Why banks make bone-headed decisions

By Felix Salmon
December 30, 2011
Stephen Dubner passes on what he calls the "bizarre story" of a man whose bank is unwilling to give him a $50,000 loan, even if it's fully collateralized in cash.

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Stephen Dubner passes on what he calls the “bizarre story” of a man whose bank is unwilling to give him a $50,000 loan, even if it’s fully collateralized in cash.

Dubner seems unsure that the story’s entirely true — but it rings absolutely true to me. So why does Dubner find it so hard to believe?

The answer is that Dubner’s looking at the bank in functional terms — as a place which makes profits by lending out money at some spread over its cost of funds. If such an institution were perfectly rational, then it would almost certainly accept this customer’s offer. There’s no real opportunity cost to extending this loan, because if the bank turns down the customer, then it’s also turning down the funding source for the loan. (The offer, of course, is essentially self-funding: the customer is offering to put $50,000 on deposit and then use that as collateral against a $50,000 loan.)

But of course there’s no such thing as a perfectly rational institution. And as banks grow, they become hyper-aware of the number of places where errors in judgment can cause losses. And their reaction is always the same: they reduce that number.

This does make a certain amount of sense — if you don’t let bank managers approve loans, then you won’t get a rogue bank manager throwing away millions of dollars of shareholders’ money. More importantly, if you approve all loans centrally rather than at the bank-branch level, then, at least in theory, you can see bank-wide risk exposures emerging which individual branch managers would never know existed.

Of course, centralizing loan approvals, and computerizing them so that they’re automated, has costs as well as benefits. For one thing, it means that errors of judgment at the loan-approval level can cost billions of dollars, rather than millions. And it also means that you’re building model risk into the system, and losing a lot of the natural diversification that you get from a heterogeneous set of individual bank managers making individual decisions to customers whom they personally know.

But the people making the decisions to centralize are also the people responsible for making the centralized lending decisions, and they tend to be very sure of themselves and their models. So bank managers get ever less freedom to do sensible and profitable things, while computers churn away making decisions which sometimes defy common sense.

I’m quite sure that there’s no one at the bank in question who thinks that its response in this case made sense. But that’s a known issue when you automate underwriting decisions: computers don’t have common sense. Some unknown proportion of sensible loans will end up not being made. But the bank will sign on to such a system anyway, because it’s cheaper than having humans make those decisions, and because it reckons that computers will make fewer errors than humans in aggregate.

After all, it’s not exactly every day that someone walks into a bank and essentially offers to lend himself money, while paying the bank a decent rate of interest at the same time. If it did happen every day, then I’m sure someone at the bank could program the computer to set attractive terms for such people. But it’s rare enough that it’s not worth the time and effort involved in doing so.

Now, from the point of view of the customer — and, indeed, of the customer-facing loan officer at the branch level — all of this is extremely frustrating and Kafkaesque. Which is one reason why it makes a lot of sense to bank with a small community bank, or a credit union, rather than some enormous centralized franchise.

But yesterday I spoke to the woman who got turned down by her credit union for a personal loan, and who was forced to go to a much more expensive installment lender instead. (I’ll return to this story once I have a bit more information.) Her experience at her credit union was also frustrating, and constrained by computer-set rules. So even credit unions with only a handful of branches aren’t immune from this syndrome. But I feel safe in saying that there’s a direct correlation between the size of the institution, on the one hand, and the chance of running into this kind of frustrating stupid-computer situation, on the other.


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There are inevitably three Cs in a credit decision – Capacity,Collateral and Credit. Ostensibly we know the particulars of one of those,the collateral. We have no idea as to the capacity of the borrower to repay the loan nor do we know his credit profile. So maybe we ought to cut the bank some slack until we see the entire picture.

I seem to recall that glossing over the elements of a good loan did cause us to encounter a bit of a rough patch recently.

Posted by TomLindmark | Report as abusive

I’m confused. If the customer already has the cash why does he need a loan?

Posted by Anonymous | Report as abusive

Anonymous, it was ostensibly to prove he was “credit worthy” for future loans.

Posted by TFF | Report as abusive

Isn’t this the most basic form of money laundering?

Getting access (laundering) to dirty money (collateral) by doing a classic back-to-back?

The dirty money sits at a bank, somewhere, someplace, untouched and unused.

And somewhere else someone spends a clean loan seemingly unlinked to the cash.

Posted by carambas | Report as abusive

@TFF – I’ve been asking myself “does taking out a loan against your own cash collateral do anything to prove actual credit worthiness” ??? I’m not sure of the answer…

Posted by KidDynamite | Report as abusive

I did a little work experience in a bank many years ago, helping program computers to do exactly this! Specifically I was working with the mortgage applications: approval/rejection computer program.

