Industry Insights

August 10, 2018
Securing the Most Favorable Prices for Securities Transactions
By Robert Segal, CEO, Atlantic Capital Strategies, Inc.

Banking regulations require that financial institutions implement robust systems to monitor, manage and control risks related to investment activities. The agencies state further that effective management of the risks associated with securities represents an essential component of safe and sound practices. The FDIC, for example, says it is prudent for management to fully understand all relevant market and transaction risks. Accordingly, management has the responsibility to put systems in place to assure that all reasonable efforts are made to obtain the most favorable price for each securities transaction.

The market for fixed-income securities has evolved significantly in recent years. However, according to the Financial Industry Regulatory Authority (FINRA), the amount of “pre-trade” pricing information (bids and offers) is still relatively limited as compared to equities, and generally not readily accessible by the investing public. While new technology and communications in the fixed-income market have advanced, the market remains decentralized, with much trading still occurring on an over-the-counter basis.

Compared to equities, transaction costs for fixed-income securities remain stubbornly high. Academic studies have shown that transaction costs for even small orders of equities are a few pennies per share, while commissions for corporate and municipal bonds can be several dollars per $100 of bond principal value, or one hundred times higher or more.

Approximately ten years ago, the SEC instituted a “post-trade” reporting system that distributes information about bond transactions. Under the program, dealers are required to report, with a 15-minute delay, the price and quantity of every transaction. Corporate bonds were the first sector in the platform, followed by municipals and agencies, and more recently, Treasuries and mortgage securities. This innovation improved transparency by allowing investors to obtain more current information about market values.

In a recent regulatory notice, FINRA reiterated its commitment to best execution as a key investor protection requirement. The agency noted that in light of the advanced nature of fixed-income markets, brokerage firms need to regularly review their procedures to ensure they are designed to incorporate and reflect best execution principles, as the broker is “under a duty to exercise reasonable care to obtain the most advantageous terms for the customer.”

FINRA requires that brokerage firms establish, maintain and enforce robust supervisory procedures and policies regarding “regular and rigorous reviews” for execution quality. As part of its own regulatory reviews, FINRA conducts statistical analyses, establishing pricing parameters for comparison to other transactions in the same security. In fact, if certain transactions show a meaningful variance, FINRA may deem the firm to be in violation of best execution principles.

It is important to keep in mind that best execution does not always mean the lowest possible price. In its Trust Examination Manual, the FDIC said management should consider other factors when determining the quality of execution, including quality of research provided, speed of execution and certainty of execution. Regulators also recognize that obtaining quotes from too many sources could adversely affect pricing due to delays in execution and other factors.

Given the regulatory environment and improvements in transaction reporting, bank management may wish to implement a “back-testing” program to assure that the institution is receiving the most favorable prices for securities transactions. This surveillance tool could compare the institution’s pricing to prevailing market prices at the time of the trade, while also analyzing the bid/offer spread to confirm that the transaction “mark-up” was fair and reasonable.

A direct benefit is that the financial institution should see improved profitability as it routes business to brokerage firms that provide the lowest overall transaction costs. Corporate governance can be enhanced as risk management policies and procedures continue to be strengthened.

As the programs evolve, bank treasurers can ultimately establish a system for evaluating broker/dealer performance. The FDIC requires that financial institutions develop and approve an effective vendor management program framework. What the FDIC is looking for, according to industry observers, are well-defined documentation processes. The regulators see vendor risk management as needing continual monitoring and ongoing risk assessments.

Finance officers typically scrutinize the P&L in a finely-tuned manner. At the same time, most bankers acknowledge they don’t know what they’re paying for brokerage costs for securities transactions. Transaction costs can vary greatly based on the scope of the transaction and access to the most liquid dealers. A review of individual transactions indicates that investors may be “leaving a lot of money on the table.” Thus, a more diligent approach toward trading efficiencies could help support the bottom line.

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

About the Author

Robert Segal is the founder and CEO of Atlantic Capital Strategies, Inc., which provides investment advisory services for financial institutions. He has over 35 years of experience in the banking industry, having worked in several community banks with roles in mortgage banking, sales and trading and ALM. Bob is also currently a Director-at-Large on the FMS Board of Directors.

