Managing & Accounting for Risk

Management has a lot of roles. One very important role is to lead the organization in a way that produces acceptable returns within acceptable risk limits.

Credit risk has always been of primary importance in the long-term success of financial institutions. An overwhelming percentage of community bank failures have resulted from loan losses.

There are many ways to mitigate credit risk. Theoretically, a bank could severely limit its loan portfolio. (Community Reinvestment Act & related regulations make this approach virtually impossible.) Risk can be mitigated by lending only to certain types of enterprises that are deemed to be less likely to fail. (Even unlikely candidates for failure may find themselves in difficult financial situations.) Risk could be accounted for by providing allowances for losses that may ultimately occur. (This approach was used until the accounting rules were changed to allow reserves only for known losses.)

Bottom line: There are few, if any, guarantees in the lending business.

Long ago, in a quieter and more civil time, community banks were managed to assure consistent earnings streams. Management knew "good times" don't last forever and some sector or sectors of the economy would become stressed. Allowances were provided for losses that were not "known" but were expected to occur. Securities were purchased to provide a return and liquidity and were managed prudently. If liquidity was needed, securities that best met the bank's liquidity and earnings goals were sold. Decisions were based on current conditions.

Although accountants say they only report results, accounting rules dictate how the results are reported and force management to make decisions that would not have been made under different circumstances.

Accounting rules require a security to be classified as either held-for-sale or held-to-maturity at the time it is purchased as if the purchaser knew in advance what interest rates, bond markets, and securities issuers would do in the future. Securities classified as held-to-maturity can't be sold prior to maturity except under unusual circumstances without severe accounting consequences.

What's wrong with the notion of allowing community banks to operate in a way that provides for expected potential losses and allows investing decisions to be made on the basis of current conditions?