Small Banks Will Face New Risks in 2013

Much ink has been spilled over the systemic risk posed by banks that are Too Big to Fail. But the problems facing the industry are not limited to the biggest institutions. 

Banks of all sizes, including smaller community banks, remain plagued by a confluence of factors that are eating away at profits. Quality loan demand is weak. Net interest margins are compressed at their lowest level in three years. New regulations have reduced fee income and increased compliance costs. Non-current loans and loan losses continue to trend downward, but remain stubbornly well above pre-crisis levels, serving still as an overhang on bank performance and a drag on the economy.

What's a banker to do in the face of such challenges? The Office of the Comptroller of the Currency has appropriate concerns that are as troubling as they are predictable: To make up for lost profits, small and mid-sized banks are taking on greater risk.

The OCC's Semiannual Risk Review, which was released earlier this year, finds many banks' efforts to reduce costs have increased operational risks. The historically low interest rate environment, the agency said, is also making banks vulnerable to rate shocks. And small banks, in particular, are increasingly adding to investment portfolio positions and increasing durations to obtain higher yields.

We've seen this movie before. I call it the "Venus flytrap." Banks, in search of yield in protracted low or negative real interest rate environments, are beguilingly lured into extending durations of their investment and loan portfolios. This extension invariably occurs at the worst possible time. When interest rates inevitably regress to the historic mean, the assets' fair market value quickly erodes. This leaves banks with two options, neither of them good. If the asset is sold, the institution must immediately recognize a loss. If the asset is retained, the bank suffers the lost opportunity inherent in ongoing net interest margin underperformance.

Those of us with long memories recall that this Venus flytrap scenario was the root cause of the failure of the savings and loan industry in the 1980s. But the trap is far from an unusual or isolated situation.

The OCC report shines a light on other real risks. While smaller banks appear to be well capitalized, with a deeper cushion than maintained by banks with assets greater than $10 billion, they have less diverse revenue streams as well as greater geographic and customer concentrations. As a result, often their greatest risk resides with people, systems and training.

Specifically, smaller FIs tend to pay less, making recruitment of top talent more difficult. They also tend to downsize personnel levels to reduce costs, which often affects staff in audit, loan review, compliance, accounting, risk management, marketing and training. They may engage boards and governance teams that often lack sufficiently updated financial experience or knowledge of emerging risks and best practices and face budgetary limits regarding keeping software and computer systems at industry-leading levels commensurate with increasing uncertainty and heavy regulatory burdens.

Additionally, they often over-rely on "checkbox compliance" as well as misunderstood, incomplete and non-integrated risk analytics, insufficient capital adequacy assessment and underutilized reports.

There are other strongly emergent risks as well. In the current low-interest rate environment, many consumers have parked money in demand-deposit or money market accounts. This trend may be temporary. Once options for a reasonable rate of return become available, and there is more confidence and less uncertainty, consumers likely will withdraw this money as quickly as they first deposited it. 

By inaccurately classifying such deposits as "core," many banks are greatly underreporting their liquidity, interest and market risks. Assumptions about core deposits must be revisited with analytical rigor, which is also true for prepayment assumptions on loans. Banks should be aggressively working to build loyalty among all newly acquired depositors through such means as: improving penetration of electronic bill pay and safe deposit box ownership; increasing cross-sale ratios with risk-adjusted profitable product sales and using risk-adjusted profitability reward programs.

Banks should also move carefully to minimize the "new product" risk that the OCC warns about, especially as fee regulations force some banks to look elsewhere to recover lost revenue. As Jamie Dimon, CEO of JPMorgan Chase, famously said, "If you're a restaurant and you can't charge for the soda, you're going to charge more for the burger."

To extend the analogy, banks are not only trying to re-price their existing burgers and drinks. They are expanding the menu into, what is for them, unfamiliar territory. This unfamiliar territory for some banks may include reverse mortgages, digital wallets and deposit products laden with creative options.

As in previous periods of earnings compression, we are seeing banks assume greater risk on the strategic side, by entering unfamiliar product territory, and on the cost side, by devoting fewer resources for risk management. These risks must be properly understood and managed if small- to mid-sized FIs are to weather the transition from historically low interest rates and subpar loan growth.

Risk management must be increasingly embedded in both strategic and capital planning. Banks should be aggressively working to implement risk-adjusted profitability and capital adequacy assessments into their banking models if they are to avoid being snared by the Venus flytrap and other emerging risks.  

Orlando Hanselman is education programs director at Fiserv, a financial services technology provider.