Recently Chartered Banks’ Vulnerability
to Real Estate Crisis
by Chiwon Yom*
Even while the U.S. banking industry continues
to consolidate and the number of banks continues
to shrink, de novo banking activity remains vigor
ous. De novo banks play important roles in pre
serving competition in the market, providing
credit to small businesses (DeYoung, Goldberg,
and White [2000]), and promoting an entrepre
neurial spirit (Brislin and Santomero [1991]).1
At the same time, however, these fledgling insti
tutions are financially fragile and more susceptible
to failure. Although they are sound in their early
years, with large capital cushions and low levels of
nonperforming loans, their financial condition
typically deteriorates as capital reserves and the
quality of their loans move toward industry levels
but earnings remain low. Furthermore—and this
may not be widely known—new banks are vul
nerable to real estate crises because they concen
trate heavily in real estate loans. The extent of
new banks’ exposure to the real estate market is
reflected in their poor ratings on the Real Estate
Stress Test (REST). This model measures the
severity of a bank’s exposure to real estate lend
ing, projecting what would happen to a bank if
the real estate market experienced a downturn
similar to the New England real estate crisis in
the 1990s.2
The FDIC closely monitors recently chartered
banks and thrifts. For purposes of offsite monitor
ing, the FDIC defines young banks as commercial
banks and thrifts that are eight years old or
younger based on studies showing that new banks
need more than three years to fully mature
(DeYoung [2000], DeYoung and Hasan [1998]).
Newly chartered banks tend to be small, and
roughly 80 percent of all young banks are located
in metropolitan statistical areas (MSAs). This
study examines these young banks. Specifically, it
examines the vulnerability of these young banks
to real estate problems: how their financial condi
tion evolves over time, the degree of risk they
bear because of their real estate lending, how they
* The author is a senior financial economist in the Division of Insurance and
Research at the Federal Deposit Insurance Corporation. The author would
like to thank Daniel A. Nuxoll, George Hanc, Kenneth Jones, Valentine V.
Craig and Christine E. Blair for valuable comments and suggestions.
1 In this article, the terms banks and institutions refer to all insured institu
tions—commercial banks, savings banks and thrifts.
2 See Collier, Forbush, and Nuxoll (2003). The stress test was developed on
the basis of the New England real estate crisis in the 1990s, and information
from a bank’s balance sheet and income statement are used to rate the
institution. The REST ratings are directly comparable to CAMELS ratings; a
REST rating of 1 indicates least vulnerable to a real estate crisis, and a rat
ing of 5 indicates most vulnerable. The REST model is part of the FDIC’s
offsite monitoring system and is used to help identify and monitor the insti
tutions that are most vulnerable to a real estate crisis.
FDIC BANKING REVIEW 1 2005, VOLUME 17, NO. 2
to Real Estate Crisis
by Chiwon Yom*
Even while the U.S. banking industry continues
to consolidate and the number of banks continues
to shrink, de novo banking activity remains vigor
ous. De novo banks play important roles in pre
serving competition in the market, providing
credit to small businesses (DeYoung, Goldberg,
and White [2000]), and promoting an entrepre
neurial spirit (Brislin and Santomero [1991]).1
At the same time, however, these fledgling insti
tutions are financially fragile and more susceptible
to failure. Although they are sound in their early
years, with large capital cushions and low levels of
nonperforming loans, their financial condition
typically deteriorates as capital reserves and the
quality of their loans move toward industry levels
but earnings remain low. Furthermore—and this
may not be widely known—new banks are vul
nerable to real estate crises because they concen
trate heavily in real estate loans. The extent of
new banks’ exposure to the real estate market is
reflected in their poor ratings on the Real Estate
Stress Test (REST). This model measures the
severity of a bank’s exposure to real estate lend
ing, projecting what would happen to a bank if
the real estate market experienced a downturn
similar to the New England real estate crisis in
the 1990s.2
The FDIC closely monitors recently chartered
banks and thrifts. For purposes of offsite monitor
ing, the FDIC defines young banks as commercial
banks and thrifts that are eight years old or
younger based on studies showing that new banks
need more than three years to fully mature
(DeYoung [2000], DeYoung and Hasan [1998]).
