Looking for revenue? Lean into risk-based lending

The many threats to fees and other income are top of mind for everyone today. And for good reason. Most credit unions wouldn’t have a positive bottom line without fees and other income.

Credit union leaders are engaged and committing time, talent, and financial resources to advocate against the threats to fee income. Truly it is a time for all credit union leaders to work together to protect credit unions’ ability to earn fair fees and other income. Hopefully, we can be successful in winning the right outcomes for credit unions. But, what if we don’t win all of the best outcomes?

Risk-based lending

Unfortunately, many credit unions today have become very credit risk averse. I review hundreds of Financial Performance Review reports annually – you see this aversion in the lower average loan yields, lower provision expense trends, and weaker organic loan growth rates too.

Yeah, I know, charge-offs and delinquency rates are higher now. Members are still feeling the pinch of inflation. I argue this is the scenario when credit union members need us even more! What does it say about us when we avoid helping members when times are tough. What is our message? “Dear member, we’re sorry, but losses are trending a little higher right now, please come back later when the economy is better, and we are more comfortable with our loss ratios – then we will be happy to help you”. Wow, that sounds like a consumer advocate, not-for-profit coop, right?  We can’t complain about banks relocating out of lower-income communities (and they are) if we are going to stop helping consumers when they have less-than-perfect credit. In my mind, it’s the same thing.

Mission focused – Risk-based lending provides better member service. The bottom line is that successful risk-based lenders help more people get what they need. They approve more loans, increasing access to affordable credit. This higher level of service is more likely to win deeper member loyalty because you were there for them when they needed you most. For some members, when we say ‘no’ to a used auto loan or a personal loan – we are denying access to affordable transportation, or funds needed for an important personal need. When we say ‘yes’ – we provide more than an affordable car loan, we help them improve their credit and save a lot of money on payments that would otherwise have gone to a predatory lender. We help make their life better.

Margin focused – Risk-based lending is more profitable. We work with hundreds of small and midsized credit unions. Hands down, our clients who are expert risk-based lenders consistently have higher net income and organic growth rates than their peers and even credit unions much larger than them. In my experience, it’s credit unions that have loan portfolios with 20-30% non-prime credit pools that are in the highest quartile for income and growth.

Credit union leaders frequently tell me they offer risk-based lending and that their teams are risk-based lending experts. However, when I look deeper, they have a very small percentage (10-12%) of non-prime credit in their portfolio. I ask, “why it is so small” and I hear “we are approving all that we possibly can”. In their minds, they are approving all that they can—but I would bet that I could take their denial files and have another credit union lender that would identify some loans from the group they would be comfortable underwriting.

We do A LOT of CDFI work. Access to grant funding is attractive and can make a big difference in leveraging a credit union’s balance sheet, the biggest value to being CDFI isn’t the grant dollars – it’s the business model. What do I mean by business model? CDFI credit unions financially outperform non-CDFI credit unions. It’s not because of the grants, it’s because of the lending. Successful CDFI’s are masters at risk-based lending. And by the way, they don’t get grants first, then do the risk-based lending. They earn grants because they are already expert risk-based lenders. They do it for mission and one of the many outcomes includes margin.

Consider the following data from the 2020 Inclusiv Finance Report. CDFI credit unions outperform non-CDFI credit unions. “Year on year since 2013, CDFI credit unions have consistently outperformed their mainstream peers in key financial performance categories of earnings and growth; this holds for those who have received awards as well as those that have not.”

These lenders lend deeply and responsibly. Compare the asset category:

• CDFI Group 1 Asset tier $10-50 million, ROA was 34% higher than the non-CDFI peer.
• CDFI Group 2 Asset tier $50-100 million ROA was 44% higher than the non-CDFI peer.
• CDFI Group 3 Asset tier $100-500 million ROA was 24% higher than the non-CDFI peer.

These higher ROA ratios are due in large part to higher average loan yields and loan-to-share ratios.

• Group 1 had loan yields 22% higher with non-prime loans of 51% and loan to share of 76.99%.
• Group 2 had loan yields 17% higher with non-prime loans of 48% and loan to share of 83.16%.
• Group 3 had loan yields 14% higher with non-prime loans of 34% and loan to share of 91.66%.

Risk-based lending is a tried-and-true service and revenue model.

Overcoming roadblocks

Risk aversion at the board, management, or loan officer level are the biggest barriers. The board sets the tone for risk management. The board needs to fully support risk-based lending, even when delinquency creeps up from time to time. Management must actively support it so loan officers will trust that it is OK to put their name on the line for a loan. Of course, management is responsible for setting appropriate risk, revenue, and growth targets. They are also responsible for making sure their team has the expertise needed to underwrite at a deeper level.

Education is another roadblock. Many lenders have only known one way of underwriting, and that way is very risk averse. These people need training on how to evaluate applications and risk differently. I’ve always been a fan of the University of Lending. I know many lenders that use their model and are very successful. But – if you send people for training, it’s a waste of money if they don’t come back with a desire to help change the process and culture of lending.

Examiners can also be perceived as roadblocks. But, you don’t work for the examiners, you are responsible to your membership, especially those members that need your help with a loan. My experience with examiners is that their concerns are usually resolved when they see a solid business plan that lays out what your risk-based lending criteria are, with appropriate risk limits and internal expertise. Examiners respond the same way for any new product or service you pursue—they want to see a solid plan in place to manage the risk. If you are using your examiners as an excuse, you’re hurting your shop and membership.

Why it matters

Fee and Other Income are at risk. Look around you—consider all the levers at your disposal to generate greater revenue and net income. In the unfortunate event that Fee and Other Income decreases 10, 20, or more BP annually, how will you make up the difference? Will you lay off people or close branches? Will you reduce provision expenses (not much to cut if you are already highly risk-averse)? Will you raise all other member fees to try to make up for the interchange or overdraft fee deficit? Will you add a new product or service, if yes, what is the learning curve, risk, investment cost and likelihood of material success? Credit union leaders must have a solid plan B for any potential reduction in fee and other income scenarios.

Risk-based lending is how most credit unions got started. Historically, we approved good loans for good people that other lenders at the time deemed too risky. Today, credit union leaders face many risks including loss of revenue and relevance—now might be an excellent time to re-evaluate and embrace what has been a core service, risk-based lending to help more members, grow loans, and increase revenue.