapidly rising rents 

and single-digit vacancy rates, suggesting the likelihood of further development. 

•	 New funds directed toward commercial real estate 

are being increasingly supported by commercial 

mortgage-backed securities and real estate investment trusts. 

•	 Some analysts have expressed concern that these 

financing vehicles may serve to heighten competitive pressures that will lead to more aggressive 

loan pricing. 

In the wake of declining values and the large losses of 

the late 1980s and early 1990s, commercial real estate is 

making a comeback. There are two stories here of interest to lenders. The first entails the remarkable resurgence in commercial real estate demand. The second 

involves the major changes taking place in how real 

estate is owned and paid for and—of greater interest to 

banks—who is financing this expanding activity. 

Commercial Banks Show Renewed Interest 

in Commercial Real Estate 

Strong evidence of commercial real estate’s rebound 

can be seen in its renewed attractiveness to lenders. 

TABLE 1 

Federal Reserve figures show that nearly $58 billion of 

new commercial mortgage debt was added to the market in 1995 and 1996 (see Table 1). While this new net 

lending pales in comparison with that of the late 

1980s—when nearly $74 billion in net new debt was 

added in 1987 alone—it positively shines when compared with the $89 billion shrinkage of commercial real 

estate loans from 1991 to 1994. Table 1 shows that commercial banks are leading this resurgence with a $37 

billion net increase in mortgage lending during 1995 

and 1996. 

Perhaps the most convincing evidence of commercial 

real estate’s recovery comes from the market itself. 

Rising prices and tightening supplies of space in most 

major markets and for most property types suggest a 

growing demand for new commercial property stock. 

Numerous indices and market studies support this 

notion: 

•	 As measured by Koll/NREI national composites, 

prices and rents turned up sharply after 1993, with 

rents surpassing their 1988 to 1989 levels by 1995 

(see Chart 1, next page). For office properties in particular, the ten fastest-growing cities in terms of rental 

rates saw increases exceeding 20 percent in 1996.1 

1 Those cities are, in order, Minneapolis, Columbus, Dallas, Portland, 

Salt Lake City, Atlanta, San Jose, Phoenix, San Francisco, and San 

Diego. 

Banks Are Increasing Their Flow of Funds into Commercial Real Estate ($ Billions) 

1991 1992 1993 1994 1995 1996 

NET NEW BORROWING, ALL SOURCES $ − 15.6 $ − 47.1 $ − 21.5 $ − 4.4 $ 22.6 $ 35.1 

COMMERCIAL BANKS 3.1 − 8.4 − 4.3 7.5 18.0 18.7 

CMBSS 1.3 8.7 10.3 11.3 10.6 16.1 

SAVINGS INSTITUTIONS − 22.4 − 18.5 − 7.5 − 6.8 − 1.8 0.8 

LIFE INSURANCE COMPANIES − 5.6 − 15.1 − 13.4 − 10.5 − 3.3 − 2.5 

ALL OTHER SOURCES 8.0 − 13.5 − 6.6 − 5.9 − 0.9 2.3 

EQUITY CAPITAL FLOW, ALL SOURCES $ 4.9 $ 3.1 $ 17.4 $ 21.6 $ 21.5 $ 30.3 

REIT EQUITY OFFERINGS 1.6 2.0 13.2 11.1 8.2 13.0 

PENSION FUNDS − 4.8 − 4.3 − 0.7 9.6 13.8 14.3 

ALL OTHER SOURCES 8.1 5.4 5.0 0.9 − 0.5 3.0 

Sources: Federal Reserve, National Association of Real Estate Investment Trusts (NAREIT), LaSalle Advisors 

Investment Research 

New York Regional Outlook 9	 Fourth Quarter 1997 
In Focus This Quarter
 

•	 Property capitalization rates, which measure the 

annual income generated by a property as a percentage of its purchase price, are falling (see Chart 2). 

These falling rates indicate that investors are paying 

higher prices for each dollar of current income generated by the property. Overall, however, prices have 

not yet caught up with rents, which now exceed their 

previous highs in some markets, suggesting that the 

current recovery is not yet peaking. 

•	 Declining vacancy rates reflect strong demand for 

office properties, which Grubb & Ellis cast as the 

hottest sector in its 1997 forecast. Nationwide, office 

vacancies have fallen dramatically, by 5 to 10 percentage points during the last four years (see Chart 

3). Moreover, Torto-Wheaton Research estimates 

that 21 of the 56 metropolitan areas it tracks had 

single-digit vacancy rates at the end of first quarter 

1997. Not surprisingly, many of the tightest markets 

are those with the greatest rent inflation. 

While the unrestrained commercial development of the 

1980s continues to cast a shadow over the industry, that 

shadow is fading as declining vacancy rates and rising 

rental rates for existing properties fuel optimism 

among lenders and investors and strengthen the case 

for new development. Lenders, examiners, and analysts, however, must be diligent in monitoring commercial real estate markets to identify possible imbalances 

between supply and demand. It is particularly important that lending decisions be made on the basis of economic feasibility and realistic property cash flow 

projections rather than solely on the basis of competitive pressures. 

Borrowers’ Financing Options Expanding 

Although banks are clearly the largest source of financing for resurgent commercial real estate markets, a 

broader and more competitive financing market has 

emerged. In this market, financing often bypasses 

banks, being funneled instead through entities that purchase and securitize commercial real-estate-secured 

debt or the properties themselves, parceling them into 

smaller, more standardized, and thus more liquid pieces 

that are attractive to institutional and individual 

investors alike. This trend is illustrated in Table 1, which 

shows the increasing roles commercial mortgagebacked securities (CMBSs) and real estate investment 

trusts (REITs) have played in funding commercial real 

estate over the past five years. This increase in public 

CHART 1 

Prices and Rents on Upswing Nationwide 

Index (1986 = 1.00)
 

1.30
 

1.20
 Rents
 

1.10
 

1.00
 Prices
 

0.90
 

0.80
 

1990 1991 1992 1993 1994 1995 1996 

Source: Koll National Real Estate Index 

CHART 2 

Property Capitalization Rates Dropping 

8.0 

8.5 

9.0 

9.5 

10.0 

10.5 

11.0 

11.5 

1990 1991 1992 1993 1994 1995 1996 1997 

Overall Cap Rates (%)

Office 

Retail 

Apartment 

Source: Donaldson, Lufkin & Jenrette 

CHART 3 

National Downtown and Suburban
 

Class A Vacancy Rates Falling
 

8 

13 

18 

23 

Downtown 

Suburban 

Vacancy Rates (%) 

1988 1989 1990 1991 1992 1993 1994 1995 1996 

Source: CB Commercial / Torto-Wheaton Research 

New York Regional Outlook 10	 Fourth Quarter 1997 
In Focus This Quarter
 

financing left financial institutions in 1996 with 

approximately a one-third share of all new net commercial real estate financing, down from well over half just 

a decade before. 

From a lender’s perspective, CMBSs offer several 

advantages over traditional portfolio lending. Most significantly, lenders can generate fee income from loan 

production and servicing activities while avoiding the 

excessive concentrations of credit risk that plagued 

lenders during the last real estate downturn.2 According 

to Commercial Mortgage Alert, outstanding CMBSs 

reached $125 billion in 1996 on a record $30 billion of 

new issuance. While outstanding volume is still dwarfed 

by the $3 trillion market for residential mortgagebacked securities (MBSs), the growth in CMBS volume 

has been remarkable considering that such securities 

were virtually nonexistent prior to 1991. 

At present, most commercial banks are not active in 

issuing CMBSs, accounting for only $2.6 billion of 

CMBS issuance in 1996, according to E&Y Kenneth 

Leventhal Real Estate Group. Rather, the primary 

source of these securities is investment banks, which 

generate substantial fees by converting existing loans 

into securities. CMBS issues also are being increasingly underwritten by conduits, which are entities created 

to originate mortgage loans for distribution to investors 

in the secondary market. Nomura Securities 

International estimates that such conduits accounted 

for over one-third of CMBS issuance in 1996, nearly 

double the volume of 1995. Only a handful of the 

largest commercial banks have set up conduit programs—the five largest banks accounted for $3.3 billion of the $10.2 billion in conduit issuance during 

1996. Aside from this relatively small number of bank 

competitors, investment banks are among the largest 

and most active conduit issuers. 

