Is it possible to originate safely in this environment?
Author | Eric Steinhoff
“If you’re not growing, you’re dying” – we’ve all heard a version of this quote, and it surely didn’t come about as part of a discussion about a credit portfolio. However, if you’re reading this post you probably are well aware of the adverse effect slowed growth can have on your portfolio performance and perhaps, if you’re a monoline lender, the whole existence of your business.
An economic downturn like the one we’re in creates a perfect storm where credit losses increase at the exact same time that interest revenue from new lending dries up. How can you adapt and refine your originations strategy over the coming weeks and months to come out the other side stronger?
Lending Through the Cycle
If you have been involved in lending over the last 10 years, you have experienced the typical growing economy lending pattern – credit losses outperform risk models, credit strategy loosens, more competitors enter, credit strategy loosens more to enable continued growth. At times it has seemed to credit personnel that marketing and sales have been dictating credit strategy!
Things have obviously changed. We hope the efforts of governments around the globe to provide a safety net will soften the impact of the shutdown and position us for more of a V-shaped than a U-shaped recovery. However, economic growth may remain depressed for the 12-18 months we are told that it will take to develop and distribute a vaccine for COVID-19. That’s a bit unsettling, and hardly gives a credit expert confidence to start originating in this uncertain environment.
But this is the time that we credit experts earn our living. Our job is not just to shut down originations and reforecast losses/reserves, anyone who understands the basics of lending can do that. Credit must find a way to get back into the business of lending money. The question is – how can we do that and still sleep at night?
Originating in this Environment
First, we must think big – focus on the forest of credit risk strategy not the trees. Don’t be afraid to completely overhaul your credit application and underwriting procedures – making your application longer/more detailed, adding verification steps, etc. may slightly reduce your application completion rate, but these are not times to be trying to maximize application volumes.
Income and debt servicing capabilities are key right now. You should be confident that any consumer you lend to is receiving a paycheck and will be able to meet their loan obligations. For SMB lending, you must verify that the business is still operating and generating revenue.
You should also review your model cutoffs and consider a full model rebuild. Models built in the last few years will be overfit on a benign economic environment – there just weren’t enough macro-induced “bads” to support a model that could be both relevant (based on recent data) and robust through a full economic cycle.
Here are some questions you should be asking about your credit strategy:
Credit Application. Is your current application designed to effectively underwrite in this environment? Are you capturing all of the information you need to make a credit decision you feel confident in?
Verification. Are you doing employment, income, or revenue verification? Are you confident that new approvals will be able to pay you back?
Cutoffs. Are you confident you haven’t over- or under-tightened your model cutoffs? Will your cutoffs be appropriate when FICOs start to drop as the wave of unemployment leads to unpaid bills?
Stress Testing and Forecasting. How bad can things get? Is your portfolio prepared to withstand the sustained 18-month U-shaped recession that is very possible?
Risk Models. How recently were your models built? Have you tested them on a real-world economic downturn scenario?
Take the Steering Wheel
There’s another saying, this one from politics – “Don’t let a good crisis go to waste.” Credit Risk Officers are the most important person in the room right now, and now is the time to be decisive and take steps to ensure your credit strategy is sustainable.
Redesigning your originations strategy and underwriting models will help you position your business to survive the next few months and more importantly thrive when the economy starts to stabilize, be that this year or next.
This can be a massive undertaking, and you may still experience some sleepless nights if you don’t feel adequately staffed or equipped to handle it all. Scienaptic is here to help. You can reach us at firstname.lastname@example.org.
Over 150 years of cumulative credit risk experience has led us to create a diagnostic toolkit that helps risk/lending leaders prioritise 5-6 initiatives under these adverse economic circumstances.