Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 2000 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

John M. Anderlik,
 

Regional Manager
 

Jeff W. Walser,
 

Regional Economist
 

Troy D. Osborne,
 

Financial Analyst
 

Regional Perspectives 

◆ The Region’s Economic Conditions—Prices for major field crops are 

expected to remain depressed in 2000, while livestock prices will likely improve. 

Farm incomes will continue to depend on the level of government payments 

approved this year. Performance in the Region’s farm banks remains strong. Higher vacancy rates in the St. Louis office market may suggest a risk of overbuilding, 

as population and employment growth appear insufficient to support the current 

level of construction activity. See page 3. 

By Troy D. Osborne, Financial Analyst 

Jeffrey W. Walser, Regional Economist 

In Focus This Quarter 

◆ Banking Risk in the New Economy—This article summarizes current economic conditions, with a primary focus on potential risks to insured depository 

institutions. It explores the implications of long-term trends that have led to the 

New Economy. Recent high rates of economic growth with low inflation have been 

made possible by increases in productivity arising from new technologies, higher 

investment spending by businesses, and large-scale industrial restructuring. Underlying these trends has been a financial environment that has largely accommodated 

the growing borrowing needs of consumers and businesses. Market-based financing, 

provided in large part through securitizations and mutual funds, has made capital 

readily available to start-up “new economy” firms as well as mature companies that 

seek to merge or restructure. Despite the clear benefits of market-based financing 

in supporting economic activity, there are also concerns. A recurrence of financial 

market turmoil, such as that experienced in fall 1998, has the potential to quickly 

change the currently positive economic outlook to one that is far more challenging. 

Detail is provided on commercial credit quality, market sources of revenue, and 

other risks to watch in banking. See page 13. 

By the Analysis Branch Staff 

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

Insurance Corporation as an information source on banking and economic issues for insured 

financial institutions and financial institution regulators. It is produced 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. For 

more information or to provide comments or suggestions about the Kansas City Region’s Regional Outlook, please call John Anderlik at (816) 234-8198 or send an e-mail to janderlik@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 Prices for major field crops are expected to remain depressed in 2000, while livestock prices will likely 

improve. The Region’s farm incomes will continue to depend on the level of government payments approved 

this year. 

•	 Performance of the Region’s farm banks remains strong based on aggregate earnings, capital, and delinquent loan levels. 

•	 Higher vacancy rates in the St. Louis office market may suggest a risk of overbuilding, as population and 

employment growth appear insufficient to support the current level of construction activity. 

Agricultural Conditions Remain Depressed,
 

with Little Improvement Expected in 2000
 

The cumulative effects of four consecutive years of 

bumper crops in major agricultural countries continue 

to depress prices for the major field crops. As Table 1 

shows, prices for corn, wheat, and soybeans have 

declined dramatically since 1996. A long run of unusually favorable weather, both at home and abroad, led to 

the increasing accumulation of stocks, which is the 

most important determinant of field crop prices. 

Although corn production declined last fall as farmers 

reduced planted acreage in response to low prices, ending stocks are forecast to remain nearly unchanged, 

resulting in even lower average prices this year. Similar 

to the situation for corn, wheat production declined in 

1999, but accumulated stocks should continue to 

depress prices in 2000. Soybean production set another 

record in 1999 as farmers continued to increase planted 

acreage. Soybean plantings have increased steadily 

since the Federal Agriculture Improvement and Reform 

(FAIR) Act of 1996 abolished the traditional system of 

deficiency payments that tended to favor planting corn. 

Year-end soybean stocks are forecast to be comparable 

to last year’s, resulting in prices significantly below $5 

per bushel. 

The outlook for livestock prices is more optimistic. 

Pork producers reduced breeding inventories in 1999 in 

response to the disastrously low prices in the winter of 

1998–99. As a result, pork industry analysts expect 

prices to rise above $40 per hundredweight for 2000. 

Similarly, cattle prices appear headed for improvement 

this year. While cattle numbers have been declining 

since 1996, beef production has not declined significantly until this year’s forecast. 

However, long-range trends in both the cattle and hog TABLE 1 

Agricultural Prices Are Expected 

to Remain Depressed through 2000 

PROJ. 

1996 1997 1998 1999 2000 

CORN 3.24 2.71 2.43 1.94 1.91 

SOYBEANS 6.72 7.35 6.47 4.93 4.70 

WHEAT 4.55 4.30 3.38 2.65 2.50 

HOGS 53.39 51.36 34.72 34.00 44.50 

CATTLE 65.06 66.32 61.48 65.56 69.50 

Notes: Grain prices refer to crop’s marketing year.
 

Crop quantities are per bushel; livestock are per
 

hundredweight.
 

Source: U.S. Department of Agriculture, April 11,
 

2000, World Agricultural Supply and Demand Estimates
 

industries will likely constrain significant, permanent 

price improvements. During the 1990s, the hog industry 

consolidated rapidly, shifting partially to integrated production systems that have benefited from many costsaving technological and managerial innovations. As 

production costs continue to decline, prices have tended 

to follow. Many industry analysts believe that this 

reduction in prices could be permanent, reflecting the 

changing structure of the industry. The cattle industry, 

of major importance in the Plains states, is facing longrun difficulties of another kind: beef producers continue to lose market share to the more technologically 

savvy poultry and pork industries. The poultry industry, 

and more recently the pork industry, has achieved high 

degrees of vertical integration, followed by advances in 

Kansas City Regional Outlook 3	 Second Quarter 2000 
Regional Perspectives
 

genetics and improved feeding practices. In contrast, 

the highly fragmented cattle industry has not adopted 

competitors’ integrated supply chain strategies and has 

been slow to respond to shifting consumer tastes. 

Record Government Payments Are 

Supporting Farmers’ Incomes 

The U.S. Department of Agriculture (USDA) forecasts 

that U.S. net farm income will decline from $48.1 billion in 1999 to $40.4 billion in 2000. Much of the 

decline is based on assumptions of lower government 

payments in 2000. Chart 1 displays the trend of net farm 

income in the 1990s and the increasing importance of 

government payments. Despite the FAIR Act’s phaseout of government support, substantial payments were 

made to farmers in 1998 and 1999 in the form of emergency aid and loan deficiency payments. The USDA 

forecast for 2000 does not assume additional emergency 

aid in 2000, but this cannot be ruled out in an election 

year, as congressional candidates from agriculturedependent areas of the country try to appeal to their 

constituents. 

In 1999, the USDA began to regionalize its forecasts, 

based on the crops and livestock grown in different 

parts of the country. Map 1 shows how the USDA’s 

regional analysis applies to the Kansas City Region. The 

Region’s seven states make up parts of five USDA 

regions. North Dakota and most of South Dakota are 

in the USDA’s Northern Great Plains; Northern Minnesota is in the Northern Crescent; Iowa, most of Missouri, and parts of Nebraska, South Dakota, and 

CHART 1 

Net Farm Income Levels Have Been 

Supported by Government Payments 

60 Net Farm Income 

50 

Billion 

40 

30 

Government 

Payments 

$

20 

Farm Operating Income 10 

0 

’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 F 

Note: F = forecast 

Source: Economic Research Service, U.S. Department of Agriculture 

MAP 1 

The USDA’s Farm Resource Regions 

in the Kansas City Region 

Northern Crescent 

Northern Great Plains 

Prairie Gateway 

Heartland 

Eastern Uplands 

Source: U.S. Department of Agriculture (USDA) 

Minnesota are in the Heartland; Kansas and southern 

Nebraska are in the Prairie Gateway; and a small portion of southern Missouri is in the Eastern Uplands. 

The USDA’s regional forecast is shown in Chart 2, 

which presents the proportion of farms with negative 

net cash incomes, comparing 1998, 1999, and the forecast for 2000. As the chart indicates, all USDA regions 

are expected to show increases in farms with net losses 

in 2000. The Heartland, which recorded a low incidence 

of farms with negative net cash income in 1998, was 

only one of three regions to experience an increase in 

such farms in 1999, despite the high level of government payments. In contrast, the Northern Crescent, the 

Northern Great Plains, and the Prairie Gateway showed 

some improvement in 1999, although these regions are 

expected to experience an increase in the number of 

farms showing net losses in 2000. 

Another indicator of potential problems in the Region 

can be found in an Iowa State University (ISU) analysis. This analysis, based on surveys of 1,076 Iowa commercial farms, assesses prospects for grain and 

livestock farms if commodity prices remain at 1999 levels through 2001. The study is summarized in Chart 3, 

which compares the financial conditions of the farms 

under three scenarios: (1) actual conditions that prevailed in 1997; (2) conditions forecast by ISU in its 

1998 survey, which assumed 1998 commodity prices 

would prevail through 2000; and (3) conditions forecast 

by the current study. The study concludes that 49 percent of Iowa’s commercial farms will be characterized 

by “weak” or “severe” financial conditions by year-end 

Kansas City Regional Outlook 4 Second Quarter 2000 
Regional Perspectives
 

CHART 2 

All USDA Regions Are Expected to Show a Significant Increase in Repayment Problems in 2000 

Percent 

Percentage of Farms with Negative Net Income 

0 

5 

10 

15 

20 

25 

30 

35 

Heartland Northern Northern Prairie Eastern Southern Fruitful Basin and Mississippi All farm 

Crescent Great Gateway Uplands Seaboard Rim Range Portal businesses 

Plains 

1998 1999 (forecast) 2000 (forecast) 

Source: Economic Research Service, U.S. Department of Agriculture (USDA) 

2001, even after factoring in expected governmental 

support. The results of the Iowa State study may also 

apply to other states in the Region—such as Minnesota, 

Nebraska, and Missouri—that depend on similar commodities. 

