Order Code RL32542
CRS Report for Congress
Received through the CRS Web
The Condition of the Banking Industry
August 24, 2004
Walter W. Eubanks
Specialist in Economic Policy
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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The Condition of the Banking Industry
Summary
Mortgage lending in the current low-interest rate environment made 2003 a
banner year for the U.S. banking industry. Banks earned a record $120 billion last
year. However, the industry continues to become more concentrated with fewer
small banks. Smaller banks are less able to garner cheaper funds for lending from
wholesale markets and are less able to mitigate their credit and interest rate risks
through participation in securitization and syndication markets. Smaller banks are
more vulnerable to the increased indebtedness of borrowers and anticipated rising
interest rates. The three largest banking institutions have assets in the range of one
trillion dollars each. Their combined assets represent 30% of FDIC-insured banks.
The next four banks hold another 13% of these assets, and the top 25 banks hold
more than 50% of the assets of FDIC-insured banks. As a result of bank
consolidations, at the end of 2003 there were 118 fewer commercial banks, and 55
fewer savings institutions, than there were at the end of 2002. The Senate Committee
on Banking, Housing, and Urban Affairs held a hearing on the condition of the
banking industry on April 20, 2004, where most of the issues in this report were
discussed.
Despite the overall growth in deposits in the banking system, deposits at smaller
banks have begun to decline as deposits at the larger banks continue to grow.
Deposits at commercial banks grew at 7.2% and 5.0% at saving institutions between
2002 and 2003. However, in the same period for all FDIC-insured institutions with
less than $100 million in assets, deposits declined by 5.0% while deposits grew
10.0% at institutions with assets greater than $10 billion.
The high liquidity and profits in the banking system could be reduced rapidly
if relative yields on alterative investments increase sharply due to higher interest
rates. In the recession of 2001, smaller banks had not heavily lent to nonfinancial,
high-tech companies, which became financially troubled during the recession. Large
banks were doing most of that lending, but they were also better prepared for the
recession because they had diversified their sources of funding. Despite their
preparation, the noncurrent asset ratio (loans at least 90 days past due divided by
total assets) for FDIC-insured banks went up to 1.00% for commercial banks with
assets greater than $10 billion. Since then, these same institutions’ noncurrent asset
ratio declined to 0.80%. Smaller commercial banks (less than $100 million in
assets) have seen a slight increase in noncurrent assets since the 2001 recession. The
ratio went from 0.81% in 2001 to 0.83% in 2003. This slight increase might reflect
smaller commercial banks’ increased exposure to interest rate risk.
Larger banks are likely to become even more efficient users of regulatory capital
under Basel II and thereby better able to expand lending with the planned
implementation of Basel II capital rules. Smaller banks would continue to operate
under the more burdensome regulatory capital standard, Basel I.
This report will be updated as legislative and financial developments warrant.

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Contents
The Bottom Line . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
The Risk Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Interest Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Competition in the Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Cost of Funds Is Lower for Large Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Large Banks’ Real Estate Lending Adds Stability
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Compliance with Basel II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
List of Tables
Table I.
FDIC-Insured Institutions’ Numbers, Assets, Profits, Equity Capital
Ratios, and Noncurrent Assets, 2001 and 2003 . . . . . . . . . . . . . . . . . . . . . . . 2

