Bank Credit Policy and Concentration Management

About Concentration Management and a Cautionary Tale

The other day, I was talking credit policy with a friend of mine. My friend was hired a couple of months ago by a newly bought community bank {there are a lot of those these days}, and one of his duties will be to develop new credit policy and procedures for his new employer. My friend’s background is that of a lender, but fifteen years ago we were both underwriters for the same employer.

Our conversation centered about concentration management, which was the portion of the policy he was working on. I told him that his best bet was to buy the latest version of the Sheshunoff’s Loan Policies Manual, and just modify the section on concentration management to suit the needs of his new bank. Nobody really writes bank policy from scratch that would be crazy and take several months.
For those that are not familiar, concentration management deals with the credit risk to a financial institution from giving out large loans to a single borrower, related borrowers, or to different borrowers where the loans might behave the same under particular circumstances due to their characteristics.

For example, most people know that banks are limited by regulation from lending unlimited amounts to any one particular borrower. This amount is called the legal lending limit, and is approximately 15% of the bank’s capital. This is usually enough to safeguard a bank from collapsing if their biggest borrower defaults.

The idea of limiting overreliance to one borrower or group of related borrowers makes sense. However, there are other ways a bank can’t get hurt with excessive concentration and that happens when a group of loans share a characteristic. In this instance, the regulators demand
that banks create policies and procedures to manage concentration risk in their loan portfolio. This is what my friend was doing at the time he called me. The concentration policy’s complexity is dependent on the size of the institution. Taking into consideration that my friend’s bank is about 80 times smaller than my employer, the regulators would only expect something simple and easily managed. But at the very least they would want to see:

  • Concentration limits to loans dependent on the same source of repayment.
  • Concentration limits to loans extended to an industry or to economic sectors.
  • That the policy is set up in a way that recognizes the risk of each pool of loans {i.e.: a regulator would expect a lower concentration limit for a pool of loans with a perceived higher risk than a different pool of loan with a perceived lower risk}
  • That the bank’s board has a system in place to periodically review and update the concentration limits.

Then again, all of the concentration policies in the world will not help a bank if they don’t hold themselves to the guidelines. There is a double edge sword regarding self created policies. On the one hand, they are usually the ones that make the most sense since only a fool
would create cumbersome policies that the institution can not comply with. On the other hand, the temptation to change them is high in order to meet lending goals.

That brings me to something I experienced at a previous employer. For that bank, I used to attend loan committee where policies where often discussed. Back in the days of commercial real estate lending growth, we increased our land concentration limits twice because there were a lot of loan requests for that particular collateral. If I remember correctly, there was no discussion about the risk of the move only about how many more millions of loans we could book if we increased the limits. Sadly enough, that bank is out of business and one of the reasons was their lack of concentration management. Let those failures serve as cautionary tales for the bankers of the future.

Lately I have been putting a link to related books for sale in Amazon, but the subject of credit policy is so industry specific that there really isn’t any books in the subject in Amazon. You really going to have to spend the big bucks and get something like Sheshunoff or get a hold of somebody else’s policy.  However, here is a link if you want to buy something from Amazon so I can drink a diet coke in your honor.

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