Commercial loan portfolio management - with emphasis on risk management - is essential for profitability in the 1990s. A tenet Of managing the portfolio is industry analysis, which addresses both macro portfolio issues and micro credit underwriting concerns. First presented in a June 1988 Journal article by John B. Morgan and Nigel Ogilvie, these ideas on industry analysis are still germane. This overview of industry analysis within the commercial, banking environment describes seven objectives and discusses the theory and application of each.
Many large banks use industry analysis as a part of their portfolio management programs. While this top-down (macro) approach is useful as a tool to diversify a loan portfolio, industry analysis also must work as a bottom-up (micro) process for both large and small banks to influence credit underwriting, credit analysis, and credit monitoring. It is the micro aspects of industry analysis that can keep improperly structured, poorly suited credits off banks' balance sheets.
Objectives of Industry
The value of industry analysis for commercial loan management can be illustrated by seven objectives:
1. Understanding endogenous risks of the loan portfolio.
2. Understanding the dynamics of the loan portfolio.
3. Targeting industries for the loan portfolio.
4. Developing industry strategies within the loan portfolio.
5. Developing industry credit analysis for underwriting.
6. Developing industry underwriting guidelines.
7. Monitoring industry credits in the loan portfolio.
The first four objectives deal with macro (top-down) portfolio issues. These issues need to be addressed to achieve a basic understanding of the portfolio and to develop overall portfolio and industry strategies.
The last three objectives for industry analysis deal with more micro (or bottom-up) concerns: credit analysis, credit underwriting, and credit monitoring. Although the macro portfolio issues are important, it is these micro components that are the true test of an effective industry analysis program.
Industry risk is one of the major inherent risks in a commercial loan portfolio (see Figure 1). (Other risks include single-obligor risk, product risk, geographic risk, maturity risk, and others associated with portfolio composition.) Industry risk is particularly dominant because it cuts across all the other risk factors. For example, a reserve-based loan to an oil and gas company may affect geographic risk, product risk (secured by gas reserves), maturity risk, and, if large enough, single-obligor risk.
Large concentrations to any one industry or sector expose the portfolio to nonsystematic risks (that is, risks that cannot be reduced by diversification). Many banks have industry loan concentrations. Often, small banks with limited geographic markets have large industry concentrations reflecting their local economy. Industry concentrations occur also in large banks that have built expertise and portfolios in related-industry sectors but may lack an overall portfolio strategy.
Once entrenched and an important source of earnings, an industry concentration is difficult to reduce. Often, it is easier - politically - to increase other industry groups while limiting or capping growth on the existing concentration. Even so, senior managers need to realize one of the tenets of portfolio theory: Industry concentration increases the risk profile of the portfolio, and diversifying industry exposures reduces the overall risk of the portfolio.
Even if a given portfolio is not susceptible to individual industry risk, it may be exposed to interindustry risk (also called covariance risk).(1) Interindustry risk results from the interaction and linkages of seemingly separate industries. As an example of an interindustry linkage consider the types of businesses related to building houses: lumber, carpet manufacturers, household appliances, and housing construction, to name a few.
Understanding interindustry linkages is an important step in understanding the overall risks of the portfolio, but there is no single method to define or quantify interindustry risk. Some analysts use product end-markets, industry inputs, or industries related through common economic factors.
How the portfolio may react to exogenous factors (influences outside the portfolio) is the next major question of industry analysis. Exogenous factors may include economic conditions, oil prices, commodity prices, interest rates, environmental regulation, government policies, financial market innovations, and technological evolutions.
Some exogenous changes may be directed at one or two industries. For example, cable TV reregulation affected mainly the cable TV industry, with some effects on the telephone and broadcast industries.
Other types of changes cut across industries. For example, an oil price increase will affect many industries in different ways. Industries that use oil as a primary input (refiners, chemicals, utilities) and industries in which oil is a major cost factor (airlines and trucking) can be identified, and the sensitivity of the portfolio to an oil price shock can be quantified using econometric models.
Understanding the dynamics of the portfolio helps in forecasting portfolio performance. Industry analysis can identify which industries might have problems during an economic recession. However, deductive logic does not always work in portfolio management. Forecasting that metal manufacturers might have problems during a recession, for example, does not necessarily mean that the metal manufacturers in the bank's portfolio will have problems. Therefore, the assumptions and limitations of a portfolio forecast should be spelled out.
