FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1997
 

FDIC
 

SAN FRANCISCO
 

REGION
 

DIVISION OF
 

INSURANCE
 

CATHERINE I.
 

PHILLIPS-OLSEN,
 

SENIOR REGIONAL
 

ANALYST
 

GARY C. ZIMMERMAN,
 

REGIONAL ECONOMIST
 

ROGER STEPHENS,
 

FINANCIAL ANALYST
 

In Focus This Quaitei
 

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

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

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

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

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

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

come under considerable pressure. See page 3.

• Banking on the Internet: New Technologies, New

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

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

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

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

Regu[ai Featuies
 

+Regional Economy +Financial Markets +Regional Banking

 · Economic Overview · Asset-Backed Securities · Overall Conditions

 · Service Sector · Bond Values · Commercial Real Estate

 · Manufacturing Sector · Price/Earnings Ratios · Merger Activity

 · Construction Growth · Thrift Recovery

 · Economic Softening

Hawaii

Alaska

Montana

Wyoming

See page 11 See page 15 See page 20

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

Insurance Corporation for the following eight geographic regions:

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Center for current pricing on bulk orders.

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

more information or to provide comments or suggestions about the San Francisco Region's Regional

Outlook, please call Catherine I. Phillips-Olsen at (415) 974-4247 or send an e-mail to caphillips­

@fdic.gov.

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

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

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

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

the Federal Deposit Insurance Corporation.

Chairman Ricki Helfer

Director, Division of Insurance Arthur J. Murton

Editor George E. French

Managing Editor Stephen Linehan

Associate Editor Maureen E. Sweeney

Assistant Editors Paul C. Bishop

Steven K. Burton

Richard A. Brown

Diane Ellis

Kathy R. Kalser

Ronald L. Spieker

Publications Managers Nancy Maginn

Diane Ellis

Publication Date: April 24, 1997
 
In Focus This Quarter
 

WillfCreditfScoringfTransformfthefMarketffor
 

Small-BusinessfLending?
 

• 	 Small-business lending, traditionally a segment in

which small banks have enjoyed comparative

advantages, is receiving greater focus from

larger banks and nonbank financial companies.

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

loan underwriting to include the use of credit

scoring models.

• 	 The use of small-business lending credit scoring

models, while providing banks opportunities for

underwriting and servicing efficiencies, carries

with it a number of potential risks.

Background

As of 1994, there were more than 22

million small businesses in the U.S.,

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

business in which small banks have

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

spread over smaller loan balances. Some institutions

are now beginning to use credit scoring technology to

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

especially, appear to be looking to the efficiencies of

credit scoring to help provide quick loan approvals and

more competitive loan rates. With the aid of this

technology, some institutions are rapidly expanding their

loan portfolios, in some cases venturing into markets

well beyond their local economies.

Commercial bank small­business lending exposures in

the San Francisco Region are considerable. (For purposes of this article, small business lending refers to

loans categorized as commercial and industrial loans

with original amounts of $1 million or less reported on

the June Call Reports.) At midyear 1996, commercial

banks in this Region reported $25 billion of small

business loans, amounting to 25 percent of all commercial and industrial loans. This is an increase of $1.4

billion or 6 percent from one year ago. There are 382

banks in the Region with small­business loan exposures

exceeding equity 100 percent of equity and 103 banks

with exposure exceeding 200 percent of equity.

Small banks, those with assets under $1 billion, have a

substantial share of the Regions' small­business loans,

holding 39 percent. However, large banks over $10

billion are increasing their presence in the smallbusiness lending market. These large banks seem to be

concentrating their efforts on smaller­size loans

(under $100 thousand), which grew 35 percent in the

last year (see Chart 1 next page).

In California, the trend is even more pronounced, as

some of the state's largest banking companies have

announced nationwide programs to increase their market

share of small business lending. These nationwide

programs may have been prompted by the new credit

scoring technology. Several of these companies reportedly are offering pre­approved and pre­qualified lines

of credit through the use of credit scoring technology.

ThefGrowingfImportancefoffCreditfScoring

While credit scoring technology

is not new, until recently it typically has been associated with

consumer lending, particularly

with credit card lending. Primarily using credit bureau information, credit scoring provides

lenders with a tool to rank risks

or probabilities of default, assigning statistically derived numerical ratings or scores based upon a borrower's past experience with paying debt. Based upon

the enormous volume of historical information on consumers contained in credit bureaus, model developers

link incidences of good and bad credit performance with

borrower characteristics. Applicants then are compared to these credit performance indicators in order to

make credit extension decisions. While credit scoring

has helped consumer lenders reduce origination costs

and to grow receivables at rapid rates, the recent rise in

credit card charge­offs has raised concerns about the

effectiveness of such models, or at least about how the

scoring models are being used.

Small­business credit scoring is a relatively new conRegional Outlook	 3 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

CHART 1
 

3% 6%

14%

10% 8% 8% 6% 6%

35%

-5% -3%

0%

5%

10%

15%

20%

25%

30%

35%

40%

< $1Billion $1 - $10 Billion > $10 Billion Region Nation

The Region's Small Business Growth Rates Soar in Large Banks

(1995-1996)

Loans <$100,000

Loans <$1 million

Source: Bank Call Reports

Growth Rate

Banks by Asset Size

cept in scoring technology, but is gaining more attention

from lenders. Small­business credit scoring models

are similar to consumer credit scoring models in one

significant aspect ­­ the most important indicator of

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

bureau information. Other business information from

companies such as Dun and Bradstreet Corporation and

Experian (formerly TRW) also is used in the scoring

process.

A primary vendor of these scoring models has cited

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

credit performance for small­business loans. The reasons for this result may be due to inconsistency in

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

of principals' credit history and financial statement

information in predicting credit performance was found

to change somewhat with the size of the business ­­ the

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

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

significant characteristics of credit scoring. In many

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

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

loan applications. In some cases, financial statements

are not required at all. Reducing paperwork helps to

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

as reported by one large bank at a recent conference on

credit scoring. While it is impossible to know whether

the information presented in Table 1 is representative of

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

significant departure from traditional underwriting

methods.

