View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

The lending behavior of the high- and
low-quality-loan banks differed sharply.
Between 1977 and 1982,loan growth
was 49 percent at low-quality-loan
banks, compared to 34 percent at highquality-loan banks. Although this difference was statistically insignificant,
the difference in loan growth relative to
deposit growth for the five-year period
was significant at the 1 percent level.
Low-quality-loan
banks apparently
directed nearly all of their deposit
inflows to lending, while high-qualityloan banks used a sizable amount of
their deposit growth to expand their
investments in securities and other
assets. Low-quality-loan banks were
indeed aggressive lenders, particularly
given relatively weak economic conditions in their market areas. The rapid
expansion of loans in slower-growing
areas was apparently a primary reason
why the low-quality-loan banks became
saddled with the high volume of nonperforming loans.
The loan-to-asset ratio variable used
to study the Ohio sample further emphasizes that the low-quality-loan
banks were aggressive lenders. In 1982,
they held 57 percent of their assets in
loans, compared to 46 percent for highquality-loan banks. Of course, the lowquality-loan banks, seeing their non performing loans mounting, reacted by cutting back on lending. Between 1982 and

1985, their loan growth was only 16 percent, or nearly three times lower than
the loan growth at the high-quality-loan
banks. This caused the loan-to-asset
ratio of the low-quality-loan banks to
fall and to approach the level maintained by the high-quality-loan banks.
The loan composition of the high- and
low-quality-loan banks was also significantly different. Low-quality-loan banks
made a larger share of business loans,
which are often riskier than consumer
loans. They held nearly 16 percent business loans and 26 percent consumer
loans, compared to 12 percent business
loans and 33 percent consumer loans for
the high-quality-loan banks. No meaningful differences were detected between
the two groups of banks in their share
of real estate and farm loans.'!
Finally, the low-quality-loan banks in
Ohio had nearly three times as many
insider loans than the high-quality-loan
banks. Insider transactions have often
been cited in financial circles as being a
common contributing factor in bank
failures. Insider loans, as defined in
Federal Reserve Regulation 0, are
extensions of credit to all executive
officers, to principal stockholders, and
to their related interests.

13. See Larry D. Wall, "Why Are Some Banks
More Profitable?" Economic Review, Federal
Reserve Bank of Atlanta, vol. 68, no. 9, September 1983, pp. 42-48; Donald R. Fraser, "The
Determinants of Bank Profits: An Analysis of
Extremes," The Financial Review, 1976, pp. 6987; Marvin M. Phaup, Ir., "Characteristics of

High Performance Banks 1969-1975," Economic
Review, Federal Reserve Bank of Cleveland, Fall
1976, pp. 12-22;John A. Haslem, "A Statistical
Analysis of the Relative Profitability of Commercial Banks," Journal of Finance, vol. 23, no. 1,
March 1968, pp. 167-176.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

Summary and Conclusions
Local economic conditions and lending
behavior differed significantly between
the high- and low-quality-loan banks in
Ohio. The low group operated in areas

with higher unemployment rates and
slower economic growth. Despite presumed weaker credit demand, the lowquality-loan banks were aggressive
lenders with faster loan growth. relative to deposit growth, higher loan-toasset ratios, and more business and insider loans. No appreciable differences
either in local bank concentration or in
the presence of thrift institutions were
found between the two groups of banks.
More research is needed on loan quality before any broad conclusions can be
reached. Findings from the sample of
Ohio banks, however, imply that if
lenders were more cautious in making
loans, particularly in areas with lessfavorable economic conditions, the
volume of nonperforming loans would
be much lower than it is today.
While all lenders face increasingly
competitive pressures, the local banking structure did not seem to have an
effect on bank-loan quality. Perhaps the
threat of potential competition is strong
enough to offset any differences in the
existing local banking structure.
Regardless of the competitive conditions, however, the evidence suggests
that unfavorable economic conditions
increase nonperforming loans and that
bank management is a key determinant
of loan quality.

14. There were seven low-quality-loan and six
high-quality-loan banks with more than 25 percent of their loans made to farmers. Banks with
such concentration of farm loans are classified as
farm banks by the FDIC.

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

Address Correction Requested:
Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

Federal Reserve Bank of Cleveland

January 1, 1987
ISSN 0428-1276

ECONOMIC
COMMENTARY
Bank earnings nationwide, as measured by return on assets, have been
falling in the 1980s.1 Sixteen percent of
the more than 14,000 commercial banks
in the United States 'incurred net losses
in 1985, up fourfold from the 1980 level.
Bank loan quality continues to deteriorate and is causing increasing concern among regulators, investors, and
analysts. Loan charge-offs have more
than doubled in the last four years and
have been a large contributing factor to
the decline in bank earnings."
The general deterioration in loan
quality and bank earnings stems largely
from the depressed farm and energy
sectors of the economy, as well as from
the foreign debt problem and from the
weak commercial real estate market in
certain domestic regions. Banks continue to pay for overly optimistic credit
decisions that were made years ago.
The unexpected shift of the economy
from inflation to disinflation has amplified the repayment difficulties of borrowers, particularly those in or exposed
to depressed economic sectors.
In addition to general economic factors, the banking industry also faces an
increasingly competitive environment
that has been fostered by financial innovation and deregulation. Deposit deregulation and broader lending powers of
thrift institutions, for example, have significantly expanded the number of deposit and credit alternatives for consumers
and businesses. Some economists argue
that the increased competition for both
deposits and loans has squeezed profit

