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The Risky Businesses of Banks Chasing Yield

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One idea underpinning Dodd-Frank and other recent regulatory reforms is that banks should not gamble with depositors' money.

The concept, in oversimplified terms, is that banks will go back to the "old days" of simply taking deposits and making loans. Much has been written about the increased pressure banks of all sizes are facing on their net interest margins, combined with requirements to increase capital. The latter is meant to make the banks safer.  In fact, the stress of margin compression, combined with the need to generate additional income to maintain investors' return on equity hurdles, is driving more and more community banks to move into riskier businesses in search of yield.

Many lessons regarding the benefits of establishing proper risk management programs should have been learned over the past five years. A number of high quality banks, in the slow-growing Northeast and Midwest, were drawn to Florida by the unending demand for development loans. Now, the Florida portfolios of nonperforming loans and repossessed properties are the only blemishes on their otherwise spotless balance sheets.

I had a chance to speak with the CEO of a conservatively run thrift. His bank had weathered the crisis with barely a scratch, maintaining tangible equity levels at around 6%. He shared how he was facing pressure by the regulators to increase his capital level to 8%, and that, in order to maintain ROE, he would have to make riskier loans to generate the additional income.

A $500 million-asset bank recently started an equipment leasing division. Although leasing can be viewed as another form of financing, it is not a typical community bank business. In this case, the bank has set its risk parameters tightly, by focusing on growth industries with good cash flows and high-quality lessees.

Community banks and independent mortgage companies are evaluating strategic alternatives to work together. Although mortgage loans seem vanilla, in today's world of consent orders, putback claims and the newly issued CFPB guidelines, banks must be aware of the additional regulatory requirements they will be inheriting as they move into this business.

Other community banks are looking at entering the money and payment services businesses. Interestingly, the opportunity for these smaller banks has arisen as larger banks (with larger balance sheets, more capacity to manage and more capital) have quit the field.

One of the key tenets of finance is one must take risks to generate returns. A strong risk management program is not meant to eliminate risks, but to set parameters of acceptable risk and make sure the businesses stay within those guardrails. Risk can never be eliminated in banking. With each loan you make there is a chance you might not get paid back. The key to a bank's risk management program is to define the risks it is willing to take, and manage to them.

Although the returns can be attractive from these various businesses, banks considering this kind of diversification should ensure they are filtering these decisions through this risk management processes. This requires the banks to understand the risks associated with the increased returns, and whether the bank has the resources and tools to monitor and manage that risk.  In some of these businesses, such as payment services with its heavy anti-money-laundering regulations, the banks must address more than financial risk.

They must also consider reputational risks.  As a good friend who runs a healthy bank recently said to me, "Just because you are a good cardiologist doesn't mean you should try brain surgery."

Innovation and creativity should be supported in all industries, including the financial services industry. Even the CFPB recognizes this, recently sponsoring a meeting on innovation in the industry. As banks look to expand into new businesses, they will be smart to ensure they are expanding their risk management practices as well.  

Daniel F. Hayes, a senior director at Treliant Risk Advisors, can be reached at dhayes@treliant.com.

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Comments (2)
Compensation systems need to be re-engineered at banks, both large and small. A dangerous "sales" mentality developed that rewarded bankers for originating loans and then not punishing them when losses mounted because they were 'top producers'.

The solution is to use a five year average, just like vesting, to calculate the real return from each banker. This is long enough to encompass most business cycles, and drives home the fact that a loan is a gift until its collected.
Posted by Pegasus Intellectual Capital Solutions | Wednesday, February 13 2013 at 9:05AM ET
If as Daniel Hayes points out community banks are increasingly going into financial areas like leasing that they have not undertaken traditionally, this means they are increasing their credit, market, operational, and reputational risks. Aren't community banks inviting some Basel like framework on themselves if they continue to chase yield? www.MRVAssociates.com
Posted by Mayra Rodriguez Valladares, MRV Associates | Wednesday, February 13 2013 at 8:00PM ET
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