Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1999 

FDIC
 

Boston
 

Region
 

Division of 

Insurance 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Senior Financial
 

Analyst
 

Andrea
 

Vincequere,
 

Economic Analyst
 

In Focus This Quarter 

◆ Falling Prices in Commodities and Manufacturing Pose Continuing 

Risks to Credit Quality—Falling prices are causing problems for a wide range 

of commodity industries—a collection of agricultural, mining, and manufacturing 

industries that produce standardized products and face global competition, mostly 

on the basis of price. Firms in these industries have experienced slow or negative 

profit growth even as they reduce payrolls to cut costs. There are signs that these 

trends are contributing to higher credit risk for insured institutions. The effects of 

these problems on local economies and community banks could grow if low prices 

persist. See page 3. 

By Richard A. Brown and Alan Deaton 

◆ Shifting Funding Trends Pose Challenges for Community Banks— 

Several long-term trends are making it more difficult for some institutions to economically fund asset growth with deposits in today’s marketplace. As a result, 

traditional measures of liquidity and liability composition for commercial banks 

reflected record-low levels of deposit funding at year-end 1998. The need to augment lagging deposit growth to meet loan demand has led many community banks 

to seek more wholesale funding sources, particularly borrowings. If the trend 

toward greater reliance on nondeposit funding continues, liability management 

may become more important and more challenging for community banks that have 

historically relied upon deposits for funding and net interest revenues for profitability. See page 11. 

By Allen Puwalski and Brian Kenner 

Regional Perspectives 

◆ Regional Economic and Banking Conditions—The Region’s labor market showed slower growth through June 1999, but increased factory output helped 

mitigate the pace of manufacturing job losses...Residential building activity moderated following a surge in 1998, while demand for existing homes remained 

strong...The Region’s commercial lending institutions have been hit hard by recent 

refinancing activity, as evidenced by a sharp decline in net interest margins. See 

page 18. 

◆ Insured Institutions Are Increasingly Relying on Alternative Funding Sources—Reliance on noncore funding to support asset expansion has 

become more prevalent, especially in areas with aggressive competition...However, 

insured financial institutions may face additional pressure on margins as assets are 

booked at smaller marginal spreads because of competition and an increasing 

reliance on noncore funding results...Some institutions may seek higher yielding 

assets, which could result in somewhat higher levels of credit risk...The shifting 

funding structure of insured institutions may also contribute to greater volatility in 

funding and increase the institutions’ sensitivity to changing market conditions. See 

page 20. 

By the Boston Region Staff 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

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 Boston 

Region’s Regional Outlook, please call Daniel Frye at (781) 794-5678 or send an e-mail to 

dfrye@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Falling Prices in Commodities and Manufacturing 


Pose Continuing Risks to Credit Quality
 

•	 Prices have fallen sharply across a wide range of 

commodities and manufactured goods. 

•	 Signs of stress are apparent in some industry 

sectors. 

•	 These trends are contributing to rising credit risk 

for insured institutions. 

•	 Effects on local economies and community banks 

could grow if low prices persist. 

The performance of the U.S. economy during the midto late-1990s has been generally positive for banking. 

Economic activity grew in 1998 at an inflation-adjusted 

rate of 3.9 percent for the second consecutive year. Continued low inflation has helped to hold interest rates low 

and extend the expansion into its ninth consecutive year. 

However, one downside of low inflation has been that 

firms in certain commodity industries have encountered 

slow or negative growth in revenues because of the low 

prices they receive for their products. 

Commodity industries are defined in this article as a 

collection of agricultural, mining, and manufacturing 

industries that produce standardized products and face 

global competition, mostly on the basis of price. Since 

the beginning of 1997, price weakness has extended 

across a wide range of commodity industries, from agricultural products to oil, chemicals, textiles, paper, semiconductors, steel, and even some segments of the auto 

industry. While many firms have retooled and restructured to cut costs, clear signs of financial stress have 

become apparent. 

The potential importance of problems in commodity 

industries to the FDIC was illustrated by the banking 

problems related to oil and agriculture during the 1980s 

and early 1990s. As documented in a 1997 study by the 

FDIC Division of Research and Statistics, regional 

economic dislocations related to declining farmland 

values and declining oil prices contributed to large 

increases in credit losses and the eventual failure of 

hundreds of federally insured banks and thrifts. The 

analogy to the 1980s is far from perfect—for example, 

oil and agriculture have not experienced booms comparable to those that preceded their collapse in the 

1980s—but exposures to commodity industries remain 

important for many insured institutions. 

This article summarizes recent adverse trends in commodity and manufacturing sectors and discusses why 

industry-sector problems are important in banking. It 

takes a high-level approach, emphasizing the economic 

fundamentals that are driving prices across the economy 

while ignoring many of the industry-specific factors 

that are also driving the performance of individual sectors. The goal is to evaluate the effects of these trends 

on bank credit quality if they persist through 1999 and 

beyond. 

Prices Have Been Declining across a Range 

of Commodities and Manufactured Goods 

Low inflation has been a boon for consumer spending 

and business investment during the economic expansion 

of the 1990s. As of March 1999, the Consumer Price 

Index had risen at an annualized rate of less than 2.0 

percent for 8 consecutive quarters and at an annualized 

rate of less than 4.0 percent for 

33 consecutive quarters. The 

prices of many popular and 

essential consumer goods— 

from computers to gasoline— 

have generally fallen throughout 

the decade, even as the prices of 

most services continue to rise 

steadily. Businesses, too, have 

benefited from the ability to 

purchase goods cheaply, as well as from the generally 

low interest rates that have accompanied low inflation. 

The declining average wholesale price of goods is 

reflected in Chart 1 (next page), which shows changes 

in the producer price index (PPI) and some of its key 

components since the beginning of 1997. The PPI 

focuses on goods, omitting changes in the price of services. The decline of nearly 5 percent in the PPI since 

the beginning of 1997 has been led by falling prices for 

mining products, petroleum, and steel. Moreover, economy-wide price declines for wholesale goods have been 

steady over time, with the PPI registering year-over-year 

declines for 26 consecutive months through May 1999. 

Boston Regional Outlook 3	 Third Quarter 1999 
In Focus This Quarter
 

CHART 1	 CHART 2 

Widespread Pricing Pressures Are Evident in the 

Components of the Producer Price Index 

Percent Change in Selected Components of the Producer Price 

Index, January 1997 to May 1999 

–45 

–40 

–35 

–30 

–25 

–20 

–15 

–10 

–5 

0 

Agricultural Prices Are Down Sharply Since 1997 

Percent Change in Reported Price Between 

January 1997 and May 1999 

Source: Wall Street Journal (Haver Analytics) 

Cotton 

Corn 

Hogs 

Wheat 

10 

5 

0 

–5 

–10 

–15 

–20 

–25 

–30 

–35 

–40 

Source: Bureau of Labor Statistics (Haver Analytics) All Commodities Lumber & Wood Chemicals Textiles Automobiles Electrical Machinery 

Iron & SteelPetroleumProductsMining 

3.3 

–4.0 

0.6 –1.9 –2.5 –2.5 

–10.0 

–19.8 

–33.2 

Although they are only indirectly included in the PPI 

numbers, the prices of several important agricultural 

commodities have also fallen substantially. Chart 2 

shows that the price of wheat has fallen by more than 35 

percent since January 1997, with the price of corn, 

hogs, and cotton also registering double-digit rates of 

decline. While the price of hogs has rebounded significantly since the end of 1998—more than doubling from 

its low of less than 15 cents per pound—prices for corn, 

wheat, and cotton continued to decline through May 

1999. 

Reasons for Broad-Based Commodity 

Price Weakness 

Pricing trends in disparate industries such as electronics 

and agriculture, or oil and steel, are driven in part by 

industry-specific factors. For example, weather patterns 

heavily influence agricultural prices, while global politics tends to drive world oil price levels. In manufacturing, technological developments can significantly alter 

the demand for a product or its cost of production, 

thereby influencing its market price. For example, 

improvements in semiconductor manufacturing techniques—from shrinking the size of chips to using larger 

silicon wafers—have significantly increased production 

yields in that industry during the 1990s.1 

However, the pervasiveness of recent price declines 

across a wide range of commodities and manufactured 

1 See “Semiconductor Industry Trends,” Standard and Poor’s Industry 

Surveys, May 27, 1999, p. 4. 

goods suggests that a number of common factors are 

driving prices lower: 

•	 Low inflationary expectations. Since 1980, inflation rates have gradually declined worldwide as central banks shifted their focus toward price stability. 

Disinflation has profoundly altered the expectations 

of investors, consumers, and businesses, and in the 

process has altered the course of events in individual markets and in the economy as a whole. As a 

result, commodities have lost much of their appeal 

as a hedge against inflation. This has contributed to 

a decline of more than 50 percent in the price of 

gold since 1980. The expectations of many businesses have also changed, because with less pricing 

power they must continually cut costs to remain 

competitive. 

•	 Overcapacity because of large-scale investment. 

Global investment in productive capacity accelerated 

during the early to mid-1990s in a number of commodity and manufacturing industries. Many U.S. 

firms have implemented new technologies and 

moved their operations closer to their markets or to 

areas where low-cost labor is available. For example, 

major U.S. and foreign automakers have invested billions of dollars in recent years in new production 

facilities in the emerging markets of Asia and Latin 

America as part of a “build-where-you-sell” strategy.2 Because these additions to capacity largely have 

not been offset by the closure of existing plants, analysts say that global productive capacity in autos 

2 Barbara McClellan, “Asia Woes Worsen,” Ward’s Auto World, 

November 1998, pp. 28–31. 

