Banking

Each year, more than $1 billion is stolen from accounts at small and mid-sized banks across the U.S. and Europe. Unless the nature of the threat is recognized and addressed, this amount will only continue to grow. This week, we released of our latest webinar, Fraud Moving Downstream: Navigating Through the Rough Waters Ahead. Julie Conroy, research director at Aite Group and I team together to address this growing risk for regional and mid-sized banks, providing an overview of the current threat landscape and explain how the existing conditions are creating the perfect storm for fraudsters. Key topics discussed in this webinar include: How Regional Banks are Enhancing Online Offerings: Regional banks are responding to customer demand for more offerings, especially mobile banking options, which exposes them to new threats. The Rise in Sophisticated Fraud Attacks: Fraud rings and other new attack types (malware, man-in-the-middle, man-in-the-browser, etc.) are occurring at a higher rate than ever and pose serious threats to regional banks that lack strong, multi-layered defenses. Regional Banks’ Lack of Resources: Second and third tier banks have less manpower and less sophisticated solutions in place, which makes reviewing transactions and identifying repeat and cross-channel attacks incredibly difficult. You can access the on-demand webinar here. Also be sure to check out our infographic that illustrates this growing threat of fraud for small and mid-size banks, found here.

Contributed by: David Daukus As the economy is starting to finally turn around albeit with hiccups and demand for new credit picking up, creditors are loosening their lending criteria to grab market share. However, it is important for lenders to keep lessons from the past to avoid the same mistakes. With multiple government agencies such as the CFPB, OCC, FDIC and NCUA and new regulations, banking compliance is more complex than ever. That said, there are certain foundational elements, which hold true. One such important aspect is keeping a consistent and well-balanced risk management approach.  Another key aspect is around concentration risk. This is where a significant amount of risk is focused in certain portfolios across specific regions, risk tiers, etc. (Think back to 2007/2008 where some financial institutions focused on making stated-income mortgages and other riskier loans.) In 2011, the Federal Reserve Board of Governors released a study outlining the key reasons for bank failures. This review focused mainly on 20 bank failures from June 29, 2009 thru June 30, 2011 where more in-depth reporting and analysis had been completed after each failure. According to the Federal Reserve Board of Governors, here are the four key reasons for the failed banks: (1) Management pursuing robust growth objectives and making strategic choices that proved to be poor decisions; (2) Rapid loan portfolio growth exceeding the bank’s risk management capabilities and/or internal controls; (3) Asset concentrations tied to commercial real estate or construction, land, and land development (CLD) loans; (4) Management failing to have sufficient capital to cushion mounting losses. So, what should be done? Besides adherence to new regulations, which have been sprouting up to save us all from another financial catastrophe, diversification of risk maybe the name of the game. The right mix of the following is needed for a successful risk management approach including the following steps: Analyze portfolios and needs Predict high risk accounts Create comprehensive credit policies Decision for risk and retention Refresh scores/attributes and policies So, now is a great time to renew your focus. Source: Federal Reserve Board of Governors: Summary Analysis of Failed Bank Reviews  (9/2011)

By: Mike Horrocks This week, several key financial institutions will be submitting their “living wills” to Washington as part of the Dodd-Frank legislation.  I have some empathy for how those institutions will feel as they submit these living wills.  I don’t think that anyone would say writing a living will is fun.  I remember when my wife and I felt compelled to have one in place as we realized that we did not want to have any questions unanswered for our family. For those not familiar with the concept of the living will, I thought I would first look at the more widely known medical description.   The Mayo Clinic describes living wills as follows, “Living wills and other advance directives describe your preferences regarding treatment if you're faced with a serious accident or illness. These legal documents speak for you when you're not able to speak for yourself — for instance, if you're in a coma.”   Now imagine a bank in a coma. I appreciate the fact that these living wills are taking place, but pulling back my business law books, I seem to recall that one of the benefits of a corporation versus say a sole proprietorship is that the corporation can basically be immortal or even eternal.  In fact the Dictionary.com reference calls out that a corporation has “a continuous existence independent of the existences of its members”.  So now imagine a bank eternally in a coma. Now, I cannot avoid all of those unexpected risks that will come up in my personal life, like an act of God, that may put me into a coma and invoke my living will, but I can do things voluntarily to make sure that I don’t visit the Emergency Room any time soon.  I can exercise, eat right, control my stress and other healthy steps and in fact I meet with a health coach to monitor and track these things. Banks can take those same steps too.  They can stay operationally fit, lend right, and monitor the stress in their portfolios.   They can have their health plans in place and have a personal trainer to help them stay fit (and maybe even push them to levels of fitness they did not think they could reach).  Now imagine a fit, strong bank. So as printers churn, inboxes get filled, and regulators read through thousands of pages of bank living wills, let’s think of the gym coach, or personal trainer that pushed us to improve and think about how we can be healthy and fit and avoid the not so pleasant alternatives of addressing a financial coma.

