Scoring Models

Put yourself in the shoes of your collections team. The year ahead is challenging. Workloads are increasing as consumer debt escalates, and collectors are working tiring, stressful shifts talking to people who don't want to talk about their debts.

What kind of incentives can improve your collections performance and at the same time as create a well motivated and productive team?

Introduction

Financial incentives have long been a popular method to help boost staff performance. These rewards usually relate to the achievement of certain goals -- either personal, team, organizational or a combination of all three. A well-constructed incentive plan will increase staff morale and loyalty, as well as making a valuable difference to the bottom line. It can help ensure you are managing a team who are running at full speed and capability during these busy, turbulent times.

However, collections managers can also implement alternative non-monetary incentive programs that can boost staff commitment and effectiveness.

This series of postings identifies cash and non-cash alternatives that can help build and maintain a motivated team.

Getting Started

Before introducing a new incentive plan, clearly explain your objectives to the team. If your main goal is to maximize profitability, boost morale by letting your team know they are a major source of profit. Their understanding of how individual performance relates to the business will deepen their commitment to the program once it begins.

To help you decide what to include in the incentive plan, you must first understand what drives your team. This should be ascertained by conducting regular performance appraisals, call monitoring, attitude surveys and informal conversations. Your staff will likely tell you that increased status and recognition, higher pay, better working conditions and improved benefits would increase both morale and performance. We can look into incentives that address these requirements individually, but let's begin with the most obvious: money.

Money is a powerful motivator

The current economic climate guarantees that money is more important to your team members than ever; they want to be financially rewarded for their efforts. In this industry, collectors work individually so it is wise to target them in this way when using financial incentives.

Comparing individuals can also achieve higher performance levels because the cachet of being 'top dog' is a real motivator for some people.

Our advice is to begin by targeting staff in three familiar areas and ensure from the start that your collections system delivers the depth and granularity of management information to support your incentive program.

I would like to thank the Experian collections experts who contributed to this four-part series. The rest of the series will be posted soon!

-- By Kari Michel

In my last blog I gave an overview of monitoring reports for new account acquisition decisions listing three main categories that reports typically fall into:  (1) population stability; (2) decision management; (3) scorecard performance.

Today, I want to focus on population stability.   Applicant pools may change over time as a result of new marketing strategies, changes in product mix, pricing updates, competition, economic changes or a combination of these. Population stability reports identify acquisition trends and the degree to which the applicant pool has shifted over time, including the scorecard components driving the shift in custom credit scoring models. 

Population stability reports include:

• Actual versus expected score distribution
• Actual versus expected scorecard characteristics distributions (available with custom models)
• Mean applicant scores
• Volumes, approval and booking rates

These types of reports provide information to help monitor trends over time, rather than spikes from month to month.  Understanding the trends allows one to be proactive in determining if the shifts warrant changes to lending policies or cut-off scores.

Population stability is only one area that needs to be monitored; in my next blog I will discuss decision management reports.

 

-- by Kelly Kent

The title of this edition, ‘The risk within the risk’ is a testament to the amount of information that can be gleaned from an assessment of the performances of vintage pools.

Vintage pools offer numerous perspectives of risk. They allow for a deep appreciation of the effects of loan maturation, and can also point toward the impact of external factors, such as changes in real estate prices, origination standards, and other macroeconomic factors, by highlighting measurable differences in vintage to vintage performance.

What is a vintage pool?

By the Experian definition, vintage pools are created by taking a sample of all consumers who originated loans in a specific period, perhaps a certain quarter, and tracking the performance of the same consumers and loans through the life of each loan.

Vintage pools can be analyzed for various characteristics, but three of the most relevant are:

* Vintage delinquency, which allows for an understanding of the repayment trends within each pool;

* Payoff trends, which reflect the pace at which pools are being repaid; and

* Charge-off curves, which provide insights into the charge-off rates of each pool.

