In the banking and alternative small business lending industries, getting new loans closed and on the books is the first step to growing a profitable loan portfolio. Unfortunately, not enough lenders realize that the loan portfolio management process is equally important. Portfolio monitoring occurs after the loan documents have been tucked away and the borrowers have resumed their businesses as usual. Effective portfolio monitoring gives lenders valuable insight into which loans are performing well and which loans are hindering profitability. Continue reading to learn more about how and why portfolio monitoring is becoming the new standard for banks.
What is portfolio monitoring and why it is important in banking?
Portfolio monitoring is an ongoing evaluation of a financial institution’s loan portfolio. The process analyzes several financial and performance metrics for their loans, identifying risks and opportunities for the lender. The types of data being reviewed and used to monitor portfolios include the borrowers’ creditworthiness and any changes in financial data since the loan origination period. Proper portfolio monitoring is important in banking because it reduces portfolio risk, promotes regulatory compliance, and minimizes losses.
Credit monitoring works hand in hand with a bank’s underwriting process. When a new loan application is reviewed, the borrower’s credit risk is measured by evaluating the following:
- Articles of incorporation
- Individual borrowers’ credit scores
- Business credit history
- Business financial statements
- Business assets, in terms of liquidity
- Business banking activity
- Debt-to-income (DTI) ratios
During the credit assessment process, the lender focuses on the borrower’s ability to pay back the funds according to the repayment schedule. When borrowers are less likely to meet the terms of the loan, they are considered higher risk and may be denied for a loan with that financial institution or be forced to consider higher interest rates or securing the loan with collateral, like real estate. If the underwriting process determines the borrower has an acceptable risk rating, the loan offer is extended to the applicant.
The bank, or commercial lending institution then assumes the borrower’s credit profile will remain satisfactory throughout the life of the loan. Typically, covenants are included in the loan agreement which provides borrowers with a set of minimum financial performance standards and guidance on future conduct. However, without a robust loan portfolio management process, lenders are not always aware that borrowers are no longer meeting performance standards.
One of the primary responsibilities of the loan officer is to protect the bank’s investment. Portfolio monitoring makes that possible. Regular loan reviews give lenders access to real-time feedback about each loan and how it impacts their overall portfolio performance while there is still time to take corrective action. Whether navigating rising interest rates or working with a borrower experiencing a financial crisis, real-time risk management lets lenders step in and make informed decisions.
Identifying and assessing risks
Identifying and assessing risks is an important part of underwriting business loans and maintaining a well-performing loan portfolio. More and more lenders are turning to advanced risk analytics, like those offered by Biz2X, to accurately measure the long-term potential of a credit decision. Risk Analytics initiatives give portfolio managers the confidence and transparency they need to quickly identify risk patterns and calculate metrics. With automated risk analysis, banks can access cash flow forecasting and analysis tools that help them optimize their portfolios from a single dashboard.
Mitigating and managing risks
When risks are identified in an efficient manner, lenders can take corrective actions sooner. Understanding the financial metrics surrounding a specific loan agreement, interest rate fluctuation, or a borrower’s declining revenues can give loan officers an opportunity to quickly consider a mitigating action like repricing or recalling the loan.
- Repricing – One way banks and lenders can minimize financial losses in their loan portfolios is through repricing. Repricing means increasing the interest rate on a loan after the initial repayment terms have been distributed. If risk analysis methods identify a certain loan as higher risk, repricing is a way the financial institution can increase its current revenue on the loan to minimize the potential future loss in the event of the borrower’s default.
- Recalling – If risk measurement tools have identified a loan where delinquency is likely to harm the performance of the portfolio, the lender may choose to recall the loan. When a loan is recalled, the issuing financial institution notifies the borrower that they are demanding full repayment of any outstanding principal, interest, and fees. Typically, borrowers are given 30 days after being notified to repay the loan in full. Allowance of recalls is usually tied to periodic financial reviews and is addressed in the loan origination documents.
Evaluating portfolio performance
As we’ve already explained, commercial loan agreements typically include several borrower requirements. The listed covenants may include reporting requirements that require the borrower to submit bank statements, income statements, balance sheets, or other financial statements to the lender on a quarterly and/or annual basis. There may be specific financial metrics required for the borrower to be eligible for reduced financing costs. In the case of metrics, like the Debt Service Coverage Ratio (DSCR), the loan documents typically state that the borrower is responsible for monitoring their financial metrics and submitting calculations and supporting documents to the bank. Depending on the size of a lender’s loan portfolio, tracking these covenants manually is not ideal, which is why digital underwriting and portfolio management automation become useful.