Up to this point, I’ve been writing about loan originations and the prospects and challenges facing bankcard, auto and real estate lending this year.  While things are off to a good start, I’ll use my next few posts to discuss the other side of the loan equation: performance. If there’s one thing we learned during the post-recession era is that growth can have consequences if not managed properly.  Obviously real estate is the poster child for this phenomenon, but bankcards also realized significant and costly performance deterioration following the rapid growth generated by relaxed lending standards. Today, bankcard portfolios are in expansion mode once again, but with delinquency rates at their lowest point in years.  In fact, loan performance has improved nearly 50% in the past three years through a combination of tighter lending requirements and consumers’ self-imposed deleveraging.   Lessons learned from issuers and consumers have created a unique climate in which growth is now balanced with performance. Even areas with greater signs of payment stress have realized significant improvements.   For example, the South Atlantic region’s 4.2% 30+ DPD performance is 11% higher than the national average, but down 27% from a year ago.   Localized economic factors definitely play a part in performance, but the region’s higher than average origination growth from a broader range of VantageScore® credit score consumers could also explain some of the delinquency stress here. And that is the challenge going forward: maintaining bankcard’s recent growth while keeping performance in check.  As the economy and consumer confidence improves, this balancing act will become more difficult as issuers will want to meet the consumer’s appetite for spending and credit.  Increased volume and utilization is always good for business, but it won’t be until the performance of these loans materializes that we’ll know whether it was worth it.

By: Staci Baker In my last post about the Dodd-Frank Act, I described the new regulatory bodies created by the Act. In this post, I will concentrate on how the Act will affect community banks. The Dodd-Frank Act is over 3,000 pages of proposed and final rules and regulations set forth by the Consumer Financial Protection Bureau (CFPB). For any bank, managing such a massive amount of regulations is a challenge, but for a median-size bank with fewer employees, it can be overwhelming. The Act has far reaching unintended consequences for community banks.  According to the American Bankers Association, there are five provisions that are particularly troubling for community banks: 1.       Risk retention 2.       Higher Capital Requirements and Narrower Qualifications for Capital 3.       SEC’s Municipal Advisors Rule 4.       Derivatives Rules 5.       Doubling Size of the Deposit Insurance Fund (DIF) In order meet new regulatory requirements, community banks will need to hire additional compliance staff to review the new rules and regulations, as well as to ensure they are implemented on schedule. This means the additional cost of outside lawyers, which will affect resources available to the bank for staff, and for its customers and the community. Community banks will also feel the burden of loosing interchange fee income. Small banks are exempt from the new rules; however, the market will follow the lowest priced product. Which will mean another loss of revenue for the banks. As you can see, community banks will greatly be affected by the Dodd-Frank Act. The increased regulations will mean a loss of revenues, increased oversight, additional out-side staffing (less resources) and reporting requirements. If you are a community bank, how do you plan on overcoming some of these obstacles?

