What? Me Worry?

What happened? What went wrong? Things were humming along nicely and then…BAM! The bottom fell out. Sound familiar? Certainly, we see it and hear it frequently today. We are all “victims,” right? Wrong! Not true in personal life and certainly not true in your business. That said, we do experience failure at times. So why do banks and lending institutions fail?

First, let’s define “failure.” For our purposes it is when the financial institution cannot meet its obligations to creditors and depositors. Most generally this occurs when asset values fall below the market value of liabilities or obligations to creditors and depositors; generally due to bad loans.

Banks and lending organizations are typically highly leveraged. As history has shown, sheer size is not a protection against failure as Washington Mutual’s (WAMU) failure in 2007 attests. At the time, WAMU had total assets of $307 billion. Continental Illinois had been around since 1910 and was considered by many as the premier commercial and industrial lending bank before it failed in 1984. Asset size was $40 billion. So, given the highly leveraged nature of a bank’s balance sheet, what is the key to longevity and success? Two words with a single emphasis: Risk Management. One needs to identify the risks and manage them appropriately.

It is popular to believe that bank failures are caused by adverse economic conditions. While plausible and at least partly true, the OCC did a report called, Bank Failures, an Evaluation of Factors Contributing to Failures of National Banks. The OCC concluded that bank management – including the boards of directors – were ultimately responsible for performance. Poor management and other internal problems were the common denominators.

The OCC report found the following common characteristics in the bank failures analyzed:

• Nonexistent or poorly followed loan policies (81% of failures)
• Inadequate systems to ensure compliance with internal policies (69% of failures)
• Inadequate controls or supervision (63% of failures)
• Inadequate problem loan identification systems (59% of failures)

As we discussed in a previous blog, a simplistic view of lending practices and risk management falls along the “fear vs greed” continuum. When fear is in control, lending organizations tend to be tight-fisted and experience low growth. If, however, we move toward the greed end of the spectrum, the organizations tend to be very aggressive in pursuit of growth. Looking back at the definition of bank failure, where asset values fall below market values of liabilities, what management/portfolio decisions might lead to this hyper growth (and higher risk) scenario?

• Industry concentration. Organizations should stick with industries that they know and understand. Just because you can underwrite a convenience store doesn’t make you an oil and gas expert. Most of us don’t know what we don’t know. Also, too much of one thing is not a good thing. A diverse portfolio is a good hedge.
• Lending organizations that stay within their footprint and have a firm idea of their market area are going to be more successful. Continental Illinois stepped out of its industry and geographic expertise when it purchased $1billion in oil and gas loans from Oklahoma-based Penn Square. In addition, they expanded into foreign debt. As they found out, what you don’t know (or understand) can hurt you.
• Buying Participations. This is an easy way to puff up the balance sheet by buying participations. This can be risky because these participations are generally outside the bank’s footprint and may be an industry with which management may be unfamiliar. Other risks include not having any voting rights control over decisions in the bank relationship and the level of expertise of the lead bank.
• Mergers and Acquisitions. This can be a particularly sensitive area. Do you have the necessary expertise to conduct the due diligence? Is the portfolio made up of loans and clients that are consist with your lending philosophy and expertise? What is the credit culture like?
• Loans to Insiders. A large number of loans to bank insiders (upper management, board members, close associates) can be a red flag. The OOC found that insider abuse and fraud were significant factors in more than 1/3 of failed and problem banks.
• Asset/Liability Mismatch. The tenor/duration of assets and liabilities need to be in balance. Funding 30-year mortgages with short term floating rate obligations just doesn’t work.

So why the concern now about risk and failure in today’s good economic environment? Businesses are generally doing well, there is low unemployment, good wage growth, etc. As much as it pains me to say it, the government might have gotten this one right. The key finding in the OCC report was that lending institutions need to establish strong policies, controls, and systems when economic conditions are good as this greatly increases the chances of remaining profitable when conditions are bad. (Ouch, that hurt!) The team of colleagues here at Enlighten Financial are here to assist you in that mission whether it be credit policies and procedures, risk identification and management or due diligence engagements.

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.