April 2010

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Asset Allocation: Striking a New Balance between Risk and Reward

By Annetta Cortez

As banks move beyond the worst of the recent U.S. financial crisis, management teams are turning more attention to the question of loan growth. And, true to form, most are largely equipping their dashboards with goals and measurements pertaining to individual lending categories, everything from commercial realty to retail credit cards.

The problem, however, is that critical risk diversification issues can be overlooked in the drive to max out each discrete line of business. Too little consideration is given to the sympathetic risk exposure of various lending categories.

In such circumstances, there is a heightened risk that poorly diversified banks will undercut their own progress. While setting what they consider to be appropriate allocations of effort and capital, they can be inadvertently compromising overall portfolio risk/return characteristics. And this type of flaw typically worsens over the lending cycle as fast-growing asset categories overtake the portfolio mix.

Coming out of the biggest financial crisis since the Great Depression, banks have every reason to consider new frameworks for asset allocation, a critical exercise in shaping the market outreach and overall asset posture. Indeed, the weaknesses of conventional tools and approaches were clearly exposed during the crisis:

• In many cases, budgets and loan growth objectives were set without examining the overall portfolio implications. Institutions often under-priced for risk, which had the effect of exaggerating growth in higher-risk loan categories and among less creditworthy borrowers.
• Risk models were based on a limited range of recent results achieved in a period of strong economic growth, without appropriately reflecting the implications of prior or potential future down periods — contributing to a false sense of security.
• Potential high-stress market scenarios were rarely considered, and even when they were, institutions typically did not consider how risk correlations can morph in a crisis (i.e., the risk covariance between home equity and credit card lending leaps from, say, 40% in steady-state conditions to 80% in a market collapse).