Executive Summary: History provides some great lessons for bankers wishing to minimize the impact of the current downturn and avoid the next one. Managing five key areas can help management steer a clearer course or even avoid future problems.
November’s RMA Journal presents a terrific article by Ed Morsman. Ed retired from banking over a dozen years ago but before that he was chief lending officer of Norwest Bank Minnesota. I came to know and respect Ed when I was consulting at Norwest.
Ed based his article on his long career with one of the best banks of its time. His article, “Lessons Learned from Looking Back” reflects on economic theory, the efficient market hypothesis, and characteristics of economic bubbles. He also offers us five areas that bank management should focus on to avoid bubbles and minimize performance volatility.
Credit Culture
I have never worked with a bank at which a senior executive did not insist that they had a strong credit culture. However, I have worked with many banks that were deluding themselves.
Why do they delude themselves? In some cases, the bankers believe that they are objective enough to uphold high credit standards. In others, compensation tilts banker’s in the direction of maximizing near-term earnings. Whatever the reason, Ed’s article discusses the need for a bank to operate with a unified vision from the top down concerning risk, including a targeted range for loan losses over an economic cycle.
In most cases, banks fail to promote this type of explicit discussion. Further, bubbles often lead to the denigration of the credit process. Lenders push for “creativity”, and credit personnel find themselves marginalized by a senior management and, in some cases, a Board that has become hypnotized by growth. Long ago, Ed mentioned how many banks seem to operate along a pendulum-like arc that swings from selling at one extreme to an emphasis on credit on the other. Optimally, a bank operates within a tight middle range; however, in our current environment a credit emphasis likely assures survival; a sales emphasis does not.
Budgeting
Morsman warns that the budgeting process can focus bankers on activities that no longer are in the bank’s best interest “when external conditions change, as they inevitably do. It [the budget] is as much a political document as a financial one because it can dictate compensation issues and behaviors that may be adverse to the credit culture.”
If budgets mindlessly drive activity, they set a bank on a collision course. We have seen banks in which key personnel believed that the bubble they had been floating on was about to pop. Nonetheless, they kept putting on loans in part because of the high growth expectations they had to meet. Neither the bank’s culture nor the budget system itself provided a sufficient opportunity for rethinking the yearly numbers once the business year had begun.
Compensation
Ed writes that compensation needs to be based on performance over a cycle rather than on short-term results. To this day, short-term compensation dominates at most banks. Further, compensation is often out-of-sync in promoting a good credit culture. Not only do banks need to lengthen their compensation time frames, they also need to reweight what they pay for. For example, quality liability and recurring fee business should be given clear priority over loans, but, too often, banks say they want deposits and fees while paying more for loans.
Concentrations
Morsman noted that excessive concentrations drive volatility. At the same time, excessive concentrations can also drive growth. I remember a conversation with Ed from about 20 years ago during which he described how Norwest set and communicated concentration limits for its banks. This “upfront guidance” would help to focus the bankers’ marketing activity, for example, directing them toward certain industries and away from others.
When we work with failed banks, almost inevitably concentration risk emerges as the key factor driving a bank’s failure. We all know now of the excessive concentrations in residential and commercial real estate that has destroyed many banks. Just review the banks that the FDIC takes over each Friday night. Did the Boards approve these high levels of concentration? Did they have any idea of the implication of doing so? We doubt most knew what to ask for from the bankers or fully understood what was being presented to them.
However, it is difficult not to be seduced by the call of concentration, particularly when other banks are showing high growth. Banks’ managements often act in response to the actions of their peers. If others are generating growth from CRE, they will look to generate growth in the same way. Going back to the first point I mentioned from Ed, banks need to agree on and articulate their risk vision; fundamental but usually not achieved.
Models
Ed states that models can be useful: “They work well in ‘normal’ times, but can be disastrous when the unusual inevitably occurs.” In the last year we saw how “rocket scientists” can create models that blow themselves up. We continue to see bankers putting too much stock in models, failing to question their output and “poke” at underlying assumptions. Model builders tend to have great self-confidence; sometimes that confidence is unjustified. If we did not know it before, we know now: numbers can lie.
Final Thought
Bank management needs energy and courage to make sure the credit culture thrives, to rethink or throw out budgets mid-year, to change traditional compensation practices, to limit bites at an attractive growth apple, and to question rocket scientists. Unfortunately, energy and courage appear to be in short supply these days.