How will NCUA’s new member-business lending rule impact risk management?
As credit unions await the finalization of the National Credit Union Administration’s (NCUA) proposed changes to rules for business lending, they may do well to remember Spider-Man’s creed that “With great power comes great responsibility.”
That’s because the proposed rule shifts from prescriptive rules to a principles-based approach that eliminates detailed collateral requirements and portfolio limits and instead focuses on broader principles for commercial lending activities. These changes, in other words, provide both more opportunity for credit unions, but they also bring the potential for more risk to the financial institution that isn’t properly prepared.
The comment period for the NCUA’s proposed member-business lending rule closed Aug. 31, and the changes are expected to be implemented 18 months after the rule is finalized.
“In the past, the NCUA had very specific criteria and limits for underwriting,” said Elizabeth Williams, managing director of portfolio review and consulting firm CEIS Review Inc. “Now they want to remove many of the specific requirements and let each credit union define its own acceptable risk appetite. This should give credit unions a lot more flexibility in terms of the types of loans they can pursue and underwrite. But at the same time, it’s going to mean a broader spectrum of risk, and credit unions need to make certain they have the appropriate risk management framework in place to be ready for that.”
The proposed rule should provide credit unions with the ability to grow and expand into other types of loans, Williams said. Credit unions should be able to take on more risk and in theory, improve yields or returns. In order for credit unions to handle these changes effectively, however, they need to identify the risk they’re taking on, understand it and assess whether it is an appropriate level of risk for the institution, she added.
Sageworks Senior Risk Management Consultant Rob Ashbaugh noted that uncertainty about credit unions’ underwriting and risk-management processes is one source of opposition by many banks to the proposed NCUA changes. In numerous comment letters to the NCUA on the proposed rule, bankers alleged credit unions lack the experience and expertise needed for business lending.
“Credit unions will have to develop a risk-management process, essentially from scratch,” Ashbaugh said. “This requires financial and manpower resources.”
He and Williams said credit unions will need to define the types of deals they intend to underwrite, identifying how much exposure they want to take on with respect to different levels of risk or concentrations.
“Clearly credit unions will be expanding into some new product areas or taking on additional risk, so they’ll need to capture those risks in the allowance for loan and lean losses methodology and process,” Williams said. “Even taking a step back, because the risk-rating system is part of what feeds in the ALLL, credit unions will want to make sure they have a sufficiently granular risk-rating scale, and that they are identifying these different levels of risk.”
Portfolio management is probably a key to implementing the new approach successfully, according to Williams. For example, if a credit union targets building up a concentration of loans to restaurants, it may develop strict underwriting criteria for those loans and track any exceptions to those underwriting criteria, she said. It will likely manage and monitor that portfolio concentration closely and perhaps even do some stress testing to identify the risk to capital if restaurant-industry conditions deteriorate.
“You’re going to want to make sure you have the expertise and processes in place to manage that risk,” she said.
Credit unions should have some time between the time the rule is finalized and implementation, according to Williams. “Try and prepare now in terms of portfolio management,” she said. “Make sure you have the right staff for the type of loans you want to consider and make sure you have the proper framework to manage the varying levels of risk.”
To learn more about managing credit risk, attend the 2015 Risk Management Summit hosted by Sageworks. The Summit, in its fourth year, gives professionals from banks and credit unions actionable insights from industry experts and a chance to ask questions about how other institutions tackle challenges related to loan loss reserves and stress testing.
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