We all know better than to put all our eggs in one basket. Unfortunately, many banks ignored this time-tested wisdom when it came to constructing their loan portfolios, contributing to the financial crisis and credit crunch of the past few years.

Specifically, these banks allowed high concentrations of risky types of loans to build up in their portfolios without considering the potential impact on the bank should things turn south. Often, this was unintentional, as banks didn’t realize the high degree of covariance that existed among borrowers.

A good example is single-family home construction and acquisition and development (A&D) financing. In what became an all-too-common scenario, some community banks ended up lending money to different builders and developers that were all building the same types of homes, in the same types of subdivisions, at the same price points. When the mortgage crisis hit and these borrowers started defaulting on their loans, it didn’t take long for the banks to start going under.

Not so Obvious
But covariance isn’t always so obvious. Consider a community bank doing business in a local area heavily dependent on a specific type of agriculture — let’s say corn. What would happen if the federal ethanol subsidy suddenly disappeared? The price of corn would likely plummet, harming not only farmers, but also rippling throughout the entire local economy: vendors, suppliers, retailers, you name it.

Or, for a real-life look at the dangers of ignoring covariance, look no further than the demise of the U.S. auto industry. Community banks in Michigan may not have thought they were overly exposed to the auto industry, but they have learned that as this single industry goes, so goes the health of the state’s economy.

Lesson Learned
One of the lessons community banks can take from the financial crisis is to monitor concentrations and covariance within their loan portfolios, and then strive for a more diversified mix of borrowers.

Particular attention should be paid to concentrations among certain types of high-risk borrowers (e.g., A&D, commercial real estate, agriculture), as well as within specific industries, lines of business, property and collateral types, and particular geographic areas. For example, industries that have historically been risky for banks include those with high fixed costs, heavy debt loads, and high retiree pension and healthcare costs, as well as industries where executives enjoy extravagant corporate and personal lifestyles.

Ask yourself these three questions as you look at the level of borrower concentration and covariance in your loan portfolio:

  • Is a disproportionate percentage of your borrowers located in the same geographic area?
  • Is this area dominated by a single industry or large employer?
  • Are many of your borrowers interrelated in the sense that they are either directly or indirectly dependent on a single industry?

If you determine your portfolio’s level of concentration and covariance is higher than you’re comfortable with, there are several steps you can take to lessen your risk and help bring it back into proper balance. These include:

  • Tightening your underwriting guidelines
  • Lowering collateral advance rates
  • Using government agency guarantees, such as the Farm Services Administration (FSA), to help mitigate agriculture loan risk

Please contact us for help in monitoring borrower concentrations and covariance in your loan portfolio.