3 Ways to Fortify Your Lending Strategy in a Changing Economy

Financial institutions are reevaluating and tightening all lending criteria, and rightfully so. While the Federal Reserve paused its rate hike campaign in September, relief may be short-lived as the board indicated we’re likely to see another increase before the end of the year. Businesses and consumers are also operating cautiously with a cloud of stubborn inflation hanging overhead.

In short, everyone is keeping their cards (and cash) close to their vests. Lenders are hunkering down as loans continue to outpace deposits. The aggregate loan-to-deposit ratio, a key indicator of liquidity, rose consecutively for the third time in March, according to S&P. Credit unions, in particular, are facing a challenging lending environment.

A Shift in Automotive Financing

Historically, when large banks tighten their lending standards, consumers turn to credit unions for loans. The Fed’s quarterly Senior Loan Officer Opinion Survey, released in May, found most of the 84 responding banks have tightened standards across consumer loan categories, including automotive, and will continue doing so throughout the rest of the year. Unlike larger banks, credit unions aren’t as beholden to market fluctuations because of their ownership structure – putting them in a better position to provide loans during economic uncertainty.

For someone making the national median income, it would take them close to 10 months to purchase an average new vehicle, according to the Cox Automotive/Moody’s Analytics Vehicle Affordability Index. Kelley Blue Book determined the average price of a new vehicle currently hovers close to $48,000 and $26,000 for used vehicles. And while affordability issues are improving incrementally, millions of Americans are still being priced out of vehicle ownership – increasingly, non-prime buyers are being squeezed out of the automotive market entirely.

Analysis from Equifax and CUNA reported in their June 2023 “Credit Union Auto Lending Monthly Report” revealed that when non-prime borrowers choose a credit union, they achieve life-of-loan savings between $5,700 and $11,000 compared to similar borrowers at banks for a $40,000 automotive loan over 72 months. Additionally, lower monthly payments result in better payment behavior among credit union members.

Credit unions have consistently held a large percentage of the automotive lending market, but in Q1 2023, captives became the largest shareholder for the first time in several years, according to Experian. To compete amid uncertain consumer demand and an unpredictable economic outlook, credit unions must adjust their lending strategy to ensure financial security while serving their members.

3 Steps to Mitigate Liquidity Risk

Updating your credit union’s lending strategy can help you maintain stability, increase ROA, grow yield, and effectively mitigate liquidity risk. And with the automotive lending season in full swing and inventory finally starting to show signs of recovery, the time for credit unions to optimize their lending processes is now.

Liquidity is always top of mind for credit union leaders, but it comes into sharper focus amid an unstable economic environment. Follow these steps to ensure your financial institution is responding properly to macroeconomic trends.

1. Diversify your data. Over two-thirds of lenders in the Open Lending Benchmark Survey only look at a borrower’s FICO score and proof of income, which yields too narrow a view of someone’s creditworthiness. Lenders must look at more than just FICO scores to identify qualified borrowers and assess risk.

To predict the probability and severity of default with the highest level of accuracy, lenders should analyze alternative borrower data, such as mobile phone payments, bank account data, and rental history. This approach paints a more accurate picture of a borrower’s track record to help you better understand your risk.

Automotive lenders also need to analyze historical automotive data. For example, lenders can assess a specific vehicle and predict what a default after 20 months would look like versus after 30 months at the make and model level. Each instance brings a different level of liability to the lender, and the lenders should incorporate that probability when pricing the loan.

2. Expand your borrower base. Non-prime borrowers are often overlooked for automotive lending opportunities. But extending loans to this credit segment can prove crucial to portfolio resilience in an unstable economy.

While catering to non-prime borrowers may seem risky, the opposite is true: Relying too heavily on FICO scores and lending solely to prime borrowers leads to high variability and risk. To build non-prime relationships, credit unions should create clear underwriting guidelines tailored to this segment. Combined with close monitoring of monitoring borrowers’ progress, this tactic can ensure that only viable candidates receive loans.

Expanding your borrower base not only minimizes risk but also allows you to extend credit to individuals on the cusp of improving their credit standings. Once a relationship is established, borrowers are more likely to return to your credit union for other financial needs, such as mortgages or business loans.

3. Price loans more accurately. Pricing loans correctly to risk and yield targets may seem like an obvious way to mitigate liquidity risk. But many lenders might not consider if they’re adapting their pricing and decisioning to the changing market and consumer information required. A disciplined approach to pricing loans is crucial. Lenders can achieve a higher level of accuracy by assessing a lender’s costs and risk levels – originating fair, profitable and less risky automotive loans with the speed and consistency required in the post-pandemic economy.

Striking the most profitable balance for subprime and prime loans is critical to protecting liquidity. To achieve this, lenders should determine the optimal number of monthly loans to target and increase the number of subprime loans with higher yields while decreasing the number of prime loans.

Automotive lenders, especially credit unions, play an undoubtedly critical role in their communities and for their borrowers. At a time when borrowers who are considered riskier are being priced out of the automotive market and fall outside the tightened lending standards, credit unions must evolve their strategies to meet the moment. By employing advanced data and pricing tactics, credit unions can seize opportunities and maintain steady growth while upholding their commitment to service.

Matt Roe is Chief Revenue Officer for Open Lending, a lending technology company based in Austin, Texas.