Lines of Defense

By Steve Klinkerman

Economic boom times are tempting banks to ignore the fundamentals, says a top federal regulator, who warns that they do so at their peril.

Clear sailing or calm before the storm? In a cresting economy, it's often hard to tell the difference. But James Sexton is not taking the question lightly. Director of the division of supervision at the Federal Deposit Insurance Corp., he is responsible for the oversight of roughly 5,300 state-chartered banks and 540 savings banks, with combined assets of $1.25 trillion. From an even larger perspective, he gets involved in any type of institutional crisis or policy debate that would affect the safety and soundness of the deposit insurance fund.

Though the times may be idyllic, Sexton says lenders cannot relax their standards. "We're encouraging the industry to safeguard its ability to play defense, because the time will come when it will need to," he says in a Banking Strategies interview.

He really does know what he's talking about. During his former tenure in the same post at the FDIC, Sexton witnessed the devastating effects of the 1982 Penn Square Bank failure in Oklahoma, a harbinger of Oil Patch lending troubles that ultimately contributed to the 1984 failure of Continental Illinois National Bank and Trust Co., Chicago. He also saw the downside of interest rate risk while working through the wave of New York savings bank failures in 1981-1982.

After an 18-year career that carried him from an assistant bank examiner in Fort Worth to the FDIC's top supervisory post in Washington, Sexton left the agency in 1983 to become the Texas banking commissioner. He came on the Lone Star scene just before an energy and realty collapse endangered virtually the entire banking industry in that state.

While grappling with that historic crisis, Sexton championed the cause of interstate banking in Texas, encouraging legislation that ultimately paved the way for a bevy of regional banking companies in other parts of the country to enter Texas, many of them via federally-assisted acquisitions.

Working for a decade thereafter as a consultant, Sexton returned to his former post at the FDIC in January. Since then, he has been urging bankers and the FDIC's roughly 2,000 examiners to redouble their attention to underwriting standards.

He says bankers have "every bit of the skill" they need to manage today's risks, but insists that skill must be matched with resolve if institutions are to uphold lending standards amid withering competition and a buoyant financial climate that tempts lenders to relax.

Banking Strategies: What's your top-level view of the health of the banking industry?

Sexton: The banking industry is in good shape by most measures. Earnings in the first quarter of 1999 were at historic highs. The number of problem banks is at what I call a core level - the lowest you get. It is heartening to see these results.

But bank regulators such as myself aren't supposed to be unduly swayed by that. There are a few troubling things. We are seeing a bit of overbuilding in certain places around the country. We see banks being extremely aggressive.

Once lenders exhaust a finite pool of prime loans, competition pushes them in the direction of assets that pose more risk - the current wave of subprime loans being a conspicuous example. Terms and enforcement of loan covenants can weaken. Documentation can be less extensive and timely.

So, good shape, but there are some things that certainly have caught my attention and the attention of the other regulators. We know that economic recessions occur, and we know that in such environments the institutions that tended to their knitting during the good times are going to fare better than those that did not.

Banking Strategies: In past downturns, certain economic shocks pressurized - in some cases devastated - the entire lending environment. The collapse of the Texas energy industry comes to mind. What sort of risks in the larger economic environment do you see right now?

Sexton: As the saying goes, it is never the truck you see coming that runs over you. But my principal concern would be the U.S. export status and the effects of an adverse balance of trade. I see no manifestations of other problems at this point. But I will note that I have never seen a correction that did not affect commercial real estate. The point is that it's not only the initial shock that requires our vigilance, but also the potential aftershocks.

Banking Strategies: Do you think that banks have materially diversified their revenues in this decade to the point that lending pressures are attenuated somewhat?

Sexton: During the first quarter of 1990, fee income accounted for 32% of banking's operating revenue. That figure had risen to 42% at the end of the first quarter of 1999. Some high-visibility institutions have led the charge in this area. But progress is uneven. Many banks still rely primarily on the intermediation of funds to make a profit. When they don't lend, they don't make much money.

Banking Strategies: This raises questions about the Securities and Exchange Commission's recent stance on loan-loss reserves, to the effect that some institutions may be keeping them at unrealistically high levels. On one hand, it seems clear that institutions can manipulate earnings reports by doctoring the level of loss reserves and the rate at which funds are earmarked for that purpose. On the other hand, it seems almost shockingly naive to characterize banks as being over-reserved, given the volatility inherent in that business. What's your take?

Sexton: I have never stipulated that serving Wall Street's informational needs and serving the financial system's safety and soundness needs are inconsistent goals. As a matter of fact, we believe that the banking industry overall reserves quite fairly and in a way that is appropriate, given this stage of the economic cycle. I also don't have any problem with a mandate that the handling of loss reserves be made transparent to the investor. These priorities are symmetrical.

