Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1998 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

John D. Weier,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael J. Feeney,
 

Financial Analyst
 

In Focus This Quarter 

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

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

still reverberating throughout the global economy. There are growing indications 

that some sectors of the U.S. economy are beginning to experience slower growth 

directly attributable to problems in Asia. Consequently, lenders should be cognizant 

of their customers’ exposure to global markets. Lending and strategic decisions 

predicated on an assumption of continued robust economic growth should be carefully scrutinized. See page 3. 

By Paul C. Bishop 

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

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

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

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

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

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

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

evaluating its capital adequacy trends. See page 8. 

By Kathy Kalser and Allen Puwalski 

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

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

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

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

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

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

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

By Gary Ternullo 

Regular Features 

◆ Regional Economy—Several developments at midyear threatened the Chicago Region’s economic vigor...growth in household and business incomes may come 

under downward pressure because of an inventory correction...lenders in communities where General Motors and its suppliers are a significant presence faced dampened activity...farm incomes could flatten or even weaken this year. See page 20. 

By Chicago Region Staff 

◆ Regional Banking—Most insured institutions in the Chicago Region continue to maintain strong capital and earnings positions...however, adverse weather, low 

commodity prices, and reduced government payments have raised interest in the 

financial trends of banks dependent on the farm sector...managers of those banks 

may want to review risk-control systems associated with the above trends, as well as 

recent changes in loan structures, funding sources, and loan loss reserves. See page 24. 

By Chicago Region Staff 

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)
 

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

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

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

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

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

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

Region’s Regional Outlook, please call John Weier at (312) 382-7512 or send an e-mail to 

jweier@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Assistant Editors Gary L. Beasley 

Robert L. Burns 

Norman Gertner 

David T. Griffiths 

Suzannah L. Susser 

Karen A. Wigder 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

The Asian Economic Crisis:
 

Implications for the U.S. Economy
 

•	 The impact of the Asian economic crisis on the 

U.S. economy has been increasingly evident, with 

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

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

months owing to falling demand for commodities, 

manufactured goods, and agricultural products. 

•	 Slower U.S. growth resulting from reduced export 

sales and lower corporate profits could affect 

institutions throughout the nation. 

The economic crisis in Asia is now more than one year 

old, yet the consequences of the unprecedented slide in 

currency values are still reverberating throughout the 

global economy. There are growing indications that 

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

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

how significant and long-lasting the effects of the crisis 

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

would pass quickly and be followed by renewed growth 

were too optimistic. The consensus among economists 

and analysts now is that the recovery will be measured 

in years, not months. 

Causes of the Crisis 

Most economists agree that the Asian economies1 are in 

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

Indonesia’s gross domestic product fell by more than 12 

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

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

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

values, rising corporate bankruptcies, and growing 

problem loan portfolios among financial institutions. It 

is generally agreed (with the benefit of hindsight) that 

the conditions that precipitated these events included 

the following2

: 

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

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

South Korea, Taiwan, and Thailand. 

•	 Reduced Export Competitiveness: Most of the 

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

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

more than 42 percent against the Japanese yen and 

by 23 percent against the German mark. This 

increase significantly worsened the international 

competitiveness of many Asian firms relative to 

Japanese or European competitors in export markets, 

since the value of their currencies and the price of 

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

1995, export growth among the Southeast Asia 

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

zero. 

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

domestic saving was not sufficient to fund the 

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

foreign capital funded rapid capacity expansion in 

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

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

by 1996. The increase in production capacity put 

downward pressure on prices and reduced earnings 

growth in key export sectors.3 

•	 Rapid Asset Price Appreciation: Real estate, land, 

and share prices on the region’s stock markets soared 

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

example, the Jakarta Composite stock index 

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

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

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

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

expected to reach 4.66 million light vehicles annually—2 million 

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

vehicles is expected through 2002. Worldwide excess capacity in light 

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

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

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

has been downward pressure on prices of domestically produced 

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

increases of less than 1 percent since mid-1996. 

Chicago Regional Outlook 3	 Third Quarter 1998 
In Focus This Quarter
 

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

•	 Deteriorating Credit Quality: Slower export 

growth and eroding competitiveness hampered Asian 

firms’ ability to repay debt incurred to finance the 

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

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

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

than 12 months. Additionally, the debt denominated 

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

firms struggling to repay mounting debt, banks 

began to experience a further deterioration in credit 

quality. 

Some of the uncertainty about the strength and speed 

of the recovery in Asia is attributable to concerns 

about the faltering Japanese economy. As the second 

largest economy in the world and the engine of 

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

Asia. With Japan currently in a deep recession and the 

outlook for its economy clouded by the halting pace 

of financial reform efforts, there is considerable 

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

repaired. 

Impact on the U.S Economy 

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

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

Banks may be exposed through 

changes in the financial condition 

of Asian borrowers. Other firms 

may be less directly exposed to 

economic conditions but will be 

affected by changes in relative 

prices and trade flows between the United States and 

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

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

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

Banking 

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

exposure to the Asian economies than either European 

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

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

which accounted for 8.5 percent of all international 

lending to Indonesia, Malaysia, the Philippines, South 

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

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

overall direct lending exposure of the U.S. banking 

industry may be relatively small, the indirect exposure 

resulting from changing economic conditions in the 

United States as a result of the crisis could potentially 

affect small and large institutions in all areas of the 

country. 

Agriculture 

Key to understanding the impact on agriculture is the 

fact that in world markets, agricultural commodities are 

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

decline in value of Asia’s currencies means that the 

price of imported agricultural commodities has rapidly 

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

stimulate production in the importing countries that can 

displace demand for imports. Thailand, for example, is 

positioned to increase production of poultry and sugar. 

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

suppliers of some agricultural products to the Asian 

market than the United States. 

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

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

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

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

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

other world producers increase production in response to 

changing relative prices among major grain exporters. 

Overall, USDA expects agricultural exports to fall by 3 

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

level of exports had the Asian crisis not occurred. 

Commodities 

Asian countries have become increasingly important 

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

Chicago Regional Outlook 4	 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

International Claims by Nationality of Reporting Bank 

End December 1997 

TOTAL INTERNATIONAL 

CLAIMS (MILLION U.S. $) 

U.S. 

CLAIMS PERCENT 

JAPAN 

CLAIMS PERCENT 

EUROPE* 

CLAIMS PERCENT 

OTHER 

CLAIMS PERCENT 

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

Malaysia 

Philippines 

South Korea 

27,528 

19,732 

94,180 

1,786 

3,224 

9,533 

6.5 

16.3 

10.1 

8,551 

2,624 

20,278 

31.1 

13.3 

21.5 

12,997 

9,317 

29,614 

47.2 

47.2 

31.4 

4,194 

4,567 

34,755 

15.2 

23.1 

36.9 

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

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

* Includes France, Germany, Netherlands, and United Kingdom 

Source: Bank for International Settlements 

modity markets have been affected by falling demand for 

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

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

year ending June 1998. Asian developing countries also 

had stepped up their demand for petroleum products, 

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

inventories expanded, causing prices to tumble from $20 

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

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

prices has reduced the prices of gasoline and other 

refined petroleum products, but it has cut into profits of 

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

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

Manufacturing 

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

trade in manufactured goods. Between 1990 and 1996, 

U.S. exports of manufactured goods to Asia increased 

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

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

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

whole, machinery, food products, and chemicals are the 

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

exports. Together, these industries account for nearly 70 

percent of U.S. exports to Asia. 

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

goods from Asia rose from $176 billion to more than 

$285 billion. Increased imports from China accounted 

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

are dominated by machinery and manufactured goods, 

including electronics and semiconductors, which 

together account for 93 percent of imports. 

