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Research paper adds a twist to the question of concentration risk

Lending concentrations can be a good thing.

Banks are less likely to collect audited financialstatements from their commercial clients if they have greater exposure to theindustry or region, according to a group of academic researchers. Theresearchers looked at commercial lending and found that broadly, the mostconcentrated positions at banks tended to carry the lowest audit rates.

Their recently presented paperfound banks tend to use audits when they lack experience with a concentratedexposure, and that time, rather than volume, seems to be the biggestdeterminant in reducing audit reliance. Each additional year a bank maintaineda concentration, the audit rate of that concentration declined. The use of softinformation helps offset the potentially costly expense of seeking audits.

Andrew Sutherland, an assistant professor at the SloanSchool of Management at the Massachusetts Institute of Technology and one ofthe researchers, said concentrations create exposure to an area that can leadto experience, allowing the bank to accept soft information that informsdecision-making as opposed to "hard information" from audits.

"Concentration on its own isn't bad if the bank has theexpertise and is also doing soft information collection," Sutherland said.

The paper was presented on Sept. 29 at a conference hostedby the Federal Reserve Bank of St. Louis and the Conference of State BankSupervisors.

The paper comes at an interesting time for banks andregulators as they consider how to manage concentration risk in another popularlending area for banks: commercial real estate. Conference attendees grappledwith what to make of the implications of the findings and reconcile them withthe current supervisory approach to CRE, as demonstrated by recent actions frombanks and regulators. Those actions have included consent orders andenforcement actions, capital raises, improvements to enterprise risk-managementsystems, backing away from the space, and merging with a larger institution.

The researchers also looked for a connection between thenext year's losses at a concentrated bank that is not collecting many auditedstatements and found "no effect, no relation whatsoever" between theaudit activity and losses. However, Sutherland cautioned that that finding camewith warning labels. The researchers did not have exposure-level data and maynot prove true in certain cases where audits can become increasingly relevantfor predicting losses, including CRE or economic activity that could indicatethe beginnings of a crisis.

The study spoke to the tension between regulator's interestin enterprise risk management around concentration and exposure, and the factthat concentration can create expertise that banks can use efficiently, saidTodd Vermilyea, senior associate director and economist at the Board ofGovernors for the Federal Reserve System and moderator of the panel. Vermilyeasaid he read the paper through the "lens" of the "liveregulatory issue" of commercial real estate concentrations at banks. Theresearchers looked at the information dynamic between banks and theirborrowers, but hinted at the "very different point of view" anddynamic between a bank and its regulator, he said.

The current regulatory approach demands heightened riskmanagement from banks that choose to carry a CRE concentration, demonstrable toboth examiners and the board, he said.

"If your answer … is that 'I'm good at soft informationand my loans are better than everyone else's,' and you're sitting on a largeCRE concentration, that's probably not an answer … that will fly with theregulator," he said. "I hope that's not an answer that flies withyour board. But [Sutherland] and his coauthors demonstrate that this softinformation really does have value, and expertise leads to the ability to getless hard information and do that efficiently. It's an interesting problem."

When it comes to concentration, Vermilyea said thatconversations between examiners and bankers should happen "more at theportfolio level," a recommendation echoed by Glen Jammaron, vice chairmanand president of Glenwood Springs, Colo.-based Alpine Banks of Colorado. Its unit breaks down its portfoliointo further categories based on information about the credit or borrower andseparates them into high-, medium- and low-risk buckets.

"A person building their own home with a constructionloan falls in the same bucket on the call report as a land development loan,but they're not the same risk, so through our experience we've been able tobreak that down and this is somewhat soft information," he said."We've talked about how you manage that concentration risk. We're lookingat it from a portfolio standpoint, saying 'These types of loans carry much lessrisk or much more risk than the overall portfolio, so how do we manage those atthat level?'"