How to Break Through the Concentration Limit Ceiling

How to Break Through the Concentration Limit Ceiling

By Adam Mustafa, Invictus Group CEO


Here’s a problem that’s rarely discussed, even though it’s happening frequently across the country: Community banks are maxing out their own lending limits for certain types of loans. When this happens, bank management must go to the board of directors for permission to raise the limits so they can continue growing loans, putting everyone in an awkward spot.

Management can only point to the lack of recent historical problems as evidence that things are fine. But the elephant in the room looms large; past performance is not a good predictor of future results.

Meanwhile the board is supposed to be providing oversight. It doesn’t want to come across as rubber stamping management’s plans, and it certainly doesn’t want to make an irresponsible decision, given the regulatory focus on concentrations. But it also doesn’t want to unnecessarily constrain the bank from pursuing responsible growth and earnings just because of an arbitrarily determined limit.

The reality is that nobody really knows what the limits should be right now. Banks lack proper tools to quantify them.[1] Community banks should take the opportunity to rethink and refresh their approach to determining concentration limits. Some banks do not have enough limits in place; some have too many.  Others have carved out their concentration buckets from the wrong angle or have unintentional conflicts between buckets (such as a concentration limit for hotel loans and a concentration limit for CRE loans, without considering the overlap).

The factory analogy is commonly used in the banking industry when discussing deposits (the raw materials) and loans (the finished goods). Let’s extend this analogy to capital and concentration limits. Capital represents the amount of floor space that is available for loan production. Concentration limits represents how much of that floor space is allocated to various product lines (loan segments). It’s time to redesign the layout of the factory so that the right product lines have the right amount of floor space allocated to them. And the redesign should be performed in a manner that provides the bank with unlimited flexibility to adjust floor space allocations (limits) as necessary moving forward.

The strategic plan is key to this reallocation.  A sound capital plan is designed to support the strategic plan. Concentration limits serve as the guard rails within the capital plan. It clearly wouldn’t make any sense to have concentration limits that are lower than the projections in the strategic plan, nor would it make sense to limit the growth in the strategic plan solely because of random concentration limits that were arbitrarily determined.

Let’s return to the factory analogy. One of the most important KPIs in a factory is the capacity utilization rate. Factories often target a capacity utilization rate of around 80 or 85 percent as opposed to 100 percent so that there is cushion and some margin for error. Banks should think about their concentration limits in the same manner. They should be slightly higher than their strategic plan targets to provide management with breathing room, especially if the timing of the loan growth happens faster than anticipated and the bank’s capital has not had enough time to keep pace.

But determining concentration limits simply by just padding projected concentration levels within a bank’s strategic plan is not sufficient. How does the bank know if it has set those limits too high?  The answer is that there is a trade-off that must be recognized. If a bank increases a concentration limit of a given loan category from 100 percent to 125 percent, then that 25-point increase needs to be traded for either (a) available unallocated excess capital or (b) a reduction in the limit of another segment.  And the size of the trade-off is different for each concentration segment; riskier segments will require larger trade-offs.

The next time management goes back to the board to raise one or more concentration limits, they should do so in a holistic manner that includes these trade-offs, backed by quantitative analysis. This will allow management to execute its plans with more breathing room and provide the board with the information it needs to satisfy its fiduciary duty.


[1] Invictus Group has developed groundbreaking software that enables banks to actively quantify their concentration limits in a manner that optimizes their capital. The software uses stress testing techniques to estimate the bank’s excess capital and the capital “charge” for each loan segment.  Banks can select segments of their portfolio they want to set limits for, and then see how it affects their excess capital in real time. This allows banks to optimize all their concentration limits with a click of a few buttons.  For more information, please contact George Callas at gcallas@invictusgrp.com or (718) 219-0441 and ask for a 30-minute demonstration of the software.