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

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

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

to Asia (including both manufactured goods and other 

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

Changes in the volume of exports at the national level 

do not adequately describe the variation in the export 

exposure of different regions of the country. Chart 2 

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

CHART 1 

U.S. Exports to Asia Drop While Imports 

Continue Modest Growth 

Source: Bureau of the Census 

–25 

–20 

–15 

–10 

–5 

0 

5 

10 

15 

20 

Jan-96

Mar-96

May-96

Jul-96

Sep-96

Nov-96

Jan-97

Mar-97

May-97

Jul-97

Sep-97

Nov-97

Jan-98

Mar-98

May-98 

Percent Change - Year Ago

Imports Exports 

Chicago Regional Outlook 5 Third Quarter 1998 
In Focus This Quarter
 

CHART 2 

Western and Midwestern State Exports Are
 

Vulnerable to Changes in Asian Demand
 

Percentage of Total 

State Exports Destined 

for Asia (1997) 

More than 30% (14) 

21% to 30% (16) 

10% to 20% (17) 

Less than 10% (4) 

Source: Bureau of the Census, International Trade Administration 

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

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

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

exports from the Midwest also is destined for Asia, 

including chemicals and machinery such as construction equipment.6 

In the initial stages of the crisis, the consensus view 

suggested that the United States would be overwhelmed 

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

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

has been well below expectations. In May 1998, goods 

imports were up by just 4.8 percent over the previous 

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

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

institutions. Many Asian manufacturers are dependent 

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

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

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

value in assessing regional exposures and remain the most complete 

data available. 

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

the U.S. Department of Commerce. 

on components imported from neighboring countries or 

purchased on world markets. With the drop in currency 

values, all imported goods, including finished goods 

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

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

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

firms cannot secure the capital to acquire imported 

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

“credit crunch” abates, imports from Asia should 

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

Corporate Profits 

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

prices for import-competing goods and plummeting 

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

producers of import-competing goods will be under 

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

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

Asian market profits offset by continuing strong sales in 

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

impact of the crisis on corporate profits must be viewed 

in the context of gains and losses caused by changing 

relative prices of a firm’s products and inputs. 

A number of recent earnings announcements have 

failed to meet analysts’ expectations. According to 

IBES International,7 the crisis has contributed to a 

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

demand for semiconductors and oil. Operating profits 

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

stock index increased by 4.4 percent in the first quarter 

of 1998, the smallest increase since 1991. Excluding the 

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

firms increased by 8.6 percent in the first quarter. On 

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

firms in a few industries. 

Summary and Implications 

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

economies has already reduced U.S. export shipments 

and put downward pressure on prices of commodities 

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

Chicago Regional Outlook 6 Third Quarter 1998 
In Focus This Quarter
 

tinue is uncertain, but most analysts have dismissed the 

chances of a speedy recovery in Asia. Although most 

economists are not anticipating a recession in the 

United States in the foreseeable future, the indirect 

impact of the Asian crisis will be felt to some extent 

across most regions of the country. 

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

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

borrowers that have little or no 

direct exposure to export markets. What is clear for insured 

institutions is that at this stage of 

the economic expansion and with 

a number of uncertainties about 

the global economic outlook, 

lending and strategic decisions 

predicated on an assumption of 

TABLE 2 

continued robust economic growth should be carefully 

scrutinized. 

References 

Asia Crisis Home Page. New York University. www. 

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

“Automobile Glut Worries Analysts Even as Some Cut 

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

1998. 

The Importance of Asia to the State Economies. 1998. 

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

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

“World Agriculture and Trade.” Agricultural Outlook. 

United States Department of Agriculture, Economic 

Research Service. February 1998. 

Paul C. Bishop, Economist 

Chicago Region: Merchandise Exports to Asia—1997 

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

PERCENT 

EXPORT OF EXPORTS EXPORT 

VOLUME GROWTH TO ASIA BY EXPOSURE 

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

TOTAL EXPORTS TO ASIA 18,619.1 64% 100% 15% 

TOP FIVE EXPORT INDUSTRIES 

INDUSTRIAL MACHINERY & COMPUTERS 3,844.7 78% 21% 15% 

ELECTRIC & ELECTRONIC EQUIPMENT 3,526.2 84% 19% 24% 

CHEMICAL PRODUCTS 2,748.8 35% 15% 23% 

TRANSPORTATION EQUIPMENT 1,848.5 41% 10% 6% 

SCIENTIFIC & MEASURING INSTRUMENTS 1,272.2 54% 7% 23% 

TOTAL OF TOP FIVE EXPORT INDUSTRIES 13,240.3 62% 71% 14% 

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

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

Source: International Trade Administration 

Chicago Regional Outlook 7 Third Quarter 1998 
In Focus This Quarter
 

CLOs Lure Another Major Bank Asset
 

off the Balance Sheet
 

•	 Securitization of corporate loans and bonds is in 

full swing, with 1997 issuance exceeding that of 

securities backed by credit card loans. 

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

dramatically since 1996. Both CLOs and CBOs 

are potential bank investments that may grow in 

popularity if a current proposal to lower the risk 

weights for AAA-rated securities is enacted. 

•	 These bonds may offer a higher yield than other 

AAA-rated securities, but they also may carry 

both deal- and issuer-specific risks that warrant 

closer scrutiny. 

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

an increasingly demanding secondary commercial loan market. 

•	 Securitizing investment-grade commercial loans 

has implications for capital adequacy. 

CBOs and CLOs are fixed-income securities that share 

many similarities with other asset-backed securities. In 

a CLO or CBO, commercial loans or bonds are pooled 

and securitized, and participation certificates in the 

underlying assets are sold to investors. The first CLO 

and CBO transactions occurred in the late 1980s, but 

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

securitized was $54 billion, more than double the 

amount securitized in 1996. In fact, the combined 

issuance of CBOs and CLOs in 1997 was more than the 

amount of credit card loans securitized during the year. 

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

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

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

JP Morgan, September 1997. 

CBOs and CLOs: A Natural Development in the 

Asset-Backed Securities (ABS) Market 

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

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

The increasing comfort level of the capital markets with 

these asset classes and the various structures used to 

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

obligations and bank commercial loans. CBO and CLO 

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

loans. 

Increased standardization of terms among commercial 

lenders and more information flow on returns, defaults, 

and recoveries also have made commercial loans and 

corporate debt more desirable to institutional investors 

and an asset class viable for securitization. In addition, 

CLOs provide a way for investors, including banks, to 

own a credit-enhanced interest in a diversified pool of 

loans without directly owning the individual loans. 

Investors are increasingly considering collateralized 

bond and loan products as higher yielding alternatives 

to other ABS. 

CHART 1 

CBO and CLO Issuance Is Growing 

Source: JP Morgan 

0 

10 

20 

30 

40 

50 

60 

1990 1991 1992 1993 1994 1995 1996 1997 

($ Billions)

CBO CLO 

Chicago Regional Outlook 8	 Third Quarter 1998 
In Focus This Quarter
 

Foreign and, to a lesser extent, domestic banks have 

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

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

CLO and CBO securities issued in 1997. Insurance 

companies dominated the purchase of the middle or 

mezzanine class of CLOs and CBOs.2 

Last year the Federal Financial Institutions Examination 

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

CBOs, could increase substantially if the proposal is 

approved. 

Lower Capital Requirements, Higher Return 

Ratios Attract Banks to CLO Market 

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

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

designed to purge the lender’s balance sheet of lower 

quality commercial loans, the recent bank-issued CLOs 

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

A bank that is capital constrained may view the CLO 

structure as an alternative to issuing additional equity. 

