Risk Management - A Science, Art Form, Gut Feel, Experience, Or Biometrics

To all the guys in our business who have made the tough loans during good times and bad times, let me confess. I've never been there. I only watched, and here are some things I discovered about lending.While working as an IT guy for a large regional bank in Providence, I got a call from an ethnic-based loan company in Fall River, Massachusetts. The owner wanted to know if we could automate their loan portfolio and transaction processing. Business was robust and they couldn't keep up with their manual system. Six months later, and 10 pounds heavier (the owner would only meet with us after hours during dinner which he gladly paid for), I was pleased to announce that our Installment Loan system had been customized to do the job. During the celebration dinner (after the conversion), I made the naive mistake of asking the owner how the loan company evaluated loan applicants. He said, "We ask them two questions. Do you have a job? Where are the Azores located? If the answers were "yes" and "about 1000 miles west of Lisbon, the loan was approved." When I asked what the default rate was, the owner laughed. "What do you think we are a bank?" These people don't default. How nice to know your customers.

When I launched my consulting practice, I thought it would be wise to have a line of credit as backup in case I encountered some "on the beach" time. I walked into a Madison Avenue branch of First National City Bank of New York (now Citi), and spoke to a loan officer. All I had was a copy of my resume. When he asked me why I had left a prestigious consulting firm like Booz, Allen & Hamilton, I said, "There are 15,000 other banks besides First National City that need my services and can afford me." He said, "Sign here", and I had my $25K line of credit. Sometimes name dropping buys a lot of credibility.

As a fledgling independent consultant, I took any legitimate work I could get. One project was "handed" to me by a top official at the Department of Health Education and Welfare, to work as a sub on a contract to prevent Medicare fraud. The prime contractor was a fellow who had developed systems to spot the most-likely candidates who would cheat the system. During a lull in the project, and while enjoying a fine dinner at Le Cheval Blanc, I asked Dave if his system could spot poor credit risks also. You know you're dealing with a brilliant Ph.D. when he looks at you after he takes a sip of wine and quietly says, "I could do it." I set up a meeting with "the right guys" at Citibank and Dave made his pitch. A few weeks later Citibank sent us a deck of punched cards representing known cases and challenged Dave to identify the bad guys. Dave ran the data and sent the results to Citibank. In the NYC style of Mayor Ed Koch, I asked Citibank, "How'd we do?" Dave's results were over 95% accurate. The reason they couldn't be precise was because Citibank had misidentified some of their known cases. Sometimes science works.

One thing I never liked about the banking business is the line item called, "reserve for loan losses." In my business, I wouldn't dream of taking on a new client if I thought it would go sour. In banking, one could do a lot of things right during the year, and yet be wiped out if one segment of the business didn't work out as planned. I believe Chuck Prince might agree with me. Believing that technology might provide a few checks and balances in the process of evaluating lending situations, I had developed a concept to be used in loan committee meetings that would provide the "final answer" when the committee couldn't agree. But first, I wanted to test the concept with some trusted bankers who would not just patronize me. Their comments surprised me because most of them trusted biology more than technology. Here's what I heard. "I look the guy right in the eyes and I can tell if he's going to perform on the loan." "I trust my seat-of-the-pants judgment more than I do technology." "By the time I review the situation, I get a feeling in my gut that tells me what I should do." Having just read Gerd Gigerenzer's "Gut Feelings," I now might agree with that banker. A software company in Eden Prairie, MN didn't pay attention to my focus group testing and produced the concept as software to run on an IBM PC. They called it, "Decision Maker." I still have the first shrink-wrapped package complete with disk and user manual. It sits on my book shelf and it looks very professional in its box. It never made it outside the box, however. Biometrics prevailed.

To all the entrepreneurs out there, if you have a thirst to produce a technology that the more established tech vendors have overlooked, and even the wannabes, rush out to your garage and get to work. There couldn't be a better time.One thing I never liked about the banking business is the line item called, "reserve for loan losses." In my business, I wouldn't dream of taking on a new client if I thought it would go sour.