Each depositor insured to at least $250,000 per insured bank

Atlanta Regional Perspectives

Despite nearly a decade of economic expansion, growth has not been uniform. Some financially stressed industries may be more vulnerable to an economic downturn or increasing global competition. Others may be undergoing a structural transformation that has constrained growth. Evidence of particular industries coming under pressure may be reflected by the fact that default rates on speculative bonds have been increasing. By comparing data from three industry analysis providers--KMV Corporation, Standard & Poor's (S&P), and Morningstar--we identified seven industries that are important in the Atlanta Region and that appear vulnerable in the event of an economic downturn: health care; wholesale trade; restaurants; apparel, footwear, and textiles; agriculture; construction; and retail.

One approach to quantifying industry risk is the use of the KMV Corporation's Expected Default Frequency (EDF^TM) for publicly traded firms. This approach was referred to in the In Focus segment of Regional Outlook, third quarter 1999. KMV Credit Monitor^® uses information from a firm's equity prices and financial statements to derive the EDF^TM, which is the probability that the firm will default within a one-year period. The primary determinants of a firm's likelihood of default are asset value, volatility of the asset value, and degree of financial leverage. We then assume that issues facing publicly traded firms also exist for privately held firms in the same industry segment. This approach allows us to use median industry EDFs^TM as an indication of an industry's relative risk in the Atlanta Region. Data from S&P's Monthly Investment Review (December 2000) and industry stock performance (as of December 12, 2000) from Morningstar also were used to develop comparable industry risk rankings.

The majority of the workforce in nearly one-fourth of all counties in the Atlanta Region is employed in the stressed industries we identified through the use of data supplied by KMV Corporation, Morningstar, and S&P. Rural areas tend to have the highest exposure to these industry concentrations and therefore may be disproportionately affected should an economic downturn occur. Lower managed-care payments, a critical nursing shortage, and federal reimbursement cuts are generating considerable pressure on the health care services industry. Industry vulnerability, however, may be more pronounced in Florida, home to nearly 40 percent of the Region's medical services employment. Retailers are increasingly concerned that higher energy costs, a changing interest rate environment, weakening consumer confidence, and lower stock returns could curtail consumer spending and narrow profit margins. Certain areas in the Region may be more vulnerable to overbuilding after nearly a decade of economic growth that has stimulated demand for residential and commercial construction activity, particularly in rapidly growing metropolitan areas.

The Atlanta Region's banking industry could be affected by further stress in the industries identified in this article. Indirectly, layoffs could result from deteriorating conditions in markets served by stressed industries. Layoffs could negatively affect consumers' ability to meet debt obligations and, ultimately, could affect credit quality. Insured financial institutions also could experience a decline in asset quality if these industries have difficulty meeting financial obligations.

The condition of Boston Region insured institutions remains stable. Excluding credit card specialists, the aggregate return on assets for the Region was 1.26 percent as of September 30, 2000, an increase of 6 basis points from a year ago. However, net interest margins continued to decline, with the largest institutions leading the trend. Loan growth among the Region's small and medium-size institutions continued to be robust, particularly in the commercial, commercial real estate, construction and development, and consumer sectors. This loan growth helped maintain low past-due loan ratios.

Loan composition in the Region's banks reflects a continued shift into traditionally higher-risk loan categories. Commercial loans are typically higher risk than traditional real estate loans, both commercial and residential. As of September 30, 2000, the Region's institutions, on an aggregate basis, reported the highest ratio of commercial loans to total loans in the past 11 years. Commercial loans as a percentage of the total portfolio at the Region's commercial banks rose steeply in the past three years. The Region's savings institutions also are shifting into a higher concentration of commercial loans, although at a slower pace than commercial banks. While concentrations are below the national average, the change reflects an increasing risk profile for the Region's banks.

The pace of loans migrating to nonperforming status has increased. On an aggregate level, the Region's insured institutions show favorable and historically low past-due loan levels. While the larger institutions' aggregate past-due ratios are beginning to increase slightly, primarily because of rising levels of problem commercial loans, overall, past-due ratios are being diluted by robust commercial loan growth. New loan volume is masking the migration of previously booked loans to past-due status. The aggregate ratios continued to fall for the Region's smaller institutions and remained low compared with the national average. However, migration analysis indicates that the rate at which seasoned commercial loans are becoming past due began increasing in 1998; if new loans were not being booked, the past-due ratios would be increasing.