The Future of Farm Policy Remains Uncertain 

The direction of farm policy has far-reaching implications for the Region’s farmers. While many farmers 

considered the FAIR Act a fundamental shift in farm 

policy, permanently reducing the federal government’s 

role in agriculture, events since then have cast doubt on 

this assessment. In 1996, when high commodity prices 

prevailed, FAIR Act supporters argued convincingly for 

phasing out the traditional deficiency payments in 

return for ending planting restrictions. However, three 

CHART 3 

years of low prices have resulted in many questioning 

the wisdom of the FAIR Act. The decision by Congress 

to appropriate emergency funds for farmers in 1998 and 

1999 suggests that lawmakers continue to be willing to 

support the agricultural sector during periods of stress. 

At the USDA’s annual Agricultural Outlook Forum in 

February 2000, U.S. Secretary of Agriculture Dan 

Glickman suggested that the farm bill to be debated in 

2002 should continue income support for farmers and 

broaden the federal government’s role in agriculture. In 

particular, Secretary Glickman suggested that farm policy should be (1) directed toward supporting the 

incomes of farmers most in need rather than the producers of particular crops; (2) broadened to include 

farmers outside the traditional agricultural states; and 

(3) integrated with rural development policy to the benefit of all rural citizens. 

The future of farm policy remains uncertain, and the 

Strong Stable Weak Severe 

Financial Condition of 1,076 Iowa Farms Studied 

Source: Iowa State University 

Farm Conditions in Iowa Are Expected to 

Deteriorate if Low Prices Persist through 2001 Percentage of Total Farms 

1997 Condition 

2001 (Forecast) 

1998–2000 (Forecast) 

0 

10 

20 

30 

40 

50 

60 

next two years undoubtedly will be critical in determining the government’s strategy for supporting this sector. 

Reported Farm Bank Results Remain Positive 

In the aggregate, as of year-end 1999, the Region’s 

1,279 farm banks1 continued to report sound conditions. 

Earnings remained strong, as seen by the aggregate 1.18 

percent return on assets (ROA) ratio, contributing to 

adequate reported capital levels. Record government 

1 Farm banks are defined by the FDIC as insured financial institutions 

with farm loans and loans secured by farm real estate totaling at least 

25 percent of total loans. 

Kansas City Regional Outlook 5 Second Quarter 2000 
Regional Perspectives
 

payments to farmers partially offset the impact of low 

commodity prices in 1999, resulting in moderate levels 

of problem loans and reserve levels sufficient to provide 

a cushion against potential loan problems. Funding is a 

concern as farm banks continue to have difficulty 

increasing core deposits and are turning instead to noncore funds to support asset growth. Noncore funds, such 

as large time deposits, Federal Home Loan Bank borrowings, and brokered deposits, typically are more 

expensive and volatile than core deposits. As a result, 

increased interest expenses, coupled with more intense 

competition for loans, have put moderate pressure on 

net interest margins. Farm banks in the Region reported 

an aggregate net interest margin of 4.09 percent in 

1999, down from 4.15 percent in 1998 and 4.25 percent 

in 1997. 

In addition, though aggregate past-due loan ratios 

remain moderate, stress in the farm lending industry 

can be seen in increased carryover debt at farm banks. 

Typically, farm sector problems do not adversely affect 

loan portfolios for two to three years because unpaid 

operating loans are carried over into the next operating 

cycle. For example, farm banks’ reported conditions in 

the 1980s did not deteriorate significantly until 1984, 

Another area of concern is farm banks’ increasing loanto-asset (LTA) ratio. Farm banks in the Region reported 

an aggregate LTA ratio of 61.6 percent at year-end 

1999, up from 60.1 percent a year before and significantly higher than the 46.3 percent ratio reported at 

year-end 1989. Kansas City Regional Outlook (third 

quarter 1999) reported that a bank’s LTA ratio was the 

most significant indicator of bank failure during the 

farm crisis of the 1980s. Loans typically carry more risk 

than other bank investments. Management that opted to 

increase loan volumes in the 1980s may have had a 

higher tolerance for risk and, as a result, relaxed underwriting standards. Current high LTA ratio levels, if considered alone, are not necessarily cause for concern. 

However, if accompanied by lax underwriting practices 

or a higher-than-average tolerance for risk, these higher 

levels could become more problematic. 

CHART 4 

Carryover Debt Levels Are Increasing 

at FDIC-Supervised Farm Banks 

Percentage of Institutions Examined
 

in the Past Six Months Showing
 50
 

three years into the farm crisis. Historically, in pro- 40 

longed crises, increases in carryover debt foreshadowed 

increases in delinquent loans and charge-offs. FDIC 

examiners evaluate farm banks’ carryover debt levels, 

and as part of an underwriting survey completed at the 

Percent 

30 

20 

10 

end of each exam, examiners indicate whether they have 

identified an increase in carryover debt compared with 0 

March Sept. March Sept. the previous examination. As Chart 4 illustrates, exam­ 1998 1998 1999 1999 

iners are reporting higher carryover debt levels at many Source: FDIC farm banks nationally. 

an Increase in Carryover Debt 

The St. Louis Office Market Is Heating Up 

Economic prosperity is boosting real estate activity in market, characterized by rising rental rates and increasthe St. Louis metropolitan real estate markets. Benefi- ing property values, the potential for overbuilding 

ciaries include the suburban submarkets as well as the exists. For example, office construction vacancies 

much-beleaguered downtown submarket. At a local climbed from 8.8 percent at the end of 1998, the lowest 

level, factors such as the city’s relatively low cost of liv- level in more than a decade, to 12.1 percent at June 30, 

ing, low unemployment level, and a diversifying indus- 1999. This article analyzes the potential for overbuildtrial base are fueling real estate activity. Commercial ing in the St. Louis office market and the possible 

construction starts in 1998 reached a peak for the effects on commercial banks operating in the metropoldecade, and residential building permits are not expect- itan area. 

ed to slow. However, even during a robust real estate 

Kansas City Regional Outlook 6 Second Quarter 2000 
Regional Perspectives
 

Vacancy Rates 

Office vacancy rates jumped during the first half of 

1999, prompting concern about whether this increase is 

a temporary distortion or the beginning of a long-run 

buildup in surplus office space. Since 1989, St. Louis’s 

office vacancy rate fell gradually from near 18 percent 

to below 10 percent in 1997 and 1998 (see Chart 5). 

Despite double-digit vacancies, the city’s office vacancy rate was at or below the national average for most of 

the 1990s. The building boom of the 1980s created surplus office space and low rental rates, keeping new construction at low levels during the first half of the 1990s. 

Vacancy rates not only represent normal turnover of 

rentable space, but can also reflect the existence of 

functionally obsolete and therefore difficult-to-rent 

office space. Nearly 61 percent of the office space in St. 

Louis is class B and class C space, compared with only 

46 percent nationally.2 Many of these buildings, especially in the downtown submarket, are old and obsolete, 

resulting in declining or depressed rental rates. Many of 

today’s office users demand sophisticated lighting, 

wiring, and environmental standards to accommodate 

computer and communications technology, much of 

which is beyond the capacity of older office space. The 

costs to update and equip older office buildings to 

match the needs of present-day office users are often 

prohibitive compared with the alternatives of more 

recently constructed office space. St. Louis has nearly 

1.8 million square feet (41 percent of all office vacanCHART 5 

cies) of vacant class B and class C space in the downtown submarket alone, the highest of all St. Louis submarkets. Typically, it takes years for the value of these 

older, vacant buildings to drop to a level low enough to 

justify renovation or conversion to a less intense use, 

such as residential space. 

As in other metropolitan areas, St. Louis’s class A office 

space shows lower vacancies than its class B and class 

C office space. In the past few years, however, the 

vacancy rate spread between classes has declined. At 

the end of 1997, 5.4 percent of class A space and 12.1 

percent of class B and class C space were vacant. As of 

June 1999, these percentages rose to 9.4 percent and 

13.8 percent, respectively. 

Compared with the high office vacancy rates in the 

1980s, St. Louis’s average 12.1 percent rate is not yet 

high enough to cause investor concern, even though it is 

higher than the 9.5 percent national average. Some analysts suggest that the large volume of class B and class 

C space in the downtown area actually masks the 

strength of the St. Louis office market.3 What may be of 

concern, however, is the concentration of vacant class B 

and class C office space within the downtown submarket. The vacancy rate in downtown St. Louis averages 

17.0 percent, while the vacancy rate in the suburbs averages 9.4 percent. Renewed interest and investment in 

revitalizing downtown St. Louis may have unanticipated effects on other submarkets. To better understand the 

direction of the St. Louis office market and to help 

An Abundance of New Office Space Is Driving Up Vacancy Rates in the St. Louis MSA 

2,500 

2,000 

1,500 

1,000 

500 

0 

Vacancy Rate (right scale) Construction Starts (left scale) 20

Square Feet (000s)

Note: MSA = metropolitan statistical area 

Source: CB Commercial/Torto Wheaton Research 

2 Torto Wheaton Research. Fall 1999. Office Outlook. 

New Completions (left scale) 

’90 ’91 ’92 ’93 ’94 

15 

10 

5 

0 

Percent 

’95 ’96 ’97 ’98 ’99 

3 National Real Estate Index, Third Quarter 1999, Metro Market Facts 

states that nearly 720,000 square feet is vacant in the class C inventory in the downtown and northwest county submarkets. This space 

accounts for 25 percent of the metropolitan area’s total vacancy. 

Kansas City Regional Outlook 7 Second Quarter 2000 
Regional Perspectives
 

answer the question of whether it may be at risk from 

overbuilding, it is necessary to examine the factors that 

affect office space demand and supply. 

Population and Employment Flows 

Influence Office Demand 

Taken together, it does not appear that population and 

employment flows will be able to sustain an increase in 

office demand during the next few years. Without some 

indication that office demand is trending upward, or at 

least approximating the national average, any significant surplus in office space will not likely be absorbed 

quickly, which could place downward pressure on rents 

and asset values. 

