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What Regulators Want – Slice and Dice the Portfolio

June 21, 2012

Our clients are telling us that the regulators are asking them to be able to address three important issues:

  • Slice and dice the loan portfolio
  • Stress test the loan portfolio
  • Maintain a computer based loan review system

 

We have comments on Stress testing before, so today we will address the first of these issues – Slicing and Dicing the Loan Portfolio.

A problem with many cores systems is that they do not capture the data needed to slice and dice the 0loan portfolio. A second issue is that they are often designed to efficiently capture information necessary for the accounting system, not for flexibly reporting on the characteristics of the loan portfolio. A further limitation is that data that is not directly related to issues such as accounting and regulatory reporting is often incomplete or missing.

When clients acquire a system that is capable of slicing and dicing the loan portfolio, they obtain a much more comprehensive and robust view of the portfolio, the first consequence of which is to discover that data in the core system is inaccurate, incomplete or missing entirely. So task number one is to clean up the data, determine what additional information is necessary to support analysis of the loan portfolio, and then get the new and cleaned up information into the system. This can be a formidable task, to say the least!

Once the data is cleaned up, the portfolio can then be sliced and diced by a wide variety of characteristics such as:

  • Geography (State, Region, Market, County, City, etc.)
  • Lending Office
  • Collateral Type
  • Industry
  • Loan Type
  • Department
  • Lending Officer
  • Loan Program
  • Loan Purpose
  • Relationships
  • Tenant Characteristics
  • Occupancy Rates
  • Tenants and Tenant Industry
  • Loan Rating Distribution (and rating upgrades and downgrades)
  • Lots more!

 

Also, it is valuable to evaluate the results of queries such as:

  • What is the exposure to the high tech industry both in terms of C&I loan to that industry and tenants in that industry that occupy properties secured by CRE loans.
  • Which loans are in a particular market and are secured by a particular property type?
  • Which loans have leases that expire in the next few months where the tenants occupy more than a specific percent of the property?

 

Needless to say, all this analysis and much more can be done quickly and easily with the Madison System’s reporting and filtering functionality. But be forewarned, the easier it is to slice and dice the portfolio the more you will find that you are presented with the need to clean up the data on which the analysis is based.

Filed Under: Loan Review, Regulatory Compliance, Stress Tests
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Measuring Concentration Risk

April 12, 2012

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.

Filed Under: Credit Exposure, Regulatory Compliance
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Loan Rating Migration

January 4, 2012

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.

Filed Under: Credit Exposure, Loan Review, Regulatory Compliance
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Commercial Loan Risk Management – Regulatory Issues

December 20, 2011

Commercial Loan Risk Management- Regulatory IssuesIncreasingly, regulators are placing emphasis on automation and computer support for the risk management of commercial loan portfolios. Some of the features they expect to see at banks they are examining include:

  1. 1. Comprehensive portfolio risk reporting. That is, an automated process for preparing standard risk management reports such as watch lists, delinquency reports, stress test reports, trend analysis, missing or out dated information, etc.
  2. The ability to slice and dice the portfolio — the ability to quickly and easily prepare reports that evaluate the portfolio based on factors such as loan type, collateral type, loan officer, region or market area, and numerous other parameters.
  3. Portfolio Stress testing — the ability to stress items such as collateral income, collateral value, borrower income and expenses, increases in interest rates, and other factors to determine whether loans are strong enough to withstand the stressed conditions.
  4. Loan Rating Migration — how have loan grades changed over time. Is the distribution of ratings over time is an important measure of the credit quality of the portfolio as seem by bank management, and has important implications for the allowance for loan losses.
  5. Automation of the Loan Review process. In the past Loan Review Departments captured the results of their analysis on paper forms that made it difficult to then prepare reports that summarize the results of their analysis of a portfolio. Hand entry of data is also inefficient since much of the information about the loans is already in the bank’s core system.

The Madison System includes comprehensive support for these and many other features requested by regulators. The trick for banks is to be able to create the necessary information, analysis and reports with a minimum of effort so. A fully automated system for doing so is often the best solution.

Filed Under: Regulatory Compliance
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Stress Tests – Effect of Higher Rates on Coverage Ratios

September 15, 2011

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.

Filed Under: Credit Exposure, Regulatory Compliance, Stress Tests
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Enterprise Risk Management

May 26, 2011

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 largest single category of risk, effective ERM needs to take an institution wide perspective to achieve the best balance between risk and opportunity. There are trade-offs between risk and profit. In the case of loans, higher risk can garner higher margins but expose the lender to higher levels of risk. And Interest Rate Risk strategies may point you toward certain lending strategies so 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.

Filed Under: Credit Exposure, Regulatory Compliance
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Stress Test Filtering

April 19, 2011

 

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.

Filed Under: Credit Exposure, Regulatory Compliance, Stress Tests
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Stress Testing Loan Covenants

March 23, 2011

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.

Filed Under: Credit Exposure, Regulatory Compliance, Stress Tests
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Stress Testing Participations

March 23, 2011

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.

Filed Under: Credit Exposure, Regulatory Compliance, Stress Tests
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Portfolio Stress Testing

December 10, 2010

Portfolio Stress Testing

Portfolio Stress TestingOverview: Portfolio stress testing is important today because of the soft economy and because bank regulators are expecting lenders to be able to stress test their portfolios. We think that portfolio stress test should be able to assist in evaluating the impact that various changes will have on the quality of individual loans and the total portfolio.

Some of the parameters that should be stressed include:

  • Higher interest rates for floating rate loans and refinancing rates for fixed rate loans.
  • Cap rates for commercial real estate loans – changes in cap rates will affect valuations.
  • Collateral or business income
  • Collateral or business valuations

Users should also be able to specify the Default Conditions that give rise to losses and the cost to collect defaulted loans. Losses should reflect the value of all collateral for the loan.

Stress tests should apply conditions on a loan by loan basis, showing the results for each loan and for the total portfolio. Going from simple to complex, stress test results may include:

  • A simple ranking of loans by stressed Debt Service Coverage Ratios (DSCRs) and Loan to Value Ratios (LTVs)
  • Estimated changes to Loan Ratings
  • Estimated loan losses
  • Estimated changes in the Allowance for Losses on Loans and Leases (ALLL)

Stress tests conditions and parameters should be easy to apply to the portfolio and facilitate the ability to perform “what if” analysis, eventually ending up with parameter sets such as best case, expected case, and worst case.

Stress test can be applied to the portfolio as it stands right now, or by projecting scenarios into the future to see how conditions would change based on scenarios of future conditions. The time series analysis embodied in future projections can allow users to project forward recent trends to better understand their future consequences. But this analysis requires more data for the portfolio and more time developing and evaluating future scenarios.

Results also need to be in a format that supports presentations to senior management, directors and regulators. All assumptions should be noted on the document and other notes and analysis should be included as well.

Filed Under: Regulatory Compliance, Stress Tests
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