But more often, banks are motivated to securitize 

investment-grade commercial loans because by doing 

so they effectively subject themselves to the market’s 

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

that banks earn on investment-grade loans to the point 

that more institutions are considering investment-grade 

lending to be an inefficient use of capital. As margins 

have declined, the CLO market has helped relationship 

managers rationalize lower pricing from the perspective 

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

& Co., Inc., December 1997. 

investment-grade-performing commercial loans have 

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

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

bank can improve certain profitability measures, but 

possibly with a higher risk profile. 

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

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

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

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

requirement if the assets remained on the balance sheet. 

The assumptions reflect the spreads and reserve 

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

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

requirement is minimized by the tiering of tranches in 

the securitization, which provides credit enhancement 

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

issuing bank, represents recourse to the bank from the 

sold assets and requires capital at 100 percent under 

“low-level” recourse. 

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

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

Large commercial banks with significant holdings of 

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

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

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

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

they come under pressure to improve capital ratios and 

remove distressed loans from their balance sheets. 

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

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

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

Chicago Regional Outlook 9 Third Quarter 1998 
In Focus This Quarter
 

TABLE 1 

CLOs Can Facilitate a Higher RAROC on Investment-Grade Assets 

ASSUMPTIONS: 

AMOUNT OF LOANS IN CLO: $1 BILLION 

LOAN PORTFOLIO YIELD: LIBOR + 50 BPTS 

BANK FUNDING COSTS: LIBOR − 10 BPTS 

CLO FUNDING COSTS: LIBOR + 24 BPTS 

BANK RETAINS 1% RESERVE FUND: $10 MILLION 

BEFORE CLO 

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

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

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

RAROC $6 MILLION/$80 MILLION = 7.5% 

AFTER CLO 

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

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

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

RAROC $2.6 million/$10 million = 26% 

Source: Bear, Stearns & Co. Inc. 

Arbitrage Opportunities Motivate Most 

Securitization of Subinvestment-Grade Debt 

Issuance of CLOs backed by subinvestment-grade loans 

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

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

and CBOs, contain higher yielding, riskier securities 

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

diversified pool of higher yielding investments, asset 

managers can limit aggregate event risk and create a 

security with a lower required yield than the underlying 

collateral. Securitizations can include a combination of 

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

A Closer Look at CLO Structures 

While the structures of CLOs and CBOs are similar, 

banks’ involvement as issuers of CLOs, and the forces 

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

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

to purchase a diversified pool of assets from a bank 

originator or issuer. The purchase of the assets by the 

SPV is funded through the sale of debt securities to 

investors. The structure of the SPV may include one or 

more tranches of debt that are secured by the pool of 

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

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

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

credit ratings in the CLO structure. The rating of the 

senior class typically is higher than the average rating 

of the underlying pool of assets due to the tiering of 

claims among the debt classes and credit enhancement 

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

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

portion may be retained by the issuing entity as a form 

of credit enhancement or sold to third-party investors 

who want a potentially higher return investment. 

CLO collateral has included both funded and unfunded 

loan commitments, loan participations, and different 

types of credit default swaps. Loan assignments also 

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

CHART 2 

Simplified Collateralized Loan Obligation Structure 

Originating Bank 

Special Purpose Vehicle 

(Purchases assets from originator and 

sells debt and equity to investors) 

Senior Class A Notes 

(90% of debt) 

(Investment Grade) 

Mezzanine Class B Notes 

(9% of debt) 

Reserve 

(1%) 

(May be retained by bank) 

Proceeds 

Sale, assignment, or 

participation of loans or credit 

linked notes to special purpose 

vehicle (SPV) 

Assets purchased from 

originator are collateral for debt 

and equity issued by the SPV 

Relative size 

varies by deal 

Proceeds 

tain borrower relationships. The issuer may transfer the 

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

risk to investors. 

CLOs typically rely on an asset manager or servicer 

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

collateral. The investment style or role of the asset 

manager may change depending on the purpose of the 

CLO. Securitizations that use an asset manager to 

actively manage the performance and market value of 

the collateral are referred to as “market arbitrage” or 

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

manager can trade assets into and out of the securitized 

pool in order to maximize the market value of the 

securitized portfolio. In contrast, most bank-issued 

CLOs are designed as “cash flow” transactions, in 

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

as a portfolio trader. These structures rely primarily on 

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

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

transactions. 

Chicago Regional Outlook 11 Third Quarter 1998 
In Focus This Quarter
 

An Introduction to Delinked 

and Linked CLO Structures 

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

form of credit enhancement, the ability of the asset 

manager or servicer to adjust the asset pool, and the 

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

Despite the variations, two basic structures have 

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

The primary difference between these two is the extent 

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

issuer may consider many factors when determining the 

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

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

of the securitized loan. 

In a delinked structure, the collateral is transferred from 

the issuer to the SPV. Delinked structures are generally 

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

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

sheet. Delinked CLOs are structured to insulate the 

investor from the credit quality problems or insolvency 

of the issuer. Ratings on delinked CLOs are predicated 

on the projected performance of the collateral and the 

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

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

master trust structure is advantageous because it allows 

for the securitization of different types of assets, such as 

fixed or floating rate or revolving or term loans. 

In linked transactions, also known as credit linked 

notes, the issuer retains ownership of the underlying 

collateral, and the cash flow generated by the collateral 

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

credit risk from the underlying assets is transferred to 

the CLO investor using credit derivatives. As in 

delinked CLO structures, credit protection is provided 

through the layering or tranching of the debt sold and 

other credit enhancements. 

Investors in linked CLOs are not completely insulated 

from the credit risk of the issuer. Because the issuer 

retains ownership of the underlying loans, a default or 

bankruptcy by the issuer could affect the transmission 

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

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

issuer may become insolvent. Because of this dual 

exposure, ratings on linked structures are typically 

capped by the credit rating of the issuer. 

The accounting and regulatory capital treatments of 

delinked and linked CLOs also differ. Linked structures 

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

remain under the control of the issuer. Issuers of linked 

CLOs may be granted some regulatory capital relief 

under the Basle Accord if the cash received from the 

securitization is assigned as collateral for the underlying 

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

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

of risk-free marketable securities such as Treasury 

bills.4 While linked CLOs may provide some form of 

capital incentive for foreign banks under the Basle 

Accord, linked structures offer 

little relief to U.S. banks 

because U.S. banks must maintain minimum leverage capital 

ratios in addition to risk-based 

capital ratios. Since the securitized loans count as assets of 

the bank issuer in a linked 

structure, the leverage ratio 

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

Consequently, the linked CLO structure has been more 

popular among foreign banks. 

The Role of Investment Rating Agencies 

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

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

principal payments to holders of the debt. This analysis 

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

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

assets collateralized by cash or Treasury securities generally receive a 

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

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

Federal Deposit Insurance Corporation Financial Institution Letter 

number 64–96 dated August 22, 1996. 

Chicago Regional Outlook 12 Third Quarter 1998 
In Focus This Quarter
 

generated by the pool, the credit enhancement, and any 

additional protection provided to the investors based on 

the structure of the securitization. The rating agencies 

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

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

the life of the transaction. If the underlying collateral is 

not already rated—most commercial loans are not—the 

rating agency will grade the underlying loans and assign 

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

of the loans and the underwriting criteria used by the 

lender. Estimates of default probabilities, timing of 

default, and recoveries in the event of default are 

assigned to the loans and vary by collateral type and 

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

agencies. 

Implications for Insured Institutions 

The advent of CLOs poses new opportunities and risks 

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

highest grade assets, they are effectively lowering the 

weighted average credit quality of their retained assets. 

