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National Edition Regional Outlook, Fourth Quarter 2001

In Focus This Quarter

Risk in the Banking Sector during a Time of Uncertainty


After slowing significantly during the first eight months of 2001, the U.S. economy suffered an additional shock from the September 11 terrorist attacks on New York and Washington. While the immediate effects were most severe for industries such as airlines, insurance, lodging, and gaming, the broader effects have included a more widespread erosion of consumer and business confidence. As a result, the U.S. economy contracted slightly in the third quarter of the year, and most economists now agree that the economy will experience at least two consecutive quarters of negative growth. The depth and duration of this downturn, however, will be determined by a confluence of factors, including the effects of monetary and fiscal stimulus and the degree of financial vulnerability in the consumer and business sectors.

Overall, the U.S. banking industry appears well positioned to withstand a period of economic adversity and continue to provide credit to finance the economic recovery. That said, however, current trends suggest that insured institutions will face challenges across the balance sheet. The effects of the slowdown could be most pronounced for institutions with growth-oriented business models or high credit risk profiles. In addition, institutions in previously booming metro areas with concentrations in traditionally higher-risk loan categories may need to consider carefully the implications of a significant slowdown in their local economies.

The U.S. Economy Was Slowing Sharply before September 11

The U.S. economy appeared to be headed for a recession before the terrorist attacks. Following a 1.3 percent increase in first quarter 2001, growth in gross domestic product (GDP) virtually stalled in the second quarter, with an annualized quarterly growth rate of a mere 0.3 percent. The slowdown in the economy throughout the first half of 2001 was driven primarily by weaknesses in the corporate sector. Following two consecutive years of double-digit growth, corporate profits plummeted. Corporate operating profits for the S&P 500 companies fell 19 percent in the second quarter of 2001 from a year ago (see Chart 1). Reflecting the sharp decline in corporate profits and falling share prices, business investment also trended downward throughout the year. During second quarter 2001, business investment fell by 2 percent from a year earlier, the first year-over-year decline since early 1992. Investment in equipment and software fell by an annualized 15.4 percent during the same quarter, the third consecutive quarterly decline. This measure of business investment has not declined for three consecutive quarters since the recession of 1981-1982.

Chart 1

[D] Chart 1. Corporate Profits Dropped Markedly in the First Half of 2001

The slowing economy and difficulties in the corporate sector led to an unprecedented decline in demand for office space during the first half of 2001. Overall, net absorption in 53 markets tracked by Torto Wheaton Research was negative for the first time in the 20-year history of this series (see Chart 2).1 During the first six months of this year the U.S. office vacancy rate rose by 250 basis points, to 10.8 percent. At the same time, weaknesses in the manufacturing sector contributed to negative absorption of industrial properties. As demand for space for storage and distribution fell, the vacancy rate for industrial properties jumped 140 basis points, to 8.1 percent nationwide.2

Chart 2

[D]Chart 2 Office Markets Experienced Unprecedented Negative Absorption in Early 2001

1 Negative net absorption means that the amount of vacated space exceeds the amount of newly occupied office space. For additional information, see "Slowing Economy Reduces Demand for U.S. Office Space," Regional Outlook, third quarter 2001.

2 Data from Torto Wheaton Research.

The consumer sector continued to prop up the U.S. economy through the early months of the year, although some signs of vulnerability in the sector began to emerge. Low interest rates and the relatively healthy employment market helped to maintain modest growth in consumer spending throughout the first half of the year. Home sales remained near historically high levels as mortgage rates fell. Lower mortgage rates also boosted mortgage refinancing activities, which provided additional liquidity to fund consumer spending. According to Freddie Mac, nearly 60 percent of mortgage loans refinanced in second quarter 2001 were for cash-out refinancing, where the refinanced amount exceeded the original loan amount by 5 percent or more. Automobile sales also remained strong in the first half of the year.

However, problems in the corporate sector have begun to spread to the consumer sector as the steady stream of corporate layoffs pushed the unemployment rate up sharply this year. Although low by historical standards, the steady upward trend in the unemployment rate throughout the year is consistent with a recession. Meanwhile, unprecedented growth in consumer indebtedness began to weigh on consumers, and the total household debt-service burden3 exceeded 14 percent in second quarter 2001, the highest level since 1987.4 Personal bankruptcy filings have spiked for two consecutive quarters (see Chart 3), and mortgage loan delinquencies, particularly among high loan-to-value mortgages, rose sharply in the first half of the year.

