September 28, 2015

Monitoring the Balance Sheet: Key to Banking Profitability

Constantly monitoring the balance sheet is important for banks to minimize risk and boost profits.

When it comes to becoming profitable and staying that way, banks absolutely need to consistently monitor their balance sheets. And a key component to balance sheets is a healthy proportion of loan portfolios.

Asset quality is a critical factor in determining a bank's overall financial strength, considering the fact that the majority of bank failures are a direct result of a degradation in the loan portfolio. And while loan losses initially have an impact on asset quality, they can quickly affect other components, including earnings, capital, and liquidity.

For this reason, it's imperative that banks take the necessary steps to effectively manage risk associated with their loans, even when prudent loan underwriting standards are adhered to. Portfolio segmentation and consistent monitoring of the balance sheet are important in managing credit portfolios. Allowing too much exposure to one specific sector can have a significant impact on risk.

For the majority of banks, loans are the biggest source of credit risk. Yet there are other sources of credit risk both on and off the balance sheet, including the investment portfolio, letters of credit, derivatives, and foreign exchange.

Part of the financial crisis in 2008 was caused by a breakdown in underwriting standards in the country, which encouraged a deeper concentration in higher-risk assets. Banks that didn't take the necessary measures to ensure solid underwriting standards ended up suffering grave losses as a result.

The risk of repayment is either increased or decreased by a bank's credit risk management efforts. A bank's first line of defense against significant credit risk is sound underwriting standards, and a balanced approval process. And management of credit risk must continue long after a loan has been made in order to avoid quality credit decisions being crippled by imprudent loan structuring or incompetent monitoring.

Diversified Loan Portfolios - Key to Growth

Portfolio concentrations in high-risk securities can easily and quickly result in large credit losses for banks, which can negatively affected earnings, capital, and liquidity. If there was one take-home lesson from the recent financial crisis, it's that having a diversified loan portfolio is critical to a competent growth strategy. And growth is vital for financial institutions to adequately meet their clients' financial needs.

Wells Fargo has seen a rise in earnings largely as a result of its loan growth.

Determining which loans make a good fit in a portfolio and which ones should be eliminated requires a constant monitoring of the balance sheet. This is key in maintaining profitable proportions within the loan portfolio, and in fueling growth. And plenty of banks have proved this effort to be successful.

Loan Growth Fuels Earnings

Mississippi-based BancorpSouth recorded higher second-quarter profits thanks to a boost in loan volume and a drop in sour loans. The bank's income increased by 29 percent since the same time in 2014, and by 41 cents per share.

Loans with BancorpSouth increased 7.5 percent to $10 billion, with loan and lease yields declining to 4.23 percent. Thanks to higher mortgage lending and insurance commissions, non-interest income increased 6.4 percent to $74.3 million.

San Francisco-based Wells Fargo ended the first quarter with a 4 percent jump in loans, up $34.8 billion since last year. Core loans increased 7 percent, commercial and industrial loans jumped 13 percent, and auto loans grew 7 percent year-over-year.

JP Morgan reported loan growth of 5 percent and a core loan growth of 10 percent in its first-quarter results. It's second-quarter profit increased 5.2 percent, beating expectations.

Importance of Understanding the Management of Loan Portfolios and Balance Sheets

Effective management of the balance sheet and the loan portfolio requires a high level of understanding and control of the bank's risk profile and credit culture. As such, thorough knowledge of the composition of the loan portfolio and its innate risks is paramount. An understanding of the processes and practices carried out to control the risks of loans and ensure portfolio sections are sound is also of great importance.

At Garnet Capital, our team is well-versed in determining what proportion of balance sheets loan portfolios should comprise, along with portfolio diversification, loan product mix, and loan growth targets. We are consistently keeping tabs on the market to effectively help banks sell the loans that are not profitable, and purchase the loans that are.

We invite you to sign up for our newsletter to find out more about how we can help your bank maintain a balance sheet that minimizes risk while maximizing profits.