Boston Regional Outlook 4	 Third Quarter 1999 
In Focus This Quarter
 

could exceed demand by more than 20 million units 

annually by 2000.3 A similar situation has developed 

in the semiconductor industry, where capital investment in chipmaking equipment tripled between 1993 

and 1996, contributing to a glut of memory chips and 

plunging prices.4 

•	 Curtailed global demand in the wake of emerging 

market crises. The economic crises that have developed in Asia, Russia, and parts of Latin America 

since 1997 have crimped global demand for commodities and manufactured goods. For example, 

demand for new cars in Korea fell by 50 percent in 

1998.5 Asia received approximately 30 percent of 

U.S. feed grain exports in 1996, but declining Asian 

demand since then has contributed to a sharp decline 

in global grain prices. The slowdown of economic 

activity in crisis countries and the resulting decline 

in their demand for imports is only one factor that 

has hurt the pricing power of U.S. producers. Another problem is the pricing advantage conferred on 

countries that have experienced currency devaluation. Firms operating in a country that has devalued 

its currency experience a reduction in the price of 

their exports in U.S. dollar terms. This process further depresses the pricing power of U.S. farmers and 

businesses that sell their goods in global markets. 

Recently, there have been signs that some hard-hit Asian 

economies may soon begin to recover. However, the 

other factors cited above—low inflationary expectations and rapid investment in productive capacity—may 

well be longer-term trends. In any event, U.S. farmers 

and businesses that participate in commodity industries 

must be prepared for the possibility that pricing pressures will not dissipate in the near term. 

Signs of Stress Are Showing 

for Affected Industry Sectors 

As commodity prices continue to stagnate, signs of 

stress are emerging among firms in the commodity 

industries. A long-term trend toward reduced levels of 

employment in manufacturing has accelerated in the 

midst of the current economic expansion. Chart 3 shows 

that employment levels declined in a wide range of 

commodity industries in the 24 months ending in May 

3 “1997 Automotive Outlook,” Automotive Industries. This report is
 

available at http://www.ai-online.com.
 4 “Semiconductor Industry Trends” (1999), p. 3.
 

5 Barbara McClellan (1998).
 

CHART 3 

Total Percent Change in Payroll Employment, May 1997 to May 1999 

Employment Levels Have Declined across a Wide 

Range of Commodity and Manufacturing Sectors 

* Percent change between 1997 and 1998 based on county-level estimates 

of payroll employment in agriculture and agricultural services 

Sources: Bureau of Labor Statistics (Haver Analytics); WEFA 

Electronics and Semiconductors 

Textiles 

Autos 

Primary Metals/Iron and Steel 

Chemicals 

Oil and Gas 

Mining 

Lumber and Paper 

Agriculture* 

–20 –15 –10 –5 0 

1999. The total manufacturing sector lost more than 

420,000 jobs during that period, while another 64,000 

jobs were lost in the mining sector, which includes oil 

and gas extraction. The trend toward lower levels of 

employment in mining and manufacturing not only 

reflects pricing pressures but also attempts by firms in 

these sectors to maintain profitability by investing in 

labor-saving technologies. 

The profit picture has begun to deteriorate as well for 

firms operating in commodity industries. Four-quarter 

trailing earnings through March 1999 for oil-sector 

firms in the Standard & Poor’s 500 dropped by more 

than 44 percent from a year ago (see Chart 4), while the 

earnings of steel firms fell by almost 32 percent. The 

losses experienced by firms in some of these industrial 

sectors extended to the farm sector as well, where net 

CHART 4 

–50 –40 –30 –20 –10 0 10 20 

Agriculture* 

Year-over-Year Percent Change in Earnings from Continuing Operations 

for S&P 500 Companies, by Sector, for the Year Ending in March 1999 

Earnings Have Declined across a Wide Range 

of Commodity and Manufacturing Sectors 

Oil and Gas 

* 1998 percent change in net farm income 

Sources: Standard and Poor’s (Bloomberg); U.S. Department of Agriculture 

Lumber and Paper 

Mining 

Chemicals 

Primary Metals/Iron and Steel 

Autos 

Textiles 

Electronics and Semiconductors 

Boston Regional Outlook 5	 Third Quarter 1999 
In Focus This Quarter
 

incomes fell by more than 7 percent in 1998, according 

to the U.S. Department of Agriculture. 

Affected Industries Have Found Ways to Cope 

with Pricing Pressures Thus Far 

Despite the signs of stress in industries where prices are 

weak or declining, U.S. farmers and industrial firms 

have shown themselves to be fairly resilient thus far in 

their ability to cope with the situation. Agricultural producers have been making greater use of carryover debt 

to keep their operations running even if they were not 

able to fully retire their operating loans during the previous crop year. The FDIC Report on Underwriting 

Practices shows that 29 percent of FDIC-supervised 

agricultural lenders reported at least a moderate 

increase in carryover debt during the six-month period 

ending in March 1999, compared with only 10 percent 

in March 1998. Although the use of carryover debt is 

not an uncommon practice in agriculture, it indicates 

that low prices and declining subsidies have contributed 

to financial stress for farmers. 

Many industrial firms have found ways to increase productivity and cut costs to offset declining revenues. 

Chart 5 follows trends in annual total revenue and costs 

for U.S. corporations operating in a selected group of 

commodity industries. It shows that growth in revenue 

and costs slowed noticeably in 1997. Both revenue and 

costs in these sectors declined in 1998, illustrating that 

firms in these sectors have needed to cut costs to preserve profit margins. Cost cutting in the manufacturing 

sector is further illustrated by a steady decline in the 

index of unit labor costs for manufacturing, which started from a value of 100 in 1992 and fell to less than 96 

CHART 5 

U.S. Corporations Operating in 

Commodity Industries Have Trimmed 

Costs to Offset Falling Revenue* 

* Totals represent a summation of revenues and costs for the following industry 

sectors, as reported by the Bureau of the Census: textile mill products, paper and 

allied products, chemicals and allied products, industrial chemicals and synthetics, 

petroleum and coal products, lumber and wood products, iron and steel, electrical 

and electronic equipment, motor vehicles and equipment, and mining. 

Source: Bureau of the Census (Haver Analytics) 

1992 1993 1994 1995 1996 1997 1998 

Billions of Dollars 

Costs 

Revenues 

1,250 

1,450 

1,650 

1,850 

2,050 

2,250 

by the first quarter of 1999. Falling unit labor costs 

means that the productivity of manufacturing workers is 

rising faster than the cost of their services. This trend 

demonstrates that manufacturing firms have been successful at implementing new technologies and new capital equipment to cut production costs. 

Cost savings and industry consolidation have been 

accomplished in part through mergers. According to 

Merger Stat, the dollar volume of merger and acquisition transactions involving U.S. firms exceeded $1.2 

trillion in 1998, an increase of more than 80 percent 

from 1997 levels. Both the number and dollar volume of 

mergers announced in 1998 far exceeded the volumes 

recorded during the “merger mania” of the 1980s. Some 

of the largest mergers announced in 1998 involved 

firms looking for ways to increase market share and cut 

costs in markets characterized by overcapacity. Examples include the $39 billion Daimler-Chrysler transaction announced in May 1998 and the $80 billion 

Exxon-Mobil transaction announced in December 

1998. Furthermore, merger activity recorded in early 

1999 suggests that total merger volume for the year 

could exceed the record pace of a year ago. 

Industries plagued by oversupply and weak prices 

require consolidation to reduce capacity and improve 

profit margins. Mergers and acquisitions represent a 

fairly orderly way for firms operating in a troubled 

industry to consolidate on their own terms. Bankruptcy 

filings are an alternative means for severely troubled 

firms to reduce capacity and achieve consolidation 

within an industry. Regardless of how industry consolidation is achieved, it often results in reductions in 

employment (such as those documented in Chart 3). 

However, from a lender’s perspective, an orderly consolidation process through mergers and acquisitions is 

preferable to a disorderly shakeout of firms through 

bankruptcies. 

Recent favorable capital market conditions have 

allowed firms in troubled industries to consolidate 

through mergers. Acquisitions are sometimes financed 

through corporate borrowings or, more commonly, by 

swapping equity shares that have been rising in value 

during the bull market of the 1990s.6 Recent consolidation in commodity industries could be depicted as an 

6 According to Loan Pricing Corporation’s Gold Sheets, syndicated 

and leveraged lending related to mergers and acquisitions reached a 

record high of $80 billion in the second quarter of 1998, which represents about 30 percent of the total syndicated and leveraged lending 

market for that period. 

Boston Regional Outlook 6 Third Quarter 1999 
In Focus This Quarter
 

orderly process, associated with record-high merger and 

acquisition activity, near-record-low business bankruptcy filings, and low credit losses on commercial and 

industrial (C&I) loans. However, a sudden change in 

financial market conditions characterized by sharply 

higher interest rates, lower stock values, or both could 

inhibit the ability of businesses to restructure and retool 

on their own. This could lead to a much more disorderly shakeout of firms accompanied by a rise in business 

bankruptcies and losses to lenders. 

Signs Point to Rising Credit Risk 

in the Commodity Industries 

In dollar terms, the largest commercial bank exposures 

to the commodity industries are in the portfolios of 

large banks. Chart 6 provides an estimated breakdown 

of the aggregate exposure of insured institutions to 

commodity industries based on corporate balance sheet 

information collected by the Bureau of the Census.7 The 

chart shows that the aggregate exposure of the bank and 

thrift industries to these sectors is approximately $206 

billion, or 26 percent of the total industry C&I portfolio. The largest single industry exposure is to the chemical industry, which represents approximately 9.5 

7 Because of the limitations of the data, bank exposures to corporations engaged in agriculture are not broken out in Chart 6. 

