When it comes to asset concentrations, community banks face a sort of “Catch 22” dilemma: On the one hand, concentrated exposure to certain types of loans, collateral or borrowers increases risk, violating the precept that you shouldn’t put all your eggs in one basket. On the other hand, community banks, by definition, exist to serve their communities. Naturally, this can lead to high concentrations in local commercial real estate (CRE) and in industries prevalent in the area, such as agriculture, forestry, energy, technology, manufacturing or fishing.
Risk vs. Reward
Asset concentrations increase a bank’s risk by exposing it to significant potential losses. This makes it vulnerable to significant losses in the event of a local industry or economic downturn. But that doesn’t mean that banks should avoid such concentrations at all costs. On the contrary, asset concentrations enable banks to better serve their communities by taking advantage of local industry expertise and market knowledge. The key to managing asset concentrations is to take a balanced approach that weighs the risks against the benefits — and to implement measures to mitigate those risks.
Here are some best practices banks should consider when addressing asset concentrations:
Review credit risk management policies. Evaluate your credit risk management policies, keeping in mind that asset concentration risks are felt well beyond the area of concentration. Suppose a bank has a heavy concentration of loans to businesses in a particular industry. A downturn in that industry could not only affect the ability of businesses in the industry to repay their loans, but could also make it harder for individuals who work in the industry to repay their auto loans or mortgages.
So it’s critical to consider the impact of asset concentrations on your entire loan portfolio and to implement policies to address the elevated risk. Such policies might include:
- Tightening underwriting standards,
- Placing caps on asset concentrations,
- Conducting global cash-flow analyses,
- Stress testing, and
- Monitoring loans carefully.
Evaluate capital and reserves. Ensure that your bank’s level of capital and reserves is commensurate with its concentration risk. If your bank has a significant concentration of loans in a particular industry, market or loan type, it’s important to consider the relationships among these loans when evaluating the sufficiency of your capital and determining an appropriate allowance for loan and lease losses (ALLL).
Take a judicious approach to diversification. An obvious solution to a risky asset concentration is to diversify. But diversification presents its own risks, so it’s important to handle the process carefully. For example, a bank with a heavy concentration of loans in an industry or geographic territory might diversify by making loans to businesses in other industries or territories. But doing so would require the bank to venture out of its comfort zone into areas where it might not possess the same level of knowledge and expertise.
Look for ways to diversify within a particular industry. For example, a bank with a high concentration of agricultural loans should consider lending to both crop producers, such as corn or soybean farmers, and livestock producers. This can mitigate the bank’s risk because economic and other external forces that hurt one industry segment may help the other. A decline in crop prices, for instance, would harm crop producers but it would benefit livestock producers by reducing their feed costs.
Another diversification strategy is to increase the size of your bank’s securities portfolio. Doing so instantly shrinks the bank’s loan-to-asset ratio. (A high ratio is often a red flag.) But keep in mind that investing in securities poses problems of its own and may divert capital away from the community the bank serves.
Federal banking regulators have long been concerned about asset concentrations, particularly concentrations of CRE. In 2006, for example, before the subprime mortgage meltdown that contributed to the U.S. financial crisis, the major federal banking agencies issued guidance on the risks associated with concentrations of CRE loans. And in 2011, the Federal Reserve issued Supervisory Expectations for Risk Management of Agricultural Credit Risk, which outlines minimum risk-management practices for banks with significant agricultural exposure.
More recently, in 2015, banking regulators issued a joint statement reiterating the concerns raised in 2006 and outlining supervisory expectations regarding CRE concentrations. (See “CRE concentrations: What are examiners looking for?”)
Strike a Balance
It’s important for community banks to address the risks that asset concentrations present. At the same time, they should recognize the benefits these concentrations provide to the community, and develop risk management practices that strike a balance between the two.
Sidebar: CRE Concentrations: What Are Examiners Looking For?
In 2015, the Federal Reserve, FDIC and OCC issued a joint Statement on Prudent Risk Management for Commercial Real Estate Lending. According to the statement, banks with high CRE concentrations should, among other things:
- Establish adequate and appropriate loan policies, underwriting standards, credit risk management practices, concentration limits, lending strategies and capital adequacy strategies,
- Conduct global cash-flow analyses based on reasonable assumptions and perform stress testing of their CRE loan portfolio,
- Implement procedures for monitoring volatility in the real estate industry, and
- Implement processes for reviewing appraisal reports.