Whatever Doesn’t Kill You, Makes You Stronger

Although the inestimable Yogi Berra claims he never actually said this, it really does seem like u00e2u20acu0153du00c3u00a9ju00c3 vu all over again.u00e2u20ac 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 Hampshireu00e2u20ac”which were each rather small since the Granite State is itself rather smallu00e2u20ac”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 industryu00e2u20acu2122s present-day crisis began when the U.S. residential real estate marketu00e2u20ac”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 loansu00e2u20ac”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 marketu00e2u20acu2122s collapse has quite possibly dragged the U.S. economy into a recession, which is bad news for thousands of small banks and their customers. Itu00e2u20acu2122s 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: Todayu00e2u20acu2122s 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 weu00e2u20acu2122re better for it.

However, the industry still has a ways to go when it comes to risk managementu00e2u20ac”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 managementu00e2u20acu2122s jobu00e2u20ac”not the boardu00e2u20acu2122su00e2u20ac”to manage risk. True, but most governance experts would probably agree that it is the boardu00e2u20acu2122s job to decide how much risk the institution should be takingu00e2u20ac”to set a boundaryu00e2u20ac”and then oversee managementu00e2u20acu2122s compliance. But to oversee effectively, directors must have knowledge and insight, otherwise one management decision looks as good as another.

Donu00e2u20acu2122t 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 u00e2u20acu0153increased supervisory attention.u00e2u20ac And while most of his comments were focused on the need for management to be more vigilant about controlling risk, the feds arenu00e2u20acu2122t 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), u00e2u20acu0153Risk management is 90% mentalu00e2u20ac”and the other half is physical.u00e2u20ac Learning the language and practice of risk management wonu00e2u20acu2122t be easy for many outside directors, but it will make the industry stronger, and weu00e2u20acu2122ll all be better for it.