Painful Tendencies

People tend to be overconfident in their own abilities until someone kicks them in the midsection. Study after study shows that the psycological make-up of a human being leads us to rely on our own natural tendencies. We inherently make decisions based purely on emotion, rather than by a process of dispassionately examining all of the information at hand and then deciding upon the best path. Consider something as simple as funding. Banks will often set up borrowing capacity for Fed Funds when they first open their doors, then only irregularly request increases from their correspondent banks. Logic tells us that the more we grow, the more leveraged we become and the more we need to maintain liquidity. As such, banks growing quickly should consistently request increases in their Fed Funds lines and other borrowing capacity to ensure ongoing liquidity is maintained. Waiting until the strain is already upon the bank, limits options and squeezes performance. Credit lines will shrink over time relative to the size of the institution, which can hamper effective funds management. For banks with excess money to invest, having to break Fed Funds into smaller pieces at worse rates, due to some outdated line list can reduce flexibility and limit performance. Larger blocks of Fed Funds generally command a premium in the market, so unnecessarily tight credit lines can be costly. Of course, prudent credit policy requires that limits be set and that banks monitor their credit exposures carefully. However, these limits need to be reviewed on a regular basis (we suggest semi-annually) and adjusted if conditions, capitalization and bank growth warrant it. Credit risk also rises with time to maturity. Despite the fact that this is obvious, many institutions still set counterparty credit limits based on a simple dollar value, rather than on duration or time-to-maturity risk measures. Such a process makes little sense and increases risk for the institution. Banks should conduct a comprehensive review of their biggest credit exposures, including an examination of how both long-term and short-term credit risks are calculated. While it may sound counterintuitive to say a Prime based loan has more credit exposure than a long-term fixed rate, many lenders still emotionally believe this to be true. Consider a small business customer that locked into a Prime+1 loan when Prime was at 4.00%. Their monthly payment was about $4,225 for every $1mm borrowed. Now that Prime is only days away from reaching 8.25%, this same customer is certainly coming under strain. As we all hope the FOMC will soon stop raising rates, this customer is servicing a monthly payment of $7,815 for every $1mm borrowed. What once was a great loan for the bank is now a customer under strain, forced to make a monthly payment nearly double to where they began. Talk to your customers, increase your borrowing capacity, actively monitor risks and consistently question whether the position you are taking is one driven by emotion, or based on facts. Don't wait for the proverbial kick in the ribs to begin evaluating, examining and protecting your bank.