PUBLICATIONS
Commercial lenders have long defined risk as the loss that will occur when a loan goes into default, or generically, the loss that they can see over the near-term horizon. Today, this definition of risk most closely aligns with Expected Loss which is the numerical average of a distribution of possible losses. Only very recently have bankers come to understand the concept of Unexpected Loss, or variation around this average. The subprime mortgage crisis and the resulting Great Recession of the last decade are near-term reminders of the extreme losses that emerge in periodic credit crises, so-called “tail risk”.
I have long been fascinated with these credit crises and I have developed an idea for why they occur which I call the Excess Capital Hypothesis. I am skeptical that stress testing and capital management programs mandated by banking regulators will address the next such crises, partly because these programs do not address the uncertainty underlying Unexpected Loss and they don’t address the elements of the Excess Capital Hypothesis.
In the publications below, I share with you some of these ideas and I welcome any comments you may have. Please feel free to click on the underlined citation of any article to get a downloadable copy.
CURRENT EXPECTED CREDIT LOSS (CECL)
The new accounting standard for losses on credit instruments, Current Expected Credit Loss (CECL), has the potential to revolutionize commercial banking. The change from the incurred loss standard to expected loss will cause lenders to make much greater provisions for credit losses resulting in lower profits on lending. Implementation of CECL poses many challenges for these lenders. In the publications below, I highlight issues in estimating expected loss and I propose resolutions for them.
STRESS TESTING
While stress testing has been a common practice in assessing risk in trading portfolios, it was rarely applied to credit portfolios, especially bank loan portfolios. All of that changed with the Financial Crisis in the second half of the 2000’s, when the Dodd-Frank Act gave risk to the regulatory requirement that banks of $10 billion in total assets must conduct annual stress tests and derive capital plans from those tests. Bank of $50 billion or more must conduct additional stress tests and capital plans under the Comprehensive Capital Analysis and Review Program. In the following publications, I highlight how human behavior influences the magnitude of market crises and suggest that the macroeconomic scenarios in this regulatory stress testing programs don’t fully address that uncertainty that causes the worst crises.
THE EXCESS CAPITAL HYPOTHESIS
Throughout my career, I have been fascinated with credit crises and their causes. Most commentators have attributed them to economic forces in which recessions cause both commercial and retail borrowers to lose the capacity to repay their loans. This idea that credit crises are caused by the macroeconomy underlies the Dodd-Frank Act and the requirement that U.S. banks of $10 billion must conduct stress tests against three scenarios of the U.S. economy. Banks now use mathematical models in which key components of their operations are linked directly to characteristics of the economy.
I take different view. The Excess Capital Hypothesis holds that when loan growth exceeds economic growth, that excess capital flows to borrowers who, under equilibrium conditions, would not be considered creditworthy. Such sub-prime or non-investment grade borrowers have exponentially higher probabilities of default than their prime or investment grade counterparts. Eventually, those higher default probabilities become actual defaults and when those default occur en masse, as they often do, a credit crisis emerges.
COMMERCIAL LOAN PORTFOLIO MANAGEMENT
Commercial lending is a highly competitive business in the United States and banks routinely find that, in order to build a profitable business, they must build extensive concentrations of on-balance sheet loans, extend credit to non-investment grade borrowers and offer options on loans that may not be profitable, such as committed but undrawn revolving lines of credit. Throughout my career, I have advocated for the management of commercial loans using the tools of portfolio theory.
The Tail Wags The Dog in Commercial Lending. 2010. Commercial Lending Review, May-June, pp. 3-11.
The Intrinsic Value of a Commercial Loan: Understanding Option Pricing. 1995. Commercial Lending Review 11(4)