Financial Services

We continue to receive inquiries from our clients, and the market in general, around whether they are required to comply with the Red Flag Rule or not. That final decision can be found with the legal and compliance teams within your organization. I am finding, however, that there generally seems to be too literal and narrow an interpretation of the terms ‘creditor’ or ‘financial institution’ as described in the guidelines.  I often hear an organization state that they don’t believe they’re covered because they are not one of those types of entities. Ultimately, as I said, that’s up to your internal team(s) to establish. I would recommend, however, that you ensure that opinion and ultimate determination is well researched. It may sound simple, but reach out to your examining agencies or the Federal Trade Commission (FTC) and discuss any ambiguities you feel exist related to covered accounts.  There is some great clarifying language out there beyond the initial Red Flag Rule. For example, the FTC provided a very useful article (www.ftc.gov/bcp/edu/pubs/articles/art11.shtm) that described how even health care providers can be covered under the Red Flag Rule.  At first glance, they may not seem to fall under the umbrella of a ‘creditor or financial institution.’ As stated in the article, the extension of credit “means an arrangement by which you defer payment of debts or accept deferred payments for the purchase of property or services. In other words, payment is made after the product was sold or the service was rendered. Even if you’re a non-profit or government agency, you still may be a creditor if you accept deferred payments for goods or services.” Maybe it’s just me, but that description is arguably much broader-reaching than one might initially think. Long story short: do your research, and don’t assume you or your accounts are not covered under the guidelines. Better to find out now instead of after your first examination….for obvious reasons.

We have talked about: the creation of the vision for our loan portfolios (current state versus future state) – e.g. the strategy for moving our current portfolio to the future vision. Now comes the time for execution of that strategy. In changing portfolio composition and improving credit quality, the discipline of credit must be strong (this includes in the arenas of commercial loan origination, loan portfolio monitoring, and credit risk modeling of course). Consistency, especially, in the application of policy is key. Early on in the change/execution process there will be strong pressure to revert back to the old ways and stay in a familiar comfort zone.  Credit criteria/underwriting guidelines will have indeed changed in the strategy execution. In the coming blogs we will be discussing: • assessment of the current state in your loan portfolio; • development of the specific strategy to effect change in the portfolio from a credit quality perspective and composition; • business development efforts to affect change in the portfolio composition; and • policy changes to support the strategy/vision. More to come.

In my last blog, I talked about the overall need for a vision for your loan portfolio and the similarity of a loan portfolio to that of an investment portfolio.  Now that we have that vision in place, we can focus on the overall strategy to achieve that vision. A valuable first step in managing an investment portfolio is to establish a targeted value by a certain time (say, our targeted retirement age).  Similarly, it’s important that we establish our vision for the loan portfolio regarding overall diversification, return and risk levels. The next step is to create a strategy to achieve the targeted state.  By focusing on the gaps between our current state and the vision state we have created, we can develop an action plan for achieving the future/vision state.  I am going to introduce some rather unique ideas here. Consider which of your portfolio segments are overweight?  One that comes to mind would be the commercial real estate portfolio.  The binge that has taken place over the past five plus years has resulted in an unhealthy concentration of loans in the commercial real estate segment.  In this one area alone, we will face the greatest challenge of right-sizing our portfolio mix and achieving the appropriate risk model per our vision. We have to assess our overall credit risk in the portfolios next.  For small business and consumer portfolios, this is relatively easy using the various credit scores that are available to assess the current risk.  For the larger commercial and industrial portfolios and the commercial real estate portfolios, we must employ some more manual processes to assess risk.  Unfortunately, we have to perform appropriate risk assessments (current up-to-date risk assessments) in order to move on to the next stage of this overall process (which is to execute on the strategy). Once we have the dollar amounts of either growth or divestiture in various portfolio segments, we can employ the risk assessment to determine the appropriate execution of either growth or divestiture. Stick with me on this topic because in my next blog we will discuss appropriate risk assessment methodologies and determine appropriate portfolio distributions/segmentations.