Chart 3

[D]Chart 3. Personal Bankruptcy Filings Rose Sharply during the First Six Months of the Year

3 The household debt-service burden is an estimate of the ratio of mortgage and consumer debt payments to disposable personal income.

4 Data provided to Haver Analytics by the Federal Reserve Board.

The September 11 Attacks Have Increased Uncertainty about the U.S. Economy

The events of September 11 had immediate adverse effects on certain industries. Air transportation, insurance, lodging, and gaming, which were experiencing difficulties before September 11 as the economy slowed, were particularly hard hit. Forecasts for the airlines issued after September 11 call for losses amounting to $6.5 billion in 2001 and $3.5 billion in 2002.5 Insured loss estimates associated with September 11 range from $30 billion to $70 billion, making it the largest insurance loss event in U.S. history.6 With curtailment in tourism and business travel, hotel occupancy rates have fallen sharply. Nationwide, the occupancy rate was estimated at 30 percent in late September, well below breakeven.7 Revenues per available room (RevPAR) for 2001 are forecast to be significantly lower than a year ago, with some estimating a 9 percent to 13 percent annual decline in RevPAR for the year. 8

5 Merrill Lynch. October 2001. Airline Industry.

6 Deutsche Banc. Alex Brown. October 2, 2001. P & C Insurance Monthly.

7 Givens, David. September 26, 2001. "Unoccupied." The Dismal Scientist.

8 Goldman Sachs. September 27, 2001. Lodging.

In addition, the attacks adversely affected consumer and business confidence. According to the Conference Board, the consumer confidence index dropped to 85.5 in October, the lowest level since early 1994. This followed a 16.4-point drop in September, the largest one-month drop since Iraq invaded Kuwait in August 1990 (see Chart 4). The U.S. economy contracted slightly in third quarter 2001 for the first time in more than eight years.9 According to the Blue Chip Economic Indicators surveyed since September 11, the consensus forecast calls for two consecutive quarters of negative growth in the third and fourth quarters of 2001.10 The consensus forecast for growth in first quarter 2002 is also less than one sixth of the estimate before September 11.

Chart 4

[D]Chart 4. Consumer Confidence Dropped Sharply after September 11 amid Growing Uncertainties

9 According to the National Bureau of Economic Research (NBER), the U.S. economy entered a recession in March 2001.

10 November 10, 2001. Blue Chip Economic Indicators.

Given the high level of uncertainty in terms of national security and the economy, the turning point for the U.S. economy is difficult to determine. By all indications, the current economic environment is very different from the two previous recessions, in the early 1980s and 1990s. While the high inflationary pressure that accompanied recent recessions is absent this time, there are a number of new vulnerabilities in the economy. The depth and duration of this downturn will be influenced by a confluence of factors, including the effects of monetary and fiscal policies designed to stimulate the economy and vulnerabilities in the consumer and business sectors that developed during the 1990s expansion.

Throughout the year, monetary and fiscal authorities have responded aggressively to signs of weaknesses in the economy. The Federal Reserve has lowered the benchmark Federal Funds rate by 150 additional basis points since September 11, with a cumulative rate cut for the year of 450 basis points. At the same time, growth in the money supply has been robust throughout 2001 and has accelerated as the U.S. economy slowed. Low inflation has given the Federal Reserve more flexibility to ease its policy stance in response to a slowing economy. As the federal government responds to the aftershock of the terrorist attacks, some analysts estimate that the combination of tax cuts and increased federal spending could represent about 112 percent of GDP this year.11 These fiscal stimuli could contribute to an economic recovery over the longer term.

11 October 8, 2001. Morgan Stanley. Global Economic Forum.

Vulnerabilities in the Economy May Offset Some of the Positive Effects of Recent Policy Changes

Many economists expect a relatively short and mild recession because of the magnitude of monetary and fiscal stimulus.12 However, several underlying vulnerabilities in the economy could deepen or prolong the current downturn. The extent of these vulnerabilities, ranging from the unwinding of asset price bubbles13 to a high level of consumer and business leverage, is likely to determine the effectiveness of recent policy actions.

