Perspectives

July 18, 2017
Identifying Defendable Modeling Assumptions 
By Jerry Clark, Senior Vice President – Sales and Marketing, ZM Financial Systems

The words “Asset Liability Management” make our field sound very precise, but often the most important part of managing your risk and profitability is overlooked: assumptions.

Assumptions are critical when modeling potential future outcomes, as the data your model reports is only as good as the data put into the model. Where do you get your assumptions and how do you know they are “right?” First, a few key points to consider when developing modeling assumptions:

1.  Assumptions should be grounded in specific historical experience whenever possible.
2.  Adjustments should be made to reflect changes from the past (such as new management).
3.  Common sense and intuition are allowable.
4.  Industry averages and/or third-party supplements may be appropriate when lacking quantifiable experience.
5.  Stress testing your assumptions is very important.

AL models differ in look and feel, but most offer the ability to perform valuation and income simulation. Assumptions are grouped into those that impact cash flows, pricing and economic factors, but before delving into an assumption discussion, it is important to reiterate the age-old saying “garbage in garbage out.” The data you use as a foundation for your modeling must be as accurate and complete as possible. Layering assumptions on top of bad data, regardless of the correctness of the assumptions, can magnify inaccuracies and lead to wrong conclusions. Loan and deposit details should be loaded by instrument to correctly capture attributes such as caps, floors, pricing and payment structures.


Cash Flow Adjustments
1. Prepayments occur when borrowers make payments ahead of schedule on their loans. These should be layered onto contractual cash flows for lending-based products such as mortgage loans, commercial loans and mortgage-backed securities.

Most AL models allow the use of prepayment speed projections (e.g., CPR) and allow you to vary the speeds by forecast scenario. Commercial and other loans can be more challenging given their unique structure. Regression analyses and formulas are more appropriate, although it may be simplest to calculate historical averages and apply them to your projections for these loans. Some AL models also allow integration with third parties to incorporate multiple factors beyond rates, providing more dynamic prepayment modeling.

On a related note, prepayment penalties exist in many loan contracts and should be modeled when they exist.

2. Structured Cash Flows are unique to instruments such as CMOs. The correct way to model these is to use an engine backed by a deal library containing the payment rules for a particular scenario. Another approach is to import scenario-specific cash flows for your portfolio from the broker who provides the instruments – this is acceptable as long as the scenarios you receive match up with the scenarios you are modeling. Many institutions model CMOs like regular mortgages, ignoring the payment rules and only applying simplified prepayment matrices. This is rarely an acceptable approach and can lead to hidden risk. You should strongly consider the significance of these balances before taking such an approach.

3. Defaults and Recoveries happen when loans cannot be repaid under the contractual terms. Modeling for these has become common in AL models, given that DFAST, CCAR and CECL have hit the mainstream. Probability of default (PD) and loss given default (LGD) are the most common projection metrics, although migration matrices are also popular.

4. Early Withdrawals are very similar to prepayments, and occur when depositors withdraw their money prior to maturity for their term deposits. Decays are declines in deposit balances that do not have specific maturities. Deposit studies may be required to understand your unique behavior. As with loans, early redemption penalties often exist on term deposits and should be modeled when they exist.


Pricing
1. Pricing/Spread is an assumption driven more by policy and committee than historical experience. A recent historical analysis is a great place to start. You might look at loans or deposits originated last month against a driver rate or yield curve to get a baseline; however, understanding your pricing process could lead you to model future business differently than past business. One hint here: remember that business is negotiable – published spreads often differ from reality, so spend a little time researching and comparing before settling on spread assumptions.

2. Rate Responses and Lag Effects are used to mimic the timing delay between market rate moves and rates on products such as deposits. Single- and multi-betas are often the assumptions derived and then put into AL models for forecasting these rate movements.

3. New Business Term Structure is tied to pricing/spread in most models: instruments are priced by referencing term points on a yield curve. Development of this assumption also requires research of your recent history to understand patterns and behaviors. A data warehouse can be an excellent tool for understanding both the pricing and term structure behavior in your new business.


