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FDIC: National Edition Regional Outlook, Third Quarter 1999

Atlanta Regional Perspectives Sustained price weakness in certain agricultural and industrial commodities could adversely affect the Atlanta Region's economy, given the importance of agriculture and manufacturing in the Region. Low inflationary expectations, excess productive capacity, and curtailed global demand have driven down prices for a number of commodities produced in the Region. Hog, soybean, and cotton prices have been among the hardest hit. Meanwhile, as many Asian and Latin American nations linger in recession, the U.S. economy is among the few displaying consistent strong growth. That fact has resulted in a severe and growing imbalance between imports and exports in the steel, textile and apparel, and paper and allied products markets. For further analysis, see this quarter's In Focus article, Falling Prices in Commodities and Manufacturing Pose Continuing Risks to Credit Quality. While overall economic growth in the Region remains strong, most gains during this expansion have occurred in the larger and more economically diverse metropolitan areas. Much slower growth has been recorded in many rural areas, where production of some of the commodities facing the greatest price declines is concentrated. If price stagnation persists, certain agricultural and manufacturing-based communities could experience further declines in income and employment. Those conditions, in turn, could damage insured institutions serving those communities, particularly those with significant direct credit exposure to the affected industries. Consistent with the national trend, banks in the Atlanta Region are becoming more reliant on borrowings to meet their funding needs (see this quarter's In Focus article, Shifting Funding Trends Pose Challenges for Community Banks). Bank funding has changed considerably in the 1990s. Change has been driven in part by cyclical factors, but differences in the way the industry is funded compared with previous expansions suggest that factors other than the business cycle are influencing funding decisions. Deposit growth at Atlanta Region banks has lagged loan demand since the current economic expansion began in 1992. The increase in loan growth relative to deposit growth has led to a greater reliance on noncore funding by both large and small banks in the Region. Slower deposit growth has resulted in part from increased competition from nonbank financial services providers such as mutual funds and credit unions, as well as from an increase in alternative, nondeposit funding sources available to banks. A more diverse funding mix can offer benefits with regard to pricing and balance sheet management, but a shift from core to noncore funding is not without new potential risks. With net interest margins already pressured by pricing competition and a flattened yield curve, there is some concern that the higher interest costs normally associated with noncore funding could lead to more risk taking (credit risk or interest rate risk) in search of higher asset yields. The move from core to noncore funding also may have liability-side liquidity implications. As banks turn more attention to alternative funding, there may be less focus on gathering retail deposits. This raises the question of whether banks could recapture deposit share lost to competitors such as mutual funds or credit unions in the event that financial market turmoil or credit quality concerns unexpectedly diminish alternative funding. Community banks may face greater funding challenges than larger banks. A 1998 survey conducted by the American Bankers Association found that four of ten community bankers nationwide reported core deposit growth lagging loan demand. In addition, a 1999 Grant Thornton survey showed that three of four community bankers believe core funding will be a greater challenge three years from now. Factors that could constrain community bank funding relative to that of large banks include limited access to the capital markets, a smaller geographic presence from which to solicit deposits, and slower rural population growth. According to an article in the June 7, 1999, American Banker, some small banks are soliciting out-of-market deposits to meet loan demand because core deposit growth is insufficient. This practice can increase interest costs, however, and because many community banks have limited fee income opportunities, they are structurally more reliant than larger banks on spread income from taking deposits and making loans. Many industry observers believe that the funding challenges facing banks are long-term rather than cyclical. This will add to the complexity of asset and liability management going forward. Maintaining a cost structure consistent with the mix of retail and wholesale funding will be critical for banks to continue to grow without sacrificing profitability. Regardless of how funds are acquired in the future, managers of insured institutions must allocate those funds so as to achieve earnings and growth objectives without subjecting institutions to undue credit, interest rate, or liquidity risks. Boston Regional Perspectives The Region's seasonally adjusted unemployment rate inched lower during 1999, bottoming out at 3 percent in April, then moving to 3.2 percent by June. New Hampshire continued to have the Region's tightest labor market, with an unemployment rate of 2.6 percent in June. 