Part of the reduction in underwriting costs may come

from improvements in the allocation of underwriting

resources. It has been argued that credit scoring allows

banks to more easily identify those applicants which are

clearly either approvals or denials. This process would

enable banks to reallocate their underwriting resources

more efficiently to those loans which pose intermediate

risks and require closer attention. Other advantages of

credit scoring systems that often are cited are greater

consistency in underwriting, better measures for pricing

TABLE 1

SMALL-BUSINESS LENDING: CREDIT SCORING

VERSUS TRADITIONAL LOAN UNDERW RITING

1993 1996 1997

PERCENT OF LOANS

REQUIRING ANNUAL 100% 20% - -

FINANCIAL STATEMENTS

PERCENT OF LINES

REVIEWED ANNUALLY 100% 0 - 5% - -

PROCESSING TIME FOR LOANS 3 1 1

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

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

CREDIT SCORING.

Regional Outlook 4 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

strategies, and the potential to enhance the ability to

securitize small­business loans.

WhatfArefthefRisks?

Small­business lending has historically been a profitable area of bank lending. This situation is most likely

attributable to lenders thoroughly analyzing potential

customers, persistently monitoring their performance,

and building solid lending relationships. Credit scoring

for small­business lending raises the possibility that

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

lending. To the extent that credit scoring is used to

rapidly gain new customers by either targeting out­ofterritory customers, or customers with less business

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

change in profile may be significant due to the risks

associated with newer borrowers. For example, new

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

percent of new businesses failing within the first four

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

volatile characteristics.

There are potential dangers associated with placing

undue reliance on credit scoring models. The predictive

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

purposes or customer types. Therefore, misuse of a

scoring system could expose an institution to considerable losses. Since only the largest banks have smallbusiness loan portfolios large enough to create statistically valid scoring models customized for their own

customer base, smaller companies should be especially

aware of potential misuse. This risk takes on added

meaning when one considers that a $1 million smallbusiness loan represents substantially more capital to a

$100 million bank than to a $10 billion bank. Adding

further uncertainty, small­business credit scoring has

been implemented during a period of relatively strong

performance by businesses, with commercial and industrial loan delinquency ratios near historical lows. How

well these models perform during an economic downturn remains to be seen.

Depending on the manner in which it is implemented,

credit scoring for small­business lending may represent

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

consumer loan and, thus, granting credit more on the

strength of the principals' personal credit history and

CHART 2
 

Business Dissolution Rate Shows Early Risk

100%

53%

Cumulati e Dissolution Rates

24%

62%

71%

80%

123456 7 8 9 10

80%

60%

40%

20%

0%

Years

Source: Small Business AMministration

less on the financial strength of the business itself.

While this may be appropriate in some cases, it is

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

loans. Banks that do not analyze business financial

statements or periodically review their lines of credit

may lose an opportunity for early detection of credit

problems.

Competitive pressures in small­business lending are

increasing not only because of large banks' efforts to

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

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

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

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

and other services such as consulting, accounting and

investment services. Some observers have suggested

that the cost advantages of credit scoring may cause

small­business lending in the future to be dominated by

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

competition, there may be strong motivation for some

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

lower credit scoring thresholds for loan approvals.

The most recent FDICfSurveyfoffUnderwritingfPractices and the FederalfReserve'sfSeniorf LoanfOfficer

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

easing of standards on small­business loans. Aggressive competitive pressures and loan growth goals were

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

regard to small­business credit scoring techniques, the

Regional Outlook 5 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

Federal Reserve survey pointed out that banks were

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

Summary

Credit scoring has the potential to transform the market

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

tremendous pressure from larger banks and nonbank

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

changes in underwriting methods for small­business

lending. These changes may facilitate short­term revenue generation as business can be expanded rapidly

and underwriting costs can be slashed. It is extremely

important, however, that banks understand and control

the potential risks inherent in such a strategy. The

application of credit scoring to small­business lending

merits the close attention of both bankers and their

supervisors.

Andrea W. Bazemore, Banking Analyst

Regional Outlook 6 Second Quarter 1997
 
In Focus This Quarter
 

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

• 	 Despite the potential for lower transaction costs,

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

• 	 Although competitive risks are pushing banks to

create an Internet presence, operational risks

remain an obstacle to actually using those sites

for moving information or money.

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

and is developing training programs for its examiners.

The Allure of Cyberbanking

On-line Banking is a comprehensive term for transactions conducted

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

and, more recently, banking over the

Internet. Internet banking, frequently

referred to as cyberbanking, is of particular interest to

banks because it exploits an existing and geographically

extensive public network infrastructure and promises a

range of new operating and marketing benefits. One

such benefit is the ability for an institution to expand its

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

even countries -- without a commensurate expansion of

its branch structure. This greater geographic reach can

CHART 1

do more than simply increase volume. It also can offer

institutions -- particularly smaller ones -- the potential

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

volatility of any single one. Another benefit is the lower

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

Allen & Hamilton Inc. estimated an average Internet

transaction cost of $0.01 compared to $0.27 for an

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

Slow Migration to the Future

Another 1996 study, this one by Grant Thornton in July

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

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

bank services or staying abreast of competitors -- rather

than with an intent to grow deposits or capture the

transaction economies that cyberbanking could provide.

Of the 44 Internet institutions surveyed, only one in three

expressed intentions to begin offering bill payment or

funds transfer over the Internet by the end of the second

quarter of this year. Even this subdued enthusiasm now

appears optimistic. Despite the perceived benefits and

the scarcity of competition, few banks have to date

ventured into this area in a meaningful way. According

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

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

Internet site and only 18 of those permit transactions. In

the San Francisco Region, 120 institutions have an

Internet presence but only three allow customers to pay

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

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

Review Account History

Transfer Funds

Apply for Mortgages

Pay Bills

Banking on Cybercommerce: A Survey of Internet Bank Product Plans

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

Mid 199 

(Projected)

Mid 1996 (Actual)

Regional Outlook	 7 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

bills or transfer funds. A major question, then, is why so

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

Risk
 

The reason is risk. Banks are familiar with the control

of exposures found in proprietary or private payment

channels, but they are less comfortable with the new

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

are operational exposures that convincingly argue

against rushing headlong into cyberspace. On the other

hand, there are competitive risks. Nonbank competitors

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

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

These opposing forces help explain the large numbers of

banks establishing web sites that stop short of actually

moving information or money.

