Focusing on the fundamentals

RMA Journal, The, May, 2004 by Lee B. Murphey

I was serving as chairman of RMA's Credit Division Council in the early 1990s when our group of volunteers looked at the state of the industry coming out of the recession of the late 1980s. That recession was a bloodbath for bank loan portfolios because the industry had once again failed to learn the lessons of the past. Billions in loan losses resulted primarily from the same mistakes we had made in the early 1980s, not to mention the mid-1970s. RMA undertook a campaign to raise members' awareness of these repetitive mistakes and to attempt, once and for all, to stop the cycle of bad loans made during good times.

This month The RMA Journal focuses on C&I (commercial and industrial) lending. When asked to introduce this month's theme, I immediately recalled RMA's work of a decade ago and it was "deja vu all over again." Clearly, the issues facing the industry in 1991 are very different from those we face in 2004. Yet maybe that's where we always get ourselves in trouble. We see the forest and not the trees because coexisting with the differences are similarities. And those similarities seem to get us every time, don't they?

Since 1991, bank loan portfolio managers have learned that the process of risk management is critical to the safety and soundness of the loan portfolio. I am convinced that today's risk management controls and systems played a vital role in ensuring a reduced negative impact on our portfolios this time around.

Typically, though not always, the larger the institution, the better and2 more sophisticated the control environment. Many institutions still rely on the "I know my customer" mantra in managing risk, which, following an unpleasant surprise, frequently becomes "I thought I knew my customer." At the core of these surprises, poor lending practices continue to lurk like some stubborn virus.

So when we talk about returning to the basics in 2004, are we talking about the same "basics"?

As bankers, we are charged by our shareholders, our managements, and our regulators to conduct lending in a manner consistent with the principles of safety and soundness. To do so, whether in 1791, 1891, 1991, or today, we must manage our portfolios in a balanced manner. A simple metaphor describes this balance--the three-legged stool.

For a three-legged stool to work properly, each leg must be balanced to the others or the stool will wobble or fall over. In C&I lending, the first leg of the stool is growth, the second is profitability, and the third is quality. To meet the safety-and-soundness standard, we must achieve all three objectives, and we must do so in a balanced manner.

Think of it this way. If we achieve growth at the expense of quality or profitability, have we met the standard? Obviously not, for the bank that follows this path is left with a large portfolio of high-risk loans that do not provide an acceptable return on shareholder equity. On the other hand, if a bank competes solely on price and ignores both quality and growth, the bank is left with cheaply priced loans, but quality and growth may suffer. And finally, if the bank goes for pure quality, it does so by sacrificing growth and profitability. Many clearly bankable loans are simply left on the table.

So the lesson for 2004 is that the industry must remain focused on the fundamentals of lending by balancing the "legs" that ensure our individual success--a healthy, growing, and profitable loan portfolio. We may have more modern tools with which to craft those legs, but our goal must remain the same.

But how many of us are using tools--traditional or new--properly? As I look at our industry today, I see certain parallels to some of our past problems.

* I see some banks attempting to pursue "popular" forms of lending or industries. These banks are letting their competition dictate their lending strategies, rather than setting their own internal priorities or defining their own market niches.

* I see some banks with aggressive incentive plans for their loan production staff. I have to wonder if these incentive systems are designed to produce balanced results or if they are too focused on growth.

* I see some banks whose mission statement seems to be "grow, grow, grow," rather than the more balanced approach dictated by the three-legged stool.

* I still see some lenders who focus far more on collateral in underwriting their loans than on cash flow.

* I see some lenders attempting to lend to industries they know absolutely nothing about.

* And, given today's environment of historically low interest rates, I see some banks underwriting their loans with very narrow debt coverage ratios, obviously ignoring what may happen to the customer's capacity to repay when rates go up again.

And this is just the short list of historical sins that certain lenders are committing.

I also see solid signs that many banks and bankers have remembered that lending money is a pretty basic business. What we do is not rocket science. Successful lending requires that those participating in this activity follow certain basic rules that have been around for something like 50 years now--the tried and true fundamentals embodied in the Cs of credit. It may seem corny or trite to some, but the principles of character, capacity, capital, conditions, and collateral must be the cornerstone of every loan decision. Take these principles to heart, and you will not be caught committing the sins of the past!