Risk Management

Beyond the financial risk management considerations related to a bank’s capital, which would be directly impacted by Troubled Asset Relief Program (TARP) participation, it should be clear that TARP also involves business (or strategic) risk. We have spoken in the past of several major categories of risk: credit risk, market risk, operational risk and business risk. Business risk includes a variety of risks associated with the outcomes from strategic decision making, corporate governance considerations, executive behavior (for better or worse), management succession events (Apple and Steve Jobs, for instance) or other leadership occurrences that may affect the performance and financial viability of the business.

Aside from the monetary impact on the bank’s capital position, TARP involves a new capital securities owner being in the mix. And, with a roughly 20 percent infusion of added tier one capital, we are almost always talking about a very large, new owner relative to existing shareholders. The United States Department of the Treasury is the investor or holder of the newly issued preferred stock and warrants. The Treasury Department says it does not seek voting rights, but none-the-less has gotten them in at least some cases. The real “kicker” is embedded in the Treasury’s Securities Purchase Agreement – Standard Form. 

The most interesting clause, that appears to represent a very open-ended business risk to management decision making, is one relatively small paragraph, named Amendment, in the middle of Article V - Miscellaneous, just ahead of governing law (which is federal law, backed up by the laws of the State of New York).

Amendment begins normally enough, requiring the usual signed agreement of each party, but then states: “provided that the Investor may unilaterally amend any provision of this Agreement to the extent required to comply with any changes after the Signing Date in applicable federal statutes.” Wow. My reading of this is that if in the future Congress enacts anything that Treasury finds applicable to any aspect of the previously signed TARP Agreement, the bank is bound to go along. Regardless of whether the Treasury negotiates any voting rights, once the TARP Agreement is executed by the bank, management is not only bound by what is in the document to begin with, it is subject to future federal law as long as the TARP shares are held by the government. As a result, many banks have said no thank you to TARP.

At least four banks have recently paid back $340 million to repurchase the government’s shares. And, apparently another bank has offered to pay back $1 billion but, according to Andrew Napolitano at Fox Business Channel, the offer was turned down and the bank was threatened with adverse consequences if it persisted in its attempt to get out.

More pointed and public, and much larger in size, is the dance taking place now between Chrysler Corporation, Fiat, the UAW, four lead lenders and, you guessed it, the federal government. The secured loans in question total almost $7 billion and the government wants J.P. Morgan Chase, Goldman Sachs, Citicorp and Morgan Stanley to exchange $5 billion of the loans for Chrysler stock. The banks know they would do better (for their shareholders) by selling off Chryslers assets. This is an example of why bankruptcy exists. The stakes are large and so is the business risk of the influence from the government. It will be interesting to see how things turn out.

So, this new major owner does have a voice. If Congress wants certain lending volumes or terms, or they want certain compensation levels, it needs to be enacted into federal law. Short of having to pass a law, there is the implied threat of the big stick in the TARP agreement. The Purchase Agreement covers what the new owner wants now and may decide it wants in the future. This a form of strategic business risk that comes with accepting the capital infusion from this particular source.

This post continues the feature from my colleague and guest blogger, Mark Sofietti, Associate Process Architect in Advisory Services at Baker Hill, a part of Experian.

In today’s market, the banking industry seems to be changing at a very rapid pace.  The current crisis that we are in, as an industry and as a nation, is forcing institutions to revisit risk management policies and procedures to make the appropriate changes needed to remain healthy and profitable.  However, the current crisis is not the only reason why institutions should focus on change management.  Change management needs to be appropriately handled in bad and good times.  Understanding change management is always a necessity to a well-run organization.  Whether it is a reorganization, a new software system, a new policy or moving to a new building, change can cause a great deal of stress and uncertainty -- but it can also cause benefits.

So, as managers, you may be asking, “What can I do to ensure that positive changes are happening within my organization?  What are some of the items that I should consider when I am bringing about organizational change?” 

There are four necessary steps that need to be taken in order to improve the success of an initiative that is causing change to an institution. I covered two in my last post. Here are the additional steps.

3. Consider methods of change
One method of change is the education of individuals about new ways of operating.  This method should be used when there is more resistance to change and when individuals lack a clear understanding or knowledge of the change being made.  Education may cause the implementation to take longer, but those involved will better understand the effects of the change.

A second method is gathering participation from different levels and skill sets within the organizations.  Building a team should be used when there is the highest risk of failure due to change resistance and when more information needs to be gathered before an effective implementation can be completed.

Negotiation is a method that is used when a group or person is going to be negatively affected by the change.  This method could alleviate the discomfort by giving the person or group some other benefit.  Negotiations could allow an organization to avoid resistance, but it may be very costly and time consuming to implement the change.

