Is Bank Risk-Taking an Endangered Practice?

WASHINGTON — Once upon a time, being a bank was all about taking risks.

Today, that fundamental mission is itself at risk.

The effects of the crisis, the regulatory shake-up and other factors have made the industry perhaps more cautious than ever — particularly with credit risk. Banks are increasingly drawing comparisons to risk-averse public utilities. Standardized credit products with limited downsides such as the regulator-approved "qualified mortgage" dominate. With satisfying government rules a high priority, banks seem as focused on avoiding certain businesses as they are on growth.

How long will this retrenching last? Many argue a complete return to risk-taking by federally insured banks is unlikely. But others see another shift already under way. They say the dynamic environment is opening up opportunities for a select number of banks to innovate in new ways, potentially leading others to spread their risk-taking wings again.

"There are known, quantifiable reasons to think that the bank sector as a whole will be less risk-averse four or five years from now," said Raj Date, managing partner at Fenway Summer. "I don't think we'll allow comically underwritten stated-income mortgages to devour the economy. But I've seen enough turns that I'm not fully confident we've somehow banished cyclically driven risk events."

The "Safe Zone"
To be sure, it's relatively common for a downturn in the economy to lead to heightened regulation and increased caution. But observers say the most recent repositioning away from risk is more pronounced, with banks exiting whole product lines.

"Historically we've always had the same push and pull where the regulators are adding rules and the industry is saying they're too costly and burdensome, and everyone takes that debate for granted," said Jo Ann Barefoot, chief executive of Jo Ann Barefoot Group. "But today, we're seeing something different: a lot of the industry rethinking whether they want to stay in these products and especially whether they want to serve the low- and moderate-income consumer."

Some have said that banks increasingly resemble public utilities: entities meeting a basic service need with limited returns. In a paper released in June, Anthony Saunders, a professor at New York University, argued that international capital rules will lead to banks' return on equity declining to between 8% and 10%, similar to that of energy firms.

"In my view the net effect of these changes in Basel III is that banks will become something similar to electric companies and other public utilities, earning a safe but low return on capital for investors," Saunders wrote.

Yet the energy and banking businesses are not the same. Banks essentially must make bets on borrowers of credit while facing risks unique to the current environment.

Eugene Ludwig, the chief executive of Promontory Financial and a former comptroller of the currency, said banks continuing in real estate lending, for example, are doing so despite extremely tight net interest margins.

"Some banks lending on owner-occupied real estate are willing to engage in long-dated lending with narrow spreads at fixed rates. Those kinds of loans clearly bear market risk and credit risk," he said. "Owner-occupied real estate lending, which is a traditional banking business, is not by any stretch of the imagination a risk-free business."

But others note that banks' lending strategies are falling into rigid patterns. For example, some community bankers see mortgage lending as the territory of the biggest banks, which have the volume and compliance capability to make it profitable, while smaller institutions would rather focus on commercial lending.

"For community banks, the risk they are willing and able to take — and take very well — is commercial … risk," said Robert Franko, the chief executive of the $617 million-asset First Choice Bank in Cerritos, Calif.

As a community development financial institution, Franko said, First Choice is technically exempt from a rule that requires borrowers to have the "ability-to-repay" a loan before it is made. But he said the amount of people he needs still to comply with the various rules is not worth the volume of mortgages his bank would be able to originate.

"If I'm only doing one mortgage a week and still need to have … a skilled compliance officer in residential mortgages; that's expensive and time-consuming for my bank," Franko said. "Let's say Wells Fargo has 100 people in residential compliance and they're doing probably a thousand loans a day. Their compliance cost embedded as an overhead cost in that mortgage is insignificant."

Bill Nayda, the principal and founder of Second Pillar Consulting, said regulators "are not necessarily saying" not to take the risk, "but the associated compliance cost is making it harder and harder.

"Especially in a small banking institution, you're afraid to do anything wrong when it comes to a mortgage these days because of the repercussions," Nayda said. "So what do you do? You don't do mortgages, in effect."

The mortgages that are issued by banks are now largely dominated by QM — a class of standardized, 30-year loans with capped debt-to-income ratios and none of the risky features of boom-era products — which automatically comply with the new underwriting regime of the Consumer Financial Protection Bureau.

"There are tremendous pressures that are pushing the industry toward becoming more utilitylike and more concentrated, with advantages for the bigger players compared to the community banks in terms of scale," Barefoot said.

Banks are staying "inside the QM lines," she added, because of the uncertainty around complying with the CFPB's more rigorous "ability-to-repay" rules that govern riskier loans. Some banks are offering non-QM products, but they are typically jumbo loans for the affluent.

"The regulators would like the banks to be able to fine tune underwriting for lower-income people and not return to the mistakes of the subprime era," Barefoot said. "But it's a knife-edge balance — it's very risky to try to walk that line. I don't know that it will last forever. Over time, we ought to have more regulatory clarity start to emerge. But right now, the industry is tending to stay in the safe zone."

Making Way for "Path-Breakers"
Still, some observers say the future may see a softening of those patterns and a rise in risk appetites.

"With the passage of time, there is likely to be a little bit of a loosening up," said William Longbrake, a former executive at Washington Mutual who now teaches at the University of Maryland.

Longbrake said one development could be regulators taking steps to relax recent rules, but a more telling sign will be when banks feel they have enough experience with the tougher regime.

"Banks will learn over time how to comply with the new rules," he said. "There will be tests through the regulatory process, perhaps even through the courts, that will increase the degree of certainty. As that occurs, … I think you will see much more active lending than you see today. It's a learning process."

