WASHINGTON — The Office of the Comptroller of the Currency is worried about small banks that have responded to the steady decline in core deposits by loading up on wholesale money and funneling it into commercial loans.

Poring over data from 2,000 banks with less than $1 billion of assets, Deputy Comptroller Nancy Wentzler concluded that institutions that are heavily reliant on wholesale funds also have higher interest rate and credit risk. “Banks with a high dependence on wholesale funding also generally have higher-risk assets,” Ms. Wentzler said in an interview Friday. “Those banks need to be very careful with the management of liabilities and with asset management. They have a dual responsibility to keep an eye on both sides of the ledger.”

During the 1980s, the industry’s core deposits grew an average of 8.3% per year, and loans grew by just 7.6%, according to OCC data. The core deposits gave banks an inexpensive and stable funding source with which to meet loan demand.

However, during the 1990s, as many customers moved money from low-yield savings accounts into stocks and other higher-yielding assets, the average annual loan growth of 7.3% outstripped the 3.8% core deposit growth rate — a trend that concerns regulators, particularly now that the economy has slowed.

Banks unable to generate enough liquidity from core deposits often tap more expensive funding sources, such as Federal Home Loan Bank advances. To offset the added interest cost, bankers need more profitable assets, which often leads them to riskier commercial and industrial loans with relatively long maturities, Ms. Wentzler said.

The OCC divided the 2,000 small banks into quartiles and compared data on the 500 that are most reliant on wholesale funds with the 500 that are least reliant. The data show that loan growth at the banks most reliant on wholesale funding was 14.6% last year, compared with 8% in the least-reliant group.

Banks most reliant on wholesale funding had more than 30% of their assets invested in business loans, compared with 16.9% in the other group. Finally, Ms. Wentzler said, the banks reliant on wholesale funding had committed themselves to longer maturities for more of their loans, driving up interest rate risk.

Banks with a lot of business loans are historically the hardest hit during bad economic times, she said. For instance, OCC data show that banks dependent on business loans had the biggest declines in return on assets during the 1990-91 recession.

“Banks that are heavily dependent on wholesale funding have to reach for higher returns to make that payoff,” she said. “When the economy slows, it hits manufacturing and business lending first, which is something these banks have to watch very carefully.”

During a press conference last week to review the industry’s performance in 2000, Ms. Wentzler also noted which parts of the country have been most adversely affected by the economic slowdown.

With $1 billion again used as the asset criterion, small banks in 25 states had increases in their ratios of noncurrent to total loans last year, she said. The problem is concentrated in the Southeast and West. In 1999 only one state had a similar increase, making last year’s change the biggest since 1992, when noncurrent-loan ratios rose at small banks in 32 states.

Of the 25 states where loan quality deteriorated, employment growth is slowing in 16. Forecasting where noncurrent-loan ratios might rise, Ms. Wentzler pointed to more than a dozen states, mostly in the Upper Midwest and Middle Atlantic states, where employment growth also is slowing.

This is happening “predominantly in states that have a greater reliance on manufacturing activities,” she said. “Banks in these areas are seeing a blip in business lending. When that leaks into consumer and real estate activities, those activities will show a little wear.”

Though regulators are seeing these warning signs, they are also quick to point out that banks are better prepared to handle a slowdown or even a recession than they were a decade ago. The industry is coming off eight consecutive years of record profits, and most banks are well capitalized and have plenty of reserves against bad loans.

“Even the weakest performers are far better positioned to handle a slowdown than banks were last time,” Ms. Wentzler said.

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