By: Tom Hannagan I was hoping someone would ask about this. Return on Equity (ROE) is generally net income divided by equity, while Return on Assets (ROA) is net income divided by average assets. There you have it. The calculations are pretty easy. But, what do they mean? ROA tends to tell us how effectively an organization is taking earnings advantage of its base of assets.  This used to be the most popular way of comparing banks to each other -- and for banks to monitor their own performance from period to period. Many banks and bank executives still prefer to use ROA…though typically at the smaller banks. ROE tends to tell us how effectively an organization is taking advantage of its base of equity, or capital. This has gained in popularity for several reasons and has become the preferred measure at larger banks. One huge reason for the growing popularity of ROE is, simply, that it is not asset-dependent. ROE can be applied to any line of business or any product. You must have “assets” for ROA, since one cannot divide by zero. This flexibility allows banks with differing asset structures to be compared to each other, or even for banks to be compared to other types of businesses. The asset-independency of ROE also allows a bank to compare internal product line performance to each other. Perhaps most importantly, this permits looking at the comparative profitability of lines of business like deposit services. This would be difficult, if even possible, using ROA. If you are interested in how well a bank is managing its assets, or perhaps its overall size, ROA may be of assistance. Lately, what constitutes a good and valid portrayal of assets has come into question at several of the largest banks. Any measure is only as good as its components. Be sure you have a good measure of asset value, including credit risk adjustments. ROE on the other hand looks at how effectively a bank (or any business) is using shareholders’ equity. Many observers like ROE, since equity represents the owners’ interest in the business. Their equity investment is fully at risk compared to other sources of funds supporting the bank. Shareholders are the last in line if the going gets rough. So, equity capital tends to be the most expensive source of funds, carrying the largest risk premium of all funding options. Its deployment is critical to the success, even the survival, of the bank. Indeed, capital allocation or deployment is the most important executive decision facing the leadership of any organization. If that isn’t enough, ROE is also Warren Buffet’s favorite measure of performance. Finally, there are the risk implications of the two metrics. ROA can be risk-adjusted up to a point. The net income figure can be risk adjusted for mitigated interest rate risk and for expected credit risk that is mitigated by a loan loss provision. The big missing element in even a well risk-adjusted ROA metric is unexpected loss (UL). Unexpected loss, along with any unmitigated expected loss, is covered by capital. Further, aside from the economic capital associated with unexpected loss, there are regulatory capital requirements. This capital is left out of the ROA metric. This is true at the entity level and for any line-of-business performance measures internally. Since ROE uses shareholder equity as its divisor, and the equity is risk-based capital, the result is, more or less, automatically risk-adjusted. In addition to the risk adjustments in its numerator, net income, ROE can use an economic capital amount. The result is a risk-adjusted return on capital, or RAROC. RAROC takes ROE to a fully risk-adjusted metric that can be used at the entity level and that can also be broken down for any and all lines of business within the organization. As discussed in the last post, ROE and RAROC help a bank get to the point where they are more fully “accounting” for risk – or “unpredictable variability”. Sorry about all of the alphabet soup, but there is a natural progression that I’m pointing to that we do see banks working their way through. That progression is being led by the larger banks that need to meet more sophisticated capital reporting requirements, and is being followed by other banks as they get more interested in risk-adjusted monitoring as a performance measurement. The better bank leadership is at measuring risk-adjusted performance, using ROE or RAROC, the better leadership can become at pricing for all risk at the client relationship and product levels.

