Monitoring What Risks Economic Uncertainty Is Adding to Your Loan Portfolio

Economic uncertainty makes assessing risk in a credit union’s portfolio much more difficult. 

While managing and monitoring risks is the role of the CEO, it is wise for a board to have periodic updates on risk. But beyond that, when risks begin to change, such as during periods of economic uncertainty, it is wise for a board to ask the CEO what management is doing to predict and monitor the changing risks encountered in the credit union. 

Credit unions can take advantage of existing reports to tease out signals and indicators to help determine what’s happening within their sphere.

Ask an economist if the U.S. economy is going to stay strong or slip into a recession and they will probably just give you a perplexed look. Why? The economic signals are terribly mixed. Traditional indicators of health or recession are occurring simultaneously, and no one knows where things are going from here.

But a variety of internal reports can give your board and management team an idea about whether your credit union’s risks are increasing or decreasing. The traditional measures of credit risk, namely delinquency and charge-offs, will not tell you that your risks are changing. These are “lagging indicators.” These tell you of a problem in the past, not that a problem may be starting to happen. 

What Can You Do?

Our suggestion is that management set up and monitor indicators that are still “lagging,” but not so far behind the curve as delinquency and charge-offs. Once set up, we suggest that the CEO share the results, perhaps quarterly, with the board of directors. We call these special, in-depth reports “deep dives.”

Here are some ways management could delve into the possible changing risk in its lending portfolio: 

1. Credit score migration. This requires a software program that can look at the current credit scores of borrowers already on your books. It tells you if the borrower’s credit score has improved or declined since origination. If these begin to decline, borrowers are having trouble keeping up with their borrowing obligations. The programs can also show whether the value of the loan’s collateral is enough to cover the current balance or not.
2. Percentage of loans with force-placed or lapsed insurance. Your auto and home borrowers are required to obtain casualty and property insurance on the collateral they use for a loan. If borrowers are beginning to have financial problems and need to cut expenditures, they often stop paying their insurance before they stop paying on a loan. When the credit union receives notice that a borrower’s insurance has lapsed, it can record this. If the percentage of lapsed insurance in a portfolio rises, it often indicates borrowers are beginning to suffer financial problems. 
3. Percentage of loans with late loan fees. Much like the report above, a higher percentage of loan payments starting to come in late could also indicate the weakening of borrowers’ financial condition. 
4. Average credit score of new loans added to the portfolio. If the credit score of new loans coming into your loan portfolio begins to decline, it suggests that the risk in your portfolio is growing. This report has many uses, but a key one is the indication of a weakening market of borrowers. 

Watching for Weakening (or Strengthening)

Using the above four kinds of reports, a management team and board can often begin to see a weakening (or strengthening in good times) of the credit union’s loan portfolio long before delinquency or charge-offs change. 

If the indicators begin to point to weakening in the financial condition of your borrowers, the credit union may consider a more conservative lending risk appetite. The lending risk appetite needs to flow with the economic cycles. In good cycles, lending can be more aggressive and earn a higher yield. When the cycles turn downward, caution may be the word of the day so that new risks are not added to your portfolios when borrowers’ personal financial situations weaken. These reports won’t tell you what to do, but they can indicate if changes, positive or negative, are beginning to occur. 

Risk Intelligence, not risk avoidance, is so important at the board and management level. Reports like this can bring greater information to a board and management team. With better information, risk-intelligent decisions are easier to make. Just because the economy drops doesn’t mean your borrowers are suffering. Conversely, just because the market is good doesn’t mean your borrowers are in good shape. These reports give you a picture of how your borrowers are doing.  

As the management team monitors these and other useful reports, sharing its findings with the board in a deep dive keeps the board informed of the possible change of risk the credit union is experiencing. Information is key for making decisions—not general information about the economy, but specific data about your members and how their personal economies are being affected and how they are affecting your credit union.

I’m sure your credit union has other helpful reports and ideas to monitor risk in your portfolio. By including these items, your team can get an even better picture of your overall lending risk cycle.

Tim Harrington is CEO and Kevin F. Smith is publisher of TEAM Resources, Tucson, Arizona.

Apply It to Your Boardroom

1. What lagging and more leading indicators does your board currently monitor?
2. How often does your board check in on how the economy is impacting risk and the loan portfolio specifically?
3. Which of the four factors considered in this article would be good ones for your board to be considering in “deep dives” about the impact on your credit union of economic uncertainty?