Monitoring Whether the Current Economic Uncertainty is Bringing Greater Risk to Your Loan Portfolio
By Tim Harrington
Economic uncertainty makes assessing risk in a credit union’s portfolio that much more difficult. Credit unions can take advantage of existing reports to tease out signals and indicators to help determine what’s happening within their sphere.
Ask an economist if the U.S. economy is going to stay strong or slip into a recession and they will probably just give you a perplexed look. Why? The economic signals are terribly mixed. Traditional indicators of health or recession are occurring simultaneously, and no one knows where things are going from here.
But as a board and management team, there are a variety of internal reports that can give you an idea whether your credit union’s risks are increasing or decreasing. The traditional measures of credit risk, namely delinquency and charge-offs, will not tell you that your risks are changing. These are “lagging indicators.” These tell you of a problem in the past, not that a problem may be starting to happen.
What Can You Do?
Suggestion: management can set up and monitor indicators that are still “lagging,” but not as far behind the curve as delinquency and charge-offs. Set up and review the following measures and share their results, perhaps quarterly, with the board of directors:
- Credit Score Migration: This requires a software program that can look at the current credit scores of borrowers already on your books. This tells you if the borrower’s credit score has improved or declined since origination. If these begin to decline, borrowers are having trouble keeping up with their borrowing obligations. The programs can also show whether the value of the loan’s collateral is enough to cover the current balance or not.
- Percent of Loans with Force Placed or Lapsed Insurance: Your auto and home borrowers are required to obtain casualty and property insurance on the collateral they use for a loan. If a borrower is beginning to have financial problems and needs to cut expenditures, they often stop paying for their insurance before they stop paying on a loan. When the credit union receives notice that the borrower’s insurance has lapsed, they can record this. If the percentage of lapsed insurance in a portfolio rises, it often indicates borrowers are beginning to suffer financial problems.
- Percent of Loans with Late Loan Fees: Much like the report above, a higher percentage of loans starting to come in late, could also indicate the weakening of a borrower’s financial condition.
- Average Credit Score of New Loans Added to Loan Portfolio: If the credit score of new loans coming in to your loan portfolio begins to decline, it suggests that the risk in your portfolio is growing. This report has many uses, but a key one is the indication of a weakening market of borrowers.
Watching for Weakening (or Strengthening)
By using this group of reports, a management team and board can often begin to see a weakening (or strengthening in good times) of their loan portfolio long before delinquency or charge-offs worsen. If the indicators begin to point to weakening in the financial condition of your borrowers, the credit union may consider a more conservative lending risk appetite. The lending risk appetite needs to flow with the economic cycles. In good cycles, lending can be more aggressive and earn a higher yield. When the cycles turn downward, caution may be the word of the day so that new risks are not added to your portfolios when borrowers’ personal financial situations weaken. These reports won’t tell you what to do, but they can indicate if changes, positive or negative, are beginning to occur in the credit union.
Risk Intelligence, not risk avoidance, is so important a the board and management level. So reports like this can bring greater information to a board and management team. With better information, risk intelligent decisions are easier to make. Just because the economy drops doesn’t mean your borrowers are suffering. Conversely, just because the market is good doesn’t mean your borrowers are in good shape. These reports give you a picture of how YOUR borrowers are doing.
I’m sure your credit union has other helpful reports and ideas to monitor risk in your portfolio. By including these items, your team can get an even better picture of your overall lending risk cycle.