United States / Industry Insights
Understanding the Risks That May Impact A Bank's Loan Portfolio

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by IBISWorld's Media Team
Feb 25 2011

As seen in the American Banking Association‘s Commercial Insights 

Portfolio managers are tasked with managing and reducing the bank’s overall probability of default exposure within a loan portfolio. In order to achieve this goal, portfolio managers need to segment their loan portfolio by varying degrees of risk to the bank. By identifying high-risk loans and the concentration of risk within a diverse group of loans, portfolio managers are then in a better position to focus their efforts on potential loan losses, determine appropriate industry exposure limits and reserves as well as capital requirements for their bank.

Given the rapid changes during the recession, many portfolio managers (and regulators) are finding it difficult to create accurate models on how to identify the looming risks associated with their segmented loan portfolios. In order to get a handle on the bank’s industry risk exposure, portfolio managers should use multiple sources and tools so that they will have a well-rounded picture of the risks that could potentially impact their bank’s various loan portfolios.

From an industry perspective, the three most important risks that portfolio managers should analyze are: the industry’s structural risk, revenue growth risk and external sensitivity risk (such as macroeconomic, demographic or supply chain drivers).

Structural risks show the portfolio manager the fundamental, non-financial characteristics of the industry. The most important forms of structural risk include the level of competition, the industry’s life cycle stage and annual revenue volatility. For example, a portfolio that contains men’s apparel manufacturers (NAICS 31522) raises concerns for a portfolio manager because the industry is highly competitive, in the decline phase of its life cycle, and has a high degree of revenue volatility. Growth risk analyzes the industry’s forecasted revenue growth potential and recent growth performance. The final and most important risk is sensitivity risk, which helps satisfy the “conditions” portion of the five C’s of credit by identifying how vulnerable the industry is to external changes in the economy over which an individual company has no control.

Charged with monitoring the overall health of a bank’s loan portfolio — the credit department must look at the impact of loans both individually and collectively. Building on the components of industry risk, portfolio managers should create industry stress tests that incorporate the bank’s internal macroeconomic assumptions. These stress tests allow portfolio managers to perform important “what if?” analyses on the bank’s loan portfolio.

Industry stress testing is designed to help portfolio managers determine how a portfolio of industries will be affected when the economy goes in an unexpected direction. By pushing a macroeconomic variable like the price of oil in industry-specific stress tests, portfolio managers can run stress tests to analyze the change in the portfolio’s expected “probability of default” when under stress.

Outside of fundamental industry risks, portfolio managers can use industry research to identify potential supply chain issues. By identifying which industries a client buys from, and sells to, the portfolio manager can analyze additional risks that influence the probability of default. For example, a portfolio manager with a portfolio containing auto parts retailers must be cognizant of auto manufacturing and auto parts wholesaling. They must also be mindful of industries that supply auto parts manufacturers, such as iron and steel manufacturers and metal stamping. By analyzing the supply chain risk, portfolio managers can highlight those industries with risky suppliers and customers, avoiding potential defaults in the portfolio.

The following is an example of issues that a portfolio manager should analyze in order to have a full picture of a specific industry. The complete picture involves following both similar and competing industries, as well as the supply chain and the market-leading companies of the industry. In conjunction with internal metrics such as historical defaults and the level of portfolio concentration, the portfolio manager uses risk scores from the industries to formulate a complete picture of risk.

Many portfolio managers find opportunities when they analyze an industry’s risk trend. Over time, each industry’s risk score will change. Trend analysis starts with making a risk matrix using the three forms of industry risk. Portfolio managers should perform internal credit forensics by tracking industries that are migrating to different risk profiles. An industry with high risk that is decreasing is more attractive than an industry that is medium risk and has an increasing risk trend. Industry risk trends should be communicated to customer relationship managers and new sales teams in order to attract the “right” kind of business and help focus staff attention on looming problem areas. Many banks have such risk metrics built into their customer relationship systems to give their staff the “real time” knowledge that they need to seek, book and manage the “right business” for the bank.

For a printable PDF of Industry Research Tools Provide a Well-Rounded Picture of the Risks That May Impact a Bank’s Loan Portfolio, click here.