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The Condition of the Banking Industry
The Bottom Line1
Last year was a banner year for the U.S. banking industry. As Table 1 shows,
the industry comprising commercial banks and thrifts or savings institutions earned
a record $120.6 billion, surpassing the 2002 record earnings of $105.6 billion. These
are Federal Deposit Insurance Corporation (FDIC) -insured institutions. The
historically high profits are attributable to the low-interest rate environment that has
held since 2001. Specifically, mortgage lending is a major contributor to the
profitability of banking mainly because of application and servicing fees. In contrast,
the demand for business loans and for underwriting equity securities was weak in
2002 and 2003.
Recent profitability is diffuse throughout the industry. More important, the
safety and soundness of the industry as measured by bank capital — the owners’
money that is the first line of defense against bank failure — have also been strong.
Despite the growth in capital, FDIC-insured commercial banks reported a net profit
of more than $102 billion in 2003, as shown in Table 1, column (4), and an overall
equity capital ratio of 9.10% as shown in column (6).2 Similarly, total thrift profits
were $18.056 billion in 2003, up 17.86% from the previous record of $15.244 billion
in 2002. Only one thrift institution fell below the well-capitalized standard. In sum,
the bottom lines of all 7,769 commercial banks were only slightly more profitable
than the 1,411 thrift institutions covered. The return on assets (ROA) for the
commercial banks in 2003 was 1.40%, while the thrifts had a ROA of 1.28%.
1 The Senate Committee on Banking, Housing, and Urban Affairs held a hearing on
the condition of the banking industry on April 20, 2004, where most of the issues in
this report were discussed.
2 The Controller of the Currency speaking about nationally chartered banks said, “Today,
all national banks, with the exception of a few small banks under special supervision, have
risk-based capital ratios [capital divided by total assets] above 8 percent [the regulatory
requirement] and more than 90 percent of national banks have risk-based capital ratios
above 10 percent.” Testimony of the Comptroller of the Currency, John D. Hawke, in U.S.
Congress, Senate Committee on Banking, Housing, and Urban Affairs, An Examination of
the Condition of the Banking and Credit Union Industry, Apr. 20, 2004, p. 9, at
[http://banking.senate.gov/_files/ACF23F.pdf].

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CRS-2
Table I.
FDIC-Insured Institutions’ Numbers, Assets, Profits, Equity
Capital Ratios, and Noncurrent Assets, 2001 and 2003
Institutions
# of
Total
Total
Return
Equity
Non-
Non-
Inst.
Assets
Profits
on
Capital
current
current
(bil. $)
(mil. $)
Assets,
Ratios,
Assets to
Assets to
%
%
Total
Total
Assets
Assets
2001
2003
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Commercial Banks
7,769
7,602
102,546
1.40
9.10
0.97
0.77
Greater than $10 billion
83
5,543
76,505
1.43
8.64
1.00
0.80
$1 billion to $10 billion
341
947
13,165
1.46
10.58
0.73
0.65
$100 million to $1
3,434
910
11,061
1.27
9.91
0.73
0.71
billion
Less than $100 million
3,911
201
1,815
0.93
11.27
0.81
0.83
Thrift Institutions
1,411
1,474
18,050
1.28
9.41
0.66
0.62
Greater than $10 billion
47
981
13,352
1.43
8.90
0.53
0.65
$1 billion to 10 billion
110
217
2,305
1.11
9.91
0.79
0.51
$100 million to $1
776
251
2,136
0.88
10.59
0.60
0.57
billion
Less than $100 million
478
25
263
1.07
13.24
0.78
0.82
Total/Weighted
9,180
9,077
120,596
1.39
9.15
0.77
0.75
Averages
Source: FDIC Quarterly Banking Profile, Tables II-A, II-B, IV-A, IV-B, for the Full Year 2001 and 2003.
Available at [http://www2.fdic.gov/qbp/2003dec/all2a.html], [http://www2.fdic.gov/qbp/2001dec/all2.html], and
[http://www2.fdic.gov/qbp/2004mar/sav2.html].
The Risk Considerations
Credit Risk
Meeting and even exceeding regulatory capital requirements is relatively easy
when the industry is making record profits. As some analysts argue, regulatory
compliance gets cheaper as profits grow. But, changing macroeconomic conditions
can expose the banking industry to risks. The rapid growth in bank profits was
generated when the economy grew rapidly in 2003 (nominal GDP grew 4.9% ). The
slower rate of economic growth is expected to increase the industry’s exposure to
credit risk. Credit risk is the risk that borrowers may fail to fully make the obligated
payments of their loans. In short, credit risk is probability of default. According to
Alan Greenspan, “At present, credit risk-management practices [in the banking
industry] are perhaps least developed in measuring risk associated with exposures

