Some 20 years ago, bankers abhorred risk. At the same time, they knew nothing about managing risk other than to avoid it!
I well recall the views of William S. Gray, the former chairman of the Hanover Bank 1929-61, who often said, "Bankers never borrow, customers borrow." This negative epigram encapsulates and innocent and obsolete world-view that could never work today: banks as fortresses of soundness amidst an uncertain world, the banker a nay-sayer with no vision of the future, no stake in economic development.
Most contemporary banks, certainly all large banks, have now embraced risk as an inevitable concomitant to the strategies of their enterprises. They have gradually learned to do this over (roughly) two decades, in response to three driving forces:
* first, the people who run banks have an unavoidable responsibility to their shareholders, measured by their attainment of a competitive return on equity. To abdicate this responsibility is, in effect, to adopt a strategy of retrenchment.
* Second, bank policies are in part shaped by public policy: It cannot be denied that since 1961 successive administrations have strongly urged banks to support various domestic and foreign economic development goals.
* Third, there is a widespread excitement that comes to pervade any industry, like banking, that is modernizing and expanding on many facets. this enthusiasm, once established, becomes self-perpetuating, leading to further explorations of opportunity.
In most large banks, these three driving forces to accept risk are disciplined by what is commonly called good management. Still other banks are under-managed, and a few -- a very few -- have been overwhelmed by the magnitude of risks they have knowingly or unwittingly assumed. Map of Bank Risks
Isn't it about time, therefore, that we drew a map of the risk of banking? If risk mismanagement causes banks to fail, and if good management lets them prosper, we should want to analyze what are the risks of banking that all larger banks face! Excessive risks is what causes banks to fail. Let's try to agree, then, on what risk is.
This map should have four attributes:
* First, our catalog of risks should not be so truncated as to blur important differences among types of risk, nor should it be so lengthy as to lose the attention, say, of a board of directors.
* Second, the categories of risk should be immediately understandable to the common sense of senior bankers: If we cannot engage their attention we will accomplish nothing.
* Third, the categories of risk should reflect the analytic concerns of funds-providers and investors as well, so that risk analysis can be shared with outsiders.
* Finally, the headings that make up this list should be, wherever possible, amenable to quantitative, comparative analysis. In this way, risk appraisal can be tested against objective standards. The two key standards, of course, are the performance of peers and the performance criteria of market.
I call my contribution to this dialogue the Seven Deadly Risks of Banking. In the same breath let me reemphasize that risk is a constructive and inevitable companion to the business of banking and that managers of banks should equally think of these risks as challenges and opportunities. Degrees of Severity
My list is ordered according to the speed with which each type of risk can destroy a banking institution. The first two, when sufficiently present together, will bring a market-funded bank down overnight. The next three risks work more slowly, rarely causing sudden failure. The final two determine whether a bank (or bank holding company) will survive under its own charter or be forced to merge in order to survive:
* Funding Risk. Can a bank readily renew its uninsured liabilities?
* Asset Quality Risk. Are its assets collectible at better than 99 cents on the dollar?
* Control Risk. Is the bank threatened by financial liability arising from operations other than outright lending?
* Interest Rate Risk. Will earnings be seriously diminished by deliberate or involuntary mismatching?
* Overhead Risk. Are profits -- and pricing flexibility -- choked by excessive support costs?
* Strategy Risk. Has the bank chosen viable marketing goals, and does it possess the technology to see it through?
* Capital Risk. Can the bank occasionally find new capital -- including acquisitions -- on favorable (that is, nondilutive) terms?
Clearly, these risks, challenges, and opportunities are interrelated. Clearly, they are more complex than my over-simplified summaries. This anatomy, however, seems to make intuitive sense to bankers and analysts alike. It's framed in such a way to generate largely quantitative answers, and it lends itself, for the most part, to hard comparative analysis. Whether you accept this anatomy of banking risk, or some other, it is hard to imagine a useful discussion of the future of banking that does not address the kinds of risk to which the industry has become subject. How to Forestall Crisis
What I want now to address is how we go about stabilizing the rate of bank failure in general, and in particular how we can forestall crisis among large banks. These goals may not attainable, but they are approachable, the more so if all participants in the process understand one another and work together as a preventive coalition. To put the problem in perspective, let me point out that if there are 75 bank failures in 1984, this will be only one-half of 1% of the 15,000 banks now in existence!
As I see it, there are three -- and only three -- sources of discipline acting to constrain the risk-taking which, in the extreme, causes larger banks to fail: the regulator, the funds-provider/investor, and the manager -- yes, the manager! Of the three, I will argue that the third, like it or not, is by far the most crucial, for which in fact there is no substitute.
