This article was first published on June 1, 2020.
THE CURRENT ECONOMIC OUTLOOK AND THE ROAD AHEAD
What's happening in consumer credit so far
Oliver Wyman recently held a virtual roundtable on Consumer Credit Challenges during COVID-19. This pandemic has created a huge impact on the consumer credit arena—through the scale and onset, degree of uncertainty, tough economic outlook, and the level of government support.
Unemployment is forecasted to spike quickly and dramatically (possibly up to 20 percent) before returning to pre-COVID levels in late 2021. The peak during the 2008 financial crisis was 10 percent, and what is expected is significantly worse than anything we’ve seen since World War II. However, this forecast may change depending on the response to the pandemic, and how multiple peaks and waves unfold.
The economic outlook will be closely linked to the pandemic’s evolution—so understanding how the pandemic may unfold can inform what unemployment and other consumer credit indicators may look like.
With the combination of these factors, it is expected that there will be a long tail of financial, operational and reputational implications. There is no historical precedent, and the credit environment ahead is uncertain. While it’s important to act in a coordinated manner and with some urgency to keep pace with the crisis, well-planned actions will help control risk and win goodwill with customers, especially once the crisis fades. In time, they will become a foundation for competitive excellence post-crisis.
Oliver Wyman Partners Deepak Kollali, Mike Duane and Adam Schneider recently brought together a panel comprised of senior industry leaders to share their experiences, knowledge and wisdom on how to navigate through these challenges ahead. Below is an excerpt from our roundtable conversation. To listen to the full recording please click here.
The current economic outlook and the impact on consumer lending. Where do we go from here?
QUESTION 1: CREDIT CARDS
Credit cards are perhaps the most volatile part of consumer debt. What would you be doing in terms of both supporting customers, and managing credit risk at this point in time?
There are four areas of focus. The first thing is to increase investment in customer support programs. Today these programs are largely payment holidays and about 10 percent of the customers are prime. I think this number is going to rise rapidly and turn towards subprime.
Avoid over-analyzing when offering payment holidays. Keep it simple; in the long run it pays off to offer them to anyone who asks. It’s risky to isolate customers who need temporary assistance with liquidity versus those with more permanent loss in income, such as a business closing or job loss. Next, make sure that the credit, servicing and marketing strategies are all aligned to recognize the difference. Encourage customers to enroll for online pay post the payment holiday. On reduced minimums due, ensure that customers make the first payment before the program executes.
The second area to focus is on recalculating and modifying risk scores. However, currently with the COVID-19 pandemic, the historical delinquencies, gross domestic product (GDP), government stimulus programs and unemployment rates don’t offer an adequate forecast or accurate risk assessment.
So how do you build a segmented view that builds on your existing score, and takes into account conversations you are having with customers about their current situation, the spread of infection and the unemployment rate? It’s important to segment your portfolio and make short-term enhancements in both the models and strategy. Example of segments are: your own customer assistance programs, spread of the coronavirus, the economic response, and unemployment rate by geography. These adjustments must evolve with time and be central to all credit, servicing and marketing actions. You should have a process where adjustments are able to be made regularly.
Third area is to collaborate with your finance team to set proper reserves. Well-built models can be leveraged to narrow the forecast between likely reserves and severe forecast scenarios, and help your company work more effectively.
Lastly, create a triage office to ensure that the marketing, servicing and risk management actions are all aligned with each other. This office should be managed by a senior person in the organization, who has an understanding and authority to act on behalf of all three of these areas.
Make sure your focus is not just to reduce credit losses but to also maximize profitability. It’s important to recognize that for those of us who work in risk management it’s a moment of change and we have access to the attention and larger mindshare of colleagues. This time should be used to invest in capabilities—especially digital and AI—for both short and medium-term.
It’s important to recognize that for those of us who work in risk management it’s a moment of change and this time should be used to invest in capabilities—especially digital and AI—for both short and medium-termASH GUPTA, Oliver Wyman Senior Advisor; Formerly Chief Risk Office, American Express:
QUESTION 2: HOME LENDING
In home lending, what should banks and servicers be focused on if the crisis extends beyond the timeframe of existing forbearance programs?