There is no fundamental reason why banks cannot take 

greater part in the rapidly growing CMBS market. In 

fact, they possess many distinct advantages over investment banks. Their distribution networks, lending experience, and back-office capabilities are naturally suited 

to facilitating loan demand, evaluating repayment risk, 

servicing loans, and monitoring a project’s development. Obstacles of scale may preclude smaller institu2 While securitization of loans purports to shift credit risk to investors, 

many analysts and rating agencies have recently expressed concern 

over recourse arrangements, both contractual and voluntary, whereby 

the seller/servicer effectively assumes all or most of losses experienced by the security. 

tions from directly issuing CMBSs ($500 million in volume is often cited as a minimum for efficiently assembling a deal). However, if the CMBS market develops 

like that for MBSs, standardized underwriting may 

enable small institutions to remain competitive either by 

cooperatively forming their own conduits or by selling 

their loans to existing conduits. 

Whether or not banks take part, the continuing development of a market for securitized commercial real estate 

assets raises a number of efficiency issues for direct 

lenders. Securitization provides property developers and 

owners access to a much larger pool of potential funding 

sources and a wider array of funding options. Moreover, 

the costs of public financing reflect efficiencies born of 

standardization and liquidity. In short, investors, including banks, can price, enter, and exit their positions in 

securitized debt more easily than could be done with 

whole loans. While improved efficiencies are a positive 

aspect of the growth in securitized investments, these 

efficiencies threaten to dictate bank pricing, thereby 

potentially reducing margins or driving institutions to 

lend on less economically feasible projects in an effort to 

preserve margins and market share. 

REITs: An Alternative to Traditional 

Capital Sources 

Commercial real estate financing is evolving in other 

ways. REITs have become major players in the industry 

since 1993, accounting for fully one-fifth of funds flowing into real estate in 1996. REITs are much like mutual funds in that they allow indirect investment in real 

estate through purchases of equity in the REIT. The 

REIT itself holds title to the underlying properties and, 

provided it meets certain requirements, can directly pass 

through its earnings to investors without any intermediate tax. Although Moody’s estimates place REIT holdings at less than 3 percent of all U.S. commercial real 

estate, outstanding REIT shares have grown considerably, with market capitalization doubling nearly three 

times in just four years (see Chart 4, next page). 

Accompanying this rise in capitalization has been an 

equally dramatic rise in bank lending to REITs. 

According to Loan Pricing Corporation, bank lending 

to REITs surged to $12.8 billion in 1996, a 16 percent 

increase over 1995’s then-record volume and more than 

a tenfold increase over the period 1990 to 1992. 

The rise in REIT capitalization can be attributed in part 

to pent-up institutional demand for real estate. REITs 

New York Regional Outlook 11 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 4 

REIT Capitalization Soaring 

0 

10 

20 

30 

40 

50 

60 

70 

80

$ Billions 

0 

400 

1996

50 

100 

150 

200 

250 

300 

350 

Market Capitalization (Left Scale) 

Number of REITs (Right Scale) 

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 

Source: National Association of Real Estate Investment Trusts

have a particular appeal to fund managers since they 

offer the benefits of investment diversification without 

the dual headaches of property management and asset 

illiquidity. Aside from the direct credit risk posed by 

lending to REITs, their rising popularity confronts banks 

with an indirect threat as well—the threat that banks 

could be crowded out of lending opportunities if 

investors find REIT funding structures more attractive 

from a cost and control standpoint. The degree to which 

this crowding out may occur is unclear, for according to 

Nomura Research, REITs historically have borrowed 40 

cents for each dollar of real estate held. However, well 

over half of this borrowing takes place through public 

offerings of secured and unsecured debt, leaving only a 

small portion to be financed by banks and other private 

lenders. Because REITs tend to focus on the highest 

quality projects, their increasing presence also creates 

concerns that banks may be driven to lend to less attractive or more risky properties to preserve market share. 

Many analysts have also expressed unease over the rapid 

rise in the valuations of REITs, some of whose shares 

are priced at a considerable premium to the properties 

themselves. Anecdotal evidence suggests that premiums 

as high as 40 percent over market value have been paid 

for some REIT shares in recent months. Such marketbased valuations create concern over the extent to which 

an REIT’s capital structure allows it to pay more for 

properties than an investor who employs greater financial leverage. Accordingly, while REITs may make up a 

fairly nominal amount of overall real estate holdings, 

they may be quite influential in determining how commercial properties are being valued or appraised. 

Commercial Real Estate Securitization: 

Some Broader Implications 

Maturing CMBS markets could eventually improve the 

overall stability of commercial real estate markets not 

only by improving market liquidity but also by enabling 

investors to diversify and share their credit exposures 

among a greater number of participants. In addition, 

loan performance could become increasingly transparent to the general marketplace, thereby encouraging 

more uniform and prudent underwriting standards. 

However, concern naturally arises because CMBSs are 

a major source of commercial real estate market funding that has not been tested through a serious market 

downturn. This situation leads to questions concerning 

the impact they will have on property values and market 

liquidity and whether today’s underwriting terms, driven 

largely by competitive factors, will stand up to tomorrow’s market downturn. Another question is whether the 

standardized structures underlying these securities offer 

enough flexibility to borrowers to renegotiate loan 

terms—a critical workout tool during times of financial 

stress. The answers to these questions will ultimately 

determine the extent to which lenders and investors suffer as a result of the inevitable cyclical swings in commercial property values. 

There are also questions about how REITs will affect 

commercial real estate markets. One argument is that 

the appetite for REIT investments, combined with the 

premiums that the trusts can pay for properties, will 

push the price of commercial space beyond sustainable 

levels. Those who hold this view see REITs, and other 

Wall Street innovations that increase the supply of funding, as potentially amplifying cyclical swings in real 

estate values. The contrary view holds that REITs will 

improve market efficiency by providing continuous 

pricing benchmarks through daily share price movements and thus enforce discipline upon developers and 

lenders. This discipline, it is argued, will prevent excessive development and dampen the severity of real estate 

cycles. 

As an investment, commercial real estate is quickly 

regaining the broad favor it lost during the last market 

downturn. But the channels through which a lender or 

investor can participate in this market are expanding 

even more dramatically. Investment exposures to real 

estate are no longer effectively limited to private equity 

or debt. The choices are multiplying, with liquid public 

markets for both debt and equity providing the foundation for existing and future commercial real estateNew York Regional Outlook 12 Fourth Quarter 1997 
In Focus This Quarter
 

based instruments—instruments such as swaps, options, 

and property derivatives—that will permit the tailoring, 

hedging, and even creation of synthetic real estate 

investment positions. Although financial institutions are 

participating in this revival, it is clearly a different world 

from the old, and one in which they will have to choose 

how best to compete against—or participate in—these 

new real estate financing strategies. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

Falling Office Vacancy Rates 

Spur Development 

Vacancy rates for office properties have been declining throughout the Region (see Table 2). However, 

aggregate commercial real estate loans held by 

insured institutions have yet to make a resurgence. As 

of June 30, 1997, loans secured by commercial real 

estate in the Region totaled $68.9 billion, or 7.29 percent of total loans outstanding; these figures are down 

from $76.6 billion and 8.72 percent of total loans outstanding at year-end 1990 (see Chart 5). Lending for 

real estate construction and land development loans 

also has declined from a high of $49.9 billion at yearend 1990 to $10.8 billion as of June 30, 1997. This 

pattern of moderation in commercial real estate lending is not uniform, however. As of June 30, 1997, 19.6 

percent of banks in the Region that make commercial 

real estate loans reported growth in their portfolios of 

at least 30 percent from a year earlier. Also, 367 of 

these banks, or 41.4 percent, have commercial real 

estate loan portfolios that exceed 100 percent of equity capital. 

According to Insignia/Edward S. Gordon, office 

leasing jumped 59 percent in New York City during 

the first six months of 1997 compared with the same 

period in 1996. The midtown Manhattan market, the 

nation’s largest office market, was particularly active. 

Midtown leasing activity in the first six months of the 

year rose 44 percent to 8.9 million square feet, pushing rental rates up 2.7 percent to an average of $33.86 

per square foot. On Long Island, despite a strengthening local economy and a shortage of prime office 

space, rents have not yet risen enough to justify new 

construction. In Westchester County, cautious 

lenders are still holding back on development dollars, 

claiming that the wave of corporate turnovers and 

downsizings is not yet over in the county. 