Economic Forecasts
1. Determining the Rates to use when modeling depends on your purpose:
-For valuations, an implied curve derived from market rates is preferable. Bloomberg and Reuters are commonly used sources of market rates.
-Stress testing can take many forms. Rate shocks, ramps and twists are usually derived from market rates, again from a source such as Bloomberg.
-When projecting earnings, it is generally appropriate to use an internally-developed rate forecast. The premise is that you plan based on expectations, so your budgets and goals should be set based on some sort of most likely forecast. Some institutions are uncomfortable making projections, in which case they rely on S&P (Global Insights) or another consensus-type forecast.

2. Balance and Fee Projections usually come from either line of business feedback or top-down goals. Advanced institutions may use econometric models to estimate behavior, but direct feedback and estimates are usually preferable. Mortgage servicing contains very unique attributes that may require external assistance to model.

3. Economic Factors such as CPI, GDP and unemployment are important ingredients when moving beyond basic income forecasting to projecting losses, capital, liquidity and other aspects of your business.

AL models contain other broad assumptions such as discount curves and volatilities, as well as instrument-specific assumptions, including discounting methodologies and spreads. Assumptions in your modeling process should be understood and defendable by someone in your organization. The last thing you want is for an examiner or your manager to ask a question you cannot answer.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Jerry Clark is Senior Vice President of Sales and Marketing for ZM Financial Systems and has more than 30 years of experience in market risk, treasury, accounting and finance.


June 27, 2017
Creating Funding Stability During Uncertain Times 
By D. James Lutter and Todd A. Terrazas, PMA Financial Network

The days of cheap funding appear to be winding down. Since 2008, financial institutions have been able to access and maintain stable deposit balances. Due to risk aversion among the general public, deposits across all institution sizes have witnessed significant growth with relative ease.

Accessible funding has been a great benefit to financial institutions. However, with most economists and Wall Street professionals believing the economy to be in the latter stages of a bull cycle, it is important for institutions to document and understand how each source will react in various stress situations. Understanding funding sources and how they will react to different markets can help lead to a proper liquidity balance.

Identify and Define Funding Sources
There are a variety of funding options available to financial institutions, and it is important to incorporate those that fit within your strategic plan. In doing so, you can identify what gaps exist within your current funding sources by answering a few basis questions:

- Are deposits in-footprint or out-of-footprint?
- Are deposits operating or non-operating?
- Are deposits commercial, retail or institutional?
- What are your noncore funding sources – wholesale, reciprocal or listing service?
- What are concentrations amongst the various sources and what are their investment objectives (rate, diversification, etc.)?
- What degree of interest rate sensitivity exists and how are you hedging it?

By answering these questions, a financial institution can obtain a quick snapshot of its deposit mix and begin to effectively define an operating and contingency funding plan.


Which Funding Sources Are Right for Your Institution?
After recognizing current funding sources and any pitfalls that may exist, a financial institution should look to bridge the gaps. Once appropriate funding options have been determined, the next step is to identify the role each option will play within an operating and contingency funding plan. It is critical that diversification, credit sensitivity and concentration limits be included.

A good test of these attributes can be identified through analysis of the strengths, weaknesses, opportunities and threats (SWOT). For example, a SWOT analysis of a municipal depositor may resemble the following:

Strengths – A municipal depositor is typically local, has a predictable deposit cycle and can be a stable funding source

Weaknesses – Deposit capabilities can fluctuate and are cyclical, usually requiring some form of collateralization (per state statute or investment policy); credit restrictions may also be present

Opportunities – A municipal client can become a significant, multifaceted relationship through transaction activity, long-term banking service contracts, borrowing, safekeeping, etc.; additionally, diversification among multiple municipalities may mitigate cyclicality risk

Threats – General economic conditions may deteriorate, creating revenue shortfalls from a declining tax base and/or a delay in state or federal aid

Regulators expect a financial institution to have established funding policies, ensuring that proper controls are in place to adequately address the environment in which it operates. Testing sources on a regular basis allows the institution to readily access funds as needed, while eliminating the element of surprise.


