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Part 2 To continue the discussion from my last post, we also must realize that the small business borrower typically doesn’t wait until we are ready to perform our regularly scheduled risk management review to begin to show problems.  While a delinquent payment is a definite sign of a problem with the borrower, the occurrence of a delinquent payment is often simply too late for any type of corrective action and will result in a high rate of loss or transfer to special assets. There are additional pitfalls around the individual risk rating of the small business borrower or the small business loans; but, I won’t discuss those here.  Suffice to say, we can agree that the following holds true for portfolio risk management of small business loans: Active portfolio management is a must; Traditional commercial portfolio management techniques are not applicable due to the cost and effectiveness for the typical small business portfolio; and Collection efforts conducted at the time of a delinquency is too late in the process. One last thing, the regulators are starting to place higher demands on financial institutions for the identification and management of risk in the small business portfolio.  It is becoming urgent and necessary to take a different approach to monitor that portfolio. Just as we have learned from the consumer approach for originating the loans, we can also learn from the basic techniques used for consumer loan portfolio risk management. We have to rely upon information that is readily available and does not require the involvement of the borrower to provide such information.  Basically, this means that we need to gather information (such as updated business scores and behavioral data) from our loan accounting platforms to provide us with an indication of potential problems.  We need to do that in an automated fashion.  From such information we can begin to monitor: Changes in the business score of the small business borrower; Frequency and severity of delinquencies; Balances maintained on a line of credit; and Changes in deposit balances or activity including overdraft activity. This list is not exhaustive, but it represents a solid body of information that is both readily available and useful in determining the risk present in our small business portfolio.  With technology enabling a more automated assessment of these factors, we have laid the groundwork to develop an efficient and effective approach to small business portfolio management.  Such an approach provides real- time regular assessment of the portfolio, its overall composition and the necessary components needed to identify the potential problem credits within the portfolio. It is past time to take a new approach toward the proactive portfolio management of our small business loan portfolio retaining the spirit of commercial credit while adapting the techniques of consumer portfolio management to the small business portfolio.

Part 1 In reality, we are always facing potential issues in our small business portfolio, it is just the nature of that particular beast. Real problems occur, though, when we begin to take the attitude that nothing can go wrong, that we have finally found the magic formula that has created the invincible portfolio.  We’re in trouble when we actually believe that we have the perfect origination machine to generate a portfolio that has a constant and acceptable delinquency and charge-off performance. So, we all can agree that we need to keep a watchful eye on the small business portfolio.  But how do we do this?  How do we monitor a portfolio that has a high number of accounts but a relatively low dollar amount in actual outstandings? The traditional commercial portfolio provides sufficient operating income and poses enough individual client credit risk that we can take the same approach on each individual credit and still maintain an acceptable level of profitability.  But, the small business portfolio doesn’t generate sufficient profitability nor has individual loan risk to utilize the traditional commercial loan portfolio risk management techniques. Facing these economic constraints, the typical approach is to simply monitor by delinquency and address the problems as they arise.  One traditional method that is typically retained is the annual maturity of the lines of credit.  Because of loan matures, financial institutions are performing annual renewals and re-underwriting these lines of credit -- and complete that process through a full re-documentation of the line. We make nominal improvements in the process by changing the maturity dates of the lines from one year to two or three year maturities or, in the case of real estate secured lines, a five year maturity.  While such an approach reduces the number of renewals that must be performed in a particular year, it does not change the basic methodology of portfolio risk management, regularly scheduled reviews of the lines.  In addition, such methodology simply puts us back to the use of collections to actually manage the portfolio and only serves to extend the time between reviews. Visit my next post for the additional pitfalls around individual risk rating and ways to better monitor your small business portfolio.