CHART 6 

Commodity Industries Make Up
 

Over One-Quarter of Bank C&I Loans
 

to Corporate Borrowers
 

Mining Total Loans Lumber & Paper* 3.2% 4.4% Outstanding

as of 12/31/98= Petroleum & Coal $778.3 Billion** 1.2% 

Electronics 

4.2% 

Chemicals* 

9.5% All Other 

73.5% Textiles
 

1.2%
 

Iron & Steel 

1.1% 

Automobiles 

1.7% 

* “Lumber & Paper” includes lumber and wood products and paper and allied 

products as reported by the Bureau of the Census; "Chemicals" includes chemical 

and allied products and industrial chemicals and synthetics as reported by the 

Bureau of the Census. 

** Total includes bank loans not elsewhere classified to the nonfarm nonfinancial 

corporate business sector as reported in the Flow of Funds. Component loan 

amounts represent short-term and long-term bank loans on corporate balance 

sheets, by sector, as reported by the Bureau of the Census. 

Sources: Bureau of the Census (Haver Analytics); Federal Reserve Board 

percent of bank C&I loans. In the syndicated loan market, where large U.S. banks dominate in terms of originations, about 25 percent of all loans made in 1998 were 

to firms operating in the manufacturing sector. 

A rough indicator of recent trends in the credit risk 

associated with bank loans to commodity industries can 

be found in expected default frequencies (EDFs) calculated by KMV Corporation. The EDF is an estimate of 

the probability that a firm will default on its bond obligations within one year.8 Chart 7 tracks the median EDF 

for firms operating in commodity industries compared 

with the median for all other firms rated by KMV. This 

chart shows that while the median EDF for commodity 

industries has consistently exceeded the median for all 

other firms in the recent past, this difference has 

widened appreciably since the middle of 1998. Over the 

past year, the median EDF for commodity industries has 

more than doubled, rising from 0.8 percent to 1.9 percent, while the median EDF for all other firms has doubled as well, from 0.6 percent to 1.2 percent. These data 

indicate that the level of credit risk associated with corporate borrowers has been increasing, led by an 

increased probability of default among firms operating 

in commodity industries. 

8 KMV’s proprietary calculation for EDF is based on 1) the current 

market value of the firm, 2) the structure of the firm’s current obligations, and 3) the vulnerability of the firm to large changes in market 

value. 

CHART 7 

The Default Risk of Firms Operating 

in Commodity Industries Has 

Risen over the Past Year 

Median Expected Default Frequency (EDF)* 

(Probability that a Firm Will Default on Bond 

Obligations within One Year) 

KMV’s proprietary calculation for EDF is based on 1) the current market value of the firm, 

2) the structure of the firm’s current obligations, and 3) the vulnerability of the firm to large 

changes in market value. 

* Sectors included in the calculation of EDF for commodity industries include 

the following KMV aggregates: agriculture; automotive; chemicals; electrical 

equipment; electronic equipment; lumber and forestry; mining; oil refining; oil, 

gas, and coal exploration and production; paper; semiconductors; steel and metal 

products; and textiles. 

Source: KMV Corporation 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

Firms in Other Industry Sectors 

Firms in Commodity Industries 

05/96 12/96 07/97 02/98 09/98 04/99 

Boston Regional Outlook 7 Third Quarter 1999 
In Focus This Quarter
 

Effects on Local Economies and 

the Banks That Operate in Them 

The economic effects of adversity in commodity industries tend to be most severe in local areas that depend 

heavily on these sectors for employment and income. In 

the 1980s, problems in the agricultural and oil sectors 

kicked off a “rolling recession” that spread through the 

Plains states and oil-producing regions of the southcentral and western states. In agricultural regions, farmland values began to decline around 1981, contributing 

to the failure of hundreds of FDIC-insured banks 

between 1984 and 1990.9 Similarly, declining oil prices 

in the mid-1980s contributed to the failure of federally 

insured banks and thrifts in Texas, Oklahoma, 

Louisiana, and other states, while the attempts of some 

institutions to diversify into risky real estate investments resulted in still more failures. The FDIC’s analysis of these episodes emphasizes how industry-sector 

problems can affect local economies and bank credit 

quality.10 Moreover, the study shows that there can be a 

significant lag between the onset of industry-sector 

problems and the emergence of performance problems 

9 Federal Deposit Insurance Corporation, 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. pp. 275–276, http://www.fdic.gov/databank/hist80/
 

index.html.
 

10 Federal Deposit Insurance Corporation (1997). See Chapters 8 


and 9.
 

TABLE 1 

in the banking industry. Although banks with direct 

credit exposures to a troubled industry are likely to be 

affected first, virtually all banks that operate in areas 

that are heavily dependent on a troubled sector will 

eventually have to contend with the indirect effects on 

the local economy. 

To evaluate the extent of local economic effects that 

might have resulted from the recent adverse trends in 

the commodity industries, we have conducted analysis 

on 1,027 U.S. counties identified as particularly dependent on at least one commodity industry (see Table 1 for 

a list of the commodity industries studied).11 The purpose of this analysis is not to identify every county that 

might be affected by these trends; instead, this analysis 

focuses on the U.S. counties most concentrated in the 

commodity industries and determines if these counties 

and banks that operate in them are showing any symptoms of widespread distress. 

Table 2 compares 1998 average job growth and unemployment rates in these “most concentrated counties” 

against the average for all U.S. counties. This comparison shows that the concentrated counties tended to have 

moderately lower job growth and higher unemployment 

than the U.S. average. However, further analysis shows 

11 Counties identified as being highly dependent on one or more commodity industries had an average population of 36,250 in 1998 versus 

86,055 for all U.S. counties. 

U.S. Counties Most Concentrated in Commodity Industries 

by 1998 Payroll Employment 

NUMBER OF 

PERCENT OF COUNTIES WITH 

1998 COUNTY EMPLOYMENT 

EMPLOYMENT IN CONCENTRATION STATES WITH THE MOST 

THE INDUSTRY IN 1998 DESIGNATED COUNTIES 

AGRICULTURE >30 295 TX, NE, SD, KS, MO 

LUMBER AND PAPER >5 305 GA, AL, MS, AR 

OIL AND GAS >5 83 TX, OK, LA 

CHEMICALS >5 46 TN, IL, NC, TX 

STEEL >5 70 KY, OH, AR, IN 

AUTOS >5 118 MI, IN, OH, KY, TN 

TEXTILES >5 156 GA, NC, SC, VA, AL 

ELECTRONICS AND SEMICONDUCTORS >5 33 TX, NY, IN, IA 

Any Commodity Industry N/A 1,027 TX, GA, NC, TN, AL 

All U.S. Counties N/A 3,142 N/A 

Source: WEFA, based on data from the Bureau of Labor Statistics 

Boston Regional Outlook 8 Third Quarter 1999 
In Focus This Quarter
 

TABLE 2 

Relative Economic Performance of Counties 

Most Concentrated in Commodity Industries 

1998 AVERAGE 1998 AVERAGE 

EMPLOYMENT GROWTH (%) UNEMPLOYMENT RATE (%) 

AGRICULTURE 1.1 4.8 

LUMBER AND PAPER 1.3 6.9 

OIL AND GAS 1.4 5.6 

CHEMICALS 1.3 6.0 

STEEL 1.7 5.6 

AUTOS 1.8 4.4 

TEXTILES 0.9 5.1 

ELECTRONICS AND SEMICONDUCTORS 1.9 3.7 

Any Commodity Industry 1.3 5.5 

All U.S. Counties 1.6 5.1 

Source: Bureau of Labor Statistics, Household Survey (Haver Analytics) 

that the current situation is not unusual in that job markets in concentrated counties have tended to consistently underperform other U.S. counties over the past two 

decades. On the whole, the economic picture did not 

noticeably deteriorate in 1998 for the concentrated 

counties. Average unemployment declined in 1998 for 

every group of concentrated counties except oil counties, and average job growth increased in every group of 

counties except textile counties. These data indicate that 

while recent problems in the commodity industries 

might be having severe effects in specific areas, these 

problems had not translated into a broader weakening of 

economic performance through the end of 1998. 

The financial performance of insured institutions operating in concentrated counties is evaluated in Table 3 

(next page). The table provides average C&I loan performance and profitability ratios for 1,915 banks and 

thrifts identified as having at least 25 percent of their 

deposits in at least one of the concentrated counties as 

of June 1998.12 The average C&I loan charge-off ratio 

for concentrated counties overall was higher than the 

U.S. average, driven largely by higher average charge12 This analysis identifies the location of deposits by county through 

the Summary of Deposits report for June 1998, the most recent report 

available. The analysis is limited to institutions reporting at least $1 

million in C&I loans as of December 31, 1998. Institutions operating 

in one or more concentrated counties and meeting all the selection 

criteria averaged $195 million in total assets as of December 31, 

1998, compared with an average of $733 million in assets for institutions operating in any U.S. county. 

offs in both agricultural and oil and gas counties. Comparisons of past-due and noncurrent C&I loans also 

indicate that institutions operating in agricultural and 

oil and gas counties tend to have more problem credits 

than the U.S. average.13 During the 12 months ending in 

December 1998, the average noncurrent loan ratio 

jumped from 4.8 percent to 6.1 percent for institutions 

operating in agricultural counties, while the average 

ratio rose from 2.7 percent to 3.8 percent for institutions 

operating in oil and gas counties. 