The credit grade of each borrower within a vintage pool is extremely important in understanding the vintage characteristics over time, and credit scores are based on the status of the borrower just before the new loan was originated. This process ensures that the new loan origination and the performance of the specific loan do not influence the borrower’s credit score. By using this method of pooling and scoring, each vintage segment contains the same group of loans over time – allowing for a valid comparison of vintage pools and the characteristics found within.

Once vintage pools have been defined and created, the possibilities for this data are numerous...

Much of the discussion on Capitol Hill revolves around sufficient risk-based capital and the derivation of how much tier 1 capital and/or common equity capital is appropriate. Most of our solution offerings and consulting services address various aspects of risk management, from targeting prospective customers, through loan origination and risk-based pricing, to ongoing relationship management and portfolio monitoring. We have been addressing risk management with our clients long before the recent financial and economic crises. We are both ready and able to assist new and existing clients in many ways: to effectively and efficiently address the management of credit and other risks and to develop strategies that offer optimal risk-based profit performance. We are always monitoring regulatory developments and, as always, will strive to assist our clients with new best practices to operate as effectively as possible under any new regulations affecting risk management policies, processes and governance responsibilities.

-- By Kari Michel

What is your credit risk score?  Is it 300, 700, 900 or something in between?  In order to understand what it means, you need to know which score you are referencing.  Lenders use many different scoring models to determine who qualifies for a loan and at what interest rate. For example, Experian has developed many scores, such as VantageScore®..  Think of VantageScore® as just one of many credit scores available in the marketplace.

While all credit risk models have the same purpose, to use credit information to assess risk, each credit model is unique in that each one has its own proprietary formula that combines and calculates various credit information from your credit report.  Even if lenders used the same credit risk score, the interpretation of risk depends on the lender, and their lending policies and criteria may vary.

Additionally, each credit risk model has its own score range as well.  While the score range may be relatively similar to another score range, the meaning of the score may not necessarily be the same.   For example, a 640 in one score may not mean the same thing or have the same credit risk as a 640 for another score.  It is also possible for two different scores to represent the same level of risk. If you have a good credit score with one lender, you will likely have a good score with other lenders, even if the number is different.
 

• Risk isn't evident in the general ledger
• Risk certainly DOES exist
• Risk needs to be identified, measured and managed
• Without (in spite of) Generally Accepted Accounting Practices, banks need other risk analytics
• Risk measures need to assist bankers with product level and relationship-level pricing and profitability

• Maximizing client retention
• Maximizing cross-sell opportunities
• Minimizing loss potential due to credit-risk issues
• Minimizing loss potential due to operational risks
• Maximizing profitability through the timely identification o f risk and the appropriate allocation of capital

Below are a few risk management strategies that your financial institution can implement through the utilization of automated portfolio monitoring:

Special accounts strategies
Focus your internal resources on accounts with a high probability of recovery. Minimize "distractions" of resources and determine the probability of rehabilitation. By utilizing these strategies, your financial institution may be able to handle more accounts with same staff levels and have quicker and more accurate responses.

Focus your internal resources
Focus your risk management resources on the accounts that are showing signs of deterioration, those that have fallen below minimum thresholds and show a significant decline from prior year performance. By doing this you can avoid credit review by identifying continuing high performers and negligible declines in credit quality.
 

• Take a look at how your perception of small business loans has kept you from preventing problem situations.
   
• Consider migrating to a more proactive approach in your loan renewal/review process; it can have an impact on your profitability.
   
• Consider freeing up more time for your lenders and relationship managers and investigate what could be done with that time to better benefit your financial institution.

• Price your transactions during the pre-sales process for differential risk (for all risk types).
• Sell services to your clients through relationship management based on risk-adjusted profit.
• Consider looking at risk-based lender performance metrics in your financial institution.
• Benchmark your entity performance over time.
• Benchmark your entity performance and compare that to your peers.