July 2, 2018
Managing with a Forward View
By Mary Ellen Biery, Research Specialist – Sageworks

Dealing with the day-to-day challenges of operating a bank or credit union can keep top management “in the weeds” of lending or credit operations. This can leave little to no time for surveying the entire “field” of the portfolio, its risks and its impact on the institution’s financial results.

It’s the same challenge the institution’s small business customers often face. When owners’ days are filled with handling current-day issues and reviewing recent results, they end up with little time for big-picture planning. It’s not until these businesses begin forecasting sales and expenses, and managing with a forward-looking perspective, that they are able to generate meaningful growth.

Banks and credit unions, many of which are small businesses themselves, can also make more informed strategic decisions that aid growth when they manage with a forward view. Managers may currently rely solely on Excel-based reports of last month’s loan delinquencies, charge-offs and the like. But executives can quickly understand trends in the portfolio and use insights to inform strategic planning by incorporating forward-looking indicators, many of which can be generated automatically through technology.

Indeed, in a recent FDIC Supervisory Insights article, an analyst for the FDIC’s Division of Risk Management Supervision emphasized the importance of forward-looking risk indicators. Such indicators, senior analyst Michael McGarvey wrote, “can be indicative of future performance and should be the focus of a sound credit management information system program to proactively identify and mitigate risk exposure.” The article described a scenario where one bank relied heavily on lagging risk indicators, resulting in inadequate risk identification. Another bank, meanwhile, was able to be more proactive in risk management, thanks to forward-looking metrics.

According to the FDIC article, an example of incorporating forward-looking credit metrics would be monitoring concentrations in relation to capital so that the institution can establish strategies to decrease, maintain or increase exposure to a certain concentration or identify concentrations approaching or exceeding limits. Metrics to aid in this approach include data related to:

- Loan category (C&I, CRE, unsecured, auto, etc.)
- Industry breakouts on C&I loans
- Individual and related borrowers
- Geographic concentrations

Another example of incorporating forward-looking data would be monitoring the institution’s performance and risk indicators against policy limits and the risk appetite statement. Tracking the volume of loan exceptions, underwriting trends, loan grade migrations and concentration risks would aid in developing this type of report, the FDIC analyst wrote.

“The FDIC is absolutely right to focus on this issue,” says Neill LeCorgne, vice president of Sageworks and a former bank president. “What typically happens in the banking world is when the economy goes well and everybody’s doing well, there’s not a deal that a bank doesn’t want to take a look at. When the economy starts to turn down, everyone starts to pull back. Now is the time to start getting your management information systems established and working and following some of these practices.”

LeCorgne says a banking technology platform that has heavy analytical capabilities at the portfolio level makes it easier to slice and dice concentrations and global relationship exposures, and to provide custom visual summaries to share with the board, auditors and examiners.

Data generated using technology at the front end of the origination process – such as an online loan application – can interact with an automated tickler system to track correspondence and data requests on a go-forward basis. That way, banking staff don’t have to manage all of the quarterly or annual reports on borrowing-base analyses, quarterly/annual reviews or renewals. Instead, time previously spent on those tasks can be used to look at the big picture regarding the potential future impact of credit exposures and underwriting trends.

At the other end of the loan’s lifecycle, technology that helps banks leverage the results of calculations for the allowance for loan and lease losses (ALLL) – especially results under the upcoming current expected credit loss model, or CECL – can also provide forward-looking insight. Institutions can use the results of CECL calculations to back-test risk rating models and scorecards and develop sound risk-based pricing systems. In this way, executives can more effectively manage profit in a CECL world.

While historical performance metrics typically convey what has occurred in the past in the portfolio, forward-looking metrics throughout the life of the loan can help financial institutions identify underlying risks that could potentially affect not just future performance but also future strategic decisions. Banks and credit unions strengthening credit management information systems with the assistance of automated data generation and tracking, as well as sound governance, will be better able to respond to emerging risks in the years ahead. Like their business customers utilizing forward-looking information, these institutions can aid their growth when they rise above “the weeds” to survey the entire credit and business landscape.

