The Storm is Upon Us: Loan Portfolio Monitoring as a Proactive Approach
The concept of loan portfolio monitoring is not new, but with innovative solutions entering the market there are now more ways to enhance your loan portfolio management efforts. In this blog, we explore how you can leverage modern solutions to effectively manage and tackle any impending disruptions or changes that could negatively impact your existing portfolios.
Why Proactive Portfolio Management Matters in the Finance Industry
To gain a better understanding on how a modern approach to loan portfolio management can prove beneficial, it’s prudent to get some insights on the current state of the finance industry. In an effort to curb inflation, the Federal Open Market Committee (FOMC) is increasing rates and reeling in the amount of cash flow in the economy. Unfortunately, this involved pulling the plug on monetary support via check stimulus payouts to consumers.
There has also been a significant increase in credit card usage and delinquencies. Situations like this can be associated with “the wealth effect”, which is a theory that suggests consumer spending behavior is impacted by changes in the value of financial assets. Therefore according to this theory, if a consumer believes they have more financial wealth, they may be inclined to spend more, and consequently save less as a result – and vice versa.
Beyond this, a recent article by American Banker indicates that the Federal Deposit Insurance Corporation (FDIC) is planning to put banks under the microscope to gain deeper insights on commercial real estate exposure, mainly due to issues related to inflation, supply-chain and changes in the industry as a direct result of the pandemic.
Essentially, less consumer spending directly slows the economy. The actions of the FOMC are taking place in the midst of a slowing economy that’s notching two sequential negative GDP quarters and an inverted yield curve with the 10-Year minus the 2-Year Treasury at -45bps. There’s also no way to predict how long the recession will last, but during the 2008 recession the Consumer Price Index (CPI) peaked at 5.9% in July 2008 and by the time the recession ended in July of 2009, CPI was -2.1%. In other words, it was a case of fewer dollars chasing fewer goods.
While some businesses somehow managed to flourish in the face of such uncertainty, others could not withstand the recession of 2018. What we can deduce here is that a simple NAICS code does not determine the resilience of the business – the owner does. The global pandemic is proof of that, as many American entrepreneurs figured out how to pivot and survive in spite of the daunting situation COVID-19 presented.
How then can forward-thinking leaders take a pre-emptive approach and avoid the pitfalls of recession? The answer lies in proactive portfolio management. With this perspective, financial institutions can leverage the data they already have on hand and use powerful tools to make better decisions and evade instances where bad loans end up affecting financial stability.
The Adverse Impact of Poor Portfolio Management
In our Federal Reserve Economic Data (FRED) chart below, you’ll see how loan delinquency among community banks spiked after the 2008 recession. The rise started before the recession was officially called, moving aggressively upward as the recession approached. Today, we see the credit card delinquency curve rising and the personal savings rate plummeting as middle-class consumers get crushed by rising prices and stagnant wages.
If you are managing a loan portfolio and were not working in banking in 2008 or 2009, then you have likely seen a large number of bad loans. It is crucial then to have an understanding of where your problem loans are, long before they become problematic.
But where do you start? We recommend the following four factors to consider when you begin loan portfolio monitoring, so you can keep a close watch on your customers and get an earlier indication of challenges that may impact their ability to pay as agreed.
Four Factors That Can Help You Successfully Monitor Your Loan Portfolio
Consistent Cash Flow
Maintaining and generating consistent cash flow is key to every business I’ve helped run. This is because changes to cash flow ultimately reverberate throughout the business, causing a domino effect. Lenders, suppliers, employees, and owners are the key players who are impacted by any material changes to cash flow. Cash in the form of deposits into your bank are a leading indicator of the overall health of that business. Any change to deposit balances also provides you with an alert to investigate any potential issues brewing within a business. By monitoring deposits at scale, you’ll also be able to get an earlier indication on who may be facing trouble. From here, you can prioritize and reach out to businesses with reduced deposit activity so that you’re ahead of the curve.
Investigating Line Utilization
If you have multiple lines of credit in your portfolio, it’s time to look into it on a deeper scale. First, find out which customers are maintaining a high line utilization. From there, delve into why they are consistently tapped on their line. There could be many reasons for this – perhaps their supplier lines dried up, or they could have funded a hefty equipment purchase using their line. This isn’t an immediate cause for concern, as some reasons may be perfectly fine and just indicate that the business requires a larger line, or potentially a different tool like a term loan. The red flags to look out for? If suppliers are cutting them off. Suppliers are very sharp because they consistently deal with the same industry and see operators with varying degrees of operating prowess. This gives them greater knowledge about specific industries, and this is insight you may not necessarily have unless you’re a niche lender. However, this provides you an avenue to ask suppliers questions, get the answers you seek, and move forward appropriately. All you need to do is identify high utilization lines at scale and reach out to gain more information on why the utilization is particularly high.
