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By: Tom Hannagan Part 5 This continues the updated review of results from the Uniform Bank Performance Reports (UBPR), courtesy of the FDIC, for 2008. The UBPR is based on the quarterly required Call Reports submitted by insured banks. The FDIC compiles peer averages for various bank size groupings. Here are some findings for the two largest groups, covering 494 reporting banks. I wanted to see how the various profit performance components compare to the costs of credit risk discussed in my previous post. It is even more apparent than it was in early 2008 that banks still have a ways to go to be fully pricing loans for both expected and unexpected risk. Peer Group 2 (PG2) consists of 305 reporting banks between $1 billion and $3 billion in assets. PG2’s Net Interest Income was 5.75 percent of average total assets for the year. This is also down, as expected, from 6.73 percent in 2007. Net Interest Expense also decreased from 3.07 percent in 2007 to 2.31 percent for 2008. Net Interest Margin, also declined from 3.66 percent in 2007 to 3.42 percent in 2008, or a loss of 24 basis points. These margins are 31 bps or 10 percent higher than found in Peer Group 1 (PG1), but the drop of .24 percent was much larger than the .05 percent decline in PG1. As with all banks, Net Interest Margins have shown a steady chronic decline, but the drops for PG2 have been coming in larger chunks the last two years -- -24 basis points last year after dropping 16 points from 2006 to 2007. Behind the drop in margins, we find loans yields of 6.53 percent for 2008, which is down from 7.82 percent in 2007. This is a decline of 129 basis points or 16 percent. Meanwhile, rates paid on interest-earning deposits dropped from 3.70 percent in 2007 to 2.75 percent in 2008. This 95 basis point decline represents a 26 percent lower cost of interest-bearing deposits. Again, with a steeper decline in interest costs, you would think that margins should have improved somewhat. It wasn’t meant to be. We see the same two culprits as we did in PG1. Total deposit balances declined from 78 percent of average assets to 77 percent which means again, that a larger amount had to be borrowed to fund assets. Secondly, non-interest bearing demand deposits continued an already steady decline from 5.58 percent of average assets in 2007 to 5.03 percent. This, of course, resulted in fewer deposit balances relative to total asset size and a lower proportion of interest-cost-free deposits. Check my next blog for more on an analysis of Peer Group 2’s fee income, operating expenses and their use of risk-based pricing.
By: Tom Hannagan Part 4 Let’s dig a bit deeper into why Peer Group 1’s margins didn’t improve. We see two possible reasons: Total deposit balances declined from 72 percent of average assets to 70 percent. This means that a larger amount had to be borrowed to fund their assets. Secondly, non-interest bearing demand deposits declined from 4.85 percent of average assets to 4.24 percent. So, fewer deposit balances relative to total asset size, along with a lower proportion of interest-cost-free deposits, appear to have made the difference. Fee income Non-interest income, again as a percent of average total assets, was down to 1.12 percent from 1.23 percent in 2007. This was a decline of 9 percent. For Peer Group 1 (PG1), fees have also been steadily declining relative to asset size, down from 1.49 percent of assets in 2005. A lot of fee income is deposit based and largely based on non-interest bearing deposits. So, the declining interest-free balances, as a percent of total assets, are a source of pressure on fee income and have a negative impact on net interest margins. Operating expenses Operating expenses constituted more bad news as they increased from 2.63 percent to 2.77 percent of average assets. Most of the large scale cost-cutting didn’t get started early enough to favorably impact this number for last year. Historically, this metric has moved down, irregularly, as the size of the largest banks has grown. This number stood at 2.54 percent in 2006, for instance. We saw increase in both 2007 and again in 2008. As a result of the decline in margins and the larger percentage decline in fee income, while operating costs increased, the Peer Group 1 efficiency ratio lost ground from 57.71 percent in 2007 up to 63.70 percent in 2008. This 10 percent increase is a move to the bad. It means every dollar in gross revenue [net interest income + fee income] cost them almost 64 cents in administrative expenses in 2008. This metric averaged 55 cents in 2005/2006. The total impact of changes in margin performance, fee income, operating expenses and the 2008 increase in provision expense of 87 basis points, we arrive at a total decline in pre-tax operating income of 1.23 percent on total assets. That is a total decline of 80 percent from the pre-tax performance in 2007 of 1.53 percent pre-tax ROA to the 2008 result for the group of only .30 percent pre-tax ROA. It would appear that banks have not been utilizing pricing enough credit risk into their loan rates. This would be further confirmed if you compared bank loan rates to the historic risk spreads and absolute rates that the market currently has priced into both investment grade and below-investment-grade corporate bonds. These spreads have decreased some very recently, but it is predicted that more credit risk is present than bank lending rates would indicate.
