Risk Management

We've seen and heard a lot about enterprise risk management. Programs have been developed. Consultants have been consulted. Regulations have been proposed and adopted.

In spite of all that, we experienced a financial train wreck that will have an impact on our economy for years to come.

If enterprise risk management had been applied to some of the large "too-big-to fail" companies, it is obvious their analysis failed.

Seems to me, enterprise risk management shouldn't be that difficult.

First, do we have a complete understanding of the product or service we are considering? If not, do not move forward until a complete understanding is obtained.

Second, how much can we afford (or are willing) to lose?

Third, what is the impact on our organization if we actually lose the amount determined above?

Fourth, for each area/product/service within the organization ask, "what happens if.....?" Even though the possibility of loss may be small, don't assume loss is not possible. Quantify the answers to this question in two ways. First, quantify your assessment of the total potential loss. Then, quantify your assessment of potential loss based on a realistic assessment of probability of loss.

Fifth, total the impact of potential losses determined in step four - both for total potential losses and probable potential losses.

Finally, study the results. If you are comfortable with the results, begin to think about how you would deal with losses in any area of the bank in the event one does occur. If you are not comfortable with the results, make the changes necessary to reduce the potential and probable loss levels - then begin work on contingency plans.

A final note, it is fair to consider U.S. government obligations to be safe. If the government fails, none of us will be in business anyway. However, do not assume an insurance company or any other third-party will necessarily be able to make good on its promises.

Defense vs Offense

2009 was a difficult year for many. Good, productive employees became unemployed. Businesses experienced reductions in sales and earnings. Banks experienced increased loan losses, tougher regulatory demands and squeezed interest margins.

We saw two basic approaches to the economy - defensive and offensive. Is one "right" and the other "wrong"? Probably not. However, it is difficult for a good defensive team to win if it doesn't have any offensive capabilities.

The Offensive Approach
We have problems, so let's identify them and deal with them. We can also identify potential opportunities in our market, so let's figure out how best to capitalize on those opportunities. Perhaps the opportunities will offset the problems. Even if the opportunities don't totally offset the problems, they will provide some relief and will put us in a better position as the problems are solved.

The Defensive Approach
We have problems, so let's rally the troops and deal with them. Dealing with problems is our first and only priority. We are going to cut back on everything that is "non-essential" - travel, education, marketing, employees, etc. Someday, when the problems have been dealt with, we will start to do some of the things that helped drive our past success.

The Difficult Choice
It is difficult to be anything be defensive when the world seems to be crumbling around you. Adopting an offensive strategy in the midst of difficulties may not appear to make any sense at all. Even so, some balance is required in all except the most difficult situations where basic survival is at stake. Don't let the focus on problems result in neglect of opportunities.

New Year Already!?!

It is difficult to believe the New Year is almost here and I haven't posted anything since September!

At this point the best I can do is to wish everyone a Happy New Year.

My wish for you is for 2010 be the best year ever both financially and personally.

MANAGING EARNINGS

It always amazes me that CEOs and CFOs get criticized for "managing earnings." Isn't that what CEOs and CFOs are hired to do?

CEOs lose their jobs when the businesses they run aren't profitable.

Critics respond, "That's not what we mean by 'managing earnings'. 'Managing earnings' involves actions like timing sales of securities to either increase or reduce reported net income or increasing loan loss allowances when everything seems to be going well."

Isn't that a wonderful concept!

Community bankers don't run securities trading accounts. They don't sell and repurchase their entire portfolio on a daily basis. In general, they realize gains and losses from securities much the same way individual investors do - and income taxes often play an important part in determining when it is advantageous to realize gains and losses.

Community bankers also know that good times don't last. Economic cycles have happened throughout the history and no amount of government planning and intervention has been able to put an end to them. Community bankers don't make loans when they know the borrower will not be able to repay them. However, they also know changes in economic conditions, incorrect assessment of borrowers, and other factors will result in loan losses.

Years ago, banks were required to maintain arbitrary loan loss allowances of 2.4% of total loans. Over time, the percentage was reduced and ultimately eliminated. Most recently, bank loan loss allowances were limited to amounts that were the equivalent of losses that had already been incurred - an interesting theoretical concept that essentially put loan losses on a cash basis.

Consider the following questions.

• How much different would the current "banking crisis" have been if banks had been allowed or even encouraged to build loan loss allowances in "good times"?

• Would investors have been in a better or worse position today if the accounting and practices of twenty years ago which resulted in "managing earnings" had continued?

I would like to have your perspectives. Post a comment - positive or negative.

Another Push for Mark-to-Market Accounting

The following excerpt from an August 19, 2009 story by By Jeff Kearns apparently written for Bloomberg reveals the thinking of award winning economists.

