Commercial real estate markets generally remained strong in the Boston Region. The Region's office vacancy rates continued to decline compared with one year ago, thanks to a lack of construction and rising demand (see Table 1). Rents continued to rise, in some locations around Boston by as much as 40 percent in third quarter 2000 from a year ago.2 However, the scarcity of office and certain kinds of industrial space, particularly around greater Boston, may be cause for concern. Demand continues to outpace construction, forcing tenants to commit to high rental rates in advance in order to meet future space needs. Some tenants reportedly are seeking to lock in new space as much as three years in advance. According to Meredith & Grew Inc., tenants are leasing space when it is available, even if they do not currently need it, in anticipation of future demand. Such practices not only inflate rents but may prove troublesome if market conditions falter, leaving tenants with high-rate rental contracts for space they will not occupy.
2 "Rents Can't Get Higher? Think Again." Boston Business Journal. August 28, 2000.
In downtown Boston, average rents for class A space are at an all-time high, and with more than 4.5 million square feet of leasing transactions completed in 2000 alone, the market continues to absorb any available space. According to Cushman & Wakefield, downtown Boston boasted a 2 percent vacancy rate as of the end of second quarter 2000. Some relief may be in sight within the next 24 months, as six new office towers are under construction, which will add a total of 3.9 million square feet to Boston's market (or about 8 percent of existing inventory in the central business district). However, a significant portion of this space reportedly has been preleased.
Hartford's office market continues to improve. Although its overall vacancy rate of 15.3 percent is still high, it is the lowest rate since the mid-1980s. Demand has not improved uniformly; most of the city's suburbs show markedly lower vacancy rates. Some analysts have indicated that office rents around Hartford are finally high enough to support new construction. However, given downtown Hartford's 23 percent vacancy rate as of second quarter 2000, it seems unlikely that any new construction will occur there. More likely, any new building will accommodate growing demand in the city's outlying areas first.
Boston Region Banks Report Stable Conditions
The Region's insured institutions continue to report stable conditions (see Table 2). Excluding credit card specialists, the aggregate return on assets for the Region was 1.28 percent as of June 30, 2000. This is an increase of 7 basis points from the same period in 1999. Net interest margins (NIMs) in the Region's largest institutions (assets greater than $25 billion) continued to decline, while margins at the medium-sized institutions (assets between $1 billion and $25 billion) rose. The Region's small institutions (assets less than $1 billion) showed slight increases in NIMs compared with June 1999, but margins were unchanged during the past three quarters.
Some signs of weakening have emerged among the larger banks, as aggregate past-due loan and net charge-off ratios rose slightly. Nationally, many larger institutions have experienced increasing credit problems with syndicated commercial loans, and this is likely occurring in the Region's larger banks as well. While the past-due ratio has increased for the large banks, it continued to fall for the Region's smaller institutions and remained low in aggregate compared with that of the nation. Loan growth in small and medium-sized institutions continues to be robust, particularly in the commercial, commercial real estate, construction and development, and consumer sectors. The Region's largest institutions showed essentially no loan growth, in part because of sales of loans associated with divestitures related to merger activity.
Core deposits alone have not been sufficient to fund loan and asset growth. To compensate, insured institutions have turned increasingly to alternative funding sources. These alternatives may decrease liquidity and increase levels of credit and interest-rate risk.
Core Deposit Growth Is Slow
Core deposits, the primary funding source for the banking industry, are declining in importance. Historically, loan and asset growth have been generally tied to the amount of new core deposits generated in the economy. However, during the past decade, this relationship has not held true. Typically, annual loan and asset growth have outpaced core deposit growth in the Region since the early 1990s (see Chart 1).
Slow core deposit growth may be attributed in part to the public's increased knowledge of, and access to, domestic and global capital markets. The recent high returns offered by the stock market are widely publicized and frequently advertised. The information obtained from advertisements and media sources such as the Internet and television could have encouraged many savers to select equities over traditional bank deposits. In addition, the advent of mutual funds and online trading on the Internet have made capital markets more accessible to less wealthy investors. Both mutual funds and online investing require less financial commitment and lower transaction costs than other methods of investing.
