November 2010

Lending is the principal business activity for most credit institutions. The loan portfolio is typically the largest asset and the predominate source of revenue. As such, it is one of the greatest sources of risk to an organisation’s safety and soundness.

The lifeblood of each lending institution is its loan portfolio and the success of the institution, depending on how well that portfolio is managed.

What is a loan portfolio?

A loan portfolio is the cash amount of loans outstanding at any time, that is, money that has been advanced but not yet repaid.

A loan portfolio does not include:

• Amounts already paid
• Loans approved but not disbursed
• Loans being processed
• Loans written off
• Loans fully repaid

What is portfolio management?

Portfolio management is the identification of measured risk exposures that are controlled in the context of defined risk tolerance. Other acceptable definitions include managing a portfolio of assets to achieve the best possible mix as distinct from managing individual assets within the portfolio, and lastly, some other definitions describe portfolio management as a tool to minimize aggregate risk problems while achieving or exceeding hurdle returns for risks the lender is willing to accept.

Systems influencing a Loan Portfolio:

It is important to distinguish among three systems that influence a financial institutions loan portfolio.

The accounting system and loan tracking management information system (MIS) produce information. The loan administration system consists of policies and procedures that govern loan operations.

These systems will now be explained.

1. Accounting system: Receives information about individual loan transactions, but its purpose is to generate aggregate information that feeds into financial statements.
   
   
2. Loan Tracking MIS: Is focused on information about individual loans, including:
   
   • Identity of the client;
   • Amount disbursed;
   • Loan terms, such as interest rate, fee, maturity, and so on;
   • Repayment schedule – amounts and timing;
   • Amount and timing of payments received;
   • Amount and ageing of delinquency;
   • Outstanding balance.
   
   Ideally the loan tracking MIS should contain this information not only for current loans, but for past loans as well. The main purpose of the loan tracking MIS is to provide information relevant to the administration of the portfolio, regardless of whether this information feeds into the financial statements.
   
   Some information captured by the loan tracking MIS are:>
   • Client identity;
   • Payment schedules;
   • Delinquency information;
   • Disbursements;
   • Payments;
   • Accrued interest.
3. The Loan Administration System: The Loan Administration System, like Compuscan’s Proloan system, is not an information system, but rather the policies, procedures, written or unwritten, that govern the financial institution’s loan operations and this includes:
   • Loan marketing;
   • Client and loan evaluation;
   • Loan size and terms;
   • Loan approval;
   • Handling of disbursements and payments by loan officers and cashiers;
   • Recording of disbursements and payments in the “back room”;
   • Client supervision;
   • Collection policies for delinquent loans;
   • Rescheduling of delinquent loans;
   • Internal controls.

The Steps in Portfolio Management

The first step of loan portfolio management is to analyse the loan portfolio. To do this, you need to review the portfolio report and use ratios to measure quality and collection rates of the portfolio.

The second step is to identify loans at risk. Risk is associated with delinquency, arrears and default. If you have analysed the portfolio correctly, you should be able to see where loan (and even whole portfolios) are at risk.

Having identified portfolios at risk, the third step is to take action to fix loans at risk. There is no point in analysing a portfolio, and identifying the loans at risk, if you have no intention of doing something about them.

Factors impacting Loan Portfolio Management

A financial institution must have systems and processes in place that result in adequate planning, directing and controlling of lending operations. These systems and processes comprise loan portfolio management and are discussed in this section.

• Sound strategic planning is a critical component of loan portfolio management and provides the framework from which management direct and control lending operations.
• Strategic planning is important because it defines the goals and objectives of the loan portfolio and gives management the opportunity to anticipate conditions in the institution’s operating environment and react accordingly.

• Mission statements should provide some insight as to the type of credit “provider” the institution intends to be.
• Mission statements should also provide some insight into the board’s philosophy on generating profits from lending operations. Due to the broad and fundamental nature of mission statements, examiners need to review lending goals and objectives in the business plan and lending policies to gain further perspective into the company’s credit philosophy and approach to conducting lending operations.

