The best banks are already taking steps to insulate themselves from the consequences of the next market downturn.
These banks have established organizations to monitor and manage commercial loan portfolios and have created tools to quantify risk and return in their portfolios. The most commonly used tools are quantitative risk rating models, risk-adjusted pricing models (so-called Raroc, or risk- adjusted return on capital, models), and portfolio diversification tools.
Many of these banks routinely conduct portfolio analyses to compare their portfolios with those of their peers and to market aggregates on credit quality as well as loan pricing and structure. This comparison allows a bank to monitor two important aspects of the credit cycle: the behavior of other lenders in a market, and particularly, the early warning indicators of deteriorating credit quality; and how a bank's own lending standards compare with those of its market peers.
One key to successful portfolio management of commercial loans ultimately lies in secondary market liquidity. However, the secondary markets for commercial loans are small and restricted to broadly syndicated loans to large commercial borrowers and to bulk sales, usually of troubled assets.
Attempts to create markets for securitized commercial loans have met with limited success thus far.
In the absence of a significant secondary market that allows lenders to correct their mistakes or rebalance their portfolios, most banks are "originate and hold" investors. Such investors create portfolios only through originations and await the outcome of individual loans: successful repayment or default. This strategy contrasts with that of investors in liquid secondary markets who can create or rebalance their portfolios through active trading.
The key portfolio decisions of originate-and-hold investors occur at origination: Does the loan yield adequate returns relative to risk? Does it fit within the bank's target market criteria? Lending mistakes typically cannot be corrected except through new originations, making the origination decision one of the most important a commercial banker can make.
Among the most significant developments in commercial loan portfolio management has been the qualification of portfolio dynamics. Several banks, particularly those that suffered significant asset quality problems in the early part of the decade, have developed models to forecast the composition and quality of loan portfolios.
These models enable the bank to test whether a new loan added to the portfolio increases or decreases the overall portfolio risk, whether the new loan or the portfolio as a whole can withstand the stress of hypothetical "shocks" or "crisis events" - such as recession or regulatory action - and whether the risk-adjusted return of the portfolio is satisfactory both today and in the future. Thus, those tools enable the commercial lender and the loan portfolio manager to test the sensitivity of the origination decision on the portfolio.
The banks that are best at active portfolio management routinely forecast the likely outcome of their portfolios under these modeling scenarios. Indeed, several have taken the portfolio planning model one step further: an integrated approach that links together portfolio loss forecasting for loan-loss reserve purposes, loan growth and asset quality forecasting for strategic planning, and finally, due-diligence analysis for target acquisitions of portfolios or institutions.
The portfolio planning approach thus allows a bank to test the impact of hypothetical credit cycles on a loan portfolio even if the dynamics of the cycle cannot be predicted with certainty.
Bankers know that the credit cycle exists and that the next likely phase is a downturn. When this downturn will occur cannot be predicted precisely, and its depth will likely be shallower than the last crisis at the beginning of the 1990s.
Well-run banks are taking no chances on the magnitude and timing of the downturn and are planning for these stresses now as they construct and manage their commercial loan portfolios.
Mr. Stevenson is vice president and director of portfolio valuation at Loan Pricing Corp. in New York