The Federal Trade Commission (FTC) suspended enforcement of the new Red Flag Rule until May 1, 2009.  According to the FTC’s Enforcement Policy, “…during the course of the Commission’s education and outreach efforts following publication of the rule, the Commission has learned that some industries and entities within the FTC’s jurisdiction have expressed confusion and uncertainty about their coverage under the rule.  These entities indicated that they were not aware that they were undertaking activities that would cause them to fall within FACTA Sections 114 and 315 definitions of ‘creditor’ or ’financial institution’.” So, depending upon which enforcement entity (or entities) will be knocking on your door in the coming months, you may (and I emphasize “may”) have some extra time to get your house in order.   While many of you are likely confident that you have a compliant written and operational Identity Theft Prevention Program, this break in the action can be a great time to take care of setting up some ongoing procedures for keeping your program up to date.  Here are some ideas to keep in mind along the way: 1. Make sure you have clear responsibilities and accountabilities identified and assigned to appropriate persons.  Lack thereof may lead to everyone thinking someone else is keeping tabs. 2. Start setting the stage for a process to update your program based on: a. Your new experiences with identity theft; b. Changes in methods of identity theft; c. Changes in methods to detect, prevent, and mitigate identity theft; d. Changes in the types of accounts you offer or maintain; and e. Changes in your business arrangements, including mergers, acquisitions, alliances, joint ventures and service provider arrangements. 3. Set up a process for program review at the board level.  Remember that your program does not have to be approved by your board of directors annually, but the board (or a committee of the board) or senior management must review reports regarding your program each year.  They must approve any material changes to your program should they occur. 4. Prepare now for follow up actions associated with your first Red Flag Rule examination(s).  There will surely be suggestions or mandates stemming from that exercise, and now is a good time to start securing appropriate resources and time. My key message here is that, while there may be lull in the world of Red Flags activity, this is a great time to keep momentum in your program development and upkeep by planning for the next wave of updates and your impending examinations.  Best of luck.

I’m working with many of our clients in reviewing their existing or evolving Red Flags Identity Theft Prevention Programs.  While the majority of them appear to be buttoned up from the perspective of identifying covered accounts and applicable Red Flag conditions, as well as establishing detection methodologies, I often still see too much subjectivity in their response and reconciliation procedures. Here are a few reasons why the “response” portion of a strong Red Flags Identity Theft Prevention program needs to employ consistent and objective process, decisioning, and actions: 1. Inconsistent or subjectively varied responses and actions greatly reduce the ability to measure process effectiveness over time.  It becomes increasingly difficult for retro-analysis to identify which processes and specific steps in those processes were successful in either positively or negatively reconciling potential fraudulent activity.  Subsequently, it clouds any ability to make effective or necessary changes to specific activities that may not be working well. 2. Examiners may focus heavily on the response portion of your program.  During operational side by sides, or even written program reviews, the less ambiguity and inconsistency identified or perceived, the better.  A quick rule of thumb for any examination: preempt any questions with exhaustive information and clarity.  Examiners that don’t need to ask many, or any, questions are happy examiners. 3. Objective and consistent process allows for more manageable staff training.  It is much easier to educate your staff around a justified and effective uniform process than around intuitive and haphazard procedures and consumer interactions.  It is tough to set expectations with your staff if there are gaping holes in the activities they are expected to execute. 4. Customer experience will certainly be more positive, and less of a worry for managers, as inequity of treatment is removed from the equation.  It is better to have each customer progress through similar steps toward authentication than varied ones from the perspective of time, perception, effectiveness, and convenience.   Now, certainly, a risk-based approach allows for varied treatment based on that risk.  The point here is more toward the need to apply those varied techniques consistently. 5. Social engineering.  Fraudsters are pretty good at figuring out if an operational process is open to interpretation and manipulation.  They’ll continue to engage in a process with the goal of landing with the right associate who may be following a more easily penetrable fraud detection method.  Bottom line: keep the walls around your business the same height throughout. Until next time, best of luck as you continue to develop and improve your Red Flags programs.

