Managing Assets for Compliance
Many banks have recently been focusing on the liability side of the balance sheet in order to comply with capital adequacy requirements.
Active management of the loan portfolio is used less often as a way to meet the standards. Difficulties in altering the contents of a loan portfolio fast enough to take advantage of transitory market opportunities have kept many banks from employing this technique.
But missing these opportunities may be costly.
The financial markets have reacted to the banking industry's need for capital with demands for premium yields on bank debt. Consequently, the cost of funding existing loan portfolios while ensuring the maintenance of minimum capital ratios has been escalating.
Given these facts, it makes sense to consider the relative expenses and potential advantages of shrinking or otherwise managing the loan portfolio and adjusting its composition.
It is generally thought that the means to implement such a process are available primarily to major institutions. In fact, a completely functional asset-management system can be developed for banks of all sizes.
The first step is to develop a list of key loan characteristics. Such basic features as aggregate amounts outstanding, term to maturity, and performance status should be included. The customer should be identified for each loan, so that credit line usage can be easily determined.
Once loan characteristics have been chosen, a flexible classification matrix should be created to ease portfolio decisions.
For example, the portfolio manager may want the portfolio to contain only those loans of less than $10 million outstanding, maturing in less than five years, and absorbing no more than 25% of a customer's credit limit. Loans conforming to these standards will be held within the portfolio up to some desired maximum portfolio size. If there are not enough loans to add up to the desired size, there is a loan purchase or creation potential. If too many loans qualify, there is a loan sales potential.
Parameters can be customized using general data bases running on personal computers.
Once the mechanisms are in place for categorizing and analyzing the bank's loan portfolio, attention should be directed towards the market, where the buyers and sellers of loans must be identified.
The private market for loan placements market can provide valuable services and market indications, as can brokers. However, it is important to establish a network of direct counterparties. Dealing directly preserves the portfolio's underlying value by reducing the need to pay fees and commissions.
In building a network of direct counterparties, banks should look to their larger correspondents. Such institutions offer insights into some key issues and may, in fact, be seeking new loan trading partners.
Another market opportunity is the syndicate members with which a bank has participated in major credits.
It is also advisable to speak with peers within the bank's regional area. Perhaps several banks are contemplating entry to the loan exchange market, and the pooling of resources can provide beneficial synergies.
Once the counterparties are identified, the preferences of each institution must be defined. The relative appeal of certain loan sizes and maturities and of industry sectors should be noted for each potential counterparty, as should special attractions such as foreign currencies. With this information, a targeted marketing approach and efficient dealing activities become possible.
Just as in defining the loan portfolio, the definition of a target market can be automated in a modest PC-based data base.
Form a Committee
The procedures described so far will position a bank to begin activities in the loan exchange market. Active portfolio management, however, requires some additional functions. These functions generally can be described as integration policies.
An integrated portfolio management procedure is one in which asset liability management functions, investment product offerings, and credit exposure standards are all considered in determining what assets to create, buy, sell, and enhance.
The first step toward integration is to establish an asset portfolio committee. Its mandate is to develop and ensure the execution of policies that respond to asset liability management requirements, credit constraints, and customer needs.
A typical committee deliberation might establish standards for the types of assets to retain and to dispose. Also, the characteristics of a particular loan that is slated for sale might be viewed in terms of how some credit enhancement could facilitate quick sale. Certain loans might be allocated to the investment products area, where a potential asset-swap transaction is possible.
Another major function of the committee is to review and approve standardized documentation. There must be a clear definition of sales made with recourse and without.
A Valuable Tool
Applying the basic principles of active management to the loan portfolio provides benefits to both large and small banks.
For one thing, it provides another tool to ensure compliance with capital adequacy standards. When the cost of raising funds is high, asset sales may be a more cost-effective way to maintain capital compliance. Extra business with good customers becomes possible as the sales process reopens credit lines.
Active portfolio management will provide a controlled, sound vehicle for moving toward the dealing orientation demanded of banks in the 1990s.
Mr. Wigler is president and chief executive of Credo Group Inc., Stamford, Conn., a consulting firm to the financial community. Before establishing Credo, he was a manager in Andersen Consulting's financial services group.