Fill - Free fillable A3q1999 Regional Outlook - Atlanta

Regional Outlook

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1999

FDIC

Atlanta

Region

Division of

Insurance

Jack M.W. Phelps,

Regional Manager

Scott C. Hughes,

Regional Economist

Pamela R. Stallings,

Senior Financial

Analyst

W. Brian Bowling,

Senior Financial

Analyst

In Focus This Quarter

 Falling Prices in Commodities and Manufacturing Pose Continuing

Risks to Credit Quality—

Falling prices are causing problems for a wide range of

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

industries that produce standardized products and face global competition, mostly

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

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

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

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

persist. See page 3.

By Richard A. Brown and Alan Deaton

 Shifting Funding Trends Pose Challenges for Community Banks—

Several long-term trends are making it more difficult for some institutions to eco-

nomically fund asset growth with deposits in today’s marketplace. As a result,

traditional measures of liquidity and liability composition for commercial banks

reflected record-low levels of deposit funding at year-end 1998. The need to augment

lagging deposit growth to meet loan demand has led many community banks to seek

more wholesale funding sources, particularly borrowings. If the trend toward greater

reliance on nondeposit funding continues, liability management may become more

important and more challenging for community banks that have historically relied

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

By Allen Puwalski and Brian Kenner

Regional Perspectives

 Agricultural and industrial commodity price declines are adversely

affecting some Atlanta Region producers—

Hog, soybean, and cotton prices

have fallen sharply in recent years as a result of low inflationary expectations, excess

productive capacity, and weakened global demand. Lower prices have led to reduced

farm income and employment in some parts of the Region. Industrial commodities

such as steel, textiles and apparels, and pulp and paper also have been hurt by a

strong U.S. dollar and financial turmoil overseas. While the Region’s overall econo-

my remains strong, the troubled agricultural and manufacturing sectors are largely

concentrated in less diverse rural areas where economic growth has been much slow-

er. Persistent price stagnation could lead to further financial stress in these areas,

which could negatively affect credit quality at some insured institutions. See page 18.

 Bank funding has changed considerably during this economic

expansion and differs from previous cycles—

Loan demand has outpaced

deposit growth at Atlanta Region commercial banks since the current economic

expansion began in 1992. This situation has led to an increase in noncore funding,

particularly borrowings, at both large and small banks.A more diverse funding mix

may offer advantages with regard to asset and liability management, but it also rais-

es some new potential risks. Many industry observers believe funding issues repre-

sent a major long-term challenge to the industry and one that is likely to affect

community banks more than large banks. See page 22.

By Atlanta Region Staff

A Publication of the Division of Insurance

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

Insurance Corporation for the following eight geographic regions:

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

Boston Region (CT

, MA, ME, NH, RI, VT)

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

Dallas Region (CO, NM, OK, TX)

Kansas City Region (IA, KS, MN, MO, ND, NE, SD)

Memphis Region (AR, KY, LA, MS, TN)

New York Region (DC, DE, MD, NJ, NY, PA, PR, VI)

San Francisco Region (AK, AZ, CA, FJ, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY)

Single copy subscriptions of the Regional Outlook can be obtained by sending the subscription

form found on the back cover to the FDIC Public Information Center. Contact the Public Informa-

tion Center for current pricing on bulk orders.

The Regional Outlook is available on-line by visiting the FDIC’s website at www.fdic.gov/

publish/regout. For more information or to provide comments or suggestions about the Atlanta

Region’s Regional Outlook, please call Jack Phelps at (404) 817-2590 or send an e-mail to

jphelps@fdic.gov.

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

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

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

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

the Federal Deposit Insurance Corporation.

Chairman Donna Tanoue

Director, Division of Insurance Arthur J. Murton

Executive Editor George E. French

Editors Lynn A. Nejezchleb

Maureen E. Sweeney

Publications Manager Teresa J. Franks

In Focus This Quarter

Falling Prices in Commodities and Manufacturing

Pose Continuing Risks to Credit Quality

• Prices have fallen sharply across a wide range of

commodities and manufactured goods.

• Signs of stress are apparent in some industry

sectors.

• These trends are contributing to rising credit risk

for insured institutions.

• Effects on local economies and community banks

could grow if low prices persist.

The performance of the U.S. economy during the mid-

to late-1990s has been generally positive for banking.

Economic activity grew in 1998 at an inflation-adjusted

rate of 3.9 percent for the second consecutive year. Con-

tinued low inflation has helped to hold interest rates low

and extend the expansion into its ninth consecutive year.

However, one downside of low inflation has been that

firms in certain commodity industries have encountered

slow or negative growth in revenues because of the low

prices they receive for their products.

Commodity industries are defined in this article as a

collection of agricultural, mining, and manufacturing

industries that produce standardized products and face

global competition, mostly on the basis of price. Since

the beginning of 1997, price weakness has extended

across a wide range of commodity industries, from agri-

cultural products to oil, chemicals, textiles, paper, semi-

conductors, steel, and even some segments of the auto

industry. While many firms have retooled and restruc-

tured to cut costs, clear signs of financial stress have

become apparent.

The potential importance of problems in commodity

industries to the FDIC was illustrated by the banking

problems related to oil and agriculture during the 1980s

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

FDIC Division of Research and Statistics, regional

economic dislocations related to declining farmland

values and declining oil prices contributed to large

increases in credit losses and the eventual failure of

hundreds of federally insured banks and thrifts. The

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

oil and agriculture have not experienced booms compa-

rable to those that preceded their collapse in the

1980s—but exposures to commodity industries remain

impor

tant for many insured institutions.

This article summarizes recent adverse trends in com-

modity and manufacturing sectors and discusses why

industry-sector problems are important in banking. It

takes a high-level approach, emphasizing the economic

fundamentals that are driving prices across the economy

while ignoring many of the industry-specific factors

that are also driving the performance of individual sec-

tors. The goal is to evaluate the effects of these trends

on bank credit quality if they persist through 1999 and

beyond.

Prices Have Been Declining across a Range

of Commodities and Manufactured Goods

Low inflation has been a boon for consumer spending

and business investment during the economic expansion

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

Index had risen at an annualized rate of less than 2.0

percent for 8 consecutive quarters and at an annualized

rate of less than 4.0 percent for

33 consecutive quarters. The

prices of many popular and

essential consumer goods—

from computers to gasoline—

have generally fallen throughout

the decade, even as the prices of

most services continue to rise

steadily. Businesses, too, have

benefited from the ability to

purchase goods cheaply, as well as from the generally

low interest rates that have accompanied low inflation.

The declining average wholesale price of goods is

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

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

components since the beginning of 1997. The PPI

focuses on goods, omitting changes in the price of ser-

vices. The decline of nearly 5 percent in the PPI since

the beginning of 1997 has been led by falling prices for

mining products, petroleum, and steel. Moreover, econ-

omy-wide price declines for wholesale goods have been

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

declines for 26 consecutive months through May 1999.

Atlanta Regional Outlook 3 Third Quarter 1999

In Focus This Quarter

CHART 1 CHART 2

Widespread Pricing Pressures Are Evident in the

Components of the Producer Price Index

Percent Change in Selected Components of the Producer Price

Index, January 1997 to May 1999

–45

–40

–35

–30

–25

–20

–15

–10

–5

Agricultural Prices Are Down Sharply Since 1997

Percent Change in Reported Price Between

January 1997 and May 1999

Source: Wall Street Journal (Haver Analytics)

Cotton

Corn

Hogs

Wheat

–5

–10

–15

–20

–25

–30

–35

–40

Source: Bureau of Labor Statistics (Haver Analytics)

All

Commodities

Lumber

& Wood

Chemicals

Textiles

Automobiles

Electrical

Machiner

Iron & Steel

Petroleum

Products

Mining

3.3

–4.0

0.6

–1.9

–2.5

–10.0

–19.8

–33.2

Although they are only indirectly included in the PPI

numbers, the prices of several important agricultural

commodities have also fallen substantially. Chart 2

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

percent since January 1997, with the price of corn,

hogs, and cotton also registering double-digit rates of

decline. While the price of hogs has rebounded signifi-

cantly since the end of 1998—more than doubling from

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

wheat, and cotton continued to decline through May

1999.

Reasons for Broad-Based Commodity

Price Weakness

Pricing trends in disparate industries such as electronics

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

industry-specific factors. For example, weather patterns

heavily influence agricultural prices, while global poli-

tics tends to drive world oil price levels. In manufactur-

ing, technological developments can significantly alter

the demand for a product or its cost of production,

thereby influencing its market price. For example,

improvements in semiconductor manufacturing tech-

niques—from shrinking the size of chips to using larger

silicon wafers—have significantly increased production

yields in that industry during the 1990s.

However, the pervasiveness of recent price declines

across a wide range of commodities and manufactured

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

Surveys, May 27, 1999, p. 4.

goods suggests that a number of common factors are

driving prices lower:

• Low inflationary expectations. Since 1980, infla-

tion rates have gradually declined worldwide as cen-

tral banks shifted their focus toward price stability.

Disinflation has profoundly altered the expectations

of investors, consumers, and businesses, and in the

process has altered the course of events in individ-

ual markets and in the economy as a whole. As a

result, commodities have lost much of their appeal

as a hedge against inflation. This has contributed to

a decline of more than 50 percent in the price of

gold since 1980. The expectations of many busi-

nesses have also changed, because with less pricing

power they must continually cut costs to remain

competitive.

• Overcapacity because of large-scale investment.

Global investment in productive capacity accelerated

during the early to mid-1990s in a number of com-

modity and manufacturing industries. Many U.S.

firms have implemented new technologies and

moved their operations closer to their markets or to

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

major U.S. and foreign automakers have invested bil-

lions of dollars in recent years in new production

facilities in the emerging markets of Asia and Latin

America as part of a “build-where-you-sell” strate-

gy.

Because these additions to capacity largely have

not been offset by the closure of existing plants, ana-

lysts say that global productive capacity in autos

Barbara McClellan, “Asia Woes Worsen,” Wa rd ’s Au t o Wo rl d ,

November 1998, pp. 28–31.

