Larger credit unions are showing healthy growth in their loan portfolios but their profitability has not necessarily followed suit. Smaller credit unions are struggling to increase loan portfolios and their profitability is faring even worse than their larger peers. A recent, well-researched article in the Credit Union Journal authored by Palash R. Ghosh (Credit Union Journal, November 30, 2015) gives some insight into what factors might be contributing to this dilemma. Factors contributing to low profitability sighted in Mr. Ghosh’s article include:
- Low loan rates have compressed net interest margins
- Credit unions are relying more on indirect loans – dealer reserves cut into net earnings
- Credit unions are not accounting for the full cost of making loans in their loan pricing
- Small credit unions are hesitant to retain mortgage loans in their portfolios
- Seasoned, higher rate loans are rolling over into lower yielding loans
- Credit unions have struggled to cut expenses relating to loan activities
These factors noted in Mr. Ghosh’s article will probably continue to drag on credit union profitability into the foreseeable future. I agree with Mr. Ghosh’s points. In my studies and research, I have come across a few additional factors that are now, or will soon be, barriers to credit unions’ profitability objectives. In addition to Mr. Ghosh’s list, I would include the following lending issues that present obstacles to profitability:
- Managers are shifting toward higher exposure to Interest Rate Risk – credit unions have been booking more long term loans matched to low-rate short-term deposits
- Managers are diverting more and more time and resources to regulatory compliance as opposed to spending time and resources on projects that enhance earnings
- Managers continue to be hesitant to make loans to less-than-prime borrowers due to fear of increasing write-offs and collection costs
Achieving loan income objectives can be a daunting and frustrating undertaking. There are ways to overcome obstacles to achieving earnings objectives. I have found through research and observation that credit unions (including small credit unions) can improve their chances of achieving their profitability goals by making some basic changes in existing loan programs or implementing relatively uncomplicated new programs. This article will focus on one change that could make significant improvement in loan profitability.
Managers need to seriously consider shifting their resources and efforts into making more direct loans and away from making indirect loans. There are ways to increase loan portfolios and improve net earnings by “reaching deeper” into the loan pool and extending credit to “less than prime (LTP)” borrowers. Lending to LTP borrowers is a science in itself and must be approached using carefully researched, stochastically-derived models to assure risk is managed and profitability objectives are reached. I have seen as much as a 55 basis point improvement in ROA when credit unions shift into making more loans to lower FICO score borrowers. To assure profitability when loaning to the LTP market, credit unions need to be sure they are using statistically-validated modeling processes from carefully researched resources. To assure profitability and avoid disastrous results by reaching deeper into the LTP market place, credit unions should implement:
Clear Loan Concentration Risk policies:
Credit unions need to set limits to risk in all their operations and be sure to note these limits in their policies. Ideally, these risk limits are arrived at using empirical processes as opposed to relying on anecdotal methods or guessing. Marketing and lending procedures should then be drafted around the limits noted in the Loan Concentration Risk policy. Limits need to be adhered to when increasing lending to LTP borrowers. Loan Concentration Risk policies should be reviewed at least annually and changes made according to loan program outcomes.
Stochastically-derived Risk Based Loan Pricing tools:
To assure accurate pricing of loans according to risk, stochastic models need to be utilized that assure:
- All costs associated with loan programs are quantified and applied to rates;
- Costs (including collection and charge-off expenses) are accurately measured and assigned to each credit grade independently to assure risk is quantified;
- The replacement cost of money is measured and assigned to appropriate loan terms;
- Profit margins (in excess of costs) are measured accordingly as rates are set and evaluated;
- Potential losses and cross grade subsidies are identified and corrected;
- The use of simulations to test the impact of changes in loan rates under consideration.
Empirically-derived Credit Migration models:
Empirically-derived Credit Migration models can be used in a number of ways to significantly improve portfolio risk management and profitability. Management and profitability enhancement methods using Credit Migration include:
- Managing loan portfolios through on-going decisioning processes including: (1) stress testing; (2) concentration-risk testing and policy development; (3) multi-dimensional analysis to identify specific losses; and (4) calculating imbedded losses by rescoring loans and then determining current loan-to-value ratios on collateral
- Managing borrowers who experience deteriorating credit scores including timely dialogue with borrowers; reducing lines-of-credit; and determining loss mitigation actions
- Managing borrowers who experience improving credit scores, i.e. marketing and sales opportunities
Limiting lending to higher credit score borrowers will probably limit the potential for profitable loan programs. The competition is too keen and many lenders are trying to stay in the business by undercutting competitors’ rates which in many cases results in lending at a loss. More creative methods for increasing loan income will need to be considered including reaching out more to LTP borrowers.