Friday, November 21, 2014

Deposit Decay Rates

by Sean Doherty

There is an ongoing debate within the industry (both financial and regulatory) about the validity of using Decay Rates to calculate the value of Non-Maturing Deposits (NMD) in the required Economic Value of Equity analysis from the 2010 Interagency Advisory on Interest Rate Risk.

Decay Rates imply that a certain amount of a financial institutions deposits will mature or "disappear" from the balance sheet over a period of time. While this may be true of any specific account, it cannot be said to be true for balances as a whole. In fact, a look at deposit trends for the industry would indicate that overall deposit balances are increasing, not declining.

So where did this assumption come from? Back in the day, when the first models were being developed (OTS and others), there was an attempt to value these deposits in an effort to more fully understand the long term sensitivity of a balance sheet. This was both a necessary and valuable contribution to our understanding of these deposit relationships.
During this time, a theory began to be discussed as how to best measure these deposits, and it appears that one of the classic mistakes in statistics was made, extrapolating to the general population the characteristics of a specific case. Since Deposit Studies were rare and expensive, this seemed to be a good compromise, and over time, this thinking has become the standard. Some will even refer to this as "best practice", however, "saying so doesn't make it true". Oftentimes, this is an excuse for the vendor to throw a number into their model to get a value, any value.

Further, as rates became volatile, and valuations using this methodology became volatile as well, the issue of deposit life began to take center stage. Modelers and regulators had difficulty in accepting the fact that any NMD could have a life beyond "x" years, and so "Truncation" became the buzzword. Truncation is an arbitrary number of years, after which ALL NMD are said to disappear. This is typically done so that the valuations generated from the analysis fit into the real world deposit premiums being paid in acquisitions. As rates have generally declined over the last two decades, these "deposit premiums" have declined as well. Non Maturing Deposits are simply not as valuable in a low rate environment as they are in a high rate environment, and acquirers rightly justify these lower premiums using this logic.

Having said this, Deposit Premium is NOT what is required to be calculated in the 2010 Advisory. As modelers, and as bankers, in order to comply with this requirement, we are asked to value the "Replacement Value" of these liabilities, not the value that another institution places on them. And this is where we believe much of the misunderstanding resides. Accountants, model validators, auditors and many examiners (because they have been taught the "best practices" sited above) confuse Deposit Premium with Replacement Value. There are many things that go into the Deposit Premium including, franchise value, expected credit losses, OREO, fixed assets, depreciation costs, non-interest income sources, expense management, etc. So in essence, the value of the entire organization, both tangible and intangible, is encapsulated in the Deposit Premium calculation.

Replacement Value, on the other hand, is the value of any particular asset or liability at today's rates (and shocked rates as well). So each component part of the balance sheet is valued on its own merits, without regard to credit risk on assets. To measure this, an institution must be able to accurately measure the amount of time current NMD deposits have been in the bank, as well as the ability of the institution to retain these deposits over a number of years. So "industry standards"  do not apply. If you are currently using some made up numbers, or numbers that are not specific to your institution, then be prepared to explain their relevance to your organization. In most cases this is a futile effort.

We all understand that these deposits have value beyond the one day contractual obligation of the depositor. We have spent many years and an incredible amount of resources to ensure that our clients get this correct. including a detailed Deposit Study and Retention Analysis to determine at which point on the curve your particular liabilities should be valued. Don't take  "Best Practices" as the answer for your institution. More on this in a our next post...
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Saturday, September 6, 2014

Do Bankers Still Need to be Good at Math?

by AMG


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.





 





Thursday, August 21, 2014

Which Rate Scenario is Most Important?

by AMG

One of the inherent flaws of modeling complex systems (such as bank balance sheets) is the tendency to run too many scenarios to try to account for as many potential outcomes as possible.  We create a "can't see the forest for the trees" situation.



