Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 1998 

FDIC
 

Memphis
 

Region
 

Division of
 

Insurance
 

Gary L. Beasley,
 

Regional Manager
 

David T. Griffiths,
 

Regional Economist
 

Robert L. Burns,
 

Financial Analyst
 

In Focus This Quarter 

◆ Y2K—Preventing the Year 2000 (Y2K) computer problem is becoming ever more 

costly as the time and resources left to do so disappear. Equally costly, according to 

some estimates, will be the litigation that follows in the problem’s wake. A failure to 

address Y2K exposures immediately and successfully may amount to a gamble backed 

by the value of the bank franchise and the officers and directors who run it. See page 3. 

By Gary Ternullo 

◆ Trends in Commercial Real Estate Loan Pricing and 

Underwriting—An abundant supply of financing is placing pressure on commercial real estate loan pricing and underwriting standards. Underwriting standards are being increasingly influenced by the rapid growth in commercial 

mortgage-backed securities and real estate investment trusts. While many within the 

industry believe that broader public funding of commercial real estate projects will 

lead to greater market transparency and improved underwriting discipline, there 

are a number of unique risk considerations related to the rapid growth and continuing development of these alternative funding sources. See page 7. 

By Steven Burton 

◆ Total Return:A Useful Tool for Monitoring Investment Portfolio 

Risk—The Federal Financial Institutions Examination Council is rescinding the 

1991 policy that required “high-risk” testing for mortgage derivative products and 

has released for comment a policy encouraging risk management across all types of 

instruments on an investment portfolio basis. Total return, a concept that includes 

fluctuations in market value, is a useful tool for measuring the performance of an 

investment portfolio and providing information about market risk at the portfolio 

level. See page 13. 

By Allen Puwalski 

Regular Features 

◆ Regional Economy—Growth in the Region has not kept pace with national growth, and indications are that the divergence is widening...a tight national 

labor market is slowing in-migration...although the Region has been generally less 

dependent on exports than the nation, concentrations in food processing, chemicals, 

and agriculture may cause repercussions from the Asian crisis to be felt disproportionately in some areas. See page 16. 

By David T. Griffiths 

◆ Regional Banking—Strong loan growth continued for the Region’s institutions through the third quarter of 1997...banks are turning to alternate funding 

sources as deposit growth has not kept pace with loan growth...even with increased 

concern over credit quality, allowance levels are declining relative to growing loan 

portfolios. See page 21. 

By Gary L. Beasley, Robert L. Burns 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Information Center for current pricing on bulk orders. 

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

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

Region’s Regional Outlook, please call Gary Beasley at (901) 821-5234 or send an e-mail to 

gbeasley@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Daniel Frye 

Craig A. Rice 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Y2K: Banking in the twenty-first century may provide
 

grand new opportunities—but you have to get there first
 

•	 As a result of a three-decades-old programming 

convention, January 1, 2000, may find some computer systems unable to function correctly, if at 

all. Links within and between systems and organizations make the problem a complex one. 

•	 Cures are expected to be difficult and costly. If 

those cures fail, litigation could be equally costly, 

and much of it may be aimed at directors and 

officers. 

•	 Accordingly, senior bank management should be 

actively involved in making sure the cure takes 

place. A failure to do so amounts to a gamble 

backed by the value of the bank franchise and 

those who run it. 

Complex Problem, Complex Cure 

By now the story is well known. At midnight on 

December 31, 1999, computer systems that process 

dates using only the last two digits of a year will cease 

to function correctly, if at all. Equipment that contains 

embedded systems—chips or circuitry designed to perform specific functions—also may fail. And the problem is pervasive. It lies within systems and between 

systems, in both software and hardware. The large number of ways dates are used, the number of places they 

can occur, and the number of creative ways for naming 

them confounds an accurate assessment. 

Fixing the Year 2000 (Y2K) problem will require considerable time and effort. Computers and applications 

must be inventoried, examined for date usage, corrected 

where necessary, and then tested—not just by themselves but in combination with every other system with 

which they interact. This includes not only a bank’s own 

systems but also those of its servicers, correspondents, 

customers, vendors, and trading counterparties. 

Moreover, there are a variety of ways to address the 

problem, ranging from expanding date fields to four 

digits to simply subtracting 28 years from every date 

before processing—any of which could introduce new 

incompatibility problems when systems that have been 

fixed in different ways attempt to interact.1 And because 

not all systems can be corrected at once, interfaces or 

bridges between corrected and uncorrected systems also 

must be developed to maintain business system continuity. Most important, it must all be done before the 

non-negotiable deadline of December 31, 1999. 

For bank management, there are two ways to find out 

how serious the problem will be. The first is to commit 

resources to determining just how exposed the bank’s 

systems are—the first concrete step in actually solving 

the problem. The second is to gamble the franchise by 

doing little or nothing and letting the century date 

change provide the ultimate stress test. 

Costs 

The costs of a cure are many. First, there are the costs of 

actually finding and fixing the problem. Estimates of 

this cost have ranged widely, although the Gartner 

Group’s estimate of $300 to $600 billion worldwide is 

the most widely quoted. Using a different approach, 

Software Productivity Research (SPR) places the global number at over $1.3 trillion, including a $176 billion 

slice for the United States alone. Then there are the estimated costs of litigation. At the low end, SPR places 

them at $300 billion globally and projects that fully onethird of that amount will be generated in the United 

States. At the high end, the Giga Information Group 

sees a much more litigious future—estimating that 

Y2K-related legal costs could exceed $1 trillion. 

Significant opportunity costs may accrue as well, and 

the degree to which Y2K-related outlays fail to provide 

1 Every 28 years the same combination of dates and days recurs. 

Subtracting 28 years from a date before processing and then adding 

them back upon output has been suggested as a temporary but partial 

remedy because it permits applications to continue measuring time by 

subtracting two-digit years from each other. Windowing is another 

partial correction whereby some two-digit years—say those less than 

“50,” for example—are assumed to be preceded by “20” (thus “49” 

becomes “2049” in date calculations) while the remainder are 

assumed to be preceded by a “19” (thus “50” becomes “1950”). Both 

approaches only delay the need for permanent corrections. 

Memphis Regional Outlook 3	 First Quarter 1998 
In Focus This Quarter
 

more efficient or functional systems will serve as a 

starting point for measuring the value of technology 

investments forgone. These forgone improvements will 

be especially costly for institutions that have started 

their repairs too late. They may find not only that the 

time for system improvements and upgrades has slipped 

away, but that they have insufficient time for anything 

beyond a patchwork solution that will continue to cost 

them beyond the year 2000. 

At the macro level, the tally of potential Y2K costs 

includes declining stock values, business failures, and 

recession. J.P. Morgan has estimated that as much as 40 

percent of organizations’ remediation costs have not 

been accounted for in their information technology budgets, presumably indicating that many firms will see 

their share value erode as the costs of Y2K fixes and 

related losses are priced into their future earnings. The 

cost of not being Y2K compliant might be substantial as 

well. According to the Gartner Group, as many as one 

in two firms may discover just how substantial as they 

head into 1999 with even their most mission-critical 

systems unfixed. The potential for these firms to fail 

looms large among the factors that have led Edward 

Yardeni, chief economist at Deutsche Morgan Grenfell, 

to assign a 40 percent chance of recession in the year 

2000. Peter de Jager, a consultant who also has commented extensively on Y2K issues, went even further, 

suggesting that 1 percent of all businesses would fail 

because of Y2K problems. Whatever the eventual 

number, many of these businesses will also be bank 

borrowers. 

Systems and Systemic Risks 

More immediate than the risk of borrower failures is the 

risk that a bank’s own systems may fail. Banks are heavily dependent on software applications that employ 

dates. Among other things, they use them for calculating interest paid or due and for managing the horizons 

of their assets and liabilities. If these applications begin 

returning erroneous calculations, bank operations could 

be seriously disrupted.2 If they fail altogether, the bank’s 

2 For example, interest due from borrowers for a one-year period 

beginning in 1999 and ending in 2000 might be calculated not as one 

year’s interest due but rather as nearly one century of interest payable 

(00 − 99 = − 99) if only the last two digits of the year are used in the 

calculation. Similarly, any other time calculation that straddles the 

century date change might return answers wrong in both size and 

sign. 

credibility—and hence its franchise value—can be substantially damaged or even irrevocably lost. 

The solution is often described in software terms, but 

executable software is not the only problem. Correcting 

software to process four-digit years does little good if 

bank databases that store the critical information about 

who owes what to whom and when still store them in 

two-digit form. Hardware is another critical area. 

Nearly all electronic devices have embedded, permanently programmed chips that can be difficult to find 

because the functions they perform are not always 

apparent. This situation could lead to a host of nuisances, with automated teller machines, point-of-sale 

terminals, bank vaults, check and credit card processing 

equipment, and even building systems succumbing to 

the Y2K problem. 

This dependence on external components and services 

creates a systemic exposure as well. The substantial 

efficiencies that now exist in transmitting payments 

among and between banks and borrowers are a direct 

result of technology. Servicers and 

clearinghouses fulfill computerintensive intermediary roles in this 

high-velocity business—pooling 

payments from those who owe and 

redistributing them among those 

to whom they are due. Anything 

that interrupts these flows can 

have a substantial impact on the ability of banks to settle with their customers and with each other. 

Accordingly, both the Bank for International 

Settlements and the U.S. Federal Reserve are concerned 

about the Y2K threat for two reasons—first because it 

can interrupt the operations of systems dedicated to 

making interbank payments and second because it can 

interrupt the operations of the individual participants 

and generate a liquidity shock that could cause other 

institutions to fail. 

Unfortunately for banks, even a fully successful, 

industry-wide Y2K fix will not completely mitigate 

their risk. The year 2000 story is simply too dramatic 

and lends itself too well to sensationalism. Therefore, 

in addition to managing the cure, bankers will have to 

manage the perceptions of their customers and of the 

public at large—a considerable challenge given that a 

loss of confidence by a small number of customers 

could precipitate liquidity problems for institutions 

even in the absence of a genuine threat. 