Monitor and Maintain Your Funding Sources
To avoid undue stress, it’s important for financial institutions to monitor the inherent risk characteristics of its funding sources, as well as the evolving needs of those sources. Gaining a comprehensive understanding of your funding sources and the relationships to their investors and depositors provides much needed information to help understand how those deposits will respond under stress.

Adverse effects to a financial institution’s credit profile will increase the cost of funds and may limit its ability to access funding. Different depositors have diverse investment criteria and yield expectations. A comprehensive understanding of these metrics will enhance the financial institution’s ability to price and access funding sources. Furthermore, it allows the institution to execute a risk-averse operating and contingency funding plan. To build a solid, ongoing understanding of its funding sources, a financial institution should continually ask these important questions:

-How does the market view my institution? Do I know the credit criteria my funding sources monitor (qualitative and quantitative)? What are the implications if the criteria are breached?
-Do I understand my funding sources’ (depositors’) investment objectives (safety, liquidity, yield, etc.)?
-Have I identified, and do I monitor, the factors that could affect my ability to access various funding sources?
-Does my funding source have concentration limits?
- Have I documented each funding source’s role and communicated it where applicable?


Conclusion
Developing reliable, diversified funding sources is critical to the success of a financial institution. By defining, identifying and maintaining funding sources, an institution can gain further insight and discover tools that help mitigate risks when issues arise. A well-defined plan will help maintain stability, provide sound liquidity and interest rate management, and add value through increased earning.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Authors

D. James (Jim) Lutter, Senior Vice President of Trade Operatons, PMA Financial Network
D. James Lutter is is the Senior Vice President of Trading and Operations at PMA Financial Network, Inc. and PMA Securities, Inc., where he oversees PMA Funding, a service of both companies that provides over 1,000 financial institutions with a broad array of cost-effective funding alternatives.

Todd A. Terrazas , Business Development & Product Manager, PMA Financial Network
Todd Terrazas is the Business Development & Product Manager for PMA Funding, where he is responsible for developing financial institution partner relationships and managing funding product solutions and association affiliations.



June 15, 2017
FMS Quick Poll: Succession Planning
By Financial Managers Society

What will become of your community institution when the current senior leadership decides to call it a career and head to the golf course? Is there a CEO-in-waiting ready and able to take the reins in a seamless transition? Is your next CFO just down the hall? Will you have to go outside your bank or credit union to find the talent needed to keep the institution growing?  

Those are the questions we had in mind when we went out to the FMS membership with our latest Quick Poll. Among the almost 140 responses received, we found that succession planning is certainly an item on the agenda at most institutions, but where it ranks on that to-do list – and why – varies quite a bit.   

Of the 137 respondents in the poll – 117 from banks and 20 from credit unions – 49% characterize the level of concern around succession planning at their institution to be “significant,” viewing it as one of their top concerns in the near term, while 13% see it as a “critical” issue in need of immediate attention (Figure I). Meanwhile, 28% have succession planning on their radar, but only as a lower-level priority for the coming years, and 10% of poll participants see it as a lukewarm issue that can fall in line behind other more pressing areas of concern.  

FMS Quick Poll

So how much work do they have to do to address their succession planning issues? That is, where do their efforts currently stand? Most respondents are at least headed in the right direction, with 60% reporting they have a strong plan in place already and another 31% noting they’re in the process of formatting a plan; the remaining 9%, however, don’t have in a place and have yet to take steps toward getting started (Figure II).

FMS Quick Poll

These results align closely with the responses from 400 community institution leaders in “Community Mindset: Bank and Credit Union Leadership Viewpoints 2017,” a recent FMS research survey of the industry. Responding to the same question, more than half of respondents (57%) said they have a strong plan in place for succession, 33% noted they were working toward a plan and 10% reported that they did not have a plan.

