Page 6 The Banker’s Advocate
Hot Topic
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quality, earnings perform- ance and equity. There are various rea- sons to test loan portfo- lios for risk but one of the most common is to assess interest rate risk and the potential effects on the debt coverage ratios of customers. Some institu- tions perform this on a loan-by-loan basis as a pricing tool only. Other financial institu- tions go beyond the basic pricing structure and as- sess the potential effects of rate changes on indi- vidual credits as well the overall impact to their net interest margin and equity. Further impacts also are assessed, including to overall credit quality and the likelihood of provision expenses if loan quality deteriorates as a result of the debt coverage ratio falling below 1:1. These results are often used to determine if the assump- tions within a bank’s in- terest rate risk monitoring tools should be altered. This information may give some indication of poten- tial risk and future per- formance, and can help managers and directors set acceptable risk limits. Institutions experienc-
ing a decline in asset qual- ity from economic issues or a decline in a particular industry or sector, such as commercial real estate,
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kansas. But with that authority
comes an equal amount of responsibility. I believe it is imperative
that a bank and its regula- tor work together to en- sure the institution emerges from the eco- nomic downturn and into a sustained recovery fi- nancially sound.
Assume a bank with a
About the author Gary Bush is a Certified Examinations Manager at the Arkansas State Bank De- partment, where he supervises one of two groups of commercial examiners assigned to Little Rock. Bush has been at the Department for almost 18 years.
may exhibit elevated risk for exposure. In these cases, it would be prudent for management to per- form portfolio stress tests for changes in interest rates and collateral values. Testing portfolios for
specific industry concentra- tions that affect loan qual- ity, such as commodities, may also be necessary if price fluctuations could pose repayment risk or affect the value of the un- derlying collateral. Exam- ples of this would be loans related to agriculture or commodities such as oil and gas.
In cases where institu-
tions are heavily concen- trated in commercial real estate, the effect of chang- ing rates on debt coverage and valuation of the under- lying real estate collateral
should be assessed. A common way to perform this task would be to assess the potential decline in value if net operating in- come decreases because of rising rates, using current or increasing market cap rates.
Credit exposure may be
pronounced for institu- tions exhibiting high con- centrations of problem assets such as commercial real estate if debt coverage ratios are break-even in the current market and their cash flows do not improve as rates begin to rise. As a result, institutions may ex- perience some net interest margin compression and negative effects to income and equity if additional provisions are necessary to offset risk due to declining collateral values.
March 31, 2011
corporate culture that values strong asset quality, stable funding with tested alternative sources, and robust risk management across all functions and departments. For this bank, our job is
to not get in the financial institution’s way. Of course, as we have seen since 2007, things can go wrong in a bank. Risk management breaks down, sometimes on its own but often in tandem with a distressed econ- omy.
When this happens, our
job is to work with a bank to restore it to a sound condition. In cases like this, it’s important to de- velop a focused response commensurate with the extent of the problems. A regulatory response that is too excessive must be avoided. I am certain that Ala-
bama congressman Spencer Bachus, who is chairman of the House Financial Services Com- mittee, would agree. But
See VIEW, Page 7
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