Atlanta Regional Outlook 4 Third Quarter 1999

In Focus This Quarter

could exceed demand by more than 20 million units

annually by 2000.

A similar situation has developed

in the semiconductor industry, where capital invest-

ment in chipmaking equipment tripled between 1993

and 1996, contributing to a glut of memory chips and

plunging prices.

• Curtailed global demand in the wake of emerging

market crises. The economic crises that have devel-

oped in Asia, Russia, and parts of Latin America

since 1997 have crimped global demand for com-

modities and manufactured goods. For example,

demand for new cars in Korea fell by 50 percent in

1998.

Asia received approximately 30 percent of

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

demand since then has contributed to a sharp decline

in global grain prices. The slowdown of economic

activity in crisis countries and the resulting decline

in their demand for imports is only one factor that

has hurt the pricing power of U.S. producers. Anoth-

er problem is the pricing advantage conferred on

countries that have experienced currency devalua-

tion. Firms operating in a country that has devalued

its currency experience a reduction in the price of

their exports in U.S. dollar terms. This process fur-

ther depresses the pricing power of U.S. farmers and

businesses that sell their goods in global markets.

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

economies may soon begin to recover. However, the

other factors cited above—low inflationary expecta-

tions and rapid investment in productive capacity—may

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

and businesses that participate in commodity industries

must be prepared for the possibility that pricing pres-

sures will not dissipate in the near term.

Signs of Stress Are Showing

for Affected Industry Sectors

As commodity prices continue to stagnate, signs of

stress are emerging among firms in the commodity

industries. A long-term trend toward reduced levels of

employment in manufacturing has accelerated in the

midst of the current economic expansion. Chart 3 shows

that employment levels declined in a wide range of

commodity industries in the 24 months ending in May

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

available at http://www.ai-online.com.

“Semiconductor Industry Trends” (1999), p. 3.

Barbara McClellan (1998).

CHART 3

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

Employment Levels Have Declined across a Wide

Range of Commodity and Manufacturing Sectors

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

of payroll employment in agriculture and agricultural services

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

Electronics and Semiconductors

Textiles

Autos

Primary Metals/Iron and Steel

Chemicals

Oil and Gas

Mining

Lumber and Paper

Agriculture*

–20 –15 –10 –5 0

1999. The total manufacturing sector lost more than

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

jobs were lost in the mining sector, which includes oil

and gas extraction. The trend toward lower levels of

employment in mining and manufacturing not only

reflects pricing pressures but also attempts by firms in

these sectors to maintain profitability by investing in

labor-saving technologies.

The profit picture has begun to deteriorate as well for

firms operating in commodity industries. Four-quarter

trailing earnings through March 1999 for oil-sector

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

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

earnings of steel firms fell by almost 32 percent. The

losses experienced by firms in some of these industrial

sectors extended to the farm sector as well, where net

CHART 4

–50

–40

–30 –20 –10 0 10 20

Agriculture*

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

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

Earnings Have Declined across a Wide Range

of Commodity and Manufacturing Sectors

Oil and Gas

* 1998 percent change in net farm income

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

Lumber and Paper

Mining

Chemicals

Primary Metals/Iron and Steel

Autos

Textiles

Electronics and Semiconductors

Atlanta Regional Outlook 5 Third Quarter 1999

In Focus This Quarter

incomes fell by more than 7 percent in 1998, according

to the U.S. Department of Agriculture.

Affected Industries Have Found Ways to Cope

with Pricing Pressures Thus Far

Despite the signs of stress in industries where prices are

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

have shown themselves to be fairly resilient thus far in

their ability to cope with the situation. Agricultural pro-

ducers have been making greater use of carryover debt

to keep their operations running even if they were not

able to fully retire their operating loans during the pre-

vious crop year. The FDIC Report on Underwriting

Practices shows that 29 percent of FDIC-supervised

agricultural lenders reported at least a moderate

increase in carryover debt during the six-month period

ending in March 1999, compared with only 10 percent

in March 1998. Although the use of carryover debt is

not an uncommon practice in agriculture, it indicates

that low prices and declining subsidies have contributed

to financial stress for farmers.

Many industrial firms have found ways to increase pro-

ductivity and cut costs to offset declining revenues.

Chart 5 follows trends in annual total revenue and costs

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

commodity industries. It shows that growth in revenue

and costs slowed noticeably in 1997. Both revenue and

costs in these sectors declined in 1998, illustrating that

firms in these sectors have needed to cut costs to pre-

serve profit margins. Cost cutting in the manufacturing

sector is further illustrated by a steady decline in the

index of unit labor costs for manufacturing, which start-

ed from a value of 100 in 1992 and fell to less than 96

CHART 5

U.S. Corporations Operating in

Commodity Industries Have Trimmed

Costs to Offset Falling Revenue*

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

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

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

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

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

Source: Bureau of the Census (Haver Analytics)

1992 1993 1994 1995 1996 1997 1998

Billions of Dollars

Costs

Revenues

1,250

1,450

1,650

1,850

2,050

2,250

by the first quarter of 1999. Falling unit labor costs

means that the productivity of manufacturing workers is

rising faster than the cost of their services. This trend

demonstrates that manufacturing firms have been suc-

cessful at implementing new technologies and new cap-

ital equipment to cut production costs.

Cost savings and industry consolidation have been

accomplished in part through mergers. According to

Merger Stat, the dollar volume of merger and acquisi-

tion transactions involving U.S. firms exceeded $1.2

trillion in 1998, an increase of more than 80 percent

from 1997 levels. Both the number and dollar volume of

mergers announced in 1998 far exceeded the volumes

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

of the largest mergers announced in 1998 involved

firms looking for ways to increase market share and cut

costs in markets characterized by overcapacity. Exam-

ples include the $39 billion Daimler-Chrysler transac-

tion announced in May 1998 and the $80 billion

Exxon-Mobil transaction announced in December

1998. Furthermore, merger activity recorded in early

1999 suggests that total merger volume for the year

could exceed the record pace of a year ago.

Industries plagued by oversupply and weak prices

require consolidation to reduce capacity and improve

profit margins. Mergers and acquisitions represent a

fairly orderly way for firms operating in a troubled

industry to consolidate on their own terms. Bankruptcy

filings are an alternative means for severely troubled

firms to reduce capacity and achieve consolidation

within an industry. Regardless of how industry consoli-

dation is achieved, it often results in reductions in

employment (such as those documented in Chart 3).

However, from a lender’s perspective, an orderly con-

solidation process through mergers and acquisitions is

preferable to a disorderly shakeout of firms through

bankruptcies.

Recent favorable capital market conditions have

allowed firms in troubled industries to consolidate

through mergers. Acquisitions are sometimes financed

through corporate borrowings or, more commonly, by

swapping equity shares that have been rising in value

during the bull market of the 1990s.

Recent consolida-

tion in commodity industries could be depicted as an

According to Loan Pricing Corporation’s Gold Sheets, syndicated

and leveraged lending related to mergers and acquisitions reached a

record high of $80 billion in the second quarter of 1998, which rep-

resents about 30 percent of the total syndicated and leveraged lending

market for that period.

Atlanta Regional Outlook 6 Third Quarter 1999

In Focus This Quarter

orderly process, associated with record-high merger and

acquisition activity, near-record-low business bankrupt-

cy filings, and low credit losses on commercial and

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

financial market conditions characterized by sharply

higher interest rates, lower stock values, or both could

inhibit the ability of businesses to restructure and retool

on their own. This could lead to a much more disorder-

ly shakeout of firms accompanied by a rise in business

bankruptcies and losses to lenders.

Signs Point to Rising Credit Risk

in the Commodity Industries

In dollar terms, the largest commercial bank exposures

to the commodity industries are in the portfolios of

large banks. Chart 6 provides an estimated breakdown

of the aggregate exposure of insured institutions to

commodity industries based on corporate balance sheet

information collected by the Bureau of the Census.

The

chart shows that the aggregate exposure of the bank and

thrift industries to these sectors is approximately $206

billion, or 26 percent of the total industry C&I portfo-

lio. The largest single industry exposure is to the chem-

ical industry, which represents approximately 9.5

Because of the limitations of the data, bank exposures to corpora-

tions engaged in agriculture are not broken out in Chart 6.

CHART 6

Commodity Industries Make Up

Over One-Quarter of Bank C&I Loans

to Corporate Borrowers

Total Loans

Mining

Lumber & P

aper*

3.2%

Outstanding

4.4%

as of 12/31/98=

Petroleum & Coal

$778.3 Billion**

1.2%

Electronics

4.2%

Chemicals*

9.5%

All Other

73.5%

Textiles

1.2%

Iron & Steel

1.1%

utomobiles

1.7%

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

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

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

Bureau of the Census.

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

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

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

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

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

percent of bank C&I loans. In the syndicated loan mar-

ket, where large U.S. banks dominate in terms of origi-

nations, about 25 percent of all loans made in 1998 were

to firms operating in the manufacturing sector.

A rough indicator of recent trends in the credit risk

associated with bank loans to commodity industries can

be found in expected default frequencies (EDFs) calcu-

lated by KMV Corporation. The EDF is an estimate of

the probability that a firm will default on its bond oblig-

ations within one year.

Chart 7 tracks the median EDF

for firms operating in commodity industries compared

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

chart shows that while the median EDF for commodity

industries has consistently exceeded the median for all

other firms in the recent past, this difference has

widened appreciably since the middle of 1998. Over the

past year, the median EDF for commodity industries has

more than doubled, rising from 0.8 percent to 1.9 per-

cent, while the median EDF for all other firms has dou-

bled as well, from 0.6 percent to 1.2 percent. These data

indicate that the level of credit risk associated with cor-

porate borrowers has been increasing, led by an

increased probability of default among firms operating

in commodity industries.

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

market value of the firm, 2) the structure of the firm’s current oblig-

ations, and 3) the vulnerability of the firm to large changes in market

value.

CHART 7

The Default Risk of Firms Operating

in Commodity Industries Has

Risen over the Past Year

Median Expected Default Frequency (EDF)*

(Probability that a Firm Will Default on Bond

Obligations within One Year)

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

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

changes in market value.

