One advantage of community banks is the business relationships they’re typically able to develop within their local communities. This includes providing loans to local industries and businesses that may have a strong impact on the bank’s profitability — for better or worse. Asset concentration in local industries can be a strength. However, it’s important to manage those assets carefully to avoid the downsides, including the risk of heavy concentration in an industry that’s losing ground.
Determine the risks and rewards
Asset concentrations increase a bank’s risk by exposing it to potential losses. For example, banks with concentrated assets are vulnerable to significant losses in the event of a local industry or economic downturn. But that doesn’t mean that banks should avoid such concentrations at all costs. On the contrary, asset concentrations enable banks to better serve their communities by taking advantage of local industry expertise and market knowledge. So, you should weigh the risks against the benefits — and implement measures to mitigate potential risks.
First, evaluate your credit risk management policies, keeping in mind that asset concentration risks are felt well beyond the area of concentration. Suppose a bank has a heavy concentration of loans to businesses in a particular industry. A downturn in that sector could make it harder for businesses in the industry to repay their commercial loans and for individuals who work in the industry to repay their auto loans or mortgages.
So, it’s critical to consider the impact of asset concentrations on your entire loan portfolio and to implement policies to address the elevated risk. Such policies might include tightening underwriting standards, placing caps on asset concentrations, conducting global cash-flow analyses, performing stress tests and monitoring loans carefully.
Also ensure that your bank’s level of capital and reserves is commensurate with its concentration risk and aligns with the bank’s strategic plan. If your bank has a significant loan concentration in a particular industry, market or loan type, consider the relationships among these loans when evaluating the sufficiency of your capital and determining an appropriate allowance for loan and lease losses (ALLL).
Use diversification strategies wisely
In addition, take a judicious approach to diversification. An obvious solution to a risky asset concentration is to diversify. But diversification presents its own risks, so handle the process carefully. For example, a bank with a heavy concentration of loans in an industry or geographic territory might diversify by making loans to businesses in other industries or territories. But doing so might require the bank to venture out of its comfort zone into areas where it doesn’t possess the same level of knowledge and expertise.
Look for ways to diversify within a particular industry. For example, a bank with a high concentration of agricultural loans should consider lending to both crop producers, such as corn or soybean farmers, and livestock producers. This can mitigate the bank’s risk because economic and other external forces that hurt one industry segment may help the other. A decline in crop prices, for instance, would harm crop producers but it would benefit livestock producers by reducing their feed costs.
Another diversification strategy is to increase the size of your bank’s securities portfolio. Doing so instantly shrinks the bank’s loan-to-asset ratio. (A high ratio is often a red flag.) But keep in mind that investing in securities poses problems of its own and may divert capital away from the community the bank serves.
Stay on top of the local economy
A superficial understanding of the industries in which your customers operate may lead to bad decisions. Your bank’s lending officers need to be conversant with the many factors involved in the local business environment in order to analyze, and react to, its fluctuating risks and rewards.