These results indicate that while profitability in 1998 

remained solid for the average bank operating in concentrated counties, credit losses appeared to be on the 

rise in agricultural and oil and gas counties. However, 

because this analysis relies on annual data that extend 

only through 1998, it is by design a backward-looking 

test for the local effects of problems in the commodity 

industries. There is every reason to expect these credit 

problems to intensify over time if commodity prices 

remain low.14 These considerations suggest that bankers 

in commodity-dependent counties should continually 

13 Past-due loans are defined as loans that have been past due for 30 

to 89 days. Noncurrent loans are defined as loans that have been past 

due for 90 or more days plus loans placed in nonaccrual status. 

14 For more information on how the agricultural outlook could affect 

FDIC-insured institutions, see the statement of FDIC Chairman 

Donna Tanoue to the Committee on Agriculture, U.S. House of 

Representatives, February 12, 1999, http://www.fdic.gov/publish/ 

speeches/99spchs/spc13apr.html. 

Boston Regional Outlook 9 Third Quarter 1999 
In Focus This Quarter
 

TABLE 3 

Relative Financial Performance of Insured Institutions Operating in Counties 

Most Concentrated in Commodity Industries 

NUMBER OF AVERAGE C&I AVERAGE AVERAGE NET 

BANKS WITH AT LOANS PAST DUE NONCURRENT C&I LOAN 

INCLUDES ONLY INSURED LEAST 25% OF 30 TO 89 DAYS, C&I LOANS, CHARGE-OFFS, AVERAGE 

INSTITUTIONS WITH DEPOSITS IN A AS PERCENT AS PERCENT AS PERCENT OF RETURN ON 

AT LEAST $1 MILLION DESIGNATED OF LOANS, OF LOANS, AVERAGE LOANS, ASSETS, 

IN C&I LOANS COUNTY 12/31/98 12/31/98 1998 1998 

AGRICULTURE 416 5.08 6.12 1.58 1.16 

LUMBER AND PAPER 465 3.38 1.89 0.78 1.21 

OIL AND GAS 163 3.44 3.78 1.18 1.29 

CHEMICALS 81 2.47 2.97 0.79 1.18 

STEEL 186 2.53 2.06 0.59 1.08 

AUTOS 341 2.64 2.05 0.66 1.12 

TEXTILES 264 2.91 1.92 0.70 1.10 

ELECTRONICS AND 

SEMICONDUCTORS 107 2.71 2.36 0.68 0.87 

Any Commodity 

Industry 1,915 3.39 3.03 0.93 1.13 

All U.S. Counties 8,485 2.91 2.50 0.76 1.05 

Noncurrent loans include loans past due 90 or more days plus loans placed on nonaccrual status. 


C&I = Commercial and industrial.
 

Sources: Summary of Deposits, Division of Research and Statistics, FDIC; Bank and Thrift Call Reports (Research
 

Information System)
 

monitor their local economy for signs of stress related 

to problems in the commodity industries. 

Conclusion 

Businesses operating in a range of commodity and manufacturing industries continue to grapple with weak or 

declining prices. This problem is not solely the result of 

industry-specific factors; it is part of long-term economic trends that may continue for some time. Signs of 

stress among firms in these industries are apparent in 

the form of declining levels of employment and slow or 

negative profit growth. However, there are few signs to 

date of any disorderly industry shakeouts involving 

widespread business bankruptcies and losses to lenders. 

Thus far, most firms have managed to cope with 

the situation by cutting costs and consolidating operations through mergers. At the same time, more forwardlooking indicators show that the level of credit risk 

associated with commodity industries may be on the 

rise. An analysis of the U.S. counties most heavily 

dependent on these industries showed few signs of a 

widespread deterioration in the performance of their 

economies or in the profitability of their local depository institutions through the end of 1998. However, there 

are signs of rising credit losses among local depository 

institutions in counties with the highest concentrations 

of agriculture and oil and gas extraction. A continuation 

of today’s weak pricing picture in these industries has 

the potential to result in higher credit losses for insured 

institutions during the next few years. 

Richard A. Brown, Chief, 

Economic and Market Trends Section 

Alan Deaton, Economic Analyst 

Boston Regional Outlook 10 Third Quarter 1999 
In Focus This Quarter
 

Shifting Funding Trends Pose Challenges 


for Community Banks 


•	 Several long-term trends are making it more difficult for some institutions to economically fund 

asset growth with deposits in today’s marketplace. 

•	 Lagging deposit growth in recent years has resulted in greater reliance on alternative funding 

sources to meet loan demand. 

•	 Liability management may become more important and more challenging for community banks 

that have historically relied upon deposits for 

funding and net interest revenues for profitability. 

For the past few years, assets have been expanding 

faster than deposits at many commercial banks. The 

result is an increased reliance on equity and borrowings 

for funding. Since 1992, commercial bank assets have 

grown at an average annual rate of 6.3 percent compared with a 3.9 percent average annual growth rate for 

deposits. Traditional measures of liquidity and funding 

for commercial banks reflected record-low levels of 

deposit funding at year-end 1998. Large commercial 

banks have traditionally made greater use of nondeposit 

funding alternatives. However, many community 

banks,1 which have typically relied more on deposit 

funding, may face liability management challenges as a 

result of shifting funding trends. This article surveys the 

factors influencing the ability of banks to fund loan 

growth with deposits, discusses community bank funding trends, and considers the implications of these 

trends for community banks. 

Factors Influencing Deposit Funding Trends 

The percentage of commercial bank assets, particularly 

loans, funded with deposits has declined steadily in the 

1990s. As shown in Chart 1, the industry’s ratios of 

deposits to assets and loans to deposits reflect a longerterm shift away from deposit funding. Although the 

level of these industry ratios is heavily influenced by 

larger banks, the trend toward lower deposit funding 

exists for both large banks and community banks and 

points to secular factors that are affecting banks’ ability 

to raise deposits in step with asset growth. 

Trends in Household Wealth Accumulation 

One factor affecting the ability of banks to attract 

deposits is the recent trend in the way households are 

amassing wealth. While the total wealth of U.S. households has soared in recent years because of unrealized 

capital gains on housing and investments, annual net 

purchases of new financial assets2 by households as a 

percentage of disposable income have actually trended 

downward since the mid-1980s (see Chart 2, next page). 

A falling personal savings rate and fewer purchases of 

financial assets may suggest that households are more 

comfortable consuming a higher percentage of current 

income as long as capital gains are adding to their accumulated wealth. However, because households have 

been setting aside less of their current income for savings, the pool of new funds available to purchase bank 

deposits has been growing more slowly. 

Higher-Yielding Investment Alternatives 

At the same time that households have been setting 

aside less of their current income for savings, the share 

of total new household savings flowing into bank 

deposits has declined in the 1990s as competition from 

higher-yielding alternatives has increased. During the 

1980s, over 30 percent of the cumulative net increase in 

2 Financial assets are defined as deposits, money market and mutual 

fund shares, credit market instruments, corporate equities, life insurance reserves, pension fund reserves, and trust reserves. 

CHART 1 

The Deposit-to-Asset and Loan-to-Deposit
 

Ratios Reflect Reduced Deposit


 Funding for Commercial Banks
 

Recession 

Ratio (%) Deposit-to-Asset Ratio 

90 

85 

80
 

75
 

70
 

65
 

60
 

55
 

50
 

Loan-to-Deposit Ratio 

’70 ’74 ’78 ’82 ’86 ’90 ’94 ’98 

Sources: FDIC Historical Statistics on Banking; Research Information System 1 Defined here as banks with total assets of $1 billion or less. 

Boston Regional Outlook 11	 Third Quarter 1999 
In Focus This Quarter
 

CHART 2 

Total Annual Additions* to Financial Assets 

of Households and Nonprofit Organizations 

Have Declined with Personal Savings Rate 

Percentage of Disposable 

Personal Income 

Net Acquisition 

15 

10 

5 

0 

20 

of Financial Assets 

Personal Savings 

’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

* Excludes capital gains 

Sources: Federal Reserve Board; Flow of Funds 

financial assets by households and nonprofit organizations flowed into deposits. In contrast, less than 15 percent of the cumulative net increase in financial assets 

has flowed into deposits during the 1990s, although an 

increasing proportion has been allocated to deposits in 

recent years. 

Not only do banks face intensifying competition from 

other banks and thrifts, as indicated by 66 percent of the 

respondents in Grant Thornton’s 1999 Sixth Annual 

Survey of Community Bank Executives,3 but they also 

3 Grant Thornton’s 1999 Sixth Annual Survey of Community Bank 

Executives, “Community Banks: A Competitive Force,” http://www. 

grantthornton.com/resources/finance/banksurvey99/survey99w.html. 

CHART 3 

face increasing competition from mutual funds and 

other nonbank financial service providers, such as credit unions. 

Mutual Funds. Increasingly, consumers are pursuing 

higher yields by investing in mutual funds. Beyond 

yields, however, many mutual fund companies also are 

competing effectively with banks on the basis of convenience by offering money market accounts that allow 

check writing, automated teller machine cards, and 

check cards. Chart 3 shows the changes in the composition of household liquid assets during the 1990s. In 

1990, bank deposits constituted 38 percent of households’ liquid assets versus 11 percent for mutual funds 

and money market funds; at year-end 1998, the shares 

were nearly even. While some of the change in composition can be explained by rising mutual fund share 

prices, other measures indicate a shifting preference for 

mutual funds as a savings vehicle. For example, data 

from the Investment Company Institute show that net 

inflows into mutual funds have exceeded net increases 

in insured institution deposit accounts in all but three 

quarters during this economic expansion. Moreover, the 

first quarter of 1999 marked the seventeenth consecutive quarter that mutual fund inflows outstripped 

increases in deposits for all FDIC-insured institutions. 

