Top 4 Reasons Banks Should Have a Diversified Portfolio
April 5, 2016
More than 60 years ago, Harry M. Markowitz, a famous American economist and winner of the Nobel Prize in Economics, introduced the modern portfolio theory (MPT) in his paper “Portfolio Selection” to emphasize the importance of portfolio diversification in managing risks efficiently and maximizing returns. Though the MPT has been proven empirically and mathematically over the past six decades, many business professionals wonder if Markowitz’s concepts are still valid in the current economic environment.
Since the choice of diversification or focus is one of the topics investors and bank executives have high up on their agenda nowadays, we have decided to present four reasons why diversifying portfolios by adding new asset categories, such as manufactured home loans, is key to improving investment efficiency.
Portfolio Risk Reduction
A few years back, a regulatory study published by the Division of Banking Supervision and Regulation confirmed a significant correlation between loan portfolio concentrations and bank failures. Based on this study and many other research papers, financial experts have concluded that capital levels and portfolio risk management practices don’t evolve positively with the level and nature of portfolio concentrations but with portfolio diversification. Typically, banks generate financing from various sources, such as depositors, debt holders and equity holders, and allocate funds to portfolios composed of different products, including stocks, bonds, currencies, commodities, loans, mortgages, mutual and hedge funds, etc.. On one hand, a more diversified portfolio allows banks to enhance asset quality, performance and resilience; on the other, it minimizes portfolio risks and reduces the need for external financing along with the high costs associated.
A Higher Rate of Return
Though some industry watchers argue that concentrated, large cap value strategies are associated with lower risks and higher profit margins, this theory is valid only under certain circumstances. According to an earlier study performed at the University of South Carolina, the portfolio size per se doesn’t matter when it comes to portfolio returns. It’s rather the composition of the portfolio that affects the profitability ratio for the risk taken. In simple terms, the higher the number of non-correlated asset classes in a portfolio, the lower the risk of incurring significant financial losses due to negative market events. Another important point bank executives should be aware of is that a diversified portfolio can negatively impact returns if it has a high level of risk. A high rate of return can be achieved only when there is moderate exposure to “downside risks” (e.g. when returns are lower than the thresholds expected) and when efficient risk monitoring practices have been implemented, as shown in the white paper “Should Banks Be Diversified?” published by the New York University.
Good Portfolio Performance during Market Downturns
A diversified portfolio that combines a variety of loan products that belong to different asset classes in an optimal way will help a bank survive much easier to an economic storm than if it would provide loans in the same asset category. While we can understand that a bank will always have concentrations, adopting a proactive, strategic approach to portfolio management and teaming up with a reliable loan origination and servicing company will help you enhance your portfolio performance and meet new regulatory requirements.
Market Share Expansion
Portfolio diversification can help banks steer away from densely populated industry sectors and discover underserved markets, such as the secondary market for manufactured home loans. Not only will this expose a bank to a larger investment universe with a wider selection of asset classes, but it will also provide more attractive and lucrative opportunities for growth. As an example, the entire manufactured housing industry is expected to grow exponentially over the next decades, especially due to two main factors: 1) manufactured homes represent a critical source of affordable housing; 2) increasing numbers of potential home buyers continue to be priced out of other housing options.
Many people assume that loan portfolios diversify on their own as banks expand their service offerings to cover more lending needs. But that's not always the case. Focusing on growing the size of the portfolio without adding new asset classes leads to a concentrated portfolio with a high risk level. Conversely, when a bank builds a diversified portfolio, only some of its segments will be threatened by negative economic events. This will make the bank less susceptible to failure.
If you’re looking for an innovative way to diversify your portfolio, but you don’t have sufficient resources, knowledge or experience to oversee and service a new loan category, contact us at (800)-522-2013 Ext. 1287. Our friendly financial experts are ready to guide you through the process of selecting the right asset allocation model for your portfolio and building your future investment strategy.