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 continued declines in manufacturing employment. The Region's housing market continued to advance in the first part of 1999; sales of existing homes remained strong, although growth in building permit issuance moderated. 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. Across New England, residential building permit issuance jumped by nearly 17 percent in 1998, the strongest advance since 1992. Most of the new building is concentrated in single-family dwellings, with multifamily units accounting for only 15 percent of total permit issuance. Through May 1999, only about 2 percent more permits were issued than in the same period in 1998; however, until data for the entire 1999 building season are available, a complete determination of overall residential construction activity cannot be made. The Boston Region's insured institutions performed well through the first quarter of 1999, but earnings strains are evident as a result of steadily declining margins. Asset quality remains strong; the past-due ratio continues to improve and remains well below the national average. Commercial lending institutions in particular have experienced a sharp decline in net interest margins (NIMs). The median NIM of 4.42 percent has declined 25 basis points since March 1998, with net interest income continuing to be pressured by declining asset yields and the inability to decrease interest expense significantly. The median return on assets (ROA) for these institutions for the quarter ended March 1999 was 1.05 percent, 5 basis points below year-earlier levels, but delinquencies are 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. Strong loan growth, coupled with the shift in loan mix, underscores the need to maintain underwriting standards to ensure that credit quality is not compromised. Insured institutions are becoming increasingly reliant 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 more than 40 percent of total interest-bearing 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, earnings. The Federal Home Loan Bank (FHLB) system continues to expand lending activity in the Region. 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, with a shift toward longer-term advances. 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 more than 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 have needed 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 such funding. Increasing use of noncore funding sources such as FHLB borrowings can provide stable, competitively priced funding alternatives for insured institutions. However, overreliance on any single funding source may limit an institution's liquidity flexibility during periods of stress. Existing supervisory guidance recommends that effective liquidity management include the identification and testing of several reliable sources of funding and ensure that an institution does not become overly reliant on any single funding source. Chicago Regional Perspectives While the Region's economy remains healthy, growth has slowed. The past year's slowdown in job growth reflects, in part, the Region's record low unemployment rate of 3.7 percent. However, the slowdown also reflects the loss of manufacturing jobs and slower job growth among firms providing business, professional, and other services. These two sectors accounted for almost half of all jobs in the Region last year. Some strengthening in manufacturers' orders for nondefense goods suggests that the past year's weakening among the Region's firms may not worsen in coming quarters. Even the steel industry may improve once the effects of recently negotiated trade sanctions and agreements to reduce steel imports are felt. In addition, a correction of last year's inventory bulge and a first-quarter reversal of declining production levels indicate that a modest improvement may be occurring in this sector. Should interest rates continue rising, negative repercussions likely will be felt in many ways, including lower consumer confidence and spending, reduced residential and commercial construction, and weakness among interest-sensitive manufacturers and other sectors. Bank and thrift performance in the first quarter remained healthy despite continued contraction in the net interest margin. Noninterest income continues to support improvement in the Region's level of profitability. In spite of weakness in the mortgage market in the first quarter, the Region's thrifts performed well by increasing noninterest income and controlling overhead expenses. Weakness persists in the agricultural sector. Continued weakness in crop and hog prices has led to falling repayments, rising past-due levels, and increasing carryover debt. Government estimates forecast a decline in the Region's farm income in 1999. Production loan demand remains strong, as weak commodity prices caused farmers to use more of their borrowing capacity to finance planting needs. One survey notes that agricultural lenders continue to see a decline in