Memphis Regional Outlook 4 First Quarter 1998 
In Focus This Quarter
 

Liability in the Executive Suite 

It bears frequent repeating that Y2K is a business problem and not just a technical one. Its intricacies go 

beyond those of the systems themselves and extend into 

the labyrinth of business relationships and fiduciary 

obligations that bind directors and officers—and the 

assorted attorneys, auditors, consultants, and service 

providers who assist them—to their banks. Through this 

network could pass liability and litigation that could be 

several times the cost of fixing the problem itself. And 

although the problem may have had a technical origin, 

claims would likely be directed against those with deeper pockets who jointly and severally, it will be argued, 

should have corrected or disclosed the institution’s Y2K 

exposures. 

While the bank failures of the late 1980s and early 

1990s are often attributed to unforeseen economic 

events, it will be difficult to assert such a defense for a 

failure to address the Y2K problem. It is simply too visible and offers too much advance notice. This is one reason why the potential potency of Y2K litigation should 

be taken seriously. Moreover, placing the blame, no 

matter how well deserved, at the feet of vendors and 

consultants may offer little protection. The Federal 

Financial Institutions Examination Council (FFIEC) 

has indicated that senior bank management should be 

fully aware of their vendors’ progress and develop contingency plans should those vendors fail.3 This pronouncement has elevated the standard for prudent Y2K 

actions in such a way as to make imperative the active 

involvement of top bank management in both solving 

3 Safety and Soundness Guidelines Concerning the Year 2000 Business 

Risk, December 1997. The full text is available on the FFIEC website 

at www.ffiec.gov. 

Managing the Y2K Process 

On May 5, 1997, the Federal Financial Institutions Renovation. Renovation includes not only fixing the 

Examination Council—an interagency group com- problem internally but monitoring the efforts of cusposed of the Federal Deposit Insurance Corporation, tomers, counterparties, vendors, and service 

Federal Reserve, Office of the Comptroller of the providers. The prudent execution of due diligence and 

Currency, Office of Thrift Supervision, and National best practices at this stage will provide a measure of 

Credit Union Administration—released a statement confidence that exposures have been addressed. It 

on Year 2000 project management awareness that will also provide a measure of protection from liabilincluded an outline of the Y2K management process. ity claims should problems nevertheless emerge. 

That outline identified five phases that each financial 

institution would have to navigate in identifying and Validation. Validation means testing how a bank’s 

fixing its Y2K exposures: systems will respond on their own as well as when 

connected with those outside the bank. The FFIEC 

Awareness. Before Y2K exposures can be fixed, they believes that one full year should be available for testmust be seen as problems. Creating awareness, how- ing and correcting problems that either remain or are 

ever, is not easy because the pervasiveness of compo- introduced by the renovation process. Accordingly, 

nents and intersystem links that can harbor or pass the institutions should plan on completing the previous 

problem create complexities that are neither intuitive three phases by the end of 1998. 

nor easily quantified. However, it is critical that senior 

managers understand the problem and fully support Implementation. Testing corrected systems to ensure 

the commitment of resources to fixing it. their compliance does not complete the process. The 

final step is to gain acceptance by the users as to the 

Assessment. In this phase, all information systems, ability of the system to satisfy business requirements. 

electronic equipment, and building systems must be A failure at this stage will require further correction 

evaluated for specific Y2K exposures. Remediation or the implementation of contingency plans. 

plans must then be devised. In addition to plans for 

fixing the problem, contingency plans will be needed For the full text of this and other FFIEC guidance, see
 

as a precaution against unforeseen Y2K failures orig- the FFIEC website at www.ffiec.gov.
 

inating from both within and outside the bank.
 

Memphis Regional Outlook 5 First Quarter 1998 
In Focus This Quarter
 

the problem and ensuring that the franchise will be protected if one or more of those solutions fail. 

Betting the Franchise 

The FFIEC has divided Y2K remediation into five 

phases—awareness, assessment, renovation, validation, 

and implementation (see Inset 1, page 5). As a benchmark for progress, the FFIEC has indicated that the validation phase—the phase in which testing of Y2K fixes 

is conducted—should be well under way for all banks 

by the end of 1998. This leaves less than a year for laggards to complete the first three phases. Banks that are 

not devoting adequate resources to identify and address 

their exposures need to be aware that the consequences 

of delay or inaction could be severe. The bank supervisory agencies, Congress, and the financial markets are 

taking the risk to heart. So too are attorneys intent on 

sharing in what has been described as potentially the 

most expensive litigation in history. 

Insurance companies are concerned as well, as evidenced by extremely high Y2K policy premiums or outright refusal to write Y2K coverage. Thus, any business 

interruptions and liability that emerge may have to be 

financed from the bank income statement and balance 

sheet. As such, a bet that Y2K will not be a problem 

might well amount to a gamble backed by the bank franchise and those who run it. (See Inset 2 below for additional sources of information.) 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

For Further Information 

Further information on the Y2K problem can be obtained from banking regulatory agencies at the websites shown 

below. 

Federal Deposit Insurance Corporation (FDIC) www.fdic.gov 

Federal Financial Institutions Examination Council (FFIEC) www.ffiec.gov 

U.S. Federal Reserve Board of Governors www.bog.frb.fed.us 

National Credit Union Administration (NCUA) www.ncua.gov 

Office of the Comptroller of the Currency (OCC) www.occ.treas.gov 

Office of Thrift Supervision (OTS) www.ots.treas.gov 

The following websites contain additional information concerning the Y2K problem. Their inclusion here does 

not serve as an endorsement by the FDIC of any information contained therein. 

Market Partners Inc.—Year 2000 Resources for Banks www.marketpartners.com 

Gartner Group—Technology Consultant www.gartner.com 

Software Productivity Research (SPR)—Technology Consultant www.spr.com 

De Jager LLC (Peter de Jager)—Technology Consultant www.year2000.com 

Giga Information Group—Technology Consultant www.gigaweb.com 

Y2K LLC (Williams, Mullen, Christian & Dobbins)—Attorneys www.Y2K.com 

Economics Network (Dr. Edward Yardeni)—Economist www.webcom.com/yardeni 

Memphis Regional Outlook 6 First Quarter 1998 
In Focus This Quarter
 

Trends in Commercial Real Estate 

Loan Pricing and Underwriting 

•	 An abundant supply of capital is placing signifi- CHART 1 

cant pressure on commercial real estate loan Banks’ Commercial Real Estate and pricing. Construction Lending Rebounds 

• Considerable evidence suggests that a large per- Construction Loans 

centage of insured institutions are easing commercial real estate and construction lending 

underwriting standards. 

• The rapid rise in commercial mortgage-backed 

securities and real estate investment trust funding 

could change the way banks underwrite commercial real estate loans and have important effects 

on their competitive position in the lending 

Year-over-Year (%) Growth

20 Commercial Real Estate Loans 

10 

0 

–10 

–20 

–30 

YE90 YE91 YE92 YE93 YE94 YE95 YE96 3Q97 

markets. 

As reported in last quarter’s Regional Outlook, banks 

provided the largest share of funding for commercial 

real estate during 1995 and 1996 compared with all 

other financing sources (see Strong Demand and 

Financial Innovation Fuel Rebounding Commercial 

Real Estate Markets). Chart 1 shows that banks’ commercial real estate and construction lending continues 

to increase and that year-over-year growth rates in these 

two loan categories are accelerating. At the same time, 

however, alternative funding sources in the form of 

commercial mortgage-backed securities (CMBS) and 

real estate investment trusts (REITs) are also experiencing significant growth. Commercial Mortgage Alert 

reports that $26 billion in CMBS was issued through 

September 1997, up from $17 billion for the same period in 1996. The same publication projects that CMBS 

issuance will top $40 billion during 1997, compared 

with last year’s record issuance of $29.8 billion. 

Measures of REIT activity also indicate impressive 

growth. According to the National Association of Real 

Estate Investment Trusts, REITs issued $26.3 billion in 

equity through October, compared with $12.3 billion 

for all of 1996. In addition, REIT market capitalization 

rose $50 billion (64 percent) through the first nine 

months of 1997. 

While it is good news to borrowers, the abundance of 

capital for commercial real estate projects raises the 

often-quoted concern that “too much money is chasing 

too few deals.” Market observers worry that fierce competition and an excessive supply of financing are leadSource: Commercial Bank Call Reports 

ing to both inadequate loan pricing relative to risks 

borne by lenders and looser loan underwriting standards. This article examines current trends in commercial real estate loan pricing and loan underwriting. It 

also explores the possible influences of CMBS and 

REITs on loan underwriting practices and commercial 

real estate markets. 

An Abundance of Capital Has Placed 

Significant Pressure on Commercial Real 

Estate Loan Pricing 

Chart 2 (next page) shows that prime-graded commercial mortgage spreads have steadily declined since 1992 

and are now at levels not seen since the real estate boom 

years of 1988 and 1989. At 113 basis points above tenyear treasuries, current spreads on ten-year commercial 

mortgages are only slightly higher than A-rated ten-year 

industrial corporate bonds, which traded at spreads of 

66 basis points over comparable-term treasuries as of 

September 1997. Some property sectors have experienced more narrowing of spreads than others. 

