Establishing Concentration Limits
Establishing concentration limits that enable you to make sustainable, sound business decisions while trying to satisfy new regulatory pressure is very tricky.
The supervisory letter on concentration risk states that examples of concentrations within an asset class include…
“Residential Real Estate Loans—collateral type, lien position, geographic area, non-traditional terms (such as interest-only, payment option, or balloon payment), fixed or variable interest rates, low or reduced underwriting documentation, and loan-to-value (LTV).”
If you are contemplating multifactor concentration limits as described above, consider the following example and how this approach could impact your strategy and business decisions.
Let’s assume:
8 real estate types, with
4 different LTV ranges for
20 ZIP codes (geographic areas) and
6 credit score ranges, would result in
3,840 total risk limits for the Residential Real Estate Loans
Keep in mind the above example is just for Residential Real Estate. Imagine applying the same multifactor approach to other asset categories. The number of limits can become daunting and unmanageable.
We recommend listing every limit on a single piece of paper to help decision makers understand the magnitude of their potential policy commitments.
Slicing and dicing portfolios absolutely is a key component of portfolio analysis and risk management. However, we are concerned that the establishment of these limits in policy is being rushed in anticipation of the next exam or, during the exam process, examiners are pressuring credit unions to establish concentration limits quickly.
Rushing to establish concentration limits without appropriate analysis, including potential impact to strategy and business model, could result in unintended consequences with serious implications. Not to mention the red flag noted in the supervisory letter regarding changing concentration limits if a credit union is outside of policy.
We highly recommend following a deliberate process to establish limits. Test drive your limits under various economic scenarios to understand, in advance, how they will impact strategy and business decisions. This includes the changes that may be necessary to the credit union’s business model in order to manage within the new limits.
This blog addresses only a sliver of the issues regarding concentration limits. There certainly will be more to follow, such as the correlation between the speed with which concentration increases and poor financial performance.