repayments. In addition, the FDIC's most recent Report on Underwriting Practices suggests that carryover debt is increasing at agricultural banks. With loan growth outpacing deposit growth in recent years, many insured institutions have sought alternative funding sources. Loan-to-deposit ratios have been rising steadily in the Region as more institutions turn to noncore funding sources. An increase in Federal Home Loan Bank system advances has contributed significantly to this trend. Higher levels of noncore funding have compressed net interest margins. However, institutions that have shifted significantly toward noncore funding over the past decade have offset the higher costs through capital retention and increased noninterest income. The diversity of funding sources now available even to small institutions has many benefits but underscores the need for heightened management expertise. Institutions should have policies and procedures to ensure that the benefits and risks of all funding sources are understood, appropriate limits are established, and effective liquidity monitoring is practiced. With the implementation of appropriate safeguards and growth in noninterest income to offset potentially higher costs, alternative funding sources may be a viable option for many of the Region's institutions. Dallas Regional Perspectives Nonfarm payroll employment data through the first half of 1999 continue to point toward a strong but slowing economy in the Region. Seasonally adjusted payroll employment growth rates for the first five months of 1999 show that Oklahoma (2.3 percent), Colorado (2.5 percent), and Texas (2.9 percent) continue to grow at or above the national average rate (2.3 percent). The only exception was New Mexico (1.3 percent). Employment growth remains strong in the Region largely because of expanding activity in construction, transportation and communications, and financial and business services. Meanwhile, economic weakness among the Region's major trading partners and low oil prices caused by overproduction and weak demand have led to significant job losses in the mining and manufacturing sectors. Approximately 33,000 jobs were lost in these two industry sectors during the year ending May 1999. Economic and employment growth are expected to slow somewhat further during the second half of this year. Agricultural producers in the Region face continuing stress. Prices of the Region's primary agricultural commodities have been depressed, and many agricultural production centers have experienced weather-related problems. The near-term outlook for agriculture is uncertain. Farm income is expected to remain depressed by low commodity prices largely attributable to high global production and large inventories. In addition, agricultural producers have had to contend with weak export demand for U.S. commodities and a strong U.S. dollar. For example, Texas's agricultural crop exports declined more than 40 percent during the first quarter of 1999, compared with a year earlier, and livestock exports declined by more than 50 percent. Despite a slight increase in past-due loans during the first quarter, farm banks in the Region continue to report healthy profits and strong credit quality. Another year of low prices or extreme weather conditions, however, could place enough stress on weaker agricultural producers to begin affecting farm banks' loan quality and earnings. Dallas Region banks and thrifts reported good, but somewhat weaker operating results for the first quarter of 1999. Average return on assets was 1.11 percent, 14 basis points less than the same period one year ago. Additionally, credit quality appears to show initial signs of weakening, with past-due loans as a percentage of total loans increasing during each of the past four quarters. The sharpest increases in past-due loans were in commercial and industrial loans, followed by loans secured by farmland. A growing number of institutions reporting losses and initial signs of weakening credit quality may be a forewarning of poorer performance ahead, particularly in the face of a slower-growing economy in the Region. Although savings institutions in the Dallas Region follow the nationwide trend of increasing reliance on noncore sources to fund loan growth, commercial banks differ materially. Commercial banks continue to rely heavily on deposit funding and enjoy an extraordinary low cost of funds thanks to a high percentage of noninterest-bearing deposits. However, the Region's commercial banks have not experienced the growth in loans seen at the Region's savings institutions over the past several years. If commercial banks begin to lose core deposits or experience strong loan growth, they may be compelled to use more noncore funding. Pressures to maintain interest margins caused by higher funding costs associated with greater noncore funding, as well as heightened competition, may also tempt institutions to seek higher yields and could result in higher credit risk. This potential shift in funding structure may contribute to greater volatility in funding and increase sensitivity to changing market conditions. Kansas City Regional Perspectives The 1980s were marked by a turbulent agricultural economy that saw rapidly declining farm