Economic Capital for Consumer Loans

By Wilhite, Gary | The RMA Journal, March 2004 | Go to article overview

Economic Capital for Consumer Loans


Wilhite, Gary, The RMA Journal


No single economic capital approach has yet emerged as best practice for consumer lending. This article discusses mean variance, asset value correlation, and econometric models. Work continues on model development as lenders seek the best framework for analyzing the risk of consumer loans.

Consumer lending has been the late bloomer in the family of credit risk capital models. It's not surprising that commercial loans were first to receive attention from capital modeling pioneers. After all, larger loans to corporations represented bigger individual risks, and commercial loan losses had historically been more volatile than consumer loan losses. Further, the size of commercial loans justified the collection and analysis of more borrower-specific information, and the market provided observable information about the estimated ability of public companies to generate cash flow to repay debt as they built value for shareholders.

Modeling for consumer lending, on the other hand, developed in a different direction. Although lenders were reluctant to rely on commercial loan default models, consumer lending presented an ideal environment for the application of scorecards and other default-prediction techniques. Most banks had far more consumer loans than commercial accounts and numerous defaults. Many banks wanted to avoid the expense of individually analyzing the information they collected on their consumer borrowers, and this data was easily amassed in databases where analysts could identify patterns and link behavior to characteristics of the borrower or loan. Such expected loss models were especially important to support securitization activities, which developed both to fund these loans and to avoid the regulatory capital required for low-risk consumer assets.

Indeed, understanding expected behavior remains by far the most important element in managing the risk of consumer lending. Consumer loan losses are not nearly so vulnerable to swings in the economy as commercial loans, but large, unexpected losses have unfortunately cost quite a few banks' shareholders plenty. In most cases, these losses occurred not because the economy hurt otherwise healthy borrowers, but because the borrowers were not as healthy as originally believed (or hoped). Adequate modeling identifies the characteristics that differentiate performance and segments accordingly, so that the lender knows when performance is likely to change. Good risk management is aware of the competitive environment, sensitive to changes in acceptance rates, and on guard against adverse selection. Changes in product offerings are tested in a disciplined fashion so that high losses are limited to test cells. It's also necessary to understand the timing of losses to avoid being misled by the fact that most consumer loans have lower loss rates in their first months on the books than in their second and third years.

The expected behavior of consumer loans must also consider the role of prepayments--a factor that is not as important in commercial lending. Estimating lifetime loss rates requires a projection of future losses and future balances. Further, as many lenders discovered in 2003, higher-than-expected prepayments do not come evenly from all parts of the portfolio. Good customers are often more likely to refinance, leaving a shrinking pool of paying customers to offset charge-offs. In such cases, a bank must extract additional revenues from the remaining portfolio--through additional usage, lees, or increased interest rates--or risk having losses overtake their margin income. Even if prepayments have only a modest effect on loss rates, the value of high-quality consumer loan portfolios may be driven more by prepayment rates than by credit losses.

It is difficult to overstate the importance of modeling expected behavior for consumer lending. The best capital models will produce meaningless results if the inputs are wrong. But good analytics provide a solid basis on which capital models can be built. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Economic Capital for Consumer Loans
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.