A Time for Being Very Careful

There have been no bank failures for two years-an extraordinarily long period for an industry that saw multitudes of fallen banks in the 1980s. And the FDIC’s troubled bank list is the shortest it’s been in many years. In fact, banks’ profits continue to set records even though they are operating during a period when the yield curve continues to be flat, near flat, or even negative.

In addition to all this, inflation is relatively low and appears to be under control.Thus it poses no impending threat to the banking system, even though many bankers and analysts might say it is a bit higher than desirable.

So all is well in the financial system, right? There is little chance of problems of any systemic size, right? Right.

Well, maybe.

Countering all this glowing news is a series of factors that may indeed play a role in the performance of banks and the decisions directors make in the coming year.These factors include the following:

Real estate market values are heading down, especially in the condo area. Many bank portfolios have about half of their loans in real estate. Some banks have construction loans with no long-term lender takeouts.The home mortgage business is in a down cycle, which is problematic because it has been a mainstay of many banks’ profits for some time now. Home equity loans (second mortgages), in particular, have been an important source of bank profits. It is important to remember that there has seldom been a substantial problem in the real estate market that has not significantly affected bank profits.

The major banks are large lenders to the highly leveraged fund industry. There are billions available for hedge fund operations, but a substantial part of the funding is bank debt.

Trillions of dollars of option derivatives are held by our major financial institutions. Understanding the valuation of these contract positions is very difficult, because currently there is no accurate way of determining a market value for them. Many of the finest financial minds go blank when they try to evaluate the risk in these derivative portfolios-certainly my poor old regulator’s mind can’t really evaluate the risk. However, I know enough about it to know that the risk could be huge if things go wrong in the international financial markets.

International bondholders may be in jeopardy. International money flows and markets are distorted due to the huge U.S. balance of payments deficits, resulting in large foreign investments in U.S. government securities. When will these holders of U.S. bonds say they have had enough?

The capital in the banking industry is the highest in history, but a closer view shows caution is warranted. Over 95% of U.S. banks are considered to be “well capitalized” by regulators. Reported capital risks are above 8% on a risk-based measure. The caveat, though: More than one-third of the capital in the banking system is classified as goodwill and intangibles-which is hard to liquidate when the going gets tough.

Lending standards have weakened. This is a normal reaction on the part of lenders going through prosperous periods. “Bad loans are made in good times” is as true today as it has been in the past.The bottom line: Don’t let down your guard.

Global political instability cannot be ignored. The international financial system is experiencing a huge transfer of wealth from friends in developed countries to parties in less-developed countries who are less friendly, i.e., Arabs, Russians, Venezuelans.This creates a large risk of political instability. It is a time to be very careful!

All these factors affect the duties and responsibilities of bank boards as they analyze their portfolios and balance sheets and prepare to make good business decisions for the year ahead. Yes, banks are doing very well from a historical standpoint and many aspects of the industry look rosy, yet it is important to proceed with caution to help ensure the long-term safety and soundness of our U.S. banking system.

As we used to say in law school-further deponent sayth not!