Those 52 institutions in the Quick Poll still in the early stages of trying to pull a plan together are encountering a number of challenges, including a lack of qualified internal candidates for leadership positions, the absence of an in-house program or track for grooming such candidates, a lack of urgency from the board to get a plan in place and, most of all, a lack of time and resources, as other priorities take precedence (Figure III).

FMS Quick Poll

When they do find the time and motivation to get down to the serious business of putting together a plan, those institutions can take a lesson from the 82 respondents who are further down the road as they hone their efforts. Among those institutions with a strong plan in place, having a clear process for identifying and cultivating internal talent and having a solid written plan both ranked highly as key elements toward a good succession plan, while buy-in from leadership and the board also came into play (Figure IV).

FMS Quick Poll

Thanks again to everyone who participated in our latest FMS Quick Poll. If you didn’t have a chance to complete the poll, be sure to weigh in with your views on social media or on FMS Connect!




May 24, 2017
Five Ways to Unlock the Full Value of Loan Review 
By  Ancin Cooley, Principal, Synergy Bank Consulting and Synergy Credit Union Consulting

If you grew up north of the equator, you can probably remember the excitement you felt playing in the freshly fallen snow each winter. As you bounded toward the front door, ready to throw yourself into a fluffy pile of wintertime fun, you were stopped by a parent, ready to burden you with a heavy coat, gloves, scarf and hat. As the layers piled on, you wondered who could possibly have fun in all of this. However, once outdoors, you realized that your protection made the snowy adventure even more enjoyable.

A similar analogy can be drawn about loan review. Attempting to quickly grow your loan portfolio or move into new areas of business without a fully functioning loan review program is like trying to play in the snow without a coat on. You’ll never enjoy the snow if you’re not equipped to withstand the freezing temperatures that will undoubtedly accompany it. Likewise, you’re unlikely to see the sustained growth you seek for your institution if you fail to implement key processes that protect you from the imminent pitfalls associated with growing or integrating a new loan product.

Even the most conservative institutions pin growth and profitability as primary goals. However, in order to maintain healthy growth, institutions must keep a reliable pulse on the performance of their loan portfolio and accompanying credit risk issues. Effective loan review keeps that pulse by consistently monitoring the risk management function. With a strong loan review department to keep things on track, the institution will have the freedom to explore new products and industries with confidence.

If it’s true that loan review is the key to monitoring risk, then where was it during the last major downturn? Amid the slew of potential issues that crippled loan review and lead to the last downturn, these primary issues took precedence, and in many cases their continued presence is still putting institutions in jeopardy:
- Insufficient analysis to support the risk rating
- Failure to document major issues and the answers leading to their conclusion
- Failure to discuss credit administration weaknesses
- Insufficient numbers and experience of staff
- Failure to discuss and address portfolio risks
- Organizational and hierarchical missteps
- Lack of follow-up

Today, commercial real estate levels are back to where they stood pre-downturn. Institutions that have a strong early warning system – built by loan review – are able to identify and remediate problems faster.

Once your institution realizes the full value of the protection offered by a high-functioning loan review team, you may actually look forward to having an independent group of professionals hand you a pair of gloves, fit you with a coat and wrap you tightly in a scarf before sending you off to your next deal. To make sure your institution is getting the full value out of its loan review process, be sure to pay close attention to these five practices:

Craft a Risk Appetite Statement
The risk appetite statement helps your institution determine the direction of its lending program in an effort to grow more intentional portfolios that will bolster its overall health. When crafted as part of your yearly strategic planning process, your institution will be primed to grow portfolios by aligning your goals with your unique risk appetite.

This statement serves as a crucial guide by outlining the institution’s risk appetite, risk capacity and risk profiles, driving your institution’s decision-making over the next year.