An institution’s loan loss reserving policies and capital 

adequacy should take into account the implications of 

its CLO strategy. 

While the issuance of CLOs may be confined to larger 

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

desire a greater exposure to this type of lending may 

consider investing in CLOs. These instruments offer 

banks the opportunity to invest in a diversified pool of 

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

debt issued by the CLOs can earn a higher investment 

rating than the average rating on individual loans in the 

pool. Despite the investment rating, banks that invest in 

CLOs should be aware that CLO structures are less 

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

issuer and deal specific. 

Kathy Kalser, Chief, Financial Sector Analysis Section 

Allen Puwalski, Senior Financial Analyst 

Chicago Regional Outlook 13 Third Quarter 1998 
In Focus This Quarter
 

The Payment System: Emerging Issues
 

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

system is undergoing considerable change as new 

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

business. 

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

products and services while protecting their traditional payments business from technologically 

adept nonbank competitors. 

•	 For regulators and a handful of the largest banks, 

large-value payments present the most serious 

challenges, as technology has enabled increasing 

payment velocity and volume but also has created 

the potential for systemic failures. 

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

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

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

most users because of its dependability in moving value 

safely. Historically, banks have been essential to this 

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

revenues both as payment agents and as the holders of 

the funds from which those payments are made. 

Broadly speaking, the payment system encompasses the 

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

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

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

foreign exchange, and even cash. This product-based 

definition is a relevant one for many bankers, since it 

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

functions that are measured instead by their cost. A 

1 Estimate for 1996 from the National Automated Clearing House 

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

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

divided into systems that carry small-value or retail 

payments and those that carry large-value or interbank 

payments. This latter classification is oriented more 

toward infrastructure than product but is convenient 

from a regulatory perspective because the seriousness 

of the risk posed varies considerably by payment size. 

However defined, the payment system today is a source 

of new opportunities and exposures—a result of a host 

of new technologies that the “information revolution” 

has spawned. These technologies create different issues 

for banks and regulators. For banks, the issues involve 

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

nontraditional competitors that specialize in its creation 

and use. For regulators, the issues involve managing the 

risks—principally systemic risk—that accompany the 

large increases in payment volume and velocity enabled 

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

participants to shape payment products and channels in 

a way that favors their own objectives. 

Small-Value Payments: 

A Technological Brawl 

Nowhere has the battle to shape the payment system 

been more contentious than in the small-value segment, 

where emerging information technology can best be 

leveraged into new fee-based retail products. There are 

two battles here. The first involves maintaining the 

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

United States.2 While this infrastructure is interbank— 

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

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

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

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

Chicago Regional Outlook 14	 Third Quarter 1998 
In Focus This Quarter
 

The second battle involves exploiting new technologies 

either to attract new customers or to serve existing ones 

more profitably. This battle is both highly visible and 

highly technical and underscores the potential of the 

passing of information to eclipse the passing of value as 

the most critical profit opportunity in payments. The 

best example of this potential is bill presentment, the 

process of posting vendor invoices—such as credit card 

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

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

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

otherwise add value during the billing process. Owners 

of customer-specific data also can tailor new services— 

a process that can develop loyalty as well as related 

sales. Losing this battle would be doubly costly for 

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

payment process, to the benefit of vendors and largely 

at the expense of banks. 

Another battle is building between banks and nonbanks 

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

considered too small for credit cards. Whether they 

reside on a computer or a smart card, these applications 

substitute electronic data for actual cash, with the 

amount stored on each card covered dollar for dollar by 

balances on account with an issuer. The struggle is for 

the right to issue this value, and the American Bankers 

Association has contended that regulated depository 

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

balances that back this electronic value could provide 

issuers with substantial new sources of income. 

With some new payment technologies, the distinction 

between opportunity and risk can blur. As the Internet 

enables the distance between shopper and shopkeeper to 

increase, the need to authenticate unseen customers, 

merchants, and banks increases as well. At the same 

time, the open nature of the Internet requires that the 

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

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

aba.com. 

Emerging Issues in 


Small-Value Payments
 

Maintaining the payment system monopoly. Access 

to Federal Reserve payment services has historically 

been limited to depository institutions. Maintaining 

that monopoly—and thus maintaining its centrality to 

current and future payment products and services—is 

an important issue to the banking industry. 

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

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

Digital cash and stored value are applications in 

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

back electronic value, because, unlike with paper cash, 

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

Securing online transactions. Ensuring the integrity, 

privacy, and authenticity of electronic transactions is 

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

necessity. Current implementations use combinations 

of encryption algorithms and specialized hardware. 

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

public key infrastructure in which trusted organizations 

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

CAs. Others are weighing the benefits and largely 

uncertain exposures of providing such a service. 

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

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

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

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

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

be able to handle remittance information—information 

that accompanies payments and identifies sender and 

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

them on to their customers. 

Point of sale check truncation. Checks are costly to 

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

check into an electronic transaction at the point of sale. 

Although banks will have fewer checks to handle under 

check truncation, they will lose float and the return on 

investment in check-handling equipment. 

Chicago Regional Outlook 15 Third Quarter 1998 
In Focus This Quarter
 

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

than the individual parts. 

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

and their customers will need to navigate in securing 

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

transaction.4 These certificates are electronic messages 

that contain a decryption key for the sender that is itself 

authenticated by a trusted third party. The infrastructure 

for storing, distributing, and vouching for these keys, 

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

will be difficult and costly to implement. Banks not 

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

may represent a logical progression in banking services, 

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

signature disputes. These voids leave unanswerable the 

question of whether the expected gains from providing 

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

A major stimulus for electronic payments could come 

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

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

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

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

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

value.5 The second challenge is that the EFT mandate 

applies internationally as well as domestically. Given 

the need for each international payment to settle in two 

currencies and countries, the ability to provide efficient 

cross-border EFT will vary considerably from country 

to country.6 

4 Depending upon card brand and SET version, consumer certificates 

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

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

Perhaps more challenging to many financial institutions 

is that electronic payments to vendors, unlike those to 

individuals, will require electronic remittance data to 

accompany the payment itself. This information goes 

beyond simple routing instructions and includes the 

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

correctly. According to a study by Booz-Allen & 

Hamilton, only slightly more than 5 percent of financial 

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

capacity will therefore be an industrywide challenge. 

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

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

enable financial institutions to retain control of—and 

add value to—business-to-business transactions when 

commercial payments migrate to the Internet. 

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

costly paper-based payments. Vendors too are pressing 

for the elimination of the slow check presentment 

process wherein checks must physically be moved 

from vendor to vendor bank to issuer bank before 

funds can be transferred. Point of sale check truncation 

shortens this process by converting the check into an 

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

transaction that will settle like a debit card—and in 

doing so eliminates much of the potential for check 

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

the volume of checks that must be physically handled 

decreases, so too will the income from float and the 

returns from past investments in check-handling 

capacity. 

Large-Value Payments: Making the 

World a ‘Good and Final’ Place 

Unlike small-value payments, the issues surrounding 

large-value payments are not strategic ones for banks, 

and less technological wizardry pervades them. Instead, 

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

the Federal Reserve and the world’s other central 

banks—take very seriously the payments “plumbing” 

that is otherwise obscure even to many bankers. In an 

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

gov/eft/remit.html. 

Chicago Regional Outlook 16 Third Quarter 1998 
In Focus This Quarter
 

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

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

referring to funds that are both irreversible and fully 

collected. 

