How to Stack Your Bank’s Portfolio with More Winners and Fewer Losers

Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending

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HOW TO STACK YOUR BANK’S PORTFOLIO WITH MORE WINNERS AND FEWER LOSERSUnderstanding Prepayment Risk and the Business Cycle


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INTERPRET REPAYMENT RISKS

Understanding how an industry affects a business can help you

interpret the repayment risks associated with lending to that

business.


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INTERPRET REPAYMENT RISKS (CONT.)

• Porter, a professor at Harvard Business School, intended his model to help companies create a business strategy that responds to five competitive forces in an industry.

Michael Porter's framework for analyzing industries and competitors helps you assess a company’s ability to succeed.


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Lenders use Porter's model to identify an industry's

most significant competitive challenges.


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Then they use that knowledge to interpret

whether a borrower has adopted an effective

strategy to counter them.

The five competitive forces in Porter's model are

derived from the relative strengths of the participants

in an industry.


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Understanding how an industry affects a

business can help you interpret the repayment risks associated with

lending to that business.


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PORTER’S FRAMEWORKOne traditional approach to assessing the influence

of a company's industry on its ability to succeed is Michael Porter's framework for

analyzing industries and competitors. (Porter is a professor at Harvard Business School.)

The model is designed to help

companies create a

business strategy that responds to five competitive

forces in an industry.

Lenders use Porter's model to identify an industry's most

significant competitive challenges.

They use that knowledge to interpret whether a borrower

has adopted an effective strategy to counter challenges.

The five competitive forces in Porter's model

are derived from the relative strengths of the

participants in an industry.


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PORTER’S FIVE COMPETITIVE FORCES

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The bargaining power of customers.

The bargaining power of suppliers.

The threat of new entrants.

The threat of substitute products or services.

The intensity of competitive rivalry.

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THE BARGAINING POWER OF CUSTOMERS

There are a few, large-volume buyers.

Products are easily replaced with a

substitute without incurring a large

expense.

Suppliers have high fixed costs and feel pressure to

stem sales losses by lowering prices (to keep plant/equipment running at a break-even point.)

Customers could produce the product

themselves.

The product produced is not of

strategic importance to customers.

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Customers have high bargaining power when they can impose pressure on the seller’s or the company's margins. Buyers are powerful when:


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THE BARGAINING POWER OF SUPPLIERS

Suppliers have high bargaining power when they exercise control over the price or availability of products needed by their customers. Suppliers are powerful when:

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The industry's market is dominated by a few

large suppliers.

The industry's customers are not

concentrated in a few large players.

There are no substitutes for the product suppliers

make.

It is expensive for a customer to switch from one supplier to

another.

Suppliers could take their customers' place in the industry product chain and gain scale

economies and higher margins.


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THE THREAT OF NEW ENTRANTS

There is a high threat of new entrants in an industry when it is easy and inexpensive to enter that industry's market. A high threat of new entrants to an industry exists when:

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A company does not need to be large to earn a profit

and higher-volume competitors do not gain a significant cost advantage

compared to smaller companies.

Customers are not influenced by a brand as

they decide which company to purchase

from.

There are no legal barriers, such as

copyrights or patents, to competing in the industry.

Existing competitors do not control access to vital resources, such as raw

materials or creative expertise.

It is not expensive or difficult for customers to switch to a new provider

or product.

There are no regulatory barriers to entering the

industry, such as government-sanctioned monopolies or exclusive

rights.


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THE THREAT OF SUBSTITUTE PRODUCTS OR SERVICES

A threat of substitute products exists when customers can easily locate alternative products with lower prices, or products are more readily available, and that meet their needs. A high threat of substitute products exists when:

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Customers have no brand loyalties or there are no

established brands.

Switching to another product saves customers money without causing

them to sacrifice features or performance.

It is easy and inexpensive to change to another

product.

Makers of substitute products have high

margins and can easily attract the new buyers with price reductions.


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THE INTENSITY OF COMPETITIVE RIVALRY

Intense competitive rivalry exists in an industry when competitors have opportunities to use various competitive forces against one another. An industry exhibits intense competitive rivalry when:

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There are many companies of about the same size.

Competitors and their products are indistinguishable, which

invites price competition.

The industry is mature or in a declining life-cycle stage,

(means that growth is possible only at expense of another

company.)

It is expensive for companies to get out of the business.


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A SIXTH FORCE

In addition to Porter's five forces, subsequent strategists have suggested a sixth force that contributes to a company's success or failure in an industry. • This force is the influence that non-competitors

or stakeholders exert over a company's ability to succeed in an industry.

• These stakeholders include governments, creditors, employees, and shareholders.

