There is a classic debate in banking of whether it is better to diversify your loan portfolio or to “stick to what you know.” The logic of the stick-to-what-you-know camp is that since you understand X (insert your specialty – real estate, doctors, residential, etc.) your return will offset any gains in diversification.
Some bankers talk like overall portfolio management is optional, as if they are immune to basic laws of sector credit risk. We understand that it is easy to feel powerful in the knowledge of the chief credit officer, as their insight into medical groups or office buildings may indeed be above average. However, in the long run, acting like an artist is a self-limiting move as you will always expose your bank to outsized risk. It is far better to act like a scientist.
The problem is that credit does not have to default to underperform. Multi-family housing, for example is doing well on the credit side, but producing low risk adjusted returns for banks. Meanwhile, spreads on some retailers and medical groups are increasing and the CCO may be unaware. A bank’s portfolio strategy, no matter how much management knows about a sector, has an embedded bias. Holding 60% real estate, for example may make you feel comfortable, but it shouldn’t as C&I, hotels, credit cards and other areas are running circles around commercial real estate on a risk adjusted return basis. C&I, for instance, has a lower default rate and a better return. Banks shouldn’t care about risk, rather banks should care about residual risk and the return on that risk.
If you constantly feel comfortable in only one asset class, like real estate, that is giving credence to the notion that your bank is so superior in borrower and loan selection that it can offset the risk of concentration. The more concentrated, the more the CCO better be good at choosing above average performing credits. As concentration increases, it becomes humanly impossible to be so good at borrower selection as to offset the risk.
When CCOs think in terms of their overall portfolio and ask the question each quarter where do they want to be at the end of the period – then decisions on loan mix, maturities, reset periods, pricing and volume help make better risk decisions. It is bad enough that most community banks are hampered by a geographical concentration, but compound that with a loan sector concentration and a bank materially elevates its odds of underperforming banks that are national and diverse in scope given a ten year time frame. Lending is hard enough without these headwinds.
To overcome this problem, bank management must be open to new geographies and new lending areas. Yes, you will get regulatory push back, but only if you don’t know the market. The goal is to create a strategic initiative to help you acquire the talent or knowledge to be able to make loans safely in different sectors. Partnership, such as working with other banks with specialty knowledge, also works well.
Changing pricing, underwriting standards, marketing resources and a host of other variables is also central to driving diversification. For this matter, so is being able to buy and sell loans. This is one reason why we sell a variety of nationally originated C&I loans just to help banks offset their existing real estate portfolio concentrations.
Being able to strategically influence risk is a subtle, but powerful point as if you recognize that over a two year horizon your bank has many different asset choices to expand into, the ensuing freedom of that realization is cathartic. This epiphany alone will help make intelligently designed choices. Thinking in overall portfolio performance goals will keep everyone focused on the risk the bank is taking.
The other argument that we also hear is that diversification serves dampen return. This is true on a nominal basis, but not on a risk-adjusted return basis. While municipal exposure lowers return, it helps diversify risk so that the net incremental portfolio return is improved over time. This allows lower required capital levels and lower allowances which means better pricing for your quality customers.
CCOs need to place their bets and place them carefully, intelligently and hopefully in diverse fashion. Loan diversification isn’t a path to a superior ROE, customer relationship management is. However, having a diversified loan portfolio is a powerful plan to keep your bank in the game while it figures out customer strategies to make you an outstanding performing bank. The last downturn has taught us that there is recent and overwhelming evidence that you can’t earn a decent return in the long run unless you have a solid strategic and tactical plan for steering clear of big mistakes in the short term. Obvious, perhaps, but too often ignored in lending practice.
Submitted by Chris Nichols on March 24, 2014