Paul R. Watro is an economist at the Federal Reserve Bank of Cleveland. The author would like to
thank John N. McElravey for his excel/ent research
assistance.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

margins and thus motivated lenders to
take greater risks. It is also argued that
the mispricing of deposit insurance has
encouraged additional risk-taking by
federally insured banks.'
This Economic Commentary uses a
sample of Ohio banks to examine nonperforming bank loans, and identifies
some factors that contributed to loanquality differences between individual
banks. The sample of banks used include those with relatively large
amounts of non performing loans and
those with small amounts of such loans.
An analysis of the sample reveals differences in local economic conditions
and in lending behavior between the two
groups of banks. Since the bank sample
was limited to smaller institutions, the
findings are not geared to macropolicy issues. They may be useful, however, for
banking regulators in monitoring the
financial condition of individual banks.
Method Used and Bank Sample
Analysts often use the volume of nonperforming loans to measure loan quality. Nonperforming loans are loans that
are still on the books, but that are past
due by 90 days or more, are nonaccruing, or have been renegotiated.' Nonperforming loans are also generally
viewed as good indicators of future loan
losses. Data on these loans have been
publicly available only since 1983.
For each of the high- and low-qualityloan banks in Ohio, data were collected
on a variety of factors, such as institutional size, location, branches, owner1. The average return on banking assets fell
from 0.82 percent in 1980 to 0.64 percent in 1985.
See Ross Waldrop, "Commercial Bank Performance in 1985," Banking and Economic Review,
Federal Deposit Insurance Corporation, vol. 4, no.
3, April 1986, p. 21.
2. Net loan charge-offs as a percentage of bank
loans rose from 0.34 percent in 1981 to 0.82 percent in 1985. When banks write off loans, they
charge their loan-loss reserves, rather than their
earnings. Consequently, charge-offs reduce earn-

Loan -Quality
Differences:
Evidence from
Ohio Banks
by Paul R. Watro

ship, growth, loan composition, and
asset structure. Data were also gathered
on local competitive and economic conditions, such as the number of banking
organizations, bank concentration, deposit share of thrift institutions in the
local markets, unemployment rates, population, per capita income, and personal
income growth. For each of these variables, a mean value was computed for
the high-quality-loan group and for the
low-quality-loan group. Using at-test,
the mean values were examined to determine if there are significant differences
between the two groups of banks.
The sample of Ohio banks used in
this study included all those institutions
that held either a large or small amount
of nonperforming loans in the 1983-85
period. Specifically, the sample consisted
of those banks with a three-year average of 4 percent or more of their loan
volume classified as nonperforming and
those banks with a three-year average
of less than 1 percent of their loan
volume in the nonperforming status."
A three-year average was used to minimize any differences in non performing
loans due to differences in charge-off
policies among banks. For example,
some banks may have had a lower level
of nonperforming loans on the books at
a given time simply because they wrote
off loans aggressively in prior periods.
Some banks, including those established in the last 10 years, those with
deposits over $500 million, and those
with a substantial presence in more

ings in the current period only to the extent that
banks add funds to their loan-loss reserves to
offset all or part of the charge-offs,
3. See James B. Thomson, "Equity, Efficiency,
and Mispriced Deposit Guarantees," Economic
Commentary, Federal Reserve Bank of Cleveland,
July 15, 1986.

than one local market, were excluded
from the selection process. Metropolitan statistical areas and counties were
used to approximate local markets.
The Ohio sample included 84 banks:
40 with a relatively large number of subquality loans and 44 with only a few
subquality loans. The average highquality-loan bank had nonperforming
loans equal to only 0.5 percent of total
loans, while the average low-quality-loan
institution had 6.4 percent of its loans
in the nonperforming status."
Within the low-quality-loan bank
group, four banks held nonperforming
loans equal to more than 10 percent of
their loans outstanding; the highest one
held 14.5 percent in the last three
years. Two-fifths of the institutions in
the sample held between 4 percent and
5 percent in non performing loans.
Within the high-credit-quality bank
group, 21 banks had less than one-half
of one percent of nonperforming loans,
and the other 23 banks had between
one-half to one percent of nonperforming loans. Nine banks held less than
one-quarter of one percent, and two of
them had no nonperforming loans on
the books at year-end 1983, 1984, and
1985.
High- and low-credit-quality banks
were widely and equally scattered
throughout Ohio. Of the state's 88
counties, 30 had at least one high-creditquality bank and 32 had at least one
low-credit-quality bank. Both a highand low-credit-quality bank were
located in eight counties. Two or more
high-quality-loan banks were headquartered in 12 counties, and two or
more low-quality-loan banks were
located in six counties.
Competitive and economic conditions
in local areas should influence the
volume of non performing loans held by
banks. Except for the largest ones,
banks generally confine lending activity to areas in close proximity to their
offices. Although banks can buy and
sell loans and enter into loan participations with other lenders, available evidence suggests that these activities
have been done on a relatively limited
basis by smaller banks."