By: Tom Hannagan I have referred to risk-adjusted commercial loan pricing (or the lack of it) in previous posts. At times, I’ve commented on aspects of risk-based pricing and risk-based bank performance measurement, but I haven’t discussed what risk-based pricing is -- in a comprehensive manner. Perhaps I can begin to do that now and in my next posts. Risk-based pricing analysis is a product-level microcosm of risk-based bank performance. It begins by looking at the financial implications of a product sale from a cost accounting perspective. This means calculating the revenues associated with a loan, including the interest income and any fee-based income.  These revenues need to be spread over the life of the loan, while taking into account the amortization characteristics of the balance (or average usage for a line of credit). To save effort (and to provide good client relationship management), we often download the balance and rate information for existing loans from a bank’s loan accounting system. To “risk-adjust” the interest income, you need to apply a cost of funds that has the same implied market risk characteristics as the loan balance. This is not like the bank’s actual cost of funds for several reasons. Most importantly, there is usually no automatic risk-based matching between the manner in which the bank makes loans and the term characteristics of its deposits and/or borrowing. Once we establish a cost of funds approach that removes interest rate risk from the loan, we subtract the risk-adjusted interest expense from the revenues to arrive at risk-adjusted net interest income, or our risk-adjusted gross margin. We then subtract two types of costs. One cost includes the administrative or overhead expenses associated with the product. Our best practice is to derive an approach to operating expense breakdowns that takes into account all of the bank’s non-interest expenses. This is a “full absorption” method of cost accounting. We want to know the marginal cost of doing business, but if we just apply the marginal cost to all loans, a large portion of real-life expenses won’t be covered by resulting pricing. As a result, the bank’s profits may suffer. We fully understand the argument for marginal cost coverage, but have seen the unfortunate end. Using this lower cost factor can hurt a bank’s bottom line. Administrative cost does not normally require additional risk adjustment, as any risk-based operational expenses and costs of mitigating operation risk are already included in the bank’s general ledger for non-interest expenses. The second expense subtracted from net interest income is credit risk cost. This is not the same as the bank’s provision expense, and is certainly not the same as the loss provision in any one accounting period.  The credit risk cost for pricing purposes should be risk adjusted based on both product type (usually loan collateral category) and the bank’s risk rating for the loan in question. This metric will calculate the relative probability of default for the borrower combined with the loss given default for the loan type in question. We usually annualize the expected loss numbers by taking into account a multi-year history and a one- or two-year projection of net loan losses. These losses are broken down by loan type and risk rating based on the bank’s actual distribution of loan balances. The risk costs by risk rating are then created using an up-sloping curve that is similar in shape to an industry default experience curve. This assures a realistic differentiation of losses by risk rating. Many banks have loss curves that are too flat in nature, resulting in little or no price differentiation based on credit quality. This leads to poor risk-based performance metrics and, ultimately, to poor overall financial performance. The loss expense curves are fine-tuned so that over a period of years the total credit risk costs, when applied to the entire portfolio, should cover the average annual expected loss experience of the bank. By subtracting the operating expenses and credit risk loss from risk-adjusted net interest income, we arrive at risk-adjusted pre-tax income. In my next post I’ll expand this discussion further to risk-adjusted net income, capital allocation for unexpected loss and profit ratio considerations.

By: Tom Hannagan Here’s a further review of results from the Uniform Bank Performance Reports, courtesy of the FDIC, through the third quarter of this year. (See my Dec. 18 post.) The UBPR is based on quarterly call reports that insured banks are required to submit. I wanted to see how the various profit performance components compare to the costs of credit risks discussed in my previous post. The short of it is that banks have a ways to go to be fully pricing for both expected and unexpected risk. (See my Dec. 5 blog dealing with risk definitions.) The FDIC compiles peer averages for various bank size groupings. Here are some findings for the two largest groups, covering 490 reporting banks. Here are the results: Peer Group 1 consists of 186 institutions with over $3 billion in average total assets for the first nine months. • Net interest income was 5.34 percent of average total assets for the period. This is down, as we might expect based on this 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 2.16 percent for the nine months to September 30th. • Net interest margin, the difference between the two metrics, was down slightly from 3.16 percent in 2007 to 3.14 percent so far in 2008, or a loss of 2 basis points. It should be noted that net interest margins have been in steady decline for at least ten years, with a torturous regular drop of 2 to 5 basis points per annum in recent years. This year’s drop is not that bad, although it does add to the difficulty in generating bottom-line profits. To find out a bit more about the drop in margins, especially in light of the steady increase in lending over the same past decade, I looked at loans yields. • Loan yields averaged 6.22 percent for 2008, down (again, expectedly) from 7.32 percent in 2007. This is a drop of 110 basis points or a decline of 15 percent. • Meanwhile, rates paid on interest-earning deposits dropped from 3.41 percent in 2007 to 2.48 percent so far in 2008. This 93 basis point decline represents a 27 percent lower cost of interest-bearing deposits.   