Values are Contingent; Debt is Forever

As banking enters an environment of higher economic risk, the challenge is straightforward: how to successfully manage the bank given the current downturn and inherent volatility. Here are the key questions directors should be asking: First, how will your customers and your loan portfolio be affected, given the worst-case scenario of a falling stock market and a dramatically slowing economy? Senior management should methodically evaluate every significant individual credit exposure as well as those of industry sectors. Remember that true risk diversification in a geographically concentrated loan portfolio can be difficult to achieve. On the other hand, don`t go as far as one international lender once did when risk diversification came to mean it had a piece of every disaster … no matter where it happened. Second, is your capital strong enough to absorb extraordinary losses? Years ago I remember a number of well-capitalized banks (by regulatory standards) failing. The regulatory capital adequacy standard should be reviewed often. The banker`s standard should be to have enough capital to absorb the economic risks of banking, mistakes made by management and, quite simply, bad luck. Ultimately, the level of capital the bank chooses to maintain is a management and board decision, and not one that should be abdicated to the regulators. Third, how will the regulators react to current economic realities? Will regulators put career protection concerns ahead of helping the bank work through its problems? This could become a big issue for some banks as individual regulators decide whether to take an extremely hard-line or more moderate approach to what may be temporary valuation problems. As valuations fluctuate, cash flow will take on an even greater importance in analyzing individual credits. The bottom line is that management and the board are responsible for the ultimate safety and soundness of the bank, regulatory oversight notwithstanding. The good news is that strong, well-managed banks of all asset sizes will have opportunities to grow in the new economic environment, because shrewd customers, excellent employees, and long-term investors will want to be involved with quality institutions. With those questions in mind, there are three things a proactive board should do: develop a risk assessment profile, evaluate its real estate lending portfolio, and strategically plan for deflation.

Risk assessment

One approach we use to evaluate risk, called a Canary Report, focuses on establishing ratios in three major areas: credit risk, interest rate risk, and liquidity risk. Each of 15 ratios has a threshold value, which, if exceeded, highlights an area of potential regulatory concern. The rule of thumb is that if a bank exceeds the risk threshold on three ratios in any one category or on eight overall, that bank is likely to pop up on the regulators` radar for additional scrutiny. Remember that the ratios are only risk indicators. Many banks will choose as a matter of policy to exceed some thresholds, and yet they may still be fundamentally sound. For example, a highly leveraged bank, which is rapidly growing its loan portfolio in a few concentrated areas and funding the bank with short-term purchased funds, is not going to look great in its risk profile. Undergoing this type of in-depth analysis is one prudent way to ward off regulatory problems and concerns from outside constituents. In an increasingly risk-adverse world, not only regulators but also sophisticated and informed customers, whether they be primarily depositors or borrowers, will want more information on the safety and soundness of banks.

Real estate lending

A look at real estate lending brings to mind the memorable statement by the great Yogi Berra: “It`s du00c3u00a9ju00c3 vu all over again.” Residential real estate has three potential problems relating to valuation: First, shrinking personal income will drive affordability and hence, prices, down. In addition, many buyers may elect to buy less-expensive homes because of economic concerns and job uncertainty. Second, comparable prices are likely to go down as some sellers become anxious to get out as quickly as possibleu00e2u20ac”perhaps due to job relocation or simply owning a house too large relative to their projectable income. Third, the dramatic increase in home equity lending over the past decade, against the backdrop of a falling stock market, is likely to create the need to sell, especially if the borrowed funds were invested in the market. Directors should take a hard look at the high-end residential real estate market (especially valuations), borrower reliance on the stock market, and high levels of home equity loans. The next wave of lending policies could easily result in de facto nationwide credit standards being set by the major financial institutions. Commercial real estate presents its own array of challenges (see sidebar). The demand for space is going down, along with rents in many markets. At the same time, the supply of new space is increasing, resulting in lower prices.

Deflation and the bank

While no one wants to talk about it, every banker knows what deflation is and understands its impact on the bank. Deflation is the banker`s enemy: valuations go down; economic activity slows; borrowing decreases. On the other hand, moderate inflation can be the banker`s friend: valuations rise; economic activity picks up; borrowing increases. Where do we stand today? Even more important, where are we headed in the future? As businesses begin to focus on expense controlu00e2u20ac”rather than revenue growth and new product introductionu00e2u20ac”as the main source for increasing profits, they become both leaner and not as well positioned to grow longer term. Ideally, it`s best to strike a balance between profitable revenue growth and expense management in all businesses, including banking. But if (and this is a big if) a large number of businesses choose to manage conservatively for harder times, then harder times become a self-fulfilling prophecy. On the upside, the Federal Reserve Board has not been called upon as the “lender of last resort” to contain or avert a financial crisis in quite a while. However, while the Fed`s periodic 50-basis-point rate cuts point to clear evidence of sluggishness, the real warning sign of a slowing economy is that consumers and businesses are cutting back because they lack the confidence to increase their spending and business investments. So what does all this mean for banks? The role of the local banker is going to take on increased importance. Consumers, businesses, and communities need bankers who will protect their deposits and provide the credit necessary to make the community work. This is a tremendously important and often underestimated economic role. If a large number of banks step back from lending because of decreasing loan demand, uncertainties over credit quality, or regulatory concerns, it could easily slow a recovery. Interestingly, by promoting and protecting sound lending policies, the regulators` approach to evaluating credit quality could have more of an effect on stimulating economic activity than a small reduction in interest rates. Another wild card is the effect security analysts and institutional investors will have on shaping bank lending policies and standards. For example, if credit-restrictive banks are rewarded with significantly higher price/earnings multiples, then more institutions will try to emulate J.P. Morgan Chase & Co. The result could be a race to see who can be the most restrictiveu00e2u20ac”hardly a recipe for moving the economy forward. At the end of the day, the level of sound, believable political leadership will make the difference in how the economy performs. Elected and nonelected officials will need to set politics aside and make the thoughtful economic decisions for the long term, thus building a base for future growth.