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Don’t be the next bank failure.



 

Don’t be the next financial institution to fail.


History repeats itself. Why is it every time there is a bank failure it was so obvious after the fact? Because everything is fine until it simply isn’t. There is always an inflection point, but they are often driven by fundamentally different issues and as a result, they still tend to catch people off guard.


The problem is no one ever believes there will truly be an inflection point and sometimes, no one wants to believe there will be an inflection point. In the 2000s, I owned credit risk for a $100 billion residential portfolio and started to anticipate an inflection point.


In the chase for volume and growth, the company I worked for GMAC/Ally started putting more ARM loans on our balance sheet, followed by interest only (IO) loans and other limited documentation loans. Business was booming and, in a bonus-driven culture, everyone was content except for me and a few others who were worried about the risks these assets presented to the company’s future.


For those of you unaware, GMAC/Ally was basically ground zero for the last crisis. At one time and for context, due to our significance, my areas were being audited by seven groups.


Dark clouds forming in the distance. Housing prices were still rising and in the context of residential mortgage loans, nationwide rising housing prices eviscerate credit risk. However, interest rates were rising, exposing tons of borrowers to massive increases in housing payments due to ARM loans resetting higher and the principal portion of IO loans coming due. Add this to a risky borrower base and you had matches along with a dry kindling.


A certain inevitability. I was a purveyor of doom and gloom during this period; one can imagine the grim reaper appearing in every senior leadership meeting bemoaning of a tomorrow that was far different than a bountiful times of the day. One big voice facing the sea is not enough to turn the tide. The company did agree to take billions in balance sheet write downs but did not have the will or desire to move or hedge assets that were bound for massive additional write downs.


It had not happened yet, but just like a storm in the distance heading your way, it does not take a lot to imagine what will happen. The argument against me was two-fold, nationwide home price declines don’t happen, and we had record profits at the time, not exactly a recipe for disaster.


To me, it could not be any more obvious. While something had not happened yet, it was a simple mathematical probability that was going to happen. What happened next changed banking from that point forward. Nationwide house prices tumbled largely driven by borrower distressed from rising rates and lenders/banks were crushed. Washington Mutual, Lehman Brothers and countless others failed. The entire system nearly broke.


A different time a different problem. Fast forward to today, and relatively speaking, consumer credit has held up relatively fine so far compared to the last crisis. However, easy money does not always equal easy risk management. Many banks were flush with cash and put a variety of assets on their balance sheets. Some of those assets were not hedged and their market values were highly susceptible to rising interest rates.


This poses a massive risk to institutions if large depositors start withdrawing significant amounts of cash. While the face value of that asset might be fine, when you need to sell, the only thing that matters is the market value. When depositors want their cash, and your institution cannot liquidate assets at values carried on your balance sheet, you have an obvious math problem.


Risk is always contextual. The truth about good risk management is that it can literally save a company from failure, but it can also power higher and better-quality earnings.


Risk comes in a variety of shapes and sizes. Risk always exists, but risk metrics are always contextual. If risk has been properly appraised and contingencies related to the various risks faced are in place, companies will survive and thrive in a variety of market conditions.


An institution could have a highly delinquent book, but if they priced for it and accounted for it, their risk is relatively lower than an institution with lower delinquency that priced improperly and/or failed to account for its level of delinquency.


The same goes for interest rates. If risk positions have been stressed for a variety of outcomes, rising rates may not be a problem and may even present opportunities. Risk management is a tricky discipline. Numbers require context. Sometimes smoke doesn’t mean fire and sometimes it screams it.


SOPHIACI. I was talking to a former CRO at GMAC/Ally a few years ago and they said, all GMAC/Ally had to do was listen to you (as in me). In reality, all GMAC/Ally had to do was listen to the numbers. At GMAC/Ally, I created a risk operations environment that was far ahead of every other large bank and financial institution. We created a strong data environment, we created strong models, we created strong model operations, and we created strong reporting and analytics. They were all inter-connected, fully integrated and silos were eliminated.


In the years past, after consulting with many of the nation’s leading financial institutions, everyone still struggles with all these same activities. At SOPHIACI, we took my people-based philosophies of risk management operations and transformed it into a software-based capability.


Is smoke fire? One of our products enables customers to interact with banking data to compare banks to each other. Relativity matters in a competitive marketplace. In dark times, capital seeks safety. One measure of leverage in our Industry Data product (core capital) had both Silicon Valley Bank and Signature bank as being leveraged at the 95th percentile of all banks. Contextually, both also had high amounts of their depository base above the FDIC limit, and both were highly susceptible to liquidity issues due to rising interest rates.


What’s Next? Investor and depositor emotions are extremely tough to gage. Obviously, the Federal Government and banking leaders understand this, and that is why we consistently see messages of reassurance even if there is private consternation. Emotions drive markets. This makes understanding what happens next many degrees more difficult to project.


Where the future is murky, what is less murky is the need for proper tools to measure and assess risk and business opportunities. The best tools in the world are not useful if they are too complicated, too difficult to deploy or are not widely adopted.


Financial services leaders who ignore investment in proper capabilities put their shareholders, depositors, employees, and the entire financial sector at risk. “Pennywise, dollar foolish”, can literally wipe out a company.


The financial service sector is both complicated and simple. It is complicated because cashflows are driven by a series of events that have yet to occur. It is simple because it is numerically based and with strong operations, these businesses can largely operate like a plane through dense clouds; all the information you need is present for a variety of circumstances.


Much like radar that guides pilots who cannot see in clouds, operationally strong companies can set themselves up to be able to “fly” during any conditions. Perhaps you might still experience a little turbulence, but tools can guide you to limit the frequency and severity of these “atmospheric” events allowing your business to not be disrupted while others are grounded.




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