12 The consensus forecast of 51 economists surveyed by Blue Chip Economic Indicators calls for negative 1.3 percent growth in real GDP for the fourth quarter of 2001. The consensus forecast shows 0.5 percent growth for first quarter 2002.

13 In the context of this article, the term "asset bubble" refers to rapid appreciation in equity prices relative to growth in corporate earnings. One measurement of equity fundamentals, the price-to-earnings ratio for the S&P 500, peaked at 43.5 in April 2000, nearly three times higher than the long-term average between 1901 and 1999. For more discussion of asset price bubbles, see Robert J. Shiller. 2000. Irrational Exuberance, Princeton University Press.

Synchronized Global Economic Downturn

The global economy is in the midst of the first synchronized economic downturn since the oil crises of the 1970s. As the three largest economies-the United States, Japan, and Germany-are at or near recession, the global economy currently lacks an anchor to sustain growth (see Chart 5). In addition to weak domestic demand, the U.S. economy is likely to face a sharp decline in exports, making an export-driven recovery difficult to achieve.

Chart 5

[D]Chart 5. Many Industrial Countries Are Experiencing a Synchronized Economic Downturn

Unwinding of Asset Price Bubbles

On the corporate side, the rapid asset price appreciation that preceded the current downturn contributed to a significant amount of overinvestment in certain industry sectors, such as telecommunications and computer equipment. Resulting supply imbalances may take longer to correct than previously anticipated as demand continues to falter. Analysts now expect the decline in corporate profits in the high-tech sector to continue into early 2002. The communications service sector, which began to experience difficulties in third quarter 2000, is expected to report lower earnings through the end of this year.14

14 First Call.

Capital Market Weaknesses

Increased risk aversion in financial markets following recent events may further constrain the amount of credit available through capital markets. Lifted by the buoyant equity market, many businesses increasingly relied on capital markets throughout the 1990s. Poor equity market performance all but dried up initial public offerings (IPOs) in third quarter 2001, and the outlook for IPOs in the near future remains negative.15 At the same time, the yield spread between investment-grade and high-yield bonds widened sharply in late September (see Chart 6).16 Although the spread narrowed somewhat in October, it remains very high from a historical perspective. The spread is likely to remain wide as uncertainty about the economy tempers investors' appetite for risk, creating a challenging borrowing environment for non-investment-grade companies.

Chart 6

[D]Chart 6. The Credit Spread Has Widened Further Following the Terrorist Attacks

15 According to, only 11 IPOs came to market in July and August, and there were no offerings in September. In comparison, 134 IPOs were brought to market in third quarter 2000. For historical data on IPOs, see

16 The spread of the effective yield between Merrill Lynch investment-grade and speculative-grade bond indices reached 809 basis points on October 2, 2001, the highest level in nearly ten years.

High Degree of Leverage

A high degree of leverage among consumers and businesses alike raises concerns about their vulnerability to a slowing economy. The ratio of corporate debt to cash flow reached an historic high of 655 percent in second quarter 2001.17 As cash flow weakens during a slowing economy, highly leveraged businesses may experience greater difficulty in servicing debts. A high level of consumer indebtedness also leaves the consumer sector vulnerable in an economic environment that is characterized by rising unemployment, weaker real personal income appreciation, and lower asset values.

17 Corporate debt-service burden is total nonfarm, nonfinancial corporate credit market debt as a percentage of total cash flow. Data provided to Haver Analytics by the Federal Reserve Board.

Slowdown in Home Price Appreciation

Mortgage origination and refinancing, bolstered by appreciation in home prices, has injected additional liquidity into the economy over the past few years. However, the sustainability of recent rates of home price appreciation is in question as the economy enters a cyclical downturn. Although median existing home prices continued to appreciate in third quarter 2001, median new home prices fell by 4.2 percent during the quarter, the sharpest quarterly decline since third quarter 1990. Growth in home prices slowed during the past two recessions as inflation-adjusted personal income fell.18 Continued appreciation in housing prices is particularly important to homeowners who relied on high loan-to-value loans to purchase their residences and those who obtained liquidity through cash-out refinancing using a home equity buildup. If home price appreciation drops significantly and the employment situation continues to worsen, homeowners' capacity and willingness to repay mortgage loans could decline, resulting in higher mortgage loan losses.