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

About the Author

Mary Ellen Biery is a research specialist at Sageworks, a financial information company that provides lending, credit risk and portfolio risk solutions to over 1,200 financial institutions across the country.

June 25, 2018
FMS Quick Poll: CFO Responsibilities

It’s no secret that the role of the CFO in financial institutions has been changing over the past several years. What was once largely a numbers-focused position has grown and evolved to encompass more strategic responsibilities than ever before – not to mention more technology- and compliance-related oversight as well.

To get a better idea of how that broadened focus is manifesting itself in the day-to-day operations of their banks and credit unions, we went out to member CFOs for our latest Quick Poll, asking what their direct and indirect reporting relationships look like these days. More than 130 CFOs (85% from banks or thrifts and 15% from credit unions, representing a broad cross-section of asset sizes largely between $200 million and $2.5 billion) took time out from their increasingly busy schedules to give us a clearer picture.

In terms of direct reports (see Figure 1), 29% of our CFOs are overseeing corporate support areas such as human resources, facilities and administration, while 27% are directly responsible for risk management components like BSA, compliance and internal audit (in addition to the 11% who directly oversee ERM in their institutions). Operations for loans and deposits come under the direct purview of around 19% of the respondents in our Poll, while 8% wrote in an option of direct responsibility for IT. While these results weren’t necessarily surprising, they are nevertheless instructional in getting a better understanding of just how far afield today’s CFOs range from the traditional finance tasks of yore.


But it’s not just direct reporting responsibilities that are taking up more and more of the CFO’s time these days. A follow-up question asking about indirect reports in these same functional areas yielded fewer responses overall (likely owing to the fact that those with direct reports in these areas passed on the question), but largely fell in line with the general trends from the direct reporting question. Of the 83 respondents who weighed in here, 56% have indirect reports in corporate support areas, 44% in risk management and 41% in operations (Figure 2). The one significant jump in terms of indirect over direct oversight was in the area of business lines (including lending and branches), where 25% of CFOs have indirect reports, compared to just 2% with direct oversight of these functions.


These expanding responsibilities – direct and indirect – have led to a wider range of concerns for CFOs as well. In our final question, we asked respondents to identify the business challenges they expect to most significantly impact their institutions in the coming years (see Figure 3). While they were allowed to choose up to three of the presented options, it’s clear that the ongoing push for deposits and liquidity is foremost on the minds of CFOs, as their institutions try to keep up with the continued steady demand for loans amid an increasingly competitive industry. Accounting changes, too, are high on the list of formidable challenges to come, especially as the implementation deadline for CECL continues to bear down in the coming years.


Thanks again to all of the CFOs who took the time to participate in our latest FMS Quick Poll!

April 9, 2018
Leadership For An Industry 4.0 World
By David E. Perry and Ron Wiens

The world is entering its fourth Industrial Revolution, often called Industry 4.0. While Western economies ruled the first three industrial revolutions, the economies that will dominate the 4.0 World have yet to be determined. With the future up for grabs, what will the differentiator be for winning organizations?

Ushered in by the steam engine, the first Industrial Revolution led to the mechanization of work. The second, led by the electrification of factories and machinery, enabled mass production on a grand scale. The third, occurring in the second half of the twentieth century, introduced computers to the workplace and led to the automation of everything from back-office administration to the teller’s window.

The common theme of these revolutions has been a decline in the dependence on human capital. But Industry 4.0 is about to change that.

Knowledge + Connectivity = Industry 4.0
Industry 4.0 is driven by an electronically connected world. In the emerging 4.0 World, people are connected not only to each other, but also to each other’s knowledge. The impact of this connectivity is best summed up by the following observation from Dr. Nick Bontis of McMaster University: “In the 1930s, the cumulative codified (i.e., written down) knowledge base of the world doubled every 30 years; in the 1970s… it doubled every 7 years.” Bontis predicted in 2000 that by 2010, the world’s codified knowledge would double every 11 hours.

Maybe we haven’t reached that fateful 11-hour figure, but we now live and work in a world in which knowledge is growing exponentially. Since knowledge equals opportunity, the opportunities available to organizations are also growing exponentially. And because everyone is connected to this knowledge, everyone is connected to these opportunities. Therefore, competitive advantage today lies in an organization’s ability to exploit this knowledge and spot opportunities before anyone else – companies that can consistently do this faster than their competition will thrive.

