Lending to “Credit Invisibles”: A “visible” opportunity for credit unions?

In April 2016, NCUA’s Office of Small Credit Union Initiatives published a letter addressing a segment of the American population to whom the Consumer Financial Protection Bureau (CFPB) refers to as “Credit Invisibles” (CI).  “Credit Invisibles” are typically consumers with documented credit histories so limited that they don’t have credit scores (with the big three national credit bureaus) or if they do have credit scores, they are inaccurate.  The CFPB is concerned that “Credit Invisibles” are largely ignored by mainstream banking providers and therefore are missing out on financial opportunities typically afforded most consumers.  According to NCUA’s paper, credit unions are potentially missing out on growth and revenue opportunities by not tapping into the “Credit Invisible” markets.  NCUA goes on to point out in their paper that credit unions can help CI members by increasing their visibility in the traditional credit reporting system thus building good credit scores.

The purpose of this article is to introduce credit union managers to the unique qualities of the “credit invisibles” marketplace, how their credit union might benefit by providing the CI with services, and what preparations need to be in place to serve “Credit Invisibles” successfully.

According the CFPB, there are 26 million U.S. adults who have no credit history with the three national credit bureaus: TransUnion, Experian, and Equifax.  These are the CI and since they have no credit histories they have no credit scores in the traditional sense.  CFPB goes on to explain that many CI consumers do use credit in the form of rent payments, insurance premiums, utility payments, and so forth.  Often, payments to these non-banking service providers are current.  If their payment history was being tracked, many CI consumers would otherwise be considered good credit risks.

Roughly one out of ten U.S adults has no credit history with one of the three national credit bureaus. These are the “Credit Invisibles” and according to the CFPB they typically share some common traits: (1) often they live in low income neighborhoods; (2) they are more likely to be Black or Hispanic; and (3) they usually are very young adults (over 18 and under 25).  We should recognize that some “Credit Invisibles” are “invisible” by choice – preferring to perform their financial transactions on a primarily cash basis.  Others may have no other choice than paying bills using cash only.

There are distinctions between “Credit Invisibles”, “non-prime borrowers” and “subprime borrowers”.  While the CI consumer does not have a credit score, non-prime borrowers do have scores.  “Non-prime borrowers” are not “prime borrowers” (low risk of default), however, and are considered potentially riskier than prime borrowers.  Subprime borrowers have low credit scores and weak credit histories and are considered significant credit risks. Credit scores are calculated by traditional credit bureaus who usually assign a three-digit score using mathematical formulas measuring the statistical probability of a consumer defaulting on their loans.  Most lenders rely on credit scores in their loan pricing and/or loan approval processes. Other businesses such as insurance companies and landlords may also depend on credit scores.  Statistically, credit scores have been found to be the best predictor of borrowers’ propensity to default on their loans.

According to NCUA, credit unions have a potential new source for loan and membership growth by serving the 26 million CI consumers.  Besides income and growth, a credit union could benefit from positive public relations in its community as a result of helping the underserved.

To be sure, however, getting into a new market which includes consumers who don’t have traditional credit scores comes with risks.  NCUA notes that these risks include:

• A higher probability of loan losses
• Higher liquidity risk as loan portfolios grow in relation to liquid investments
• More compliance risk since there is a good chance that more disclosures will need to be issued to the CI
• Greater strategic risk in that growth goals, earnings goals, loan loss goals, etc. may be missed resulting in a negative perception of the credit union and/or its management

The April 2016 paper issued by the NCUA Office of Small Credit Union Initiatives goes on to offer suggestions as to how a credit union could mitigate risks when beginning to expand into the CI market.  These risk-reducing suggestions include:

• Establishing policies and procedures that specifically address CI borrowers
• Starting CI members with small loans initially and moving borrowers into larger loans as their payment histories allow
• Establishing a plan as to how the CI expansion program will be approached and managed
• Establishing objectives to be accomplished by serving CI
• Considering how CI loans will be priced taking into account the probable increase in operational costs and charge-offs
• Establishing how much of a credit union’s net worth should be set aside for increased loan losses specific to the CI loan growth
• Planning for staff training taking into account a different approach to loan approval and management methods specific to CI borrowers
• Assuring the CI loan portfolio is isolated and monitored with greater oversight than traditional loan portfolios
• Establishing loan applicant evaluation methods that utilize information other than traditional credit scores
• Making sure loan delinquency reports are able to spot problem loans quickly and that robust collection methods are established

The April 2016 paper issued by the NCUA Office of Small Credit Union Initiatives contains a plethora of useful information that most credit unions will find helpful if they decide to pursue the “Credit Invisibles” market.

Credit unions looking to pursue the CI market may want to join the National Federation for Community Development Credit Unions.  The Federation is a valuable resource for credit unions, particularly those who are involved with serving “underserved” members.

There are additional risk-mitigation processes credit union managers should implement in addition to those suggested by NCUA in its April 2016 paper to assure success with existing or new lending programs.  These include having in place stochastically derived and statistically validated risk management tools such as:

Risk Based Loan Pricing (RBLP) that prices loans by credit grade, loan type, payment durations, and so forth.  Efficacious RBLP systems take into account a credit union’s unique operational expenses, its collection and charge off costs and its cost of funds.  Certainly credit unions can potentially improve loan income by expanding into the “Credit Invisible” market.  Credit unions can also improve profitability by expanding more into the non-prime lending market place so long as they are using a stochastically developed RBLP model.

Credit Migration (CM) modeling that tracks and reports movements in borrowers’ credit scores broken out by individual loans, credit grade sectors, loan pools, etc.  Better CM models will expose problem loans long before traditional delinquency reports.  The most effective Credit Migration tools will integrate with a credit union’s ALLL placement processes.

Concentration Risk policy to establish loan portfolio limits.  Every credit union should have policies in place reflecting how much of their total loan portfolio will be allocated to different types of loans and credit grades.  Concentration Risk policies should be revisited annually and adjusted to reflect new objectives.

Asset Liability Management Modeling (ALM) that is practical and usable for long-term planning and managing Interest Rate Risk.  Not all ALM models are the same, however.  This author has found that Earnings at Risk as opposed to Net Economic Value is a far better method for forecasting how earnings/equity will be impacted when interest rates shift in one direction or another.

Delinquent Loan Tracking Report (DLT) that tracks movement of individual past-due loans from one “aging silo” to another.  A DLT allows management to know which individual delinquent loans are improving or worsening month by month.  This report also provides totals for each aging silo so managers can see if the overall delinquency picture is improving or worsening and why.   This report provides a quick picture as to the performance of loan and collection staff and weaknesses in the collection process.

In summary:

Lending to the “Credit Invisibles” is one way for a credit union to grow and generate incremental revenue.  Caution, careful management and using the right modeling resources is mandatory, however, to assure that outcomes are what boards and managers had intended.