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Four Pillars of effective Risk management. Session Leader: Randy Thompson, Ph.D. Thompson Consulting & Training Eagle, Idaho Co-presenter Leslie Hoffman LEH Consulting Group Albuquerque, New Mexico. Current Conditions. Slow economic growth Low loan demand from higher credit borrowers - PowerPoint PPT Presentation
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FOUR PILLARS OF EFFECTIVE RISK MANAGEMENTSession Leader: Randy Thompson, Ph.D.Thompson Consulting & TrainingEagle, Idaho
Co-presenter Leslie HoffmanLEH Consulting GroupAlbuquerque, New Mexico
Current Conditions
• Slow economic growth
• Low loan demand from higher credit borrowers
• Decreasing loan to share
• Decreasing interest income
• Risk aversion
Lender Response• Competitive Environment
• High demand from lenders for lowest risk loans
• Desire to minimize loss exposure
• Tighter underwriting standards
Effect on Lenders• Focus on A+ and A loans for minimum risk
• Competition forcing rates lower
• Results in declining yields from the loan portfolio
Income tied balance and yield
Lending Organization 2011 Yield 2012 Yield Change Loan Balance Interest Income Lost
1 5.57% 4.71% -0.86% $129,714,000 ($1,115,540.40)2 7.28% 6.46% -0.82% $26,910,000 ($220,662.00)3 7.54% 6.58% -0.96% $10,888,000 ($104,524.80)4 7.43% 5.81% -1.62% $79,484,000 ($1,287,640.80)5 6.45% 5.64% -0.81% $18,933,000 ($153,357.30)6 8.16% 7.29% -0.87% $199,438,374 ($153,357.30)7 5.76% 4.87% -0.89% $182,550,000 ($1,624,695.00)8 6.29% 5.48% -0.81% $136,821,000 ($1,108,250.10)9 6.28% 5.91% -0.37% $18,448,000 ($68,257.60)
Many Lenders are on a Collision Course with Disaster
-1% Down-shock Org 1 Org 2 Org 3 Org 4Base Year Equity $3,552,117 $30,690,069 $6,392,026 $11,188,339 Year 5 Equity $2,861,356 $26,126,872 $4,730,003 $6,526,093Cumulative Equity Change
$(690,761) $ (4,563,197) $ (1,662,024) $(4,662,246)
Base Year Equity Ratio 8.46% 8.97% 12.07% 9.66%Year 5 Equity Ratio 6.82% 6.60% 7.94% 5.63%Equity Ratio Change -1.64% -2.37% -4.13% -4.03%
Examples and Impact
• Can each organization quantify that the loans they are funding will cover all loan related costs and provide a adequate return?
or…
• Are they offering loan to simply attract a volume of unprofitable business?
Down-shock and Impact We have been actively operating in the down shock
environment for the past 3 years.
Base Interest Rates◦ June 2010 4.62%◦ June 2013 2.97%
Reduced rates are useful if demand is strong
If demand is stagnate, reduced rates simply reduce yield and income
Strategies to Improve Performance Maintain current volume of prime grade loans
Add lower grades loans equal to 30%-35% of current volume
Average rate on non-prime loans 12%
Increase ALLL to account for increased risk
Impact on Earnings• Increased non-prime loans carries higher risk
• Accommodate risk with higher allowance funding
• Estimate of increased risk is 4% of balances annually
• Subtract increased allowance from increased earnings to identify net earnings increase.