An interesting by-product of this knowledge explosion is that the days of the all-knowing, all-seeing manager are over. Knowledge workers today are often more aware of new knowledge than management is. It’s not that managers have gotten dumber, but rather that employees have gotten smarter – or at least better educated.

Organizations are ripe with highly educated knowledge workers. That’s a key difference between now and the first Industrial Revolution, when our current management systems were invented. Here’s a nice bit of alignment: we have an explosion of knowledge, and at the same time that we have growth in the capability of the organization’s employees to understand and make use of this knowledge. The continued prosperity of already successful organizations now depends directly on the ability of their workers to continuously generate new value. Winning organizations have awoken to this fact.

The Power of Leadership
What does ‘waking up’ mean? At its core, it means a fundamental shift in how people are managed and led. The 4.0 World is all about leadership.

The current approach to managing people tends to focus almost exclusively on maximizing the productivity of individuals. This is Leadership 1.0 – steam age leadership, in which the whole is viewed as the sum of its parts. Industry 1.0 leadership can be summed up by the following philosophy: “We all have a job, and if we each do our job we will be successful.”

In an Industry 4.0 World, the view is quite different – the whole can be much more than the sum of its parts. 4.0 leaders still work at maximizing the performance of the individual, but they also focus on maximizing the performance of the team. This means looking at recruiting leaders through a new lens. In a 4.0 World, the skills and behaviors needed in a leader have changed considerably.

Building an environment that facilitates the ongoing creation of new value means managing not only the individuals who make up a team, but also the interaction space between these individuals. A lesson learned from the IT industry – which was the forerunner to Industry 4.0 and provides insight to the 4.0 World – is that between any two individuals on a team there is a hidden creative force. When the interaction space between individuals is effectively managed, this force emerges and the creative impact of the team is multiplied. In a 4.0 World, an organization’s ongoing prosperity now directly depends on its leaders’ ability to draw out this creative energy.

Building an organizational culture that facilitates the ongoing creation of new value is not rocket science. But it requires a fundamental change in perspective on the part of the organization’s managers – a change that will challenge current management practices, including how a manager’s performance is measured and evaluated. To be successful in a 4.0 World, organizations will now need to evaluate their managers not only on the basis of what they have delivered, but also by the readiness of their teams to deliver in an unknown future. Contrary to popular belief, winning in the fourth Industrial Revolution is not about speed – it’s about non-stop strategic change that constantly advances the organization toward its stated goals.

What does a 4.0 leader look like? 4.0 leaders not only manage the space in between people while building a high-performance culture. They never rest. They never allow the organization to crest. They know success is not a sprint but a marathon. Change is ongoing in a 4.0 World, which is why the 4.0 Leader is constantly developing and strengthening the organization’s change muscle. The successful organization in a 4.0 World reflects this kind of leader by constantly moving forward – never stopping, never resting.

Building a 4.0 Team
The goal in hiring isn’t to find the best talent looking for work, or at least it shouldn’t be; what it should be is finding the best talent period. Today that means recruiting leaders who are comfortable in a 4.0 world, and therein lies the recruiting challenge. The best leaders – the 4.0 talent – already have good jobs. The key to recruiting successfully in a 4.0 world now means going after talent that isn’t looking for work.

But hiring the best is not about money – it never was. Surprisingly enough, the best will come to an organization not to make more money, but because of what the organization stands for and what it’s trying to achieve. Work is personal to 4.0 talent, which is why you have to first engage their heart. Once you’ve spoken to the heart, the next step is to speak to their head – the best will want to understand the organization’s business goals, its challenges, its assumptions and its blind spots. Once the head is engaged, you next have to address the feet – the best will want to understand the organizational culture that drives the way people interact and how things get done. To do all of this, you need a systematic approach to finding 4.0 talent by engaging their interest and assessing their alignment with your goals.

Two Alternatives
In the ‘Old West’, it was said that there were two kinds of people – the quick and the dead. In the Industry 4.0 world, there are just two types of banks and credit unions – the quick and the dying.

