Strategic Risk-Based Lending for Shapiro Credit Unions CCUL AMC – October 29, 2013

1. Strategic Risk-Based Lending for Shapiro Credit UnionsCCULAMC – October 29, 2013 DIANA MICHAELS, President & CEO Western Healthcare Federal Credit Union & Randy C. Thompson, Ph.D. TCT, Inc.

2. What’s this all about? • What’s NCUA telling us about risk-based lending • What are risk-based pricing and risk-based lending • Is tiered pricing all we need • Why is it so hard to turn a profit • What is a “BAD” loan • Does knowing my costs really matter

3. What’s this all about? • Show a real-life success story because… • WE WANT YOU TO KNOW THAT YOU CAN DO THIS TOO!

4. Risk Based Lending - Definition • NCUA Guidance Letter - 174 • “Risk-based lending allows credit union management to assess the risks involved in different types of loan products and price these products based upon the inherent risk associated with individual borrowers. • The end result is a more diversified loan portfolio mixing lower-yielding, lower risk loans with higher-yielding, but riskier loans.” • “Prior to beginning a risk-based lending program, it is important that the credit union board determine the parameters for the riskier loans based on the credit union's financial condition, business plan, lending and collection history, and asset liability management (ALM) program.” August 1995

5. Risk Based Lending - Considerations • NCUA Guidance - Letter 174 • “Credit unions should engage in risk-based lending, not as a means of re-pricing existing balance sheets, but as a tool to reach out to the under-served and take a risk that might otherwise be avoided. • Risk-based lending involves setting a tiered pricing structure that assigns loan rates based upon an individual's credit risk. • Through a carefully planned risk-based lending program, credit unions may be able to make loans to somewhat higher-risk borrowers, as well as better serve their more credit-worthy members.” August 1995

6. What is Risk Based Lending? • Risk Based Lending consists of two parts: • Underwriting (Do you want to make this loan?) • Pricing (What rate must I charge to account for the risk?)

7. Risk Based Pricing • We define risk, in relation to the loan portfolio, as the likelihood that money that has been expended or extended by the credit union will not return. • Money expended includes cost of funds, loan operations and collections. • Money extended includes charge-offs of principle balances. • These items are identified as costs and as such can be statistically (stochastically) quantified and measured. • The consistent and complete measurement of these costs is foundational to an accurate and effective loan pricing system.

8. Types of Loan Pricing in Credit Unions • 1. Tiered pricing – assumes a base rate and then stair steps in equal steps • Incomplete identification of costs causing a non-empirical measurement of costs • Results in imprecise costs and rates • Looking over the fence at the rates across the street syndrome • 2. Empirical Risk Based Pricing – identifies precise costs associated with each loan grade consistent with their costs and business model Empirical, cost-based provides a precise, accurate measurement of costs Assures that all loans provide equitable return on investment

9. Benefits of Empirical Risk Based Loan Pricing versus Tiered Pricing • Empirical risk based loan pricing offers these benefits to a credit union: • Assures all loans provide a positive margin above costs • Covers allrisk/costs associated with the loan portfolio • Expands ability to increase yield with higher risk loans • Enhances earnings and builds equity (capital)

10. Tiered Pricing – Actual Effects • Over the past four years, credit unions have reduced rates on loans dramatically while they all compete for a diminishing share of A+ and A grade loans. • Survey of 75 credit unions • 2010 average A+ loan rate was 4.62% • 2013 average A+ loan rate is 2.01% • Drop of 2.61%

11. Tiered Pricing – Income Effects

12. Many Credit Unions are on a Collision Course with Disaster: by not pricing loans and deposits correctly, shrinking the margin resulting is eroding capital.

13. NCUA Guidance - Letter 174 “Risk-based lending philosophy does not intend for a credit union to grant "bad loans," however, it assumes that proper pricing and conservative terms may justify higher risk loans. Credit unions offering risk-based lending should aim towards diversification and management of risk. This can be accomplished by establishing policies, procedures, and pricing ranges broad enough to serve low-risk, average, and higher-risk borrowers.” August 1995

14. Risk Based Pricing – Intent & Application • What is a “Bad Loan”? • A “Bad Loan” is one that results in a loss to the credit union. • Loan with charge offs • Loan priced below costs

15. Key Questions Related to Risk Based Pricing • Will the rates a Credit Union offers cover all loan related costs and provide a return? • or… • Are rates set to simply attract a volume of unprofitable business? • Could pricing loans below costqualify as an unsafe practice?

