The Federal Deposit Insurance Corp.'s third-quarter Regional Outlook, released Monday, examines the implications of trends in community bank funding.

At yearend, banks with less than $1 billion of assets got 72% of their funding from core deposits, compared with 43% at larger banks. But the number of community banks borrowing money to fund growth doubled in the 1990s, the FDIC said.

"A fundamental challenge that confronts bank management is the strategic response to the cost increases associated with wholesale funding sources," according to the agency's report.

Overall profitability could suffer if a bank cannot offset higher borrowing costs with additional fee income or by cutting expenses, the FDIC warned. Banks may be tempted to make riskier loans to boost asset yields.

But the FDIC's more immediate concern was the added interest rate and liquidity risk as core deposits shrink and institutions turn to costlier funding sources. Shifting away from core deposits "requires greater expertise ... to avoid unexpected liquidity strains or exposures to changing interest-rate environments," the report said. It also contains an article on how a downturn in commodities industries could affect credit quality.

More than a quarter of commercial and industrial loans, or $206 billion worth, are made to companies that produce standardized products, such as chemicals, electronics, or textiles, the FDIC said.

So far, low prices in these businesses are not reducing bank profits. But a continuation of current trends, the FDIC warned, "has the potential to result in higher credit losses for insured institutions during the next few years."

The FDIC's report also includes analysis from its eight regional offices customized to local markets. -- Barbara A. Rehm

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