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

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

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

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

products; and textiles.

Source: KMV Corporation

0.0

0.5

1.0

1.5

2.0

2.5

Firms in Other Industry Sectors

Firms in Commodity Industries

05/96

12/96

07/97

02/98

09/98

04/99

Atlanta Regional Outlook 7 Third Quarter 1999

In Focus This Quarter

Effects on Local Economies and

the Banks That Operate in Them

The economic effects of adversity in commodity indus-

tries tend to be most severe in local areas that depend

heavily on these sectors for employment and income. In

the 1980s, problems in the agricultural and oil sectors

kicked off a “rolling recession” that spread through the

Plains states and oil-producing regions of the south-

central and western states. In agricultural regions, farm-

land values began to decline around 1981, contributing

to the failure of hundreds of FDIC-insured banks

between 1984 and 1990.

Similarly, declining oil prices

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

insured banks and thrifts in Texas, Oklahoma,

Louisiana, and other states, while the attempts of some

institutions to diversify into risky real estate invest-

ments resulted in still more failures. The FDIC’s analy-

sis of these episodes emphasizes how industry-sector

problems can affect local economies and bank credit

quality.

Moreover, the study shows that there can be a

significant lag between the onset of industry-sector

problems and the emergence of performance problems

Federal Deposit Insurance Corporation, Division of Research and

Statistics (1997). History of the Eighties: Lessons for the Future,

Vol. 1, An Examination of the Banking Crises of the 1980s and

Early 1990s. pp. 275–276, http://www.fdic.gov/databank/hist80/

index.html.

Federal Deposit Insurance Corporation (1997). See Chapters 8

and 9.

TABLE 1

in the banking industry. Although banks with direct

credit exposures to a troubled industry are likely to be

affected first, virtually all banks that operate in areas

that are heavily dependent on a troubled sector will

eventually have to contend with the indirect effects on

the local economy.

To evaluate the extent of local economic effects that

might have resulted from the recent adverse trends in

the commodity industries, we have conducted analysis

on 1,027 U.S. counties identified as particularly depen-

dent on at least one commodity industry (see Table 1 for

a list of the commodity industries studied).

The pur-

pose of this analysis is not to identify every county that

might be affected by these trends; instead, this analysis

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

commodity industries and determines if these counties

and banks that operate in them are showing any symp-

toms of widespread distress.

Table 2 compares 1998 average job growth and unem-

ployment rates in these “most concentrated counties”

against the average for all U.S. counties. This compari-

son shows that the concentrated counties tended to have

moderately lower job growth and higher unemployment

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

Counties identified as being highly dependent on one or more com-

modity industries had an average population of 36,250 in 1998 versus

86,055 for all U.S. counties.

U.S. Counties Most Concentrated in Commodity Industries

by 1998 Payroll Employment

NUMBER OF

PERCENT OF COUNTIES WITH

1998 COUNTY EMPLOYMENT

EMPLOYMENT IN CONCENTRATION STATES WITH THE MOST

THE

INDUSTRY IN 1998 DESIGNATED COUNTIES

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

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

IL AND GAS >5 83 TX, OK, LA

HEMICALS >5 46 TN, IL, NC, TX

TEEL >5 70 KY, OH, AR, IN

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

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

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

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

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

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

Atlanta Regional Outlook 8 Third Quarter 1999

In Focus This Quarter

TABLE 2

Relative Economic Performance of Counties

Most Concentrated in Commodity Industries

1998 AVERAGE 1998 AVERAGE

EMPLOYMENT GROWTH (%) UNEMPLOYMENT RATE (%)

AGRICULTURE 1.1 4.8

UMBER AND PAPER 1.3 6.9

IL AND GAS 1.4 5.6

HEMICALS 1.3 6.0

TEEL 1.7 5.6

UTOS 1.8 4.4

EXTILES 0.9 5.1

LECTRONICS AND SEMICONDUCTORS 1.9 3.7

Any Commodity Industry 1.3 5.5

All U.S. Counties 1.6 5.1

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

that the current situation is not unusual in that job mar-

kets in concentrated counties have tended to consistent-

ly underperform other U.S. counties over the past two

decades. On the whole, the economic picture did not

noticeably deteriorate in 1998 for the concentrated

counties. Average unemployment declined in 1998 for

every group of concentrated counties except oil coun-

ties, and average job growth increased in every group of

counties except textile counties. These data indicate that

while recent problems in the commodity industries

might be having severe effects in specific areas, these

problems had not translated into a broader weakening of

economic performance through the end of 1998.

The financial performance of insured institutions oper-

ating in concentrated counties is evaluated in Table 3

(next page). The table provides average C&I loan per-

formance and profitability ratios for 1,915 banks and

thrifts identified as having at least 25 percent of their

deposits in at least one of the concentrated counties as

of June 1998.

The average C&I loan charge-off ratio

for concentrated counties overall was higher than the

U.S. average, driven largely by higher average charge-

This analysis identifies the location of deposits by county through

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

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

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

in one or more concentrated counties and meeting all the selection

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

1998, compared with an average of $733 million in assets for institu-

tions operating in any U.S. county.

offs in both agricultural and oil and gas counties. Com-

parisons of past-due and noncurrent C&I loans also

indicate that institutions operating in agricultural and

oil and gas counties tend to have more problem credits

than the U.S. average.

During the 12 months ending in

December 1998, the average noncurrent loan ratio

jumped from 4.8 percent to 6.1 percent for institutions

operating in agricultural counties, while the average

ratio rose from 2.7 percent to 3.8 percent for institutions

operating in oil and gas counties.

These results indicate that while profitability in 1998

remained solid for the average bank operating in con-

centrated counties, credit losses appeared to be on the

rise in agricultural and oil and gas counties. However,

because this analysis relies on annual data that extend

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

test for the local effects of problems in the commodity

industries. There is every reason to expect these credit

problems to intensify over time if commodity prices

remain low.

These considerations suggest that bankers

in commodity-dependent counties should continually

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

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

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

For more information on how the agricultural outlook could affect

FDIC-insured institutions, see the statement of FDIC Chairman

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

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

speeches/99spchs/spc13apr.html.

Atlanta Regional Outlook 9 Third Quarter 1999

In Focus This Quarter

TABLE 3

Relative Financial Performance of Insured Institutions Operating in Counties

Most Concentrated in Commodity Industries

NUMBER OF AVERAGE C&I AVERAGE AVERAGE NET

BANKS WITH AT LOANS PAST DUE NONCURRENT C&I LOAN

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

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

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

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

AGRICULTURE 416 5.08 6.12 1.58 1.16

UMBER AND PAPER 465 3.38 1.89 0.78 1.21

IL AND GAS 163 3.44 3.78 1.18 1.29

HEMICALS 81 2.47 2.97 0.79 1.18

TEEL 186 2.53 2.06 0.59 1.08

UTOS 341 2.64 2.05 0.66 1.12

EXTILES 264 2.91 1.92 0.70 1.10

LECTRONICS AND

SEMICONDUCTORS 107 2.71 2.36 0.68 0.87

Any Commodity

Industry 1,915 3.39 3.03 0.93 1.13

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

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

C&I = Commercial and industrial.

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

Information System)

monitor their local economy for signs of stress related

to problems in the commodity industries.

Conclusion

Businesses operating in a range of commodity and man-

ufacturing industries continue to grapple with weak or

declining prices. This problem is not solely the result of

industry-specific factors; it is part of long-term eco-

nomic trends that may continue for some time. Signs of

stress among firms in these industries are apparent in

the form of declining levels of employment and slow or

negative profit growth. However, there are few signs to

date of any disorderly industry shakeouts involving

widespread business bankruptcies and losses to lenders.

Thus far, most firms have managed to cope with

the situation by cutting costs and consolidating opera-

tions through mergers. At the same time, more forward-

looking indicators show that the level of credit risk

associated with commodity industries may be on the

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

dependent on these industries showed few signs of a

widespread deterioration in the performance of their

economies or in the profitability of their local deposito-

ry institutions through the end of 1998. However, there

are signs of rising credit losses among local depository

institutions in counties with the highest concentrations

of agriculture and oil and gas extraction. A continuation

of today’s weak pricing picture in these industries has

the potential to result in higher credit losses for insured

institutions during the next few years.

Richard A. Brown, Chief,

Economic and Market Trends Section

Alan Deaton, Economic Analyst

Atlanta Regional Outlook 10 Thir

d Quarter 1999

In Focus This Quarter

Shifting Funding Trends Pose Challenges

for Community Banks

• Several long-term trends are making it more dif-

ficult for some institutions to economically fund

asset growth with deposits in today’s marketplace.

• Lagging deposit growth in recent years has result-

ed in greater reliance on alternative funding

sources to meet loan demand.

• Liability management may become more impor-

tant and more challenging for community banks

that have historically relied upon deposits for

funding and net interest revenues for profitability.

For the past few years, assets have been expanding

faster than deposits at many commercial banks. The

result is an increased reliance on equity and borrowings

for funding. Since 1992, commercial bank assets have

grown at an average annual rate of 6.3 percent com-

pared with a 3.9 percent average annual growth rate for

deposits. Traditional measures of liquidity and funding

for commercial banks reflected record-low levels of

deposit funding at year-end 1998. Large commercial

banks have traditionally made greater use of nondeposit

funding alternatives. However, many community

banks,

which have typically relied more on deposit

funding, may face liability management challenges as a

result of shifting funding trends. This article surveys the

factors influencing the ability of banks to fund loan

growth with deposits, discusses community bank fund-

ing trends, and considers the implications of these

trends for community banks.

Factors Influencing Deposit Funding Trends

The percentage of commercial bank assets, particularly

loans, funded with deposits has declined steadily in the

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

deposits to assets and loans to deposits reflect a longer-

term shift away from deposit funding. Although the

level of these industry ratios is heavily influenced by

larger banks, the trend toward lower deposit funding

exists for both large banks and community banks and

points to secular factors that are affecting banks’ ability

to raise deposits in step with asset growth.

