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Are credit unions lending to their “best” members only? The industry’s low charge-off rate and delinquency rate (.49% and .72% respectively, according to mid-year NCUA data) suggest that may be the case. While these figures appear positive at first glance, they raise the question of whether less-than-ideal borrowers are inadvertently underserved by their credit unions. In search of a better way to meet members’ borrowing needs, many credit unions are turning to risk-based pricing – using new technology solutions that make the approach more viable than ever. Risk-based pricing – the use of a tiered set of loan rates, with the rate matching the borrower’s risk level – isn’t new to the industry, although it’s gaining in popularity. Opponents argue that it doesn’t treat members equitably, while proponents believe just the opposite, i.e., it offers the fairest rate to each borrower. (Contrary to popular belief, “equitable” doesn’t mean equal; it means fair or just.) Lower-risk members are rewarded with lower rates, while higher-risk members pay more. Conversely, with a “one-rate-fits-all” approach, lower risk members tend to pay a higher rate than they should, while higher-risk members pay a lower rate than they should. Borderline borrowers are often denied under this approach, forcing them to look elsewhere – perhaps to sub-prime lenders – for their borrowing needs. Furthermore, the credit union’s loan growth can suffer, because it’s denying loans it could otherwise sensibly make under a risk-based pricing program. But while most credit unions want to drive loan growth and serve the needs of more members, they also need to run a fiscally sound business by avoiding undue risk. Done properly, risk-based pricing can help the credit union achieve all of those objectives. And the use of risk-based pricing software is one way to handle the process properly. In the past, the assignment of risk-based rates was almost always handled manually – a time-consuming, error-prone, and inconsistent process. Now, risk-based rates can be assigned automatically and consistently, either through a credit union’s core processing system or a separate loan origination solution. A simple interface from a credit bureau to the lending system will generate a credit score; from there, the lending system can automatically return the appropriate rate for each member, based on the credit union’s own business rules. Functionalities like these are now standard components of many core systems and loan origination systems, making risk-based pricing easier and more viable. If you opt to put a risk-based pricing technology solution to work as part of a shift in your lending approach, best practices like these can help ensure success. * Document the benefits first. The board and senior management will need compelling reasons to switch to a risk-based approach. Emphasize potential advantages such as the ability to increase loan volume, expand service to a wider array of members, diversify the asset base, and avoid the problem of “better” members borrowing elsewhere at more attractive rates. * Choose your approach. Some risk-based programs are criteria-based, which means they consider factors such as loan type, loan-to-value ratio, term, and others in calculating the rate. Score-based programs (driven primarily by the credit score) are viewed by many as more objective and consistent. Since the three major credit bureaus validate and revalidate their scoring models regularly, their use can bring a greater degree of objectivity to the evaluation process. * Choose a flexible system. At any given credit union, loans may originate by phone, through an MSR, via a call center, through a Web site, or from indirect channels. The solution you select must enable you to implement risk-based rates on all loans, across all channels. The system should also give loan processors the ability to accept or reject the rate provided, or manually override it later in the process if there is a valid reason. Be sure to track and review such overrides, to ensure your practices are being followed and are non-discriminatory. * Try a pilot. Before jumping in, test the waters to see if risk-based pricing will work for you. Start with a single loan type; then monitor the results and make adjustments before rolling out the new approach. * Avoid discrimination. When using a score-based approach, be sure to use a credit scoring model that’s non-discriminatory, empirically driven, validated, and re-validated regularly. Establish the policies that will govern your loan pricing, consulting with legal counsel in the process. Once your policies are set, communicate them clearly, remind staff of them regularly, and enforce strict compliance. * Train your staff. It’s a given that you’ll provide training for the staff members who’ll use the risk-based pricing software. But since the move to this approach is a cultural shift, your educational efforts need to go beyond that. Lending staff will need guidance on how to quote rates to members before an application is submitted. They’ll also need to learn how to counsel higher-risk borrowers appropriately, from the application through the closing, to help reduce the odds of delinquency. With such training, they can learn to stay alert to opportunities to reduce product risk when working with a higher risk member. Collections staff also will need to understand the system, recognize the different risk levels, and adjust their response accordingly. * Monitor and adjust. How will the board and senior management define the success of this effort? It’s important to identify the metrics you’ll track and the reporting mechanisms you’ll use to determine if the program is working. While delinquency and charge-off rates are important, don’t view them in a vacuum. Remember to look at the broader picture, too, such as your overall return on assets. You may find a slightly higher charge-off rate is more than made up by a higher ROA. In a tight economy, more of your members are likely to fall into the “gray” category that’s tough to serve with a single-rate approach. To best serve your members and to grow loans in this economy, you’ll want to find ways to make the right higher-risk loans – rather than finding reasons to deny them. A closer look at the merits of risk-based pricing and the technologies that support it can serve both credit unions and their members well.

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