Once the risks and dynamics of the portfolio are understood, industry analysis helps identify the types of credit facilities, customers, and industries that should be sought to reduce overall portfolio risk while improving earnings. For example, if the portfolio has concentrations in metals and heavy manufacturing, diversifying into health care, broker/dealers, and utilities would better balance portfolio cyclicality.(2) Moreover, specifying the types of preferred credit facilities (term loans, lines, and standby letters of credit) to these industries helps to balance product and maturity risk.
Senior management must take the lead in portfolio allocation decisions. A senior committee (often the credit policy committee) needs to act as a clearinghouse of risk and establish portfolio management directives. In this way, senior management is attuned to the marketing strategies of industry groups and is assured that the risk appetite of an industry group is compatible with the overall portfolio management goals of the bank.
It is important for portfolio management directives to be clear and simple. Lending units need to know that if they follow the portfolio directives and present properly underwritten loans of a certain credit quality from a particular industry, the chances of approval are good. Lenders get easily discouraged if every credit is a "jump ball" or if the "spigot gets turned off and on."
The line manager should develop an industry strategy using input from credit and portfolio managers. Industry analysis helps to divide a given industry into segments so that varying strategies can be developed for each segment. For example, the steel industry can be divided into integrated producers, minimills, and specialty steel producers.
The strategy should specify the types of companies and products (credit and noncredit) desired in the industry portfolio. Companies and prospects can be ranked and senior management can work with the line to gamer the business.
Note that industry expertise, while important, does not prevent losses in the industry, since industry experts sometimes are the last to acknowledge major industry problems. Moreover, an industry group may take on more risk as its expertise and experience increase. This can happen because the group runs out of high-quality companies in its limited customer base and begins to call on low-quality companies to continue to build the portfolio. Thus, it is important for senior management to review current trends and risks in the industry periodically and to approve the lending strategy.
Developing Credit Analysis
Industry analysis provides a foundation for understanding and developing proper credit underwriting. As credits have become more complicated in recent years, loan officers must demonstrate an intimate understanding of the industry structure, its risks, and the accounting issues that surround it. Furthermore, loan officers must know how the company fits into the industry. Given this knowledge, credits can be better structured to mitigate industry-specific and company-specific credit risks.
Understanding the Industry
Industry credit analysis begins with the loan officer understanding the industry.(3) What is the basic structure of the industry - monopoly, oligopoly, perfect competition? Competition in some industries, such as airlines, can be fierce as the participants fight for survival. Other industries, such as telephone companies, may still be learning how to compete.
Capacity utilization is an important credit factor for industries with high fixed-cost structures. Lenders must know if there are plans to increase capacity within the industry. One recent problem of the paper industry occurred because the major paper companies brought on new capacity at about the same time their competitors were doing likewise. Although each company was acting rationally, the combined result of the new capacity reduced industry margins for several years. Excess capacity coupled with deteriorating margins may be the beginning of an industry shakeout.
Also, the product life cycle of an industry is an important factor to understand. Lending to a new and growing industry often masks mistakes in credit structure because earnings growth accelerates. However, lending into a mature product market (mainframe computers, for example) can be risky, as earnings and margins are declining and, perhaps, turning negative.
Some industries have specialized risks that are not seen in an ordinary "vanilla" credit. These industry - specific risks need to be evaluated. Some of the risks include:
* Regulation - increases or decreases - such as that which affected the health care and cable TV industries.
* Environmental regulation - changes in environmental law and regulations directly affecting the industry.
* Technology - obsolescence factors.
* Reserves - uneconomic reserves or unproven reserves.
Understanding the Company's
Given the overall structure of the industry, a lender must know how the company fits into the industry.(4) Is the company a leader or a follower? If the company is a leader, it may garner a price premium. If the company is a follower, its flexibility to raise prices will be limited. However, its expenses in research and development and strategic planning may be considerably less than those of an industry leader.
Comparing a company's credit ratios with other companies in the industry often leads to important insight. The RMA Annual Statement Studies is an excellent source of industry financial information. Analyzing comparative financial ratios such as inventory-to-sales, margins, and leverage offers important information for credit analysis.
Sometimes it is difficult to draw valid comparisons for a particular company with industry groupings in the Annual Statement Studies. As is the case if the company operates in several lines of business and does not fit into any one industry. In these cases, an industry sample can be constructed from public data sources, such a Compustat, and the user can select comparable companies and ratios.
A knowledge of the accounting conventions used in the industry is essential. For example, utilities use statutory accounting, not generally accepted accounting principles. Interindustry comparisons of ratios, such as the current ratio, would be misleading and inaccurate. The accounting for new utility construction is also important to understanding this industry.
For contractors, it is important to know which method of recording revenue (percentage of completion, completed contract, or the like) is used. Adjustments to company financial statements for different options within Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," also may be necessary.
