TUCSON, Ariz. And DENVER, Colo. – Risk-based lending has brought dramatic changes to credit union business models, according to Ron Parker, partner involved in the credit union practice at the Tucson, Ariz., office of Clifton Gunderson. The CPA firm handles work for some 250 credit unions of all sizes. Parker indicates a very high percentage of larger credit unions have embraced risk-based lending. Sheila Balzar is senior audit manager at Holben Cooper Christian Hay & Husman, a Denver CPA firm that also has a long list of credit union clients. Like Parker she has seen credit unions with more than $100 million in assets move into risk-based lending over the past few years. Now credit unions in the $20 to $50 million asset range are adopting it. "I've been in the credit union industry for 35 years," Parker says. "The traditional business model has been one price for all. That has changed pretty dramatically. But in my mind, risk-based lending is still in accordance with the credit union philosophy. What it has allowed us to do as an industry is to go deeper into C and D paper, make loans to certain members we might not have been able to serve with one rate for all, and at the same time compete more effectively in the A paper ranks." The primary concern, he continues, is pricing the various tiers correctly. The rate should be related to the risk and the cost of processing the loan. Then it's vital to monitor those tiers and adjust them when necessary. He notes as interest rates and the cost of funds increase, lenders have to maintain a certain net interest margin. You also have to factor in that rising interest rates are likely to impact C and D borrowers more than A borrowers. "Over the past ten years credit unions have gone though more philosophical challenges than they probably did in the prior 50 years. Risk-based lending is certainly one of them," Parker says. "There are some very capable credit unions with wise management that have not gone to risk-based pricing. But we (credit unions) are competing with a number of entities that do use risk-based pricing. In order to compete effectively you should consider it. I would also keep emphasizing that it is in accord with the credit union philosophy and allows us to serve more members." Balzar cautions that credit unions without sophisticated lending personnel, at least at the manger or vice president level, should perhaps be more careful about getting into risk-based lending. Credit unions must also be willing to carry out the analysis needed to establish and monitor risk threshold. A risk-based strategy, she notes, indicates you are going to be doing some lending in the C or D category and will price those loans to reflect the risk. "I do sometimes see people who have a risk-based program but continue to focus on members with really good credit. Although you don't want to get everything in the C and D category, there will be some of that. The question is how you price it," Balzar says. "If you define an A borrower as someone with a credit score of 700 or better, is that too narrow? Is someone at 680 really a higher risk than someone at 700? You have to analyze where you set your cutoff lines. You also have to have to evaluate the categories by return versus costs such as collections. If you generated enough income at the start of a loan before it went bad, and had costs but actually earned 8 percent over the life of the loan, you might still be willing to make that loan." Balzar believes there's also a hazard that in risk-based lending the loan staff becomes too fixed on credit scores as the only tool for evaluating a member. Maybe someone with a high credit score earning $40,000 a year applying for a loan to purchase a $60,000 car shouldn't receive virtually automatic approval simply based on their score. As for changes in interest rates, "You must recognize interest rates have to be going up over the next few years. If you're doing a true risk-based portfolio, I don't know that you just say everybody's rate differential goes up the same amount depending on the rate environment. The rate should be set based on what you think the risk of that portfolio is." There are other factors, she continues. For example, a credit union may want to establish itself as the financial institution with the area's lowest auto loan rates. Each month a Denver newspaper publishes the best rates. There are credit unions who price their loans so they will appear in the top five. A credit union heavily invested in mortgage loans may use auto loans to help manage asset/liability interest risk in their mortgage portfolio. Balzar cites a lending example she recently saw at a credit union that doesn't use risk-based lending. Two members applied for an unsecured loan. One had a great credit and employment history – the perfect application. The second member had some credit problems in the past. The two got the same loan at the same rate at the same maximum amount. She asked the credit union CEO why the credit union wouldn't want to loan the first member more. Without risk-based lending they didn't really distinguish between the two. -

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