Magazine article The Journal of Lending & Credit Risk Management

Improving Earnings and Diversification: Loan Portfolio Management Strategies for Community and Regional Banks

Magazine article The Journal of Lending & Credit Risk Management

Improving Earnings and Diversification: Loan Portfolio Management Strategies for Community and Regional Banks

Article excerpt

In a two-part article, the author explores a number of portfolio diversification and profit management strategies in the corporate lending business that can be used by community and regional banks. The first part, presented here, provides an overview of the issues and potential solutions; the second part, to appear in the May 1998 issue of the Journal, presents a series of empirical studies to illustrate the benefits of the proposed strategies.

It is a well-recognized dilemma of corporate lending that banks prefer to manage credit risk by lending to those market segments they know best, even though this practice leads to unsafe credit risk concentrations on the banks' balance sheets. The common attitude is, in effect, "I prefer the devil I know to one that I don't."

Portfolio diversification has proven itself as an important risk management tool that also can improve earnings. A number of healthy trends are already underway that either directly or indirectly offer prudent diversification opportunities:

1. Out-of-market bank mergers tend to be motivated by achieving economies of scale in the areas of product branding, systems, specialized product expertise, and by eliminating redundancies. However, they also tend to provide a side benefit of improved portfolio diversification.

2. The continued development of the syndicated corporate loan market enables the banking industry to offer issuers larger credits than would otherwise be possible, provides a means of liquefying selected segments of banks' balance sheets and provides a new source of fee income for structuring and distribution services. Formal syndication tends not to be efficient, however, for smaller credits.

3. The market for pooled loan investment vehicles has grown exponentially over the past few years. Collateralized loan obligations (CLOs), which are essentially loan securitization vehicles, have evolved to include not only noninvestment grade highly leveraged credits but investment grade assets as well. Apart from collateralized loan obligations, other pooled loan investment vehicles include simple pass-though loan funds, loan funds with financial leverage, and investment grade structured notes supported by pools of noninvestment grade loans. These structures create opportunities for banks as both sellers and buyers of credit risk.

4. The gradual acceptance by banks of a portfolio management approach towards their corporate loan books is the next logical step in functional specialization in corporate lending. We have already seen the establishment of specialized origination, structuring, distribution, credit review, and workout groups. With the adoption of loan portfolio management comes basic risk controls, such as industry and obligor concentration limits, the use of more sophisticated analytics, and the development of views about the portfolio that lead to a search for a means to rebalance the portfolio.

Loan portfolio management at banks is still in its early stages of development. Significant barriers remain. Most of the external issues involve the limited liquidity of the loan assets, but these external barriers are rapidly falling by the wayside. The greatest barriers are internal to the banks and revolve around lending versus investment management culture clashes, relationship management overhangs, and revenue-versus-risk management tradeoffs. These internal barriers, while significant, can nevertheless be overcome with a thoughtful approach together with clear and forceful leadership.

Progressive Model

A progressive bank approaching loan portfolio management would be expected to establish and empower a separate portfolio management group with credit approval authority. The bank would also be expected to implement a market-based transfer pricing system between origination/loan structuring and the portfolio management group. Critically important is the need to empower the portfolio management group to do two things:

1. …

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