Examiner High Expectations: What's Causing all the Fuss?
Michael Cochrum, Direct of Lending
As little as a decade ago, credit union examinations, as they pertained to lending, were centered mostly on the credit union’s adherence to policy, proper lending controls, and compliance with lending regulations. Today, regulators have a very high expectation of credit unions to demonstrate that they are properly managing loan portfolio risk. These expectations have placed added pressure on many, especially smaller, credit unions to provide documentation of ongoing and detailed portfolio management, even requiring credit unions to cease certain lending activities until documentation can be provided. A disruption in lending activities can have a detrimental effect on credit union profitability, further exacerbating any issue that poor portfolio management could cause, even if those restrictions are only placed on a certain type of loan product.
Going back ten years or so, credit unions generally monitored overall portfolio profitability, delinquency, and losses. In the time between then and now, credit union loan portfolios have changed dramatically. Back then, most credit unions had personal loans, direct auto loans and perhaps a few revolving and mortgage accounts. It’s hard to imagine, but it hasn’t been that long since a majority of credit unions did not use risk-based pricing strategies. But, an expansion of membership opportunities, along with an economic downturn that ushered in the new millennium, brought a gradual change in the mix of loan types in the typical credit union portfolio. With these new types of loans came new risk factors that had rarely been considered in the credit union arena.
In late 2001, credit union lending virtually dried up as auto manufacturers started to offer 0% financing in the wake of 9/11 and the tech bubble burst, leaving many formally high-wage earners with less disposable income to buy big-ticket items. The pressure on credit unions to make loans in the highly competitive lending environment left some to consider lending opportunities that had never been considered before: sub-prime auto lending and indirect lending to list some obvious suspects. Loan participations also became very popular as these loans represented high-growth opportunities without the need to expend a great deal of limited resources. While the recession of 2001-2002 was relatively short-lived in comparison to the more recent economic depression, the residual effect of the change in lending strategies took longer to be exposed. The two most impactful effects were a trend toward loosened lending criteria and the acceptance of “sure-thing” proclamations from trusted sources taken at face value.
As some of our credit union brethren were not prepared for the increased risk associated with these new lending opportunities, the regulators too were not certain of what danger signs to look for. By 2005, many of these changes in lending practices began to catch up with the credit unions that did not manage the risk well. Regulatory bodies began to raise the level of expectation when it came to internal portfolio risk analysis; that is, analyzing certain characteristics of loans within the portfolio that represent increased risk. One of the first of these was the inherent risk characteristics of indirect loans. Another was the “Third Party Originator.”
It’s taken about six years for regulators to get to the level of heightened scrutiny we’ve seen in the last couple of years. But one must consider that previous credit union failures were more digestible as healthier credit unions could be counted on to pick up the slack and save the failing institution. Today, the results of “good-loans-gone-bad” are a little more difficult to absorb and has cost the insurance fund significantly. Voila! It’s time to take this issue seriously.
The fact is that financial institutions of another breed have been doing the level of internal risk analysis now required of credit unions for years, because what is relatively new for us is old news for them. The requirement placed on credit unions to do this heightened level of portfolio analysis is actually a good thing, in that it will enable them to continue to compete in these and other emerging lending arenas; this is evident with the credit unions that skirted disaster in the past and now have a strategy to conduct ongoing, regular portfolio analysis today. We’ve seen some of these credit unions leave indirect lending, for example, but then return, ready to compete with a new concentration on monitoring and reacting to risk.
Internal risk analysis has several benefits, even for a seemingly simple loan portfolio product mix. Segmenting a portfolio based on certain risk criteria will enable credit unions to maintain more profitable pricing strategies, as analysis can be done by risk tier to determine if pricing assumptions are correct. Looking at the performance of loans by age brackets can help the credit union determine where marketing dollars should be targeted, tailoring the message to attract the most profitable age demographics. Predictability can be gained by following portfolio trends by origination pool, enabling the credit union to more easily and accurately plan for the future. While the old adage, “This is going to hurt me more than it hurts you,” probably does apply to the regulator vs. credit union relationship, as it does for the parent-child relationship, there is a benefit to the required discipline that credit unions are adjusting to today. Credit unions will be stronger and better able to meet their members’ needs, while withstanding the undulation of economic uncertainty.