As I'm preparing for traveling to the Baker Hill Solution Summit next week, I thought I would revisit the ideas of risk-based loan pricing.

Risk Adjusted Loan Pricing – The Major Parts 

I have referred to risk-adjusted commercial loan pricing (or the lack of it) in previous posts. At times, I’ve commented on aspects of risk-based pricing and risk-based bank performance measurement,  but I haven’t discussed what risk-based pricing is -- in a comprehensive manner. Perhaps, I can begin to do that now, and in my next posts.

Risk-based pricing analysis is a product-level microcosm of risk-based bank performance. You begin by looking at the financial implications of a product sale from a cost accounting perspective. This means calculating the revenues associated with a loan, including the interest income and any fee-based income. These revenues need to be spread over the life of the loan, while taking into account the amortization characteristics of the balance (or average usage for a line of credit). To save effort (and in providing good client relationship management), we often download the balance and rate information for existing loans from a bank’s loan accounting system.

To “risk-adjust” the interest income, you need to apply a cost of funds that has the same implied market risk characteristics as the loan balance. This is not like the bank’s actual cost of funds for several reasons. Most importantly, there is usually no automatic risk-based matching between the manner in which the bank makes loans and the term characteristics of its deposits and/or borrowing. Once we establish a cost of funds approach that removes interest rate risk from the loan, we subtract the risk-adjusted interest expense from the revenues to arrive at risk-adjusted net interest income, or our risk-adjusted gross margin.

We then subtract two types of costs. One cost includes the administrative or overhead expenses associated with the product. Our best practice is to derive an approach to operating expense breakdowns that takes into account all of the bank’s non-interest expenses. This is a “full absorption” method of cost accounting. We want to know the marginal cost of doing business, but if we just apply the marginal cost to all loans, a large portion of real-life expenses won’t be covered by resulting pricing. As a result, the bank’s profits may suffer.

We fully understand the argument for marginal cost coverage, but have seen the unfortunate end-result of too many sales -- that use this lower cost factor -- hurt a bank’s bottom line. Administrative cost does not normally require additional risk adjustment, as any risk-based operational expenses and costs of mitigating operation risk are already included in the bank’s general ledger for non-interest expenses.

The second expense subtracted from net interest income is credit risk cost. This is not the same as the bank’s provision expense, and is certainly not the same as the loss provision in any one accounting period.  The credit risk cost for pricing purposes should be risk adjusted based on both product type (usually loan collateral category) and the bank’s risk rating for the loan in question. This metric will calculate the relative probability of default for the borrower combined with the loss given default for the loan type in question.

We usually annualize the expected loss numbers by taking into account a multi-year history and a one- or two-year projection of net loan losses. These losses are broken down by loan type and risk rating based on the bank’s actual distribution of loan balances.

The risk costs by risk rating are then created using an up-sloping curve that is similar in shape to an industry default experience curve. This assures a realistic differentiation of losses by risk rating. Many banks have loss curves that are too flat in nature, resulting in little or no price differentiation based on credit quality. This leads to poor risk-based performance metrics and, ultimately, to poor overall financial performance. The loss expense curves are fine-tuned so that over a period of years the total credit risk costs, when applied to the entire portfolio, should cover the average annual expected loss experience of the bank.

By subtracting the operating expenses and credit risk loss from risk-adjusted net interest income, we arrive at risk-adjusted pre-tax income. In my next post we’ll expand this discussion further to risk-adjusted net income, capital allocation for unexpected loss and profit ratio considerations.

2007 and 2008 saw a rapid change of consumer behaviors and it is no surprise to most collections professionals that the existing collections scoring models and strategies are not working as well as they used to. These tools and collections workflow practices were mostly built from historical behavioral and credit data and assume that consumers will continue to behave as they had in the past. We all know that this is not the case, with an example being prioritization of debt and repayment patterns.