Population Flows 

As in the majority of other metropolitan statistical areas 

(MSAs), St. Louis’s population has flowed away from 

the central city and into the suburbs since the 1950s (see 

Table 2). But the degree to which St. Louis City has lost 

population has had a profound effect on economic 

TABLE 2 

growth and real estate development in the metropolitan 

area. 

Older industrial central cities, such as those in St. Louis 

(referred to as St. Louis City), Cleveland, and Detroit, 

lost about half their populations between 1950 and 

1990. The magnitude of St. Louis City’s continuing 

population decline, however, is legendary among U.S. 

cities. Between 1950 and 1998, St. Louis City lost more 

than one-half million residents, or 60 percent of its population. Compared with other central cities in the 

nation, this is the highest percentage of population 

decline. During the 1990s alone, St. Louis City lost 

nearly 15 percent of its population. Table 2 shows the 

changes in population over time in St. Louis City and 

the effect on the larger metropolitan area’s population 

growth. It also shows that St. Louis City’s political 

boundary remained fixed at a relatively small size. St. 

Louis’s current boundaries were established in 1876, 

when voters approved separating the city from St. Louis 

County. As noted in one history of the city, “Since the 

charter set the city-county boundary permanently, the 

city cannot annex new territory. While other cities can 

expand their territorial reach to include new and future 

The Region’s Major Metropolitan Areas Have Grown despite Central City 

Population Declines 

1950 1960 1970 1980 1990 1998 

ST. LOUIS 

CITY POPULATION (000S) 857 750 622 453 397 339 

MSA POPULATION (000S) 1,681 2,060 2,456 2,417 2,496 2,564 

CITY/MSA POPULATION RATIO 51.0 36.4 25.3 18.7 15.9 13.2 

CITY LAND AREA (SQ. MI.) 61 61 61 61 62 N/A 

MINNEAPOLIS/ST. PAUL 

CITY POPULATION (000S) 833 796 744 641 641 609 

MSA POPULATION (000S) 1,117 1,482 2,026 2,208 2,548 2,831 

CITY/MSA POPULATION RATIO 74.6 53.7 36.7 29.0 25.2 21.5 

CITY LAND AREA (SQ. MI.) 106 109 107 108 108 N/A 

KANSAS CITY, KS/MO 

CITY POPULATION (000S) 586 597 675 609 587 583 

MSA POPULATION (000S) 814 1,039 0,385 1,452 1,587 1,737 

CITY/MSA POPULATION RATIO 72.0 57.5 48.7 41.9 37.0 33.6 

CITY LAND AREA (SQ. MI.) 99 170 373 424 419 N/A 

Note: MSA = metropolitan statistical area 

N/A = not available 

Source: U.S. Census 

Kansas City Regional Outlook 8 Second Quarter 2000 
Regional Perspectives
 

industrial parks, housing developments, retail centers, 

and manufacturing interests, St. Louis cannot. It must 

attract those tax-paying entities back to the city, reversing local and national trends.”4 After World War II, central city residents and companies left the crowded living 

and working conditions for the less dense suburbs. As a 

result, St. Louis City’s average population per square 

mile dropped from more than 14,000 in 1950 to about 

5,400 in 1998. Other cities—such as Minneapolis and 

St. Paul, Minnesota; Kansas City, Kansas; and 

Kansas City, Missouri—also experienced population 

density declines over the same time. However, each 

city’s political boundary was large or flexible enough to 

allow it to retain much of the population outflow. 

St. Louis City’s population decline and the resulting 

metropolitan area’s slow population growth place this 

MSA at a competitive disadvantage with other MSAs, 

which are competing for consumers and businesses. For 

example, from 1990 to 1998, the St. Louis MSA grew 

by 2.9 percent, far below the national average growth 

rate of 8.7 percent. Its population growth rate also lags 

the Region’s other large MSAs, Kansas City and Minneapolis, which grew 9.7 and 11.5 percent, respectively. 

Despite significant population declines in St. Louis 

City, the MSA grew.5 The severity of population losses 

in St. Louis City disguises the strength of its suburban 

markets, which is important because most new office 

development has taken place in the suburban submarkets. Population gains in the areas outside St. Louis City 

have increased demand for new office development in 

those areas, but they do not justify a large surplus of 

office space. 

Employment Flows 

Along with population flows, employment flows also 

help determine office demand. The trend in St. Louis’s 

employment growth does not suggest that local office 

employment growth will equal or exceed the national 

growth rate over the next few years. Slow population 

growth has prompted some analysts to predict slower 

employment growth for the St. Louis MSA over the 

near term. 

The St. Louis labor market displays a number of positive 

characteristics: unemployment is low, employment is 

4 The Relationship between People and Government. St. Louis Historic Context: People and Government. http://stlouis.missouri.org/ 

government/heritage/history/popgov.htm 

5 Rybczynski, Witold, and Peter D. Linneman. Spring 1999. How to 

Save Our Shrinking Cities. Public Interest. 

diversified across a number of industries, and high-technology employment as a percentage of total employment 

ranks respectably among the top metropolitan areas. 

Despite these generally positive signs, overall job formation in St. Louis is slow relative to the rest of the 

nation, restraining potential economic growth. From 

1990 to 1998, overall employment growth was 11.2 percent for St. Louis and 18.0 percent for the nation. 

One way to measure the demand for office space is to 

assess the growth in office employment, a subset of 

total employment growth.6 Except for 1991, St. Louis’s 

office employment growth has been positive during the 

past 20 years. Office employment growth in the 1990s 

slowed since the previous decade. Chart 6 (next page) 

shows that the city’s office employment growth during 

the 1990s tracked the national average until 1997, when 

it dropped below the national average. These trends suggest that St. Louis is unable to support a surplus in 

office space that exceeds the national average. 

Slowing office employment has driven down absorption, which is the net change in physically occupied 

space. Holding other factors constant, such as the 

amount of office space per worker, if office demand is 

heating up, then net office absorption should also be 

increasing. Chart 6 shows the relationship between the 

nation’s and St. Louis’s office employment growth and 

net office absorption. This chart shows that net office 

absorption appears to lag office employment growth by 

about a year. The trend in net office absorption is down, 

except for 1997. Average net office absorption dropped 

from over 1.1 million square feet annually during the 

1980s to about 0.6 million square feet during the 1990s. 

More recently, net office absorption appears to be dropping as office space supply grows more rapidly. 

The Office Supply Cycle 

Notwithstanding the importance of office demand factors, the office cycle is thought to be more closely tied 

to its own supply cycle than to market demand.7 This 

contrasts with the supply of other types of real estate, 

such as retail space, which is more closely tied to market demand generated by the general economy. The 

major risk with regard to office property investment is 

6 DiPasquale and Wheaton. 1996. Urban Economics and Real Estate 

Markets, Englewood Cliffs, N.J., Prentice Hall, Inc., 270: “Over the 

long term, the growth of office space seems to match reasonably 

closely with the growth of office employment.” 

7 Torto Wheaton Research. Real Estate Cycles & Outlook 1999, 2. 

Kansas City Regional Outlook 9 Second Quarter 2000 
Regional Perspectives
 

CHART 6 Square Feet (000s) 

St. Louis Low Office Employment Growth Has Caused Absorption to Slow 

St. Louis Net Office 

Absorption (left scale) 

National Office 

Employment Growth 

(right scale) 

St. Louis Office 

Employment Growth 

(right scale) 

Percent 

(through 

6/99) 

–200 

0 

200 

400 

600 

800 

1,000 

1,200 

1,400 

1,600 

1,800 

’93 ’94 ’95 ’96 ’97 ’98 ’99 

–5 

0 

5 

10 

15 

20 

’90 ’91 ’92 

Source: CB Commercial/Torto Wheaton Research 

the tendency for periodic “boom-to-bust” cycles that are 

unrelated to general economic demand factors. The St. 

Louis office market seems to be going through such a 

period of overbuilding. 

Developers of office space project market demand 

using current and estimated information, but these projections are far from perfect. It is difficult, if not impossible, to know with any degree of accuracy where rental 

rates, interest rate levels, or attractive submarkets will 

be in two years. It could take this long to plan and complete an office building—and several newly planned 

projects could be competing for expected future office 

demand. Consequently, this competitive pressure to 

build may result in an oversupply. 

St. Louis office rental rates increased steadily during 

the 1990s, prompting developers to build and plan additional office space. Office construction starts trended 

upward during the second half of the 1990s, averaging 

nearly 1.3 million square feet annually, compared with 

about 0.8 million square feet during the first half of the 

decade (see Chart 6). In contrast, the net amount of 

physical office space being absorbed was greater in the 

first half of the 1990s and has declined in the second 

half of the decade. Net office absorption averaged nearly 0.8 million square feet during the first half of the 

decade and approximately 0.5 million square feet during the second half. Torto Wheaton Research estimates 

that new office completions will total 1.8 million square 

feet for 1999 and 2000 combined, far above the amount 

that net office absorption appears to be able to support. 

The net effect is that developers are constructing more 

office space than can be absorbed in the short run, 

resulting in a rising vacancy rate. 

In addition to office construction starts, other indicators 

point to an increase in future office supply. For example, office construction projects in the early planning 

stage have grown significantly since 1995.8 Anecdotal 

evidence also suggests that aggressive community revitalization efforts are encouraging the rebuilding of public infrastructure and the renovation of office space.9 

Overbuilding could result from the rush to capitalize 

on rising rents. The expected increase in new completions, coupled with a significant amount of planned 

activity and slowing office demand, may result in an 

oversupply of office space. Office construction is now 

most robust in suburban submarkets, particularly in 

west, northwest, and mid-county. However, planned 

office construction includes significant amounts of 

office space downtown and in the suburbs, and the 

rationalization for this is not immediately apparent. 

