More and more financial institutions are considering lending to higher- risk customer segments as a way to expand market share and increase profitability in their consumer lending business. Lenders who understand the dynamics of subprime lending have proven that it can be a profitable business, but because of the various risks, KPMG believes that it requires careful planning and implementation.
Competition for customers is intense. The growth and variety of competitors for consumer loans in recent years are making it difficult for bankers to keep their traditional customers. Consumers are barraged constantly by offers for credit cards, auto loans, mortgages, and personal loans.
Although this competition has intensified in recent years, few bankers have developed a viable strategy for expanding their lending business and improving performance over the long term.
Some bankers are cautious about entering the subprime market given the increased competition and current economic conditions. Some banks are in this business nevertheless, yet the key success factors may not be widely known. Making the grade is a leap for most bankers, requiring careful planning and implementation.
A key problem: Subprime customers are a nontraditional customer segment for banks.
Banks have dominated the market for customers with the best credit in consumer lending. The definition of prime can vary, but one thing is certain: Customers who do not meet the bank's definition of prime are typically turned away.
Dividing potential borrowers into prime/subprime categories based only on credit reports and income levels obscures the fact that both segments contain a mix of high and low credit risks. Credit bureau scores and income levels alone cannot predict how the borrower will perform.
Some bankers, however, are discovering what finance companies have known all along - not all customers with bad credit are bad customers. They can be the source of far greater yields than the typical borrower in a bank's consumer loan portfolio. Furthermore, understanding the behaviors of customers with bad credit makes the lender more effective in managing its overall consumer loan portfolio.
There are many reasons why a creditworthy customer can have bad credit. Distinguishing customers with temporary problems from those with habitually bad credit is the first step in understanding the subprime market.
A different mind-set is needed to succeed in subprime lending. Risk- based pricing is its foundation. It is far less expensive and risky to recognize the credit risk up front, price accordingly, and then manage the performance of the loan.
Higher chargeoffs and delinquencies are expected and factored into the cost of doing business. When operating successfully in the subprime market, it is conceivable that the worst risks have the potential to generate the most stellar profits.
Success requires a focus on the entire structure of the deal and not just on the customer's repayment capacity. Bankers can then create a menu of loan programs that are priced differently from their usual loans - utilizing differences in the term, the down payment, and the type of collateral to minimize the risk further.
Lenders should be aware that extending credit to a subprime prospect requires more work and judgment on the front end. Once the decision is made to extend credit, getting the borrower off to a good start will reap benefits in the long run. It is important to let the customer know up front what the bank's expectations are, and what the repercussions will be if the customer does not live up to the loan agreement.
Clear communication of payment instructions and providing easy access to the customer service area is also important.
On the back end, awareness of how these loans will perform makes managing the business much easier. Knowing the typical delinquency curve for subprime customers helps a banker staff and differentially manage collection and recovery activities.
In general, the subprime customer places more demands on the collection area. Late payments are common. Quick responses to late payments and enforcing the collection of late fees is one method for controlling delinquencies.
In embarking upon a subprime lending program, it is critical to manage the expectations of senior management, shareholders, and regulators about delinquency and chargeoff rates. The best way to do this is to segregate the loan portfolio according to risk category, and report on the performance of each segment individually. It will then be easier to illustrate that different segments produce different results.
Senior management will also come to see a major side benefit of lending to the subprime customer. Since this is a customer who typically has had difficulty in obtaining credit, the institution that is willing to work with a customer in credit rehabilitation is likely to be rewarded with loyalty.
As a result, lending to the subprime customer can be a new and fairly reliable source of other loan, deposit, and investment business.
In summary, bankers should take the leap, but with careful planning and implementation.
Eventually, subprime lending will be an acceptable part of most banks' loan portfolios. Already, there is a growing secondary market for such loans.
As the market develops, more entrants will appear, pricing will become irrational, and only those lenders who fully understand the subprime market and risk-management procedures will be able to succeed.
Subprime customers are more vulnerable to changes in the economy. Given recent economic trends banks may experience a period of relatively high delinquencies.
Subprime lending may not be appropriate for every bank. But in our experience, there is a profitable market opportunity in subprime lending for those bankers who make an effort to understand the market and to manage it well.
Mr. Rabb and Mr. Neyland are partners and Mr. Arnold a senior manager of KPMG Peat Marwick.