This week, American Express unveiled a new payments offering that will surely compete with not just other prepaid options, but will impact debit and credit sales volume as well. The prepaid card offered by American Express carries no fee for activation, reloading or lost card replacement. The card also offers consumers the option of drawing cash at an ATM. Since the consumer funds all transactions, default risk goes away, exponentially opening up the market potential. The question becomes, how will this impact other plastic and mobile payment sales today and down the road? Back in the year 2000, credit cards dominated purchase volume generating 77% of all merchant sales on general purpose cards, versus 23% on debit. Last year, debit and prepaid purchases captured close to half of all general purpose card spend with credit sales capturing ~53%, debit 44% and the remaining volume coming from prepaid cards. With all of the regulatory changes impacting bank revenue and cost positions, financial institutions are having to rethink existing practices eliminating rewards programs tied to debit charge volume and resurrecting monthly checking account fees in large scale. It's not a question of bank gouging, rather how do financial service providers offset lost interchange income of $0.40+ per transaction down to $0.12 to $0.20 as is being mandated with the quickly approaching implementation of the Durbin Amendment on July 21st. Add to that reduced fee income from Dodd-Frank and institutions have to figure out how to still be able to afford to offer these services to their customers. Who will the winners and losers be?Let's start with the Merchant perspective. With companies now actively promoting services to help merchants calculate which payment vehicles generate the lowest costs without impacting sales volumes, we very well may start to see more of the "Costco" business model where only certain pay-types are accepted at different merchants. My predictions are that first, merchants will continue to send a message loud and clear that they perceive the cost of interchange to be too high. Smaller institutions, presumably protected from interchange caps, will be forced to reduce rates anyway to sustain merchant acceptance unless existing federal law requirements remain unchanged, precluding retailers from following the laws of capitalism. One certainty is that we will see continued development of alternatives similar to Wal-Mart and Starbucks payment options.Credit and Debit sales will be impacted although they will continue to be valued highly by specific segments. The affluent will continue to expect rewards and other benefits deeming credit cards highly relevant and meaningful. Additionally, small business owners will need the payment float utility to fund services they typically don't get paid for up front. At the same time, many consumers will continue to deleverage and sustain favoritism to debit over credit. Prepaid and emerging Mobile Payments technology will continue to attract younger consumers as well as the early adapters that want to leverage the newest and coolest products and services. The negatives will take some time to surface. First, how will the CFPB react to prepaid growth and the fact that the product is not subject to interchange caps stipulated under Durbin? Next, how will merchants react and again, will we continue to see retailer specific options dominate merchant acceptance? Lastly, when fraudsters figure out how to penetrate the prepaid and mobile space, will consumers swarm back to credit before advanced fraud prediction models can be deployed since consumers bear the brunt of the liability in the world of prepaid?

By: Kari Michel As consumers and businesses continue to experience financial hardship, the likelihood of continued bankruptcy filings is fairly strong. Data from the Administrative Office of the U.S. Courts show there were 1,222,589 filings through September, versus 1,100,035 in the first nine months of 2009. According to American Bankruptcy Institute executive director Samuel J. Gerdano, "As the economy looks to climb out of the recent recession, businesses and consumers continue to file for bankruptcy to regain their financial footing. With unemployment hovering near 10% and access to credit remaining tight, total filings in 2010 will likely exceed 1.6 million." Given the bankruptcy trends, what can lenders do to protect themselves from acquiring consumers that are at risk for filing for bankruptcy? Bankruptcy scores are available, such as Bankruptcy PLUS, and are developed to accurately identify characteristics specific to a consumer filing for bankruptcy. Bankruptcy scores are typically used in conjunction with risk scores to set effective acquisition strategies. _________________ Source:  http://www.collectionscreditrisk.com/news/bankruptcy-filings-up-3003998-1.html  