18 The housing price index compiled by the Office of Federal Housing Enterprise Oversight shows a sharp slowdown in housing price appreciation in 1982 and late 1990 through 1991.

A Confluence of Factors May Squeeze Bank Earnings

The current economic environment will pose challenges for the banking industry, with possible effects across the balance sheet. Insured institutions can expect higher loan losses as the economic downturn begins to affect their borrowers. Some institutions also may experience lower earnings from their capital market activities. Although low short-term interest rates may benefit insured institutions in the longer term, some community banks may continue to experience a squeeze in the net interest margin (NIM) in the near term, as their variable-rate loans reprice downward more quickly than their deposits.

Credit Quality

Depending on the length and depth of the economic slowdown, credit weakness, which to date has been limited mainly to large syndicated loans, may spread to some degree to medium and smaller credits, commercial real estate, and consumer credit. Results of the 2001 Shared National Credit  (SNC)19 review, completed before September 11, showed a marked deterioration in the performance of loans to larger companies. During this review, adversely rated loans rose 93 percent from year-earlier levels to $193 billion, or 9.4 percent of total SNC commitments. The quality of loans to smaller companies deteriorated somewhat in the third quarter, with some regional banks reporting more than a 20 percent increase in nonperforming loans among medium and smaller credits between second and third quarter 2001.20

19 The annual interagency review encompasses roughly $2.1 trillion in commercial loan syndications, covering credit commitments totaling $20 million or more that are shared between two or more supervised lending institutions.

20 Chaffin, Joshua, and Silverman, Gary. October 17, 2001. "Credit Problems Spreading, Say Banks." Financial Times.

Prospects for near-term improvement in corporate credit quality are not good. According to Moody's, corporate bond rating downgrades outnumbered upgrades more than four to one in third quarter 2001.21 These revisions correspond to a significant rise in the rate of speculative bond defaults, which rose to 9 percent during the 12 months ended September 30, 2001, from 5.7 percent for the 12 months ended December 31, 2000. Following the terrorist attacks, Moody's revised its forecast of peak speculative bond default rates from 10 percent to 11 percent during the first half of 2002 (see Chart 7).

Chart 7

[D] Chart 7. The Default Rate on Speculative Bonds Rose Sharply during the First Nine Months of the Year

21 October 11, 2001. "Rating Reviews Suggest Bumpy Road Ahead for U.S. Corporate Credit Worth." Moody's Credit Trends.

Consumer loan performance also has weakened somewhat during 2001. Significant and continuing layoffs following the September 11 attacks have begun to push the unemployment rate upward. Following two consecutive monthly declines, nonfarm employment dropped by an additional 415,000 in October. The unemployment rate in October jumped to 5.4 percent from 4.9 percent a month earlier. Increasing unemployment, combined with historically high household debt burdens, could place upward pressure on consumer loan loss rates in the coming months.

Market-Sensitive Revenues

Insured institutions also may experience earnings pressure from nontraditional activities. Financial market weakness may continue to depress market-related activities and put significant downward pressure on market-sensitive revenues that have supplemented traditional sources of income, particularly among large banking companies. Revenues derived from investment banking; advisory, brokerage, and trading activities; and venture capital tend to be sensitive to changes in financial market conditions, including valuation, trading volume, and new security issuance.

The S&P and NASDAQ fell by 9 percent and 14 percent, respectively, between August and October 2001. Equity underwriting volume dropped by more than 50 percent in the third quarter from a quarter earlier, while debt underwriting volume declined by about 41 percent during the same period.22 Merger and acquisition volume in the third quarter is estimated to be off by 45 percent from a year ago.23 These capital market weaknesses are expected to continue in the near term, which may squeeze earnings among banking companies that derive significant income from capital market activities.

22 U.S. Bancorp Piper Jaffray. October 2001. Banks & Investment Banks: Capital Markets Quarterly.

23 Data from Thomson Financial.

Margin Pressures

Although the effects of falling short-term rates and a steeper yield curve may benefit bank earnings in the long run, many community banks may experience a squeeze in NIM in the near term. In particular, banks with relatively interest-rate-sensitive asset portfolios may suffer margin compression, as loans tied to prime or LIBOR (London Interbank Offered Rate) reprice downward quickly. Rates on deposits, which are near what some observers see as a functional floor, may have less room to reprice downward. Additionally, a sharp increase in mortgage refinancing activity as mortgage rates fall may result in the origination of long-term, low-rate assets, further squeezing NIMs.

