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Let's work as banks and bankers to prevent a perfect storm

Lessons learned, let's apply them going forward and avoid trouble

There have been a number of articles in the financial press recently about the exposure to banks' income and asset values due to a rise in market rates of interest.

With interest rates at historic lows and net interest margins under severe pressure for several years, it's probably inevitable that some banks have reached for yield by extending the average maturities of their investment portfolios. Other banks are engaged in pricing practices that allow borrowing customers to lock in low rates of interest for long periods of time--years in some cases, according to anecdotal information.

And no doubt some banks are doing both of these things simultaneously to their possible peril.

Another concern--and it's not unrelated--seems to be moving to the forefront of thinking by economists and fiscal planners and that's the anemic growth of our national economy. Most regional economies are relatively slow too, though there are sectors, energy and agriculture for example, that continue to do quite well.

Still, bank loan demand is not in the overall sense particularly robust. So it's tempting for banks to compete for available loan business by offering concessionary terms involving rate and maturity.

Where could this lead?

What is particularly concerning to many observers is that these tendencies--extending maturities of the investment portfolio for small increments to interest income and making low fixed-rate loans to build loan interest income at the bottom of the rate trough--are likely happening simultaneously.

I wonder if some banks have become so insensitive in recent months to these tendencies figuring that the last 18 months or so have become the "new normal."

Let's page back a bit.

The several years of the 1970s are often thought of in modern economic terms as a perfect storm. The national economy was experiencing relatively high and persistent rates of inflation and business was not performing very well in terms of economic growth. Economists gave these linked phenomena the label of "stagflation."  They were difficult periods. Business wasn't really very good, while inflation is a silent killer of economic value and ultimately can best be tamed by such harsh measures as abruptly higher rates of interest.

I lived through that as both a lender and as a consumer. My customers seemed to be hedging their inflationary expectations with inventory accumulation and my bank was expected to be the funding source for this purpose. It's not "normal" to think about inventory purchases as speculative activity. But at some point, it's simply a matter of degree that separates normal business operations and the same thing undertaken with an emphasis on inflationary hedging.

By 1980, the prime rate was 18.5% and the rate on my home mortgage in Midland, Texas, was 12.5%. Rates for business and personal borrowers like that put the brakes on economic activity and it wasn't much fun living through that adjustment that took the better part of two years.

It did cure the prevailing inflation. But I think we'd all have been better off avoiding the whole cycle of excess that so many of us suffered through back then.

Another perfect storm?

So, I wonder if we're unwittingly setting ourselves up for another perfect storm.

Will we be able to unwind the massive infusions of liquidity by the Federal Reserve without triggering inflation? 

Can we avoid a sharp increase in market rates of interest? 

What are our options (if, indeed, we even have any) if we work for banks that are demanding short-term earnings performance? 

What will our customers expect of us?

The outlook is uncertain and in many ways, it's potentially very dangerous. Business is distrustful of government gridlock and the politicians are at loggerheads over the size of government and how it will be financed. Uncertainty breeds caution and fear and these are almost palpable right now and have been for a year or more. The problems seem large enough to cast a significant pall over our national economic outlook.

This is not good for business or for banks in the longer run.

How should banks handle these conditions?

What should lenders be doing right now? I think there are two categories of answers to this question. One of them is institutional, while the other is personal.

Institutionally, banks should be wary of interest rate changes that could be very destabilizing to short-term economic performance.

This is primarily the "S" in the CAMELS acronym--sensitivity to market risk. Fortunately, most banks track their exposures to interest rate risks pretty carefully. But the jury is perhaps out on how well those risks are understood, given the variety of ways of dealing with (hedging) these challenges.

Financial models often yield surprises and the capacity to surprise and confound has been magnified by their complexity in recent years.

On a personal level, each lender should understand the risks in his personal portfolio.

I'm not talking about the principles of lending, such as the Five Cs of Credit. Nor am I talking about the application of the rulebook, that is, the credit policy specifics relating to such things as advance ratios on collateral or exceptions to policy embedded in the loans under individual management.

Rather, I'm referring to vigilance. That's the vigilance needed today to develop and maintain a firsthand "feel" of the marketplace and how our customers are faring day to day.

If there's a problem, you can reasonably assume that in an uncertain environment such as we are living through today, the changes are not working in the bank's or the customer's favor.

The real risk here is that you don't know that there's a soft spot or deterioration.

This is the time for maximum attention to detail and heightened powers of observation. The way to do this best is to stay close to the customer's financial situation and make frequent contact of more than a superficial nature.

This is in part what stress testing of individual credits is all about. But it requires a sense of what we need to be looking for and what curative actions might be appropriate.

Now is the time to spot trouble

Most credit problems seem pretty transparent in hindsight.

But so often we fail to spot them on a timely basis. Is that because we're simply not looking and are distracted by the noise of our daily environment?

Any experienced hand knows that effective workout techniques involve early warning systems and keen powers of observation to what may be changing. We are probably entering such a period right now and how well we adapt in the months ahead may largely determine whether our banks will prosper or founder.

Ed O’Leary

Banking Exchange Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent more than 40 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses. You can e-mail him at etoleary@att.net. O'Leary's website can be found at www.etoleary.com.

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