When it comes to underwriting, it is not so much the risk that causes banks concern, but the volatility around the risk that is the problem. The major industry with the highest probability of default for banks is trucking at a 4.7% annual probability of default, but if you price and reserve for 1.4% of the loan, you have mitigated that risk. That is, lending to a trucking company is no more risky as lending to a pig farmer, which incidentally has the lowest probability of default as of June of 2017 at 0.95% and would require pricing and a reserve of about 0.29%. Once mitigated, the static credit risk is nearly identical.
It is the Volatility of Risk That Hurts
As we have written about before, to be a successful lender you not only have to understand the current credit risk of a company or a tenant but the volatility around that credit risk. It is the change in credit risk over time that causes banks to under or over reserve and loses efficiency when matching capital with risk. We detailed the top and the bottom ten industries that are the most volatile HERE, but today we look at which industries were the most volatile during the first part of 2017.
These industries are detailed below and culled from Paynet data, which we use to help drive our credit model where we lack data of our own. Below are popular community bank industries ranked by the greatest absolute change from year end 2016. We have presented the ten most improved industries for the year to date and the industries where credit deteriorated the most. For example, dairy farm credit improved their probability of default by 45 basis points, a 24% improvement during the first part of 2017. Conversely, Specialty Hospitals increased their probability of default by 69 basis points, over a 21% change.
Putting This into Action
Any change represents a risk. While banks have largely been concerned with their credit downside, we point out that an improvement is also a form of risk. Having capital tied up in reserves takes that capital away from being leveraged and being used in other areas of the bank. A bank with large reserves but low relative credit risk is likely a bank that is safe, but a bank that is underperforming. This underperformance can create an equal or greater risk to the bank as being under-reserved.
To optimize lending, banks need to correctly ascertain the credit risk of any given credit AND then reassess that risk on an ongoing basis in order to make adjustments. Industries and credits that tend to be more volatile may get more frequent reviews and/or might have more resources directed at it for monitoring.
By our estimation, the average community bank is approximately 20% over-reserved in good times and about 40% under-reserved in times of credit stress. That is a large swing of capital that can impact the bottom line directly. By knowing both the probability of default and the volatility around that probability of default, banks can materially increase performance.
Submitted by Chris Nichols on June 26, 2017