Frontier Bank Offers Object Lesson

The collapse of Frontier Bank, which was closed and sold to Union Bank of San Francisco this week, teaches us the risk of judging a company purely based on its ability to generate profits. In 2006, when I was editor of Washington CEO Magazine, we came close to choosing Frontier Bank as the company of the year. It seemed like a smart choice at the time. The bank’s profits had soared, while its return on assets was stellar. The bank was so well-respected in the industry that several securities analysts told me Frontier Bank might well be the best-managed bank in the country!

In retrospect, of course, we know that the very thing that made Frontier so strong at the time, its heavy investment in real estate, was the very thing that doomed the bank. We as an economy and society often reward companies that throw all their chips on one big bet, companies and individuals that throw their hearts and their talents into what they believe in, But while that system may work in the start-up world where survival of the fittest is the order of the day, it is not appropriate in the banking world where failure impacts so many more than simply the employees in that particular bank. Failures iin risk assessment tend to build and contribute to failures throughout our financial system. In the world of banking the ability to evaluate risk should be the basis on which we judge success. (The unwillingness of banks to lend to strong small businesses today shows the extend to which they have lost their ability to assess risk.) Aggressive bets on any single industry like real estate should be a red flag. When those of us following the industry began judging the success of banks purely based on their profit growth, on their return on assets, we were making the same mistakes as the bankers. We were giving higher grades to those that took more risks.

The challenge, of course, is knowing how to assess the risk that banks and other lenders are making when they lend money. Securities analysts failed during our recent financial crisis. Accountaints also failed. The biggest failure was by Moody’s and the other credit companies whose job it was to assess those risks. The industry had simply become too complex to understand. The incentives that were in place encouraged all players to take more risks.

The goal of financial regulation should be to limit risk in the system to prevent massive failure of the kind we recently experienced. But another goal should be to improve transparency so it is easier for people at every level to assess the risks bank managers and others are taking.

Update: We profiled Frontier CEO Pat Fahey in our July 2009 issue, at a time when Frontier’s prospects were less bleak.