Why BAD Loans Happen to Good Banks

RMA Journal, The, Nov, 2001 by John McGovern

When this article was published in February 1993, the author had been observing a sharp decline in the character of many borrowers during the preceding few years. Lax lending policies that thrived in the 1980s, bank complacency, the proliferation of unguaranteed credits, and the changing cultural environment were all contributors to the trend. His observations and recommendations for mitigating these problems retain the ring of truth today.

In the past year or two, my experience as a credit administrator has uncovered a growing phenomenon, which has been corroborated in discussions with other lenders throughout the country. This phenomenon, which represents a significant challenge for lenders, is the decay of borrowers' characters.

Character has, of course, always been a paramount C of credit and a major determinant in the decision to lend money. However, now, many of us are being surprised by once-trusted, good-character borrowers who walk away from their obligations with shocking frequency.

Character failure is by no means the only reason banks suffer unexpected loan losses. But in the waning economic downturn, it has become a bigger factor than it was in the 1974-75 and 1981-82 recessions. The problem is particularly germane to community banks and those banks (like mine) that focus on lending to small to mid-size companies. Given the nature, size, and strength of these borrowers, we put a significant degree of reliance on character--the owner's commitment to back up his or her company and its credits.

Contributors to the Problem

Before talking about safeguards for the future, let's look at the current situation and explore how we may have gotten here.

Relaxed lending standards and complacency. After the recession of the early 1980s, the U.S. experienced a period of economic prosperity. At the same time, traditional commercial banks faced competition on many fronts: from large, national, and wholesale banks; from savings and loans, which were given greater latitude to venture into banks' traditional areas of expertise; and even from each other.

The combination of rosy economic times and the quest for quick asset growth proved to be deadly, contributing to a general loosening of standards. For some banks it was no longer as important to know the character of the people behind borrowed funds. A few good years of returns (helped along by a sustained economic expansion) were enough to foster the feeling of "Let's book the deal and move on to the next one."

Times were good for all banks--or at least it was perceived that they were. Therefore, complacency riddled the industry. Standards were allowed to slip, and traditional policies were ignored by many community bankers who felt they could mimic the type of lending that was done for large publicly traded companies. But once savings and loans started to fail--partly because of the practice of unguaranteed lending to large real estate developers--a crack in the wall of the banking industry became evident.

Banks that focused on rapid asset growth did so at an incredibly high price, as they abandoned traditional prudent practices and, in effect, pulled lending standards down for all lenders.

Unguaranteed credits. Another facet of the problem was unguaranteed credits. Some bankers in the heady 1980s began to grant credits without requesting the guarantee of an owner. This inclination, they felt, was a way to compete for seemingly desirable credits. Problems for many of these loans cropped up early in the repayment process and were exacerbated by the recession. Credits began to go bad in increasing numbers, with no guarantees to back them up.

Amid mounting loan defaults, one fact became clear: When faced with the choice between safeguarding personal assets or protecting the assets of a bank, owners and guarantors choose the way of less integrity.

A cultural influence. Another ingredient--the cultural phenomenon known as the "me" generation--was thrown into this recipe for trouble. I am a member of that generation; therefore, I can be critical of it without being accused of generation bashing.

The generation that preceded mine, the one whose members lived through the Great Depression and World War II, exhibited an admirable sense of integrity and pride. The trust extended by a lender making loans in that era was reciprocated by deep-seated appreciation. This appreciation manifested itself in the reality that an owner would personally ensure that the debts of the business were repaid, despite the personal sacrifices or economic hardships that may have inclined him or her to direct funds elsewhere.

My generation, unfortunately, does not seem to share that conviction. As bankers, we must therefore factor that change into our decision process.

Strong societal changes in the past 30 years are obvious, and daily evidence of these changes is as close as the nearest television or newspaper. Many standards to which we once held ourselves have been eroded. Consider bankruptcy, for example. It no longer holds nearly the traumatizing stigma that it once held.