With literally thousands of variables, there is a real danger to over-simplifying the environment in trying to reduce it to a clean and simple model that gives us "right" and "wrong" answers to our strategy questions.  To combat this, we keep adding scenarios until pretty soon we drown in the depth of the analysis, and we come out less informed than when we started.  I have seen banks that run hundreds of different interest rate scenarios so that they can be sure they have modeled every possible scenario and can be properly prepared.  But, guess what?  They still won't get it right, and will have done nothing but irritate and confuse the bank's decision makers.

We ran a post back in 2012 that discussed the "which rate scenarios to model" question.  I stand by that post, as it still covers what we believe are the essential scenarios without going overboard.  However, that still leaves 21 separate rate scenarios.  When evaluating a bank's exposure, which is most important? 

In discussing this question earlier this week, we had an interesting conversation.  We came back to a concept that should be familiar to both investors and credit risk managers.  We need to evaluate not only the outcome given a scenario, but also the probability of that scenario happening.  So, can rates fall by another 300 basis points?  Technically, yes, as the 30 year bond still yields above 3.00%.  That would mean rates falling across the yield curve to 0%, and the 30 year Treasury yielding about 0.20%.  I'm guessing your net interest income looks VERY ugly in this scenario.  Does that mean we need to immediately put on a hedge to protect us from a 300 basis point rate drop?  No, of course not, because the probability of that happening is extremely low.

So, given that basic approach, which scenarios should be getting extra attention?  That will depend on your interest rate conviction, but for what it is worth, here are the scenarios that I personally have been focusing on with clients:

  • Flat rates:  Even though bank balance sheets have extended out on the curve, the majority of both assets and liabilities still reside on the shorter end.  While there will be some fluctuations within a small range, these rates will not move meaningfully until the FPOMC begins hiking the Fed Funds target rate.  We are likely still a year away, meaning flat rates are the most likely scenario over the next year.  In addition, I think it is always wise to start by evaluating what kind of risk is "baked in" if everything stays the same.
  • Rates ramp up by 200 basis points in 1 year:  There is no magic to this scenario - it simply matches the basic pace at which the Fed has increased rates in the past.  Until told otherwise, I am expecting well telegraphed rate increases of about 0.25% per Fed meeting until the rate is back to "normal" (whatever that may mean now).  With 8 FOMC meetings per year, that works out to 2.00% over 12 months.  Now, could the pace be different this time?  Of course it could, especially given how extreme the Fed's accommodation has been through this cycle.  But, this is the best idea we have at the moment.  Also, we know that the FED is not starting this increase immediately.  However, if we continue to monitor this scenario, we should have an idea of how our balance sheet will react once the move starts.
  • Curve flattening:  As Grant explained in his post, we have a decent chance of seeing long term rates stay low even if the Fed does hike overnight rates.  In fact, this is exactly what we "typically" see during a Fed tightening.  I also think this is worth watching because it is precisely where many banks are vulnerable at the moment.  Higher short term rates will directly impact funding costs, and a lesser increase out on the curve means that the longer asset base will not benefit to the same degree.

My approach is to spend a little more time on these three scenarios, and then look through the others just make sure there is nothing too ugly in the forecast.  And, of course, this list will change as circumstances change.  The point is, though, that we at some point need to pick a few outcomes to which we can manage, and continue monitoring all of the others.  This allows us to manage the risk while having some scenarios in which if we are right, we can optimize the balance sheet to benefit and generate a better return.

Tuesday, August 19, 2014

Guest Post: A Case for Low Rates

The following is a guest post from Grant LacKamp of Country Club Bank Capital Markets Group.  The Capital Markets Group, like AMG, is a part of Country Club Bank.  Grant specializes in fixed income securities portfolios, specifically for financial institutions.  Grant can be reached by email, or you can connect with him on LinkedIn.

A Case for Lower Rates Regardless of Fed Action


Beginning last fall, the Federal Reserve began winding down its trillion dollar asset purchase program, also known as QE3, and should complete its monthly purchase of securities by October of 2014.  Although the Fed tells us that this is NOT tightening, it certainly has changed ones outlook on when short-term rates may begin to move higher.  The Fed officials tell us that the first rate change will likely take place in the summer of 2015, but thanks to a previous post by Dallas below, we know that the Fed has consistently missed its target as far as future interest rates are concerned.  That being said, regardless of if the Fed should act next summer and begin to tighten by moving up their overnight rate, the case can certainly be made that rates will not move to levels seen prior to 2008 for a long, long time.

