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  • Writer's pictureJohn Demeritt

Creating Loan Concentration Confidence

4 Critical Impacts Every Institution Should Evaluate

Now Is the Time to Do Our Homework on Deposits

In my role as a balance sheet and capital management consultant, one of the most common questions I get is, “John, where should we set our loan concentration policy limits?” I always answer in the same anti-climactic way: “It depends.”

Specifically, it depends on what steps the institution has taken to understand the potential impact of loan concentrations on four key areas: asset quality, liquidity, earnings, and capital. Going through the exercise of evaluating these linkages in the context of different economic environments is the key to achieving clarity on where to set policy limits.

Four Critical Impacts

1. Asset Quality

When considering loan concentration limits, it’s crucial to understand the range of loss possibilities under a variety of different economic environments. Making correlations between economic conditions (e.g., unemployment, inflation, credit spreads, house prices etc.) and losses allows for a dynamic look at what could happen in a range of baseline to moderate and severe stress events. Once one makes the relationships between macroeconomic conditions and losses, understanding how the losses could change based on different concentration levels is easy. The results provide invaluable inputs into other risk management models.

One note of caution. The most common approach is to take historical loan losses from the great recession, and to apply those losses to today’s environment as a stress. But does it make sense to take data from a time when interest rates were essentially 0%, inflation was non-existent, and unemployment was 10% and apply it to an environment today when interest rates are elevated, inflation is stubbornly high, and unemployment is at 3.7%? Probably not. Be sure that your stress scenarios are in line with actual economic conditions.

2. Liquidity

How might liquidity be impacted by varying loan concentrations? If loans are being charged off and delinquencies are mounting, then cash flow would be reduced as expected payments decline, creating a liquidity need or shortfall. The severity of this will depend on the specific economic conditions and loan mix/volume at the time of default. For example, greater construction loan losses may have a more severe liquidity impact as cash flows are generally short and losses can be more severe in a downturn.

Quantifying the loan collateral impact and related reduction in wholesale funding capacity is critical to understanding the full impact to liquidity. What will happen to your ability to borrow at the Federal Home Loan Bank or the Federal Reserve if loans are being charged off? Will avenues for funding be materially reduced? By how much? Depending on the economic conditions modeled, these impacts could be exacerbated by reductions in collateral values as

market values decline (investment and loan) in a rising rate environment, for example. In some cases, higher concentration levels can increase liquidity depending on how the growth is funded.

3. Earnings

In most cases, increasing concentrations results in higher earnings – but what if the credit environment changes? Prudent risk management requires understanding how income could be impacted under both moderate and severe stress events. Unfortunately, many institutions find it difficult to accurately quantify this impact due to lack of communication between internal stakeholders. Earnings simulations and budgeting are typically performed by the Finance department, while credit sensitivity and scenario stress testing are often a Credit department function. Many institutions perform these analyses in isolation, prohibiting other stakeholders from leveraging the output.

A key point to remember is to keep stress scenario characteristics consistent. If the economic environment modeled is Oxford Economics’ “Asset Price Crash” where interest rates rise to combat high levels of inflation, then be sure to model the credit hit to earnings based on a higher interest rate environment.

4. Capital

Think of capital forecasting as the culmination of all the above analysis. Capital forecasts and stress tests should not only include capital deterioration based upon loan charge offs, but also the earnings impact of rising losses and non-accruals. Potential earnings exposures associated with the rate environment modeled must be captured. If the posture of the balance sheet is liability sensitive and rates are rising, how does that exacerbate pressure on capital ratios over time? What about the growth impact to leverage and net worth ratios? How are risk weighted assets changing? All of these variables should be considered. Those institutions that account for these variables in their stress testing and what-if exercises will have better information for strategic decision making today, and in times of stress.

Case Study: How Does This Analysis Impact Decision Making Today?

DCG works with a community bank that currently operates at the top end of their Commercial RE concentration policy guideline (300% of capital). The bank frequently sells pools of CRE loans to remain compliant with the guideline. By evaluating the four steps above, they were able to quantify and document the impact of maintaining an even higher CRE concentration level. The result was favorable: they gained clarity and confidence to support raising their CRE concentration level to 400% of capital. Earnings are much higher today as loans are held in portfolio, at a time when funding cost pressures are elevated. There are similar stories in the credit union space regarding auto lending.

In Conclusion: From Arbitrary to Confident

When I ask institutions how they arrived at their loan concentration policy limits, I often find that the policy formulation process was somewhat arbitrary in nature. By not properly supporting or testing loan concentration policy guidelines, institutions run the risk of leaving earnings on the table, and/or taking excessive risk. Having documentation and support for the guidelines the institution puts in place will create confidence. In turn, management, the Board, and regulators will gain more comfort in the ability of the institution to make informed strategic decisions, leading to opportunity.


For more information on the potential impact of loan concentrations on asset quality, liquidity, earnings, and capital, and how to evaluate these linkages in the context of different economic environments, contact Darling Consulting Group.



John Demeritt is a Managing Director at Darling Consulting Group, working directly with financial institution executives to improve the effectiveness of their asset liability management (ALM) process. In this capacity, he provides insight and education in managing interest rate risk, liquidity risk, credit risk and capital. John also advises on regulatory compliance, stress testing, and contingency planning.


© 2023 Darling Consulting Group, Inc.


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