Reports from other markets across the Region indicate increased activity as well. New Jersey, the 

fourth-largest office market in the nation, is becoming 

an increasingly dynamic market. The amenities of the 

suburban campus environment offered by many New 

Jersey office complexes, coupled with easy access to 

housing and a skilled labor force, continue to attract 

Office Vacancy Rates Are Dropping 

METRO AREA 1991 1993 1995 1996 1997/ 

Q2 

BALTIMORE 19.1 17.2 13.8 11.5 10.5 

LONG ISLAND 18.9 14.4 13.8 10.5 8.8 

MID-NJ 20.7 18.6 20.5 14.9 12.2 

NORTHERN NJ 22.5 20.8 16.2 12.6 11.2 

MANHATTAN 16.5 15.1 14.9 11.6 10.6 

PHILADELPHIA 16.5 16.6 13.3 13.2 12.3 

WILMINGTON NA 19.5 13.1 12.8 12.8 

WASH, DC 14.9 11.3 9.6 8.3 7.7 

WESTCHESTER 21.5 22.1 22.4 17.0 17.0 

UNITED STATES 18.9 17.0 14.1 12.1 11.2 

Source: CB Commercial Property Information Systems 

TABLE 2 CHART 5 

Loans Secured by Commercial Real Estate (RE) 

Continue to Decline in the Region 

Source: Bank and Thrift Call Reports 

65 

70 

75 

80 

0 

2 

4 

6 

8 

10 

1990

1991

199219931994199519961997 

$ 

Billions Loans Secured by 

Commercial RE (right axis) 

Commercial RE Loans

 as a % of Total Loans (left axis) 

New York Regional Outlook 13 Fourth Quarter 1997 
In Focus This Quarter
 

companies seeking relief from New York City’s high 

taxes and regulatory burden. In the most competitive 

markets in northern New Jersey, a scarcity of Class A 

space may lead to speculative development as asset 

values quickly approach replacement costs. 

The suburban Philadelphia market also is becoming 

increasingly active. Developers are converting older 

industrial buildings to keep pace with demand; however, plans for new construction are minimal. 

Developers indicate that new construction is too timeconsuming and can cost twice as much as renovating 

older buildings. In Pittsburgh, the office market continues to be suppressed by “rightsizing,” technological innovation, and a slower economy. New 

speculative development in the city requires a large 

portion of the building to be preleased and some state 

and local government funding or tax incentives, 

according to Grubb & Ellis’ 1997 Real Estate 

Forecast. Absorption in the Harrisburg area has 

depleted the existing inventory, and rental rates are 

increasing. Demand for office space is strong in this 

part of Pennsylvania because of the backlog in 

demand and the need to replace obsolete space. 

The recovery of the Baltimore market continues after 

downsizings and consolidations (particularly among 

banks) appear to have ebbed. The Society of 

Industrial and Office Realtors forecasts increased 

leasing activity in Baltimore’s central business district, which should drive up sales and rental rates. The 

District of Columbia, the third-largest downtown 

office market in the country, behind New York City 

and Chicago, is still highly affected by federal government downsizing, which reports indicate will continue over the next three years. 

Norman Gertner, Regional Economist 

Kevin P. Hemhauser, Examiner 

Suzannah L. Susser, Regional Manager 

Karen A. Wigder, Financial Analyst 

New York Regional Outlook 14 Fourth Quarter 1997 
Regular Features	 Regional Economy
 

New York Region: Modest Job and
 

Labor Force Expansion Continues 


•	 The New York Region continues to benefit from a modest economic expansion. During the first half of 1997, 

the Region added 333,000 new jobs. Over the same time, the Region’s labor force grew at an annual rate of 

263,000 workers. With more jobs available, more people are looking for work. 

•	 Prices for single-family homes generally are rising throughout the Region. However, demand for new singlefamily homes varies widely. 

• Tourism has become an increasingly important component of the Region’s economy, pushing up hotel occupancy rates, increasing retail business, and stimulating traffic at the Region’s major airports. 

The New York Region continues to benefit from a 

strong economic expansion that is increasing both 

employment and the labor force. During the first half of 

1997, the number of employed persons in the Region 

increased by 333,000, or 1.5 percent, over the first half 

of 1996. During the same period, about 263,000 individuals who had previously been neither working nor 

looking for work entered the Region’s workforce, an 

increase of 1.1 percent. Overall, the Region continues to 

lag the nation in job growth, although the gap has been 

closing recently (see Chart 1). 

With More Jobs Available, More People 

Are Looking for Work 

As more jobs and employment opportunities have been 

created, more people have begun to look for work. 

Changes in the labor force roughly have followed the 

employment pattern in the Region, especially since 

1995 (see Chart 2). During the first half of 1997, 

employment growth in every state in the Region and 

Puerto Rico exceeded or matched growth in the labor 

force, when measured on a year-over-year basis (see 

Table 1, next page). This has meant falling unemployment rates and tightening labor markets throughout the 

Region. 

According to statistics published by the Bureau of 

Labor Statistics, labor force participation rates—which 

measure participation by those already working or 

actively seeking employment—have risen for nearly all 

demographic subgroups over the past year. For example, 

formerly discouraged workers, who may have dropped 

out of the workforce during the downsizings of the early 

1990s, are finding new employment opportunities and 

reentering the job market. Stronger labor market conditions are apparently encouraging older individuals to 

postpone retirement and pulling many retired workers 

CHART 1	 CHART 2 % Change 1981 1983 1985 1987 1989 1991 1993 1995 1997* 

Payroll Employment in the Region Has Lagged 

the Nation but Recently Has Been Gaining 

5 United States Region 

4 

3 

2 

1 

0 

–1 

–2 

–3 

* First half of 1997 over first half of 1996 

Source: Bureau of Labor Statistics 

19901991199219931994199519961997 

Increased Employment Opportunities Have 

Resulted in Significant Labor Force Growth 

Millions Millions 

of Jobs of People 

23 24 

22 

23 

21 

20 22 

Source: Bureau of Labor Statistics 

New York Regional Outlook 15	 Fourth Quarter 1997 
Regular Features Regional Economy
 

TABLE 1 

Growth in Jobs Has Closely 

Paralleled the Growth 

in the Labor Force 

Labor 

Employment Number Force Number 

Growth of Jobs Growth of People 

(% Change) (Thousands) (% Change) (Thousands) 

DE 3.2 11.7 2.7 10.2 

MD 0.4 10.9 0 − 1.3 

NJ 1.7 64.3 0.9 34.8 

NY 1.2 98.3 1.2 104.4 

PA 2.2 121.3 1.6 95.4 

PR 2.9 31.6 2.2 28.3 

Note: Data represent first half of 1997. 

Source: Bureau of Labor Statistics 

back into the labor force. A combination of welfare 

reform and a strong job market also has led to a sharp 

increase in labor force participation for young women. 

A 1997 study by Merrill Lynch found that rapid labor 

force growth serves as a safety valve, preventing excessive labor market tightening as new job opportunities 

become more abundant. The study also suggests that 

increased labor force growth may help to hold down 

wage inflation, because if the labor markets become too 

tight, wages would rise. Merrill Lynch cites the employment cost index, a measure of wage inflation that 

includes benefit costs, to support this argument. During 

the second quarter of 1997, that index was up just 2.8 

percent from one year earlier. This rate matches the 

index low in 1995 and is probably the smallest annual 

rise in labor compensation in 50 years. The report forecasts that although some pickup in wage growth is likely at this stage of the business cycle, labor cost 

pressures will remain slight because there are still 

untapped pools of potential workers that will help cap 

wage pressures. For example, labor force participation 

rates for men ages 25 to 54 are still below 1980s levels 

and could easily rise further without straining the labor 

pool. 

Despite the good news on job growth, the New York 

Region still has areas of high unemployment, with some 

of the larger cities reporting unemployment rates in the 

8 percent to 10 percent range. The Region proportionally lost more jobs than the rest of the nation during the 

recession of the early 1990s, and its recovery has been 

slower. This is particularly true for the large metropolitan areas, such as New York City, Philadelphia, and 

Baltimore. There is a bigger surplus of labor in these 

areas that can act as a safety valve on local wages than 

elsewhere in the Region. In New York City, for example, as individuals became aware of new job opportunities, they began to reenter the workforce at a rate faster 

than the rate at which new jobs were being created. As 

a result, New York City’s unemployment rate rose to 

double digits. Some economists believe that this surplus 

may draw employers to move or expand into the New 

York Region if labor markets tighten further in areas 

such as the Sun Belt and the Midwest. Moreover, as discussed in a previous Regional Outlook, price inflation 

in the Region has been slowing relative to the rest of the 

nation. Historically, the Region has been a high-cost 

area. However, if these recent trends persist, the Region 

could become a more attractive place to do business. 