Population flows would seem to justify new office 

development in the suburbs, rather than downtown, 

where population declines continue. Employment 

flows may warrant some amount of new office development, but perhaps not enough to sustain the present 

amount of planned office projects for the MSA. 

8 FDIC Real Estate Report. Various issues. 9 The Downtown Now! Action Plan identifies four focus areas for 

revitalization and includes a program for each area. The plan calls for 

almost 2,700 new housing units; nearly 2 million square feet of 

office, retail, and other nonresidential space; a major new cultural 

facility; a pedestrian promenade between the Arch and the Old Courthouse; and nearly 6,000 new parking spaces. 

Kansas City Regional Outlook 10 Second Quarter 2000 
Regional Perspectives
 

Will the St. Louis Office Market 

Become Overbuilt? 

Developers sometimes overshoot expected office 

demand, and our analysis suggests that the St. Louis 

office market is in such a period of overbuilding. The 

extent to which the St. Louis office market may become 

overbuilt is of concern to commercial bankers and other 

real estate creditors. 

Torto Wheaton Research predicts that, along with a rise 

in vacancy rates, rents will peak during 1999 and begin 

a long period of decline as newly completed office 

space comes on line. As evidence of the boom-to-bust 

phenomenon, Torto Wheaton also predicts that vacancy 

rates will rise to 18 percent by 2002. A glut of office 

space can produce unanticipated competitive effects in 

a metropolitan area. For example, newly completed 

downtown office space will directly compete with suburban office space. The result might be a shift in vacancy rates between submarkets. Torto Wheaton expects 

office vacancies downtown and in the suburbs to converge in the double-digit range, which is a significant 

change from the present. 

The consensus among a sample of other real estate analysts is that the St. Louis office vacancy rate will rise 

over the next year, but these analysts stop short of forecasting an 18 percent office vacancy.10 

Implications for Commercial Banks 

How could rising vacancies affect the credit risk levels 

of commercial banks11 headquartered in St. Louis? 

Although office building loans are not reported separately from other commercial real estate loans, we can 

10 ReiSource America expects vacancies to climb to near 12 percent 

by the end of 2000. According to this group’s analysis, slow population growth may actually prevent the office market from overheating. 

Landauer Real Estate Counselors forecasts a generally positive nearterm outlook for the St. Louis office market. Landauer expects 

absorption, construction, and vacancies to increase between 1 and 5 

percent, while rents should remain stable. 

11 Commercial banks holding less than $1 billion in assets as of 

December 31, 1999, and headquartered in the 11-county metropolitan 

statistical area (MSA). The MSA’s Missouri counties include 

Franklin, Jefferson, Lincoln, St. Charles, St. Louis, and Warren, and 

the city of St. Louis. The MSA’s Illinois counties include Clinton, Jersey, Madison, Monroe, and St. Clair. The asset level of $1 billion 

ensures that a significant proportion of each institution’s business was 

conducted in the MSA. 

look at the growth in nonresidential real estate loans to 

determine potential areas of credit risk. For our analysis, the Kansas City and Minneapolis MSAs serve as 

benchmark comparisons. 

Table 3 shows a snapshot of real estate loan composition at banks in the St. Louis, Minneapolis, and Kansas 

City metropolitan areas at December 31, 1999. Nearly 

three-fourths of total loans at St. Louis’s commercial 

banks were secured by real estate, compared with about 

one-half of total loans for banks in Kansas City and 

Minneapolis. The same trend holds true for nonresidential real estate loans as a percentage of total loans. 

Chart 7 (next page) displays the relationship over time 

of commercial real estate loans to total assets for commercial banks in the three metropolitan areas. As the 

chart shows, commercial banks in St. Louis have 

increased holdings of commercial real estate loans to a 

greater degree than have banks in the comparison 

MSAs. Since many commercial banks make loans 

secured by office buildings, this exposure could be 

problematic should overbuilding occur in this sector. 

The implications of an overbuilt office market to community banks are clear. Higher office vacancies could 

result in projects that generate less net operating 

income, which translates into less cash available to service debt. In addition, expectations of slower rental rate 

TABLE 3 

St. Louis Commercial Banks Hold 

Large Portfolios of Commercial Real 

Estate Loans 

% OF TOTAL LOANS
 

AS OF
 

DECEMBER 31, 1999
 

ST. MINNE- KANSAS 

LOUIS APOLIS CITY 

ALL REAL ESTATE LOANS: 72.1 55.7 54.1 

COMMERCIAL REAL
 

ESTATE
 36.5 30.8 33.3 

MULTIFAMILY RESIDENTIAL 2.8 1.7 1.9 

1-4-FAMILY RESIDENTIAL 28.3 18.1 15.7 

HOME EQUITY LOANS 2.8 3.9 1.6 

FARM LOANS 1.7 1.1 1.6 

Note: Commercial real estate loans include construction loans and loans secured by nonresidential real 

estate. 

Source: Bank Call Reports (Commercial Banks under 

$1 Billion in Assets as of December 31, 1999) 

Kansas City Regional Outlook 11 Second Quarter 2000 
Regional Perspectives
 

CHART 7 increases or declining rents will depress the market 

Banks Headquartered in St. Louis Hold a High 

and Increasing Share of Commercial 

Real Estate (CRE) Loans 

value of office buildings that serve as collateral. Importantly, because of lending limitations, smaller commercial banks are more likely to fund class B and class C 

buildings, and these types of properties appear to be 

experiencing the greatest competitive pressure. 30% 

20% 

10% 

Minneapolis MSA 

St. Louis MSA Kansas City MSA 

CRE Loans/Total Assets 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

Note: MSA = metropolitan statistical area
 

Source: Call Reports (Commercial Banks under $1 Billion in the St. Louis,
 

Minneapolis, and Kansas City MSAs)
 Troy D. Osborne, Financial Analyst 

Jeffrey W. Walser, Regional Economist 

Kansas City Regional Outlook 12 Second Quarter 2000 
In Focus This Quarter
 

Banking Risk in the New Economy
 

The Division of Insurance periodically assesses conditions in the economy and the banking industry to identify and evaluate trends that could adversely affect the 

performance of insured depository institutions. At this 

time, the banking industry as a whole continues to 

enjoy record profits and solid financial ratios.1 Much of 

the industry’s strength derives from the remarkable performance of the U.S. economy, which has been expanding for the past nine years. This article explores factors 

that have shaped this unusually robust economic environment and discusses how changes in the economy 

may create new types of risks for insured depository 

institutions. 

During 1999, the FDIC reported the first annual loss for 

the Bank Insurance Fund since 1991. This loss primarily resulted from an uptick in unanticipated and highcost bank failures. Some of these failures were 

associated with high-risk activities such as subprime 

lending, and some were related to operational weaknesses and fraud. The emergence of these problems in 

the midst of a strong economic environment raises concerns about how the condition of the banking industry 

might change if economic conditions deteriorate. 

The Longest U.S. Expansion 

In February 2000, the U.S. economy entered its 108th 

month of expansion, making this the longest period of 

uninterrupted growth in U.S. history.2 This recordsetting performance has also been marked by a recent 

acceleration in the rate of real gross domestic product 

(GDP) growth, which has exceeded 4 percent in each 

year since 1997. Meanwhile, price inflation has 

remained relatively subdued. The core inflation rate, 

which excludes the volatile food and energy components, was just 2.1 percent in 1999, the lowest core rate 

since 1965. 

Recent economic conditions have been highly conducive to strong loan growth, low credit losses, and 

record earnings for the banking industry. The important 

1 For a recent summary of financial performance and condition of the 

banking and thrift industries, see the FDIC Quarterly Banking Profile, fourth quarter 1999, http://www2.fdic.gov/qbp/. 2 The chronology of U.S. business cycles is available from the National Bureau of Economic Research, http://www.nber.org/cycles.html. 

question going forward is how long these favorable conditions might last. Is this remarkable economic performance the result of some long-term upward shift in the 

pace of economic activity, or is it the temporary result 

of a few transitory factors? More important, are there 

new and unfamiliar dangers that, at some point, could 

significantly impair banking industry performance? To 

evaluate these questions, we must assess the factors that 

have contributed to recent economic performance and 

think ahead to possible developments that could end this 

expansion. 

What Is the New Economy? 

The term used most often to describe the recent period 

of economic performance has been somewhat controversial: the New Economy. Much of the controversy has 

arisen because people interpret the term in different 

ways. Wall Street analysts use the term to refer to the 

high-technology sectors of the economy, such as computers and software, biotechnology, and especially the 

Internet. Some of these New 

Economy firms have been able to 

raise large amounts of capital and 

command market valuations in 

the tens of billions of dollars well 

in advance of earning a profit or 

even booking significant cash 

revenues. 

Economists tend to employ the term New Economy in a 

slightly different way. To them, it refers to evidence that 

some of the traditional economic relationships have 

changed. For example, intangible assets now appear to 

play a much larger role in the valuation of investments 

than they have in the past.3 Firms in some industries 

now may exhibit increasing returns to scale (rather than 

diminishing returns), reflecting the fact that the value of 

their product rises as it becomes a de facto industry 

standard.4 Individual decision making, too, may be 

changing. Some believe that investors have reduced the 

risk premium they demand to hold equity positions 

3 Nakamura, Leonard. Federal Reserve Bank of Philadelphia. 

July/August 1999. Intangibles: What Put the New in the New Economy? Business Review. http://www.phil.frb.org/files/br/brja99ln.pdf. 4 Brown, William S. March 2000. Market Failure in the New Economy. Journal of Economic Issues, 219–27. 

