For businesses, the past few years have been anything but business as usual. Between the COVID-19 pandemic and other ongoing challenges, such as inflation and supply chain issues, small businesses have had no shortage of economic concerns to navigate. All of these factors will affect how credit unions monitor and manage portfolio risk for small business loans.
Credit unions should also recognize that some of the economic impacts of the pandemic will become more evident over the next two years. For example, many small businesses would have eventually closed even without the pandemic, but managed to stay afloat by securing relief funds, such as the Paycheck Protection Program (PPP) and impact loans. COVID-19. Nearly one in five businesses fail in their first year, and failure rates increase over time, as nearly half of all businesses close after five years, according to Bureau of Labor statistics. Now that repayments are needed for relief funds, some struggling businesses may default on these loans.
Meanwhile, many companies in certain sectors, such as manufacturing, are still struggling with supply issues. Due to supply chain uncertainty, companies are increasingly looking for quick financing to source inventory when it is available. Yet the recent rise in interest rates may make companies think twice about borrowing.
The good news is that credit unions can navigate this complex lending environment with the right risk management strategy for their small business loan portfolios. Here are four things credit unions should consider.
1. Evaluate credit policies and understand what your credit union is willing to negotiate.
Each industry has been impacted differently by economic challenges in recent years. Even the latest interest rate hike will have varying effects, depending on the industry in which a company operates. For example, companies in the construction sector could face a slowdown, due to lower demand for new homes and slower commercial real estate development. On the other hand, industries that are less dependent on physical materials, such as software companies, tend to be more resilient to interest rate hikes.
Considering these nuances will help your credit union evaluate its credit policies and adjust them accordingly. Properly analyzing credit risk means understanding your borrower, as well as their business. Every business is unique and to make the best credit decisions, it is important to understand their business needs and the risks their business model is exposed to. Make sure your credit union has the technology and processes that ensure an accurate approach to financial risk analysis every time. Ideally, your credit union will have automated, centralized systems that eliminate the tedious work of entering financial statements and tax return data into statement spreads. After all, you want your credit analysts to be analysts, not data entry clerks.
Credit unions may also see an uptick in new small business loan applications from commercial members seeking a fixed rate loan as several rate hikes are expected this year. Credit unions can get a head start by analyzing their portfolios to understand their organization’s current risk tolerance so they can respond quickly to business. Once a credit union has defined its current risk tolerance, it is also easier to identify the types of industries or businesses it is willing to lend to and on what terms. For example, your team may decide to accept different types of collateral for certain business loan applications in the future. Decisions like these will help your credit union find opportunities for growth while mitigating exposure to additional risk.
2. Focus on behaviors to understand your loan portfolio.
To get ahead of any future defaults on existing loans, credit unions should strive to adopt proactive portfolio management, which requires focusing on trends and behaviors to understand your portfolio.
Solid data is needed for this. Credit unions need to manage risk with current and accurate desk data; data on loans, deposits and guarantees; and financial statement data from internal and external systems. The right lending technology can be configured to import this data from your credit union’s central system or other systems to give your team a complete view of portfolio risk.
With a better, more complete view of the portfolio, your credit union can anticipate risk by looking at leading indicators of trouble rather than lagging indicators. Credit unions should not rely on lagging indicators, such as missed or late payments. These are issues that, once noticed, are too late to fix. Instead, you want to look at as many leading indicators as possible to get a head start.
The main indicators of a problem are often changes in behavior. For example, credit rates and high line of credit utilization will show the financial stress a business member faces long before a loan is 90 days past due. Deposits are another key indicator of a small business’ financial health. By monitoring changes in deposits, credit unions can determine if a company’s revenue is declining, which can signal future problems with loan repayments. This makes it easier to anticipate risks and, if necessary, proactively adjust loan terms to keep the borrower on track.
3. Consider the cost of refinancing.
The Federal Reserve plans to raise interest rates again before the end of the year. For member companies with an existing loan, they may want to refinance, especially if they are on a variable rate loan. Many will want to refinance at a fixed rate. Fixed rate refinancing can be beneficial for the business but does not have to be free. Refinancing comes at a cost, as underwriting and documenting the loan involves time and expense, among other tasks required for refinancing.
At the same time, many financial institutions will handle refinance requests, so your credit union needs to be price competitive. Credit unions must be prepared to examine a member company’s overall relationship with its institution to price refinanced loans accurately and competitively. To do this, your team will need to leverage data from core and internal systems, as well as your credit union’s existing risk scoring criteria.
Today’s lending technologies make it easy to customize the loan pricing structure by considering a member’s overall relationship with your credit union, existing loan data, deposit data, and ancillary products. Tools like these make it easy for you to price each refinanced loan consistently based on data and accurately calculate expected return while maintaining strong relationships with business members.
4. Protect your wallet and grow with confidence.
The goal of credit unions is to uncover opportunities to better serve their member businesses while minimizing risk, no matter what new economic challenges arise. This means that credit unions should consider all of the above when making new business loans in order to make sound underwriting decisions.
The types of business loans, industries, and collateral that work well should be the focus of origination. In addition, it may be useful to perform sensitivity analyzes when making new business loans. Your credit union can test the loan with a rate increase of 1%, 2%, or even 4% and see how the loan performs.
Ultimately, the current economic environment poses many complexities when it comes to lending. While no one can predict the future, credit unions can prepare for it by establishing proactive risk management strategies and ensuring strong loan portfolio performance and a more positive borrowing experience for members.
Bryan Peckinpaugh is SVP, Key Accounts for Baker Hill, a vendor based in Carmel, Ind. lending, risk management and analytics solutions for financial institutions.