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Portfolio Theory and Bank Lending Avoiding Concentrations of Credit Risk Through Strategic Diversification

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Portfolio Theory and Bank Lending Avoiding Concentrations of Credit Risk Through Strategic Diversification PORTFOLIO MANAGEMENT Portfolio Theory and Bank Lending Avoiding Concentrations of Credit Risk through Strategic Diversification by Paul Bennett ow can a lender profitably add value using the comparative advantages to be gained from understanding its customers Hwithout becoming overly exposed to specific categories of credit risk? Portfolio management theory points to a strategy for suc- cessfully balancing the goals of creating valuable loan assets and avoid- ing excessive risk concentration. n accepted credo among a price movements, economic slumps, almost any financial asset can be growing number of banks or foreign exchange rate shifts. bought, sold, or securitized, the Ais that lending risks must While avoiding large concen- lending officer adds value through be managed not only at the individ- trations of exposure is a key respon- his or her specialized understanding ual borrower level but also at the sibility of loan portfolio manage- of the customer’s strengths, weak- portfolio level. A well-capitalized, ment, most experienced lenders nesses, and needs. well-diversified lender generally would agree that successful portfo- can remain strong even when sever- lio management involves much Portfolio Theory and Bank al borrowers encounter credit prob- more than simple diversification Lending lems. across a large number of borrowers. Financial portfolio theory pro- It’s not easy, however, for In a competitive environment, suc- vides practical insights into how a lenders to determine when larger cess lies in strategic diversification, bank should structure a loan portfo- concentrations within a portfolio which, in turn, lies in a lender’s lio in light of its goals. At the risk may be exposed to risk. Such con- comparative advantages—and the of oversimplification, a bank’s goals centrations of risk often are essence of both sound bank lending can be seen as threefold: revealed only after the fact by such and competitive advantage is to 1. Earn strong profits. A bank’s events as major commodity or asset know your customer. Today, when profitability is ultimately © 1999 by RMA. Bennett is a financial economist and senior vice president at the Federal Reserve Bank of New York. The views expressed in this article are his own and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System. This article is based on the author’s “Applying Portfolio Theory to Global Bank Lending,” an article written 15 years ago for the Journal of Banking and Finance (see the first entry under NOTES, page 67). 64 The Journal of Lending & Credit Risk Management July/August 1999 Strategic Diversification derived from its ability to add values will bid up the prices of low economic value for its cus- beta stocks (stocks that are less cor- Measuring Portfolio Risk tomers. Although this point related with the market) relative to Concentrations may seem obvious, in the con- high beta stocks. Lenders can find it difficult to text of risk management it is It is important for lenders to identify potential concentrations of helpful to remember that profits know how portfolio theory, intro- credit risk in a loan portfolio are sine qua non. duced in the third goal, helps to rec- because most borrowers have never oncile the apparent tension between experienced major problems. 2. Avoid large losses. A bank’s the first two goals, that is, the trade- Unfortunately, this factor diminish- economic value as an ongoing off between profitability through es the value of recent history as a franchise is at stake if poor specialization and the need to guide to potential risk. For this rea- lending threatens the organiza- spread risk through diversification. son, models based primarily on sta- tion with failure. Careful loan Because of the expertise required tistical track records of loan per- underwriting and effective risk for sound and profitable lending, a formance will have limited ability diversification help keep the bank aiming to diversify into new to measure correlations of credit likelihood of failure tolerably industries, countries, or elsewhere risk across loan assets. Therefore, a low. faces the heightened risk of weak deeper understanding of the factors 3. Maintain high shareholder underwriting and diluted profitabili- influencing borrowers’ financial value. Here, portfolio theory ty. By attempting to diversify, a conditions is needed. makes an interesting contribu- bank could lose its shirt! Portfolio The same knowledge and infor- tion. The theory emphasizes theory, however, emphasizes that a mation that bankers use to guide that the market value of an asset bank’s owners already can diversify