"Concentration" is usually a bad word in lending circles, and something that regulators warn against regularly, but maybe an attitude adjustment is in order.
That's the view of researchers at the Massachusetts Institute of Technology and the University of Chicago, who in a recent paper found that banks did a good job of diversifying their commercial loan portfolios over a 10-year period.
The researchers also raised concerns that the audit and data-gathering requirements imposed on banks that lend heavily to certain sectors or types of borrowers are sometimes too costly and discourage banks from making more loans. Experience in certain types of credits and the instincts that come with specialization need to be rewarded, and some reporting requirements should be selectively eased, one of the authors said.
"We are not trying to say that concentration is not a problem," said Andrew Sutherland, an assistant professor from MIT Sloan School of Management, who co-wrote the paper with Philip G. Berger and Michael Minnis at the University of Chicago Booth School of Business. "We are just saying that concentration can give a bank expertise. And when [lenders] have that expertise, they don't need hard information, they don't need audits as much."
Could the idea take root in a suddenly more deregulatory-minded Washington? Outside experts interviewed for this story raised some red flags on safety-and-soundness grounds, and they predicted banking reform efforts will be focused more on consumer lending initially.
Still, the notion is provocative, and it may have as good of a chance as ever of finding an audience given the Republican sweep of the White House and both houses of Congress, pressure to stimulate lending, and fading memories of the financial meltdown.
The Findings
Regulators naturally sought to tighten credit-quality guidelines after the 2008 meltdown because so many lenders were heavily exposed to inflated real estate markets. The more recent energy crisis was a fresh reminder about how big banks and community banks near the Gulf Coast were vulnerable to the collapse in oil prices that hurt drillers and other energy firms.
Examiners expect banks to demonstrate that they are collecting more information from their larger commercial and industrial exposures to offset concentration risk, the paper said. The conventional wisdom is that the more hard information such as audited financial statements that lenders have about the financial health of business borrowers, the less likely they are to suffer widespread loan losses.
However, in studying 728 banks, including the 10 largest C&I lenders, the researchers found that from 2002-2011 the banks collectively did business with with more industries in more regions and their portfolios, as measured with the Hirschman-Herfindahl index, grew more diverse. (See related chart)
Moreover, banks collected audited statements less often from borrowers in regional industries in which they had more concentration. And there was no evidence that chargeoffs rose or returns dropped as a result.
"Banks with more exposure to a sector have more interactions with borrowers and are thus more informed," the paper says. Banks with expertise in specific loan areas have substitute sources of information, such as relationships and knowledge about an industry, and don't need to order up as many formal audits and other reports from borrowers as they are required to do.
"If a bank has had a large concentration for many, many years, [it is] least likely to need the audit," Sutherland said. "Whereas a bank that is brand new to a concentration, [that] first enters a new sector and has a very large exposure to that sector, that's where we would say that the audit should be collected."
Though banks may be willing to make a loan based on their expertise in a certain sector, audit requirements may stop them from doing business with "opaque" firms that are reluctant to supply the kind of information that bankers feel their examines want.
"Banks want to use their expertise," Sutherland said. He added that that level of information can be very costly for lenders to collect and borrowers to supply. That reality drives some small businesses to seek credit from nonbanks that are not required to ask for as much information.
Sutherland argued that bank regulators should consider the amount of experience that a bank has when conducting examinations. The banks that have the most experience and use better techniques to monitor and minimize concentration risks should be allowed to use alternative sources of information to reduce their need to collect audits from firms, he said.
The Pushback
There are plenty of skeptics.
Ted Peters, a former banker who is chairman of Bluestone Financial Institutions Group, which invests in public companies and regional banks, doubts the arguments. Regulators have good reason to impose tough requirements to protect the financial system against reckless actors, he said.
"To really watch concentrations, and to not allow banks to have too much concentration, is a good thing," said Peters, who has owned three banks during his 38-year career. "The bank environment is littered with banks over the last 30, 40 or 50 years who've gone out of businesses because they concentrated in one area and that area blew up."
Expert lenders "may require a little less specific or less detailed" data, but they still need to collect extensive information, he said.
The Trump administration and lawmakers would be better served to focus on easing burdens in consumer lending so banks can compete with payday and other controversial nonbanks, Peters said. "They really need to ease up on banks on all the data and all the information we have to keep in the consumer area," he said.
Ethan Heisler, who worked in supervision at the Federal Reserve Bank of New York and was a banker at Citigroup for 22 years, buys the research paper's argument up to a point.
"I do agree that if a bank has expertise, the examiner doesn't need to insist on the 'check the box' financial statements," Heisler said. Yet he said he think most examiners already grant that leeway and that reform efforts would be better spent on consumer lending.
Rohit Arora, CEO and co-founder of Biz2Credit, a U.S. leading online loan marketplace, said he is neutral about the arguments that portfolio concentrations could give expert banks the excuse to rely on their soft information to make credit decisions.
"The best lending portfolios are those where you have some concentration because concentration also means that you built specialization and built expertise," he said. "Typically, as a lender if you are concentrated in not more than four or five sectors, you will do very well."
Yet use of "too much soft data in any of the sectors … can lead to more bad loans," Arora said.
Arora favors some easing of examination burdens. He would prefer that more flexible guidelines replace hard rules that in some instances cannot keep up with changing times. "The problem with a lot of regulations is that a lot of them are backward-looking," Arora said. "They are not very good at predicting what will happen during the next crisis."
Bert Ely, an adjunct scholar at the Cato Institute and a banking consultant, said that giving banks too much freedom in deciding which financial information to collect from borrowers has proven dangerous.
"A lot of banks failed because they did not do a good job in lending," Ely said in discussing the aftermath of the financial crisis. "Quite frankly, in a lot of the cases they made lousy lending decisions in part because they didn't get enough of the right kind of data and didn't look critically enough at the information they were supplied."
