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Measuring Concentration Risk

Credit Concentration Risk

Concentration risk is the risk that a segment of the loan portfolio experiences a high level of loan losses, and that because the loan portfolio is highly concentrated in that segment, the losses may threaten the safety and soundness of the institution. Because of concentration risk, lenders monitor the concentration of the loan portfolio by loan type, collateral type, geographic market, borrower and tenant industry, and a variety of additional factors.

The ability to quickly and easily monitor concentration risk is a characteristic of commercial loan applications such as the Madison System. Concentration risk can be measured by the concentration of the current loan balance by segment, or of total exposure where exposure is the current loan balance plus the additional amount that may be drawn under existing lines. For example, if there is a high concentration in the Detroit market, if that market experienced significant economic weakness, the bank might have higher loan losses.

If the loan portfolio is further concentrated by other factors such as collateral type, potential losses could be even greater. If the portfolio has a high concentration of loans collateralized by office properties in the Detroit market, and there is a weakness in that segment, losses could have an adverse effect on bank capital. So it is valuable to be able to drill down into portfolio segments to gain a fuller understanding of concentration risk.

For commercial real estate loans it may also be important to measure exposure by the industry of major tenants. If there were a high concentration of tenants in the auto industry the portfolio might be riskier than if tenants were more diversified by industry.

Another key dimension of concentration risk is by borrower industry, especially for C&I loans.

Concentration Policy Limits

Because of the importance of concentration risk, most lenders have policy limits designed to prevent undue concentration of risk. So it is valuable to be able not only to easily view concentration risk, but also compare it to policy limits.

The Madison System includes automated features that allow users to measure concentration risk quickly and easily with the simple click of a mouse. The easier it is to see concentration risk, the easier it is to manage it, and present reports to the Loan Committee and Board of Directors.

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Loan Rating Migration

It is important to be able to evaluate how loan ratings have changed over time. For example, what percentage of loans that were originally rated a 2 are still rated a 2, what percent have declined to 3, to 4, etc. Madison�s commercial loan software allows you to prepared detailed analysis of these trends for your commercial loan portfolio.

That analysis can be filtered by a variety of factors:

  • Loan Origination Date. If, for example, you feel that loans originated in the year 2005 and 2006 were underwritten more aggressively, you can filter the report to include only loans originated in 2005 and 2006 so you can better understand how the ratings of these loans have changed.
  • Collateral Type. How have the ratings of loans collateralized by a particular collateral type changed over time? You can filter reports by one or more collateral types.
  • Geographic Market or Region. Some geographic regions or markets may have experienced greater weakness than others so it will be important to understand how the ratings for loans from these locations have changed over time.
  • Other Filter Categories. The Madison commercial loan software allows you to filter by many other loan characteristics so that you can best understand how ratings have migrated.
  • Combine filters. Filters can be combined for greater depth of analysis. For example, you can evaluate loans in a particular market(s) that were originated in 2005 and 2006. Or loans collateralized by (a) office properties (b) in a particular market(s) (c) that were originated in a particular year(s).


For presentation purposes, the Madison commercial loan software provides a summary matrix that displays percentages, a summary matrix that displays dollar amounts, and a detailed matrix that shows the performance of each loan.

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Stress Tests – Effect of Higher Rates on Coverage Ratios

Financial Stress TestWhile interest rates are at historic lows, many lenders are mindful that rates will not stay low forever. Increasingly, they are concerned about their ability to measure the effect of future interest rate increases on coverage ratios. The objective is to be able to quickly and easily get an understanding of potential exposure and risk.

Their first effort is to simply identify when loans will reprice or mature with indications of:


  • The loan balance that will reprice,
  • The current rate and spread,
  • The index on which the loan reprices, and
  • The current coverage ratios.


With this information in hand, clients are able to identify situations where the coverage is thin and will be significantly adversely affected by higher rates. They can also identify any concentration of repricing in future time periods — for example, do a lot of loans reprice in three years?

Once the repricing schedule is available, analytics can be applied to it to automate measuring the impact on future coverage ratios.

  • The current balance can be amortized down to the repricing date to better estimate the impact of higher rates on coverage.
  • Potential exposure from utilization of available lines can be measure.
  • Interest rate projections can be established, future loan payments can be recalculated, and stressed coverage ratios can be presented.
  • Projected coverage ratios that are below a user specified threshold can be identified for further analysis.


While all the information necessary to perform this analysis is resident in most core systems, the ability to create reports that present the information and perform the analytics is more difficult to achieve. Systems that easily provide this information to clients allow them to better measure this component of credit risk.

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Enterprise Risk Management

Enterprise Risk Management (ERM) has evolved over the years and taken on increase importance due to the current economic environment as well as increased regulatory attention. While there are many components to ERM probably the three major categories are Credit Risk, Interest Rate and Market Risk, and Operational Risk. The later is probably the hardest to get your arms around but there are systems that can help with this such as WolfPAC by Wolf & Company in Boston. For Interest Rate and Market Risk there are quite a number of systems that can help such as those offered by friends of ours at DCG Consulting in Newburyport, MA.

Probably the single largest risk category is Credit Risk, which is addressed by the Madison System. But, while credit risk may be the credit risk implications need to be evaluated along with any operational risk implications.

A well rounded ERM system will rely on systems such as the Madison System, and the others such as those mentioned above, to assist in the process of measuring the risk and the profit, as well as assisting in managing risk on a going forward basis.

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Stress Test Filtering


Financial Stress Test Filtering

Stress testing the commercial loan portfolio has been an important function for many years. Increasingly, we find clients are stress testing more granular subsets of the total portfolio. Here are some of the criteria we find clients using. See if any would make sense for you. The easier it is to select the desired sub group the more likely you are to conduct more granular analysis, and the less staff time is required to get the desired result.