Implications: Increased participation in the labor force 

signals improved optimism among workers that jobs 

can be found more easily. More people working and 

looking for available work can be expected to stimulate 

demand for items such as homes, automobiles, and 

other consumer durables that require financing. 

Housing Industry Reflects Higher Prices 

but Uneven Demand 

In general, prices for single-family homes continue to 

rise in the Region, although clearly not at the pace of 

the mid to late 1980s. According to data supplied by 

the Office of Federal Housing Enterprise Oversight 

(OFHEO), prices in the mid-Atlantic area (defined by 

OFHEO as New Jersey, New York, and Pennsylvania) 

have leveled off during the 1990s but are at or close to 

their all-time highs. Home prices are still more than 20 

percent higher than prices in the United States as a 

whole (see Chart 3). Prices for Delaware and Maryland, 

which are not part of OFHEO’s mid-Atlantic area, have 

trended somewhat lower but still exceed the U.S. 

average. 

Information supplied by the National Association of 

Realtors (NAR) on median single-family home prices 

supports the OFHEO data. According to the NAR, most 

of the Region’s metropolitan areas have experienced 

price increases over the past year (see Chart 4). 

However, there are exceptions—for example, Buffalo, 

Syracuse, Albany, and Newark all have endured falling 

or flat housing prices for several years. 

New York Regional Outlook 16 Fourth Quarter 1997 
Regular Features Regional Economy
 

CHART 3 CHART 4 

Source: Office of the Federal Housing Enterprise Oversight 

Region’s Housing Prices Continue to Rise 

0 

50 

100 

150 

200 

250 

1980 1982 1984 1986 1988 1990 1992 1994 1996 

Index 1980 Q1 = 100 

United States 

Mid-Atlantic 

Delaware Maryland 

Data on Permits Tell a Mixed Story 

In the Region, permits for single-family home construction have not reached their pre-recession levels. After 

recovering somewhat during the mid-1990s, permit 

activity fell off in 1995 and by 1996 was 37 percent 

below the 1989 level (see Chart 5). Between 1995 and 

1996, newly issued permits grew only 2.7 percent. 

Despite the recent employment growth in the Region, 

which would normally stimulate permit activity, other 

factors apparently have played an offsetting role, including low population growth and limited availability of 

land. At present, New Jersey is the only state experiencing a surge in permits for single-family homes. 

While permits rose 25 percent on a year-over-year basis 

during the first six months of 1997 in New Jersey, permit activity in other states in the Region was barely 

improving or actually declining. Even Pennsylvania, 

which began the year with a sharp surge in single-family permits, has since trailed off. 

In addition to examining trends at the state level, we 

also looked at new permits for single-family homes in 

the top 15 major metropolitan markets in the Region. 

Although these trends also vary extensively, they seem 

to loosely track with employment patterns at this level. 

For example, permits for single-family homes were up 

more than 47 percent in Atlantic City through the first 

six months of 1997 compared with the same period in 

1996. Atlantic City is presently one of the fastest-growing cities in the Region. In addition, permit activity also 

was up 18 percent in Dover and 13 percent in 

Harrisburg, both cities also experiencing employment 

gains. In upstate New York, an area that has experienced 

weak or no employment growth for the past several 

Home Prices Rise in Many Parts of the Region 

Source: National Association of Realtors. Data represent first half of 1997 

over first half of 1996. 

Bergen-Passaic 

Baltimore 

Atlantic City 

Pittsburgh 

Syracuse 

Albany 

-4 -2 0 2 4 6 8 

Washington, D.C. 

Trenton 

Nassau-Suffolk 

Rochester 

Newark 

Buffalo 

% Change 

years, new permit activity was down sharply. For example, in Buffalo, new permits for single-family homes 

dropped 28 percent through the first six months of 

1997. In Syracuse, permit activity was off 25 percent, 

while in Rochester it was off by more than 7 percent. In 

other markets, however, permit activity did not appear 

to track well with employment patterns. In New York 

City, which is currently experiencing renewed employment growth, permit activity was off 2.5 percent. On the 

other hand, permit activity was up more than 6 percent 

in Philadelphia, which has had virtually no employment growth over the past year. 

CHART 5 

Single-Family Home Construction Has 

Not Reached Pre-Recession Levels 

Thousands of Units 

200 

150 

100 

50 

0 

Source: U.S. Census Bureau 

1988 1989 1990 1991 1992 1993 1994 1995 1996 

New York Regional Outlook 17 Fourth Quarter 1997 
Regular Features Regional Economy
 

Home resale figures provide another indication that 

housing activity is erratic around the Region. Existing 

home resales (including single-family homes, condos, 

and co-ops) were up almost 10 percent from one year 

ago in Pennsylvania during the first quarter of 1997, but 

were up only 2 percent in New York State. Over the 

same period, housing sales were down more than 2 

percent in Maryland and more than 3 percent in 

Washington, D.C. More recent data for Albany report 

that residential real estate sales were down 6 percent 

during the first six months of 1997 compared with the 

same period in 1996. 

Housing Is Still Difficult to Afford 

The inconsistency in housing markets may, in part, reflect the high 

cost of housing in many areas of 

the Region. A recent study of 

housing costs by E & Y Kenneth 

Leventhal Real Estate Group 

looked at the most and least 

affordable housing markets among 

75 U.S. metropolitan markets. The study considered 

rental costs, home prices, and mortgage rates among 

other factors determining affordability. Median incomes 

were used as a proxy for local market incomes. 

Differences in taxes and tax deductions associated with 

home ownership also were considered. 

Not a single city in the New York Region was among the 

25 most affordable markets. The most affordable areas 

in the Region were Buffalo and Rochester, both, ironically, locales with weak economies. Central New 

Jersey and Nassau and Suffolk Counties on Long 

Island were considered to be in the 50 metropolitan 

areas having the most affordable housing. New York 

City ranked next to last. 

Implications: Although housing activity has picked up 

in some areas, growth remains inconsistent. Improving 

employment conditions in the Region suggest improvement in the housing market and increased loan demand 

for residential mortgages. In the Region, residential 

mortgages for one- to four-family homes increased 

about 10 percent between June 1995 and June 1997, but 

these gains were not geographically uniform. For example, residential mortgages grew more than 12 percent 

over this period in downstate New York, an area regaining economic strength, but were down almost 3 percent 

in upstate New York, an area with a weak economy. 

Single-family homes in many places are still difficult to 

afford compared with other parts of the nation. Areas 

identified as having low affordability could pose risks to 

banks originating mortgages. In areas of low affordability, home purchasers faced with a greater gap 

between their ability to afford a home and the costs of a 

home purchase must either stretch their budgets further 

to afford a house or leave the area to purchase elsewhere. To the extent that their budgets are stretched, the 

risks of personal financial difficulty increase. 

Tourism Is a Major Source of the Region’s 

Economic Growth 

The Region’s economic expansion has drawn support 

from its strength in tourism and travel-related services. 

More than 266,000 individuals work in the Region’s 

hotel and lodging industry alone, representing about 13 

percent of the nation’s total and generating more than 

$1.2 billion in wages and salaries. Tourism also has 

stimulated supporting businesses such as eating and 

drinking establishments, amusement facilities, airports, 

and travel-related services such as car rentals. 

The benefits of tourism are being felt in many areas of 

the Region. For example, according to the Public 

Affairs Research Institute of New Jersey, the tourist 

industry generated $18 billion in revenues in 1995, 

employed 348,000 workers, and produced $2.4 billion 

in tax revenue. In 1996, Atlantic City casino-hotels 

employed more than 40,000 people representing a total 

payroll of $2 billion. The number of annual travelers to 

New York City in 1996 was a record 31.2 million, 

according to the New York Convention and Visitors 

Bureau. Even the Visitors and Convention Bureau of 

Center County expects visitors to spend well over $100 

million next year in that part of Pennsylvania. 

An example of the importance of tourism to one metropolitan area is shown by a recent study of Long Island. 

Although it is difficult to separate tourist from business 

travel, the recent study by the Long Island Convention 

and Visitors Bureau found that tourism supports 

152,000 jobs on Long Island, or up to 12 percent of its 

workforce. They estimate that tourism is responsible for 

$2.8 billion in salaries and wages, or 10 percent of the 

island’s entire payroll (see Table 2). 