The coercion change method is when a change is implemented with little room for diversion from the plan.  Employees are told what the change is going to be and they have to accept it.  This method should be used when speed is of the utmost importance, or if the change is not going to be easily accepted.  Most employees do not like this approach and it may cause resentment or it might cause staff members to leave.

The final method of change uses manipulation, the conscious decision to share limited information about the change that is taking place.  This method should only be used when no other tactic will work, or if time or cost is major issues.  This approach is dangerous because it can lead to more problems in the future.

4. Create plan of action
A plan should be created for the implementation of change to clearly address reservations and define the change strategy.  It should include internal and external audiences who can be affected by the change.  It is common to forget those who are indirectly impacted by the change -- and these audiences (customers, for example) may be the most important.  Objectives of the change need to be clearly outlined in the plan in order to understand how the new future state of the organization will look and operate.  The plan needs to be communicated to all those involved so that the transition can be understood and everyone can be held accountable.  The plan should be periodically revisited after implementation in order to review progress.  Creating a plan of action is a very important step to ensure that those who resisted the change do not revert back to their old habits. 

Achieving change is not an easy process, especially when time is not on your side.  If you take a second look at the change that you are trying to implement and do the necessary planning, you have a greater chance for success than if you or your organization fails to fully evaluate the consequences. 

Effective change management should be part of any financial risk management process. Take charge of your institution’s future through a calculated approach to change management and your organization will be in a better position for the next change that is coming around the bend.
 

This post is a feature from my colleague and guest blogger, Mark Sofietti, Associate Process Architect in Advisory Services at Baker Hill, a part of Experian.

Change is inevitable.  If you are not changing, then you are standing still and the world around you is changing.  In today’s market, the banking industry seems to be changing at a very rapid pace.  The current crisis that we are in, as an industry and as a nation, is forcing institutions to revisit their risk management policies and procedures to make the appropriate changes needed to remain healthy and profitable.  However, the current crisis is not the only reason why institutions should focus on change management.  Change management needs to be appropriately handled in bad and good times.  Understanding change management is always a necessity to a well-run organization.  Whether it is a reorganization, a new collections software system, a new policy or moving to a new building, change can cause a great deal of stress and uncertainty -- but it can also cause benefits.

So, as managers, you may be asking, “What can I do to ensure that positive changes are happening within my organization?  What are some of the items that I should consider when I am bringing about organizational change?” 

There are four necessary steps that need to be taken in order to improve the success of an initiative that is causing change to an institution.

1.  Understand current situation and needs
The first item necessary to have a successful implementation of change is to understand the current climate and reason for the change.  People are scared of change and many believe that “if it is not broken, don’t fix it.”  This is why the reasons for change need to be understood and communicated to all employees.  Changing, just for the sake of changing, causes a great deal of unrest to a department or organization.  With clearly defined reasons and objectives, the implementation of change can have a lower degree of failure.

2.  Identify resistance
During change, there will be some form of resistance.  As a manager, you will need to have thought through from where resistance might come and consider how to work through confrontations. 

One type of major resistance can be people who are looking out for their own self-interests.  People have their own agendas within the workplace and could view change as a threat to their advancement.  When dealing with these situations, you will need to have a good deal of collaboration and involvement from these individuals in order to successfully implement change.  Note, given this resistance, that the change will not happen as quickly and your timelines should be appropriately set. 

Another major resistance that may slow down the implementation of change is the lack of trust in the leaders enacting the change.  In these situations, management should build teams of trusted and respected people whose objective is to eliminate underlying resistance. 

Finally, providing facts and examples regarding the change is a necessity for a successful implementation.  Doing so can reassure employees that the change being made is beneficial to the organization.

The next post will continue with the additional two necessary steps that need to be taken in order to improve the success of an initiative that is causing change to an institution.

 

Good day all. My last blog revolved around practical approaches to effective client relationship management. It time to get back to a “risk” type conversation.

I recently told my wife that if I hear the phrase “…in this economic environment …” uttered as a caveat one more time, I’m going to scream. I have truly come to anticipate the beginning or introduction to interviews and articles to lead in with this sentiment and it’s driving me nuts.

In these economic times (you can tell I’m from the sales side, I cleverly changed the phrase), it is clearly not business as usual within most financial institutions. Conversations with CEOs and bank presidents over the past two months have usually followed the same theme, “I’ve got money to lend, but I just can’t find a decent deal” or “I’ve got applications up the wazoo, but the quality just isn’t there.”

So, what is going on?
The obvious answer is that we are looking at applications more closely and the credit side (risk management guys) is deliriously happy because everytime they make a recommendation about “reviewing the opportunity further” they also don’t hesitate to mention, “in this economic environment.”

