Are No Loan Losses Community Losses?

We know the goal of lending money is to be repaid our principal plus interest. If the principal is not repaid, we must deduct this loss from capital. If too many loans cannot be repaid, we will no long have any capital, and depositors might not be fully repaid. That is a scary prospect, so heavy emphasis is placed on making sure the odds of repayment is exceedingly high.

But, can a financial institution be too conservative? Is it wrong to set standards so high that we virtually assure all loans are repaid, and no measurable losses can be recorded? While this may make our regulators happy, it might actually conflict with the mission of the institution. After all, credit unions were not chartered with the goal of pleasing their regulators, but rather they were chartered to serve their membership. If they become too concerned with trying to receive perfect regulatory feedback, they might also be stringently limiting risks, and failing to serve their membership to their full extent.

There is naturally competing interests in this circumstance, but it is worth recognizing that either extreme is undesirable. Taking too much risks means depleting capital and putting deposits at risk. Taking too little risk means offering little opportunities to your field of membership. Realistically, a credit union should strive to find middle ground with the guidance from the board of directors. A credit union should not be afraid to incur some losses, because that is actually an indication that they are trying to serve their membership. And, the board of directors should provide guidance to help management understand how many losses are acceptable losses, and at what point it becomes excessive and unacceptable.

From my experience as a bank examiner, I have seen several banks with a composite CAMELS rating ranging from 1 to 5, with 1 being the best rating and 5 being the worst. Institutions with 1 ratings were often proud of their rating, but they all had similar characteristics. They had few, if any, loan losses. They tended to keep large amounts of cash and government securities, and had notably smaller loan portfolios than their peers. They had smart people in management who rigidly adhered to policies. But, this presented unique challenges in small communities, because local businesses often struggled to have access to credit from the bank, and the banks tended to focus on lending to higher net worth individuals.

On the other hand, many banks that had a composite rating of 2 felt like they were always under the gun because they recorded loan losses. However, these banks would provide riskier loans to the local grocery store to help keep it going, or higher risk loan to the local café so it could remain open to serve senior meals and keep a community meeting place available. While these institutions would inherently accept more risk, they were a 1 rated bank as far as the community was concerned.

Losses, while unfortunate and undesirable, are not immediately an indication of a systemic problem in a credit union or bank. Some losses indicate they are taking risks in their community, and making sure credit is widely available. It is only when those losses become high or excessive that a true problem is manifesting itself. Otherwise, credit unions with loss rates exceptionally below their peers should ask themselves if they are doing enough to serve their members.