Of these two types, operational risks are the most

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

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

theft or misappropriation of internal data or external

transmissions, transaction fraud, errors in underwriting

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

regulatory and legal infrastructure, noncompliance with

existing laws or regulations that were not designed for

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

Some Concerns for the CyberBanker,right).

Systemic Threats and a New Payments Model

In addition to bank-specific risks there are the systemic

threats that a public domain payments model could

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

be used for a given transaction and therefore the failure

of any one path or node will not affect the functionality

of the network as a whole. This feature presents a

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

previously unconsidered points of vulnerability to

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

attack may not be much more severe than those which

accompany credit card crime. However, there is good

reason to expect that Internet transaction sizes will

continue to grow. According to one software vendor,

Internal Data Security. The Internet cannot distinguish

between customers and criminals. Invasive attacks can range

from simple vandalism to theft or destruction of proprietary

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

insurance can limit such exposures.

External Transmission Security. Because the Internet is an

open network, transaction messages are completely exposed,

rendering them vulnerable to theft or tampering. Message

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

greatly if large value or interbank transactions migrate to the

Internet.

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

problem takes new dimensions in cyberspace because no

physical relationship with a customer exists. Encryption

protocols which include digital signatures are one response.

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

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

in establishing their creditworthiness. The lack of a personal

relationship is one factor. The limited knowledge of local

employers and credit grantors that appear on applications is

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

Liquidity Risks. Internet transaction volume and velocity

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

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

can affect liquidity if affected customers decide to close their

accounts.

Lack of Technical Standards. An institution building an

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

which standards will endure.

Lack of Regulatory and Legal Infrastructure. Regulators

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

adopted. Similarly, a lack of legal precedent hinders criminal

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

Reputation Risk. An image of solidity is a cornerstone of

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

Competitive Risks. Unlike the operational risks discussed

above, competitive risks accrue to institutions not securing an

Internet foothold. They involve the threat of lost market

share or payment system position to more aggressive peers

and nonbank competitors.

Regional Outlook 8 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

interbranch payments on the Internet are likely to begin

in 1997 with interbank activity to follow a year or so

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

relative to bank liquidity. An attack or disruption of the

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

banks in the same way that bad weather at a major

airport can disrupt air traffic throughout the country.

New Technologies, Old Reporting

The advent of fully transactional web sites also could

heat up bank competition for low cost deposits and

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

deposits and program trading in which a computer

program could search the Internet for the highest deposit

rates and immediately reallocate deposits accordingly.

In the long run, such activities could harmonize local

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

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

the regulatory perspective, this transaction velocity --

and its potential to rapidly alter bank balance sheets --

could present new challenges in a world of quarterly

Call Reports and examination intervals that can exceed

one year.

FDIC -- the CyberRegulator

New risks demand new supervision techniques and the

FDIC's Division of Supervision (DOS) has responded

with their recently-released electronic banking safety

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

TABLE 1

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

Safety and soundness examination procedures focus on

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

successive tier adds an additional level of scrutiny to

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

training program for all safety and soundness examiners

already has begun, and technical training for information

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

also is being established.

Measured Steps in a New Environment

Banks increasingly are becoming distributors of

commodity-like products. As such, profitability may

become dependent upon both cost efficiencies and high

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

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

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

sort. They face instead the risk that their competitive

position will pass to more innovative competitors --

competitors with new technologies and the drive to

accomplish old business in thoroughly new ways.

Gary Ternullo, Senior Financial Analyst

gternullo@rdic.gov

THE DIVISION OF SUPERVISION CLASSIFICATIONS FOR INTERNET BANKS

LEvEL 1 LEvEL 2 LEvEL 3

DESCRIPTION AN INFORMATION-ONLY

SITE

A SITE PERMITTING

ELECTRONIC

SUBMISSION OF LOAN

OR DEPOSIT

APPLICATIONS

TRANSACTIONAL SITE

OFFERING ELECTRONIC

BILL PAYMENT OR FUNDS

TRANSFER SERVICES

SPECIALIST

EXAMINATION

REQUIREMENT

(IN ADDITION TO

SAFETY AND

SOUNDNESS EXAM)

INFORMATION

SPECIALIST REVIEW

REQUIRED ONLY IF SITE

IS TIED INTO INTERNAL

BANK SYSTEMS.

CONSULTATION WITH

INFORMATION

SPECIALIST REQUIRED

TO DETERMINE IF

FURTHER REVIEW IS

WARRANTED.

CONCURRENT

INFORMATION

SPECIALIST EXAMINATION

REQUIRED.

Regional Outlook 9 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In Focus This Quarter
 

For More Information:

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

Cynthia Bonnette, Examiner

Chairman, New Banking Technologies Task Force

(202) 898-6583

Stephen White, Inrormation Systems Review Examiner

Chairman, Inrormation Systems Subcommittee

Federal Financial Institutions Examination Council Task Force on Supervision

(202) 898-6923

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

coordinating outreach efforts with consumer community groups.

John Jackwood, Special Assistant to the Director

(202) 942-3854

Regional Office Contacts	 J. Richard Mayher, Assistant Regional Director

Division or Supervision

San Francisco Regional Orrice

(415) 546-0160

Charles Hasman, Review Examiner

Division or Compliance and Consumer Arrairs

San Francisco Regional Orrice

(415) 974-4476

Office of Policy Development	 OPD provides leadership in developing FDIC policies, including those addressing

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

Consumer Electronic Payments Task Force.

Sharon Powers Sivertsen, Director

(202) 898-8710

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

FFIEC http://www.ffiec.gov

NETBanker http://www.netbanker.com

Bankweb http://www.bankweb.com

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

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

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

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

Regional Outlook	 10 Second Quarter 1997
 
Regular Features	 Regional Economy
 

San Francisco Region: Following Separate Paths
 

• 	 The economic performance of the states in the San Francisco Region generally fell into one of two distinct

groups in 1996, those that were among the nation's top performers or those that were at the bottom of the

list in both personal income and employment growth.

• 	 Nevada remains the nation's fastest growing state in both employment and personal income. Joining

Nevada at the head of the pack in 1996 were Arizona, Utah, Oregon and Washington, with California and

Idaho close behind.

• 	 Hawaii, Alaska and Wyoming ranked at the bottom nationally in personal income and employment growth

in 1996. While Montana recorded near average employment growth, it also fell at the bottom of the list

for personal income growth. Soft economic conditions in these states are accompanied by modest

deterioration in bank asset quality.