Trends in Household Wealth Accumulation

One factor affecting the ability of banks to attract

deposits is the recent trend in the way households are

amassing wealth. While the total wealth of U.S. house-

holds has soared in recent years because of unrealized

capital gains on housing and investments, annual net

purchases of new financial assets

by households as a

percentage of disposable income have actually trended

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

A falling personal savings rate and fewer purchases of

financial assets may suggest that households are more

comfortable consuming a higher percentage of current

income as long as capital gains are adding to their accu-

mulated wealth. However, because households have

been setting aside less of their current income for sav-

ings, the pool of new funds available to purchase bank

deposits has been growing more slowly.

Higher-Yielding Investment Alternatives

At the same time that households have been setting

aside less of their current income for savings, the share

of total new household savings flowing into bank

deposits has declined in the 1990s as competition from

higher-yielding alternatives has increased. During the

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

Financial assets are defined as deposits, money market and mutual

fund shares, credit market instruments, corporate equities, life insur-

ance reserves, pension fund reserves, and trust reserves.

CHART 1

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

Ratios Reflect Reduced Deposit

Funding for Commercial Banks

Recession

Ratio (%)

Deposit-to-Asset Ratio

Loan-to-Deposit Ratio

’70 ’74 ’78 ’82 ’86 ’90 ’94 ’98

Sources: FDIC Historical Statistics on Banking; Research Information System

Defined here as banks with total assets of $1 billion or less.

Atlanta Regional Outlook 11 Third Quarter 1999

In Focus This Quarter

CHART 2

Total Annual Additions* to Financial Assets

of Households and Nonprofit Organizations

Have Declined with Personal Savings Rate

Percentage of Disposable

Personal Income

Net Acquisition

of Financial Assets

Personal Savings

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

* Excludes capital gains

Sources: Federal Reserve Board; Flow of Funds

financial assets by households and nonprofit organiza-

tions flowed into deposits. In contrast, less than 15 per-

cent of the cumulative net increase in financial assets

has flowed into deposits during the 1990s, although an

increasing proportion has been allocated to deposits in

recent years.

Not only do banks face intensifying competition from

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

respondents in Grant Thornton’s 1999 Sixth Annual

Survey of Community Bank Executives,

but they also

Grant Thornton’s 1999 Sixth Annual Survey of Community Bank

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

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

CHART 3

face increasing competition from mutual funds and

other nonbank financial service providers, such as cred-

it unions.

Mutual Funds. Increasingly, consumers are pursuing

higher yields by investing in mutual funds. Beyond

yields, however, many mutual fund companies also are

competing effectively with banks on the basis of conve-

nience by offering money market accounts that allow

check writing, automated teller machine cards, and

check cards. Chart 3 shows the changes in the composi-

tion of household liquid assets during the 1990s. In

1990, bank deposits constituted 38 percent of house-

holds’ liquid assets versus 11 percent for mutual funds

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

were nearly even. While some of the change in compo-

sition can be explained by rising mutual fund share

prices, other measures indicate a shifting preference for

mutual funds as a savings vehicle. For example, data

from the Investment Company Institute show that net

inflows into mutual funds have exceeded net increases

in insured institution deposit accounts in all but three

quarters during this economic expansion. Moreover, the

first quarter of 1999 marked the seventeenth consecu-

tive quarter that mutual fund inflows outstripped

increases in deposits for all FDIC-insured institutions.

Credit Unions. In addition to mutual funds, credit

unions also are formidable competitors for consumer

savings. Membership in credit unions has increased

more than 20 percent over the past decade, while

deposits and share accounts have risen by over 90 per-

Households Are Holding a Greater Share of Liquid Assets in Mutual Funds

1990 1998

U.S. Government

Securities

Equities, Bonds,

and

Commercial

Paper 44%

Money Market

Fund Shares

Mutual Fund

Bank Deposits

(excl. Foreign)

38%

Money Market

Mutual Fund

Fund Shares

22%

Equities, Bonds,

Bank Deposits

and Commercial

(excl. Foreign)

Paper 35%

30%

U.S. Government

Securities

Source: Federal Reserve Board

Atlanta Regional Outlook 12 Third Quarter 1999

In Focus This Quarter

cent.

Credit unions also offer federal insurance on share

accounts as well as competitive rates on comparable

deposit-type vehicles relative to other types of financial

institutions. For example, according to information from

the National Credit Union Association, on average,

credit unions have offered rates on one-year share cer-

tificates in excess of one-year bank certificates of

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

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

certificates over the 12 months ending May 1999 were

consistently higher than rates offered by banks or thrifts

and approached retail rates offered by brokerages.

Demographic Shifts

Some analysts maintain that rural community banks

face additional funding challenges as a result of demo-

graphic shifts. According to the Federal Reserve Bank

of Kansas City, rural bankers perceive that sluggish

deposit growth is at least partially attributable to the

migration of deposits to cities as urban-dwelling heirs

of rural depositors relocate funds. While evidence for

this deposit migration remains anecdotal, economists at

the Federal Reserve Bank of Kansas City indicate that

the demographic shift is still in process, and its full

effect may not be felt for some time. Further challeng-

ing deposit growth for banks, additional evidence sug-

gests that urban dwellers tend to place less of their

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

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

CHART 4

Bank One-Year CD Rates Have Recently Lagged

Those Offered by Competitors

Average Retail Rates Offered for

One-Year Certificates (%)

6.0

3.0

3.5

4.0

4.5

5.0

5.5

Thrifts

Credit Unions

Banks

Brokerages

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

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

Sources: BanxQuote and Bank Rate Monitor

savings in banks than their rural counterparts do.

This

trend poses additional consequences for bank deposits

as rural populations migrate to suburban areas.

Community Bank Funding Trends

Community banks traditionally rely more heavily upon

core deposit funding than larger banks do. For example,

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

community bank assets were funded with core deposits

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

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

deposits. This difference in liability structures reflects

large banks’ broader use of wholesale funding alterna-

tives and greater access to capital markets instruments.

While large banks have respond-

ed to factors influencing deposit

growth by making greater use of

alternative funding sources,

funding options for community

banks tend to be more limited.

Because of high fixed costs, community banks may find

it more difficult than larger institutions to make cost-

effective use of capital market instruments such as secu-

ritizations or public debt and equity offerings (see

“Industry Consolidation Presents Unique Risks and

Challenges for Community Banks,” Regional Outlook,

Fourth Quarter 1998, for a discussion of additional non-

deposit funding sources for community banks).

The need to augment lagging deposit growth to meet

loan demand has led many community banks to acquire

more noncore funds. These funds include time deposits

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

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

nearly 75 percent of community banks held noncore lia-

bilities representing 10 percent or more of total liabili-

ties. As recently as 1993, only 42 percent of community

banks exceeded that threshold. Moreover, over the same

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

as total deposits less time deposits greater than

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

community banks declined each quarter.

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

Rural Banks Facing Increased Funding Pressures? Evidence from

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

Also see “Regional Banking,” Regional Outlook, Kansas City Edi-

tion, Second Quarter 1998, p. 24.

Atlanta Regional Outlook 13 Third Quarter 1999

In Focus This Quarter

CHART 5

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

Large Banks Community Banks

(total assets over $1 billion)

(total assets under $1 billion)

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

Source: Bank Call Reports (Research Information System)

Other

Domestic

Deposits

Borrowings

16%

Other

Liabilities

12%

Equity and

Subordinated

Debt

Core

Deposits

43%

Foreign

Deposits

13%

Other Domestic

Deposits

11%

Borrowings

Other

Liabilities

Equity and

Subordinated Debt

10%

Core

Deposits

72%

As community banks’ use of noncore funds has

increased, they are relying more on federal funds pur-

chased, repurchase agreements, other borrowings,

demand notes, and mortgages (collectively referred to

as borrowings). After adjusting for mergers, borrowings

funded 12 percent of new community bank asset growth

from 1992 through 1998—three times more than the

percentage of new asset growth funded by borrowings

from 1985 to 1990. Possibly reflecting a shift toward

greater acceptance of wholesale funding by community

bankers, growth in borrowings has been largely driven

by increased use of nonovernight borrowings,

which

have become the dominant form of borrowings at com-

munity banks. As shown in Chart 6, the proportion of

community banks reporting nonovernight borrowings

has doubled in the 1990s. This trend coincides with

growing community bank membership in the Federal

Home Loan Bank (FHLB) system and increasing use of

FHLB borrowings.

Federal Home Loan Bank Membership

Over the past five years, community banks have sub-

stantially increased their membership and participation

in the FHLB system. According to data from the Feder-

al Housing Finance Board, for the five-year period

ending in 1998, the percentage of FDIC-insured com-

munity banks that were members of the FHLB more

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

advances outstanding for community banks grew by

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

Nonovernight borrowings are defined here as all borrowings other

than federal funds purchased and repurchase agreements.

FHLB advances represented approximately 80 percent

of all nonovernight borrowings for community banks.

Analysts have cited a number of reasons why communi-

ty banks are joining the FHLB system. Community

banks are using FHLB advances to meet contingent li-

quidity needs, manage interest rate risk, fund new asset

growth, and leverage capital to maintain or boost

returns on equity. Recent surveys indicate that FHLB

advances will continue to have a role in community

bank liability management. Almost one-half of respon-

dents to Grant Thornton’s 1999 Annual Survey of

Community Bank Executives considered FHLB bor-

rowings an important funding source over the next three

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

advances in 1999. Similarly, the American Bankers

Association’s 1999 Community Bank Competitiveness

CHART 6

’97

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

The Percentage of Community Banks Reporting

Nonovernight Borrowings* Is Rising

Community Banks

Reporting Nonovernight

Borrowings (%)

* Includes all borrowings other than federal funds purchased and repurchase

agreements

Source: Bank Call Reports (FDIC Research Information System)

Atlanta Regional Outlook 14 Third Quarter 1999

In Focus This Quarter

Survey

reported that FHLB advances are the preferred

nontraditional funding product. In addition, legislative

changes enacted in third-quarter 1998 have eased mem-

bership requirements for banks with assets less than

$500 million, significantly increasing access to FHLB

advances for smaller banks in rural areas.

