Lessons for risk management: 6 Reasons banks fail

Developing a strong Enterprise Risk Management (ERM) system requires understanding the risks that commonly trip up other financial institutions, according to regulatory and management consultant Bruce Bugbee of Bugbee Warner PLLC. In this guest column, Bugbee outlines some of those potential hazards.

When developing your Enterprise Risk Management (ERM) system, consider why banks fail 

By Bruce Bugbee

Enterprise Risk Management (ERM) has been practiced for decades in financial institutions but with varying degrees of success and formality. I was filling out exhaustive checklists for bank clients in the 1970s with Peat Marwick (now KPMG), and exhaustive checklists are still being completed to address specific risks. I’m pleased to see the process has been expanded, though, with the efforts of the regulators and the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

To develop a strong ERM system requires some understanding of what has caused financial institutions to either fail or come close to failing in the past. Over the course of many years, we have worked with a number of community banks that failed. It’s instructive to study what caused the failures and make sure that your ERM system incorporates those risks. Here are some examples:

Bickering at the board level 

A new bank board consisted of 18 successful entrepreneurs, and each one thought they knew more about banking than all the others, including the CEO, who was unable to provide strong leadership. Board meetings were contentious, the CEO was not respected, and a clear strategy was never agreed upon. The bank failed in its third year.

Nepotism 

This practice was a favorite of the old S&Ls, and you see how well that worked. It still creeps in today in a few community banks. This creates unhealthy gossip at best, and bitter feelings about fairness at worst. We have seen it destroy morale and, ultimately, the bank.

The wrong strategy 

Sometimes big ideas (and big egos) get in the way of developing a reasonably solid strategic plan. One small community bank set a grand plan in motion with totally inadequate capital. The plan was never achievable and cost shareholders dearly. Another successful community bank expanded into a new market in a grand way without adequate discussion of the risks. That bank failed. A number of astute board members could have been invaluable in moderating this plan, but the internal environment was not a healthy give and take among board members and senior management.

An incompetent CEO 

Don’t join (or remain on) a bank’s board unless you’re willing to vote for dismissing a CEO or fellow board members for poor performance. We recently were asked by the board of a financially sound bank to evaluate the CEO’s performance because several senior managers were thinking of leaving. We interviewed the board members and management individually and in confidence and found the CEO had lost the confidence of everyone in the organization. However, no action had been taken. This is one reason that we feel outside board members should always meet in executive session, however briefly. A “lead director” should be elected to chair executive sessions in cases when the CEO is also the chairperson of the board.

Rapid growth 

There is a reason that regulators dislike rapid growth; managing growth is an art that some may not completely understand. All too often, a culture of production versus a culture of credit quality accompanies rapid growth. This has been a key ingredient in many of the troubled banks we have worked with over the years.

Poor credit administration practices 

If the focus is on production, it is easy to get sloppy with the business of lending. Watch out for vague credit policies where an actual exception to policy is essentially never possible. Good exception reporting and a strong external loan review that document credit exceptions are essential. Get the board involved in this process.

To learn more about avoiding dangerous pitfalls and streamlining procedures within your institution, download this free whitepaper: 9 Ways to Prepare for Your Next Examination 

Bruce Bugbee has more than 40 years of experience in the financial services industry, including 17 years as a national partner in charge of thrift institution consulting with KPMG Peat Marwick’s consulting group. He is a founding partner of Bugbee Wagner PLLC, which is headquartered in Gig Harbor, Wash. The firm provides enterprise risk management, regulatory advisory, and other traditional management consulting services to financial institutions.