American Council of Life Insurance (ACLI) data show 

that mortgage spreads relative to treasuries compressed 

31 basis points for industrial, 22 basis points for hotel, 

21 basis points for retail, 11 basis points for multifamily, and 10 basis points for office real estate from March 

1996 to March 1997. Moreover, because of continuing 

downward pressure, current pricing varies little across 

Memphis Regional Outlook 7	 First Quarter 1998 
In Focus This Quarter
 

CHART 2 CHART 3 

Commercial Mortgage Spreads Are Pricing Narrows between High- and 

Tightening 

Basis Point Spread over

Ten-Year Treasuries 

Source: Barron’s/John B. Levy 

0 

50 

100 

150 

200 

250 

Jan ’87Jan ’89Jan ’91Jan ’93Jan ’95Jan ’97 

Spread between AAA and BBB


Grades (Ten-Year Average Life)
 

Medium-Grade CMBS 

Basis Points 

140 

120 

100 

80 

60
 

40
 

20
 

0 

Q1 ’95Q3 ’95Q1 ’96Q3 ’96Q1 ’97Q3 ’97 

Source: Nomura Securities International 

the quality spectrum. For instance, Chart 3 indicates 

that spreads between AAA- and BBB-rated CMBS have 

narrowed considerably since year-end 1995, from 110 

basis points to a scant 28 basis points. 

It seems likely that competitive factors will continue to 

place pricing pressure on lenders. The relatively recent 

entrance of Wall Street firms into the financing arena 

via conduits is a striking example of just how competitive the market for commercial real estate financing has 

become.1 Conduits are rapidly becoming the dominant 

issuer of CMBS and underlie much of the rapid growth 

in CMBS noted above. Through the first nine months of 

1997, Commercial Mortgage Alert reported that conduits accounted for 50 percent of total CMBS issuance, 

compared with 30 percent during the same period in 

1996. 

Many industry participants see conduits and REITs as 

significant and increasing competitive threats to traditional lenders. For example, a recent issue of 

Commercial Real Estate South discussed the continuing expansion of conduit business into a much wider 

range of property and credit quality types. This publication noted that conduits have a particular incentive to 

aggressively pursue higher quality loans in order to 

strengthen pools that contain weaker credits. Such 

aggressiveness threatens to squeeze banks’ profit margins on low-risk deals, which might give banks an 

incentive to pursue lower quality credits. Given their 

focus on larger credits, conduits presently pose a competitive threat primarily to larger lenders. However, the 

1 Conduits are entities created to originate mortgage loans for distribution to investors in the secondary market. 

rapid growth of capital within the industry may eventually force larger lenders to target smaller markets, which 

would in turn increase competition at the regional or 

local community level. While their influence is less 

direct, the growing use of REITs to finance commercial 

real estate projects also places pressure on loan pricing 

spreads, since lenders must compete for a smaller pool 

of customers. With their access to a seemingly limitless 

source of public funding, REITs could pose a particular 

threat to community bankers by dominating certain geographic markets or property sectors. 

Narrowing pricing spreads raise concerns over whether 

lenders are being adequately compensated for the operational, funding, credit, and market risk inherent in 

originating, servicing, and holding commercial real 

estate loans. More important, tightening spreads raise 

prospects that lenders will ease other loan terms and 

relax loan standards to the extent that they are unable to 

differentiate their product based solely on price. While 

such easing may enable lenders to retain business in the 

face of stiff competition, imprudent underwriting could 

ultimately lead to higher loan losses than would otherwise be the case in the event of a downturn in commercial property markets. 

Are Commercial Real Estate Loan Underwriting 

Standards Becoming Looser? 

Most industry experts have argued that the memory of 

the real estate downturn of the late 1980s and early 

1990s keeps lenders from becoming overly aggressive 

in making commercial real estate loans despite the 

abundance of funding alternatives currently available to 

Memphis Regional Outlook 8 First Quarter 1998 
In Focus This Quarter
 

borrowers. These experts point out that today’s loan-tovalue (LTV) ratios are lower than they were at the peak 

of the last real estate boom, that lenders are concentrating more on obtaining adequate debt-coverage ratios, 

and that lenders are requiring borrowers to bring more 

cash equity to the table. One might also argue that practices have improved and become much more uniform 

with the implementation of regulatory appraisal standards and the adoption of interagency guidelines for 

real estate lending policies. Rating agencies impose 

additional guidelines and standards as lenders originate 

loans for possible sale into the secondary markets. 

While information about specific quantitative underwriting criteria applied to new loan originations by 

commercial banks is not readily available, some sense 

of industry trends may be gleaned from competitors’ 

practices. For example, the ACLI performs a quarterly 

survey of underwriting criteria for commercial real 

estate loan commitments originated by major life insurance lenders. The ACLI’s second quarter 1997 survey 

indicated that new commitments (total volume of $4.1 

billion) had a weighted average LTV for all property 

types of 66 percent and a weighted average debt-coverage ratio (DCR)2 of 1.6 times. These figures compare 

favorably to an LTV ratio in late 1989 approaching 75 

percent and a DCR just under 1.3 times. 

ACLI data suggest that recent commercial mortgage 

originations are better supported by borrower equity 

and property cash flows than they were in the late 

1980s. It is important to recognize, however, that LTV 

and DCR ratios are driven largely by market conditions 

and expectations. Property valuations take into account 

recent sales and expected cash flows, and cash flows 

available to service debt are based on projected net 

operating revenues, which often incorporate projected 

increases in rents and other revenue sources. In other 

words, the overwhelmingly favorable conditions in 

today’s real estate markets may also be a factor in the 

improved LTV and DCR ratios. Keeping in mind the 

cyclical nature of real estate, one can easily see how a 

shift from today’s positive outlook to a more pessimistic 

outlook might result in a sharp reversal in these commonly cited ratios. 

Notwithstanding these quantitative considerations, 

there are indications that banks are easing commercial 

2 The debt-coverage ratio measures annual net operating income generated by a property relative to annual principal and interest payments 

due on the underlying loan. 

real estate underwriting standards. This evidence, 

derived from industry and examiner surveys conducted 

by the three banking agencies, includes the following 

observations: 

•	 In the Office of the Comptroller of the Currency’s 

(OCC’s) 1997 Survey of Credit Underwriting 

Practices, OCC examiners reported eased commercial real estate lending standards in 38 percent of 

banking companies surveyed. For comparison purposes, the 1996 survey reported eased standards in 

16 percent of banking companies surveyed. Among 

institutions with eased lending standards in the 1997 

survey, examiners noted a 75 percent incidence of 

reductions in loan fees or rate spreads, a 43 percent 

incidence of eased guarantor requirements, and a 29 

percent incidence of lower collateral requirements. 

Examiners cited competitive factors and a change in 

economic outlook as the main reasons for changes in 

underwriting standards. 

•	 Chart 4 summarizes current and historical results of 

the Federal Reserve Board Senior Loan Officer 

Opinion Survey for responses to the question of 

whether bank credit standards for approving applications for commercial real estate loans have eased, 

tightened, or remained unchanged. These survey 

results show that banks have had a tendency to ease 

underwriting standards since the fourth quarter of 

1996. This tendency appears to have become 

stronger through the third quarter 1997 survey but 

moderated somewhat in the most recent survey. The 

most recent survey showed that large banks (over 

$15 billion in assets) were much more likely to indicate easing commercial real estate standards than 

CHART 4 

Survey Shows Tendency to Ease Commercial 

Real Estate Underwriting Standards 

Percentage 

Source: FRB Senior Loan Officer Opinion Surveys 

2Q96 3Q96 4Q96 1Q97 2Q97 3Q97 4Q97 

–15 

–10 

–5 

0 

5 

10 

15 

20 

25

 % Respondents Tightening

 % Respondents Easing

 Net % Tightening (Easing) 

Memphis Regional Outlook 9	 First Quarter 1998 
In Focus This Quarter
 

smaller banks. Specifically, 21 percent of large 

banks reported easing standards, while only 3 percent reported tightening standards. In comparison, 

only 9 percent of smaller banks reported easing 

standards, while 13 percent reported tightening 

standards. 

•	 Results from the FDIC Report on Underwriting 

Practices indicate possible easing of standards for 

construction and development (C&D) loans at 

FDIC-supervised banks. A comparison of examiner 

responses for the third quarter 1997 survey (covering 

examination reports filed from April through 

September 1997) with responses for the third quarter 

1996 survey leads to the following observations3

: 

•	 The percentage of banks frequently or commonly 

originating C&D loans tied to speculative projects 

(that is, projects lacking meaningful preleasing or 

presales, or loans without a formal take-out commitment for permanent financing following completion 

of construction) rose markedly, from 11 percent to 

29 percent. 

•	 The percentage of banks frequently or commonly 

granting C&D loans without considering alternative 

repayment sources other than income generated by 

the project being financed rose significantly, from 8 

percent to 20 percent. 

•	 The percentage of banks frequently or commonly 

basing C&D loans on unrealistic appraisals rose 

from 5 percent to 11 percent. 

•	 The percentage of banks frequently or commonly 

funding or deferring interest payments during the 

term of construction loans rose from 7 percent to 15 

percent. 

Much of the commentary in recent issues of various 

trade journals echoes the results of these regulatory surveys.4 In brief, many industry participants are seeing a 

higher incidence of (1) banks funding construction loans 

without preleasing commitments on major portions of 

rentable space, (2) banks easing LTV ceilings, (3) 

3 The authors of this survey note that comparisons of survey results 

across time periods must be interpreted with caution since the survey 

samples are dictated principally by examination scheduling factors. 

As a result, sample populations may be materially different from one 

period to another. 

lenders curtailing reserve requirements for such items as 

tenant improvements and insurance, and (4) nonrecourse 

lending. Some industry participants have also noted the 

increasing acceptance of “trended rents,” whereby property valuations are based on positive rent projections 

extrapolated several years into the future. Of course, 

these trended rents will hold true only if economic circumstances remain favorable for extended periods— 

an assumption that may not be reasonable given 

the cyclical nature of real estate coupled with 

the advanced age of the current economic 

expansion. 

With a combination of relatively low 

interest rates, rising real estate prices, 

and an expanding economy, it is perhaps not too surprising that some 

lenders have eased commercial real 

estate underwriting standards. Such 

easing may be a natural response to 

improved confidence in the real estate 

markets. However, indicators that show 

loosening standards may also be warning flags that lenders have succumbed to tighter pricing 

and competitive pressures. To avoid losses like those 

sustained by banks during the last real estate downturn, 

prudent lenders will refrain from incorporating unrealistic expectations into their lending practices. 