 
By this point, we are all aware that the Great Recession of 2008 was created by the overindulgence of debt, not only by the American public, but by consumers, corporations, banks, and governments across the globe.  Looking at the graph below of Total Public Debt (including households, corporations, banks, and the government), it’s clear that we have really barely begun to digest all of the debt that we’ve taken on since the onset of the 1980’s. 
 

 


This massive amount of debt we’ve taken on coincides with the 30-Year bull market that we’ve seen in Treasuries.  As total debt has increased over the last 30 years, we’ve consistently seen lower highs and lower lows from a yield perspective on the 10-Year Treasury.  This is simply a coincidence right?  Wrong.  As we have taken on more and more debt, it has subsequently taken much smaller fluctuations in interest rates to throw the brakes on the economy and inflation.  This is because that small change in interest rates has a much larger effect on a household balance sheet, a corporate balance sheet, a bank balance sheet, and a government balance sheet.  With the enlarged amount of debt on the books, it takes a much smaller change in interest rates to have a much more resounding impact. 

 
Think of this as a set of speakers in your home.  If you’ve got a crowd coming over to watch the big game and you have a set of small speakers for your surround sound, you’re going to have to crank those things up so that everyone can hear.  If you’ve got a set of wall sized – wave makers, it takes a very small move of the volume knob to blow out a set of eardrums. 

 




 
Should the Fed indeed begin to raise the short-end of the yield curve next summer, anticipate a flattening of the yield curve with shorter rates moving up to meet longer rates as we saw in 1994 and 2004, only at much lower levels than we’ve seen before.  Interest rates will continue to hit lower highs and lower lows and the bond bull market will rage on until balance sheets (both public and private) are able to digest the debt levels they’ve take on.

 Should this fit with your interest rate bias, then we continue to recommend adding the following items to the investment portfolio to add interest rate and prepayment protection:

·         Agency Non-Callable Bullets

·         Municipals, both Taxable and Tax-Free

·         Newer Issue, Lower Coupon 15 and 20 Year Amortizing MBS

·         Discounted Callable agencies and step-ups

 

Let us know how we can help.

 

Grant LacKamp

Assistant Vice President

Country Club Bank
glackamp@countryclubbank.com

Tuesday, July 15, 2014

The Logistics of a Fed Rate Hike

by AMG

Although we are still squinting towards the horizon to see the eventual rate increase from the FOMC, the market is definitely telling us that we have shifted from "ZIRP Forever!" to "ZIRP for a couple more years!"  A subtle shift, but a meaningful one nonetheless.  We can see the evidence in the belly of the yield curve, with volatility arriving first in the 5 year area and now in the 3 year (chart via US Department of the Treasury):


As you can see, the 3 year yield has been rising steadily since the spring of 2013.  (And as an aside, isn't it really hard to fathom the 3 year yielding 5% again?)

Since the timing of the rate increase is slowly gaining clarity, I thought this post from Sober Look (More clarity from the FOMC on the mechanics of liftoff) would be helpful.  The post is short and worth the read, but here is a quick snippet:

The latest FOMC minutes provided some clarification on the approach the Fed is expected to take as it begins normalizing short term rates in the US. Here is a quick overview of the Fed's strategy and potential implications.
The Fed has chosen the interest rate on excess reserves (IOER) as the primary tool to control interest rates during the normalization process. While working with IOER is certainly more effective than the Fed Funds rate, there are a some drawbacks.

CLICK HERE for the rest

Thursday, July 3, 2014

Lending to Small Business

by AMG

I thought that this infographic from Intuit (found here) would be interesting to bankers.  Most community banks pride themselves as being the primary source of credit for small businesses in their market.  According to this data, we still have a lot of work to do:



The numbers that jumped out at me:
  • Large banks still winning by a mile over community banks as the source for loans (60% to 47%)
  • 27% of small businesses have changed banks in the last four years.  That is HUGE turnover (and a big opportunity), and finding a better deal was not the leading cause of the turnover.  Remember that for small businesses, feeling mistreated might be code "the bank said no."
Anyway, interesting food for thought since we all seem to be chasing the same few viable deals out there...

