Financial Services
By: Tom Hannagan Much of the blame for the credit disaster of 2007 and 2008 has been laid at the risk management desks of the largest banks. A silver lining in the historic financial disaster of today may be the new level of interest in management of risk -- particularly, of the relationship between capital and risk. Financial institutions of all sizes must measure and monitor their risk-based capital for three critical reasons. Ownership interest First, equity capital represents the ownership interest in a bank. Although a relatively small portion of the balance sheet, equity capital is the part that actually belongs to a bank’s owners. Everything else on the liability side is owed to depositors or lenders. All of the bank’s activities and assets are levered against the funds contributed by the equity investors. This leverage is roughly 10-to-1 for most commercial banks in the United States. For the five major investment banks, this risk-based leverage reached 30-to-1. Their capital base, even with new infusions, could not cover their losses. It is necessary and just good business sense to regularly let the owners know what’s going on as it relates to their piece of the pie—their invested funds. Owners want to know the bank is doing things well with their at-risk funds. Banks have a duty to tell them. Funding expenses Second, equity capital is by far the most expensive source of all funding. Transaction deposit funds are usually paid an effective rate of interest that is lower than short-to-intermediate-term market rates. Time depositors are competitively paid as little as possible based on the term and size of their commitment of funds. Most banks are able to borrow overnight funds at short-term market rates and longer-term funds at relatively economical AA or A ratings. Equity holders, however, have historically received (and typically expect) substantially more in the way of return on investment. Their total returns, including dividends, buybacks and enhanced market value, are usually double to triple the cost of other intermediate-to-long-term sources of funds. From a cost perspective, equity capital is the dearest funding the bank will ever obtain. Risk factor This brings us to the third reason for measuring and monitoring capital: the risk factor. A very large portion of banking regulation focuses on capital sufficiency because it directly affects a bank’s (and the banking industry’s) continued solvency. Equity capital is the last element of cushion that protects the bank from insolvency. Although it is relatively expensive, sufficient equity capital is absolutely required to start a bank and necessary to keep the bank in good stead with regulators, customers and others. Equity holders are usually conscious of the fact that they are last in line in the event of liquidation. There is no Federal Deposit Insurance Corporation (FDIC) for them, no specific assets earmarked to back their funding and no seniority associated with their invested money. We all know what “last in line” means for most shareholders if a failure occurs -- 100 percent loss. There is a clear and direct relationship between equity risk and cost—and between equity risk and expected return. It is now more important for bank executives to monitor and measure their organization’s activities based on the relative risk of those activities and based on the equity capital required to support those risks. This means using return on equity (ROE) a lot more and return on assets (ROA) a lot less. Because of the critical need and high cost of risk-based equity and the various risks associated with the business of banking, decisions about the effective deployment of capital always have been the primary responsibility of bank leaders. Now, the rest of the world is focusing more on how well, or poorly, management of risk has been done. I’ll comment on using ROE more in later posts.
For those of us that have been following the Red Flag Rules adoption for more than a year now, the recent arrival and passing of the November 1 compliance deadline allows us to pause to assess where we are -- and where we are heading. One question seems to surface regularly these days: How ready or compliant is the market today? Well, I think it’s safe to say that the market is certainly not 100% home when it comes to compliance readiness. Experian surveys registrants on our Red Flags online resource site. As of October 31 -- a.k.a. ‘Compliance Eve’ -- nearly half of the registrants (48%) fell into the category of ‘just starting to review the rules and determine a compliance plan’. Other industry surveys, interviews, and analyst reports suggest an even lower rate of compliance (closer to only one-third of covered institutions) in the market. The Federal Trade Commission seemed to sense this market condition, and granted a six-month reprieve from Red Flags compliance enforcement – to May 1, 2009. While this extension is welcome news for those institutions falling under the FTC’s jurisdictional umbrella, other institutions are arguably out of compliance today, and face pending examinations in the coming months. So, is the market ready today? The broad answer is a resounding ‘no.’ Much of the market’s effort has gone into the creation of written Identity Theft Prevention Programs as part of the Red Flag Rule requirements. How well will these written procedures be received by the examining agencies? How will these written programs translate into effective and (as importantly) manageable operational processes? The first wave of examinations will help answer some of these questions and concerns….and ongoing cost analysis (associated with: referral volumes; application acceptance rates; manual or automated processes; and, of course, fraud losses) will help paint a clearer picture in the months to come.
We know that financial institutions are tightening their credit standards for lending. But we don’t necessarily know exactly how financial institutions are addressing portfolio risk management -- how they are going about tightening those standards. As a commercial lender, when the economy was performing well, I found it much easier to get a loan request approved even if it did not meet typical standards. I just needed to provide an explanation as to why a company’s financial performance was sub-par and what changes the company had made to address that performance -- and my deal was approved. When the economy started to decline, standards were suddenly elevated and it became much more difficult to get deals approved. For example, in good times, credits with a 1.1:1 debt service coverage could be approved; when times got tough – and that 1.1:1 was no longer acceptable – the coverage had to be 1.25:1 or higher. Let’s consider this logic. When times are good, we loosen our standards and allow poorer performing businesses’ loan requests to be approved…and when times are bad we require our clients perform at much higher standards. Does this make sense? Obviously not. The reality is that when the economy is performing well, we should hold our borrowers to higher standards. When times are worse, more leniency in standards may be appropriate, keeping in mind, of course, appropriate risk management measures. As we tighten our credit belts, let’s not choke out our potentially good customers. In the same respect, once times are good, let’s not get so loose regarding our standards that we let in weak credits that we know will be a problem when the economy goes south.
Learn More Image