Really, what is the scoop and how do we adjust on the front line?
Clearly, we know that deeper reviews and management of risk is being undertaken. The problem is that the established standards are no longer valid. Yes, the basics ratios still need to be run, but let’s face it, in this economic environment a company’s historical performance is no longer an effective indicator as to their future performance. The playing field is no longer consistent. The past two to three years of financials are based on circumstances that no longer apply. This means that the analysts are having a difficult time establishing effective benchmarks from which to apply credit policy – and we know that those guys are the paragons of adaptability.

We are being asked to evaluate risk in an uncertain circumstance. We are looking at projected revenues and earnings and examining receivables. We are also comparing this business to others in the industry, determining which other market segments have a direct (and indirect) impact on the performance of this one, reviewing business plans and evaluating management depth and experience. And, at the end of the day, either saying no, saying yes but not so much or holding our breath and hoping that divine intervention shows us the way.

Does any of this should sound familiar to you?
It should. We see these type of deals all of the time and we call them the start-ups.

Ok, so what am I recommending? Quite simply, that we take a step back from our typical approach to the established business and engage with them the way we would a start-up.

When an opportunity or request presents itself, restrain the urge to go down the garden path. Slow down! No... stop! Take a deep breath, put on your “economic development hat ” and approach the deal the way you would if it were a start-up (and I don’t mean running away at top speed in the opposite direction screaming). You should: 

• look for or help them construct a short term (next four to six month) tactical action/priority plan;
• help them or review their 12-month business plan;
  o NOTE: If the business hasn’t realized that they need a short-term survival plan and a mid-term business plan… run! Run far and run fast!
• examine their market and have them explain why they will make it versus the competition;
• dig into their management expertise (think AIG);
• have them explain how their tactical and 12-month business plan will keep the doors open and the lights on (since its coming into summer we’ll cut them some slack on the heat); and finally
• review and revise their projections.

If at the end of this, you still feel that the deal has legs, it probably does, and you’ve done a pretty thorough job building the business case for the credit side.

Or, you could just lament that there really isn’t much out there in this economic environment.
 

Part 2

Two additional tactics that you should incorporate into your relationship management penetration strategy include:

• Conducting relationship reviews in addition to loan reviews; and
• Identifying and proactively monitoring changes in client behavior.

Relationship reviews
Relationship reviews are a comprehensive and thorough examination of the client’s business and should be the foundation for your relationship management process. They seek to provide both the client and the relationship manager with a roadmap for the upcoming 14- to 16-month period by identifying specific goals and concerns, as well as constructing a snapshot of the client today. The purpose of a relationship review is to understand the broader direction.  Bluntly put, an annual loan review is not a penetration activity. Its primary focus is to verify the ongoing credit worthiness of an existing deal in the books. More details will come about this topic in a future blog.

Monitoring changes in behavior
Monitoring changes in client behavior through the use of “activity thresholding” is quickly becoming a mainstay in the financial industry. The idea isn’t new; however, the application of the concept to penetration is. Instead of having changes in credit score trigger an alert related to risk management and mitigation, we would instead look at thresholds related to line usage, number of deposit transactions, changes in average deposit amount and credit card transactions.

These kinds of client behaviors and activities provide insight into what is occurring within a clients business and as such, allow us to provide recommendations for products and services that are meaningful and appropriate.
 
 

This post is a feature from my colleague and guest blogger, Barry Timm, Senior Process Architect in Advisory Services at Baker Hill, a part of Experian.

2008 has proven to be an unbelievably challenging year for the economy as a whole, let alone the financial industry.  Never before have we experienced the type and degree of turmoil that we did in 2008, even since the “Great Depression”.
 

These economic challenges have been quick, severe and widespread; and, from large corporations to the individual consumer, all have been impacted to some degree.  The stock market is down, unemployment up, consumer confidence down, delinquencies up ….not exactly a pleasant roller coaster ride. 
 

And, there is no longer any projecting as to when the “bubble” is going to burst.  It happened.   Decreased real estate values have occurred not only in high impact geographic regions but throughout the country.  While home equity products have traditionally been the “golden child” of consumer loan product offerings, recent economic changes have caused a shift in that perspective.  As a result, tightened underwriting standards have limited the availability of the product as a whole.  In some markets the product offering has even been temporarily halted.
 

We frequently hear the terminology “bailout” being used in the news.  While we all have expectations as it relates to the bailout approach, I thought I would “Google” the word “bailout” to see what would magically appear.  Interestingly enough, the first listing was titled “Walk away from your home”, with a link to the home page for a mortgage default legal team.  This is not exactly what I was expecting to find, but is definitely reflective of the times.
 

And, according to the FDIC, there have been 25 failed financial instituions in the year 2008.  This single year number equates to the total number of failed financial institutions between the prior periods 2001 through 2007. 

