Kill All the Bankers!
(with apologies to The Bard)
I am delighted to welcome my old friend, and credit analyst extraordinaire, Rory Laughna
back to this space, with a uniquely insightful look at banking regulation, and its impact on economic growth.
The recent Big Short movie was entertaining, generally accurate, and captured Michael Lewis’ knack for simplifying complex subjects. It also reinvigorated attention to the financial crisis fallout. Combined with the quadrennial political silly season, glib remedies are back in vogue. My tongue in cheek invocation of Mr. Drysdale recalled that bygone era when deposit protection was supreme (here). Those days have been long banished by rampant fiscal malpractice in the midst of increasingly complex global commerce. Constant and informed attention to emerging risks characterizes a healthy financial system, but the movie was woefully inadequate to credential the casual viewer as a reform expert. In fact, it may have perversely accentuated hazards by suggesting otherwise. A wise banker abides by the adage, “if it seems too good to be true, it probably is.” Be forewarned before embracing easy solutions.
If the financial system allocates capital to its most productive use in a disciplined manner, we will enjoy maximum growth and minimal mishaps. In spite of the missteps, the U.S. still does this best and accordingly remains the global financial leader. The industry has large scale, so like other substantial activities such as movies and pro sports, top performers will be paid very well. Get over it. Ideally, the people challenged daily to wade through the capital allocation risks are most capable of designing a healthy system. Unfortunately, certain scoundrels destroyed the requisite trust during the crisis. So effective risk vigilance is the core of essential discipline and should be the reform focus. But it is mistaken to impose obstacles to the core mission, or other burdens irrelevant to industry purpose. For insistence, insisting compensation is aligned with true value creation is a constructive condition for providing federal deposit insurance. Constraining compensation for resentment’s sake is not.
Dodd Frank was a logical reaction to the demands for strong reform. While the principal sponsors would never be mistaken for industry pawns, they had long experience and recognized the need for a strong financial industry. Still it is a highly prescriptive law that inherently risks unintended consequences and imposes burdens of questionable effectiveness. I prefer efforts to restore cultural stewardship. Managements engaged with the evolving market landscape should be incented to prioritize safety and soundness controls appropriate for their specific institution. Obviously, earning the necessary trust has a long way to go before that is realistic. However, I fear the current crop of demagogues is so bent on retribution that the industry will remain hunkered in a defensive posture, overlooking growth opportunities and effective solutions for the next set of emerging risks. That is unsustainable as the brightest and crucial talent exits the industry. Ultimately, it will backfire as financial intermediation increasingly migrates to less regulated sectors.
Who among them will actually foster growth?
A recent Dodd Frank implementation step generated a proposed rule on bank compensation. This is a delicate task as it requires coordination among six agencies, balancing the core safety and soundness incentives without discouraging prudent credit growth. The basic elements of the proposed rule focus on deferring senior executive compensation to ensure the loan performance indeed generates positive income consistent with expectations. That is, since loan losses usually occur well in the future after origination, profitability is ultimately determined only when the loan is repaid. This is meritorious and can support an enhanced culture. Still, its effectiveness will likely be inconsistent across different institutions.
Loan Loss Accounting Summary
Early in my career, I worked with a managerial accounting system that directly connected loan loss expense to changes in risk ratings assigned to portfolio loans. It effectively forced “credit cost” recognition at loan inception. For instance, if a loan had characteristics that on average, one should expect to lose 5% of principal in 5 years, a 5% allowance for loss was booked at inception. In effect, we were self-insuring the portfolio against future loan losses by assessing each loan for its inherent risk. Given the abundance of market loan default data and internal experience, the immediate expense recognition was logical. Just like insuring your car, a pool was filled for the day the “accident”, or loan default occurred. At age 16, did your father buy increased insurance when you started driving, or after wrapping the family car around a telephone pole? Likewise, is it logical to manage default consequences only after it occurs?
Buy insurance before he turns the key
Bankers scrutinize the loss allowance heavily, but new loans generally attract a loss allowance expense consistent with historical experience for the bank’s pool of commercial loans. Consider further the moral hazard in not taking the foregoing approach when considering a somewhat riskier loan strategy. While a loan with a 5% expected loss is at the very risky end of the spectrum for bank loans, it is still a reasonable bet for a loan originator to take the 1 in 20 chance the specific loan will default. If the officer’s compensation plan to any extent references net income, why not advocate booking the loan? Why forego compensation for a 1 in 20 chance of suffering consequences 5 years out? The credit committee is expected to control this, but why not account for it in a manner that more clearly illustrates whether the interest coupon sufficiently profitably covers all expected expense?
Beyond the initial booking, risk ratings over the life of the loans were adjusted along with changing prospects for repayment. Adjusted allowance provisioning occurred simultaneously, providing an immediate alignment of credit costs with the changing conditions of the loan portfolio. This enhanced transparency for managers, shareholders and regulators, and enabled accountants to better identify whether accounting principles were reliably presenting our economic position.
Subsequently, I applied the same principles when designing an allowance for the loan and lease loss policy at a new employer. We referenced Moody’s published default frequencies to assign a default probability to each risk rating, adjusted for collateral coverage. As a relatively small specialized equipment finance subsidiary of a much larger organization, our parent found it very useful in monitoring our portfolio quality. Our accountants agreed that it fairly presented our financial position and accepted the methodology for our GAAP financial statements.
