THE ALLL/CAPITAL SWEET SPOT

Tired of the Pendulum Swing Between Safety and Growth?

An essential, indeed required, element of risk management is putting aside resources to protect the bank against future, unfavorable outcomes. You rely on ALLL to cover expected losses and on sufficient Capital to provide a final backstop for any ugly surprises, and your approach to managing those resources is a determinant of your long-term financial success.

At its simplest, the purpose of all that portfolio analysis is to allow you to manage ALLL and Capital to optimal levels. But what is optimal?

The goal of risk management in general, and of optimizing ALLL and Capital in particular, is simply:

The Pendulum and the Sweet Spot

On the one hand, insufficient ALLL and inadequate Capital will not cover losses when they occur, threatening the financial health, and even the survival, of the bank.

On the other, it is possible to put aside too many resources to mitigate risk, draining what might be available to build success.

And most banks have been at both ends of that spectrum in the last several years.

Think of the President's limousine, which is full of compromises. We know that being in an open convertible presents significant risks to his safety. A desire to get close to the people, to be easily visible, and even to be able to maneuver the vehicle quickly and smoothly through crowds all work against the need for protection.

Better versions have armor plating and bullet-proof glass. They have recently rolled out a new model of this car, which is much safer, with thicker armor and other enhancements.

Now, they could add more and more armor, giving more and more protection. But at some point, the car will be so heavy that it cannot move. The President will be safe. He just cannot go anywhere.

In banking, many institutions headed into the recession with the lightest possible "armor" so they could travel at the greatest possible "speed." They put the maximum possible financial resources into growth, into marketing services, developing new products, and booking new business. And when things turned bad, they quickly disappeared. They didn't have anything near the protection they needed to handle the losses they saw.

Now, with the regulators all over us, we are erring on the safe side. We have swung past the sweet spot where we find the optimal balance of protection and growth.

If you can find that sweet spot, and more importantly, hold onto it in the face of the cycles your competitors will swing through again and again, your bank has a much better opportunity to enjoy consistent prosperity over the years.

What It Takes ...

You need more than just a good portfolio analysis program to manage this sweet spot. You need a demonstrably comprehensive approach to risk management!

Right now, a lot of it comes down to your conversations with regulators, who will always be happier with more and more "armor." How do you convince them you know where that sweet spot is?

Part of it is explaining how your analytical model works and why you have confidence in it, certainly. But if you can show them ...

• how your processes generate high-quality data from meaningful risk ratings;
• how your culture ensures consistent practices and adherence to standards; and
• how your training program leads to optimal practices at the front lines,

... you have a much better chance of earning the flexibility to manage your ALLL/Capital allocations to the benefit of the bank and its shareholders.

Continue here for more about how Risk Ratings are under-used in risk management ...

There is a best of both worlds in ALLL/Capital Adequacy, IF you have the right tools, processes and people supporting your risk management efforts.