Okay … enough doom and gloom.  In spite of all that has occurred within the economy, some financial institutions continue to maintain a strong credit quality position in their consumer portfolios and have maintained profitability throughout all of the market volatility.  

What are the strong survivors doing that differentiates themselves from the others?

1. They understand their portfolio.  
Advisory Services frequently assists clients with various types of portfolio management analysis and often presents those findings to senior management.  We often hear that management is surprised by the results of that analysis. The point is that high-level management reporting is not enough these days. Additional detail and depth are necessary. 

More specifically, as opposed to evaluating payment performance at the portfolio level, it is important to consider the following:

• Do you know your delinquency numbers at the product level? 
• How do delinquencies compare to your product approval rates? 
• Do you routinely compare approval/decline rates and delinquencies to scorecard results and/or credit bureau scores?  
• Do you know where pricing exceptions are being made and are you receiving sufficient return for the level of risk?

2. A focused strategy is in place.
It is important to re-emphasize the specific, strategic direction and focus of your defined market.  Now is not the time to be “pushing the envelope” and extending into untested waters.  There is something to be said about focusing on your strengths, staying within your defined footprint and meeting the needs of your core, proven line of business while following sound financial risk management.

3. The underwriting process is under control.
This does not automatically mean that a “tightening” of underwriting standards is necessary.  It does mean, however, that stronger attention to detail is warranted.  It is important that underwriting criteria is reviewed and that you are sure that defined underwriting practices are consistently applied.  As noted in item number one above, this may require digging a little deeper and reviewing current and past decisioned loans (preferably with a critical eye of an independent third party).  Assessing the underwriting process becomes increasing complex and more critical with a decentralized underwriting approach.

Focus on the positive
Now that 2008 is behind us, let’s continue to focus on the positives to come in 2009.  Reflect on the past, but strive to center your attention on ongoing portfolio monitoring, financial risk management assessments and improvements for the future. 

 

Part 1

Ok, it’s me again, your business development guy in financial risk management clothing. In my first blog, I promised that I would start providing specific tactics related to optimizing penetration and retention efforts.
 
So, in “non-consultant” speak, we’re trying to figure out:

• how we are going to get deeper with existing clients;
• keep the (good) business we have; and 
• find new opportunities.

Today, we’ll focus on client penetration strategies. Some of this should be pretty self-explanatory.  If it is, that’s good. If it isn’t, you have a lot of work to do.

First, let’s recognize that not clients are going to be suitable candidates for increasing the existing relationship. Secondly, we can’t focus strictly on those “A” clients in our portfolio (assuming that you’ve implemented even the most rudimentary sales segmentation strategy, which is categorization into three to four tiers based on total relationship). There simply aren’t that many and if you’ve done your job effectively, there shouldn’t be many more “A” clients to add.

Getting deeper requires a defined approach. It doesn’t just happen. Clients will not call you on a regular or on-going basis and tell you that they need more services (well not usually). Rather, the responsibility rests on our shoulders to uncover changes in their operations and to look for signs that indicate growth, changes in direction and/or priority or changes in their day-to-day activities.

Sounds simple right? So, how should you do this?

One approach might be to engage in a “client call/touch routine” that will have you contacting the upper 65 percent of your portfolio on a pre-defined schedule or frequency. The rationale being that continued and consistent interaction with the client base will result in both uncovering possible “new” needs as well ensuring that in the event there is a competitive effort underway, we will have the opportunity to provide our recommendation.  

My next blog will feature two additional tactics to include in your relationship management process.
 

Part 6

Peer Group 2 fee income
Non-interest income again, as a percent of average total assets, declined to .86 percent from .95 percent in 2007. For Peer Group 2 (PG2), fees have also been steadily declining relative to asset size, down from 1.04 percent of assets in 2005. A smaller, non-interest bearing deposit base with no other new and offsetting sources of fee income will lead to increased pressure on this metric.

Operating expenses
Operating expenses also put more pressure on earnings on these smaller banks. They increased from 2.79 percent to 2.83 percent of average assets. That’s four basis points on the negative. Historically, this metric has been flattering for this size bank and usually moves up or down from year-to-year. It was almost equal at 2.82 percent of assets in 2004.

As a result of the sizeable decline in margins, the continued decline in fee income and the slight increase in operating expenses PG2’s efficiency ratio lost ground from 59.52 percent in 2007 to only 64.72 percent in 2008. That means that every dollar in gross revenue cost them almost 65 cents in administrative expenses this year. This metric averaged 56 cents in 2005/2006. It’s amazing how close these numbers are for banks of very different size where you would expect clear economies of scale.

The total impact of margin performance, fee income and operating expenses, plus the huge increase in provision expense of 59 basis points leads us to a total decline in pre-tax operating income of .96 percent on total assets. That is a total decline from 1.58 percent pre-tax ROA in 2007 to .64 percent pre-tax ROA, a loss of 61 percent from the pre-tax performance in 2007. My same conclusion as above would hold regarding the pricing of risk into bank lending (although the smaller banks didn’t perform a badly as the larger in this regard).