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DIFFERENT STAGES OF THE BUSINESS CYCLE

Understanding the cycles that influence a company's

viability and interpreting their effect on company asset

acquisition and operating cycles is equally as important as

evaluating industry competitive forces.


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DIFFERENT STAGES OF THE BUSINESS CYCLE (CONT.)

A business cycle is a recurring but irregular long-term period of alternating growth and decline in

the economy.

The official peaks and troughs of the U.S. cycle are determined by the

National Bureau of Economic Research (NBER).

These peaks and troughs are identified by assessing factors such as gross domestic product, or GDP,

and employment growth.


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General economic cycles of expansion and contraction affect most businesses in predictable

ways… but not all companies are affected by cycle changes equally

or at the same time.


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Understanding the business cycle is a key

factor in understanding a business's ability to

successfully navigate the challenges that these

cycles bring.


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FOUR STAGES OF THE BUSINESS CYCLEThe business cycle has a significant impact on companies and their need for funds. The business cycle has four stages:

Early Expansion Late Expansion

Early Contraction Late Contraction

These stages of expansion and contraction are also referred to as economic cycles.


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EARLY EXPANSION (RECOVERY)

Occurs when national output begins to recover

after reaching the trough of the prior cycle.

Credit is available to companies, and they respond to this with optimism about the

future.

Companies increase sales and profits, begin

to expand plant/equipment, rebuild

inventories, add employees, start new

business lines, or introduce new products.

Interest rates are relatively low

(during the early stage of the cycle).

Customer and business credit is

plentiful.

Consumers have high levels of disposable income, partly from

secure jobs and increasing wages and partly from available

credit.


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EARLY EXPANSION: FUNDING NEEDS

Funding is needed to:

• Support sales growth and working capital.

• Pay for additional inventory.• Cover additional funds tied up in

accounts receivable. • Finance capital expenditures.


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LATE EXPANSION (BOOM)Consumer and business

spending and demand for credit increase, pushing interest rates

up.

Capacity utilization climbs and the price of goods and services

stabilizes.

The higher cost of credit, goods, and services begins to slow

consumer spending and business expansion.

Occurs when national output grows quickly and culminates in

the peak of the cycle.

Credit is available to companies and their optimism is at its peak.

Companies hire workers, market aggressively, increase sales and profits, invest in plant/equipment, and let their inventories build until

sales growth stops.


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LATE EXPANSION: FUNDING NEEDS

Funding is needed

to:

• Support continued sales growth and to finance capital expenditures that add to their capacity.


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EARLY CONTRACTION (SLOWDOWN)Consumers and businesses are less optimistic about the future.

Fewer new projects or additions are begun.

Less credit is demanded as borrowers try to reduce reliance on debt and

become more liquid.

Occurs when national output is still growing but the pace of growth

slows and then stops.

Credit is available to companies, but they are less optimistic.

Companies reduce debt and try to become liquid, stabilize or reduce

their inventories, and reduce investment in plant and equipment.

Companies may also relax credit standards to generate new sales and

growth.


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EARLY CONTRACTION: FUNDING NEEDS

Funding is needed

to:

• Cover the lengthening of collections, if they relax their terms.

Companies also will reduce inventory to generate funds.


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LATE CONTRACTION (RECESSION)

Unemployment goes up and interest rates gradually fall.

Supplies of goods and services shrink

to the point that businesses begin to

see new opportunities for

growth.

The early-expansion stage of the business

cycle begins again.

Occurs when national output declines and

eventually bottoms out at the trough of

the cycle.

Credit is available to only the most creditworthy

companies and companies overall are pessimistic.

Companies lay off workers, reduce inventory at a discount, stop

investments in plant and equipment, watch

sales and profits decrease, and lean on

trade credit.


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LATE CONTRACTION: FUNDING NEEDS

Companies need

funds to:

• Cover fixed outlays such as lease and loan payments and also to offset slower collections from weak credit customers.

Companies may generate some funds by inventory liquidation and trade credit.


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TYPICAL IMPACT OF THE BUSINESS CYCLE

In the early and late stages of contractions, many companies have financing needs that are

problematic for banks.


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FINANCING NEEDS PROBLEMATIC TO BANKS

Earn a profit.

Collect from

customers.

Cover fixed expenditures, such as lease and loan payments. Other fixed

expenses include:

Depreciation of manufacturing buildings and

equipment

Factory overhead.

Maintenance of a base level mgmt./admin. employees so the company can continue to function.


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TYPICAL IMPACT OF THE BUSINESS CYCLE (CONT.)

Companies often look to their banks for financial help during contractions; of course, this is

exactly when banks' credit analysts tell them the

companies are in a weakened debt-repayment state.


