Gonzobanker For Those About to RAROC

“If you applied even a partial capital charge to the banking industry for the $9 trillion in total securitizations, then the entire industry would be woefully undercapitalized and the largest banks would be sub-investment grade… A public debate about the capital banks require to navigate the modern day financial markets seems long overdue.” –Comments from The Institutional Risk Advisor, 2008

As we sit here on a Monday, searching for glimmers of hope in a post-TARP world, does anyone think the banking industry has gained the wisdom and prowess necessary to avoid major financial crises in the future?

I was a young banker in the early 1990s, the last time a major “war against risk” was being waged in our industry. The S&L crisis had hit, FDICIA laws were passed and the acronym RAROC was coming to the fore.

This risk-based profitability framework that was started by Bankers Trust in the late 1970s promised to create wiser and more analytic bankers. As opposed to jumping willy nilly into new ventures or making dumb loans, bankers would scrutinize their risk-taking opportunities and only proceed if the transaction could jump over a hurdle rate on economic capital.

Young and idealistic, I immediately became a RAROC groupie. I built Lotus 123 spreadsheets to analyze loan portfolios, hung around at Sendero conferences and devoured books on chaos theory. “Yes,” I thought, “This new thinking and sophisticated tools will rid our industry of stupid decisions for once and for all!”

Yet, even as a 29-year old industry consultant, I can recall worrying about the need to change banks’ internal cultures to truly manage risk. Full of spit and fire, I wrote in a July 1993 editorial to the American Banker the following passionate plea:

The fundamental mission of a financial organization is balancing – balancing risk and return, deploying capital to appropriate transactions. But when this process is fragmented so the balancing dynamic cannot be tracked and bankers cannot learn from the outcomes of past decisions… the industry is consigned to a future of boom and bust.

Ahh, such a sage warning, but anyone can write about managing risk – it’s actually living up to risk management principles that’s hard to pull off. Although we witnessed the pain of Sarbanes Oxley paperwork and weighty new enterprise risk management (ERM) structures in most banks, our industry has clearly done a miserable job of slaying the risk dragon since the last banking crisis.

We’ve seen the large players fall under the weight of sophisticated stupidity in the form of complex securities, reinsurance and credit default contracts. We’ve seen liar loans anointed by government-sponsored risk models. At the same time, it hasn’t just been large banks that lost their RAROC mojo. For smaller banks, the explosion of construction lending is a dire symbol of sloppy risk-taking. Here’s how the story unfolded. From 1998 – 2008, construction loans in the banking industry knocked out a 16% average annual growth rate and increased by a whopping $500 billion. These loans became the lifeblood of small community banks. Competition heated up and soon these deals were being done with minimal spreads and fees. The watchword inside most banks was to not lose any deals to competitors, and price was the weapon of choice.