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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…

When you begin thinking about financial risk management, you must begin with a vision for your loan portfolio and the similarity of a loan portfolio to that of an investment portfolio.  Now that you have that vision in place, we can focus on the overall strategy to achieve that vision. A valuable first step in loan portfolio monitoring is to establish a targeted value by a certain time (say, our targeted retirement age).  Similarly, it’s important that we establish our vision for the loan portfolio regarding overall diversification, return and the management of risk levels. The next step is to create a strategy to achieve the targeted state.  By focusing on the gaps between our current state and the vision state we have created, we can develop an action plan for achieving the future/vision state.  I am going to introduce some rather unique ideas here. Consider which of your portfolio segments are overweight?  One that comes to mind would be the commercial real estate portfolio.  The binge that has taken place over the past five plus years has resulted in an unhealthy concentration of loans in the commercial real estate segment.  In this one area alone, we will face the greatest challenge of right-sizing our portfolio mix and achieving the appropriate risk model per our vision. We have to assess our overall credit risk in the portfolios next.  For small business and consumer portfolios, this is relatively easy using the various credit scores that are available to assess the current risk.  For the larger commercial and industrial portfolios and the commercial real estate portfolios, we must employ some more manual processes to assess risk.  Unfortunately, we have to perform appropriate risk assessments (current up-to-date risk assessments) in order to move on to the next stage of this overall process (which is to execute on the strategy). Once we have the dollar amounts of either growth or divestiture in various portfolio segments, we can employ the risk assessment to determine the appropriate execution of either growth or divestiture.

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.

Part 3 Reducing operational and overhead costs starts with the automation of tasks that would otherwise be performed by a human resource. By leveraging an advanced segmentation approach, it is possible to better identify accounts that will not require collector intervention. While automation is not a new concept to collections, significant benefits of modern systems include: • enabling more functions to be automated; • effectiveness of the automated functions to be validated; and • more changes made per year versus legacy systems. Fixing a bad phone number: The old way To illustrate effective automation, let’s use an example where an account is found to have a bad phone number. A common approach to this problem might be for the outbound collector to route the account to a skip specialist who can perform research. This often has the receiving party starting the process after the nightly batch process has transferred the account across departments. If a phone number is found, the account may be manually routed back to an outbound queue and if not, a no-contact letter may be generated. Additionally, there are tasks that need to be performed such as noting accounts that consume a collector’s time. Fixing a bad phone number: The new way A more efficient and cost-effective approach would be for the employee identifying the need for a new number to click a pre-defined button to let the collections system know of the issue. The system could then automatically call out to an external data source to: • collect the new number; • repopulate the appropriate field; • reroute the account back to the most appropriate outbound queue; • log a history of all automated functions performed, and • do all of this within just a few seconds! If the appropriate number cannot be located, the system would know which letter to send and then route the account to the most appropriate holding queue. Reducing operational costs After automation, the operational costs are further reduced by identifying which actions can be effectively replaced by lower-cost options that yield the same results, or even eliminating actions that present no substantial value. For example, why make a call when a letter will suffice? And what happens if we subsequently replace that letter with a text message or take no action at all? Intelligent features of modern systems such as champion/challenger testing can be employed to support a continuous learning process that increases the financial benefits of automation as experience and knowledge is gained. As new automation is introduced and validated as beneficial, other improvement theories can be tested and subsequently abandoned or adopted. Considering the possible impact of automation and action reductions on cost savings let’s assume that three dial attempts are made on the average delinquent account in the first 30 days at a cost of 25 cents each and on the fourth attempt there is a right party contact, which costs an additional $2.50 (assuming the talk time is five minutes). Adding one letter at 75 cents, we have a total cost to collect of $4.00 before the account hits 31 days past due. With 250,000 customers entering collections each month, we can save $200,000 each month in the early stage alone with just a 20 percent improvement. This result could easily be achieved by reducing talk time and eliminating unnecessary actions or unproductive call attempts. Annually that adds up to approximately $2.5 million dollars in savings, in this example. Champion/challenger tests, as well as, the improved functionality of modern systems can also be extended beyond the in-house work stream. Evaluating and comparing external agencies can significantly improve agency performance as well as enable the lender to better manage placement costs. For example, if a lender allocates 1,000 accounts to an external agency each month, with an average balance of $3,000, the total dollars allocated annually is $36 million. If 22 percent of the debt is collected and a 25 percent commission is charged, the net to the lender is nearly $6 million. Improving that return by a mere 4 percent through better allocation strategies, which is a conservative goal, we add another million to the bottom line each year. By factoring in the ability of next generation collections systems to automate most aspects of the placement process itself, including recalling accounts, we further improve efficiencies, free up valuable resources and allow management greater control of the process. Additional benefits of functionally rich modern systems also enable management to grant external resources various levels of remote access to the collections systems to better monitor activities and ensure that transactional data is properly captured. In addition to granting external agencies remote access, modern collections systems can also enable collectors to work from home-based workstations to further reduce operational costs. Many industry analysts see this as an emerging trend over the next few years, particularly when productivity can be monitored in real-time. My next blog will continue the discussion on the benefits of next generation collections systems and will provide details on improved change management processes.  