CMBS Could Change the Way 

Lenders Underwrite Loans 

Much as residential mortgage lending standards were 

shaped by the advent of mortgage-backed securities, 

CMBS promise to change the way banks underwrite and 

service commercial real estate loans. For instance, lending terms and practices could become increasingly standardized as lenders attempt to improve the liquidity and 

marketability of their commercial mortgage portfolios. 

Banks that choose to deviate from these emerging standards will sacrifice flexibility in terms of their ability to 

manage portfolio risks and respond rapidly to liquidity 

demands. 

The ability to securitize commercial real estate loans 

also may fundamentally alter the way lending decisions 

4 See, for example, Commercial Real Estate South, “Public Markets 

Fuel Financing Glut” (October 1997); Midwest Real Estate News, 

“Wall Street and Main Street Squeeze Lenders” (October 1997); and 

Commercial Property News, “Michelson, Greenland Seize Low 

CMBS Spreads” (1 May 1997). 

Memphis Regional Outlook 10	 First Quarter 1998 
In Focus This Quarter
 

are made. Before the development of CMBS markets, 

loan approval was essentially a binary, good-or-bad, 

accept-or-reject decision whose primary focus was on 

the credit risk inherent in a single asset. In contrast, the 

most important elements in CMBS are deal structure, 

price execution for multiple tranches, credit enhancements, and portfolio composition. Here, the loan originator is more likely to use a portfolio approach in 

making credit decisions: That is, how will this loan 

enhance the expected return and risk diversification of 

the overall pool? 

External rating agencies will become increasingly 

important as CMBS markets expand, since these agencies’ guidelines will effectively dictate the underwriting 

standards applied to securitized loans. While such standardization could arguably improve market discipline 

and loan performance disclosure, there are several 

potential risks to consider as the CMBS markets evolve: 

•	 While rating agencies do incorporate qualitative considerations into their analysis, issue ratings and credit enhancement level decisions are driven primarily 

by quantitative factors, namely debt service coverage 

and expected loss levels. Moreover, most of the qualitative factors the agencies consider involve an 

analysis of portfolio balance and pool diversification. Hence, weak or poor qualitative standards (for 

example, lack of alternative repayment sources or 

minimal borrower equity in the project) applied to 

individual loans within the pool may receive only 

secondary consideration. A quantitative perspective 

also ignores such immeasurable factors as borrower 

“character” and the existence of long-standing 

lender-borrower relationships. 

•	 Rating agencies cannot be relied upon as a backstop 

to unsound underwriting practices. While they generally review a substantial volume of the loans within a pool, typically the largest individual credits, they 

are not practically able to review every credit in the 

securitization. Some within the industry have even 

suggested that investment bankers commonly move 

one problem property, discovered through one 

agency’s sample, into pools reviewed by another 

agency in the hope that it will not be sampled. 

•	 Competition among the rating agencies could 

become a factor in the underwriting process. This 

“shopping of the agencies” could result in continual 

pressure for rating agencies to ease their underwriting guidelines. 

•	 In theory, bank-issued CMBS transfer much of the 

underlying credit risk associated with commercial 

real estate lending to investors. However, like other 

types of asset securitization, CMBS raise concerns 

over the degree to which banks will voluntarily 

absorb investor losses. Bank issuers may be more 

likely than nonbank issuers to provide voluntary support to poorly performing CMBS for at least two reasons: A tarnished reputation in one aspect of a bank’s 

operations could carry over to other business activities like deposit taking and borrowing due to a bank’s 

broad brand name association within the marketplace; and banks often have greater financial 

resources than nonbanks with which to support securitization activities. 

Because the rapid growth in CMBS has been a relatively recent phenomenon, current underwriting guidelines 

applied by the rating agencies to CMBS have not been 

tested during a cyclical downturn in real estate prices. It 

remains to be seen how the market will react to rising 

loan losses that result in investor losses. 

Will Increased Public Funding through CMBS 

and REITs Improve Market Discipline? 

Many contend that the increased transparency brought 

to the market by CMBS will temper cyclical swings in 

real estate values. This viewpoint argues that investors 

will serve as a constraint against the natural tendency to 

overbuild commercial real estate during boom periods, 

since less funding will be allocated to segments of the 

market where excess capacity exists. This viewpoint 

presupposes that the investing public is sophisticated 

enough to recognize when markets are out of balance 

and when projects are economically infeasible. In this 

sense, CMBS shift much of the burden of monitoring 

credit quality standards and credit performance from 

lenders to public investors. 

In contrast, others have argued that lenders are much 

better suited than investors to make judgments about 

credit quality standards and project feasibility. This line 

of reasoning suggests that the increase in public ownership of property through CMBS and REITs could actually reduce market discipline, since the most 

sophisticated participants with access to the best information (that is, lenders) may come to have less at stake 

in making prudent credit decisions. Of course, excessive losses attributable to any one CMBS issuer might 

lead to differentiation in pricing based on investors’ 

Memphis Regional Outlook 11	 First Quarter 1998 
In Focus This Quarter
 

perceptions of the quality of underwriting applied by 

specific issuers.5 

Putting market efficiency arguments aside, the sheer 

volume of REIT and CMBS activity causes some concern over the extent to which such financing is driving 

property valuations. With such an abundance of capital 

flowing into the commercial real estate market, it is perhaps easy to see why lenders might opt to ease standards 

rather than lose business. However, to the extent securitization activities are driving decisions in today’s commercial real estate markets, lenders might wish to 

consider how property values would react if the availability of such financing were sharply diminished. The 

most recent real estate downturn provided a ready 

example of how tighter credit availability compounded 

the effects of declining commercial property values by 

limiting the ability of lenders to sell distressed properties. While there may not be consensus on whether 

CMBS and REITs will temper cyclical price swings, the 

underwriting standards and practices evolving in 

response to these financing vehicles will likely play a 

crucial role in determining the magnitude of losses 

experienced by investors and banks during the next 

downturn in commercial property values. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Selected Articles
 

for Further Reading
 

Bloomfield, Craig. “Michelson, Greenland Seize 

Low CMBS Spreads.” Commercial Property News. 

1 May 1997. p. 33. 

“CMBS Issuance Seen Topping $40 Billion.” 

Commercial Mortgage Alert. 10 November 1997. 

p. 1. 

Fitch Investor Services, Inc. “Commercial 

Mortgage Stress Test.” Fitch Research: Structured 

Finance Special Report. 8 June 1992. 

Office of the Comptroller of the Currency. Advisory 

Letter 97-3: Credit Underwriting Standards and 

Portfolio Credit Risk Management. 3 March 1997. 

Sinderman, Martin. “Public Markets Fuel 

Financing Glut.” Commercial Real Estate South. 

October 1997. p. 1. 

Wolf, Barney. “Wall Street and Main Street 

Squeeze Lenders.” Midwest Real Estate News. 

October 1997. p. 1. 

5 The evolution of the credit card securitization markets is one example of how investors now differentiate between issuers in terms of 

pricing. 

Memphis Regional Outlook 12 First Quarter 1998 
In Focus This Quarter
 

Total Return: A Useful Tool for
 

Monitoring Investment Portfolio Risk
 

•	 The Federal Financial Institutions Examination 

Council (FFIEC) is replacing the 1991 policy that 

contained a specific “high-risk test” for mortgage 

derivative products (MDPs) held by insured institutions with a policy that encourages risk management across all types of instruments on an 

investment portfolio basis. 

•	 A good way to start measuring portfolio risk is by 

monitoring an appropriate measure of return. 

•	 Total return, a concept that includes fluctuations 

in market value, is a more appropriate tool than 

simple yield for measuring the performance of an 

investment portfolio, especially one that contains 

bonds with embedded options. 

The Federal Financial Institutions Examination Council 

(FFIEC) has released for comment a new Joint Agency 

Policy Statement on Investment Securities and EndUser Derivatives Activities that will replace a statement 

issued February 3, 1992. While much of the content of 

the former statement has been retained, the section 

requiring specific “high-risk” testing for mortgage 

derivative products (MDPs) has been eliminated. The 

“high-risk” test applied specifically to bonds collateralized by residential mortgage pass-through certificates 

or whole loans but that distributed cash flows to bondholders on a basis other than pro rata.1 

The goal of the original policy statement was to deter 

banks from investing in products that presented risks 

that they were not able to adequately monitor and control. MDPs were singled out because of their rapid 

growth, nontraditional and potentially risky nature, and 

common use by insured financial institutions. The new 

policy states that, as a sound management practice, 

institutions should conduct prepurchase and ongoing 

analysis of all their investments at a level appropriate to 

the size and complexity of those holdings. 

1 A security was deemed “high risk” if it exhibited any of the following characteristics: (1) it had a weighted average life of more than ten 

years; (2) its average life extended by more than four years or shortened by more than six years from a 300 basis point parallel shift in 

rates; (3) its price changed by more than 17 percent given a 300 basis 

point parallel shift in rates. 

The policy change is in part a response to increasing 

bank investment in securities that have complex cash 

flows analogous to MDPs but that escaped the analysis 

requirement of the previous policy. Mortgage index 

amortizing notes are an example of popular bank investments that potentially exhibit all the risks of MDPs but 

were not subject to the testing requirement of the soonto-be rescinded policy because they are not collateralized by mortgages. Callable agency and “step-up” 

bonds are popular bank investments because they offer 

a slightly larger spread to Treasury than noncallable 

agency securities, and they were not subject to the 

“high-risk” test under the old policy. However, the additional yield offered on these kinds of securities compensates the investor for assuming additional risk. 

Appropriately measuring portfolio return can enhance 

the ability to monitor the extent to which these kinds of 

securities put future earnings at risk. 