By: Tom Hannagan Part 3 I believe it is quite important to compare your bank or your investment plans in a financial institution to the results of peer group averages. Not all banks are the same, believe it or not. In this column, we use the averages. Again, look for the differences in your target institution. About half of them beat certain performance numbers, while the other half are naturally worse. It can tell a useful story. This continues the updated review of results from the Uniform Bank Performance Reports (UBPR), courtesy of the FDIC, for 2008. The UBPR is based on the quarterly required Call Reports submitted by insured banks. The FDIC compiles peer averages for various bank size groupings. Here are the findings for the two largest groups that cover 494 reporting banks. I wanted to see how the various profit performance components compare to the costs of credit risk discussed in my previous post. It is even more apparent than it was in early 2008 that banks still have a ways to go to be fully pricing loans for both expected and unexpected risk. Peer Group 1 (PG1) is made up of the largest 189 reporting banks or those with over $3 billion in average total assets for 2008. Interest income was 5.25 percent of average total assets for the period. This is down, as we might expect, based on last year’s decline in the general level of interest rates from 6.16 percent in 2007. Net Interest Expense was also down from 2.98 percent in 2007 to 2.06 percent average for the year. Net Interest Margin, the difference between the two metrics, was down from 3.16 percent in 2007 to 3.11 percent as a percentage of total assets. It should be noted that Net Interest Margins have been in a steady, chronic decline for at least 10 years, with a torturous regular drop of 2 to 5 basis points per annum in recent years. Last year’s drop of five basis points is in line with that progression and it does add to continuing difficulty in generating bottom-line profits. To find out a bit more about why margins dropped, especially in light of the steady increase in lending over the same past decade, we looked first at loan pricing yields. For PG1 these averaged 6.12 percent for 2008, down (again, expectedly) from 7.32 percent in 2007. This is a drop of 120 basis points or a decline of 16 percent. Meanwhile, rates paid on interest-earning deposits dropped from 3.41 percent in 2007 to 2.39 percent in 2008. This 102 basis point decline represents a 30 percent lower interest expense on interest-bearing deposits. Based only on these two metrics, it seems like margins should have improved and not declined for these banks. Check my next blog for more on the reasons for Peer Group 1’s drop in margins and an analysis of the fee income and operating expenses for these institutions.
Recently we conducted an informal survey, the results of which indicate that loan portfolio growth is still a major target for 2009. But, when asked what specific areas in the loan portfolio -- or how loan pricing and profitability -- will drive that growth, there was little in the way of specifics available. This lack of direction (better put, vision) is a big problem in credit risk management today. We have to remember that our loan portfolio is the biggest investment vehicle that we have as a financial institution. Yes; it is an investment. We choose not to invest in treasuries or fed funds -- and to invest in loan balances instead -- because loan balances provide a better return. We have to appropriately assess the risk in each individual credit relationship; but, when it comes down to the basics, when we choose to make a loan, it is our way of investing our depositors’ money and our capital in order to make a profit. When you compare lending practices of the past to that of well-tested investment techniques, we can see that we have done a poor job with our investment management. Remember the basics of investing, namely: diversification; management of risk; and review of performance. Your loan portfolio should be managed using these same basics. Your loan officers are pitching various investments based on your overall investment goals (credit policy, pricing structure, etc.). Your approval authority is the final review of these investment options. Ongoing monitoring is management of the ongoing risk involved with the loan itself. What is your vision for your portfolio? What type of diversification model do you have? What type of return is required to appropriately cover risk? Once you have determined your overall vision for the portfolio, you can begin to refine your lending strategy.