While business loans are not subject to the same federal consumer protection laws as home mortgages and personal loans, banks must comply with requests from both state and Federal regulators. Since risk management processes, reserve account maintenance, and underwriting standards are most frequently scrutinized, loan portfolio monitoring aids lenders in meeting reporting requirements, quantifying risks, supporting due diligence requests, and calculating capital.
Meeting regulatory requirements
Federally insured financial institutions must comply with the lending policies set and enforced by the FDIC’s Federal Deposit Insurance Act. Section 39 of the Act instructs each federal banking agency to establish safety and soundness standards for depository institutions. The FDIC examines lenders’ policies based on their credit extension policies and the overall quality of the loan portfolio. During an FDIC evaluation, a loan portfolio will be examined using individual loan appraisals. The lender will also have to provide the FDIC with guidelines surrounding the following commercial lending policies:
- Type of loans the institution issues
- Lending authorities of loan officers
- Involvement of a Board of Directors in loan approvals
- Interest rates
- Procedures for gathering and storing customer credit information
- Maximum loan volume
- Portfolio mix and diversification efforts
Adhering to industry standards
There is a lot of competition in the business lending industry. However, banks, credit unions, and alternative lenders must balance their profit margins with industry standards. As other commercial lenders adopt new underwriting and portfolio management standards, it is important to understand how the direction of the industry standards will affect your portfolio performance. For example, many commercial lending institutions have needed to adopt IT standards to minimize the risk of cyber-security threats. Other lenders have adopted the industry standard of delivering instant decisions on credit applications.
Avoiding penalties and fines
The FDIC has the authority to penalize any individual or financial institution through the Financial Institutions Regulatory and Interest Rate Control Act of 1978 (FIRIRCA). Through the FDIC, civil money penalties can be assessed for any violation of a law or regulation including unauthorized changes in the control of the bank, nondisclosed financing costs, and violations of cease-and-assist orders.
Effective portfolio monitoring minimizes financial losses. Monitoring loans throughout the entire loan term identifies loans, through stress testing, that have a high probability of defaulting in the current year, generating a financial loss for the lender.
Maximizing return on investment
Bankers and lenders compile loan portfolios for the profit of making more money for the financial institutions. The return on investment (ROI) of each loan shows debt issuers how much profit or loss each lending decision yielded. By analyzing the ROI of current debt arrangements in the portfolio, lenders can increase future ROI by repeating lending decisions that yielded the highest returns.
Identifying opportunities for growth
Regularly evaluating a loan portfolio allows loan officers and banks to isolate patterns of profitability. By understanding the predicted movement of interest rates and loan volumes on their portfolio, they can begin to adopt loan screening processes to optimize the overall performance of the portfolio. The best way to identify these patterns is by consistently measuring and recording rate activity and current loan performance metrics.
While some losses are unavoidable in the business lending process, the loan loss rate of a financial institution can impact relationships with potential investment partners and shareholders if there are too many unexpected contribution requests. Using automated loan portfolio management allows lenders to mitigate risks and minimize losses before they impact the portfolio. Depending on the identified risks, banks can minimize losses by increasing high-earning, short-term loans or reducing the number of high-risk debts through practices like repricing or recalling.
Superior loan portfolio management has many benefits for the lenders, but one key advantage that is often overlooked is customer satisfaction. Having the right tools at your disposal allows you to offer small business customers a faster, simpler lending process.
Ensuring customer satisfaction
Borrowers turn to banks to secure capital for a variety of business needs, but they all share a common interest of finding the most affordable financing option for their business. Lenders that use an automated underwriting process can deliver faster decisions and more predictable eligibility requirements with increases customer satisfaction.
Identifying customer needs and preferences
Most commercial lending customers have unique needs when it comes to repayment schedules and loan terms. Automated portfolio management tools let lenders diversify their portfolios to include several different types of business loans and even lines of credit. Digital underwriting can identify trends in customer preferences which creates an opportunity for lenders to customize future loan offers, extending the relationship with borrowers.
Improving product and service offerings
Along with extending borrower relationships, lenders can also increase their service offerings when they rely on software for portfolio management. Analyzing the current strengths and weaknesses of the loan portfolio gives loan officers insight into which types of loan programs and credit risks can fit into the portfolio to improve, or stabilize, performance.
Loan portfolio management systems give lenders insight into the overall performance of their portfolios on an ongoing basis. While most lenders implement a thorough underwriting and approval process, portfolio monitoring gives real-time financial data that can be used to protect the bank’s investment, reduce risks, maximize profits, and improve customer relations. More and more banks are relying on automated software, like Biz2X Lending Software, to manage loan portfolios because it provides a cost-effective way to maximize profits while adhering to industry standards.