income and farm real estate values. This situation led to the failure of many farm banks,1 especially within the Kansas City Region. With prices for wheat, corn, soybeans, hogs, and cattle depressed again in 1999, many people are beginning to ask if the agricultural crisis of the 1980s is about to recur. This question has important ramifications for the Region, because over half the Region's institutions are farm banks, and over half the nation's farm banks are located in the Region. To understand the 1980s farm crisis, we must review the conditions present in the 1970s, a decade of unprecedented agricultural prosperity. Export demand for farm products boosted U.S. agricultural exports to record levels. Encouraged by the federal government, farms increased supply dramatically. In addition, negative real interest rates and widely available credit caused massive investment in farm real estate, pushing up farmland values. Farmers' debt levels escalated but were offset by large gains in farmland equity. However, the prosperity unraveled in the 1980s. Demand for farm exports subsided, decreasing the Region's farm income significantly. Inflation was stabilized, but high nominal interest rates were slow to fall, making it difficult for debt-saddled farmers to meet their financial obligations. Farmland values fell back to historical levels. During this period, many farmers sold out or went bankrupt, and diminished collateral values were often less than underlying debt levels. Farmers' fortunes improved considerably between 1987 and 1990. Aggregate debt levels declined significantly as a result of an increase in loan charge-offs and farmers' attempts to reduce debt levels. Farmers also benefited greatly from federal government payments during the last part of the 1980s. 1 The Federal Deposit Insurance Corporation (FDIC) defines farm banks as FDIC-insured financial institutions that have at least 25 percent of their loans for agricultural production or secured by agricultural real estate. Current difficulties in agriculture include continued low commodity prices and declining farmland values. The U.S. Department of Agriculture forecasts that prices for wheat, corn, and soybeans will remain depressed through 2000 and that prices for cattle and hogs will improve only modestly. Farmland values have declined recently in much of the Region. Despite these difficulties, the level of risk in the agricultural sector is considerably lower today than in the 1980s. Current debt levels, in real terms, are similar to levels prior to the buildup of the 1970s. Land values have not increased as dramatically as they did in the 1970s, instead rising only gradually with improvements in agricultural productivity. As a result, despite recent small declines, farmland values appear less vulnerable to the precipitous declines seen in the 1980s. Finally, low debt levels and stable farmland values have caused aggregate debt-to-equity ratios to be commensurate with levels reported over most of the past 40 years. On the banking side, studies by the St. Louis Federal Reserve Bank and the FDIC have shown that the most significant quantifiable indicator of farm bank failure in the 1980s was the loan-to-asset (LTA) ratio. Concentration in farm loans was also an indicator of failure, while higher capital levels indicated less risk of failing. At year-end 1998, farm banks in the Region had a significantly higher aggregate LTA ratio than their counterparts in 1982, possibly indicating increased risk. In aggregate, this increased risk appears to be offset by higher levels of capital and loan loss reserves. Some farm banks in the Region, however, show higher-than-normal risk, as they have elevated LTA ratios and lower-than-average capital. In conclusion, although a recurrence of the agricultural crisis of the 1980s is not expected, concerns persist. Continued low commodity prices, farm banks' apparent increased risk tolerance, and uncertainty surrounding the federal farm programs cloud the future for farm banks in the Region. Memphis Regional Perspectives The Memphis Region's employment growth continues to lag that of the nation. Most sectors reported slower growth with job losses continuing in the nondurable manufacturing sector, which reported a 3 percent decline in employment during 1998. Some sectors are growing strongly, most notably the gaming, construction, and automobile industries. Mississippi's gaming industry remains a strength in a slowing state economy. Employment gains in Mississippi can be linked to the thriving Tunica County and Gulf Coast gaming markets. This growth includes direct employment at the 29 operating casinos totaling 38,000 people, or approximately 3 percent of the state's total employment, as well as indirect employment of approximately 28,000. Expansion of the casino industry and improvements to infrastructure designed to support the industry are driving strong construction employment growth. Metropolitan markets continue to post high real estate construction activity. Nashville reports strong construction activity and rising office and industrial vacancies. The announced construction of a major computer manufacturing facility in the city should boost most real estate market segments, however. The New Orleans