By: Tom Hannagan 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.
By: Tom Hannagan 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 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.
By: Tom Hannagan 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!
By: Tom Hannagan 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.
By: Tom Hannagan 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
The difference between market risk and credit risk By: Tom Hannagan Market risk is different than credit risk. The bank’s assets are mostly invested in loans and securities (about 90% of average assets). These loans and securities have differing interest rate structures – some are fixed and some are floating. They also have differing maturities. Meanwhile, the bank’s liabilities, deposits and borrowings also have differing maturities and interest rate characteristics. If the bank’s (asset-based) interest income structure is not properly aligned with the (liability-based) interest expense structure, the result is interest rate risk. As market rates change (up or down), the bank’s earning are impacted (positively or negatively) based on the mismatch in its balance sheet structure. The bank can offset market risk by purchasing interest rate swaps or other interest rate derivatives. The impact of insufficient attention to interest rate risk can damage earnings and may, again, negatively affect the bank’s capital position. So, ultimately, the bank’s risk-based capital acts as the last line of defense against the negative impact from, you guessed it, unpredictable variability – or “risk.” That is why equity is considered risk-based capital. Good risk management, predicting and risk-based pricing leads to safer earnings performance and equity position.
By: Tom Hannagan In my past postings, we’ve discussed financial risk management, the role of risk-based capital, measuring profitability based on risk characteristics and the need for risk-based loan pricing (credit risk modeling). I thought it might be worthwhile to take one step back and explain what we mean by the term “risk.” “Risk” means unpredictable variability. Reliable predictions of an outcome tend to reduce the risk associated with that outcome. Similarly, low levels of variability also tend to reduce risk. People who are “set in their ways” tend to lead less risky lives than the more adventuresome types. Insurance companies love the former and charge additional premiums to the latter. This is a terrific example of risk-based pricing. Financial services involve risk. Banks have many of the same operational risks as other non-financial businesses. They additionally have a lot of credit risk associated with lending money to individuals and businesses. Further, banks are highly leveraged, borrowing funds from depositors and other sources to support their lending activities. Because banks are both collecting interest income and incurring interest expense, they are subject to market, or interest rate, risk. Banks create credit policies and processes to help them manage credit risk. They try to limit the level of risk and predict how much they are incurring so they can reserve some funds to offset losses. To the extent that banks don’t do this well, they are acting like insurance companies without good actuarial support. It results in a practice called “adverse selection” – incorrectly pricing risk and gathering many of the worst (riskiest) customers. Sufficiently good credit risk management practices control and predict most of the bad outcomes most of the time, at least at portfolio levels. Bad outcomes (losses) that are not well-predicted, and therefore mitigated with sufficient loan-loss reserves, will negatively impact the bank’s earnings and capital position. If the losses are large enough, they can wipe out capital and result in the bank’s failure.
Part 2 Reason one Unfortunately, there is a management issue regarding their transparency with the investment community and/or client base. Regrettably for the managers and leaders choosing this approach, if this problem persists too long, the organization may choose to rectify with a change in the management and leadership Reason two The solution is both simple and complex. In simplistic terms, the financial institution must evolve its portfolio risk management reduction techniques and take a more proactive stance. Both internal and external data exists that can provide significant insight to the portfolio, its trends and potential future loss. Such data sources include: Internal behavioral characteristics (negative changes outside of just delinquencies) High line usage Non sufficient funds frequency & severity (for those borrowers who also have a deposit account with the institution) Deposit account closuresExternal data Regular rescore of the borrowers (both small business and consumer) Derogatory payment trends with other creditors (the borrower may be current with you but for how long?) Judgments or liens Such data can be used to create models for portfolio performance calculating: Delinquency trends by score (as the portfolio trends up or down in the score ranges we can adjust the expected loss rates, delinquency rates, etc.) Within score ranges and based upon other behavioral characteristics, what is the likelihood for charge-off or recovery. The biggest takeaway is that these portfolio management techniques are not new and untested. Your data provider (such as Experian), has used these techniques and has the data to support the effectiveness. While we are in trouble, we may find ourselves wanting to keep the “dirty secrets” to ourselves. Too often such an approach leads to one’s demise. Seek information, seek help, get control and truly start to move in a positive direction.