The quick embrace new ways of leading and creating value, while the dying hang on for dear life to what brought them success in the past. Which will you choose to be?

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

About the Authors

A well-known name in executive search circles with over 30 years of work as an executive recruiter under his belt, David Perry helps companies find and bring aboard Industry 4.0 leaders as the founder and managing partner of Perry-Martel International. A noted speaker on the topics of leadership and cultural change, Ron Wiens ( has spent the past 35 years helping organizations build high-performance cultures.

April 2, 2018
Applications of Risk Ratings
By Alison Trapp, Sageworks

Risk rating is integral to underwriting and managing commercial loans. Regulators expect that lending institutions not only assign risk ratings in an accurate and timely manner, but also that they use them in their processes.¹ Institutions should benefit from this expectation, as aligning processes to risk rating can impact their financial performance and human resource efficiency – particularly when used in the following areas.

New Originations
Risk rating is a means for ensuring an institution is originating and renewing loans in a safe and sound manner. For that reason, the underwriting process should include an assessment of risk rating early, rather than leaving it for a “check-the-box” exercise right before approval (or worse, closing). Accurate rating within the Pass grades is important to ensure that other processes are correlated to the proper risk levels.

An institution may also tie approval authority levels to risk rating. In this instance, so as to avoid biased results, it is especially important that the person responsible for assigning the risk rating is not influenced by the person with the approval authority.

Risk rating may also govern commitment and hold levels, when a guarantor is required, or what structures are available to a given borrower. For example, some borrowers have weaker cash flow that would result in an unacceptable rating unless there are structural enhancements that reduce that risk.

Loan Pricing
Intuitively, risk managers and lenders understand that higher-risk loans should have higher fees or interest, or a shorter tenure. Explicitly tying loan pricing to risk rating allows an institution to implement these structural elements more consistently. It also allows the institution to evaluate any exceptions to the pricing policy within a framework. In certain cases – for instance, the institution may deem it advantageous to stray from its own policy for a bigger purpose – having the policy in the first place allows it to understand the cost of such a move.

Resource Management
Risk rating can be a powerful guide for managing resources. A starting point is to align experience levels with accounts from different risk grades. A more experienced analyst should be the lead on lower-rated assets, while less experienced analysts may have a secondary role on these accounts or a lead role on more highly rated assets with oversight.

When the portfolio is managed with risk rating, the institution can use data to understand how changes to the portfolio will affect the resources required to manage the assets effectively. For example, if the institution is planning to acquire a portfolio of loans and it knows (a) the risk rating distribution of those assets and (b) the amount of a full-time resource that each risk grade requires to manage to its standards, it can estimate the additional resources it will need. The institution can thereby determine if it has enough current resources to absorb the acquisition, if it needs to find efficiencies (perhaps through the use of software or by streamlining processes) or if it needs to hire additional resources.

Portfolio Rhythms
An institution should align distinctions in risk ratings to its ongoing portfolio management processes. For example, the institution can tie the frequency of review to risk ratings. An institution with five grades of Pass along with Special Mention, Substandard, Doubtful and Loss might set account review frequency as follows:

Additionally, the institution can use its data to understand how changes to a process will impact it. For example, if an institution with the above structure decided it was spending too much time in meetings and wanted to move Pass 3 from a semi-annual review to annual, it could estimate how much time would really be saved. Performance of the Pass 3 credits should then be monitored separately for a time to make sure that the change did not have a detrimental impact to overall portfolio quality.

Allowance for Loan & Lease Losses (ALLL)
There is a logical correlation between risk rating and ALLL as supported by the OCC calling risk rating the underpinning of ALLL.² Embedding risk rating in the ALLL process explicitly systematizes what institutions would be doing instinctively – aligning reserve levels with risk levels. Most institutions are already using risk rating in their ALLL process, while those not currently doing so are likely contemplating including it as part of the transition to their upcoming Current Expected Credit Loss (CECL) calculation.

By developing a robust risk rating policy and applying it consistently to all loans, financial institutions can glean benefits across the life of the loan, from origination to portfolio risk management.

