A Current Perspective on Concentrations of Credit

By: Tommy Troyer, Executive Vice President

Concentrations of credit are certainly not a new risk for community banks, but for many banks they are an increasing challenge. While effective concentration risk management involves much more than we have room to discuss here, we would like to use this article to highlight a few timely considerations related to concentration risk management.

Growing Concentrations
We all know that, though we can calculate statistical averages for various measures across community banks, there is no “average community bank” in the real world. Each bank has its own unique combination of characteristics. However, concentrations of certain types of credit do seem to be increasing across community banks as average loan-to-asset ratios have been increasing and banks are, for the most part, still trying to stick to in-market lending and to loan types with which they have experience.

Continued regulatory emphasis on prudent concentration risk management practices, especially related to CRE, has been one result of these trends. One of the ways some banks have experienced this attention is to have examiners note a greater interest in measures of total CRE exposure, including owner occupied loans, as opposed to the more traditional measures of non-owner occupied concentrations described in the well-known 2006 interagency guidance on CRE concentrations. (This emphasis has been driven in part by the growing realization that the industry’s loss history on these two types of CRE loans has not been that different over the last decade.)

As a simple example of the growth in credit concentrations for community banks, I collected some data on commercial banks and savings banks in four Midwestern states (Ohio, Michigan, Indiana, and Illinois) with less than $2 billion in total assets. While we work with community banks nationwide and with some banks larger than this threshold, I thought this would be a sample of banks of interest to many of the readers of this newsletter. Of these banks, 700 met these criteria as of 2017Q3. I compared selected concentration levels for these banks to their levels five years earlier, as of 2012Q3.

  • The number of banks with construction and land development loans totaling 100% or more of total capital doubled, though it certainly remains low at just 2% of the sample.
  • The number of banks with non-owner occupied loans totaling 300% or more of total capital increased from 29 to 42.
  • The number of banks with total CRE loans totaling 400% or more of total capital increased from 50 to 66.

None of the figures above total even 10% of the banks in the sample, but I have also chosen to test quite significant concentration levels. Our consulting work indicates that many more banks, which have chosen to set their internal concentration limits at more conservative levels than described above, are experiencing challenges as they near internal limits. This applies for both broad categories of concentrations, such as non-owner occupied CRE, and for more narrowly defined categories, such as hotels.

In some other cases, concentrations that banks have always understood were necessary given the community they serve have become more concerning. For example, many community banks operate in markets where agriculture is a dominant industry. Such banks have always accepted the risk associated with heightened ag concentrations, but continued challenging ag conditions have made such concentrations more of a concern in recent years.

Risk Management Considerations
The fundamentals of effective management of concentration risk are well-known, and can be found in a variety of regulatory sources. I will not rehash all of them here, though I do feel obliged to emphasize that concentration risk must be factored into capital planning and must be appropriately evaluated as a qualitative factor impacting the ALLL. I would also like to highlight a couple of trends in concentration risk management we have noted recently:

  • Incorporating concentration considerations into strategic planning. Yes, detailed analysis of concentration risk and recommendations for concentration limits will likely be provided to the board by management. However, such limits should reflect the board’s risk appetite and desired strategic direction for the bank. It has been encouraging to me to hear in several recent strategic planning retreats thoughtful, forward-looking discussion about what the bank should look like in the future and what that means for the bank’s approach to credit concentrations.
  • Incorporating a proactive approach to monitoring and managing relationship levels. We have seen an increasing number of clients take what can be described as a more proactive and sophisticated approach to monitoring and actively managing concentration levels. Instead of testing concentration levels quarterly and simply “turning off the spigot” when a limit has been reached, these banks incorporate a proposed loan’s impact on their concentration profile into their underwriting analysis. They also use their pipeline and runoff projections to forecast their various concentration levels in coming quarters, and then manage prospective and existing borrowers to maximize the quality and profitability of a given portfolio. This can help prevent, for example, a couple of marginally profitable and purely transactional deals that may be easy to “win” from crowding out prospective deals that can lead to profitable long-term banking relationships.
  • Utilizing portfolio stress testing. Portfolio stress testing has long been a tool for evaluating concentration risk, but more community banks seem to be making efforts to implement forms of portfolio stress testing than ever before.
  • Utilizing collateral valuation and collateral management. One important way of ensuring that downturns in an industry in which a bank has a concentration do not cause excessive losses is to have in place effective practices for both managing the initial valuation and assessment of the collateral (especially for real estate collateral) and for monitoring collateral on an ongoing basis. The ongoing monitoring of the status and value of collateral can be especially important for banks with ag concentrations. While we see plenty of good work done by banks in both of these areas, we would also note that these seem to be some of the most common areas about which we, and also often examiners, provide recommendations for improvements in practices.

Conclusion
Effectively managing concentrations of credit will remain important for as long as lending remains a primary source of income for banks (in other words, forever). Young & Associates, Inc. has assisted clients by providing portfolio stress testing services (both CRE and ag), loan reviews, and more targeted consulting focused on enhancing collateral valuation processes or credit policies. We also assist clients by facilitating strategic planning sessions that encourage the board and management to think about and plan for the future of the bank. This can result in a bank better defining its lending strategy and ensuring its lending approach is consistent with its overall strategy. To discuss this article or any of our services further, please contact Tommy Troyer at ttroyer@younginc.com or 330.422.3475.