Newly chartered banks tend to be small, and
roughly 80 percent of all young banks are located
in metropolitan statistical areas (MSAs). This
study examines these young banks. Specifically, it
examines the vulnerability of these young banks
to real estate problems: how their financial condi
tion evolves over time, the degree of risk they
bear because of their real estate lending, how they
* The author is a senior financial economist in the Division of Insurance and
Research at the Federal Deposit Insurance Corporation. The author would
like to thank Daniel A. Nuxoll, George Hanc, Kenneth Jones, Valentine V.
Craig and Christine E. Blair for valuable comments and suggestions.
1 In this article, the terms banks and institutions refer to all insured institu
tions—commercial banks, savings banks and thrifts.
2 See Collier, Forbush, and Nuxoll (2003). The stress test was developed on
the basis of the New England real estate crisis in the 1990s, and information
from a bank’s balance sheet and income statement are used to rate the
institution. The REST ratings are directly comparable to CAMELS ratings; a
REST rating of 1 indicates least vulnerable to a real estate crisis, and a rat
ing of 5 indicates most vulnerable. The REST model is part of the FDIC’s
offsite monitoring system and is used to help identify and monitor the insti
tutions that are most vulnerable to a real estate crisis.
FDIC BANKING REVIEW 1 2005, VOLUME 17, NO. 2
Recently Chartered Banks’ Vulnerability to Real Estate Crisis
compare with established banks in this respect,
and what explains the heightened vulnerability of
young banks to real estate crises.
For our benchmark group we choose small estab
lished banks, defined for this study as institutions
that are more than eight years old, have assets of
less than $300 million, and are located in MSAs.
In addition, our benchmark group excludes spe
cial-purpose institutions, such as credit card banks
and banks with extensive trust operations.
This study is preceded by a review of the litera
ture and followed by a summary and conclusion.
The Purpose of This Study in Relation
to the Literature
Recent studies have furthered our understanding
of newly established banks by examining the
determinants of bank start-ups and identifying the
factors that determine the performance of de
novo banks. De novo banking activity is more
likely during periods of favorable economic condi
tions (Dunham [1989]) and in areas that have
undergone merger activity (Dunham [1989], Berg
er, Bonime, Goldberg, and White [1999], Seelig
and Critchfield [2003]). Moreover, new banks
tend to locate in urban areas (DeYoung [2000])
and in markets where economic growth is high
(Moore and Skelton [1998]).
Among researchers who identify the factors that
determine the performance of de novo banks,
DeYoung (2003) finds that the relationship
between external conditions (for example, intense
competitive rivalry or slow economic growth) and
higher failure rates is more systematic for the de
novo banks than for established banks. Hunter,
Verbrugge, and Whidbee (1996) find that adverse
economic conditions have contributed to the fail
ure of recently chartered thrifts.
Endogenous factors have also been found to play
a significant role in the performance and survival
of newly chartered banks. Hunter, Verbrugge,
and Whidbee (1996) find that credit risk, low
capital stocks, and cost inefficiencies have con
tributed to the failure of de novo banks. Hunter
and Srinivasan (1990) find that differences in
operating costs, credit policy, and leverage
account for most of the performance variations
among the sample banks relative to the estab
lished target group during the early years of opera
tion. Arshadi and Lawrence (1987) find that
operating costs, deposit growth, composition of
loan portfolios, and deposit pricing are important
in determining the performance of newly char
tered banks; they conclude that the performance
of new banks is a function of endogenous factors.
Other studies relate the performance of de novo
banks to the banks’ business strategies and risk
management. Brislin and Santomero (1991) find
that de novo banks in the third Federal Reserve
district (Pennsylvania, New Jersey, and Delaware)
tend to concentrate in single types of loans—for
example, real estate loans—and they caution that
because of the lack of diversification, such strate
gies increase portfolio risks. Gunther (1990)
attributes the large number of failures of new
Texas banks in the 1980s to the banks’ aggressive
strategies, such as concentrating in commercial
and industrial (C&I) loans, maintaining low liq
uidity, and relying heavily on purchased funds.
Hunter and Srinivasan (1990) find that real
estate lending has consistent and significant
effects on the performance of new banks in the
later years of operation.