Total Return Analysis Is a Useful Tool for 

Analyzing Risk at the Portfolio Level 

Total return analysis is a basic but useful tool that can 

alert management to the level of certain risks in an 

investment portfolio. It can also provide information 

that is useful for validating the assumptions used in 

more sophisticated models. Total return is calculated 

from three components: beginning price, income and 

reinvested cash flow, and ending price (market value) at 

a horizon date. Total return incorporates the change in 

the market value of the investment, resulting in a more 

comprehensive measure of performance than other 

measures that ignore such changes. Monitoring total 

return on a portfolio basis can provide institutions with 

important information about the risks inherent in the 

portfolio and how these risks may be changing over 

time. 

In two articles in the ABA Banking Journal,

2 Nicholas 

Betzold and Richard Berg convincingly dispute the 

2 The articles were published in December 1996 and April 1997. 

Reprints of the articles are available at the ABA Banking Journal website at http://www.banking.com.aba/backissues.htm. 

Memphis Regional Outlook 13	 First Quarter 1998 
In Focus This Quarter
 

view that if the investment strategy is to buy and hold to 

maturity, total return is not relevant. Consider the following example. In 1990, Bank A purchases a sevenyear security yielding 8.83 percent that is callable after 

three years. At the same time, Bank B buys a noncallable seven-year agency security yielding 8.53 percent. For three years, Bank A’s bond yields 30 basis 

points more than Bank B’s. However, from 1990 to 

1993, interest rates fell almost 300 basis points. Bank 

A’s bond would likely be called, forcing the bank to 

reinvest at a significantly lower rate for the remaining 

four years of the seven-year investment horizon. Over 

the seven-year horizon, Bank A could expect an average 

yield that is about 150 basis points less than Bank B’s. 

From the yield perspective, 

Bank A enjoyed three years of 

superior performance. However, during those three years, 

monitoring total return might 

have revealed a less favorable 

but more accurate picture of 

Bank A’s performance relative 

to Bank B’s. Here is why: As 

rates fell from 1990 to 1993, bonds gained in value. 

However, as rates fell, the market value of the callable 

security would have gained incrementally less than the 

noncallable bond because each downward tick in rates 

increased the expectation that the bond would be called, 

and the higher coupon would be earned over a shorter 

period. In contrast, the noncallable security’s market 

value would have enjoyed the full benefit of the falling 

rate environment because its maturity and cash flows 

are fixed. 

The disparate change in the market value of the two 

bonds reflects the fact that Bank A, in essence, sold a 

call option to the bond issuer. The issuer bought the 

right to repurchase the debt at par after three years. 

Bank A was compensated for selling this right to the 

issuer with increased yield. In the example, the issuer’s 

option to call the bond would have gained value as rates 

fell. The increasing positive value of the call option to 

the issuer represents an increasing negative value to the 

bondholder and erodes the value of the bond. 

Step-up bonds present reinvestment risk similar to that 

of generic callable bonds, but with the added complexity of a coupon that rises, usually annually, if the bonds 

are not called. Total return analysis would similarly 

reveal adverse changes in the value of the embedded 

call options and the extent to which the additional 

coupon is compensating for call risk. 

UBPR Yield 

Bank management often uses the portfolio yield that is 

calculated in the Uniform Bank Performance Report 

(UBPR) to assess performance of the bank’s securities 

portfolio against its peers. This yield measure is calculated by dividing annualized book income on a tax 

equivalent basis (plus or minus amortization or accretion of any premium or discount) by the amortized cost 

of the securities. This measure of present yield says little about potential future yield and the extent to which, 

because implicit options have been sold, the latter has 

been put at risk for the sake of the former. 

Total return measures the risk-adjusted return of a portfolio more closely than yield because it incorporates 

changes in reinvestment risk over time. Ultimately, a 

portfolio manager who earns total returns consistently 

higher than average will earn more in terms of simple 

yield. Conversely, a manager who earns less in terms of 

total return will eventually find an unfavorable reinvestment environment that will erode reported yield. 

The popularity of using yield to gauge the performance 

of bank securities portfolios may be due to the convenient presentation of bank peer portfolio yields in the 

UBPR. Some managers may be reticent to evaluate 

portfolio performance using total return without a peerlike benchmark for calibrating total return expectations. 

Betzold and Berg have devised an investment portfolio 

index (introduced in the April 1997 ABA Banking 

Journal) that is designed to track the total return of a 

typical bank portfolio composed of the same percentages of investment sectors as the average bank. The 

portfolio on which the index is based is rebalanced 

monthly as principal pays down, and it is rebalanced 

quarterly to reflect the latest Call Report data on portfolio allocations. Table 1 depicts the investment weighting of the index as of December 31, 1996, based on 

September 30, 1996, Call Report data. 

According to Betzold and Berg, this index produced 

total returns that closely approximated those of the actuMemphis Regional Outlook 14 First Quarter 1998 
In Focus This Quarter
 

al median bank total portfolio measured by Call Report 

data from 1993 through third quarter 1997.3 They concluded that their index seems to provide a reasonable 

proxy for the total return of the “average” bank investment portfolio. 

Chart 1 shows the performance of the index so far this 

year.4 Changes in the index value over time can be translated into total returns that approximate the median 

bank portfolio’s total return. For example, the annualized total return for the index from year-end 1996 

through third quarter 1997 was 6.72 percent and is calculated as follows: 

Calculate the bond equivalent semiannual yield 

and express the semiannual bond equivalent yield 

as an effective annual yield. 

4

: 105.00 3

6.72% = 100 [(:) − 1

100.00 ]

The performance of the index for 1997 suggests that 

banks’ total investment portfolio returns were highly 

negatively correlated with changes in the five-year 

Treasury rate (see Chart 2). This finding indicates that 

changes in total return from period to period can provide useful information about the level of a portfolio’s 

interest rate sensitivity. As emphasized above, these 

changes in total return over time include the effects of 

changes in market value of any call options on a bank’s 

investment securities and hence provide information 

about the degree to which future income is at risk. 

Given the increasing level of optionality embedded in 

the average bank securities portfolio—even if it arises 

solely from callable agency debt and “step-up” structured notes—yield should not be the sole measure of 

overall portfolio performance. Total return analysis is an 

appropriate supplement that gauges the risk-return characteristics of an investment strategy that involves selling 

implicit options. 

Allen Puwalski, Senior Financial Analyst 

3 While the Call Report does not contain the information necessary to
 

compute total return precisely, the authors computed an estimate
 

using the reported yield and market value data.
 

4 The index is published monthly in the ABA Banking Journal.
 

TABLE 1 

Composition of Betzold Berg Index 

December 31, 1996 

PERCENT 

SECURITY TYPE OF INDEX 

TREASURIES 24.52 

AGENCIES 24.38 

MUNICIPAL BONDS 12.26 

FIXED-RATE MORTGAGE OR 

MORTGAGE-RELATED PRODUCTS 19.93 

OTHER SECURITIES 6.09 

ADJUSTABLE-RATE SECURITIES 13.00 

Source: Bank and Thrift Call Reports, September 30, 

1996 

CHART 1 Index Value 

Index Tracks the Total Return of an 

“Average” Bank Portfolio 

Source: ABA Banking Journal 

100.84 

104.31 

Dec Jan Feb Mar Apr 

100 

101 

102 

103 

104 

105 

106 

May Jun Jul Aug Sep 

100.51 100.71 

101.49 

102.23 

103.06 

104.03 

105.00 

100.00 

CHART 2 

Total Return Index Is Correlated 

to Changes in Interest Rates 

Source: ABA Banking Journal, Bloomberg 

5-year Treasury 

(right scale) 

Betzold Berg Index 

(left scale) 

Percent Change Percent Change 

–10 

–5 

0 

5 

10 

Jan-97

Feb-97

Mar-97

Apr-97

May-97

Jun-97

Jul-97

Aug-97

Sep-97 

–0.20 

0.00 

0.20 

0.40 

0.60 

0.80 

1.00 

Memphis Regional Outlook 15 First Quarter 1998 
Regular Features	 Regional Economy
 

Further Slowing Evident in the Memphis Region
 

•	 A period of more moderate activity for most states in the Region is evident, although the Kentucky economy remains vibrant. 

•	 Significant differences in economic performance characterize the Memphis Region, with job gains in the 

northeast and losses in the southwest. 

•	 Single-family building permit activity has slowed in Arkansas and Tennessee. 

•	 The risk outlook is increased for the Region as a result of the Asian currency crisis. 

In the last recession (1990–1991), the Memphis 

Region’s economy barely lost jobs, continuing to outperform the nation until 1995. Since then, its growth has 

not kept pace with that of the nation, and recent indications are that the gap is widening. Competitive forces in 

international trade are important determinants of structural change in the Region. Losses in the textile sector 

from foreign competition have been offset significantly 

by the migration south of the automobile industry, 

which has benefited from lower labor costs. Since 1991 

the Region has shown more consistent annual growth 

than in the previous two decades (see Chart 1). And the 

emergence of the casino industry in the south helped 

make 1994 a banner year for employment growth. 

The Region’s economy continued to decelerate in the 

second and third quarters of 1997. Household employment growth declined to 1.3 percent in the third quarter 

compared with a year ago, below the 2.1 percent recorded for the nation. However, personal income, measured 

on a quarter-to-quarter basis, grew strongly at 5.2 perCHART 1 

cent, exceeding national growth by 0.3 percentage 

points in the second quarter. This anomaly is explained 

by strong crop prices, which boosted the Region’s farm 

income. Although farm income averages only a little 

over 5 percent of earnings, its effects are amplified by 

its occasional wide variability. Year-over-year calculation of employment masks the fact that employment 

was virtually flat in the second quarter and declined 

modestly in the third quarter. Declines in seasonally 

adjusted employment on a quarter-to-quarter basis last 

occurred during the 1990 to 1991 recession. 

The sustainability of growth is a key issue in evaluating 

the prospects for the Region. Concerns at this stage of 

the long positive national business cycle are as follows: 

•	 A tight national labor market is slowing in-migration, resulting in labor shortages in specific locations 

and industry sectors and a general slowing of 

demand growth in the Region. 