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CRS-3
related to construction projects and to financing commercial real estate, which have
grown rapidly, particularly among regional and community banks.”3 In 2003, this
type of asset constituted a record 19% share of all bank lending. Credit risk is highly
correlated with interest rate risk because higher interest rates tend to reduce
borrowers’ available income and increase the probability of default as borrowers take
on new loans with higher required payouts.4
The level of consumer indebtedness is a major credit risk concern. Total
household indebtedness is at an historic high of 112% of after-tax income. In 2003,
homeowners use about 14% of their disposable income to meet their major financial
obligations. In 1993, they used 12%. The situation is worse for renters. They are
using 31% of their disposable income for financial obligations. In 1993, they used
only 24% of their disposable income to meet these financial obligations.5 Rising
household indebtedness has raised concerns about the sustainability of the growth in
consumer spending (the main source of recent economic growth). Since interest rates
are beginning to rise, banks may see a rise in nonperforming loans because
households now have a greater exposure to variable-rate consumer loans and
adjustable mortgages. Some borrowers with weaker credit histories and balance
sheets may well experience problems meeting their obligations.
Interest Rate Risk
Low interest rates have been a source of bank profitability; the probability of
interest rates rising is also a major source of interest rate risk exposure for banks.
Lending exposes banks to risk due to changes in the market interest rates. This is
best illustrated by an example: suppose a bank makes a two-year, $1 million loan for
which it charges 10% interest per annum. And, the bank faces the choice of market
financing of the loan with a two-year time deposit at 9% per annum or with a one-
year time deposit at 8% per annum.6 The 9% choice would result in $10,000 in
certain interest earnings for each of the two years for a total of $20,000. However,
if the bank chooses the one-year financing, it will earn $20,000 in year one. But its
earnings in year two will depend on the currently unknown one-year interest rate that
will prevail a year from now. Should the one-year interest rate remain unchanged at
8%, the bank will earn a second year of $20,000 for a total of $40,000. If in the
second year the one year interest rate falls to 5%, the bank would do even better and
record a second year earning of $50,000 for a total of $70,000. But if the market
interest rate rises to 13%, the bank would suffer a loss of $30,000 in year two, wiping
3 Testimony of the Chairman of the Board of Governors of the Federal Reserve System Alan
Greenspan, An Examination of the Condition of the Banking and Credit Union Industry,
April 20, 2004, p. 3, at [http://banking.senate.gov/_files/ACF243.pdf].
4See Stuart I. Greenbaum and Anjan V. Thakor, Contemporary Financial Intermediation
(New York: Dryden Press, 1995), p. 361.
5See CRS Report RL30965, Rising Household Debt: Background and Analysis, by Brian W.
Cashell.
6Market financing a loan means that the bank borrows the funds it uses for the loan from
lenders in the financial marke. The bank charges its borrower a higher interest than it pays
for those funds in the market.

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CRS-4
out all profits plus $10,000 or 50% of the earnings it made in the first year and taking
a loss overall. The risk could be avoided by choosing the two-year financing.
The example reveals the reason for concern that banks may be taking advantage
of the low-interest environment to maintain or boost their interest income by using
short-term financing for higher earning long term loans, but that could make them
increasingly vulnerable to a rise in rates. On the other hand, prepayment is a concern
of bankers when market interest rates fall, leading mortgage borrowers to pay off
their higher interest rate mortgages with new lower interest rate mortgages.
Prepayments tend to lower banks’ interest income and profits.

Competition in the Industry
Over the last two decades, the banking industry has been rapidly consolidating
through mergers and acquisitions, which means that there are fewer but larger banks.
According to the chairman of the FDIC, “Once the recently announced mergers are
complete, there will be three banking companies whose assets are in the range of one
trillion dollars each. Their combined assets will account for approximately 30
percent of the assets of FDIC-insured institutions. The next four largest holding
companies will have assets in the range of $200 to $400 billion, and they will account
for another 13 percent of industry assets. The top 25 banking companies hold over
one-half of industry assets, while the top 100 hold almost three-quarters.”7 As a
result of the bank consolidation, at the end of 2003 there were 118 fewer commercial
banks, and there were 55 fewer thrifts than there were 2002.8
Cost of Funds Is Lower for Large Banks
In the low-interest rate environment, larger banks clearly have an advantage over
smaller banks in raising deposits that fund loans. Residential real estate loans held
by banks rose about 20% in both 2002 and 2003. Consumers have taken advantage
of declining mortgage rates to extract funds from the increased value of their homes.
A sizeable part of these funds from refinancing and home equity loans has been used
to pay off higher credit card and installment debts.9 Smaller banks have a greater
reliance on retail funding which mainly comes from their customers’ deposits. The
interest rate difference between the lower mortgage loan rates and the rates banks pay
7 Testimony of Chairman Federal Deposit Insurance Corporation Donald E Powell, in U.S.
Congress, Senate Committee on Banking, Housing and Urban Affairs, An Examination of
the Condition of the Banking and Credit Union Industry, Apr. 20, 2004, p. 8, at
[http://banking.senate.gov/_files/powell.pdf].
8See Office of Thrift Supervision, 2003 Fact Book and Federal Deposit Insurance
Corporation, Quarterly Banking profile, Mar. 2004, [http://www.ots.treas.gov/docs/
1 7 3 4 0 . p d f ] , a n d [ h t t p : / / w w w 2 . f d i c . go v/ q b p / 2 0 0 4 ma r / c b 1 . h t ml ] , a n d
[http://www2.fdic.gov/qbp/2004mar/sav1.html].
9Testimony of John D. Hawke, Jr. before the Committee on Banking, Housing, and Urban
Affairs, An Examination of the Condition of the Banking and Credit Union Industry, Apr.
20, 2004, p. 6, [http://banking.senate.gov/_files/ACF23F.pdf].