Kansas City Regional Outlook 13 Second Quarter 2000 
In Focus This Quarter
 

because of their perception that holding equity is not, 

after all, substantially riskier than holding debt.5 Such a 

shift in investor attitudes could help explain why the 

price-to-earnings ratio for the S&P 500 index has 

recently approached all-time highs.6 

Perhaps the most important underlying change in the 

economy is the relationship between high rates of economic growth and changes in inflation. Economists have 

long maintained that rapid growth in economic activity 

has a tendency to lead to excess demand for goods (thereby raising consumer and producer prices) and excess 

demand for labor (thereby raising wage rates). But during 

the late 1990s, as growth accelerated and inflation 

remained low, economists began to reevaluate their 

notions of these trade-offs. Some argued that the low rate 

of inflation during this expansion was the fortunate result 

of temporary factors, such as a strong dollar and low 

energy prices, both of which could diminish or reverse 

direction over time.7 Only a few analysts were so bold as 

to suggest that the fundamental workings of the economy 

had changed in such a way as to allow a sustained period 

of high economic growth with low inflation. 

An early Wall Street description of the New Economy 

appeared in an article released by Goldman Sachs in 

January 1997.8 It describes a number of fundamental 

changes in the economy—driven by global competition 

and advancing technology—that may permit business 

cycle expansions to last longer than they have in the 

past. At the same time, it warned that longer economic 

expansions might have a tendency to contribute to 

greater financial excess and the possibility of more 

severe recessions and more sluggish recoveries. 

If this hypothesis is correct, and an emerging New 

Economy would contribute to longer expansions and 

more severe recessions, there may be implications for 

how banks manage risks. Since the Great Depression, 

U.S. business cycle recessions have not necessarily been 

catalysts for large numbers of bank and thrift failures. 

5 January 24, 2000. Has the Market Gone Mad? Fortune.
 6 September 1999. Earnings: Why They Matter. Money.
 7 Brown, Lynn Elaine. Federal Reserve Bank of New England.
 

May/June 1999. U.S. Economic Performance: Good Fortune, Bubble,
 

or New Era? New England Economic Review. http://www.bos.frb.org/
 

economic/pdf/neer399a.pdf, and Brinner, Roger E. Federal Reserve
 

Bank of New England. January/February 1999. Is Inflation Dead?
 

New England Economic Review. http://www.bos.frb.org/economic/
 

pdf/neer199c.pdf.
 

8 Dudley, William C., and Edward F. McKelvey. January 1997. The
 

Brave New Business Cycle: No Recession in Sight. U.S. Economic
 

Research, Goldman Sachs.
 

During the period from 1983 to 1989, when the U.S. 

economy was in the midst of a long expansion, some 

1,855 insured banks and thrifts failed. This wave of 

failures has been attributed to a variety of factors, 

including severe regional economic downturns, realestate-related problems, stress in the agricultural sector, 

an influx of newly chartered banks and banks that converted charters, and high nominal interest rates.9 However, the potential for significantly more severe national 

recessions would represent largely uncharted territory 

that could cause losses and loss correlations to depart 

from historical norms, posing a new set of risk management challenges for the industry going forward. 

The Productivity Revolution 

As the essential element that links faster economic 

growth and low inflation, productivity growth is the cornerstone of the New Economy. Productivity refers generally to the amount of output that can be obtained from 

a fixed amount of input. Labor productivity is usually 

measured in terms of output per hour. Chart 1 shows 

that output per hour in manufacturing has risen at an 

average annual rate of 4.5 percent during the current 

expansion, compared with rates of just over 2.5 percent 

in the three previous long economic expansions. Moreover, productivity growth accelerated in 1999 to a rate 

of 6.3 percent. Why is productivity growing so fast now 

compared with previous expansions? Even economists 

who believe that economic relationships have fundaCHART 1 

Productivity Has Grown at a Faster Rate in This 

Expansion than in Previous Long Expansions 

Average Year-over-Year Growth 

in Manufacturing Output per Hour 

5.0% 

4.0% 

3.0% 

2.0% 

1.0% 

0.0% 

1961–69 1975–79 1983–90 1991–2000 

Source: Bureau of Labor Statistics (Haver Analytics) 

9 FDIC Division of Research and Statistics. 1997. History of the 

Eighties: Lessons for the Future, Vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s, 16–17. http://www. 

fdic.gov/bank/historical/history/contents.html. 

Kansas City Regional Outlook 14 Second Quarter 2000 
In Focus This Quarter
 

mentally changed are hard-pressed to explain why all of 

the factors came together in the late 1990s and not 

before.10 Still, explanations for the increase in productivity tend to focus on three main factors. 

Increased Competition. Expanding global trade during 

the 1980s and 1990s has subjected U.S. firms to new 

competition from around the world. Annual U.S. 

exports of goods and services grew by over 230 percent 

(after inflation) between 1982 and 1999, while imports 

grew by 315 percent. The construction of new production facilities around the world in industries such as 

autos and chemicals has led to excess manufacturing 

capacity that has kept prices low. In other industries, 

including air travel, trucking, telecommunications, and 

banking, competition has been intensified through 

domestic deregulation. Facing intense competitive pressures and a low rate of general price inflation, firms 

cannot rely on annual price increases to help expand 

top-line revenue. Instead, there is pressure to continually cut costs in order to increase earnings. For many 

firms, this means adopting new technologies and new 

ways of organizing operations. 

Expanded Investment. U.S. firms of all sizes have 

invested in new technologies at a rapid pace during this 

expansion. Chart 2 shows that business investment in 

equipment and software represents almost one-quarter 

of total net GDP growth during this expansion, comCHART 2 

Business Investment in Equipment and Software
 

Has Been Robust during This Expansion
 

Average Percent Contribution of Real Investment 

in Durable Equipment and Software 

to Net GDP Growth by Expansion 

25 

20 

15 

10 

5 

0 

1961–69 1975–79 1983–90 1991–99 

Note: GDP = gross domestic product
 

Source: Bureau of Economic Analysis (Haver Analytics)
 

10 One possible explanation is that there is a learning curve for adopting new technologies and that technology diffusion is an inherently 

slow process. David, Paul A. Organization for Economic Cooperation 

and Development. 1991. Computer and Dynamo: The Modern Productivity Paradox in a Not-Too-Distant Mirror. In Technology and 

Productivity: The Challenge for Economic Policy, 315–47. 

pared with around 15 percent or less during previous 

long expansions. While this investment has been motivated by the need to cut costs, it has also been fueled by 

the availability of new computer technologies that have 

fallen in cost over time and by the ready availability of 

financial capital on favorable terms. 

Industrial Restructuring. The third aspect of the productivity revolution is large-scale restructuring in the 

U.S. corporate sector. Chart 3 shows that both the annual number and dollar volume of mergers in the late 

1990s far exceeded the pace of the so-called merger 

mania of the late 1980s. Two classes of firms are leading the new wave of mergers. First, companies in 

mature industries such as oil, autos, and banking are 

faced with excess productive capacity and intense price 

competition. For these firms, mergers are useful in 

expanding market share and removing redundant operations. Second, the largest dollar volume of mergers is in 

some of the most volatile emerging industries, including telecom, media, and the Internet. It is in these sectors of the economy, in particular, where the business 

models are evolving rapidly and where technological 

standards are still being determined. Firms in these 

industries that can grow rapidly through mergers have 

the chance to achieve long-term market dominance in 

what appear to be some of the fastest growing industries 

of the new century. 

The implications of the productivity revolution for the 

banking industry have been decidedly positive. Higher 

productivity has allowed a long expansion and faster 

economic growth with low inflation, all of which are 

conducive to robust financial performance by depository institutions. Higher rates of business investment 

CHART 3 

Note: M&A = merger and acquisition 

Source: Houlihan Lokey’s Mergerstat 

The Volume of Corporate Mergers Set 

Another New Record in 1999 

Number of M&A Deals M&A Deal Value, Billions of Dollars 

’70 ’72 ’74’76’78’80 ’82 ’84’86 ’88 ’90’92’94’96 ’98 

0 

2,000 

4,000 

6,000 

8,000 

10,000 

1,000 

1,200 

1,400 

1,600 

0 

200 

400 

600 

800 

Kansas City Regional Outlook 15 Second Quarter 2000 
In Focus This Quarter
 

have generated demand for credit that is supplied, in 

part, by banks and thrifts. Perhaps most important, the 

recent large-scale industrial restructuring has been 

highly supportive of strong business credit quality. This 

process has moved economic resources to more productive uses in an orderly fashion, without the high levels 

of bankruptcies and defaults that often accompany 

industrial restructuring. Given the volumes of corporate 

assets that have changed hands in recent years (more 

than $1.4 trillion in 1999 alone), it is fortunate indeed 

that this restructuring has proceeded in this fashion. 

The Role of the Capital Markets 

A critical factor in heightened business investment and 

restructuring during this expansion has been the 

remarkably favorable conditions in the financial markets. Financial capital has generally been readily available to business borrowers, usually on favorable terms. 

One factor that has held down the cost of capital for 

publicly traded corporations has been sharply rising 

stock prices. Many of these firms have been able to use 

equity shares as a currency with which to finance mergers. Furthermore, existing accounting rules do not 

always require the amortization of good will that comes 

onto the balance sheet as a result of a merger.11 

By far the largest amount of external business financing 

has been debt financing. U.S. nonfinancial corporations 

issued net debt in the amount of $535 billion in 1999 

and repurchased equity shares, on net, for the sixth consecutive year. Businesses have used this debt to purchase capital equipment, finance mergers, and buy back 

equity shares. This increase in debt issuance has not 

been limited to highly rated corporations. Venture capital financing amounted to almost $15 billion in the 

fourth quarter of 1999 alone, with over 60 percent of 

that amount going to Internet firms.12 

Banks have been active participants in nearly every 

facet of this financing activity. Syndicated loan origination volumes rose by 17 percent in 1999 to just over 

$1 trillion, despite relatively high credit costs and facility fees, factors that helped keep total volume below 

1997’s record $1.1 trillion in issuance. Syndicated loans 

to leveraged companies also rose 17 percent in 1999 to 

a record $320 billion. More impressive still was the 

growth in high-yield transactions, which rose nearly 50 

11 April 17, 2000. Techdom’s New Bean-Counting Battle. Business 

Week. 