•	 Weakness in the textile and apparel sectors may conMemphis Region Lags U.S. Job Growth 

–1 

0 

1 

2 

3 

4 

5 Region 

Growth Percentage 

–2 

Source: Bureau of Economic Analysis, Bureau of Labor Statistics 

U.S. 

’79’81’83’85

’87

’89’91’93’95 

’97 (est) 

tinue to be a drag on manufacturing employment, 

resulting in isolated pockets of severe distress in 

otherwise healthy areas. 

•	 Slowing population growth may lead to continued 

softening in residential construction. 

•	 The repercussions of East Asian financial problems 

may dampen demand for the Region’s exports, which 

have recently contributed significantly to growth. 

•	 The Region’s high share of more volatile manufacturing employment may amplify the local effect of a 

potential slowing in the national economy. 

Memphis Regional Outlook 16	 First Quarter 1998 
Regular Features Regional Economy
 

Despite these concerns, the Region retains significant CHART 3 

labor and business cost advantages relative to the 

nation, an important factor in light of increasing global 

competition. The Region’s dependence on cost-sensitive 

manufacturing jobs has been mentioned: 18.6 percent of 

total employment for the Region was in manufacturing 

in 1996, significantly more than the 15.4 percent for the 

nation. (See the Regional Outlook, second quarter 

1997, for a discussion of manufacturing employment 

volatility.) In addition, rapid in-migration to most states 

in the Region has resulted in construction, infrastructure, and service industry activity as well as supplying 

the labor to sustain high employment growth. Chart 2 

shows the importance of net migration as a component 

of total population growth for the Region and its link to 

employment. 

Net Migration Is Past Its Peak 

–30 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

90/91 91/92 92/93 93/94 94/95 95/96 

Thousands 

AR KY LA MS TN 

Source: Bureau of the Census 

Net migration to the Region has fallen from its peak of 

91,000 persons in 1993–94 to 63,000 in 1995–96. This 

downward trend is likely to continue, as employers are 

increasingly complaining that they cannot find skilled 

workers, despite the fact that pockets of high unemployment persist in some rural areas. Labor shortages 

are particularly evident in the oil, shipbuilding, and construction sectors. The declining trend in net migration 

can be seen in Chart 3 and is evident for all states in the 

Region. The migration peak corresponds with the 1994 

employment growth peak depicted in Chart 1. 

After a period of strong activity, the construction industry may be poised for a downturn as a result of slowing 

population growth. Evidence of a decline in building 

permits in the Region, particularly in Arkansas, is an 

indication of potential risk. For that state, year-to-date 

single-family home-building permits through 

CHART 2 

Jobs and Population Change Move Together 

1990–1996 Jobs 400 

300 

Migration 

Natural Increase 

Thousands 

November were down 17 percent compared with last 

year. Multifamily activity is even lower. Although the 

permit data are a volatile series, these declines are significant. Because construction activity follows permit 

issuance, current permit information may provide an 

indication of future activity. Although Louisiana and 

Mississippi do not show significant declines in permits, 

Tennessee single-family permits are down 3 percent 

from a year ago, and multifamily activity is much lower. 

In Kentucky, permit activity and employment growth 

remain strong. Existing home sales for the Region have 

remained strong. Despite these mixed indications of 

weakening construction, low mortgage interest rates 

have spurred refinancing activity, which began to pick 

up in the summer. In terms of the Region’s residential 

loan exposure, outstanding loans of commercial banks 

in the one- to four-family sectors increased from 21.7 

percent of all loans in 1990 to 29.0 percent by mid1997. 

Significant Differences in Economic 

Performance Characterize the Region’s States 

In spite of the similarities of relatively low cost structure, there has been substantial variation across the 

Region in nonfarm employment growth. The fastest 

growing state in the third quarter was Kentucky (2.2 

percent), followed by Louisiana (1.3 percent), Arkansas 

(0.9 percent), Tennessee (0.8 percent), and Mississippi 

(0.6 percent). These differences are shown by county in 

Chart 4 (next page). 

The following brief tour of the states examines selected 

200 

100 

0 

–100 AR KY LA MS TN 

Sources: Bureau of the Census, Bureau of Labor Statistics locations and issues. 

Memphis Regional Outlook 17 First Quarter 1998 
Regular Features Regional Economy
 

CHART 4 

Job Gains in Northeast, Losses in Southwest 

Source: Bureau of Economic Analysis, Bureau of Labor Statistics 

under –1% 

over 1% 

–1% to 1% 

Farm Income Boosts Arkansas Economy, 

Although Construction Permits Are Down 

Arkansas’s second-quarter compounded annualized personal income growth of 9.5 percent was first in the 

nation (quarter over previous quarter). This extraordinary performance was buoyed by a substantial increase 

in farm earnings from crop cash receipts, particularly 

soybeans and cotton. These gains contrast with thirdquarter employment losses, and concern exists that they 

may not be sustainable, particularly in light of the recent 

price weakness in these commodities, which is attributable in part to the East Asian crisis. Areas of relative 

strength have been trade, construction, restaurants, and 

general merchandise stores; other sectors have suffered 

job losses. A key factor in the stability of the economy 

continues to be the poultry industry, which is heavily 

dependent on grain prices. Another factor is in-migration, estimated to be 20,700 persons per year at its peak 

in 1992–1993 but recently estimated by the census to be 

down to 15,600 in 1995–1996. 

Kentucky Continues to Match National Growth 

Kentucky’s personal income growth in the second quarter was 1.3 percent, twenty-fifth in the nation and tied 

with that of Tennessee. This is the state that was most 

affected in the Region by the nationwide UPS strike, as 

the company’s main U.S. air hub is in Louisville. The 

August strike, which involved some 9,000 workers, 

caused a large temporary decline in transportation, 

communications, and utilities employment. On a positive note, UPS reported recently that the hub is ahead of 

projected revenues. Additions to the Ford truck plant, to 

be completed in the first half of 1998, will add 1,000 

new jobs in the Louisville area, with an annual payroll 

of $50 million. The fact that jobs will be filled by union 

workers from plants elsewhere will boost net migration 

and should stimulate residential construction activity. 

Meanwhile, other forces have affected the rural areas of 

the state. The Fruit of the Loom layoffs in the south 

(Camblesville and Jamestown) have been partially offset by a good tobacco harvest, which has produced a 

large temporary increase in farm labor. The manufacturing expansions in the north should widen the economic gap between urban and rural areas. However, the 

northern areas remain vulnerable to national trends in 

domestic automobile production. (See Regional 

Banking Conditions for a discussion of certain 

Kentucky banks that have significant levels of “other 

borrowed funds.”) 

Louisiana Sees Some Resurgence in Oil 

While Textiles Remain Weak 

At 0.8 percent, Louisiana ranked forty-sixth nationally 

in personal income growth in the second quarter of 

1997. The state is reducing its dependence on the textile 

industry, with just 2.5 percent of the 1.22 million nonfarm jobs now in this sector. With its large chemical 

industry, one-third of whose value is exported, exchange 

rates and the economies of the countries that buy its 

products are important factors. Major trading partners 

are Mexico, Canada, and Japan. The relative stability of 

natural gas prices over the past several years has triggered a resurgence in the chemical industry, with an 

estimated $2 to $3 billion in expansion and construction 

activity. New defense contracts and repair work associated with offshore exploration have boosted shipbuilding, fabricated metals, and machinery manufacturing in 

the south. Louisiana has one of the highest unemployment rates in the nation, but finding qualified workers 

for technical positions is said to be a problem. 

Shipbuilders are seeking permission to hire foreign 

workers to fill the need for welders, shipfitters, electricians, and other jobs. If oil prices fall below the $15 to 

$16 per barrel break-even point, some slowing of activity can be expected. 

Recently, statewide payroll gains in oil and gas have offset apparel losses two to one. Optimism is reportedly 

high in the oil and gas sectors, where manufacturing 

orders are strong. Further potential employment adjustments for oil and textiles are indicated, as average weekly hours were up sharply in petroleum refining and 

down in textiles. Eating and drinking places added a 

robust 5,300 jobs (4.5 percent year-over-year growth), 

with the convention and casino business in the south as 

Memphis Regional Outlook 18 First Quarter 1998 
Regular Features Regional Economy
 

a driver. Also, strong commercial construction starts 

were recorded in the second quarter. Employment in the 

Shreveport-Bossier City area, which has been dependent on mining (gas) activity, should benefit from the 

recent opening of the land-based 606-room Horseshoe 

Casino. There are plans to open four more hotel/casinos 

in the Shreveport area by 1999. Casino boat revenues in 

Baton Rouge are up by double-digit percentages from a 

year ago. In the New Orleans area, there has been 

recent evidence of renewed strength, with real estate 

investment trust purchases of the Louisiana Light and 

Electric tower and the Texaco Center signaling a resurgence in commercial property and construction activity. 

However, the area remains highly dependent on petroleum and petroleum-based products, which comprise 25 

percent of total earnings, and thus is still vulnerable to 

oil price shocks. 

Mississippi Textiles Are Weak While Casinos 

and Tourism Show Some Strength 

Mississippi income growth in the second quarter was 

1.1 percent, thirty-first in the nation. Hotel occupancy 

rates have been rising on the strength of the casinos 

along the coast; however, the textiles and apparel sector 

continues to erode, with more than 850 jobs lost in nine 

plants since the beginning of 1997. Virtually all sectors 

except construction and services show third-quarter 

employment declines. Casino gaming revenues 

accounted for $1.86 billion in 1996 (in an economy of 

$47.7 billion in personal income) and recorded 7.8 percent growth year-over-year in October. Gulf Coast 

county revenues grew slightly faster than those for 

Mississippi River casinos. Relative to the national slowing in gaming revenue, this growth can still be considered quite strong; the banner years of national 

double-digit growth for gaming appear to be past. 