Industry underwriting guidelines should contain the specific due diligence, credit structuring, and financial analysis required for a specialized industry. The guidelines should focus on the key issues involved in analyzing and structuring a credit. Moreover, the guidelines should detail how the credit can be structured to mitigate inherent industry risks.
Experience from the line must be coupled with industry analysis to make underwriting guidelines realistic and workable. Good industry underwriting guidelines also enable loan officers to know what is expected in structuring a credit. Good underwriting guidelines should prevent "dumb" mistakes in credit structure and should keep poorly structured credits from getting on the bank's balance sheet.
Underwriting guidelines should contain the following three basics: preferred products and maturities, collateral, and coverages.
Preferred Products and Maturities
Industry underwriting guidelines need to specify what products and maturities are appropriate. Products for broker/dealers most likely are short-term liquidity facilities. Retailers require medium-term revolvers and working capital lines. Cable TV loans can be five- to seven-year secured term loans. Aircraft leases of 15 to 20 years may be the preferred way to finance the airline industry.
Some industries seek backup lines and standby letters of credit, while revolver/term loans are common in other industries. Balancing industry and product risks is the beginning of good underwriting.
Guidelines on collateral should specify any acceptable and unacceptable collateral. For example, in retailing, advance rates for apparel allow for a mixture of private labels and national name brands, as well as for seasonal and promotional items.
Oil and gas loans specify the level and type (proven, probable, or potential) of reserves necessary to support the loan. The bank's policy on oil and gas rig valuation should be stated explicitly.
Given environmental liability concerns, some banks have policies on accepting manufacturing plants or industrial real estate as collateral. The underwriting guidelines should spell out those policies.
Debt service coverages vary among industries and credit structures. A 1.6 to 1 debt service coverage for a cable TV company can be acceptable, given its cash flow nature. However, lenders to the steel industry might seek a higher debt service coverage, given the industry's cyclicality.
Leverage also varies. While it can be acceptable for debt to equity to reach 10 to 1 for finance companies, leverage for chemical companies can average 2 to 1. By specifying the acceptable range of leverage and other ratios in an industry, the underwriting guidelines help loan officers screen acceptable marketing prospects.
Monitoring Industry Credits
Industry underwriting guidelines are helpful even after the loan is made by specifying credit monitoring requirements. For example, certain operation and reserve reports are necessary to evaluate the performance of a mine. Retailers should supply same-store sales statistics.
Underwriting guidelines should list early warning signals of credit quality deterioration. For example, in aircraft leasing, the building backlog and recent sales of used aircraft are important barometers. An accident in a chemical plant (and how the company responds to the accident) can be an important indicator of the future.
By listing possible red flags in the underwriting guidelines, loan and credit officers are better attuned to possible changes in the industry and company performance.
Industry analysis provides a framework to address both macro portfolio and micro credit underwriting issues. At the macro level, industry analysis can develop an understanding of portfolio risks and can target industries to better balance these risks. Industry analysis also can help segment an industry and develop a marketing strategy.
At the micro level, industry analysis provides the foundation for understanding individual credit risk. The industry, its risks, and the company's role in that industry are basic to the credit analysis. Industry underwriting guidelines provide direction to the loan officer on due diligence, credit structuring, and analysis for the industry. The guidelines should also indicate appropriate credit structures that have a high probability of acceptance by credit approvers. Finally, industry analysis can specify requirements for credit monitoring and can identify some early warming signals.
The importance of the micro components of industry analysis - industry credit analysis, underwriting guidelines, and industry monitoring - cannot be overstated. A credit culture that emphasizes micro credit underwriting issues in industry analysis will be more attuned to the broader macro issues of industry concentration and portfolio management.
(1) For a good discussion of industry covariance see Paul Ross, "Is Your Loan Portfolio Really Diversified?," American Banker, October 2, 1992. (2) For ways to incorporate modern portfolio theory in portfolio strategies and portfolio construction, see Robert S. Chirinko and Gene Guill, "A Framework for Assessing Credit Risk in Depository Institutions: Toward Regulatory Reform," Journal of Banking and Finance, Fall 1991, and Terri Gollinger and John Morgan, "Calculation of an Efficient Frontier for a Commercial Loan Portfolio," Journal of Portfolio Management, Winter 1993. (3) RMA's Lending to Different Industries, vol. 1,2, and 3, RMA's Credit Considerations, vol. I, II, and III, and Standard & Poor's Industry Surveys are important references in industry credit analysis. (4) For a good overview of the role of industry competition, see Michael E. Porter, "How Competitive Forces Shape Strategy," Harvard Business Review, March/April 1979.…