credit risk issues for lenders - cml conference oct 2013

© 2012 Grant Thornton UK LLP. All rights reserved.© 2011 Grant Thornton UK LLP. All rights reserved.

Credit Risk Issues for Lenders

Tony MoroneyDirector – Financial Advisory9th October 2013

© 2012 Grant Thornton UK LLP. All rights reserved.

The Risk Landscape ‐ Key risks on our clients’ radar

Credit RiskCredit Risk

Operational RiskOperational Risk

Conduct RiskConduct Risk

Market RiskMarket Risk

Reputational RiskReputational Risk

Technology RiskTechnology Risk

Risk of losses in positions arising from market price

movement

Risk arising from (lack of) stakeholder confidence

and trust

Risk arising from inadequate or failed

information technology asset

Risk that a borrower will default on a debt

obligation

Risk of loss from inadequate or failed

process, people, system or external event

Risk to the FSA’s statutory objective of consumer Protection


Credit Risk Issues

“The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation”.


•all forms of interactive dialogue, whether face to face, telephone, social media, or online propositions Distribution (All Advised Market)

• those giving advice through the system must comply with minimum standardsDistribution(Approved Persons)

• asses the repayment strategies of borrowers through putting clear policy and controls in place along with the requirement to check repayment vehicles at least once during the termInterest Only

• mortgages should only be granted where there is no reliance on future property price appreciation• lenders must verify income and be able to demonstrate that the mortgage is affordable• lenders must take account of the impact on payments of market expectations of future interest rate increases

Responsible Lending

The Key Impacts of MMR‐ Responsible lending comes to the fore


Responsible Lending ‐ Not uniquely British

• On a global basis, regulators are seeking to implement new mortgage rules which strike the right balance between protecting consumers while also enabling lenders to comply with reforms.

• In Europe, the European Commission is seeking reforms under its Mortgage Credit Directive and has stated for the record that:

"The financial crisis has shown the damage that irresponsible lending and borrowing practices can have on consumers, lenders, the financial system and the economy at large. We are therefore determined to learn from mistakes to ensure that lending and borrowing takes place in a responsible manner”.

• In the USA, the rules required by the Dodd‐Frank Act of 2010 address head‐on causes of the mortgage meltdown and ensuing recession: – “many lenders made high‐risk, often deceptively‐packaged home loans without considering whether

borrowers could repay them ‐ lenders now must assess a mortgage borrower’s ability to repay a loan”. – the rules’ definition of a safe mortgage—known as a “Qualified Mortgage”— also means that restrictions

on harmful loan terms such as balloon payments, teaser rates and high fees.• The premise of these regulatory interventions is that if lending is carried out responsibly the best outcome will

be achieved for borrowers, mortgage lenders and the economy as a whole: – lenders will have lower default rates, – borrowers will be issued a mortgage in which they are able to meet their repayments and– governments and the general public will have a stable financial system.


Financial Stability Board ‐ Espoused Principles for Sound Underwriting Practices

The FSB Principles for Sound Residential Mortgage Underwriting Practices aim to provide a framework for jurisdictions to set minimum acceptable underwriting standards. The European Banking Authority embraced these principles in June of this year.

1. Effective verification of income and other financial information • make reasonable inquiries and take reasonable steps to verify a borrower’s underlying income capacity• maintain complete documentation of the information that leads to mortgage approval• accurate representation of borrowers’ income and other financial information

2. Reasonable debt service coverage• appropriately assess borrowers’ ability to service and fully repay their loans without causing the borrower undue

hardship and over‐indebtedness• make reasonable allowances for committed and other non‐discretionary expenditures in the assessment of

repayment capacity• make prudent allowances for future negative outcomes• provide borrowers with sufficient information to clearly understand the main elements which are taken into account

in order to determine a borrower’s repayment capacity, the main characteristics of the loan including the costs, and risks associated with the loan in order to enable borrowers to assess whether the loan is appropriate to their needs and financial circumstances

3. Appropriate loan‐to‐value (LTV) ratios4. Effective collateral management5. Prudent use of mortgage insurance6. Implementation framework7. Effective supervisory tools and powers


Responsible Lending in the USA‐ Ability‐to‐Repay (ATR) Rule

• ATR Requirement operational language – A creditor shall not engage in a covered transaction unless the creditor makes a reasonable and good

faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms

• Bureau commentary provides guidance – Whether an ATR is reasonable and in good faith will depend not only on the creditor’s underwriting

standards but on the facts and circumstances of a particular extension of credit and how a creditor’s standards were applied to those facts and circumstance

• Underwriting Requirements – Lenders can set their own underwriting standards – Creditor may determine standards for DTI or monthly residual income in making a good faith

determination of a consumer’s ATR– Standards must be applied consistently– Early payment default will often be persuasive evidence that the creditor did not have a reasonable and

good faith belief in the consumer’s ATR– However, a change in circumstances that cannot reasonably be anticipated from a consumer’s application

or records use for the ATR determination (such as a significant reduction in income due to job loss or a major medical expense) is not relevant to determining a creditor’s compliance with the ATR Rule


Ability To Repay Rule ‐ Reasonable and/or in good faith lending?