As someone heavily engaged with the market and our clients discussing Red Flag Rule compliance, Red Flag guidelines, etc...this question has come up over and over again.  You’d think by now I’d have a simple, clever, and strategically created product name to throw out there.  Well, I don’t, and here’s why: we had Red Flag relevant products before Red Flags were in vogue.  So, why didn’t we just rename them under the Red Flag brand?  Because honestly, that would border on irresponsibility.  Let me explain briefly… If you recall, the Red Flags Rule requires that covered institutions employ a written and operational Program that addresses the four mandatory elements of: • Identifying Red Flags applicable to covered accounts and incorporating them into the Program; • Detecting and evaluating the Red Flags included in the Program; • Responding to the Red Flags detected in a manner that is appropriate to the degree of risk they pose; and • Updating the Program to address changes in the risks to customers, and to the financial institution’s or creditor’s safety and soundness, from identity theft. You read in these requirements words like “applicable” and “appropriate” and “degree of risk.”  You don’t read words like “use this tool” or “detect this specific set of conditions.”  My point here is that, over the past year, we’ve been working with our clients to map in the “appropriate” and “applicable” set of products and services to allow them to become Red Flag compliant.  These products and services range in data leverage and provision, predictive power, decisioning, and of course, cost.  That is a good thing, as our clients require individualized tool sets and processes based on their serviced market, gathered information, consumer relationships, products offered, and risk associated with all of those factors. We don’t offer an unlimited or overwhelming number of Red Flag relevant products, but we do offer a diverse enough set that has afforded our clients an opportunity to select the best fit.  Whether you choose to adopt Experian as your Red Flag partner or another service provider, keep in mind that one size does not fit all, and be wary of those claiming to be just that.  As Red Flag examinations start rolling out in the coming months, there will be a focus on ensuring that your programs are comprehensive and effective.  Examiners will be looking at your programs, not your service provider.  Be sure to collaborate with your partners to meticulously apply the best solution.  At Experian, we’ve taken this collaborative approach with each of our clients, and have employed products ranging from our robust Precise ID SM consumer authentication platform to our Fraud Shield SM risk warning product.  Time spent up front in identifying your Red Flag requirements and working with your service provider to determine the best course of action will pay dividends down the road, and ensure you implement a compliant process once….not twice.

By: Tom Hannagan In previous posts, we’ve dealt with the role of risk-based capital, measuring performance based on risk characteristics and the need for risk-based loan pricing. What about risk mitigation? Some of the greatest sins of the financial industry in the current malaise have been the lack of transparency, use of complex transactions to transfer risk and the creation of off-balance-sheet entities to house dodgy investments. Much has been made of the role of Credit Default Swaps (CDSS) as one of the unregulated markets (and therefore guilty parts) of the current credit meltdown. The regulatory agencies and the media are aghast at the volume (peak of some $62 trillion in notional value) of CDSS that have resulted from a totally private market. The likes of Lehman Brothers, Bear Sterns and AIG were all big issuers of CDSS. And the trillions of notional value of open CDSS is as much as 100 times the underlying value of the actual debt being insured. There are problems here, but it may be worth clarifying the useful risk management activities from the potentially abusive excesses involving such instruments. CDSS are derivative contracts whereby one party buys credit protection from a counterparty. The buyer pays a premium to the seller either in a lump sum or periodically over the life of the contract. If a credit event such as a default on a loan or a bond occurs, the seller of the CDSS pays the holder for the loss or purchases the initial debt, the reference obligation, at a pre-set price.  So, a CDSS is in effect a put option that is deep-out-of-the-money. They expire upon termination and most are never exercised. They are subject to fair-value accounting and can change in value from month to month as the credit markets premiums for similar cover moves up or down. Banks and others can use CDSS to, in effect, adjust the nature of credit risk in their portfolios by both buying and selling such contracts. Asset securitizations, whether mortgage-backed securities or other formulations, are in fact broken-down and re-packaged forms of assets that can be sold -- transferring certain rights, values and risk to another party for payment received. They are complex and therefore mostly opaque to the general public and even many practitioners. They often involve the use of special purpose entities or trusts that can further confuse investors. These tactics have added to the difficulty of the credit crisis and the collapse of capital markets. But, CDSS are contingent in nature