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June 2024

Balance Sheet Concentrations — Inevitable or Avoidable?
by Andrew Giltner, Lead Examiner, Supervision and Regulation, Federal Reserve Bank of Chicago*

What immediately comes to mind when you hear the word concentration? Most people probably associate it with increased mental exertion or intense focus on a particular thought or object, but for bankers and regulators, the term likely emits an immediate association with the concentrations present within financial statements, such as a bank’s balance sheet. Regulators have always emphasized the importance of identifying, measuring, monitoring, and controlling concentrations; however, since the Great Recession (2007–2009), there has been a renewed focus by bankers and regulators alike on balance sheet concentrations, particularly for banks with significant exposure to commercial real estate (CRE). The lessons learned from the Great Recession continue to resonate with bankers and regulators and have shaped the way that standards concerning prudent CRE concentration risk management practices have been elevated.

The importance of appropriately identifying and managing funding concentrations has also escalated because of the role that concentrations of uninsured deposits played in the lead-up to the failures of Silicon Valley Bank, First Republic Bank, and Signature Bank in 2023. In addition to managing asset concentrations, ensuring that deposit concentrations are appropriately identified, monitored, and controlled and that liquidity risk management practices are commensurate with the inherent level of a bank’s liquidity risk profile have become top priorities for regulators. This article discusses some of the most prevalent balance sheet concentrations held by community banks, highlights the corresponding risks inherent in each type of concentration, and reiterates the current guidance and supervisory expectations for prudent concentration risk management practices.

Common Asset Concentrations

Many community banks typically have lending concentrations¹ based on the types of businesses and industries prevalent in the communities and markets they serve. Therefore, certain loan concentrations may be inevitable purely based on loan demand driven by the location of a bank and the inherent dynamics of its geographic footprint. Banks located in heavily populated or urban areas may experience more loan demand for commercial purposes, such as funds to support the operations of local companies or for the purchase of CRE, whether as an owner-occupied enterprise or for investment and leasing purposes. Banks located in more rural areas may have exposure to the agricultural industry, and the financing needs of farmers and producers can represent the largest type of loan demand present in their markets. By and large, loan concentrations held by community banks are driven by the dominant forms of commerce in their marketplace, and purchasing loan participations of similar types can compound a concentration. Conversely, purchasing different types of loan participations could alleviate a concentration and diversify a portfolio; however, bankers should ensure they possess the commensurate knowledge and expertise for all types of purchased loans to fully understand the credit risk associated with them. The residual risk associated with an asset concentration can vary significantly from bank to bank because of factors such as a bank’s asset quality and the level of capital, earnings, and liquidity relative to the concentration, as well as the adequacy of the bank’s risk management framework.

Commercial Real Estate

The heightened attention that regulators give to banks with CRE concentrations is warranted because CRE loans can experience volatile performance during periods of economic stress and the underlying property values may decline. Therefore, such concentrations can dramatically impact a bank’s financial condition when the credit quality of CRE loans deteriorates and losses ensue. Assessing CRE concentrations remains a top supervisory priority because of the prominent role that the CRE downturn played during the Great Recession.

Before the Great Recession, there were 7,196 community banks² in total in the country as of December 31, 2007; for 64.6 percent (or 4,651) of those banks, CRE loans represented 25 percent or more of total loans.³ Of those CRE-concentrated community banks, 55.2 percent had CRE levels equal to or exceeding 300 percent of total capital. As of June 30, 2023, there were 3,963 community banks in total across the country; for 67.3 percent (or 2,668) of those banks, CRE loans represented 25 percent or more of total loans. A modestly smaller subset of 42.7 percent of those CRE-concentrated banks had CRE levels equal to or exceeding 300 percent of total capital (Figure 1). This comparative analysis reveals that, although the proportion of community banks with CRE concentrations relative to total loans has increased, community banks are now maintaining higher levels of capital on average to better mitigate the higher inherent risk associated with CRE loans. This is a positive sign that more bankers are making a strategic decision to hold higher levels of capital against their CRE concentration in the event of deterioration within this segment and to protect their banks against potential future losses.

In addition to ensuring a sufficient capital buffer is in place, supervisors also consider several other factors when evaluating a bank with a CRE concentration. Supervision and Regulation (SR) letter 07-1, “Interagency Guidance on Concentrations in Commercial Real Estate,”⁴ is a valuable resource that outlines strong risk management practices that are paramount to effectively mitigating risk associated with having a CRE loan concentration. Specifically, effective board and management oversight, portfolio-wide management, management information systems, market analysis, credit underwriting standards, and portfolio stress testing and sensitivity analysis, as well as an effective credit risk review function, are sound elements of a comprehensive CRE risk management framework. The principles outlined in this guidance are evaluated by examiners when assessing the appropriateness and effectiveness of a bank's risk framework over a CRE concentration. The Community Banking Connections article “Managing Risks of Commercial Real Estate Concentrations” provides more details about the inherent risks and supervisory expectations regarding CRE concentrations.⁵

Agriculture

Community banks have a rich history of supporting farmers and landowners, and the performance of a bank’s local agricultural economy can directly influence other local businesses, employment conditions, and the overall health and prosperity of communities with strong ties to agriculture. Compared with regional and large banks, community banks hold roughly $140.6 billion in agricultural loans, or approximately 76 percent of the total outstanding agricultural loans financed by all commercial banks nationwide as of June 2023 (Figure 2).