Department and Broad Portfolio Types. These are very broad categories such as commercial real estate (CRE) loans, C&I loans, construction loans, asset based lending, etc. In many cases there is a lot of overlap between departments and portfolio types. Not only would the appropriate stress values differ, but the particular ratios that you many want to test will differ. For Example, you may want to stress LTV and DSCR for CRE loans but DSCR and loan interest rates for C&I.

Geographic Criteria. Different markets and geographic areas may have substantially different economic conditions, some may be strong while others quite weak. Geographic criteria would include region, state, market or city.

Collateral or Loan Type/Loan Category. Needless to say, different collateral and loan types exhibit quite different risk characteristics.

Loan Programs.  Loan programs may be directed at different customer groups and/or have different terms and structures that merit separate analysis.

Origination Period. Loans originated in periods when underwriting criteria were especially aggressive may exhibit heightened risk.

Participation Loans. Purchased participations were originated by another lender, so even though your organization also reviewed the underwriting of the loans, servicing will be by another lender and they will have more direct contact with borrowers and performance information. And Participations sold, while underwritten and serviced by your organization, may be larger implying worse consequences if they go bad but they may also have been underwritten against more rigorous criteria. Either way, the ability to look at participation loans separately from the rest of the portfolio is valuable.

Rate Reset Dates and Indexes. The particular characteristics of floating rate loans give rise to risks associated with higher loan payments if interest rates increase. The ability to easily identify situations where variable rate loans may reprice upward and evaluate the resulting potential DSCR is also valuable.

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Stress Testing Loan Covenants

Stress Testing Loan Covenants

Stress Testing Loan CovenantsOverview: It is important to be able to stress test many variables, applying various techniques to stress testing the portfolio. Stress testing loan covenants is one such approach that many find useful.

For a long time the Madison System has enabled clients to identify loans that violate loan covenants, or come close to violating the covenants. We have recently added a new feature to one such report – the ability to stress LTV and DSCR covenants by changing the value of collateral or businesses supporting loans to stress LTV, and by changing the income of collateral or businesses to stress DSCR (Debt Service Coverage Ratio).

In this report users may determine the amount of the stress to either collateral value or income, or both, and the Madison System will then recalculate the LTV and DSCR for each loan to display those that violate the covenants which are highlighted in red, or those that come within 15% of violating the covenants which are highlighted in yellow. The report can be set to display only violations, only violations and near violations, or all loans.

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Stress Testing Participations

Stress Testing Participation Loans

Stress Testing ParticipationsOverview: Participation loans often have characteristics quite different from other loans in the portfolio, and therefor it is useful to be able to stress test those loans separately from others. A recent addition to the Madison Report library makes it easy to stress test participation loans separately from other loans in the portfolio.

There are many factors that make participation loans different from others in the portfolio. They are usually larger loans, participations purchased were originated by another lender and are typically serviced by that lender, and the underwriting standards applied to these loans may be more rigorous than others in the portfolio.

Consequently, when stress testing the portfolio it may be useful to exclude participation loans so that the other loans in the portfolio may be evaluated. Or it may be useful to exclude only participations purchased so that stress tests are applied only to loans that were originated by the client organization.

Finally, while participation loans may have been underwritten with more demanding criteria, they also tend to be larger loans, so that if a problem occurs, the consequences are more pronounced. That being the case, it is useful to be able to select only participation loans, or only participations purchased, or only participations sold and test those loans.

The ability to easily include or exclude participation loans from stress tests provides added value to stress test reporting.

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Find Credit Exposure Weaknesses

Find Credit Exposure Weaknesses

Overview: So you (or your boss) is worried that commercial real estate loans secured by retail property (or maybe strip malls) in a particular market or group of markets is very weak. He/you want to know your exposure to this situation, and whether the condition of the loans is strong or weak. What would you do now to answer this question?

We are told that many organizations would require several hours or perhaps a couple of days for an analyst to get the information. With the Madison System, the answer is found in seconds.

What you would so is go to the portfolio filter page and select the collateral types that are of concern, and select the geographic markets or cities or states or regions or (if you must!) zip codes that are of concern. This will immediately filter the portfolio to the subset of loans that are collateralized by the respective properties in the respective markets.

You can then call up any report in the Madison System and it will display information about these loans. One report, for example, will list the loans� current balance, current exposure, as well as the loan rating, LTV, DSCR, occupancy, and inspection rating for these loans and properties. With this information at hand, you can immediately determine whether this is an exposure to be concerned with or not.

You can do this kind of exposure analysis based on virtually every appropriate variable in the System in seconds, not hours or days. And the reports that are produced are presentation ready, all set to give to the Board or Management Committee.

Another Variation – Find Loans with Weak LTVs or DSCRs

You may also want to see all the loans in the portfolio with ratings worse than �X� an LTV worse than �Y� and/or a DSCR worse than �Z.� Apple would say they have an app for that. We say we have a report for that, so you can get the list of loans in seconds in a presentation ready report including graphics.

Yet Another Variation – Find Tenant Exposures

You are concerned about tenants in a particular set of industries and want to find out how many loans are secured by collateral where these tenants occupy more than �X� percent of the building and the lease expires in �Y� months. We have a report for that too. Get your results in seconds in a presentation ready report.

OK, Just One More – Find Loans with Advere Loan Ratings

Want to see loans with a recent loan rating that is worse than the prior rating? You guessed it, the Madison System has a presentation ready report for that too.