Implications of Funding Trends

for Community Banks

According to community banker opinion surveys, the

trend toward greater reliance on noncore or alternative

funding sources appears likely to continue. Grant

Thornton’s 1999 Annual Survey of Community Bank

Executives found that 75 percent of community bankers

expect funding with core deposits to be more difficult in

three years than it is today. Moreover, more than 20 per-

cent of community bankers responding to the American

Bankers Association’s 1999 Community Bank Compet-

itiveness Survey do not expect to derive the bulk of their

funding from deposits five years from now. Liability

management is an important aspect of a bank’s opera-

tions and a key driver of interest expense. Responses to

funding challenges will likely influence strategic busi-

ness decisions that shape the risk profiles of insured

institutions, particularly community banks that histori-

cally have relied more heavily upon core deposits to fund

asset growth and net interest income for profitability.

A fundamental challenge that confronts bank manage-

ment is the strategic response to the increased costs

associated with wholesale funding sources. As shown in

Chart 7, the reported interest costs of nondeposit fund-

ing alternatives, such as federal funds purchased and

repurchase agreements, subordinated notes, and FHLB

advances, have traditionally exceeded the interest cost

of core deposits for commercial banks. Therefore, as

institutions that have typically relied upon core deposits

increase the use of nondeposit sources, funding costs

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

interest margins (NIMs) may be pressured.

To some extent bank managers may be able to offset the

higher interest costs of wholesale funding strategy by

improving efficiency through greater management of

overhead expenses and increases in noninterest income.

However, community banks face challenges to their

ability to increase noninterest income (see “Industry

Consolidation Presents Unique Risks and Challenges

CHART 7

Subordinated Debt

FHLB Advances

’93 ’94 ’95 ’96 ’97 ’98

Reported Interest Cost for Commercial Banks (%)

Nondeposit Alternatives Have Typically Cost

More than Core Deposits

Federal Funds

Core Deposits*

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

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

deposits greater than $100,000.

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

Home Loan Bank (FHLB) System Annual Reports

’

for Community Banks,” Regional Outlook, Fourth

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

banks are unable to fully offset higher funding costs

with increases in noninterest income or reductions in

noninterest expenses, overall profitability could suffer.

Community bankers in the upper Midwest expressed

this concern in a 1998 survey conducted by The Feder-

al Reserve Bank of Minneapolis, which found that 57

percent of respondents expect the shift away from

deposit funding to decrease bank profitability.

As bank

managers search for additional ways to offset the rela-

tive rise in funding costs, they may be tempted to

increase asset yields by pursuing additional portfolio

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

higher asset yields.

Funding challenges also could alter the liquidity and

interest rate risk positions of community banks. The rel-

ative complexity and volatility of some nondeposit

sources require greater expertise and attention to asset-

liability policies and practices to avoid unexpected

liquidity strains or exposures to changing interest rate

environments. Strategies that result in the pledging of

liquid assets, overreliance on purchased funds, or con-

centrations in price-sensitive long-term assets could

adversely affect a bank’s relative liquidity or interest

rate risk position. Moreover, interest rate risk manage-

ment can be further challenged by the complexity of

nondeposit funding sources. For instance, some FHLB

advances may contain embedded options that required

greater expertise and attention to policies and practices

that, if not managed properly, could lead to undesirable

outcomes if interest rates change adversely.

ABA Banking Journal, February 1999, p. 30.

Fedgazette, July 1998, p. 2.

Atlanta Regional Outlook 15 Third Quarter 1999

In Focus This Quarter

Differences between Community Banks with

High and Low Levels of Core Deposit Funding

To evaluate how a shift from a core deposit funding

strategy might change the profile of a community bank,

TABLE 1

performance and condition measures for community

banks that rely most heavily on core deposits were con-

trasted with those that are least reliant on core deposit

funding. Table 1 compares 1998 funding, earnings, and

asset performance measures for these community bank

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

ALL COMMUNITY BANK COMMUNITY BANK

COMMUNITY BANKS

AGRICULTURAL LENDERS

COMMERCIAL LENDERS

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

DEPOSIT DEPOSIT DEPOSIT DEPOSIT DEPOSIT DEPOSIT

FUNDING

FUNDING FUNDING FUNDING

Selected Aggregate Measures

NUMBER OF

BANKS IN GROUP 405 405 106 51 126 185

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

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

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

Selected Median Liquidity and Funding Measures (%)

1998 GROWTH IN TOTAL ASSETS 9.02 11.16 5.96 6.42 12.75 18.50

1998 G

ROWTH IN TOTAL DEPOSITS 9.74 8.79 6.40 5.31 13.56 11.93

1998 G

ROWTH IN BORROWINGS (50.00) 28.62 (64.49) 31.85 (51.87) 42.87

1998 G

ROWTH IN TOTAL EQUITY CAPITAL 5.93 7.53 3.46 5.39 9.94 8.85

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

ORE DEPOSITS-TO-TOTAL ASSETS RATI O 87.29 53.87 87.10 55.81 87.21 54.03

ORROWINGS TO TOTAL ASSETS RATIO 0 9.58 0 4.15 0 8.55

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

Selected Median Performance Ratios (%)

RETURN ON EQUITY 12.65 10.19 11.10 10.93 14.49 9.52

ETURN ON ASSETS 1.07 1.04 1.01 1.19 1.10 0.92

ET INTEREST MARGIN 4.76 4.03 4.51 3.98 5.25 4.22

ROSS EARNING ASSET YIELD

8.17 8.02 8.24 7.89 8.45 8.26

OST OF FUNDING EARNING ASSETS

3.33 4.07 3.74 4.05 3.21 4.05

ONINTEREST INCOME TO AVERAGE ASSETS 0.76 0.61 0.59 0.44 1.01 0.64

ONINTEREST EXPENSE TO AVERAGE ASSETS 3.49 2.90 3.23 2.40 3.99 3.12

FFICIENCY RATIO

69.01 63.68 68.59 57.48 68.99 67.00

Selected Median Credit Quality Measures (%)

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

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

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

1998 G

ROWTH IN NONPERFORMING ASSETS (9.10) 7.50 10.57 11.79 (17.32) 23.97

1998 G

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

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

Agricultural lenders are banks with 25 percent or more of assets in agricultural real estate loans or agricul-

tural production loans.

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

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

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

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

of all community banks.

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

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

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

FHLB = Federal Home Loan Bank

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

Atlanta Regional Outlook 16 Third Quarter 1999

In Focus This Quarter

groups. High core deposit funders are defined as those

community banks with core deposit-to-asset ratios in

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

1998. Low core deposit funders are those community

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

percent.

A similar comparison is included for agricul-

tural banks and commercial lending specialists, which

combined make up roughly 60 percent of each of the

total community bank funding groups.

This comparison reveals several differences. First, a

tradeoff between heavy reliance on core funding and

asset growth is evident. Median measures for the groups

indicate that the typical bank that relies less on core

deposit funding is larger and growing faster than the

typical bank in the high core funding group. Second,

less core deposit funding appears to be associated with

a lower NIM, primarily the result of higher funding

costs. However, overall profitability

is similar between the groups

mainly because of a lower ratio

of overhead expenses to aver-

age assets for the low core

funders. These characteris-

tics are also evident across

the agricultural and com-

mercial specialists groups.

Asset quality indicators suggest that the low core fund-

ing groups may exhibit greater credit risk. Although

higher asset yields resulting from increased portfolio

risk are not evident, median measures for each low core

funding group reflect higher levels of noncurrent loans

and higher growth in nonperforming assets and net loan

losses relative to its high core funding group counter-

These groups exclude community banks with equity-to-asset ratios

greater than 25 percent.

part. For example, the median growth in nonperforming

assets for commercial lending specialists with less

reliance upon core deposits was nearly 24 percent in

1998 versus a 17 percent decline for the high core fund-

ing group.

Summary and Conclusions

Commercial banks have been experiencing a long-term

trend toward lower deposit funding of loans and assets.

Increasing competition among banks and from thrifts,

nonbanks, and higher-yielding investment alternatives

has made it more difficult and expensive for some

banks to attract deposits in step with asset growth.

While some nondeposit funding alternatives may pro-

vide a stable source of funds for insured institutions

(especially those located in areas characterized by

aggressive competition and slow deposit growth), better

matching of asset cash flows, and greater flexibility in

asset-liability management, they also may pose certain

risks. To some extent community banks may be able to

manage noninterest expense and noninterest income to

offset the relative increase in interest expense incurred

to acquire nondeposit funding sources. However, if

overall profitability suffers, banks may be tempted to

pursue additional portfolio risk to generate higher off-

setting asset yields. As a result, liability management

may become more challenging for community banks

that have historically relied upon deposits for funding

and net interest revenues for profitability. In addition,

the complexity of some nondeposit funding sources

requires greater expertise and attention to policies and

practices to avoid unexpected liquidity strains or expo-

sures to changing interest rate environments.

Allen Puwalski, Senior Financial Analyst

Brian Kenner, Financial Analyst

Atlanta Regional Outlook 17 Third Quarter 1999

Regional Perspectives

• Sustained agricultural and industrial commodity price weakness could adversely affect the Atlanta Region.

Hogs, soybeans, and cotton are among the Region’s farm commodities that have witnessed significant price

pressures in recent years.

• In the industrial markets, steel, textiles and apparel, and pulp and paper producers experienced the effects

of increased imports and weak export demand because of the strength of the dollar and the Asian economic

crisis.

• The disparity between loan and deposit growth during this economic expansion has resulted in an increase

in borrowings at banks in the Region. Longer-term trends suggest that factors other than the business cycle

may be affecting bank funding.

Commodity Price Weakness Could Affect the Atlanta Region’s Economy

Price weakness in agricultural and industrial commodi-

ties markets is due to a number of factors, including low

inflationary expectations, overcapacity resulting from

excess investment, and curtailed global demand in the

wake of emerging-market crises. For further analysis, see

Falling Prices in Commodities and Manufacturing Pose

Continuing Risks to Credit Quality, page 3. If sustained,

commodity price weakness could adversely affect the

Atlanta Region’s economy, given the importance of agri-

culture and manufacturing in the Region.