The hypothesis that banks are losing deposits to capital markets appears to be credible in light of national trends in time and savings deposits against equities and mutual fund shares. Since 1990, time and savings deposits as a percentage of total personal financial assets have fallen from 21 percent to 10 percent, while equities and mutual funds have soared from 19 percent to 35 percent (see Chart 2). Indeed, many bankers have recognized the public's preference for mutual funds and equities and have implemented nondeposit sales programs. These programs are designed to collect fee income from investors who management concedes would not otherwise deposit money at the bank.
Although core deposit growth has been slow across all types and sizes of institutions in the Region, institutions with total assets greater than $25 billion have experienced the greatest decline in core deposits. In recent years, these banks have had very little success in obtaining or maintaining core deposits. As Chart 3 shows, the largest banking institutions have actually experienced declines in core deposits. This is in part because regulators have required some of the largest institutions to sell retail branches as a result of merger activity. However, some of the decline may result from management's willingness to pursue alternative sources of funds rather than aggressively pursue or maintain core deposits. In addition, subsequent to mergers, some customers may leave the enlarged institution, believing they can obtain better service and value at a smaller institution.
For other institutions, marginal core deposit growth can be measured relative to new loans or new assets. Over the past seven years, the Region's insured institutions with less than $25 billion in total assets (excluding credit card banks) have matched every dollar of new loans with 74 cents in new core deposits. This fraction is reasonably consistent among all categories3 of institutions, regardless of asset size, ownership type, or geographic location. The same institutions over the same period have matched each dollar of new assets with 42 cents in new core deposits. This fraction is even lower (33 cents) for large public institutions with total assets between $1 billion and $25 billion. The greater mismatch between core deposit and asset growth for these institutions may be related to stockholder pressures to increase returns through balance sheet expansion.
3 Excludes credit card banks and insured institutions with more than $25 billion in total assets.
Borrowings Are Increasing
When core deposit growth does not match asset growth, other sources of funding are used. Regional data point primarily to borrowings, which are a more expensive and potentially volatile source of funds. They are expensive because the pricing structure is closely tied to the market, and borrowings are potentially volatile because lenders may either call the funds or withdraw them at maturity. Presumably, during a slowdown in the economy or when an institution experiences financial problems, the borrowings may become too expensive to maintain or may become unavailable for institutions without sufficient collateral or capital. To pay off the debt, management would have to sell assets or raise capital. As shown in Chart 4, despite the potentially volatile nature and expense of borrowings, borrowings as a percentage of assets are at an all-time high both in the Boston Region and nationally.
Federal Home Loan Bank System (FHLB) advances are a primary source of credit for small banks and thrifts. As of June 30, 2000, FHLB advances to FDIC-insured institutions nationwide totaled $427 billion, or 29 percent of total borrowings outstanding. As shown in Chart 5, advances to members both in volume and as a percentage of total borrowings have increased rapidly. Recent regulatory changes promulgated as a result of the Gramm-Leach-Bliley Act (GLBA) appear to facilitate even more borrowing. These changes are as follows:
All FDIC-insured institutions with less than $500 million in assets (community financial institutions) may become members of the FHLB. (Before GLBA was passed, only institutions with 10 percent of assets in residential housing assets could join.)
Advances to "nonqualified thrift lenders" are no longer restricted to 30 percent of total assets.
"Community financial institutions" may use advances to fund small business and small agricultural loans.
"Community financial institutions" may also use small business and small agriculture loans as collateral for advances.
Increased exposure to borrowings may heighten risk levels for several reasons. First, some forms of borrowings carry regulatory risk. For instance, regulations, such as those promulgated as a result of the enactment of the GLBA, could be changed in the future and become more restrictive on FHLB borrowing. Second, borrowings tend to be relatively expensive and may cause significant earnings problems. Higher funding costs may entice return-conscious managers to assume more risk to compensate for the higher costs. Third, borrowings can be extremely sensitive to interest rates. Other features, such as callable advances, may also negatively affect funding costs. Fourth, borrowings increase liquidity risk by reducing the amount of available credit and lowering the amount of readily marketable assets. Typically, the most liquid investments are pledged as collateral for secured borrowings.
Another perspective is that secured borrowings may lead to greater losses to the FDIC insurance funds. Because of the secured nature of the borrowings, the highest-quality assets become encumbered. Therefore, if an institution failed, the FDIC would presumably have lower-quality assets available for sale to satisfy its obligations to insured depositors.