Chicago Regional Perspectives

Transition to slower economic growth triggers some imbalances. It is unclear whether the deceleration in growth that began midyear 2000 represents a temporary pause after rapid gains in early 2000; a "soft landing" to sustained, moderate growth; or something more severe. On the positive side, the level of economic activity remained high in early 2001, even though growth was slowing in some key sectors. Moreover, lower interest rates may temper disruptions that typically accompany a significant slowing of economic growth.

Of importance to the Chicago Region is the fact that motor vehicle sales nationally during fourth quarter 2000 were relatively high, although they were 11 percent lower than during the first quarter. As a result, inventories were high and production was curtailed early in 2001. Similarly, permits for single-family houses in the Region are relatively high but trending down. Meanwhile, the Region's private-sector job growth slowed to around 0.6 percent at year-end, the slowest since early 1992.

Transitions to slower growth, by themselves, often generate short-term imbalances as firms and households adjust to changing conditions with a lag. Firms' earnings and repayment abilities may be reduced, while households relying on the continuance of income growth and asset appreciation may face challenges as labor or financial market conditions soften. Historical experience suggests that credit quality problems start appearing during transitions to significantly slower economic growth, not just when a recession takes hold. For example, the percentage of problem consumer loans started to rise a year before the beginning of the last recession in mid-1990. In contrast, the percentage of past-due and nonaccrual commercial and industrial (C&I) loans increased only slightly before the beginning of the last recession but then rose quickly.

Exposure to credit risk is rising. C&I credit quality warrants monitoring in light of the Region's insured institutions' rising exposure to C&I loans. In addition, historical experience shows that C&I charge-off rates tend to be higher than for many other loan categories. Although the strongest C&I loan growth has occurred among the Region's largest institutions, increased C&I exposure is evident at some community institutions as well.

Thirty-nine percent of the Region's institutions held C&I loans equal to 100 percent or more of Tier 1 capital on September 30, 2000, compared with 34 percent five years earlier. Furthermore, these institutions increased in relative importance from 66 percent of the Region's total assets in 1995 to 75 percent in 2000. Thus, the Region's exposure to C&I loans has increased.

In aggregate, the Region's large institutions (with assets of $1 billion or more) reported that C&I loan growth accelerated to 16 percent for the 12 months ending September 30, 2000, the largest gain in five years. Meanwhile, these institutions also experienced declining reserve coverage of nonperforming loans.¹ Even though large insured institutions have been increasing allowance for loan and lease loss levels, such increases have not kept pace with growth in total nonperforming loans, which has been driven higher by nonperforming C&I loans. As of September 30, 2000, 1.23 percent of aggregate C&I loans held by large institutions were nonperforming, a 41-basis-point increase over two years.

¹ Nonperforming loans are either delinquent at least 90 days or in nonaccrual status.

In general, asset quality indicators for community banks and thrifts (insured institutions holding assets less than $1 billion) appear favorable; however, certain trends are worth noting. During the past five years, the percentage of community institutions with significant exposures to commercial real estate and C&I lending has risen as loan-to-asset levels have increased. Despite this rising exposure to credit risk, the 1.09 percent aggregate allowance for loan losses on September 30, 2000, was almost unchanged from 1.10 percent ten years earlier. However, aggregate capital levels have increased substantially during the same period, providing an additional cushion should weaker economic conditions contribute to declining loan quality.

Dallas Regional Perspectives

Oil and gas is an important industry in the Dallas Region. The Region produced more than 715 million barrels of crude oil in 1997, employing 206,000 workers in the oil and gas extraction industry. Rising oil prices played a key role in the Region's booming economy during the 1970s, and declining oil prices contributed to the recessions of 1982 and 1986.

Oil prices increased threefold from January 1999 to October 2000. Contributing factors to higher U.S. oil prices include low inventories, a booming global economy, reductions in oil exploration budgets, industrywide consolidation, lack of qualified personnel, and outdated delivery systems.