Back during World War I, the concept of “triage” was first introduced to the battlefield.  Faced with massive casualties and limited medical resources, a system was developed to identify and select those who most needed treatment and who would best respond to treatment.  Some casualties were tagged as terminal and received no aid; others with minimal injuries were also passed over.  Instead, medical staff focused their attentions on those who required their services in order to be saved.  These were the ones who needed and would respond to appropriate treatment. Our clients realize that the collections battlefield of today requires a similar approach.  They have limited resources to face this mounting wave of delinquencies and charge offs.  They also realize that they can’t throw bodies at this problem. They need to work smarter and use data and decisioning more effectively to help them survive this battle.Some accounts will never “cure” no matter what you do.  Others will self-cure with minimal or no active effort. Taking the right actions on the right accounts, with the right resources, at the right time is best accomplished with advanced segmentation that employs behavioral scoring, bureau-based scores and other relevant account data. The actual data and scores that should be used depend on the situation and account status, and there is no one-size-fits-all approach.Future related articles will dive deeper into the various segmentation approach options and explain how advanced decisioning provides additional benefit over the score-only methods. 

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.

Part twoImproved collector productivity and cash flow is the concept of doing more work with existing staff or doing the same amount of work with fewer human resources. In its most simplistic form, the associated metric is the number of cases worked per employee in a given amount of time. While the definition of cases worked can be open to interpretation, the most common qualifier is that an action from a pre-defined list must be executed and documented for each account.When leveraging modern technology to achieve these results, the first objective is to channel the accounts that benefit the most from human intervention. Real-time segmentation that considers the most current status of the case is a key feature in new systems that ensure accounts are placed in the right place at the right time. This makes certain that accounts find their way to the most appropriate skill level so that less experienced staff are not overwhelmed and more experienced staff are not tasked with easier activities that distract them from solving more complex situations.  Context-sensitive screens and menus can further improve the productivity gains when collectors are working accounts. When collectors have the data they need to perform a task or make a decision without having to sift through irrelevant information, handling time is significantly reduced.  Refreshing the screens and menus in real time as an account status changes is another key feature in today’s technology that ensures the appropriate information is always presented to the collector.Real-time scriptingReal-time scripting that is capable of being updated along with the changing situation is another productivity contributor, as is user-friendly screens. Not only is handling time further reduced, but gains can be found in significantly shorter training time for new staff members. Enabling the business users to change screen content, scripting, menus and visual aids on the fly is a powerful benefit of next generation collections systems. The ability to support champion / challenger testing for any visual or screen content changes further enables the organization to test and validate work stream improvements. In addition to the benefits mentioned above, advanced scripting and on-line help can significantly assist an organization to adhere to legal and compliance requirements.Real-time segmentationReal-time segmentation, coupled with context sensitive screens that refresh as the account situation changes (even in the midst of a negotiation) facilitate more effective negotiations. This lets collectors send more appropriate and relevant messaging to customers.  