Overall economic growth in the Atlanta Region remains

strong. In April 1999, employment in the Region was up

3.0 percent compared to the national increase of 2.3 per-

cent. However, most gains were occurring in larger met-

ropolitan areas, which have greater economic diversity.

Rural and smaller metropolitan areas—where many of

the industries facing price pressures are located—saw

less pronounced growth. Persistent price stagnation

could lead to further layoffs in manufacturing and

financial stress on the Region’s farmers, and could ulti-

mately affect credit quality.

that in the fourth quarter of 1998, nominal farm income

did rise, but this likely was the result of the approval of

an additional $6 billion in federal farm aid in October

1998.) Declines in agriculture income can have a ripple

effect on rural communities as farmers scale back con-

sumption and purchases of farm equipment. Long-term

price declines also could affect farmers’ ability to ser-

vice loans and ultimately could pressure farmland val-

ues, which are often used as collateral for loans. In the

Atlanta Region, hog farming, soybeans, and cotton, all

economically important sectors of agriculture, have

experienced price declines.

Hog farming has seen dramatic growth in the Atlanta

Region in recent years, with every state in the Region

CHART 1

The Nation’s Farm Income and Agriculture Prices

Have Moved Together in Recent Years

120

Farm Price Index (1990–92=100)

Farm Proprietors’ Income with

Inventory Valuation Adjustment

and Capital Consumption Adjustment

(Seasonally Adjusted Annual Rate), right axis

Prices Received by Farmers:

All Farm Products, left axis

110

Farm Income ($ Billions)

115

Agricultural Prices Continue to Decline

Agriculture commodity prices have been declining

since 1996. In the first quarter of 1999, prices for all

farm products were down 5.2 percent from one year ear-

lier and were 21 percent below their peak in the third

105

100

2Q 3Q 4Q 1Q 2Q 3Q

2Q 3Q 4Q 1Q

quarter of 1996. According to Bureau of Economic

’96 ’96 ’96 ’96 ’97 ’97 ’97

’97

’98 ’98 ’98 ’98 ’99

Analysis data, this decline in agriculture prices has been

Source: U.S. Department of Agriculture, Bureau of Economic Analysis (Haver

Analytics)

paralleled by a drop in farm income (Chart 1). (Note

Atlanta Regional Outlook 18 Third Quarter 1999

Regional Perspectives

now engaged in the industry. The industry is most heav-

ily concentrated in North Carolina, which accounted

for 15.7 percent of the nation’s hog and pig inventory in

1997; North Carolina inventories have tripled over the

past 10 years, according to the U.S. Department of

Agriculture (USDA).

Considerable media attention was given to the dramatic

hog price declines in late 1998. In December, hog prices

stood at $13.79/cwt,

less than half the level at the end

of the third quarter of 1998 and the lowest level in more

than three decades. Most analysts give hog farmers a

break-even price of around $35/cwt. The dip has been

transitory, however, as prices rebounded to nearly

$37/cwt by May 1999. The recent volatility in hog

prices likely was an aberration, as the pork industry was

coming off a period of high production while slaughter-

house capacity was at low levels and thus unable to

process pigs quickly. In that case, the recent sharp drop

and recovery in prices, though causing short-term pain

for the industry, may not affect hog farmers in the

future.

Despite the recent rebound, hog prices remain well

below the year-ago level and below the long-term trend

(Chart 2). According to data from the Wall Street Jour-

nal, since July 1988, the trend in hog prices has been

slightly negative. Many analysts attribute the downward

trend to structural changes in the industry. Technologi-

cal and organizational (vertical integration and con-

tracting) changes have resulted in a trend toward larger

farms and greater specialization. Economies of scale

cwt = 100 pounds.

CHART 2

Hog Prices Rebound but Remain

that the larger farms enjoy have placed downward pres-

sure on hog prices over the long term and may make it

increasingly difficult for smaller producers to compete.

Recent short-term price declines may have exacerbated

competitive pressures on smaller producers.

In recent years, supply and demand shifts have resulted

in downward pressure on soybean prices. The United

States and other nations, such as Brazil, have seen

bumper crops, while the crisis in Asia has crimped

demand. In May 1999, soybean prices fell to

$4.53/bushel (Chart 3), down nearly 30 percent from

one year earlier to their lowest level in more than 20

years. According to the USDA, U.S. soybean production

in 1999 may reach record levels, which may offset any

improvement in Asian demand and lead to continued

price weakness. The USDA forecasts soybean prices to

level off at $4.35/bushel in 2000. In the longer term,

U.S. farmers may face further global competition as for-

eign acreage and yields climb. In April 1999, a buyers’

group in North Carolina contracted to purchase 75,000

tons of soybeans from Brazil for use as feed. According

to a recent Wall Street Journal article, Brazil, seeing

surging agricultural exports because of its recently

devalued currency, may be able to open several million

acres of land for soybean farming in its western savan-

na. The Atlanta Region’s soybean production is concen-

trated near coastal areas, particularly in eastern portions

of the Carolinas.

Price weakness persists in the cotton market. In May

1999, the price of cotton was 56 cents/lb., down nearly 14

percent from one year earlier and down nearly 50 percent

from its previous peak in the summer of 1995 (Chart 3).

CHART 3

Soybean and Cotton Prices Continue to Decline

$10

$20

$30

$40

$50

$60

$70

Hog Price: Iowa–South Minnesota Avg

($/cwt)

Hog Price

Trend: 1988–1999

May

’99

Jul

’88

Jul

’89

Jul

’90

Jul

’91

Jul

’92

Jul

’93

Jul

’94

Jul

’95

Jul

’96

Jul

’97

Jul

’98

Below Long-Term Trend

Jan Jul Jan Jul Jan Jul Jan Jul Jan May

’95 ’95 ’96 ’96 ’97 ’97 ’98 ’98 ’99 ’99

Cotton Price (cents/lb)

Soybean Price ($/bu)

Price: Cotton, 1-1/16", Avg 7 Mkts (cents/lb)

Price: Soybeans, #1 Yellow: Central IL ($/bu)

120

100

Source: Wall Street Journal (Haver Analytics)

Source: Wall Street Journal, Journal of Commerce (Haver Analytics)

Atlanta Regional Outlook 19 Third Quarter 1999

Regional Perspectives

Despite weak prices that are near or at the break-even

CHART 4

point, the USDA anticipates that farmers nationwide will

Industrial Commodity Prices Remain Below 1995

continue to shift into cotton as competing crops are

Peaks, Particularly in the Steel Industry

expected to bring lower prices. Cotton farming in the

120

Atlanta Region exists in all states except West Virginia,

with production concentrated in Alabama, Georgia, and

North Carolina. In 1998, poor weather and low prices

aggravated the financial situation of many farmers in the

Region, particularly in South Georgia.

Potential implications for insured institutions will

Price Index, 1995/01=100

110

100

Paper and Allied Products

Textiles

Scrap Steel

depend on the magnitude and duration of the price

declines in agriculture. If recent price declines prove to

be transitory, many farmers may be able to meet current

obligations by placing crops under marketing loans or

having lenders capitalize interest on debt, according to

a recent report from the College of Agricultural, Con-

sumer, and Environmental Sciences at the University

of Illinois at Urbana-Champaign. However, if the

nation’s agricultural sector has entered a prolonged peri-

od of price stagnation, especially if it is accompanied by

declines in farm property values, farm credit quality

could deteriorate. In the Atlanta Region, agricultural

credit risk is most heavily concentrated in Georgia,

where 28 of the Region’s 39 agriculture banks, with

$1.6 billion in assets, are located. (For a detailed dis-

cussion of agriculture in the Atlanta Region, see Atlanta

Regional Outlook, First Quarter 1998.)

Industrial Commodity Prices Are Also Declining

A strong U.S. dollar and economic and financial turmoil

overseas have depressed prices for several key industrial

commodities produced in the Atlanta Region. Many

Asian and Latin American nations are in a lingering

recession that has depressed con-

sumption and may have created a

dependence on export trade as a

means of recovery. The U.S. econo-

my is among the few displaying

strong growth, resulting in a severe

and growing imbalance between

imports and exports in the steel, tex-

tile and apparel, and paper and allied products markets.

The American steel industry was restructured in the

1980s, and as a result of major capital investments, pro-

ductivity was enhanced, but thousands of jobs were lost.

The steel industry is now experiencing a challenge from

foreign imports. Recently, steel imports reached record

levels, and prices have declined sharply (see Chart 4).

U.S. manufacturers claim profits have suffered as they

Jan Jul Jan Jul Jan Jul Jan Jul Jan May

’95 ’95 ’96 ’96 ’97 ’97 ’98 ’98 ’99 ’99

Source: Journal of Commerce, Department of Labor (Haver Analytics)

compete with imports sold at prices well below the cost

of production. According to Curtis H. Barnette, presi-

dent and chief executive officer of Bethlehem Steel

Corporation, the surge in steel imports has caused over

10,000 layoffs and an increase in the number of steel

laborers working reduced hours or receiving reduced

pay incentives. The growing trade imbalance within the

industry has resulted in substantial production cuts, lost

or cancelled orders, and significant price declines.

Although the volume of imported steel has dropped

slightly in recent months, the levels remain well above

those prior to the collapse of many Asian economies,

and industry recovery is expected to be slow.

Weirton Steel, West Virginia’s second largest private

employer, laid off about 25 percent of its workforce

(1,000 workers) last Christmas as a result of increasing

losses. The company has sustained $41.5 million in

losses since steel imports began flooding U.S. markets.

However, the Associated Press reported that increased

demand for tin-plated steel in recent months has

brought about the recall of nearly half the displaced

workers. Some steel producers in Alabama and North

Carolina have adopted “no layoff ” policies to preserve

loyalty and motivate their workforce; however, such

practices may have resulted in lower wages through the

reduction or elimination of bonuses and overtime.