12 May 2000. Venture financing data are derived from a PriceWaterhouseCoopers/Money Tree survey, as cited in Upside, 43. 

percent in 1999 to $190 billion. It is difficult to determine precisely how much syndicated loan exposure 

resides on the books of insured institutions or, more 

important, how much high-yield exposure is retained by 

commercial banks. Loan Pricing Corporation estimates that 64 percent of high-yield volume in the first 

half of 1999 was retained by banks.13 Insured commercial banks are the dominant originators of syndicated 

loans, with a 79 percent market share of investmentgrade originations and a 56 percent market share of 

non-investment-grade originations in 1999. Commercial banks have also expanded their presence in the venture capital market. For some of the largest banks, 

profits from venture capital operations account for a 

large portion of total earnings. Chase Manhattan reported venture capital investment earnings of $2.3 billion in 

1999, accounting for 22 percent of total net income.14 

Innovation in the capital markets continues to provide 

new and more efficient vehicles for business financing. 

For example, issuance of asset-backed securities totaled 

$346 billion in 1999, up from only $50 billion in 1990. 

In this ongoing revolution in finance, market-based 

intermediaries, such as mutual funds and asset pools, 

have assumed an increasing role in the credit markets. 

Chart 4 shows that net holdings of credit market instruments by mutual funds, government-sponsored enterprises, and asset pools exceeded the debt held by 

depository institutions for the first time in 1997. 

CHART 4 

Market-based Lending Is Becoming More 

Important as a Source of Business Financing 

Share of Total Net 

Credit Market Lending1 

70% 

60% 

50% 

40% 

30% 

20% 

10% 

0% 

Market-based Lenders3 

Depository Institutions2 

’60 ’63 ’66 ’69 ’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 ’99 

1 Total net credit market lending is defined as net holdings of open-market paper,
 

government and municipal securities, corporate and foreign bonds, mortgages,
 

and other loans.
 

2 Depository institutions include commercial banks, savings institutions, and credit
 

unions.
 

3 Market-based lenders include mutual funds, closed-end funds, government-


sponsored enterprises, and asset pools.
 

Sources: Federal Reserve Board (Haver Analytics); Regional Financial Associates
 

13 September 13, 1999. Junk Loan Market Is Feeling the Pinch of 

Oversupply and Rising Interest Rates. The Wall Street Journal. 14 April 3, 2000.What’s Really Driving Banks’ Profits. Business Week. 

Kansas City Regional Outlook 16 Second Quarter 2000 
In Focus This Quarter
 

While the expansion in market-based financing has 

made credit more available to business and consumer 

borrowers, it also creates some concerns. One issue is 

the susceptibility of the financial markets to periodic 

bouts of turmoil. These episodes, such as the one triggered by the Russian government bond default and the 

near-failure of the Long Term Capital Management 

hedge fund in the fall of 1998, can result in the interruption of capital flows even to creditworthy borrowers. 

During the 1998 episode, private yield spreads widened 

sharply as investors sought the safety of U.S. Treasury 

securities. Some companies that had planned to issue 

debt to the markets during that period were unable to do 

so. For companies whose business models depend heavily on a continuous supply of liquidity from the financial markets, the effects of these episodes can be 

catastrophic. For example, the relatively short-lived 

episode of financial turmoil during late 1998 resulted in 

significant liquidity problems for a number of commercial mortgage firms. Nomura, Lehman Brothers, CS 

First Boston, and others incurred losses, while Criimi 

Mae, Inc., was forced to declare bankruptcy. 

Because market-based financing has played such a large 

role in facilitating the orderly restructuring of the U.S. 

economy through mergers and the formation of new 

businesses, a recurrence of financial market turmoil 

could contribute to the end of the current expansion. 

Moreover, such an event could have serious consequences for business credit quality. A prolonged interruption of market-based financing could, in this very 

competitive economic environment, prevent businesses 

from restructuring themselves through mergers and 

deprive them of capital needed to invest in cost-cutting 

technologies. The loss of financial flexibility would 

leave businesses much more vulnerable to the effects of 

CHART 5 

competition and could result in more firms seeking 

bankruptcy protection. Such a scenario has the potential 

to bring about a significant increase in charge-off rates 

for business lenders. 

Financial Imbalances 

Another concern that arises from increased dependence 

on market-based financing is that it may contribute to 

the emergence of financial imbalances in the economy. 

These imbalances could, in turn, increase the potential 

for financial market turmoil as a result of some unforeseen shock to the markets. 

As recently as 1993, the public deficit was near the top 

of the list of economists’ concerns about the U.S. economy. During that year, the combined deficit of the federal, state, and local government sectors exceeded $300 

billion. However, on the strength of a long economic 

expansion, lower interest rates, and lower federal spending on defense, the consolidated government sector 

posted its second consecutive surplus in 1999 (Chart 5). 

As the government has moved from deficit to surplus, 

households and businesses have continued to borrow 

hundreds of billions of dollars every year. Taken together, the annual net borrowing of businesses and households has been referred to as the “private deficit.” In 

1999, the private deficit narrowed to $913 billion from 

a record $1.02 trillion the year before. Although this private borrowing indicates confidence on the part of consumers and businesses about future prospects, it also 

raises concerns about the ability to service debt if interest costs rise or if incomes level off or decline. 

Kansas City Regional Outlook 17 Second Quarter 2000 

Flow of Net Sectoral Lending 

(Lending Less Borrowing), 

in Billions of Dollars Domestic Financial Sector 

Note: “Nonfinancial business” includes farm and nonfarm, corporate and noncorporate businesses. 

Source: Federal Reserve Board (Haver Analytics) 

Net Borrowing by Businesses and Households Represents a Growing “Private Deficit” 

–1,200 

–900 

–600 

–300 

0 

300 

600 

900 

1,200 

Foreign Sector 

Nonfinancial Business 

Households 

Government 

’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 
In Focus This Quarter
 

The largest part of the private deficit was again 

financed in 1999 by domestic financial institutions 

($649 billion) and an inflow of capital from abroad 

($207 billion). Both of these sources of financing are 

potential causes for concern. The rapid expansion in 

credit created by the financial sector raises questions 

about credit quality. Financial institutions theoretically 

serve as the gatekeepers of the economy, financing only 

the most creditworthy projects and rejecting those that 

are not viable. The sheer volume of credit extended to 

businesses and households—almost $1.4 trillion in new 

net lending over the past two years—raises the possibility that underwriting has become more lax and that 

average credit quality is slipping. (See the inset box on 

page 17 for a discussion of recent trends in commercial 

credit quality.) 

Reliance on inflows of foreign capital raises a different 

set of issues. The fact that the U.S. economy has been 

growing significantly faster than the economies of its 

major trading partners has contributed to a U.S. trade 

deficit that reached $268 billion in 1999 and could 

exceed $300 billion in 2000. This deficit puts hundreds 

of billions of dollars annually in the hands of foreign 

investors. As long as foreign investors largely choose to 

reinvest their excess dollars in U.S. factories and financial instruments, as has been the case in recent years, 

the United States can continue to enjoy a strong dollar 

and relatively low inflation and low interest rates. However, if foreign investors should choose to invest elsewhere, they must sell their dollars in foreign exchange 

markets. Doing so would put downward pressure on the 

dollar and upward pressure on U.S. inflation and interest rates. 

Recent Shocks to the U.S. Economy 

Despite the potential for a declining dollar as a result of 

U.S. reliance on foreign capital, other adverse developments have confronted the U.S. economy over the past 

year. The two factors of most consequence to the macroeconomic outlook have been rising energy costs and rising interest rates. These trends have played a role in 

recent equity market volatility that may have implications for the future direction of the economy. 

Rising Energy Prices. After declining to a low of 

around $10 per barrel in December 1998, oil prices have 

risen dramatically over the past year and a half. The spot 

price per barrel of West Texas Intermediate crude 

peaked in March 2000 at just under $30 before declining slightly in April. The rapid increase in oil prices during 1999 was sparked by a cutback in output by oilproducing nations that was instituted just as global economic growth was recovering from the crisis of 1998. 

The OPEC nations and other major oil producers 

reached a new agreement in March 2000 that provides 

for a production increase of some 1.5 million barrels a 

day. But, because demand is rising and gasoline inventories remain lean, analysts do not look for a significant 

decline in gasoline prices in the near term.15 

The effects of higher oil prices on the U.S. economy at 

this time are uncertain. According to some estimates, 

the economy is only half as dependent on oil as it was 

25 years ago, when the United States was experiencing 

the effects of its first “oil shock.”16 Still, higher oil 

prices were responsible for nearly all the increase in 

consumer price inflation during 1999. While year-overyear growth in the Consumer Price Index rose from 1.6 

percent in December 1998 to 2.7 percent in December 

1999, the core rate of inflation (excluding food and 

energy items) actually fell. The question now is whether 

higher energy prices will be passed along to the rest of 

the economy through rising wage and price demands 

during the remainder of 2000. 

Rising Interest Rates. From low points at the end of 

1998, both short-term and long-term interest rates have 

risen substantially, contributing to a higher cost of debt 

service for businesses and households. At the short end 

of the yield curve, the Federal Reserve (the Fed) raised 

the Federal Funds rate six times between June 1999 and 

May 2000, for a total increase of 175 basis points. 