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

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

President’s Commission on Critical Infrastructure 

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

that vulnerability, in the eyes of the commission, 

stemmed not so much from a lack of security as from 

the critical importance of those systems to settling 

financial transactions throughout the economy and the 

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

was feared that the payment infrastructure provides an 

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

Concentration refers to the fact that while banks are 

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

more central than others. According to March 1998 Call 

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

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

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

system liquidity and disruption of domestic and foreign 

financial systems alike. While this concentration is not 

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

and whether to inoculate the payment system from the 

weight of these super-institutions will become an issue 

for the regulatory community. 

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

and the increasing velocity of payments, threats to one 

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

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

on transaction accounts held on behalf of other public and private 

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

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

held approximately 25 percent of all reported interbank transaction 

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

increase that concentration to over 34 percent. 

Emerging Issues in 


Large-Value Payments
 

Payment system vulnerability. According to the 

PCCIP, the nation’s core payment systems may present 

a serious physical vulnerability within the financial 

system. 

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

smaller number of superbanks. 

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

problem to banks that have. 

The Euro. Bank and interbank systems in Europe 

and abroad must be modified to accept the Euro. In 

addition, the resources required to implement the 

Euro must be diverted from resolving Y2K problems. 

Foreign exchange settlement risk. Foreign exchange 

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

essential liquidity from international markets. 

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

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

Collateralizing net payment systems. According to 

the BIS, systems that do not permit immediate final 

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

participant’s failure. Like finality, collateralizing helps 

prevent the internationalization of a domestic failure. 

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

cross-border concerns. The most immediate and visible 

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

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

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

this context, the concern is that any banks that have 

failed to correct their Y2K exposures will transmit that 

failure via the payment system to other institutions 

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

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

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

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

rates as an issue in itself—demanding the modification 

Chicago Regional Outlook 17 Third Quarter 1998 
In Focus This Quarter
 

of bank and interbank payment systems throughout the 

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

launch. 

Although less well known to the general public, foreign 

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

its member central banks. This exposure arises because 

cross-border payments, unlike domestic payments, have 

no single central bank to guarantee settlement, leaving 

U.S. banks exposed to their foreign counterparties and 

correspondents—sometimes for several days—for more 

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

this problem include netting—offsetting risks so that 

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

banks to provide simultaneous cross-border settlement, 

a project known as the Continuous Linked Settlement 

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

each country whose currency it settles. 

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

finality in payments—a term meaning that a completed 

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

the liquidity for those that follow. One way of speeding 

up finality is with real time gross settlement (RTGS) 

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

settled in the full amount for which the original payment 

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

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

more are developing or planning them. Complementary 

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

for each participant over the course of some period— 

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

House’s Clearing House Interbank Payment System is 

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

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

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

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

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

www.bis.org/publ. 

Sources of Additional Payment
 

System Information
 

Electronic Bill Presentment 

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

Microsoft-First Data 

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

Digital Cash and Stored Value 

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

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

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

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

Securing Online Transactions 

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

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

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

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

Certificate Authorities 

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

Digital Signature Trust . . .www.digsigtrust.com 

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

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

Electronic Funds Transfer ’99, Financial 

EDI, and POS Check Truncation 

National Automated 

Clearing House 

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

U.S. Treasury Financial 

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

Payment System Vulnerability 

President’s Commission on 

Critical Infrastructure 

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

The Euro, Foreign Exchange 

Settlement Risk, Payments Finality, 

and Collateralization 

Bank for International 

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

Federal Reserve Board 

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

New York Clearing 

House Association . . .www.chips.org 

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

Chicago Regional Outlook 18 Third Quarter 1998 
In Focus This Quarter
 

bers’ liquidity positions if a major creditor bank fails. 

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

preferably two, of each system’s largest net creditor 

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

in developed nations, the increasing extent to which 

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

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

Differing Perceptions, Common Threat 

Banks are united neither in their perceptions of these 

issues nor in their desire for regulation to address them. 

With respect to small-value payments, large and small 

banks have disagreed over whether the Federal Reserve 

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

faction earlier this year when the Fed announced that it 

would remain an active and, according to some large 

banks at least, a subsidized competitor in clearing and 

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

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

settlement. There also has been disagreement, again 

along lines of size, over whether the issuance of new 

products such as stored value cards should be limited to 

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

competition. Few small banks will feel compelled to 

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

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

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

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

most critical of all payments issues facing banks, for 

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

dependability, nothing short of their payments franchise 

may rest on their ability to market this success to their 

customers as a feature essential to the entire range of 

current—and future—payment services. 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

Chicago Regional Outlook 19 Third Quarter 1998 
Regular Features	 Regional Economy
 

Inventory Accumulation, Strike at General Motors,
 

and Falling Crop Prices Are Areas of Interest
 

•	 For over a year, Regional Outlook has reported that economic conditions in the Chicago Region were 

healthy, albeit also vulnerable to a slowdown. 

•	 At midyear 1998, high—and perhaps excess—inventory stocks appear to have accumulated in parts of the 

economy. Incomes of households and businesses may come under downward pressure as steps are taken to 

reduce surplus inventories. 

•	 Repercussions from a labor dispute between General Motors (GM) and the United Auto Workers Union also 

threatened the Region’s economic vigor. Lenders to households and small businesses may be affected 

through year-end, especially in communities where GM and its suppliers are a significant presence. 

•	 Forecasts of lower crop prices, along with reduced federal payments, heighten the prospect that farm sector 

incomes will flatten or even weaken this year. A first-quarter survey of credit conditions at agricultural 

banks found that requests for renewals or extensions of farm loans were higher than they were a year 

earlier. 

Manufacturing Sector: Inventory Accumulation 

Bears Watching while Strikes’ Impact Is Felt 

Recent developments suggest that many of the Region’s 

manufacturers face intensifying challenges as 1998 

unfolds and leads up to 1999. Against the background 

of a long-lived cyclical expansion and the impact of 

Asian developments (see recent editions of Regional 

Outlook), this article discusses two of the more recent 

challenges: 

•	 a significant amount of the inventory buildup since 

late 1997 likely was unplanned; and 

•	 possible repercussions from the United Auto Worker 

(UAW) union’s strikes against GM. 

Either situation could significantly threaten the manufacturing sector’s vigor in the Region. 

Inventory Correction Ahead? 

Excess inventory accumulation is one imbalance that 

often occurs in aging expansions. It arises because 

growth in demand moderates or falls short of expectations, but firms are slow to recognize this development 

and to trim their production schedules. For over a year 

now, output (as measured by real gross domestic product, or GDP) has been rising faster than sales (see 

Chart 1, left panel). In fact, over one-third of the 

increase in real GDP in the fourth quarter of 1997 and 

first quarter of 1998 went to nonfarm inventories rather 

than to end users. 

Available data do not distinguish whether or not the 

recently rapid inventory accumulation was planned. 

However, because the economy’s short-term capacity for 

robust growth is limited, it is reasonable to assume that 

recent stockpiling was not purposely done in anticipation of a sustainable burst of economic growth. To some 

extent, the falloff in demand from Asian countries and 

increased competitiveness of goods made there may 

have contributed to the current increase in inventories. 

The inventory buildup appears to be fairly widespread 

among manufacturers, wholesalers, and retailers. In the 

manufacturing sector, one-third of the recent stockpiling involves finished goods (see Chart 1, right panel), 

suggesting that producers face difficulties in quickly 

moving goods out the door in return for payment. Manufacturers’ stockpiles of production inputs and of semifinished products also are rising fairly rapidly. Unless 

final demand strengthens, fabrication of these stocks 

will produce more finished goods, which could exacerbate any existing excess. 

