Let’s imagine your favorite barbecue chain is ready to expand. They choose the ideal spot – a strip mall’s pad site, right next to your dry cleaners. It couldn’t be more convenient. And, you hear that the profitable eatery is ready to put 50 percent down to purchase the property. You figure you’ll be enjoying takeout on the patio in no time.
But months later, nothing happens. The hometown bank turns down this seemingly can’t-miss opportunity because of financial uncertainty in Greece and Spain. The strip mall’s outparcel is undeveloped. There’s no scent of roasted meat, and no savory sauce on your patio.
Although this is an imaginary scenario, it can “absolutely” happen, says Culverhouse Professor of Finance Robert Brooks, Ph.D.
Everyone knows the primary task of the bank is to decide whether the barbecue restaurant is credit worthy. But it’s not just about that, says Brooks. In addition to investing depositors’ money in low-risk local loans, banks also invest in securities. Those securities can be compared to individual investors’ mutual funds, with their diverse stock mix. And, those securities include international loans, to protect depositors against local financial disaster, such as a local recession or even weather-related events, like Tuscaloosa’s horrific April 27, 2011 tornadoes.
“Prudent banking says you should diversify your credit exposure globally. So, local banks can’t escape a degree of dependency on the local economy, but they make an effort to diversify that through other investments,” says this director of the Culverhouse Master of Science in Finance.
“Large banks like J.P. Morgan create these baskets of loans, and put them all together, like a mutual fund, and then sell slices to investors. Back in 2007, European instruments were offering a higher yield that looked like excellent investments. So, a local banker could have credit exposure in Europe.”
The 2008 housing crisis left many large and small U.S. banks with bad (or “non-performing”) loans. Coupled with what turned out to be non-performing national and international securities, even hometown banks may not be able to bear any more credit risk, Brooks says, “no matter how good that barbecue restaurant has done -- even if they can put 50 percent down.”
Headlines about European debt may not rivet the attention of those outside the finance realm, but professionals like Brooks know the realities of today’s global economy. And, although those realities may be frightening when you realize that its impact might reach your patio, Brooks tells his students that those same factors offer unprecedented opportunities for their generation.
“The story that’s not getting told is that never in the history of mankind have the opportunities been greater,” says Brooks, who is also president of Financial Risk Management, a derivatives consulting firm.
Jeannie McLean is a guest blogger for Culverhouse.