Tuesday, June 17, 2014

The Fed's Flawed Forecasts

by AMG

I think we can all agree that the effectiveness of the Fed's actions during financial crisis starting in 2008 will be debated for many years to come.  One thing we can already agree on, though, is that the Fed (specifically the FOMC) is really terrible at providing forward guidance.  Check out this picture that Barry Ritholtz posted at the Big Picture courtesy of BofA Merrill Lynch:



I think that nicely sums up how the last few years have gone.  Basically, the Fed keeps saying "we're almost there, and rates will have to rise just around the corner."  And then the recovery is weaker than expected.  Wash.  Rinse.  Repeat.

We saw a lot of banks structure bond portfolios in 2009 and 2010 (when the balances were growing like crazy) so that they had a giant block of maturities to reinvest in 2012 when the Fed said rates would be higher.  Oops.  We also saw (and still see) bankers holding giant cash and Fed Funds Sold positions to keep as "dry powder" for the higher rates that are coming soon.  Bigger oops.

So now the Fed is saying that the increases may start in the second half of 2015.  Maybe they will, but the chart above sure disagrees.  So, what do you do?  Our answer is the same - don't try to outsmart the markets.  Decide on a consistent and disciplined investing strategy and stick to it.  The banks that have done that since 2008 have wildly outperformed.  The added income far outweighs the slight (and temporary) advantage to be found if you happen to time the rate change exactly right.

Anyway, I thought it was good food for thought as we wait for the latest from the Fed this week...

Tuesday, June 10, 2014

Why is Interest Rate Risk a Regulatory Priority?

by AMG

Industry regulators have been stressing the importance of interest rate risk for the last few years, and at the end of 2013 they publicly stated that it would be a focal point in exams for 2014.  With bankers struggling to process thousands of pages of new regulations, a few common questions emerged.  Why this specific topic?  And why now?  Aren't there bigger to fish to fry at this point in the cycle?

The answers to these questions can be found by digging around in some of the trends in the call report data.  We will start by looking at net interest margins, in this case for all FDIC insured institutions since 1994:



As you can see, after a spike immediately following the Fed's crisis rate cuts, margin compression resumed and we are now sitting at all time lows.  Now let's look at the same metric over the same time frame, but divide between larger and smaller institutions (larger being any bank over $10 billion in assets):

As expected, the large banks (red line) look like the overall industry trend, since they make up the bulk of industry assets.  What is interesting is the area that is highlighted, where the margins of small banks flatten out while margins at larger banks drop like a rock.  What is causing this?  Are small banks doing a better job at managing margins? 

Unfortunately, this is another case of one of our favorite sayings here at AMG:  not all margin is created equal.  Let's look at one more chart, this one comparing the percentage of long term assets in small and large banks, and how those percentages changed from 2010 (when the lines diverge) to the most recent quarter (3/31/14):


This chart shows that the larger banks (on the left side) extended slightly, with the share of long term assets (more than 5 years until maturity or repricing) moving from just under 25% to just over 25%.  However, smaller banks doubled their long term assets, moving from around 18% to over 36%!  Community banks have gone from being shorter (and more conservative) to far longer than the larger banks.  What's worse is that the trend is still intact - the assets continue to get longer each quarter. 

While rates have moved off their record lows, we are still inarguably in a very low rate environment, meaning small banks have locked in low rates for a very long time.  While we can argue the timing of a rate increase, it is inevitable that rates will someday go up from current levels.  Which group has made the right call?  The large banks that have stayed consistent at the sake of short term earnings, or the smaller banks that have extended out on this steep yield curve, forsaking tomorrow's earnings to maintain margins today?

