Credit Lending
By: Tracy Bremmer It’s not really all about the credit score. Now don’t get me wrong, a credit score is a very important tool used in credit decision making; however there’s so much more that lenders use to say “accept” or “decline.” Many lenders segment their customer/prospect base prior to ever using the score. They use credit-related attributes such as, “has this consumer had a bankruptcy in the last two years?” or “do they have an existing mortgage account?” to segment out consumers into risk-tier buckets. Lenders also evaluate information from the application such as income or number of years at current residence. These types of application attributes help the lender gain insight that is not typically evaluated in the traditional risk score. For lenders who already have a relationship with a customer, they will look at their existing relationships with that customer prior to making a decision. They’ll look at things like payment history and current product mix to better understand who best to cross-sell, up-sell, or in today’s economy, down-sell. In addition, many lenders will run the applicant through some type of fraud database to ensure the person really is who they say they are. I like to think of the score as the center of the decision, with all of these other metrics as necessary inputs to the entire decision process. It is like going out for an ice cream sundae and starting with the vanilla and needing all the mix-ins to make it complete.
-- 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.
The debate continues in the banking industry -- Do we push the loan authority to the field or do we centralize it (particularly when we are talking about small business loans)? A common argument for sending the loan authority to the field is the improved turnaround time for the applicant. However reality is that centralized loan authority actually provides a decision time almost two times faster than those of a decentralized nature. The statistics supporting this fact are from the Small Business Benchmark Study created and published by Baker Hill, a Part of Experian, for the past five years. Based upon the 2008 Small Business Benchmark Study, those institutions with assets of $20 billion to $100 billion used only centralized underwriting and provided decisions within 2.5 days on average. In contrast, the next closest category ($2 billion to $20 billion in assets) took 4.4 days. Now, if we only consider the time it takes to make a decision (meaning we have all the information needed), the same disparity exists. The largest banks using solely centralized underwriting took 0.8 days to make a decision, while the next tier ($2 billion to $20 billion) took an average 1.5 days to make a decision. This drop in centralized underwriting usage between these two tiers was simply a 15 percent change. This means that the $20 billion to $100 billion banks had 100% usage of centralized underwriting while the $2 billion to $20 billion dropped only to 85% usage. Eighty-five percent is still a strong usage percentage, but it has a significant impact on turnaround time. The most perplexing issue is that the smaller community banks are consistently telling me that they feel their competitive advantages are that they can respond faster and they know their clients better than bigger, impersonal banks. Based upon the stats, I am not seeing this competitive advantage supported by reality. What is particularly confusing is that the small community banks, that are supposed to be closest to the client, take twice as long overall from application receipt to decision and almost three times as long when you compare them to the $20 billion to $100 billion category (0.8 days) to the $500 million to $2 billion category (2.2 days). As you can see - centralized underwriting works. It is consistent, provides improved customer service, improved throughput, increased efficiency and improved credit quality when compared to the decentralized approach. In future blogs, I will address the credit quality component.
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.
We have talked about: the creation of the vision for our loan portfolios (current state versus future state) – e.g. the strategy for moving our current portfolio to the future vision. Now comes the time for execution of that strategy. In changing portfolio composition and improving credit quality, the discipline of credit must be strong (this includes in the arenas of commercial loan origination, loan portfolio monitoring, and credit risk modeling of course). Consistency, especially, in the application of policy is key. Early on in the change/execution process there will be strong pressure to revert back to the old ways and stay in a familiar comfort zone. Credit criteria/underwriting guidelines will have indeed changed in the strategy execution. In the coming blogs we will be discussing: assessment of the current state in your loan portfolio; development of the specific strategy to effect change in the portfolio from a credit quality perspective and composition; business development efforts to affect change in the portfolio composition; and policy changes to support the strategy/vision.
By: Tom Hannagan 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.
By: Prince Varma Hello. My name is Prince Varma and I’ve spent the better part of the last 16 years helping financial institutions (FI) successfully improve their in business development, portfolio growth and client relationship management practices. So, since the focus of this blog is to speak to readers about risk management, many of you are probably wondering what a “sales and business development” guy is doing writing a piece related to mitigating and managing risk? Great question! The simple fact is that the traditional or prevailing sentiment or definition related to risk management – mitigating credit risk -- is incomplete. A more accurate and comprehensive approach would be to recognize, acknowledge and address that “risk” cuts across the entire client relationship spectrum of: client penetration/growth; client retention; and client credit risk mitigation. How do penetration and retention count as “risk factors”? (this is where the sales guy stuff comes in) From a penetration perspective, the failure to recognize potential opportunities either within the existing client base or in the operating market, introduces revenue growth risk (meaning we aren’t keeping our eye on the top line). Ultimately it impacts the FI’s ability to add assets (either deposits or loans) and also has a direct affect on efficiency and deposit to loan ratios. From a retention perspective, the risk is even more obvious. Our most valued clients are the ones that we must continuously engage in a proactive manner. Let’s face it. In even the smallest markets, there are no less than four to six other institutions waiting to jump on your client in the event that you grow complacent. There is a huge difference between selection and satisfaction. And, if we aren’t focused on keeping a client after securing them, our net portfolio growth targets will be impossible to achieve. Considering the current market environment, now more than ever, effectively managing these three elements of “risk/exposure to the FI” is crucial to an institutions success both practically and pragmatically. Everyone internally at the bank is focused on the “credit risk mitigation” piece. The conversations that are occurring outside of the bank’s walls however are focused on the “L” word or liquidity and getting credit flowing again. How many times have we read or more frankly been beaten with this comment from business owners “…there’s no one making loans anymore…” or “…its impossible to get credit…?” That should be read as … penetration and retention Striking a balance between effective and appropriate credit risk exposure and deepening or growing the portfolio has been a challenge facing those of us in the front office for as long as I can remember. The “sales revolution” is effectively over. We’ve learned the critical lesson that we need to evolve beyond being strictly a credit officer (you did learn that right??!!). And, you didn’t/shouldn’t become a “banking products generalist” with no analytical depth. Knowing all this, it is important that we return to the guiding principles of effective lending which include: - evaluating the scope of the opportunity; - isolating the risk and identifying a reasonable and realistic recovery/mitigation remedy; - determining what other alternatives the borrower might be considering; and - being willing to let the “bad deals” walk. In subsequent blogs, I’ll provide you with specific tactics aimed at optimizing penetration and retention efforts and implementing effective and practical client management strategies. After all what would you expect from a business development guy…
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.
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 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.
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.
Learn More Image
