06 May The Business Case for Dynamic Concentration Risk Management
By Adam Mustafa, Invictus Group CEO
Say goodbye to the days in which concentration risk management was as simple as assigning an arbitrary limit to commercial real estate and construction loans and calling it a day. Concentration risk management is rapidly becoming a dynamic process that will be fueled by data and analytics. This will ensure optimal risk management and capital planning, which are essential to safety and soundness. And it will also prevent banks from becoming so risk averse that they miss opportunities to grow loans, earnings, and ultimately shareholder value.
The catalyst for this paradigm shift is the COVID-19 Pandemic. To be blunt, community banks are fortunate that the government and the Fed injected an unprecedented amount of stimulus into the economy, and bank regulators encouraged loan modifications and deferrals without any negative impact. Otherwise, the pandemic could have led to a bloodbath of loan losses and some bank failures. The banks most at risk would have been those with outsized concentrations to industries disproportionally affected by the pandemic. The truncated lesson to be learned is that banks need to expand their concentration risk management practices, particular by industry sector.
The first step in this process is to identify the industry concentrations that are relevant. Relevance can be defined with three criteria:
- Any exposure to industries (using NAICS codes and property types) that is larger than 25 percent of capital may be considered a relevant concentration if it also includes one of the other criteria outlined below. It should be noted that concentrations by industry could span multiple loan categories and even other parts of the balance sheet (securitizations, other real estate owned, etc.).
- Is the risk profile of the loans to borrowers in this industry group disproportional to the relative size of the portfolio?
- Is this an industry that management is targeting for growth?
The second and most critical step is to assign targets to these relevant concentration buckets. These targets represent limits, or the maximum amount that each category can represent as a percentage of the bank’s capital. Before we continue further with this concept, let’s pause for a moment and think about what this really means, if done properly: The bank is allocating its capital to different industry sectors of the economy. This is not dissimilar from how one might construct a stock portfolio using a top-down approach to earmark certain portions of the portfolio to various industries.
But why is this concept so important to recognize in this critical step? Because the policy limits that are determined for each bucket must be determined relative to one another so that the cumulative allocation of capital to all the buckets does not exceed the bank’s available capital, or fails to utilize all the available capital, either.
Also keep in mind that all loans are NOT created equal. Increasing one bucket by 10 percent does not necessarily mean a decrease in another bucket by 10 percent because of differences in risk and reward between the two categories. In addition, a bank that chooses to increase its dividend or launch a stock repurchase plan is now diverting capital for these new actions, and as a result, management may need to reduce its concentration limits to the relevant industry buckets. This is why concentration risk management must become a dynamic and not a static, one-time exercise.
Protecting and Optimizing Capital
The purpose of this article is not to discuss the analytical methods that can be used to address these issues to create an optimal capital plan. We will save that deep dive for a future article. For now, let’s accept that the analytical tools exist. The point of this article is to make it clear that dynamic concentration risk management is a mechanism by which a bank allocates its capital to different parts of the economy, optimizing yet protecting the bank from a capital adequacy standpoint.
This is not just about playing defense, though. The irony of this approach to concentration risk management is that community banks often find they have more capacity to handle concentrations in certain industries than they might have expected. By taking an analytical approach to identifying concentrations and quantifying their limits, banks have the best of both worlds: increased conviction to support further growth in certain industries and the ability to tie their capital plan (which contain these limits) into their strategic plan in a manner that satisfies both their boards of directors and regulators.
This is where capital planning and strategic planning naturally should interact. In a post-pandemic world, the smartest community banks are already planning their future, less from the loan category perspective and more from the industry exposure perspective. This is a paradigm shift that most of the industry has not recognized. But it helps explain the sound reasoning behind some of the more unconventional M&A transactions that appear to be way “out of market” on a map, such as BancorpSouth’s (Mississippi) merger with Cadence Bancorp (Texas), New York Community Bank’s acquisition of Flagstar Bank in Michigan, and Enterprise Bank’s (Missouri) purchase of First Choice Bank (California). Thanks to technology, geography is becoming less relevant. And keep in mind, labeling certain markets as “high growth” or “low growth” is labeling the effect, not the cause. The cause is actually the composition of the various industries that comprise the economic activity in each market.
After the stimulus sugar high from the economy reopening wears off, growth and margins are going to be difficult to come by for most community banks. Loan growth will primarily come from a handful of sectors, and those banks that position themselves to have increased exposures to those industries will be the winners. Dynamic concentration risk management provides the guard rails to these strategies and enables the bank to optimize its capital.
The New Playbook
The bottom line is the new era of community banking borne out of the pandemic is about managing and optimizing exposures to different industries. This will lead banks to focus less on loan categories, while becoming far more open to geographic expansion to increase exposures to targeted industries and perhaps decrease exposures to others. Concentration risk management by industry that is a dynamic, living and breathing process must serve as the new defensive playbook.