Asset Concentrations Present Deep Tradeoffs for Community Banks and Bank Supervisors
by Ron Feldman, Executive Vice President and Senior Policy Advisor, Supervision, Regulation and Credit, Federal Reserve Bank of Minneapolis
Community banks serve the areas in which they operate. In doing so, they accumulate information on local borrowers. Building up this information facilitates the provision of credit in ways out-of-area lenders cannot; therefore community bankers can facilitate effective, informed credit risk management. In this way, local communities and banks benefit from assest concentration.
But asset concentration also defines the accumulation of risk; it is the classic example of “putting one’s eggs in a single basket.” Not lending into a well-diversified pool of borrowers exposes community banks to potentially large losses. The losses can materialize if a downturn in an industry or economic sector significantly reduces the repayment ability of the bank’s concentrated borrower base and/or the collateral these borrowers pledge. In short, the assumption of asset concentrations allows banks to produce socially beneficial activity, while at the same time presenting a real risk to the bank.
This challenge exists for many banks in the Ninth Federal Reserve District, which is overseen by the Federal Reserve Bank of Minneapolis. The states of Montana, North Dakota, South Dakota, and Minnesota fall within the District, along with the western portion of Wisconsin and the Upper Peninsula of Michigan. Commodity-related production and industries, including those related to agriculture, timber, minerals and mining, and energy, have a long history in the Ninth District. Community banks in the Ninth District have always lent to firms that operate directly in these industries, as well as to firms that provide support to these industries and households with members working in these industries.
The numbers tell the story: Forty-nine percent of all community banks in the Ninth District have a concentrated exposure to agriculture, with more than 25 percent of total loans used for agricultural production or secured by agricultural real estate.1 Further, 26 percent of the banks are highly concentrated in agriculture, with over 50 percent of their total loans used for agricultural production or secured by agricultural real estate. This does not include the many banks heavily exposed to the other commodities already mentioned. The Bakken oil patch of North Dakota and Montana has created a whole set of banks with borrowers heavily exposed to the price of crude oil.
Commodity exposure heightens the risk that standard asset concentration raises, as commodity markets have a particularly high degree of volatility. Banks with many borrowers dependent on commodity prices and markets must manage a concentration with unpredictable and significant ups and downs.
Of course, concentrations certainly go beyond basic commodities. Concentrations in local real estate lending come easily to mind given the centrality they played in the last financial crisis and the banking crises before it. Within the Ninth District, 34 percent of the banks meet or exceed the supervisory screening criteria for commercial real estate (CRE) concentrations.2 And CRE concentrations are not unique to the Ninth District. There are 4,824 community banks outside of the District, with 24 percent having more than 25 percent of their loans in agriculture and 42 percent that meet or exceed the supervisory screening criteria for CRE concentration.
These data and prior discussion make it clear that an open question for supervisors concerns the ability of banks to manage asset concentrations. Banning concentrations would curtail beneficial lending. Ignoring concentrations would fail to consider important risks to safety and soundness.
Supervisors have responded to this challenge by issuing guidance that details specific risk management practices that banks are expected to have in place to appropriately manage concentrations. For example, the Federal Reserve issued guidance specific to the management of agricultural credit risk, which has particular salience for agricultural banks (see SR letter 11-14, “Supervisory Expectations for Risk Management of Agricultural Credit Risk”). The Federal Reserve, along with the other banking supervisors, also issued guidance for the management of CRE concentrations (see SR letter 07-1, “Interagency Guidance on Concentrations in Commercial Real Estate”). I encourage bankers to read the guidance and implement the practices noted.
I will try not to summarize the guidance in the rest of this article. Instead, I will describe some general approaches that banks should consider as they balance the costs and benefits of their concentrations.
Start with Capital and Reserves
Concentrations, as previously noted, mean higher inherent risk. Banks should hold capital and reserves commensurate with that risk to protect against the higher chance of loss. Minimum prompt corrective action capital levels, as a result, are not typically appropriate for banks with concentrations.3 Likewise, banks with a significant exposure to a particular loan type, market, or industry should incorporate the likelihood of strong correlations among the loans when determining the appropriate allowance for loan and lease losses. The exact capital level that a bank targets depends on the facts and circumstances of its operations. But, all else equal, I would generally expect to see higher capital for higher concentrations. While “all else is not equal,” I am surprised that banks with concentrations do not, on average, hold more capital as their concentration levels rise, as the figure shows.
The figure below reports the average capital level for concentrated banks, broken out by the type of concentration (for example, agriculture and CRE). The level of concentration is reported by decile within each type of concentrated bank. So, for example, the figure reports the average level of capital for agricultural banks that are the least concentrated (up to the 10th percentile) and the most concentrated (at or over the 90th percentile). The capital levels are not materially different for more concentrated banks, with most banks having a leverage ratio of about 10 percent. This fact should give the banking industry and supervisors some pause.
Diversify, but Carefully
The natural cure to an asset concentration is diversifying. Many agricultural banks are able to achieve a level of diversification by lending to both row crop producers and livestock operations. Some of the forces that stress one loan segment may benefit another segment. For example, low crop prices will hurt the crop producers but can be a benefit to livestock operators by lowering feed costs. This type of diversification provides some protection from concentration risk; however, many of the stressors cross agricultural sectors.