Although all 490 banks are declining in all profit metrics, the smaller banks seem to have an edge in pricing loans, but not deposits. Although up dramatically in 2007, and even more in 2008 for both groups, the PG2 banks seem to be suffering fewer credit losses relative to their asset size than their larger brethren. Both groups have resulting huge profit declines, but the largest banks are under the most pressure through this period.

An interesting point, with higher loan yields and fewer apparent losses, is whether PG2 banks are somewhat better at risk-based pricing (for whatever reason) than the largest bank group. Results are results. The 2009 numbers aren’t expected to show a lot of improvement as the general economy continues to slow and credit and financial risk management issues continue. We’ll probably comment on 2009 as the quarterlies become available this year.

Hello. My name is Prince Varma and I’ve spent the better part of the last 16 years helping financial institutions (FI) successfully improve their in business development, portfolio growth and client relationship management practices.

So, since the focus of this blog is to speak to readers about risk management, many of you are probably wondering what a “sales and business development” guy is doing writing a piece related to mitigating and managing risk?

Great question!

The simple fact is that the traditional or prevailing sentiment or definition related to risk management – mitigating credit risk -- is incomplete. A more accurate and comprehensive approach would be to recognize, acknowledge and address that “risk” cuts across the entire client relationship spectrum of:

• client penetration/growth;
• client retention; and
• client credit risk mitigation.

How do penetration and retention count as “risk factors”?
(this is where the sales guy stuff comes in)

From a penetration perspective, the failure to recognize potential opportunities either within the existing client base or in the operating market, introduces revenue growth risk (meaning we aren’t keeping our eye on the top line). Ultimately it impacts the FI’s ability to add assets (either deposits or loans) and also has a direct affect on efficiency and deposit to loan ratios.

From a retention perspective, the risk is even more obvious. Our most valued clients are the ones that we must continuously engage in a proactive manner. Let’s face it. In even the smallest markets, there are no less than four to six other institutions waiting to jump on your client in the event that you grow complacent. There is a huge difference between selection and satisfaction. And, if we aren’t focused on keeping a client after securing them, our net portfolio growth targets will be impossible to achieve. 

Considering the current market environment, now more than ever, effectively managing these three elements of “risk/exposure to the FI” is crucial to an institutions success both practically and pragmatically. Everyone internally at the bank is focused on the “credit risk mitigation” piece. The conversations that are occurring outside of the bank’s walls however are focused on the “L” word or liquidity and getting credit flowing again.

How many times have we read or more frankly been beaten with this comment from business owners “…there’s no one making loans anymore…” or “…its impossible to get credit…?”

That should be read as … penetration and retention

Striking a balance between effective and appropriate credit risk exposure and deepening or growing the portfolio has been a challenge facing those of us in the front office for as long as I can remember. The “sales revolution” is effectively over. We’ve learned the critical lesson that we need to evolve beyond being strictly a credit officer (you did learn that right??!!). And, you didn’t/shouldn’t become a “banking products generalist” with no analytical depth. Knowing all this, it is important that we return to the guiding principles of effective lending which include:
- evaluating the scope of the opportunity;
- isolating the risk and identifying a reasonable and realistic recovery/mitigation remedy;
- determining what other alternatives the borrower might be considering; and
- being willing to let the “bad deals” walk.

In subsequent blogs, I’ll provide you with specific tactics aimed at optimizing penetration and retention efforts and implementing effective and practical client management strategies.

After all what would you expect from a business development guy…
 

What is porfolio risk management? It is the active and effective oversight of the current client base with the intent of:

• Maximizing client retention –LOVE
  • Everyone wants to retain clients and deepen relationships!
• Maximize cross-sell opportunities –LOVE
  • Again, everyone wants to retain clients and deepen relationships!
• Minimize loss potential due to credit risk issues –HATE
  • No one wants credit issues to develop!
• Minimize loss potential due to operational risks –HATE
• Maximize profitability through timely identification of risk and appropriate allocation of capital –LOVE / HATE

• Which clients are likely to need additional products and services?
• Which clients have a high potential of leaving your financial institution?
• When do you shift from client retention to credit risk management?
  
   

Part 2

In my last post, I started my review of the Uniform Bank Performance Reports for the two largest financial institution peer groups through the end of 2008.

Now, lets look at the resutls relating to credit cost, loss allowance accounts and the impacts on earnings. Again, as you look at these results, I encourage you to consider the processes that your bank currently utilizes for credit risk modeling and financial risk management.

