Loan Portfolio Management Can Help in Building Revenue, Reducing Risk

Article excerpt

With the credit problems of the 1980s still fresh in everyone's memory, banks' heightened interest in loan portfolio management is not surprising.

Now some bankers are beginning to look ahead, seeing benefits in portfolio management that go well beyond avoiding unhappy credit surprises - benefits that have more to do with building, rather than simply preserving, the bottom line.

Most banks are still in the early stages of implementing portfolio management, or even of thinking about it. And since their interest can be motivated by external scrutiny as well as internal reflection, the degree of commitment from senior management, along with the level of sophistication, can vary widely.

Loan Demand Will Grow

During 1988 and 1989, bankers showed-little interest in loan portfolio management. The leveraged buyout and commercial real estate lending booms were in full swing, and credit problems had not yet materialized.

In 1990 and 199 1, credit problems started emerging, and many banks entered a serious workout mode. But there still wasn't much interest in loan portfolio management; people were too distracted by the fires they were fighting to pay attention to it.

In 1992 and 1993, once banks began the rebuilding process, interest in loan portfolio management started to take off. Bankers started to think about how to revamp their lending practices in anticipation of increased new business.

An increase in loan demand has been slow to materialize in certain sectors due to a sluggish economy and the heavy refinancing of bank loans with bonds, but it will happen.

3 Major Issues

One of the main goals of senior management -- indeed the key goal -- is to maximize shareholder value. Where the credit portfolio is concerned, that means managing three financial elements: revenues, costs (especially the cost of credit), and risk.

Risk can be expressed in terms of capital required to protect against the volatility of loan values and outright credit losses, which is often referred to as "economic capital."

High Standards

To the extent loan portfolio management helps get the cost of credit under control, it makes a big contribution to safeguarding the bottom line. But beyond control benefits lie the revenues that will accrue to bankers who can price credit risk and special features of loan agreements more accurately.

To be truly effective, bank loan portfolio management must meet high standards. The goal should really be nothing short of bringing the management of bank loan portfolios up to the professional standards already applied to other major asset classes, such as stocks and bonds. That may take some effort, but it is achievable.

Institutional investors are already managing portfolios of bank loans as a stand-alone business, independent of a relationship-management framework. And asset allocation is now practiced across multiple asset classes.

It is important to bring research on corporate loans to the point where they can be included in asset allocation analyses. This requires a far higher level of specificity than has been evidenced in the few studies done to date in the academic literature.

The technique of structured portfolio management sets portfolio concentration and return targets, measures performance, and organizes the delegation of authority.

Adequate Data

What is needed for banks to get past the early stages of thinking about and implementing portfolio management and to establish a firm foundation for loan portfolio management?

Clearly, the first requirement is adequate portfolio data. This entails centralized data collection, which typically requires a major systems upgrade.

Equally important, a sound, quantitatively-based risk rating system opens the door to good loan pricing, credit loss forecasting and economic capital models. …