But diversifying may not always prove to be so easy for a community bank. A geographically concentrated bank may look to out-of-area loans to reduce risk. This may seem particularly tempting in an environment in which bank profits are under pressure. A prudent bank needs to underwrite an out-of-area loan or participation using the same effective credit risk management practices it uses for in-territory loans. That standard can be very hard to meet for a bank that does not have rich information on the out-of-market borrowers or specialized expertise for out-of-market loans. Does a bank focused on energy loans have the expertise to buy out-of-area CRE loans? Note that the same is true for banks lending into an area of potential concentration. Out-of-territory participations that originated out of shale boom areas could provide needed returns to a bank in an agricultural area, for example. Yet, it is not a trivial task for an agricultural-expert bank to underwrite a loan for which repayment is tightly linked to oil/gas development.
An alternative way to seek diversification is through the size and composition of a bank’s securities portfolio. Diversification can occur in at least two ways. Banks can use the securities portfolio to reduce their overall loan-to-asset ratio. This ratio proved to be an effective forecaster of agricultural bank failure in the agricultural banking crisis of the 1980s, for example.4 Banks can also purchase securities that have less of a link to the local economy than do their typical loans.
Of course, these options have very important limitations. Banks can take on risks they do not fully understand when they purchase securities. Perhaps more detrimental, a purchase of a Treasury security does not serve the local community. There is no free lunch for banks seeking to serve a relatively undiversified local community.
The Importance of Effective Credit Risk Management for All Loans
Lending in an area of potential concentration creates a potential risk across the entire loan portfolio. A shale boom area turns virtually all loans into energy-related loans. For example, an auto loan could be dependent on income from oil exploration employment for repayment. This means that banks must adjust underwriting standards to meet the specific risk posed by a borrower and a point in time. Perhaps most critically, banks must consider the potential downturn in the area of concentration and its implications across the full portfolio when they initially underwrite a loan and when they periodically review the loan. What does this principle mean in practice? Effective banks in the Ninth District and elsewhere make use of many strategies, including:
- recognizing the collateral risk and using a conservative loan-to-value ratio when determining how much to lend against the collateral;
- ensuring that borrowers can repay loans even if their income falls below historical norms; and
- availing themselves of government guarantee programs or other risk-sharing approaches.
Critical to all credit risk management approaches is the amassing of private information about borrowers. There is a distribution of credit quality among borrowers in an area of concentration. Some borrowers have a stronger ability to generate income than do others. Some borrowers have higher quality resources to fall back on if their income falters. And still other borrowers have a greater willingness to repay debt. A bank that seeks to thrive, or even survive, with a concentrated portfolio must have the information to sort out these borrowers and ensure that its underwriting and pricing match the risks assumed by the bank.
Strong underwriting of credits is necessary but not sufficient to manage concentration risk effectively. The bank needs to have a strong system for early identification of deterioration in credits. The credit review system should not only identify deterioration in individual credits but also provide management and the board with an early warning of the potential for related credits to deteriorate. Early problem loan identification will facilitate efforts to address emerging problem credits quickly and effectively.5
The need for specialized information goes beyond deeply understanding a specific borrower. Bank management and the board of directors need to routinely monitor conditions that affect the area of concentration locally, nationally, and internationally. This will come as no surprise to bankers. I have been frequently impressed with the industry-specific knowledge that many bankers bring to bear as they manage concentrations. Effective bankers also bring this deep industry knowledge to bear when they underwrite specific credits.
Board and Senior Management Oversight
The board and senior management play a critical role in ensuring a bank has appropriate controls over concentrations. Roles for the board include establishing the level of risk tolerance by setting limits on concentrations or ensuring it considers concentrations when assessing capital and reserve needs. The board needs to receive reports that provide it with sufficient information to allow it to understand and, if necessary, react to changes in the level of concentrations and the risk profile of the portfolio.
The Limits of Timing as Risk Management
Timing matters, but it is nearly impossible to time your way to effective risk management. It seems likely that financing the first new hotel in an energy boom’s heretofore small locale is less risky than financing the 20th hotel. But timing markets with a fair amount of volatility is challenging to say the least. Banks trying to make the last loan at the peak seem more dependent on luck than skill.
Concluding Thoughts: The Middle Road for Supervisors
While it is a cliché, supervisors must find a balanced approach to the potential risks I just noted. Just because times are at their best does not mean the tide is about to turn. Moreover, banks exist to provide credit, and a boom in an industry may justify a prudent increase in credit to borrowers benefiting from the good times. At the same time, supervisors cannot count on a permanent elimination of volatility to ensure that banks are safe and sound. Finding the right lines is the challenge for banks and supervisors.
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- 1 For supervisory purposes, the Federal Reserve uses the term “community banking organization” to describe entities with $10 billion or less in total consolidated assets.
- 2 The guidance sets forth the supervisory screening criteria as (i) construction and land development loans exceeding 100 percent of a bank’s capital or (ii) all CRE loans exceeding 300 percent of a bank’s capital and growth in CRE over the last three years exceeding 50 percent. CRE loans exclude nonfarm, nonresidential loans for which the primary source of repayment is cash flow from the ongoing operation of the property owner or an affiliate thereof (in other words, “owner-occupied” CRE loans).
- 3 See the Commercial Bank Examination Manual, section 3020.1, “Assessment of Capital Adequacy,” for additional discussion.
- 4 Michael T. Belongia and R. Alton Gilbert, “The Effects of Management Decisions on Agricultural Bank Failures,” American Journal of Agricultural Economics, 72(4) (November 1990), pp. 901–910.
- 5 The appropriate response to problem credit may include working with the borrower to address weaknesses and need not include curtailing a credit line. See SR letter 11-14, “Supervisory Expectations for Risk Management of Agricultural Credit Risk,” and SR letter 09-7, “Prudent Commercial Real Estate Loan Workouts.”