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
• 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
Base Year Equity
Year 5 Equity
Cumulative Equity
Change
Base Year Equity Ratio
Year 5 Equity Ratio
Equity Ratio Change
Org 1
Org 2
Org 3
Org 4
$3,552,117
$2,861,356
$30,690,069
$26,126,872
$6,392,026
$4,730,003
$11,188,339
$6,526,093
$(690,761)
$ (4,563,197)
8.46%
6.82%
8.97%
6.60%
12.07%
7.94%
9.66%
5.63%
-1.64%
-2.37%
-4.13%
-4.03%
$ (1,662,024) $(4,662,246)
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
◦ June 2013
4.62%
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:
CU
2012
Yield
2013
Yield
Change
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
Loan Balance
Income Gained
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
Pillar I: Credit Analysis
• 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 II: Empirically Derived Risk Based Pricing
• Accounting for costs
• Identifying replacement cost of money
• Assuring an adequate margin/return
• Regular model validation
Pillar II: Empirically Derived Risk Based Pricing
• 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
• 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
Booking
A+
1.12%
A
1.12%
B
1.12%
C
1.12%
D
1.12%
E
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 Pricing
A
SECTION ONE
SECTION TWO
SECTION THREE
Weighted
MODEL 1 (2% FIXED MARGIN)
ACTUAL RATES
MARGIN
Average
B
690Term 740+ 739
C
660689
D
630659
E
600629
R
524599
A
Term 740+
B
690739
C
660689
D
630659
E
600629
R
524599
A
Term 740+
B
690739
C
660689
D
630659
E
600629
R
524599
Spread
All Loans
36
3.98% 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%
48
3.98% 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%
60
3.98% 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%
72
4.13% 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%
84
4.26% 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 Migration
Definition:
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
Pillar III: Credit Monitoring
• 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
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 loans
Dollar
Original credit Grades
Current credit
A+
A
B
C
D
E
Not
Reported
Grand Total
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
Not
Reported
<600
91,237
610,842
1,026,951
2,088,359
717,708
643,272
563,043
5,741,413
75,089
29,047
481,778
-
300
472,982
1,248,632
22,546,043
22,990,809 10,643,908
Grand Total
44,724,643
189,437
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
Current credit
A+
A
B
C
D
E
Not Reported
Grand Total
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
Not
Reported
<600
91,237
610,842
1,026,951
2,088,359
717,708
643,272
563,043
5,741,413
75,089
29,047
481,778
189,437
300
472,982
1,248,632
22,546,043
22,990,809 10,643,908
2,386,776
7,381,182
114,579,017
Grand Total
44,724,643
3,905,658
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
43
Pillar IV: Managing Repayment
A Continuous Process
Marketing
Application
Underwriting
• Messages
should support
philosophy
• Target clients
should be clear
• Offer value in
this stage
• Be thorough
• Think about
what a collector
may need later
• Codified, clear
standards
• Regular
portfolio
monitoring to
ensure the right
risk parameters
Account
Management
Customer
Service
• Find multiple
ways to be in
touch
• Are clients clear
about where
their account
stands?
• What you
appreciate in
the relationship
will appreciate!
44
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.)
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 loans
Dollar
Original credit Grades
Current credit
A+
A
B
C
D
E
Not
Reported
Grand Total
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
Not
Reported
<600
91,237
610,842
1,026,951
2,088,359
717,708
643,272
563,043
5,741,413
75,089
29,047
481,778
-
300
472,982
1,248,632
22,546,043
22,990,809 10,643,908
Grand Total
44,724,643
189,437
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
1
2
3
4
5
Days Delinquent
11-29
30-44
45-59
60-89
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 Success
Outcomes:
• 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
54
Resources
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.com
Readings:
• Motivational Interviewing: Preparing People for Change,
Rollnick & Miller, 2002.
• Crucial Conversations: Tools for Talking When the Stakes
are High, Patterson, et al.,2002.
Contact Information
Randy C. Thompson, Ph.D.
Thompson Consulting & Training, Inc.
208-939-8366
rthompson@tctconsult.com
Leslie Hoffman
LEH Consulting Group
505-299-3888
Leslie@LEHConsultingGroup.com