Potential direction of oil prices in the near term. Oil prices are likely to remain high through midyear 2001 because few oil-producing countries are able to increase production substantially. As a result, supplies are unlikely to rise to a level that would push down oil prices. In the interim, prices will be extremely volatile, as oil markets remain vulnerable to disruptions and cold weather.

Vulnerability of the U.S. economy to higher oil prices. Surging energy prices were a contributing factor in three of the past four recessions (1973-75, 1980, 1990-91). However, the U.S. economy is better able to handle an oil price shock today than it was 20 years ago. For example, technology has allowed many industries to become more efficient users of oil.

Effects of higher oil prices on the Dallas Region. The benefits from higher oil prices have diminished somewhat as the oil and gas industry has gradually declined in importance during the past two decades. At the same time, the high-tech, construction, and financial services sectors have grown in importance.

The impact of higher oil prices has not been widespread. Rather, the effects are more specific to consumers of petroleum products. Corporate profitability has eroded in energy-intensive industries such as transportation, textiles, lumber, paper, chemicals, rubber and plastics, and steel. Higher gasoline and heating oil prices have reduced consumers' real income and displaced demand for other goods and services.

Effects of higher oil prices on energy lending and Dallas Region insured institutions. During the 1980s, the relationship among the oil and gas industry, the Region's economy, and the fortunes of banks was a more direct one. Today the relationship is not as clear-cut, as the Region's economies, particularly in Colorado and Texas, are increasingly diversified. Moreover, the degree of economic diversification has varied by area, and, as a result, the effects of rising oil prices will vary by area as well.

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Kansas City Regional Perspectives

The Kansas City Regional Outlook, first quarter 2001, discusses the strong positive correlation between an insured institution's loan-to-asset (LTA) ratio and net interest margin (NIM). However, some banks in the Kansas City Region diverged from this relationship in 1999, reporting high LTA ratios and low NIMs, or low LTA ratios and high NIMs.

Chart 1 plots the Region's community banks by reported 1999 LTA ratios and NIMs and segments the middle quintile. In general, this scatterplot shows that higher LTA ratios correspond with higher NIMs and vice versa. However, the chart also shows unexpected relationships: some banks report low LTA ratios but high NIMs, or high LTA ratios but low NIMs.

Chart 1

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The LTA/NIM relationship is an indicator of increased vulnerability to an economic downturn, particularly for banks with higher LTA ratios. Our analysis ranks each quadrant's relative risk profile using loan levels and composition, growth, and leverage performance variables that are largely responsible for the variance among the quadrants.

This analysis suggests that the two groups of banks characterized by higher LTA ratios may be somewhat more vulnerable during an economic downturn than banks with low loan levels. Moreover, given similar LTA ratios, banks with higher NIMs are more vulnerable than banks with lower NIMs.

Analysis of insured institutions in the Kansas City Region during the 1980s agricultural crisis supports these results and shows that among banks reporting higher LTA ratios, those with high NIMs experienced a significantly higher potential for failure than those with lower NIMs. In the case of banks reporting lower LTA ratios, the NIM level did not result in material differences in failure rates.

Although not predictive of community bank failure rates, the results of our analysis suggest that banks reporting high LTA ratios and high NIMs appear to have a higher risk profile than banks reporting low LTA ratios and low NIMs.

Memphis Regional Perspectives

As the economic expansion reaches a historic ten-year anniversary, there are signs of weakening. The nation's gross domestic product, the sum of all goods and services produced, continued to grow, but at a substantially slower rate than in previous periods. The Memphis Region experienced moderating economic growth consistent with that of the nation in the third quarter of 2000. Sluggish durable goods sales and growing inventories, particularly in the automobile industry, led to some temporary plant closures and layoffs. As a result, the Region's employment growth trailed the nation's for the eighth consecutive quarter.

Competitive pressures continue to drive bank credit exposure. Despite the economic slowdown during the third quarter of 2000, banks and thrifts in the Memphis Region reported increasing credit exposure, with insured institutions' aggregate loan-to-asset (LTA) ratio reaching a historical high in third quarter 2000. Loan growth is concentrated in traditionally higher-risk loan types. Pressured by rising competition, banks and thrifts have appeared willing to accept greater levels of credit risk to improve asset yields and maintain net interest margins (NIMs).