To minimize further accumulation, various businesses 

trimmed their orders in the first quarter, thus contributChicago Regional Outlook 20	 Third Quarter 1998 
Regular Features Regional Economy
 

CHART 1 

Significant Real Inventory Accumulation 

among Manufacturers 

Source: Bureau of Economic Analysis, via Haver Analytics, Inc. Change from a Year Earlier ($ Billions)

$(20) 

$(10) 

$– 

$10 

$20 

$30 

$40 

Q1:88 Q1:90 Q1:92 Q1:94 Q1:96 Q1:98 

Total 

Finished Goods 

Final Sales Growth Shy of Output Growth, 

Suggesting Inventory Building 

Source: Bureau of Economic Analysis, via Haver Analytics, Inc. 

–2% 

–1% 

0% 

1% 

2% 

3% 

4% 

5% 

6% 

Q1:88 Q1:90 Q1:92 Q1:94 Q1:96 Q1:98 

% Change from 4 Quarters Earlier

Output > Sales 

Real Final Sales 

Real Gross Domestic Product 

ing to a 3.2 percent drop (at an annual rate) in manufacturers’ new orders, exclusive of defense. Other typical responses currently taking place include reducing 

overtime work, shortening employees’ workweeks, or 

even laying off employees. These developments underlie many economists’ expectations of an inventory correction and slower GDP growth this year. In light of the 

Chicago Region’s heavy reliance on manufacturing, the 

impact of an inventory correction likely will be heavier 

here than in much of the nation. 

UAW Strikes’ Impact Could Intensify Any 

Inventory-Related Slowdown 

The effect of two early-June strikes against GM by local 

UAW unions in Flint, Michigan, have negative implications for the economy as a whole and for many communities in this Region in particular. The 115,000-plus U.S. 

workers laid off by GM because of shortages of parts 

greatly exceed the 9,200 people on strike. About 42 percent of the idled GM workers in the U.S. are in Michigan; 19 percent are in Ohio; and 8 percent are in 

Indiana. Idled GM facilities are indicated by stars on 

Chart 2 (next page), where the graduated shading 

reflects the importance of the motor vehicles and parts 

industry in general to individual counties. 

Repercussions along the supply chain for the motor 

vehicle industry quickly spread beyond GM facilities 

to other firms such as those making wiper blades, car 

seats, dashboard components, and similar products. 

A rough rule of thumb is that one to two jobs in related industries are affected for every production-line job 

at GM. 

Analysts’ studies of previous strikes suggest that about 

half of the production and income losses experienced 

during the strike will be made up in following quarters 

as GM and supplier firms ramp up production and fill 

their distribution lines again.1 For local businesses outside the vehicle industry but dependent on it, any poststrike catch-up may be limited, especially if the business 

sells services (e.g., restaurants, vacation rentals, entertainment, and travel) rather than goods. 

The longer the strikes and associated layoffs last, however, the more significant will be the adverse effects not 

only on GM and its suppliers but also on household 

incomes and local business activity. For a hypothetical 

UAW household earning $52,000 a year on GM’s production line, a six-week layoff would trim annual 

income by about 8 percent (or $4,200), even if maximum unemployment benefits were received. Even if 

workers make up some of their lost income after the 

strike, their financial cushions may be strained during 

the strike period. 

Lingering in the background is the possibility of additional strikes later this year at other GM facilities. 

Should they occur and again temporarily shut down 

1 Keith Bradsher, “Money and Other Hardening Positions in Strikes at 

G.M.,” The New York Times, June 27, 1998. 

Chicago Regional Outlook 21 Third Quarter 1998 
Regular Features Regional Economy 

CHART 2 CHART 3 

The Motor Vehicles and Parts Sector 

Is Important in the Chicago Region 

Business Incorporations Climb 

in Chicago Region 

120 

Sources: Bureau of Economic Analysis, General Motors Corporation 

★ 

★ 

★ 

★ ★ 

★ 

★ 

★ ★

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

★ 

Number of Units (thousands)

Percentage of Earnings 

from Motor Vehicles 

and Parts 

0% to 5% 

5% to 10% 

10% to 25% 

25%+ 

Unspecified 

(324) 

(43) 

(37) 

(8) 

(25) 

100 

80 GM Plant(s) (27) 

60 

1980 1982 1984 1986 1988 1990 1992 1994 1996 

Source: Dun and Bradstreet, via Haver Analytics, Inc. 

short term, bankers should consider the possibility 

that small business and personal bankruptcy filings 

in affected communities might increase if the strike 

much of GM, strains on the repayment abilities of some 

households and small businesses would be intensified. 

Implications: During an inventory correction, manufacturers, wholesalers, and retailers may resort to price 

discounting to eliminate excess stocks, thus pressuring 

their profit margins. Meanwhile, some entities whose 

repayment ability is stressed by slower revenue growth 

may increasingly draw on their operating lines with 

banks to fund excess inventories. Such situations likely 

will test bankers’ ability to balance the needs of business customers against the need to maintain adequate 

overall credit quality. 

The GM-UAW situation raises additional concerns, 

which include: 

•	 The ability of laid-off and striking workers to make 

timely payments on mortgage, home equity, vehicle, 

and other loans may be challenged. 

•	 Small businesses in communities with a heavy exposure to GM, its suppliers, or both also may face difficulties repaying loans. 

•	 Households and small businesses could increasingly 

use credit card lines to finance their spending until 

the strike is over and incomes rebound. While 

increased lending may be viewed positively in the 

is prolonged. 

In addition, any significant slump in the Region’s economic health caused by either situation could trigger 

some fallout among the 625,000 businesses incorporated in the Region since 1991 (see Chart 3). They represent a pool of borrowers that have never weathered an 

economic downturn. Many may be smaller establishments, which may not have considerable cash flow or 

equity cushions with which to ride out a downturn. 

Crop Farmers Deal with Adverse Weather 

and Lower Prices 

Considering that corn and soybeans generate about 46 

percent of agricultural cash receipts in this Region, several areas deserve monitoring as the crop year unfolds. 

•	 A late-June progress report by the U.S. Department 

of Agriculture (USDA) indicates that smaller shares 

of the corn and soybean crops in Illinois, Indiana, 

and Michigan were rated good or excellent than 

shares among the major planting states as a whole. 

Illinois appears to lag the most, with 52 percent of 

the state’s corn crops in late June rated good or excellent, down from 79 percent a year ago. Only 49 percent of its soybean crops were rated good or 

excellent, compared with 68 percent last year. 

•	 Even so, prices may remain under downward pressure, partly because of falling demand from Asia and 

Chicago Regional Outlook 22	 Third Quarter 1998 
Regular Features	 Regional Economy
 

CHART 4 

Source: U.S. Department of Agriculture 

Rising Farmland Values in the Chicago Region $ Billions 

20 

40 

60 

80 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 

Illinois 

Indiana 

Ohio 

Wisconsin 

Michigan

 0 

Source: U.S. Department of Agriculture 

Debt-to-Asset Ratio Low among the Chicago 

Region’s Farmers 

Percent 

10 

15 

20 

25 

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996 

Ratio of Debt to Assets 

existing carry-over stocks. From April to June, Central Illinois cash prices for soybeans were 25 percent 

lower than a year earlier, and corn prices were 14.5 

percent lower. For each crop, USDA projections call 

for even lower prices ahead, with soybean prices perhaps heading to the lowest level in more than a 

decade. 

•	 Per-unit production costs for soybeans are predicted 

to edge upward for a typical Central Corn Belt producer this year.2 

•	 Cash payments to farmers continue to be reduced 

under terms of the 1996 Farm Bill. 

Another cautionary note comes from the Chicago Federal Reserve Bank’s recent survey of credit conditions 

during the January–March quarter. It found that, among 

agricultural banks in the Federal Reserve’s Seventh 

(Chicago) District, requests for renewals or extensions 

of farm loans (excluding real estate loans) were higher 

than they were a year earlier. Although some analysts 

suggest that changes in farmers’ marketing strategies 

may explain why farmers are holding crop inventories 

and perhaps repaying loans more slowly, any such 

strategies would bear monitoring if prices are more likely to fall than rise in coming months. 