• Factors that may be evidence that a consumer’s ATR was not reasonable or in good faith – Consumer defaulted on the loan a short time after consummation or, a short time after recast – Creditor used underwriting standards that have historically resulted in comparatively high levels of

delinquency and default during adverse economic conditions – Creditor applied underwriting standards inconsistently or used underwriting standards different from

those used for similar loans without reasonable justification– Creditor disregarded evidence that the underwriting standards it used are not effective at determining

consumers’ repayment ability – Creditor disregarded evidence that consumer may have insufficient residual income to cover recurring

obligations and expenses, taking into account consumer’s assets other than the security property, after making monthly payments for the covered transaction, any simultaneous loans, mortgage‐related obligations, and any current debt obligations

– Creditor disregarded evidence that the consumer would have the ability to repay only if the consumer subsequently refinanced the loan or sold the property

– Inconsistent application of underwriting standards may indicate that a creditor is manipulating those standards to approve a loan despite a consumer’s inability to repay

• None of the preceding factors are requirements that the borrower must prove to establish an ATR violation


Ability To Repay Rule ‐ Consequences for Failure to Comply

Liability for Failure to Comply with the ATR Rule

• General Truth in Lending Act damages – Actual damages – Statutory damages – Attorneys fees and costs

• Special ATR statutory damages – Up to sum of all finance charges and fees paid by consumer

• Unless creditor demonstrates the failure was not material

• Foreclosure provision – When a creditor, or an assignee or other holder initiates a foreclosure action, a consumer may assert an

ATR violation as a matter or defence by recoupment or setoff – No time limit on the use of this defence


Responsible Lending‐ Here to stay!

• Mortgage credit is a key element to allowing consumers to buy and retain their own home. • Critically, a mortgage is likely to be the single greatest financial commitment the majority of consumers will enter

into in their lifetime.• However, mortgage credit can also give rise to risks for consumers and these risks need to be mitigated:

– by consumers making responsible borrowing choices; – by credit institutions taking responsible lending decisions; and – by competent authorities protecting consumers from poor lending practices.

• The financial crisis has prompted a more comprehensively view of the ways in which the risks can materialise, as well as the causal linkages between them, including:– how creditors’ retail conduct might pose a risk also to creditors and to financial stability, for example as a

result of imprudent lending standards which might lead to an expansion of creditors’ balance sheets in the short term, but may fuel an ‘asset bubble’ in residential properties in the long run that could, if burst, have a substantial impact on creditors’ viability as going concerns and financial stability more widely (unless costs are externalised and the system is supported through taxpayer and/or central bank support).

– how creditors’ retail conduct might give rise to consumer detriment and pose a risk to consumer protection, for example as a result of misleading product disclosure, non‐transparent pricing and product characteristics, and/or unsuitable advice.

• Mortgage Regulation therefore is only part of the equation; lenders must also look at their credit policies through the lenses of customer outcomes i.e. Conduct Risk


Conduct Risk Issues

“Conduct risk is any action of an individual bank or the banking industry that leads to customer detriment or negatively impacts market stability”.


Regulation is wider and more intrusive ‐ Conduct Risk management is central

Business Model

ConductFCA

PrudentialPRA

Business Strategy

Governance and Control

MI, Customer Feedback and Evidence of Compliance

• Risk Management

• Stress Testing• Resilience• Horizon Scanning

• Individual Accountability

• NPD• Customer Focus• Customer

Outcomes

Market Stability• Customer protection• Transparency• Market Integrity

Risk ManagementReg

ulat

ion

Bus

ines

s

Evidence

Equal Standing


'Fairness', ‘Customer Centricity’ and ‘Conduct Risk‐Mortgage lenders need to demonstrate fairness and consideration

Marketing & Acquisition

• Access to a holistic picture of the customer through Single Customer View/CRM system

• Targeted marketing focused on ‘suitability’, segmenting customers using flexible analytics and modelling tools, backed up with rich customer data

Product Design

• Products demonstrably satisfying a market or customer segment need

• Sophistication level appropriate to the individual customer requirement/need

• Profitable but not to the detriment of the customer

• “Fair” open & transparent charging structure

• Ongoing product reviews that validate market, charging structure and profitability

