Four Pillars of effective Risk management

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



• 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%


• 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


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.

http://www.aba.com/

http://www.rmahq.com/

Contact InformationRandy C. Thompson, Ph.D.Thompson Consulting & Training, [email protected]

Leslie HoffmanLEH Consulting Group505-299-3888 [email protected]

mailto:[email protected]

mailto:[email protected]

Documents

Four Pillars of effective Risk management