-

.

4. Banks are permitted to count as income any
interest that is due but not received, provided
that the interest and principal are less than 90
days overdue, or the obligation is well-secured
and in the process of collection. Nonaccruing
loans are overdue loans that do not meet either of
the above conditions. Renegotiated loans are
those that have been restructured or renegotiated
to provide a reduction of either interest or principal because of a deterioration in the borrower's
financial position.

Table 1 Differences Between High- and Low-Quality-Loan
LowQuality-Loan
Banks

Institutional Factors (1985)
Deposit size (millions)
Single office banks
Number of branches
Location (percentage in
metropolitan area)
Member qf multi bank
holding company
Local Financial Structure (1984)
Number of banking organizations
Three-bank concentration ratio
Herfindahl-Hirschman index
Thrift deposit share
Local Economic Conditions
Average unemployment rate
(1983, 1984, 1985)
Personal income growth
(1977 to 1982)
Per capita income (1983)
Total population (1983) (thousands)
Lending Behavior (percent)
Loans-to-assets (1982)
(1985)
Loan growth (1977 to 1982)
(1982 to 1985)
Loan growth minus deposit
growth (1977 to 1982)
(1982 to 1985)
Loan composition (1985)
Commercial and industrial
Consumer
Real estate
Farms
Insider loans'

HighQuality-Loan
Banks

Ohio Banks
Difference"

$64.1
42.5%
2.9

$70.8
43.2%
3.0

-6.7
-0.7
-0.1

40.0%

36.4%

3.6

15.0%

25.0%

-10.0

10.7
70.7%
2,246
35.6%

12.3
73.0%
2,340
31.6%

-1.6
-2.3
-94.0
4.0

11.5%

10.7%

0.8b

48.0%
$9,772
286.6

57.3%
$9,635
308.5

-9.3b
137.0
-21.9

57.2
51.4
49.0
15.7

46.2
48.6
33.5
45.0

11.0d
2.8
15.5
-29.3d

2.6
-13.1

-16.7
6.0

19.3d
-19.1d

15.9
26.5
46.2
15.4
0.4

11.9
33.1
44.6
11.5
1.1

4.0c
-6.6c
1.6
3.9
-0.7d

a. A t-test was used to determine if mean values are statistically different from zero.
b. Denotes significance at 10 percent level.
c. Denotes significance at 5 percent level.
d. Denotes significance at 1 percent level.
e. Includes farm loans secured by real estate.
f. June 30, 1984, figures were used for this ratio. One high-quality-loan bank was excluded from the
analysis because it deviated dramatically from the group's behavior.
SOURCE: Condition reports of banks; Federal Reserve System Board of Governors; Ohio Bureau of
Employment Services; and U.S. Bureau of Census.

5. Although the 4 percent and 1 percent criteria
were arbitrary, they provided a large enough
sample for reasonable statistical testing.
6. The low-quality-loan banks had non performing loans that were more than three and one-half
times their loan-loss reserves and over one-third
of their primary capital.

7. Although condition reports of banks do not
give loan purchases, they do disclose loan sales.
During the fourth quarter of 1985, only 60 of the

292 banks in Ohio with deposits under $500 million reported loan sales. The ones that did sell
loans had average loan sales equal to only 2.3
percent of their total loans.
8. See Lynn A..Nejezchleb, "Declining Profitability at Small Commercial Banks: A Temporary
Development or a Secular Trend?" Banking and
Economic Review, Federal Deposit Insurance
Corporation, vol. 4, no. 5, June 1986, p. 19.

Local economic and competitive conditions where banks are headquartered
have less influence on loan portfolios of
large and geographically diversified
banks. Large banks lend outside local
areas and compete with banks on a
regional, national, and even international basis. Banks generating a.sizable
amount of business from branch officeslocated in more than one market are'
subjected to multiple economic and
competitive conditions.
To avoid the problem of estimating
the overall conditions faced by large
and geographically dispersed banks,
those institutions along with new institutions were omitted from the sample.
New banks could bias the results
because they initially hold no bad loans
and experience enormous growth in
their formative years.
Findings
The mean values for the high- and lowquality-loan banks and the statistical
differences between the two groups are
presented in table 1.
The effect of institution size on bank
loan quality has public policy implications. Much concern has been expressed
about the future viability of small independent banks in a deregulated environment. Lending opportunities for small
banks are typically limited to local residents and small businesses. Loans to
smaller firms generally carry more risk
because the bankruptcy rate has traditionally been higher at smaller firms.
Findings for the Ohio sample indicated that the average deposit size of
the high-quality-loan banks was $70.8
million, compared to $64.1 million for
the low-quality-loan banks. This size
difference, however, was statistically
insignificant. Also, no meaningful differences in location, branching, or
ownership were found between the
high- and low-quality-loan banks.
About 60 percent of the banks in both
groups operate in non metropolitan
counties; about 20 percent of them
belong to multibank holding companies.
The average high-and low-quality-loan
bank operates three branch offices.