By: Tom Hannagan An article in American Banker* today discusses how many community banks are now discouraging new deposit gathering. We have seen many headlines in the past couple of years about how banks are not lending. Loan origination has been trending downward for many months. Now, they aren’t seeking deposits either. You would think this is the ultimate way to lower risk, but that’s not necessarily so. There are many different reasons why banks have or may be reducing their balance sheets. Tighter credit standards, and relatively low loan demand are chief among them. This is largely a reaction, on the part of banks and borrowers, to the economic contraction and painfully slow recovery. The softness in real estate is still a large overhanging problem – for consumers, businesses, governments and the banks. Banks are still working on loss provisioning in an attempt to deal with the embedded credit risk from the last recession. Even though they may be shrinking, or very slowly growing their loan portfolio, all of the forward risk management considerations are still there. That is true for the lending business and for managing the overall balance sheet. Most apparent among all these considerations is that the entire existing loan portfolio is steadily coming up for renewal consideration. That is as much of an opportunity for reconsidering a loan’s risk and return characteristics as is considering a new loan. It is also an opportunity to review the relationship management strategy, including the value of other relationship services or the time to sell new services to that client. All these sales situations involve risk and return considerations. Not least among them are the deposit services – existing and potential – associated with the relationship. The main point in the American Banker article was that banks can have trouble putting new deposit funds to work profitably. That makes sense. Deposits involve operating risk and operating costs. The costs include both fixed and variable costs. There are four or five major types of deposits. Each of them has very different operating cost profiles, balance behavior and levels of interest expense. They also involve market risk in that their loyalty or likely duration varies. So, it is important to take both the risk and return factors of new/renewed loans into account AND to take the risk and return factors of new/existing deposit balances into account as part of ongoing relationship management – and the bank’s resulting balance sheet direction. This is a lot to consider. A good risk-based profitability regimen is as critical as ever. *American Banker, Tuesday, July 27, 2010. In Cash Glut, Banks Try to Discourage New Deposits. By, Paul Davis

By: Tom Hannagan While waiting on the compilation of fourth quarter banking industry results, I thought it might be interesting to relate the commercial real estate (CRE) risk management position facing commercial banks from the third quarter. CRE risk is an important consideration in enterprise risk management and for loan pricing and profitability. The slowdown in the global economy has affected CRE credit risk because of increased vacancy rates, halted development projects, and the loss of value affecting commercial properties. As CRE loans come up for renewal, many will find that there have equity deficits and that they are facing tightened credit standards. If a commercial property loan started life at 80 percent loan to value, and the property value has dropped 25 percent, the renewed loan balance will be down at least 25 percent, requiring a substantial net payoff from the borrower. This net cash payoff requirement would be tough to accomplish in good times and all-but-impossible for many borrowers in this economy. After all, the main reason for the decline in property value to begin with is its reduced cash flow performance. Following the third quarter numbers, total U.S. commercial real estate is generally estimated at $3.4 to $3.5 trillion. Commercial banks owned just over half of that debt, or about $1.8 trillion according to Federal Reserve and FDIC sources. The (possibly only) good news with that total is that commercial banks owned a relatively small share of the commercial-mortgage-backed securities (CMBS) slice of CRE exposure. CMBS assets were 21 percent of total CRE credit or $714 billion, but banks owned a total of $54 billion, which represented only 3 percent of total bank CRE assets. Unfortunately, the opposite is true for construction lending. U.S. banks, in total, had $486 to $534 billion (depending on the source) in construction and land loans, representing 27 percent to 30 percent of banks’ total CRE holdings. The true credit risk management picture is much more revealing if we cut the numbers by bank size. According to Deutsche Bank research, the largest 97 banks (those with over $10 billion in total assets) had $14.8 trillion in total assets and $1.0 trillion of the banking industry’s CRE credits.  This amounts to about 7 percent of the total assets for this group of larger banks. The 7,500 community banks, with aggregate assets of $2 trillion, had about $786 billion in CRE lending. This amounts to about 28 percent of total assets. That is roughly four times the level of exposure found in the larger banks. The 7 percent level of credit risk average exposure at the large bank group is less than their average level of equity or risk-based capital. For the banks under the $10 billion level, the 28 percent level of CRE exposure is almost three times their average equity position. The riskiest portion of CRE lending is clearly the construction and land development loans. The subtotals in this area confirm where the cumulative risk lies. Again, according to Deutsche Bank research, the largest 97 banks had $299 billion of the banking industry’s $534 billion in construction loans. Although this is 56 percent of total bank construction lending, it amounts to only 2 percent of this group’s total assets.  The 7,500 community banks had aggregate construction loans of $235 billion. This amounts to about 8.5 percent of total assets. That is a bit over four times the level of exposure found in the larger banks. The 2 percent level of construction credit risk exposure at the large bank group is one-fourth of their average level of common equity. At banks under the $10 billion level, the 8.5 percent level of CRE exposure, compared to total assets, is about the same as their average equity position. According to Moody’s, bank have already taken about $90 billion in net loan losses in CRE assets through the third quarter of 2009. That means the industry has perhaps another $150 billion in write-offs coming. This would total $240 billion in CRE credit losses for the banking industry due to this economic downturn. That would equate to 13.3 percent of the banking industry’s share of total CRE credit. With the decline in commercial property values ranging from 10 percent to 40 percent, a 13 percent loss is certainly not a worst case scenario. Banks have ramped up their loss reserves, and although the numbers aren’t out yet, we know many banks have used the fourth quarter 2009 to further bolster their allowances for loan and lease losses (ALLL). The larger the ALLL, the safer the risk-based equity account. Risk managers are aware of all of this and banks are very actively developing their strategies to handle the refunding requirements and, at the same time, be in a position to explain to regulators and external auditor how they are protecting shareholders. But the numbers are very daunting and not every bank will have enough net cash flow and risk equity to cover the inevitable losses.  