These trends are most evident in the Region's metropolitan areas. During the past three years, funding costs among the Region's metropolitan banks have increased at a faster rate than for rural banks. In response, many insured institutions operating in the Region's metropolitan areas have tapped into relatively strong loan demand to bolster sagging NIMs. Although insured institutions operating in the Region's metropolitan areas historically have reported LTA ratios well below national levels, recent loan growth has reversed this trend, and regional levels are now higher (see Chart 1).

Chart 1

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Within the Region, banks in the Memphis metropolitan area have reported the greatest increase in funding costs. In 1997, Memphis banks reported aggregate funding costs well below the median reported for all metropolitan markets nationally. Since that time, however, relative funding costs have climbed sharply and are now higher than those in 96 percent of metropolitan areas. Economic prosperity in the Memphis area throughout much of the 1990s encouraged the formation of new insured institutions; 12 new banks have opened in Memphis since 1991, with 9 opening during the past three years. The significant number of new insured institutions striving to grow market share is likely a major factor driving the increase in relative funding costs.

Community banks in the Memphis market have responded to rising relative funding costs by focusing on asset yields and accepting higher inherent credit risk. In the past three years, loans have climbed from 60.5 percent of total assets to 67.8 percent. In addition, banks have participated in the robust real estate market by accepting significantly higher concentrations in commercial real estate loans.

Insured institutions in other metropolitan areas in the Region, including Lexington, Louisville, and Nashville, also face high or rising relative funding costs. These banks have generally followed a similar strategy of increasing loan levels or migrating into traditionally higher-risk loan types, although not to the extent of Memphis banks. Nashville banks will likely experience further competitive pressures in the near term, as the city is reporting considerable new bank activity.

How will banks respond to competition in a slowing economy? In an environment of slower economic growth, the effects of intense competition on earnings in certain markets may become more apparent. If loan demand softens with slowing economic conditions, banks in these markets likely will face difficult strategic decisions that could affect asset quality, earnings performance, or market share.

New York Regional Perspectives

After a record nine years of economic expansion, growth in the Region's economy slowed as 2000 came to a close. The Region enjoyed strong productivity, high levels of household income, and generally favorable commercial real estate (CRE) conditions during the past few years. However, slower job and income growth suggest that the Region's economy will slow further in 2001. Job growth declined because of tight labor markets, which have been constrained by limited population growth in some of the Region's states and slower growth in the manufacturing and financial services sectors. The Region's housing sector also may be softening, evidenced by declining sales volume in some of the Region's larger cities.

The Region's economy may be more vulnerable to certain economic risks than the nation's, particularly weakness in the capital markets. Wall Street and many ancillary businesses represent a significant portion of the Region's economy. Furthermore, higher business costs, prevalent in many of the Region's larger cities, also could make the Region more susceptible to a slowing economy. In addition, geographic areas that are experiencing higher labor and real estate costs or a greater reliance on oil products could be more vulnerable as companies downsize or relocate to contain costs.

The Region's insured institutions reported slightly lower profitability for the nine months ending September 30, 2000, than a year ago. The Region's banks have benefited from the nation's long economic expansion, experiencing strong loan demand and favorable credit quality. However, competition for bank products and services is becoming increasingly aggressive among bank and nonbank providers. Furthermore, because loan demand has outpaced core deposit growth, the Region's banks have increased their reliance on noncore funding, which has constrained net interest margins (NIMs) and heightened liquidity risk at some institutions. Higher short-term interest rates compared with a year ago contributed to increased funding costs, which further pressured NIMs at all banks.

The Region's large banks¹ reported a continued weakening of commercial and industrial (C&I) credit quality. Although well below levels reached toward the end of the 1980s business cycle, the median C&I past-due ratio reported by large banks reached the highest level since 1993. Moreover, an increase nationwide in the number of criticized Shared National Credits, higher corporate bond defaults, and an increased proportion of bond rating downgrades to upgrades suggest that large banks' C&I credit quality may weaken further.

¹ Insured institutions with assets greater than $25 billion.