Risk, Fraud, and Compliance• Revised risk model that is consistent with an FCA Conduct Risk environment• Automated MI and audit trails of logic and supporting data to evidence suitability through the lifecycle

Customer Relationship Management

• Improved understanding of customer needs throughout the lifecycle using better real-time customer data with “softer information” on behaviour and attitude

• Automated identification of lifestyle events to prompt suitability review

Sales & Service Distribution

• Enhanced decisioning ensuring products match latest customer needs

• Automated triggers/ alerts for main servicing events, driven off up to date information

• Optimised channels balancing customer need with cost to serve

• Increased self servicing through customer access to supporting tools

Supporting Functions - Business Services, Technology Services, Finance, HR etc.• Financial models that reflect the revised product/customer set and suitability based forward projections• Remuneration model based on customer satisfaction, with roles in place to assure adherence to FCA Conduct Risk principles

Suitability

Advice

Arrears?

Risk


Conduct Risk ‐ Organisational Readiness

1. Have you an established conduct risk appetite? Is this reflected in your customer and business strategies?2. How do you identify the areas of your business that conduct risk has the greatest impact?3. Can you quantify the conduct risk for your current products and back book – and how are you mitigating it?

4. Are your staff aware of their regulatory obligations to your customers?5. How is conduct risk identified and managed within your overall risk model? 6. How far does your Treating Customers Fairly framework help to mitigate your conduct risk exposure? Have you a clear action

plan covering how, and where, your Treating Customers Fairly framework may need to be improved? 7. What customer feedback do you gather? How does it support your conduct risk management performance?

Definition and Impact

Communication and Understanding

8. Do your new product development activities robustly support the FCA’s conduct requirements? 9. How do you show that your marketing and customer segmentation activities meet conduct obligations? 10. Are you clear on your conduct risk obligations where your products are sold by third parties?

Impact on Business

11. How do complaints and root cause analysis of complaints and arrears to ensure improvements in the way you deliver to your customers?

12. Aside from in complaint handling, are you undertaking root cause analysis on other sales and servicing activities?

Prevention


Conduct Risk– Credit and Risk Policies

1. Measure Conduct Risk separate to Credit Risk and Operational Risk • use an appropriate risk methodology and establish a Risk Profile

2. Demonstrate due care in assessing a customer's needs including credit needs at the point of sale and throughout the expected lifetime of the product.• Is the customer eligible to buy this product and is it suitable for their needs?

3. Formally document the intended Customer's needs at the beginning of the Product Development Lifecycle. Build in mandatory requirements for evidence of repayment capability and plausibility.

4. Undertake frequent product reviews to confirm products still meet their objective and that those objectives still meet intended customer needs. In particular, look at mortgage loans that default early.

5. Incorporate Root Cause Analysis from Customer Complaints and Arrears in to the design of new products and use it to alter and/or remove products and/or change credit criteria.

6. Train all staff at all levels of the organisation, not just customer‐facing staff, and have an appropriate governance and controls framework supporting Conduct Risk.

7. Evidence, Evidence, Evidence • How did we consider the customer when designing the product? • How have we ensured the right customers end up with the right products? • How have we ensured our risk policy appropriate and delivering the right customer outcomes? • What have we done to either improve or remove products not delivered on customer outcomes?


Conclusion

• Mortgage lenders must focus on all the traditional elements of risk, however, since the financial crisis, there has been a sea change with a real emphasis now on responsible lending – there is no going back!

• Yet credit risk is only one of the lenses a mortgage lender should use when dealing with retail customers; Conduct Risk and how this manifests itself in customer outcomes is of paramount importance.

• Lenders who take a narrow compliance approach will struggle to provide the evidence now required by the FCA both in terms of responsible lending and their conduct.

• Boards and executives must now apply the same level of rigour to reviewing customer outcomes as they do to monitoring the financial performance of the business.

• This includes the need to review new and existing products and services (including mortgage credit) and above all ‘walk the walk’ as well as ‘talk the talk’ when it comes to the conduct risk agenda.

• Ultimately having responsibility for managing conduct risk throughout the product lifecycle opens the way for much more retrospective action and reputational risk and as such, should be taken seriously.

• We know that “good profits” come from making sure products and services are suitable for the people they’re being sold to, they understand what they’re buying and they’re getting appropriate value for money.

• Setting the right tone at the top and embedding a culture of doing the right thing by customers, clients and counterparties is the only way to get this right.

• Think Credit Risk, Market Risk, Operational Risk, Technology Risk and wrap around this Conduct Risk and the potential resulting Reputational Risk – this is the mind set now required to succeed in mortgage lending

credit risk issues for lenders - cml conference oct 2013

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