San Francisco Region Outperforms Nation

Despite the sharp differences in performance within

the Region, as a whole it easily outpaced the nation in

economic growth in 1996. Employment growth in the

Region rose from 2.7 percent in 1995 to 3.4 percent for

1996. In contrast, the employment growth rate for states

outside the Region dipped from 2 percent in 1995 to 1.9

percent for 1996. The Region's seven rapidly expanding states accounted for about 29 percent, or almost

CHART 1

-2 0 2 4 6 8

Nevada

Arizona

Utah

Oregon

Washington

California

Idaho

Montana

Wyoming

Alaska

Hawaii

Region

U.S.

The Region's Employment Growth Outpace

 the Nation in 1996

Source: Bureau of Labor Statistics

Percent

740,000 of the 2.6 million jobs added to U.S. payrolls in

1996. This growth is impressive, since the Region as a

whole accounts for only 19 percent of nonfarm payroll

jobs nationally.

Nevada lead the nation in 1996 employment growth

(7.7 percent) and personal income growth (10.4 percent at an annual rate for the first three quarters of

1996). Arizona, Utah, Oregon and Washington followed

closely behind, ranking second through fifth nationally

with employment growth rates ranging from 5.4 percent

to 3.4 percent in 1996. California employment grew at

a 3 percent rate to rank eleventh in the nation, followed

closely by Idaho, which fell back to fourteenth nationally with a 2.9 percent growth rate. Each of these states

also ranked above the national average in personal

income growth in 1996. Chart 1 shows the strength in

employment growth across the Region in 1996. Moreover, the Federal Reserve's Beige Book reports that the

western region is expected to continue to outperform the

nation in 1997.

Services Remain Strong in the Region

Service ob growth accelerated to a 5.3 percent rate in

1996, well above the 3.7 percent rate elsewhere in the

nation, and service employment grew by nearly

340,000 positions in the Region. This key sector

accounts for about 30 percent of all jobs in the Region,

close to the 29 percent share for the nation. The Region

was paced by Arizona, Utah and Nevada, states that

increased their service­sector growth rates to better

than 7 percent for the year. Two other fast­growing

states, Oregon and California, also ranked near the top

in service­sector growth rates. Lodging and recreation,

Regional Outlook	 11 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

business services, computer and software services, mo­ Region exceeded the national average by such a wide
 

tion pictures and entertainment all recorded robust margin for more than one year in a row.
 

growth, and their outlook remains favorable.
 

Improved Real Estate Conditions Spur ConManufacturing Bucks National Downturn struction Growth

The Region's manufacturing expansion shifted into
 

high gear in 1996, expanding by almost 84,000 obs in
 

1996, or 2.9 percent, up from a 2.1 percent increase in
 

1995. The Region's manufacturing employment boom is
 

tightening labor markets in some states, and contrasts
 

sharply with the slight contraction nationally, as can be
 

seen in Chart 2.
 

Washington's 6.5 percent increase in manufacturing employment, boosted by the surge in commercial aircraft
 

production, added almost
 

22,000 jobs to thatstate's payrolls. High­technology exports and manufacturing also
 

played a key role in the Region, boosting durable goods production, especially for
 

computers and electronic equipment, in California, Oregon, Idaho, Arizona, Utah and Nevada. Nondurable
 

production was helped by a modest expansion in food
 

products in California and Idaho. In addition, California reported robust growth in the apparel industry.
 

Implications: The strong, and generally broad­based

growth, in the seven fast­growing states in the Region

typically is reflected in the health of the banking

industry in those states. While the robust manufacturing growth compared to the nation in 1996 is positive, it

has been unusual for the Region to sustain such rapid

growth relative to the rest of the nation for much longer

than one year. In fact, only once since the 1960s has the

CHART 2

1996 Manufacturing Employment Growth for the

Region Climbs as the Nation's Falls

Percent

7

6

5

4

3

2

1

0

-1

WA

CAUT

Ig

OR

A 

Region

U.S.

Real estate markets in the Region have been picking

up. Residential and, in some cases, multifamily housing

markets have tightened in Seattle, Portland, Las Vegas,

Phoenix and the San Francisco Bay Area. Conditions in

commercial real estate also have improved. Metropolitan office vacancy rates are now below or well below

the national average in most parts of the Region, except

for some parts of Southern California and Honolulu.

Underscoring the revival of commercial real estate in

the Region, Marketscore's Fall 1996 issue rated

several cities in the Region as having excellent real

estate investment potential, including San Francisco

(office, retail and apartments), San Jose (retail and

apartments), Seattle (office), Portland (office and retail), Salt Lake City (office), Phoenix (suburban office),

Sacramento (retail), Oakland­East Bay (apartments) and

Las Vegas (retail).

Improved real estate market conditions in the San

Francisco Region are reflected in both increased real

estate lending and construction employment in the Region. Construction jobs expanded at a 6.4 percent

rate in 1996, down slightly from 6.8

percent in 1995, but just above the

growth rate nationally. For the Region as a whole, housing permits, an indicator of future

activity, also rose at a comparable rate to construction

employment. Construction was an important factor in

adding jobs in Nevada and Oregon, two of the seven

fast­growing states that have experienced rapid population inflows.

Implications: Notwithstanding the generally favorable real estate market statistics reported above, there

also are signs of potential concern on the horizon. For

example, the Beige Book recently reported slower sales

for middle­market housing in the fast­growing intermountain states. This slowdown may be evidence of

lower population inflows that could affect the building

industry in these states. Furthermore, recent increases in

long­term interest rates also could dampen the demand

for housing. Finally, increased construction and commercial real estate lending in the Region appear to be

concentrated at regional and community banks, instituSource: Bureau of Labor Statistics tions that in some cases already have a relatively high
 

concentration of such loans in their portfolios (see

Regional Outlook 12 Second Quarter 1997
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features	 Regional Economy
 

Current Regional Banking Conditions).

Hawaiian Recession Continues

Despite the strong overall performance of the Region

in 1996, four states ranked in the lower half nationally

in economic growth; and three, Wyoming, Alaska and

Hawaii, ranked in the bottom five. Hawaii ranked

fiftieth in the nation in both employment and personal

income growth rates. The evidence for 1996 indicates

that the state still did not turn the corner on its longlasting recession. For example:

• 	 Real personal income growth was negative.