So our concerned reaction to this issue, particularly to an article published this spring by the Financial Accounting Standards Board, was not based on philosophical differences. It was because we were afraid, with all of the conversations that were going on about what to do with supposed excess reserves, that some banks might be coaxed, or cajoled, or scared into making sharp reductions in loss reserves. To us, there is nothing that seems more inappropriate at this point in time.

Banking Strategies: One gets the impression that the SEC took it on itself to act, and got out in front of a sister agency in trying to treat whatever issues there might have been.

Sexton: The SEC apparently perceived some circumstances that got its attention. And that's fine. If it sees situations where people are manipulating earnings statements by intentionally over-reserving, we certainly have no problems with SEC intervention. We were just a little fearful that there was going to be some reaction by the banking industry that would be inappropriate for this point in the cycle.

(Editor's note: Subsequent to this interview, the federal bank regulatory agencies and the SEC issued a joint statement recognizing market "instability" as a condition that "consequently requires higher allowances for credit losses than were appropriate in more stable times." The agencies jointly published principles for handling loss reserves and pledged "to continue to cooperate and communicate" on related policy issues.)

Banking Strategies: How do you feel about bank funding quality? A recent FDIC report says inflows into mutual funds have exceeded inflows into deposits for the past 16 quarters in a row. The public seems to have an ever-growing appetite for alternative places to park its money.

Sexton: The public has become very perceptive about the value of its money in this investment environment. And I am not sure what a core deposit is anymore. Traditionally, core deposits were seen as the embodiment of customer loyalty - as funds that would stay with an institution through all types of financial climates. Nowadays, it doesn't take very many basis points of extra yield to lure customers' money from one place to the next. In some instances, we are seeing traditional funding replaced by single-source funding mechanisms, notably the Federal Home Loan Banks.

However, banks now have close to 20 years' experience competing in a market where interest rates are unregulated. So I don't think it's a huge problem. I think that banks are able to get the funding they need - with the critical proviso that they have something worthwhile and profitable to invest in. The core deposit is quickly going away, but institutions can still get the money they need to intermediate and to make a profit.

Banking Strategies: Funds from brokers and other wholesale sources become notoriously unreliable in times of trouble. Are banks going too far beyond traditional avenues in finding sources of liquidity for the assets they are booking, perhaps courting funding troubles when the market tightens?

Sexton: As deposit gathering becomes inexorably more reflective of an organized market - such as we now see developing on the Internet - dependencies on core deposits will fade. Availability of deposit funding, however, probably won't be an issue. Even in times of stress, banks can still sell insured deposits, which generally are perceived to be of unquestioned quality and desirability. The issue instead goes to affordability - of whether the deposits can be gathered at rates that will still afford a profit while undertaking prudent lending and investment risks.

Banking Strategies: Has the risk profile of the banking industry improved as a result of mergers?

Sexton: I think you can make an argument that stretching across state lines and around the nation has indeed provided an opportunity for diversification. And diversification is essentially good. Now, I am not quite sure how to quantify that. I don't think I would say that it makes mega-banks measurably safer or sounder than others, but it does provide a benefit.

Banking Strategies: One question is whether control - essentially underwriting quality - erodes with size, offsetting some of the benefits of diversification. Do you have a sense that coordination and control has been maintained even as institutions have grown?

Sexton: It's hard to generalize. I know that I have seen some well-controlled organizations that operate in multiple states. Maybe you give up some flexibility by imposing standardized lending policies. But multi-regional banking can be done. It can be done properly. It can be done safely. And it can be done in a way that serves the public.

Banking Strategies: How do rate the readiness of the banking industry for Y2K?

Sexton: I truly believe that the banking industry is - if not the best prepared - certainly among the industries best prepared to deal with this. Banks have really done, I think, a fabulous job, and the bank regulatory agencies have done a good job as well.

At the present time, we are satisfied with the preparedness of 99% of the banks. And the concerted resources of the regulatory agencies are available to deal with the remaining 1%. That is a very manageable caseload and, of course, we will continue to insist that the stragglers catch up with everybody else.

With regards to public confidence, we know that the public's age-old reaction to crisis-tinged stimuli of any sort is, "I want liquidity." And the banking industry is preparing to send a very strong message: "If you want liquidity, here it is. The money's in the bank, and there is no safer place for it than in the bank."

Banking Strategies: We've discussed the performance pressures on banks and the kinds of risks that can materialize when the economy shifts. The question then becomes: Amid these good times, how can prudent managers prepare themselves for a soft landing?

Sexton: The biggest challenge is figuring out how to cope with the competition. Mostly, the intermediation rules are made by everyone that is playing the game, because all of the players are dealing with essentially the same sources of funds.

Unfortunately, from one perspective, deposit insurance makes all institutions seem equally worthy in the eyes of the people who are supplying the funding. Conservative institutions can find themselves in situations where the risky proposals they reject are being funded by their more aggressive counterparts, which pollutes the underwriting environment. The irony becomes that in an extremely forgiving environment, the aggressive lenders at least temporarily become high performers.