2 Doane’s Agricultural Report, June 12, 1998. 

Implications: Currently, farmers’ repayment capacity 

and collateral in farmland appear to be positive, as illustrated in Chart 4. Farmland values rose by 7.5 to 10 percent in the Region last year, to all-time highs in several 

states. This appreciation contributed to the improved 

asset coverage of debt loads (see Chart 4, left panel). 

Historical experience, however, suggests that high values on a limited number of farmland transactions can 

lead to inflated estimates of land values and unrealistically low estimates of debt-to-asset ratios. Thus, lenders 

need to guard against over reliance on land collateral 

values and to continue careful evaluation of current 

cash flows and income projections. 

Chicago Region Staff 

Update on UAW-GM Situation 

Striking UAW workers in Flint, Michigan, ratified a 

settlement with GM in late July, and full operation 

of all parts and assembly plants is estimated to be 

reached by mid-August. Although overtime hours 

associated with catch-up production may temporarily boost workers’ paychecks, at least some households will need this boost in income to repay loans 

taken out during the shutdown or to meet postponed 

debt payments. 

Chicago Regional Outlook 23	 Third Quarter 1998 
Regular Features	 Regional Banking
 

Trends to Watch: Banks Dependent on the Farm Sector 

•	 Most insured institutions in the Chicago Region continue to maintain strong capital and earnings positions. 

•	 A combination of adverse weather, low commodity prices, and reduced government payments has raised 

interest in the financial trends of banks dependent on the farm sector. 

• Managers of banks dependent on the farm sector may want to review risk control systems associated with 

the above trends, as well as recent changes in loan structures, funding sources, and loan loss reserves. 

Overview 

Insured institutions in the Chicago Region continue to 

adapt to a rapidly changing environment. For example, 

the trend of fewer but larger institutions continued during the first quarter of 1998. The first three months of 

the year saw a net reduction of 27 insured institutions 

operating in the five-state area, but the Region’s total 

assets increased by over $12 billion to $933 billion. 

Banks and thrifts in the Region have generally been able 

to manage such changes and maintain relatively strong 

capital and earnings positions (see Chart 1). Thus far in 

1998, the Chicago Region’s institutions have: 

•	 increased aggregate leverage capital to 8.0 percent of 

average assets; 

•	 recorded a solid aggregate return-on-assets (ROA) of 

1.26 percent; and 

•	 maintained good overall asset quality. 

CHART 1 

Chicago Region Institutions Continue to
 

Show Financial Strength
 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

Percent

1996 

YTD 1998 

1997 

Tier 1 

Leverage 

Return on 

Assets 

Net 

Interest 

Margin 

Past-Due 

Loans 

Source: Bank and Thrift Call Reports as of 3/98 

The financial strength described above continues to 

provide significant flexibility to meet emerging risks. 

This flexibility is important in an environment where 

institutions have to address concerns resulting from the 

Year 2000 computer problem and continuing reports of 

aggressive loan underwriting standards. 

Having sufficient flexibility to deal with potential problems and changing conditions is always important, but 

even more so when an institution concentrates a good 

portion of its business in one or two sectors of the economy. In that regard, a combination of factors has recently raised interest in the trends of banks dependent on the 

farm sector. 

Concerns over Farming Vary 

Previous articles in this publication have noted rapid 

consolidation in some hog and dairy operations and 

more volatile pricing in associated commodities. Additional potential problems, which are discussed in more 

depth in the Regional Economy section of this edition, 

include: 

•	 Adverse weather conditions during the spring and 

early summer that may affect crop yields this year. 

•	 Reduced Asian demand, along with high world production and carryover stocks, has resulted in lower 

corn and soybean prices, and there are forecasts of 

continued pressure on these prices (see Chart 2). 

•	 Reduced government payments, which at least one 

study1 indicates may lead to declining farmland values in the Midwest. 

1

Charles H. Barnard, Gerald Whittaker, David Westenbarger, and 

Mary Ahearn, “Evidence of Capitalization of Direct Government 

Payments into U.S. Cropland Values,” American Journal of Agricultural Economics, November 5, 1997, pp. 1642–1650. 

Chicago Regional Outlook 24	 Third Quarter 1998 
18 

16 

14 

12 

Regular Features Regional Banking 

CHART 2 CHART 3 

Commodity Prices Have Been 

Pressured in 1997 and 1998 Farm Banks Are Located in All Five States, with 

Heavy Concentrations in Illinois and Wisconsin 

Milk, $ per Hundredweight (CWT)

10 

Soybeans 

Corn & Soybeans, $ per Bushel

Headquarters Location of 

Banks with Direct Farm 

Lending Exceeding 100 

Percent of Tier 1 Capital 

0 

1 or 2 

3 or More 

8 

6 Milk 

4 

2 

Corn 

10 0 1994 1995 1996 1997 1998 

Source: U.S. Department of Agriculture, National Agricultural Statistics
 

Service, June 29, 1998
 

The amount of concern over these conditions varies. 

From an individual bank’s standpoint, much depends on 

whether the farmers who borrow from it have financial 

cushions that are substantial enough to absorb reduced 

cash flows and still allow for prompt repayment of outstanding debt. 

Many banks that directly service this sector of the 

Region’s economy are undergoing some structural 

changes themselves, adding further potential stress to 

adverse agricultural conditions. These changes include 

consolidations of institutions, loan portfolio structure 

and funding changes, and declines in loan loss reserve 

levels. The remainder of this article defines “farm 

banks” and identifies where they are located. It also 

looks at the structural changes noted above with the 

intent of identifying where they may cause stress for 

risk-control systems. 

Identification of Banks with Significant 

Exposure to Farming 

Communities that depend on the farm sector of the 

economy are located throughout the Region. Types of 

farming activity are diverse and vary depending on geographic location. For example, in Illinois, Indiana, and 

Ohio, corn and soybeans are the primary products, 

while in Wisconsin and Michigan, dairy farming tends 

to be the most important. 

Some banks that service these businesses are easy to 

identify because they hold a substantial volume of farm 

loans in their portfolios. In addition, many other institutions do not make a significant volume of direct loans 

Source: Bank Call Reports as of 3/98 

to farmers but are still vulnerable to this sector because 

they are in communities where agriculture is a substantial component of overall earnings. 

Both types of institution will be significantly affected 

by changes in the economic conditions of farmers. 

However, given the limitations of available economic 

and bank data, we have, for the purposes of this analysis, defined “farm banks” as institutions with direct 

farm-loan exposures exceeding Tier 1 risk-based capital. Although this definition excludes many institutions 

with high indirect exposures, it still captures over 500 

banks as of March 31, 1998. These banks are located in 

each of the five states of the Chicago Region, with the 

heaviest concentrations in Illinois and Wisconsin (see 

Chart 3). 

Number of Banks with Significant 

Direct Exposure to Farm Loans 

Continues to Decline 

The number of institutions with direct agriculture loan 

exposures of over 100 percent of Tier 1 capital has 

steadily declined throughout the decade (see Chart 4). 

Some of the reasons for the reduced numbers include: 

•	 Some multibank holding companies have simplified 

their structures by consolidating several banks into 

one unit. 