9. Ohio banks are currently permitted to branch
de novo into counties contiguous to their home
office county and statewide through merger. In
1989, de novo branching on a statewide basis goes
into effect.
10. The Herfindahl-Hirschman index (HHI) is
calculated by adding the squared market share of
each competing banking institution. When a
market has only one institution, the HHI attains
its maximum value of 10,000. The value of HHI
declines with increases in the number of competi-

Rate, geographic, and product deregulation have greatly intensified deposit
and loan competition. Rate deregulation
has forced banks, particularly smaller
ones, to rely more and more on marketrate deposits, thereby increasing the
cost of funds for banks. In the long
term, deregulation will enable banks to
become more cost-efficient, but in the
transition period of the last few years,
bank costs have risen, particularly at
small retail institutions." Liberalization
of branching restrictions has reduced
geographic barriers to entry and has
fostered a greater degree of existing
and potential competition in banking.
Ohio, for example, moved from homecounty branching to essentially statewide branching in 1979.9
In addition to rate and geographic
deregulation, expanded asset and liability powers of thrift institutions have
dramatically increased the number of
institutions providing a full range of
banking services. These developments
have increased pressure on bank profit
margins, which may have encouraged
lenders to accept more credit risk.
Several variables that are thought to
mimic the intensity of market competition were examined in relation to the
Ohio sample. They include the number
of banking organizations, the three-bank
concentration ratio, the HerfindahlHirschman index, and the percentage
of market deposits held by thrifts.'?
Findings indicated that low-qualityloan banks operated in markets with
fewer competitors, less concentration,
and a larger deposit share held by
thrifts. These differences were relatively small and statistically insignificant. Thus, contrary to expectations,
both groups of banks operated in markets with similar levels of bank concentration and nearly equal presence of
thrift institutions. This does not necessarily imply that local competition is
unimportant. Perhaps traditional
market-structure variables are poor
measures of the competitive environment in local markets. Alternatively,
these findings are consistent with the
contestable market view, which indicates that the threat of entry by new

businesses keeps markets competitive,
regardless of the number of actual
competitors or market concentration.'!
General economic condi tions were
approximated for the Ohio bank sample
by four variables-the
level of per capita income, population, income growth,
and average unemployment rates in
local markets. These economic variables can serve as crude proxies for loan
demand. Weaker credit demand exerts
downward pressure on loan rates and
perhaps also on loan quality. The
unemployment rate is also assumed to
reflect the ability of borrowers, or at
least individuals, to repay debt. Higher
unemployment rates have been linked
to higher loan delinquencies in past
studies." Therefore, low-quality-loan
banks are more likely to operate in
markets with slower income growth,
less population, higher unemployment
rates, and lower per capita income levels. As expected, personal income
growth was slower and the unemployment rate was higher in the markets of
the low-quality-loan banks, as compared with markets served by the highquality-loan banks.
Although bank management has little or no influence over the competitive
and economic environment, it has
direct control over asset structure,
lending growth, and loan type within
its own banks. When economic conditions deteriorate, one would expect loan
demand to fall and banks to cut back
on lending and to direct more funds
toward buying securities and other
investments. Alternatively, banks
could choose to make more risky loans
in order to maintain profit margins
consistent with stronger loan demand.
Past studies have pointed largely to
management, either explicitly or implicitly, as the key element in bank performance.P When using loan quality as a
measure of performance, results found
in our analysis are consistent with previous findings. Several variables were
used to capture managerial decisions
regarding the lending behavior of individual institutions-the
bank's loan
growth, loan-to-asset ratio, loan composition, percentage of insider loans, and
loan growth relative to deposit growth .

tors and as the competitors become more equal in
their market share. Thrift institutions include all
savings and loan associations and mutual savings banks that are federally insured.

12. See, for example, Gene D. Sullivan and R.
Mark Rogers, "Residential Mortgage Delinquencies and Foreclosures: Improvement's Underway," Economic Review, Federal Reserve Bank of
Atlanta, December 1983, pp. 34-44; Charles A.
Luckett, "Recent Developments in the Mortgage
and Consumer Credit Markets," Federal Reserve
Bulletin, vol. 68, no. 5, May 1982, pp. 281-290;
and George M. Von Furstenberg and Jeffrey R.
Green, "Home Mortgage Delinquencies: A Cost
Analysis," Journal of Finance, December 1977,
pp. 1545-1548.