It seems as though margins should have improved somewhat -- not declined for these banks.   Digging a bit deeper, I see two possible reasons. • First, total deposit balances declined from 72 percent of average assets to 70 percent, meaning a larger amount had to be borrowed to fund assets. • Second, non-interest bearing demand deposits declined from 4.85 percent of average assets to 4.49 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. Unfortunately, the ”big news” is that margins were only down a bit. Let’s move on to fee income. Non-interest income, again, as a percent of average total assets, was down to 1.14 percent from 1.23 percent in 2007. For this bank group, 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 – and, thus, a source of pressure on fee income. Operating expenses constituted some good news as they declined from 2.63 percent to 2.61 percent of average assets. That’s 2 basis points to the good. Hey, an improvement is an improvement. Historically this metric has generally moved down, but irregularly from year to year. The number stood at 2.54 percent in 2006, for instance. As a result of the slight decline in margins and the larger percentage decline in fee income, the Peer Group 1 efficiency ratio lost ground from 57.71 percent in 2007 to only 58.78 percent in 2008. That means the every dollar in gross revenue [net interest income plus fee income] cost them almost 58 cents in administrative expenses so far this year. This metric averaged 55 cents in 2005/2006. The total impact of margin performance, fee income and operating expenses, if you’ve been tallying along, is a net decline of 0.09 percent on total assets. When we add this to the 2008 increase in provision expense of 57 basis points, we arrive at a total decline in pre-tax operating income of 0.66 percent on total assets. (See my Dec. 18 post.) That is a total decline of 44 percent from the pre-tax performance in 2007 for banks over $3 billion in assets. It would appear that banks are not pricing enough risk into their loan rates yet – for their own bottom line performance. 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 investment grade and other corporate bonds. They are probably at extremes but still they say more credit risk is present than bank lending rates/yields would indicate.   For Peer Group 2, consisting of 304 reporting banks between $1 billion and $3 billion in assets: • Net interest income was 5.87 percent of average total assets for the period. This is also down, as expected, from 6.73 percent in 2007. • Net interest expense was also down from 3.07 percent in 2007 to 2.39 percent for the nine months to September 30th. • Net interest margin, was down from 3.66 percent in 2007 to 3.48 percent so far in 2008, or a loss of 18 basis points. These margins are at somewhat higher levels than found in Peer Group 1, but the drop of .18 percent was much larger than the decline in Peer Group 1.   As with all banks, net interest margins have been in steady chronic decline, but the drops for Peer Group 2 have been coming in larger chunks the last two years, down 18 points this year so far, after dropping 16 points from 2006 to 2007. Behind the drop in margins, loans yields are 6.69 percent for 2008, down from 7.82 percent in 2007. This is a drop of 113 basis points or a decline of 14 percent. Meanwhile rates paid on interest-earning deposits dropped from 3.70 percent in 2007 to 2.85 percent so far in 2008. This 85 basis point decline represents a 23 percent lower cost of interest-bearing deposits. Again, with a steeper decline in interest costs, you’d think margins should have improved somewhat. That didn’t happen. I notice the same two culprits. • Total deposit balances declined from 78 percent of average assets to 76 percent, meaning, again, a larger amount had to be borrowed to fund assets. • Also, non-interest bearing demand deposits continued an already steady decline from 5.58 percent of average assets in 2007 to 5.08 percent.   Fewer deposit balances relative to total asset size…along with a lower proportion of interest-cost-free deposits…and we know the result. Now, about fee income for these banks… Non-interest income, again as a percent of average total assets, was down to 0.92 percent from 0.95 percent in 2007. For this bank group, 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, without other new and offsetting sources of fee income, will mean pressure on this metric. Operating expenses constituted some good news here as well. They declined from 2.79 percent to 2.75 percent of average assets. That’s 4 basis points to the good. Historically this metric has been flatter for this size bank, moving up or down a bit from year to year. As a result of the not-so-slight decline in margins and the continued decline in fee income, the Peer Group 2 efficiency ratio lost ground from 59.52 percent in 2007 to only 61.86 percent in 2008. That means the every dollar in gross revenue cost these banks almost 62 cents in administrative expenses so far this year. This metric averaged 56 cents in 2005/2006. The total impact of margin performance, fee income and operating expenses is a net decline of 0.17 percent on total assets. When we add this to the 2008 increase in provision expense of 36 basis points, we arrive at a total decline in pre-tax operating income of 0.53 percent on total assets. (See my Dec. 18 post.) That is a total decline of 34 percent from the pre-tax performance in 2007. As I concluded above, more credit risk is present than bank lending rates/yields would indicate. Although all 490 banks are declining in efficiency, the larger banks have a scale edge in this regard. The somewhat smaller banks seem to have an edge in pricing loans, but not regarding deposits. Although up dramatically in 2007 and even more this year for both groups, the Peer Group 2 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. It’s interesting to note that, with higher loan yields and fewer apparent losses, Peer Group 2 banks are somewhat better at risk-adjusted loan pricing than the largest bank group. Results are results. The fourth quarter numbers aren’t expected to show a lot of improvement as the general economy continues to slow and credit issues continue. I’ll comment on entire year’s results in posts early next year.     Next year, too, look for my comments on risk management solutions especially relevant to enterprise risk management.