The Banking Industry Is Well Prepared Going into a Cyclical Downturn

Overall, the banking industry is more diversified geographically and much stronger financially going into a recession now than it was before the last recession. Following the implementation of the Interstate Banking Efficiency Act in 1997, many national banks were able to diversify their loan portfolios geographically, and they became less dependent on regional economic conditions than they were in the early 1990s. Geographic diversification should help banks better withstand the regional economic shock that may result from a current downturn.

Also, the banking industry is much better capitalized than it was in the early 1990s. In June 2001, fewer than 1 percent of commercial banks and thrifts reported a ratio of equity and reserves to total assets of less than 6 percent (see Chart 8). In comparison, in June 1990 about 11.5 percent of all insured institutions reported equity and reserves of less than 6 percent of total assets.24 High capital levels will give the industry a fairly large cushion to absorb the higher credit costs, lower margins, and declining fee-based revenues that may result from this cyclical downturn. In addition, the maturing of the secondary market for loans in the 1990s has enabled banks to reduce problem credits through loan sales. Credit quality among insured institutions is significantly better now than it was going into the last recession.

Chart 8

[D]The Number of Thinly Capitalized Institutions Has Declined Dramatically over the Past Decade

24 According to the National Bureau of Economic Research, third quarter 1990 marked the beginning of the 1990-1991 recession.

Industry capital levels have been augmented by strong earnings performance over the past few years, driven by loan growth and noninterest revenues from a variety of sources, ranging from capital market activities to fee income from loan servicing activities. Noninterest income represented 2.2 percent of average assets for the industry in June 2001, compared with 1.3 percent in June 1990. The return on average assets for the industry was nearly five times higher in June 2001 than it was going into the 1990-1991 recession. The number of unprofitable institutions also has declined significantly since 1990. Fewer than 8 percent of commercial banks and thrifts were unprofitable as of June 2001. In comparison, nearly 15 percent of institutions were unprofitable in June 1990.

The impact of the economic downturn on insured institutions will not be uniform but will depend on the risk exposure and market niches of particular institutions. The remainder of this article attempts to identify the banking lines of business and geographic areas that may be at higher risk in this economic slowdown.

Some Insured Institutions May Be
Vulnerable in This Environment

The effects of an economic downturn may be more pronounced for certain banking business models. Insured institutions whose earnings may be at greater risk include those that rely heavily on new accounts or rapid loan growth to sustain earnings. Slower loan growth coupled with higher loan losses could challenge these institutions. Institutions with a high degree of operating leverage also could be negatively affected. Because of relatively fixed cost structures coupled with variable revenue streams, these institutions could see a decline in profits as the economy continues to slow.

Insured institutions that engaged in aggressive loan underwriting and risk selection practices during the latest economic expansion may face increased challenges in a downturn. The rapid expansion of leveraged financing in the latter half of the 1990s is producing higher levels of problem commercial loans at some institutions. Some of the more aggressive loans underwritten during this period, which rely on "enterprise value" as a secondary source of repayment to "augment or otherwise mitigate deficient equity and values,"25 may be especially vulnerable to slowing economic conditions. Because enterprise value is often contingent upon sustained growth in borrower income and cash flows, reliance on enterprise value could increase the risk in leveraged financing.26 Similarly, some construction and commercial real estate loans made at the height of the boom in various local real estate markets may be vulnerable to the extent that property cash flows (and income-derived property valuations) fall in response to lower rents.

25 See Office of the Comptroller of the Currency (OCC), Advisory Letter AL 99-4, May 1999.

26 Primary and secondary repayment sources for enterprise value loans-equity or collateral value and cash flows-are closely linked. As a result, enterprise value can fail to provide a source of repayment in the stress environment where equity or collateral value is at risk. See OCC Advisory Letter AL 99-4 and Interagency Guideline on Leveraged Financing, April 2001.

