Comptroller of the Currency Eugene A. Ludwig's warning to guard against declining credit quality while the economy remains strong is right on target.

Performance during the next economic downturn will be largely dependent upon actions the industry takes today. Not only regulators but also bank shareholders are interested in credit quality.

It is widely agreed that continuing problems in the Pacific Rim nations will contribute to a slowing of the U.S. economy. This, coupled with the costs and risks associated with the year-2000 computer glitch, a risk the industry has never faced before, should send a clear signal to all that now is the time to ensure that risk measurement and management systems, as well as credit risk cultures, are sound and operating at peak capacity. Clearly, more troubling conditions lie ahead, and the industry must be prepared to handle them.

Most banks suffered substantial credit losses in the early 1990s because of credit decisions made during the late 1980s. However, a one-year survey RMA did with First Manhattan Consulting Group found surprisingly wide variations among banks in loan losses and the resulting impact on shareholder returns and stock price volatility during the entire economic cycle.

During the period October 1989 to October 1997, the stock market rewarded banks that had lower loan losses in the credit downturn of 1990- 1992/93. The average annual total return of banks with the best credit performance from 1989 to 1997 was 65% higher than that of banks with poor credit performance (25% annual compounded, versus 15%).

The RMA/First Manhattan survey was done to gain an understanding of the state of play in credit risk portfolio management practices; it included most North American banking companies with $5 billion or more of assets (64 institutions). Its focus was on the commercial and industrial and commercial real estate segments.

Notwithstanding the currently high level of consumer loan losses, the focus of portfolio management tends to be on C&I and CRE lending. Historically, these areas have created the largest and most volatile losses.

The survey found that many banks have upgraded credit risk measurement and portfolio management since the credit downturn of 1990-1992/93-the industry's worst since the Great Depression. Generally speaking, banks appear to be better prepared for the next credit downturn. However, the leaders are now accelerating away from the rest of the field in ways that create very real competitive advantages.

The survey, titled "Winning the Credit Cycle Game: a Road Map for Adding Shareholder Value Through Credit Portfolio Management," found five forces that have motivated the advances now under way in credit risk portfolio management.

First, bankers remember the earnings pain caused by under-diversified portfolios. In the three years from 1990 through 1992, commercial banks wrote off $26 billion of C&I loans (4.2% of C&I loans outstanding at yearend 1989). From 1990 through 1993, they wrote off $24 billion of commercial real estate loans (6.5% of CRE loans outstanding at yearend 1989).

Second, shareholders react quickly and differentially to loss levels. Almost all bank stocks reached cyclical highs in mid- to late 1989; their lows were reached a mere 12 to 18 months later. In other words, very early in the last downturn, bank investors saw that credit losses would be the most negative banking event of this decade.

Of the 50 largest banking companies in September 1987, eight reported lower than average C&I and CRE losses in the 1990-1992 period; seven had atypically high, but survivable, losses. The market "rewarded" the banks with the best credit performances with a moderate price decline of 33% from their cyclical highs in 1989 to their cyclical lows in late 1990. The stock prices of the worst credit performers among the surviving banks were hit much harder: They lost an average of 75% of their share value during the same period.

The low-loan-loss companies were then able to achieve full stock price recovery in early 1991, just six months after hitting their cyclical lows. By contrast, the high-loan-loss banks took two and a half to four years to achieve full stock price recovery. These survivors then watched as their stock prices continued to lag during the industry's recovery, creating persistent competitive disadvantages, not the least of which was a lessened ability to acquire banks during one of the industry's most active consolidation phases.

Moreover, it is important to note that 11 of the top 50 in September 1987 did not survive the credit downturn as independent institutions. This was largely, if not exclusively, because of their C&I and CRE loan losses.

The survey found that a third factor advancing portfolio management practices is increased competition. Commercial bankers in North America face new competition from investment and foreign bankers in C&I and CRE loan underwriting and funding.

Bank loans are being placed more and more with end investors (for example, investment funds, pension funds), facilitated in part by innovations such as collateralized loan obligations. In the first nine months of 1997, $18 billion of CLOs were issued.

In addition, as a fourth factor, the survey found that tools to support advances in portfolio measurement and management are becoming more widely available. Several risk-grading techniques and vended models for measuring individual and portfolio risk have been developed in recent years.

Bankers can now adopt viable techniques that, until very recently, required extensive proprietary development. Much as tools now measure interest rate and market risk, models to measure credit risk have become available.

Fifth, institutions are investing in portfolio management techniques because there is more to lose if they do not. The industry has rapidly attained huge market capitalizations-the U.S. banking industry market cap now exceeds $800 billion, versus $100 billion at the beginning of 1990. (Even banking companies with poor credit performance in the early 1990s have more than doubled their stock prices.) Clearly, shareholders, including management, have more to lose in the next credit downturn.

In coming months, examiners at the Office of the Comptroller of the Currency will meet with senior managers at national banks to ensure that they address deteriorating underwriting standards. The OCC is also developing examination procedures and industry guidance to advance portfolio credit risk management practices that it plans to release in the first quarter.

The RMA/First Manhattan survey found that a significant number of banking companies are investing in next-generation credit risk portfolio management systems. However, given the increased focus of examiners on credit risk measurement and management, additional investment may be necessary.

Better tools are now available to help bankers more effectively measure and manage credit portfolio risk. The payback on portfolio management investment extends beyond protecting share prices in the next credit downturn. It also helps create ways to serve customers more fully while diversifying the bank's overall credit risk. Further, it enables better business decisions through the accurate measurement of credit risk costs of transactions, relationships, business, and the bank as a whole.

Competitive advantages are being created by the early adopters of advanced credit portfolio management systems; they are investing today for a long-term payback. Given the upside potential and the downside risk, this might be one of the most important investments in banking today.

At RMA, we hope the industry is better prepared for the next downturn than it was last time. The tools are available, and there is too much to lose by being unready. Mr. Sanborn is president and chief executive officer of Robert Morris Associates, the trade group for lending and credit risk professionals.

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