Risk-Based Credit Line Management: A Risk-Based Approach Can Reduce a Bank's Exposure to Declining Credit Quality in Consumer Portfolios
Hulett, Jeffrey P., The RMA Journal
Using risk-based credit line management (RBCLM), banks offering consumer lines of credit--secured or unsecured--can protect their interests by proactively reducing or freezing existing limits when credit risk exceeds an acceptable level. This risk level is generally reached when credit quality has deteriorated since the time of origination due to a behavioral change in credit quality (one that is customer controlled) or to a downgrading of collateral value (which is generally market driven).
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The overall decline in home values has focused attention on reducing credit line risk. Figure 1 shows that, in 2008, home values declined up to 14% in some of the nation's largest metropolitan areas and by as much as 26% in markets in California, Arizona, Florida, and Nevada.
In addition, recent home equity line of credit (HELOC) lending standards have tightened. Table 1, which includes the OCC credit survey completed in March of this year, shows that banks are significantly tightening their underwriting standards in home equity. Yet banks are not only trying to reduce risk in new originations; they are also attempting to lower risk in their existing portfolios. While the HELOC product will be the primary focus of this article because home values are of current concern, the RBCLM approach to reducing risk can be applied to other consumer credit products as well.
Several factors can complicate proper execution of an RBCLM program. First, a customer with declining credit quality is likely to use a HELOC as a source of liquidity ("borrowing from Peter to pay Paul"). If the source of liquidity is interrupted, these credits may show higher delinquency rates. Also, reducing or freezing a HELOC will certainly affect the relationship the bank has created with the customer. For these reasons, the bank must take several key steps:
* Use an intensive testing process to identify the customer segments that will respond favorably. (Success of a risk-based credit line management program is measured by an improvement in the net loss rate [losses net of recovery] compared with a control group.)
* Have a disciplined communication program in place to help the customer understand the reason for the action.
* Implement a proactive "cure" program that will reinstate the customer's credit facility once the cause for the remediation action has been addressed.
Before developing an RBCLM program, it is critical to review the primary legal documents to make sure there are no legal stumbling blocks to freezing or reducing lines of credit. Most banks have note language that contains broad provisions allowing reductions in lines due to general reductions in credit or collateral quality. It should be noted that RBCLM programs are generally precollections programs--that is, an RBCLM action could occur when a customer account is current.
Modeling and Targeting
Understanding the risk segments that are driving serious delinquency (60+ days) is a critical, though preliminary, step in the program. Modeling will help the bank understand which credits are likely to default. Unfortunately, there is often a positive relationship between credit risk and HELOC utilization. In other words, as a consumer's credit quality deteriorates, he or she is more likely to use existing credit lines.
The key measure of an RBCLM program's success is to show that reducing or freezing HELOCs reduces the bank's exposure compared with a control group in which no changes are made to HELOC status. If a customer's line is already fully utilized, no savings will be realized by controlling the line. Regardless, freezing the highest risk lines that may not yet be delinquent is a good discipline and has the lowest customer service impact compared with other customers.
Dimensions. There are two primary kinds of dimensions: proprietary and nonproprietary.
* Proprietary dimensions are based on unique or difficult-to-obtain bank customer information, such as detailed bank payment behavior not reported to the credit bureau, combined loan to value (CLTV)/collateral value, income information, and other bank relationships. …