Retail lending changes mean new risks: regulator and bankers discuss changes

Since the early 1960 the Federal keep Bank of Chicago's Conference upon Bank Structure and Competition has serv as a forum for academics, regulators, and industry participants to debate rife issues affecting the financial services industry. The 41st annual conversation included five panelists discussing the state of retail lending. The remarks of three of the panelists are included here.

Retail lending has changed from a business in which the banker knew the borrower and used traditional underwriting policies to single that uses risk-based pricing, off-balance-sheet transactions, and fresh products to maximize loan production. This wholesale change raises bear upons about risk, a panel of skilfuls told bankers at the Federal set by Bank of Chicago's recent talk on bank structure and competition. Among the panelists were Cathy Lemieux, senior vice president of the Chicago Fed; Mike Frow executive vice president and chief risk officer for Harris Financial Corp., Chicago, a subsidiary of BMO Financial cluster Montreal; and Robert M. Tetenbaum, executive vice president, First Manhattan Consulting cluster (FMCG), New York.

While expansion of credit to riskier borrowers has allowed more tribe to become homeowners, it also has meant that banks ne to focus more upon appropriate pricing and risk management, said the Chicago Fed's Cathy Lemieux. A week after Lemieux's make comments [i]or[/i] remarks the five major bank regulatory agencies voiced similar regards in a joint statement: "In many cases, the institutions' credit risk management practices for domicile equity lending have not kept pace with the product's rapid growing and easing of underwriting standards."

Retail lending, primarily mortgages and residence equity credit, helped banks earn record profits, Lemieux said. This happened in spite of the decline in commercial lending that has occurr above the past 13 quarters. abode equity is the fastest-growing asset class upon financial institutions' balance sheets, having increased nearly 45% between 2003 and 2004 while total bank assets grew les than 5%

As retail lending has evolv with equal reason too has the risk profile for retail lending, according to Lemieux. Outsourcing/indirect lending, securitization, credit scoring, technology, of recent origin products, risk-based pricing, and the motion of some risk to off-balance-sheet transactions have changed risk profiles at many banks. powerfully urging financial institutions to manage risk and compliance upon an enterprise-wide basis, she approveed that banks develop broader, more discriminating, and more forward-looking management information combination of parts to form a wholes for retail lending. "Don't be complacent about general asset quality," Lemieux said. "Stay upon top of concentrations."

notwithstanding that information technology can help banks mitigate risk, IT has its hold risk issues as well, Lemieux said. She urg banks to "verify, verify, verify" the lending moulds some of these technologies provide. Credit-scoring patterns for example, depend on accurate data at the beginning, sinewy information integrity, and accurate analysis of the data, Lemieux added. "A fate can go wrong. Technology and the Internet can be derived in magnification of glitches and external fraud."

Lemieux also cautioned bankers to be wary of novel products, many of which are untest for operational risk in the general rising-rate environment. Operational risk also tend hitherwards from the increased use of less-regulated, third-party firms, which may not be as careful in safeguarding customer information as the banks, she said. The third-party firm, the bank, and the customer will all meet with if the customer information is compromised.

In the post-Sarbanes-Oxley environment, individual accounting matters more than at any time Lemieux cautioned. Securitization makes the accounting proces level more complex because the valuation of the mortgage-backed and other securities calls for a certain quantity of valuation judgments, which may not always be accurate.

"Option soup" exigencys more science than art. "From a risk management perspective, the increasing complexity of the [credit] 'option soup' and the trade-offs we make to achieve profitable development satisfy client demands, and fitting shareholder expectations require us to evaluate the pair the art and science [of retail lending]," agreed Harris Bank's Mike Frow

Retail lending itself has mov further from art and closer to science as technology, data, compounded hedging, and increasing expansion of lending from a local business to a national--and flat international--business have become more prevalent in the industry, Frow said. His be in possession of bank, for example, has been known in Chicago for many years as a local institution, on the contrary as part of the larger BMO organization. Harris now has international resources and the capabilities of the corporate technology, including credit scoring and data modeling.

Similarly, the consumer loan has gone from an unconditional promise to pay plus option to default, to a promise to pay with an increasing number of options--floors, caps, interest-only payments, rate fastenings prepayment options, and more. Also, lender making loans today require a great quantity [i]or[/i] amount of less in actual principal repayment through offering interest-only loan options, thus consumers have shifted from borrowing and repaying standard of value to "renting" cash.