Credit Unions. In addition to mutual funds, credit 

unions also are formidable competitors for consumer 

savings. Membership in credit unions has increased 

more than 20 percent over the past decade, while 

deposits and share accounts have risen by over 90 perHouseholds Are Holding a Greater Share of Liquid Assets in Mutual Funds 

1990 1998 

U.S. Government 

Securities
 

7%
 

Equities, Bonds, 

and 

Commercial 

Paper 44% 

Money Market 

Fund Shares 

5% 

Mutual Fund
 

Shares
 

6%
 

Bank Deposits 

(excl. Foreign) 

38% 

Money Market Mutual Fund 

Fund Shares Shares 

7% 22% 

Equities, Bonds, Bank Deposits 

and Commercial (excl. Foreign) 

Paper 35% 30% 

U.S. Government 

Securities
 

6%
 

Source: Federal Reserve Board 

Boston Regional Outlook 12 Third Quarter 1999 
In Focus This Quarter
 

cent.4 Credit unions also offer federal insurance on share 

accounts as well as competitive rates on comparable 

deposit-type vehicles relative to other types of financial 

institutions. For example, according to information from 

the National Credit Union Association, on average, 

credit unions have offered rates on one-year share certificates in excess of one-year bank certificates of 

deposit in nine of the past ten years. As shown in Chart 

4, average rates paid by credit unions on one-year share 

certificates over the 12 months ending May 1999 were 

consistently higher than rates offered by banks or thrifts 

and approached retail rates offered by brokerages. 

Demographic Shifts 

Some analysts maintain that rural community banks 

face additional funding challenges as a result of demographic shifts. According to the Federal Reserve Bank 

of Kansas City, rural bankers perceive that sluggish 

deposit growth is at least partially attributable to the 

migration of deposits to cities as urban-dwelling heirs 

of rural depositors relocate funds. While evidence for 

this deposit migration remains anecdotal, economists at 

the Federal Reserve Bank of Kansas City indicate that 

the demographic shift is still in process, and its full 

effect may not be felt for some time. Further challenging deposit growth for banks, additional evidence suggests that urban dwellers tend to place less of their 

4 Center for Credit Union Research, “Credit Union FAQ,” http:// 

wiscinfo.doit.wisc.edu/bschool/cu/cufaq.html. 

CHART 4 

Bank One-Year CD Rates Have Recently Lagged
 

Those Offered by Competitors
 

Average Retail Rates Offered for 

One-Year Certificates (%) 

6.0 

3.0 

3.5 

4.0 

4.5 

5.0 

5.5 

Thrifts 

Credit Unions 

Banks 

Brokerages 

Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 

’98 ’98 ’98 ’98 ’98 ’98 ’98 ’99 ’99 ’99 ’99 ’99 

Sources: BanxQuote and Bank Rate Monitor 

savings in banks than their rural counterparts do.5 This 

trend poses additional consequences for bank deposits 

as rural populations migrate to suburban areas. 

Community Bank Funding Trends 

Community banks traditionally rely more heavily upon 

core deposit funding than larger banks do. For example, 

Chart 5 (next page) shows that 72 percent of aggregate 

community bank assets were funded with core deposits 

at year-end 1998. In contrast, 43 percent of aggregate 

large bank assets at year-end 1998 were funded with core 

deposits. This difference in liability structures reflects 

large banks’ broader use of wholesale funding alternatives and greater access to capital markets instruments. 

While large banks have responded to factors influencing deposit 

growth by making greater use of 

alternative funding sources, 

funding options for community 

banks tend to be more limited. 

Because of high fixed costs, community banks may find 

it more difficult than larger institutions to make costeffective use of capital market instruments such as securitizations or public debt and equity offerings (see 

“Industry Consolidation Presents Unique Risks and 

Challenges for Community Banks,” Regional Outlook, 

Fourth Quarter 1998, for a discussion of additional nondeposit funding sources for community banks). 

The need to augment lagging deposit growth to meet 

loan demand has led many community banks to acquire 

more noncore funds. These funds include time deposits 

greater than $100,000, borrowings, foreign deposits, 

brokered deposits, and demand notes. At year-end 1998, 

nearly 75 percent of community banks held noncore liabilities representing 10 percent or more of total liabilities. As recently as 1993, only 42 percent of community 

banks exceeded that threshold. Moreover, over the same 

five-year period, the ratio of core deposits (defined here 

as total deposits less time deposits greater than 

$100,000 and brokered deposits) to total deposits for all 

community banks declined each quarter. 

5 William R. Keeton, Federal Reserve Bank of Kansas City. “Are 

Rural Banks Facing Increased Funding Pressures? Evidence from 

Tenth District States.” Economic Review, Second Quarter 1998, p. 56. 

Also see “Regional Banking,” Regional Outlook, Kansas City Edition, Second Quarter 1998, p. 24. 

Boston Regional Outlook 13 Third Quarter 1999 
In Focus This Quarter
 

CHART 5 

Community Banks Relied More Heavily than Large Banks on Core Deposits* at Year-End 1998 

Large Banks Community Banks 

(total assets over $1 billion) (total assets under $1 billion) 

* Core deposits include total domestic deposits less time deposits greater than $100,000 and brokered deposits issued in denominations of less than $100,000. 

Source: Bank Call Reports (Research Information System) 

Other 

Domestic 

Deposits 

7% 

Borrowings 

16% 

Other 

Liabilities 

12% 

Equity and 

Subordinated 

Debt 

9% 

Core 

Deposits 

43% 

Foreign 

Deposits 

13% 

Other Domestic 

Deposits 

11% 

Borrowings 

6% 

Other 

Liabilities 

1% 

Equity and 

Subordinated Debt 

10% 

Core 

Deposits 

72% 

As community banks’ use of noncore funds has 

increased, they are relying more on federal funds purchased, repurchase agreements, other borrowings, 

demand notes, and mortgages (collectively referred to 

as borrowings). After adjusting for mergers, borrowings 

funded 12 percent of new community bank asset growth 

from 1992 through 1998—three times more than the 

percentage of new asset growth funded by borrowings 

from 1985 to 1990. Possibly reflecting a shift toward 

greater acceptance of wholesale funding by community 

bankers, growth in borrowings has been largely driven 

by increased use of nonovernight borrowings,6 which 

have become the dominant form of borrowings at community banks. As shown in Chart 6, the proportion of 

community banks reporting nonovernight borrowings 

has doubled in the 1990s. This trend coincides with 

growing community bank membership in the Federal 

Home Loan Bank (FHLB) system and increasing use of 

FHLB borrowings. 

Federal Home Loan Bank Membership 

Over the past five years, community banks have substantially increased their membership and participation 

in the FHLB system. According to data from the Federal Housing Finance Board, for the five-year period 

ending in 1998, the percentage of FDIC-insured community banks that were members of the FHLB more 

than doubled to 50 percent. Over the same period, FHLB 

advances outstanding for community banks grew by 

more than 50 percent to $47 billion. At year-end 1998, 

6 Nonovernight borrowings are defined here as all borrowings other 

than federal funds purchased and repurchase agreements. 

FHLB advances represented approximately 80 percent 

of all nonovernight borrowings for community banks. 

Analysts have cited a number of reasons why community banks are joining the FHLB system. Community 

banks are using FHLB advances to meet contingent liquidity needs, manage interest rate risk, fund new asset 

growth, and leverage capital to maintain or boost 

returns on equity. Recent surveys indicate that FHLB 

advances will continue to have a role in community 

bank liability management. Almost one-half of respondents to Grant Thornton’s 1999 Annual Survey of 

Community Bank Executives considered FHLB borrowings an important funding source over the next three 

years, and 43 percent plan to increase the use of FHLB 

advances in 1999. Similarly, the American Bankers 

Association’s 1999 Community Bank Competitiveness 

CHART 6 

’97 

0 

10 

20 

30 

40 

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

The Percentage of Community Banks Reporting 

Nonovernight Borrowings* Is Rising 

Community Banks 

Reporting Nonovernight 

Borrowings (%) 

* Includes all borrowings other than federal funds purchased and repurchase 

agreements 

Source: Bank Call Reports (FDIC Research Information System) 

Boston Regional Outlook 14 Third Quarter 1999 
In Focus This Quarter
 

Survey7 reported that FHLB advances are the preferred 

nontraditional funding product. In addition, legislative 

changes enacted in third-quarter 1998 have eased membership requirements for banks with assets less than 

$500 million, significantly increasing access to FHLB 

advances for smaller banks in rural areas. 

Implications of Funding Trends 

for Community Banks 

According to community banker opinion surveys, the 

trend toward greater reliance on noncore or alternative 

funding sources appears likely to continue. Grant 

Thornton’s 1999 Annual Survey of Community Bank 

Executives found that 75 percent of community bankers 

expect funding with core deposits to be more difficult in 

three years than it is today. Moreover, more than 20 percent of community bankers responding to the American 

Bankers Association’s 1999 Community Bank Competitiveness Survey do not expect to derive the bulk of their 

funding from deposits five years from now. Liability 

management is an important aspect of a bank’s operations and a key driver of interest expense. Responses to 

funding challenges will likely influence strategic business decisions that shape the risk profiles of insured 

institutions, particularly community banks that historically have relied more heavily upon core deposits to fund 

asset growth and net interest income for profitability. 

A fundamental challenge that confronts bank management is the strategic response to the increased costs 

associated with wholesale funding sources. As shown in 

Chart 7, the reported interest costs of nondeposit funding alternatives, such as federal funds purchased and 

repurchase agreements, subordinated notes, and FHLB 

advances, have traditionally exceeded the interest cost 

of core deposits for commercial banks. Therefore, as 

institutions that have typically relied upon core deposits 

increase the use of nondeposit sources, funding costs 

will likely rise relative to asset yields. As a result, net 

interest margins (NIMs) may be pressured. 