Tennessee Continues to Lead the Slowdown 

Tennessee’s second-quarter personal income growth of 

1.3 percent ranked twenty-fifth in the nation. In 1996 

the state was subject to an abrupt slowdown, with personal income growth slumping to forty-seventh in the 

nation. This decline contrasts sharply with the rapid 

growth seen earlier in the cycle, in which Tennessee was 

the leader. Employment growth is being constrained 

both by supply in the sectors that are doing well and by 

weakness in specific sectors such as textiles. As a result, 

manufacturing employment has suffered losses, 

although construction has managed to remain robust. In 

Nashville there is a shortage of labor for all major trade 

contractor categories and truck drivers. One company 

has reportedly been forced to idle more than 10 percent 

of its equipment because of labor shortages. As noted 

earlier, recent permit data suggest that the residential 

construction boom may be slowing in some areas, particularly Memphis. Industry analysts estimate that 

commercial construction will be at about 80 percent of 

last year’s levels in the area. 

Implications: Divergences in economic activity resulting from differences in economic circumstances imply 

that individual banks’ experiences will differ significantly depending on their location and that these differences may increase. However, the known association 

between employment and residential loan growth suggests that the probability of a slowing in loan applications in the whole Region is increasing. This anticipated 

trend may be postponed by current low interest rates 

and increased refinance activity, which could temporarily offset any reductions in loan demand. In the Region, 

Tennessee is most dependent on in-migration to fuel 

employment and population growth, and this sensitivity 

increases exposure to the risk of a construction slowdown. 

Focus on the Asian Currency Crisis 

The Asian currency crisis has caused concerns regarding the demand for the Region’s agricultural and other 

exports. Indonesia, Korea, Malaysia, the Philippines, 

Singapore, Taiwan, and Thailand have experienced substantial declines in their currencies. Table 1 gives a 

broad indication of the Region’s potential exposure and 

TABLE 1 

A Relatively Small Percentage of the 

Region’s Exports Go to Countries 

Affected by the Currency Crisis 

TOTAL EXPORTS TO 

EXPORTS AFFECTED AREAS 

(%) (%) 

ARKANSAS 2.2 0.1 

KENTUCKY 4.8 0.3 

LOUISIANA 3.5 0.5 

MISSISSIPPI 2.0 0.1 

TENNESSEE 5.9 0.6 

U.S. GROSS 

DOMESTIC 

PRODUCT 8.0 0.9 

Source: Export Locator Series, Bureau of the Census 

Memphis Regional Outlook 19 First Quarter 1998 
Regular Features Regional Economy
 

shows the percentage of gross state product in exports 

to these countries.1 

While the Region’s overall exposure is less than that of 

the nation, concentrations in petrochemical exports in 

southern Louisiana and eastern Tennessee are potentially at risk. Precise data on exports by commodity and 

state to country of destination are either ambiguous or 

unobtainable. Partial data indicate, however, that the 

seven affected countries account for approximately 12 

percent of total chemical exports from Tennessee. 

Data limitations also preclude detailed analysis of 

impacts on the agricultural sector. However, it is known 

that cotton accounts for 19 percent of all agricultural 

exports from the Region, followed by soybeans (17 percent) and tobacco (8 percent). States that have high concentrations in food, tobacco, and agricultural exports 

are Louisiana (49 percent of total exports) and Arkansas 

(43 percent of total exports). 

The Federal Reserve Beige Book reports that contacts 

in the agricultural sector continue to anticipate a slowing in farm exports because of the crisis. There is also 

evidence that some grain elevators are at higher levels 

than normal for this time of year. The USDA Foreign 

1 State data are for 1994 and, in light of recent rapid export growth, 

will slightly understate the relative importance of exports. 

Agricultural Service initially estimated a drop in total 

U.S. agricultural exports to the four nations initially 

affected (the Philippines, Malaysia, Thailand, and 

Indonesia) of as much as 20 percent ($575 million) over 

the next one to two years. This would be a total drop in 

agricultural exports to all countries of 1 percent. 

Subsequent currency deprecations have amplified this 

figure significantly: A recent estimate released by the 

U.S. Department of Agriculture’s chief economist is of 

a $2 to $3 billion impact. Very little poultry is exported 

to most of the affected countries, which bodes well for 

the large poultry sector in Arkansas and Mississippi; 

however, substantial quantities are exported to Hong 

Kong. 

Implications: Trade uncertainty has been added to the 

outlook for the Region. Some downward effect on 

income growth resulting from the East Asian currency 

crisis is anticipated, but the Region is generally less 

dependent than the nation on exports. However, concentrations in food processing, chemicals, and agriculture may lead to disproportionate impacts in certain 

areas. Hedging strategies in the futures markets are 

often used to spread commodity and currency risks; 

interest in such activities may increase given the current 

situation. 

David T. Griffiths, Regional Economist 

Memphis Regional Outlook 20 First Quarter 1998 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

•	 Banks in the Region report strong earnings and loan growth in the third quarter. 

•	 Banks are continuing a trend toward increased use of alternate sources to fund loan growth. 

•	 Declining allowance levels have accompanied loan growth and merit close attention, given indications of 

weaker underwriting standards. 

Overview of Memphis Region Banking 

Conditions 

The third quarter of 1997 produced a continuation of 

recent favorable reports on some of the primary measures of insured institutions’ financial strength: 

•	 The aggregate leverage capital ratio increased by 11 

basis points to 9.05 percent. 

•	 Return on assets remained stable at just over 1.3 percent. 

•	 Nonperforming asset totals remained well below 1 

percent of total assets. 

Continued robust loan growth is another notable result 

of the third quarter. Third-quarter annualized loan 

growth for all insured institutions in the Region, adjusted for merger and new bank activity, was almost 14 percent, virtually the same rate as over the previous 

one-year period. By comparison, third-quarter annualized deposit growth was 6.5 percent, with growth of 

almost 9 percent over the previous one-year period. The 

Region’s insured institutions now boast the highest 

loan-to-deposit ratio level of this decade, at 83 percent. 

The rapid growth in loan portfolios seems to be a primary factor in an increased use of other borrowed funds 

(OBF), which is discussed later in this article. This 

growth is also a factor in the important issue of the adequacy of the allowance for loan and lease losses, an 

issue that has resulted in cautionary statements by bank 

regulatory agencies in recent months. 

Banks Turn to Alternate Funding Sources 

As loan growth continues to outpace deposit growth, 

banks are turning to alternate funding sources. A trend 

toward increasing reliance on large certificates of 

deposit was discussed in the second quarter 1997 

Regional Outlook. As shown in Chart 1 (next page), the 

Region’s banks are also using other borrowed funds to a 

greater degree as loan-to-deposit levels have climbed. 

For this article, “other borrowed funds” primarily 

includes federal funds purchased and securities sold 

under agreement to repurchase less any offsetting federal funds sold and securities purchased under agreement to resale, and other borrowed money as defined in 

Call Report instructions. 

More Banks Are Using OBF 

The number of banks in the Region with 10 percent or 

more of total liabilities in other borrowed funds (High 

OBF Group) has grown from 34 at year-end 1990 to 106 

at the end of the third quarter of 1997. As shown in 

Chart 2 (next page), most of the new institutions in the 

group are banks with total assets of less than $500 million. 

Geographically, the High OBF Group is concentrated in 

metropolitan areas and throughout western Kentucky. 

Kentucky and Tennessee are home to a disproportionate majority of the group, with 55 and 25 banks, respectively. Not surprisingly, these two states have the highest 

loan-to-deposit totals in the Region. 

The Primary Source of OBF Is Changing 

In 1990, federal funds purchased and securities sold 

under agreement to repurchase represented approximately 90 percent of total OBF. Since that time, banks 

have increasingly relied on additional sources of OBF, 

with federal funds purchased and securities sold under 

agreement to repurchase declining to 60 percent of the 

total at the end of the third quarter of 1997. Although 

banks do not directly report the makeup of these additional sources of funding, one primary source is 

advances from the Federal Home Loan Bank (FHLB) 

system.1 Since January 1990, when banks were first 

1 Based on information from the FHLBs of Cincinnati and Dallas. 

Memphis Regional Outlook 21	 First Quarter 1998 
Regular Features Regional Banking
 

CHART 1 CHART 2 

More Small Banks Are Joining the
 

High OBF Group
 

Source: Bank Call Reports 

Other Borrowed Funds Have Increased 

with Loan-to-Deposit Levels 

0 

20 

40 

60 

80 

100 

’90 ’91 ’92 ’93 ’94 ’95 ’96 Sep-97 

0 

3 

6 

9 

12 

15 

Loan-to-Deposit Ratios 

Other Borrowed Funds 

Loan-to-Deposit Ratio

Funds to Total Liabilities 

Ratio of Other Borrowed 

Number of Banks 

0 

20 

40 

60 

80 

100 

120 

’90 ’91 ’92 ’93 ’94 ’95 ’96 Sep-97 

Asset Size 

Over $500 

Million 

$100 to 

$500 

Million 

Less than 

$100 

Million 

allowed to join the FHLB, membership has grown to 

approximately 60 percent of the Region’s commercial 

banks. 

Banks have found several advantages to using FHLB 

advances: low overhead costs to obtain advances compared with human resource and marketing expenses 

required to generate core deposits; the absence of 

reserve requirements and deposit assessments on 

advances; and specially priced programs for affordable 

housing and community development projects. Other 

advantages are greater flexibility and control over funding, including quick and easy access to funds; ability to 

structure repayment programs; and availability of longterm (up to 20 years) funding. This flexibility and control can also be used to address interest rate risk 

concerns; for example, banks can draw 15-year 

TABLE 1 

Source: Bank Call Reports 

advances with no prepayment penalty to support 15­

year residential lending. 