By: Tom Hannagan I reviewed the Uniform Bank Performance Reports (UBPR: (http://www2.fdic.gov/ubpr/ReportTypes.asp ) for selected clients through the third quarter of this year. The 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.   Here are a few findings for the two largest groups, covering 490 banks. Peer Group 1 consists of 186 institutions over $3 billion in average total assets for the first nine months. Net loans accounted for 67.59 percent of average total assets, up from 65.79 percent in 2007. Loans, as a percent of assets, have increased steadily since at least 2005. The loan-to-deposit ratio for the largest banks was also up to 97 percent, from 91 percent in 2007 and 88 percent in both 2006 and 2005. So, it appears these banks are lending more, at least through the September quarter, as an allocation of their asset base and relative to their deposit source of funding. In fact, net loans grew at a rate of 11.51 percent for the group through September, which is down from the average growth rate of 15.07 percent for the years 2005 through 2007.  But, it is still growth. For Peer Group 2, consisting of 304 reporting banks between $1billion and $3 billion in assets, net loans accounted for 72.57 percent of average total assets, up from 71.75 percent in 2007. Again, the loans as a percent of assets have increased steadily since at least 2005. The loan-to-deposit ratio for these banks was up to 95 percent, from 92 percent in 2007 and an average of 90 percent for 2006 and 2005. So, these banks are also lending more, at least through the September quarter, as a portion of their asset base and relative to their deposit source of funding. In fact, net loans grew at a rate of 12.57 percent for the group through September, which is up from 11.94 percent growth in 2007 and down from an average growth of 15.04 percent for 2006 and 2005.  Combined, for these 490 largest institutions, loans were still growing through September. More loans probably mean more credit risk. Credit costs were up. The Peer Group 1 banks reported net loan losses of 0.67 percent of total loans, up from 0.28 percent in 2007, which was up from an average of 18 basis points on the portfolio in 2006/2005.  The Group 2 banks reported net loan losses of 0.54 percent, also up substantially from 24 basis points in 2007, and an average of 15 basis points in 2006/2005. Both groups also ramped up their reserve for future expected losses substantially. The September 30th allowance for loan and lease losses (ALLL) as a percent of total loans stood at 1.52 percent for the largest banks, up from 1.20 percent in 2007 and an average of 1.11 percent in 2006/2005. Peer Group 2 banks saw their allocation for losses up to 1.40 percent from 1.22 percent in 2007 and 1.16 percent in 2006. So, lending is up even in the face of increased write-offs, increased expected losses and the burden of higher expenses for these increased loss reserves. Obviously, we would expect this to negatively impact earnings. It did, greatly. Peer Group 1 banks saw a decline in return on assets to 0.42 percent, from 0.96 percent in 2007 and an average of 1.26 percent in 2006/2005. That is a decline in return on assets (ROA) of 56 percent from 2007 and a decline of 68 percent from the 2006/2005 era. Return on equity declined even more. ROE was at 5.21 percent through September for the large bank group, down from 11.97 percent in 2007. ROE stood at 14.36 percent in 2005. For the $1 billion to $3 billion banks, ROA stood at 0.66 percent for the nine months, down from 1.08 percent in 2007, 1.30 percent in 2006 and 1.33 percent in 2005. The decline in 2008 was 39 percent from 2007. Return on equity (ROE) for the group was also down at 7.71 percent from 12.37 percent in 2007. The drops in profitability were not entirely the result of credit losses, but this was by far the largest impact from 2007 and earlier. The beefed-up ALLL accounts would seem to indicate that, as a group, the banks expect further loan losses in the remainder of 2008 and into 2009.  All of these numbers pre-dated the launch of the TARP program, but it is clear that banks had not contracted lending through the first three quarter of 2008, even in the face of mounting credit issues, cost of credit, challenges regarding loan pricing and profitability, net interest margins,  and the generally declining economic picture. It will be interesting to see how things unfold in the next several quarter [See my December 5th post about ROE versus ROA.] Disclosure: No positions.

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. More to come.

