Never in the history of the credit union industry has so much emphasis been put on risk concentrations. There is no need to wonder why. High concentrations of certain risks are a major cause of credit union failures.
What is unique about our current environment is the number of risks that have materialized into losses during recent years. So it’s no longer just interest rate and default risks that are getting the attention of examiners. These days other risks are being emphasized with equal fervor, such as, collateral, liquidity, transaction, delivery channel and third-party risks, just to name a few.
And hovering over all these risks is concentration risk, which is having a proportionately high level of any one risk. The concern is that in the event the risk should materialize, the credit union’s earnings would deteriorate significantly.
Obviously, most credit unions have not neglected to address individual risks in the past. Each has its own method of analyzing, measuring, quantifying and maybe even qualifying various areas of risk. But it is probably safe to say that many have not combined these individual analyses into one comprehensive assessment that identifies the overall level of the credit union’s concentration risk.
Simply put, a concentration risk assessment is an umbrella analysis that combines all other risk assessments with the objective of identifying and measuring the credit union’s exposure in each risk area and for each product or service.
Combining multiple risk assessments into one analysis that produces meaningful results can be a daunting task. Developing a balanced scorecard is a great way of concisely documenting the results of various risk assessments.
The goal is to combine the individual risk analyses, many of which are very technical, into a single document that quantifies the credit union’s concentration risk position. Take this process one step further and the scorecard can also help lead strategic discussions by adding a qualitative rating that guides the credit union’s posture for the future.
A concentration risk assessment starts with segmenting assets and liabilities into groups that share similar risk characteristics. Then determine the risk categories that will be analyzed, but don’t forget profitability.
The essence of the credit union's business model is to be adequately compensated for taking risks. To exclude profitability from the analysis would result in an incomplete and unbalanced conclusion, which could lead to risk avoidance, instead of healthy diversification. So determining the profitability of each product or service is imperative to conducting a complete concentration risk program.
Once metrics have been created to measure levels of each risk, a rating system should be developed. Similar to other rating systems used throughout the financial industry, each credit union can have an internal system that essentially quantifies and qualifies the levels of risk in each asset group.
When applied to the scorecard format, the rating system will quantify the levels of concentration risk. Taking this process one step further, the ratings system can also qualify the credit union’s position, which can then be used to effect strategic planning and identify opportunities. See the Sample Rating System table.
This ratings system takes all the finding of the individual risk assessments and transforms them into a directional term, such as leverage, mitigate or improve. Applying this rating system in a simple lending concentration scorecard format is presented in the ABC Credit Union table.
ABCCU chose three asset segments and three measurement areas. The credit union already performed assessments on default risk, interest rate risk and product profitability. The results of the three assessments were used to assign a rating to each asset group. The scorecard shows the average rating for each asset group and the weighted average rating for each risk category. These average ratings make it easy to determine where ABCCU concentrations lie.
Having a rating of 2.3, the first-mortgage loan product presents a significant amount of concentration risk, but not just because this loan product accounts for 60% of the credit union’s assets. This product has high interest rate risk and is not profitable.
The scorecard also shows us that the other two asset groups are well balanced products. In other words, these two products provide sufficient income in relation to the risk each presents to the credit union.
Now take a look at the weighted average ratings for each area of risk. It is apparent that ABCCU’s loan portfolio has a low concentration of default risk, which would indicate conservative underwriting. It has a moderate concentration of interest rate risk since the first-mortgage loan product is entirely comprised of long-term fixed rate products. Overall, ABCCU is not very profitable, and therefore has a high concentration of products (first mortgages) with below average profitability.
Taking the analysis one step further, this system provides a qualitative rating that can be used to lead strategic discussions. The above example illustrates how this type of concentration risk assessment could sway ABCCU’s strategic plans. Before the assessment, ABCCU may have been bearish on unsecured loans because of the high default risk. Auto loans may have not been pursued based on the marginal profitability of the product and the credit union may have stopped booking first-mortgage loans to its portfolio.
Using the results of the scorecard, ABCCU may have different plans for the future. It may decide to promote unsecured products more aggressively despite the high default risk because these loans are very profitable and the credit union as a whole does not have a high concentration of default risk.
Therefore, the low default risk position and high profitability of unsecured loans would be leverage to increase the overall health of the credit union. Additionally, increasing the proportion of unsecured loans would improve the credit union interest rate risk position.
Another outcome may be to grow the auto loan portfolio, even though it is moderately profitable. This decision is made with the objective of improving the credit union’s interest rate risk profile and to counteract the additional default risk that will be added when unsecured loan balances grow.
The above decisions were not made on the basis of avoiding risks. On the contrary, they seek growth in areas that may have previously been avoided. Growing in these areas will improve the credit union’s overall health by lowering concentrations that currently exist.
Essentially, these decisions will lead to portfolio diversity through growth in product lines that possess strengths that counteract the current weaknesses of the credit union. Successfully growing automobile and unsecured loans will provide balance sheet strength through balance and diversity.
The complexity of a comprehensive concentration risk assessment prohibits a complete discussion in this article. The NCUA’s Supervisory Letter on Concentration Risk provides a complete guidance of how a concentration risk assessment should be incorporated into a credit union’s current risk management program.
But keep in mind–even though the objective is to set limits on concentrations, the real value of this assessment is to identify opportunities. From this awareness, strategies can be developed that lead to a more diverse and therefore healthier balance sheet.
Pete Sekul is vice president of lending at Andrews Federal Credit Union in Suitland, Md.