Late last month, Barry Ritholtz had a great piece on Bloomberg View called "Learn Math or Get Left Behind." In the article, Ritholtz laments the demise of math skills in America, and discusses the detrimental effects that "innumeracy" (the mathematical equivalent of being illiterate) can have on investing. While his audience for this post is the retail equity investor, I see the same issues cropping up with bank management teams. Many bankers, especially younger ones, assume that since we now have technology that can do the rote calculations, banking is no longer a profession that requires superior math skills.
That is a VERY dangerous assumption.
Think about the core business of banking. Too often we get distracted by the logistics of banking, which includes things like compliance, IT, marketing, budgets, board meetings, loan relationships, and the local chamber of commerce golf tournament. Don't get me wrong, all of those are essential to running a successful community bank. However, the core of banking is much simpler. Banks are just financial intermediaries, a middle man sitting between savers of capital and spenders of capital. We sit in the middle of these transactions so that we can provide efficiency and risk management to the transactions. If a widget maker in need of $100,000 had to gather $1,000 from 100 different people, the system would never work. What if he goes bust, and I am out my precious $1,000? How much should I charge for that kind of risk?
Banks are just a big math problem. What is the probability that this loan gets repaid? How much do I lose if it goes bad? How much will it cost me to fund it? How likely are those rates to change, and by how much? Yes, a fancy piece of software can do the calculations for you. But do you understand what it is telling you?
Bankers don't need to be full blown quants. However, a firm conceptual grasp of statistics and probabilities is, in my opinion, a basic requirement. Here is an excerpt from Ritholtz:
Every now and again, events occur that cause me to shake my head in dismay at people’s math skills. When the weather forecast is a 90 percent chance of a sunshine, and it rains, that doesn’t mean the forecast was wrong; rather, it was one of those cases where the low probability event occurred. Some people seem to believe that 90 percent and 100 percent are the same. Obviously, they are not.
People fall into this trap with events that have a nonzero probability of occurring. Nonzero means there is the possibility of occurrence, however unlikely.
This is an important concept that gets missed by a lot of banks. Banking is not a zero sum game. Yes, an individual transaction may be zero sum, where there is a clear winner and a clear loser. However, that does not mean that if we are on the losing end of a transaction that we should not have done it. A certain percentage of our loans will go bad - that is a mathematical certainty. If we have no losses, then we are turning away too many borrowers. Some of our bonds will show unrealized losses. Do we factor in the added earnings we accumulated before that unrealized loss showed up? An interest rate hedge may cost us money (as does life insurance if you happen to stay alive). The trick is not to win every individual transaction, but instead to understand the balance sheet as a whole, and make sure that there is a logical reason for fitting that individual transaction into bigger picture.
Asset Liability Management should be that process in a bank, but too often it gets treated as another "compliance meeting" that we have to do for examiners. Instead, treat ALM for what it really is - the lifeblood of the institution. Make sure you understand the probabilities, that you are prepared for all of those events that have a nonzero probability of occurring, and that you don't get tricked by our natural lizard brains. And as always, let us know if we can help.