I will also argue that regulatory discipline, though effective for small banks, is rather inept applied to large banks. Conversely, market discipline -- the prudential role of uninsured funds-providers and investors -- is fast becoming valuable and significant for large banks, least valuable for small banks.
In my opinion, it is vitally important that policy-makers have correct views about the true and emerging roles of these three disciplines. For example, it would be a dangerous misperception to belittle the adaptive power of bank managers, to deny the cautionary role that the market has begun to play, or to yearn for a stronger regulatory function. Carried to an extreme, such views will not only shackle an essential industry but -- ironically -- lift its level of risk to insupportable heights.
My definition of "regulatory" is not confined to the mere supervisory function, central as this is. It also includes management of the deposit insurance function governance of monetary policy, congressional oversight and, finally, administration pressure on banks to support various domestic and foreign policy goals.
Whether taken as a whole, or piece by piece, this unpredictable and politicized apparatus hardly seems capable of regulating risk in banking without crippling the patient.
Senior regulatory officials privately confess the difficulties of staying abreast of the "leading edge" activities of major banks -- interest-rate swaps, daylight overdrafts, futures, and options, to name a few. The problem is not that key people in civial service fail to understand these fast-moving, high-tech frontiers. It is just that the average examiner team in unequipped to evaluate what large banks are up to. In my opinion, this explains why the risk-constraining record of regulators is so poor: they permit risk to accumulate past the point of no return, not so much because they lack enforcement powers, but because too often they don't know what to look for, or how to interpret what they find.
Computer surveillance of banks by federal regulators is not uniform. As a result, the remote tracking systems of the Office of the Comptroller of the Currency, Federal Reserve Board and Federal Deposit Insurance Corp. give conflicting signals of which banks are on whose "watch list." More important, regulatory surveillance models have not incorporate data flowing from the holding companies which control almost all large banks. Thus bank regulators are unable to duplicate the credit/investment analysis performed by the market.
Without this ability, they can hardly be sensitive to the signals of the market. As I have insisted, it is the market, in the end, which brings large banks down. Regulators seem incapable of anticipating or understanding this key factor in large bank failure.
As if to acknowledge their incapacity to judge a bank's management of the multiplicity of risks, regulators have substituted for this crucial deficiency a preoccupation with capital. They argue, of course, that the requirement of a high level of capital slows the risk-taking entrepreneur and is, at the same time, "fair" to all banks. One of its effects, however, is to drive more risk-taking off the balance sheet into a shadow banking world immune so far from arbitrary capital rule.
A more serious effect is to force risk-taking on the part of banks reaching to achieve competitive returns on capital sufficient to keep attracting private investors. At some point, in other words, unrealistic capital standards become self-defeating as a risk deterrent.
A shocking inequity has been developing between the federal regulation of thrifts on the one hand and banks and bank holding companies on the other. While the two industries are converging in the market place, the regulatory standards are diverging, particularly with respect to capital requirements.
There are modest enough steps that the regulatory machine can take to improve its effectiveness, steps like higher recruitment standards, state-of-the art professional training, realistic compensation, merit-based promotion, and more effective computer surveillance. Without such steps, grand plans to regulate the banking industry are sure to founder as soon as they are enacted, to say nothing of the damage these clusmy efforts will cause. No Confidence in Rescues
In 1983, I was commissioned, among others, by the FDIC to research the need for deposit insurance reform and the shape this might take. In the course of my research I surveyed a number of megadepositors, such as large foreign banks, money funds, and giant corporations. I was surprised to discover that without exception they regarded the FDIC as lacking both statutory and financial capacity to rescue very large banks. These creditors, furthermore, prided themselves on their developing skills to avoid failure-prone institutions.
My studies also persuaded me that the credit-analytic sophistication possessed by the largest funds-providers (and their outside advisers) was rapidly trickling down to the middle market of uninsured creditors. This dissemination was occuring for three reasons.
First, bank/bank holding company financial disclosure is now comprehensive, frequent, and accessible. Second, analytic methods are now in place to interpret this data. Finally, analytic specialists such as Cates Consulting have developed reliable risk-assessment products specific to this large and growing market.
This was the situation prior to May 1984 when the Fed, FDIC, Comptroller's Office, and Treasury issued public statements explicitly guaranteeing the liabilities of Continential [Illinois National Bank and Trust Co.] and other very large banks. Have these statements dissolved the concerns of uninsured creditors? One can hardly imagine a more important question affecting the future of large banks! If you believe the answer is "Yes," the bulwark of market discipline is removed. With it then disappears that healthy fear among bank managers that unsound policies will be recognized -- and penalized -- by uninsured funds-providers.
