During World War II, English planes returning from bombing runs were examined to determine where the most bullet holes were. Based on this information, decisions were reached concerning the appropriate places to add to the planes’ armor to increase the survivability of the aircraft and their pilots.
The initial and intuitive response was to add armor to the areas that evidenced the most bullet holes. The opposite conclusion, armoring the planes in the area evidencing fewer bullet holes, was based upon a counterintuitive perspective. This more subtle, but important view took the position that under the circumstances, the planes that did not return must have been hit in other, more vulnerable areas. Armor these more vulnerable areas, reasoned the Royal Air Force engineers and statisticians, and the desired outcome would be more likely to be achieved.
Just as the counterintuitive response was warranted when examining bullet holes in airplanes, so too should regulators, the first line of external defense against bank failures, consider unexpected outcomes when assessing risk at the financial institutions in their charge.
And just as placing armor where it may not have been needed – where the enemy’s bullets would do cosmetic but not fatal damage – would only make it harder for the pilot to control the vehicle, weighting down banks with ill-conceived risk mitigation strategies and regulations serves the interests of neither individual banks nor the banking system as a whole.
It is widely acknowledged that certain asset categories and funding mechanisms during the early and mid-2000s contributed to the bank failures that have been part of the recent financial crisis. What is less clear is the conclusion that simply engaging in a particular behavior uniformly ensured failure.
For instance, there is ample evidence that concentrations in commercial real estate contributed to bank failures and, in the absence of forced bank closures, have placed continued pressure on capital and periodic profits. Simultaneously, there is sufficient evidence that when soundly underwritten, competently administered on an ongoing basis by an experienced management team, and not utilized to fuel rapid balance sheet growth, CRE lending can be a conservative, profitable business.
Of particular significance is the nature of the collateral. Inherently low-risk properties such as multifamily residential dwellings in stable, growing regions should be viewed quite differently than most other classes of CRE.
This kind of thoughtful analysis of bank failures and the remaining survivors will reveal differences in policy, procedure and methods of risk assessment that may be used to place a scarlet letter on the weak and mark those performers that ought to be held in high esteem.
Regulators, bankers, and other observers of U.S. banking have different responsibilities in their individual capacities. Nevertheless, they share a common obligation to promote understanding of individual banks and the system as a whole. Without an insightful process that recognizes the meaningful differences among banks, accurate risk assessment may fall short.
Without a clear vision of risk within a bank, it’s hard to calibrate the level of risk mitigation through policy, procedure and attendant internal controls. As the modernization of risk management in banks continues, effective outcomes hinge on clear-headed analysis that in some cases may require counterintuitive thinking.
Regulators, boards of directors, and management teams should encourage thinking outside of the rigid routines that typically characterize highly regulated banks while making sure that good business practice remains the focal point of risk management.
Michael P. Devine is the president and chief operating officer of Dime Community Bancshares Inc. in New York and its main operating subsidiary, Dime Savings Bank of Williamsburgh, which lends to owners of multifamily properties in New York City.
