Good portfolio management needed more than ever.

Most losses in banking are the result of poor credit decisions and controls. But excessive losses, due to inappropriate credit concentrations in economic as well as geographic sectors, result from a failure of portfolio management.

As structural shifts cause the banking industry to lose prime customers, banks increasingly have to compete for scarcer loans from a poor-quality loan demand pool. Any loan growth would therefore imply taking on more risk, causing the loss experience to increase and become more volatile.

Variations of expected losses (and therefore the expected returns) erode bank equity capital. Lower-quality portfolios have higher default and loss rates and are also highly volatile. The reality of volatile losses and regulatory incentives has caused many banks to recognize the need to address the concentration issue more explicitly.

Diversification Strategy

These concerns spotlight the need for bank portfolio managers, particularly in institutions that are large or growing. In fact, the Federal Deposit Insurance Corporation Improvement Act of 1991 strongly implies that executive management should provide the necessary leadership and demonstrate portfolio management skills in controlling losses and their volatility.

The principal defense against volatility is diversification, which, if done correctly, will also reduce overall losses for the portfolio. By diversifying appropriately, a portfolio manager creates a portfolio with less overall risk than the risk of any single loan or a narrowly defined group of loans.

Many banks have begun to address the need for portfolio management, surveys indicate. In some of the better cases, banks have formalized procedures that set and change concentration limits for various industry segments within their portfolios

Rigor Is Lacking

However, the reported processes are based on legal or house lending limits, restrictions of loan exposures to selected industry segments, and the (often painful) collective experience of a group or an individual within the institution. The implementation process is not based, as it should be, on objective methods.

Many reasons have been presented for this lack of rigor in the bank portfolio management process, especially when compared to the sophistication of capital market investors.

A major reason has been the lack of readily available tools for estimating and projecting credit losses and the related volatility for loan cohorts that have common characteristics or dependencies.

Measurement Tools Available

This lack of objective measures for risk has hampered most banks from guiding individual transactions or expressing and formulating an institutional perspective on risk.

Actual expected losses for portfolio segments, variances of these expectations, and related covariances are the measures of risk that have hitherto eluded bankers. However, tools that address these issues have now been developed.

One such source is a current effort to compile loss information on an industrywide basis (analogous to the Moody's loss information on rated corporate bonds), or a sample thereof, which would then serve as a proxy for each bank's own loss experience.

Banks who subscribe to the data base could use this information in guiding their individual transactions, but it would not serve to define or describe a risk profile of the institution

Industry Average Reflected

Besides the usual problems of timeliness, loan grading differences between banks, and reliability of such data, any pricing using this information can only reflect an industry average loss rate and would not differentiate between credit cultures of individual institutions or the monitoring and the recovery experience of each.

Also, since these loss rates are restricted to the "criticized" grades it would not serve to price new loans which would customarily be of "pass" grade quality.

In contrast to the averaging process that an industry sample data base would provide, very powerful tools are available today that can analyze each bank's unique portfolio of loans, describe its characteristics, current chargeoff, and recovery experiences.

Since these loss rates are available for both the "pass" and the "criticized" grades banks can use them to price new loans. The information can also be incorporated into decisions regarding transaction pricing and portfolio mix strategies in addition to the obvious applications in improved reserve and equity allocation.

Risk Managers

Since this information is bank specific and is available by any slice of the portfolio desired, it reflects the credit culture of the organization.

Utilizing these objective tools, a bank portfolio manager can now function as the primary risk manager of the portfolio. Such an individual should at all times be intimate with the pulse of the portfolio and be conscious of the risks inherent.

This individual should provide management, lending, and credit with a global view of the portfolio and of optimal portfolio choices from among the various economic and geographic sectors, given the necessity to maximize the return-to-risk ratio without excessive risk assumption as an institution. The role is thus a complex one.

Elements of the Job

Among the requirements and attributes of such an individual should be the following:

Portfolio quality oversight:

* Knowledge of quantitative loss characteristics of the overall loan portfolio.

* Ability to profile the quality changes in the portfolio or subportfolio on an ad hoc basis.

* Ability to estimate the expected and unexpected loss potential of loans by any segment - region, division, cost center, credit grade, industry, product, dependency.

* Ability to project losses for the portfolio or subportfolio for various time frames in the future.

* Ability to provide estimates of loan reserve for the portfolio or any segment.

Portfolio diversification oversight:

* Knowledge of modern portfolio theory and applicability to bank portfolios.

* Knowledge of the covariances and interrelationships between clusters within the segmented portfolio.

* Ability to provide choices of optimal portfolio mixes for various corporate risk-return profiles.

* Ability to set concentration limits that are defensible from a marginal portfolio risk perspective.

* Knowledge of the effect each transaction or loan has on the portfolio.

Coordination functions:

* Coordinate with treasury regarding equity allocation requirements for the portfolio.

* Provide risk-return hurdles that reflect the current portfolio status and future plans

* Assist in pricing loans that reflect the diversification needs of the portfolio.

* Assist in pricing transactions on a return on equity basis

Integrate portfolio objectives with marketing efforts.

* Integrate credit risk management, business strategy, and economic forecasts.

* Integrate portfolio management with business planning.

* Integrate portfolio management strategy with the corporate vision.

Striking a Balance

The portfolio management function should aim at integrating the business by striking a balance between the credit quality and lending opportunities. It is a function that needs to coordinate various competing interests and offer choices that meet the explicitly stated goals of the bank.

It is also a function that should provide guidance to management in setting goals and strategies, given alternative economic scenarios. As such, it is critical that the function is well understood and that the various functional relationships are defined.

A bank that is unaware of its own portfolio risk parameters, is prone to assume more risk to be competitive, while continuing to use the industry average measures as the benchmark. Over time such a bank will begin to exhibit an adverse return-to-risk profile that will eventually deplete equity capital and depress shareholder value.

Portfolio management thus necessitates integrating credit risk management and business strategy. It also lays the foundation for the soundness, profitability, and growth of the institution.

Banks that can demonstrate that their credit loss volatility is both understandable and controllable should be able to justify for lower capital requirements which, in turn, may set the stage for the survival and growth of the institution.

Mr. Abraham is vice president of the Commercial Center at Society Management Co., Cleveland.

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