and act more like fire insurance or a back-up data center. Such operational expenses are intended to control risks. The accounting treatment is complex and, to an extent (especially as regards the tax treatment), still not well defined by accounting authorities. For most banks, and most CDSS contract, the premium is amortized over the life of the contract. The premium expense entry in their general ledgers is an expense of doing business that is intended to alleviate some credit risk. We are now talking about a covered CDSS, where the bank has extended credit or invested in a debt instrument. Those who purchased uncovered CDSS are gambling on a default occurrence and used CDSS as a more cost-effective (and secretive) alternative to shorting securities. It is somewhat like a naked short. So, a covered CDSS is ultimately an expense associated with protecting the net asset value of a credit transaction. Importantly, this expense should be included in any performance analysis or pricing of the risk-adjusted profitability of the credit obligation and/or client relationship involved. This risk mitigation exercise may be in lieu of a higher required rate or fee on an otherwise uncovered/unmitigated credit transaction, or being satisfied with a lower risk-adjusted return where the bank assumes (self-insures) all of the credit risk. CDSS quotes/costs, similar to rate spreads on corporate bonds, are the open market’s current feeling regarding an entity’s credit quality or relative probability of default. There are some 400 or so participants in the CDSS market, including writers and dealers. Market data is published for many obligations. Even the previously risk-free Treasury securities now have CDSS quotes – and they have gone up considerably in recent months. It is always the buyers’ responsibility to decide if the quoted prices make sense or not and how such quotes should be used in evaluating credit and negotiating lending opportunities in addition to whether or not to purchase this insurance. Finally, the quality of the seller is a consideration. There is no good reason to buy fire insurance from someone that might not be able to pay for your building if it burns down. CDSS have been private party transactions and, as stated earlier, there have been solvency problems with some of the sellers of such instruments. There is now a move under way to create a central exchange for such transactions with both regulations governing the sellers, more standardized contracts and financial backing of the instruments from the exchange. Such an exchange will address both the transparency of the process and the efficiency of market prices. Risk mitigation strategies (risk-based pricing, portfolio risk management, credit risk modeling, etc.) need to be carried out thoughtfully. If something sounds too good to be true, it deserves a deeper look. Your bank’s credit regimen may well be better at evaluating default probability than a marketplace that is prone to feed on its own fears. But, CDSS “insurance” quotes are an outside point of reference and an option to mitigate some credit risk…no pun intended. Here are two interesting sources of information: *  BNET Business Network * Georgetown University -- Law Center

One of the more significant operational concerns around Red Flags compliance centers on the management of resultant referral volumes, i.e., the potential that the account origination or maintenance process will get bogged down due to a significant number of red flags detected.  These concerns are not without merit, and are arguably the most frequently discussed Red Flag issue with our client base. Organizations may be able to control referral volumes through the use of automated tools that evaluate the level of identity theft risk in a given transaction.  For example, customers with a low-risk authentication score can be moved quickly through the account origination process absent any additional red flags detected in the ordinary course of the application or transaction.  In fact, using such tools may allow organizations to speed up the origination process for these customers and identify and focus resources on those transactions that pose the greatest potential for identity theft. A risk-based approach to Red Flags compliance affords an institution the ability to reconcile the majority of detected Red Flag conditions efficiently, consistently and with minimal consumer impact.  Detection of Red Flag conditions is literally only half the battle.  In fact, responding to those Red Flag conditions is a substantial problem to solve for most institutions.  A response policy that incorporates scoring, alternate data sources and flexible decisioning can reduce the vast majority of referrals to real-time approvals without staff intervention or customer hardship.  Rather than implementing a “rules-based” program (one in which particular Red Flags are identified, detected and used in isolation or near isolation in decisioning), many institutions are opting to approach Red Flag compliance from a “risk-based” perspective. This “risk-based” approach assumes that no single Red Flag Rule or even set of rules provides a comprehensive view of a consumer’s identity and associated fraud risk. Instead, a “risk-based” systematic approach to consumer authentication employs a process by which an appropriately comprehensive set of consumer data sources can provide the foundation for highly effective fraud prediction models in combination with detailed consumer authentication conditions (such as address mismatches or Social Security number inconsistencies).  