11. See Gary Whalen, "Competition and Bank
Profitability: Recent Evidence," Economic Commentary, Federal Reserve Bank of Cleveland,
November I, 1986.

than one local market, were excluded
from the selection process. Metropolitan statistical areas and counties were
used to approximate local markets.
The Ohio sample included 84 banks:
40 with a relatively large number of subquality loans and 44 with only a few
subquality loans. The average highquality-loan bank had nonperforming
loans equal to only 0.5 percent of total
loans, while the average low-quality-loan
institution had 6.4 percent of its loans
in the nonperforming status."
Within the low-quality-loan bank
group, four banks held nonperforming
loans equal to more than 10 percent of
their loans outstanding; the highest one
held 14.5 percent in the last three
years. Two-fifths of the institutions in
the sample held between 4 percent and
5 percent in non performing loans.
Within the high-credit-quality bank
group, 21 banks had less than one-half
of one percent of nonperforming loans,
and the other 23 banks had between
one-half to one percent of nonperforming loans. Nine banks held less than
one-quarter of one percent, and two of
them had no nonperforming loans on
the books at year-end 1983, 1984, and
1985.
High- and low-credit-quality banks
were widely and equally scattered
throughout Ohio. Of the state's 88
counties, 30 had at least one high-creditquality bank and 32 had at least one
low-credit-quality bank. Both a highand low-credit-quality bank were
located in eight counties. Two or more
high-quality-loan banks were headquartered in 12 counties, and two or
more low-quality-loan banks were
located in six counties.
Competitive and economic conditions
in local areas should influence the
volume of non performing loans held by
banks. Except for the largest ones,
banks generally confine lending activity to areas in close proximity to their
offices. Although banks can buy and
sell loans and enter into loan participations with other lenders, available evidence suggests that these activities
have been done on a relatively limited
basis by smaller banks."

-

.

4. Banks are permitted to count as income any
interest that is due but not received, provided
that the interest and principal are less than 90
days overdue, or the obligation is well-secured
and in the process of collection. Nonaccruing
loans are overdue loans that do not meet either of
the above conditions. Renegotiated loans are
those that have been restructured or renegotiated
to provide a reduction of either interest or principal because of a deterioration in the borrower's
financial position.

Table 1 Differences Between High- and Low-Quality-Loan
LowQuality-Loan
Banks

Institutional Factors (1985)
Deposit size (millions)
Single office banks
Number of branches
Location (percentage in
metropolitan area)
Member qf multi bank
holding company
Local Financial Structure (1984)
Number of banking organizations
Three-bank concentration ratio
Herfindahl-Hirschman index
Thrift deposit share
Local Economic Conditions
Average unemployment rate
(1983, 1984, 1985)
Personal income growth
(1977 to 1982)
Per capita income (1983)
Total population (1983) (thousands)
Lending Behavior (percent)
Loans-to-assets (1982)
(1985)
Loan growth (1977 to 1982)
(1982 to 1985)
Loan growth minus deposit
growth (1977 to 1982)
(1982 to 1985)
Loan composition (1985)
Commercial and industrial
Consumer
Real estate
Farms
Insider loans'

HighQuality-Loan
Banks

Ohio Banks
Difference"

$64.1
42.5%
2.9

$70.8
43.2%
3.0

-6.7
-0.7
-0.1

40.0%

36.4%

3.6

15.0%

25.0%

-10.0

10.7
70.7%
2,246
35.6%

12.3
73.0%
2,340
31.6%

-1.6
-2.3
-94.0
4.0

11.5%

10.7%

0.8b

48.0%
$9,772
286.6

57.3%
$9,635
308.5

-9.3b
137.0
-21.9

57.2
51.4
49.0
15.7

46.2
48.6
33.5
45.0

11.0d
2.8
15.5
-29.3d

2.6
-13.1

-16.7
6.0

19.3d
-19.1d

15.9
26.5
46.2
15.4
0.4

11.9
33.1
44.6
11.5
1.1

4.0c
-6.6c
1.6
3.9
-0.7d

a. A t-test was used to determine if mean values are statistically different from zero.
b. Denotes significance at 10 percent level.
c. Denotes significance at 5 percent level.
d. Denotes significance at 1 percent level.
e. Includes farm loans secured by real estate.
f. June 30, 1984, figures were used for this ratio. One high-quality-loan bank was excluded from the
analysis because it deviated dramatically from the group's behavior.
SOURCE: Condition reports of banks; Federal Reserve System Board of Governors; Ohio Bureau of
Employment Services; and U.S. Bureau of Census.

5. Although the 4 percent and 1 percent criteria
were arbitrary, they provided a large enough
sample for reasonable statistical testing.
6. The low-quality-loan banks had non performing loans that were more than three and one-half
times their loan-loss reserves and over one-third
of their primary capital.

7. Although condition reports of banks do not
give loan purchases, they do disclose loan sales.
During the fourth quarter of 1985, only 60 of the

292 banks in Ohio with deposits under $500 million reported loan sales. The ones that did sell
loans had average loan sales equal to only 2.3
percent of their total loans.
8. See Lynn A..Nejezchleb, "Declining Profitability at Small Commercial Banks: A Temporary
Development or a Secular Trend?" Banking and
Economic Review, Federal Deposit Insurance
Corporation, vol. 4, no. 5, June 1986, p. 19.