hotel market is reporting some weaknesses, caused in part by growing competition from the nearby Mississippi Gulf Coast casino and lodging market. The city's office market also may weaken because of consolidations, relocations, and layoffs in the energy sector. The automotive industry remains strong but could weaken from higher gasoline prices. The Region's automobile sector is becoming increasingly dependent on sales of large trucks and sport utility vehicles. While these products remain extremely popular, rising gasoline prices or interest rates could lead to a slowdown in sales just as plants retool for higher production. Farm conditions are deteriorating and could lead to problems for agricultural lenders. Past-due agricultural loan levels for the 121 agricultural banks in the Region rose to 6.2 percent of agricultural loans in the first quarter of 1999, the highest level since 1987. Anecdotal evidence from bankers also suggests that farm carryover debt is increasing. Even with improved production in 1999, low prices and escalating input costs are likely to extend the time farmers require to repay carryover debt. With the problems in the sector, farm collateral values are beginning to weaken. The Region's banks and thrifts maintain healthy financial conditions, although earnings performance sagged in the first quarter of 1999. The average return on assets for the quarter was 0.92 percent, down from 1.15 percent in the first quarter of 1998. The decline in earnings was driven by a decline in the average net interest margin to 4.22 percent from 4.38 percent one year ago. Banks and thrifts in the Region report increasing loan-to-deposit ratios and declining core deposits relative to total funding sources. Core deposit growth has not kept pace with loan growth during this economic expansion, as shown in the table. Although these trends are especially evident at larger institutions, most banks and thrifts are affected. Reasons for weak deposit growth include lower consumer savings rates, increasing investments in mutual funds and other alternative investments, and competition for deposits from credit unions and brokerage firms. Because of weak deposit growth, insured institutions are increasingly turning to noncore funding sources. These changes in funding strategies point to continuing pressures on interest margins. Institutions with lower core funding levels report higher interest expenses than other institutions. They also report consistently lower net interest margins and returns on assets. New York Regional Perspectives Employment levels in the Region continue to rise. From first-quarter 1998 through first-quarter 1999, 337,000 new jobs were added to the Region's employment base, a growth rate of 1.7 percent, compared with the national rate of 2.2 percent. This year marks more than six consecutive years of job growth in the Region. Housing markets in many parts of the Region have been heating up after several years of little activity. Sales of existing homes as well as construction of new single-family homes have been on the rise in most states in the Region. Housing prices also have risen, reflecting strong demand. The Region's banks and thrifts reported generally healthy financial conditions in the first quarter of 1999. The Region's average return on assets (ROA) was 0.94 percent, compared with 1.06 percent in the first quarter of 1998 and 0.88 percent in the first quarter of 1997. The average net interest margin (NIM) declined to 3.91 percent in the first quarter, compared with 4.10 percent a year earlier. Aggregate past-due ratios continued to decline, with the exception of credit card banks. Community banks (with assets less than $250 million) reported lower average ROAs than their larger counterparts because of weaker NIMs, lower noninterest revenue, and higher noninterest expense. Stable aggregate profitability over the past several years masks an increasing variation in profitability among the Region's financial institutions (see chart). The number of unprofitable institutions is rising despite generally favorable economic conditions and relatively low loan loss levels. The increasing dispersion of the Region's ROA figures can be attributed in part to the number of new banks (less than three years old), which skews the performance downward. Additionally, community banks are experiencing a squeeze on margins. Further, although noninterest income has been rising, noninterest expense has been rising faster. A concern is that insured institutions will attempt to mitigate declining margins by engaging in riskier funding and lending strategies. Several key industries in the Region face increasing risks because of pricing pressures, heightened competition, and global economic forces affecting supply and demand. The chemical industries of Delaware and New Jersey have experienced significant downsizings because of declining exports and lower prices. Atlantic City's casinos face competition from new gambling venues in the Northeast. The health care industry is confronting consolidation as managed care gains popularity as a way to cut costs. Low-priced imports, weakened export demand, and overcapacity are hampering the Pennsylvania steel industry. Competition for consumers' financial