• 	 Job losses totaled 1,400 for the year.

• 	 Bankruptcies for households increased at a rate of

almost 65 percent between 1995 and 1996, more

than twice the national increase.

• 	 The unemployment rate for December 1996 was 6.5

percent, well above the national average of 5.3

percent during the same period.

The decline in employment marked the fourth time over

the last five years that Hawaii has experienced a net loss

of jobs. Weakness in Hawaii's economy is evident

across all sectors. Even the service sector, which

traditionally experiences milder business cycle swings

than most other sectors, grew only 1.6 percent for the

year, which ranked forty­eighth among all the states.

Tourism has been estimated to account for around 20

percent of Hawaiian economic activity, but that industry has suffered from the prolonged weakness in the

Japanese economy. Still, there has been some improvement. Both visitor counts and visitor days increased in

1996, and employment in the lodging industry rose by

3.4 percent in 1996 after declining in 1995. Business

services jobs increased over the year at a strong pace;

however the large trade sector actually shed jobs in both

retail and wholesale employment.

Hawaii's depressed real estate market conditions remain an area of concern for both the state and its

financial institutions. Construction employment fell

almost 10 percent in 1996, its fourth consecutive annual

decline. Vacancy rates for office space in Honolulu

rose slightly in 1996 and remain high compared to the

nation. Residential property values also are weak.

Housing permits fell by more than 40 percent between

1995 and 1996, portending ongoing softness in the

construction sector and raising concerns about banks'

real estate loan quality.

Implications: Analysts do not expect a reversal of

Hawaii's poor economic performance in the near term.

Tourism and investment spending still appear to be the

most likely sources of strength for a rebound in Hawaii

given the state's weak employment situation and minimal personal income growth in 1996. However, spending by Japanese visitors and real estate investors both

could be slowed by the fall in the value of the yen

relative to the dollar. Rising net charge­off and problem

loan ratios in 1996, the latter shown in Chart 3, suggest

that the state's lengthy recession is having an adverse

impact on asset quality at the state's financial institutions.

Alaskan Economy Slows Down

The Alaskan economy remained weak in 1996 after two

years of lackluster growth. While the number of

Alaskans employed rose by 1,400 over the year, the

state ranked forty­eighth in personal income growth and

forty­ninth in employment growth.

Alaska has been hurt by its heavy dependence on

energy and natural resources and by depressed prices

and strong international competition in seafood products. Employment in oil production, mining, lumber and

wood products all declined in 1996. Oil price increases have not been sufficient to offset the downward

trend in output. Increased demand for many wood

products has not had a significant impact on output in the

state either; supply is constrained since much of the

remaining timber is located in federal forests. The

announced closing of the Ketchikan Pulp Company's

pulp mill, that area's largest employer, will result in the

direct loss of over 500 jobs in Ketchikan.

CHART 3

Percent Change in

Employment

MT

W A 

HI

Region

U.S.

-1

0

1

2

3

4

Percent Change in

Employment

Problem Loan Ratios Rise in Region's States

with Weak 1996 Employment Growth Rates

Source: Bank Call Reports and Bureau of Labor Statistics

Percentage Point

Change in Problem

Loan Ratio

Regional Outlook	 13 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Economy
 

Meanwhile, the state's largest employment sector, governmental services, remained soft as reductions in federal government employment in part offset increases at

the local level. Slower energy production rates and

falling revenues also are putting pressure on state government finances, since over 80 percent of state revenues come from energy­related sources.

Still, analysts note some signs for optimism. Transportation employment should benefit from the selection

of Anchorage as an international air cargo transfer hub.

Announcements of new oil field discoveries, a pick­up

in hard rock mining operations and higher prices for

lumber could bring about moderate improvement in

1997. As with Hawaii, tourism could be a key to the

state's recovery. Visitors were drawn to Alaska in

record numbers in 1996, and increased spending by

tourists is credited with boosting both retail sales and

lodging activity.

Implications: Alaska's anemic economic performance

is likely to have an adverse impact on bank asset

quality and the health of the banking industry. Chart 3

(previous page) suggests that this is already occurring.

Conditions in the state should be monitored carefully

since the health of Alaskan banks are likely to follow the

performance of the Alaskan economy more closely than

the national economy.

Softening in Wyoming and Montana

Personal income growth for Wyoming and Montana of

around 3 percent (annualized) over the first three

quarters of 1996 barely kept pace with inflation and

was well below the national increase of 5.7 percent.

Employment growth for these two states, measured by

year­end employment levels, also has dropped sharply

since 1994. Despite the slowdown, both states still

reported year­end unemployment rates that were well

below the national average and both added jobs in 1996.

Wyoming added 1,900 jobs (an increase of 0.9 percent)

for the year even though employment peaked in the third

quarter. Montana gained 6,400 jobs (an increase of 1.8

percent), although the state only added jobs in three of

the last seven months of 1996.

Wyoming ranked last in service employment growth

rates in 1996. Service jobs rose by only 0.4 percent

despite strength in business services and a small increase in health care employment. In contrast, Montana

recorded a healthy 3.9 percent growth in service employment that accounted for more than one­half of the

state's 1996 job gain. Services in Montana were generally strong across the board, with a rapid increase in

business service employment, as well as strong increases in social services, educational, personal and

legal services.

Montana also outpaced Wyoming in the construction

sector. Wyoming reported a 1.4 percent increase in

construction jobs as the state's building boom subsided

in 1996. Montana recorded a strong upturn in construction employment for the year, but the outlook for residential construction appears to have weakened as the

number of housing permits issued in 1996 sagged well

below 1995 levels.

Both Montana and Wyoming have been hurt by weakness in natural resources­based sectors. Like Alaska,

the improved markets for these products nationally have

not had a significant impact on overall employment in

these states. Montana recorded increases in employment at its mines and sawmills, the latter helped boost

the state's small manufacturing sector. In Wyoming

rising oil prices have not offset declining production,

while higher coal production has been mostly offset by

soft prices.

Implications: Banks in both Wyoming and Montana

recorded noticeable increases in problem loan ratios

and net charge­offs in 1996. As can be seen from Chart

3 (previous page), the deterioration in economic performance in these states already is having an effect on the

banking industry.