It is likely that forbearance programs will be concentrated in first-time homebuyers, lower down-payment programs (for example, FHA program) and higher risk credit. It’s important to understand where these are concentrated in your portfolios because these segments carry a higher degree of reputation risk in terms of how you handle them.
As far as new account originations, it’s important to have a triage team that focuses on working quickly. In the home lending space, you want to focus on raising your FICO scores and tightening LTV/CLTV requirements by market (understanding HPI expectations by market) and adding credit overlays on top of investor guidelines. Also, making sure riskier product structures are not misused.
In this period of high unemployment, it’s critical to tighten your income and employment verification prior to closing loans, evaluate your measures of capacity, and to tighten post-closing liquidity requirements. Also, step up fraud investigative reviews to look for all types of fraud.
Channels are important and make sure you are focused on the wholesale channels. Reduce or eliminate higher risk origination channels and higher risk products; particularly with Home Equity products right now—until county recording offices reopen—you may be more exposed to lien stacking.
Lastly, focus on your retail banking customers and their secondary sources of repayment (asset management; deposits). Because there is more operational risk with people working from home, staff up your quality assurance functions.
On the collections and customer management side, there’s a lot of concern about mortgage servicing right now. These forbearance periods offer an opportunity to staff up and train the loss mitigation functions. It’s important to effectively use the digital channels for transmitting documentation, DocuSign capabilities, etc. Underwriters may be moved to the loss mitigation side, so make sure you have adequate training.
On the home equity side, I would strongly recommend that you build out a triggers program (bureau and internal triggers) and that you are completing periodic – at least quarterly – AVM valuations and actively looking at using line management. In the last cycle this saved the industry billions of dollars and is frankly the responsible lending thing to do since people have their homes on the line. That’s how I would handle home lending in this crisis.
In this period of high unemployment, it’s critical to tighten your income and employment verification prior to closing loans and to tighten post-closing liquidity requirements. Also, step up fraud investigative reviews to look for all types of fraudKEVIN MOSS, Oliver Wyman Senior Advisor, Formerly Chief Risk Officer at SoFi, Chief Risk Officer at Wells Fargo Consumer Lending
QUESTION 3: AUTO LENDING
The auto lending market is suffering from current conditions. What would you recommend to lenders right now, thinking about the unique positioning and requirements of that market?
These are extraordinary times for the auto industry, for example:
- Currently, manufacturers are not producing, but hopefully will start production in May 2020
- In many regions, dealerships are closed to floor traffic
- Sales are down 50 percent
- Manufacturers are starting to provide significant incentives through their capital finance relationships; this will benefit finance companies that have direct relationships with the manufacturer
- Seasonally Adjusted Annual Rate (SAAR) is down 35 percent, running what was 17 million units pre-crisis down to potentially 11 million units this year
- Auction markets are closed
- Manheim values are down 10 percent as of mid-April
- Unemployment has gone up, well above 10 percent
From an underwriting and pricing perspective, as risk leaders, you need to focus differently on the top end of the credit spectrum, including prime and near prime customers versus the sub-prime customers living pay check-to-pay check with less savings.
On the loan-to-value ratio (LTV) side, I would be adjusting down, especially on used vehicles. With the Manheim drop, it’s going to be difficult to determine the asset quality and value. In addition, non-captive finance companies need to be concerned about adverse selection as the manufacturers may role out significant and attractive finance programs.
Going to the medium to long-term, pricing for risk in this environment is critical. Leveraging stress models is important right now to understand the unemployment and demand impacts to the various segments of the originations and pricing should be adjusted accordingly.
Moving over to the collections side, managing both frequency and severity is the challenge. A supply-demand imbalance is going to occur across the industry, which will take a couple of quarters to work through. The industry is doing the right thing right now by working with customers and giving deferments where necessary. This helps both the consumers through temporary hardships and difficult times, as well as the lender that can’t dispose of the asset/vehicle regardless because auctions are closed.