assets, both from within the banking industry and from brokerages, insurance companies, and credit unions, has impeded core deposit growth. As a result, during the past decade the Region's banks have become more reliant on noncore deposits and other borrowings. Large banks (with assets over $1 billion) have experienced the greatest shift in loan-to-deposit ratios, from 82 percent in 1992 to 101 percent as of March 31, 1999. Although this shift suggests that institutions are finding acceptable alternatives to core deposit funding, there are potential risks. Noncore funds are sometimes more expensive than core deposits, which hurts interest margins and raises concern that some institutions may respond by engaging in higher-risk business strategies. In addition, depending upon the complexity of certain types of noncore funding, banks may be more vulnerable to market risk and may need to rethink their interest rate risk management processes. San Francisco Regional Perspectives Employment growth in the Region slowed modestly during the first five months of 1999 relative to the same period in 1998, in part because of a weakening in California's manufacturing sector. Nevertheless, the Region's employment growth rate exceeded that of the nation thanks to the solid performance of the construction, government, and services sectors. Employment growth rates in Nevada, Idaho, and Oregon were stronger than in 1998, while Montana saw moderate nonfarm job growth. However, California, Arizona, Washington, Utah, Alaska, and Wyoming experienced weakening job growth. Employment in Hawaii remained relatively soft through May 1999 but declined only slightly from year-earlier levels. The Region's economy has been adversely affected by a sharp slowdown in manufacturing employment growth as well as declines in agriculture caused by weak commodity prices. Oregon, Utah, Washington, and California lost jobs in the manufacturing sector during the first five months of 1999 compared with the same period in 1998, while Arizona experienced much slower growth. In addition, agribusiness in the Region has felt the strain of very low commodity prices, particularly in the rural areas of Idaho, Montana, Oregon, and Washington. The slumps in manufacturing and agriculture can be partially linked to the lingering effects of the Asian economic crisis. Despite the San Francisco Region's slower economic growth in early 1999, financial institutions' annualized return on assets increased from 1.08 percent at year-end 1998 to 1.27 percent as of March 31, 1999. The first quarter's returns track national levels and the Region's performance for the first quarter of 1998. In addition, the Region's insured financial institutions reported higher capital ratios and improved credit quality during the first quarter of 1999. However, asset quality declined at agricultural banks in several states, particularly Montana, likely as a result of lower commodity prices. Furthermore, Hawaii's insured institutions posted returns that were improved but below peer, owing to weak economic conditions in the state. Over the past several years, the Region's strong economy has stimulated credit demand. Rapid loan growth is occurring in many institutions during a time when traditional, low-cost core deposits have become more difficult to acquire. Currently, noncore funds account for a higher percentage of the Region's total assets than at any time in the past ten years. While the increases in noncore funding are evident in most of the Region's insured institutions, they are particularly evident among mortgage lenders and rural community banks. Many mortgage lenders in the Region have experienced pressure on earnings, in part because of a relatively flat yield curve since 1995, prompting changes in their funding patterns. In response, some mortgage lenders appear to be increasing their reliance on borrowings, at the expense of retail certificates of deposit. Additionally, some mortgage lenders may be increasing financial leverage to generate asset growth and increase return on equity and earnings per share. These strategies, however, may result in increased levels of interest rate risk if potential maturity, interest rate index, or optionality mismatches are not properly addressed. Owing to the sensitivity of mortgage lenders' net interest margins to interest rate changes, future changes in yield curve structure or the general level of interest rates may cause strategies that were profitable while the yield curve was flat to become unprofitable. Rural community banks in the Region, facing slowing population and core deposit growth, have seen higher loan-to-deposit ratios and reliance on noncore funds. Many of these institutions have turned to the Federal Home Loan Bank (FHLB) system to bridge the gap between core deposit and loan growth. FHLB membership among community banks is particularly prevalent in the Region's rural areas. Montana community banks, in particular, show an increased reliance on borrowings. The percentage of assets funded with borrowings is second only to Hawaii. This reliance on borrowings is not surprising given the banks' largely rural location and the current stress in the agricultural sector. 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