There are signs the American economy is improving. But, thereare very few signs that small to midsize credit unions and smallcommunity banks are seeing any improvements in their fortunes asthe result of any such improvements in the national economy.

Small to mid-size credit unions and small community banks arefacing some onerous challenges including:

• Oversight from regulatory agencies remains oppressive.Furthermore, resources available to meet increasing regulatoryburdens are limited at small financial institutions
• Consumers and small businesses continue to de-leverage theirdebt. Small financial institutions are still struggling to buildtheir loan portfolios
• Profitability for small financial institutions remainselusive
• For small financial institutions, what little growth there hasbeen in business lending has been primarily in micro-loans (loansdependent on the personal credit worthiness of the businessowner)
• Growth in auto loans has been primarily amongst high creditquality (mature) borrowers. Young and lower credit qualityborrowers are still out of the loan market as are small businessowners
• Community financial institutions continue to engage incut-throat loan pricing and lowering credit standards to attractborrowers
• Financial institutions face increases in credit loss reservesas a result of the impending “current expected credit losses”accounting method being pursued by FASB
• Credit unions in particular face significant increases ininterest rate risk and loan loss risk as a result of the shift tomaking more long-term auto loans (seven to 10 years)

Improving income from their lending activities is of utmostimportance for small credit unions and small community banks. In the current environment, two of the most productive methods toimprove loan income are:

• Reaching deeper into the pool of potential borrowers (“B, C, D,E” credit grades) utilizing empirical, risk-based loan pricingmethods.
• Actively managing and “mining” existing borrowers in loanportfolios using stochastic credit migration models.

Empirically derived credit migration models can be used in anumber of ways to significantly improve portfolio management andprofitability. Management and profitability enhancement methodsusing credit migration include:

1- Managing loan portfolios throughongoing decisioning processes. These processesinclude: stress testing; concentration-risk testing and policydevelopment; multi-dimensional analysis to identify specificlosses; calculating imbedded losses by rescoring loans and thendetermining current loan-to-value ratios on collateral.

2- Managing borrowers who experiencedeteriorating credit scores. Robust credit migration modelswill highlight potential problem borrowers long before most otherreporting methods. Studies show that a deterioration of two or morecredit grades in a borrower's score is one of the best predictorsof an impending charge-off. It is imperative that immediateand aggressive action be taken by loan collection staff to (a)pursue dialogue with the borrower to pursue remedies; (b) reduce orcurtail lines-of-credit; (c) determine what loss mitigation actionsneed to take place.

3- Managing borrowers who exhibit stablecredit scores. Most loans in a lender's portfolio willshow little change in borrowers' credit scores over theirrespective terms. A borrower with a stable credit scoretypically is experiencing little change in credit habits, income,or personal circumstances. Stable borrowers present opportunitiesfor the astute lender. A robust Credit Migration report can be usedto show those borrowers with potential for sales opportunities.

4- Managing borrowers who experienceimproving credit scores. Contrary to what lenders may think,many borrowers do experience significant improvements in theircredit scores. Typically, this happens when a consumer experienceshigher household income, a reduced debt to income ratio, and /orhas learned to better manage their finances. These consumers alsopresent an opportunity for the astute lending institution. It isimportant for a lender to be aware of these borrowers and havemarketing strategies in place. Once again, a robust creditmigration model can highlight those borrowers that presentadditional loan opportunities.

Efficacious credit migration models have many uses. Besidescontrolling loan losses and determining loan-loss reserveplacements, these models can also be used to effectively increaseloan interest income and profitability.

DennisChild is a retired credit union CEO in Logan, Utah,who has been associated with Thompson Consulting andTraining in Boise, Idaho, for 25 years.