Now for the facts. The truth is that market concerns over the creditworthiness of large banks has not dissolved. This relatively new bulwark against undue risk in banking appears to have a deep foundation in the perceptions of funds-providers. If so, it will increasingly exert its guardian role. The implications for public policy are large, for it means that the uninsured funds-provider now serves as a coregulator of the level risk in larger banks.
I have three reasons for asserting that market discipline is alive and well. The first piece of evidence is that our firm's growing sales of bank credit ratings and the analytic materials that support these ratings have continued unabated since last May. Our competitors report a similar phenomenon. Client Questions Persist
The second piece of evidence is the reasoning of our clients about why they are not altogether tranquilized by the federal press releases announcing the government's protectorate of large banks. If any of you had, say, $5 million on deposit in a large bank, you, too, would be asking these questions! What is the statutory or contractual basis of the guarantee? How many banks might it cover?
Does the FDIC have the financial capacity to make good immediately on the guarantee? Can we afford even a momentary disruption of first-rate service from our banks? Can we afford any loss of interim marketability on our certificates of deposit? How do I (say I am an assistant treasurer) look to my board if a bank in crisis shows up on our list of depositories? The easy answer to these questions, of course, is to avoid such banks prior to crisis.
My third piece of evidence is that no professional market participant believes that bank holding company paper will be ferally protected in a future crisis, despite the strange FDIC rescue of the Continental parent investors. Thus a highly visible window of discipline will continue to shine upon the commercial paper, term debt, preferred and common stock of bank holding companies.
Signals of investor distress emerging from any of these markets will be seem by the creditors of the affected banks. Indeed, the timing of the Continental crisis can be traced in large part to the poor behavior of the stock in 1984 and the growing disbelief of analysts that the common dividened was sustainable.
The ratio-analytic techniques now in place to evaluate the credit/investment worthiness of large banks are not random and meaningless exercises in tea-leaf reading. Since its modern origin some 10 years ago, bank and bank holding company credit analysis has proven to be rational, cogent, consistent, and predictive. By this, I mean that a good analytic system can distinguish those banks leas able to withstand shock, from those most able. Market discipline need do no more than this.
Across the last 20 years, banking has lost its innocence. Indeed, many banks today are as entrepreneurially stretched as some of their borrowers! Worse yet, much of the public -- both lay and professional -- has come to believe that big banking is somewhat out of control and that the term "reckless" is not exactly misapplied to the industry. It does not matter whether you or I share that belief. What matters is that a widespread public impression has been created out of the real mismanagement of a few large banks.
What we are talking about, of course, is corporate governance. The issue is whether the managements of large banks have the will and capacity to control the levels of risk within their organizations. Can it be done at all? Are senior managers of banks so driven by ambition, competition, and sheer bigness, so shielded from reality by opportunistic subordinates and passive directors, that the concept of risk has altogether lost its self-disciplinary bite? There probably is no question more important than this as we survey the future of large-scale banking. Your views on this question, therefore, will help to shape your public-policy recommendations. High Management Standards
The self-evident performance and strength of the majority of big banks seems, in my opinion, to demonstrate sufficiently that these banks are not only strong and profitable but are governed by high standards of prudence at key management positions. A wide acquaintanceship among senior and junior bankers, furthermore, tells me that there is a deeply embedded culture of risk management in the banking professions, that this professional integrity is quite passionately maintained, and that usually overrides conflicting goals such as near-term earnings gains. For this to work, however, senior management must provide strong leadership.
Not every large bank, however, is run with su ch managerial excellence. Our next question must be, "What is the outlook for a return to prudence by that minority of banks that have strayed or are straying into unacceptable risk?"
Let me give you three reasons for believing that we are now witnessing a dramatic renewal of self-discipline in banking:
* Compared to other industries, bankers are very standards conscious, which is to say that they are peer sensitive. This is not merely an accident of culture. Once aroused, the industry is its own sternest critic, simply because it is so financially interdependent! The credit of one bank affects the credit of many others, however indirectly. When banking leaders establish a standard, the message to peer bankers is quite clear.
The shock wave of the continental failure has told leadewr after leader that risk is indeed a four-letter word. Banks I know are renewing their awareness of risk, establishing top-level "exposure committees" which often transcend the loan-review and recognizing loan losses earlier rather than later. Risk assessment is fast becoming a watchword in the industry.