While risk appetite refers to the amount of risk your institution is willing to accept in pursuit of loan growth, risk capacity quantifies the maximum risk that the firm is able to withstand. Risk capacity is based on metrics like capital, liquid assets and borrowing capacity, among others. Target risk profile represents the allocation of appetite to risk categories (e.g., how many home equity or car loans you will grant?). Actual profile represents risks that are currently assumed.

When gathering information that will eventually become the risk appetite statement, it’s important to engage with and incorporate the input of parties such as the board, CEO, CFO, lenders and internal auditors.

Align Loan Review with Risk Monitoring
For some institutions, this maxim is already a no-brainer. While past industry-wide practices have placed loan review within the purview of internal audit, forward-thinking institutions are making the shift toward aligning loan review with risk management. In fact, loan review is increasingly being referred to as credit risk review, thus highlighting the shift in thinking about the functionality of loan review.

When loan review is repositioned within the organization’s hierarchy, this seemingly small organizational shift can have a seismic effect on the overall effectiveness of the loan review function. This is achieved through utilization of independent authorities that perform candid, unbiased reviews.

Put simply, a loan reviewer must be able to safely “speak truth to power.” The reporting structure should be organized in a manner that allows for both the formulaic testing and critical, open-ended examination allowed under risk management.

Further, compensation levels are another key component of loan review effectiveness. Because the loan review position is critical to the success or failure of a financial institution, the institution must hold it in esteem for internal controls and for external appearances. By providing loan reviewers a proper place in the hierarchy of the organization, the institution communicates the seriousness and intrinsic value of the loan review position and its responsibilities.

Apply Strategy to Price Monitoring
A “one size fits all” approach just doesn’t work in the land of lending. Building a strategic pricing system through close monitoring of loan administration is critical to maintaining a healthy portfolio.

Even after a borrower has been with you for some time, things like credit worthiness, collateral values, and deposit balances all change over time, requiring a change in strategy on the part of the institution. Utilized fully, your loan review department can help keep an eye on these many changes and help steer the institution toward the best set of solutions.

Hone In on Small, Targeted Reviews
While broad, sweeping reviews are seemingly effective, getting down into the devilish details can expose smaller issues before they become significant problems. Specifically, performing deep dives into your appraisal management, special asset and loan administration function create tangible value and ROI.

Perform Post-Mortems on Large Charge-Offs
There really is no better vision than hindsight. Looking at your largest losses incurred over the last three years will allow you to identify whether there are any core themes that recur throughout. When armed with knowledge about what hasn’t worked, you can mitigate similar losses in the future. This is undoubtedly a best practice.

Before implementing these practices, make sure they are codified in a strong loan review charter or policy that is signed by the board of directors. Memorializing these practices solidifies loan review as a strategic asset, and equips the loan review team to objectively and independently unlock the strategic value of loan review.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Ancin Cooley, Principal, Synergy Bank Consulting and Synergy Credit Union Consulting
Ancin Cooley is the Principal of Synergy Bank Consulting and Synergy Credit Union Consulting, both of which specialize in loan review and strategic planning.  He can be reached at acooley@synbc.com.

May 17, 2017
Top Five Attributes of High-Performing Institutions   
By  Danny Baker, Vice President – Market Strategy, Financial and Risk Management Solutions, Fiserv

Executives, employees, customers and shareholders want it all when it comes to the management of a financial institution – high growth, profitability and efficiency. Financial managers know that there is a delicate balance required to achieve strategic growth while managing expenses, but high-performing financial institutions are successfully able to walk that line every day.  

Every organization can learn from top performers, including understanding where and why they win and what drives their profitability. What do they do better than others to balance growth with efficiency? Working with a group of industry-ranked, high-performing Fiserv clients on a daily basis and observing their challenges, opportunities and best practices, we have found that these institutions shared five differentiating attributes.