Agricultural loans can be broadly separated into two major categories: (1) loans to finance farmland and (2) loans to finance agricultural production and operating expenses generally secured by farm chattel. Each type of lending activity has its own unique risk factors to consider; however, the dominant risks impacting the performance of both agricultural loan segments include commodity prices, production input costs, and farmland values. SR letter 11-14, “Supervisory Expectations for Risk Management of Agricultural Credit Risk,” ⁶ reiterates the key risk factors influencing agricultural credits and details strong risk management practices that can mitigate the credit risks associated with an agricultural loan concentration. The main principles of this guidance highlight the importance of monitoring market factors that impact the performance of agricultural borrowers and the importance of prudent underwriting, administration, and monitoring of agricultural loan customers. The Community Banking Connections article “Agricultural Lending Concentrations: Lending Well in Challenging Times” emphasizes several key risk management practices for bankers to consider and actions to mitigate the risks associated with an agricultural concentration.⁷

The proportion of community banks with agricultural concentrations is lower than that of those with CRE concentrations. Nonetheless, holding prudent levels of capital against an agricultural concentration is critical to ensure that a sufficient buffer is in place to absorb potential unforeseen losses. It is an encouraging sign that community banks with agricultural concentrations are holding more capital today relative to their concentrations than they were at the onset of the Great Recession (Figure 3).

Investments

A community bank may also have concentrations present within its investment portfolio. Possible investment concentrations could include concentrated holdings of a particular security type (e.g., municipal bonds or mortgage-backed securities) or a concentration of investments with a single issuer. Investment concentrations may result in elevated credit, liquidity, or market risk exposures. Management should carefully consider the characteristics of investment securities and perform thorough due diligence during prepurchase analyses to ensure that investments align with the established risk tolerance determined by the board of directors and that any shared characteristics are understood and reflected in management’s strategic and capital planning exercises.

Funding Concentrations

The presence of a funding concentration increases a bank’s liquidity risk profile, and a bank that exhibits a funding concentration in combination with an asset concentration compounds the level of inherent risk embedded in its balance sheet. It is critical for bankers to identify, monitor, and develop reasonable and actionable contingency plans to address the risks associated with funding concentrations, particularly to large depositors with balances greater than the Federal Deposit Insurance Corporation’s deposit insurance limit. The effectiveness of liquidity risk management practices to adequately manage and control funding concentrations is critical. Management should develop sufficient systems to identify, measure, and monitor deposit concentrations from individual depositors, specific industries, and geographic areas. Liquidity stress-test exercises should apply meaningful scenarios against funding concentrations, and realistic contingency plans should be in place to address any funding shortfalls identified in stress-test exercises. SR letter 10-6, “Interagency Policy Statement on Funding and Liquidity Risk Management,” communicates the following about funding concentrations: “In general, funding concentrations should be avoided. Undue over-reliance on any one source of funding is considered an unsafe and unsound practice.” ⁸ Bankers can mitigate liquidity risk by establishing access to sufficient and diversified sources of funds on reasonable terms.

Conclusion

The degree and level of balance sheet concentrations directly impact a bank’s risk profile. Regardless of whether concentrations manifest naturally because of the shared characteristics of borrowers or depositors in a bank’s operating footprint or stem from a strategic decision by management to target certain clientele, bankers should establish a comprehensive risk management framework to control the risks inherent in any balance sheet concentration. A strong framework will include a robust strategic plan that incorporates desired asset or funding concentrations and commensurate policies, procedures, and risk limits. Management information systems should be tailored to appropriately capture concentrations to facilitate agile ongoing oversight by management and the board of directors. Capital planning must account for any concentrations to ensure that an acceptable level of capital is maintained, and contingency plans should be in place to raise capital or reduce concentration levels when predetermined parameters are triggered. Concentrations should not necessarily be avoided by bankers because doing so may neglect the banking needs of their community members. Therefore, it would be unfair to broadly portray balance sheet concentrations as either inevitable or avoidable. In fact, some community banks excel because of their concentrations in instances when an effective risk management framework is in place and when their management teams have the corresponding knowledge and skills to effectively identify, measure, monitor, and control concentration risk.

• ^* The author thanks Jennifer Graham, senior supervision analyst, Federal Reserve Bank of Chicago, for her contributions to this article.
• ¹ For the purposes of this article, lending concentrations are defined as loan types equal to or exceeding 25 percent of total loans.
• ² Community banks are defined as banks with less than $10 billion in total assets.
• ³ Data obtained from Consolidated Reports of Condition and Income (Call Reports).
• ⁴ See SR letter 07-1, available at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.
• ⁵ See Jennifer Burns, “Managing Risks of Commercial Real Estate Concentrations,” Community Banking Connections, Second Issue 2017, available at www.cbcfrs.org/articles/2017/i2/managing-risks-of-commercial-real-estate-concentrations.
• ⁶ See SR letter 11-14, available at www.federalreserve.gov/supervisionreg/srletters/sr1114.htm.
• ⁷ See Matthew Nankivel, “Agricultural Lending Concentrations: Lending Well in Challenging Times,” Community Banking Connections, First Issue 2018, available at www.cbcfrs.org/articles/2018/i1/agricultural.
• ⁸ See www.federalreserve.gov/boarddocs/srletters/2010/sr1006.htm and www.federalreserve.gov/boarddocs/srletters/2010/sr1006a1.pdf.