Other types of lending activities that are vulnerable to a slowing economy include those focused on borrowers with lower credit quality or higher leverage, who tend to be most vulnerable to adverse economic trends. According to the FDIC's Division of Supervision, subprime lenders, which constitute less than 2 percent of all insured institutions, currently represent 13 percent of institutions with supervisory concerns. Subprime loan portfolios, which include loans extended to borrowers with weak credit histories or questionable repayment capacity, are likely to come under increasing stress as the economy slows. According to the vintage analysis of Mortgage Information Corporation, more than 10 percent of subprime mortgage loan pools originated in 1997 and 1998 were seriously delinquent in June 2001.27 Subprime mortgage loan pools originated in 2000 thus far have performed worse than earlier loan pools, exhibiting a higher rate of delinquency and foreclosure over the first 18 months of seasoning (see Chart 9). Delinquency rates on Federal Housing Administration and Veterans Administration loans also have begun to rise recently, which could mean increasing stress for mortgage lenders that specialize in high loan-to-value loans.

Chart 9

[D]Chart9.  Many Subprime Mortgage Loans Originated in the Late 1990s Are Now Seriously Delinquent

27 Loans are considered seriously delinquent if they are delinquent for 90 days or more.

The Nation's Midsection Has, Thus Far, Borne the Brunt of the Slowdown

Just as the effects of the current economic slowdown have been more pronounced on particular banking lines of business, certain geographic areas have been affected more adversely. Economic weakness through midyear 2001 has been concentrated primarily in Midwest and Midsouth states (see Map 1). Six of those states (Alabama, Indiana, Michigan, Mississippi, Missouri, and Nebraska) reported a significant decrease in employment between June 2000 and June 2001.

Map 1

[D]The Recession in the Manufacturing Sector Has Been a Factor in These States’ Weak Performance

The economic slowdown in this part of the country is related to the high concentration of manufacturing employment. The manufacturing sector has been in contraction since August 2000, according to the National Association of Purchasing Managers Index. In some states, the manufacturing sector has been affected more adversely because of the specific mix of industries. For example, appliance production has fared worse than automobile production.

The downturn in the manufacturing sector is not the only factor stressing the economic performance of these states, however. Many are also dependent on the agricultural sector. Most agricultural commodity prices have been relatively low since 1997, and certain areas, notably the South, experienced poor growing conditions in one or more years before 2001. Lingering weaknesses in this sector have had an adverse effect on many rural communities, as evidenced by lower levels of retail sales and declining demand for services. Despite these weaknesses, little deterioration has been reported in insured institution agricultural credit quality, in large part because of substantial government subsidies to agriculture and strong gains in off-farm income. Continued support from these sources is uncertain, as the 1996 Farm Bill expires next year, and new legislation could change the level and nature of government farm subsidies. In addition, off-farm income levels may suffer because of the considerable job losses now occurring in the manufacturing sector in many rural areas.28

28 For additional information on the importance of government payments and the 2002 Farm Bill debate, see Kansas City, Regional Perspectives, fourth quarter 2001.

While farm bank credit quality is not showing signs of weakness currently, the prolonged economic slowing in the nation's midsection has affected reported bank and thrift credit quality generally. Insured financial institutions in the Midwest and Midsouth are reporting rising credit delinquencies, as shown on Map 2. Increases in past-due and nonaccrual loan levels are being driven in large part by rising delinquencies in the household and commercial real estate segments of loan portfolios.29 Mounting job losses combined with high consumer debt levels are stressing the financial capacity of many households, as evidenced by the increasing number of bankruptcy petitions being filed. A slowing economy also is affecting the supply and demand balance for real estate adversely, as highlighted by the net negative absorption of office space during the first half of 2001.

Map 2

[D]The Majority of Banks Reporting a Significant Increase in Past-Due Loan Levels Are in the Midwest

29 For additional information on credit quality deterioration in the nation's midsection, see Chicago and Memphis, Regional Perspectives, fourth quarter 2001.

As previously discussed, trends before September 11 suggest that the economic slowdown was spreading to other economic sectors and geographic areas. As the national economy continues to slow, states in the nation's midsection, many of which were stressed by a prolonged localized downturn, may continue to suffer disproportionately in the near term. Similarly, credit quality of banks and thrifts operating in these areas likely will continue to be pressured.

Should the economic downturn deepen and the effects spread to other areas of the country, insured institutions operating in certain metropolitan markets that previously enjoyed rapid economic growth could experience more serious problems. These institutions may find the challenge of transitioning from an environment of dynamic growth particularly difficult.