Regulators are concerned that community banks are ill equipped to manage interest rate risk of this magnitude, and worse, they fear that small banks are victims of "duration drift."  In other words, the asset extension has not been intentional, but has instead happened over time without the banks necessarily even seeing it happen.  Because of this, expect regulatory scrutiny of interest rate risk to not only stay high, but perhaps even increase.  Are you taking on more risk than you have in the past?  And is your model up to the task of helping you manage through that risk?  Let us know if we can help.

Saturday, May 31, 2014

Vendor Management

by AMG

We have heard loud and clear that bankers are wrestling with the growing expectations in vendor management.  We are feeling the pain ourselves, as clients and prospects both have a much longer laundry list to go though in vetting us.  As with all of the other regulatory expectations, the difficulty comes from he fact that we are having to rewrite processes from scratch. 

For help with vendor management, I urge you to check out a post from Carl Ryden, the CEO of PrecisionLender.  Here is Carl's intro:


The Five C’s of Bank Vendor Assessment and Selection

In the earliest days of society, “banking” was pretty straightforward. We loaned money to people we knew and trusted, and we had a pretty good idea if they were going to pay us back. But today, things are a bit more complicated… lenders and borrowers aren’t nearly as connected, but we still need to underwrite each borrower’s ability to repay. So how do we get to that same comfort level BEFORE we hand over the cash? The answer: The 5C’s of Credit… the modern framework for understanding the credit worthiness of each and every borrower.
The story isn’t so different when it comes to buying subscription-based software solutions. Today’s landscape is like the Wild West, and knowing which vendors we can count on is getting more and more difficult. So, how do we choose? How do we ensure that the vendor we select is going to “pay us back?” We already have a framework that we know and trust, so what if we took a credit underwriter’s approach to vendor selection? Enter, The 5 C’s of Vendor Assessment and Selection… Company, Culture, Customers, Churn, and Conditions.

The whole post is great - click here to read the rest.

Friday, May 30, 2014

Managing Risk With Lizard Brains

by AMG


Last week I read a short article on Bloomberg View by Barry Ritholtz called "What Kills You and Your Investments."  Barry has been one of my favorite reads in the finance world for years, and his The Big Picture blog was a daily must read during the height of the financial crisis.  In this Bloomberg piece, Barry touches on one of his recurring themes, which is the fact that human brains are actually hard wired to be really bad at investing:

You don’t understand risk.
I don’t mean you, in your professional capacity. I mean you, the human being whose brain is desperately trying to keep you alive. An endless procession of mortal threats are trying to end your particular genomic variation, forcing your brain to respond first and think later.
Your existence is threatened by hungry predators, roving bands of Neanderthals, poison mushrooms and all manner of germs.
What’s that you say? You don’t live on a savannah where lions hunt, and there haven’t been any Neanderthals for 30,000 years?
That is irrelevant to your risk-calculating engine. Your wetware was optimized during a period when those were the highest potential threats to your well-being. 

and:

...what does this have to do with investing?
Plenty. It turns out that investors fear things that are relatively rare, such as market crashes. They also ignore little things that are likely to do damage over the long term, namely trading too much, paying too much in commissions, generating a big and unnecessary tax bill.
These are the cholesterol of investing. They won’t kill you tomorrow in a spectacular fireball or shark attack. But they will kill you in the end, slowly and quietly, and with great finality.  

While Barry is specifically referring to investing and managing equity portfolios, the same basic premise applies to managers of financial institutions.  As a general rule, our brains, which over the years learned some impressive survival tricks, work against us as we try to manage risk in a prudent and practical way.  Our instincts, or what I would call the "lizard brain," reacts to things in a way that ensured our survival for thousands of years, but that now works against us.  There are numerous ways that this happen, but here are a few of the most common that I see.


Confirmation Bias
This is the natural tendency of people to favor information that confirms a preexisting belief or hypothesis.  In fact, we don't just favor this confirming information, we actually seek it out at the exclusion of any contradictory information.  So, you know the perpetual market bears that always see a crash around the corner (and yes, every office has at least one)?  They go seeking ugly data that confirms that expectation, and are much more likely to remember and believe that data than any positive economic data they might find.  We are all guilty of this one to a certain degree, but it can be dangerous, especially in today's world where there is an unlimited supply of data and opinions that are easily accessible.  The banking world and the markets in which we operate are dynamic and ever changing, and we need to be able to adjust our opinions and strategies as we go.

