The loan portfolio is one of the greatest sources of risk to a bank, according to the Office of the Comptroller of the Currency (OCC). As such, effective loan portfolio management (LPM) is fundamental to a bank’s safety and ability to identify and take action to address changes in the credit environment. This is particularly evident when one considers the wide variety of events that can affect credit soundness: mergers and acquisitions, new product offerings, regulatory requirements, and, perhaps most importantly, the end of an expansionary cycle.
In these dynamic times, many financial institutions have found that traditional LPM is no longer adequate. It focuses primarily on originations, performance and covenant compliance and relies too heavily on trailing indicators of credit quality such as delinquency, nonaccrual and risk rating migrations, which may not provide sufficient lead time to determine systemic risk. While these activities will always be critical mainstays of LPM, with all the added stresses on financial institutions, they do not give a broad enough picture to identify and mitigate portfolio risk.
The application of traditional LPM has been exhibited in the difficulties many banks have had in managing specialized loan types, such as oil and gas (O&G), corporate real estate (CRE), highly leveraged transactions (HLT) and others.
For example, regulators have criticized a number of banks exposed to leveraged lending for working with borrowers that could not meet leverage and amortization parameters. In response, many loan portfolio managers have enhanced monitoring of leveraged loans, especially “covenant-lite” and riskier leveraged transactions, as measured by the ratio of total debt to earnings before interest, taxes, depreciation and amortization (EBITDA).
The fact that LPM is evolving should come as no surprise. Since the 2008 financial crisis, several factors continue to transform the nature of most credit management operations – factors such as enhanced regulatory guidance related to credit risk management practices and the ongoing efforts of financial institutions to improve their processes, policies and controls, to name but two.
However, unlike most bank functions that concentrate on specific loan products or classes of customers, LPM encompasses the entire loan book. In this role, LPM is well-positioned to identify and control risk throughout the credit process. It also offers the best vantage point to evaluate steps a bank might take to shore up weaknesses or anticipate them.
At Protiviti, we have identified four key areas where LPM can play a greater role than traditionally considered in enhancing an institution’s bottom line and stability.
LPM, by virtue of its cross-functional view, can spot those areas where legacy protocols are impeding change. In order to enhance its role in this area, the LPM function will need to become more closely engaged with the rest of the banking organization, particularly finance and treasury. Such collaboration across the organization, which involves a convergence of risk and finance, is a great way to leverage LPM’s portfolio management expertise and assist the bank in developing a more capital-efficient business.
Because LPM touches on a wide variety of functions, it can be the optimal function to define business requirements, with a predominant perspective on business unit, finance and risk data system needs.
The need to maintain a competitive edge and foresee risks around the corner has put ever greater emphasis on data quality, availability and timing. With demands from multiple stakeholders, from board members to operational line managers and even third-party operators, the ability of portfolio managers to promulgate a real-time stream of strong and clear financial metrics will be a major key to successful decision-making.
Access to high quality risk and finance data is essential to risk-return models, and high-quality market information can lead to better strategic decisions. Investments in data management and digital tools will also aid compliance with BCBS 239.
In an effort to make more informed business decisions, LPM functions will need to use a rigorous limit framework and evolving optimization tools. The limit framework should be in line with overall targets and limits for the balance sheet, reflecting the appropriate key performance indicators (KPIs) the institution has designated.
Prior to the financial crisis of 2008, LPM functions often leveraged transfer pricing to assess the profitability of various product lines. With changes in regulatory constraints, these tools will require several updates, or they will quickly lose their impact.
Today’s financial markets are characterized by reduced opportunities for hedging and secondary trading, as well as a smaller risk appetite for certain loan exposures. At the same time, financial institutions are searching for greater returns on investment via different asset classes. In many instances, highly leveraged transactions, oil and gas loans, agricultural investments, and CRE lending have taken on greater appeal for returns.
However, each of these areas is fraught with risk. As we have learned from recent experience, a single comment by the Fed or the CEO of a leading firm can affect market conditions, as can political upheaval in a troubled part of the globe.
Consequently, the evolving model of LPM must also take into account the specific markets themselves, not just the loans on the books. While portfolio managers cannot be experts on every niche market, they can tap into the expertise available in their organizations, and they can stay tuned in to information from trusted sources.
Regulation and Accounting Standards
Regulatory pressure continues to change the financial landscape. Increasing regulatory scrutiny of credit risk is the present-day reality of banking. Elevated expectations for board involvement and accountability are just some of those pressures directly related to portfolio management. Another important factor is the introduction of the Current Expected Credit Losses (CECL) standard for credit loss accounting.
In fact, the transition to CECL provides loan portfolio managers and data and analytics teams an opportunity to revisit the portfolio with a fresh perspective. In doing so, they can determine if their segmentation, or the way they break their loan portfolio into pools for the purpose of estimating their allowance for loan and lease losses (ALLL), complies with CECL requirements. While there is no prescribed way to solve the challenges related to segmenting the loan portfolio for CECL, a financial institution should utilize its loan portfolio managers and data and analytics teams to understand risk factors such as concentrations, loan to value (LTV), debt-service coverage ratio (DSCR) and risk rating when segmenting the loan portfolio.
In the past, LPM has played more of a second-line role when it comes to regulation, primarily ensuring compliance with risk limits and lending requirements. But in the new normal, it is being called upon to take a more proactive role in assessing the changing impact of portfolio assets on the stability and operational resilience of the organization.
Looking forward, there is no cookie-cutter format for LPM that will satisfy the changing needs of every bank. In fact, there are currently several approaches toward LPM. Some banks have made it part of the second-line risk function, while others deploy a hub-and-spoke approach in which the LPM function is split between a decentralized first-line team and a centralized second-line team aligned to risk.
At Protiviti, we believe that either of the aforementioned structural configurations can be successful. What matters is that the function has the depth and range to manage loan portfolio risk in today’s financial markets. Accordingly, every bank should ask itself, how well is our LPM function evolving to meet the challenges of the financial world?