Applying this methodology and its tools, multiple lenders have turned their yields and income around:
CU2012 Yield
2013 Yield Change Loan Balance Income Gained
1 6.46% 6.62% 0.16% $ 27,620,000 $ 44,192.00
2 6.58% 6.85% 0.27% $ 11,850,000 $ 31,995.00
3 5.50% 5.81% 0.31% $ 79,685,000 $ 247,023.50
4 5.64% 5.73% 0.09% $ 18,922,000 $ 17,029.80
5 5.48% 5.62% 0.14% $ 137,650,000 $ 192,710.00
Four Pillars of Effective Risk Management
• I: Credit Analysis
• II: Empirically Derived Risk Based Pricing
• III: Credit Monitoring
• IV: Managing Repayment
Pillar I: Credit Analysis• Underwriting that takes into account the risk associated
with the loan and the borrower
• Identifies risk components to be considered in approving or denying the loan
• Creates a loan package that manages risk and return
• Comprehensive and consistently applied policies
• Clarify acceptable loans
• Specify the amounts in each grade
• Specify terms
• Specify maximum loan amounts
• Specify minimum rate spreads
Pillar I: Credit Analysis
Pillar II: Empirically Derived Risk Based Pricing
• Accounting for costs
• Identifying replacement cost of money
• Assuring an adequate margin/return
• Regular model validation
• Account for all costs associated with loan programs
• Measure and assign costs to each grade independently
• Measure and assign replacement cost of money
• Set rates and measure margins
• Eliminate unprofitable rates and cross grade subsidies
Pillar II: Empirically Derived Risk Based Pricing
Pillar II: Empirically Derived Risk Based Pricing
• Accurate, Effective Pricing Requires:
• Identification of core costs• Cost of Funds• Processing/Maintenance• Collections• Charge-offs
• Identification of risk pools
• Application of costs to pricing
• Strategies to balance loan and share rates
• Ongoing validation of the model
Perform Regular and Complete Cost Analyses
1. Cost of Funds• Lease payment for deposits• Average of payment for all deposits• Replacement cost over time
2. Processing/Maintenance• Contribution of staff time • Application of Operational Expenses• Distribution of Administration Costs
Perform Regular and Complete Cost Analyses
3. Collections• Examining collection expenses over time• Grouping by risk pool• Grouping by risk grade
4. Charge-offs• Examining charge-offs over time• Grouping by risk pool• Grouping by risk grade
Risk-based Cost Breakout Cost Factors Fixed 2% Mark-up Costs A+ A B C D E Booking 1.12% 1.12% 1.12% 1.12% 1.12% 1.12% Collections 0.09% 0.16% 0.32% 0.36% 0.49% 0.57% Charge-Off (Risk) 0.33% 0.56% 1.13% 1.30% 1.75% 2.05% Sub-Total 1.55% 1.83% 2.57% 2.78% 3.36% 3.74% Spread Margin 2.00% 2.00% 2.00% 2.00% 2.00% 2.00% Total Mark-Up 3.55% 3.83% 4.57% 4.78% 5.36% 5.74% Cost of Funds 0.43% 0.43% 0.43% 0.43% 0.43% 0.43% Rate 3.98% 4.26% 5.00% 5.21% 5.79% 6.17% Interest Rate Differential 0.00% 0.28% 1.02% 1.23% 1.82% 2.20%
Empirically Calculated Risk Based PricingSECTION ONE SECTION TWO SECTION THREE Weighted
MODEL 1 (2% FIXED MARGIN) ACTUAL RATES MARGIN Average
Term
A B C D E R
Term
A B C D E R
Term
A B C D E R Spread
740+690-739
660-689
630-659
600-629
524-599 740+
690-739
660-689
630-659
600-629
524-599 740+
690-739
660-689
630-659
600-629
524-599 All Loans
363.98
% 4.26% 5.00% 5.31% 5.90% 6.23% 36 2.24% 3.24% 5.24% 8.24% 12.24% 15.24% 36 0.26% 0.98% 2.24% 4.93% 8.34% 11.01% 4.66%
483.98
% 4.26% 5.00% 5.31% 5.90% 6.23% 48 2.49% 3.49% 5.49% 8.49% 12.49% 15.49% 48 0.51% 1.23% 2.49% 5.18% 8.59% 11.26% 4.91%
603.98
% 4.26% 5.00% 5.31% 5.90% 6.23% 60 2.74% 3.74% 5.74% 8.74% 12.74% 15.74% 60 0.76% 1.48% 2.74% 5.43% 8.84% 11.51% 5.16%
724.13
% 4.41% 5.15% 5.46% 6.05% 6.38% 72 2.99% 3.99% 5.99% 8.99% 12.99% 15.99% 72 0.86% 1.58% 2.84% 5.53% 8.94% 11.61% 5.26%
844.26
% 4.54% 5.28% 5.59% 6.18% 6.51% 84 3.24% 4.24% 6.24% 9.25% 13.25% 16.25% 84 0.98% 1.71% 2.97% 5.67% 9.08% 11.75% 5.39%
% of Loan Portfolio by Grade
24.48% 17.57% 12.09% 11.00% 8.54% 26.32%
Pillar II: Empirically Derived Risk Based Pricing
• Assure all loan grades and types are contributing equitably• Measure returns/margins for pools and grades
• Eliminate Cross-Grade Subsidies• Identify returns that are reducing over grades
Pillar II: Empirically Derived Risk Based Pricing
We can look at expanded options to address risk
Pricing for Risk Grade
Pricing for LTV
Pricing for Term
Pillar III: Credit Monitoring
• Credit Migration of Impaired and Improved Loans
• Net Credit Change
• Ongoing Loan Decisioning
Credit Migration•Many names for the same concept
• Credit migration
• Multi-dimensional portfolio management
• On-going decisioning
• Migration Analysis
Credit Migration• No matter what name you use it is an important tool for
managing the risk in your loan portfolio;
• Examiners are asking for, and in some cases, requiring it; and
• FASBE is currently examining changing guidance to focus on credit migration in allowance calculation
Credit MigrationDefinition:
A measurement of changes in credit scores and risk for individual loans in the loan portfolio of the lending organization. The composite of these changes provides a valid measure of the current risk inherent in the total portfolio.