Observations

If the disparate performance of the Region's state

economies continues into 1997, it likely will become

more evident in the performance of the Region's banking industry as well. Montana's economy has cooled

off and is now recording below average growth. Conditions in Alaska and Wyoming have deteriorated significantly, and the economies of these states have fallen

well behind the rest of the nation in economic growth.

Along with Hawaii, where the recession continued in

1996, these states and their financial institutions should

be monitored closely in 1997 for signs of improvement

or deterioration.

Gary C. Zimmerman, Regional Economist

Regional Outlook 14 Second Quarter 1997
 
Regular Features	 Financial Markets
 

Financial Markets
 

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

quality could have adverse effects on both investors and issuers.

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

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

this time period.

• 	 During the fourth quarter 1996, the S&P Composite Bank Index and the San Francisco Region's Bank

Index both outperformed the S&P 500, gaining 12 percent and 13 percent, respectively, compared to an

almost 8 percent gain for the S&P 500.

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

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

The Asset-Backed Securities Market: The

Effects of Weakened Consumer Loan Quality

Asset­backed securities (ABS) are debt securities that

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

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

market has grown dramatically. In 1996, the issuance of

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

1993 as illustrated in Chart 1. Commercial banks and

credit card companies accounted for approximately 35

percent of total ABS issuance last year. Major buyers

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

difficult to quantify the amount of bank investment in the

ABS market, market participants have observed that

small and midsized banks have recently increased their

holdings of ABS.

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

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

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

sheet and lowers capital requirements. In order to

receive investment grade ratings on their ABS, issuers

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

enhancement from bond insurers.

Bank issuers benefit from the sales treatment of assets

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

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

CHART 1
 

0

25

50

75

100

125

150

175

1993 1994 1995 1996

ABS Issuance Is on the Rise

Sou ce: Bloombe g, nside MBS and ABS

$ Billion

 e it a 

Auto 

Home Equity

 the 

and interest coupon payment is recognized as income by

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

Banks that issue ABS usually continue to service the

underlying assets, which not only generates servicing

income but also permits customer relationships to continue.

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

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

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

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

spreads despite the overall weakening in consumer

credit quality reflects strong demand from an expanding

investor base, which increasingly includes overseas

Regional Outlook	 15 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

buyers. Spreads on selected credit card and auto ABS

products began to increase during the first quarter of

1997, however, as investors reacted to higher than

expected charge­offs reported by some of the larger

issuers.

The increasing frequency of rating agencies' reviews for

possible downgrades of credit card transactions, as

well as problems in the auto finance sector, have raised

some concerns in the ABS market. How would a further

deterioration in consumer credit affect the ABS market?

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

from the ABS. If deterioration worsens, the ABS face

potential rating downgrades. This situation may compel

the issuer to improve the overall loan quality in the ABS

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

An early amortization event may result in the termination

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

early amortization occurs, new receivables associated

with the accounts in the asset­backed security no longer

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

their balance sheet and accounted for in determining

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

the ABS market may become more costly after an early

amortization if investors demand higher yields on subsequent issues.

For the investor, the threat of a ratings downgrade

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

amortization because principal may be paid prior to the

scheduled maturity date. ABS investors would lose

principal, however, only if the deterioration in the

quality of the underlying loans is severe enough to

deplete the entire credit support. The high level of

credit support demanded by rating agencies on existing

CHART 2

ABS deals minimizes the risk of principal loss by

investors.

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

a discount, the repurchase of low quality receivables

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

reserve account of the ABS. However these strategies

were specifically cited by the Office of the Comptroller

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

FDIC is working with other regulatory agencies through

the Federal Financial Institutions Examination Council

(FFIEC) on new Risk­Based Capital Guidelines that are

expected to address limitations on post­sale actions and

capital requirements for direct credit substitutes or

credit enhancements for ABS.

Given the continuing trend of higher charge­offs and

delinquencies for credit card loans, investors consider

the ABS market less homogeneous in terms of issuer

quality and therefore are scrutinizing the securitizations

of issuers more closely. Although the risks vary by ABS

issuer, banks that issue or invest in the ABS market

should be cognizant of the changing market conditions

and potential risks associated with ABS.

Changes in Interest Rates and Bond Values

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

yield curve between September 30, 1996, and early

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

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

0

25

50

75

100

125

150

175

3§20§97

12§16§96

6§3§969§9§96

2§26§96

11§20§95

 §14§95

5§ §95

1§30§95

10§24§94

4§11§947§1 §94

1§3§94

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

11§11§91

 §5§91

1§21§914§29§91

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

Auto

 a

Sou ce: P u ential Secu ities

Basis Points

Home Equity

Regional Outlook 16 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

CHART 3 CHART 4
 

-4%

-2%

0%

2%

4%

4- ct

1 - ct

1-zo6

15-zo629-zo6

13-0ec27-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

-0.5%

-0.3%

-0.1%

0.1%

0.3%

0.5%

Mo el

Po tfolio

Sou ce: Bloombe g

5-yea 

T easu y

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

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

hange Since Septembe 30, 1996

5.0%

5.2%

5.4%

5.6%

5. %

6.0%

6.2%

6.4%

6.6%

6. %

7.0%

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

3§12§97

12§31§96

9§30§96

Sou ce: Bloombe g

curve fluctuated during this time period. The path of

yields on Treasury bonds with 5­year through 30­year

maturities changed directions four times, rising or

falling by more than 30 basis points. Movements in the

shorter segment of the yield curve have been less pronounced.

In order to consider the effect that these rate swings may

have had on banks' fixed income portfolios, Chart 4

shows the percent change in the yield on the 5­year

Treasury and the percent change in the market value of a

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

an analysis that was introduced in the first quarter 1997

edition of the Regional Outlook, which looked at the

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

TABLE 1

In order to enhance the model portfolio's applicability

to bank portfolios, the type and amount of the securities

chosen for the portfolio are based on an aggregation of

securities­related Call Report data. The limitations of

Call Report data concerning the maturity distribution of

securities required that assumptions be made when

choosing the maturity of the securities for the model

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

model portfolio that approximates, in the aggregate, the

maturity distribution of the aggregate commercial bank

portfolio. The model portfolio is shown in Table 1.

