Financial institutions are looking to develop strategies for growing their portfolios. Each institution has different goals and various appetites for risk. Risk comes in all shapes and sizes, such as credit risk, liquidity risk, market risk, and operational risk. Of the different types of risk, credit risk is widely considered the most critical type of risk. Credit risk arises for a multitude of reasons, from poor cash flow to a sudden change in market condition. In order for an institution to develop an approach that will permit it to grow in a safe, sustainable manner, it must first determine how to manage its credit concentrations to mitigate risk.
When an institution is determining its strategies for growing its loan portfolio, it must first determine how to manage its credit concentrations and mitigate risk.
How to define credit concentrations?
First and foremost, a financial institution must define what a concentration is for its portfolio before it can successfully manage the concentration. Regulatory guidance indicates that intuitions should consider concentrations as pools of loans that may perform similarly because of common characteristics or sensitivities, especially when those pools are 25 percent capital. What this means is that financial institutions need to consider not just those concentrations that may be explicitly defined by regulators (for example, CRE limits at 300 percent of capital) but also those that are unique to their institution. It is important for the institution to consider not just the level of concentration but also the risk it poses to their financial position. For example, a concentration may not require extensive monitoring even at 25 percent of capital if the underlying risk of loss and volatility of that concentration is low.
An example of this expanded view can be seen in the oil and gas (O&G) market. In recent years, this market has been particularly volatile. In July 2016, the FDIC issued a supervisory letter urging financial institutions with exposure to this industry to not only consider their direct exposure to companies engaged in O&G exploration and production but also indirect exposure that might be impacted when oil prices decline again.
How to control exposure?
Credit exposure refers to the total amount that an institution loses if the borrower defaults, which can vary in magnitude. The first step to controlling exposure is by defining concentrations in credit policy and placing limits as a percentage of capital or as a percentage of the loan portfolio. These definitions should take the defined pool’s risk characteristics into consideration. For instance, defined pools such as CRE would have a higher concentration limit than a more narrowly-defined pool, like construction loans. The second step is to use underwriting guidelines to encourage or discourage certain loans at origination. For example, an institution located in Kansas may increase the debt service coverage it requires for new loans to wheat-related borrowers as it nears its stated limit on exposure to wheat.