Understanding Credit Scores• Credit agencies continually monitor multiple risk indicators
to calculate credit scores:
• Payment history
• Amount of credit
• Available credit
• Employment history
• Repossessions
• Bankruptcies
• Foreclosures
Understanding Credit Scores• Each of these variables is dynamic
• Changes in variables may change credit
• Credit changes affect risk
• Changes in risk may be an predicator of a member’s future performance
• Consistent Credit Migration Analysis
• Original credit scores on current loans and balances
• Recent credit scores on current loans and balances
• Measure and identify impaired loans
• Measure and identify improved loans
• On-going Decisioning with impaired loans
Pillar III: Credit Monitoring
Credit Migration Matrix-Portfolio• Create migration matrix for total portfolio• Original credit and current credit
Credit Migration Matrix-Pools• Create migration matrix for each risk pool
Credit Migration
• Understanding your Loan Portfolio
• Credit risk can Increase or Decrease
• Which risk pools are improving impairing?
• What is the net credit change for each pool?
Credit Scores and Loan Types• It is also important to partition loans by risk pools and apply
the same analysis individually to each pool.
Net Credit Change• Create net credit change calculation
Credit Migration
• Identifying Potential Problems
• Isolate impaired loans and react to them early
• Reduce Credit Limits
• Freeze lines
• Adjust rates
• Understand the risk in your pools and adjust lending practices
• Adjusting debt ratios
• Adjusting LTVs
• Other underwriting changes
Credit Migration
• Why are deteriorating credit scores important to identify?
• 70% to 80% of your charge-offs come from loans with
deteriorating credit scores
Using Credit Scores to Manage Risk• How Can You Manage risk on an ongoing basis• Monitor changing risk scores and adjust:
• Rates• Allowance• Credit limits• Limits on non-prime loansDollar Original credit Grades
Grand TotalCurrent credit A+ A B C D ENot
Reported
A+ 740+
33,886,855 4,911,282 1,696,945 425,522
105,543 63,014 3,184,419
44,273,580
A 690-739
7,886,015 11,359,190 5,212,544 857,840
146,917
147,464 1,828,060
27,438,030
B 660-689
1,857,191 4,601,064 10,527,101 2,055,535 1,333,417
158,714
537,630
21,070,652
C 630-659 910,286
910,852 2,541,847 2,547,064 886,367
848,199
268,658
8,913,273
D 600-629 17,970
123,766 1,503,642 2,480,152
715,706
525,812
526,391
5,893,438
E <600
91,237
610,842 1,026,951 2,088,359
717,708
643,272
563,043
5,741,413 Not
Reported 75,089
29,047
481,778 189,437
-
300
472,982
1,248,632
Grand Total
44,724,643 22,546,043 22,990,809 10,643,908 3,905,658 2,386,776 7,381,182 114,579,017
More on Credit Migration
• Identifying Emerging Opportunities
• Recognize Members that are making smart decisions
• Proactively offer ways to help your members
• Understand which pools of loans to take on more risk
• Applying Precision in Allowance Calculation
• Statistically based calculation
• Complying to regulations
Identifying Opportunities• Improving Credit scores are also important• Central mission of helping members• Targeted marketing• Increased loyalty• Upsell opportunities
Dollar Original credit Grades
Grand TotalCurrent credit A+ A B C D E Not Reported
A+ 740+
33,886,855 4,911,282
1,696,945 425,522
105,543 63,014
3,184,419
44,273,580
A 690-739
7,886,015
11,359,190
5,212,544 857,840
146,917
147,464
1,828,060
27,438,030
B 660-689
1,857,191
4,601,064
10,527,101 2,055,535
1,333,417
158,714
537,630
21,070,652
C 630-659 910,286
910,852
2,541,847 2,547,064
886,367
848,199
268,658
8,913,273
D 600-629
17,970
123,766
1,503,642 2,480,152
715,706
525,812
526,391
5,893,438
E <600
91,237
610,842
1,026,951 2,088,359
717,708
643,272
563,043
5,741,413 Not
Reported
75,089 29,047
481,778 189,437
-
300
472,982
1,248,632
Grand Total
44,724,643 22,546,043 22,990,809 10,643,908
3,905,658
2,386,776
7,381,182
114,579,017
Process of Credit Migration
• Soft pull of credit scores/reports
• Create migration matrix
• Create net credit change calculation
• Update portfolio analysis
• Identify percentages of loans by grade
• Update allowance
• Perform individual loan analysis
Pillar IV: Managing Repayment A Continuous Process
Marketing• Message
s should support philosophy
• Target clients should be clear
Application• Offer
value in this stage
• Be thorough
• Think about what a collector may need later
Underwriting • Codified,
clear standards
• Regular portfolio monitoring to ensure the right risk parameters
Account Management• Find
multiple ways to be in touch
• Are clients clear about where their account stands?