Funds Available from Asset Sales Are Declining Also
In addition to borrowings and core deposits, funds can be obtained from asset sales. Essentially, the entire balance sheet can be sold. However, sales can come with a cost. Typically, the most liquid assets have the least embedded credit risk, and the sale can raise an institution's risk profile. The most liquid major asset categories are short-term investments, securities, and residential loans underwritten to secondary market standards.
In the Region, the amount of cash held by institutions with less than $25 billion in total assets (excluding credit card banks) has been consistent across all time periods at about 2 to 3 percent of total assets. Not surprisingly, interest-bearing assets (such as deposits with other banks) have declined from 2.2 percent of total assets in June 1990 to 0.3 percent of total assets as of June 2000. These assets earn very little compared with other earning assets and may be management's first choice among the sources of funds. Federal funds sold and reverse repurchase agreements also appear to be stable at approximately 2 to 3 percent of total assets.
As discussed earlier, many institutions, particularly large public institutions, are seeking to increase returns on equity. One method of doing so is to borrow money and invest the funds in higher-yielding securities and loans. As a result, the significant increase in borrowings in the Region has been accompanied by increases in available-for-sale securities and loans. Theoretically, management could sell the loans and securities when funds are needed. However, certain restrictions or costs may prohibit sale. The security or the loan could be pledged against a specific borrowing and may be unavailable for sale for any reason except to pay off the debt, or the resale market may be limited. Another reason might be that the security or the loan could carry unrealized losses that management does not wish to realize. As Chart 6 shows, Call Report filers in the Region appear to be shifting away from assets with short maturities to assets with longer maturities. This shift, along with recent increases in interest rates, has caused unrealized losses.
Another factor that may influence a loan's liquidity is the loan type. Generally, loans secured by 1- to 4-family mortgages are the most liquid because of the size of the secondary market. Government-sponsored agencies such as Fannie Mae and Freddie Mac, as well as many other market participants, stand ready to buy these mortgages. In addition, these loans are a primary source of collateral for FHLB borrowings. However, this asset class is also declining. In the Region, loans secured by 1- to 4-family mortgages represented over 28 percent of assets and 40 percent of loans in the early 1990s but represented only about 19 percent of assets and 30 percent of loans as of June 2000. While this decline is apparent in institutions of all sizes, it is most pronounced in those with assets of $1 billion or more. The Region's small institutions, which typically are heavier residential lenders, show slight declines in single-family residential mortgages, but those loans still account for about 40 percent of total assets and 57 percent of total loans.
Over the past decade, securitization activity has improved liquidity by allowing insured institutions to sell virtually any loan. However, the marketability of a loan depends on its quality. If loan quality declines, marketability may also decline. Moreover, the highest-quality loans may be sold first, leaving the institution with the lower-quality, higher-risk assets.
Other Sources of Liquidity
Other sources of funds include net income, principal reductions on loans and securities, and issuance of new stock. Thanks in part to the strong economy, net income at most institutions in the Region is at all-time highs. However, the strong earnings may be offset by slower principal reduction. In the past few years, interest rates have been relatively low, enticing borrowers to refinance or take on new debt. Since then, market interest rates have climbed and dampened prepayment speeds. Consequently, many new loans that are amortized over extended periods of time will pay back very little in principal. Further, if higher interest rates persist, borrowers may be less likely to refinance or prepay their debt. Issuance of new bank stock may be inhibited by lower returns in comparison to the stock market. According to Smartmoney.com, the nation's 58 largest commercial bank holding companies experienced an average stock price appreciation of 10 percent over the 52-week period ending September 22, 2000. This rate compares unfavorably to the Dow Jones Industrial Average's gain of 27 percent over the same period.
Implications
Bankers in the Boston Region are discovering that because of recent increases, alternative funding is becoming increasingly expensive. Higher funding costs put downward pressure on margins and may lead managers to take on additional risk in order to maintain income. This may already have happened at some institutions. Aggregate data for all categories of institutions show declines in historically lower-risk assets, such as residential loans, and increases in higher-risk assets, such as commercial loans. As long as the economy remains strong, higher-risk assets generally offer higher returns. These higher returns may offset funding cost increases in the short term but may exacerbate earnings problems if the economy turns down. Economic problems would also magnify the growing liquidity risk that accompanies an increasingly higher-risk asset mix funded with potentially volatile funding sources.
Boston Region Staff
The Boston Region Staff would like to express their appreciation to Thomas Wiggins, Bank Examiner, Division of Supervision, for his contributions to this article.
