Leading or Lagging? Consumer Credit Risk Portfolio Management
Carroll, Peter, Martin, Duncan, The Journal of Lending & Credit Risk Management
Early findings from a joint research project were reported by RMA and Oliver, Wyman & Company in June during RMA's annual Consumer Credit Risk Management Conference. The most pressing issue facing the retail side of the bank, the research revealed, is the integration of marketing and risk management. The complete findings have been published and are available from RMA.
Is consumer credit risk portfolio management ahead of or behind its counterpart on the wholesale side of the bank? In part, that is what RMA set out to find in a recent study. Having surveyed the wholesale side in 1997-98, the consumer side study went to 38 institutions, representing over $1 trillion of consumer assets, for detailed information on portfolio management practices, and interviewed 30 industry leaders to discover best practices and discuss priorities going forward.
What the study found is surprising. In some respects the retail side is ahead of the wholesale side; in other respects it is behind. What emerges most clearly, however, is the distinctive nature of the portfolio management challenge in consumer lending. Whereas the topical issue on the wholesale side is the separation of origination and portfolio holding functions, the most pressing issue facing the retail side of the bank is integrating marketing and risk.
What did the research actually find? First, the term "portfolio management" has very different meanings to different people within the consumer bank. To business line managers, portfolio management means the set of measures, analytics and tactics through which they run their business and attempt to enhance the profitability of their loan portfolio. Credit line increases, balance transfer solicitations, and activation incentives are all examples of this type of "portfolio management."
To people outside the line of business, including outsiders (analysts, regulators), portfolio management primarily means the set of measures, analytics and policies (such as limits and cut-offs) by which the bank guards itself against damaging levels of charge-offs.
Figure 1 illustrates the two types of portfolio management.
Within the framework of these two meanings, the RMA study had five high-level, or "thematic," findings.
1. Top-down portfolio management is focused on loss and capital calculations and the avoidance of unpleasant surprises.
The first major theme is that credit portfolio management, in the particular sense of applied modern portfolio theory (MPT), is really not being practiced in North American consumer banking. Instead, top-down portfolio management is focused on making accurate loan loss forecasts and economic capital attributions while ensuring that "unpleasant surprises" that would reduce the institution's stock price or credit rating are avoided.
The absence of MPT reflects a perception that there may be more benefits to applying MPT in wholesale than in retail. For many banks, MPT applied to wholesale portfolios can result in a significantly different perspective, with aggregate risk seen to be much lower once intra- and inter-portfolio correlations are considered. In contrast, in consumer portfolios, the degree of difference made by MPT is less marked. There is a surprisingly low correlation of risk between the members of consumer portfolios--even within regional portfolios. Across consumer portfolios there is a moderately high correlation of risk as all portfolios tend to track the economic cycle. This diminishes the difference in perspective that comes from applying MPT. Thus far, therefore, the consumer side of the bank has placed a higher priority on other important issues than on MPT. This may come to be seen as an opportunity forgone, however, since it seems likely that consumer loan portfolios reduce the volatility of total bank loan losses.
If the practice of portfolio management does not yet embrace MPT, what does it do? …