To some extent bank managers may be able to offset the 

higher interest costs of wholesale funding strategy by 

improving efficiency through greater management of 

overhead expenses and increases in noninterest income. 

However, community banks face challenges to their 

ability to increase noninterest income (see “Industry 

Consolidation Presents Unique Risks and Challenges 

CHART 7 

Subordinated Debt 

FHLB Advances 

0 

1 

2 

3 

4 

5 

6 

7 

8 

’93 ’94 ’95 ’96 ’97 ’98 

Reported Interest Cost for Commercial Banks (%) 

Nondeposit Alternatives Have Typically Cost 

More than Core Deposits 

Federal Funds 

Core Deposits* 

* Core deposit costs equal interest expense on total deposits minus time deposits 

greater than $100,000 divided by average total deposits minus average time 

deposits greater than $100,000. 

Sources: Bank Call Reports (FDIC Research Information System) and Federal 

Home Loan Bank (FHLB) System Annual Reports 

’ 

for Community Banks,” Regional Outlook, Fourth 

Quarter 1998), and there are limits to cost cutting. If 

banks are unable to fully offset higher funding costs 

with increases in noninterest income or reductions in 

noninterest expenses, overall profitability could suffer. 

Community bankers in the upper Midwest expressed 

this concern in a 1998 survey conducted by The Federal Reserve Bank of Minneapolis, which found that 57 

percent of respondents expect the shift away from 

deposit funding to decrease bank profitability.8 As bank 

managers search for additional ways to offset the relative rise in funding costs, they may be tempted to 

increase asset yields by pursuing additional portfolio 

risk, in the form of credit or market risk, to generate 

higher asset yields. 

Funding challenges also could alter the liquidity and 

interest rate risk positions of community banks. The relative complexity and volatility of some nondeposit 

sources require greater expertise and attention to assetliability policies and practices to avoid unexpected 

liquidity strains or exposures to changing interest rate 

environments. Strategies that result in the pledging of 

liquid assets, overreliance on purchased funds, or concentrations in price-sensitive long-term assets could 

adversely affect a bank’s relative liquidity or interest 

rate risk position. Moreover, interest rate risk management can be further challenged by the complexity of 

nondeposit funding sources. For instance, some FHLB 

advances may contain embedded options that required 

greater expertise and attention to policies and practices 

that, if not managed properly, could lead to undesirable 

outcomes if interest rates change adversely. 

7 ABA Banking Journal, February 1999, p. 30. 8 Fedgazette, July 1998, p. 2. 

Boston Regional Outlook 15 Third Quarter 1999 
In Focus This Quarter
 

Differences between Community Banks with 

High and Low Levels of Core Deposit Funding 

To evaluate how a shift from a core deposit funding 

strategy might change the profile of a community bank, 

TABLE 1 

performance and condition measures for community 

banks that rely most heavily on core deposits were contrasted with those that are least reliant on core deposit 

funding. Table 1 compares 1998 funding, earnings, and 

asset performance measures for these community bank 

Comparison of Banks with High and Low Levels of Core Deposit Funding 

ALL COMMUNITY BANK COMMUNITY BANK 

COMMUNITY BANKS1 AGRICULTURAL LENDERS2 COMMERCIAL LENDERS3 

HIGH CORE LOW CORE HIGH CORE LOW CORE HIGH CORE LOW CORE 

DEPOSIT DEPOSIT DEPOSIT DEPOSIT DEPOSIT DEPOSIT 

FUNDING4 FUNDING4 FUNDING FUNDING FUNDING FUNDING 

Selected Aggregate Measures 

NUMBER OF BANKS IN GROUP 405 405 106 51 126 185 

MEDIAN TOTAL ASSETS ($000S) 46,244 118,358 23,274 58,223 69,479 130,923 

MEMBERS OF FHLB (%) 32.10 49.38 17.92 47.06 38.89 50.81 

HAVE OUTSTANDING FHLB ADVANCES (%) 7.65 40.25 6.60 45.10 7.14 38.38 

Selected Median Liquidity and Funding Measures (%) 

1998 GROWTH IN TOTAL ASSETS 9.02 11.16 5.96 6.42 12.75 18.50 

1998 GROWTH IN TOTAL DEPOSITS 9.74 8.79 6.40 5.31 13.56 11.93 

1998 GROWTH IN BORROWINGS (50.00) 28.62 (64.49) 31.85 (51.87) 42.87 

1998 GROWTH IN TOTAL EQUITY CAPITAL 5.93 7.53 3.46 5.39 9.94 8.85 

TOTAL DEPOSITS-TO-TOTAL ASSETS RATIO 91.04 75.68 90.35 80.22 91.23 77.94 

CORE DEPOSITS-TO-TOTAL ASSETS RATIO 87.29 53.87 87.10 55.81 87.21 54.03 

BORROWINGS TO TOTAL ASSETS RATIO 0 9.58 0 4.15 0 8.55 

TOTAL EQUITY CAPITAL TO TOTAL ASSETS RATIO 8.25 10.24 9.00 10.09 7.74 10.16 

Selected Median Performance Ratios (%) 

RETURN ON EQUITY 12.65 10.19 11.10 10.93 14.49 9.52 

RETURN ON ASSETS 1.07 1.04 1.01 1.19 1.10 0.92 

NET INTEREST MARGIN 4.76 4.03 4.51 3.98 5.25 4.22 

GROSS EARNING ASSET YIELD5 8.17 8.02 8.24 7.89 8.45 8.26 

COST OF FUNDING EARNING ASSETS6 3.33 4.07 3.74 4.05 3.21 4.05 

NONINTEREST INCOME TO AVERAGE ASSETS 0.76 0.61 0.59 0.44 1.01 0.64 

NONINTEREST EXPENSE TO AVERAGE ASSETS 3.49 2.90 3.23 2.40 3.99 3.12 

EFFICIENCY RATIO7 69.01 63.68 68.59 57.48 68.99 67.00 

Selected Median Credit Quality Measures (%) 

NONPERFORMING ASSETS TO TOTAL ASSETS RATIO 0.39 0.44 0.40 0.51 0.46 0.61 

NONCURRENT LOANS TO TOTAL LOANS RATIO 0.53 0.72 0.53 1.02 0.52 0.77 

NET LOAN CHARGE-OFF RATIO 0.11 0.12 0.04 0.15 0.14 0.11 

1998 GROWTH IN NONPERFORMING ASSETS (9.10) 7.50 10.57 11.79 (17.32) 23.97 

1998 GROWTH IN NET LOAN LOSSES 6.09 10.24 (3.90) 23.73 9.59 30.64 

1 Community banks are banks with $1 billion or less in total assets. 

2 Agricultural lenders are banks with 25 percent or more of assets in agricultural real estate loans or agricultural production loans.
 

3 Commercial lenders are banks with 25 percent or more of assets in commercial and commercial real estate loans.
 

4 High core deposit funding group is composed of community banks with core deposits-to-assets ratios in the top 5
 

percent of all community banks, excluding those with equity-to-assets ratios in excess of 25 percent. The low core
 

deposit funding group is composed of community banks with core deposits-to-assets ratios in the bottom 5 percent
 

of all community banks.
 

5 Gross earning asset yield equals interest income divided by average earning assets.
 

6 Cost of funding earning assets equals interest expense divided by average earning assets.
 

7 Efficiency ratio equals noninterest expense divided by the sum of net interest and noninterest income.
 

FHLB = Federal Home Loan Bank
 

Sources: Bank Call Reports (Research Information System); Federal Housing Finance Board 


Boston Regional Outlook 16 Third Quarter 1999 
In Focus This Quarter
 

groups. High core deposit funders are defined as those 

community banks with core deposit-to-asset ratios in 

the top 5 percent of all community banks at year-end 

1998. Low core deposit funders are those community 

banks with a core deposit-to-asset ratio in the bottom 5 

percent.9 A similar comparison is included for agricultural banks and commercial lending specialists, which 

combined make up roughly 60 percent of each of the 

total community bank funding groups. 

This comparison reveals several differences. First, a 

tradeoff between heavy reliance on core funding and 

asset growth is evident. Median measures for the groups 

indicate that the typical bank that relies less on core 

deposit funding is larger and growing faster than the 

typical bank in the high core funding group. Second, 

less core deposit funding appears to be associated with 

a lower NIM, primarily the result of higher funding 

costs. However, overall profitability 

is similar between the groups 

mainly because of a lower ratio 

of overhead expenses to average assets for the low core 

funders. These characteristics are also evident across 

the agricultural and commercial specialists groups. 

Asset quality indicators suggest that the low core funding groups may exhibit greater credit risk. Although 

higher asset yields resulting from increased portfolio 

risk are not evident, median measures for each low core 

funding group reflect higher levels of noncurrent loans 

and higher growth in nonperforming assets and net loan 

losses relative to its high core funding group counter9 These groups exclude community banks with equity-to-asset ratios 

greater than 25 percent. 

part. For example, the median growth in nonperforming 

assets for commercial lending specialists with less 

reliance upon core deposits was nearly 24 percent in 

1998 versus a 17 percent decline for the high core funding group. 

Summary and Conclusions 

Commercial banks have been experiencing a long-term 

trend toward lower deposit funding of loans and assets. 

Increasing competition among banks and from thrifts, 

nonbanks, and higher-yielding investment alternatives 

has made it more difficult and expensive for some 

banks to attract deposits in step with asset growth. 

