Managing credit risk has always been one of the most challenging facets of directing a credit union, because of its complexity and the ripple effect a well or poorly handled portfolio casts throughout the organization.
The degree of difficulty, and the stakes, have increased substantially in the last two decades.
The advent of powerful tools that measure reams of variables indicating the current and potential health of a portfolio prompted the birth of even more statistics worth monitoring, some of a proprietary nature. And credit unions and their business partners and think-tanks strived to quickly evaluate which amalgam of factors most accurately portrayed risk — no small task given the small early sample sizes of these long-horizon exercises.
At the same time, market fluctuations have intensified, and the system has grown more interconnected. Portfolios buckled at many financial institutions during the Great Recession, and some withered under the weight. In turn, this prompted regulatory agencies to turn up the heat on credit unions with marginal or negligible capabilities of not just assessing the current conditions but also trouble spots and opportunities in the years ahead.
Through this evolution, backwards-looking loan loss analysis has become as outmoded as floppy disks, land lines, and the Walkman. To properly arm your credit union for today’s marketplace, you must employ high-performance credit risk modeling, which forecasts a loan portfolio’s degree of value fluctuations based on changes in borrowers’ underlying credit.
Credit risk modeling can address any number of concerns, including:
Internal capital adequacy assessment
Although many credit unions have found better footing in recent years, there remains a sense of uncertainty about the durability of the economic recovery. So, many credit union boards have pushed their institutions to remain or become well-capitalized, for actual and perceived assurance of their overall strength. This might become more of an emphasis should the National Credit Union Administration successfully implement its revised risk-based capital rule that would mandate credit unions to increase their capitalization buffer to remain even adequately capitalized.
With the strong backing of Congress, federal and state regulators continually emphasize they’ll apply more of their resources toward ensuring financial institutions better manage risk in their loan portfolios and investments than in the past. Fair or not, credit unions generally adhere to conservative management practices but fall under similar scrutiny applied to more speculative organizations.
Multifactor data analysis has provided a quantifiable understanding of borrowers’ ongoing creditworthiness individually and as a pool. When credit unions regularly adjust underwriting standards to incorporate these principles into a tiered pricing structure, they not only mitigate losses but also incent prime borrowers by offering rates lower than a one-size-fits-none standard. Analysis also allows self-evaluation of risk-based pricing structures to ensure compliance with Fair Lending laws and regulations, and the credit union ethos of providing financial services to the disenfranchised.
Credit unions’ ledgers depend on shifting loan yields, loan delinquency and charge-off expenses. Loan portfolio managers are most effective at positioning for growth when they’re able to clearly define an appropriate loan loss reserve and focus on opportunities in the marketplace. Credit risk modeling can divine idiosyncrasies in your membership, market, and portfolio that complement or affect statistical patterns gleaned through years of ongoing creditworthy analysis of individual borrowers. For instance, consider that — universally speaking — more than 80% of delinquencies and charge-offs can be traced to loans that dropped two or more credit grades from the original score, and that loans with unchanged credit scores contribute to less than 10% of delinquencies and charge-offs.
Credit unions must regularly assess through hard data the performance of existing and potential lending channels and pools. Concentration risk is a prime concern at many credit unions, especially those with homogeneous fields of membership, as through single select employee group (SEG) relationships or a handful of such arrangements with individual companies. Also, NCUA Chairman Debbie Matz recently dubbed 2015 the year of regulation relief, and announced as one of her priorities permitting asset securitization within larger, qualified credit unions looking to create liquidity and reduce interest rate risk. So, assessing those possibilities will take on greater importance.
Stress-testing and what-if analysis
Market uncertainty has proven paralyzing for those tied to traditional forecasting methods, as time-tested landmarks and indicators become less black-and-white. Credit risk modeling provides an opportunity for creative and intuitive loan portfolio managers to project the impact of a full range of hypothetical scenarios, and design contingency plans accordingly.