Weekly wage rates generally have declined in Alabama,

Georgia, Virginia, and West Virginia over year-ago lev-

els, and average weekly work hours of steelworkers in

the Atlanta Region have declined in all states, with the

sharpest declines occurring in Virginia and West Vir-

ginia. Fewer work hours and lower wages may increase

the likelihood that consumer credit quality in these

areas will deteriorate.

Foreign economic turmoil has hastened the ongoing

secular decline in the textile and apparel industries. The

Atlanta Regional Outlook 20 Thir

d Quarter 1999

Regional Perspectives

Asian crisis has been particularly troublesome for

apparel producers, as lower incomes and currency

depreciation have left Asian consumers with less money

to purchase U.S. merchandise. Currency depreciation

also has led to deep discounting by Asian producers in

an effort to keep their factories operating. The Journal

of Commerce reported that U.S. exporters expected

sales to Japan to exceed $1 billion in 1998, but instead

sales declined nearly 30 percent to $675 million, of

which $424 million was attributed to the apparel indus-

try. The U.S. Department of Labor reported that appar-

el prices fell 1.5 percent last year, leading U.S.

manufacturers to move some operations to Mexico and

the Caribbean, where labor is less expensive.

The Atlanta Region produces nearly 23 percent of all

apparel manufactured in the United States, with North

Carolina, Georgia, and Alabama having the largest

concentration of apparel-related employment. (For a

detailed discussion of the textiles and apparel industries

in the Atlanta Region, see Atlanta Regional Outlook,

Second Quarter 1998.) Apparel jobs are leaving Geor-

gia faster than any other state in the South, according to

the Atlanta Business Chronicle. Within the past year,

plant closings and layoffs have cost nearly 1,500 jobs in

both Georgia and Alabama, as well as several hundred

in North Carolina. Displaced workers throughout the

Region are increasingly seeking public assistance, as

their efforts to find work have resulted in lower paying

jobs, according to Harris Ryanor, southern regional

director of the Union of Needletrades, Industrial and

Textile Employees in Union City, Georgia.

While the Asian crisis has resulted in decreased exports

for most commodities, strong domestic demand has

provided some measure of stability to certain sectors of

the textile industry. Textile manufacturers in the Atlanta

Region account for over 72 percent of all textile jobs in

the nation. A strong housing market has increased sales

for carpet and fabrics used in home furnishings and has

kept prices relatively stable. A slowdown in home sales

and construction could disrupt this demand, however.

Since 1995, nearly 44,000 jobs in the Atlanta Region

have been eliminated in the textile industry. North Car-

olina, Georgia, and South Carolina have the highest

concentration of industry workers. Textile job losses

have been especially high in the production of synthet-

ic fabrics, where Asian competition has been strongest.

Prices of some fabric categories have declined by as

much as 40 percent. All states within the Region have

seen an increase in job losses in the textile industry;

however, the Carolinas have experienced the greatest

number of layoffs.

Weakness in the Asian and Latin American economies

has reduced demand for paper and allied products, which

has driven down prices.

Exports of pulp and paper

to Asia have deteriorated in

recent years, partly because

of weaker currencies rela-

tive to the U.S. dollar but

also because of structural

changes brought about by

increased automation and

modernization of paper mills throughout the world.

Greater efficiency and lower demand have resulted in

moderately high pulp inventory levels. Low-cost paper

mills, particularly in Asian countries, are reducing over-

capacity by offering products in U.S. markets at reduced

prices, making it difficult for U.S. companies to compete.

The U.S. Industry and Trade Outlook ’99 reports that

pulp exports represented slightly less than 55 percent of

the volume of all U.S. market pulp shipments in 1998—

the lowest market share this decade. The pulp and paper

industry is vital to many areas of the Atlanta Region, with

Georgia and Alabama having the highest exposure. As a

result of global pressures, plant shutdowns and layoffs

have become common throughout the Region. (For a

detailed discussion of the pulp and paper industry in the

Atlanta Region, see Atlanta Regional Outlook, Third

Quarter 1998.) Some analysts expect the pulp market to

start rebounding soon because of the slow improvement

in economic conditions in Asia.

Atlanta Regional Outlook 21 Third Quarter 1999

Regional Perspectives

Funding Issues Affect Commercial Banks in the Atlanta Region

Bank funding has changed considerably in the 1990s

(see Shifting Funding Trends Pose Challenges for

Community Banks, page 11). Change has been driven,

in part, by cyclical factors since the current economic

expansion began in 1992, but there are differences in

the way the industry is funded when compared with pre-

vious expansions. Most notably, loan growth has

increased relative to deposit growth more than in past

cycles. This situation has contributed to a shift away

from traditional core

deposits toward alternative fund-

ing sources such as noncore

deposits and borrowings.

This analysis examines funding changes at banks in the

Atlanta Region, the factors driving those changes, and

potential risks.

Deposits have declined steadily as a percentage of

assets at commercial banks in the Atlanta Region since

the current economic expansion began in 1992 (see

Chart 5). This trend has been consistent across large and

small banks. It is not uncommon for loan demand to

outstrip deposit growth during cyclical expansions, but,

as Chart 5 shows, such a sharp and sustained decline in

Core deposits include all transaction, savings, and money market

deposits, as well as time deposits less than $100,000. Core deposits typ-

ically are viewed as a stable source of funding for insured institutions.

Noncore deposits include time deposits over $100,000, foreign

deposits, and deposits placed through a broker. These are considered

more volatile than core deposits.

Borrowings include federal funds purchased, securities sold under

agreements to repurchase, demand notes issued to the U.S. Treasury,

mortgages and capitalized lease obligations, and any other borrowed

money.

CHART 5

Deposit Funding at Atlanta Region Commercial

Banks Has Fallen during This Economic

Expansion

Deposits to Assets

Source: Bank Call Reports

60%

70%

80%

90%

Commercial Banks

with Assets over

$1 Billion

Down 4

Percentage Points

Down 14

Percentage Points

’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98

Commercial Banks

with Assets under

$1 Billion

Recession

deposits relative to assets did not occur during the pre-

vious expansion in the 1980s. This shift suggests that

factors other than the business cycle are influencing

bank funding decisions. As discussed below, the move

from deposits to borrowings appears to be occurring

both from necessity, as competition from nonbank

financial services providers has slowed bank deposit

growth, and opportunity, as funding alternatives avail-

able to banks have increased.

Competition from Nonbank Financial Services

Providers Is Affecting Insured Institution

Deposit Growth

The slowdown in bank deposit growth has resulted, in

part, from increased competition from nonbank finan-

cial services providers, such as mutual funds and, to a

lesser extent, credit unions. Unquestionably, high

returns in the financial markets have helped the mutual

fund industry garner a substantial and growing share of

each household dollar in the 1990s. Fund flow data sug-

gest that there has been a demographic shift from a

“saver” to an “investor” focus in recent years, as indi-

viduals are placing a larger share of their financial

assets in the capital markets rather than in insured bank

deposits.

The Investment Company Institute

(ICI) reports that

net new cash flow into mutual funds (equity, bond, and

money market funds) reached a record $477 billion in

1998, surpassing the previous record of $374 billion set

in 1997. Moreover, during the five-year period from

1994 to 1998, nearly $1.5 trillion of new money flowed

into mutual funds, compared with only $300 billion a

decade earlier from 1984 to 1988 (a 400 percent

increase). Mutual fund penetration also has grown

steadily, as 44 percent of all U.S. households held mutu-

al fund investments in 1998 compared with 24 percent

10 years earlier. It is likely that growth in the mutual

fund sector, to some extent, is coming at the expense of

the banking industry. Banks in the Atlanta Region may

face even stronger competition with mutual funds rela-

tive to their out-of-region peers, as ICI demographic

statistics show the nation’s highest concentration of

mutual fund ownership to be in the southern states.

The Investment Company Institute, based in Washington, D.C., is

the national association of the mutual fund investment industry.

Atlanta Regional Outlook 22 Third Quarter 1999

Regional Perspectives

Nonbank financial services providers have been suc-

cessful in capturing market share during the 1990s.

Chart 6 shows, at the national level, the growth in total

funds held by various financial services providers

(banks and thrifts, mutual funds, and credit unions)

from 1991 to 1998, as reported in the Federal Reserve

Board’s Flow of Funds data. The chart illustrates how

successful insured institution competitors have been in

increasing their share of the nation’s financial assets.

Equity and bond mutual funds have been the big win-

ners; their asset volume has grown nearly fivefold since

1991. Meanwhile, money market mutual fund assets

(perhaps the closest substitute to insured institution core

deposits) have risen by 150 percent since 1991. In fact,

money market funds took in more new investment dol-

lars ($235 billion) than bond and equity funds com-

bined in 1998. (The increased flow into money market

mutual funds in 1998 may have been a “flight to quali-

ty” surrounding the equity and bond market declines

that occurred in the third quarter.)

Credit union deposits also have grown at a faster rate

than bank deposits in the 1990s. Chart 6 shows that

credit union deposits grew nearly 60 percent from 1991

to 1998, compared with only 14 percent for bank and

thrift deposits. As indicated by the bold line on Chart 6,

slow deposit growth has led insured institutions to rely

increasingly on borrowings to meet funding needs since

1992. Regional Flow of Funds data are not available,

but Call Report data suggest that deposit and borrow-

ing trends at insured institutions in the Atlanta Region

are similar to the national trends.

The mutual fund industry now holds the largest share of

financial assets. Chart 7 presents the Federal Reserve

CHART 6

Growth of Insured Institution Deposits Lags

Competition and Leads to Increased Borrowings

Index

500

450

471

Bond & Equity

Mutual Funds

400

350

Insured Institution

328

Borrowings

300

Mone

y Market

249

250

Mutual Funds

200

Credit Union

150

158

Deposits

114

Insured Institution

100

Domestic Deposits

Note: Insured institutions include U.S.-chartered commercial banks, savings and

loan associations, mutual savings banks, and federal savings banks

Source: FRB Board of Governors, Flow of Funds Accounts of the United States

1991 Stock = 100

’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98

Board’s Flow of Funds data in dollars rather than as an

index. As seen in the chart, insured institutions were

losing deposit volume to competitors from 1991 until

about 1994 (consistent with the 14 percent increase in

total deposits from 1991 to 1998 shown in the previous

chart). That equates to an average annual growth of 1.85

percent, which was less than the average interest being

credited on deposits over that period. Chart 7 also shows

that dollars held by the mutual fund industry actually

eclipsed total bank and thrift deposits in 1996 and that

the gap has continued to widen. Finally, it is important

to note that credit union deposits, despite their strong

growth in recent years, remain nominal relative to total

deposits held by banks and thrifts.

