Avoiding loan portfolio fire alarms

Banks have been pressured consistently to adopt concentration limits, particularly in regard to managing their loan portfolios.

These limits are almost always expressed as a percentage of capital, but may also be expressed in other ways, such as a percent of a given portfolio. However measured, a banker wants to avoid violating the limits. In particular, a record of violating a limit, and then asking the board to adopt a higher limit, will be frowned upon by regulators. They will bring pressure in unpleasant ways to change that behavior.

Something that can help prevent this series of events: “trigger points.”

Setting off a yellow light

With appropriate oversight, under most conditions there is no reason that a limit should be exceeded. By “most conditions” we mean any state of affairs that moves in a continuous way, even if rapid and accelerating. The solution is a set of reasonably selected trigger points.

A trigger point is a sublimit that is set below the portfolio limit. Properly set, a trigger point induces management to consider actions to maintain compliance within the adopted limits.

No CRO wants to hear “Here’s another fine mess you’ve gotten me into!” from the CEO.

In this blog I will discuss briefly how not to play Stan Laurel to your CEO’s Oliver Hardy. (For “younger” readers who don’t get that cultural reference, check it out on YouTube.)

What to do at “the trigger”

A trigger point is really about time. It answers the question: When do I need to start changing behavior to maintain compliance with the adopted limits?

Because the focus is most frequently on loan portfolio limits, let’s concentrate on that.

For most community banks, the relationship with borrowers and the reputation in the community are paramount. Abrupt changes are to be avoided. The goal is to maintain a steady hand and to signal well ahead of time any decrease in appetite that you may decide to adopt; to increase activities in areas of increased appetite; to add to capital if desired; or take other appropriate action.

To achieve this outcome, management will need a set of reports that are forward-looking, based on then-current circumstances and expectations. These reports must be issued frequently enough so if action is necessary, it is not unduly delayed.

Often, monthly reporting makes sense, but in a slower-moving environment quarterly may be fine. Factors to consider:

• Significance of the business activity relative to capital.

• Pace of the business activity—and whether the rate of growth is accelerating.

• Gestation period from serious discussion of a loan to commitment and from commitment to closing.

Making trigger points work for your bank

Imagine, happily, that you are producing high volumes of CRE loans. You will need to understand the volumes in your pipeline at each stage, and have a reasonably reliable way to predict conversion ratios from one stage to the next.

The gestation period for CRE loans is often the longest in the bank’s loan origination process, and the volumes are often some of the largest. Therefore, the bank’s focus is often on this loan category.

Useful, reliable pipeline reports are critical to project accurate closing volumes. So assembling the data in a practical and regular way over time will pay dividends. Key to making the data useful is to routinely measure time periods and conversion rates so forecasts are based on objective evidence. This is in addition to judgment, in the form of the perspective of each loan officer.

Assume for discussion that the typical time from serious discussion to closing is nine months. That means that you will want a system that induces management review at least 9 months, or even 12 months ahead of a projected breach of a policy limit.

Should you find your bank in such a position, you have multiple options. The first instinct, of course, is to increase the limit. That may be the best answer, after reflection, but it should not be at the top of your mind.

Management should consider:

• Redirecting loan officer efforts to other loan categories.

• Making changes in pricing policy for CRE loans.

• Making changes in underwriting standards.

• Finding participants to share out the credits.

• Adding capital, thereby pulling away from the limit without curtailing growth.

Essential to all strategies: Providing adequate lead time to implement whatever option(s) are chosen.

Triggers must be custom set

The right level for trigger points varies from bank to bank, and from portfolio to portfolio. Because banks are in the business of customer relationships, we need ample time to adjust behavior and to determine alternatives for servicing customers. The CRO, working with the entire management team, should determine the reasonable level in each case.

While much of this discussion has focused on aiming at sufficient lead time, there is risk that goes with selecting a trigger point that is too low.

First, it will seem like a waste of time. The future is uncertain, after all, and continued monitoring may be the best course of action.

Second, repeatedly setting off of triggers without any real action may attract inappropriate regulatory attention. Reason and balance, as always, should hold sway.

With appropriately developed trigger points, quality reporting supported by the treasury unit, and open management discussion, business objectives can be met in the most appropriate manner.

And the CRO need not be Mr. Laurel even if the CEO is Mr. Hardy!