Lending Perspectives: What an economist knows about risk-based lending that you don’t

Being a consistently great lender requires a working understanding of economics.

In the past, I’ve joked about seeing myself as an amateur economist. I’ve also joked about how I’ve predicted seven of the last three recessions. Being an amateur economist, however, does have its advantages when it comes to risk-based lending.

What’s the Point of Risk-Based Lending?

Depending on your credit union, you’re probably driven to do a good job with risk-based lending so you can help more members and/or make more income. Helping more members normally leads to more income, so the two reasons have a closer relationship than you might think at first glance.

While making more income is important and the key driver for many credit unions, why do credit unions, banks and specialty lenders often get into trouble with risk-based lending? There’s no guarantee that you’ll always make money with it; when a recession hits, you’ll likely have 12 to 24 months of higher losses and allowance for loan loss expense. The result will be a period of lower earnings. The trick to risk-based lending is to make sure you made enough extra income between recessions, right? To be successful in risk-based lending, you must have a feel for when the economy might be ready for a recession.

 

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