Bank Funding Has Diversified as More

Alternatives Have Become Available

Consistent with the national trend, banks in the Atlanta

Region are relying more on borrowings to meet their

funding needs. Chart 8 (next page) breaks down each

new dollar of funding raised by commercial banks in the

Region in 1998 into its components—core deposits,

noncore deposits, borrowings, and equity—and com-

pares that to the composition of new funds in 1988. Bor-

rowings represented a much larger share of new funds

in 1998 than in 1988 at both large and small banks in the

Region. The increase in borrowings primarily offset a

decline in large time deposits at both groups of banks,

although large time deposits still make up the bulk of

community bank noncore funding in the Region. Both

groups, meanwhile, funded a larger portion of their

asset growth with equity rather than interest-bearing lia-

bilities in 1998 than in 1988, which is consistent with

CHART 7

Note: Insured institutions include U.S.-chartered commercial banks, savings

and loan associations, mutual savings banks, and federal savings banks.

Source: FRB Board of Governors, Flow of Funds Accounts of the United States

Mutual Fund Dollars Outstrip

Insured Institution Deposits

1,000

2,000

3,000

4,000

5,000

$ Billions

1991

Insured Institution Domestic Deposits

Bond &

Equity Mutual Funds

Money Market Mutual Funds

All Mutual Funds

Credit Union Deposits

1992 1993 1994 1995 1996 1997 1998

Atlanta Regional Outlook 23 Third Quarter 1999

Regional Perspectives

CHART 8

Borrowings Increase as a Share of New Dollar

Funding at Atlanta Region Commercial Banks

Commercial Banks Commercial Banks

under $1 Billion over $1 Billion

1988

1998

1988

1998

Percent of New Funds

100

–25

Basis Points

Collapses; Long-Term Capital

Management Meltdown

Persian Gulf

War Begins

Mexican Peso Devaluation

Orange County Bankruptcy

Southeast Asian Economic

Crisis Begins

Recession

Trend

Negotiable 6-Month Bank CD Rate (Secondary Market)

Less 6-Month T-Bill Yield (Constant Maturity)

Equity

63% 61%

23%

10%

19%

8% 10%

71% 71%

18% 13%

8% 9%

Borrowings

Noncore Deposits

Core Deposits

Source: Bank Call Reports

generally higher equity levels across the industry in the

1990s. It is important to note that, while core deposits

were essentially unchanged as a percent of new funding

in 1998 compared with 1988, core deposits have

declined relative to assets at both large and small banks

in the Region over the past 10 years.

The shift from large time deposits to borrowings seen in

Chart 8 may be related to an increase in the relative cost

of large time deposits over the past few years. Chart 9

shows that, at the national level, the spread between nego-

tiable (over $100,000) bank certificates of deposit and a

benchmark six-month U.S. Treasury bill has increased

since 1994. This is notable in that, according to a 1990

report by Citicorp entitled Interest Rate Spreads Analy-

sis: Managing and Reducing Rate Exposures, this

spread normally narrows during periods of recovery and

economic stability. As seen in the chart, the spread has

widened as expected during periods of economic uncer-

tainty, such as the recession in 1990 and the Russian bond

market collapse last year. But the fact that the spread has

been increasing despite stable economic growth may sig-

nal that banks relying on this type of noncore funding

must pay higher rates in response to increased competi-

tion from within the banking industry and from nonbank

financial services providers.

In addition to competitive factors, the industry’s shift

from deposits to borrowings may be a result of greater

access to borrowed funds. The increase in borrowings

by both large and small banks in the Atlanta Region has

coincided with commercial banks gaining access to the

Federal Home Loan Bank (FHLB) system with the pas-

sage of the Financial Institutions Reform, Recovery, and

Enforcement Act of 1989. As shown in Chart 10, mem-

CHART 9

The Cost of Bank Certificates of Deposit Has

Increased Relative to Treasury Bill Yields during

This Economic Expansion

Russian Bond Market

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

January

Source: Federal Reserve Bank of St. Louis, Federal Reserve Economic Data

(Monthly Averages)

bership in and advances from the FHLB system have

been popular among Atlanta Region banks. From 1993

(earliest available data) to 1998, the number of com-

mercial banks in the Atlanta Region that were members

of the FHLB system more than doubled, from 310 to

725. Moreover, outstanding advances increased more

than tenfold, from $2 billion to $23 billion, over that

period. FHLB penetration within the Region has grown

steadily as well, as membership has increased from one

in five banks (21 percent) in 1993 to nearly two of every

three banks (63 percent) in 1998. As of year-end 1998,

72 percent of banks in the Region with assets over $1

billion were FHLB members, with advances totaling

$20 billion. Community bank membership stood at 63

percent at year-end, and advances totaled $3.3 billion.

Community bank membership is likely to continue to

CHART 10

Federal Home Loan Bank (FHLB) Membership

and Borrowings Have Increased at Atlanta Region

Commercial Banks

2,000

1,750

1,500

1,250

1,000

750

500

250

199519941993

FHLB Borrowings (Billions)

1996 1997 1998

Number and Percentage of Commercial

Banks in the Region That Are FHLB Members

Number of Commercial

Banks in the Region

$25

$20

$15

$10

21% 32% 39% 47% 55% 63%

Source: Bank Call Reports, Federal Housing Finance Board

Atlanta Regional Outlook 24 Third Quarter 1999

Regional Perspectives

grow, as the Federal Housing Finance Board amended

its membership requirements in 1998 to allow rural

banks with assets under $500 million to use combina-

tion business or farm properties on which a residence is

located to qualify for FHLB membership.

As the Region’s overall funding mix has diversified to

include more borrowings, the composition of core

deposits also has changed. Chart 11 compares the com-

position of new core deposits raised by community

banks in the Atlanta Region in 1998 with that of 1988.

Small time deposits, normally a staple of community

bank funding, fell sharply from 71 percent of new core

funds in 1988 to 27 percent in 1998. This decrease is

consistent with balance sheet data for community

banks in the Region, which show that small time

deposits have declined as a percentage of assets since

the late 1980s. This decline may be related to strong

growth in the mutual fund sector, as some consumers

might view mutual funds and small time deposits as

interchangeable products. Also, the fact that savings

and money market deposit accounts represent a larger

share of new core funds now than in 1988 may imply a

“liquidity preference” on the part of depositors to hold

nonmaturity deposits rather than time deposits, given

today’s low interest rate environment. Large banks

exhibit trends similar to those shown in Chart 11, the

only exception being that transaction accounts have

declined at large banks while representing a higher per-

CHART 11

New Core Funding Has Shifted away from

Small Time Deposits over the Past Decade

at Atlanta Region Community Banks

1988 1998

Small Time

Transaction

ransaction

(37%)

Deposits (27%)

(23%)

Savings and

Money Market

Deposit Accounts

Savings and

Small Time

(6%)

Money Market

Deposit Accounts

(36%)

Deposits (71%)

Note: Pie represents the composition of new core deposit flows during

the year and not the existing balance sheet composition. Community

banks are defined as insured commercial banks with assets less than

$1 billion and in operation at least three years. Large banks exhibit

similar trends.

Source: Bank Call Reports

centage of small bank core funding. Transaction

accounts, while free of interest costs, can be expensive

to maintain depending on transaction frequency, aver-

age account balance, and the channel (electronic, auto-

mated teller machine, or teller window) customers use

to make transactions.

The Community Bank Funding Challenge

Community banks may face greater funding challenges

than their larger counterparts. A 1998 survey conducted

by the American Bankers Association found that 4 of 10

community bankers 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 fund-

ing relative to 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 strategy could

increase interest costs, however, and because many com-

munity banks have limited fee income opportunities, they

are structurally more reliant than larger banks on spread

income from taking deposits and making loans.

Other factors that might affect community banks over the

longer term include convergence toward national, rather

than local, market pricing as a result of advances in tech-

nology. A number of community banks enjoy some pric-

ing power in their local markets, but consumers’ ability to

shop markets nationally and move money more quickly

at lower costs could pressure pricing spreads at certain

institutions. Ultimately, this could lead to more volatility

in core deposits, which currently fund 72 percent of the

Region’s community bank assets (compared with 54 per-

cent for large banks). A less stable core deposit base

would heighten the need for alternative funding sources,

which are limited for many small banks. In a recent issue

of SNL Securities’ Bank Investor, L. Bud Baker, CEO of

Wachovia Corporation, alluded to these concerns:

“…there is no such thing any longer as a core deposit…

you are going to be able to go on the Internet and find the

best price for your money…and you can move your

money with the punch of a button.”

Atlanta Regional Outlook 25 Third Quarter 1999

Regional Perspectives

Risk Implications of Funding Changes

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 pres-

sured 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. That risk may be tem-

pered somewhat by the fact that the noninterest cost of

gathering wholesale funds can be less than that of retail

funds. 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 retail deposit gathering. This raises the ques-

tion of whether banks could recapture deposit share lost

to competitors, such as mutual funds or credit unions, in

the e

vent that financial market turmoil or credit quality

concerns unexpectedly diminish alternative funding.

Many industry observers believe that the funding chal-

lenges facing banks are long term rather than cyclical.

Thus, the issues discussed here will only add to the

complexity of asset and liability management going for-

ward. Maintaining a cost structure consistent with the

mix of retail and wholesale funding will be critical for

banks to continue to grow without sacrificing prof-

itability. Regardless of how funds are acquired in the

future, insured institution managers must allocate those

funds in a manner that can achieve earnings and growth

objectives without subjecting institutions to undue cred-

it, interest rate, or liquidity risks.

Atlanta Region Staff

Atlanta Regional Outlook 26 Thir

d Quarter 1999

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