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

portfolio changed less than one­half of 1 percent since

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

representing a 1.51 percent increase from September 30,

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

TYPE OF SECURITY PAR

VALUE

PERCENT

OF

PORTFOLIO

MATURITY

OR

WAL

PERCENT

CHANGE

FROM

9/30/96

TO

12/31/96

PERCENT

CHANGE

FROM

12/31/9

6 TO

3/12/97

PERCENT

CHANGE

FROM

9/30/96

TO

3/12/97

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

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

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

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

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

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

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

Regional Outlook 17 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

Treasury rate fell to its period­low

of 5.83 percent. Observe that,

while longer term rates fluctuated

modestly over the reporting period,

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

further moderated the value

changes sustained by the portfolio.

Changes in the value of the model portfolio demonstrate

a higher correlation to changes in the 5­year Treasury

yield than to other maturities along the yield curve

because the 5­year bond's maturity better matches the

WAL of the model portfolio. Even though the 30­year

Treasury rate is often cited as a benchmark for daily rate

changes, it may not be the most significant rate in

assessing exposures of bank securities portfolios to

changes in interest rates.

On March 25, 1997, the Federal Reserve Open Market

Committee met and raised the target federal funds rate

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

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

basis points higher than the 5­year Treasury yield dated

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

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

model portfolio's market value to fall 0.56 percent to

$9,965.

This model portfolio will be used regularly to show the

effects on bond values of interest rates movements from

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

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

risk factors affect a portfolio's relative volatility.

Banks' Stock Prices and Price/Earnings Ratios

Continued to Rise in 1996. Is the Market ImCHART 5

proving its Perception of the Quality of Bank

Earnings?

During the fourth quarter of 1996, the S&P Composite Bank Index outperformed the S&P 500, gaining

over 12 percent compared to an almost 8 percent gain

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

a year during which the S&P Composite Bank Index

gained 37 percent compared to a 20 percent gain for the

S&P 500. As shown in Chart 5, the San Francisco Regional Bank Index (SFRBI) gained a little more than 13

percent in the fourth quarter 1996. Moreover, the

SFRBI increased 38 percent for the year with performance that tracked closely to the S&P Composite Bank

Index. The year's moderate economic growth, contained inflation, and favorable interest rates are credited for providing a friendly environment for bank

stocks. As 1997 began with much the same economic

conditions, bank equities have continued to do well.

The SFRBI is up over 18 percent compared to an almost 20 percent gain for the S&P Composite Bank Index and a 9 percent gain for the S&P 500.

While appreciating stock prices provide an obvious

positive signal about the health of the industry, the

market provides other information about the prospects

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

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

a multiple of its earnings per share and is derived by

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

earnings per share. Typically investors are willing to

pay a higher price for a company with earnings that are

expected to be consistent and growing. However, firms

with more volatile earnings are generally penalized by

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

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

that investors have more confidence in the outlook for

0%

10%

20%

30%

40%

30-Sep

11- ct25- ct

-zo6

22-zo6

6-0ec

20-0ec31-0ec

10--an24--an

7-Leb

21-Leb

7-Ma 

S&P 500

San L ancisco Region's Bank In ex

S&P Bank In ex

Sou ce: Bloombe g,American Banker

hange f om 9§30§96

The San L ancisco Region's Bank In ex utpe fo me the S&P 500 but not the S&P Bank In ex

Regional Outlook 18 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Financial Markets
 

future earnings performance.

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

ratios for the broader market provides further insight

into the market's perception of the quality of bank

earnings compared to other firms. Historically, bank

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

this discounted bank P/E ratio relative to the broader

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

have been viewed as being more volatile because they

are prone to rising and falling with changes in the

business cycle. For example, despite recording some of

the highest quarterly return on equity averages ever at

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

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

of the broader market P/E.

Over the past two years the magnitude of the banking

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

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

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

P/E ratio may represent a view by market participants

that bank earnings are becoming less sensitive to the

business cycle, perhaps as a result of geographic or

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

CHART 6
 

45%

55%

65%

75%

 5%

0ec-93

Ma -94

-un-94

Sep-940ec-94

Ma -95

-un-95

Sep-950ec-95

Ma -96

-un-96

Sep-960ec-96

Ma -97

S&P Majo Regional Bank In ex's

Relati6e P§E Ratio Is Rising

P§E Majo Regional Banks § P§E S&P 500

Source: Bloomberg 

acquisitions.

Allen Puwalski, Banking Analyst

Kathy R. Kalser, Chief,

Financial Sector Analysis Section

Regional Outlook 19 Second Quarter 1997
 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

• 	 Overall, the strength of the San Francisco Region's economy is providing a foundation for favorable bank

performance; however, banks in four of the Region's slower-growing states are experiencing minor

increases in past-due loans.

• 	 Institutions with assets under $1 billion increased an already high exposure to commercial real estate

loans in 1996.

• 	 The number of banks in the Region is falling due to mergers, especially in California and Montana.

• 	 Earnings at the Region's thrifts continue to improve.

Banks Continue to Outperform the Nation,

Despite a Slight Dip in Profits in 1996

Return on Assets (ROA) at commercial banks in the San

Francisco Region exceeded the nation for the third

consecutive year. Favorable economic conditions

contributed to healthy loan growth, strong net interest

margins, and hefty fee income growth. An annualized

ROA of 1.22 percent compared favorably to the 1996

national average of 1.19 percent but reflected a decline

from the Region's 1995 ROA of 1.39 percent. This

decline was primarily the result of substantial increases

in credit card loan loss provisions and merger-related

expenses.

Despite strong earnings performance at the Region's

banks, there are several trends that warrant closer

attention. Past-due loan ratios (loans 30 days or more

past-due plus nonaccrual loans, divided by total loans)

trended upward in all states except California. In

Alaska, Hawaii, and Montana, past-due loan ratios

CHART 1

Commercial Real Estate on the Rebound

Billions 

 

 

 

 

 

 

 

 

 

 

Source: Bank Call Reports

climbed between 50 and 80 basis points for the year,

topping 3 percent by year-end. Past due loan ratios in

Wyoming also climbed over 50 basis points but remained below 2 percent at year-end (see San Francisco

Region: Following Separate Paths).

In addition, commercial real estate lending activity

picked up in the Region's midsize and smaller banks.

Exposure in the Region's smaller banks (with assets less

than $1 billion) is high relative to levels held at

institutions in other asset size groups. Finally, increased

merger activity has occurred throughout the Region,

particularly in California and Montana.

