Analytics simplifies the balancing act between stakeholder needs and business risk appetite strategy
Loans are the lifeblood of a banking institution. Think of it like a car’s relationship to oil; without it, you don’t run. Credit unions, which are nonprofits, also require loans to ensure the continuity of the membership organization.
This has certainly been true since Wescom Credit Union’s start in 1934, when 13 individuals pooled $65 to create an alternative to the banks. Now, with 22 branches throughout southern California and more than $2 billion in assets, Wescom has become one of the largest credit unions in the country and serves more than 200,000 members. As a nonprofit financial cooperative, our members are our owners and excess earnings benefit our members, not a small group of shareholders.
To generate excess earnings, we have to choose wisely from the opportunities that present themselves. That decision-making process is guided by our appetite for risk – defined as the quantity and types of risk that our organization is willing to assume in pursuit of its strategic objectives.
The credit risk department has a clear mandate to grow loan originations and loan production, and monitor and mitigate risk. Fulfilling that mandate requires us to frequently assess Wescom’s risk appetite. Until 2008, when the Credit Risk department was first formed, risk appetite arose from the relationship between our membership and the credit union itself. Now, the process is influenced by numbers and analytics.
Moving the needle
Risk appetite sits on a three-dimensional, sliding scale between high risk/high return; low risk/low return; and capital allocation. Every business decision falls somewhere on this curve. Whether you want to move to one end or the other of the scale, for instance taking on more risk to get more reward, depends upon your risk appetite.
I grew up in a family business selling t-shirts, and it was a quantitative world then. Since it was a nine-to-five job, you had to find ways to make extra sales throughout the day. You had to assess your risk appetite to know whether selling more would impact gross income and tax benefits. Nowadays, we can use analytics software to instruct us on this exponential versus linear growth. For example, at Wescom we applied analytics to our pre-approval programs and were able to find a higher acceptance rate and higher profitability rate by taking on an incrementally insignificant amount of additional risk.
Instead of asking the board to develop and establish risk parameters, an internal department should be charged with bringing risk appetite scenarios to the board with varying degrees of risk as well as probable outcomes. At Wescom, the Credit Risk department does this. We present risk reports that discuss and recommend various levels of risk, and then the Asset Liability Committee and the Credit Risk Committee, fine-tune our recommendation for final delivery to the board.. We put it in a straightforward way, along with execution strategies. Everything is all planned out and ready to implement upon approval as we don’t want to explain to the board later on that we can’t actually create this scorecard or can’t price the loans as low as recommended and still surpass the required profitability benchmarks.
We account for regulations (such as those from the National Credit Union Association and the State of California) in our risk appetite analysis as they dictate, among other things, how much in reserves you must have for the loans you book. We also feel that risk appetite should be developed for individual departments versus the entire organization.
Recently, we found through a risk appetite analysis that we are able to price the same for new car and used car loans, which is unheard of in the industry. We do this by limiting the loan-to-value, or how much we’re going to loan against a car, which forces a down payment.
Our risk appetite is balanced with the needs of our membership individually and as a whole. We try to give them what they need, want and desire, but within what we think is their capability to repay. We analyze whether they really can take on a certain loan without trouble.
In our risk appetite analysis, we include reports from programs we’ve recommended and implemented such as pre-approval for auto or credit card – literally, we have nearly 100 different slices and dices of information – as well as our entire portfolio. We study from all angles such as credit score tiers, including growth and decrease; overall migration of credit scores; and seasonality. We look at the loan level on up for that one little gold ingot that’s going to give us essentially more return with less risk.
In a recent quarterly analysis, we showed that over the course of three months, pre-approval programs accounted for 68.5 percent of total new business that came on the books. By analyzing risk appetite the way we do with help from a solid analytics framework, we not only move the needle for business, we become the dial.
Download the white paper, The Art of Balancing Risk and Reward. This paper outlines executive leadership’s role in setting, implementing and monitoring risk appetite (a key input to effective risk management). It’s imperative to develop a risk culture from the top down.