“Unprecedented times”, “financial crisis”, “credit crisis” and many other terms continue to be buzzwords that we hear every day. We are almost becoming desensitized to the terms, yet we feel the impact on a daily basis. Everyone is waiting for some positive news in the financial services industry and more bad news keeps coming. Each quarter we continue to read about financial institutions claiming that the worst is over. They have recognized the risk in their portfolios through risk assessment, set aside adequate reserves or loan loss allowances and are now ready to turn the corner. Yet we continue to read about these same institutions coming back with more bad news, more credit losses and a restatement of the assurance that the problems have been recognized. As a result, this financial risk management has brought to light all of the high-risk accounts and the trend will begin to change. Why does this story keep repeating itself? Reason one Management assesses to what extent the market (both stock market and the client base) will tolerate the level or degree of bad news, recognize losses to that extent and will then work hard to try to correct any known issues before we actually have to report the next quarter. Unfortunately, this approach simply delays the inevitable and brings into question the risk management practices of the particular institution. Like the boy who cried wolf, the more times you make a statement and it proves to be false, the less likely you will be believed the next time. Reason two The financial institutions are actually surprised each quarter with a new batch of credit losses. The institution, its credit management team and workout areas are diligently trying to address the current problem. But, just when they start to see the light at the end of the tunnel, a new batch of credit problems arise. For the most part, the credit issues still persist in the high-volume, low-dollar credits such as residential mortgages, home equity loans, automobiles, credit cards and small business loans. Due to the sheer volume of clients/loans, it becomes more difficult to assess what issues may be brewing in the portfolio. For the large volume, small dollar portfolios, the notion of a pending credit issue comes when the delinquency starts to rise to a delinquency of 60 or 90 days. The real issue is identifying those accounts that are likely to go 60 or 90 days past due and then assess the likelihood that they will go into charge-off. Regardless of the reason, we have a “credibility” problem in addition to a “credit” problem.
By: Tom Hannagan Part 3 This post continues my discussion of the reasons for going through the time and trouble to analyze risk-based pricing for loans. I mentioned before that the second general major justification for going through the effort to risk-adjust loan pricing as a normal part of the lending function is financial. I thought it might help put this into perspective by offering rough numbers that relate to risk-adjusted profit performance, bottom line earnings and expand on the premise that risk has a cost. Lending, in the leveraged/banking sense, involves credit risk, market (interest rate) risk and operational risk. The fourth area, the risk of unexpected loss, is covered by capital. Unmitigated risk will eventually impact earnings and common equity. The question is when and by how much? It’s important to understand that the cost of risk mitigation efforts depend on the various risk characteristics of the bank’s loans and loan portfolio. The differential cost of market risk As an example, a floating rate loan that reprices every month involves little market risk, requiring little if any expense to offset. Compare it to a five-year fixed rate, interest-only loan that involves greater exposure to market risk. That risk costs something to offset. The difference in annualized marginal funding cost ranges widely depending on the steepness of the yield curve on the date the loan is closed. The difference between Federal Home Loan Banks 30-day rates and five-year bullet funding today, for instance, is close to 200 basis points. If risk-based loan pricing models don’t reflect this difference by using a matched marginal funding cost, the bank is voluntarily assuming some or all of the market (or interest rate) risk. Multiply an implied 200 bps risk-based funding cost difference by $100M in average loan balances and the implied annualized additional risk-free funding expense is $2,000,000. Multiply that by the average life of the portfolio to get the full risk-adjusted cost difference that the bank is assuming. And that’s just for the market risk. The implied cost of credit risk A loan with a pass risk rating of ‘2’ involves a lower likelihood of defaulting than a loan with a pass risk rating of ‘4.’ The lower risk (grade 2) loan, therefore, involves less of an Allowance for Loan Lease and Losses reserve requirement and an implied lower provisioning expense than the higher risk (grade 4) loan. Depending on the credit regimen and net loss experience of a given bank, the difference in the implied annualized expected loss due to credit risk could be 40 bps or more. Multiply the implied 40 bps credit risk cost difference by $100M in average loan balances and the implied annualized additional risk-adjusted credit expense is $400,000. Multiply that by the average tenor of the portfolio to get the full risk-adjusted cost difference to the bank. The implied difference in administrative (or operations) expenses These expenses include all mitigated (insured) operational risk. An owner occupied commercial mortgage is normally much less expensive to monitor than a line of credit backing a construction project. Those cost differences often range into several thousand dollars per annum. If, in our example of the $100M portfolio, our average credit is $400K, then we have around 250 loans. These loans multiplied by $3,000 in fully-absorbed annual non-interest expense differences would amount to $750K. A competent risk-adjusted loan pricing effort would take this cost difference into account. Again, multiply that yearly amount by the average life of the portfolio to get the full cost difference that the bank is incurring. In reality, the three sample portfolios above would not overlap perfectly. The total actual assets from the above examples would lie between $100M and $300M. However, the total pretax cost difference of these three sample risk-based costs adds up to $3.15M per annum. The after-tax negative impact on risk-adjusted earnings is therefore about $2M yearly. So, the impact on ROA would be between 2.00% (if the three portfolios overlapped perfectly, for $100M in total assets) down to .67% (if there was no overlap, for $300M in total assets). This is a huge difference in earnings, on a risk-adjusted and fully cost-absorbed basis. Finally, the amount of risk-based capital needed to back loans with differing risk characteristics, for purposes of unexpected loss, can be substantially different. This can be looked at as a difference in the implied cost of capital or in the performance ratio of ROE. In a simple application, the implied required equity might range from say 6% on the lower-risk loans up to 8% for moderate risk (average pass grade risk rating). If the portfolio in question is earning 1% ROA, the difference in risk-based equity would result in an ROE of either 12.5% for the higher risk loans versus 16.7% for the lower risk loans. The differences in fully risk-based ROE, or RAROC, could easily be more dramatic than this. As stated before, if these differences are not “priced” into the loans somehow, the bank is not getting paid for the risk it is incurring or it is charging the lower risk borrowers a rate that pays for the added risk expenses of the higher risk borrowers. The business risk to the bank then becomes losing the better clients over time rather than attracting the riskier deals. An economic look at performance We are not talking in terms of “normal” accounting practices or “typical” quarterly reporting periods. We do use general ledger numbers to start the analysis process by relying on actual balances, rates and maturities. But, GAAP doesn’t address risk. So the risk adjustments are a more “economic” look at performance. Eventually, the risk reduction approach and the GL-based results will even out. The question is not “if” risk will eventually surface, but when and how it will manifest itself in GL results. We’ve seen a lot of this in the news the past eighteen months – and there’s likely more to come as the economy is in a downturn phase. Going through the effort is worth it Once risk is created by making a loan or placing a bet, someone owns it. The reason to go through the effort to price loans (and relationships) on a fully risk-adjusted basis is to understand the impact of risk at the only point in time when you can do something about getting paid for it – at the time the loan is agreed upon. After that, the bank is pretty much along for the ride. Risk-adjusted pricing is smart banking. It not only puts some teeth in the bank’s already existing risk management policies, it is justifiable to the client and it makes sense to most lending officers.
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