By: Tom Hannagan Apparently my last post on the role of risk management in the pricing of deposit services hit some nerve ends. That’s good. The industry needs its “nerve ends” tweaked after the dearth of effective risk management that contributed to the financial malaise of the last couple of years. Banks, or any business, can prosper by simply following their competitors’ marketing strategies and meeting or slightly undercutting their prices. The actions of competitors are an important piece of intelligence to consider, but not necessarily optimal for your bank to copy. One question is regarding the “how-to” behind risk-based pricing (RBP) of deposits. The answer has four parts. Let’s see. First, because of the importance and size of the deposit business (yes, it’s a line of business) as a funding source, one needs to isolate the interest rate risk. This is done by transfer pricing, or in a sense, crediting the deposit balances for their marginal value as an offset to borrowing funds. This transfer price has nothing to do with the earnings credit rate used in account analysis – that is a merchandising issue used to generate fee income. Fees, resulting from account analysis, when not waived, affect the profitability of deposit services, but are not a risk element. Two things are critical to the transfer of funding credit: 1) the assumptions regarding the duration, or reliability of the deposit balances and 2) the rate curve used to match the duration. Different types of deposit behave differently based on changes in rates paid. Checking account deposit funds tend to be very loyal or “sticky” - they don’t move around a lot (or easily) because of rate paid, if any. At the other extreme, time deposits tend to be very rate-sensitive and can move (in or out) for small incremental gains. Savings, money market and NOW accounts are in-between. Since deposits are an offset (ultimately) to marginal borrowing, just as loans might (ultimately) require marginal borrowing, we recommend using the same rate curve for both asset and liability transfer pricing. The money is the same thing on both sides of the balance sheet and the rate curve used to fund a loan or credit a deposit should be the same. We believe this will help, greatly, to isolate IRR. It is also seems more fair when explaining the concept to line management. Secondly, although there is essentially no credit risk associated with deposits, there is operational risk. Deposit make up most of the liability side of the balance sheet and therefore the lion’s share of institutional funding. Deposits are also a major source of operational expense. The mitigated operational risks such as physical security, backup processing arrangements, various kinds of insurance and catastrophe plans, are normal expenses of doing business and included in a bank’s financial statements. The costs need to be broken down by deposit category to get a picture of the risk-adjusted operating expenses. The third major consideration for analyzing risk-adjusted deposit profitability is its revenue contribution. Deposit-related fee income can be a very significant number and needs to be allocated to particular deposit category that generates this income. This is an important aspect of the return, along with the risk-adjusted funding value of the balances. It will vary substantially for various deposit types. Time deposits have essentially zero fee income, whereas checking accounts can produce significant revenues. The fourth major consideration is capital. There are unexpected losses associated with deposits that must be covered by risk-based capital – or equity. The unexpected losses include: unmitigated operational risks, any error in transfer pricing the market risk, and business or strategic risk. Although the unexpected losses associated with deposit products are substantially less than found in the lending products, they needs to be taken into account to have a fully risk-adjusted view. It is also necessary to be able to compare the risk-adjusted profit and profitability of such diverse services as found within banking. Enterprise risk management needs to consider all of the lines of business, and all of the products of the organization, on a risk-adjusted performance basis. Otherwise it is impossible to decide on the allocation of resources, including precious capital. Without this risk management view of deposits (just as with loans) it is impossible to price the services in a completely knowledgeable fashion. Good entity governance, asset and liability posturing, and competent line of business management, all require more and better risk-based profit considerations to be an important part of the intelligence used to optimally price deposits.      

