Managing Loan Portfolio Risk Amid Inflation, Rising Rates & Other Economic Challenges

For businesses, the last few years have been anything but business as usual. Between the COVID-19 pandemic and other ongoing challenges, such as inflation and supply chain issues, small businesses have had no shortage of economic concerns to navigate. All these factors will influence how credit unions monitor and manage portfolio risk for small business loans.

Credit unions should also recognize that some of the economic impacts of the pandemic will become more evident over the next two years. For instance, many small businesses would have eventually shuttered, even without the pandemic, but they managed to stay afloat by securing relief funding, like Paycheck Protection Program (PPP) and COVID-19 impact loans. Nearly one in five businesses fail within their first year and failure rates go up over time, as nearly half of all businesses shut down after five years, according to Bureau of Labor statistics. Now that repayments are required for the relief funds, some struggling businesses may default on these loans.

Meanwhile, many businesses in some industries, such as manufacturing, are still grappling with sourcing issues. Due to the uncertainty of the supply chain, businesses are increasingly seeking quick funding to stock up on inventory when it’s available. Yet, the recent interest rate hike may force businesses to think twice before borrowing.

The good news is that credit unions can navigate this complex lending environment with the right risk management strategy for their small business loan portfolios. Here are four elements credit unions should consider.

1. Evaluate credit policies and understand where your credit union is willing to negotiate.

Every industry has been impacted differently by the economic challenges over the last few years. Even the latest interest rate hike will have varying effects, depending on what sector a business operates in. For example, businesses in the construction space could face a downturn, due to less demand for new homes and slower commercial real estate development. On the other hand, industries that rely less on physical materials, such as software companies, tend to be more resilient to interest rate hikes.

Considering these nuances will help your credit union evaluate its credit policies and adjust them accordingly. Analyzing credit risk appropriately means understanding your borrower, as well as their business. Every business is unique and to make the best credit decisions, it’s important to understand their business needs and what risks their business model is exposed to. Make sure your credit union has the technology and processes in place that ensure an accurate approach to analyzing financial risk every time. Ideally, your credit union will have automated and centralized systems that eliminates the tedious work of inputting financial statement and tax return data into statement spreads. After all, you want your credit analysts to be analysts, not data entry clerks.

Credit unions may also see a slight uptick in new small business loan applications from business members looking to lock in a fixed-rate loan, as multiple rate hikes are expected this year. Credit unions can get ahead of this by analyzing their portfolios to understand their organization’s current risk tolerance so they can respond to businesses quickly. Once a credit union defines its current risk tolerance, it is also easier to identify which types of industries or businesses your credit union is comfortable lending to and on what terms. For instance, your team may decide to accept different types of collateral for certain business loan requests moving forward. Decisions like these will help your credit union find opportunities for growth while mitigating exposure to added risk.

2. Focus on behaviors to understand your loan portfolio.

To get ahead of any future delinquencies for existing loans, credit unions should strive for proactive portfolio management, which requires focusing on trends and behaviors to understand your portfolio.

Robust data is needed for this. Credit unions must manage risk with current and accurate bureau data; loan, deposit and collateral data; and financial statement data from internal and external systems. The right lending technology can be configured to import this data from your credit union’s core or other systems to give your team a comprehensive view of portfolio risk.

With a better, more comprehensive view of the portfolio, your credit union can get ahead of risk by looking at leading indicators of trouble rather than lagging indicators. Credit unions shouldn’t rely on lagging indicators, such as missed or late payments. Those are problems that once noticed, are too late to fix. Instead, you want to look at as many leading indicators as possible to get ahead of the game.

Leading indicators of a problem are often behavior changes. For instance, credit rescores and high line utilization will show the financial stress faced by a business member long before a loan is 90 days past due. Deposits are another key leading indicator of a small business’ financial health. By monitoring for changes in deposits, credit unions can determine whether a business’ revenues are falling, which may signal future issues with loan repayments. This makes it easier to get ahead of risks and if needed, proactively adjust the terms of the loan to keep the borrower on track.

3. Consider the cost of refinancing.

The Federal Reserve plans to raise interest rates again before the end of the year. For business members with an existing loan, they may want to refinance, especially if they are on a variable rate loan. Many will want to refinance to a fixed rate. Refinancing to a fixed rate may be beneficial for the business but should not be done for free. Refinancing comes at a cost, as there are time and expenses involved with underwriting and documenting the loan, among other tasks required for refinancing.

At the same time, there will be many financial institutions managing refinancing requests, so your credit union must be competitive with pricing. Credit unions should be prepared to look at a business member’s overall relationship with their institution to price refinanced loans accurately and competitively. To do so, your team will need to leverage data from core and internal systems, as well as your credit union’s existing risk rating criteria.

Today’s lending technologies make it easier to customize loan pricing structure with consideration to a member’s overall relationship with your credit union, existing loan data, deposit data and ancillary products. Tools like these allow you to easily price each refinanced loan consistently based on data and calculate the expected return accurately while maintaining strong business member relationships.

4. Protect your portfolio and grow with confidence.

The goal for credit unions is to uncover opportunities to best serve their business members while minimizing risk, no matter what new economic challenges arise. This means credit unions should take everything discussed above into consideration when originating new business loans to support sound underwriting decisions.

Business loan types, industries and collateral that are performing well should be the focus of origination. Also, it may be worthwhile to perform sensitivity analyses when originating new business loans. Your credit union can stress test the loan with a 1%, 2% or even 4% increase in rates and see how the loan performs.

Ultimately, the current economic environment poses many complexities when it comes to lending. While no one can predict the future, credit unions can prepare for it by establishing proactive risk management strategies, and ensuring strong loan portfolio performance and a more positive borrowing experience for members.

Bryan Peckinpaugh is SVP, Key Accounts for Baker Hill, a Carmel, Ind.-based provider of lending, risk management and analytics solutions for financial institutions.