1. Forward-Looking Management
So many economic variables can affect a financial institution's future, and high performers successfully assess those factors, run multiple future scenarios and manage to those possibilities. If things change, they can more quickly understand the effects and make appropriate adjustments. Assumptions about the future underpin predicted strategies, including long-range plans and budgets. Instead of simply taking a historical view – or looking at what's happening right now – high-performing financial institutions constantly review forecasts and future scenarios to better assess their environment, customers, market and competition.

2. Strategic Planning Discipline
A good strategic process relies on data analytics and scenario creation – a forward-looking management discipline that runs multiple scenarios and analyzes the underlying drivers of success. High-performing financial institutions don't just look at superficial numbers and metrics. Rather, they consider the drivers of success and underlying assumptions and then actively measure against those assumptions. Unfortunately, many organizations employ the wrong metrics to determine if a strategy is working. Using data analytics can help financial institutions understand the market and how to measure success.

3. Effective Information Management 
Data analytics provides a wealth of insights, but organizations must determine what they really need to know. High-performing financial institutions effectively manage data and link business decisions to that information. They focus on forward-looking, prescriptive data versus information about what has happened already, constantly asking, "How can we do this better?" Just as importantly, they ensure key information is widely distributed within the organization.

4. Effective Control Structure
Are we achieving what we set out to achieve? Are we measuring and driving the right results? Establishing appropriate control structures helps ensure the desired results are achieved without destroying another aspect of performance. For example, a financial institution could meet its profitability goal, but do it in a way that doesn't best meet the needs of its customers, and in the process, damage trust, reputation and relationships.

5. Adaptable Risk Management Frameworks
Financial institutions are in the business of balancing risk – especially credit risk – and reward. The risk environment can change quickly due to macroeconomic factors, such as changing interest rates, unemployment and home values, as well as the organization's policies and appetite for risk. Effective risk management at a financial institution is closely tied to profitability. To support high-growth initiatives, risk management frameworks and accompanying strategies must be particularly adaptable to change.


Lessons from High Performers

Behind each of the five attributes that helps define and differentiate high performers are two factors: data analytics and the discipline to execute on key strategies.

If someone asked you to name your institution’s best customers, could you? Maybe you'd list those with the most money, but those may not be the accounts that are the greatest contributors to your profitability. It's very difficult to establish a good strategy – and execute on that strategy – if the institution doesn't understand what drives its profitability. High performers get it. They see the link between information, strategic thinking and the actions needed to achieve their goals.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Danny Baker, Vice President – Market Strategy, Financial and Risk Management Solutions, Fiserv
Danny Baker is the Vice President of Market Strategy within the Financial and Risk Management Solutions division at Fiserv, Inc. He is responsible for the overall market strategy and business development for the company’s risk management, performance management and enterprise financial accounting solutions.


May 10, 2017
How Risk Ratings Can Enable Optimal Growth for Financial Institutions 
By Elise Hauser, Product Marketing Manager, Sageworks

Today’s banking industry is defined by tight interest margins and increased regulatory oversight. At the same time that banks and credit unions are facing these challenges, threats from alternative lenders and mega banks make it imperative that institutions grow in order to achieve economies of scale and remain competitive and profitable. These opposing pressures mean that community banks and credit unions must optimize their opportunities to grow profitably while mitigating risk.

One way to increase profitability is to reduce the costs associated with managing risk. Banks and credit unions with efficient risk management processes will spend less time analyzing and evaluating risk in their portfolios, and thus will lower the cost of doing business. For many institutions, a best practice is a comprehensive risk-rating system, that -- when properly applied -- streamlines risk management across the institution.

Assigning a Number
A risk-rating system is deceptively straightforward: a reduction of the unique combination of risk factors on each individual loan down to one number, for example, a 3. Once a loan has been risk-rated as a 3, the institution is able to use that information to make decisions about that loan and the portfolio. This risk rating can also be used at nearly every stage of the credit process to lower the cost of managing risk. Developing, implementing and maintaining a risk-rating methodology that accurately and consistently measures risk can be challenging, but it offers tremendous payout.