Given the importance of tourism, it is not surprising that 

Maryland is seeking to take greater advantage of 

New York Regional Outlook 18 Fourth Quarter 1997 
Regular Features Regional Economy
 

TABLE 2 

Tourism Is Benefiting Long Island’s Economy 

INDUSTRY DIRECT JOBS INDIRECT JOBS TOTAL JOBS TOTAL EARNINGS 

RESTAURANTS/BARS 54,235 19,481 73,716 $1.1 BILLION 

OTHER INDUSTRIES 4,923 7,008 11,931 $448.0 MILLION 

COMMERCIAL SPORTS 2,099 6,033 8,132 $255.9 MILLION 

AUTO RENTALS 1,925 4,972 6,897 $243.0 MILLION 

MISCELLANEOUS AMUSEMENT 11,380 7,150 18,530 $162.4 MILLION 

HOTELS/MOTELS 4,729 3,735 8,464 $154.4 MILLION 

GASOLINE STATIONS 4,028 1,722 5,750 $108.1 MILLION 

MISCELLANEOUS RETAIL STORES 4,672 1,998 6,670 $106.9 MILLION 

PASSENGER TRANSPORTATION 2,299 1,550 3,849 $94.7 MILLION 

PRODUCERS/ENTERTAINERS 1,602 2,877 4,479 $83.0 MILLION 

MOVIE THEATERS 1,269 2,506 3,775 $27.1 MILLION 

TOTALS 93,161 59,032 152,193 $2.8 BILLION 

Source: Long Island Convention and Visitors Bureau/Long Island Association. Data are for 1995. 

tourism by making additional investments, according to 

a report by the Maryland Office of Tourism and 

Development. In 1996, Maryland began remodeling the 

Baltimore and Ocean City Convention Centers. In addition, the state began the construction of two new 

National Football League stadiums and is spending 

additional sums on transportation, housing, and entertainment facilities designed to attract tourists. Like 

other parts of the Region, Maryland’s hotel and lodging 

industry has seen increases in occupancy and room 

rates for five straight years. 

A report by the New York–New Jersey Port Authority 

indicates that international travel has been a key source 

of growth in the area’s tourism trade. This increase has 

been influenced by sustained economic growth throughout Asia and Latin America. According to the report, in 

1996 a 6.9 percent increase in visitors from Asia and a 

7.6 percent increase in South American tourists led the 

boom in international travel. Tourists from Europe, the 

largest single international source of visitors to the New 

York City area, advanced 2.4 percent to 2.2 million last 

year. 

A Landauer Associates analysis of the hotel market 

suggests that growth in the hospitality market in the 

coming years will be stimulated by several economic 

variables, including the strength of corporate profits, 

employment growth, and travel patterns of domestic and 

international visitors. The strong demand in hotel occupancy is consistent with the rapid growth in international air travel at the Region’s airports. According to a New 

York State Comptroller study, domestic passenger traffic at New York City’s three airports increased by 4 percent in 1996 to almost 58 million passengers. 

International traffic grew by 5.1 percent to more than 23 

million passengers. Over the past five years, these airports have experienced a 25 percent increase in international air travel. 

Growth in tourism has fueled demand for hotel rooms 

and has pushed hotel occupancy rates around the 

Region to record levels. According to PKF Consulting, 

which looks at the major tourist markets in the Region, 

New York City’s hotel occupancy rate averaged a record 

81.8 percent in 1996, up from 78.6 percent in 1995. In 

May, hotel occupancy stood at over 87 percent. Average 

daily room rates have risen to $175, compared with 

$156 in 1995. In Philadelphia, room rates reached about 

$120 in May, and occupancy rates stood at almost 84 

percent. In Washington, D.C., occupancy rates were 

about 85 percent in May, with a room costing on average $132 per day. Strength in the tourist industry is 

stimulating demand for additional hotel space in New 

York City. Since there are few vacant building sites 

available, hotel development is taking the form of renovations of existing facilities. In 1995, approximately 

1,550 rooms were added to Manhattan’s supply, mainly 

through the reopening of hotels that had undergone 

major capital improvements. A recent article indicated 

that about 4,100 new hotel rooms are being planned in 

Manhattan, and some analysts say that New York City 

could easily support an infusion of 5,000 to 10,000 new 

rooms. That many rooms probably will not open 

New York Regional Outlook 19 Fourth Quarter 1997 
Regular Features Regional Economy
 

because of the expense of developing hotels, the difficulty of obtaining financing, the shortage of sites, and 

the potential for a quicker return on high-end apartment 

buildings. On the other hand, according to PKF 

Consulting, the increasing number of investors interested in Manhattan hotels is pushing up asking prices. 

According to a report by Landauer Associates, 

investors have been active on the debt side as well, with 

major investment banks originating lines of credit, commercial mortgage-backed securities, and mortgages. 

Wall Street firms are providing financing, filling a gap 

left by more traditional lenders such as banks and insurance companies. 

Implications: A vibrant tourist industry has become 

increasingly essential to the Region’s economy. Tourism 

has stimulated a wide range of business activities, 

including lodging, entertainment, transportation, 

restaurants, and retail sales. This is beneficial for banks 

that have credit exposure to these industries. The continued strength of tourism depends on factors such as a 

strong domestic and international economy as well as 

moderate transportation costs. All these factors appear 

sound at this time. Moreover, although there is some 

hotel construction taking place in some of the markets 

we examined, the supply of new rooms does not appear 

to have outstripped demand. Nevertheless, owing to the 

possibility of an unexpected change in economic fundamentals that could dampen tourism, prudent bankers 

will manage their credit exposure to hotel developers in 

the context of a well-diversified portfolio. 

Norman Gertner, Regional Economist 

New York Regional Outlook 20 Fourth Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

• Bank holding companies of all sizes have issued trust preferred stock following the Federal Reserve’s decision in October 1996 to count these tax-advantaged capital securities toward Tier 1 capital. 

•	 Although the tax-advantaged status of trust preferred stock was not eliminated in the federal budget this 

year, there still exists the possibility that the Internal Revenue Service may alter the tax treatment of trust 

preferred dividends. 

• Institutions contemplating issuing trust preferred stock should be aware of the concerns expressed by rating agencies and of the potential risks associated with excessive reliance on debt-like capital instruments. 

Bank holding company capital requirements were effectively relaxed in October 1996 when the Federal 

Reserve ruled that trust preferred stock may be included in the portion of cumulative preferred stock that can 

compose up to 25 percent of a bank holding company’s 

Tier 1 capital. In the wake of this decision, financial 

institutions moved quickly to issue trust preferred stock. 

Trust preferred stock can be a less expensive form of 

Tier 1 capital for bank holding companies because of 

the tax deductibility of the dividend payments paid on 

this type of preferred stock. 

Approximately 90 banking organizations issued an estimated $21 billion of trust preferred shares from October 

1996 through June 1997.1 The dollar amount of trust 

preferred stock issued represented almost 95 percent of 

the incremental amount of Tier 1 capital added by those 

institutions during the period. A number of these institutions used the proceeds of trust preferred stock issues 

to fund stock buyback programs. As an example of the 

relative importance of these stock buyback programs, 

one large bank holding company’s Tier 1 capital ratio 

would be 7.25 percent excluding the trust preferred 

shares, and 8.34 percent including the shares. 

Rating agencies and investment analysts have argued 

that trust preferred stock is a weaker form of Tier 1 capital because of its limited life and debt-like characteristics. These characteristics include the tax treatment of 

trust preferred dividends,2 the limited life of the shares, 

and the ability of investors to accelerate their claims 

against the bank holding company. Institutions contem1 The amount of trust preferred stock outstanding is not delineated in 

Call Reports. 

2 Trust preferred dividends, unlike dividends on traditional preferred 

stock, are treated as a tax-deductible expense at the bank holding 

company level and as taxable income by investors of the trust preferred shares. 

plating issuing trust preferred stock should be aware of 

the concerns expressed by rating agencies and of the 

possibility that excessive reliance on debt-like capital 

instruments could increase their financial fragility during times of economic stress. 

Trust Preferred Structure 

Provides a Tax-Advantaged 

Capital Funding Alternative 

Trust preferred shares, also 

known as capital securities, are 

traded under different names 

depending on the underwriter, payment terms, and 

maturity. Some of the more common acronyms include 

TOPRS (Trust Originated Preferred Shares), QUIPS 

(Quarterly Income Preferred Shares), and MIPS 

(Monthly Income Preferred Shares). 

Although trust preferreds are issued under different 

names, they share the same basic structure (see Chart 1, 

next page). A non-taxpaying subsidiary, or “trust,” of 

the bank holding company is formed. The trust issues 

two classes of stock: common and preferred shares. The 

common stock of the trust subsidiary is owned by the 

bank holding company, and the trust preferred stock is 

sold to investors. The trust upstreams the proceeds from 

the sale of the preferred shares to the bank holding company in exchange for a long-term, deeply subordinated 

note with terms identical to the trust preferred shares. 

