RISK AND THE NATURE OF CANDY

It happens every Halloween night. The kids go out and we sit patiently at home waiting for trick-or-treaters. Between knocks, a battle rages over just how many of those mini-3 Musketeers bars we should allow ourselves to eat. We give in and the next thing we know our blood sugar level is that of Kool Aid. On a normal night, we go for a run, do a couple of sit ups and even have a salad for lunch in order to accommodate a small desert. Instead, because last night was Halloweeen, we stuffed an unplanned 8 candy bars into our mouths before we felt a need to check ourselves into Self-control Anonymous. Halloween, and our chocolate problem, underscores the nature of risk. If it is planned, it is not risk. Many banks stay away from certain lending lines, given a higher level of perceived risk. Consumer loans, agriculture, leasing or unsecured corporate credit are often turned down, citing higher levels of risk. This is a mistake. Higher loss rates are not a function of risk. A higher expected loss offsets an income stream. Instead of making 8%, you make 7% because you reserve 1%. If a loan portfolio has a 1% loss rate, there is no risk. The seasonal analogy is that if you go out for Halloween and you expect it to be cold, you grab a jacket. While it is still cold outside, you have just eliminated that risk of being cold for that given temperature. While bankers throw the term "risk" around loosely, true risk only arises to the extent that performance becomes worse than planned. It is the variability or volatility of the income stream that is the nature of risk. If you expect a 7% return, but could receive 3% return, you are exposed to risk. This is an important point, as we repeatedly hear that a bank will stick to real estate lending because "that is what we know" and that the "losses have been zero." Because of concentration, we can quantitatively prove that some banks are exposing themselves to more risk by adopting this strategy. Even though loss rates may be higher in our Sales Finance Program, adding consumer exposure diversifies the overall portfolio, thereby adding greater stability to earnings. While real estate lending has preformed well recently, it is also highly correlated to the economy. Currently, real estate lending growth has slowed and quality is decreasing (higher delinquencies). As a result, bank earnings have become more volatile. This is an indicator of risk. Meanwhile, banks with diversified lending portfolios have not suffered. Just because an alternative investment may have a higher loss rate, does not mean a bank is taking on more risk. When banks say they don't have the expertise to understand unsecured corporate lending, they are missing the point of risk management. Banks have the ability to acquire the talent needed and build infrastructure, so that an investment's true risk can be understood and mitigated. This additional cost and corresponding investment risk may be far less worrisome than having CRE concentrations in excess of 600% of Tier-1 capital. Banks are designed to take a variety of risks and have the ability to architect themselves around such exposures. Understanding the true nature of risk and how to best manage capital will ensure a stable, high-performing income stream. We could go on about risk, but those leftover 3 Musketeers are still calling our name.