Three deadly sins of portfolio credit risk management

RMA Journal, The, June, 2002 by John Barrickman

Three deadly sins lie in wait to wreak havoc on a portfolio: a disproportionate percentage of the portfolio in the low pass categories; emphasis on higher-risk types of lending; and concentrations that build in the portfolio with a small group of borrowers. Some banks commit multiple sins--aggressively underwriting individual loans to borrowers in higher-risk types of lending and taking large positions in those loans. How does your bank fare? Is it time to pass out the pitchforks?

Traditional approaches to managing portfolio credit risk have proven to be flawed. Executive management that has relied on a transaction approach has been surprised by the significant deterioration in portfolio credit quality. The deterioration occurred even though the bank did a good job of selecting, underwriting, structuring, pricing, and monitoring individual transactions.

The reliance on levels of criticized and classified loans and losses as a measure of portfolio credit quality was not adequately predictive. A more predictive approach, which focuses on the potential for volatility in portfolio credit quality, would assess the bank's vulnerability to the three deadly sins of portfolio credit risk management.

Is your bank vulnerable to the three deadly sins? Perform the following assessment and learn whether your institution is a candidate for halos or pitchforks.

1. Does your bank have a disproportionate percentage of the portfolio in the low pass categories?

To assess your bank's vulnerability to the first of the three deadly sins, your bank must have a granular asset quality rating (AQR) framework with at least five pass categories. If your bank uses a framework with only three pass categories (most community banks) and you have 60 90% in the three category, you will not be able to assess your vulnerability to the first of the three deadly sins. Your bank is guilty of the first of the three deadly sins if you have a large percentage of the portfolio in the 4 and 5 categories, where 5 is marginally acceptable.

More importantly, your bank must track shifts in portfolio credit quality that will indicate increasing vulnerability to the first of the three deadly sins. Look at the following example.

The bank in the example above had a change in management and embarked on a new strategic plan focusing on earnings and growth. To implement the strategy, the bank began to more aggressively underwrite and structure individual loans. Note the shift from the 1-3 AQRs to 4-5 AQRs. More importantly, focus on thc fact that the percentage outstanding in criticized/classified assets did not change. Obviously, there is significantly greater potential for volatility in portfolio credit performance in the third year than in the first.

A bank focusing on the criticized/classified categories or a bank with a large, undifferentiated 3 category would miss the significant deterioration in portfolio credit quality. This would enhance the bank's potential to experience large numbers of criticized and classified assets--a victim of the first deadly sin.

2. Does your bank emphasize higher-risk types of lending?

To assess your bank's vulnerability to the second of the three deadly sins, it must have a process for periodically assessing the risk in types of lending and subsets--for example, industries, property types, and types of agriculture making up the bank's portfolio. The bank should note shifts that could reflect significant increases in the potential for volatility in portfolio credit quality and portfolio performance.

Identified increases in risk in a type of lending or subset should prompt the bank to review underwriting guidelines and portfolio limits, making adjustments as appropriate. Specific actions might include restricting new lending to only the strongest borrowers and pursuing strategies to prune lesser-quality borrowers.

For example, commercial real estate lending was generally regarded as a low-risk type of lending in the early 1980s. Through the decade, the entrance of new competitors, changes in the tax laws, and subsequent weakening in underwriting, structuring, and pricing standards significantly increased the risk in this type of lending. Banks that were slow to detect the shift in risk and tighten their underwriting guidelines, reduce portfolio exposure, or even exit this type of lending found themselves with significant numbers of problem loans, and many institutions failed--for example, savings and loans.

A survey of students at the Graduate School of Banking at Madison over the past seven years indicates significant increases in risk in the following lines of business:

* Consumer direct.

* Consumer indirect.

* Credit card.

* Small business.

* Commercial real estate.

* Agriculture.

Small business, commercial real estate, and agriculture comprise industries, property types, and types of agriculture (subsets) with very different risk characteristics. To properly assess the risk in these areas of lending, a bank must regularly assess the risk within the subsets. Lenders should be particularly sensitive to subsets exhibiting the characteristics of industries and property types that have been the source of large numbers of problem loans in the past--for example, agriculture, energy, commercial real estate, and health care.