The program was VERY rudimentary in terms of risk assessment and in terms of automated verification of information against other reference sources; but to give the customers the impression of a sophisticated or even omniscient bank (which is good for the bank’s public image, and scary for potential fraudsters), it all looked very fancy on the front-end. Basically, local bank clerks interviewed customers while entering information on the program, and even if the customer was rejected on some puerile criterion on Page 1, the program would still force the customer to go through another six or seven screens of data-entry in order to be told, “No.” This was apparently to prevent the customer from being able to deduce which criterion caused their mortgage application to be rejected (which might help them game the system). Most of the bank clerks probably would have presumed at that point that the system had found some undesirable details in the customer’s credit history (which actually had to be checked manually after provisional approval), and were glad not to know the ugly details so as not to appear impolite to the customer…

In other words, all the information and power was concentrated in the hands of a faceless and rather unsophisticated computer programming department within the bank’s head office, whose job was to make the bank look good and prevent the bank from losing money to customers who had basically told them they couldn’t pay back the loans they were asking for. Nobody in the department appeared to care much if they ignored a significant number of (on average) marginally profitable customers.

The strategy worked. Only, the bank was way too mortgage-heavy and not sufficiently involved in other banking activities; and started doing significantly riskier deals (and taking a more aggressive leverage position overall) some time after I left. They ended up being bought out, after the 2008- financial crisis damaged their cash-flow and their options for borrowing on the marketplace.

The collapse of banks like this one created a hole in the capacity/confidence of the UK mortgage & lending market.
The UK government’s response (after being forced to take a stake in these banks, to keep the system going)? Audit government-supported banks for the amount of lending they’re doing, and pressure them into lending more so as to “stimulate” the economy.
The banks’ predictable response to this unwanted scrutiny from their unwanted shareholder? Check this out…

I have a wealthy friend who was being pushed by these banks into taking long-term mortgages/loans at something like 1% interest, about 18 months ago! Loans he absolutely didn’t need. For all the bank cared, he could take the money and invest it in stocks and shares, because they knew he’d pay it back and it would boost their “lending” figures during the down-turn, to impress the folks breathing down their necks to “stimulate” the economy.

Banks are staffed by people, who mostly do what will earn them a bonus or what will get them out of trouble with their manager. I think many UK banks are operating a scam right now too, where they deliberately lend money at unprofitably low interest rates to 100% safe borrowers. I think they are doing this:
1* To meet capital lending targets set by stupid politicians,
2* To demonstrate continuing unprofitability as part-nationalised banks, so as to force the government to sell their stake in the bank at a knock-down price to steadier hands in the private sector [the friends of the bank managers, no doubt] who have the skills to “return the banks to profit”, for the benefit of all of us no doubt…

I think you should look into this as well…

Posted by matthewslyman | Report as abusive

This strikes me as a correct bankruptcy call. I don’t know what happened here but when you read “I proposed to our banker that we would give him $50,000 cash to hold onto and in return, have the bank loan us $50k for 5 years. Basically we were securing the loan with cash as collateral,” that is very very different to me from “We secured the loan with cash as collateral.”

When you secure the loan with cash as collateral, if you default, the bank takes the cash and that’s that. The loan is risk-free.

When you “basically” secure the loan with cash as collateral in your own mind, by promising to park $50K at the bank as some sort of good-faith proof, if you default, the bank has a claim on your bankruptcy estate – and so do all of your other creditors. The $50K you’ve got in the bank is an asset of that estate that can be divvied up to pay the claims. The fact that it’s kept in the bank is legally irrelevant; the bank doesn’t get first dibs on it just because it’s in their vaults.

I don’t know what happened here but neither does Dubner, Felix, or likely the original writer. But I’d guess that the bank’s analysis of the legal character of its collateral mattered.

Posted by MattL | Report as abusive

I’ve actually done a version of this transaction with my credit union: I took out a one year personal loan, secured by a certificate of deposit with the same maturity. I was attempting to build credit; being new to the US, I didn’t have satisfactory credit.

It sounds like the person in question was attempting to do the same, to build credit with his bank so that he could later get credit on better terms. It sounds like he says as much in his first paragraph. So, a sensible banker would have asked him to commit to a 5 year CD and written the loan to be contingent on not withdrawing the CD early. The bank would have made a few bucks (and I assume this transaction wouldn’t have impacted liquidity at the branch – you loan out $50k for 5 years, but you have a new $50k on deposit for 5 years).

Of course, then a human banker could say, well, if you pull this transaction off, then that shouldn’t really affect my future underwriting decisions, so I’d have no reason to lower your future interest rate…

Posted by weiwentg | Report as abusive

Well I think the whole thing stinks. Let’s recap: the customer doesn’t actually need the money. He just wants to build a credit history and a relationship with the bank.

