If you step far enough back, a loan portfolio starts to look a whole lot like a basket of fixed income securities. However, there is a wealth of academic research and practical knowledge that is utilized in the investment industry that very rarely is carried over and applied to loan portfolio management, at least from a credit union perspective.
I recently completed the Chartered Financial Analyst program (partially explaining the five month hiatus from blogging!) which, among other things, thoroughly examines the investment planning and implementation process. I constantly found myself brainstorming how the processes used to construct a portfolio of securities could be applied to the construction of a loan portfolio that is not only successful, but also is constructed to avoid undue concentrations of risk.
The first stage in the process is to understand your credit union’s willingness and ability to take on risk.
- Your willingness to take risk should revolve around your membership. It should have very little to do with your personal willingness to take risk. If you’re serving a higher risk area or membership, you must have a higher willingness to take on risk.
- Your ability to take on risk should revolve around your capital position. Depending on the amount of pressure you’re receiving from the NCUA, your target risk adjusted net worth threshold will ultimately be the more conservative of your target and theirs.
- Your willingness and ability to take on loan risk is similar to your members’ willingness and ability to repay in the sense that it is limited by its weakest link. If you’re not able to take on additional risk, it doesn’t matter that you are willing to do so.
For example, ABC Credit Union has $100M in assets and $8M in capital. They set their risk adjusted net worth threshold at 6% of Total Assets, or $6M. This gives them $2M current capital in excess of their risk adjusted threshold that they can allocate to new loans.
Of course, no one reasonably expects to lose every dollar that they lend. ABC Credit Union needs to determine its Value at Risk (VaR). VaR is an estimate of the loss that is not expected to be exceeded with a given level of probability over a specified time period. We are 99% confident that ABC Credit Union’s Loan Losses will not exceed $2M over the next twelve months. ABC Credit Union’s target loan portfolio will have a maximum VAR of $2M.
There are losses already embedded in ABC’s loan portfolio. Expected losses are reserved for in their allowance for loan losses, but because they must be extremely confident their losses will not exceed $2M, they must apply extremely conservative assumptions.
ABC Credit Union has $75M are loans. They charged off approximately 1% of their loans last year and have decided to record $750K in their allowance. However, in 2008 they charged off over 2.5%. If they applied 2008 historical losses to the current portfolio, they would lose $1.95M. They are comfortable that they won’t exceed that in any economic environment.
This affords them a risk budget of $800K ($2M Excess Capital + $750K ALLL – $1.95M 99% VaR).
The second stage in the process is allocating your risk budget among your loan types. ABC Credit Union has 3 loan types.
These loan types, balances, Current VaR and VaR per $ (calculated as balances divided by 2008 Losses) are below:
- Real Estate ($30M, $450k, 0.015/$)
- Auto ($30M, $750k, 0.025/$)
- Unsecured ($15M, $750k, 0.05/$)
VaR per $ means that ABC Credit Union eats 1.5 cents, 2.5 cents, and 5 cents of its $800k Risk Budget for every $1 ABC Credit Union lends in Real Estate, Auto, and Unsecured loans, respectively.
ABC Credit Union could allocate their risk budget entirely to a single loan type and make $53.3M, $32M or $16M in additional Real Estate, Auto or Unsecured Loans, respectively. If they allocated $300k, $300k and $200k of their Risk Budget to Real Estate, Auto and Consumer loans, respectively, they could make an additional $20M, $12M and $4M in loans, respectively.
The risk budget should be allocated based on the risk/return relationship of your loan portfolio as well as the types of products that are being demanded by your membership.
The final stage in the process is to monitor your portfolio and re-balance as necessary.
- This is an ongoing process. In its simplest form, monitoring and re-balancing your portfolio consists of re-performing the first two stages of this process periodically. What has changed with your net worth, VaR and your risk/return relationship that may affect your optimal portfolio?
In the world we live in today, both from a regulatory and economic perspective, it is important to quantify everything. Working through exercises like these with your loan portfolio typically reaffirm the notion that risk isn’t always a bad thing given appropriate interest rate premiums.