Equity investments are the key tool for diversifying CU loans

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In uncertain and volatile markets, many credit unions are trying to realign their portfolios but may suddenly find methods they have traditionally relied on no longer available. On the other hand, loan investments are still an efficient and surgical tool for refining a financial institution’s balance sheet to align with evolving risk-return goals. Selling or buying credit in uncertain markets should not be viewed as a panic sale or a careless purchase; pretty immense potential benefits abound. Remaining active in loan investments in the coming months will prove to be an effective risk management tool for all parties involved.

The aim of diversification is to build a diversified portfolio of assets, including loans, that has a superior expected risk-return profile. The typical goal is to maximize the expected returns for a given risk threshold or, conversely, to minimize the risk for a given return expectation. While the expected rate of return has an inherently quantitative definition, a credit union will have more flexibility in choosing how to define and reduce risk through a combination of quantitative and qualitative measures.

Differentiation between diversification and liquidity

Depository institutions often rely on two key figures to optimize the risk / return targets of their balance sheet assets: asset diversification as well as liquidity and asset utilization (leverage). Theoretically, these risk measures are approached both jointly and dynamically with the liability management of an institution and possibly other hedging activities. In practice, however, this is often not the case. A credit union’s liabilities are often relatively static and institutions often lack control over deposit activities. As a result, there is typically much greater focus on asset management when credit unions, along with the terms on which credit is granted, exert significant control, either directly or through the acquisition of assets. Let’s turn our focus to asset diversification.

Many credit unions and banks are less diversified than they should be in terms of regions, industries, employers, or asset classes. In addition, credit unions in particular are facing additional pressure and regulatory constraints, which often result in them being even more concentrated than banks in a similar location.

Table of loan shares Source: LoanStreet

Loan investments for diversification

While a lack of diversification is more understandable in the case of credit unions, the risks are no less great and the negative consequences no less serious. For the most part, the best, and perhaps only, way for credit unions to mitigate these risks is through loan participations, which give credit unions access to a much more diverse pool of credit without investing resources to expand their presence or lending divisions. Although there are alternative methods of diversification, these are often too slow, disruptive for members or financially unsustainable.

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Equity investments allow credit unions to diversify across a variety of characteristics:

  • Geographically: Consider a loan portfolio with 100% of borrowers in a single country versus a portfolio of loan holdings spread across the country.
  • Employer industry: Consider a loan portfolio where most borrowers work for the same local employer or industry versus a loan equity portfolio that is diversified across numerous employers and industries.
  • Asset class: Consider a loan portfolio that is comprised of all home equity loans versus a portfolio of equity holdings that is comprised of mortgage loans, auto loans, solar panels, and home equity loans.
  • Credit Quality: Consider a loan portfolio made up of a narrow range of FICO scores versus a loan participation portfolio with a wider range of FICO scores but the same average score (and where the nonprime loans are from a credit union experienced in the Granting and servicing of such loans). .
  • Borrower Types: Consider a portfolio of consumer-only loans versus a loan participation portfolio that contains a mix of consumer and corporate loans.

Technology makes participation easy

Historically, loan participations were administratively complex to arrange and maintain. Legal agreements, the logistical constraints of due diligence, and ongoing performance monitoring have all helped ensure that equity investments are viewed as a last resort in terms of managing balance sheet risks.

Technological advances have eliminated these friction points so that credit unions can use these loan participation technologies to manage risk more flexibly and consciously. As with many technologies, recent innovations in loan participation technologies have democratized the space. Smaller institutions can use tools and strategies that were previously only available to their larger counterparts. Correspondingly, large and small institutions now also have access to a much broader market of opportunities that were previously only offered to larger players or not at all.

Choosing a diversification strategy

In order to strive for diversification through investments, the organization must first define its diversification goals. This begins with identifying risks (and opportunities) to which the credit union is over- (or under-staffed) and with an appropriate method of measuring the risk. This doesn’t have to be a complex task, and often the most obvious risks are those that need to be addressed the most, such as: B. a heavy focus on auto loans to borrowers in a few neighboring counties who work for the same large employer.

These types of balance sheet observations can usually be made easily by existing employees. In addition, new data analysis platforms can also help employees identify more subtle balance sheet concentrations and where holdings could offer a solution. With the help of insightful data analysis tools, achieving robust, quantitative diversification does not require Wall Street risk management training or capital market knowledge.

This qualitative heuristic approach to diversifying lending can be criticized as not being academically rigorous and without probabilistic-statistical measurement of risks such as return variance, market covariance or value-at-risk. Remember, these are statistical measures of risk – not definitions. In addition, many financial institutions simply lack the data to conduct a fully quantitative diversification of lending that might be available for other asset classes such as stocks. Even institutions that invest in sophisticated risk analysis functions should not rely solely on them or advisors to help define the basic risks of the credit union.

Risk management is never easy, especially at times like this when pivots need serious consideration as previous flaws are exposed. However, risk management must always be forward-looking, especially in these unstable times. Loan equity investments are a powerful tool for credit unions looking to proactively manage risk in their loan portfolios.

Ian Lampl

Ian Lampl is the CEO of New York-based credit technology company LoanStreet.

Michael Lanzarone Michael Lanzarone

Michael Lanzarone is Head of Corporate Development & Marketing at LoanStreet.

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