How to Identify and Evaluate Industry Risk in a Loan Portfolio: A Five-Step Approach

By Hunter, Maura Quinn | The Journal of Lending & Credit Risk Management, November 1998 | Go to article overview

How to Identify and Evaluate Industry Risk in a Loan Portfolio: A Five-Step Approach


Hunter, Maura Quinn, The Journal of Lending & Credit Risk Management


Industry analysis has become an important component of portfolio management practices at many financial institutions. The key to analyzing industry risk at the portfolio level is having a clear and comprehensive approach that articulates industry risk in a way that all areas of the bank affected by industry analysis can understand and use. In this article, the author has outlined a five-step approach to help financial professionals identify economic industry risk in a loan portfolio and to prioritize the industries that should be examined more closely.

As the economy moves into its seventh full year since the last recession, many financial institutions are attempting to pinpoint the areas of their loan portfolio most at risk when the next economic downturn occurs. The economy has a direct impact on a commercial loan portfolio through its industry composition. For example many of the large loan losses experienced by financial institutions during the 1990-1991 recession can be traced back to their concentration in real estate and construction industries. Isolating and managing industry risk in a commercial loan portfolio may be one key in weathering the next downturn. Economic industry risk in a loan portfolio can be identified in five steps. This exercise allows the lender to prioritize the industries that a financial institution should analyze more closely.

Step One: Identify Industry Composition and Concentrations

The first step in managing industry risk is to identify the current industry mix of the loan portfolio and determine if these industries are related. One of the true challenges of industry analysis is deciding how to define an industry as industries can be classified in many ways and at many levels. For example, Standard Industrial Classification (SIC) codes can be used to specify an industry either at the two-digit (Paper), three-digit (paperboard containers and boxes), or more detailed, four-digit (corrugated boxes) level. However, a more meaningful way to analyze industries may be to group them into industry sectors.

Grouping industries into sectors facilitates concentration analysis. A sector should be comprised of correlated industries that move together over the business cycle. Ignoring the correlation among industries can lead to a serious underestimation of credit risk.(1) For example, if 25% of exposure in a loan portfolio is in the carpet and rug industry, 25% in lumber, 25% in real estate, and 25% in construction materials, an argument could be made that, using these industry definitions, the portfolio is evenly distributed across industries and no concentrations exist. However, all of these industries will be affected by a decline in housing starts, which may lead to increasing losses in all areas of the portfolio. Defining these four industries as one sector shows the portfolio is concentrated in one industry that will be effected by similar economic events.

[TABULAR DATA FOR FIGURE 1 OMITTED]

Creating industry sector definitions begins with identifying and obtaining a single time series for all industries that dates back through at least one business cycle. Some examples are real revenues, sales, operating margins, cash flows, or business failure rates by industry. After obtaining the data, correlation analysis can be performed to measure the degree of association between industries. For example, if correlation analysis for growth in cash flows yields the results in Figure 1, paper, printing and publishing, and wholesale paper products can be put in one industry sector while food, restaurants, and grocery stores may be placed in another industry sector.

A financial institution may choose to use more complicated statistical procedures like factor analysis or cluster analysis to group industries into sectors. Factor analysis groups data into categories according to their underlying similarities. Cluster analysis will create clusters of industries such that industries in a given cluster are similar to each other and not similar to the industries in other clusters.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

How to Identify and Evaluate Industry Risk in a Loan Portfolio: A Five-Step Approach
Settings

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.