The pressure on community financial institutions to increase loan volume is so intense that many consider slightly lowering credit standards or providing lower-interest borrowing than in the past. That puts a heavier burden on vigorous collection systems to proactively manage any elevated risk and help ensure profitability.
Those banks and credit unions face increasing competition for business, real estate and auto loans, in addition to lines of credit – all once primary staples of community institutions only – in a challenging economic environment that permits shakier underwriting standards. In addition, compliance with new regulations, such as the Dodd-Frank financial reform law, also further weakens financial institutions already contending with diminishing profit margins.
Three ways to increase revenue are improving loan revenue, lending margins and debt collections.
How Financial Institutions Compete for Loans
Instead of focusing on methods to meet additional needs of current accountholders and build new and better relationships with more creditworthy customers, many financial institutions try to compete against each other and nonbank competitors on price and easy-credit schemes. Some industry experts believe this leaves banks and credit unions more vulnerable to client-poaching from competitors with more tempting offers.
According to a Harvard Business School white paper, community banks account for more than 50% of small-business loan volume and almost half of commercial real estate lending. Often, hometown economies depend on this underwriting capability of their community financial institutions engaged in strong, appropriately underwritten loans.
- Capital lines of credit for ongoing cash needs.
- Credit cards or unsecured revolving credit.
- Short-term commercial loans for one to three years.
- Longer-term commercial loans usually secured by real estate or other major assets.
- Equipment leasing for assets businesses don’t want to acquire outright.
- Letters of credit
Banks and credit unions also lend money for significant, but necessary items like vehicles, education and home repairs.
In the past and with the correct breakdown and aim a bank or credit union would target only those meeting pre-defined measures to offer these types of loans and avoid applicants with a poor credit history.
However, in the post 2009 crisis atmosphere, banks and non-banks became more aggressive in satisfying the consumer’s growing demand for credit. A similar policy helped grow mortgages, home equity loan and home equity line-of-credit balances.
Alternative Lenders Challenge Bank and Credit Union Loan Growth
The burgeoning online lending market fueled the alternative environment with appealing technology platforms, the capability to use alternate data sources to judge creditworthiness, rapid growth of new companies and product offerings geared to borrowers.
By using technology and unconventional underwriting techniques, many alternative lenders vied for borrowers with quicker processing times, automated apps, minimal demands for financial documentation and same-day funding, services most community banks struggled to match.
Harvard Business School called this phase the “wild west,” fueling fear that disruptors would capture a large share and dominate the lending market because for many consumers it does not matter whether a loan comes via a bank or a non-bank.
According to a Washington Post article, in 2011, 50% of all new mortgage money originated from the three biggest banks in the United States: JPMorgan Chase, Bank of America and Wells Fargo. But by September 2016, the share of loans by these three big banks dropped to 21%.
At the same time, in 2016, six of the top 10 largest lenders by volume were non-banks, such as Quicken Loans, loanDepot and PHH Mortgage, compared with just two of the top 10 in 2011.
The rising and aggressive competition from unregulated lenders, a number of bad practices, such as lending to dubious borrowers, prompted calls for regulatory action as community banks sought ways to compete. In the meantime, banks looked to attract new borrowers by either offering new or expanded loan product offerings; or dropping approval standards on current loan products; or both.
Even when banks withdrew, borrowers found ready financing from alternative lenders such as Kabbage, Accion, RapidAdvance, OnDeck, Crest Capital, Merchant Advisors, PayPal, RapidAdvance, SnapCap and Square.
Some research also suggests these nonbank lenders may offer growth opportunities for community financial institution in terms of formal partnerships and alliances.
How Risky Credit Decisions Trigger Bank Regulator Attention
With relaxed loan underwriting standards appearing amid fierce competition, particularly for vehicles, some regulatory bodies started taking notice. The practice triggered concerns that financial institutions are taking on too much risk and skirting with compliance standards.
According to data released by the Federal Reserve Bank of New York, outstanding household debt increased by 1.2% in the first quarter of 2017, bringing household debt above its 2008 peak and driving increases in almost every debt category.
