How the Pandemic Has Changed the Nature of Managing Concentrations

By Adam Mustafa, Invictus Group CEO


If you still think of concentration risk management as only applicable to commercial real estate, you’re in for a rude awakening. The primary pandemic lesson for community banks is that they need to rethink how concentration risks are identified and managed, with a focus on exposures to industry sectors.

Community banks have typically focused their concentration risk management programs on CRE and construction loans. The few exceptions include Midwestern community banks managing agricultural concentrations and Gulf Coast banks managing energy concentrations. However, concentration risk management limited to these areas was insufficient during the pandemic.

Social distancing and lockdown policies had a targeted impact on a select group of industries. Many banks with outsized exposures to sectors such as hospitality, retail, restaurants, and assisted living would have been fighting for their safety and soundness lives if it weren’t for the unprecedented amount of fiscal and monetary stimulus injected into the economy, as well as the favorable regulatory treatment of loan deferrals and modifications.

The idea here is not about managing pandemic risks. The pandemic is arguably just a proxy for a black swan event. As Nassim Nicholas Taleb articulated so well in his 2007 Black Swan book, the goal to managing unpredictability is to “build robustness against negative Black Swans that occur and be able to exploit positive ones.”

The next black swan or tail risk event may have a devastating impact on an entirely different industry or group of industries. As long as banks are recognizing and managing concentration risks across the various industries that comprise the economy, they will “build the robustness” that Taleb references without having to anticipate every possible risk event.

Just because loans in a given industry or group of industries did not have a problem in the pandemic, the 2008 Financial Crisis, or in the past in general, does not mean that they cannot become a problem in the future.  The banking industry, in general, spends too much time preparing for the last crisis and not enough time preparing for the next one, which is always different. The best way to plan for the unpredictable is to ensure that concentrations do not get out of hand.

The regulators have also picked up on this concept in recent months and it’s clear this will be an area of focus for exams in the future. The OCC updated its Concentrations of Credit handbook in October of 2020, the first update to the handbook in more than 9 years. The crux of this handbook is that banks should think about concentration risk from many different angles, including category, geography, industry, and much more.  According to a report written by a Richmond Fed senior examiner in the fourth quarter of 2020, “…an institution should establish meaningful metrics or triggers to alert management to increasing risk levels…some familiar metrics include…trends in industry concentrations.”

FDIC Chairwoman Jelena McWilliams has also been highly vocal with respect to the enhanced regulatory focus on industry concentrations. In a speech she gave to the House Financial Services Committee on November 12, 2020, she said the following:

“The FDIC has conducted heightened monitoring of financial institutions whose activities or concentrations may present additional concerns due to the economic consequences of the pandemic. We have expanded our regular risk monitoring activities, particularly for institutions that have concentrated exposures to the industries that have been most impacted by the pandemic. Various divisions across the FDIC coordinate to bring together institution-specific and macroeconomic information, including assessments of aggregate banking industry vulnerabilities to credit and liquidity risk.”

To be fair, the idea of managing concentrations by industry sector is not a new one. But it is an idea that the pandemic has shown us needs far more attention. Some banks do have concentration limits in their capital plan for key sectors and property types. The problem is that too many banks do not have them and are often unsure of which areas of concentration they should be concerned with, and those that do have limits by industry simply plucked their targets out of thin air instead of relying on data and analytics to guide them.

In addition, concentration targets are only revisited for two reasons: (1) when the bank is getting close to the limit, which means they need to ask the board for permission to raise the limits, or (2) they must begin answering regulatory questions about them.

Concentration risk management by industry can — and should — be far more dynamic than this.

Community banks need to revisit their capital plans and identify their relevant concentrations by industry using a combination of NAICS codes and property types at the loan level. From there, they need an appropriate analytical approach to quantify their concentration limits for these relevant industry exposures and ensure they align these limits with their strategic plan.  And all this needs to be done on a recurring basis; this is not a one-time exercise.

Those community banks that are ahead of the curve on concentration risk management are not only creating the best practices in risk management capital planning, they are also providing themselves with the ammunition to be more aggressive and offensive in the post-pandemic economy.