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Concentrations beyond three dimensions

More data, and deeper understanding, increase the lender’s challenge

Concentrations beyond three dimensions

Concentrations of credit are inevitable, ubiquitous, and notoriously difficult to estimate.

And in strong enough doses, often fatal.

Concentrations: a moving target

Over a long banking and lending career, I’ve seen concentration estimations evolve from the simple and obvious to more indirect and comprehensive perspectives.

Early on, lenders are taught to be inherently suspicious of underwriting factors such as a limited geographical trade area, particularly one characterized by one or a few dominant industries or loans secured by common collateral.

As banks’ gained the ability to track loans with operating systems capable of assembling a wide array of variables such as purpose, type, and classes of collateral with common risk factors, concentration measurement and management became easier and more reliable in one way—but in another, more difficult.

More data means more choices. As one’s ability to track data expands, what are the data points that should be transformed into useful information of a risk management nature? What role, for example, will stress testing play?

“Concentration Classic”

I recall the first examination I participated in at my big oil field bank in Midland, Texas, in the early 1980s. Examiners were beginning to tune in regionally on the increasing level of oil and gas reserves that were collateral for a growing volume of loans spurred by rising oil prices and the broad-based speculative activity that was becoming evident throughout the oil field.

Here, of course, we were dealing with three sorts of concentrations:

• Production loans that are high dollar and characteristic of capital intensive activity (a concentration of large and in some cases legal limit loans to total capital).

• Limited geographical trade areas.

• Common collateral in the form of oil and gas reserves in the ground.

If a bank is going to respond to the needs of its trade area and its customer base, concentrations are inevitable.  The Midland case illustrates that.

Such concentrations may be abated by lowering the ratio of loans to total assets on the bank’s balance sheet or by more conservative methods of valuing collateral for lending purposes.

Competition is a factor all banks face—no one lends in a vacuum. We were a bank in the middle of the oil field located 300 miles away from the nearest principal city. However, we were trying to preserve our dominant market share against banks from Dallas, Chicago, and New York. They were encroaching on our customers. We were between a rock (concentration of credit) and a hard place (local customer demand).

Our best defense against an excessive concentration was an aggressive program of selling participations through our extensive correspondent bank network. That worked pretty well—to a point.

We quickly learned what the wrinkle was: Big upstream banks wanted to share in all the banking business, and not just the loans.

Concentrations in soured oil and gas production credit and related oil field equipment ultimately swamped my bank. We were the first of the large oil banks that failed in that commodity price cycle—upward spiral and subsequent collapse.

Obscured concentrations: shared rationale

A few years later I was manager of my next bank’s “special assets” group in Oklahoma City. For several years the bank had been both a dominant oil field lender and a statewide real estate lender to both developers and builders. Though the oil field problems eventually abated, the real estate markets for all manner of real estate credit lagged the oil market recovery. We had a relatively large portfolio of other real estate owned (OREO).

During an exam in the middle of the real estate market trough, a small team of examiners specializing in CRE development loans sequestered themselves in one of our conference rooms and pored over our OREO files.

After a few days, they informed us of a concentration that we’d never thought of—a concentration of appraisal assumptions.

Development loan appraisals contain estimates of product absorption. How long will it take the market to absorb so many built but unsold houses, or finished lots or development tracts? 

Converted to present value, these determined carrying value of the loans or OREO asset. On the matter of unsold developed tracts, the examiners noted that due to the depressed nature of the market, most appraisers were estimating a three- to five-year absorption.

While they agreed with the reasonableness of that assumption, taken as a whole, what about the assets that would take longer to absorb?  they asked.

The number, a range really, was significant and it forced additional charge downs to the carrying value of the OREO portfolio. There was nothing in our collective experience that pointed us in the direction of that exposure which was really of a valuation nature. So it came as a very unpleasant surprise—and it could well have been fatal.

Concentration future tense: modern concentration analysis

Concentration estimation and measurement today requires a much broader mindset than the way I was trained not all that many years ago. Today, we need to look at pools of loans—loans pooled by sensitivity to the same economic, financial, or business factors could contribute to the pool’s behavior as if it were a large, singular exposure.

This is a sensible perspective and within our collective ability to measure. However, it takes imagination—and a wide-angle look at our markets and our customers to be properly inclusive of the contents of each pool.

I also think it requires a look through, as it were, the wrong end of the telescope.

What does the “little picture” tell us that might be useful? 

For example, what about exceptions?

There are lots of ways to think about them—collateral or credit; at funding or those that develop with the passage of time (e.g., financial statements become stale); by dollar or by number; by collateral type; by individual lender? 

Where should you look? Where should you start?

The short answer: “Everywhere.

Concentration once removed: loans you buy

What about indirect credit, exposures that your bank buys that you have not underwritten yourself? 

• While you can control your own underwriting practices and enforce your own internal controls and standards, are you fully conversant with the way the seller does things? 

• What’s the track record of the originator? 

• What are the relevant scorecard numbers in the area of internal controls management such as exceptions, past dues, etc.? 

• Have you done due diligence to satisfy yourself and your bank that the seller’s processes are well developed, sound, and effective?

Indirect credit wreaked havoc many correspondent banks over the years, those who were buyers of credit to increase their own earning asset totals. Banks ranging from the size and prestige of Continental Illinois to community banks in many states suffered grievous damage, the latter category as recently as three and four years ago by sloppy underwriting, a credit concentration in and of itself.

Much discussion about indirect lending today centers on the compliance aspects, i.e., does the seller of loans abide by all the consumer and fair-lending rules. My point there is, never forget the credit side of any such transaction, either.

Ultimate protection against concentration risk

Concentrations aren’t unhealthy per se and they may indeed represent considerable opportunities. But they require much more intensive scrutiny and management to establish and preserve the safety and soundness of a bank’s credit portfolio.

The best defense against a stealthy concentration of credit is a vivid imagination, a constant barrage of “what if” questions, and a broad perspective of one’s markets and operating conditions.

It’s another example of the importance of the Sixth C of Credit: Curiosity.

Ed O’Leary

Banking Exchange Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent nearly 50 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. His last job before retiring was as the CEO of a regional bank headquartered in Alburquerque, N.M. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses. You can e-mail him at [email protected]. O'Leary's website can be found at

In mid-2016 O'Leary's "Talking Credit" blog received a bronze excellence award for the Northeastern Region from the American Society of Business Publication Editors.

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