By: Tom Hannagan This blog has often discussed many aspects of risk-adjusted pricing for loans. Loans, with their inherent credit risk, certainly deserve a lot of attention when it comes to risk management in banking. But, that doesn’t mean you should ignore the risk management implications found in the other product lines. Enterprise risk management needs to consider all of the lines of business, and all of the products of the organization. This would include the deposit services arena. Deposits make up roughly 65 percent to 75 percent of the liability side of the balance sheet for most financial institutions, representing the lion’s share of their funding source. This is a major source of operational expense and also represents most of the bank’s interest expense. The deposit activity has operational risk, and this large funding source plays a huge role in market risk – including both interest rate risk and liquidity risk. It stands to reason that such risks are considered when pricing deposit services. Unfortunately it is not always the case. Okay, to be honest, it’s too rarely the case. This raises serious entity governance questions. How can such a large operational undertaking, not withstanding the criticality of the funding implications, not be subjected to risk-based pricing considerations? We have seen warnings already that the current low interest rate environment will not last forever. When the economy improves and rates head upwards, banks need to understand the bottom line profit implications. Deposit rate sensitivity across the various deposit types is a huge portion of the impact on net interest income. Risk-based pricing of these services should be considered before committing to provide them. Even without the credit risk implications found on the loan side of the balance sheet, there is still plenty of operational and market risk impact that needs to be taken into account from the liability side. When risk management is not considered and mitigated as part of the day-to-day management of the deposit line of business, the bank is leaving these risks completely to chance. This unmitigated risk increases the portion of overall risk that is then considered to be “unexpected” in nature and thereby increases the equity capital required to support the bank.

By: Heather Grover In my previous entry, I covered how fraud prevention affected the operational side of new DDA account opening. To give a complete picture, we need to consider fraud best practices and their impact on the customer experience. As earlier mentioned, the branch continues to be a highly utilized channel and is the place for “customized service.” In addition, for retail banks that continue to be the consumer's first point of contact, fraud detection is paramount IF we should initiate a relationship with the consumer. Traditional thinking has been that DDA accounts are secured by deposits, so little risk management policy is applied. The reality is that the DDA account can be a fraud portal into the organization’s many products. Bank consolidations and lower application volumes are driving increased competition at the branch – increased demand exists to cross-sell consumers at the point of new account opening. As a result, banks are moving many fraud checks to the front end of the process: know your customer and Red Flag guideline checks are done sooner in the process in a consolidated and streamlined fashion. This is to minimize fraud losses and meet compliance in a single step, so that the process for new account holders are processed as quickly through the system as possible. Another recent trend is the streamlining of a two day batch fraud check process to provide account holders with an immediate and final decision. The casualty of a longer process could be a consumer who walks out of your branch with a checkbook in hand – only to be contacted the next day to tell that his/her account has been shut down. By addressing this process, not only will the customer experience be improved with  increased retention, but operational costs will also be reduced. Finally, relying on documentary evidence for ID verification can be viewed by some consumers as being onerous and lengthy. Use of knowledge based authentication can provide more robust authentication while giving assurance of the consumer’s identity. The key is to use a solution that can authenticate “thin file” consumers opening DDA accounts. This means your out of wallet questions need to rely on multiple data sources – not just credit. Interactive questions can give your account holders peace of mind that you are doing everything possible to protect their identity – which builds the customer relationship…and your brand.  