Checking in On Credit Scores
For 11 years, I worked in niche lending, which consisted primarily of dentists but also included generally licensed professionals, like Certified Public Accountant (CPA) firms, funeral directors, veterinarians, and medical doctors, nationwide. These stakeholders primarily sought out long term Commercial and Industrial (C&I) and Commercial Real Estate (CRE) loans. In every instance, the credit score of the owner was the key indicator of how the loan would perform.
We completed global cash flow analysis and knew the collateral very well. More often than not, the global debt coverage was not enough if the owner’s score was low, and both would kill the deal. Changes to a score are indicative of changes to the practice’s financial performance. Less cash flow from the business causes payments to be late on both business and personal loans and lines of credit. Also, credit score degradation is more important than the absolute score. A score of 680 today gets the loan approved. A score of 680 today that was a score of 770 two quarters ago gets a call. One should also consider if the owner took out additional personal debt to cover the business cash flow shortfall.
Rescoring business loans can provide an early indication of risk and catch a loan before it goes bad. It does lag deposit monitoring but provides you with insight into how this business is handling its other creditors. If you don’t use a business score in your underwriting, that’s okay. You can still score your business portfolio and compare rescores to past scores, capturing relative changes and engaging where needed. Do take note though, that this only works at scale.
Frequency of Overdrafts
Frequency of overdrafts provides a significant indication that a business has issues with cash flow. They may have unexpected expenses or less revenue coming in. Either way, it’s best to reach out to them to find out more, before it impacts their ability to pay as agreed. It’s possible they may have been covering the expenses with another form of credit, like a card from another lender and that may have maxed out. Identifying accounts with frequent overdrafts may help you catch the business before it cannot make loan payment. This is too much be done at scale.
This essentially points to a financial institution’s ability to handle a high volume of accounts with little human intervention. Let’s say you have 10,000 business loan accounts and 15,000 business deposit accounts. Add a zero, it still applies. A person or team cannot monitor deposits, high-line utilization, rescores for personal and business and overdrafts for all accounts every night – but it’s simply not a scalable solution. In fact, it creates a reactive situation since they’re not relying on proactive portfolio management. It is common in situations like this to be running reports on past due loan accounts, collecting financial information, running cash flows, and checking loan covenants. This is simply because it’s all they can handle.
The workaround for this is by utilizing data that already exists to gain more knowledge into portfolios. You can do so by incorporating a rules engine that routinely reviews all your accounts nightly, or 260 times annually, and triggering an alert for the account where the rule is violated. A violation shows any form of behavior change where the account owner is concern, so you have an awareness on both past and present conduct.
If you are monitoring deposit accounts, you can create a rule to compare the account balance as it stands today to how it was 30 days ago. You could also set a trigger threshold, for example at 20%. Then, if for any reason the deposit balance falls lower by 20% than on the same day the previous month, trigger an alert. When viewed together, these alerts are even more powerful, as you’d be able to identify if the customer has lower deposits, high line utilization and an increase in overdrafts all at one go. Consider that three strikes and reach out to them with a call.
Once you’ve got the rules engine up and running and have a better perspective on how these triggers work together, you can quickly determine how to optimize the solution. In a different scenario, consider a situation where the deposit account has a much higher balance instead. You’d then look for accounts that have 30% more money than 30 days prior. That would be a cross sell trigger for a new product, like a Money Market Account or Certificate of Deposit.
Take the next step towards strategic portfolio monitoring
By considering proactive risk management in banking, you’ll be able to improve productivity and efficiency, while streamlining processes and lowering costs. Leveraging an integrated and modern solution gets you further as you’ll be able to strengthen loan monitoring by keeping a close eye on your accounts 260 days per year and determine which customers you need to speak to regarding their accounts. What’s even more encouraging is that it enables you to do so at scale, with a lean team. Get started now, let us support you through your loan portfolio management journey so you can leverage early indicators and automatic triggers to avoid any potential issues within portfolios.
If you want to learn more about loan monitoring strategies, email me and we can set up a call.
Posted on Thursday, August 11, 2022 at 9:45 AM
by David Catalano
For more than 20 years, David has worked at the senior executive level in both small private and large public companies. David has over a decade of experience in commercial lending across multiple industries and has significant experience building and growing conventional and commercial loan portfolios in the community banking space. David spent nine years as a senior executive driving business development and growth for a publicly-traded company. David has a Bachelor of Science degree in Finance from the Rochester Institute of Technology.