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Are you diversifying your portfolio appropriately?

Sageworks
March 23, 2015
Read Time: 0 min

It is only natural for community banks to have loan concentrations that result from the market(s) they serve and the markets they pursue. In today’s times, a high commercial real estate (CRE) concentration is often the result of community banks pursuing opportunity in the market. Consequently, interagency guidance on CRE concentration risk management, released in 2006, helps institutions pursue CRE lending with safety and soundness.

The guidance provides seven sound risk management practices that banks should maintain, including board and management oversight, portfolio management, portfolio stress testing and sensitivity analysis and a credit risk review function, among others. It also set criteria to identify those institutions with significant CRE concentration risk. As noted in the interagency guidance, institutions approaching or exceeding the one or both of the following criteria may be subject to further supervisory analysis:

• Total reported loans for construction, land development, and other land loans represent 100 percent or more of the institution's total risk-based capital.
• Total commercial real estate loans, as defined in the guidance, represent 300 percent or more of the institution's total risk-based capital, and the outstanding balance of the institution's commercial real estate loan portfolio has increased by 50 percent or more during the prior 36 months (or 36-month period).

Despite this guidance, many banks continue to maintain concentrations exceeding the expected levels. A recent article on Banking Exchange by Daniel Rothstein highlighted the continued need for community banks to diversify their portfolios and steps for execution of this task. Rothstein often sees banks diversify by simply adding “buckets” to their portfolios – i.e. additional commercial and industrial (C&I) or consumer loans. But by adding these new categories, is that true diversification?

Rothstein says the main benefit of diversification is more predictable performance overall. “To achieve this, it is important to construct a portfolio with loan asset classes that are not highly correlated.” Adding additional buckets may not help banks weather a future downturn if all buckets suffer an interrelated decline.

 

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One solution is to look toward countercyclical loan categories. An example provided by Rothstein is multifamily loans. “When people are losing their homes, they find apartments to live in. Landlords benefit, and the cash flow from rental units increase.” Important to note, though, is that these loans would comprise part of the 300 percent CRE limit set by the 2006 interagency guidance.

Before adding new loan categories, institutions should ensure that management has proper knowledge and insight to supervise the new category, and that sufficient resources are available for underwriting and servicing. This may include adding additional personnel with previous experience in the area or training lending staff accordingly.

Adding new loan categories isn’t the only way to improve diversification and reduce risk. Within existing categories, community banks can diversify by loan quality, according to Rothstein. He provides an example where limits could be adopted in a concentrated loan category, such as CRE. Within it, institutions could mandate that at least X% of loans in that category must be in the top higher credit quality ratings. There are certainly other metrics that could be used to create such standards, and each institution can review policies to determine the best fit. “By building loan quality metrics into your loan strategy, greater concentration makes sense.”

Diversifying by loan quality can also strengthen portfolio segmentation, where banks can gain deeper understanding of the risks inherent in their portfolios. 

 
About the Author

Sageworks

Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest

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