What a difference time makes. Three years ago, most banks were enjoying low levels of past-due accounts, criticized/classified loans and losses in their small business portfolios. Then came the recession and the financial crisis, which led to record losses and the subsequent failure of many banks.

It’s easy for bank management to point to the financial turmoil as the cause of their problems, and it has certainly been a major factor in banks’ struggles. When looked at objectively, however, it’s clear that many banks made some key mistakes and poor assumptions that resulted in making a bad situation much worse.

Past Doesn’t Equal Future
In an article published in the June 2010 issue of The RMA Journal, John R. Barrickman and Christine Corso note the primary mistaken assumption was simply this: that banks could base projections of future credit performance on past performance. Clearly, this was (and still is) not the case. The banks that have gotten into the most trouble have primarily been the ones that:

  • Aggressively underwrote higher-risk types of lending, especially commercial real estate (CRE)
  • Allowed high portfolio concentrations among small groups of borrowers, or in certain types of lending (again, CRE was a primary culprit) and/or geographic areas.

In hindsight, it’s clear that historical credit performance is not a very good indicator of portfolio risk if the history upon which the performance is based is, in essence, a best-of-all-worlds scenario. This is essentially the world in which most small businesses and banks lived prior to 2008.

Factors like the distribution of asset quality ratings (AQRs) in the portfolio, the mix of different business lines, and the degree of portfolio concentrations (as noted above) are better measures of portfolio risk and the potential for volatility.

The Lending Environment
Going forward, one of the most important things you can do to better manage portfolio risk and reduce the potential for problem loans and defaults is to take a hard look at the lending environment that exists in your institution. In other words, where does your bank fit in the framework for risk tolerance and potential for volatility that was first laid out in the classic book Strategic Credit Risk Management?

More specifically, what is your bank’s approach to maximizing shareholder value; what are the “unwritten” rules of behavior when it comes to underwriting loans; how does your bank view transaction, intrinsic and concentration risk; and what risk controls are in place when it comes to influencing, directing and controlling individual lender’s decisions? The next step you should take is to identify the specific types of loans, industries and properties that may lead to problem loans in the future. Industries with high fixed costs and significant financial leverage, as well as those undergoing significant changes and those in which participants enjoy comfortable lifestyles, have historically been ones with a high percentage of problem loans. Some good examples have been agriculture in the 1970s, energy and CRE in the 1980s, healthcare in the 1990s, and telecommunications and technology near the end of the 20th century.

Once you’ve identified broad industries that may pose higher risk, narrow your focus to look for specific borrowers in your portfolio who may pose problems in the future. Through diligent monitoring, you should be able to spot problem borrowers as early as four to five years before loans go bad. The ability to service debt always comes down to one thing: cash flow. Therefore, it’s your job to identify and monitor the things which have the potential to cause cash flow problems, such as:

  • Flat or declining sales
  • Shrinking gross margins
  • Rising overhead (especially if rising faster than sales)
  • Slowing receivables and inventory turn and slowing trade payables
  • Increasing financial leverage and over-reliance on short-term debt
  • Rapid sales growth coinciding with strained management and systems

Break Out the Shears
Based on all of the above, your final step should be to continuously prune your portfolio. This means making periodic portfolio adjustments to reflect changing conditions in the overall economy, as well as in the borrower’s specific industry and marketplace.

Implement systems that enable you to continuously monitor both individual and portfolio performance. Then summarize your findings and recommended course of action for the board of directors.

There are several different ways to prune borrowers from your portfolio, including raising their interest rate, obtaining agency guarantees and participations, using market instruments (like credit derivatives), and simply asking borrowers to move their relationship to another bank.

We can help your bank devise and implement portfolio risk management strategies and systems. Please call us to learn more.