Some Banking Markets May Be Particularly
Vulnerable during an Economic Downturn

The historic ten-year expansion contributed to significant growth and prosperity, driven by strong gains in the service sector and buoyant real estate markets in many of the nation's metropolitan areas. However, the areas that experienced the greatest economic growth may be more vulnerable during a slowing economy. Many insured financial institutions operating in these markets exhibit characteristics that suggest elevated risk profiles, including rapid loan growth, high credit exposure, intense competitive pressures, and a growing reliance on noncore funding sources.

Map 3 shows 21 metropolitan markets,30 located predominantly in the South and West, that fit this profile. The primary factors that suggest that these banking markets may be more vulnerable during a downturn are explained below. These characteristics were shown to be contributing factors to higher failure rates of insured institutions during the 1980s and early 1990s (see box for more details).

Map 3

[D]Banking Markets That Have Experienced Rapid Economic Growth, Strong Loan Growth, and High Credit Exposure May Be More Vulnerable during an Economic Downturn

30 This analysis was limited to banking markets with ten or more insured financial institutions headquartered in the metropolitan area. Only insured financial institutions considered to be tied to local economic conditions were included in the analysis; as a result, the sample excluded any institutions with more than $10 billion in total assets, credit card lenders, and special-purpose institutions.

  • Above-average economic growth. This growth could prove unsustainable. For all 21 markets shown, the average annual growth in gross metropolitan product for 1992 to 2000 exceeded the average annual growth rate of 4.43 percent for all metropolitan areas nationally. Annual growth was 5.3 percent or more in 17 of the 21 markets.

  • Rapid loan growth. The median loan growth rate of banks and thrifts in each market was among the top quintile of all metropolitan markets considered in the analysis for either a five-year or one-year period. The use of these two time periods captures markets experiencing a sustained period of loan growth and those that were among the fastest-growing markets even as the nation's economy has cooled.

  • High credit exposure. Two measures of credit concentrations relative to leverage capital were considered in determining whether a market exhibited high credit exposure: construction and development (C&D) lending and a more broadly defined "higher-risk" lending type. C&D lending was considered in isolation because of the close link between this loan type and local real estate market conditions.31 The broader category of higher-risk loans includes all commercial and commercial real estate loans. This measure of credit exposure was included because such loan concentrations traditionally have been associated with a higher rate of failure among insured financial institutions.32 A market was considered to have high credit exposure if the median concentration ratio for either measure of credit exposure among banks and thrifts in the market ranked among the top quintile of all markets considered in the analysis.

31 This measure of potential credit risk and its relationship to real estate market conditions was discussed in more detail in "Emerging Risks in an Aging Economic Expansion," Regional Outlook, fourth quarter 2000.

32 For additional information on high-risk loans, see "Economic Risks and Emerging Risks in Banking," Regional Outlook, second quarter 2001.

The 21 markets share other characteristics. In all of these markets, rapid loan growth was supported largely by higher-cost and potentially more volatile noncore funding sources.33 While banks and thrifts nationally have relied increasingly on these alternative funding sources, insured institutions in these metropolitan markets typically reported a greater reliance on noncore funding than institutions in most other areas of the country. Intense competition for local deposits has contributed to increased use of noncore funding. Competitive pressures also likely have affected loan pricing as well as underwriting standards at some insured institutions in these markets. In addition, new bank formation is a key factor driving competition, a trend that was most evident in the Southeast and West during the late 1990s. Levels of new bank formation have been particularly high in the Grand Rapids, Las Vegas, Naples, Phoenix, Portland, Salt Lake City, Sarasota, and Seattle markets.

33 Noncore funding sources include brokered deposits, certificates of deposit of $100,000 or more, Federal Funds purchased, securities sold subject to repurchase agreements, and other borrowed funds. The latter category consists largely of Federal Home Loan Bank advances.