Risk ratings are also useful in that they allow the bank or credit union to talk about risk in a standardized language across departments and across the life of the loan. Under a given risk-rating methodology, “a 3 is a 3,” meaning that everyone from the lending department to loan administration to those determining the ALLL have the same understanding of the risk level of a loan that is risk-rated as a 3. Distilling the credit risk of a loan into a single metric also allows the institution to track it over time and to see both the evolution of a single credit, as well as the portfolio as a whole.

One important note about risk ratings is that they are not in and of themselves a risk-reducing tool. They simply function to identify and categorize risk so that the institution can make informed decisions on pricing, terms and reserves based on its individual risk appetite. A strong risk-rating system allows the institution to optimize the balance of risk and reward that is right for them.

Ultimately, the single most important reason to make sure your risk-rating methodology is up to snuff is because risk ratings come into play at every stage of the life of the loan. If your risk-rating methodology is comprehensive and standardized, you have a powerful tool. If it is inconsistently applied or has gaps in coverage, then at best you aren’t able to use risk ratings when evaluating risk; at worst, you are making decisions based on faulty data.

How Ratings Help
To get a sense of just how crucial risk ratings are to every part of the credit process, consider a few different ways risk ratings are used at various points in the life of the loan:

Credit Analysis
Risk ratings come in handy even before a loan is booked. By assigning a risk rating to a loan during the initial spreads for a proposed loan, the analyst is able to see a holistic picture of the risk of that loan, and make a lending recommendation based on that information.

Loan Pricing
An important consideration when pricing loans is the level of risk the institution is taking on with that credit. Especially with pressures to price competitively, it is important that when the institution makes a pricing decision, it is adequately compensated for that risk. By risk-rating proposed loans, the loan officer or lending committee can make an informed decision about what price to set, or whether to walk away from the deal entirely.

Loan Administration
Throughout the life of any loan, it is important that the loan is risk-rated at regular intervals, such as annual reviews. The loan administration department plays a critical role in making sure that updated risk ratings are reflected in the management of the loan. For example, if a loan were to receive a worse risk rating at annual review, the institution may want to begin collecting additional documentation, update the terms of the covenants or make other changes to the way the loan is managed. These changes are implemented through the loan administration department, so they are also able to leverage the risk-rating on a loan to reduce risk through loan management.

ALLL and Stress Testing
When it comes to managing the risk of the entire portfolio, risk ratings come in handy in a variety of ways. Beyond just grouping loans by risk rating to stress test a particular segment, some ways risk ratings can be helpful in portfolio risk management include:
Migration of risk ratings by segment
Exposure in watch, special mention or substandard ratings
Changes in risk ratings under stress scenarios
Risk rating by loan officer

In today’s banking environment of tight margins and ever-increasing regulatory oversight, it is crucial that community banks and credit unions find ways to grow without compromising the desired risk levels of their portfolios. Risk ratings are crucial to accomplishing risk-managed growth. By implementing a robust risk-rating methodology, banks and credit unions can make credit risk management easier and more effective at every stage of the life of the loan.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Elise Hauser, Product Marketing Manager, Sageworks
Elise Hauser is a product marketing manager at Sageworks, where she manages new product marketing for Sageworks banking solutions.




MARCH 10, 2017
The Financial and Service Opportunities of Digital Lending Technology for Community Institutions
By Jeffrey Harper, President, BSG Financial Group

According to recent studies by both Goldman Sachs1 and Ernst & Young2, financial institutions stand to earn $30 billion in the next eight years by utilizing digital lending technology, which allows banks and credit unions to offer loans – for example, small business loans under $100,000 and consumer loans under $30,000 – online and in minutes from their website or via mobile phone. When contemplating this revenue opportunity, compare it to two decades ago, when NSF revenue tripled from $12 billion to $34 billion and interchange grew $6 billion to $18 billion between 2000 and 2010.

