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McKinsey on Payments

March 2010

Managing credit risk in the post-crisis world

Financial institutions understandably want to put recent troubles behind them. The financial crisis, however, precipitated major changes including shifts in consumer attitudes towards credit, more active regulatory intervention and a new focus on expanding customer relationships all of which have significant implications for how banks evaluate risk. These changes must be addressed for financial firms to thrive in this new environment.
Philip Bruno Deniz Cultu Abhinav Dhall Amit Garg

To succeed, banks must fundamentally rethink their approach to credit risk management in five broad areas. Briefly, they need to: 1. break down the organizational barriers that make it almost impossible to get a complete picture of their overall exposure to each customer 2. take a more flexible approach to data sources in underwriting, to build a deeper understanding of their customers 3. re-focus on the lifetime value of customer relationships 4. invest in technology to build and leverage relationships 5. systematically collect and leverage qualitative information on customer interactions. A shifting credit landscape Between 2002 and 2007 consumers withdrew $2.2 trillion from home equity lines and cash-out refinancing, 55 percent of which helped to drive consumption and

repay other debts.1 Then, the bottom fell out. Estimates now suggest that asset depreciation has left more than a third of U.S. mortgages underwater. To cope with such a drastic turnaround lenders need ways to work with consumers who can no longer tap their assets to make their loan payments. They must be able to assess not only whether borrowers can make minimum payments, but also whether they can repay their outstanding principal balance. Unsurprisingly, consumer confidence regarding credit and the economy generally is in tatters (Exhibit 1). In response, Americans have increased their savings by a factor of 8 over last 2 years2 the personal savings rate rose from an average of 0.6 percent in 2007 to 5 percent in 2009. And because the rate seems unlikely to revert to earlier levels soon, banks should be readjusting their interpretation of key credit variables. For example, a customer refinancing for a second time, or opening a home equity line, could be signaling impending financial difficulty.

1 2

Federal Reserve Bank U.S. Department of Commerce: Bureau of Economic Analysis

Managing credit risk in the post-crisis world

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Exhibit 1

Consumer spending behavior has fundamentally shifted

I no longer want to buy many of the things I used to buy Percent of respondents

Agree Disagree

Spenders1 64 68 58

Savers 71

53

55

20
Defined by percentage of savings relative to income < 10% for spenders and >10% for savers 2 Mass market = ages 36-64, income $25-50K; middle core = 46-65, $50-100K; middle affluent = ages 46-65, $100K+ Source: McKinsey Consumer Financial Health Survey, March, 2009
1

23 16 11 13

21

Mass2

Core

Affluent

Mass

Core

Affluent

Meanwhile, U.S. regulators have been boosting consumer protection efforts with measures certain to significantly affect the industry. Most notable is an effort to curb risk-based re-pricing. New regulations will lead financial institutions to pursue revenue through revised pricing strategies (such as balance-transfer fees), reduced fee waivers, and migrating customers to more profitable products; or they will compel institutions to adapt their business models. Instead of freely managing risk and return throughout the life of a card product, for instance, issuers might need to view a card as a series of installment loans, where a change of terms might lock in future balances. Finally, the industry also faces structural change. Over the last 20 years, many institutions altered their approach to risk management by focusing on specific products or industries. But the liquidity crisis is increasingly driving a consolidation. The industry will soon likely be dominated by multiproduct and industry players who develop

and exploit broader customer relationships using sophisticated risk management, pricing and marketing tools. Succeeding in a new environment In response to the changes outlined above, financial institutions have been tightening underwriting standards. A recent report revealed that 83 percent of the banks surveyed had done so up from 68 percent in 2008 and just 13 percent in 2007.3 Collateral requirements, advance rates and scorecard cutoffs were the principal means used. Banks are also increasingly using manual underwriting processes for example, extensively verifying customer documents an approach that increases costs and may not scale easily when volumes return. These reactive efforts must, however, give way to a viable longer-term credit risk management strategy. How institutions adapt to the new realities will differentiate winners from losers. And, as is often the case, the path is hardly straightforward. Success will demand fundamental rethinking about how

July 2009 report of the U.S. Office of the Comptroller of the Currency

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McKinsey on Payments

March 2010

Exhibit 2

Adding relevant variables can improve overall predictability of risk models by 20 to 25 percent

Improvement in observed home equity losses using a model with relationship variables versus a model without relationship variables
Risk deciles 1st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th -4 Predictability improvement Percent 11 13 High risk prospects 17 26 0 0 4 12 57 Moderate risk prospects Low risk prospects

Source: McKinsey analysis

institutions need to manage credit risk across five important dimensions: 1. Breaking organization silos. Prior to the current credit crisis, lending groups at many institutions operated very independently, each seeking ways to maximize its own growth. One implication of this silo approach is that business units have very different customer and risk profiles. For instance, we have found that mortgages originated through a banks broker channel have very little overlap with its retail DDA customer base despite having similar geographic footprints. A silo structure also implies that a customers full bank-wide underwriting exposure is not a primary consideration. The mortgage underwriting group, for example, might evaluate customer exposure without considering other products the customer holds at the institution, such as cards and personal loans. It is easy to see, then, how organizational silos typically create excessive exposure for banks. Using balance transfers from a credit card to pay down a loan from the same bank is hardly a novel customer practice but it is

one that silos often facilitate because they make identifying and addressing such rolling credit behavior much more difficult. Risk managers need to fully understand their institutions overall exposure to each customer across all product lines, and then manage their credit decisions for each in ways that will maximize returns while minimizing institutional risk. One paradigm, for example, might involve developing a universal risk-weighted exposure rating for each customer that would be available to all of the banks product groups. We have found in many organizations that such cross-channel decision-making helps greatly to distinguish between high- and low-value prospects in marginal populations. In one case, incorporating relationship variables reduced losses 20 to 25 percent in some customer segments (Exhibit 2). 2. Rethink the use of data sources. Credit underwriting has long relied on data readily available through external sources, particularly credit bureaus. And the risk models used often depend on factors that change with the

