Portfolio Diversification and Business Lending

Studies of bank failure generally correlate an increasing trend in problem institutions with a hostile economy, excessive asset/liability risk, flawed business strategies, inadequate board oversight and fraud. Banks are more likely to fail when the economy is in a recession, unemployment is high, regions of the country experience a boom to bust, and there is little confidence in the banking system or the central bank. Every loan originated by a bank retains some credit risk exposure resulting from the probability of default and/or the loss given default. Researchers at the Federal Reserve Bank of New York have shown the US Treasury yield curve can provide managerial information useful for bankers to manage a loan portfolio. Portfolio diversification allows bankers to reduce unexpected losses if management originates loans in less risky sectors with a lesser volatility of losses or to areas less correlated with the bank's dominant loan segment. Unfortunately, loan losses between and among major loan groups is highly correlated.