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Testimony of the 109th Congress

Bankruptcy Reform

Testimony of

R. MICHAEL MENZIES

President and CEO
Easton Bank and Trust Company
Easton, Maryland

on behalf of

THE INDEPENDENT COMMUNITY BANKERS OF AMERICA
Washington, DC

on

"Bankruptcy Reform"

Judiciary Committee
of the
United States Senate

February 10, 2005

Mr. Chairman, Members of the Committee, my name is Mike Menzies, and I am pleased to testify before you today on behalf of the Independent Community Bankers of America (ICBA)1 and its nearly 5,000 members, representing more than 17,000 locations nationwide. ICBA members hold more than $631 billion in insured deposits, $778 billion in assets and more than $493 billion in loans to consumers, small businesses and the agricultural community. I am President and CEO of Easton Bank and Trust Company, a $100 million bank in Easton, Maryland. I am chairman of ICBA's Policy Development Committee, and serve on the boards of ICBA's Mortgage Corporation and Services Network.

The Portfolio Underwriting Process

Before sharing thoughts about the environment of personal bankruptcy and its impact on our communities, allow me to offer a brief illustration of the loan risk taking process. Community banks are in the risk-taking business. They take risk whenever they make a loan to an individual. In return for that risk, the bank seeks to make a reasonable profit. The customer benefits through the enhancement of his or her financial health. The healthier the customer, the healthier the community, the healthier the bank, the healthier our overall economy and tax base. The underwriting of consumer loan risks is a fundamental driver to all local economies.

Successful consumer lending depends on the numbers. Banks must make many loans to as many people as possible to diversify exposure and spread the risk. In some respects it is almost like health insurance risk taking without all of the health insurance impediments. Consumer lending is a risk sharing business. Many small loans are made so profits from any one loan are small and profit is generated from volume. At the same time losses can be significant relative to unit profitability. This is especially true when the entire principal of a loan is lost all at once. Let me review the consumer loan portfolio example attached to my testimony2:

The example consists of two simple revolving loan portfolios, each containing 100 loans of $1000 apiece, and each paid off within a year. One portfolio has an interest rate of five percent, the other a rate of 18 percent.

If one loan in the five percent portfolio were to immediately default (regardless of causation), it would take the interest payments from 41 performing loans to compensate for that default. Lets put it another way. If you are earning 5 percent on a loan and you lose 100 percent of the principle, you have lost 20 times the interest you were earning. It would take 20 years from another loan of the same size and rate just to make up for the loss. If as few as three borrowers default, the lender has a completely unprofitable portfolio.

If one loan in the 18 percent portfolio defaults, it takes the interest from 12 performing loans to compensate for that one default. Obviously, if a lender is experiencing greater losses than anticipated, they have to either charge more or make fewer loans because of diminished capacity.

There is not much more to underwriting than that, but it is very difficult and lenders expend a tremendous amount of effort to try and get it right. A lender that provides the greatest number of borrowers with the best rate while keeping defaults to a minimum is going to have both the most profits and the most customers. Anything that enhances this process has obvious consumer benefits. Anything that detracts has obvious downsides-again we either have to raise prices or reduce lending.

Bankruptcy Policy and the Underwriting Process

Essentially, it seems to me that when we are talking about bankruptcy law, we are making policy interventions that determine how the costs of default are socialized across all borrowers through those that either loan money in return for future payment, or who render services in exchange for future payment. The ICBA supports the availability of bankruptcy for those that truly need it. These individuals should get in and out of the system as quickly as possible and the system should focus its resources on those filers that have the capacity to repay a meaningful-not just a few dollars-amount of debt. As you saw in the example I just discussed, it takes very few bankruptcies to greatly increase costs, and if we can reduce these by even a few, or increase recoveries in a meaningful way, it greatly reduces the costs that are socialized among other borrowers. The ICBA feels that S.256 greatly improves the balance in this area, and does so in a way that is not unfairly burdensome to those seeking relief.

As a community banker, we see bankruptcy close up and understand that causes of bankruptcy are complex. The industry has long understood, and since 1997, testified before both the House and Senate that many factors such as divorce, lack of health insurance etc. all play a role in causing bankruptcy.3 We cannot and would not underwrite for these types of factors-can you imagine if on the credit application, we asked about such matters? We confine our underwriting to ability to repay and feel that the same neutral approach to whether a debtor receives a complete discharge or has to repay some portion of their indebtedness is the only workable approach. The means test in S.256 seems to us to provide a reasonable approach towards making sure that those who can pay a meaningful amount do so while providing a full range of safeguards for debtors who cannot. Looking back at our underwriting examples, any other approach simply results in an unfair distribution of costs among those who are paying their bills-the vast majority of my customers.

The ICBA would also like to take this opportunity to express support for other provisions of the bill that restore balance and responsibility to the bankruptcy system overall, notably the provisions that ensure payment of domestic support obligations. While this obviously does not benefit us directly in dollars and cents terms, we believe that a society that places a priority on ensuring these obligations are met creates a better climate for both lenders and consumers and in the long term results in a fairer socialization of costs.

Conclusion

The ICBA believes bankruptcy is an appropriate solution for individuals who have legitimate reasons to walk away from their obligations. ICBA recognizes that all other borrowers pay for the losses created by those who are discharged from their debts. This tax on the majority of individual borrowers should be mitigated wherever possible. Healthy consumer borrowers benefit communities, their economies and our overall tax base. Economic disincentives such as unnecessary bankruptcies or discharge of debts hinder the wealth formation process that is necessary for social progress.

Unbalanced bankruptcy policies have significant social implications, whether manifested in the casual avoidance of domestic support obligations, state taxes or debts owed to lenders. A balanced policy will recognize that there are situations where it is appropriate to relieve individuals of all or part of their financial responsibilities, but at the same time will encourage Americans to take ownership of their financial health, which is of course intertwined with physical, spiritual and personal health.

The ICBA would like to again express its strong support for S. 256 and appreciates the efforts of the Committee to provide a modern legal framework for bankruptcy. We hope that after eight years of extensive consideration, the Committee will move expeditiously to enact this much needed legislation, and on behalf of community bankers, we stand ready to do everything possible to assist the committee in its efforts.

Attachment 1
Attachment 2

1 The Independent Community Bankers of America represents the largest constituency of community banks of all sizes and charter types in the nation, and is dedicated exclusively to representing the interests of the community banking industry. ICBA aggregates the power of its members to provide a voice for community banking interests in Washington, resources to enhance community bank education and marketability, and profitability options to help community banks compete in an ever-changing marketplace. For more information, visit ICBA's website at www.icba.org.

2 The two examples are simplified just to show how the numbers move around in a default situation-a real life portfolio is much more complicated and would account for such items as loan loss reserves and tax write-offs, which assuming you are profitable, do mitigate some of the losses. As you can see however, it is very easy to become unprofitable in the lending business.

3 Attached is a copy of testimony given in 1998 by Stuart M. Feldstein of SMR Research before the House Committee on the Judiciary that provides an excellent discussion of the causes of bankruptcy.

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