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Exhibit 3

Innovative data sources improved customer income estimates

Customers within each income category for whom estimate of income improved by over 20% through use of innovative data sources Percent
57 51

25

Source: McKinsey analysis

Low income

Medium income

High income

economy such as industry classification codes thus leading to a gradual erosion of a models predictive accuracy. Many models also rely heavily on historical data (such as prior industry risk), which result in grossly inaccurate forecasts when industry risk levels change. Consequently, some banks are taking a more flexible approach that includes a forward-looking view of risk factors that tend to vary as market conditions change. More effective exposure management will also require leveraging diverse data sources, including those that track a banks relationships with its own customers. New data sources can provide deeper understanding of borrowers and therefore improve credit model accuracy. In one case, we found adding a data source that provides deeper insight into historical delinquency performance significantly increased model accuracy, thus allowing the approval of approximately 20 percent more applications with no incremental loss. In another case, a gas card issuer was able to improve its estimates of applicant incomes by innovatively combining auto insur-

ance and other internal data with externally acquired data, such as payment histories on auto loans and vehicle taxes. Financial institutions at which customers have multiple products can often deduce customers income levels, even when significant changes occur in their earnings patterns. Such information can be an invaluable aid in managing risk exposure. At one bank, carrying a significant DDA balance was found to be the most reliable predictor of default. It is also important to leverage partnerships not only as channels for building sales, but also to improve risk management. One bank now uses utility consumption data to infer income and payment patterns and, subsequently, to refine risk estimates (Exhibit 3). We see strong potential for innovative partnerships that balance risk and reward, such as the sharing of data to enhance risk assessment models. We encountered one situation where cardholders who use their co-branded cards infrequently at those branded locations are three times more likely to default than other cardholders with

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McKinsey on Payments

March 2010

similar spending levels (Exhibit 4). Consumer privacy, of course, must always be a concern in data sharing. A partner in a regulated industry, for instance, might be prohibited from sharing transaction data, so striking data-sharing clauses from agreements would be mandatory. The same might pertain to a partner who assigns its customers to institution-defined risk or behavior categories. Maintaining sensitivity to privacy laws is, in all cases, essential. 3. Focus decisions on customer value versus risk. Banks have much to gain by centering marketing decisions more squarely on the convergence of customer risk and lifetime value (LTV). Historically, managers applied risk and marketing criteria sequentially, which frequently left few customers at the end of the prospecting funnel. One bank was eliminating some customers with poor response rates but low expected charge-off rates from the prospecting funnel. By using joint-prioritization they increased the same populations average LTV 3 to 4 percent without increasing the expected default rate.
Exhibit 4

Approaches like this will be more critical as institutions pursue growth in a world of fewer teaser offers and a reduced customer appetite for borrowing. Similar methods can be used to better align product marketing with a customers lifecycle stage. This is important because the prospect who receives conflicting product offers frequently accepts the one of less value to the institution. 4. Invest in relationship technology. To successfully leverage numerous partnerships and customer relationships, banks need to routinely upgrade their operating systems; for example, by more fully integrating those that are still largely product-centric. This will enable the creation of multi-product customer scorecards, a useful decision-making tool. Other upgrades should include developing processes and systems for pre-populating product applications where practical, and greater use of document management systems. Digitizing key documents allows the use of automatic error and fraud detection, as well as alerts on changes in risk and behavior profiles.

Gross write-off rate by spending behavior band

Number of accounts Indexed Receivables Indexed

Cardholders who did not use or only occasionally used co-branded cards at co-branded locations were much more likely to default

Does not shop at co-brand locations

100

100

Occasional shoppers

38

45

Regular shoppers

34

47

Has store card

13

39

Source: McKinsey analysis

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5. Leverage qualitative information. To fully leverage the insight it can gain from its customers, a bank must develop ways to systematically collect and use the broad range of qualitative information inherent in most customer interactions. Incorporating these insights into credit processes can improve decision quality. In one case, small business owners were asked about their educational

To fully leverage the insight it can gain from its customers, a bank must develop ways to systematically collect and use the broad range of qualitative information inherent in most customer interactions.
backgrounds and professional licenses as a means of assessing their management strength; their responses proved to be an important risk indicator. Our work has found that combining such qualitative information with traditional scoring models can improve predictability by 20 to 30 percent over purely quantitative models. The most successful banks will leverage every interaction to gain any information that could help them better understand their customers. Successfully incorporating such

information into credit decisions involves three critical steps. First, the bank must determine which qualitative factors are important to more accurately assess risk, a step that requires testing multiple factors to find those that are most predictive. Second, it must design processes that will elicit and capture the desired information from customers, which typically includes the training of frontline staff. Lastly, management must find objective ways to incorporate the newfound qualitative information as scores that will be useful in the credit process. This means defining clear guidelines for frontline staff to consistently collect and store information from customers. *** The challenges confronting the credit industry today are truly daunting and have brought it to yet another major crossroad. Nonetheless, credit is and will continue to be the engine that fuels spending and economic growth. Having reached this critical juncture, risk managers must now regroup and devise the systems, processes and practices needed to cope effectively with the new reality.
Philip Bruno is an expert principal, Amit Garg is an associate principal and Abhinav Dhall is a consultant, all in the New York office. Deniz Cultu is a principal in the Minneapolis office.