Online lenders like LendingClub and Prosper have capitalized on this market opportunity and have grown handsomely by offering the convenience of applying for loans digitally and getting funds quickly. Their focus on automating the lending process has helped them:
Outpace bank and credit union lending3
Capture the majority of unsecured consumer loans in 2015
Double their outstanding portfolio balances every year since 2000

The dramatic success of non-bank lenders, in fact, led industry advisory firm Bain & Company to say, “Banks need to accelerate investments in digital lending if they are to avoid a material decline in profits and loss in market share.” Likewise, consulting firm McKinsey; Company declared that financial institutions that do not adopt a digital lending solution could lose 60% of their retail and small business profits to non-bank entities in the next five years.

Technology Changes Everything
With digital lending, traditional loan profitability scenarios do not apply. For the past 20 years, many community institutions stopped making these loans altogether, because the cost to underwrite and service them far outweighed the income to be earned. Despite the fact that customers needed the money, it was simply not profitable, forcing account holders to seek the funding elsewhere, such as from a credit card, an alternative lender or even a competing institution.

Online lending technology changes the profitability scenario by streamlining the entire lending process – from application and underwriting to set up, review and renewal – via an end-to-end technology platform. Automating the lending process in this way can reduce the expense of processing and managing a loan from approximately $2,4004 to $1005 or less. These efficiencies can give an institution the opportunity, with only minimal effort, to re-capture loans previously lost to other funding sources, while improving customer service and reducing costs.

Additionally, with the right digital lending platform, the institution is able to utilize its own underwriting and risk-rating standards to manage risk and security. And because the institution controls the technology, it is able to keep all of the loans on its balance sheet as working assets, unlike partnering with fintech companies that typically retain ownership of the loans.

The financial opportunity that digital lending technology provides gets even better when you consider that in addition to garnering new loans and customers for your institution, it can also assist with managing existing loans. This added benefit is significant considering financial institutions currently hold more than $250 billion in small business debt that could easily and efficiently be renewed or refinanced using a consumer-friendly and efficient digital solution.

Digital is Key
Meeting consumers’ ever-increasing digital demands with an online lending solution just makes sense. A study by MagnifyMoney found that financial institutions with the highest digital adoption scores grew their assets 16 times faster than those less likely to adopt new digital technologies.

Further, banks that score highest in digital excellence measurements have reaped the lion’s share of financial rewards, according to BCG Perspectives in its 2016 Retail Banking Excellence (REBEX) benchmarking study. The report cited a 50% higher average pretax profit per customer than the median, while operating expenses per customer were 30% less. These impressive numbers are probably why more than 70% of financial institutions worldwide say that redesigning or enhancing the customer’s digital experience is one of their top three strategic priorities in 2017.6

Today’s consumers, especially millennials, seek easy, quick solutions. They use their phones to
accomplish the majority of their daily activities, and they will readily switch banks if they have a poor digital experience. With digital lending, your institution can reap the financial rewards of offering accountholders the ability to apply and get approved for the funds they need from their internet-enabled phone or desktop computer... anytime, any day, and all in less than three minutes.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the Financial Managers Society.

1https://www.scribd.com/document/268857182/Goldman-Shadow-Bank-Report-May-2015

2http://www.ey.com/Publication/vwLUAssets/ey-alternative-lending/$FILE/ey-understanding-alternative-lending.pdf

3  http://newsroom.transunion.com/transunion-analysis-finds-fintechs-outpacing-traditional-lenders-in-personal-loans-issued-to-near-prime-and-prime-borrowers

4  BAI Banking Strategies (https://www.bai.org/banking-strategies/article-detail/making-small-business-loans-profitably)

5  R.C. Giltner & Associates, LLC

6 Digital Banking Report (http://onlinebankingreport.com/subscriptions/browseresearch.html)


About the Author

Jeffrey Harper, President, BSG Financial Group
Jeffrey Harper brings more than 25 years of industry experience to his position as president of BSG Financial Group, where he heads up the Sales and Marketing divisions of the company.







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