Whatever Doesn't Kill You, Makes You Stronger
Jack Milligan

These are the times that try bankers’ souls, but no doubt, the industry will persevere and thrive.

Although the inestimable Yogi Berra claims he never actually said this, it really does seem like “déjà vu all over again.” The last time the U.S. banking industry faced as difficult a business climate as the one it faces today was in the early 1990s, when the downward leg of a vicious credit cycle resulted in the greatest number of bank failures since the Great Depression. Although big money-center banks like Manufacturers Hanover and Bankers Trust (to cite a couple of now-extinct dinosaurs) wrote off hundreds of millions of dollars in leveraged buyout loans, the really, really big money was lost in commercial real estate, which became a systemic problem for the industry. Not only did large regional institutions like Boston-based Bank of New England collapse when the real estate bubble popped (along with most of the big Texas banks), so too did many community banks. For example, the five largest banks in New Hampshire—which were each rather small since the Granite State is itself rather small—also lent heavily to finance a booming real estate market, and also failed when the bubble popped.

Did someone say the word bubble? The banking industry’s present-day crisis began when the U.S. residential real estate market—where home prices had been driven up to unsustainable levels by the combination of cheap money, a securitization industry that operated with the hungry efficiency of a cosmic black hole, and greedy investors who were snared by the high returns of mortgage securities backed by high-risk subprime loans—collapsed like (forgive the pun) a house of cards. And while most of the financial carnage to date has been sustained by such Wall Street giants as Citigroup, Merrill Lynch, and Bear Stearns, the residential market’s collapse has quite possibly dragged the U.S. economy into a recession, which is bad news for thousands of small banks and their customers. It’s no secret that in recent years, most community institutions have made their living off of commercial real estate lending in various forms, and a recession that hits Main Street hard could be devastating for them.

I have a prediction to make: Today’s real estate crisis will do for the practice of risk management what the previous meltdown did for bank capital. You may recall that all those bank and thrift failures eventually begat the Federal Deposit Insurance Corp. Improvement Act of 1991 (lovingly known as FDICIA), which ultimately led to much higher capitalization requirements for all depository institutions. There is no question that the industry heads into this crisis with a more heavily armored balance sheet than it had 20 years ago, when newly deregulated yet dangerously undercapitalized thrifts were using six-month certificates of deposit to fund risky commercial real estate loans. The industry is much stronger today, and we’re better for it.

However, the industry still has a ways to go when it comes to risk management—particularly at the board level where many directors do not have a strong grasp of such important concepts as liquidity, market, and operational risk. At our recent Bank Audit Committee Conference in Chicago, one bank director expressed the opinion that it is really management’s job—not the board’s—to manage risk. True, but most governance experts would probably agree that it is the board’s job to decide how much risk the institution should be taking—to set a boundary—and then oversee management’s compliance. But to oversee effectively, directors must have knowledge and insight, otherwise one management decision looks as good as another.

Don’t be surprised if federal banking regulators, led by Federal Reserve Chairman Ben Bernanke, begin to pressure banks to adopt more stringent risk management practices. In a speech last May, Bernanke said the Fed was giving risk management at financial institutions “increased supervisory attention.” And while most of his comments were focused on the need for management to be more vigilant about controlling risk, the feds aren’t going to let bank boards off the hook. Whether they grapple with it though the audit committee, a separately chartered risk committee, or some other governance mechanism, directors are going to have to learn a lot more about risk management than most of them know today.

To paraphrase something Berra really did say (but in an entirely different context), “Risk management is 90% mental—and the other half is physical.” Learning the language and practice of risk management won’t be easy for many outside directors, but it will make the industry stronger, and we’ll all be better for it.

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