Local economic and competitive conditions where banks are headquartered
have less influence on loan portfolios of
large and geographically diversified
banks. Large banks lend outside local
areas and compete with banks on a
regional, national, and even international basis. Banks generating a.sizable
amount of business from branch officeslocated in more than one market are'
subjected to multiple economic and
competitive conditions.
To avoid the problem of estimating
the overall conditions faced by large
and geographically dispersed banks,
those institutions along with new institutions were omitted from the sample.
New banks could bias the results
because they initially hold no bad loans
and experience enormous growth in
their formative years.
Findings
The mean values for the high- and lowquality-loan banks and the statistical
differences between the two groups are
presented in table 1.
The effect of institution size on bank
loan quality has public policy implications. Much concern has been expressed
about the future viability of small independent banks in a deregulated environment. Lending opportunities for small
banks are typically limited to local residents and small businesses. Loans to
smaller firms generally carry more risk
because the bankruptcy rate has traditionally been higher at smaller firms.
Findings for the Ohio sample indicated that the average deposit size of
the high-quality-loan banks was $70.8
million, compared to $64.1 million for
the low-quality-loan banks. This size
difference, however, was statistically
insignificant. Also, no meaningful differences in location, branching, or
ownership were found between the
high- and low-quality-loan banks.
About 60 percent of the banks in both
groups operate in non metropolitan
counties; about 20 percent of them
belong to multibank holding companies.
The average high-and low-quality-loan
bank operates three branch offices.

9. Ohio banks are currently permitted to branch
de novo into counties contiguous to their home
office county and statewide through merger. In
1989, de novo branching on a statewide basis goes
into effect.
10. The Herfindahl-Hirschman index (HHI) is
calculated by adding the squared market share of
each competing banking institution. When a
market has only one institution, the HHI attains
its maximum value of 10,000. The value of HHI
declines with increases in the number of competi-

Rate, geographic, and product deregulation have greatly intensified deposit
and loan competition. Rate deregulation
has forced banks, particularly smaller
ones, to rely more and more on marketrate deposits, thereby increasing the
cost of funds for banks. In the long
term, deregulation will enable banks to
become more cost-efficient, but in the
transition period of the last few years,
bank costs have risen, particularly at
small retail institutions." Liberalization
of branching restrictions has reduced
geographic barriers to entry and has
fostered a greater degree of existing
and potential competition in banking.
Ohio, for example, moved from homecounty branching to essentially statewide branching in 1979.9
In addition to rate and geographic
deregulation, expanded asset and liability powers of thrift institutions have
dramatically increased the number of
institutions providing a full range of
banking services. These developments
have increased pressure on bank profit
margins, which may have encouraged
lenders to accept more credit risk.
Several variables that are thought to
mimic the intensity of market competition were examined in relation to the
Ohio sample. They include the number
of banking organizations, the three-bank
concentration ratio, the HerfindahlHirschman index, and the percentage
of market deposits held by thrifts.'?
Findings indicated that low-qualityloan banks operated in markets with
fewer competitors, less concentration,
and a larger deposit share held by
thrifts. These differences were relatively small and statistically insignificant. Thus, contrary to expectations,
both groups of banks operated in markets with similar levels of bank concentration and nearly equal presence of
thrift institutions. This does not necessarily imply that local competition is
unimportant. Perhaps traditional
market-structure variables are poor
measures of the competitive environment in local markets. Alternatively,
these findings are consistent with the
contestable market view, which indicates that the threat of entry by new

businesses keeps markets competitive,
regardless of the number of actual
competitors or market concentration.'!
General economic condi tions were
approximated for the Ohio bank sample
by four variables-the
level of per capita income, population, income growth,
and average unemployment rates in
local markets. These economic variables can serve as crude proxies for loan
demand. Weaker credit demand exerts
downward pressure on loan rates and
perhaps also on loan quality. The
unemployment rate is also assumed to
reflect the ability of borrowers, or at
least individuals, to repay debt. Higher
unemployment rates have been linked
to higher loan delinquencies in past
studies." Therefore, low-quality-loan
banks are more likely to operate in
markets with slower income growth,
less population, higher unemployment
rates, and lower per capita income levels. As expected, personal income
growth was slower and the unemployment rate was higher in the markets of
the low-quality-loan banks, as compared with markets served by the highquality-loan banks.
Although bank management has little or no influence over the competitive
and economic environment, it has
direct control over asset structure,
lending growth, and loan type within
its own banks. When economic conditions deteriorate, one would expect loan
demand to fall and banks to cut back
on lending and to direct more funds
toward buying securities and other
investments. Alternatively, banks
could choose to make more risky loans
in order to maintain profit margins
consistent with stronger loan demand.
Past studies have pointed largely to
management, either explicitly or implicitly, as the key element in bank performance.P When using loan quality as a
measure of performance, results found
in our analysis are consistent with previous findings. Several variables were
used to capture managerial decisions
regarding the lending behavior of individual institutions-the
bank's loan
growth, loan-to-asset ratio, loan composition, percentage of insider loans, and
loan growth relative to deposit growth .

tors and as the competitors become more equal in
their market share. Thrift institutions include all
savings and loan associations and mutual savings banks that are federally insured.