By: Tom Hannagan For the last 16 months or so, the financial services industry has been indicted, tried, found guilty, sentenced and duly executed for ignoring accepted enterprise risk management practices.  Banks, albeit along with goofy risk ratings agencies, lax regulators, and greedy leveraged investors, have been blamed for abandoning normal and proper credit risk behavior and lending to many who did not meet basic debt servicing capability. After things went terribly wrong in capital and liquidity markets, followed by a now-official recession in the “real” economy, banks have tightened lending standards.  (See my blog posted November 13th for more about tightened lending.)   Now, following the TARP capital infusion, the press and Congress seem very upset that banks aren’t rapidly expanding their lending, or even moderating their credit risk regimen.  This dismay, with the lack of an immediate expansion of credit granting, occurs in the face of what the same press and most politicians refer to as the greatest economic meltdown since the Great Depression.   Granted, banks are historically easy whipping boys, but they now seem damned for what they did and damned if they don’t do some more of it. Although suffering in many ways, most banks are still for-profit organizations. Contrary to popular belief, they also actually have credit policies and processes that are aimed at responsible credit risk management – at least for the loans they intend to keep on their own books. Average management intelligence would dictate being cautious in the middle of an economic downturn.   The TARP capital infusion is a sudden large windfall of new equity, like a 20 percent increase for the receiving banks. It begs the question of what to do with it. To grow assets proportionately to the TARP infusion would mean a very rapid (circa plus 30 percent) growth in lending in a very short timeframe. Given the prevalence of banks, it would be very difficult for all of them to grow their loan portfolios this fast even in a good economy.   Most banks do not need TARP funds to survive in the short term. And the weakest banks are not supposed to be granted TARP funds. This is like a steroid shot into the natural process of bank consolidation. It’s obvious that the stronger banks, now infused with hot capital, are using TARP funds to acquire other banks. In many cases the acquired banks have weaknesses that they could not likely overcome on their own. So, the TARP funds are addressing the over-banked state of the financial industry and probably offsetting what would otherwise have been a drain on the Deposit Insurance Fund. I maintain that this is a good, if unintended, outcome for both the industry and the taxpayers.   I’ve heard and read comments (by people who should know better) that the hoarding of TARP funds is aiding bank earnings. Some say that those earnings are protected by TARP because it offsets credit losses. This is an accounting absurdity. The TARP will only help bank earnings if and when it is deployed successfully. This, in turn, requires two things to take place: 1) leveraging up the new capital with other sources of funds; and 2) successfully investing the proceeds in assets that provide a decent risk-adjusted return. In any event, whenever a new amount of risk-based capital comes into the equity account, the ROE will suffer for a while.   Another kind of issue with TARP, even if it isn’t needed or desired by a healthy bank, is the stigma associated with not getting it. The few banks in this category have had to go out of their way to explain why they didn’t go for it. There is a concern that, even if it really isn’t needed, a bank will be at a cash and balance sheet disadvantage in the big fish eating the little fish game.   Finally, who asked for TARP to be created? Bear and Lehman went down. Merrill was rescued. Countrywide went down early and WAMU went later. Citi is now on both a heart-lung machine and dialysis. A bunch of the big boys got killed or were in serious trouble. But not all of them. And, several of them reportedly had to be coerced into taking their share of the first $125 billion. Everyone else pretty much observed the circus on Wall Street and Capital Hill.   So, policy makers, make up your mind.  Do you want banks exercising sound credit risk management practices or not?  Do you want industry consolidation or don’t you?  Do you want sounder banks to acquire relatively weaker ones or would you rather see the FDIC pick up the pieces later?  Do you want to dictate how and when private organizations allocate risk-based capital or not?  A little clarity would be appreciated.  After all, TARP was your idea.  It wasn’t requested by the industry at large. And the flow through to businesses and consumers will take a while. Sorry. It’s in everybody’s best interest that good risk management processes prevail at this time (and always) -- in granting and pricing credit, and in managing available capital. The lack of same helped get us all to this point.

In my last blog, I talked about the overall need for a vision for your loan portfolio and the similarity of a loan portfolio to that of an investment portfolio.  Now that we have that vision in place, we can focus on the overall strategy to achieve that vision. A valuable first step in managing an investment portfolio 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 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. Stick with me on this topic because in my next blog we will discuss appropriate risk assessment methodologies and determine appropriate portfolio distributions/segmentations.