A risk-based fraud detection system allows institutions to make consumer relationship and transactional decisions based not on a handful of rules or conditions in isolation, but on a holistic view of a consumer’s identity and predicted likelihood of associated identity theft. Many, if not all, of the suggested Rules in the published guidelines are not “silver bullets” that ensure the presence or absence of identity theft. A substantial ratio of false positives will comprise the set of consumers and accounts being reviewed as having met one or more of the suggested Red Flag rule conditions. These rules and guidelines are intended neither to prevent legitimate consumers from establishing relationships with institutions nor create a burdensome and prohibitive volume of consumer “referrals.” While those rules incorporated into an institution’s Program must be addressed when detected, a risk-based system allows for an operationally efficient method of reconciliation in tandem with identity theft mitigation.

Whenever an industry encounters problems, the natural tendency is to play the blame game.  In the banking industry, credit risk managers are looking for who or what to blame for the tide of charge offs and delinquencies in their under-performing loan portfolios and in their commercial loan origination operations.  Credit scoring has definitely taken it on the chin as an easy target during 2008. Is credit scoring the problem? Absolutely not! As with anything, the more complacent we become…and the more we “turn off our brains” and stop thinking…the more risk we assume.  The more we solely rely upon the credit score alone, the more we subject ourselves to the risks inherent in “score and go” lending. We are all well aware that credit scoring measures propensity to repay and not capacity to repay.  Over the past several years, the propensity to repay has been boosted by ever-increasing real estate values and by the refinance boom.  For example, some consumers have been able to survive on a 50 percent debt–to- income due to constant use of credit cards …by paying off those cards with a home mortgage refinance.  That set of behaviors would have shown a propensity to repay…but  was it ever acceptable to have 50 percent of your income go to debt payments?! Statistically it may have worked for a few years, but once real estate values stopped escalating, the problem with lack of capacity to repay reared its ugly head. When it comes to risk management, let’s get back to reality and sound principles.

By: Tom Hannagan In my last post, I addressed the need for banks to advance their management of risk to include the relationship between capital and risk in their internal decisions and actions. While it is difficult for me to make this topic very exciting, it can’t be ignored. It very nearly resulted in bankrupting the global financial system. Beyond profitability, bank executives must measure and monitor their risk-based capital because: 1) equity capital represents the ownership interest in a bank; 2) equity capital is by far the most expensive source of funding; and 3) the risk associated with capital sufficiency and continued solvency is important. As Colonel Jessup might confirm, “Yes, we’re talking about mortal danger”. Many are scrambling to apply for the TARP (Troubled Asset Relief Program) capital infusion – and most are getting approved for these windfall funds. (Today’s investment advice from the experts: don’t buy common shares in any bank that applied and was turned down.) Let’s take a look at the impact of these funds. If we were, for example, a $10 billion total asset bank, with say $800 million in equity capital prior to TARP and had roughly $700 million in risk-weighted assets, we might get approved for $200 million in TARP-related preferred shares at a cost of 5 percent (after tax) for the next five years. If, our make believe $10 billion bank was earning an average pre-2008 economic-and-credit-crisis return on assets of 1 percent, or $100 million per annum, what are the implications of the added $200 million in capital on future earnings? That $100 million in “pre-crisis” earnings represented a return on equity of 12.5 percent on our original capital of $800 million. (Stay with me, now…)   Since we need to pay the Feds (our new shareholders) $10 million in preferred dividends per annum in after-tax money, we need to earn an added $16 million in pre-tax operating income just to break even on the deal. That would mean, in our otherwise static model, that earnings need to move from $100 million to $110 million. More importantly, pre-tax income needs to move from say $150 million to $166 million, assuming about a 33 percent effective tax rate. We’ve got the fresh $200 million to work with, assuming we don’t need part of it to cover credit charge-offs or other asset write-downs. To earn $16 million from that $200 million investment, we would need an 8  percent pre-tax operating income (that’s after expenses, folks). I’m open to suggestions at this point...And you thought banking was easy. You do that the old fashion way -- with leverage. You use the $200 million to get someone (depositors, the Federal Home Loan Bank, a Federal Reserve Bank, or anyone else) to give you more money to invest (at a critically important tax-deductible cost) along with your fresh $200 million