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CRS-5
for deposits has narrowed. Bankers call this an erosion in smaller banks’ net interest
margins. For insured commercial banks, net interest income as a percentage of
earnings declined 27 basis points [a basis point is one-hundredth of a percentage
point (0.01%)] in 2003 to 3.80%, the lowest level in more than a decade. In contrast,
larger banks rely more heavily on wholesale funding.10 Large banks are able to
borrow funds from large cash generating corporations such as McDonald’s and
ExxonMobil, insurance companies, and pension funds in domestic and international
financial markets. In a low-interest rate environment, deposits continue to flow into
banks, particularly to larger banks because the rate of return on alternative money
market instruments is lower. Consequently, deposits at commercial banks grew at
7.2% and at saving institutions at 5.0% between 2002 and 2003. However, for all
FDIC-insured institutions with less than $100 million in assets, deposits declined by
5%, while deposits grew 10% at institutions with greater that $10 billion in assets.
These larger institutions share of all deposits was 65%.11
The high liquidity and profits in the banking system could be reduced rapidly
if relative yields on alterative investments increase sharply due to higher interest
rates. In the recession of 2001, smaller banks had not heavily lent to nonfinancial,
high-tech companies, which became financially troubled during the recession. Large
banks were doing most of that lending, but they were better prepared because of their
broader sources of funding. In that recession, the noncurrent loan ratio for all FDIC-
insured institutions (loans at least 90 days past due) went up to 1.00% for commercial
banks with assets greater than $10 billion (see column (7) in Table 1). Since then,
these same banks’ (with assets over $10 billion) noncurrent asset ratio has now
declined to .80%. Smaller commercial banks (less than $100 million in assets) have
not improved. Instead, they saw a slight decline in credit quality since the 2001
recession. Their noncurrent asset ratio went from .81% in 2001 to .83% in 2003.
Large Banks’ Real Estate Lending Adds Stability
The performance of bank loans to nonfinancial firms differs from the
performance of mortgage loans over the business cycles. Commercial bank loans
backed by real estate as percentage of their total assets went from 27% in 2001 to
30% in 2003, while these loans for the smaller thrift institutions went from 58% to
59%. Because nonfinancial firms generally have the ability to pass on costs,
including high interest cost, to their customers in the form of higher prices, their
ability to keep bank payments current in higher inflationary periods is less impaired
by rising interest rates. In contrast in recessions, nonfinancial firms tend to have less
pricing power causing a decline in profitability. This in turn could impair these
firms’ ability to maintain payments on their bank loans. Consequently, noncurrent
assets of banks tend to rise in recessions.
It is important to note that noncurrent loans in real estate as well as
nonfinancial loans are likely to rise in recessions. However on residential mortgage
10Testimony of Alan Greenspan, An Examination of the Condition of the Banking and Credit
Union Industry, p. 4.
11 FDIC Quarterly Banking Profile, Table III A, A Full Year 2002 and 2003 All FDIC-
Insured Institutions.

