How strong risk management saved banks during the crisis
What went down during the financial and banking crises, and what did the FDIC learn from it? That’s the theme of the FDIC’s new book, Crisis and Response: An FDIC History, 2008-2013.
To promote the book, the agency has also released a seven-part podcast delving into highlights of the study. It’s an interesting listen (or read as the transcript is online).
The FDIC tells the familiar tale of how how the crisis was manufactured by the financial sector with its risky lending. It digs into how the FDIC had to balance warning the public about risk in the housing market with avoiding sparking a panic, the different ways the agency leveraged the Systemic Risk Exception to help floundering megabanks, and what it’s like to expand its mission and go from being an agency that insures deposits to one that insures debt as part of the Debt Guarantee Program.
These are all fascinating topics, and I encourage you to give it a listen if you have time, but the part I found most interesting explored how risk management made the difference between community banks that survived the crisis and those that went under.
Lessons in Risk Management
We all know that community banks weren’t responsible for the financial crisis. Even the ones that failed weren’t involved in subprime mortgage lending products.
Why did community banks fail? The FDIC says the banks that failed didn’t do a good job managing the risks in their commercial real estate (CRE) lending portfolios.
The FDIC made a clear distinction in the risk management practices of banks that failed and those that survived. That includes:
- Prudent growth plans and loan underwriting. Even banks with large concentrations of CRE and construction lending in their portfolio came out okay if they were more prudent.
- Boards of directors actively engaged in managing and mitigating risks.
- They were more receptive to examiner recommendations.
Banks That Failed Had Poor Risk Controls
A common denominator among failed banks was that they “grew rapidly without good controls – they had weak loan underwriting, made loans outside of the bank’s normal market area, and were usually led by a dominant bank official with limited board oversight.”
Risk Management and Governance Drive Success
The FDIC says that the crises reminded us that banking is more about than financial ratios and reports. “How well the bank manages its risk and the quality of its governance are the most important drivers of its success.”
Identifying Risks Early Increased Success
The FDIC found that “when a bank was rated 3 and received some kind of a corrective action—formal or informal—nearly two-thirds of the time it never became rated worse than 3.”
It attributes this to the importance of identifying risks early and addressing them proactively before they were beyond fixing.
The #1 Risk Management Lesson
“To me the number one lesson is the importance of addressing weaknesses in risk management at an early stage, before the weaknesses turn into real financial trouble,” notes Doreen Eberley, director of the FDIC’s Division of Risk Management Supervision
- Identifying the problem
- Taking steps to correct it
Eberley believes the FDIC “should have been more forceful in requiring correction of weaknesses in risk management practices at an earlier stage.”
Risk Management is Key to Preparing for the Next Crisis
While the FDIC says it’s not possible to see every risk or know exactly what will trigger the next economic crisis, banks can best prepare themselves with strong risk management. Particularly, the FDIC can “examine for a strong risk management culture at banks, which will help them be more resilient in the face of economic cycles.”
The Risk Management Takeaways
The FDIC’s research into the crisis provided yet more compelling evidence that risk management plays a major role in ensuring a financial institution’s success. A strong risk management culture, including tone from the top set by board and management, is essential. The earlier a risk is identified and effective plans are put into place to mitigate them, the more likely a financial institution is to weather a storm.
What kind of risk management culture does your institution have? An enterprise risk management (ERM) program is an essential tool for uncovering risks and vulnerabilities and proactively addressing them. If you don’t have an ERM program in place or aren’t confident in it, now is the time to implement one.
We don’t know when the next crisis will strike. We only know that the best way to prepare is with effective risk management.