in preferred equity. Remember, our bank is already operating with leverage, supporting $7 billion in risk-weighted assets, and $10 billion in total assets, with the pre-existing $800 million in capital. Unfortunately, leverage involves at least liquidity risk, and probably market risk -- on top of whatever direct (credit, market, operational) risks are associated with whatever end investment you choose (…and the Feds hope you choose loans). Obviously, the fastest way to get the added leverage, along with a quick addition to earnings assets, is to go buy another bank (and absorb them more successfully than the two of you ran separately). Thus, a new round of consolidation has begun. Regardless of the method used to grow into the TARP money, any bank that doesn’t take into account the risks associated with these decisions/actions is merely kidding itself. TARP funding will not make any real headway in improving risk-adjusted earnings going forward. There is (and always has been) a direct relationship between actual risk and risk-adjusted return.  It is now more important than ever for bank management to monitor and measure their organization’s activities (loan pricing and profitability, investing, deposit taking, investment management, credit risk modeling, buying other banks...and anything else they do) based on the relative risk of those activities and based on the equity capital realistically required to support those risks. This means using return on equity measurement internally as well as at the entity level. I look forward to your comments.

By: Tom Hannagan Much of the blame for the credit disaster of 2007 and 2008 has been laid at the risk management desks of the largest banks. A silver lining in the historic financial disaster of today may be the new level of interest in management of risk -- particularly, of the relationship between capital and risk. Financial institutions of all sizes must measure and monitor their risk-based capital for three critical reasons. Ownership interest First, equity capital represents the ownership interest in a bank. Although a relatively small portion of the balance sheet, equity capital is the part that actually belongs to a bank’s owners. Everything else on the liability side is owed to depositors or lenders. All of the bank’s activities and assets are levered against the funds contributed by the equity investors. This leverage is roughly 10-to-1 for most commercial banks in the United States. For the five major investment banks, this risk-based leverage reached 30-to-1. Their capital base, even with new infusions, could not cover their losses.  It is necessary and just good business sense to regularly let the owners know what’s going on as it relates to their piece of the pie—their invested funds. Owners want to know the bank is doing things well with their at-risk funds. Banks have a duty to tell them. Funding expenses Second, equity capital is by far the most expensive source of all funding. Transaction deposit funds are usually paid an effective rate of interest that is lower than short-to-intermediate-term market rates. Time depositors are competitively paid as little as possible based on the term and size of their commitment of funds. Most banks are able to borrow overnight funds at short-term market rates and longer-term funds at relatively economical AA or A ratings. Equity holders, however, have historically received (and typically expect) substantially more in the way of return on investment. Their total returns, including dividends, buybacks and enhanced market value, are usually double to triple the cost of other intermediate-to-long-term sources of funds. From a cost perspective, equity capital is the dearest funding the bank will ever obtain. Risk factor This brings us to the third reason for measuring and monitoring capital: the risk factor. A very large portion of banking regulation focuses on capital sufficiency because it directly affects a bank’s (and the banking industry’s) continued solvency. Equity capital is the last element of cushion that protects the bank from insolvency. Although it is relatively expensive, sufficient equity capital is absolutely required to start a bank and necessary to keep the bank in good stead with regulators, customers and others. Equity holders are usually conscious of the fact that they are last in line in the event of liquidation. There is no Federal Deposit Insurance Corporation (FDIC) for them, no specific assets earmarked to back their funding and no seniority associated with their invested money. We all know what “last in line” means for most shareholders if a failure occurs -- 100 percent loss.   There is a clear and direct relationship between equity risk and cost—and between equity risk and expected return.  It is now more important for bank executives to monitor and measure their organization’s activities based on the relative risk of those activities and based on the equity capital required to support those risks. This means using return on equity (ROE) a lot more and return on assets (ROA) a lot less. Because of the critical need and high cost of risk-based equity and the various risks associated with the business of banking, decisions about the effective deployment of capital always have been the primary responsibility of bank leaders. Now, the rest of the world is focusing more on how well, or poorly, management of risk has been done. I’ll comment on using ROE more in later posts.    