While some nondeposit funding alternatives may provide a stable source of funds for insured institutions 

(especially those located in areas characterized by 

aggressive competition and slow deposit growth), better 

matching of asset cash flows, and greater flexibility in 

asset-liability management, they also may pose certain 

risks. To some extent community banks may be able to 

manage noninterest expense and noninterest income to 

offset the relative increase in interest expense incurred 

to acquire nondeposit funding sources. However, if 

overall profitability suffers, banks may be tempted to 

pursue additional portfolio risk to generate higher offsetting asset yields. As a result, liability management 

may become more challenging for community banks 

that have historically relied upon deposits for funding 

and net interest revenues for profitability. In addition, 

the complexity of some nondeposit funding sources 

requires greater expertise and attention to policies and 

practices to avoid unexpected liquidity strains or exposures to changing interest rate environments. 

Allen Puwalski, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Boston Regional Outlook 17 Third Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

•	 The Region’s labor market showed slower growth through June 1999, while residential building activity 

moderated following a surge in 1998. 

•	 The Region’s commercial lending institutions have been hit hard by recent refinancing activity, as evidenced 

by a sharp decline in net interest margins. 

•	 Increased reliance on alternative funding sources to facilitate asset expansion has become necessary in 

today’s competitive environment but has long-term implications in the areas of earnings, liquidity, and 

asset/liability management. 

Regional Economic and Banking Conditions 

Region’s Economy Slowed 

Modestly in Early 1999 

The Region’s seasonally adjusted unemployment rate 

inched lower during early 1999, bottoming out at 3 percent during March and April, then moving higher to 3.2 

percent in June. In each New England state, with the 

exception of Connecticut, the unemployment rate rose 

between April and June, with Maine and Rhode Island 

witnessing the largest rises. Maine’s rate, at 4.4 percent 

for June, was again above the national average. In contrast, New Hampshire continued to have the Region’s 

tightest labor market, with an unemployment rate of 2.6 

percent. The pace of growth in the number of new jobs 

slowed during the first six months of 1999, with the 

year-over-year advance in the Region’s level of nonfarm 

payrolls averaging 1.7 percent after rising 2.3 percent 

for the full year 1998. Strength in other sectors offset 

CHART 1 

–15 

–10 

–5 

0 

5 

10 

Manufacturing Employment,

Percent Change One Year Ago

Massachusetts 

Region 

Nation 

Massachusetts Factory Payrolls Were Weakest 

in Region...but Rate of Decline Has Eased 

Source: Bureau of Labor Statistics 

1998 1999 

continued declines in manufacturing employment. 

Weakness in technology manufacturing, forest products, textiles, and apparel continued to depress the 

Region’s factory payrolls, but the pace of decline in first 

half 1999 slowed somewhat compared with the latter 

half of 1998. Chart 1 shows this moderation. Strengthening domestic demand, some stabilization in paper 

prices, and an acceleration in orders and output for 

manufactured goods (including certain technology 

products) were likely behind the moderation in manufacturing job losses across the Region. 

The Region’s housing market continued to advance in 

the first part of 1999; existing home sales remained 

strong, although growth in building permit issuance 

moderated (see Regional Perspectives, Second Quarter 

1999, for a discussion of housing prices and building 

trends across the Region). Recently revised data on 

existing home sales from the National Association of 

Realtors indicate that New England experienced a nearly 13 percent increase in sales last year and has been 

matching the national pace of growth during the past 

several years. During the first quarter, sales in the 

Region rose by almost 9 percent from a year ago, compared with about 8 percent for the nation. The Region’s 

strongest percentage gain in home sales last year and in 

early 1999 was in Rhode Island (20 percent in 1998 and 

22 percent in 1999), while New Hampshire, Connecticut, and Maine posted 13 to 14 percent advances. Sales 

volume in Massachusetts rose 10 percent last year, 

continuing at about that pace during the first quarter of 

1999. Only Vermont, which posted an increase in home 

sales last year following three years of decline, saw 

sales soften in the first quarter. Thus, despite somewhat 

higher interest rates in 1999, the demand for homes in 

New England generally remained strong. 

Boston Regional Outlook 18	 Third Quarter 1999 
Regional Perspectives
 

The number of residential building permits issued in the 

New England states during 1998 was less than one-half 

the peak levels seen during the prior decade, except in 

Maine (at 64 percent of peak). However, last year’s 

growth rate in annual building permits was impressive. 

Across New England, residential building permit 

issuance jumped by nearly 17 percent (see Table 1), the 

strongest advance since 1992. Most of the new building 

remains concentrated in single-family dwellings, with 

multifamily units accounting for only 15 percent of total 

permit issuance; regionwide, 1998 issuance of multifamily permits was 20 percent of its 1986 peak level. 

On a state-by-state basis, 1998 provided some startling 

growth comparisons. Gains in Maine and Vermont 

reflected their strongest percentage advances since 

1984. Connecticut had its best performance since 1985. 

Only Rhode Island had a modest decline in permit 

issuance in 1998, but it reversed in the first five months 

of 1999. 

For the Region as a whole, last year’s growth in permit 

issuance moderated in the first five months of 1999. 

Through May 1999, only about 2 percent more permits 

were issued than during the same period in 1998. Massachusetts (40 percent of permits issued in New 

England) and Connecticut (25 percent of permits) were 

driving the slowdown. Until data for the entire 1999 

building season are available, a complete determination 

of overall residential construction activity cannot be 

made. However, building activity did not slow in all of 

the Region’s states. In addition to Rhode Island, permit 

issuance accelerated in New Hampshire. Also, although 

Maine’s growth rate slowed from the prior year’s pace, 

it still remained high. 

Region’s Banks Continue to Perform Well 

but Are Experiencing Margin Erosion 

The Boston Region’s insured institutions performed 

well through the first quarter of 1999 but show continTABLE 2 

TABLE 1 

Residential Permit Issuance 

Surged in 1998, but 

1999 May See Slower Growth 

(percent change from year ago) 

JAN–MAY 1991– 

1999 1998 1997* 

NATION 7.1 11.9 7.2 

REGION 1.9 16.8 4.4 

MASSACHUSETTS 0.6 12.0 5.2 

CONNECTICUT –6.5 27.4 3.7 

MAINE 19.0 33.4 4.0 

NEW HAMPSHIRE 14.5 6.8 7.6 

RHODE ISLAND 7.5 –1.1 2.0 

VERMONT 9.7 20.0 –1.6 

* Compound annual rate 

Source: U.S. Bureau of the Census 

ued signs of declining margins. The aggregate return on 

assets (ROA) (excluding credit card institutions) of 1.22 

percent was a slight decline from 1.24 percent reported 

in March 1998 (merger adjusted) but still above the 

national average of 1.19 percent. The net interest margin (NIM) of 3.86 represents a further decline in the 

Region but exceeds the national average of 3.72 percent. The past-due ratio continues to improve and was 

1.63 percent as of March 1999, well below the national 

average (see Table 2). 

Institutions with more than $1 billion in assets, excluding the credit card institutions, reported an aggregate 

ROA of 1.27 percent, which is on par with the yearearlier level. The Region’s three largest institutions 

(assets greater than $25 billion) continue to raise the 

Region’s aggregate profitability. Excluding these three 

banks and the credit card institutions, the remaining 

institutions with more than $1 billion in assets posted an 

aggregate ROA of 1.10 percent, which is a decline of 11 

basis points from a year earlier. 

Boston Region Institutions Continue to Fare Better than National Averages 

BOSTON REGION INSTITUTIONS* NATIONAL AVERAGES* 

FINANCIAL INDICATORS (%) MAR 99 MAR 98 MAR 97 MAR 96 MAR 99 MAR 98 MAR 97 MAR 96 

RETURN ON ASSETS 1.22 1.24 1.19 1.20 1.19 1.17 1.17 1.06 

NET INTEREST MARGIN 3.86 3.90 4.09 3.96 3.72 3.77 3.90 3.90 

PAST-DUE RATIO 1.63 1.82 2.45 2.70 2.01 2.12 2.34 2.48 

* Excludes credit card institutions 

Source: Bank & Thrift Call Reports 

Boston Regional Outlook 19 Third Quarter 1999 
Regional Perspectives
 

Institutions with less than $1 billion in assets posted a 

collective ROA of 1.06 percent, down from a high of 

1.16 percent in June 1998. Continued margin compression, arising from a low interest rate environment and 

strong competition for both loans and deposits, is the 

primary reason for the downward earnings trend. The 

NIM for these smaller institutions has declined 21 basis 

points over the past four quarters. 

Spotlight on Commercial 

Lending Institutions 

The Region has 118 commercial lending institutions.1 

These institutions comprise about 36 percent of the 

Region’s total banking assets and have registered significant declines in net interest margins. The median NIM 

of 4.42 percent has declined 25 basis points since 

1 Commercial lending institutions are defined as institutions with the 

sum of commercial and industrial, multifamily, and commercial real 

estate loans exceeding 25 percent of total assets. Complete definitions for all institution categories are listed in the Boston Regional 

Outlook, Second Quarter 1999. 

March 1998, with net interest income continuing to be 

pressured by declining asset yields and the inability to 

decrease interest expense significantly. Commercial 

lending institutions appear to have been particularly 

affected by heavy refinancing in commercial real estate 

and commercial loan portfolios, which has lowered 

portfolio yields. The median ROA for these institutions 

for the quarter ended March 1999 was 1.05 percent, 5 

basis points below year-earlier levels. The ratio of net 

operating income to average assets actually declined 10 

basis points, suggesting a greater reliance on securities 

gains to bolster earnings. Asset quality indicators 

remain favorable, with delinquencies at historically low 

levels. However, with net interest margins pressuring 

income levels, there has been a significant shift in loan 

mix away from lower-risk residential mortgages and 

into commercial credits, with growth in commercial 

loans particularly robust (22 percent annual rate over 

the past two years). The strong loan growth experienced 

by the commercial lending institutions (13 percent overall), coupled with the shift in loan mix toward historically higher-risk credits, underscores the need to 

maintain underwriting standards to ensure that credit 

quality is not compromised. 