Credit costs
More loans, especially in an economic downturn, mean more credit risk. Credit costs were up tremendously. The Peer group 1 banks reported net loan losses of .89% of total loans. This is an increase from .28% in 2007, which was up from an average of 18 basis points on the portfolio in 2006/2005.  The Peer group 2 banks reported net loan losses of .74%. This is also up substantially from 24 basis points in 2007 and an average of 15 basis points in 2006/2005. The net loan losses reported in the fourth quarter significantly boosted both groups’ year-end loss percentages above where they stood through the first three quarters last year.

Loss allowance accounts
Both groups also ramped up their reserve for future expected losses substantially. The year-end loss allowance account (ALLL) as a percent of total loans stood at 1.81% for the largest banks. This is an increase of almost 50% from an average of 1.21% in the years 2007/2004. Peer group 2 banks saw their reserve for losses go up to 1.57% from an average of 1.24% in the years 2007/2004.

The combination of covering the increased net loan losses and also increasing the loss reserve balance required a huge provision expenses. So, loan balances were up even in the face of increased write-offs and expected forward losses.

Impacts on earnings
Obviously, we would expect this provisioning burden to negatively impact earnings. It did, greatly. Peer group 1 banks saw a decline in return on assets to a negative .07%. This is just below break-even as a group. The average net income percentage stood at .42% of average assets at the end of the third quarter. So, the washout in the fourth quarter reports took the group average to a net loss position for the year. The ROA was at .96% in 2007 and an average of 1.26% in 2006/2005. That is a 111% decline in ROA from 2007. Return on equity also went into the red, down from 11.97% in 2007. ROE stood at 14.36% in 2005.

For the $1B to $3B banks, ROA stood at .35%. This is still a positive number, however, it is way down from 1.08% in 2007, 1.30% in 2006 and 1.33% in 2005. The decline in 2008 was 67% from 2007. ROE for the group was also down, at 4.11% from 12.37% in 2007. The drops in profitability were not entirely the result of credit losses, but this was by far the largest impact from 2007.

The seriously beefed-up ALLL accounts would seem to indicate that, as a group, the banks expect further loan losses, at least through 2009.  These numbers largely pre-dated the launch of the Troubled Asset Relief Program and the tier one funding it provided in 2008. But, it is clear that banks had not contracted lending for all of 2008, even in the face of mounting credit issues and a declining economic picture. It will be interesting to see how things unfold in the next several quarters.
 

Part 1

It may be quite useful to compare your financial institution's portfolio risk management process or your investment plans , to the results of peer group averages. Not all banks are the same -- believe it or not. Here are the averages. You should look for differences in your target institution. About half of them beat certain performance numbers and the other half may be naturally worse.

As promised, I have again reviewed the Uniform Bank Performance Reports for the two largest peer groups through the end 2008. The Uniform Bank Performance Report (UBPR) is a compilation of the FDIC, based on the call reports submitted by insured banks. The FDIC reports peer averages for various bank size groupings and here are a few notable findings for the two largest groups that covers 494 reporting banks.

Peer group 1

• Peer group 1 consisted of 189 institutions over $3 billion in average total assets for the year.
• Net loans accounted for 67.31% of average total assets, which is up from 65.79 % in 2007. 
• Loans, as a percent of assets, have increased steadily since at least 2004. The loan-to-deposit ratio for the largest banks was also up to 96% from 91% in 2007 and 88% in both 2006 and 2005.

So, it appears these banks were lending more in 2008 as an allocation of their total asset base and relative to their deposit sources of funding.

In fact, net loans grew at a rate of 9.34% for this group, which is down from the average growth rate of 15.07% for the years 2005 through 2007.  The growth rate in loans is down, which is probably due to tightened credit standards. However, it is still growth. And, since total average assets also had growth of 11.58% in 2008, the absolute dollars of loan balances increased at the largest banks.

• Peer group 2 consisted of 305 reporting financial institutions between $1B and $3B in total assets.
• The net loans accounted for 72.96% of average total assets, up from 71.75% in 2007. 
• Again, the loans as a percent of total assets have increased steadily since at least 2004. The loan-to-deposit ratio for these banks was up to 95% from 92% in 2007 and an average of 90% for 2006 and 2005.

So, these banks are also lending more in 2008 as a portion of their asset base and relative to their deposit source of funding.

Net loans grew at a rate of 10.48% for this group in 2008 which is down from 11.94% growth in 2007 and down from an average growth of 15.04% for 2006 and 2005. And, since total average assets also had growth of 10.02% in 2008, the absolute dollars of loan balances also increased at the intermediate size banks. Again here, the growth rate in loans is down, probably due to tightened credit standards, but it is still growth and it is at a slightly more aggressive rate than the largest bank group.

Combined, for these 494 largest financial institutions, loans were still growing through 2008 both as a percentage of asset allocation and in absolute dollars.

