By Paul Zipkin

Here we are in early fall, 2009. It was a fairly calm summer. There were no major financial disasters. The stock market revived somewhat. The economy is still troubled, but compared to the unremittingly awful news during the previous year, it’s been a good time. I believe some credit for this happy turn of events is due to the bank stress tests conducted by the government during the spring.

The tests calculated what would happen over the next couple of years under two scenarios, a base-case scenario and a bad scenario reflecting worse economic conditions. They considered each bank’s entire position, not just standard deposits and loans but also fancy mortgage-backed securities and swaps. The question was, how much capital would each bank need to continue operating normally under the bad scenario?

The method itself is not at all novel. Many businesses, military forces and other organizations do this sort of scenario planning all the time. No one knows exactly what will happen in the future, so it makes sense to simulate several possible futures, to estimate whether the organization’s plans are robust.

But, amazingly, this was the first time the government conducted such a test of our financial system. We do have elaborate financial regulations, but those specify procedures and check whether they have been followed. In other words, they look backwards, not forwards. To look ahead at several plausible scenarios, the exact same ones for all banks, and to include all the banks’ exposures – that was unprecedented. Of course, the inspiration for the stress tests was the sequence of ugly surprises in 2008. Nobody knew how dire the situation was at Lehman and the others until it was too late.

Banks are supposed to do this sort of thing for themselves, of course, but it’s not clear how seriously they take these “risk management” exercises. Anyway, they are not required to use the same methods and certainly not to make the results public.

Before the results were revealed, many observers criticized the tests. The tests were not rigorous enough, the bad scenario was too tame, they said. (The Treasury invited some of this carping by calling the bad scenario the “worst-case” scenario. It was not that.) But the criticism largely fell silent once the tests were complete and the results announced on May 7.
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Professor Paul Zipkin argues “regulation is a necessary element of the infrastructure of free enterprise,” in an op-ed published in the Sept. 24 edition of the Raleigh News & Observer.

Defective financial products can ruin lives just as surely as bad food and faulty electrical wires. Just ask the millions of borrowers who can never hope to pay their debts, the thousands of laid-off financial professionals and factory workers, and all of us taxpayers.

The Obama administration has proposed several initiatives to help our damaged financial system. One is the Consumer Financial Protection Agency. The CFPA aims to avoid some of the ill-conceived products, such as tricky subprime mortgages, that have played central roles in the financial crisis. It’s a good idea, and we should all support it.

Bankers too should support this idea, and some do, privately. Publicly, however, the banking industry has mobilized its considerable forces to oppose the CFPA. They argue that it will hamper financial innovation. Well, that’s sort of true – in a good way. Some innovations are valuable but some are not. Read the rest of this entry »

Operations Management Professor Paul Zipkin offers the following suggestions for easing the credit crisis with a supply chain management approach to banking.

Who needs banks, anyway? The enormous recent damage to the economy has been caused mainly by the disappearance of working capital for supply chains, plus consumer panic. Maybe firms in supply chains need to become their own banks, much as they do in impoverished countries. This is already happening on a small scale.1

Seriously, our economic civilization works much better with banks. The current crisis has amply demonstrated this fact. Various remedies have been proposed to unfreeze the financial system. Here is another one: Banks can fund whole supply chains, not just individual firms. This practice already exists, again on a small scale. It’s called supply-chain finance.2

To appreciate this notion, some background will help. Why did the subprime crisis lead to a full-blown credit crisis? Why did banks stop lending? Various plausible stories have been put forth, but none of them is based on convincing facts, and none is entirely satisfactory. Right, the banks own “toxic” assets of questionable worth, but the money already injected by the government should suffice to sustain a reasonable level of commercial lending. The banks are not talking. They say they are indeed lending, despite abundant evidence to the contrary.3

I don’t have any facts, either. But here’s a better story than any I’ve heard: Banks don’t trust each other. Each one can see only its own financial condition. Even that is not so certain. There have been lots of stories over the last year of seemingly solid banks, which turned out in fact to be broke, to their own surprise as well as to others’. Still, why should that prevent a bank from lending to a real business? The reason is, banks are tied to each other in part through real businesses. Read the rest of this entry »

Duke Operations Management Professor Paul Zipkin has authored a new thought piece interpreting the financial crisis from the perspective of quality management.  Zipkin argues that lessons learned about quality in the manufacturing setting should be applied within financial institutions and across financial supply chains in order to aid recovery from the financial crisis.

Zipkin’s paper “Quality Snags in the Mortgage-Finance Supply Chain,” is available here: quality_mortgages_0902112.