Insured Institutions Are Increasingly Relying on Alternative Funding Sources
 

Funding Structure Changes 

Increased competition for consumer financial assets and 

shifts in consumer preferences toward higher-yielding 

investment products such as stocks and mutual funds 

have contributed to the slow growth of traditional core 

deposits at insured institutions. As a result, insured 

institutions have increased their reliance on noncore 

funding sources to support asset growth. 

During the 1990s, the funding structure of insured institutions has steadily shifted away from core deposits.2 In 

the pre-recession period of the late 1980s, the core 

deposit-to-asset ratio among the Region’s institutions 

with less than $1 billion in assets (on a merger-adjusted 

basis) began to increase as deposit growth exceeded 

loan growth. This trend continued until 1993. Since 

2 While the distinction between core and noncore funding has become 

blurred, core deposits are still generally considered more stable than 

noncore funding for this analysis. Core deposits are defined as the 

sum of Call Report items for demand deposits, NOW accounts, 

money market deposit accounts, other savings, and time deposits 

under $100,000. 

1993, these institutions have experienced loan growth 

well in excess of core deposit growth. They are turning 

more to noncore funding, which has increased, on average, 20 percent per year for the past five years. 

While competition from nonbanks continues to pull 

deposits from insured institutions, there have been significant shifts within the mix of the remaining core 

deposit base. After several years of high interest rates 

relative to the rate paid on savings and NOW accounts, 

interest rates on time deposits declined sharply in 1992,3 

and at times, rates paid on these nonmaturity accounts 

exceeded those being offered on new time deposits. As 

a result, deposits shifted from time deposits into savings, NOW, and money market deposit accounts (nonmaturity deposits). Nonmaturity deposits in the 

Region’s insured institutions increased steadily until 

interest rates rose approximately 300 basis points in 

early 1994. The growth in nonmaturity deposits was 

largely the result of migration from time deposits as the 

rate differential between nonmaturity and time deposits 

3 Source: Bank Rate Monitor 

Boston Regional Outlook 20 Third Quarter 1999 
Regional Perspectives
 

narrowed and a flat yield curve provided minimal incentive for depositors to invest in longer-term instruments. 

Subsequently, when rates on these nonmaturity deposits 

were lowered, customers appeared to prefer liquidity, 

keeping their funds in the nonmaturity deposit accounts. 

Although time deposit rates have increased slightly 

from the lows of the early 1990s, these deposits have 

not seen major growth. While nonmaturity deposits are 

usually viewed as stable funds, if the spread between 

market interest rates and the rates paid on these 

accounts increases significantly, a portion will likely 

migrate back to the higher-yielding time deposits or 

seek higher returns elsewhere. This phenomenon 

occurred in the mid-1980s and poses a risk to bank 

earnings should interest rates rise appreciably. Chart 2 

depicts this migration for Boston Region institutions 

(excluding thrifts) with assets of less than $1 billion in 

the late 1980s as the spread between market rates and 

the passbook savings rate reached 300 basis points, and 

again in the mid-1990s when it increased to almost 400 

basis points. 

While the prospects for sharply higher interest rates 

remain remote, insured institutions are increasingly 

relying on the ability to manage the cost of nonmaturity deposits as an asset/liability management tool. For 

most of the Region’s insured institutions, nonmaturity 

deposits now comprise over 40 percent of total interestbearing liabilities. Asset durations are extending, and 

control of interest costs on nonmaturity deposits is 

becoming increasingly important for managing the level 

of net interest income. A significantly higher interest 

rate environment may impair the effectiveness of this 

tool and, as a result, reduce earnings. 

CHART 2 

As a result of strong loan growth and slow core deposit 

growth, the Region’s average loan-to-deposit (LTD) 

ratio of 84 percent continues to climb from lows 

reached during the early 1990s (see Chart 3). Fifty-five 

percent of the Region’s institutions reported a LTD ratio 

above 75 percent at the end of the first quarter of 1999. 

Institutions with less than $1 billion in assets have an 

average LTD ratio of 78 percent, and institutions with 

more than $1 billion in assets have an average LTD ratio 

of 88 percent. 

High LTD ratios have historically suggested a tightening of liquidity; however, changes in public markets and 

the securities and loan portfolios of insured institutions 

may have reduced the effectiveness of the LTD ratio as 

a liquidity indicator. The increase in nonloan products, 

such as mortgage-backed securities and other consumer 

receivable asset-backed instruments, has helped 

increase asset cash flow. The amortization of these 

instruments may not be predictable but may be a sizable 

liquidity source. Also, it has become easier to securitize 

assets in public markets. As evidenced by the asset and 

loan growth in the Region, the changes in funding have 

not slowed loan originations or adversely affected liquidity. Despite increased use of noncore funding by the 

Region’s banks (see Chart 3), examiners are not citing 

any generalized liquidity concerns. 

While typically less reliant on noncore funding than 

commercial banks, the Region’s savings institutions 

have increased their use of noncore funding. As of 

March 1999, savings institutions had a total noncorefunding-to-assets ratio of 22 percent, with borrowings 

accounting for the largest share. Core deposits funded 

67 percent of total assets, down from 83 percent in 

CHART 3 

Funds Shift to CDs as Spread Increases 

Percent of Core Deposits

Interest Rates (percent) 

Sources: Bank Call Reports; Bank Rate Monitor; Federal Reserve 

1Q 

’87 

1Q 

’89 

1Q 

’91 

1Q 

’93 

1Q 

’95 

1Q 

’97 

1Q 

’99 

CDs (L) 

Savings and NOW (L) 

0 

10 

20 

30 

40 

50 

60 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

6.0 

7.0 

8.0 

9.0 

Passbook Rate (R) 

1 year T-bill (R) 

Loans to Deposits 

Noncore Funding to Assets 

Core Deposits to Assets 

Source: Bank and Thrift Call Reports 

Region’s Institutions Increasing Noncore Funding 

0 

20 

40 

60 

80 

Percent 

100 

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

Boston Regional Outlook 21 Third Quarter 1999 
Regional Perspectives
 

1993. Although savings institutions have historically 

been heavy residential mortgage lenders, they have 

recently focused on expanding consumer and commercial loan portfolios, and borrowings have supported 

growth in these sectors of the loan portfolio. 

FHLB Advances Appealing to More Banks 

The Federal Home Loan Bank (FHLB) system continues to market its products to banks as a competitively 

priced source of funding, and more institutions are 

using FHLB advances. According to the 1998 FHLB of 

Boston Annual Report, advances to members increased 

17 percent in 1996, 20 percent in 1997, and 21 percent 

in 1998. 

A recent survey of community bankers conducted by 

Grant Thornton indicated that FHLB funding is 

increasing in popularity; 43 percent of small banks 

nationwide plan to use more 

FHLB advances in 1999. FHLB 

use is expected to rise as the list of 

eligible collateral for advances 

expands and more institutions 

become eligible for membership. 

As stated in the 1998 FHLB of Boston Annual Report, 

a shift toward longer-term advances is occurring. At 

year-end 1998, 76 percent of total advances outstanding 

had original maturities greater than one year, compared 

with 58 percent at year-end 1997. The use of long-term 

FHLB advances is one strategy that insured institutions 

are using to offset the trend toward extension of asset 

maturities that has occurred over the past few years. 

This extension is the direct result of heavy refinancing 

activity in both the residential and commercial sectors 

of the loan portfolio in response to the recent low, flat 

yield curve environment. In the past 12 months, the 373 

institutions that filed bank Call Reports (excludes Thrift 

Financial Report filers) reported that the share of residential real estate loans that either matured or repriced 

in over five years increased from 39 percent to 50 percent. Over the same time frame, the percentage of certificates of deposit maturing in excess of one year 

declined from 25 percent to 20 percent. Clearly, insured 

institutions need to look to other sources for long-term 

funding to mitigate the widening gap between asset and 

liability durations, and the FHLB has become a major 

provider of longer-term funding. In the Boston Region, 

378 of the 429 insured institutions are members of the 

FHLB of Boston. As of year-end 1998, 69 percent of the 

members had outstanding advances. 

While the FHLB can provide a stable and competitively 

priced funding alternative for the Region’s insured institutions, overreliance on the FHLB, or any single funding source, may limit an institution’s liquidity flexibility 

during periods of stress. Existing supervisory guidance 

recommends that effective liquidity management 

include identifying and testing several reliable sources 

of funding and ensuring that an institution does not 

become overly reliant on any single funding source. 

Conclusion 

More institutions, especially those in areas with aggressive competition, are relying on noncore funding to support asset expansion. The shifting funding structure may 

contribute to greater volatility in funding and increase 

sensitivity to changing market conditions, which may 

complicate asset/liability management and liquidity 

management in the Region’s insured institutions. 

Insured financial institutions may face additional pressure on margins as competition and an increasing 

reliance on noncore funding result in assets being 

booked at smaller marginal spreads. As a result, some 

institutions may seek higher-yielding assets, which 

could result in higher levels of credit risk. In such an 

environment, great care should be taken to maintain 

adequate control over underwriting standards. 

Boston Region Staff 

Boston Regional Outlook 22 Third Quarter 1999 
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