(The subordinated note must be the sole asset of the 

trust and subordinated to all other debt of the bank holding company.) 

On a consolidated basis, the trust preferred stock is 

treated as a minority interest of the bank holding company, and the subordinated note is eliminated as interNew York Regional Outlook 21	 Fourth Quarter 1997 
Regular Features Financial Markets
 

CHART 1
 

How Is Trust Preferred Stock Structured 

to Count as Tier 1 Capital? 

Trust Preferred 

Proceeds 

Trust Preferred Shares 

Dividend Payments—funded by interest 

received on subordinated note 

Investors in Trust 

Preferred Shares 

Trust Subsidiary 

Issues trust preferred shares 

(structured as a non-taxpaying entity) 

Trust Preferred Proceeds 

(Trust preferred shares treated as 

minority interest by BHC and 

counted toward Tier 1 capital) 

Subordinated Note—same coupon 

and payment terms as trust preferred 

shares, booked as intercompany debt 

and eliminated upon consolidation 

Interest Payments—paid with 

before-tax dollars by the BHC 

Bank Holding Company 

(BHC) 

(BHC owns common stock of 

trust subsidiary) 

New York Regional Outlook 22 Fourth Quarter 1997
 
Regular Features Financial Markets
 

company debt. The interest paid by the bank holding 

company on the subordinated note, which is taxdeductible at the bank holding company level, is used to 

fund the dividends on the trust preferred shares. In 

short, the issuing trust serves as a conduit for exchanging cash flows between the bank holding company and 

the investors in the trust preferred shares. 

To be eligible for Tier 1 capital treatment, trust preferred dividends may be cumulative, but dividends must 

be deferrable for a minimum of five years. If the dividends are not paid for more than five years, the trust 

preferred shares could be exchanged for junior subordinated debt of the trust. After the exchange, the trust preferred holder could declare an event of default and 

accelerate the claim against the bank holding company. 

Trust preferred shareholders would then be treated similarly to deeply subordinated debt holders or preferred 

stockholders of the bank holding company. 

Trust preferred shares typically have maturities of 30 

years or more and contain call options and redemption 

provisions. The redemption provisions, which are subject to Federal Reserve approval, permit the issuer to 

redeem or buy back the preferred shares prior to maturity upon an adverse event such as the loss of Tier 1 capital treatment or the tax deductible status. 

Banks are not permitted to count trust preferred stock 

toward Tier 1 capital because of the cumulative feature 

of trust preferred dividends. While bank holding companies are permitted to include up to 25 percent of Tier 

1 capital as cumulative preferred stock, including trust 

preferred shares, banks must exclude cumulative preferred stock from Tier 1 capital ratios pursuant to the 

Risk-Based Capital Standards set by the Basle Accord. 

Bank Holding Companies of All Sizes 

Have Issued Trust Preferred Stock 

The flood of trust preferred stock issuance was prompted in part by the threat of extinction under the 1997 

federal budget. Bank holding companies rushed to take 

advantage of a potentially short-lived tax loophole, 

while investors were attracted by the opportunity to 

earn higher rates than on similarly rated bank debt. 

Bank holding companies have used proceeds from trust 

preferred stock to retire or call more expensive outstanding preferred issues, to provide capital to bank 

subsidiaries, to finance acquisitions, and to buy back 

common stock. 

As the tax advantage of the trust preferred stock 

remained intact through the budget negotiations, the 

pace of trust preferred issuance subsided from an estimated $4.3 billion in the first quarter of 1997 to just 

under $2.5 billion in the second quarter. Trust preferred 

issuance by larger banks declined as some approached 

their limit on Tier 1 trust preferred, while more smaller 

banks took advantage of the market for trust preferred 

stock. (See Chart 2 for a distribution of the number of 

banks in various size categories that have issued trust 

preferred stock in recent quarters.) Investment bankers 

are reportedly working on new structures that may make 

it easier and more cost effective for smaller institutions 

to issue these capital securities, perhaps through some 

pooling arrangement. 

REIT Preferred Stock—Another Type 

of Tax-Advantaged Tier 1 Capital 

Prior to the Federal Reserve’s announcement last 

October, the REIT (real estate investment trust) preferred stock structure was the chosen way for financial 

institutions to issue tax-advantaged preferred shares. 

Bank-issued REIT preferreds lost favor once trust preferreds debuted, because the trust structure is less costly and easier to administer than REIT preferreds. 

In an REIT preferred structure, the issuer establishes a 

corporation that elects REIT tax status. Proceeds from 

the preferred shares that are sold to investors are used to 

purchase qualifying real estate assets such as mortgagebacked securities or equity interests in real property. 

Cash flow from the real estate assets funds the REIT’s 

CHART 2 

More Small Institutions Issue Trust
 

Preferred Stock
 

Bank Size 

Number of < $10 billion Banks 

$10-100 billion 30 

$100+ billion 25 

20 

15 

10 

5 

0 4Q96 1Q97 2Q97 

Source: Keefe, Bruyette & Woods 

New York Regional Outlook 23 Fourth Quarter 1997 
Regular Features Financial Markets
 

operating costs and preferred dividends. As long as the 

subsidiary continues to qualify for REIT tax status,3 dividend payments on the common and preferred shares 

are tax deductible by the holding company. 

Will the Tax-Advantaged Status of Trust 

Preferred Stock Continue? 

Although the tax-advantaged status of trust preferred 

stock was not eliminated in the federal budget, the possibility still exists that the Internal Revenue Service 

(IRS) may alter the tax treatment of trust preferred dividends. (In the first half of 1997, the IRS issued a ruling 

that eliminated the tax-advantaged status of a specific 

type of preferred stock known as Step-Down preferred 

stock.) If the tax advantage is eliminated, REIT preferred shares might again become a more popular 

means of raising tax advantaged Tier 1 capital. 

Issues and Concerns 

A number of bank holding companies have embarked 

on stock buyback programs financed by trust preferred 

stock issuance, thereby boosting earnings per share by 

reducing the number of common shares outstanding, 

while maintaining Tier 1 regulatory capital ratios. 

Rating agencies and investment analysts, however, 

generally view trust preferreds as analogous to preferred stock or deeply subordinated debt of the issuer. 

In fact, Standard & Poor’s has announced that bank 

holding companies with trust preferred stock in excess 

of 10 percent of Tier 1 capital may be subject to a ratings review. This announcement reflects the view of 

some analysts that trust preferred stock is a weaker 

form of Tier 1 capital than other forms of capital such 

as common and perpetual preferred stock, because of 

its limited life and treatment upon a liquidation of the 

trust. 

A recent regulatory interpretation has underscored the 

debt-like nature of trust preferred stock. The Office of 

the Comptroller of the Currency (OCC) has determined 

that investments by banks in trust preferred stock 

should be treated as investments in debt securities.4 The 

OCC cited a number of similarities between trust preferred stock and debt securities, including the fact that 

an investment in trust preferred securities is functionally equivalent to an investment in the underlying subordinated debt issued by the bank holding company, and 

that the trading characteristics of trust preferred securities are similar to traditional debt securities. 

Banking organizations should be aware of the views of 

rating agencies and bank analysts toward trust preferred 

stock. In times of economic stress, excessive reliance on 

debt-like capital instruments could result in increased 

financial fragility of the overall organization, a higher 

cost of raising new capital, and potential ratings downgrades. In extreme scenarios, pressures on the bank to 

service the obligations (explicit or implicit) of the 

holding company could attract the attention of bank 

regulators. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

3 To qualify as an REIT, the subsidiary must comply with Section 856 

of the U.S. Federal Income Tax Code, which requires that 75 percent 

of the REIT’s income come from real property rents, interest income 

from mortgage debt on real property, and other related sources. In 

addition, the REIT must distribute at least 95 percent of its net income 

to shareholders. 

4 In a letter dated April 8, 1997, the OCC stated that subject to applicable rating and marketability requirements, bank investments in trust 

preferred stock would be treated as Type III investments under 12 

CFR Section 2 1.2 (k). 

New York Regional Outlook 24 Fourth Quarter 1997 
Regular Features	 Regional Banking
 

Current Banking Trends in the New York Region 

•	 The New York Region’s banks and thrifts continue to show solid midyear performance. 

•	 Loan losses at the Region’s credit card banks continue to rise. 