An expansion of risk may start with a few institutions before spreading to others, Longbrake added. "You will have some path-breakers that will be leading the charge that will be trying things out."

Date, a former top official at the CFPB, says right now there are reasons that banks "are much more risk averse than you otherwise would deem healthy."

"Even though profitability has returned to the industry, the reality is the median bank today does not earn its cost of equity," he said. "That's really destroying economic value, which is a tough way to run a railroad."

But he noted that data technology has made much more information available about potential borrowers — which would ease the underwriting process for banks pursuing a more aggressive lending strategy — and nonbank firms interested in the non-QM market are looking for bank partners.

"It's not exactly winner-take-all, but it is going to be just a handful of banks that end up being the preferred partners of those cutting edge firms that are out there," Date said. "There are multiple and simultaneous opportunities at this particular moment both for banks as well as nonbanks to pursue financial intermediation in ways that are relatively new."

While smaller banks may be the most hurt by higher compliance costs, they may also be in better position than larger institutions to experiment with their risk strategies in the coming years.

Nayda said the regulatory costs now amount to a "tax" on the industry, but that tax may not be applied as heavily on community banks.

"The larger banks are getting the most attention from the regulators on compliance, whereas for the smaller banks, while they may feel like they are under intense scrutiny, the examiners may just be getting started or hold them to a lower standard," Nayda said.

He added that community banks also have potential relative flexibility under Basel capital requirements, which impose stricter risk weights on big banks.

"Delinquencies and high-volatility real estate will have higher risk weights [for smaller institutions], but for the most part there is not going to be a differential between, say, a mortgage to a prime borrower and a mortgage to a subprime borrower. The community bank can in effect take more risk," Nayda said. "Anecdotally are we starting to see that already? Maybe.

"You might see risk starting to move down into the smaller banks, and two, we might see risk moving out of the system and into the shadow banking system because they're under less or seemingly no regulation."

Other factors may drive banks to redirect their strategies toward more risk-taking, such as expanded opportunities to sell loans on the secondary market, now dominated by Fannie Mae and Freddie Mac.

"As the outlets grow to turn over balance sheets — including the securitization market coming back to life a bit — and the housing and commercial real estate markets stabilize and grow, collateral-based lending decisions will become easier and more appealing," said Lee Kurman, the former general counsel of Morgan Stanley's bank subsidiary and now a managing director at Exiger.

Franko said banks that have missed profit targets under the current circumstances will have to change course.

"It's an evolution of acceptance over time. Banks eventually have to figure out a way to make a profit and to be consistently profitable. If you haven't figured out how to make a profit in your core business, then your board is going to force you to keep looking until you find something else," he said. "The companies that are having pressure on profitability will migrate out and figure out other ways to make money over time."

Meanwhile, some regulatory requirements might even encourage greater risk-taking. Date pointed to the increased "leverage ratio" required of larger institutions, which unlike risk-based capital measures essentially treats all assets in the denominator the same, regardless of their relative risk.

"If you're going to have to hold all of this capital anyway because of the non-risk-weighted ratio, and that's binding, you might as well have more risk, because it's not going to increase the amount of capital that you're going to have to hold," he said.

Non-QM Experiment
The burgeoning market for non-QM loans is emerging as a laboratory for expanding credit risk.

QM loans are the overwhelming favorite right now among banks that offer mortgages because of their advantage in dealing with new rules. Although going that route limits product offerings to vanilla mortgages, CFPB regulations say the QM class is effectively in compliance with new standards to determine a borrower's "ability to repay," absolving lenders from having to follow more rigorous underwriting and documentation requirements.

Currently, the institutions stepping outside the QM boundary are largely doing so to originate jumbo loans for high-income customers, with less risk.

But several experts say the non-QM market may expand as banks face an excess of liquidity, interest rates start to rise and lenders gain experience with CFPB compliance.

Longbrake said heightened interest among a small percentage of midsize lenders has "already started," with a more sustained expansion about three to five years away.

The jumbo loan "space is already pretty crowded, and so the opportunity longer-run is to going to be to go where it's not crowded, which is in the nonjumbo, lower-income area. It will be a matter of figuring out how to deal with the ability-to-pay, non-QM loan. Some institutions are going to figure it out," he said. "They're going to figure out how to put the documentation together, and there may be a regulatory or legal test at some point that will provide some certainty on guidelines as to what types of documentation and procedures institutions need."

Longbrake currently sits on the board of BECU, formerly Boeing Employees' Credit Union, which he said illustrates the decision-making process of institutions trying to determine if non-QM products are for them. The $12.5 billion-asset credit union is rich in deposits and has a $4 billion securities portfolio, but is considering other types of assets to add to its balance sheet, including non-QM loans.

"There is a need for assets, they have a huge membership base and members are buying homes and taking out mortgages all the time. So there is an opportunity. How do you hit that opportunity? While the credit union has not yet totally figured that out, they have taken steps to increase their mortgage portfolio," he said. "BECU does offer non-QM loans on traditional mortgage products, but volume is very low and management is discussing that as a growth opportunity in terms of how they could expand such lending and how they would manage the risk."

In a mortgage market now constrained by tight net interest margins and long terms on loans, non-QM loans provide another option, Longbrake added.

"From a balance sheet perspective, you could … increase the net interest margin and you could do it in a way that controls interest rate risk by not doing 30- and 15-year fixed-rate, fully amortizing mortgages — for example, maybe the five-year or seven-year loans that are a little more rate-flexible," he said. "But then that means you're into the non-QM space and have to worry about the ability to repay. That kind of thinking is going on in a handful of other institutions around the country."