For those of us that have been following the Red Flag Rules adoption for more than a year now, the recent arrival and passing of the November 1 compliance deadline allows us to pause to assess where we are -- and where we are heading.  One question seems to surface regularly these days: How ready or compliant is the market today? Well, I think it’s safe to say that the market is certainly not 100% home when it comes to compliance readiness.  Experian surveys registrants on our Red Flags online resource site.  As of October 31 -- a.k.a. ‘Compliance Eve’ -- nearly half of the registrants (48%) fell into the category of ‘just starting to review the rules and determine a compliance plan’.  Other industry surveys, interviews, and analyst reports suggest an even lower rate of compliance (closer to only one-third of covered institutions) in the market.  The Federal Trade Commission seemed to sense this market condition, and granted a six-month reprieve from Red Flags compliance enforcement – to May 1, 2009.  While this extension is welcome news for those institutions falling under the FTC’s jurisdictional umbrella, other institutions are arguably out of compliance today, and face pending examinations in the coming months.  So, is the market ready today?  The broad answer is a resounding ‘no.’  Much of the market’s effort has gone into the creation of written Identity Theft Prevention Programs as part of the Red Flag Rule requirements.  How well will these written procedures be received by the examining agencies?  How will these written programs translate into effective and (as importantly) manageable operational processes?  The first wave of examinations will help answer some of these questions and concerns….and ongoing cost analysis (associated with: referral volumes; application acceptance rates; manual or automated processes; and, of course, fraud losses) will help paint a clearer picture in the months to come.

We know that financial institutions are tightening their credit standards for lending.  But we don’t necessarily know exactly how financial institutions are addressing portfolio risk management -- how they are going about tightening those standards. As a commercial lender, when the economy was performing well, I found it much easier to get a loan request approved even if it did not meet typical standards.  I just needed to provide an explanation as to why a company’s financial performance was sub-par and what changes the company had made to address that performance -- and my deal was approved. When the economy started to decline, standards were suddenly elevated and it became much more difficult to get deals approved.  For example, in good times, credits with a 1.1:1 debt service coverage could be approved; when times got tough – and that 1.1:1 was no longer acceptable – the coverage had to be 1.25:1 or higher. Let’s consider this logic.  When times are good, we loosen our standards and allow poorer performing businesses’ loan requests to be approved…and when times are bad we require our clients perform at much higher standards.  Does this make sense?  Obviously not.  The reality is that when the economy is performing well, we should hold our borrowers to higher standards.  When times are worse, more leniency in standards may be appropriate, keeping in mind, of course, appropriate risk management measures. As we tighten our credit belts, let’s not choke out our potentially good customers.  In the same respect, once times are good, let’s not get so loose regarding our standards that we let in weak credits that we know will be a problem when the economy goes south.