RE-EXAMINING CREDIT LINES

Many banks we know have grown in size, yet they haven't increased their credit lines. This is particularly true in the investment portfolio. Oftentimes, credit lines are put in place when a financial institution first opens and then only sporadically revisited. That can be the case despite 20% year-over-year asset growth or following a significant acquisition. As a result, lines relative to the overall size of the institution shrink over time, which can hamper effective funds management. Banks with money to invest sometimes find that they have to break trades into smaller pieces, or trade with less competitive counterparties, simply because they are not allowed to buy securities bigger than a given par amount set some years prior. Larger blocks of Federal Funds and securities generally get better execution in the market, so unnecessarily low par amounts/credit lines carry a real and calculable cost. Of course, prudent credit policy requires that limits be set and that banks monitor their exposures carefully. However, these limits should be reviewed on a regular basis (we suggest at least semi-annually) and adjusted when conditions warrant. Interestingly, many institutions also have relatively small credit limits for corporate issuers, particularly when compared to the exposure they have to the agencies (like FNMA, FHLMC and the FHLB). While FNMA and FHLMC are creditworthy institutions, as we have seen, they are not perfect credits and are probably not 20 or 50 times more creditworthy than top-tier commercial paper issuers (such as American Honda, GECC, Nestle and others). Credit risk also rises with time to maturity. Yet many institutions have credit limits based on a simple dollar value, rather than on duration or time-to-maturity risk measures. This can prevent an institution from investing funds efficiently and can result in larger, rather than smaller, real credit risks. If your bank is starting to feel the pinch of tight credit lines, or hasn't reviewed them in a while, consider conducting a comprehensive review of the biggest exposures and examining how long vs. short-term credit risks are calculated. Chances are that you will emerge with a more rational, less risky, credit schema; that will result in greater flexibility and profitability. We often suggest banks utilize the "1% rule of thumb" for securities purchases for example. That is to say, banks with less than $1B in assets (above that things get a bit more volatile) could target 1% of total assts as an individual security par amount or piece size. For example, a $100mm asset size bank could make investments of $1mm in securities, while a $500mm bank could probably handle $5mm pieces. Using this cut-off still provides decent portfolio diversification overall, while allowing banks to have a reasonable threshold for individual investments. This approach obviously depends on the overall portfolio size, credit exposures, purpose and risk profile of the bank, but is worthy of periodic review. Institutions grow and credit migrates over time - so shouldn't the bank's credit lines also change every once in a while?