By: Tom Hannagan I was hoping someone would ask about this. Return on Equity (ROE) is generally net income divided by equity, while Return on Assets (ROA) is net income divided by average assets. There you have it. The calculations are pretty easy. But, what do they mean? ROA tends to tell us how effectively an organization is taking earnings advantage of its base of assets.  This used to be the most popular way of comparing banks to each other -- and for banks to monitor their own performance from period to period. Many banks and bank executives still prefer to use ROA…though typically at the smaller banks. ROE tends to tell us how effectively an organization is taking advantage of its base of equity, or capital. This has gained in popularity for several reasons and has become the preferred measure at larger banks. One huge reason for the growing popularity of ROE is, simply, that it is not asset-dependent. ROE can be applied to any line of business or any product. You must have “assets” for ROA, since one cannot divide by zero. This flexibility allows banks with differing asset structures to be compared to each other, or even for banks to be compared to other types of businesses. The asset-independency of ROE also allows a bank to compare internal product line performance to each other. Perhaps most importantly, this permits looking at the comparative profitability of lines of business like deposit services. This would be difficult, if even possible, using ROA. If you are interested in how well a bank is managing its assets, or perhaps its overall size, ROA may be of assistance. Lately, what constitutes a good and valid portrayal of assets has come into question at several of the largest banks. Any measure is only as good as its components. Be sure you have a good measure of asset value, including credit risk adjustments. ROE on the other hand looks at how effectively a bank (or any business) is using shareholders’ equity. Many observers like ROE, since equity represents the owners’ interest in the business. Their equity investment is fully at risk compared to other sources of funds supporting the bank. Shareholders are the last in line if the going gets rough. So, equity capital tends to be the most expensive source of funds, carrying the largest risk premium of all funding options. Its deployment is critical to the success, even the survival, of the bank. Indeed, capital allocation or deployment is the most important executive decision facing the leadership of any organization. If that isn’t enough, ROE is also Warren Buffet’s favorite measure of performance. Finally, there are the risk implications of the two metrics. ROA can be risk-adjusted up to a point. The net income figure can be risk adjusted for mitigated interest rate risk and for expected credit risk that is mitigated by a loan loss provision. The big missing element in even a well risk-adjusted ROA metric is unexpected loss (UL). Unexpected loss, along with any unmitigated expected loss, is covered by capital. Further, aside from the economic capital associated with unexpected loss, there are regulatory capital requirements. This capital is left out of the ROA metric. This is true at the entity level and for any line-of-business performance measures internally. Since ROE uses shareholder equity as its divisor, and the equity is risk-based capital, the result is, more or less, automatically risk-adjusted. In addition to the risk adjustments in its numerator, net income, ROE can use an economic capital amount. The result is a risk-adjusted return on capital, or RAROC. RAROC takes ROE to a fully risk-adjusted metric that can be used at the entity level and that can also be broken down for any and all lines of business within the organization. As discussed in the last post, ROE and RAROC help a bank get to the point where they are more fully “accounting” for risk – or “unpredictable variability”. Sorry about all of the alphabet soup, but there is a natural progression that I’m pointing to that we do see banks working their way through. That progression is being led by the larger banks that need to meet more sophisticated capital reporting requirements, and is being followed by other banks as they get more interested in risk-adjusted monitoring as a performance measurement. The better bank leadership is at measuring risk-adjusted performance, using ROE or RAROC, the better leadership can become at pricing for all risk at the client relationship and product levels.

It is the time of year during which budgets are either in the works or have been completed.  Typically, when preparing budgets, we project overall growth in our loan portfolios…maybe.  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.  I’ll comment on that in my next blog entry.

By: Tom Hannagan In several posts 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.   Risk goes to both extremes. It is equally impossible to predict who will win a record amount in the lottery (a good outcome) and who will be struck by a meteor (a very bad outcome for the strikee). Both occurrences represent significant outcomes (very high variability from the norm). However, the probability of either event happening to any one of us is infinitesimally small. Therefore, the actual risk is small – not even enough to bother planning for or mitigating. That is why most of us don’t buy meteor strike insurance. It is also why most of us don’t have a private jet on order.   Most of us do purchase auto insurance, even in states that do not require it. Auto accidents (outcomes) happen often enough that actuaries can and do make a lot of good predictions as to both the number of such events and their cost impact. In fact, so many companies are good at this that they can and do compete on their prices for taking on our risk. The result is that we can economically mitigate our individual inability to predict a collision by buying car insurance.   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.   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 management, predicting and pricing for all risks leads to safer earnings performance and equity position.

