The numbers are in, and once again, the banking industry has outdone itself. According to Federal Deposit Insurance Corporation statistics released this month, U.S. commercial banks reported net income of $59.2 billion last year, a 13% jump over 1996 figures. With successive years of record-breaking profits, a vibrant economy and merger speculation fever, bank stocks are rolling, too. But good times can breed complacency. And while no one wants to spoil a party, some regulators, congressmen — and even a few bankers — are expressing their concerns over what they perceive as a deterioration in asset quality.
Undeniably, banks are reporting healthy earnings. But scratch beneath the surface, and you’ll find that these earnings often reflect an increased reliance on non-operating items and tax benefits. And while much of the media coverage of banking focuses in on blockbuster merger deals with price tags of three-to-four times book value, comparatively little coverage is devoted to credit quality despite the explosion in consumer debt and personal bankruptcies and the perceived easing of underwriting standards.
While no one is claiming that the sky is falling, it is notable that several prominent policy wonks fear the effects of the next recessionary blow. Comptroller of the Currency Eugene Ludwig, whose term will come toa close in April, has been especially vocal, and even Alan Greenspan warned in his recent semi-annual report to Congress that “history suggests that you tend to get breakdowns in lending standards” during extended periods of prosperity. But determining the source of potential problems is another matter, so I visited via telephone recently with David Gibbons, the OCC’s deputy comptroller for credit risk. For the most part, the OCC’s worries can be capsulized into three credit concerns. Specifically, the OCC says that some banks are:
1.) Aggressively jumping into product lines for which they lack appropriate experience.
2.) Making conscious decisions to accept higher risks by granting structural concessions in existing product lines through the loosening of repayment and recourse terms, the waiving of financial analysis or 100% financing of developers’ hard and soft costs;
3.) Accumulating “worrisome” concentrations in portfolios where the product line is highly vulnerable to developing market trends or business cycles.
Gibbons says that he understands how bankers are pressured to achieve consistent quarterly earnings and are thus seeking new avenues of business development. But he says there must be a balance in place between profits and sound credit practices. While the temptation is there to loosen up a bit because economic times are so good, what happens when the tide begins to turn?
Indeed, if history is an example, banks have learned the hard way that economic changes during good times can decimate banks’ credit stability before there’s a realization that anything’s even wrong. In a recent speech, the OCC’s Ludwig cited a great example: Southwestern banks during the 1980s. When energy prices zoomed, the proceeds found an outlet in real estate. But when oil prices collapsed suddenly in the mid-1980s, they set off a chain reaction. A chilling statistic from Ludwig’s handbook is this: Nine of the 10 largest bank holding companies in the state of Texas failed shortly thereafter.
While OCC officials acknowledge that economic shifts are difficult for anyone to predict, their cautionary note is this: don’t take anything for granted just because the economy is booming. And while competition and economic shifts may be out of bankers’ control, the OCC says that credit analysis is within banks’ control. Subsequently, the OCC is concerned that bankers — in their quest for expanded profits — are actively embracing new tactics like credit scoring models, for example, without having much experience with them.
Gibbons states that some bankers think these models are foolproof because they take into account past recessionary experiences, but as Gibbons wisely stresses, “there’s no guarantee that the past will repeat itself.” Indeed, the types of economic pressures that hurt banks in the 1970s or late 1980s may be totally different from what may happen tomorrow.
While Mississippi banks have not experienced the economic highs and lows of other Southern neighbors, there are potential vulnerabilities indigenous to each part of the state. Subsequently, if bankers should learn anything from the industry’s mistakes of the past, it’s this: Good times aren’t the time to abandon tried and true credit policies. Exceptional banks possess self-discipline. Ultimately, these are the ones that can thrive during the best and worst of economic times.
Tupelo-based journalist Karen Kahler Holliday writes a monthly banking column for the Mississippi Business Journal. She is senior contributing editor for U.S. Banker magazine.