Confronting "This Time It Will Be Different" in 2013
by Ron Feldman, Senior Vice President, Executive Services, Supervision, Regulation and Credit, Federal Reserve Bank of Minneapolis
In 2009, Carmen Reinhart and Kenneth Rogoff published their influential book, This Time Is Different. The subtitle — Eight Centuries of Financial Folly — foreshadows the bottom line, which the authors spell out in the first paragraph of the preface:
This book provides a quantitative history of financial crises in their various guises. Our basic message is simple. We have been here before. No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities with past experience from other countries and from history.
They go on to identify the fallout from credit booms and debt accumulation as the hallmark of financial (and sovereign debt) crises.1
While Reinhart and Rogoff take a broad and international perspective, in this article I will consider the local implications of their message and encourage bankers in communities across the United States to do so as well. I will show how "this time it will be different" thinking could prove potentially costly to banks. I will focus my discussion on two issues that are directly relevant to the upper Midwest, where the Federal Reserve Bank of Minneapolis is located and I have the privilege of working.2 That said, I think these issues apply to a broad range of banks across the United States. The issues I will discuss concern (1) lending in an environment of rapidly increasing natural resource values and (2) operating in a stressed earnings environment produced, in part, by persistently low interest rates.
I must stress the need for balance from the outset. Humans have a tremendous asset: the ability to forget past errors. After all, the inventor who persisted through tens or even hundreds of failed experiments is a staple of news accounts and history books. Likewise, not every increase in lending, change in lending standard, or development of a new banking product is a harbinger of future problems. Indeed, supervisors work with banks to ensure that qualified firms and households have access to the credit needed to facilitate appropriate economic growth. Nevertheless, continued vigilance and a critical eye to guarding against past mistakes, at a minimum, will help guard against history repeating itself.
Lending and Increasing Natural Resource Values
A shale gas and oil boom is occurring in parts of the Ninth District, as well as other parts of the country, including Texas, Pennsylvania, and other states. As of this writing, the Bakken oil formation in North Dakota and Montana accounts for about 10 percent of U.S. oil production, up from virtually zero percent a decade ago; 40 percent of the increase in U.S. oil production over the latter half of 2012 occurred in a 12-county area in those two states.3 The increase in oil production has led to a massive increase in investment and inputs, as well as price increases and shortages across many goods and services — particularly labor and housing. By the end of 2012, average wages were up 20 percent, and the unemployment rate was 1.8 percent in the Bakken region.
A second boom has been occurring to various degrees in agricultural land and commodities over the past several years, although the precise state of play depends on the type of commodity (e.g., grain versus livestock) and the location (e.g., in an area of drought or not). Prices for corn and soybeans, for example, at year-end 2012 were at levels roughly three times what had been "normal" during the 1980s, 1990s, and much of the 2000s. Farmland values, too, have risen to record levels. U.S. crop land values — including those in agriculture-intensive states such as Kansas and Iowa are at nearly 50-year highs, as are land valuations relative to the cost of renting farmland.
How should banks and bank supervisors respond to what sounds like and often feels like the best of times? We should not assume we have reached a new normal or that booms and busts in natural resource production and prices have gone away. In short, we should not count on this time being different.
Land values in shale and agricultural locales may not continue to rise. The disconnect between rents and land values should give us pause. Perhaps rents will go up but maybe not. Expected demand for agricultural products may fall below current levels or supply may increase more than expected. Either outcome could help drive down land values. A rapid increase in interest rates at some point in the future that deviates from expectations could also drive down land values. The supply of energy may be much higher or much lower than current forecasts. Again, either outcome could have dramatic effects on energy prices and/or where that production takes place.
Supervisors and banks must consider the possibility that this time will not be different. This consideration should show up directly in underwriting, credit risk management, and capital and liquidity contingency planning, to pick three examples. In the current context, underwriters for agricultural credits could assume producer ability to repay based on commodity prices that are closer to historical norms.4 Funding of land purchases could also assume lower-than-current valuations or require higher equity contributions from borrowers. Overall credit risk management policies could set exposure limits to projects that rely to a large extent on the fate of shale energy, both on an absolute basis and in terms of growth. Capital and liquidity planning should consider the chance that the boom in agricultural or energy prices may not last.