Customer Service• What
you appreciate in the relationship will appreciate!
43
Step 1: The Right Tools and Support
How does your organization define
key terms?
Who’s collecting and when?
What expertise and resources are
available? (legal, auction, repo, etc.)
44
Step 2: The Right Information• Are you pulling regular reports on the aging of your portfolio?• Look for movement between buckets
• Are you tracking communication?• That log is a critical tool
• Do you know how your client is performing with other creditors?• Pull a credit report
Using Credit Scores to Manage Risk• How Can You Manage risk on an ongoing basis• Monitor changing risk scores and adjust:
• Rates• Allowance• Credit limits• Limits on non-prime loansDollar Original credit Grades
Grand TotalCurrent credit A+ A B C D ENot
Reported
A+ 740+
33,886,855 4,911,282 1,696,945 425,522
105,543 63,014 3,184,419
44,273,580
A 690-739
7,886,015 11,359,190 5,212,544 857,840
146,917
147,464 1,828,060
27,438,030
B 660-689
1,857,191 4,601,064 10,527,101 2,055,535 1,333,417
158,714
537,630
21,070,652
C 630-659 910,286
910,852 2,541,847 2,547,064 886,367
848,199
268,658
8,913,273
D 600-629 17,970
123,766 1,503,642 2,480,152
715,706
525,812
526,391
5,893,438
E <600
91,237
610,842 1,026,951 2,088,359
717,708
643,272
563,043
5,741,413 Not
Reported 75,089
29,047
481,778 189,437
-
300
472,982
1,248,632
Grand Total
44,724,643 22,546,043 22,990,809 10,643,908 3,905,658 2,386,776 7,381,182 114,579,017
Step 3: Set Goals, Build a Schedule• Follow a schedule/protocol
• That should start the first day of delinquency • Schedule activities
• What are the best times to reach clients?
• Set goals• No. of calls per day, week or month• Dollars collected per week or month or by staff
member
Step 4: Collect with Care and Confidence
Before the call
Your opening
Overcoming objections
Motivational appeal
“Close” the deal
Follow up
Four Pillars of Effective Risk Management
• I: Credit Analysis
• II: Empirically Derived Risk Based Pricing
• III: Credit Monitoring
• IV: Managing Repayment
Monitoring Collection Success•List of delinquent loans were collected on a monthly •Included the account number for each loan, the balance of the loan, the days delinquent and any loan balances that had been charged off each month.
•Loans were partitioned into five groups representing advanced delinquent loans, as measured by days delinquent.
Monitoring Collection Success•The breakout of loans for these groups was as follows:
Group Days Delinquent 1 11-29
2 30-44 3 45-59 4 60-89 5 90+ •Charged off loans were labeled as group 9. •Non-delinquent loans were labeled as 0.
Monitoring Collection Success•Two digit numbering system tracks the movement of loans over time.
• First number represented the DQ group from previous month. • Second number represented the DQ group from the current month.
•Examples:1. A loan that was 14 days delinquent in the previous month but paid
current in the current month would be coded 10 (group 1 the previous month and not delinquent this month).
2. A loan that was 88 days delinquent the previous month but 120 days delinquent this month would be coded 45.
3. A loan that was 90+ days delinquent last month and charged off this month would be coded 59.
Monitoring Collection SuccessOutcomes:
• Initially 45% to 60% of reportable DQs ended in charge-off
•Within a year of implementation 25% and 35% 45% to 55% of reportable DQs ended in charge-off
•Increased accountability of collection efforts and staff
Resources54
Training:• This state association!• Your state’s independent community bank association or chapter of the American Bankers Association (www.aba.com)
• National associations: Opportunity Finance Network, Association for Enterprise Opportunity
• Risk Management Association www.rmahq.comReadings:
• Motivational Interviewing: Preparing People for Change, Rollnick & Miller, 2002.
• Crucial Conversations: Tools for Talking When the Stakes are High, Patterson, et al.,2002.
Contact InformationRandy C. Thompson, Ph.D.Thompson Consulting & Training, Inc.208-939-8366rthompson@tctconsult.com
Leslie HoffmanLEH Consulting Group505-299-3888 Leslie@LEHConsultingGroup.com
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