Fear vs Greed or the Chocolate Chip Conundrum
In the previous three blog installments (see here, here and here), we looked at the elements to consider in developing a sound loan review policy and the scope and structure of the audit function. In the end, this process is an assessment of how well the financial institution is following its own policies and procedures and provides an independent analysis of accuracy and appropriateness of the risk metrics in the loan portfolio. In this segment, we would like to back the truck up a bit and explore the emotional considerations that may come into play in building the institution’s loan portfolio.
Risk assessment in the granting of credit typically involves “objective” criteria. This involves an analysis of the five C’s of credit: cash flow, collateral, financial condition, character and overall economic conditions. Institutions will also incorporate some more subjective criteria such as past/present relationships, referral source, etc. However, even the most conservative credit decision makers tend to adjust their risk tolerance or risk appetite based upon factors such as where they are in the business cycle, the local economic landscape, the competition, etc. Ultimately, I characterize this as an assessment along the fear vs greed continuum and may represent a willing or unwilling decision.
Let’s consider an analogy. As a kid, my favorite treats were warm chocolate chip cookies, and one of my favorite pastimes involved having fun outside with friends. My mother, wise woman that she was, understood the value of limits on the number of chocolate chip cookies that should be consumed; usually two. However, there were times when I thought the risk of being “greedy and going for more” was worth the risk of being caught and losing my right to be outside with my friends. What was interesting, is that even if mom didn’t catch me taking too many, I would inevitably end up with a stomach ache from over-indulgence. This is the same behavior that happens in the granting of credit.
In 2008 and 2009, the collapse of the real estate market and economic slow-down resulted in a “flight to quality,” with the result being that credit availability was very restrictive: fear was in control of credit decisions for both new and existing clients. Credit granting would generally be subject to strict standards, few policy exceptions, and restrictive covenant packages. As economic conditions began to improve, more quality credit opportunities became available. Institutions would relax applications of credit guidelines, and allow for a benefit of the doubt with appropriate structures, pricing and covenants. Fear and greed were in balance.
However, this is a short-lived situation as an abundance of liquidity, a push for growth and earning assets, and a low interest rate environment all conspire to overcome the fear that once was present. An environment that is characterized by multiple competing proposals for the limited quality opportunities results in too much credit at cheap rates with poor structure. Greed has overcome fear. After all, in this competitive part of the cycle, if things don’t work out, there will always be a “greater fool” to pay the lender off as they haven’t yet experienced the stomach ache from the result of too many chocolate chip cookies. Ultimately this condition, dominated by greed, results in a race to the bottom where credit grantors are not being compensated for the risk they are assuming with low rates and poor structures.
On the surface, borrowers might think this is beneficial to them. Lots of cheap money with few conditions? What could go wrong! Well, consider what happens when the borrower doesn’t get the order or contract they expected, or they missed their projections. Covenant defaults (on loose covenants). The lender that was giving away money is now (rightly) concerned about their ability to collect. Shareholders and regulators are concerned about the potential losses. Lenders will need to restrict availability for not only this borrower, but for other borrowers as well. The pendulum starts to swing back in a “flight to quality” in response to fear. Portfolio focus is on quality and not quantity.
Much of this reflects the normal business activity and cycles. However, consistency in application of credit standards and principles is a far better approach to building a portfolio (and for establishing long-term customer relationships) that can stand the inevitable changes in business conditions rather than falling into the emotional rollercoaster of fear vs greed.
Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call:920.264.9150.