While part of this increase merely reversed the reduction in rates that took place in late 1998, the Fed also 

voiced concerns that inflationary pressures might be 

emerging because of continued rapid U.S. economic 

growth. Given the stated commitment of the Federal 

Reserve to price stability, most analysts expect the Fed 

to continue to push short-term rates higher until growth 

in the economy slows to a more sustainable pace.17 

Bond markets also pushed up long-term interest rates 

during this period. The yield on the ten-year Treasury 

15 Energy Information Agency (U.S. Department of Energy). April
 

2000. Short-Term Energy Outlook. http://www.eia.doe.gov/emeu/
 

steo/pub/contents.html.
 

16 March 11, 2000. Fueling Inflation? The Economist.
 17 See, for example, U.S. House of Representatives. February 17,
 

2000. Testimony of Chairman Alan Greenspan Before the Committee
 

on Banking and Financial Services. http://www.federalreserve.gov/
 

boarddocs/hh/2000/February/Testimony.htm.
 

Kansas City Regional Outlook 18 Second Quarter 2000 
In Focus This Quarter
 

As Commercial Credit Quality 

Indicators Slip, Trends in Commercial 

Lending Come to the Forefront 

Commercial lending, which includes both commercial 

and industrial (C&I) and commercial real estate (CRE) 

loans, represents the greatest source of credit risk to 

insured institutions and the deposit insurance funds. C&I 

loan growth continued to be strong in 1999, although it 

did moderate from 1998 levels, and recent underwriting 

surveys have reported a slight tightening of terms.18 Nevertheless, there are signs that commercial credit quality is 

deteriorating.19 Most notably, as seen in Chart 6, C&I loan 

charge-off rates, corporate bond defaults, and corporate 

bond rating downgrades relative to upgrades have all 

been trending upward recently. For example, C&I loan 

loss rates rose to 0.56 percent of total loans in 1999, nearly double the rate of loss experienced in 1997. Although 

C&I loan loss levels are well below historical highs experienced throughout the 1980s and early 1990s, these signs 

of credit quality deterioration are occurring despite 

extremely favorable economic conditions. 

At least three factors have contributed to weakening in 

corporate credit quality. First, corporate indebtedness has 

been rising, as businesses have been spending to increase 

productivity, cut costs, repurchase equity, and finance 

mergers and acquisitions. The second factor relates to a 

greater risk appetite in the financial markets. For example, originations of leveraged syndicated loans—in particular, highly leveraged loans—have tripled over the past 

five years. Finally, stresses within industry sectors hard 

hit by structural changes, global competition, and deflationary pressures have resulted in challenges for 

borrowers. 

Construction and development (C&D) lending continues 

to be one of the fastest growing segments of banks’ loan 

portfolios, while loss rates among CRE and C&D loans 

remain extremely low. However, there are indications 

that conditions could be worsening in some markets. In 

particular, as shown in Chart 7, strong office completions and construction activity have begun to outpace 

absorptions and are projected to continue to do so over 

the next several years. Moreover, these trends have 

implications for vacancy rates. The national office 

vacancy rate moved higher during 1999 for the first time 

since 1991 and is projected to climb higher. 

In addition, some local CRE markets continue to show 

signs of overbuilding. Last year, the FDIC’s Division of 

Insurance identified nine markets in which the pace of 

construction activity threatened to outstrip demand for at 

least two property sectors.20 Seven of these nine markets 

reported an increase in office vacancy rates in 1999. 

CHART 6 

0.0 

1.0 

2.0 

3.0 

4.0 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

Note: C&I = commercial and industrial 

Source: Moody’s; Bank and Thrift Call Reports (Research Information System) 

Deteriorating Indicators Suggest Weakening 

Business Credit Quality 

Insured Institution C&I 

Charge-off Rate 

Corporate Bond 

Default Rate 

Bond Ratings 

Downgrades to 

Upgrades (columns) 

18 Both the 1999 Senior Loan Officer Opinion Survey (Federal 

Reserve Board) and 1999 Survey of Credit Underwriting Practices 

(Office of the Comptroller of the Currency) point to more stringent 

C&I loan terms since the latter part of 1998. This tightening follows a four-year period of easing C&I loan standards and predominantly reflects an increase in loan pricing. 

19 For additional detail, see Sothoron, Arlinda, and Alan Deaton. 

FDIC Division of Insurance. First quarter 2000. Recent Trends 

Raise Concerns about the Future of Business Credit Quality. 

Regional Outlook. http://www.fdic.gov/bank/analytical/regional/ 

ro20001q/na/Infocus1.html. 

20 These markets are Charlotte, Orlando, Salt Lake City, Dallas, Las 

Vegas, Phoenix, Nashville, Atlanta, and Portland. See Burton, 

Steve. FDIC Division of Insurance. First quarter 1999. Commercial Development Still Hot in Many Major Markets, But Slower 

Growth May Be Ahead. Regional Outlook. http://www.fdic.gov/ 

bank/analytical/regional/ro19991/na/Infocus2.html. 

CHART 7 

0 

20,000 

40,000 

60,000 

80,000 

100,000 

120,000 

140,000 

’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 

0% 

5% 

10% 

15% 

20% 

Source: CB Commercial/Torto Wheaton Research 

U.S. Office Vacancies Rose Last Year 

for the First Time since 1991 

Completions, Absorption 

(000 sq. ft.) Vacancy

 Rate 

Completions 

Absorption 

Projected

Actual 

Kansas City Regional Outlook 19 Second Quarter 2000
 
In Focus This Quarter
 

note rose from a low of 4.5 percent in October 1998 to 

6.5 percent by May 2000. Analysts have cited renewed 

demand for credit by a recovering world economy as 

well as concerns about inflation arising from the 

increase in energy prices as factors behind the rise in 

long-term rates. 

Higher energy costs and higher interest rates do not 

appear to have significantly slowed the pace of U.S. 

economic activity during the first quarter of 2000. The 

preliminary estimate of real gross domestic product 

growth during the quarter was 5.4 percent—a slowdown 

from the 7.3 percent rate of the fourth quarter of 1999 

but still well above what is considered a sustainable 

pace. Home construction, usually a sector that is particularly sensitive to movements in long-term interest 

rates, has remained surprisingly resilient. Still confident 

of their future prospects, homebuyers have increasingly 

turned to adjustable-rate mortgages to avoid some of the 

immediate costs of higher fixed mortgage rates. 

As for the business sector, higher costs for energy and 

debt service are most significantly affecting “Old Economy” firms that purchase commodity inputs and carry 

significant debt on their balance sheets. Airline companies in the S&P 500, for example, posted a year-overyear decline of 27 percent in net income from 

continuing operations during the first quarter of 2000.21 

Analysts have argued that New Economy firms, by contrast, are less vulnerable to recent economic shocks 

because they tend to carry little debt and consume relatively little energy. 

Equity Market Volatility. The notion that New Economy 

firms are less vulnerable to the effects of higher energy 

costs and higher interest rates may be one of the reasons 

that equity shares of firms in the technology sector 

began to dramatically outperform the broader market, 

beginning around the middle of 1999. Chart 8 shows 

that the technology-heavy NASDAQ index performed 

more or less in tandem with the Dow Jones Industrial 

Average between the end of 1996 and the middle of 

1999, but thereafter the NASDAQ soared far ahead of 

the Dow. Between October 1, 1999, and February 29, 

2000, the NASDAQ rose by 72 percent while the Dow 

declined by 4 percent. Moreover, this striking divergence between the equity returns of Old and New Economy companies was not limited to the U.S. markets. 

Parallel trends were observed in Europe, Japan, Korea, 

21 Bloomberg. The S&P 500 airline industry is composed of AMR 

Corp., Delta Air Lines, Southwest Airlines, and U.S. Airways Group. 

CHART 8 

and Hong Kong. The similarity in performance of the 

high-tech sectors across three continents suggests a 

worldwide flow of liquidity from investors to the shares 

of technology firms. 

However, emerging concerns about the technology sector contributed to significant volatility in technology 

0 

50 

100 

150 

200 

250 

300 

350 

400 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

Tech Stocks Have, Until Recently, Far 

Outperformed “Old Economy” Stocks Worldwide 

January 1997 = 100 

United States 

NASDAQ 

DJIA 

May 12, 2000 

0 

200 

400 

600 

800 

1,000 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

January 1997 = 100 

EASDAQ 

Bloomberg European 500 

May 12, 2000 

Europe 

0 

50 

100 

150 

200 

250 

300 

January 1997 = 100 

Japan 

4Q96 4Q97 4Q98 4Q99 

Source: Bloomberg 

JASDAQ 

Nikkei 225 

May 12, 2000 

Kansas City Regional Outlook 20 Second Quarter 2000 
In Focus This Quarter
 

shares during March and April 2000. The NASDAQ 

index lost 30 percent of its value between March 10 and 

May 12, 2000. Analysts cited the Justice Department 

finding against Microsoft and doubts about the ultimate 

profitability of business-to-consumer Internet firms as 

two factors in the sell-off. 

Equity market volatility also poses a threat to the economic outlook. One concern is the so-called “wealth 

effect” that a declining stock market may have on consumer spending. Since 1995, rising stock prices have 

helped raise the market value of equities held by U.S. 

households, plus their holdings of mutual funds, by 

some $5.7 trillion. This windfall is an important reason 

that households have continued to reduce annual personal savings (to just 2.4 percent of disposable income 

in 1999) and increase spending on homes, autos, and 

other consumer goods. Although it is uncertain what 

effect a prolonged stock market correction might have 

on consumer spending, the potential wealth effect has 

surely grown as more households hold a higher percentage of wealth in corporate equities and mutual fund 

shares. (See the inset box at right for a discussion of 

how financial market volatility could affect banks.) 

