Jeff Judy

Jeff's Thoughts - November 12, 2008

Your Diverse Portfolio: Fact or Fiction?

We all understand the risks associated with having too much of the bank's portfolio focused on, say, a single industry, or just a couple of large customers. Naturally, it is harder to diversify the portfolio in some markets than it is in others, that's just the nature of community banking. But we want to be well aware of those "concentrations," whether they are natural or somewhat self-inflicted, so we can make the best decisions at the portfolio level as well as at the level of the individual transaction.

As I travel around the country teaching seminars and consulting with bank leaders, I often meet bankers and managers who are proud of their efforts to avoid these concentrations. Some will mention that they keep an eye on the NAICS codes they collect among their credit customers, and that they are confident that their list is sufficiently varied to afford some protection. Another might say something like, "We have a nicely balanced mix of ag and retail customers."

Sometimes these people are right. They have a good combination of industries and types of businesses represented in their portfolio, and that's good for their long-term health.

But sometimes the bankers who tell me things like that are fooling themselves.

Take that last example, "ag and retail." In many rural communities, as we all know, agriculture drives the economy for miles and miles around. And that means that most of the retail is driven by ag dollars, whether or not they sell products directly related to farming. Come a long drought, a painful shift in crop prices, or any of a number of other threats, and not only will main street shops not sell much in the way of work clothes, they won't sell a thing in upscale clothing for fine occasions . . . or even for everyday recreational and leisure wear.

Or think Michigan and the auto industry. And the same thing happens in many, many communmities: one or two large employers can anchor the entire regional economy.

In these environments, banks may think they are picking up customers with many different sources of income, but they are actually investing in a line of dominoes, all of which will go tipping over when the first couple of big ones get hit with something they can't handle.

I call those connections among your customers "covariance," the tendency for their fortunes to move in lockstep with one another. And it is something that can easily lead you to underestimate the risk you are carrying in your portfolio.
That means the bank may take actions with either the "leaders" or the "followers" in this string of dominoes without realizing how things are really going to play out.

Admittedly, as I mentioned before, this covariance, this kind of "hidden concentration," can be hard to avoid in your market. But that's no excuse for ignoring it.

The best-managed banks are aware of concentration risk and factor it into their actions and decisions. In a later edition of Jeff's Thoughts I will highlight some of the ways this can influence how you work with your customers.

But you can't manage portfolio risks that you do not even see! Make sure you have analyzed your customers, and your market, to uncover the connections that can quickly spiral into disaster when one of your market drivers hits some bumps.

Information Without Action . . .

Maybe I should say that looking at your portfolio, as described above, is a second step in protecting yourself from ugly surprises. The first step is making a commitment to take action on what you will find out when you examine what you have on the books. The current turmoil reminds us that, in spite of what you may read or hear from some quarters, we usually do have some warning when major trouble is headed our way.

Let's just take a couple of examples of bulletins from the OCC that seem rather insightful now. In October, 2006, their "Guidance on Nontraditional Mortgage Product Risks" included the following:

"While similar products have been available for many years, the number of institutions offering them has expanded rapidly. At the same time, these products are offered to a wider spectrum of borrowers who may not otherwise qualify for more traditional mortgages. The agencies are concerned that some borrowers may not fully understand, or be able to manage, the often sizeable payment shock that accompanies amortization periods for these products."

Similarly, at the end of that year, their Bulletin on "Concentrations in Commercial Real Estate Lending" told us:

"The Agencies have observed that commercial real estate (CRE) concentrations have been rising over the past several years and have reached levels that could create safety and soundness concerns in the event of a significant economic downturn."

Don't those statements resonate much more loudly with us now than they did a year or two ago?

You have a wealth of information available from the OCC, the FDIC, the Federal Reserve, and from our trade associations. But unless you read that information with an eye to what you are going to do about it, you might as well not bother.