By: Tom Hannagan Beyond the financial risk management considerations related to a bank’s capital, which would be directly impacted by Troubled Asset Relief Program (TARP) participation, it should be clear that TARP also involves business (or strategic) risk. We have spoken in the past of several major categories of risk: credit risk, market risk, operational risk and business risk. Business risk includes a variety of risks associated with the outcomes from strategic decision making, corporate governance considerations, executive behavior (for better or worse), management succession events (Apple and Steve Jobs, for instance) or other leadership occurrences that may affect the performance and financial viability of the business. Aside from the monetary impact on the bank’s capital position, TARP involves a new capital securities owner being in the mix. And, with a roughly 20 percent infusion of added tier one capital, we are almost always talking about a very large, new owner relative to existing shareholders. The United States Department of the Treasury is the investor or holder of the newly issued preferred stock and warrants. The Treasury Department says it does not seek voting rights, but none-the-less has gotten them in at least some cases. The real “kicker” is embedded in the Treasury’s Securities Purchase Agreement – Standard Form. The most interesting clause, that appears to represent a very open-ended business risk to management decision making, is one relatively small paragraph, named Amendment, in the middle of Article V - Miscellaneous, just ahead of governing law (which is federal law, backed up by the laws of the State of New York). Amendment begins normally enough, requiring the usual signed agreement of each party, but then states: “provided that the Investor may unilaterally amend any provision of this Agreement to the extent required to comply with any changes after the Signing Date in applicable federal statutes.” Wow. My reading of this is that if in the future Congress enacts anything that Treasury finds applicable to any aspect of the previously signed TARP Agreement, the bank is bound to go along. Regardless of whether the Treasury negotiates any voting rights, once the TARP Agreement is executed by the bank, management is not only bound by what is in the document to begin with, it is subject to future federal law as long as the TARP shares are held by the government. As a result, many banks have said no thank you to TARP. At least four banks have recently paid back $340 million to repurchase the government’s shares. And, apparently another bank has offered to pay back $1 billion but, according to Andrew Napolitano at Fox Business Channel, the offer was turned down and the bank was threatened with adverse consequences if it persisted in its attempt to get out. More pointed and public, and much larger in size, is the dance taking place now between Chrysler Corporation, Fiat, the UAW, four lead lenders and, you guessed it, the federal government. The secured loans in question total almost $7 billion and the government wants J.P. Morgan Chase, Goldman Sachs, Citicorp and Morgan Stanley to exchange $5 billion of the loans for Chrysler stock. The banks know they would do better (for their shareholders) by selling off Chryslers assets. This is an example of why bankruptcy exists. The stakes are large and so is the business risk of the influence from the government. It will be interesting to see how things turn out. So, this new major owner does have a voice. If Congress wants certain lending volumes or terms, or they want certain compensation levels, it needs to be enacted into federal law. Short of having to pass a law, there is the implied threat of the big stick in the TARP agreement. The Purchase Agreement covers what the new owner wants now and may decide it wants in the future. This a form of strategic business risk that comes with accepting the capital infusion from this particular source.  

By: Tom Hannagan Part 2 There is one rather interesting clause that appears to represent an open-ended business porfolio risk management decision for the future. It is one small paragraph, named Amendment, in the middle of Article V - Miscellaneous, just ahead of governing law (which is federal law, backed up by the laws of the State of New York). Amendment begins normally enough, requiring the usual signed agreement of each party, but then states: “provided that the Investor may unilaterally amend any provision of this Agreement to the extent required to comply with any changes after the Signing Date in applicable federal statutes.” Wow. My understanding of this is that if Congress in the future, enacts anything that Treasury finds (or Congress requires Treasury to find) applicable to any aspect of the previously signed TARP Agreement, the bank is bound to adhere. Forget about the non-voting aspect of the preferred shares issued to the Treasury. Once the TARP Agreement is executed by the bank, management is not only bound by what’s in the document to begin with, it is in addition, subject to future federal law as long as the TARP shares are held by the government. So, this new major owner does have a voice. The Purchase Agreement covers what the new owner wants now and may decide it wants in the future. This a form of strategic business risk that comes with accepting the capital infusion, along with the various financial implications of the funding.