The Economic Outlook 

Despite the effects of rising energy costs, increasing 

interest rates, and equity market volatility, the U.S. 

economy continues to grow at a robust pace. The consensus forecast of 50 corporate economists surveyed by 

the May 1999 Blue Chip Economic Indicators suggests 

that the economy will grow by 4.7 percent in 2000, 

while consumer prices are projected to rise by 3.0 percent from 1999 levels. Short-term interest rates are projected to rise only slightly by year-end from early May 

levels. In short, the consensus forecast indicates that the 

New Economy formula of rapid economic growth combined with low inflation will continue for the foreseeable future. If actual events conform to this forecast, the 

result will likely be another year of generally low loan 

losses and solid earnings for much of the banking 

industry. (See the inset box on the following page for a 

discussion of other risks to watch in banking.) 

Clearly, risks are associated with the economic outlook. 

Recently, higher oil prices and higher interest rates have 

been the most visible signs of trouble for the economy. 

New Economy companies may be less vulnerable to 

these effects, but even these firms have experienced a 

sharp decrease in equity valuations as investors reevalFinancial Market Volatility Could 

Pare Earnings for Banks Most 

Reliant on Market Sources of 

Revenue 

FDIC-insured banks are deriving an increasing proportion of earnings from noninterest sources (see 

Chart 9), particularly market-sensitive sources of revenue. This is especially true for larger institutions. 

According to Deutsche Banc Alex. Brown, the 18 

most active generators of market-sensitive sources of 

revenue earned over 25 percent of net operating revenue from these potentially volatile business lines.22 

While market-sensitive sources help to diversify revenue streams, they can also introduce increased 

income volatility in the event of financial market turbulence. Deutsche Banc Alex. Brown also reports that 

for those 18 banks that generated the largest amounts 

of market-sensitive revenues during the third quarter 

of 1998, the share of total revenue derived from 

market-sensitive sources declined from 23 percent to 

13 percent. Thus, a more sustained downward trend in 

the financial markets could particularly affect the 

earnings of large banking companies that rely heavily 

on income from sources such as venture capital, asset 

management and brokerage services, and investment 

banking. 

CHART 9 

15 

30 

45 

60 

75 

90 

1970s 1980s 1990s 

Noninterest Revenues Account for a Growing 

Share of Bank Net Operating Revenue 

Percentage of Net Operating Revenue* 

* Net operating revenue is the sum of net interest income and 

noninterest income. 

Sources: FDIC Historical Statistics on Banking; FDIC Quarterly Banking 

Profile 

Net Interest Income Noninterest Income 

0 

22 Net operating revenue is the sum of interest income and 

noninterest income less interest expense. According to 

Deutsche Banc Alex. Brown, these companies are Bank of 

America Corporation; Bank of New York Company, Inc.; 

Bank One Corporation; Bank Boston; BB&T Corporation; 

Chase Manhattan Corporation; Citigroup, Inc.; First Union 

Corporation; FleetBoston Financial; JP Morgan; KeyCorp; 

Mellon Financial Corporation; National City Corporation; 

PNC Bank Corp.; SunTrust Banks, Inc.; US Bancorp; 

Wachovia Corporation; and Wells Fargo & Company. 

Kansas City Regional Outlook 21 Second Quarter 2000 
In Focus This Quarter
 

Other Risks to Watch in Banking
 

Subprime Lending 

•	 Subprime consumer loan portfolios contributed to 

the large losses associated with recent high-cost 

bank failures. During 1999, the FDIC reported the 

first annual loss for the Bank Insurance Fund since 

1991. The loss was primarily the result of an uptick in 

unanticipated and high-cost bank failures. FDICinsured institutions with at least 20 percent of Tier 1 

capital in subprime loans accounted for 6 of the 13 

bank failures that occurred between January 1998 and 

March 2000. Fraud and inappropriate accounting for 

residuals also played a role in some of these failures.23 

•	 Subprime lending remains an area of concern. 

Insured depository institutions that engage in subprime lending represent a disproportionate share of 

problem institutions. Of the 79 banks and thrifts on 

the problem bank list as of year-end 1999, 21 percent 

were institutions with at least 20 percent of their Tier 

1 capital in subprime loans.24 

Agricultural Lending 

•	 While a majority of agricultural institutions remain 

relatively strong, external conditions have put pressure on some agricultural producers. Many agricultural areas are experiencing low commodity prices as 

well as weather- and disease-related problems. Strong 

global competition and high worldwide production 

over the past several years have resulted in increasing 

inventories of many crops and poor prospects for a 

price turnaround in the near term. Moreover, in spite 

of record government farm payments in 1999, the 

U.S. Department of Agriculture projects that in the 

year 2000 one in four farms will not cover cash 

expenses, up to 20 percent of farmers will experience 

repayment problems, and 5 percent of farmers will be 

“vulnerable.”25 

23 See Puwalski, Allen. FDIC Division of Insurance. Second 

quarter 1998. Gain-on-Sale Accounting Can Result in Unstable 

Capital Ratios and Volatile Earnings. Regional Outlook. http:// 

fdic01/division/doi/outlook/2q1998/atlanta/infocus1.html. 

24 The problem bank list includes all insured depository institutions rated a composite “4” or “5.” 

25 “Vulnerable,” as defined by the U.S. Department of Agriculture 

Economic Research Service, applies to institutions that have 

debt/asset ratios above 0.40 and negative income such that they 

cannot meet current expenses or reduce existing indebtedness. 

•	 Some signs point to growing stress for agricultural 

institutions. Forty-two percent of FDIC-supervised 

banks active in agricultural lending showed a moderate or sharp increase in the level of carryover debt 

during third quarter 1999, compared with just 26 percent during third quarter 1998.26 In addition, net loan 

loss rates for agricultural production loans increased 

in 1999 to the highest level since 1991. However, at 

0.32 percent, the 1999 net loss rate is just one-tenth 

the rate experienced during the height of the agricultural crisis of the mid-1980s.27 

Operational Risk 

•	 Operational risks are becoming more prominent in 

the banking industry. Driven by consolidation and 

expansion into new product lines and markets, financial institutions are seeing an increase in operational 

complexity. Operational risk encompasses a host of 

factors not related to credit or market activities, 

including risks associated with processing transactions, legal liability, fraud, strategic missteps, and 

internal control weaknesses. Operational risks tend to 

be more pronounced when institutions engage in 

rapid growth, far-flung operations, and complex business processes. 

•	 Greater attention is being paid to operational risks 

in the financial industry. Recently, analysts have 

noted that the pressure to meet ambitious postmerger 

earnings predictions can result in cost-cutting measures that jeopardize the comprehensiveness and 

integrity of risk-management systems. In addition, 

the role that fraud has played in recent bank problems 

and failures reinforces the importance of adequate 

internal controls and audit procedures. The significance of operational risks to financial institutions has 

been noted in industry surveys and informationsharing efforts among financial firms.28 NetRisk Inc., 

a Greenwich, Connecticut, consulting firm, recently 

estimated that operational losses among financial 

institutions have exceeded $40 billion over the past 

five years. 

26 September 1999. FDIC Report on Underwriting Practices. 27 See Anderlik, John M., and Jeffrey W. Walser. FDIC Division of 

Insurance. Third quarter 1999. Agricultural Sector Under Stress: 

The 1980s and Today. Regional Outlook. http://www.fdic.gov/ 

bank/analytical/regional/ro19993q/kc/agricult.html. 

28 For additional detail, see March 2000. Operational Risk: The 

Next Frontier. RMA/PricewaterhouseCoopers Survey. April 6, 

2000. Tech Bytes: Banks Join Forces Against Operational Risk. 

American Banker. 

Kansas City Regional Outlook 22	 Second Quarter 2000 
In Focus This Quarter
 

uate the long-term prospects. Equity market volatility 

threatens to dampen consumer confidence and the ability of businesses to continue to merge, restructure, and 

invest. 

The economy has become particularly dependent on 

financing delivered through the capital markets. In this 

more permissive financial environment, rising debt levels and greater dependence on foreign capital have 

emerged as financial imbalances that may contribute to 

future problems for the economy. Businesses and 

households with high levels of debt are more vulnerable 

to problems if interest rates continue to rise or income 

growth falters. Rapid credit creation by the domestic 

financial sector suggests the possibility of lax credit 

underwriting standards. Reliance on foreign capital 

raises concerns about what would happen to the value of 

the dollar and to domestic inflation if foreign investors 

decide to invest elsewhere. 

Some analysts suggest that the New Economy, driven by 

increased productivity, heightened competition, and 

robust investment, may be characterized by longer 

expansions. Financial market imbalances may, however, 

contribute to deeper recessions and more sluggish 

recoveries compared with earlier business cycles. 

For the banking industry, it is clear that a recession 

would mean slower loan growth, deteriorating credit 

quality, and impaired profitability. But the biggest 

threat to the banking industry is a recession that is tied 

to disruptions in the financial markets. The ready availability of financing to start new businesses and restructure old businesses has been key to the New Economy. 

The process by which businesses have invested and 

restructured in response to competition has been orderly from the perspective of bank creditors. If this 

process should be disrupted, we could see a much more 

disorderly process, with more bankruptcies and higher 

losses to lenders. 

This article was prepared and coordinated by the management and staff of the Analysis Branch of the Division of 

Insurance. Contributions and feedback from analysts across the Division were essential to its completion. 

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

Richard A. Brown, Chief, Economic and Market Trends Section 

Steve Burton, Senior Banking Analyst 

Steven C. Cunningham, formerly Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, formerly Senior Financial Analyst 

Mary L. Garner, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Thomas A. Murray, Senior Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Arlinda Sothoron, Senior Financial Analyst 

Ronald Spieker, Chief, Regional Programs and Bank Analysis 

Kansas City Regional Outlook 23 Second Quarter 2000 
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