Here are five factors to consider when building a proactive monitoring strategy for small business lending.
The Fed’s recent rate hikes to curb inflation—combined with the rippling economic impacts of the pandemic and ongoing supply chain issues—are just a few of the complexities credit unions must navigate when it comes to member business lending. These issues will certainly have implications for credit union teams manage portfolio risk. Given the current state of the economy, credit union leadership should not settle for the status quo when it comes to portfolio risk management.
Consumers and small businesses are feeling the squeeze from inflation and rapidly rising interest rates. High prices and higher borrowing costs have significant impacts on consumer spending and therefore on small business income. To mitigate delinquencies and financial instability, it is crucial for credit unions to have a solid understanding of where potential problems may arise for their small business members before they negatively impact portfolio performance.
How can credit unions shift from a portfolio monitoring approach that’s traditionally reactive to a more proactive approach? To get an earlier indication of challenges before they pose a real threat, there are five factors to consider.
1. Cash Flows
To get ahead of any future delinquencies for existing loans, credit unions should focus on trends and behaviors within their loan portfolios. You can get ahead of risk by looking at leading indicators of trouble, rather than lagging indicators. Such lagging indicators as missed or late payments are problems that, once noticed, are too late to fix.
Instead, you want to look at as many leading indicators as possible to get ahead of the game. Cash flows and deposits are examples of a leading indicators. By monitoring for changes in deposits at scale, credit unions can determine which businesses’ revenues are falling, which may signal future issues with loan repayments. This makes it easier to get ahead of risks and, if needed, proactively adjust the terms of the loans to keep borrowers on track.
2. Line Utilization
High line utilization is another example of a leading indicator and can reveal financial stress faced by a business member long before a loan is 90 days past due. If revolving lines of credit have stopped revolving and balances remain high, this could be an indication that a business is facing challenges and requires attention.
There could be other, less alarming reasons for high line utilization. Perhaps the business’s supplier lines dried up or they just funded a large equipment purchase with their line. These factors could simply mean the business requires either a larger line or perhaps a different product, like a term loan. Nonetheless, identifying which business members are maintaining high line utilization and reaching out to understand why they are consistently tapped will help your credit union move forward appropriately and can help strengthen the relationship.
3. Credit Scores
Rescoring business loans can also provide an early indication of risk and catch a loan before it goes bad. While credit scores lag deposits and cash flow monitoring, credit scores will provide your team with valuable insights into how the business is managing its other debts. It is also important to note that credit score degradation is more important than the absolute score. A credit score of 680 is enough to get a loan approved, but a score that dropped to 680 from 750 in the last quarter requires a closer look.
4. Overdraft Frequency
Frequent overdrafts is another area to monitor and will allow your credit union to intervene before a business member cannot make their loan payment. More frequent overdrafts is a significant indication that a business is having issues with cash flow. The business member may have unexpected expenses or less revenue coming in.
Understandably, monitoring for these factors for all accounts across the loan portfolio cannot be done manually. Instead, credit unions should use the data that already exists within their core system and set up rules to automate reviews.
The good news is that today’s technology makes it possible to set up triggers that alert your team when there are signs of trouble with a loan. For example, if your team is monitoring deposit accounts, you can create a rule to compare the account balance as it stands today to how it was 30 days ago. You could also set a trigger threshold, such as 20%. This would trigger an automatic alert if the deposit balance dropped 20% lower than it was on the same day the previous month.
Credit unions can also set up these types of alerts to see when there has been an uptick in overdrafts or increased credit line utilization. When viewed together, alerts are a powerful way to ensure your team has a truly comprehensive view of vulnerabilities within the loan portfolio.
With an effective portfolio monitoring process that incorporates these considerations, credit unions can act quickly, rather than wait until the loan is 90 days past due and in severe default to react. In today’s rising rate environment, proactive portfolio management empowers credit unions—no matter how lean their team is—to remedy challenges early on and better support the business members they serve, despite a slowing economy.
David Catalano is senior vice president at Baker Hill.