Credit Migration Modeling to Better Manage Loan Portfolios, Improve Profitability
There are signs the American economy is improving. But, there are very few signs that small to midsize credit unions and small community banks are seeing any improvements in their fortunes as the result of any such improvements in the national economy.
Small to mid-size credit unions and small community banks are facing some onerous challenges including:
- Oversight from regulatory agencies remains oppressive. Furthermore, resources available to meet increasing regulatory burdens are limited at small financial institutions
- Consumers and small businesses continue to de-leverage their debt. Small financial institutions are still struggling to build their loan portfolios
- Profitability for small financial institutions remains elusive
- For small financial institutions, what little growth there has been in business lending has been primarily in micro-loans (loans dependent on the personal credit worthiness of the business owner)
- Growth in auto loans has been primarily amongst high credit quality (mature) borrowers. Young and lower credit quality borrowers are still out of the loan market as are small business owners
- Community financial institutions continue to engage in cut-throat loan pricing and lowering credit standards to attract borrowers
- Financial institutions face increases in credit loss reserves as a result of the impending “current expected credit losses” accounting method being pursued by FASB
- Credit unions in particular face significant increases in interest rate risk and loan loss risk as a result of the shift to making more long-term auto loans (seven to 10 years)
Improving income from their lending activities is of utmost importance for small credit unions and small community banks. In the current environment, two of the most productive methods to improve loan income are:
- Reaching deeper into the pool of potential borrowers (“B, C, D, E” credit grades) utilizing empirical, risk-based loan pricing methods.
- Actively managing and “mining” existing borrowers in loan portfolios using stochastic credit migration models.
Empirically derived credit migration models can be used in a number of ways to significantly improve portfolio management and profitability. Management and profitability enhancement methods using credit migration include:
1- Managing loan portfolios through ongoing decisioning processes. These processes include: stress testing; concentration-risk testing and policy development; multi-dimensional analysis to identify specific losses; calculating imbedded losses by rescoring loans and then determining current loan-to-value ratios on collateral.
2- Managing borrowers who experience deteriorating credit scores. Robust credit migration models will highlight potential problem borrowers long before most other reporting methods. Studies show that a deterioration of two or more credit grades in a borrower’s score is one of the best predictors of an impending charge-off. It is imperative that immediate and aggressive action be taken by loan collection staff to (a) pursue dialogue with the borrower to pursue remedies; (b) reduce or curtail lines-of-credit; (c) determine what loss mitigation actions need to take place.
3- Managing borrowers who exhibit stable credit scores. Most loans in a lender’s portfolio will show little change in borrowers’ credit scores over their respective terms. A borrower with a stable credit score typically is experiencing little change in credit habits, income, or personal circumstances. Stable borrowers present opportunities for the astute lender. A robust Credit Migration report can be used to show those borrowers with potential for sales opportunities.
4- Managing borrowers who experience improving credit scores. Contrary to what lenders may think, many borrowers do experience significant improvements in their credit scores. Typically, this happens when a consumer experiences higher household income, a reduced debt to income ratio, and /or has learned to better manage their finances. These consumers also present an opportunity for the astute lending institution. It is important for a lender to be aware of these borrowers and have marketing strategies in place. Once again, a robust credit migration model can highlight those borrowers that present additional loan opportunities.
Efficacious credit migration models have many uses. Besides controlling loan losses and determining loan-loss reserve placements, these models can also be used to effectively increase loan interest income and profitability.