While popular, the concept of the Easter Bunny is muddled and breeds gullible, hyperactive kids. There is no good back story about the whole chocolate egg connection, nor why the Easter Bunny even has to hide eggs. Finally, while Santa has plausible cover for breaking and entering, the Easter Bunny does not. So on Easter, we get our kids up early, make them dress up, try to make them sit still in church for an hour and then turn them loose on chocolate and hot cross buns. To top it all off, the parents are really the rubes here, as any 4-year old sees right thru the Easter Bunny ruse, but knows that if they tell their parents their true beliefs those divinity fudge eggs will cease. As a result, parents go around thinking their kids still believe in the Easter Bunny for years. This is why if you show up to church for early mass Sunday morning, you get an adversely selected portion of the population that are the most gullible, Type A families all with low blood sugar trying to control the most misbehaved kids on the planet. For the highest of holy days, it is ironic that if there is a hell on earth, the early Easter mass comes pretty close.
Speaking of adverse selection, the hurtful process must be guarded against in banking. Adverse selection happens when a market rule results in the least desirable outcome. For instance, life insurance policies tend to attract applicants who take high risks. Take for instance management having to undergo an expense control initiative. In an attempt to reduce overhead, we came across two banks this week that may be taking the wrong approach for their shareholders. One is offering a buyout of employees if they quit, the other is asking all employees to take a reduction in pay. While both are nice ways of achieving lower staffing expenses, both will result in the best workers leaving (the buyouts will make this occur at a faster rate) over time.
Adverse selection is also alive and well in banking these days when it comes to pricing. In the past week, we came across several instances where a bank pushed their loan production people to book loans above a certain spread or rate, thereby attracting a lower quality of credit, without regard to risk.
Rate must be taken into account as an adverse selecting mechanism. If you need to achieve a 3% margin, it is far better to set average deposit rates at 1% and loan rates at 4% (we are talking floating rate loans here), than setting deposit rates at 3% and loan rates at 6%. The latter attracts not only a less credit worthy borrower, but a more rate sensitive depositor as well.
In stressed economic types, decisions like reducing assets, managing expenses or setting pricing are tough ones to make. The trick is to be sensitive to the market mechanisms so as not to result in the opposite of expected outcome.
By always asking yourself, "Is adverse selection in play with this project," bankers can prevent profits from being as hollow as those chocolate bunnies.