¹ page 2
² page 2

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

Alison Trapp leads the credit risk practice for Sageworks’ Advisory Services team, with expertise in the areas of credit administration, risk rating development and policy implementation.

February 26, 2018
FMS Quick Poll: Tax-Inspired Raises and Bonuses
By Financial Managers Society

In the weeks following passage of the Tax Cuts and Jobs Act last December, it was rare for a day to go by without a bold headline trumpeting how another company was passing a small portion of its sudden tax windfall along to its rank-and-file employees in the form of a wage increase or one-time monetary bonus. But the news was decidedly more muted for FMS members.

In our latest Quick Poll, we asked members whether the tax changes were inspiring their institutions to give out raises or bonuses. The resounding sentiment among the 125 members (86% from banks or thrifts and 14% from credit unions, representing a broad cross-section of asset sizes) who responded to the survey? Nope. While 6% of respondents were indeed paying out one-time bonuses and 2% were raising their minimum wage and 7% were working on some combination thereof, the overwhelming majority of 85% were opting to take a pass on the notion of passing along any tax largesse (Figure I) – although 17% of these were at least taking the issue under consideration.

Lest the hard numbers suggest that these institutions are either thoughtlessly spendthrift or somehow anti-employee, the explanations of their answers from 57 of the poll respondents provide a window into the thinking behind these decisions, highlighting the fact that not every business is in exactly the same position, and no tax cut affects every organization in exactly the same way.

For example, one respondent whose $569-million bank was giving $1,000 bonuses to each of its 60 employees felt justified in distributing a small piece of the estimated $1 million the institution was expecting to save from the tax cuts. Meanwhile, a $126-million bank opted to look longer term rather than pay out one-time bonuses, with the CFO reasoning that “the tax benefit gives the company the ability to increase wages to better match our peers and help retain talent.”

But even some of those institutions who answered the poll question “no” were still planning to reinvest in human capital in less direct ways, with one CFO of a $956-million bank noting that his institution was using its tax savings to hire on more employees rather than paying out raises or bonuses to those already in the organization.

On the other hand, many of those standing pat on raises and bonuses stood by their decision, with a number of respondents pointing out that they already had robust wage and bonus structures in place prior to the tax cuts, and therefore saw no reason to make additional moves at this time. Others explained that in forgoing payouts they were simply making a business decision based on the reality of how the tax “cut” had impacted them.

Several members noted, for instance, that the deferred tax asset (DTA) revaluation included in the tax bill had resulted in a substantial end-of-year hit on their balance sheets, making it difficult to justify paying out raises or bonuses. Still, one CFO remarked that her $1.1-billion bank managed to reward its employees for the year despite its DTA setback: “We had a DTA revaluation that would have killed the regular bonus, so we excluded it and maintained our traditionally attractive bonus payout.”

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!

February 12, 2018
Auto Lending at a Crossroads
By Alec Hollis, Director – ALM Strategy Group, ALM First Financial Advisors, LLC

“Transitions to delinquency show persistent increases for auto and credit card debt; auto loan delinquency rates especially problematic for subprime auto finance loans.”

So reads the press release from The Federal Reserve Bank of New York for a recent Quarterly Report on Household Debt and Credit. Headlines like these are becoming more common in relation to auto lending as regulators cite concerns over several years of strong growth alongside eased underwriting standards and unabated flows into delinquency.

The unprecedented growth in auto debt can be derived in part by the underlying demand for the collateral. Annual auto sales have seen several consecutive years of growth, setting an all-time high of 17.5 million units in 2016. This growth has trickled down to auto lenders, as total auto loan debt notched a new all-time record at $1.21 trillion in outstanding balances at the end of the third quarter of 2017. This represents a 48% increase from ten years ago – second only to a 157% increase in student loan debt – while total household debt increased 7% over the same time period.

This growth has the OCC’s attention – the agency took notice as early as the spring of 2012, citing banks launching new products, services and processes to catalyze asset growth, and specifically mentioning the growth in indirect auto lending. While growth in and of itself is not necessarily bad, the OCC has consistently discussed auto lending, which is why it is important for financial institutions to understand the reasons behind the elevated risk status.