The pendulum has definitely swung back in favor of the credit discipline within financial institutions. The free wheeling credit standards of the past have proven once again to be problematic. So, things like cost of credit, credit risk modeling, and scoring models are back in fashion. The trouble that we have created is that, in an effort to promote greater emphasis on the sales role, we centralized the underwriting function. This centralization allowed the sales team to focus on business development and underwriting, on credit. The unintended result, however, is that we removed the urgent need to develop credit professionals. Instead, we pushed for greater efficiencies and productivity in underwriting -- further stalling any consideration for the development of the credit professional.   Now we find ourselves with more problem credits than we have seen in the past 20 years and the pool of true credit professionals is nearly gone.   Once this current environment is corrected, let's be sure to keep balance in mind. Again, soundness, profitability and growth -- in that order of priority.

By: Tom Hannagan In previous posts, we’ve dealt with the role of risk-based capital, measuring performance based on risk characteristics and the need for risk-based loan pricing. What about risk mitigation? Some of the greatest sins of the financial industry in the current malaise have been the lack of transparency, use of complex transactions to transfer risk and the creation of off-balance-sheet entities to house dodgy investments. Much has been made of the role of Credit Default Swaps (CDSS) as one of the unregulated markets (and therefore guilty parts) of the current credit meltdown. The regulatory agencies and the media are aghast at the volume (peak of some $62 trillion in notional value) of CDSS that have resulted from a totally private market. The likes of Lehman Brothers, Bear Sterns and AIG were all big issuers of CDSS. And the trillions of notional value of open CDSS is as much as 100 times the underlying value of the actual debt being insured. There are problems here, but it may be worth clarifying the useful risk management activities from the potentially abusive excesses involving such instruments. CDSS are derivative contracts whereby one party buys credit protection from a counterparty. The buyer pays a premium to the seller either in a lump sum or periodically over the life of the contract. If a credit event such as a default on a loan or a bond occurs, the seller of the CDSS pays the holder for the loss or purchases the initial debt, the reference obligation, at a pre-set price.  So, a CDSS is in effect a put option that is deep-out-of-the-money. They expire upon termination and most are never exercised. They are subject to fair-value accounting and can change in value from month to month as the credit markets premiums for similar cover moves up or down. Banks and others can use CDSS to, in effect, adjust the nature of credit risk in their portfolios by both buying and selling such contracts. Asset securitizations, whether mortgage-backed securities or other formulations, are in fact broken-down and re-packaged forms of assets that can be sold -- transferring certain rights, values and risk to another party for payment received. They are complex and therefore mostly opaque to the general public and even many practitioners. They often involve the use of special purpose entities or trusts that can further confuse investors. These tactics have added to the difficulty of the credit crisis and the collapse of capital markets. But, CDSS are contingent in nature and act more like fire insurance or a back-up data center. Such operational expenses are intended to control risks. The accounting treatment is complex and, to an extent (especially as regards the tax treatment), still not well defined by accounting authorities. For most banks, and most CDSS contract, the premium is amortized over the life of the contract. The premium expense entry in their general ledgers is an expense of doing business that is intended to alleviate some credit risk. We are now talking about a covered CDSS, where the bank has extended credit or invested in a debt instrument. Those who purchased uncovered CDSS are gambling on a default occurrence and used CDSS as a more cost-effective (and secretive) alternative to shorting securities. It is somewhat like a naked short. So, a covered CDSS is ultimately an expense associated with protecting the net asset value of a credit transaction. Importantly, this expense should be included in any performance analysis or pricing of the risk-adjusted profitability of the credit obligation and/or client relationship involved. This risk mitigation exercise may be in lieu of a higher required rate or fee on an otherwise uncovered/unmitigated credit transaction, or being satisfied with a lower risk-adjusted return where the bank assumes (self-insures) all of the credit risk. CDSS quotes/costs, similar to rate spreads on corporate bonds, are the open market’s current feeling regarding an entity’s credit quality or relative probability of default. There are some 400 or so participants in the CDSS market, including writers and dealers. Market data is published for many obligations. Even the previously risk-free Treasury securities now have CDSS quotes – and they have gone up considerably in recent months. It is always the buyers’ responsibility to decide if the quoted prices make sense or not and how such quotes should be used in evaluating credit and negotiating lending opportunities in addition to whether or not to purchase this insurance. Finally, the quality of the seller is a consideration. There is no good reason to buy fire insurance from someone that might not be able to pay for your building if it burns down. CDSS have been private party transactions and, as stated earlier, there have been solvency problems with some of the sellers of such instruments. There is now a move under way to create a central exchange for such transactions with both regulations governing the sellers, more standardized contracts and financial backing of the instruments from the exchange. Such an exchange will address both the transparency of the process and the efficiency of market prices. Risk mitigation strategies (risk-based pricing, portfolio risk management, credit risk modeling, etc.) need to be carried out thoughtfully. If something sounds too good to be true, it deserves a deeper look. Your bank’s credit regimen may well be better at evaluating default probability than a marketplace that is prone to feed on its own fears. But, CDSS “insurance” quotes are an outside point of reference and an option to mitigate some credit risk…no pun intended. Here are two interesting sources of information: *  BNET Business Network * Georgetown University -- Law Center

