By S. Scott MacDonald, Southwestern Graduate School of Banking

Today, enterprise risk management is all the rage. Although the corporate world gives it constant lip service, I’ve discovered that its true meaning and value to an organization isn’t well understood. Since the banking industry assumes other parties’ risk, an understanding of this “portfolio approach” to risk management is even more critical for the financial services industry.

So, what is an enterprise approach to risk management? Simply put, it’s taking a portfolio view of risk. When we make a loan, we assume default risk, liquidity risk, maturity risk, interest rate risk, payment risk, operational risk, compliance risk and a whole host of other types of risk. The types of loans we make as well as our loan cultures determine the significance of these risks.

We tend to focus on default risk. But, a quick look at recent trends shows that the industry’s total portfolio risk has changed over the past 15 years. For example, for banks with less than $1 billion in assets, loan-to-deposit ratios have increased from 66 percent in 1992, to 83 percent in 2005 (large banks have experienced similar growth). While our loan portfolios have grown, our concentration of loans in real estate has increased from about 30 percent to almost 50 percent of total loans. More importantly, construction and development loans have grown the fastest. While our loan portfolios have grown and become more concentrated in real estate, we’ve financed this growth with a larger proportion of borrowed funds. As retail deposits have become more difficult to obtain, total deposits have fallen over this same time period, from 77 percent to about 66 percent of total assets, while borrowed funds (FHLB, brokered deposits, subordinated debt, etc.) have increased from 11.6 percent to about 16 percent of total assets. Over this same period we’ve seen an increased regulatory burden from consumer compliance to anti-money laundering. For many, total portfolio risk likely has increased.

As bankers, we know our greatest single risk is credit or default risk. Since lending is our specialty, it’s also the risk we’re most comfortable with and likely to manage best. Since we’re most comfortable with credit risk, we’re sometimes guilty of taking additional risk in this area. Taking additional risk in an area we’re comfortable with isn’t by itself bad. After all, we’re in the business of assuming risk. How well we excel in this business is determined by which risks we assume and how well we manage these risks.  

The enterprise risk management question we must ask ourselves is: Has our total portfolio risk increased as we’ve grown our loan portfolios, with additional concentrations in real estate (in particular construction and development), while financing this growth with fewer core deposits and more borrowed funds? Some say, well, our bank hasn’t really done this.  But remember, since this trend is true for the industry, it does affect you! So, what’s happened to our bank’s as well as the industries total risk picture?

Next time we’ll take a closer look at the process of establishing a risk management system for a community bank.

<back to March 2006 Directors Digest>