Having sound and nimble distribution strategies is absolutely critical right now. If we do have a second or third wave of COVID, having a robust auction strategy, where you can pivot from one auction to the next, is important. Lenders may find themselves in situations where they need access to both physical and digital auctions.
Having sound and nimble distribution strategies is absolutely critical right now. Lenders may find themselves in situations where they need access to both physical and digital auctionsBRIAN GUNN, Oliver Wyman Senior Advisor, Formerly Chief Risk Officer at Santander USA and Ally
In the Great Recession, consumers seemingly favored auto loans over home lending. Do you have any thoughts on whether the consumer payment hierarchy will change this time?
This time, I don’t think the payment hierarchy is going to change away from home lending. In the last recession, home prices dropped so much that the loan-to-value became greater than 100 percent. This time, the loan-to-value for most homes remains low and there is a strong reason for customers to not be delinquent on home loans. I do believe that homes will stay ahead of autos. Auto prices are likely to drop, and the use of auto can change in a dramatic way.
A big factor is what happens with the sheltering at home. If sheltering at home is a longer-term requirement (due to no vaccine or large-scale treatment), then my view is people will likely value their home over their car, as long as we do not have a big drop in home values. Consumers will likely focus on keeping one car over having two or more, as we are driving a lot less than we ever have.
All of us are dealing with this shelter in place scenario right now and a lot is going to depend on what things look like when reopening happens. Consumers will still need their cars, but perhaps less if work at home becomes more accepted across the industry. So, I suggest people need both their homes and their vehicles and will less likely favor their vehicles over their home.
We have some great insight about what companies need to do, but we know it is difficult to implement change quickly. Based on your experience what are some practical steps that can be taken by institutions in the short to medium-term?
We’ve just heard what we need to do to serve customers and manage risk in this situation. Many relate to the decisioning lifecycle and taking action quickly. While there will likely be a knee jerk reaction to tighten credit standards across the customer base and in new underwriting, this leads to long-term growth and profitability issues.
Actions have to be taken in a targeted fashion and will differ depending on the kind and extent of impact that is happening on a particular segment of consumers. It is important to realize, as discussed by Ash, Kevin and Brian that BAU segmentation and strategies will probably not be relevant given the extent of the discontinuity caused by the crisis.
Things have changed so fast and in unprecedented ways, that the past is not a good predictor of the future. Banks will need to incorporate recent information, along with new data and variables to create new actionable segments. They will need to recalibrate predictive models, like probability of default scores, and policies.
New internal and external data such as COVID intensity factors (which could be regional), unemployment status (which can be industry based), whether someone asked for forbearance or not — all will become very relevant in actioning strategies. But incorporating this data needs special care. We need to ensure that permissible purpose and fair lending regulations are top of mind as well as brand and customer loyalty.
BAU bank governance, legacy technology and processes are not often geared to move this quickly in such a situation. I strongly recommend pulling together a crisis management expert team with cross-functional representation from Compliance, Data, Modelers, Business Policy/Strategy team, and production technology experts.
As it relates to new data, compliance needs to be done upfront, with the experts defining the right way to use the new data. Speed is of the essence. Compliance experts should be included in the design of various segments and action strategies so that the backend approval process is very short. Create upfront transparency on compliance metrics so that the first line knows the rules of the game right from the start. This, in my experience, is the best way even in normal times.
Models will need to be recalibrated after new segmentation variables and data are incorporated. This will take time, but it needs to start in parallel. Banks who invested in big data and machine learning-based models will have an advantage, but in all cases, it will take three to four quarters before the models catch up to the data. In the meantime, actions should be made using rules and factors based on experience and the type of customers in a defined segment.
Given the length of this crisis and the fact that there could be many waves, this may require constant adjustment of segments, strategies and actions—especially as new information and performance data loops back. It is an imperative that banks automate the decisioning workflow process. Incorporating new data in a governed manner, evaluating and approving new models and policies, and moving them to production in a matter of hours cannot be done efficiently manually — there is just too much risk of operational errors, compliance breakdowns and regulatory nightmares.