Community banks² reported strong loan growth and increased concentrations in traditionally higher risk loan categories. Much as banks did during the 1980s, today's community banks have increased loan portfolios to meet customers' financing needs. Recent loan growth has been focused on commercial lending,³ a typically higher-yielding, higher-risk lending segment. While commercial loan growth suggests an elevated credit risk profile, community banks' margins have not increased consistent with the traditional risk-reward tradeoff. Increased competition and a flat yield curve have pressured community banks' margins. Furthermore, while favorable credit quality has aided profitability, there are signs that credit quality may be peaking.

² Insured institutions with assets less than $1 billion.

³ Includes commercial, commercial real estate, and construction and development loans.

Similar to the 1980s experience, new bank formation in the Region increased during the 1990s economic expansion. However, compared with their 1980s peers, the credit risk profile of today's new banks appears to be increasing. As of September 30, 2000, the percentage of new banks in the Region slightly exceeded the level achieved at the height of the 1980s expansion. While the Region's percentage of new banks is equivalent to the national average, some of the Region's metropolitan statistical areas (MSAs) are home to a greater percentage of new banks. Strong economic conditions, high personal income levels, and bank consolidation have contributed to new bank formation. The Region's current crop of new banks reported a higher concentration of CRE loans than their 1980s peers. Furthermore, some of the Region's MSAs with a greater percentage of new banks also have exposure to troubled industries, including the manufacturing and high-tech sectors.

San Francisco Regional Perspectives

Weakness in the Region's economy has not significantly affected the area's insured institutions, which reported solid performance through third-quarter 2000. The median return on assets increased from 1.08 percent to 1.15 percent, largely because of a widening net interest margin, despite increased funding costs. Insured institutions offset these higher costs by increasing the proportion of assets invested in higher-yielding commercial real estate loans. Also, some signs of asset quality and liquidity deterioration emerged. For example, median delinquency levels for commercial and industrial loans in some states increased, particularly at community banks. Furthermore, loan growth outpaced core deposit formation and increased banks' reliance on noncore funding sources.

Although the Region's insured institutions reported relatively strong conditions through third-quarter 2000, further economic softening may weaken credit quality, especially at institutions with large unsecured or subprime consumer loan portfolios. Nearly all institutions in the Region held some consumer loans as of September 30, 2000; however, subprime and specialty credit card lenders managed the majority of the Region's consumer loan portfolio. These lenders reported relatively strong performance; however, increased bankruptcy filings, high household consumption, and elevated debt burdens may indicate potential for future consumer credit weakness.

Five of the Region's 11 states reported personal bankruptcy filing rates that exceeded the national average as of third-quarter 2000. Moreover, filing rates in Utah and Oregon continued to rise, contrary to the nationwide decline. Hawaii, which experienced a period of economic softness during the second half of the 1990s, reported the Region's largest increase in bankruptcy filing rates. The current level and trend of bankruptcy rates are important because of the historical correlation with consumer credit losses. In addition, with the exception of Hawaii, bankruptcy rates increased between 1995 and 1998 in several states despite the strong economic expansion. The moderation in filing rates in 1999 and 2000 in some states may largely be a result of additional household leverage, specifically mortgage refinancing, rather than an actual improvement in consumers' financial positions.

Household asset appreciation has contributed to higher consumer spending in recent years. Rising stock prices and rapid home price appreciation allowed consumers to spend more than their disposable income. In the second half of the 1990s, stock ownership and the value of equity holdings increased, providing consumers with access to funds through liquidation of these assets. Furthermore, home prices in several of the Region's metropolitan areas have increased recently, enabling consumers to borrow against the equity in their homes.

Widespread credit availability and a prolonged period of excellent economic conditions likely contributed to increased debt service levels among consumers. Nationwide, debt service payments in second-quarter 2000 were at the highest level since late 1987. These trends could disproportionately affect consumers with annual incomes below $10,000 because of the use of credit card debt. Surveyed consumers in this income bracket nearly tripled credit card balances held between 1989 and 1998.

The Region's consumer lenders are likely to be challenged by deterioration in the Region's consumer sector. An economic downturn could result in increased job losses and reduced stock market and home values. Consequently, consumers in the Region may find it more difficult to liquidate or leverage assets to service debts, and bankruptcy rates could rise. Increasing delinquency and charge-off rates spurred by these trends would particularly affect subprime and credit card niche lenders, because these institutions typically experience relatively higher proportions of past-due consumer loans and consumer credit losses, even in a strong economic environment.