Just as with diet recommendations, moderation needs to be the new motto for credit risk management.  Diets provide for the occasional bag of chips or dessert after dinner, but these same food items become problems if the small quantity or occasional indulgence suddenly becomes the norm.   Similarly, we, in our risk management efforts, put forth guidelines that establish limitations on certain loan types or categories that have been deemed risky should the numbers or quantity become too large a part of the overall portfolio.  Unfortunately, we have a tendency to allow earnings or portfolio growth to cloud our judgment and take an attitude of “just one more.”   In the past several years, we have experienced excesses in commercial real estate, residential development and subprime mortgages.  It is now these excesses that are creating the problems that we are dealing with today.   Bringing back these limitations – in other words, reestablishing the discipline in our portfolio risk management – will go a long way in avoiding these same problems in the future.   As I learned early in my banking career:  “…soundness, profitability and growth…in that order.”

By: Tom Hannagan The problem in the 2005 to 2007 home lending frenzy was not just granting credit to anyone who applied. It was giving loans to everyone at essentially the same price range regardless of normal credit risk scrutiny.   While “selling” financial services may be largely an art form, appropriate risk-based pricing is more of a science.   Although the financial press seemed to have discovered sub-prime lending in the last year or so, such high-risk lending isn’t new at all. It has been (and is still being) done since finance and money were invented. And, importantly, sub-prime lending has been done profitably by many lenders all along.  The secret to their success, not surprisingly, has always been risk-based pricing -- even if they didn’t call it that until recent times.   Sub-prime funding has been available in many forms and from many sources. Providers range from venture capitalists to pawn shops. It includes pay-day lenders, micro loans, tax refund loans, consumer finance companies, and even dates to Shakespeare’s merchant of Venice.   We often hear complaints that the effective rates (prices) on loans from such sources are unfairly high and predatory. The cost of that credit is high, but so is the risk of that credit. Without these kinds of sources, and their high rates, there would not be any credit granted from for-profit sources to high-risk borrowers.   Listed firms that regularly provide pay-day loans or cash advances to sub-prime borrowers have very high gross margins and very high credit charge-offs, compared to banks. They also have much higher risk-based capital (or equity) positions that range from 40 percent to 60 percent of their average assets. This risk-based capital burden is much higher than the 8 to 10 percent found at commercial banks. So the sub-prime lenders have a significantly larger capital cushion than banks. Most of these financial results and ratios are examples of successful risk management where the credit risks are identified, managed, priced and backed by sufficient capital.   Then…along came the rose-colored greed of the housing bubble that resulted in aggressive building and selling of homes, loan originations to all (no-down, no-income, no-assets, no-problem mortgages), securities packaging and attractive ratings, and global leveraged investing -- all by prime-oriented entities and all at prime-oriented prices. Well, obviously, it didn’t work.   Risk-based pricing of mortgages would have dissuaded many home buyers to begin with… but what would we have done with all of those shiny new homes? Realistic credit models (that took into account a full credit cycle and a huge proportion of sub-prime credits) would not have rated mortgage-backed securities as AAA. Regulators that were still focused on earnings correctness (the last major snafu) should have been looking into realistic net asset values. And highly compensated investment bankers, with 30-to-1 leverage ratios, would not have gone overboard with intuitively dodgy investments. Few of these players took risk management seriously.   The new danger is that banks are doing the whole thing in reverse. They are tightening lending standards -- which is, of course, a euphemism for shutting off credit. The danger has nothing to do with so-called credit standards. It’s the general over-reaction of shutting off credit to all borrowers, again, without regard to relative risk. The latest Federal Reserve Board survey of senior loan officers paints a picture of rapid tightening to record levels.   We feel that credit standards should always improve AND that loan pricing should always proportionately reflect risk-adjusted rates and terms. Opening the flood gates and then slamming them shut is a very pro-cyclical behavior pattern on the part of bankers that doesn’t reflect a measured approach, borrower-by-borrower, using reasonable risk management at the client relationship level.