But if you can get past the competitive pressure, then I think you go back and look at what happened in the Southwest in the late 1980s. And the first thing you find, in spades, is concentration of credit. That would be the common denominator in most economics-driven banking problems. Many people in the Southwest were true believers that, as the saying goes, "God only made so much real estate." They thought there was no way they could lose by loading up on it.

So the lesson here is that in addition to macro-economic issues, or trends, and micro-economic issues, or events, there is a third kind of risk that you elect to take on yourself through credit concentrations. If the industry where you are concentrated goes in the tank, then what's going to happen to you? You have to be careful with specialization.

Along with this is the need to resist tendencies toward overconfidence, and the laxity that can accompany it. Prior to the crash, Texas was awash in enthusiasm and optimism. Elation is good, and it feels good. But you have to be very careful with it. To assure you can play good defense when the time comes, you've got to keep your skills sharp as you go along. You've got to keep on making the effort to keep control of the borrowing relationships.

The rate of loan growth also bears watching. Rapid loan growth was widespread in the Southwest. It contributed to many failures in that region. Even in recent times, we've seen strong correlations between rapid loan growth and bank failures.

Why? In periods of rapid growth, quality controls weaken. There are more opportunities to make mistakes. And banks overlook the hidden costs down the road, namely, higher loan-loss provisions. Bad debt expense is as certain as interest expense if you do not maintain your underwriting controls, but that's not kept in mind by overly aggressive lenders.

Another thing to watch is asset-liability management. The relative stability of the interest rate structure can tempt bankers to book longer-term assets, which offer higher yields, and continue to fund them with shorter-term liabilities, which right now cost less. If rates should jump for any reason, banks with this sort of maturity mismatch will find their funding costs rising much faster than their asset yields, with negative consequences for earnings.

Banking Strategies: In Texas, there also was a fixation on projected asset values and not enough cash flow analysis. All too often in commercial real estate, people were counting on the appreciation of a project's market value and salability, rather than its cash flow, or rental income.

Sexton: Cash flow lending has suffered at the hands of collateral-based lending, and also at the hands of aggressive assumptions. If you let them, some borrowers will inject unrealistic cash flow assumptions to the point that their worksheets can't be called analyses at all. That is one of the areas that tend to weaken under the pressure of competition.

Banking Strategies: What about the capital strength of the industry? It does seem that equity capitalization and loss reserves are solid.

Sexton: It's certainly an environment that is conducive to piling up capital, to the point that many institutions have repurchased their shares in the name of reducing so-called "excess capital."

But here we are, in the best economy seen in many moons, and we see troublesome things happening with the consumer, like charge-offs of consumer debt and personal bankruptcies. And I wonder why. Meanwhile, banks are going after the riskier end of the consumer market - with subprime lending and high loan-to-value lending - using the same capital base that they've used since whenever, in the range of 6% to 8%.

When you load up on categories of assets that are demonstrably riskier, then clearly the 6% to 8% equity capital range is not enough anymore. For example, banks are booking more subprime loans, the sort formerly handled by finance companies, and these credits by definition are riskier than what depository institutions traditionally have handled.

It seems obvious that if the industry is going to embrace categories of assets having more risk, then it will have to maintain commensurately higher levels of capital. Lending is not just a matter of reward. It is also a matter of accepting responsibility for the risks undertaken to get the reward. Banks have to keep this in mind as they venture beyond traditional lending areas.

Banking Strategies: So, getting back to the opening question, in terms of taking your temperature, it seems that you're feeling pretty confident about the state of affairs in banking right now, with some caution around the edges. Is that a fair assessment?

Sexton: Yes, I think so. Importantly, though, the banking industry to some extent is what I would call a "sentinel species." When something happens, this industry is affected pretty quickly.

Unfortunately, the risk horizon is much broader than before. For example, events in the capital markets, perhaps related to the fortunes of foreign economies that are somewhat opaque to us, can pose material problems on short notice. Furthermore, the average consumer is saving absolutely nothing, giving the quality of consumer credit a troublesome aspect of vulnerability.

For these and other related reasons, I feel that this is the most difficult time of all to be a bank examiner. You have to believe there are cycles. But people aren't sufficiently mindful of that right now because of the rewards that the stock market gives good performers and the pressures of competition, and because we're in the midst of a 100-month economic expansion. Some people in the banking industry don't remember anything else beyond these good times.

It is difficult at the present time for bank examiners to sell practices - to convince people to pay close attention to the fundamentals. But that is what we are doing. We are pressing on practices. And, more and more, practices are going to determine how FDIC examiners rate a bank. Amid tightening economic conditions, practices become a far better indicator of performance.

We are hopeful for the industry. We like the results that banks are achieving. We love this expansion. But people ought not to be over-influenced by that. We're encouraging the industry to safeguard its ability to play defense, because the time will come when it will need to.

Mr. Klinkerman is Managing Editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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