Economic conditions in some of these markets may have weakened somewhat from the generally optimistic expectations that developed during the strong expansions in the late 1990s. Portland and San Jose, for example, already appeared to be in localized contractions by midyear 2001 because of considerable exposure to a weak high-tech manufacturing sector. Atlanta, Memphis, Orlando, and Phoenix also reported substantial slowing during 2000. Additionally, certain of the identified markets have high economic exposure to sectors that could be adversely affected by the national economic downturn. Las Vegas and Orlando remain heavily dependent on tourism, while markets with heavy exposure to a weakened air transportation sector, such as Fort Worth and Memphis, will be affected by reduced air travel and air cargo shipping. Also, real estate markets in many of these areas may be vulnerable to supply/demand imbalances as the economy slows.34

34 Real estate market conditions for many of these markets are discussed in "Slowing Economy Reduces Demand for U.S. Office Space," Regional Outlook, third quarter 2001. Some metropolitan areas were not considered in the analysis of real estate conditions because of limitations in real estate data availability; therefore, omission from this list does not suggest that specific real estate markets are not vulnerable.

Obviously, other banking markets are not immune to the risks posed by a national economic downturn. In fact, many other markets share some of the same characteristics that may result from dynamic economic growth and rising credit exposure. Most of these additional metropolitan area markets are in the Southeast and West. Few are in the Northeast, an area of the country that was hit hard during the 1990-1991 recession (see box for a discussion of metropolitan areas at risk in the late 1980s).

Rapid growth and the acceptance of heightened levels of credit risk during the recent expansion enabled many banks to achieve extraordinary levels of profitability. However, the strategies, policies, and practices that were implemented during a more vibrant economy may not be appropriate today. Just as past economic strength in many metropolitan markets allowed banks more latitude in underwriting standards and credit administration practices, the current economic downturn suggests the need for increased attention to risk management functions.

Why Focus on Economic Activity, Loan Growth,
and Credit Exposure?

While the banking sector has evolved with the emergence of new business models, some lessons gleaned from the past may still hold true. During previous economic downturns, banks and thrifts operating in areas of the country that previously had exhibited the most rapid rate of growth were often the most severely affected by a downturn. A 1997 study35 of banking crises in the 1980s and early 1990s described some common characteristics of insured financial institutions most affected by economic downturns:

35 1997. Federal Deposit Insurance Corporation. History of the Eighties-Lessons for the Future, Volume I: An Examination of the Banking Crises of the 1980s and early 1990s. Washington, D.C.: Federal Deposit Insurance Corporation.

  • Bank failures generally were associated with regional downturns that had been preceded by rapid regional expansions. This pattern of "boom-bust" economic and banking activity was evident first in banking markets in the Southwest, then in the Northeast and California.

  • During periods of local economic expansion, many banks pursued a strategy of aggressive loan growth in response to strong credit demand, leading to relatively high credit exposure.

  • Banks that failed during subsequent downturns generally had higher credit exposure than banks that survived.

A review of metropolitan markets in the late 1980s, using the methodology described in this section,36 would have revealed a much more geographically concentrated list of markets than depicted in Map 1. These markets were primarily in the Northeast and in California. During the subsequent five-year period, banks headquartered in these markets failed at over two and a half times the national rate (4.7 percent for banks meeting the sample criteria).

36 The analysis of potentially vulnerable markets in 1988 did not include savings institutions because of inherent data limitations and the overall condition of the thrift industry at that time.

  • Markets in the Northeast that would have been identified at year-end 1988 using the previously described methodology include Bergen, Boston, Hartford, Monmouth, Nassau-Suffolk, Newark, New Haven, Portsmouth, and Providence. Banks in these markets experienced an 18 percent failure rate in the subsequent five-year period.

  • Markets in California that would have been identified include Fresno, Los Angeles, Orange County, Riverside, San Jose, and Ventura. Banks in these markets experienced an 11.3 percent failure rate during the subsequent five-year period.

  • Markets elsewhere in the nation that would have been identified are concentrated in the Southeast and include Atlanta, Charlotte, Macon, Phoenix, Sarasota, and Tallahassee. Banks in these markets experienced an 8.8 percent failure rate in the subsequent five-year period.

However, not all of the identified markets in 1988 experienced a high rate of bank failures in the subsequent recession. For example, none of the sampled banks in the Nassau, Fresno, or Ventura metropolitan markets failed during the five-year period after 1988. Likewise, not all banking markets that report elevated risk profiles today will necessarily experience serious problems during the current downturn.

Robert Burns, Senior Financial Analyst
Lisa Ryu, Financial Economist

Regional Outlook Information
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Last Updated 12/11/2001

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