The board of directors is responsible for determining how a bank positions itself during the boom. The board sets the bank’s risk tolerance, establishes the framework the bank follows to manage that risk, and approves contingency plans addressing worse-than-expected outcomes.5 These steps should be straightforward in principle, simple to explain, and not quantitatively complex. However, they may not be painless to implement. In the short run, these steps could reduce profits. Even more challenging, they may require banks to reduce exposure to the local economy they serve. Experience over the years, however, has shown that making prudent choices during boom times puts a bank in a better position to withstand severe stress later. The majority of Ninth District bankers I talk with report taking the longer view, typically motivated by scars from prior downturns in natural resource markets.
Operating in a Prolonged Stressed Earnings Environment
Community bank earnings face pressure from many sources. Interest rates are low and will be until the labor market outlook substantially improves. Reductions or recoveries in loan-loss provisions should diminish as a source of earnings. In addition, community banks must always be aware of compliance costs.
Banks may take on more risk in response. Banks could take on more duration or interest rate risk. Banks may also offer new products or renew focus on existing products. Banks may decide to grow their commercial and industrial lending, particularly if prior lending concentrations — especially in commercial real estate lending — have diminished. Of course, banks can succeed by taking on more well-managed risk. But these same strategies have led banks of all sizes to fail. That challenging history should not become a forgotten relic.
I encourage bankers and supervisors to read the First Quarter 2013 issue of Community Banking Connections, which included an article by my colleague Teresa Curran from the Federal Reserve Bank of San Francisco, detailing the factors bank management and boards should consider when offering new products or services.6 Banks and supervisors should have these risks at the front of their minds. Just a few years ago, for example, banks looking for earnings expanded into new markets and products by purchasing out-of-area participations without having proper risk management in place to address the associated risks. An article in this issue of Community Banking Connections talks in greater detail about effective risk management for loan participations. We cannot forget that weak risk management in good times, especially in commercial real estate lending, defined and underpinned the recent crisis.7
Past issues of Community Banking Connections have also included articles emphasizing the critical importance of proper management of interest rate risk.8 These articles discuss the core tenets of effective interest rate and duration risk management, focusing on the principles outlined in federal interagency guidance issued over the past few years.9
Effective bank management recognizes that risks from the past can occur again in the future. Bank management, therefore, is effective precisely when it recognizes that this time may not be different.
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- 1 Carmen M. Reinhart and Kenneth S. Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press).
- 2 The Federal Reserve Bank of Minneapolis operates in the Ninth Federal Reserve District, which includes the states of Montana, North Dakota, South Dakota, and Minnesota; the western portion of Wisconsin; and the Upper Peninsula of Michigan. See www.minneapolisfed.org.
- 3 The Federal Reserve Bank of Minneapolis provides data on many aspects of the Bakken oil formation at www.minneapolisfed.org/publications_papers/fedgazette/oil/index.cfm.
- 4 See SR Letter 11-14, "Supervisory Expectations for Risk Management of Agricultural Credit Risk," for more details on managing agricultural related credit risk, at www.federalreserve.gov/bankinforeg/srletters/sr1114.htm.
- 5 For a more detailed discussion of corporate governance of banks, see Kevin Moore, "View from the District: The Importance of Effective Corporate Governance," Community Banking Connections, Fourth Quarter 2012, at www.communitybankingconnections.org/articles/2012/Q4/Importance-of-Effective-Corporate-Governance.
- 6 See Teresa Curran, "View from the District: Considerations When Introducing a New Product or Service at a Community Bank," Community Banking Connections, First Quarter 2013, at www.communitybankingconnections.org/articles/2013/Q1/Considerations-When-Introducing-A-New-Product.
- 7 See Governor Sarah Bloom Raskin (2011), "Community Bankers and Supervisors: Seeking Balance," speech delivered at the Federal Reserve Bank of New York Community Bankers Conference, New York, April 7, at www.federalreserve.gov/newsevents/speech/raskin20110407a.htm.
- 8 Doug Gray, "Interest Rate Risk Management at Community Banks," Community Banking Connections, Third Quarter 2012, at www.communitybankingconnections.org/articles/2012/Q3/interest-rate-risk-management, and Doug Gray, "Effective Asset/Liability Management: A View from the Top," Community Banking Connections, First Quarter 2013, at www.communitybankingconnections.org/articles/2013/Q1/Effective-Asset-Liability-Management.
- 9 See SR Letter 12-2, "Frequently Asked Questions on Interagency Advisory on Interest Rate Risk Management," at www.federalreserve.gov/bankinforeg/srletters/sr1202.htm, and SR Letter 10-1 , "Interagency Advisory on Interest Rate Risk," at www.federalreserve.gov/boarddocs/ srletters/2010/sr1001.htm.