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CRS-6
loans, higher interest rates tend to drive up homeowners’ payments, particularly in
the case of the recently more popular variable-interest rate mortgages. If
homeowners’ incomes do not rise with higher interest rates, homeowners’ ability to
keep up with these higher mortgage payments may be impaired. As a result,
noncurrent bank assets will rise if homeowners fail to keep up with their mortgage
payments. On the other hand, in recessions when interest rates usually fall,
homeowners usually see their payments fall. Or, to take advantage of the lower rates,
fixed mortgage rate holders refinance at lower rates to pay off higher interest rate
mortgages.12 In recessions with accompanying lower interest rates, noncurrent
mortgage payments to banks tend to decline on real estate backed loans. In short, the
quality of nonfinancial loans and mortgages tends to offset each other over the
business cycle, which helped to stabilize bank income over the recessions.
Table 1 shows that overall noncurrent assets of FDIC-insured institutions are
down since the 2001 recession. For commercial banks noncurrent assets went from
0.97% in 2001 to 0.77% in 2003. Similarly, for thrift institutions the noncurrent
assets moved in the same direction from .66% in 2001 to .62% in 2003. All banking
institutions might be more vulnerable to higher interest rate risk because of their
heavier mortgage lending. But smaller banks might be already feeling the negative
impact of their heavy mortgage lending for which some of them might not be
equally prepared as the larger banks. Table 1 shows that noncurrent assets for
commercial and thrift institutions with less than $100 million have increased since
2001. Not shown in the table is that the smaller banks usually carry a significantly
higher percentage of noncurrent real estate loans than larger banks. For institutions
less than $100 million in assets these past due loans were 1.36% in 2003 and 1.56%
in 2001. For all FDIC-insured institutions with assets over $10 billion, these same
past due real estate loans were 0.93% in 2003 and 1.41% in 2001. Both figures are
larger for the smaller banks. That may explain why nine smaller banks are already
under special supervision by regulators.
Risk Management
Bank regulators have been encouraging banks to take specific steps to ensure
the safety and soundness of the banking system. As mentioned above, banks overall
have long met or exceeded the regulatory risk-based capital standards. The regulators
are now placing great emphasis on improving credit-risk management, developing
and improving their methods of measuring risk on a transaction-by-transaction basis.
These methods are to better quantify risk and establish a more formal and disciplined
process to recognize, price, and manage risk. To ensure compliance, bank regulators
have been moving from the traditional regime of periodic examinations to in-house
examiners. The Office of the Comptroller of the Currency, for example, has placed
resident examiners in the 24 largest national banks. These examiners, and specialists
in areas such as commercial and retail credit, capital markets, bank technology, and
asset management provide the regulators with real time risk management
information.
12 Prepayments create additional problems for banks if banks financed the original
mortgages with higher interest rate and longer term funds that they can not prepay.

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CRS-7
At the same time, regulators are still using periodic on-site visits for smaller
banks’ regulatory compliance examinations. But the requirement to manage risk on
a transaction-by-transaction basis is applied to smaller banks as well. Large banks
are expected to take a holistic, portfolio view of management using advances in
technology to garner information to help them underwrite and manage their credit
risk. Regulators claim that larger banks have reduced their credit risk exposure to
concentration by using the syndicated loan markets which broadly distribute credit
exposure within the U.S. banking system as well as to foreign bank and non-banking
organizations.13 Similarly, the greater use of securitization markets has provided
another way to manage risk concentration and to diversify their funding sources to
provide greater access to under served markets. Moreover, the growth of derivatives
markets has provided larger banks tools to manage their interest risk exposures. For
example, because residential real estate lending is typically associated with low credit
risk because of diversification, solid collateral, and borrowers’ vested interest, banks
are able to reduce this exposure by using hedges like interest rate swaps and options,
which then enable banks to manage future shifts in interest rates while expanding
lending. Most smaller banks are unable to take advantage of these tools because of
the cost of these instruments.14
The use of these risk mitigating tools to protect against interest rate risks poses
two challenges for regulators. First, risk mitigating tools are complicated,
contingency instruments whose hedge value is extremely difficult to determine before
hand. Regulators as well as bankers often rely on judgment to estimate their
protective value against risks. Second, if these derivative instruments are truly
effective protection against interest rate risk, smaller banks are disadvantaged by their
availability almost exclusively to larger banks. Most smaller banks don’t have
enough assets to enter these markets, or their management is not sophisticated
enough to understand how to use them successfully.
Compliance with Basel II
Some U.S. banks will be operating under new capital requirements that could
change their profitability in the domestic as well as in the international banking
markets. Both houses of Congress have held hearings on Basel II Capital Accords.
On May 9, 2003, the United States Financial Policy Committee for Fair Capital
Standards Act (H.R. 2043) was introduced at a hearing of the House Financial
Services Committee. The Senate Committee on Banking, Housing, and Urban
Affairs held a hearing entitled A Review of the Basel Capital Accord on June 18,
2003. From these hearings it is clear that U.S. regulators are committed to
13 Ibid. Hawke, pp. 9-11; and Greenspan, pp.6-8.
14 Both commercial and saving institutions borrow through advances from the Federal
Home Loan Banks (FHLBs) at very low interest rates to make mortgage loans. In 2003,
FDIC-insured commercial banks borrowed $245.3 billion from the FHLBs; thrift institutions
borrowed $234.3 billion, but thrift institutions’ advances from the FHLBs grew 8.3%
between 2002 and 2003, while the commercial banks’ advances grew about half as fast or
4.8%, according FDIC data. This suggests that the larger commercial banking institutions
have been more successful at garnering funding from more competitive non-FHLB sources
than the generally smaller institutions.

