Retail lending changes mean new risks: regulator and bankers discuss changes

RMA Journal, The, Sept, 2005 by Phillip J. Britt

Since the early 1960s, the Federal Reserve Bank of Chicago's Conference on Bank Structure and Competition has served as a forum for academics, regulators, and industry participants to debate current issues affecting the financial services industry. The 41st annual conference included five panelists discussing the state of retail lending. The remarks of three of the panelists are included here.

Retail lending has changed from a business in which the banker knew the borrower and used traditional underwriting policies to one that uses risk-based pricing, off-balance-sheet transactions, and new products to maximize loan production. This wholesale change raises concerns about risk, a panel of experts told bankers at the Federal Reserve Bank of Chicago's recent conference on bank structure and competition. Among the panelists were Cathy Lemieux, senior vice president of the Chicago Fed; Mike Frow, executive vice president and chief risk officer for Harris Financial Corp., Chicago, a subsidiary of BMO Financial Group, Montreal; and Robert M. Tetenbaum, executive vice president, First Manhattan Consulting Group (FMCG), New York.

While expansion of credit to riskier borrowers has allowed more people to become homeowners, it also has meant that banks need to focus more on appropriate pricing and risk management, said the Chicago Fed's Cathy Lemieux. A week after Lemieux's comment, the five major bank regulatory agencies voiced similar concerns in a joint statement: "In many cases, the institutions' credit risk management practices for home equity lending have not kept pace with the product's rapid growth and easing of underwriting standards."

Retail lending, primarily mortgages and home equity credit, helped banks earn record profits, Lemieux said. This happened in spite of the decline in commercial lending that has occurred over the past 13 quarters. Home equity is the fastest-growing asset class on financial institutions' balance sheets, having increased nearly 45% between 2003 and 2004, while total bank assets grew less than 5%.

As retail lending has evolved, so too has the risk profile for retail lending, according to Lemieux. Outsourcing/indirect lending, securitization, credit scoring, technology, new products, risk-based pricing, and the movement of some risk to off-balance-sheet transactions have changed risk profiles at many banks. Strongly urging financial institutions to manage risk and compliance on an enterprise-wide basis, she recommended that banks develop broader, more discriminating, and more forward-looking management information systems for retail lending. "Don't be complacent about current asset quality," Lemieux said. "Stay on top of concentrations."

Though information technology can help banks mitigate risk, IT has its own risk issues as well, Lemieux said. She urged banks to "verify, verify, verify" the lending models some of these technologies provide. Credit-scoring models, for example, depend on accurate data at the beginning, strong information integrity, and accurate analysis of the data, Lemieux added. "A lot can go wrong. Technology and the Internet can result in magnification of glitches and external fraud."

Lemieux also cautioned bankers to be wary of new products, many of which are untested for operational risk in the current rising-rate environment. Operational risk also comes from the increased use of less-regulated, third-party firms, which may not be as careful in safeguarding customer information as the banks, she said. The third-party firm, the bank, and the customer will all suffer if the customer information is compromised.

In the post-Sarbanes-Oxley environment, proper accounting matters more than ever, Lemieux cautioned. Securitization makes the accounting process even more complex because the valuation of the mortgage-backed and other securities calls for some valuation judgments, which may not always be accurate.

"Option soup" needs more science than art. "From a risk management perspective, the increasing complexity of the [credit] 'option soup' and the trade-offs we make to achieve profitable growth, satisfy client demands, and meet shareholder expectations require us to evaluate both the art and science [of retail lending]," agreed Harris Bank's Mike Frow.

Retail lending itself has moved further from art and closer to science as technology, data, complex hedging, and increasing expansion of lending from a local business to a national--and even international--business have become more prevalent in the industry, Frow said. His own bank, for example, has been known in Chicago for many years as a local institution, but as part of the larger BMO organization. Harris now has international resources and the capabilities of the corporate technology, including credit scoring and data modeling.

Similarly, the consumer loan has gone from an unconditional promise to pay plus option to default, to a promise to pay with an increasing number of options--floors, caps, interest-only payments, rate locks, prepayment options, and more. Also, lenders making loans today require much less in actual principal repayment by offering interest-only loan options, so consumers have shifted from borrowing and repaying money to "renting" cash.