Jeff Judy

Jeff's Thoughts - January 7, 2009

Probability or Consequences?

When I was younger, there was a classic game show called "Truth or Consequences." The show, which started in radio, ran for more than 20 years on television. It was so popular that the town of Hot Springs, New Mexico, changed the town name to "Truth or Consequences, N.M."

Contestants had to answer (trick) questions, and when they got one wrong, they ended up facing ridiculous consequences, meaning they performed various messy or embarrassing stunts. The focus of the show was clearly on the consequences -- nobody remembers any of the questions.

I wish more bankers had the same focus!

We need to look at what we call "risk" through two filters: the likelihood of the event, and the impact of the event. The simple truth is that people aren't very good, by nature, at looking at both factors in a systematic way.

As individuals, in our private lives, we tend to be impressed by dramatic consequences. We fear tornadoes more than thunderstorms, and rattlesnakes more than bees. And that makes a certain amount of sense when we encounter these threats on an individual basis.

Bankers, though, tend to think in terms of probability. They define "highest risk" as "most likely to happen." Bankers worry more about lightning, which kills more people than tornadoes every year, and about bees, which kill more (allergic) people than do poisonous snakes.

The problem is that bankers often do a terrible job of preparing for rare, but catastrophic, events. Looking at their portfolios, most bankers can easily list risks in order of probability, but they don't even think about ordering them by impact of the threat. They are sitting ducks for an unlikely, but disastrous, turn of events.

We need to balance both factors. We need to be ready for the most likely events that might lead to problems for our customers, and their ability to repay us. But we also need to work to lessen the impact of catastrophic events that have a low, but real, chance of coming to pass.

That's why the "Challenges To Repayment" perspective I discussed recently, and awareness of "covariance," is so helpful. For example, you may rate the "risk" of a significant downturn, or even failure, in a major business or key industry in your market to be low. But you may have underestimated the total risk to your broader portfolio, if you haven't taken into account how failure of that large company or specific industry would "trickle down" to smaller businesses, service and retail outfits. The "risk" doesn't stop with that first company, it encompasses the combined outstandings of many customers.

Identifying the links between customers in your portfolio helps you better estimate both the likelihood and the severity of future problems. It helps you structure your relationships in ways that, at the very least, should reduce the potential pain when problems are transmitted from one business to another.

So make sure you address the most likely negative events that could damage your portfolio, keeping connections between businesses in mind. But then rank the problems by magnitude of consequences, and make sure you have taken steps to protect the bank from the most catastrophic events that are at least plausible, in your market.

You will have to stand firm through long stretches where you feel like you're doing more work than your rivals, just to prepare for something that may never happen. But the current economic crisis, the housing collapse, the dot-com collapse, and hurricane Katrina were all events that a lot of people thought "would never happen".

The truth is, if you do your homework, when that next disaster strikes, all your competitors (at least the ones that survive) will be looking at you with envy, and wringing their hands because they didn't foresee the consequences, and act against them, as well as you did.