Saturday, August 12, 2017

Bank Loan Leading Indicators

I recently shared a long ride with a colleague discussing a Capital Plan project we were working on. In Capital Plans, you would typically use baseline projections, usually taken from the strategic plan, and apply adverse events that, based on the bank's balance sheet and strategy, can occur. Even if they are not particularly likely to occur. 

But it's planning. And planning for bad stuff is part of planning. Life isn't all sunshine and rainbows.

As part of our commute discussion, we talked about leading versus lagging indicators of adverse events in order to reduce the impact of such events. Many if not most adverse events are beyond the bank's control. Because risks don't typically come home to roost at the time the Board or Management decide to accept the risk. Lagging indicators are easy, such as the migration from 30-89 days past due, 90+ past due, and non-accrual loans.

But lagging indicators are history. It would've been nice to know that Lee Harvey Oswald was heading to the sixth floor of the Texas School Book Depository. Unless you're Oliver Stone. Then you're wondering who Lyndon Johnson is talking to. I digress. Stopping Oswald or diverting him likely would've ended in a different result.

Can banks identify leading indicators that can reduce risk at the right time?

I was never a lender. And my firm is not in Loan Review or other areas involved with the evaluation of credit. Nor are we an ALCO firm, estimating Interest Rate Risk or Liquidity Risk. But we do Strategic Plans, Capital Plans, Process Reviews and General Advisory that deals with how banks identify and mitigate risk. 

Credit risk remains the greatest risk to a financial institution by far, in my opinion. Not even close. Although examiners and consultants will tick off a laundry list of risks that could put your bank in peril, like reputation risk. The way reputation risk is likely to roost is through liquidity risk. Customers lose confidence in your bank and your liquidity position takes a nosedive. But has many financial institutions suffered as much reputational damage as Wells Fargo recently? And their liquidity ratio is over 40%. They have plenty of liquidity.

No, I'll stand by my credit risk statement. Take the IndyMac domino effect. They had credit problems that came home to roost, Senator Chuck Schumer wrote a letter to the OTS about the bank's problems, and due to the reputation risk customers made a run on the bank. Liquidity is what put them under. Credit is what pushed the first domino.

Identifying leading indicators for credit risk isn't particularly difficult. Finding research that makes the correlation is. But I will list what I think are common-sense leading indicators to credit risk that may very well be effective, and hopefully can be tracked and monitored automatically so we don't have seven risk management analysts on staff hunting and gathering data.

JFB's Credit Risk Leading Indicators
1.  Residential and Commercial Real Estate, and Construction Lending: Trend of days on market (by property type)

2.  Residential and Commercial Real Estate, and Construction Lending: Trend of the difference between initial asking price and actual sale price (by property type)

3.  Commercial and Consumer Lending: Trend of average balance per commercial checking (by NAICS code), and retail checking accounts

4. Residential and Construction Lending: Trend of price index for single family homes under construction

5. Residential, Commercial Real Estate, and Construction Lending: Average checking account balance trends for your customers in the Real Estate Development NAICS

6.  Commercial Real Estate and Multi-family Lending: Trends in occupancy rates.

These are a few that I have seen or make sense to me. Could they be downloaded into a dashboard so bank management could see the trends, and modify risk appetites to curtail new lending in categories that are showing yellow or red? And advise your bank's borrowers on how to navigate difficult times to preserve their business to fight another day?

Do you agree with the above indicators and what others should be considered?

~ Jeff





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