Loan diversification … and its discontents

Are you struggling with the call to diversify your loan portfolio? 

Feeling the need to go where your bank has not gone before? 

Are you anxious about the availability of good loans in categories you haven’t explored before? 

Are you trying to grow, but keep certain loan categories, which have ample high-quality opportunities for you, within certain limits? 

And are you wondering if you’re really going to be better off—and at lower risk—with a loan portfolio that contains new loan categories for you?

You are not alone.

Conundrum of concentration versus diversification

These are the challenges faced by many a community banker, as regulators eye what they deem concentration risk at many community banks. Typically, there is pressure to reduce what regulators view as too much capital at risk in what is often deemed to be an over-concentration in a broad and disparate portfolio called Commercial Real Estate.

Driven by analysis of bank failures, one regulatory study concludes that CRE concentrations are highly correlated with bank failures. The study itself is analytical. Its primary conclusion is that there is substantially high risk of failure with acquisition, development, and construction (ADC) lending combined with rapid growth. It goes on to say, however, that CRE concentrations alone still had a statistically significant positive correlation with observed bank failures.

Regulators took this to heart, and in 2006 issued guidance that calls for enhanced risk management practices in banks with concentrations that exceed 100% in ADC loans or 300% in overall CRE loans.

The exceedingly positive message from this guidance is that banks should manage their loan portfolios at the portfolio level, not just at the individual loan underwriting level.

That’s a view that is spot on—and which we should all endorse.

However, when it comes to implementation, the message the regulators drive home may affect banks in adverse ways.

Let’s examine why that may happen; what’s missing from the approach the regulators have adopted; and how you should consider thinking about how to both comply and at the same time enhance the quality and resilience of your loan portfolio.

Looking more closely at diversification

The goal is to diversify. The approach we often see is to add more loan “buckets” to our loan portfolios. Because the “enemy” cited in the study is CRE concentration, this often takes the form of adding C&I or consumer exposure to our balance sheets.

But by doing so, are we necessarily diversifying?

The primary benefit of a diversified portfolio is smoother, more predictable performance in the aggregate. To achieve this, it is important to construct a portfolio with loan asset classes that are not highly correlated.

Imagine Bank A, that has one large (CRE) bucket in its loan portfolio. The bucket is filled with loans to a certain level.

Now imagine Bank B. It has ten smaller buckets in its portfolio, each of which is filled with loans to the same relative level as Bank A’s one big bucket.

On the surface, it seems Bank B is more diversified than Bank A, making it better able to survive a storm.

Perhaps so—but perhaps not.

Diversification can be a fallacy

When the storm comes along, it does not help Bank B if all ten buckets tend to tip and spill water to the same degree as the one large bucket at Bank A. Just as much water is lost.

Unfortunately, data on correlation of bank loan portfolios is not only skimpy, but to the extent it exists it even reflects contradictory results. We seek countercyclical loan asset classes, but we do so in an information-poor environment.

One countercyclical loan category favored by many a Chief Credit Officer over many years is permanent multifamily lending. Think of the performance of multifamily loans in the wake of the 2008 crisis.

When people are losing their homes, they find apartments to live in. Landlords benefit, and the cashflow from rental units increases. So a good complement to the portfolio of a lender making ADC loans and other procyclical income property loans is to build a portfolio of multifamily loans as well.

Ironically, multifamily loans are included as part of the CRE 300% concentration limit.

Taking a closer look at your buckets

What’s going on when a bank, in response to regulatory pressure, adds more loan buckets? Without specifics, the effect on overall risk is unknown, and the net effect may even increase risk in the loan portfolio.

When a bank adds new loan categories, it assumes the strategic risks of proper selection and competent execution:

• Does the new loan asset class really perform with low correlation to the rest of the portfolio? 

• Has the bank made the right amount and quality of resources available to competently underwrite and service the new loan category?

• Does senior management and the board have sufficient knowledge to oversee the new business?

The large majority of community banks are naturally concentrated in their risk profiles. The quantity and quality of loans available in the markets served drive the structure of these portfolios. Very often, this results in a CRE concentration.

Other community banks are specialists by design. They build substantial expertise in managing one or two large loan buckets, with proven track records through good times and bad.

But implied in the 2006 guidance is an under-emphasized solution to make all this come together in a way that should satisfy bankers and regulators—the role of loan quality.

Quality can reside in every bucket

Imagine a loan portfolio strategy of lending to borrowers in any industry, so long as they are in the top 25th percentile in recognized credit quality metrics for that industry.

What happens when a major recession occurs? Not much.

A bank with such a loan portfolio will experience modest defaults and limited losses. That’s true even if there are only a few industry segments that comprise the portfolio.

For defaults to be significant with borrowers of high credit quality, the industries themselves need to be devastated. What most often happens is that the industry suffers a significant setback with many individual businesses disappearing.

However, the strong survive. They meet their obligations, and they are set to prosper when conditions change.

I’m not suggesting a community bank can fill its loan portfolio solely with loans of this high quality—there are just not enough of them.

But this thought process leads us to diversification not only by loan category, but also by loan quality.

Building a spectrum of risk and pricing

One simple approach might be to adopt a limit in an otherwise concentrated loan category such that at least 75% of the loans in that category will be in the top 3 credit quality ratings in the pass category, if the rating system has 4 pass ratings.

A similar approach is to limit permanent CRE loans with cash flow coverage ratios below 1.25x or less to a 25% portfolio limit.

Each bank should be in a position to think through these kind of quality metrics for each of its loan categories, based on practical accessible data.

Having thought it through, they must then adopt reasonable limits for each category.

Diversification comes in multiple facets

The current pressure to diversify is strong, with some regulators pushing it more than others. As a community bank, you will have concentrations. By building loan quality metrics into your loan strategy, greater category concentration makes sense.

The 2006 CRE guidance mandates enhanced risk management practices. This is one of them.

A proactive, strategic approach, communicated to your regulators, will go a long way to meeting regulatory requirements and to enhancing your bank’s loan portfolio performance.