6 minute read 15 Sep 2020
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Five capabilities necessary for great loan portfolio management

Matt Noll
By Matt Noll

EY Americas FSO Strategy and Transactions Senior Manager

Capital markets and credit risk executive. Passionate follower of the markets and user of business intelligence. Father of three, sailor.

6 minute read 15 Sep 2020
Related topics Innovation in financial services Financial Services COVID-19 Cybersecurity Strategy and Transactions
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COVID-19 pandemic brings a new urgency to a key element of lender strategy.

In brief

  • To make loan portfolio management a strategic imperative, lenders need the flexibility to impute forward-looking risk ratings and adopt risk-adjusted return measures.
  • Banks should devise ratio measures that account for risk and return in thoughtful and pragmatic ways, with an eye to exiting or accelerating product lines to improve risk mitigation.
  • Lenders also need the ability to track each business line’s contribution to the enterprise’s overall return target and devise loan concentration targets to improve its realization.

At the core of investment theory is the concept that risk and reward can be objectively measured and optimized with precision. Can a lender, managing a loan portfolio, optimize risk and reward like an investment manager while also managing borrower relationships? We introduce five capabilities needed to elevate loan portfolio management to the center of lender strategy.

When credit managers are asked to describe loan portfolio management, they tend to point to sound underwriting and proper credit administration. The thinking goes: if risks are well controlled at the loan level, then risks will be well controlled at the portfolio level, and all is fine.

The COVID-19 pandemic, however, has presented lenders with one of the most dramatic economic shocks in modern history and has exposed serious gaps in common practices. These gaps include weak integration of macro indicators into decision-making, haphazard application of forward-looking views on industry sectors, poor flexibility in risk-rating frameworks, arbitrarily defined concentration limits, poor linkage of the loan portfolio to capital at risk, no emphasis on the linkage of the loan portfolio to strategic return objectives, no use of risk-return trade-off measures, and little willingness or ability to rapidly make a decision and execute the offloading of risky loans or exit unprofitable/unwinnable business lines.

Portfolio management – nice concepts, but wrong context for lenders?

In 1997, the Office of the Comptroller of the Currency (OCC) drafted Advisory Letter 97-3 to encourage banks to view risk management in terms of the entire loan portfolio. The OCC followed this letter with its Loan Portfolio Management Handbook in 1998. At that time, the Handbook noted that “few banks use modern portfolio concepts to control credit risk.” Twenty-two years later, the use of modern portfolio theory (MPT) in a bank context remains limited. The reasons are generally due to the difficulty in conforming a lender’s realities to the portfolio manager’s context that MPT is intended.

MPT addresses the selection of stocks, which have transparent market-based indicators of risk, return and correlation. MPT also assumes that an investor can trade stocks in a liquid market. Lenders, on the other hand, deal in loans, many of which have no direct pricing indicators and are underpinned by hard-fought banking relationships—not simply something to be traded away.

The Basel capital accords formalized credit, market and operational risk, as well as the internal ratings-based (IRB) approach to risk-rating loans. With the onset of the financial crisis in 2008, resources that banks may have used for further advancing strategic risk management were spent on triaging credits and subsequently working to comply with the passage of the Dodd-Frank Act in 2010. For a period, the Dodd-Frank Act Stress Test (DFAST) effectively could serve as a reasonable justification for a bank claiming that loan portfolio management was being practiced.

Risk disparities have rarely been more acute

Fast-forward to today. DFAST is no longer a requirement for all but the largest US banks. Lenders are facing a highly uncertain return to normalcy. Nearly five million small business loans have been created by the Paycheck Protection Program (PPP). Commercial and industrial (C&I) loan balances in the US have risen 28%, to nearly US$3 trillion in less than one year. Uncertainty in the macroeconomic outlook prevailed entering the 10th year of the prior recovery. In the COVID-19 crisis, uncertainty remains as prevalent as ever. Credit risk managers have been dealt conditions that provide an immediate proving ground for re-tooling risk management practices.

Five capabilities that lenders need to make loan portfolio management the strategic imperative it needs to be are as follows:

  1. Flexibility to impute forward-looking risk ratings. The risk in every lender’s loan portfolio changed dramatically with the onset of the COVID-19 crisis. No approach could have perfectly anticipated the COVID-19 crisis, but the capability to easily “scenario-play” rating transitions is more possible today than ever. Leaving ratings untouched until the last 12 months of post-COVID-19 crisis results are provided does not work in today’s environment. Lenders should complement their through-the-cycle ratings with point-in-time ratings. A point-in-time rating can come from a range of sources or could simply be the bank’s own expert judgment informed by alternative measures of risk. The risks of uncertainty and shocks of COVID-19 crisis-like events demand an ability to handle shock events and dramatic shifts. Manual risk-rating processes are too cumbersome and time-consuming to provide loan portfolio managers with the information needed to proactively get ahead of issues
  2. Adopting risk-adjusted return measures. Every loan has a yield and multiple measures of risk. Each relationship has its own measures of strategic value and profitability. Banks need to devise ratio measures that account for risk and return in thoughtful and pragmatic ways. These measures can be complex, but they needn’t be. The benefit of using such indicators (e.g., a risk-adjusted yield measure or a Sharpe ratio) is that they help drive strategic decisions for the firm. The loan portfolio is too important to the lender for it to not be clearly and objectively doing so.
  3. Tracking each business line’s contribution to the enterprise’s overall return target. The single greatest contributor to a lender’s returns is the gross yield on the loan portfolio. Easily a dozen other major factors can drive equity returns, but a lender’s focus on return on average equity (ROAE) should be unambiguous, measured and thoroughly understood. Loan portfolio management ensures that the largest contributor to those returns is designed, managed and controlled. The method of the Dupont decomposition of ROAE is one of the simplest approaches to not only diagnosing where management needs to be focused, but also what level of loan portfolio return is needed to reach return goals. Banks shouldn’t be playing guessing games with setting loan portfolio target yields, and those targets need to be informed about the risks taken.
  4. Devising loan concentration targets. MPT answers the question of how to weight the selection assets in a portfolio. In a lending context, lenders need to optimize for the best risk-adjusted return while maintaining a desired level of diversification. Only when the entire asset earning portfolio is aggregated to meet the return target (with a relatively minimized level of risk) can a lender know that it is on the right track. Concentration limits are fundamental, but do not go far enough to be considered good loan portfolio management.
  5. Planning the options for de-risking, exiting and/or accelerating product lines. When risk/reward is imbalanced, lenders need to not only recognize it, but have options about what to do about it. De-emphasizing a loan type, segment or risk exposure is never something a growth-minded banker wants to hear, but, if the COVID-19 pandemic has taught us anything, it’s that adapting is possible … and a necessity. Lenders must operate with a strategic playbook to be able to pivot when risk and reward are not acceptable.

Lenders’ historical emphasis on controlling the quality of individual loans continues to be essential, but the door to better risk management methods has never been opened wider. Measuring the trade-offs of risk and reward accrues benefits to risk management, profitability and strategy, and will be greatly beneficial to strategic decision-making of the firm across all phases of the cycles. 

Summary

The COVID-19 pandemic has exposed serious gaps in loan portfolio management. We’ve outlined five capabilities essential for lenders to elevate loan portfolio management to the strategic imperative it needs to be in the current environment.

About this article

Matt Noll
By Matt Noll

EY Americas FSO Strategy and Transactions Senior Manager

Capital markets and credit risk executive. Passionate follower of the markets and user of business intelligence. Father of three, sailor.

Related topics Innovation in financial services Financial Services COVID-19 Cybersecurity Strategy and Transactions
Upvote