"Myron Scholes and Robert Merton shared the 1997 Nobel price for economics, and they are now united in calling for banks to give more accurate valuations on their illiquid assets.

Financial institutions should use mark-to-market accounting or list the hard-to-value securities on public exchanges whenever possible, Scholes said in a Bloomberg Radio interview yesterday. Scholes, winner of the Nobel with Merton for helping invent a model for pricing options, said investors need better data on prices to accurately value the debt and equity securities of banks.

“I’d like to see us encourage many more securities held on the books of the banks be migrated to exchanges if possible,” he said. Doing so would “allow for market discovery and market pricing as much as possible,” Scholes added.

Banks that oppose new accounting standards on asset values want to conceal depressed prices, Merton wrote in the Financial Times yesterday. He composed the column with Robert Kaplan, a professor at the Harvard Business School along with Merton, and Scott Richard, a professor at the University of Pennsylvania’s Wharton School.

“This is not the way forward,” they wrote. “While regulators and legislators are keen to find simple solutions to complex problems, allowing financial institutions to ignore market transactions is a bad idea.”"

The problem, of course, is they are only partially correct. Consider:

1. Using mark-to-market accounting sounds like a commercial for the use of a valuation model such as the Black-Scholes model co-developed by one of the economists. Could a valuation model be applied to a commercial loan? Of course! What is the probability the result would be correct, comparable or meaningful given the range of judgments that are required by any model? I suspect the answer is less than 50%. Do you suppose any of these economists have ever tried to value a community bank commercial loan portfolio?

2. The amount of documentation required to list any security on an exchange is staggering. How much documentation would be required to list a $1 million commercial loan to a privately held, non-rated corporate entity? Frankly, listing hard to value securities on public exchanges sounds like a fairy tale. (It also assumes those securities are for sale, which is usually not the case.)

3. Proponents of mark-to-market accounting apparently believe that every bank asset is being held for sale. In fact, most bank assets are not for sale. Their value arises from the payment of interest and principal over time. Mark-to-market accounting is liquidation value - not the value to a going concern.

4. If today's problem assets had been valued at "market" two years ago, most of them would have values at or near "par."

5. If you purchase a U.S. Treasury Note today and interest rates go up, the market value of the Note goes down. You would have suffered an economic loss because you would have earned a higher return if you had been able to buy that security today. However, we also know it is impossible to accurately time the market, so you would have suffered an economic loss if you had held cash instead of purchasing securities when you did. In addition, there is no assurance you would have purchased the securities at the optimum time. Fortunately, you don't need or want the cash represented by my investment in this Note so you wait another year and watch the value go back to par when it matures. Substitute "bank" for you and "commercial loan" for the U.S. Treasury Note and we have described the typical scenario for a community bank loan portfolio. Observations:

• A community bank loan portfolio is difficult, if not impossible, to accurately value because most privately owned commercial entities are not rated by credit agencies and industries, management, corporate culture and local economies vary widely.
• If a bank and its borrower can weather economic storms, the likelihood of repayment is usually very high.
• When a loan is deemed to be uncollectible in full or in part, current accounting and regulatory rules effectively require the loan to be valued at recovery value - cash that is likely to be received from payments and/or sale of the collateral. (This information is provided in the financial statements.)
  

Mark-to-market accounting works well for securities that are traded regularly on an active exchange.

Overdraft Fees

Some banks do have significant amounts of revenue from overdraft fees. They also generate revenue from interest on loans and investments, service charges, and other sources.

At one time overdrafts were an exception. Checks that would have resulted in an overdraft were returned and the customer was charged a fee generally the same amount as an overdraft fee. Someone didn't get paid because the check was returned. That person (or company) typically charged a fee to cover their collection costs and contacted the person who wrote the check and demanded cash or cash equivalent in payment. The result? The check writer was charged at least two service charges and had a black mark on his record. The person who received the bad check was inconvenienced, at best, and perhaps forced to borrow to make up for the lost funds.

If the bank paid the check and allowed an overdraft to be created, the customer is charged a fee and the person or company who received the funds is not affected.

Which choice is the best deal for the customer? Which choice is the best deal for the person who received the funds?

The High Cost of Government Intervention

Here's a link to an interesting article by Rajshree Agarwal, a business professor at the University of Illinois. According to Ms. Agarwal, "Massive bailouts and other moves by the U.S. government to stem a near-epic economic meltdown could set the U.S. economy back by more than a half-century..."

This story presents another aspect of the "too big to fail" argument that doesn't receive a lot of press.

Interested? Click here to access the article.