Chicago Regional Outlook 25	 Third Quarter 1998 
Regular Features	 Regional Banking
 

CHART 4 

0 

10 

20 

30 

40 

50 

Mar-88 Mar-90Mar-92Mar-94Mar-96Mar-98

400 

500 

600 

700 

800 

900 

Source: Bank Call Reports 

Number of Banks with 100% or More of Tier 1 

Capital Invested in Farm Loans Declines 

Number of Banks

Assets in $ Billions

Number 

Assets 

•	 Institutions have merged to take advantage of potential growth opportunities or perceived efficiencies. 

•	 Owners sell when they, or key personnel, are ready to 

retire. 

•	 Urbanization of some agricultural areas has reduced 

the number of farms and changed the customer base 

that these banks serve. 

Over the past several years, the trends noted above have 

occurred during relatively prosperous times for Midwest farmers. These prosperous times have helped many 

of the remaining farm banks to manage such changes 

and maintain good operating performance. 

Financial Conditions of Most Farm Banks Are 

Favorable, but Some Show Weaknesses 

On an aggregate basis, the Region’s farm banks appear 

healthy. As of March 31, 1998, their aggregate: 

•	 Tier 1 leverage capital ratio of 9.2 percent exceeded 

the overall average of all institutions in the Region; 

•	 ROA was slightly below the Region’s overall average, at about 1.2 percent, but was stable; and 

•	 asset quality also remains adequate, though there 

has been a modest increase recently in past due loan 

levels. 

While measures of aggregate farm bank performance 

remain good, a small but growing number of individual 

institutions (64) in this group have elevated (over 5 percent of total loans) past-due loan levels. In addition, 

approximately 65 institutions reported substantially 

(more than 50 basis points) lower than average earnings 

during the first quarter. Banks exhibiting these characteristics may need to be especially cautious, given the 

potential added stress their farm customers may experience in the current environment. 

Even institutions not exhibiting weaknesses may need 

to closely review their risk-control systems, especially 

in cases where increased competition has led them to 

change loan portfolio structures and funding sources. 

Increased Competition Is One Factor Changing 

Loan Portfolio Structures 

Increased competition from several fronts is trimming 

banks’ share of farm debt. Among the contributing factors are: 

•	 Equipment manufacturers, seed companies, and 

other agricultural vendors are more active in offering 

credit to farmers. 

•	 A rising number of crop farmers are leasing equipment through manufacturers instead of using traditional credit. 

•	 The Farm Credit System has recently become more 

active. 

These competitive factors and the strong financial 

health of some farmers have resulted in only moderate 

growth in direct farm loans at farm banks. For much 

of the 1990s, direct farm loan growth, measured from 

March to March of each year, has been at 3 percent or 

lower. While growth improved in 1998, with almost 10 

percent growth in direct farm lending noted, there is 

some concern that part of this increase may be 

explained by reports of more farmers delaying repayment of loans in the Midwest (see Regional Economy: 

Inventory Accumulation, Strike at General Motors, 

and Falling Crop Prices Are Areas of Interest). 

Competition and urbanization also have resulted in 

changes in the types of loans made. For example, many 

farm banks in the Region have greatly increased residential and commercial real estate lending since 1990 

(see Table 1). As a result, 1- to 4-family mortgage loans 

now exceed total farm debt at over half of the Region’s 

Chicago Regional Outlook 26	 Third Quarter 1998 
Regular Features Regional Banking
 

TABLE 1 

Commercial Real Estate and Residential Loans Become More 

Important to Farm Banks* in the Chicago Region 

DOLLARS INVESTED DOLLARS INVESTED AS A % 

(IN BILLIONS) OF TIER 1 CAPITAL 

LOAN CATEGORY MAR. 90 MAR. 98 MAR. 90 MAR. 98 

1- TO 4-FAMILY RESIDENTIAL 4.9 7.5 168.5 214.1 

FARM 5.0 6.3 171.6 181.0 

COMMERCIAL REAL ESTATE 2.1 3.9 71.0 112.0 

COMMERCIAL 2.9 3.4 101.1 98.4 

INDIVIDUALS 3.3 2.9 112.5 83.2 

ALL OTHER 0.5 0.7 17.3 18.9 

* Direct Farm Loans exceed Tier 1 Capital 

Source: Bank Call Reports 

farm banks. In addition, over 31 percent of farm banks 

have commercial real estate loan exposures exceeding 

100 percent of Tier 1 capital. 

The activities described above may require some institutions to reassess how they monitor the risk contained 

in their loan portfolios. Obviously, the need for a strong 

review of direct farm loans remains important—especially an appropriate assessment of the adequacy of 

cash flows and collateral values. In addition, some institutions may need to enhance their reviews of credit risk 

related to commercial real estate, while others need to 

assess how increases in mortgage lending may have 

altered their interest rate risk profile. 

Allowance for Loan and Lease Losses 

Coverage of Gross Loans Is Declining 

These risk reviews are all the more important given a 

steady reduction in the ratio of allowance for loan and 

lease losses (ALLL) to gross loans for farm banks in 

this Region since 1993. On an aggregate basis, the 

ALLL as a percentage of gross loans has declined from 

1.57 percent at year-end 1993 to its present level of 1.29 

percent (see Chart 5). This decline was a common 

occurrence, as about 230 of 503 farm banks now operating saw their reserve ratios drop by over 20 basis 

points over the same time frame. In addition, 38 of these 

institutions experienced a decline of over 100 basis 

points. 

The trend of a declining ALLL ratio is somewhat 

expected, given current modest levels of past-due and 

problem loans. However, this ALLL trend may not continue, as the Region already has approximately 115 

farm banks that had loan reserve levels of less than 1 

percent of their total outstanding loan portfolios as of 

March 31, 1998. It is also interesting to note that 49 of 

these same institutions reported year-to-date return-onassets of less than 1 percent. While these institutions do 

not show signs of loan problems on an aggregate basis, 

modest ALLL coverage and earnings may make them 

more vulnerable during any downturn or localized problems in the agricultural economy. 

Changes in Funding Structure May Make 

Earnings More Volatile in the Future 

Another area of change is how farm banks are funding 

growth. Of interest is that aggregate loan growth has 

outpaced deposit growth for the past several years. This 

CHART 5 

ALLL to Total Loans Has Been 

Declining at Farm Banks* in Region 

* Direct Farm Loans Exceed Tier 1 Capital 

Source: Bank Call Reports Mar-88 Mar-90

Mar-92Mar-94Mar-96Mar-98

0.0 

2.0 

4.0 

6.0 

8.0

Past Due to Total Loans (%)

ALLL to Total Loans (%) 

Past Due 

ALLL 

1.0 

1.2 

1.4 

1.6 

1.8 

Chicago Regional Outlook 27 Third Quarter 1998 
Regular Features Regional Banking
 

development, widespread among banks, has increased 

the loan-to-deposit ratio for farm banks from 62 percent 

as of March 31, 1990, to almost 77 percent at the end of 

the first quarter this year. As of March 31, 1998, over 40 

percent of these institutions had loan-to-deposit ratios 

exceeding 75 percent, in contrast with only 10 percent 

in 1990. 

Weak core deposit growth appears to be due, in part, to 

stiff competition. Large banks, credit unions, and nonbank entities are expanding into rural areas, increasing 

competition for consumer deposits. As a result, farm 

banks have had to alter their funding strategies. For 

example, during this decade, Chicago Region farm 

banks have quadrupled their use of borrowed funds, 

from 1.2 percent of total assets at year-end 1990 to 4.9 

percent at the end of the first quarter this year. 

Two risks emerge with these funding shifts. First, liquidity risk increases because these funds may be more 

interest-rate sensitive and therefore less stable than core 

deposits. Second, this increased interest-rate sensitivity 

may make earnings more volatile in the future. 

Chicago Region Staff 

Chicago Regional Outlook 28 Third Quarter 1998 
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