But NOT FOR TWENTY FIVE THOUSAND. It’s either fifty thousand or nothing!

Who _doesn’t_ smell a rat at this point?

If his goals were what he stated them to be, the smaller sum should work just as well. The idea that this is something he would pitch a bit of a fit over makes my spider-sense tingle.

Let’s add to that the fact that it is not at all clear that he is _actually_ securing the loan with cash, as MattL points out. “Basically” securing the loan seems to mean “not really” in this case.

But in any case, and even if this was completely legit: the bank made the right call. Banks exist to carry out a small number of well-defined transactions. They _should_ demur when the parameters of a deal stray outside their well-defined comfort zones. Wouldn’t we all be a lot better off if they always did so?

Posted by ckbryant | Report as abusive

I think I’ve come up with a plausible scenario? Essentially a way to double-dip your collateral.

Borrower hopes to purchase a property for $200k with zero downpayment. Arranges a deal with a motivated seller to trade the property at $250k with a $50k kickback. Unfortunately the lender on that deal insists that he show proof of a 20% downpayment before authorizing the loan. He doesn’t have that money, so he is stuck!

Ah, but he borrows $50k from a friend/brother and arranges this deposit/loan scheme. Once it clears, he can return the $50k to his friend and show the bank statement with the $50k deposit to the mortgage lender.

Deal closes and he has 100% financing on his new purchase.

P.S. If somebody came to ME with an offer like this, I would also reject it. The stated rationale is implausible, meaning either the borrower is irrational (hah!) or a swindler.

P.P.S. Felix, I know this Nigerian prince…

Posted by TFF | Report as abusive

@MattL, TFF and others: Impressed with the quality of the remarks here. Instructive and stimulating discussion…

Posted by matthewslyman | Report as abusive

We have seen this issue firsthand (albeit overseas) and it’s ridiculous. It’s got little to do with computers making decisions and a lot to do with bad bank policies and entrepreneurs beginning down a path that makes little sense, ie, levering up and getting none of the benefits of leverage.

We wouldn’t walk away from the bank in question, we’d run. If all the banks around offer the same terms, we’d rethink our business plan’s capital structure section and send whatever docs we have collected along they way to Felix so he can run a story about collusion by the banks instead of what he’s got above.

Posted by WeWereWallSt | Report as abusive

It’s called leveraging and this was once the financial credo for US investors: Never use your own cash.

So if the customer succeeded in paying back the loan plus interest-he then has a successful investment PLUS his own 50,000 plus interest.

Posted by spiderbite | Report as abusive

spiderbite, the scheme as described represents 1x leverage. You can achieve 1x leverage even without a loan, simply by using your own cash.

Posted by TFF | Report as abusive

I applied for an $16K loan to buy a piece of test equipment for my business. This was when the economy was getting pretty bad back in 2008. The bank turned me down without an explanation other than the usual “does not meet our criteria”. I had around $40,000 in CASH in various accounts, CD’s etc. at that bank and had had that level of cash there for years.

As an early poster also mentioned, I realized I was loaning them money in those various accounts but they weren’t willing to lend me money.

I simply withdrew all my accounts from the bank IN CASH (the CD was a promotional one allowing early withdrawal) and deposited it in a bank with its decisions being made in Oklahoma, not New York. I had to go to three branches to get all of my money, my branch was a small one in a supermarket but it still took an additional two full size branches to get a lousy $40K in cash.

Posted by HalinOK | Report as abusive

Why banks make bone-headed decisions?

Unmitigated Greed!

Posted by Gordon2352 | Report as abusive

Unmitigated Greed should not prevent a bank lending someone their own money back. My bank bank tries to do that as often as possible.

Posted by y2kurtus | Report as abusive

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Posted by KSH | Report as abusive

I’m happy to share with you!!!

Posted by KSH | Report as abusive

The whole point of mega-bank mergers was to try to achieve economies of scale based on automation. But,

since at least the ’90′s on the technology side we have seen DIS-economies of scale. Running lots of cycles on your IBM or Oracle/Sun mainframe does not make you a more efficient business, since a small nimble competitor (all five of the local credit unions that me and the kids bank with qualify) with smart tech backing can match any sophistication with a cheap HP/Dell box and a good package for much less money. And even if that IBM cycle is 1/5 of the aggregate price of that cycle on the HP (which it’s probably not), it’s 5 times of the price of next to nothing for the little guy.

But, again, if you actually look at most of these mega-bank mergers, they do a very, very, very bad job of integrating those legacy systems. Periodically one of the biggies comes forth with a statement on how they will reduce their data center count from 150 to 20 and save buckets of money, and you end up wondering how they got there in the first place, and why they need as many as 20. You need to understand that Citi, BofA, etc. do lots of technology, but very badly.

Posted by ARJTurgot2 | Report as abusive

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