Tune in to my next blog to read more about the results shown relating to credit costs, loss allowance accounts and the impacts on earnings.
 

This post is a feature from my colleague and guest blogger, John Robertson, Senior Process Architect in Advisory Services at Baker Hill, a part of Experian.

Years ago, I attended a seminar at which the presenter made a statement that struck me as odd, but has proven to be quite prophetic.  He simply stated, “margins will continue to narrow … forever!” He was spot on.
At that time, a variety of loan products (such as mortgage loans) were becoming commoditized and this emerging market acted as an intermediary for needed cash to provide banks the wherewithal to continue to lend in their respective locales. The presenter continued by making a call for a systematic and effective pricing methodology then and “forever”.
Pricing loans in a competitive market does not necessarily translate into smaller yields. Nor should banks be willing to accept smaller yields for less than quality loans. There are several viable options to consider when loan pricing in a market where the margins continue to shrink.

Cutting operating expenses
Generally, a financial institution’s first reaction to narrowing margins is to cut operating expenses. Periodically the chaff does need culling, but most banks run efficient shops by depending heavily on technology to create those efficiencies and for risk management. They continually measure themselves with efficiency ratios which, in part, help to drive their strategic operating decisions. So, when the edict comes from above to cut operating expenses, there aren’t too many options.

So, why is a bank’s first reaction usually an all-out call to cut operating expenses? Generally, it’s because these operating expenses are more easily identifiable and banks still lack effective tools to measure the value of their customers and relationships. Couple that with the perception that there is no control over a competitive market with narrowing margins. As a result, banks price accordingly -- just to get the deal. Consequently, their efficiency ratios may look good, but what about the potential impact on yield, service and internal morale? Community banks, in particular, pride themselves on customer service and, in fact, site it as one of their strengths against larger banks. Do you give up that advantage?

Relationship management
To price effectively in a market where margins have narrowed, the bank has to also consider the relationship’s value. The value of deposits should be measured and included to allow for more competitive pricing. The influence of deposits on the relationship allows the bank to be more aggressive in its loan pricing or can enhance the relationship yield itself.
Loan pricing in a competitive market does not have to translate into smaller yields and/or credit quality. The key to staying ahead of competition is measuring the value of the relationship and applying any or all of the outlined effective risk-based pricing methodologies to position the bank to win the deal and still meet the targeted return objectives. While the phrase “margins will continue to narrow … forever” may seem to hold true, banks can counter by using the “power of pricing” to offset the impact to earnings …forever!
 

At which stage of the application process does the Red Flags Rule apply?

The Red Flag Rule would apply whenever you detect a Red Flag in connection with an application. This could occur as soon as you receive an application, for example:

• if the application appears to have been altered or forged; or
• the consumer’s identification appears to be forged or is inconsistent with the information on the application.

Is the social security number (SSN) check a requirement?

No, but an invalid SSN may be a Red Flag – i.e., an indicator of possible identity theft – and obtaining and verifying a SSN may be a reasonable means of application risk management to detect this Red Flag when opening accounts. You may be able to utilize your existing procedures under your Customer Identification Program under the USA PATRIOT Act.
 

Part 2

There is one rather interesting clause that appears to represent an open-ended business porfolio risk management decision for the future. It is one small paragraph, named Amendment, in the middle of Article V - Miscellaneous, just ahead of governing law (which is federal law, backed up by the laws of the State of New York).

Amendment begins normally enough, requiring the usual signed agreement of each party, but then states: “provided that the Investor may unilaterally amend any provision of this Agreement to the extent required to comply with any changes after the Signing Date in applicable federal statutes.” Wow. My understanding of this is that if Congress in the future, enacts anything that Treasury finds (or Congress requires Treasury to find) applicable to any aspect of the previously signed TARP Agreement, the bank is bound to adhere. Forget about the non-voting aspect of the preferred shares issued to the Treasury. Once the TARP Agreement is executed by the bank, management is not only bound by what’s in the document to begin with, it is in addition, subject to future federal law as long as the TARP shares are held by the government.

So, this new major owner does have a voice. The Purchase Agreement covers what the new owner wants now and may decide it wants in the future. This a form of strategic business risk that comes with accepting the capital infusion, along with the various financial implications of the funding.
 

Part 1

Beyond the risk management considerations related to a bank’s capital position, which is directly impacted by Troubled Asset Relief Program (TARP) participation, it should be clear that TARP also involves business (or strategic) risk.  We have spoken in the past of several major categories of risk: credit risk, market risk, operational risk and business risk.

Business risk includes:

• A variety of risks associated with the outcomes from strategic decision making;
• Governance considerations; 
• Executive behavior (for lack of better terminology);
• Management succession events or other leadership occurrences that may affect the performance and financial viability of the business.