•	 Institutions in the Region are turning to alternative funding sources as consumers place more of their savings in mutual funds and other nondeposit investment products. 

•	 New York State continues its role as host to foreign banking organizations. 

The Region’s Insured Institutions 

Remain Healthy 

The Region’s banks and thrifts continue to report solid 

financial results (see Chart 1) despite a narrowing net 

interest margin and a modest decline in return on assets. 

For the quarter ended June 30, 1997, insured institutions 

in the New York Region reported: 

•	 a return on assets (ROA) of 1.08 percent, down from 

1.21 percent one year earlier when aggregate results 

were bolstered by noninterest income in commercial 

banks with assets over $1 billion; 

•	 a modest decline in net interest margin (NIM) of 9 

basis points to 3.59 from one year earlier (rising 

yields on earning assets have not kept pace with 

increased funding costs over the past year in commercial banks with assets over $10 billion); and 

CHART 1 

New York Region Institutions 

Continue to Show Strength 

4.0% 

6/96
 

6/95
 

3.0% 

6/97 

2.0% 

1.0% 

0.0%
 

ROA NIM NPA/TA
 

Source: Bank and Thrift Call Reports 

•	 a decline in nonperforming assets (NPA) as a percentage of total assets (TA) to 0.84 percent in the 

second quarter of 1997 from 1.02 percent a year ago 

(the decline is primarily due to improvement in commercial real estate loan portfolios). 

Thirty-nine insured institutions, with combined assets 

of $29.6 billion, reported net losses at midyear 1997. 

Together, these institutions lost a total of $39.7 million. 

Combined assets of these institutions equaled less than 

2 percent of aggregate assets in the Region. Sixteen 

institutions reporting midyear losses were de novo institutions (those beginning operations since 1994), and six 

were credit card banks. 

Credit Card Banks Show Declining 

Asset Quality 

Credit card banks in the Region continued to report 

higher charge-off rates in the second quarter. Their 

weighted average charge-off rate was 5.67 percent as of 

June 30, 1997, compared with 4.86 percent on March 

31, 1997, and 3.72 percent on December 31, 1996. 

However, past-due and nonaccrual rates declined to 4.5 

percent in the second quarter of 1997, from 4.69 percent 

on December 31, 1996. This decline may be a result of 

the trend toward rolling delinquent credit card debt into 

home equity debt consolidation loans or may reflect 

more stringent underwriting and collection standards 

implemented by many credit card banks in 1996 (see 

Regional Outlook, third quarter). Outstanding credit 

card receivables, which fell by 6 percent in the first 

quarter, increased in the second quarter to match the 

year-end 1996 level. On a positive note, Bernstein 

Research reported that personal bankruptcy filings 

showed slower growth in June than forecasted. They 

New York Regional Outlook 25	 Fourth Quarter 1997 
Regular Features Regional Banking
 

project that bankruptcy filings will be relatively stable 

over the next three to four quarters. 

Funding Patterns Change as Competition for 

Consumer Deposits Increases 

Regional banks and thrifts are changing their funding 

strategies as a result of the increasingly competitive 

market for consumers’ financial assets. As consumers 

shift an increasing percentage of their assets into mutual funds and other nondeposit investment products, 

banks have had to scramble to maintain deposit 

accounts. Mutual fund assets, which exceeded $4 trillion in July 1997, have more than quadrupled since 

1989, while bank core deposits have shown little or no 

growth since the late 1980s. In 1980, banks held 54 percent of the total financial assets of financial institutions 

in the United States; by June 1995, that figure had fallen to 32 percent. In 1980, consumers placed about 34 

percent of their assets in savings and checking accounts, 

compared with just 17 percent in 1995; this trend is 

likely to continue given the growth of mutual funds and 

401(k) plans. The stiff competition from financial services companies increases the need for banks to find 

alternative sources of funding. 

Insured institutions in the New York Region always have 

relied less on core deposits for funding than banks 

across the nation (see Charts 2 and 3). For example, the 

ratio of core deposits to assets as of June 30, 1997, for 

all insured institutions in the United States was approximately 53 percent, but the New York Region’s average 

was only 37 percent. Conversely, noncore funding in the 

Region, which for this analysis includes time deposits 

CHART 2 

The Region Uses More Noncore 

Funding Than in the Past... 

% of Total 

Assets 

70 Region Core 

Deposits 

60 

50 

40 

30 Region Noncore 

Funding 

20 

87 88 89 90 91 92 93 94 95 96 97 

Source: New York Region Bank and Thrift Call Reports 

over $100,000 (large certificates of deposit [CDs]), foreign deposits, federal funds purchased, and other borrowings, accounts for 46 percent of total assets. The 

national average in June 1997 was only 34 percent. 

Large commercial banks in the Region drive this result. 

The ratio of noncore funding to assets at the Region’s 

commercial banks with total assets over $10 billion is 

53 percent, compared with 43 percent for all U.S. banks 

with assets over $10 billion. Reliance on noncore funding in the Region’s largest banks has been increasing 

modestly over the past few years. The trend toward 

greater reliance on noncore funding by the Region’s 

commercial banks continues in those banks with total 

assets between $1 billion and $10 billion, for which 

noncore funding to assets is 46 percent, compared with 

the national ratio of 31 percent in similar-sized banks. It 

is only in commercial banks with less than $1 billion in 

assets that Regional reliance on noncore funding falls 

into step with national ratios. The Region’s historically 

higher reliance on noncore funding may indicate a better ability for the Region’s banks, especially the larger 

commercial banks, to adapt in today’s changing environment. Still, the changing marketplace presents new 

challenges for all the Region’s institutions. 

Since 1992, noncore funding has consistently outpaced 

growth in core deposits but continues to lag growth in 

mutual funds (see Chart 4). Spurred on first by “other 

borrowed money” (including term federal funds and 

Federal Home Loan Bank debt) and then by foreign 

deposits and large CDs, the Region’s banks have shown 

that in the current environment, alternative funding 

sources are readily available to support asset growth. 

CHART 3 

... And More Noncore Funding Than the 

Rest of the Nation 

% of Total 

Assets 

U.S. Core 

30 

40 

50 

60 

70 Deposits 

U.S. Noncore 

Funding 

20 

87 88 89 90 91 92 93 94 95 96 97 

Source: U.S. Bank and Thrift Call Reports 

New York Regional Outlook 26 Fourth Quarter 1997 
Regular Features Regional Banking
 

CHART 4 

Mutual Funds Surge While Deposit 

Growth Remains Flat 

Sources: Bank Call Reports, Investment Company Institute *As of June 

–20 

–10 

0 

10 

20 

30 

88 89 90 91 92 93 94 95 96 97 

Noncore Core Deposits Funding 

% Growth Mutual Funds

* 

–30 

Pressure on deposit bases has led banks to turn to the 

capital markets as a source of funding, utilizing capital 

notes and subordinated debt. Securitization of consumer 

mortgage and credit card debt also is becoming a more 

popular vehicle to fund loan growth. According to CFO 

Alert, overall debt issuance by banks doubled in the first 

half of 1997 compared with the same period last year. 

The favorable market conditions, including strong earnings and low interest rates, have prompted a significant 

number of smaller banking institutions to tap the public 

market for the first time and could widen the array of 

banks actively using the capital markets. Market experts 

predict that this trend is likely to continue, especially if 

interest rates remain low. However, an investment banker 

at Stifel Nicolaus & Co., Inc., noted that issuing senior 

debt for funding purposes does not yet provide community banks with a cost-effective alternative to deposits. 

Increased use of noncore funding may lead to more 

volatile funding costs and liquidity concerns in an environment of rapidly changing interest rates. The relatively stable interest rates over the past few years have not 

provided a test for banks’ performance under more 

volatile conditions. Stifel Nicolaus & Co., Inc., for 

example, warns that increasing interest rates could 

deflate the market for bank bond issues. However, some 

noncore funding sources, such as long-term Federal 

Home Loan Bank advances, can be relatively stable. 

In addition, the costs of different noncore funding 

sources are converging. This makes it relatively inexpensive to use a variety of noncore funding sources, 

while providing more options in managing liquidity. For 

example, foreign deposits in 1997 cost about the same 

as large CDs. Banks also are finding that sometimes 

noncore funding is cheaper than retail time deposits 

(deposits less than $100,000) because of competition 

for funds. This may be especially true in the New York 

Region, where large banks in some major metropolitan 

markets tend to pay higher rates on retail CDs than the 

U.S. average. Nevertheless, banks must recognize the 

potential liquidity and interest-rate risks that accompany noncore funding and ensure that proper procedures 

are in place to manage these risks. 