As shown in Table 1, FHLB membership and use of 

FHLB advances by community banks with less than 

$500 million in total assets is not uniform throughout 

the Region. Banks in states served by the FHLB of 

Cincinnati had higher membership levels and more 

members using advances as of October 31, 1997. As 

previously noted, banks in these states have experienced 

higher loan demand. Among banks served by the FHLB 

of Dallas, those in Arkansas are using the system for 

the greatest dollar volume. (This fact may be partially 

attributable to the fact that the FHLB of Dallas used to 

operate a satellite office in Arkansas.) 

FHLB Use Varies by State and Federal Home Loan Bank 

INFORMATION BANK PERCENT BANKS WITH ADVANCES ($ MILLIONS) 

AS OF 10/31/97 MEMBERS OF BANKS NUMBER ADVANCES 

DALLAS FHLB: 

ARKANSAS 120 55 63 $ 337
 

LOUISIANA
 78 52 39 101
 

MISSISSIPPI
 52 54 34 155 

CINCINNATI FHLB: 

KENTUCKY 178 69 143 1,029
 

TENNESSEE
 136 62 99 1,005 

Note: Includes only banks with $500 million or less in total assets 

Source: FHLB of Dallas and FHLB of Cincinnati 

Memphis Regional Outlook 22 First Quarter 1998 
Regular Features Regional Banking
 

Implications: The advantages of OBF come at a cost, 

typically in the form of higher interest rates or greater 

interest rate risk. The median net interest margin for 

banks in the High OBF Group has ranged from 18 to 40 

basis points below the remainder of the Region’s banks 

during the 1990s. While this overall difference can be 

attributed to many causes, the higher interest expense 

typically associated with OBF was probably a factor. 

Note that while the use of other borrowings may result 

in lower net interest margins, the addition of earning 

assets supported by these funds, as well as potential 

reduction in overhead costs, may be improving return 

on equity. 

The potential for interest rate risk arises with OBF as 

with all funding sources, particularly when federal 

funds purchased or short-term FHLB advances are used 

to fund longer term assets. In addition to timing mismatches, the use of OBF can result in additional yield 

curve or option risk. However, many banks have found 

that certain FHLB advances, managed properly, can be 

used to reduce interest rate risk, as described above in 

the example involving 15-year mortgage loans. 

Another potential risk arises when OBF are used to create rather than fund growth. Bankers can quickly leverage their balance sheets and reduce capital ratios 

through such borrowings. An example is a “government 

arbitrage” strategy employed by some Memphis Region 

institutions as a means of using capital in excess of regulatory minimums. In such an investment, the bank borrows from the FHLB at a floating rate and reinvests in 

floating rate mortgage-derivative products to earn the 

spread. While such strategies may improve return on 

equity, the bank’s risk profile is likely to increase as a 

result. 

Allowances for Loan and Lease Losses 

Are Falling 

Funding is only one area of concern arising from loan 

growth. Another results from loan portfolios growing 

faster than allowances for loan and lease losses (ALLL), 

resulting in declining coverage levels. This trend has 

drawn increased regulatory attention. In August 1997, 

the Office of the Comptroller of the Currency (OCC) 

issued an Advisory Letter (AL-97-8) noting trends 

toward weaker loan underwriting standards and declining levels of allowance coverage and discussing concern 

over weaknesses in methodologies being used to determine ALLL adequacy. 

CHART 3 

The Region’s Asset Quality Concerns Edge Up 

since 1994, While ALLL Continues to Decline 

Source: Bank and Thrift Call Reports 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

’92 ’93 ’94 ’95 ’96 Sep-97 

0.0 

0.5 

1.0 

1.5 

2.0 

Noncurrent 2.5

Allowance 

Gross Loan Losses

Noncurrent and Losses/Total Loans

Allowance/Total Loans 

By traditional measures, the allowance coverage for 

Memphis Region banks and thrifts has fallen in recent 

years, as shown in Chart 3. The initial reduction in 

allowance levels during 1993 and 1994 occurred during 

a period associated with overall improvement in asset 

quality. Since then, however, certain risk measures, 

including noncurrent loan levels and loan loss rates, 

have increased. Noncurrent loans, although down from 

1996, rose from 0.82 percent of total loans at the end of 

1994 to 0.90 percent at the end of the third quarter of 

1997. Gross loan charge-offs have likewise increased, 

from 0.41 in 1994 to an annualized 0.48 percent of total 

loans at the end of the third quarter of 1997. Also, the 

deterioration in these ratios may be somewhat understated because of the substantial increase in total loans 

during the period. These quantitative indicators of loan 

quality do not seem to support the decline in allowance 

coverage that has continued since 1994. 

Additionally, considerable attention has been focused 

on changes in bank underwriting standards, particularly 

for commercial and commercial real estate loans. 

Concerns over underwriting standards were raised in the 

Federal Reserve’s November 1997 Senior Loan Officer 

Opinion Survey on Bank Lending Practices, the 

OCC’s 1997 Survey of Credit Underwriting Practices, 

and the FDIC’s Report on Underwriting Practices for 

April to November 1997. These subjective assessments 

also point to increased loan portfolio risk. 

The declining allowance coverage is fairly consistent 

among banks of differing asset size and geographic 

location. The overall trend also holds among banks with 

varying lines of business concentrations, as shown in 

Table 2 (next page). 

Memphis Regional Outlook 23 First Quarter 1998 
Regular Features Regional Banking
 

Banks in the Region that currently have a concentration 

in commercial loans (25 percent or more of total loans) 

exhibit generally higher allowance levels, at 1.61 percent of total loans, than the Region overall. The higher 

allowance level for this group is somewhat expected, as 

such loan concentrations are historically associated with 

higher risk levels. Another traditionally higher risk line 

of business concentration, commercial real estate and 

construction lending, does not follow this pattern, as 

these banks have a slightly lower allowance to total 

loans than the Region overall. Banks with concentrations in consumer lending show the weakest allowance 

coverage. This group also has significantly lower coverage of gross loan losses (2.06 times gross charge-offs) 

than the 2.97 times coverage of the Region overall. The 

historically greater degree of risk associated with commercial real estate and current concerns over consumer 

lending suggest that allowance coverage for these banks 

should be higher than the Region overall rather than 

lower. 

Another group of banks exhibiting higher risk profiles 

and declining allowance coverage is the High Loan 

Growth Group,2 also shown in Table 2. The most signif2 The group includes banks with less than $1 billion in total assets that 

experienced 50 percent loan growth or greater from December 31, 

1994, to September 30, 1997. Any banks involved in mergers or consolidations, and banks chartered after December 31, 1991, were 

excluded from the group. 

TABLE 2 

icant decline in allowance coverage occurred in institutions in which one- to four-family residential lending 

was the primary component of loan growth. Although 

loan losses in one- to four-family residential lending 

have traditionally been modest, recent changes in 

underwriting standards, such as higher loan-to-value 

limitations and debt-income ratios, may reduce the usefulness of historical experience in this area. Institutions 

in which commercial real estate and construction lending was the primary component of overall loan growth 

also showed significant declines in allowance coverage. 

The low and declining ALLL for these banks warrants 

close attention because of the greater risk typically 

associated with this growth component. 

The decline in allowance coverage has occurred in spite 

of considerable increases in quarterly provisions. With 

increased revenue, banks have set aside more money 

into the allowance for loan losses. As shown in Chart 4, 

provisions relative to net income have more than doubled since 1994, during a period of rising net income 

levels. These provisions have more than covered net 

loan losses but have not kept pace with overall loan 

portfolio growth. 

Chart 4 displays provisions, charge-offs, and net income 

for each quarter as a cumulative total through the year; 

for example, the third quarter 1997 is a cumulative ratio 

for all three quarters. This format serves to normalize 

the high provisions and charge-offs that normally occur 

in the fourth quarter for many banks. 

Overall Decline in ALLL Is Consistent among Groups 

BANKS IN ALLL/TOTAL LOANS 

GROUP DEC-94 SEP-97 

UNITED STATES 9,215 2.22 1.89 

MEMPHIS REGION 999 1.86 1.51 

BANKS WITH LINE OF BUSINESS CONCENTRATIONS IN: 

COMMERCIAL LENDING 106 2.18 1.61 

COMMERCIAL REAL ESTATE LENDING 244 1.71 1.48 

CONSUMER LENDING 223 1.67 1.44 

HIGH LOAN GROWTH BANKS AND GROUPS BY 

PRIMARY COMPONENTS: 

TOTAL HIGH LOAN GROWTH GROUP 216 1.59 1.32 

PRIMARILY 1- TO 4-FAMILY RESIDENTIAL 107 1.63 1.26 

PRIMARILY COMMERCIAL REAL ESTATE 68 1.53 1.36 

Source: Bank Call Reports 

Memphis Regional Outlook 24 First Quarter 1998 
Regular Features Regional Banking
 

CHART 4 

Provisions Are Rising Relative to Income, 

as Are Net Loan Losses in the Region 

20 

18 

Provision Expense 16 

14 

12 

10 

8 

6 

4 

2 

0 

Percent of Net Income

Net Loan Losses 

Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 

Note: This chart displays provisions, charge-offs, and net income for each quarter 

as a cumulative total through the year; for example, the third quarter 1997 is a 

cumulative ratio for all three quarters. This format serves to normalize the high 

provisions and charge-offs that normally occur in the fourth quarter for many 

banks. 

Source: Bank Call Reports 

Implications: A lower allowance level may limit a 

bank’s ability to respond effectively to increasing loan 

losses. In the event of declining asset quality, institutions with low allowance levels relative to risk could see 

greater earnings volatility as a result of the combined 

impact of lost earnings from nonearning assets and 

higher necessary provisions for loan and lease losses. 

These effects could be more pronounced in banks with 

elevated risk profiles resulting from concentrations, 

higher intrinsic risk in certain lines of business, or faster 

loan growth rates. 

Gary L. Beasley, Regional Manager 

Robert L. Burns, Financial Analyst 

Memphis Regional Outlook 25 First Quarter 1998 
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