In particular auto loans have been growing rapidly thanks to numerous Americans who went on a motor vehicle shopping spree in recent years. Many paid for their vehicles by taking out a loan. That explains why a record 107 million Americans, about 43% of the entire adult population in the U.S., have auto loan debt.
In early 2012, only 80 million Americans had car loans. In fact, more Americans had home mortgages than auto loans in 2012. Today the number of auto loans far and away outperforms home loans.
The concern is that six million people are 90 days or more behind on their car payments, according to the Fed data.
The Office of the Comptroller of the Currency warned that the $1 trillion car loan industry has gotten more dangerous due to its unprecedented growth in auto loans, rising delinquencies, dwindling used car values, and relaxed underwriting standards.
The OCC report, for example, also raised concerns about auto loans, especially the lower-quality agreements known as subprime. Some industry onlookers even admitted that auto lending looked stretched. Indirect auto lending, where banks give dealers cash to lend to car buyers, is also an area to watch for “significant fair lending risk,” the OCC said.
Several regulatory bodies are also currently engaged in some aspect of the online lending market for small business loans as well but no federal regulator currently has explicit authority over non-bank business lenders.
Following the 2009 mortgage lending crisis, the cost of complying with new regulations and the risk of making mistakes forced numerous financial institutions to pay fines, retract flawed loans and reduce their mortgage business.
Simultaneously, meeting stress tests and having more capital on hand to handle more defaults became added requirements. Non-banks don’t need capital.
According to the OCC, credit risk continues to require the most attention by federal banking regulators. The OCC noted particular concern about commercial real estate concentration risk at community banks. The regulators issued a joint statement in December 2015 to reinforce the importance of prudent risk management practices for CRE lending.
How to Reduce Credit Risks at Financial Institutions
Several credit risk trends in particular warrant attention from financial institutions including sales practices, portfolio composition and credit philosophy.
Sales Practices – Following the Wells Fargo scandal over bogus accounts, the OCC added a strong emphasis on governance of sales practices. “Control breakdowns over the governance of retail product sales practices can erode trust in the banking system,” the agency said. “Effective systems to detect and address fraud and possible unfair or deceptive practices in a timely manner, including effective complaint management systems, are critical.”
Portfolio Composition – Community banks and credit unions face several risk issues related to their loan portfolios. In an effort to drive revenue and locate new revenue sources, some have begun to offer riskier products such as subprime, student and mezzanine loans, a hybrid of debt and equity financing.
Credit Philosophy – Surrendering to the pressure for more loan volume more community institutions offered new products and eased underwriting just to drive their loan volume up. Risky layering, such as additional policy exceptions, higher loan-to-value ratios and flimsier covenants, amplifies the continuing trend to facilitate underwriting.
The mounting credit risk— along with the increased cost of regulatory obedience, low interest rate environment, general uncertainties and the need to stay compliant — created apprehensive bankers. Especially since state and federal guidelines govern repayment conditions regardless of loan type to protect consumers from unsavory practices.
Powerful collection software helps keep outstanding loan repayment delinquencies down, prevents some charged-offs, and provides for improved recoveries on prior charged-offs; while increasing net income.
A robust collection system uses fully automated debtor messaging whenever possible such as voice messaging, email, text, voice to voice, and letters to encourage repayment on time. It also provides a complete 360-degree debtor view and account relationship profile.
This provides banks and credit unions with the best techniques to help leverage specific scores (contact-ability, collectability, overall recovery) during the loan servicing life (versus loan origination scores), and best channel appropriate collection work flows that yield the best possible results to the financial institution.
Another important byproduct is strong compliant collection-documentation with automated portfolio performance tracking and reporting.
In order to remain successful and grow lending revenue, financial institutions must ensure they retain all of their current customers’ needs while adding new accounts that endure.
Banks and credit unions with solid loan collection data reporting can better measure their risk tolerance while increasing loan effectiveness without compromising credit quality or going beyond their risk appetite.
Holding debtors accountable to their payment commitments with swift, often automated, reaction to failed payment promises, and rewarding debtors who honor payment promises with an automated thank you, helps maintain order and ensures greater profitability even in a riskier loan environment.