Common Pitfalls in Consumer Credit Risk Management: The Leap before the Look

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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 third in a series of four articles that will explore these pitfalls, including what motivates the errors in the first place, how you can tell that a problem exists, and what tools and strategies you can use to develop a better approach.

Consider JKL Bank and MNO Credit Union, two fictional financial institutions with comparable regional footprints in Florida that have enjoyed great success with their lending portfolios over the past several years. Both have experienced stable returns, as both clearly understand their respective customers' risk profiles.

JKL Bank decides to expand its operations into Georgia. It opens several branches in key metropolitan areas and meets a favorable initial response to its lending sales efforts, which are supported by the exact same underwriting criteria that have historically brought JKL success. Unfortunately, after several months JKL begins to experience significantly higher delinquency rates than expected. Losses follow, and by the end of the first year JKL finds itself below its profit target, with an unprecedented volume of loans in collection status.

MNO Credit Union has a history of giving its members' needs top priority. A recent survey by MNO's marketing team has shown that MNO members desire online access to their accounts, so MNO implements an online banking initiative. As part of this effort, MNO begins to accept loan applications via the Internet. Senior management is convinced that the traditional loan marketing efforts through the brick-and-mortar branch network miss the more technologically savvy segment of their target population. They implement the exact application process in the online channel that has been so successful in the branches. The response to the online application channel is tremendous. Unfortunately, there is also a significant increase in first-pay-default rates and delinquencies. The collections manager complains that the rate of bad phone numbers and skip accounts has increased, even further hampering recovery efforts. As with JKL Bank, MNO Credit Union finds itself facing unexpected losses and a headache-causing collections volume.

What went wrong for these institutions? Both fell into a trap that I refer to as the Leap before the Look. In other words, both pursued expansion initiatives without accurately assessing the risks they would face. In JKL Bank's case, management assumed consumers in neighboring geographies would have similar risk profiles. MNO Credit Union made itself vulnerable to increased fraud attacks by assuming that a process that provides sufficient protection in a face-to-face transaction would provide equal protection in an online environment. In both cases, intuitive assumptions led to unexpected losses. The key to avoiding the Leap before the Look is to identify all potential risks associated with an expansion effort, evaluate the magnitude of those risks with as much objectivity and analytical rigor as possible, and devise expansion strategies with a conscious intent to manage those risks.

Dangerous Leaps

Competition is fierce in the lending industry, and it's growing in intensity daily. The prime credit markets are saturated, and the pressure to maintain growth while meeting ever-larger volume goals has forced lenders to expand their account acquisition strategies aggressively. These expansion efforts can take the form of new geographic footprints, new products and channels, and relaxed underwriting policies in existing target populations. The pressure to grow portfolios is so strong that many lenders pursue expansion along multiple dimensions simultaneously. Yet lenders are hampered by the fact that they do not generally have a permissible purpose to directly access and analyze credit performance data in support of these efforts, and each of these dimensions carries its own risks. …