Portfolio Theory and Bank Lending: Avoiding Concentrations of Credit Risk through Strategic Diversification

Article excerpt

How can a lender profitably add value using the comparative advantages to be gained from understanding its customers without becoming overly exposed to specific categories of credit risk? Portfolio management theory points to a strategy for successfully balancing the goals of creating valuable loan assets and avoiding excessive risk concentration.

An accepted credo among a growing number of banks is that lending risks must be managed not only at the individual borrower level but also at the portfolio level. A well-capitalized, well-diversified lender generally can remain strong even when several borrowers encounter credit problems.

It's not easy, however, for lenders to determine when larger concentrations within a portfolio may be exposed to risk. Such concentrations of risk often are revealed only after the fact by such events as major commodity or asset price movements, economic slumps, or foreign exchange rate shifts.

While avoiding large concentrations of exposure is a key responsibility of loan portfolio management, most experienced lenders would agree that successful portfolio management involves much more than simple diversification across a large number of borrowers. In a competitive environment, success lies in strategic diversification, which, in turn, lies in a lender's comparative advantages - and the essence of both sound bank lending and competitive advantage is to know your customer. Today, when almost any financial asset can be bought, sold, or securitized, the lending officer adds value through his or her specialized understanding of the customer's strengths, weaknesses, and needs.

Portfolio Theory and Bank Lending

Financial portfolio theory provides practical insights into how a bank should structure a loan portfolio in light of its goals. At the risk of oversimplification, a bank's goals can be seen as threefold:

1. Earn strong profits. A bank's profitability is ultimately derived from its ability to add economic value for its customers. Although this point may seem obvious, in the context of risk management it is helpful to remember that profits are sine qua non.

2. Avoid large losses. A bank's economic value as an ongoing franchise is at stake if poor lending threatens the organization with failure. Careful loan underwriting and effective risk diversification help keep the likelihood of failure tolerably low.

3. Maintain high shareholder value. Here, portfolio theory makes an interesting contribution. The theory emphasizes that the market value of an asset cannot be determined in isolation based on its risk and return features. Rather, the real issue faced by bank owners is how their shares in the bank will affect risk and return in their own portfolios.

The third goal puts a different twist on risk and return. A classic example from portfolio theory is a stock that is "risky" in the specific sense that its price fluctuates widely. However, if these movements have low correlation with the overall stock market, then within a larger portfolio they should tend to wash out due to a law-of-large-numbers effect. In contrast, another stock might appear less volatile, but if it is highly correlated with the overall market, then adding it to the investor's portfolio would raise its volatility disproportionately. Portfolio theory predicts that investors seeking stable portfolio values will bid up the prices of low beta stocks (stocks that are less correlated with the market) relative to high beta stocks.

It is important for lenders to know how portfolio theory, introduced in the third goal, helps to reconcile the apparent tension between the first two goals, that is, the tradeoff between profitability through specialization and the need to spread risk through diversification. Because of the expertise required for sound and profitable lending, a bank aiming to diversify into new industries, countries, or elsewhere faces the heightened risk of weak underwriting and diluted profitability. …