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Lender's resolution: that this year will be better than last

Take aim at operational risk--before it bites you

It's very traditional to make New Year's resolutions. Too bad it's not part of that same tradition to keep them.

Threats to our banks' prosperity come from two types of sources--internal and external. It seems strange to think that the more deadly threats are often from the inside. Here's why I think so.

What lurks inside operational risk?

I've been thinking about operational risk a great deal of late. The number-one threat to our long-term viability as a business enterprise is probably buried within the category of operational risk. For so long, operational risk was simply an umbrella term for threats to the disruption to our business models or plans. We thought of such risks primarily in the form of natural disasters or large- scale failures of our operating systems. 

Mostly, we probably regarded them as the sorts of things that were fundamentally beyond our control, and therefore included in those types of risk from external sources.

Operational risk can take multiple forms but it's convenient to think of it arising from three broad causes--natural disasters, system failures, and system obsolescence.

Disasters defy specific analysis or prediction, as banks caught up by outages and the ravages of Hurricane Sandy this past fall have found out. But the planning and business support available since the First Interstate headquarters building fire in Los Angeles 25 years ago have insulated most banks and their customers from the effects of the very worst of such hazards. But it's easy to pigeonhole operational risk with the mindset that these are primarily in the nature of a fire or an earthquake and miss threats that are much more real, insidious, and likely.

System failures can be of a catastrophic nature or they can be the equivalent of death by a thousand cuts. The best example of a systems failure to me is a failed system conversion. Periodically banks must convert or significantly upgrade/replace systems and they are very vulnerable during the conversion period and its aftermath.

I remember hearing some marketing people talking recently about how most banks experience a 10% account turnover rate each year just by virtue of people moving or becoming dissatisfied with their banks for routine, day to day reasons. But when large conversions occur, turnover often spikes to 20% or 25% in the months following the conversion. This is a major threat to account stability as well as a major source of expense; yet most of us hardly think about it in terms of operational risk.

Competitive side of operational risk

Banks that are short sighted about what they feel they can "afford" in terms of systems are particularly vulnerable to longer-term competitive degradation. They risk falling farther behind other market participants in terms of day-to-day competitive sharpness and capacity while often not recognizing the degraded position that they have put themselves in by neglecting to maintain system competitiveness.

Perhaps some of you would be surprised to learn that there are banks that still do not have the ability to calculate account or relationship profitability on a consistent basis.

If a bank doesn't know who among the customer base is unprofitable, how can management even pretend to have a viable business model? Outright system failures or system conversion disasters are comparatively rare but creeping obsolescence seems not to be.

Ultimately, operational risk is the risk to earnings, capital, and long-term viability of being less than optimally profitable on a consistent and sustainable basis. This is the threat that can move us gradually and inexorably into a position of being unable to earn a competitive and adequate return on common equity. We don't necessarily have to perform in the top decile compared to peer banks--but if we are unable to make it consistently into the top quartile of important performance metrics, we're a long-term candidate for merger.

Operational risk and your lending efforts

Some might call such gradual degradation a form of strategic risk. That's not necessarily an inappropriate way to look at it. But strategic risk, to me, is more like having a choice among a variety of options and choosing the wrong one. Or, it might be a case of missing important inflection points in the way the industry does business.

Operational risk is much more a case of execution. Top-notch execution requires resources too, and to starve the resource base is to flirt with operational risk if it is not succumbing to it outright.

So what can the lending officers and staff resolve to do this coming year to reduce operational risk?

If I were the senior lending officer, I'd create a focus among the lending staff on key measures of credit risk.

This would assure that these are maintained on an improving trend line and at a level of consistently superior performance compared to peer banks. Key measures of credit risk include past dues and exception monitoring both by both dollar and number; recoveries as a ratio of last year's charge offs; and non-performing loans as a ratio of total loans. Your own list might be longer or a little different. The point is to bring focus where it's needed.

Account profitability is another area where close and consistent attention can bring substantial long-term benefits. Loan officers frequently control or at least substantially influence a large segment of a bank's core deposit base. The loan function should be closely tied to the business of gathering deposits. It used to be that way, especially when liquidity had to be carefully managed, but we've gotten away from the level of discipline that I remember from not too many years ago.

Core deposits are generally cheaper and more loyal than non-core sources and the most direct influence we have is often through the bank's note case. We can do better in coming years but we have to start now. What are needed are techniques that remind everyone in the bank to keep our collective eye on this long-term strategic imperative.

Do this now--already

One final item to include on our list is to root out unprofitable business.

This requires an internal tool kit of systems and focus. It's not that we don't understand what we need to do--but getting serious about doing it is often the problem.

If an account is not profitable, then we should either figure out how to make it profitable by cross selling additional services, doing a serious job of repricing or aggressive service charging.

Allowing unprofitable borrowers or depositors a subsidized ride in this environment of the skinniest net interest margins in modern economic history is just nuts.

It's not a matter of working harder. We've been sprinting as an industry since business tanked in 2008. Rather, it's time to work smarter and that's by changing our habits and our attitudes.

And that's precisely what New Year's resolutions are designed to do.

Ed O’Leary

ABA Banking Journal Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent more than 40 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses and has been a frequent speaker in ABA's Bank Director Telephone Briefing series. You can e-mail him at etoleary@att.net. O'Leary's website can be found at www.etoleary.com.

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