Thankfully, newer plug-and-play automation capabilities do exist that can enable legacy technology banks to deploy well-defined decision workflow automation capabilities within an 8-12-week period. If banks focus and remove red tape, this is a good opportunity for banks and fintech to collaborate and implement new innovation at startup speed.
Banks who invest now will have a key competitive differentiator — not only in navigating the crisis, but in going on offense faster by developing growth strategies as we start come out of the pandemic.
Banks who invest now will have a key competitive differentiator — not only in navigating the crisis, but in going on offense faster by developing growth strategies as we start come out of the pandemicMANISH GUPTA, CEO and Founder of Corridor Platforms
If this was a baseball game, which inning are we in?
We are in the top of the first or second inning at best. I think the key is getting a better understanding of what are all the collateral impacts. The volatility around the risk is very high right now. As the landscape changes, and a vaccine is developed, we can accelerate where we are in the game very quickly.
Given the uncertainty, we might be in the second inning but could suddenly jump to the 6th inning with a vaccine. Similarly, we could reverse as quickly with second waves of infection. There is simply too much unknown. In this environment, you need to be nimble and act with a sense of urgency.
I agree with Ash but I would say the analogy a bit differently. I feel we are in a rain delay, and until it stops raining, we won't know the full extent of the damage until we start to reopen again.
One thing is, it is going to be a tough and long game. So, it is necessary to think about the medium to long-term and build strategies and capabilities with a long tail in mind.
I feel we are in a rain delay, and until it stops raining, we won't know the full extent of the damage until we start to reopen againBRIAN GUNN, Oliver Wyman Senior Advisor, Formerly Chief Risk Officer at Santander USA and Ally
QUESTION 7: CLOSING THOUGHTS
Any last thoughts for our audience?
This crisis has demonstrated that it’s a necessary requirement to have well developed digital channels for lending and deposits. This enables many more high health-risk customers (disabled, elderly, etc.) to transact with financial institutions. It helps companies realize cost efficiencies, automate operational tasks that may be manual, and reduce expensive overhead from branches.
It expands the volume of applications that a financial institution can handle, helping to reduce cycle times and improving customer experience. It also facilitates the delivery of documentation and instant approval/funding, which promotes higher conversion and customer satisfaction. And it helps to potentially reduce biases (fairness/lending risks) by ensuring a more consistent customer treatment with technologically-based decisioning. Banks will probably be accelerating their investment in the digital channels, especially in the collections space.
Crisis is a good time to learn, compress timelines and drive innovation — to get things done. This is going to be the silver lining during this period. Luckily the capabilities that we need to successfully maneuver through this are identical to what is needed to drive digital transformation. If you build them now, they are there for the long term.
With digital transformation, we talk about the need to incorporate new and alternate sources of data in a compliant manner; migrating to faster machine learning models and big data; and making decision/strategy changes quickly to react to the economy, competition and consumer needs. These are exactly the capabilities you need to act with speed and get through the crisis. Now would be the time to compress what can usually be done in a bank in two years into a matter of months.
A crisis often provides organizations with the opportunity to reinvent themselves as I experienced firsthand with GMAC, which is now Ally, back in 2008. We really had to reinvent ourselves during the heat of the crisis. It’s a great time to learn what’s going to work and not work.
While the market is down and even in recovery, organizations should be ensuring that they are in the lending segments they want to be in, perhaps expand into others and look for ways to become more efficient through game changing ways in the industry. Lenders need to be nimble across the entire lifecycle and have the tools to be able to do it in the new world we are operating in.
Putting customers first in this environment is central in what we are trying to do.
The most important skill is be nimble, observe external developments and have a segmented enhancement of your models and strategy — all with a sense of urgency. Listen to customers and monitor every action in detail, stay aligned with your cross functional colleagues, and seek help rather than become overwhelmed.