16. Fundamental Elements of Empirical Risk Based Pricing • A statistically valid pricing system requires: • Identification of costs • Cost of Funds • Loan Operations (Activity Based Costing) • Collections • Charge-offs • Accurate measurement of costs • Application of costs to loan volume • Set rates that will cover all costs and feed equity.

17. Quarterly Loan Operation Expense

18. An empirical analysis of all loan related costs provides this picture of loan rates An empirical analysis of all loan related costs provides this picture of loan rates

19. Empirical Risk Based Pricing – More than a Model.

20. Empirical Risk Based Pricing – More than a Model.

21. Empirical Risk Based Pricing – More than a Model.

22. Empirical Risk Based Pricing – More than a Model.

23. Applying Risk Based Pricing methodology and its tools, multiple credit unions have turned their yields and income around:

24. Maintaining a Standardized Empirical Risk Based Pricing Metric • Quarterly updating of costs • Quarterly updating of rates and margins • Semi-annual validation reports consistent with NCUA requirements • Annual updating of loan distributions • This is not an ALM report. It is a pricing methodology!

25. Our Actual Experience Initial Considerations • In order to improve yield we had to be prepared to increase certain aspects of risk. • This is not to imply that we would throw open the doors to all high risk loans, in an effort to improve yield. • On the contrary, our goal was to implement tools and techniques in order to serve a wider spectrum of members and manage the risk inherent in this broader book of business.

26. Our Actual Experience Possibilities • We considered multiple options for expanding risk • Pricing for Risk Grade • Pricing for LTV • Pricing for Term

27. Our Actual Experience Five elements to improve yields and sustain viability. • Comprehensive and consistently applied policies • Effective risk mitigation technique and tools • Empirically calculated Risk Based Pricing • Consistent Credit Migration Analysis • Concentration-risk monitoring and management

28. Our Actual Experience • Policies that work • Clarify acceptable loans • Specify the percent for each grade • Specify terms for each grade • Specify maximum loan amounts for each grade • Specify minimum rate spreads for each grade

29. Our Actual Experience • Tools to control risk • Tools and techniques that mitigate risk of collateral loss • Allows greater flexibility in lending decisions • Provides behavior modification to increase timely payments • Tracks collateral to marginalize loss of collateral

30. Effective Risk Mitigation Techniques and Tools • Collateral Tracking Systems • Indicator light showing payment is due • Starter interrupt to prevent usage if delinquent • GPS locator to aid collection and repossession • Short-Term Financing • Minimum exposure • Requires automated payment • Transformational Interest Rate • Reinforces timely payments • Promotes long-term members

31. Identifying and Applying Costs to Loans • Perform regular and complete cost analyses • Cost of Funds • Processing/Maintenance • Collections • Charge-offs • Assure all loan grades and types are contributing equitably • Eliminate Cross-Grade Subsidies

32. Empirical Risk Based Pricing – More than a Model.

33. Empirical Risk Based Pricing – More than a Model.

34. Empirical Risk Based Pricing – More than a Model.

35. Empirical Risk Based Pricing – More than a Model.

36. Credit Migration • Definition • A measurement of changes in credit scores and risk for individual loans in the loan portfolio of the credit union. • The composite of these changes provides a valid measure of the current risk inherent in the total portfolio. • This provides an early warning sign for potential losses

37. Credit Migration • Understanding your Loan Portfolio • Credit risk can Increase or Decrease • Which risk pools are improving impairing? • Identifying Potential Problems • Isolate impaired loans and react to them early • Understand the risk in your pools and adjust lending practices • Identifying Emerging Opportunities • Recognize Members that are making smart decisions • Proactively offer ways to help your members • Understand which pools of loans to take on more risk • Applying Precision in Allowance Calculation • Statistically based calculation • Complying to regulations

38. Using Credit Scores to Manage Risk Monitor changing risk scores and then change: • Rates • Allowance • Credit limits • Limits on non-prime loans

39. Identifying Opportunities • Central mission of helping members • Targeted marketing • Increased loyalty • Up-sell opportunities

40. So what did this do for WHFCU? Six Measures • Loan Balances • Loan to Share • Loan Yield • Loan Distribution (Non-Prime) • Delinquent Ratio • Charge Off Ratio

41. So what did this do for WHFCU?

42. So what did this do for WHFCU?

43. So what did this do for WHFCU?

44. So what did this do for WHFCU?

45. So what did this do for WHFCU?

46. So what did this do for WHFCU?

47. So what did this do for WHFCU?

48. Were are we going? • Continue with empirical risk-based pricing • Continue with credit migration • Expand non-prime lending • Explore new lending options • Increase loan yield • Monitor, monitor, monitor and monitor some more

49. Questions?