Meanwhile, within the broader industry, the accounting community and the SEC were concerned that bank managements were exercising too much discretion in booking loss reserves, and therefore manipulating earnings. In 1998, the SEC took action to require SunTrust Bank to restate earnings for the years 1994-1996 and reduce loan loss accruals by $100 million. Yes, the SEC sanction addressed the assessment that earnings were understated. That was painful for SunTrust management, and certainly noted throughout the industry. The pertinent accounting standard, still in effect, is that banks may increase their loan loss allowance when it becomes highly probable that a loss is imminent, and if the amount of that loss can be reasonably estimated. Oversimplifying again, assume a portfolio of loans each with an original 5% default probability, deteriorates so that each loan now has a 20% default probability. That portfolio most assuredly will realize higher losses than originally anticipated, but there is no imminent loss for any individual loan. The additional loss recognition will have to wait.
The intent of the rule has been to promote transparency and minimize management discretion. While there certainly have been instances of managements manipulating earnings, it is curious that systemic insufficient loss reserving was not the greater concern given the recurring credit distress cycles over the past 30+ years. Fundamentally, the “transparency” argument seemed fallacious, and inconsistent with the core tenet of matching revenues and expenses. Further, regulatory examinations were undermined. Accounting policy has long been a source of tension between bank regulators focused on safety and soundness, and the accounting profession aligned with the SEC focused on “transparency”. The delayed expense recognition diluted the impact of transaction downgrades identified by regulators. Also, step back and consider the cultural impact. The SunTrust action was no financial crisis deterrent. I remain mystified that accounting policies have garnered minimal blame in the crisis aftermath. Presumably, hysterical shrieking about “crooks” and “a rigged system” is more entertaining.
A newly issued accounting standard update, albeit esoteric, merits attention. Post crisis, the Financial Accounting Standards Board recognized the need for change and the new standard has been debated over the past 5 years. The loss allowance standard references a current expected credit loss model. Another useful adage is “you get what you measure”. Timely credit cost measurement begets timely problem resolution, and addresses emerging risks before they ripen into crises.
To be clear, accounting changes do not alter real results absent behavior modification. In that regard, unintended consequences surface again. If implemented instantly, banks would take an immediate charge to net income to build the higher loss allowance, and thereby reduce equity capital. Economically, bank assets would still provide the same protection to depositors. So careful implementation will be required to avoid imprudent application of capital and other rules, as well as minimize implementation costs. In 2020 large publicly traded institutions will apply the model to measure the allowance for losses. Other institutions will have an additional year for implementation, and community banks will be given more flexibility in continuing to use their own information systems when measuring the loss. The latter makes sense from both a practical perspective – these institutions have not been systemically problematic, but also recognizes that local market conditions and customer bases are more relevant factors for them.
Effective managers will seize the opportunity to address risk objectives by aligning compensation with net income, and more narrowly with specific metrics tied to accruals to the loss allowance. This enables the opportunity to enhance the risk culture. The deferrals and “clawbacks” are fine, but recall the earlier example of taking the bet that a specific loan will not be the one in 20 to default. Senior managers may be induced to change the odds but the casino remains in business. I say the pay the insurance premium and eliminate the betting line.
Insured risk, or a casino culture?
Big Short Reprised
Maybe my accounting review has provided a surefire insomnia cure, but if you are still conscious we return to the Big Short. At the end of the movie, a number of criticisms and supporting images were flashed on the screen. It was wearisome that developments in the years between the book publishing and movie release were ignored. For instance, that all of the bank TARP money was repaid was conveniently disregarded. In no way does that diminish the gravity of the crisis, just that dishonest assertions poison the dialogue and distract from effective solutions. Most revealing was Jamie Dimon’s image flashed concurrently with the declaration that bankers returned to corruption. As CEO of JPM Morgan Chase, Dimon established a strong risk credit culture and avoided the distress level experienced by many peer institutions. Sheila Bair, the Federal Deposit Insurance Company head during the crisis referred to Dimon as the “grown up in the room” in her book recounting the critical negotiations to resolve the crisis. At the behest of regulators, Chase agreed to buy distressed Washington Mutual and Bear Stearns, and agreed to the Treasury’s insistence that Chase accept Tarp money as an inducement for all targeted banks to participate, though it was not clearly needed. Dimon provided a contrast for the value of an effective culture and was specifically instrumental in the crisis recovery. His thanks? Multiple government lawsuits mainly related to activities at Washington Mutual and Bear Stearns prior to their acquisition. The expedited acquisition of a failing institution to minimize losses to depositors and government insurance has long historical precedent. Not so the follow up litigation which will likely discourage similar options in the future, increasing the systemic risk. While far from perfect, he is a credible leader for large bank reform.
There are many sincere people intent on restoring a stable and strong financial system. The exacting labors of responsible managers and conscientious regulators do not energize the Twittersphere. My concern is that appeals to populist impulses are counterproductive if not corrosive. I highlight the accounting development that has real potential for improvement, but needs embracement and support by industry leaders to make it effective. So I ask, are we better served by challenging the Jamie Dimon’s of the world to apply the accounting rule to enhance risk management? Or should we expend our energies lashing out for retribution, absent any clue of the likely results?