Our industry has enjoyed extremely high asset quality for many years. As side benefits of one of the longest periods of prosperity on record, borrowers are repaying their loans; collateral is worth what it was appraised at, or even more; and loan losses and chargeoffs have consistently been very low.
Don't let these facts lull you, however.
While recession is nowhere in sight, we know with certainty it will come. We just don't know when. Thus, bankers are well advised to prepare for a downturn well before it arrives by installing early detection systems that pick up warning signs in the loan portfolio before the economy- nationwide or local-craters.
Here are some suggestions:
Have a capital-raising strategy ready so you can act on opportunities to acquire the unwise. During bad times, institutions that did not monitor their asset quality will experience difficulties, and some will have to be sold.
Identify early warning indicators and monitor them. For example, when loan pricing deteriorates to the point of being uneconomical, that is, insufficient to cover both interest rate and credit risks, you may want to slow down your lending in that area and watch bad loans being made by others.
In some markets today, construction lending is being done at prime with no points. Pretty soon, we will get to 100%-plus financing of real estate acquisition, development, and construction. And we all know where those practices have led in the past.
Another early warning indicator is rapid expansion in an industry. Many outsiders, for example, are flocking into the building business as opportunities arise. In a couple of years, this will create an oversupply that could cause lower collateral values. Lenders beware.
In addition, inexperienced builders make mistakes and are much more likely to fail. All these factors contribute to a need for extra caution.
Pull in your portfolio when everything is going well. It is a tough thing to pull back when everyone is expanding like popcorn. Have the discipline to make loans consistent with your historically proven credit practices, and don't get swept into the most recent credit fad. This requires discipline and is often unpopular with your loan officers. But it will pay off in the long run.
Don't overreach. As companies try to improve earnings, they sometimes do things that pay off in the short run but may bankrupt them in the long term. As a manager, you need to take the longer-term earnings perspective despite pressures from analysts. Don't mortgage the future for short-term gains. You may be betting the bank.
Encourage your lenders to identify portfolio problems. For example, Sterling Bank in Houston praises loan officers who flag portfolio problems. By the time someone else does so, it's a problem not only for the lender and but also for the bank president. Require that lenders "own their portfolio" for better or for worse. It's important that the lender be held accountable for the entire portfolio performance over time.
Don't offer incentives for volume. We know that incentives change behavior. If loan officers are rewarded on volume alone-not on longer-term asset quality-they will deliver volume but not value. Incentive compensation should include only loans, not chargeoffs, over a sufficiently long period to assure that the portfolio is truly performing.
Economic downturns are not all bad, particularly if you carry out a coordinated preparation strategy. When a downturn occurs, it will offer opportunities to acquire ailing banks and to fund credits that now will be shunned by many banks not because they are bad but because of the banks' own credit problems.
Downturns present excellent relationship-building opportunities for prudent lenders who are prepared to stand by their quality borrowers during temporary financial impairment.
In summary, while all has been well for a very long time, we can use the reminder that it will not be so forever. And careful preparation for deteriorating asset quality not only protects your institution but also positions it to capture an additional share of customers' wallets, as well as entirely new relationships.