Why Are Credit Unions Being Ask To Test Their Concentration Risk Policy Now?
Just a few years ago, as I toured the credit union conference circuit discussing loan portfolio risk, I was often asked about Risk Concentrations. Specifically, many would ask me if there were some best practices that I could share with them related to what their concentration thresholds should be. I would explain that the practice of setting concentration risk thresholds was not about finding the magic threshold that examiners were seeking, but actually going through the process of measuring risk and determining the level of risk the credit union could live with. The initial NCUA guidance was provided to credit unions in 2010 and over the subsequent years, credit unions began to solidify their concentration risk polices. Little more has been said on this topic, until recently.
Like many risk advisories from regulators, there is a tendency to focus on the issues for some time and then move to the next issue as concerns shift. The mistake that credit union leaders can make is in assuming that, if examiners are not asking about it now, it is probably not that important anymore. This is a natural human tendency when we feel as if we are over-regulated in the first place. It’s not unlike when a new speed zone is set up on our route to work. Initially, we pay close attention to our speed as we enter the zone as compliance is being strictly enforced. Over time, we begin to realize there are few people being pulled over and we allow our speed to creep upward, especially if there have been no incidents related to speed in that area.
Lately, I’ve been told by an increasing number of clients that examiners are beginning to ask them to demonstrate how they have been “stress-testing” their concentration risk thresholds and the credit union has been unable to do so, because they haven’t, in fact, been testing them. In other words, examiners have been asking credit unions to test their risk concentrations to determine whether a significant change in the economy or loan performance would have a deleterious effect on the credit union’s profitability and stability. We haven’t seen any significant, rapid shifts in economic conditions over several years, so concerns have been relatively low, as long as loans are performing well at the baseline. So, why are examiners revisiting this topic with some credit unions? Well, there are a number of reasons.
Way back in 2011 and 2012, when people were asking me about concentration risk policies, I was also advising them to fully consider ALL risks associated with making a loan. One example I liked to use was medallion lending, where credit unions were securing loans with taxi cab medallions as collateral. At the time, many lenders were migrating to medallion loan participations as they promised respectable yields with a history of very low risk. The premise was, taxi cab medallions were in high demand and new ones were not being created. This is a recipe for increased value, year-over-year, and because of high demand, the sale of medallions was almost certain. Even still, Medallion Bank (the largest medallion lender in the U.S.) listed seventeen specific risks that they monitored in their annual report to investors. I was actually criticized for providing my cautionary recommendation, based on the evidence above, but the fallacy is what is today will always be.
We now know that the low-risk promise of medallion loans was not exactly what it seemed to years ago. In fact, last year, we witnessed at least two credit unions fail due, in large part, to large, under-performing medallion loan portfolios. Medallion loans are not the subject of this article, per se, but had these credit unions been testing scenarios of risk concentrations, it is highly likely that they would not have accumulated the volume of medallion loans that ultimately put an end to their operations. This can be true of any type of loan. But there are other changes occurring today that could impact the performance of loan concentrations.
Interest rates are increasing. Long-term loans with market low rates will struggle to contribute to positive cash flow as the cost Subprime Auto Finance News reports that sub-prime borrower performance is deteriorating into 2018 and is expected to continue, even while unemployment rates continue at historic lows[i]. According to the Washington Post[ii] and Forbes[iii] many economists are pointing to the year 2020 as a prime year for a recession. While recessions are of varying impact and severity, it would be hard to guess what region or sector would be hardest hit. Finally, we know that the way and frequency of vehicle purchasing is and will change. Will this impact collateral values over time? The point is, if we are expecting things to stay the same, they most definitely will not. Run the scenario testing is my advice.
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