Total originated auto loans surpassed $430 billion through the first three quarters of 2017, with roughly $88 billion of those loans considered to be subprime (credit scores below 620). Subprime auto loan originations have not been growing as fast as in preceding years, as some major market participations have capped subprime production, but overall originations continue unabated, with an ongoing streak of year-over-year increases.

At the close of 2017, roughly 20% of auto loan originations were subprime, compared to 21% in 2016, 23% in 2015 and 29% pre-crisis in 2007. Despite this decrease, Figure 1 shows that subprime origination volume has nevertheless has accelerated to roughly pre-crisis levels today, while originations with excellent credit have far surpassed pre-crisis levels.

Figure 1

Delinquencies in the auto lending space have likewise ticked up. Auto loans 90+ days delinquent measured 3.97% of the outstanding balance in the third quarter of 2017, continuing a streak of quarterly increases. Delinquency flow (newly delinquent loans) has also been increasing steadily for several years. Figure 2 shows the outstanding seriously delinquent balance, which has increased steadily since 2014.

Figure 2

Although widespread delinquencies have yet to materialize, there are certainly problematic sectors. Auto finance companies represent $602 billion – or roughly half of the $1.21 trillion outstanding – in auto loan debt. When it comes to subprime lending, auto finance companies dominate, representing 74% of outstanding balances with credit scores at origination of less than 620.

Auto financing companies might not look quite so dominant, though, when digging into delinquency flows. Figure 3 shows the flow into serious delinquency for auto loans originated with a credit score of less than 620. These flows have diverged from banks and credit unions in a major way, and are currently at levels not seen since the financial crisis for this major subset of subprime auto lenders.

Figure 3

The OCC has been consistently discussing and monitoring the trends in delinquencies since they first mentioned the drift higher in 2013. Asset quality indicators such as delinquency ratios and net charge-offs are trailing indicators, meaning that they take time to materialize as the credit lifecycle matures for a particular vintage of loans. Many are expecting delinquencies to continue to rise, as aggressively underwritten vintages continue to mature. To prepare for this, it is important for financial institutions to ensure collections operations can meet the potential delinquencies and that reserves are appropriate given this expectation.

Indirect Auto Lending
As it relates to auto lending, the OCC has widely discussed fair-lending risk, a result of yielding underwriting decisions to auto dealers or other third parties. Not only does this practice create a risk to credit standards, but it also carries significant compliance risk.

A notable case in 2013 involved Ally Financial, a large lender in the indirect auto space. The Consumer Financial Protection Bureau (CFPB) and the Department of Justice (DOJ) took action against discriminatory lending practices present in Ally’s program. Incentivized by dealer markups, minority borrowers were being charged higher interest rates at the discretion of the auto dealer. As a result, Ally was required to pay a total of $98 million in damages and penalties.

This example demonstrates how crucial it is for financial institutions to have adequate controls and appropriate compensation for dealer relationships. The last thing an institution needs is a dealer making underwriting decisions – not to mention the potential multimillion dollar penalties that may accompany them.

Action Plan
Recent news is riddled with coverage on auto loan delinquencies, subprime auto lending and large institutions scaling back from auto lending. Most recently, TCF Financial Corporation, a Minnesota-based bank holding company with $23 billion in total assets, announced discontinuation of all indirect auto lending. Other big banks have announced the limitation of auto loan originations in general, citing rising stress and protection from credit risk. As far back as 2015, Wells Fargo announced a cap on subprime production, after years of being aggressive lenders in the space. Moves like these could indicate some concern.

Particularly in regards to indirect lending, institutions need to understand the importance of assessing the additional risks posed by dealer relationships, as well as the additional fees. Return-on-capital models can objectively assess the profitability of product lines – if risks are mounting, institutions can take a cue from TCF and perhaps take a step back from the market.

Overall, auto lending can be a very important part of the balance sheet for many consumer-focused financial institutions, and indirect lending and dealer relationships can be an excellent tool to expand the institution’s reach. However, if ensuring safe and steady growth is the goal, history has shown that loosening credit standards to increase loan volume is not often successful in the long run.

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

Alec Hollis is a Director in the ALM Strategy Group at ALM First Financial Advisors, LLC.

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