Last month, we wrote about the sad story of Georgian Bank, which failed in September of 2009. The point of the story was to highlight that not only did the board and management team fail to recognize the significant risks the bank was taking until it was too late, but so did the regulators. Could the risks have been flagged long before the bank’s failure? Could this be prevented from happening at your bank? The answer is a resounding “yes!”
In the process of writing about Georgian Bank’s story, m.rae initiated a risk/return analysis to see how far in advance the risks could have been flagged. We modeled capital risk, credit risk, earnings at risk, liquidity risk, and an overall risk ranking for the bank. Similar to the key components of CAMELS, the model ranked the individual bank versus all community banks in the nation.
Signs and Signals
In 2006, Georgian Bank received a 2 CAMELS rating for capital, a 1 CAMELS rating for asset quality, and a 2 CAMELS rating for liquidity and sensitivity. On an overall basis, each area’s risk was trending upward, signaling the bank as high risk.
Through November of 2008, the bank’s CAMELS ratings remained the same. However, by 2007, our model showed a significant jump in credit risk. Overall, we found that not only was the bank’s risk high in 2007 and 2008, but its risk trending was steadily deteriorating. This represents a three-year advanced warning to potential bank failure.
Not only did our modeling show high risk three years before the bank failed, but the bank’s Canary red flags showed a similar disturbing trend. The Canary Report was developed by the OCC as a method to proactively monitor warning signs of bank’s that were taking excessive risk. The ratios were culled from the experience of banks that became problem banks.
There are 15 calculations that are divided among credit risk, interest rate risk, and liquidity risk. The average number of Canary red flags in the nation is four. m.rae has found that if a community bank exceeds seven Canary red flags, regulators will most likely issue board resolutions, MOUs, or cease and desist orders.
In 2006, the same year it was receiving 1 and 2 CAMELS ratings, Georgian Bank had seven Canary red flags. There were three red flags for liquidity risk and four red flags for credit risk. This confirmed our ranking of high risk.
In 2007, the banks Canary red flags rose to nine. Both liquidity risk and credit risk rose by one red flag. This also confirmed our assessment of higher risk with deteriorating trends.
In 2008, credit risk declined by one red flag. While this may appear as a declining trend, the red flags changed, but risk did not decline.
The credit risk red flags for Georgian Bank are an interesting and telling twist on risk that underlines the importance of the credit risk Canary red flags. The components of the red flags are thresholds in loan loss reserves, change in loan portfolio mix, growth in loans, loans to assets, and loans as a percentage of equity and yield on loans.
For instance, Georgian Bank in 2007 had red flags for a high growth in loans, a large change in the bank’s loan mix, and they received yields on the entire loan portfolio that were in the highest 25th percentile of all banks in the nation. One can only imagine this feat! How can you grow loans at an above-market rate, while changing the type of loans written, and get the highest rates? You guessed it; by taking excessive risk! To top it off, the bank also added to its risk by having high loans to assets and a high-risk loans to equity ratio.
In 2008, the credit risk Canary red flags shifted. Loan growth declined. Reserves increased to produce a red flag. The bank’s yield on loans declined below the 25th percentile. This is evidence that issues in the bank’s credit quality were increasing as the recession began.
Lessons Learned
Many times, lessons are learned the hard way. In the case of Georgian Bank, the early risk indicators were not heeded. On one hand, the regulators did not provide the directors with early warnings of the risk. The risks escalated, and the regulators were too late in preventing the aftermath.
The lesson is that directors and management team members must be well educated and vigilant in risk management, risk assessment, setting risk parameters, and monitoring risk. It is imperative that you evaluate the tools you are using to model risk trends and flag early warning signs.
It appears that Georgian Bank was comfortable with the perceived risks they were taking. Do not become too insulated and complacent with any one risk assessment tool. Rather utilize different perspectives to stay knowledgeable and thriving.