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CRS-8
implementing Basel II as soon as problems with certain regulations are resolved.
Basel II relies more heavily on bankers’ and regulators’ judgments of the methods
used in determining risk and required capital than the set formula approach of Basel
I.15
The planned implementation of Basel II in the United States will bifurcate bank
regulatory capital standards, which some regulators believe will give a greater
advantage to some larger banks operating under Basel II. U.S. financial regulators,
led by the Federal Reserve, intend to require Basel II for only the most important,
internationally active banks, and presume that other major banks will also eventually
join the system. On August 4, 2003, U.S. federal banking regulators jointly issued
an advance notice of proposed rulemaking (ANPR).16 According to the ANPR, the
overwhelming majority of commercial banks in the United States will continue to
operate under Basel I. The agencies expect to identify only 10 large international
banks to be designated core banks. Another 10 banks may voluntarily opt into the
new standards after meeting infrastructure and other supervisory and disclosure
requirements. These 20 banks combined account for about 99% of foreign assets
held by the top 50 domestic banking organizations and approximately two-thirds of
U.S. domestic banking assets.17 This means that the overwhelming share of the
international banking business will be under Basel II, but an overwhelming majority
of U.S. banks are not likely to be. Because of the up-front costs that Basel II would
impose on banks, most U.S. banking institutions are likely to remain exempt. Basel
II could enable the larger banks under it to expand lending at more competitive
rates.18
Conclusion
The banking system was more profitable in 2003 than it has ever been and the
system’s safety and soundness in terms of capital is better than it has been for
decades. However, the industry is getting more concentrated. Larger banks clearly
have advantages over smaller banks in funding assets and also mitigating credit and
interest rate risk. Banks are benefitting from the low-interest rate environment that
has raised consumers’ willingness to take advantage of declining mortgage rates to
extract funds from the increased value of their homes. A sizeable part of the funding
from refinancing and home equity loans has been used to pay off higher credit card
15 See CRS Report RL31984, The Basel Capital Accord: A return to Bank Supervisory
Judgments, by Walter W. Eubanks.
16 U.S. Department of the Treasury, “Internal Ratings-Based Systems for Corporate Credit
and Operational Risk Advanced Measurement Approaches for Regulatory Capital,” Federal
Register, vol. 68, no. 149, Aug. 4, 2003, pp. 45948-45988.
17 Roger W. Ferguson, Jr. Basel II: Scope of Application in the United States, statement
before the Institute of International Bankers, New York, New York, June 10, 2003,
[http://www.federalreserve.gov/boarddocs/speeches/2003/200306102/default.htm].
18 See George French et al., Risk-Based Capital Requirements for Commercial Lending : The
Impact of Basel II, Apr. 21, 2003, [http://www.fdic.gov/bank/analytical/fyi/2003/
042103fyi.html].

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CRS-9
and installment debt. This process has left banks vulnerable to increased credit and
interest rate risks should rates rise and the economy slow significantly. Consumers
are spending a larger portion of their disposable income on financial obligations
which exposes the banks to credit risk. Credit risk is the risk of default. Banks are
also vulnerable to interest rate risk because of the declining interest rate margin
between the interest the banks pay for funds which they loan and the interest they
receive from the borrowers. Rising interest rates could result in reduced profitability,
especially if the rates result in losses on longer term loans. This particularly is true
for smaller banks that rely heavily on retail funding.

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