NCUA’s “Tough Love” – The Final Nail in Many Credit Unions’ Coffins?
By Dennis Child, Marketing Director, Thompson Consulting and Training
Struggling credit union CEOs express concern and frustration with their regulators who are insisting their institutions implement significantly less risk in their operations. After comprehensive study and evaluation, we at Thompson Consulting and Training (TCT) conclude that NCUA may well be doing more damage than good by insisting that credit unions be overly conservative.
In this article, we will outline the consequences when credit unions focus too much on reducing risk in their loan portfolios and limit lending primarily to “A+” and “A” loans. We will also offer a better alternative.
Credit unions, like all financial institutions, are in the risk management business. They are not in the risk avoidance business. Indeed, TCT’s studies show there is great profitability risk in taking too little risk when it comes to lending. Our studies also show how credit unions can improve profitability by booking and carefully managing “B, C, and D” loans.
In today’s tight economic environment, there is little loan demand (especially among “A+” and “A” consumers) and much competition among lenders under pressure to loan out excess deposits. The result is nothing short of a price war to attract high credit score borrowers. We at TCT find that “A+” and “A” loans are often being written at rates too low to cover the costs of making and maintaining those loans. Furthermore, the more these low rate loans replace the older, higher rate loans in a portfolio; a credit union spirals deeper into a self imposed down-shock scenario. The final outcome could well be disastrous.
The solution to this problem lies in credit unions implementing empirical, statistically validated risk based loan pricing (RBL) models such that a credit union can responsibly expand lending to include less-than-prime borrowers. A proper risk based lending tool needs to take into account a credit union’s unique loan expenses, cost of funds, delinquency, charge offs, minimal profit margin, etc.
Research and testing performed by TCT shows that a credit union using a RBL model as described above, with a robust Concentration Risk policy, can boost ROA by as much as 50 basis points. This improvement in profit is possible even after setting aside 5% (tests show that 3% is adequate) of the earnings on these less-than-prime loans for increasing the ALLL to cover the additional charge offs inherent with having an increased number of less-than-prime loans in a portfolio.
Advising credit unions to limit their lending to “A+” and “A” paper is arguably irresponsible. Today, there is more risk of failure for those credit unions that deal primarily in high grade loans compared with those who expand their lending activities to include less-than-prime loans under carefully managed conditions.