While the business of lending is booming, many banks are ratcheting down their standards just enough to cash in on the market's extraordinary profit potential.
And why not? The economy is robust, borrowers are receptive, and competitors of all kinds are scooping up market share. New technology has taken some of the guesswork out of lending.
Here's why not: When lenders get hooked on good times-through either the lulling comfort of goals that are suddenly within reach or the adrenaline rush of cutting corners as competitors do-they pay dearly when the inevitable economic downturn occurs.
That's when lax credit standards, inconsistent practices, and inattention to the fundamentals of risk management are exposed. By that time, the damage cannot be undone without significant spending and loss of competitive momentum.
Eugene A. Ludwig, former comptroller of the currency, was trying to save banks, not skewer them, when he warned that examiners would seek out problems and get tough on banks that appeared to be accepting higher risk in almost every loan category. At a recent meeting of the American Bankers Association, he cautioned that banks engaging in risky lending "will suffer when the economy becomes more volatile and the loans turn sour.
"We have learned before that imprudent loans made in the heady atmosphere of good times come back to haunt you when the good times fade," Mr. Ludwig said.
Bankers who have seen booms turn into busts echo that sentiment. As president of Bank of New England in the early 1990s, Bruce Wheeler remembers the impact of questionable credit practices when recession hit. "Those were painful lessons," he said. "Not only did banks suffer a weakening of their balance sheets, but some lost their entire franchises.
"Bankers today have enjoyed the fruits of a robust U.S. economy for seven years. But they must continue to be diligent about credit quality because the question is not if a downturn will occur, but when."
That is why the best long-term market growth strategy is sound, consistent credit quality. In today's hot economy, the most savvy bank lenders are abiding by the following ground rules that let them increase loan revenue now without sacrificing credit quality later:
Look before you leap onto the "prequalify" bandwagon.
The strategy of prequalifying borrowers has hit an all-time high. The rationale makes sense: Generate enough volume, and you increase revenue even if a few risky loans go bad. But before you jump on this bandwagon, be sure that your bank's prequalifying strategy has not been paired with a subtle (or not so subtle) cut in credit standards. If standards drop, a softer economy will leave you with a portfolio of B and C loans, poor credit quality, and a lot of competitive catching up to do. That is too high a price to pay for short-term revenue gains.
Play by your own rules, not your competitors'.
Nonbank lenders like American Express are using prescoring to locate qualified borrowers and, unlike banks, are able to set their prices higher to cover the higher risks they incur. Other bank and nonbank providers are using creative pricing to scoop up lower quality loans.
It is difficult to avoid getting sucked into a revenue game that competitors seem to play so well. But being willing to accept higher risk without higher revenue and more rigorous loss control is a game that no lender can win. The real winners will be the banks that stick to their own credit standards and play by their own rules.
If it wasn't a good idea then, it's not a good idea now.
In the race for market share, many banks are willing to loosen standards and make loans they would not have made a few years ago. Commercial loans are a good example. Instead of evaluating a business' operation for five years, lenders now require only three or four years' results.
But what happens in a softer economy? Many business managers have never successfully coped with a downturn. Their loans have an increased risk of going bad. Bankruptcies rise and force banks to increase loan-loss reserves. If lending to fledgling companies was risky then, it is even riskier now. And in the end, no one will pay more than the lender.
A jettisoned loan is one you don't want either. One new trend has some large banks systematically dumping clients that are not profitable. Should a competing bank reduce its credit standards and pick up that easy market share? Not really. If you would not have made those B and C loans then, don't take the risk now.
Think of scoring as a tool, not a substitute.
Credit scoring is a powerful tool when used as an enhancement by well- trained lenders employing high-quality credit standards. But credit scoring relies on data base information to predict how customers may behave, and much of these data have yet to be tested by a recession.
It is dubious that computer models alone can do much to recognize the early warning signs of a downturn and mitigate its effects. Lenders who use credit scoring to enhance solid loan management and decision skills don't need to worry; lenders who rely on credit scoring as a substitute for their own decision-making probably do.
Keep developing your lenders' skills.
Mr. Ludwig prescribed specific actions for banks to take-including evaluating their ability to deal with problem loans and developing tighter risk management standards-to help prepare for a softer economy. Consider one more: tactical training to hone lenders' skills before crises hit.
When a slowdown occurs, lenders must make a hundred judgment calls that could be better handled if the bank has a consistent approach to improving credit skills.
For example, a common commercial loan early-warning signal is an industry change that could affect the borrower. Without training, the generation of lenders that has never experienced a recession will be ill- equipped to recognize, much less act upon, such subtle cues. Don't wait for a recession to build lenders' ability to make the informed decisions that will sustain credit quality.
Follow the cash flow.
In good times and bad, cash-flow-based lending is the basis of sound credit. Understanding cash flow is the best way to understand borrowers' ability to repay. Lenders who get consistent and continual cash-flow-based credit training, supported by close observation and targeted coaching by their managers, are much better at mitigating risk and making sound credit decisions. That, in turn, produces more effective loan practices and a better bottom line.
If banks want to survive, they must look beyond the boom times and be positioned for success when things slow down. Because when banks encourage their lenders to get hooked on relaxed credit standards, the risks eventually outweigh all the rewards.