Is loan portfolio growth the blessing you think it is?

Credit unions will need to be sure they are prepared for the coming risks that loan portfolio growth poses.  

Managers are cheering remarkable loan growth

Impressive growth in loans for the past three years has been greeted by credit union managers as mostly good news.  This growth in loans is projected to continue in 2017 as consumers enjoy rising income levels and better employment prospects.   

But dark clouds are gathering

Optimism for boards and CEOs should be cautious, however.  Every silver lining has a dark cloud.   While loan growth has been mostly greeted with cheers, there are signs that serious challenges lie just ahead.  Some of those signs include:

• Lenders have been operating on thinner and thinner interest margins as competition has driving them to more aggressive loan pricing and terms.  A number of financial institutions are subsidizing some of their loan portfolios with other sources of income.
• New car sales are projected to decline in the near future as the pent up demand resulting from the Great Recession is becoming satiated – which will drive lenders to even more aggressive pricing and terms to maintain lending portfolios.  Lenders will be taking on even more risks.
• Sub-prime loan delinquencies and losses are accelerating – recently reaching levels that are the highest in the past seven years.
• Mortgage delinquencies and foreclosures are rising (72 basis point increase in the fourth quarter of 2016).
• Business loan delinquencies and charge-offs are also increasing (87 basis point increase in past two years).
• Personal bankruptcies have begun an upward trend – increasing 5.4% in the past 12 months.
• Rising interest rates could drastically pinch interest margins for those credit unions that have not been using validated and back-tested Interest Rate Risk management models.

Credit unions had better be managing lending risk through policy and practice

Credit risk in loan portfolios needs to be managed through two primary means – in policy and in practice.

Credit unions need to manage risk through policy

Managing loan portfolios through policy means making sure the policies are compliant with regulations.  It also means making sure policies provide guidance to management and reflect the credit union’s risk-management philosophy.  Loan policies have become much more detail and encompassing as a result of regulations and the growing complexity in loan portfolios.  At a minimum, credit unions should have policies addressing:

Loan Concentration Risk Management:  Loan concentration policies reflect the concentration limits the credit union will allow in its loan portfolio(s) for different categories of loans. Concentration limits should be broken out by credit grade, loan type, loan source (participations/purchases, indirect, etc.) and so forth.

Credit Risk Management: Credit risk policies describe the amount of risk the credit union will tolerate in its loan portfolio as well as how the credit union will identify credit problems early and respond to those problems.  Credit Risk management policies should also describe the tools the credit union will use to manage credit risk and describe how those tools will aid in carrying out policy.  Credit Risk Management policies should support other loan policies including Loan Concentration Risk.

Loan Process Management: Loan process policies describe the credit union’s overall lending philosophy, instructions for loan officers, and so forth.  Many credit unions have individual loan policies for business loans, consumer loans, collection practices, mortgage loans, etc.  Loan process-type polices have grown much more descriptive and complex as a result of regulatory requirements.  

And credit unions need to manage risk through practice

Managing loan portfolios through practice is achieved by actively managing risk through procedures and the use of effective management tools.  These tools should be empirically-derived management tools that have been proven to help credit unions manage and control risk in their loan portfolios.  This author recommends credit unions utilize the following risk-management tools:

Risk Based Loan Pricing (RBL) :  This tool should be derived using statistically derived methods to accurately price loans according to the unique risk each borrower poses based on individual credit scores.  An effective RBL tool will take into account all costs incurred by an individual credit union relative to making loans for each credit grade.  An accurate RBL tool will allow “reaching deeper” into the loan market and will assure loans are priced profitably according to operating costs and risks.  RBL tools should provide an effective method for “back-testing” loan pricing methodologies to determine potential risk in existing portfolios.

Credit Migration (CM):  An efficacious CM tool will allow management to: (1) track and monitor loans individually and collectively (by class and loan type)  that are digressing or improving using changes in credit scores for each and every loan; (2) forecast excesses or shortfalls in the Allowance for Loan and Lease Losses; (3) assure boards and regulators that they are using a tool that is: (a) using methods according to latest regulations and GAAP; (b) using a credit union’s unique data and market area data for purposes of establishing environmental factors; (c) validated by CPA firms; and (d) effective for determining changes necessary in loan policies and practices in a timely way.

Delinquent Loan Tracking Report (DLT):  This type of tool is used by only a few credit unions but is becoming recognized as an effective delinquent loan management method.  A DLT will track the movement of individual past-due loans as they progress/digress from one “aging silo” to another.  Management benefits from knowing which individual delinquent loans are improving or worsening month by month.  An effective DLT 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 relating to the performance of loan and collection staff and weaknesses in the collection process.  An effective DLT will also indicate on a timely basis where changes in policies and/or procedures are necessary.  

Asset/Liability Management Modeling (ALM):  There are a number of ALM modeling processes in the market place.  This author recommends Earnings (Equity) at Risk (EAR) as opposed to traditional ALM models that employ Net Economic (Equity) Value (NEV).  Students of NEV are aware of the weaknesses this method poses as a process to assess how interest rate changes might impact a credit union.  EAR is a far better method for forecasting how earnings/equity will be impacted when interest rates shift in one direction or another.  Any significant changes or additions to loan portfolios being considered by credit union managers should first be tested by running simulations using a proven ALM model to determine the effects on earnings and Interest Rate Risk (IRR).  As a result of recent changes, NCUA examiners will utilize NEV as an IRR testing method so managers should look for an ALM model that provides reports in EAR and NEV formats (EAR for effective management and NEV for the examiners).  

So, will loan growth be a blessing?

For those credit union managers who are managing their risks through effective policies and practice using empirically derived management tools – loan portfolio growth will probably prove to be a blessing.