The credit correction that began with a re-evaluation of the risk-reward parameters for subprime lending is not over. There will be several very challenging weeks and months before it is.
There remains a sizeable overhang of the steeply adjustable and low-documentation subprime loans that have not repriced upward, and other credit markets have been and will be affected. For those of us who managed through past August surprises, like the one in August of 1998, this feels like deja vu all over again.
Importantly, and unlike many previous credit corrections, this problem has not originated in the commercial banking sector. The problem began with the failure of underregulated financial institutions to originate credits carefully or to evaluate and price risk adequately, and has evolved into a fundamental liquidity imbalance.
Banks have generally been cautious, and the bank supervisory agencies have been appropriately prudent with their guidance and oversight throughout what has been a period of excess.
This does not mean that banks are unaffected. Virtually all financial market participants will be affected and ultimately the whole economy will be affected.
However disciplined a bank has been, the credit correction is a sizeable change in market realities and must be confronted. Banks should:
- Carefully examine their exposures; however pristine a portfolio may look now, it may have weaknesses that are easier to address as the correction begins than when it is mature. Firms that act on their problems and potential problems early are better served. As is always true of a credit correction, lenders are affected not just by direct, but also indirect impacts of the correction.
- Ensure collections and workout divisions are well staffed. It is always easier to collect a credit earlier in the process rather than later. Adding collect ion and workout staff after the problems have become urgent is typically more expensive and less effective.
- Be alert to the rapidly changing nature of the credit correction. We have seen many fine financial institutions hurt because they have not reacted quickly enough to changing market realities. Boards and executive management should set a tone of open discussion of potential problems. The rule should be "good news fast, bad news faster." The best chance to fix a problem is to address it promptly and decisively.
- Consider scenario analysis and stress testing. I recently attended a board risk committee where management presented various challenging scenarios to directors as a way of preparing for difficult times.
- Assess opportunities. This turbulent marketplace will present important opportunities for those banks that have been disciplined and are disciplined through the correction. Good customers and good potential customers will look for solid financial counseling and assistance in these times and these customers can by loyal for years to come.
Meanwhile, policymakers should avoid imposing excessive new regulations on the banking industry. The bank supervisors already have strong tools and they have used these tools well for a number of years.
They also should explore sensible regulation and supervision of the underregulated sector of the financial services market such as independent mortgage brokers, where an irregular pattern of state regulation has not worked well.
We will of course get through this credit correction and industry fundamentals and profitability will revive.
However, conditions are likely to be volatile for a good while. It may not be business as usual, but banks that continue to evaluate both internal and external pressures, and make cautious - not panicky - business decisions, will come out successfully.