Commercial Real Estate Loan Portfolios

Growing Once Again

After declining from 1991 through 1993, commercial

real estate lending began to pick up again in 1994. As

shown in Chart 1, by year-end 1996, commercial real

estate loans (including loans secured by commercial

properties, construction projects, and multifamily properties) had returned to levels last seen at the beginning

of the decade.

Commercial real estate exposures in this Region vary

substantially by bank size, with the smaller banks

generally having the greatest exposure (see Chart 2 next

page). Smaller institutions (with assets less than $1

billion) have continued to build their commercial real

estate portfolios throughout the 1990s. Over the past

year, midsize institutions (with assets of $1 to $10

billion) also have begun adding to their portfolios.

As of year-end 1996, more than one-half of institutions
 

with assets of less than $10 billion had commercial real
 

Regional Outlook	 20 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features Regional Banking
 

CHART 2

Commercial Real Estate Concentrations Are

High and Rising in Banks Under Billion

Percent Assets under Billion of Loans

%

 %

 %

 %

%

 %

 %

%

%

Assets to Billion

Assets over Billion

Source: Bank Call Reports

real estate exposures exceeding 25 percent of theirtotal

loan portfolios. In contrast, the Region's largest

institutions generally had much lower commercial real

estate concentrations.

Region's Merger Activity Picks Up

Similar to the nationwide trend, the San Francisco

Region has seen the number of insured commercial

banks decline by 228 since 1990. This decline includes

257 unassisted mergers, 57 failures, and 12 other

closures and absorptions resulting from charter conversions and self-liquidations. However, the declines were

offset, in part, by 98 new charters. The rate at which the

Region's banks are merging has gradually increased

over the past six years. In 1996, the Region reported 50

mergers as compared to 44 in 1995 and 35 in 1994.

(Wells Fargo's acquisition of First Interstate Bancorp

accounted for seven of the 50 mergers in 1996.) New

bank activity also has increased. There were 24 new

charters granted in 1996, which is up from 21 in 1995

and only 5 in 1994. Alaska and Hawaii were the

Region's only two states that did not add new banks in

1996.

The decline in the number of banks is

not evenly distributed across the Region. The number of banks in California declined by 122 in the last six years,

representing 54 percent of the Region's

total contraction in bank charters.

However, California continues to hold

a dominant share of the Region's

financial institutions, with 360 banks or
 

active state in terms of numbers of

mergers, picked up after the 1989 change

in that state's mergers and acquisitions

banking law. Since 1990, Montana has

experienced a net reduction of 56 banks,

or a 36 percent decline in the number of

banking charters in that state. Table 1

(next page) shows rapidly expanding

Nevada at the opposite end of the spectrum with seven

new banks.

Increased competition from

banks and nonbank financial

institutions, coupled with the

arrival ofinterstate banking this

year, likely will result in further

industry consolidation.

Prospects for further consolidation are particularly

evident in Montana where legislation to allow intrastate

branching recently passed. Under the old regulations,

Montana's 100 banks could branch only on a countywide basis. Passage of this bill could result in a

reduction in the number of banks in the state by at least

20 if all 12 multibank holding companies in the state

convert their subsidiary banks to branches.

A Thrift Recovery in Progress

The third quarter SAIF deposit insurance assessment

temporarily depressed an otherwise improving thrift

industry performance (see Chart 3). Exclusion of this

one-time charge from 1996 thrift earnings reveals a

0.74 percent ROA for the full year versus an unadjusted

ROA of 0.31 percent. Improved earnings are attributed

to a reduced cost of funds and a loan growth rate of 9.24

percent. The 1996 loan growth was centered in

CHART 3

Return on Assets Continues to Climb for the 

Regions Thrifts*
 

Return on Assets Region
 

 . %

 . %

- . %

- . %

 . %

 . %

 . % California

- . %

45 percent of the Region's total banks. The pace of Source: Thrift Call Reports * ROA adjusted for SAIF assessment

mergers in Montana, the second most active state in

Regional Outlook 21 Second Quarter 1997
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Regular Features	 Regional Banking
 

centered in consumer, single-family residential, and

construction loans.

Rising earnings at the Region's thrifts appear to be

fostering merger activity, particularly in California

where earnings are catching up with the Region as a

whole. In the San Francisco Region, 12 nonaffiliated

thrifts merged in 1996 compared to only five in 1995.

Nine of the 12 thrifts that merged in 1996 were

headquartered inCalifornia. This is more than twice the

number of 1995 nonaffiliated California thrift mergers.

Analysts are predicting further merger activity in the

near term. Among the reasons cited are the following:

• 	 A 39 percent market share of California's bank and

thrift assets;

• 	 Extensive retail branch networks;

• 	 Favorable tax accounting provisions enjoyed by

thrifts with respect to bad debt reserves; and

• 	 An improving state economy.

TABLE 1

As has been widely publicized, both San Franciscobased First Republic Bancorp, with $2.2 billion in assets, and the $41.3 billion

Great Western Financial

headquartered in Chatsworth,

California, have been targeted by suitors as potential

merger candidates.

Catherine I. Phillips-Olsen, Senior Regional Analyst

Roger Stephens, Financial Analyst

David Pfeifer, Examiner, Division of Supervision

BANK CONSOLIDATIONS IN THE SAN FRANCISCO REGION

FOLLOW NATIONAL TRENDS

STATE INSURED INSURED

COMMERCIAL BANKS* COMMERCIAL BANKS

12/31/90 12/31/96

PERCENT

CHANGE

ALASKA 9 9 0%

AMERICA SAMOA 1 1 0%

ARIZONA 38 35 ·8%

CALIFORNIA 482 360 ·25%

MICRONESIA 1 1 0%

GUAM 1 2 100%

HAWAII 21 14 ·33%

IDAHO 22 15 ·32%

MONTANA 156 100 ·36%

NEVADA 19 26 37%

OREGON 51 44 ·14%

UTAH 55 48 ·13%

WASHINGTON 106 96 ·9%

WYOMING 71 54 ·24%

REGION TOTALS 1,033 805 ·22%

U.S. TOTALS 12,799 10,117 ·21%

SOURCE: BANK CALL REPORTS

* COMMERCIAL BANK CHARTERS: NATIONAL, NONMEMBER, STATE MEMBER, MUTUAL INSURED

Regional Outlook	 22 Second Quarter 1997
 
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