Further improvements can be attributed to enabling a holistic view of the customer relationship and the relevance and effectiveness will be more consistent across the organization. The net effect is collecting more dollars per negotiation from the same population of customers that will be contacted in a faster manner.Real-time segmentation of accounts also provides the added benefit of keeping accounts in an active status and as a result makes your collections work stream more efficient. Not being dependent upon a batch process to update and route accounts ensures that each case is always in the right place at the right time and never in a holding pattern awaiting a transfer between work queues or departments. As a result, the organization will see more efficient case handling and a faster collection of debt.Improved productivity and real-time dashboardingImproved productivity reporting and real-time dashboarding enable line managers to provide appropriate feedback to collectors to make certain that Key Performance Indicators (KPI) goals are met on a regular basis. The resources in need of coaching or training can be identified before the substandard performance significantly reduces team objectives and collectors that excel can be provided with timely and accurate positive reinforcement.Gains in productivityWhen migrating to modern technology, it is very common that organizations experience at least a 20 percent gain in productivity improvement initially. This equates to the possibility of 20 fewer headcount in a team of 100 to handle the same workload. Alternatively, the existing team could handle 20 percent more accounts with approximately the same average results per account. Assuming a fully loaded cost of $50,000 a year per headcount, a 20 percent productivity boost in this example would roughly translate to a million dollars annually in financial benefit. When considering the additional benefit of reduced cost of training, this number will be even higher.Thanks for coming back. My next two blogs will provide additional details on the benefits of next generation collections systems including reduced operational and overhead costs and improved change management process.Stay tuned! 

Part oneIn today’s collections environment, the challenges of meeting an organization’s financial objectives are more difficult than ever.  Case volumes are higher, accounts are more difficult to collect and changing customer behaviors are rendering existing business models less effective.When responding to recent events, it is not uncommon for organizations to take what may seem to be the easiest path to success — simply hiring more staff. Perhaps in the short-term there may appear to be cash flow improvements, but in most cases this is not the most effective way to cope with long-term business needs. As incremental staff is added to compensate for additional workloads, there is a point of diminishing return on investment and that point can be difficult to define until after the expenditures have been made. Additionally, there are almost always significant operational improvements that can be realized by introducing new technology and the relevant ROI models often forecast very accurately.So, where should a collections department consider investing to improve financial results? The best option will probably not be the obvious choice and the mere thought can make the most seasoned collections professionals shudder … replace the core collections system with modern technology.That said, let’s consider what has changed in recent years and explore why the replacement proposition is not nearly as difficult or costly as it once was. In addition, I’ll discuss how the value proposition typically makes this option extremely appealing today.The collections system software industry is on the brink of a technology evolution to modern, next-generation offerings. Legacy systems are typically inflexible and do not allow for an effective change management program. This handicap leaves collections departments unable to keep up with rapidly changing business objectives that are a critical requirement in surviving through these tough economic times. Today’s collections managers face the need to reduce operational costs while improving other objectives such as reducing losses, improving cash flow and promoting customer satisfaction (particularly with customers that pose a greater lifetime profit opportunity).  The next generation collections software squarely addresses these business problems and provides significant improvement over legacy systems. Not only is this modern technology now available, but, the return on investment models are extremely compelling and have been proven in markets where successful implementations have already occurred.This blog is the first of a four part series. I will continue to explain, in detail, the benefits of next generation collections systems while specifically focusing on improved productivity and cash flow; reduced operational and overhead costs; and improved change management processes.Please check back soon! 

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.