Western Independent Banker - July/August 2008 - (Page 16)

By Rex Beach Revisiting Credit Quality and Risk Management due diligence, failed to do so. Such failure simply fueled the rise and issuance of even more complex credit products. Further, many investors relied on credit rating agencies, which frequently failed in properly assessing risk. Poor Performance by Credit Rating Agencies The credit rating agencies were not up to the task, failing on several fronts, including weaknesses and deficiencies in rating models and methodologies, inadequate due diligence, insufficient transparency or clarity about underlying risk assumptions, and insufficient attention to conflicts of interest in the rating process. Incentive Distortions Among other things, the incentive schemes and packages in financial institutions and among mortgage brokers encouraged volume at the expense of risk considerations, reflecting intense demand by investors for securitized credit products such as residential mortgage-backed securities. Disclosure Weaknesses Financial institutions frequently failed to disclose the magnitude of risks associated with off-balance sheet activities, which added to the crisis in confidence. If they did disclose such risks, they often did so partially or with lack of clarity and transparency. Snowballing Feedback Effects In a period of market turbulence and widespread suspicion, asset write-downs immediately triggered questions about capital adequacy, which forced asset sales, which further drove down asset prices and placed more pressure on capital adequacy. Regulatory Weaknesses Finally, the report clearly states that public authorities “… failed to take effective countervailing action, partly because they may have overestimated the strength and resilience of the financial system.” Looking Ahead In sifting through the various causes, it becomes readily apparent that a collapse in underwriting standards and adequate risk measurement – through ignorance or omission – played a major role in explaining the present credit and financial crisis. It stands to reason that regulatory agencies will become particularly vigilant in reviewing each of these areas of weakness or omission going forward, perhaps with extra vigor since they have been so roundly criticized for failing to prevent the crisis. In a practical sense, the banking community might expect to see renewed supervisory focus on the following issues: quality of underwriting standards; effective application of underwriting standards; ability to monitor and contain risk; and quality and timeliness of financial information underlying risk assets. In a word, watch for a renewed focus on credit quality, which has systems and personnel implications for every lender. The credit quality issues become even more relevant if the economy fails to rebound quickly and vigorously as it has after the last two recessions. A slower economy exerts far more pressure on company and property management to run effective operations, very likely under competitive and economic conditions that few managers today have personally experienced. In addition, a vast number of lending personnel assessing credit and devising risk management schemes have not experienced a serious economic downturn in their business careers. Adding to the problem is the fact that credit training, once a staple in the banking community, has fallen by the wayside in the rush to develop business, book assets, and grow profits. Rex Beach is founder of Shockproof! Training in Walnut Creek, Calif. He can be reached at (925) 465-4755 or rexbeach1@ yahoo.com. He is the principal instructor for WIB’s Commercial Lenders Institute. Read more from Rex at www.shockproof.biz/blog/. www.wib.org Western Independent Banker THE FINANCIAL STABILITY Forum – a group of representatives from major central banks, finance ministries, and international agencies – recently published an assessment of the present financial and credit crisis, along with a series of recommendations to strengthen the oversight and performance of the international financial system. It is both interesting and informative to review the root causes of the present crisis identified in the report, particularly because of the implications for future corrective action and the likely ensuing impact on the banking industry. Poor Underwriting Standards Loan originators made massive volumes of subprime loans, beginning in late 2004, that could be serviced only if the rise in housing prices never ceased to accelerate. Poor Risk Management Practices As the report states “… market participants severely underestimated default risks, concentration risks, market risks and liquidity risks, particularly for supersenior tranches of structured products.” Structured products refer primarily to residential mortgage-backed securities. Poor Investor Due Diligence Many investors, including institutional investors with the capacity to undertake 16 http://www.shockproof.biz/blog/ http://www.wib.org

Table of Contents Feed for the Digital Edition of Western Independent Banker - July/August 2008

Western Independent Banker - July/August 2008 Contents A Message from the President & CEO Getting Creative and Competitive with Leaders' Incentive Compensation Financial Covenants - What Good Are They Really? Homes Within Reach Revisiting Credit Quality and Risk Management Loan Yield Shock Wave - What Can You Do? What Lending Crisis? - Community Banks Flex with Lending Strength How to Fine-Tune ALLL During Uncertain Times Productivity, Technology and Export Growth Trump Housing's Fall in the Long Run - The Economy According to Brian Wesbury Distressed Real Estate Loans and Their Property Tax "Kicker" WIB Calendar Welcome New Members Index to Advertisers advertiser.com

Western Independent Banker - July/August 2008

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