• This analysis should specifically consider the factors that may impact the institutions loan portfolio.
• An analysis should be completed in order to identify the risks in the loan portfolio, the threats to the loan portfolio, and the opportunities that the institution may want to consider for enhanced profitability or growth.
• Once these are identified, the analysis should determine the impact of those factors on the loan portfolio so that appropriate goals, objectives, and strategies can be established.

• Once the institution’s analysis of its operating environment is complete, goals and objectives for the loan portfolio should be established.
• Management should also establish strategies that are designed to accomplish their loan portfolio goals and objectives and to proactively position the loan portfolio to manage threats and maximise opportunities.

• Goals and objectives should be directed at the desired level of credit risk in the portfolio.
• This level of risk should be determined through the institution’s review of internal and external factors, with particular emphasis on the institution’s capital adequacy, profitability, and overall risk-bearing capacity.
• Strategies that can be employed to achieve goals and objectives in this area include:
  • Modifying loan underwriting standards to allow more or less risk or to require compensating strengths when certain credit factor weaknesses exist;
  • Establishing credit administration standards, i.e., use of loan servicing plans and loan covenants;
  • Modifying terms of credit extended, such as loan amortisation requirements;
  • Adjusting interest rates based on loan characteristics;
  • And modifying capital and risk funds positions.

• Goals and objectives should focus on the desired portfolio mix and level of diversification to limit concentrations of credit relative to the institution’s permanent capital or risk funds.
• Commodity or product concentrations within a loan portfolio exist when a group of similar borrowers have the same sources of repayment, collateral, economic, or geographic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions.
  
  

• Management should establish goals and objectives that address the desired profitability of the loan portfolio.
• These goals and objectives should be based on the level of risk in the loan portfolio, costs of operations, capital needs, and competitive position of the institution.
• Strategies that can be employed to achieve goals and objectives in this area include modifying loan pricing policies and procedures, identifying and monitoring profitability on a loan-by-loan and portfolio sector basis, or adjusting the interest rate spread or method of interest collection on loans.

• Goals and objectives that address growth and market share are necessary for institutions to survive in the constantly changing and competitive financial services industry.
• The opportunities for growth or increased market share should be identified through the institution’s review of internal and external factors.
• The external review should include an analysis of key demographic data and trends to determine the existing and potential markets.
• Also, changes in legislation, regulations, technology, interest rates, and competition should be closely monitored as they often create opportunities for growth or market share.
• Strengths within the institution, such as experience and tenure of opportunities for taking on additional growth or solidifying market share.

• Lending policies and procedures are key elements of loan portfolio management.
• Lending policies and procedures provide valuable direction and control over lending operations and should exist for each lending program authorised by the management of the organisation.
• Also, policies and procedures should specifically address the institution’s analysis and documentation of loans and loan servicing requirements.

10. Risk Parameters

• Risk parameters communicate to management what the board considers an acceptable range of risk exposure.
• The establishment of risk parameters should be a dynamic process that flows out of the business planning effort and the review of internal and external factors affecting the institution.
• Therefore, the establishment of risk parameters should be tailored to the unique lending environment of each institution.

11. Risk Identification

• Properly identifying risk in the loan portfolio is critical to the overall effectiveness of loan portfolio management.
• The examination of an institution’s risk identification process should primarily focus on management’s ability to identify aggregate risks in the loan portfolio. Aggregate risks that should be identified include:
  
  
  • Criticised and adversely classified assets;
  • Past due loans;
  • Non accrual loans;
  • Restructured loans;
  • Other property owned;
  • Concentrations of credit;
  • Dependence upon a single or a few customers;
  • Loans that do not comply with underwriting criteria;
  • Lack of borrowers’ current and complete financial data;
  • Other credit administration deficiencies; and
  • Loans with common credit factor weaknesses.
  • Learning Activity

Compuscan Academy has developed a learning programme, called ‘Managing Loan Portfolios’, on this subject. Please click here to view the course brochure. If you want to learn more about this topic, please contact Compuscan Academy at Tel: 021 888 6000 or e-mail us at This e-mail address is being protected from spambots. You need JavaScript enabled to view it