Common Pitfalls in Consumer Credit Risk Management: Retention at All Costs

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Risk managers in many financial institutions often follow strategies that seem reasonable on the surface, but in reality may mask the true underlying risk dynamics of their portfolios. This is the last in a series of four articles that explore these pitfalls, with a discussion of what's behind the errors in the first place, how you can identify when a problem might exist, and what tools and strategies you can use to develop a better approach.

CONSIDER THE COMPETITIVE pressures faced by PQR Bank, a fictional financial institution with large credit card, mortgage, and home equity line of credit (HELOC) portfolios across several Midwestern states. PQR's direct-mail solicitation campaigns have suffered from decreasing response rates over the past several months. Price competition has narrowed profit margins, while account volume has remained relatively flat over the past year. PQR correctly attributes these challenges to saturation in the prime credit markets. However, to meet shareholder expectations the bank still must expand its customer base. In response, PQR management has cautiously planned expansion campaigns into both new geographies and somewhat riskier target markets to achieve growth.

In addition, PQR management recognizes that net account growth can in part be achieved through reducing attrition. To that end, PQR establishes a dedicated retention team within its customer service organization, giving it broad powers to reduce interest rates and waive fees for customers threatening to close their accounts. In no uncertain terms, the retention team is told to do whatever it takes to keep customers on the books. All customer service representatives are instructed to immediately transfer all calls from customers wishing to close their accounts to this retention team.

Given such latitude, it is not surprising that the retention team is enormously successful. Attrition rates drop by 15% within eight months of the team's inception, and PQR succeeds at meeting its goals for account volume growth. Despite this success, however, PQR management is surprised to learn that average revenue per account has plummeted, and by the end of the year the bank has missed its overall profit goals.

The reason for this precipitous drop in performance is that PQR fell into a Retention At All Costs mindset. In taking a monolithic approach to retention, management did not consider which customers were worth retaining. Nor did it approach retention as a question of balance, by finding the respective level of concessions that would retain each customer while still maintaining adequate returns. Moreover, PQR only considered retention efforts aimed at customers who call in to close their accounts, while ignoring the more general issue of customers who essentially end their relationship with the bank without formal notification. Finally, the broad latitude PQR gave its retention team to waive fees and reduce interest rates undermined the risk-based pricing structures put in place to account for the risk of credit loss. A comprehensive approach to retention should take into account the balance between risk and returns, and it should include strategies to address all of the many ways customers end their relationships with the lender, both formal and informal.

Is the Customer Always Right?

Competition is fierce in the lending industry and becoming more so every day. The prime credit markets are saturated, as evidenced by the numerous direct-mail solicitations people receive each week. From a net loan volume perspective, lenders are correct in thinking that retention of existing customers is equivalent to gaining new customers. However, it is important to recognize that not all customers are worth retaining. This is a drastic departure from the philosophy that the customer is always right, or in other words the concept that satisfying one's customers in every situation is necessary to keep their business going forward. …