By: Tom Hannagan For the last 16 months or so, the financial services industry has been indicted, tried, found guilty, sentenced and duly executed for ignoring accepted enterprise risk management practices.  Banks, albeit along with goofy risk ratings agencies, lax regulators, and greedy leveraged investors, have been blamed for abandoning normal and proper credit risk behavior and lending to many who did not meet basic debt servicing capability. After things went terribly wrong in capital and liquidity markets, followed by a now-official recession in the “real” economy, banks have tightened lending standards.  (See my blog posted November 13th for more about tightened lending.)   Now, following the TARP capital infusion, the press and Congress seem very upset that banks aren’t rapidly expanding their lending, or even moderating their credit risk regimen.  This dismay, with the lack of an immediate expansion of credit granting, occurs in the face of what the same press and most politicians refer to as the greatest economic meltdown since the Great Depression.   Granted, banks are historically easy whipping boys, but they now seem damned for what they did and damned if they don’t do some more of it. Although suffering in many ways, most banks are still for-profit organizations. Contrary to popular belief, they also actually have credit policies and processes that are aimed at responsible credit risk management – at least for the loans they intend to keep on their own books. Average management intelligence would dictate being cautious in the middle of an economic downturn.   The TARP capital infusion is a sudden large windfall of new equity, like a 20 percent increase for the receiving banks. It begs the question of what to do with it. To grow assets proportionately to the TARP infusion would mean a very rapid (circa plus 30 percent) growth in lending in a very short timeframe. Given the prevalence of banks, it would be very difficult for all of them to grow their loan portfolios this fast even in a good economy.   Most banks do not need TARP funds to survive in the short term. And the weakest banks are not supposed to be granted TARP funds. This is like a steroid shot into the natural process of bank consolidation. It’s obvious that the stronger banks, now infused with hot capital, are using TARP funds to acquire other banks. In many cases the acquired banks have weaknesses that they could not likely overcome on their own. So, the TARP funds are addressing the over-banked state of the financial industry and probably offsetting what would otherwise have been a drain on the Deposit Insurance Fund. I maintain that this is a good, if unintended, outcome for both the industry and the taxpayers.   I’ve heard and read comments (by people who should know better) that the hoarding of TARP funds is aiding bank earnings. Some say that those earnings are protected by TARP because it offsets credit losses. This is an accounting absurdity. The TARP will only help bank earnings if and when it is deployed successfully. This, in turn, requires two things to take place: 1) leveraging up the new capital with other sources of funds; and 2) successfully investing the proceeds in assets that provide a decent risk-adjusted return. In any event, whenever a new amount of risk-based capital comes into the equity account, the ROE will suffer for a while.   Another kind of issue with TARP, even if it isn’t needed or desired by a healthy bank, is the stigma associated with not getting it. The few banks in this category have had to go out of their way to explain why they didn’t go for it. There is a concern that, even if it really isn’t needed, a bank will be at a cash and balance sheet disadvantage in the big fish eating the little fish game.   Finally, who asked for TARP to be created? Bear and Lehman went down. Merrill was rescued. Countrywide went down early and WAMU went later. Citi is now on both a heart-lung machine and dialysis. A bunch of the big boys got killed or were in serious trouble. But not all of them. And, several of them reportedly had to be coerced into taking their share of the first $125 billion. Everyone else pretty much observed the circus on Wall Street and Capital Hill.   So, policy makers, make up your mind.  Do you want banks exercising sound credit risk management practices or not?  Do you want industry consolidation or don’t you?  Do you want sounder banks to acquire relatively weaker ones or would you rather see the FDIC pick up the pieces later?  Do you want to dictate how and when private organizations allocate risk-based capital or not?  A little clarity would be appreciated.  After all, TARP was your idea.  It wasn’t requested by the industry at large. And the flow through to businesses and consumers will take a while. Sorry. It’s in everybody’s best interest that good risk management processes prevail at this time (and always) -- in granting and pricing credit, and in managing available capital. The lack of same helped get us all to this point.