Various Misunderstandings of Statistics
There are enough of these to write an entire book, so I will group them together.  They include things like total disregard for sample size (or believing results we have a seen a few times in a data set too small to actually be useful, or seeing patterns in data that is actually random), the anchoring effect (our brain's inability to move far enough away from an initial number once it has been lodged in our conscience), and the gambler's fallacy (thinking that past results have any effect on future results of a random pattern, or something be "due" to happen). 

However, the most important in managing risk in banks is probably "regressive bias."  Regressive bias refers to the fact that we grossly overestimate events that have a high likelihood, and we grossly underestimate events that have low likelihood.  If we hear "there is a 95% chance that these loans will pay as agreed," then our brains think of it as a certainty.  In reality, if our loans only pay as agreed 95% of the time, we will be out of a job.  The flip side is essentially the "black swan" issue.  Rare and unexpected events are actually more likely to happen than our brains allow us to believe, and can be catastrophic to our business (see 2008).

Sunk Costs
And finally, my pet peeve.  Banking, of all businesses, should always be about evaluating where we are at the moment, and making the optimal decision for going forward.  Unfortunately, that is not how decision making works at all.  Instead of ignoring sunk costs (those costs that have already been incurred and cannot be recovered), they are often a major driving force in determining ongoing strategy.  We spent X dollars on the software, so we are sticking with it even though it is clearly not the best solution.  We took those advances to hedge those specific loans, so we cannot pay them off early.  We started moving rates down last month, so we can't move them up this month.  We have invested too much time and money in that branch to close it. You get the idea.

Lizard Brains in Action
Some of the risks in banking are direct, tangible, and a little easier for our brains to process.  For example, on an individual loan, it is fairly easy for us to process the probability of default, and the loss given a default.  The risk is also quantifiable and easy to see; if the loan goes bad, we see the direct effect on the income statement.

Other risks are not so easy to see.  Interest rate risk is just that kind - we can be subject to sunk costs, and anchoring, and the gambler's fallacy all in one transaction.  Our lizard brains keep us from making the optimal decision, and what's worse, we do not see the direct cost of that mistake.  Instead, the risks accumulate over time, and when this risk shows up, we just see it in the form of underperformance, or a growing potential exposure, or a lost opportunity that would have been much better.  For example, we feel like rates have been low for too long, and are "due" to go up.  Our lizard brain finds a pattern where there really isn't one (sample size error), and so we stay in Fed Funds Sold making 0.25% instead of buying a bond that will earn 1.50%.  Or maybe we price a long fixed rate loan at an aggressive rate when a shorter bond was the better risk adjusted investment.  We never have to make a loss provision, and we never write a check, but we definitely underperformed.

So, I've laid out the problem.  What is the answer?  There is no easy answer, but a combination of a few things should help:

  1. Be openly and consistently aware of these weaknesses.  We need to know that our initial instinct, especially when managing complex risks, is often going to be wrong.  We need to back up, shut down the lizard brain, and try to take a more clinical approach to decision making.
  2. Invest the time and resources in an understanding of statistics.  Data becomes a bigger part of our business every day, and those that do not know how to properly interpret data will be fooled by it.  They will see patterns where there are none, be confident in faulty data, and not ask the right questions about data driven decisions and conclusions.  The entire team may not have a knack for this, but someone in the room should have a firm grasp of the basic principles.
  3. The management team needs to be comfortable with challenging each other.  We will all be victims of our lizard brain occasionally.  The danger is in groupthink, where we are afraid or unable to challenge and question every strategic and risk management decision we make.  Is the organization's leader willing to be questioned?

Banking is tricky business, as we operate on razor thin margins.  Properly managing the risks in front of us is vital, not only for success, but for the business to merely survive.  So, while our brains are organized for spotting and avoiding danger like saber toothed tigers, we have to take the extra step to translate that into an ability to spot and avoid complex financial risks.