12. See, for example, Gene D. Sullivan and R.
Mark Rogers, "Residential Mortgage Delinquencies and Foreclosures: Improvement's Underway," Economic Review, Federal Reserve Bank of
Atlanta, December 1983, pp. 34-44; Charles A.
Luckett, "Recent Developments in the Mortgage
and Consumer Credit Markets," Federal Reserve
Bulletin, vol. 68, no. 5, May 1982, pp. 281-290;
and George M. Von Furstenberg and Jeffrey R.
Green, "Home Mortgage Delinquencies: A Cost
Analysis," Journal of Finance, December 1977,
pp. 1545-1548.

11. See Gary Whalen, "Competition and Bank
Profitability: Recent Evidence," Economic Commentary, Federal Reserve Bank of Cleveland,
November I, 1986.

The lending behavior of the high- and
low-quality-loan banks differed sharply.
Between 1977 and 1982,loan growth
was 49 percent at low-quality-loan
banks, compared to 34 percent at highquality-loan banks. Although this difference was statistically insignificant,
the difference in loan growth relative to
deposit growth for the five-year period
was significant at the 1 percent level.
Low-quality-loan
banks apparently
directed nearly all of their deposit
inflows to lending, while high-qualityloan banks used a sizable amount of
their deposit growth to expand their
investments in securities and other
assets. Low-quality-loan banks were
indeed aggressive lenders, particularly
given relatively weak economic conditions in their market areas. The rapid
expansion of loans in slower-growing
areas was apparently a primary reason
why the low-quality-loan banks became
saddled with the high volume of nonperforming loans.
The loan-to-asset ratio variable used
to study the Ohio sample further emphasizes that the low-quality-loan
banks were aggressive lenders. In 1982,
they held 57 percent of their assets in
loans, compared to 46 percent for highquality-loan banks. Of course, the lowquality-loan banks, seeing their non performing loans mounting, reacted by cutting back on lending. Between 1982 and

1985, their loan growth was only 16 percent, or nearly three times lower than
the loan growth at the high-quality-loan
banks. This caused the loan-to-asset
ratio of the low-quality-loan banks to
fall and to approach the level maintained by the high-quality-loan banks.
The loan composition of the high- and
low-quality-loan banks was also significantly different. Low-quality-loan banks
made a larger share of business loans,
which are often riskier than consumer
loans. They held nearly 16 percent business loans and 26 percent consumer
loans, compared to 12 percent business
loans and 33 percent consumer loans for
the high-quality-loan banks. No meaningful differences were detected between
the two groups of banks in their share
of real estate and farm loans.'!
Finally, the low-quality-loan banks in
Ohio had nearly three times as many
insider loans than the high-quality-loan
banks. Insider transactions have often
been cited in financial circles as being a
common contributing factor in bank
failures. Insider loans, as defined in
Federal Reserve Regulation 0, are
extensions of credit to all executive
officers, to principal stockholders, and
to their related interests.

13. See Larry D. Wall, "Why Are Some Banks
More Profitable?" Economic Review, Federal
Reserve Bank of Atlanta, vol. 68, no. 9, September 1983, pp. 42-48; Donald R. Fraser, "The
Determinants of Bank Profits: An Analysis of
Extremes," The Financial Review, 1976, pp. 6987; Marvin M. Phaup, Ir., "Characteristics of

High Performance Banks 1969-1975," Economic
Review, Federal Reserve Bank of Cleveland, Fall
1976, pp. 12-22;John A. Haslem, "A Statistical
Analysis of the Relative Profitability of Commercial Banks," Journal of Finance, vol. 23, no. 1,
March 1968, pp. 167-176.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

Summary and Conclusions
Local economic conditions and lending
behavior differed significantly between
the high- and low-quality-loan banks in
Ohio. The low group operated in areas

with higher unemployment rates and
slower economic growth. Despite presumed weaker credit demand, the lowquality-loan banks were aggressive
lenders with faster loan growth. relative to deposit growth, higher loan-toasset ratios, and more business and insider loans. No appreciable differences
either in local bank concentration or in
the presence of thrift institutions were
found between the two groups of banks.
More research is needed on loan quality before any broad conclusions can be
reached. Findings from the sample of
Ohio banks, however, imply that if
lenders were more cautious in making
loans, particularly in areas with lessfavorable economic conditions, the
volume of nonperforming loans would
be much lower than it is today.
While all lenders face increasingly
competitive pressures, the local banking structure did not seem to have an
effect on bank-loan quality. Perhaps the
threat of potential competition is strong
enough to offset any differences in the
existing local banking structure.
Regardless of the competitive conditions, however, the evidence suggests
that unfavorable economic conditions
increase nonperforming loans and that
bank management is a key determinant
of loan quality.