The present study adds to the literature by explor
ing the role of real estate lending in relation to
the performance and lending strategies of banks
established between 1995 and 2003. In the latter
half of the 1990s, after severe problems in the
banking industry during the 1980s and early
1990s, de novo banking activity picked up. Table
1 reports the number of banks and savings institu
tions chartered in the United States between
1995 and 2003 that were not affiliates of a hold
ing company.3 The table disaggregates de novo
institutions by state and type of charter (national
bank charter, state bank charter, and savings
institution charter). During this period, the five
3 I thank Tim Critchfield at the FDIC’s Division of Insurance and Research for
providing these data.
2005, VOLUME 17, NO. 2 2 FDIC BANKING REVIEW
compare with established banks in this respect,
and what explains the heightened vulnerability of
young banks to real estate crises.
For our benchmark group we choose small estab
lished banks, defined for this study as institutions
that are more than eight years old, have assets of
less than $300 million, and are located in MSAs.
In addition, our benchmark group excludes spe
cial-purpose institutions, such as credit card banks
and banks with extensive trust operations.
This study is preceded by a review of the litera
ture and followed by a summary and conclusion.
The Purpose of This Study in Relation
to the Literature
Recent studies have furthered our understanding
of newly established banks by examining the
determinants of bank start-ups and identifying the
factors that determine the performance of de
novo banks. De novo banking activity is more
likely during periods of favorable economic condi
tions (Dunham [1989]) and in areas that have
undergone merger activity (Dunham [1989], Berg
er, Bonime, Goldberg, and White [1999], Seelig
and Critchfield [2003]). Moreover, new banks
tend to locate in urban areas (DeYoung [2000])
and in markets where economic growth is high
(Moore and Skelton [1998]).
Among researchers who identify the factors that
determine the performance of de novo banks,
DeYoung (2003) finds that the relationship
between external conditions (for example, intense
competitive rivalry or slow economic growth) and
higher failure rates is more systematic for the de
novo banks than for established banks. Hunter,
Verbrugge, and Whidbee (1996) find that adverse
economic conditions have contributed to the fail
ure of recently chartered thrifts.
Endogenous factors have also been found to play
a significant role in the performance and survival
of newly chartered banks. Hunter, Verbrugge,
and Whidbee (1996) find that credit risk, low
capital stocks, and cost inefficiencies have con
tributed to the failure of de novo banks. Hunter
and Srinivasan (1990) find that differences in
operating costs, credit policy, and leverage
account for most of the performance variations
among the sample banks relative to the estab
lished target group during the early years of opera
tion. Arshadi and Lawrence (1987) find that
operating costs, deposit growth, composition of
loan portfolios, and deposit pricing are important
in determining the performance of newly char
tered banks; they conclude that the performance
of new banks is a function of endogenous factors.
Other studies relate the performance of de novo
banks to the banks’ business strategies and risk
management. Brislin and Santomero (1991) find
that de novo banks in the third Federal Reserve
district (Pennsylvania, New Jersey, and Delaware)
tend to concentrate in single types of loans—for
example, real estate loans—and they caution that
because of the lack of diversification, such strate
gies increase portfolio risks. Gunther (1990)
attributes the large number of failures of new
Texas banks in the 1980s to the banks’ aggressive
strategies, such as concentrating in commercial
and industrial (C&I) loans, maintaining low liq
uidity, and relying heavily on purchased funds.
Hunter and Srinivasan (1990) find that real
estate lending has consistent and significant
effects on the performance of new banks in the
later years of operation.
The present study adds to the literature by explor
ing the role of real estate lending in relation to
the performance and lending strategies of banks
established between 1995 and 2003. In the latter
half of the 1990s, after severe problems in the
banking industry during the 1980s and early
1990s, de novo banking activity picked up. Table
1 reports the number of banks and savings institu
tions chartered in the United States between
1995 and 2003 that were not affiliates of a hold
ing company.3 The table disaggregates de novo
institutions by state and type of charter (national
bank charter, state bank charter, and savings
institution charter). During this period, the five
3 I thank Tim Critchfield at the FDIC’s Division of Insurance and Research for
providing these data.
2005, VOLUME 17, NO. 2 2 FDIC BANKING REVIEW