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Analysts and management should discuss a company's susceptibility to the effects of an economic downturn and

how management can respond by reducing

expenses and adopting other strategies.


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Some companies are especially vulnerable to sharp swings in business volume,

e.g., firms involved in heavy construction.

These companies need to create a financial condition that

will allow them to weather a downturn without defaulting on

payments.

They also need to trim expenses, including reducing

inventories, without handicapping themselves for a

recovery. This means they need to operate with

less debt, or at least with lower scheduled payments, and lower interest

expense than firms that react more slowly to economic conditions, such as

health care companies.


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WHAT TO LOOK FOR

Even if a company is in an industry that is particularly susceptible to economic contractions, it can benefit from a recession. • Look for company characteristics that

suggest potential resilience or weakness.


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STRONGER COMPANIES

Stronger companies

can take advantage of a

recession's effect on

weaker competitors.

• For example, strong companies may be able to offer extended payment terms, which can help them retain customers and win business from competitors who cannot extend terms.

• These companies may have the confidence of their suppliers or be a critical customer, which may win them generous pricing terms.

• Also, these companies may be able to acquire weaker competitors as an inexpensive way to grow permanent market share, enter new markets, or add new technology.


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WEAKER COMPANIES

Weak companies

are those unable to

receive or provide supplier

financing.

• They will see both sales and cash flow squeezed.

• If unable to reduce expenses enough to avoid non-recoverable losses during a recession, they may go out of business or sell to strong competitors to avoid bankruptcy.


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RESPONSES TO CYCLE CHANGES

Some companies and industries are less susceptible than others to the challenges of contractions because the

business cycle does not, necessarily, influence

economic activity at the same time or to the same extent in

all regions of the country.


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RESPONSES TO CYCLE CHANGES

Regional economies can be stronger than the national economy. And while some industry sectors are immediately

affected by a contraction, others generally experience a reprieve before feeling the full brunt of a recession.

E.g., manufacturing experiences an early

reduction in demand as retailers and wholesalers

begin to reduce inventories.

E.g., businesses in the service sector respond more

slowly to contractions.


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INDUSTRIES AFFECTED BY A CONTRACTION

Highly Susceptible Industries

• Construction.• Household furniture and appliances. • Personnel supply services. • Plumbing supplies. • Stone, clay, and miscellaneous

mineral products. • Metal coating and engraving. • Concrete, gypsum, and plaster

products. • Cutlery, hand tools, and hardware. • Carpet and rugs. • Motor vehicles, equipment. • Retail trade.

Less Susceptible Industries

• Beverages. • Agricultural chemicals. • Accounting and auditing. • Educational services. • Commercial sports. • Communications equipment. • Membership organizations. • Museums and botanical gardens. • Pharmaceuticals. • Insurance. • Grocery and food services. • Energy. • Medical and health-related. • Federal, state, and local

government-related services.

According to a study that reviewed recessions from 1977 to 1997, certain industries are greatly affected by a contraction. It is likely that the conclusions will hold true in all periods of contraction.


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INDUSTRIES AFFECTED BY A CONTRACTION (CONT.)

Highly Susceptible Industries

• Many of the highly susceptible industries provide products and services that consumers and businesses can postpone purchasing during a recession.

• Others are tied directly or indirectly to construction industries, which are particularly sensitive to recessions.

Less Susceptible Industries

• Many of the less susceptible industries provide necessities or public goods for which demand remains strong throughout the business cycle.

• Other industries listed, such as professional sports and museums, illustrate that demand for entertainment is resilient.

• Similarly, many economists have observed that sin industries, such as tobacco and liquor, are recession-resistant.


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EXAMPLE OF HOW A PRODUCT'S LIFE-CYCLE STAGE CAN INFLUENCE A COMPANY'S SUSCEPTIBILITY TO

BUSINESS-CYCLE DOWNTURNS.

Technology-related industries can enjoy prosperity during an overall

economic contraction.

This occurs when introductions of new

technology create high demand for new or

substantially upgraded products.

For example, in a recession, when

companies must reduce costs to survive, new

technology that introduces efficiency and thus lowers costs can be

very appealing.

The weakest companies may not have the means

to acquire the technology, but stronger

companies with the support of capital

providers often acquire the technology to reduce

current costs.

Stronger companies also achieve permanent

efficiency improvements that will pay off

significantly when demand for their own

product rebounds during a recovery.


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The Lending Decision Process

(http://www.rmahq.org/lending-decision-process/).

Or contact

your regional manager.

Or email

[email protected].

ABOUT THE LENDING DECISION PROCESSFor In-depth Information:

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How to Stack Your Bank’s Portfolio with More Winners and Fewer Losers

Economy & Finance