14. There were seven low-quality-loan and six
high-quality-loan banks with more than 25 percent of their loans made to farmers. Banks with
such concentration of farm loans are classified as
farm banks by the FDIC.

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

Address Correction Requested:
Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

Federal Reserve Bank of Cleveland

January 1, 1987
ISSN 0428-1276

ECONOMIC
COMMENTARY
Bank earnings nationwide, as measured by return on assets, have been
falling in the 1980s.1 Sixteen percent of
the more than 14,000 commercial banks
in the United States 'incurred net losses
in 1985, up fourfold from the 1980 level.
Bank loan quality continues to deteriorate and is causing increasing concern among regulators, investors, and
analysts. Loan charge-offs have more
than doubled in the last four years and
have been a large contributing factor to
the decline in bank earnings."
The general deterioration in loan
quality and bank earnings stems largely
from the depressed farm and energy
sectors of the economy, as well as from
the foreign debt problem and from the
weak commercial real estate market in
certain domestic regions. Banks continue to pay for overly optimistic credit
decisions that were made years ago.
The unexpected shift of the economy
from inflation to disinflation has amplified the repayment difficulties of borrowers, particularly those in or exposed
to depressed economic sectors.
In addition to general economic factors, the banking industry also faces an
increasingly competitive environment
that has been fostered by financial innovation and deregulation. Deposit deregulation and broader lending powers of
thrift institutions, for example, have significantly expanded the number of deposit and credit alternatives for consumers
and businesses. Some economists argue
that the increased competition for both
deposits and loans has squeezed profit

Paul R. Watro is an economist at the Federal Reserve Bank of Cleveland. The author would like to
thank John N. McElravey for his excel/ent research
assistance.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

margins and thus motivated lenders to
take greater risks. It is also argued that
the mispricing of deposit insurance has
encouraged additional risk-taking by
federally insured banks.'
This Economic Commentary uses a
sample of Ohio banks to examine nonperforming bank loans, and identifies
some factors that contributed to loanquality differences between individual
banks. The sample of banks used include those with relatively large
amounts of non performing loans and
those with small amounts of such loans.
An analysis of the sample reveals differences in local economic conditions
and in lending behavior between the two
groups of banks. Since the bank sample
was limited to smaller institutions, the
findings are not geared to macropolicy issues. They may be useful, however, for
banking regulators in monitoring the
financial condition of individual banks.
Method Used and Bank Sample
Analysts often use the volume of nonperforming loans to measure loan quality. Nonperforming loans are loans that
are still on the books, but that are past
due by 90 days or more, are nonaccruing, or have been renegotiated.' Nonperforming loans are also generally
viewed as good indicators of future loan
losses. Data on these loans have been
publicly available only since 1983.
For each of the high- and low-qualityloan banks in Ohio, data were collected
on a variety of factors, such as institutional size, location, branches, owner1. The average return on banking assets fell
from 0.82 percent in 1980 to 0.64 percent in 1985.
See Ross Waldrop, "Commercial Bank Performance in 1985," Banking and Economic Review,
Federal Deposit Insurance Corporation, vol. 4, no.
3, April 1986, p. 21.
2. Net loan charge-offs as a percentage of bank
loans rose from 0.34 percent in 1981 to 0.82 percent in 1985. When banks write off loans, they
charge their loan-loss reserves, rather than their
earnings. Consequently, charge-offs reduce earn-

Loan -Quality
Differences:
Evidence from
Ohio Banks
by Paul R. Watro

ship, growth, loan composition, and
asset structure. Data were also gathered
on local competitive and economic conditions, such as the number of banking
organizations, bank concentration, deposit share of thrift institutions in the
local markets, unemployment rates, population, per capita income, and personal
income growth. For each of these variables, a mean value was computed for
the high-quality-loan group and for the
low-quality-loan group. Using at-test,
the mean values were examined to determine if there are significant differences
between the two groups of banks.
The sample of Ohio banks used in
this study included all those institutions
that held either a large or small amount
of nonperforming loans in the 1983-85
period. Specifically, the sample consisted
of those banks with a three-year average of 4 percent or more of their loan
volume classified as nonperforming and
those banks with a three-year average
of less than 1 percent of their loan
volume in the nonperforming status."
A three-year average was used to minimize any differences in non performing
loans due to differences in charge-off
policies among banks. For example,
some banks may have had a lower level
of nonperforming loans on the books at
a given time simply because they wrote
off loans aggressively in prior periods.
Some banks, including those established in the last 10 years, those with
deposits over $500 million, and those
with a substantial presence in more

ings in the current period only to the extent that
banks add funds to their loan-loss reserves to
offset all or part of the charge-offs,
3. See James B. Thomson, "Equity, Efficiency,
and Mispriced Deposit Guarantees," Economic
Commentary, Federal Reserve Bank of Cleveland,
July 15, 1986.