Aside from the monetary impact on the bank’s capital position, TARP involves a new capital securities owner being in the mix. And, with a 20% infusion of added tier 1 capital, we are almost always talking about a very large, new owner relative to existing shareholders. The United States Department of the Treasury is the investor or holder of the newly issued preferred stock and warrants. The Treasury Department does not have voting rights like common shareholders, but the Treasury’s Securities Purchase Agreement – Standard Form includes at least 35 pages of terms, plus the required Letter Agreement, Schedules attached to the Letter Agreement and at least five significant Annex’s to the Purchase Agreement. It’s NOT an easy, quick or fun read.

In the Recitals section, it states that the bank: “agrees to expand the flow of credit to U.S. consumers and businesses on competitive terms as appropriate to strengthen the health of the U.S. economy” and, later, “agrees to work diligently, under existing programs, to modify the terms of residential mortgages as appropriate to strengthen the health of the U.S. economy.” Fortunately, if you’re a banker, these topics are not (currently) revisited elsewhere in the document, period. However, these are examples of the new shareholder effecting business decision making without the need to be on the Board of Directors, or voting common shares.

The Agreement covers a number of other requirements and limitations, such as executive compensation, dividend payments, other capital sourcing and retention of bank holding company status. None of these are particularly onerous, but they must be taken into account by management.

Visit my next post to read about the very interesting Amendment clause that may represent an open-ended business portfolio risk management decision for the future.
 

We have been hearing quite a bit about the ponzi scheme that was created and managed by Bernie Madoff.  Almost $50 billion dollars was taken from those that were considered to be sophisticated and definitely not the typical type to be scammed.  So, what created the environment that allowed such large sums of money to be lost in such a basic con game as a ponzi scheme?  I believe there are a few basic factors that prompted these seemingly sophisticated people to invest in this ill-fated “investment.”

• A strong desire to generate investment returns when the typical channels were not delivering.
• The reputation(s) of the existing client list -- If they invested why shouldn’t I? 
• The thought that if it paid off with smaller dollar investments, just think what could be made with larger dollars!

Hmmm!  Sounds like how we got ourselves into today’s credit situation.  Basically, we were distracted by the items noted above and ignored the warning signs. 

Putting the items above into credit industry terms it can be summed up as follows:

• We have to continue to grow and we are pressured to find more opportunities.  If we go lower in the credit quality spectrum, it can generate immediate volume from the existing application volume.
• Other financial institutions have gone into this type of lending and they aren’t showing any signs of significant distress in their portfolios.  We need to do the same.  (Everyone in the herd in favor of this action please respond by saying “Moo.”)
• Our test portfolio has performed acceptably, so let’s increase the volume.

Let’s continue the correlation between these two “problems.”  In the Madoff ponzi scheme, there were warning signs that cropped up - some earlier than others. These included:

• In 2000, the Securities and Exchange Commission received a letter from an outside money manager which warned of a possible scheme.
• In 2005, the Bostonian submitted an 18-page document to the SEC citing 29 red flags and indicated some level of corruption within Madoff’s investment company. 
• The SEC’s own earlier investigation conducted in 1999, included an acknowledgement that they had received “credible allegations” but these allegations were ignored.

So, what were the signs that were in front of us but we simply chose to ignore?

• Were the portfolios turning over so fast that we could not actually gather statistically valid data to support performance?
• Since we were selling off the loans, either individually or in bulk, did we ignore the actual risk that was taken by the industry? 
• Were we appropriately monitoring the portfolio growth and performance, utilizing risk reduction and risk avoidance techniques, doing regular rescores and tracking potential behavioral issues?

Whether the signs were visible to us or not, the fact remains that they existed in the past and they will likely exist in the future.  As we continue to clean up the mess of our past, we need to consider a few items:

• What we did in the past will no longer be acceptable going forward. We must change. We must improve.
• Regulatory pressures will increase and changes will continue to be made. 
• We will not have the luxury of time to respond to these pressures and/or changes. We must act now.

What is a financial institution to do?  Well, the worst thing we can do is wait for the regulators to tell us what to do because that is simply too late.  We need to act and act now.

• Assess the risk management methods that were employed in the past and determine deficiencies. Note the gaps between the historical tools and data sources compared with the updated credit decisioning tools and sources available in the industry.
• Develop a plan for implementing the new risk reduction methods and tools. Determine the estimated lift and manage/monitor your performance against your estimates.
• Don’t forget about the new additions to the portfolio. Once you have the existing risk identified, you should make the appropriate adjustments to the product risk parameters and terms and conditions to improve the overall quality of the new portfolio.

Overall, the worst thing that we can do is nothing. 

Remember,

“Those who do not remember the past are condemned to repeat it.”
George Santayana, a philosopher, essayist, poet, and novelist