Increased Regulatory Scrutiny for Indirect Consumer Lending on the Way?


 recent survey conducted by the OCC confirms that underwriting standards within commercial and retail products continued to ease for the third year in a row as banks respond to competitive issues for limited loan demand, ample liquidity and higher yields in the current low interest-rate environment.

Within the retail segment, indirect consumer loans were again identified for underwriting standards being eased resulting in increased levels of credit risk that will likely result in additional regulatory scrutiny in the near term.

The survey covers the 12-month period ending June 30, 2014, including the 91 largest national banks and federal savings associations with loans of $4.9 trillion or approximately 94% of all loans in the federal banking system.

38% percent of the banks surveyed responded that they felt underwriting standards for indirect consumer loans had eased from 2013 to 2014, while seperately, 38% responded that the level of credit risk in indirect consumer loan portfolios had increased from 2013 to 2014.  An additional 71% indicated that they expect more credit risk increases going entering 2015.

According to the Federal Reserve, outstanding auto loans totaled $943.8 billion as of September 2014 compared to $809 billion two years earlier making it one of the fastest growing lending segments since 2006.

Recent regulatory examinations have found that the following practices are being applied to grow the auto lending segment:

  • Permitting auto dealers to use manufacturers’ rebates on new vehicle purchases in order to finance negative equity on the used vehicle trade-in
  • Easing or having no loan to value limit or no dollar limit when financing negative equity on vehicle trade-ins
  • Financing high mileage autos (greater than or equal to 100 thousand) for sixty to seventy-two months which exceeds the useful life of the vehicle
  • Easing underwriting/scorecard standards to include higher maximum debt-to-income ratio limits, increased advance rates, longer loan maturities, relaxed loan terms and granting loans to borrowers with lower credit scores, or subprime borrowers (credit score <620), that carry the additional risk of higher default rates.
  • Having no established portfolio limit for borrowers with lower credit scores
  • Inadequate pricing based on credit risk
  • In addition, examiners are concerned that banks are not adequately adjusting their ALLL or maintaining sufficient reserves to cover the increased risk exposure from subprime lending.

The rapid growth in indirect auto loans can lead to a material shift in a bank’s balance sheet composition that, if not properly managed, may contribute to increased risks in credit quality, liquidity, transaction, and compliance. A January 8, 2015 Wall Street Journal article reported that 8.4% of car-loan borrowers with weak credit scores that financed a purchase in the first quarter of 2014 had missed payments by November. The article further states that, in order to maintain momentum in 2015, industry analysts expect lenders to push more aggressive finance deals and extend credit to borrowers with weaker credit. 

After ESSA Bank acquired Franklin Security Bank in April 2014, they took on approximately $88 million in indirect paper, a new venture for the bank that, prior to acquisition, did not participate in the indirect business. "We retained a large majority of the experienced staff [from Franklin] and run it as its own separate entity," said Charles Hangen, Senior Vice President of ESSA's Lending Services Division.  

Furthermore, Mr. Hangen says that despite the survey results, ESSA's standards have not eased.

"We haven't eased any of our lending standards or financed high mileage vehicles, we haven't increased our debt-to-income ratios and we carefully track our subprime borrowers," he said.  "We do price based off what we believe the credit risk is depending on term, credit scores and loan-to-value."

Banks concerned about heightened risk in their indirect lending portfolios should use industry data to identify trends in repossessions, delinquencies and charge-offs that warrant closer supervision. Other “red flags” that can reveal underlying issues include: 

  • A high concentration of indirect loans to total loans without adequate controls and limits in place
  • Inadequate analysis of underwriting metrics (i.e. number and type of policy exceptions, loans by credit score stratification) and overall indirect loan portfolio performance
  • High occurrence of first payment defaults, payment deferments and re-agings
  • Insufficient loan documentation
  • Poor dealer management when the bank: (a) relies on the dealer’s finance and insurance department to obtain borrower’s credit report; (b) accepts loan payments from the dealer and not directly from the borrower and (c) permits dealer-created down payments through incentives, inflated or fraudulent trade-ins or prepayments
  • Failure to review underwriting standards at least annually or more frequently if risk levels increase or negative trends surface

If your bank is concerned about potential gaps in its indirect portfolio risk management, please contact Ardmore Banking Advisors.  Our credit risk professionals can help you examine your portfolio for weaknesses, make you aware of what items the regulators are focused on and help you gain peace of mind in your policies and procedures.