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. …