Magazine article The Journal of Lending & Credit Risk Management

The Impact of Portfolio Management on Market Value

Magazine article The Journal of Lending & Credit Risk Management

The Impact of Portfolio Management on Market Value

Article excerpt

The effect of portfolio management on market valuation is a key theme for the senior management of any bank. The recent surge in interest in portfolio management models can be traced to factors that are rooted in banker experience and technological advances. This article explores these and other factors and looks to the future of portfolio management. When combined with appropriate diligence and sound judgment in assessing data provided by a model, portfolio management can indeed reduce risk, offer new opportunities, and enhance equity value.

Today's equity prices are far preferable to valuations of the early 1990s. Impressive gains have been driven by earnings growth and, more important, by multiple expansion. Some banks could approach or, perhaps, exceed a market multiple.

There are risks inherent in the current valuation levels. Low multiples in the past were caused by weak earnings with downside volatility driven largely by excessive wholesale credit losses. Any sign of a return to this environment would trigger a double whammy - lower earnings combined with lower multiples. This event would be just as painful as the upward revaluation has been enjoyable.

In Creating Value in Banking: The Next Steps, Ron Mandle, Bernstein Research, holds that because the coming years are unlikely to be as favorable to banking as the past five, this is the time to ensure that value creation continues. Long-term value creation is tightly linked with earnings per share (EPS), and steady growth and book value per share drive EPS growth. Mandel stresses that management should not be tempted to subtract book value, which most often occurs in the form of credit losses, to maintain the appearance of growth. Just as the problem loans from 1989 to 1991 had their roots in loans made during the benign economic environment of 1984 to 1986, bankers can expect problems in 1999, 2000, or whenever the next recession occurs from loans made now if bank management does not maintain loan underwriting discipline.

Lending is among the most cyclical of businesses because of underlying changes in volume, pricing, and credit losses. During the growth phase of the cycle, loan volumes grow and spreads decline. Underlying client strength helps to keep losses down, and gross returns and return on equity (ROE) look good. As the slowdown begins, volume moderates but spreads continue to be flat to down; the banks are protected by a continued moderate level of losses. However, when the downturn hits, volumes decline, spreads do not rebound with sufficient speed or magnitude, and losses multiply. The result is a classic squeeze on bank ROE and earnings. Banks then retrench, poise to recover, and begin the process all over again.

There's a great deal of discussion these days about the "death of the business cycle." But to paraphrase Mark Twain, reports of the cycle's death are greatly exaggerated. Major changes in technology, employment, and finance, along with the globalization of production and consumption, may have reduced economic volatility in the industrialized world. However, risk managers still need to position themselves for a downturn in the economic cycle at some point in the foreseeable future. Portfolio management is one of the tools used to protect against this downside risk.

Greater Sophistication of Data and Equipment

The basic building blocks of credit risk identification and measurement are much better understood now than they were a decade ago and, therefore, more easily utilized. In particular, risk-rating systems now have more definition and integrity. In some cases, they also have:

* Explicit linkages to external ratings.

* Loan equivalent factors for use in converting all types of credit exposures to a common denominator.

* Improved estimates of default probabilities and loss given default factors.

* Better understanding of correlation risks and the benefits of diversification. …

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