New York Is the Center of Foreign Bank 

Operations in the United States 

New York State has a long history of hosting foreign 

banks operating in the United States. In the 1960s, the 

appeal of overseas markets increased, and U.S. banks, 

led by the New York money center institutions, aggressively expanded their worldwide operations. This dramatic expansion changed the character of banking 

markets around the world and compelled major banks in 

Europe and Japan to increase their own international 

activity. As the U.S. dollar became the dominant currency in world trade and as foreign corporations turned 

to the growth-oriented economy of the United States for 

expansion, foreign banks recognized the need to establish a U.S. presence. New York, the principal financial 

center in the United States, became the entry point for 

many foreign banks. 

New York State hosts 387 foreign bank offices, or 44 

percent of total foreign bank offices in the United 

States. These offices have total assets of $667.8 billion, 

or 65 percent of assets, booked in foreign bank offices 

(see Chart 5, next page). Fifty-five countries have bank 

operations in New York State, with Japan having the 

largest representation. As of June 30, 1997, 15 insured 

branches1, with aggregate assets of $6.6 billion, had 

estimated insured deposits totaling $2.4 billion. All 

insured branches in the Region are located in New York 

City. Thirty-four insured subsidiary banks2 of foreign 

1 An insured branch is a branch of a foreign bank whose deposits are 

insured by the FDIC. FDIC insurance is required whenever retail 

deposit activity is conducted. Under the Foreign Banks Supervision 

Enhancement Act of 1991 (FBSEA), foreign banks wishing to conduct retail deposit taking activity may do so only through an insured, 

domestically chartered subsidiary bank. Branches that had FDIC 

insurance prior to FBSEA may continue to accept retail deposits, but 

no new insured branches may be established. 

2 An insured subsidiary bank is a separately capitalized institution 

whose parent is a foreign banking organization. Deposits are insured 

by the FDIC. These subsidiary banks have all the banking powers 

exercised by domestic banks. 

New York Regional Outlook 27 Fourth Quarter 1997 
Regular Features Regional Banking
 

CHART 5 

U.S. Assets of Foreign Banks Are Concentrated in New York
 

California 

$122.5 Billion 

155 Offices 

Texas 

$11.1 Billion 

41 Offices 

Florida 

$18.5 Billion 

74 Offices 

Georgia 

$10.6 Billion 

24 Offices 

New York 

$667.8 Billion 

387 Offices 

Illinois 

67 Offices 

$111.0 Billion 

Note: Offices include branches, representative offices, agencies, banks, and Edge Act corporations. 

Source: 1997 Yearbook of Foreign Banks in the United States 

banking companies had aggregate assets of $96.6 billion, with estimated insured deposits of $49.5 billion. 

These banks are located across the Region in Delaware, 

Maryland, New York, Pennsylvania, and Puerto Rico. 

Foreign bank assets in the U.S. reached a record high of 

more than $1 trillion by year-end 1996. The increase in 

total assets of 2.8 percent, though modest, reversed a 

decline reported at midyear 1996. The International 

Banking Regulator characterized the rise in assets as 

impressive considering several negative circumstances, 

including the retreat of Japanese banks, a decline in foreign assets in California, and the significant changes 

currently taking place in the U.S. financial services 

industry. Some analysts, however, contend that foreign 

banks will need to rethink their strategies and develop 

new product lines to ensure that they can compete effectively in an era of financial modernization. In response, 

foreign banking organizations have developed nonbanking activities, boosted their retail operations, and 

increased off-balance-sheet activities, including derivative trading. 

These initiatives into increasingly sophisticated business lines can add a new layer of risk, particularly if 

control procedures do not keep pace with innovations. 

Over the past few years, a number of dramatic and wellpublicized incidents involving fraudulent activities have 

been uncovered at both domestic and foreign financial 

institutions. These events have proven costly to—and 

even threatened the existence of—the institutions 

involved. 

New York State Adopts New Audit Regulations 

for Foreign Branches and Agencies 

To maintain and enhance safety and soundness, the New 

York Banking Board adopted Part 5 of the General 

Regulations. Part 5 is titled Internal and External 

Audits at Branches and Agencies of Foreign Banking 

Corporations, and it establishes a set of new auditing 

regulations for foreign banks’ New York branches and 

agencies. 

“We learned our lessons from the control issues that 

arose in institutions such as Daiwa and Barings,” said 

Acting Superintendent Elizabeth McCaul. “Thus, the 

New York State Banking Department is formalizing a 

regulatory framework, which will hopefully prevent 

other institutions from meeting the same fate. The 

Banking Department has always recommended the 

retention of internal or external auditors in the past. 

These new regulations enable us to require foreign 

banks, in certain instances, to hire qualified internal and 

external auditors.” 

Under the new rules, foreign branches and agencies 

with a ROCA Composite rating of 4 or 5 (see box) and 

a separate Operational Controls rating of 4 or 5 must 

New York Regional Outlook 28 Fourth Quarter 1997 
Regular Features	 Regional Banking
 

The ROCA Examination Rating 

System for Branches and Agencies 

of Foreign Banking Organizations 

Conducting Business in the 

United States 

The term ROCA stands for Risk Management, 

Operational Controls, Compliance, and Asset 

Quality: 

•	 Risk Management is the process of identifying, 

measuring, and controlling risk. Primary components of sound risk management include a 

comprehensive risk assessment approach; a 

detailed structure of limits, guidelines, and other 

parameters used to govern risk taking; and a 

strong management information system for 

monitoring and reporting risks. 

•	 Operational Controls assessment measures the 

effectiveness of the branch’s operational controls, including accounting and financial controls. Control procedures should ensure that 

operations are conducted in accordance with 

internal guidelines and regulatory policies. 

•	 Compliance refers to the branch’s ability to comply with all applicable state and federal laws and 

regulations, including reporting and special 

supervisory requirements. 

•	 Asset Quality is evaluated to determine whether 

a financial entity has sufficient capital to absorb 

prospective losses. The evaluation of asset quality in a branch differs from that of a separately 

capitalized entity because the branch relies on 

the financial and managerial support of the foreign banking organization as a whole. 

The overall Composite Rating indicates whether, in 

aggregate, the operations of the branch may present supervisory concerns and the extent of any 

concerns. 

retain the services of an independent external auditor, 

subject to the approval of the Superintendent of Banks. 

These auditors must then conduct certain specified 

procedures related to the office’s finances and internal 

controls. On a case-by-case basis, foreign bank offices 

that receive a rating of 3, 4, or 5 in the specific area of 

Operational Controls, regardless of their Composite 

rating, also must engage an independent external 

auditor. 

The Superintendent of Banks also is empowered to 

require internal audits if the bank’s Composite rating is 

4 or 5 and its Operational Controls rating is 4 or 5. 

Further, the Superintendent, on a case-by-case basis, 

may require foreign bank offices with an Operational 

Controls rating of 3, 4, or 5 to conduct internal audits. 

Basic elements of a control system should promote the 

prevention and detection of error, safeguard assets, and 

ensure the reliability of financial records. An adequate 

control system is equally important to both domestic 

and foreign insured financial institutions, particularly as 

they undertake new strategies and business lines in the 

era of financial modernization. While examinations are 

not conducted to detect fraud or ensure the complete 

accuracy of financial records, an overall assessment of 

the control system remains an important examination 

function. Examiners’ principal efforts should continue 

to be focused on the detection, exposure, and correction 

of important weaknesses in an institution’s records, 

systems, and auditing procedures. 

Kevin P. Hemhauser, Examiner 

Suzannah L. Susser, Regional Manager 

Karen A. Wigder, Financial Analyst 

For More Information 

1997 Mutual Fund Fact Book, Investment Company 

Institute, March 1997.
 

1997 Yearbook of Foreign Banks in the United States,
 

Thomson’s International Banking Regulator, 1997.
 

Bankruptcies Decelerate; Credit Card Losses Should 

Improve, Bernstein Research, July 18, 1997.
 

“Capital Securities Changing Face of Capital Markets,”
 

CFO Alert, July 7, 1997.
 

“Clueless Bankers,” Fortune, November 27, 1995.
 

“Foreign Bank Assets Hit Highest Level,” Thomson’s
 

International Banking Regulator, June 2, 1997.
 

Foreign Banks in New York, New York State Banking
 

Department, August 12, 1996.
 

New York Regional Outlook 29	 Fourth Quarter 1997 
✁
 

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