lending decisions can also be organ- cannot be determined in isola- their own risks to a large extent by ized for portfolio management pur- tion based on its risk and return spreading purchases over a large poses. The trick is to organize this features. Rather, the real issue number of investments. information efficiently. There are so faced by bank owners is how many subtle distinctions among their shares in the bank will Strategic Diversification individual loans and loan customers affect risk and return in their Portfolio theory does not imply that it is easy to lose sight of the own portfolios. that a bank can neglect diversifica- forest for the trees. As a practical tion; rather, it suggests that a bank matter, it is very difficult for indi- The third goal puts a different should diversify strategically. vidual loan level information to twist on risk and return. A classic Owners and investors will place a “percolate up” into a useful under- example from portfolio theory is a high value on the bank that exploits standing of overall risk concentra- stock that is “risky” in the specific its comparative skill advantages to tions. sense that its price fluctuates widely. make profitable loans. At the same An alternative to traditional However, if these movements have time, the bank requires sufficient organizational methods is “scenario low correlation with the overall diversification to avoid the types of analysis.” Initiated from the top, stock market, then within a larger risk concentrations that would seri- scenario analysis is a potentially portfolio they should tend to wash ously weaken its organization, fran- effective tool for cutting through the out due to a law-of-large-numbers chise, and deposit base. individual loan detail and revealing effect. In contrast, another stock In short, a business strategy major portfolio risk concentrations.1 might appear less volatile, but if it is consistent with portfolio theory Scenarios are built in three highly correlated with the overall principles requires—in addition to stages. First, the portfolio is tested market, then adding it to the an ability to identify profitable for its sensitivity to each of several investor’s portfolio would raise its lending opportunities—a sound selected economic, financial, or volatility disproportionately. approach to measuring the risk of a other variables affecting loan quali- Portfolio theory predicts that loan portfolio as well as an effective ty. Variables chosen might be com- investors seeking stable portfolio means of managing that risk. modity prices, U.S. or foreign eco- 65 Strategic Diversification Based on such experiences, I NITIATED FROM THE TOP, SCENARIO ANALYSIS IS A once a risk concentration has been identified in the portfolio, it is POTENTIALLY EFFECTIVE TOOL FOR CUTTING THROUGH worthwhile to consider the likeli- THE INDIVIDUAL LOAN DETAIL AND REVEALING MAJOR hood that, under a given scenario, knock-on effects might exacerbate PORTFOLIO RISK CONCENTRATIONS . the problem. Unfortunately, the degree to which such effects could nomic growth rates, interest rates, nario. Experience has shown that worsen a risk concentration is very exchange rates, or other broadly such behavioral shifts can raise cor- difficult to assess in advance. Fra- defined asset prices. Requiring relations sharply and unexpectedly. gile funding sources, rapid credit lending officers to analyze the There are a number of examples: growth, and optimistic lender broad effects of shifts in such vari- • In the case of intermediaries assumptions may indicate a need to ables can be very revealing. For carrying complex “hedged” give particular attention to a risk example, in the 1980s, a large U.S. positions involving diverse concentration. bank might have found itself with market instruments, in a bad bad loans to a Venezuelan food scenario the hedges have bro- Managing Portfolio Risk processor, with bonds on a default- ken down, that is, negative cor- Concentrations ed nuclear power project, and with relations have become positive. Having identified an uncom- a high write-off rate on a portfolio fortably large concentration of cred- of mobile home loans in Oklahoma • Diversification of stock market it exposures, a lender faces the chal- and Texas. The common element of investments across national lenge of reducing the concentration these events, of course, would have borders has not always been a while protecting profits as much as been the boom-bust in energy reliable means of offsetting risk possible. Methods might include prices. Analysis of the portfolio’s in domestic investments loan sales or securitizations, sensitivity to energy prices might because of investor spillover depending on the asset types. A spe- have brought the extent of the over- selling when markets are at cialized lender with a strong reputa- all risk concentration to manage- 2 their worst.
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