* The market of bank funds-providers and holding company investors is also prompting bankers to rediscover that risk has teeth. If -- as I expect -- the discipline of the market does not dissolve in the wake of a few high-sounding federal press releases, the recent emergence of creditors as coregulators of banking will be a constant reminder to wayward managements.
I want to emphasize that this "chill factor" is a new element in bank risk control. In the wake of 1974-75 (a comparable prior episode of bank failure and funding nervousness), the just-crafted tools of modern bank credit analysis were still primitive and little-recognized. Today, the skeptical depositor/investor in large bank paper knows the right questions to ask and has the data to document these questions.
Compare this development in banking, by the way, to other financial services companies, notably thrifts, insurers, and securities brokers. Because of disclosure requirements, large banks and bank holding companies have become fishbowls for beady-eyed inspection by funds-providers. By contrast, that sort of market discipline is almost absent in the other financial industries. Since these other industries are also less regulated, the effect is to place large banks under double jeopardy: the market and the regulator, both loaded for bear. My point is not that this is unfair (though it is), but rather that large bank management now has two layers of unsympathetic kibitzers to deal with.
* Directors of larger banks may be collectively passive as a board but are usually man-eating tigers as individuals. This strange paradox carries with it some uncomfortable contradictions which occasionally cause a board to rise up and takje charge of a crisis. My guess is that many bank boards will now begin to insist on more objective assessments as a basis for judging the performance of management.
As it is, their typical menu of monthly or quarterly financial reports is all internally generated. One way to insert objectivity into this process is to give a board, at least annually, a comparative presentation based on credit analytic principles. Since credit analysis is nothing more than risk analysis from a market perspective, the board gets to look not only at the company's risk profile but at the market perception of that profile as well.
To emphasize this point, consider whether the Continental board, in late 1982 or early 1983, might not have risen up, cut the dividend, reversed the suicidal growth strategy, and installed conservator, work-out management. If this had occurred, it is unlikely, in my opinion, that the bank would have lost the confidence of its funds-providers. Risk Controls Needed
I will close my talk with four observations. First, risk management in banking has nothing to do either with governmental "deregulation" or "reregulation." If risk controls are in place -- as they are for the majority of large banks -- new ventures will be under-taken, as in the past, within that mantle of self-protection. If, conversely, risk is poorly managed, no amount of government regulation will protect the industry from itself.
This is because risk management in banking is an exceedingly intricate process that occurs simultaneously on many fronts, some of a credit nature, some of an operational nature. Were the intensified regulation to be as inept and bureaucratized as the old regulation, how could it possibly cope with the realities of bank risk? As I said earlier, banking -- at least large banking -- seems to have outgrown regulation.
My second observation is that banks, by definition, are in a risk business. The objective is not to try to reduce these risks to zero, but to understand them, accept them, lose a bet occasionally, and -- stay in control! A corollary point is that the occasional crisis must also be controlled. To illustrate, the fall of Continental, in my view, was as much due to the blindness of directors post Penn Square as it was to the strategy that permitted the Penn Square involvement.
Third, let us not forget that mismanagement of risk must be severe indeed to break a bank. Our study of larger bank failures reveals that each was caused by massive, multiple, and repeated misjudgments. The fall of larger banks is not caused by isolated events, however large. This means that the prudent management of risk is not a superhuman task but a very manageable, indeed a prosaic challenge. Failure simply does not overtake the reasonably prudent and alert banker.
Finally, the banking industry trade and professional associations have, I think, a major role to play. Not only can they assist in managerial consciousness-raising but in showing the public that bankers, after all, understand their business.
An important development of this sort is the emerging proposal of the Association of Reserve City Bankers (ARCB) to self-regulate the risk inherent in wire transfer "daylight" overdrafts. This industry initiative has far greater value than if the Federal Reserve Board were arbitrarily to "cap" the volume of these overdrafts. Under the ARCB proposal, not only can large bank managements play a determining role in guiding and monitoring overdrafts, but the industry would be seen by Congress and the public as itself regulating a large risk frontier.
Bank Administration Institute the sponsor of this conference, can be uniquely influential as a forum to help the manager of smaller banks master new perspectives on risk. For example, how can bank managers harness credit/investment analysis -- the tools of market discipline -- as key benchmarks for corporate planning? How can bank directors strengthen their objective assessment of bank performance? How can a common language of bank risk analysis be shared by managers, regulators, investors and funds-providers? Discussion programs of this sort will help bankers establish themselves -- with one another, with employees, with investors/creditors, and with regulators -- as hands-on managers of the risk process. If not the industry, who else?…