So we know we need to determine the overall net yield on assets required to cover the cost of funds and the operating expenses but how? In the movie Moneyball, the Oakland A’s develop a strategy to win 99 games by scoring 814 runs and only allowing 645 runs by the opposition. In order to generate the necessary runs, Peter Brand boils down all the stats into one number, on base percentage. By looking at the on-base percentage of all the players in the league, Brand is able to determine the likelihood of generating runs.
There are a few key phrases/quotes from this scene that need to be highlighted:
- “it’s about getting things down to one number”
- “People are overlooked for a variety of biased reasons and ‘perceived’ flaws.”
- “Bill James and mathematics cut straight through that [biased reasons and perceived flaws].”
Getting things down to one number is the liberating element for the Oakland A’s and for banking. We have already identified the one number for banking – Net Yield on Assets. Let’s define this a bit further though. For this exercise, net yield means the gross yield (interest income plus fee income) on assets less charge offs. We are looking to see what is going to be the consistent return on the assets less what can be expected net charge off related to the assets.
When Billy Beane and Peter Brand got it down to the one number “On Base Percentage” it altered the player selection process and highlighted the biases of the scouts such as:
- Giambi’s brother was “getting a little thick around the waist”
- “Old Man” Justice
- Justice will be “lucky if he hits his weight” in July and August
- Justice’s “legs are gone
- Hatteberg “can’t throw”
- Hatteberg’s “best part of his career is over”
- Hatteberg “walks a lot”
None of the above comments used any facts or data to disprove each player’s on base percentage. Can you imagine if they were underwriters or lenders? What type of compliance issues would we have on our hands with the above comments? Biased against disabilities (Hatteberg with nerve damage); Age Discrimination (“Old Man” Justice), Physical Appearance (Giambi’s brother “getting a little thick around the waist”), these scouts would be a compliance liability let alone obstacles in any type of organizational change.
But one can readily see how focusing on one number liberates the thinking and removes the old constraints or ways of thinking. One of the scouts commented that Hatteberg had a high on base percentage because he walks a lot, considering a walk as a negative while a hit is a positive but why? Why is getting on base by being walked a negative but getting on base with a hit is positive? The result is the same as the movie points out.
How about in commercial lending? If we focus on net yield on the portfolio as the one number, does that do anything to remove biases? I believe that it does. One example is the perception of charge offs in a portfolio. To this day the notion of a charge off in a commercial portfolio, even in the small business portfolio, is frowned upon and can jeopardize one’s career. Similar to the walk, the charge off is not desired but if we focus on the one number, net yield, it actually removes the stigma of the charge off!
If we need at minimum a 6% net asset yield and we are able to generate a gross yield of 9% with an expected loss rate of 2%, we actually exceed our “one number” of a targeted net yield of 6% with an expected net yield of 7%. With that change that removes the biases and flawed perception, can we now start to find opportunities that provide us with the ability to step away from the norm; stop competing with the rest; and generate that higher return that is required? What are the potential biases and flawed perceptions that will need to be addressed?
- “High Risk” Industries?
- “Undesired” Loan types?
- Consumer vs. Commercial?
- Real Estate Secured vs. Unsecured?
- Loans vs. Treasuries or other earning asset types?
But just as in the movie, you need to be prepared for the response you may get from the traditional ‘seasoned’ lenders in your organization. When Billy Beane puts the new strategy into place at the Oakland A’s, the lead scout responds with:
- “You don’t put a team together with a computer”
- “Baseball isn’t just numbers, it isn’t science. If it was anybody could do what we do but they can’t.”
- “They don’t know what we know. They don’t have our experience and they don’t have our intuition.”
Ah, just like the traditional baseball scout is the traditional commercial lender with the years of experience, judgment and intuition. I used to be one and used almost word for word the same argument against credit scoring and small business before I truly understood what it was all about. Don’t get me wrong. Experience, judgment and intuition is valuable and necessary. But that type of judgment tends to get into trouble when it stops looking outside for data and only relies on past personal experience to assess the next moves. Experience is always important but it has to continually review, assess and interpret the data.
So let’s start looking at the different types of data.
On deck – How do we know how many runs the opposition is going to score? The use of external data.