Its been assumed and validated for decades that consumers will let their credit card lines go before an auto loan and that the mortgage obligations would be the last trade to remain standing before bankruptcy. Today, that is certainly not the case and there are other significant behavior shifts that are contributing to today's weak business models.

There are at least three compelling reasons to believe now is the right time for updates:

• It appears that most of the consumer behavioral shift is over for collections. While economic recovery will take many years, more radical changes in the economy are unlikely. Most experts are calling for a housing bottom sometime in 2009 and there are already signs of hope on Wall Street.
   
• What is built now shouldn't be obsolete next year. A slow economic recovery probably means that the life of new models will be fairly long and most consumers won't be able to improve their credit and collections scores anytime soon. Even after financial recovery (which at this point is not likely over the short term for many that are already in trouble), it can take two to seven years of responsible payment history before a risk assessment is improved.
   
• We now have the data with which to make the updates. It takes six to12 months of stability to accumulate sufficient data for proper analysis and so far 2009 hasn't seen much behavioral volatility. Whether you build or buy, the process takes awhile, so if you still need a few more months of history in will be in hand when needed if the projects are kicked off soon.

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.

 

Have you ever wondered how your current collections workflow process evolved to its current state?  To start at the beginning, let’s rewind to medieval England …

The Tallyman
The earliest known collections system was essentially a door-to-door program, as there were no modern day devices to make the process more efficient. The system of record at that time was typically a hardwood stick with carved notches representing loans and payments between a lender and borrower. This door-to-door collector was known as the Tallyman, which referred to the collection of tally sticks he carried to document financial transactions.

The beginning of modern times
As technology evolved, telephones and letters became the collections management tools of choice, with a personal visit being a last resort action. The process where a collector managed the repayment strategy and relationships for his assigned customers was still in practice. Collections operations were typically in decentralized branches and small teams of skilled collectors were able to effectively manage this “cradle-to-grave” approach.

Yesterday
When expense management became a priority, the migration to larger, centralized operations became an industry trend.  Many companies found it difficult to hire large teams of highly-skilled collectors in their geographic regions and the bucket system was born. The concept was simple and effective -- let the less experienced staff work the accounts that are the easiest to collect and focus the experienced collectors on the more difficult cases.  Advanced collections tools such as automatic dialers arrived on the market to increase efficiency and were shortly followed by decision engines used to support behavioral scoring and segmentation strategies.

Today
Current trends in collections include the migration towards a risk-based segmentation and strategy approach. Cutting edge tools and collection management software, designed to address today’s collections business objectives, are hitting the market and challenging the traditional bucket approach most of us are used to. As the economic conditions of the past few years deteriorated, many organizations began shifting their spending focus towards the collections department and this, in turn, has inspired investment and innovation from software, analytics and data vendors. New collections scores were recently unveiled that yield predictiveness that has never been seen and collections data products have become significantly more sophisticated. Modern technology is also empowering collections managers to control the destiny of their business units by freeing them from the constraints of over-burdened IT departments and inflexible systems. There is also an emerging trend to consider the collective power of multiple products working in tandem. Collections experts are finding that the benefit of the complete solution equals much more than just the sum of the parts.

Tomorrow
Once we all migrate to the next level and employ today’s modern marvels to make our businesses more productive and efficient, what’s next?  It’s highly probable that tomorrow’s collections workflow will consider the entire relationship and profit potential of a customer before a collections action is executed. Additionally, the value in considering the entire credit and risk picture associated with a customer will be better understood and we will learn when each of the holistic view options is most appropriate. There are a number of roadblocks in the way today, including disparate systems and databases and siloed business units with goals and objectives that are not aligned. Will we eventually get there? The business leaders with long-range vision certainly will … just as some unknown visionary had the initiative to embrace emerging technology and abandon his tally sticks.

For more information and to read the Decision Analytics newsletter that features one of my previous blogs, "Next generation collections systems", click here.   

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 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.