Three Ways to Mitigate Risk in MBL

Member business lending is nothing new to U.S. credit unions. Since their inception, credit unions have offered business-related loans to their members. But recently, the industry has experienced significant movement towards expansion of MBL with the NCUA’s recent guidance.

Credit unions considering developing or expanding an MBL program should be cognizant of the risks that are unique to MBL. Ensure that each are properly identified and mitigated, as this will ultimately determine the success and profitability of the program. Credit unions would then do well to proceed with a strong implementation plan.

Develop a strategy.

Developing a sound MBL strategy, or tightening one already in existence, can prove to be a decisive factor in achieving long-term success in managing risks with MBL. A successful MBL program seeks to appropriately balance inherent risks against perceived opportunities.

It is the responsibility of the board of directors to protect the credit union and its members, so it is important for directors to outline upfront the goals behind increasing MBL. Directors should decide how such an approach fits into the credit union’s existing strategy, designate resources and expertise available to achieve the outlined goals, ensure adequate capital levels, determine an appropriate rate of safe and sound growth, and settle on the specific focus of the MBL (for example, an industry niche) and implement credit risk management solutions.

In developing an appropriate strategy, credit unions should analyze the different approaches they may take given their personnel, operational and financial resources. Furthermore, when appropriate, credit unions should not be afraid to start small, expanding their MBL exposure in a measured way, remembering that it’s often the slow and steady that win the race. The new NCUA guidance even includes exemptions for credit unions that have low volumes of MBL.

This allows management to incrementally assemble the resources and expertise to implement a life-of-loan business lending program without subjecting the credit union to unnecessary risks.

Establish policies.

Once an acceptable and sound strategy has been developed, the next step in mitigating the risks of an MBL program is to define lending policies that promote the implementation and success of the determined strategy. Not only does this satisfy regulatory requirements, but identifying and recording board-approved lending policies also alleviates unnecessary pressure on the institution and its employees by reducing the subjectivity inherent in unbridled interpretations of unwritten goals and practices.

Although established policies should be tailored to institutions’ specific needs, capabilities, offerings and strategy, the following policy areas are recommended for consideration and attention by all credit unions engaged in MBL:

Cash flow analysis

Focus on drafting policies that provide guidelines for performing consistent, accurate cash flow analyses and requirements for documentation. Specifically, policy should set which documents are collected for loans, how cash flow will be used in determining the borrower’s debt service coverage ratio and how ratios are used in the approval process. For complex borrowers, a global cash flow will be necessary, so policies must outline the cases in which this analysis is encouraged and instructions on how to consistently perform a global analysis.

Credit risk rating system

Establish a credit risk rating system that is understandable for staff and also upholds the requirements outlined by the NCUA. Commercial risk ratings are a kind of currency in the credit union, so they need to be meaningful and comparable to provide value on the loan and portfolio levels. Policy should dictate when credit ratings are to be updated and how risk ratings will be used to monitor overall portfolio risk, which includes regular reports to keep management and the board informed.

Audit review and control

Independent, third-party reviews and internal audits can be effectively used by credit unions with significant MBL activity to verify that the right controls are in place, and policy can be used to dictate the role that the audit function fills. This includes validating that in-house audits and underwriting quality is satisfactory.

The board of directors is ultimately responsible for formally approving established loan policies and providing continual oversight, as well as engaging in annual reviews of such policies for safety and soundness and compliance checks.

Developing or expanding an MBL program is an increasingly popular way U.S. credit unions are capitalizing on their community relationships and growing loan portfolios, while also providing small businesses with much-needed access to credit. Looming in the shadow of these opportunities are inherent risks that are different than traditional consumer lending practices. Shore up a formal business lending strategy and establish written policies that keep growth in line with risk plans at the institution.

Libby Bierman is an analyst at Sageworks, Raleigh, N.C., where she is responsible for analyzing trends in the financial data collected from private companies as well as the development of new products for enterprise clients.