Thursday, April 12, 2018

Consumer Lending: Should Banks Do It?

We’re running out of assets.

When I first read Standards Needed for Safe, Small Installment Loans from Banks, Credit Unions by the Pew Charitable Trusts that encouraged financial institutions to get back into small ticket consumer lending, I thought “what are they nuts!”

Consumer loans for those banks that utilize my firm’s outsourced profitability reporting service lost (0.26%) as a percent of the average consumer loan portfolio in the fourth quarter. And it wasn’t an anomaly. Ever since we formed our company in 2001, this has been the case.

Sure, home equity lines of credit made 0.71% for the fourth quarter. But it was the only sub-product that showed a profit. Fixed home equity loans… nope. Indirect loans, unsecured personal loans? No and no. So why would banks expand small-ticket, unsecured personal lending?

Because we’re running out of assets. Pretty soon we’ll be left with small to mid-sized business loans and commercial real estate that isn't big enough for large banks or conduits. And there are FinTechs, loan brokers, insurance companies, and investment funds chipping away at them.

Mortgage lending is getting away from us. Mortgage bankers and brokers own a significant share of market (although less than prior to the 2007-08 financial crisis). And Quicken Loans is in the top 5 HMDA market share in nearly every market we analyze. Oh, and Quicken is hammering away at home equity lending too.

We lost auto loans to the indirect market. Who comes to our branch for a car loan today? If we don’t consider how we intend to defend our small business and CRE lending, and re-enter some of these other loan markets, we may end up as a balance sheet for hire. Which we already do via buying mortgage back securities and using loan brokers in metro areas.

Are you ready to be Web Bank, part deux?

So I reconsidered my knee-jerk reaction to the Pew Charitable Trusts report. Most community financial institution strategies has some sort of “community” focus. It’s implied whenever someone says “we’re a community bank”. Which nearly everyone does. Even the big banks. So maybe we should put some moxy behind those words. Profitable moxy, though. Not charitable moxy.

Why do consumer loans consistently lose money? Looking at our peer group numbers, the consumer loan costs a little above $1,100 per year in operating expense to originate and maintain. Expensive. This is a fully absorbed number. Meaning that all bank resources that are dedicated to the consumer loan function is fully allocated to the product, whether they are being used or not. And recently, they have not been used.

For example, there is a fair amount of branch expense in that number, because branches are typically responsible for originating those loans, and participate in their maintenance. If we got rid of consumer loans, that expense would migrate elsewhere. And if we are not originating new loans, then resources dedicated to origination, such as branch staff and credit, for example, are dormant but must be paid for by the existing loans in the portfolio.

Four Ways to Bring Back Consumer Loans, Drive Volume, and Increase Profits

1.  Make consumer loans more than an accommodation. Not many financial institutions consider consumer loans as a strategically important product group that will drive growth and profitability into the future. Perhaps it is because of the hurdles to achieving meaningful growth and market share. Or the competitors that wedged themselves into the dominant market position. But if executive management and the Board aren't committed to pursuing consumer lending to be more prominent on your balance sheet, then you will not succeed.

2. Align your credit culture and risk appetite to be successful consumer lenders. It is not lost on me that the last bastion of consumer lending at banks is home equity loans. Real estate secured. Hard collateral. Relatively low charge-offs. It is difficult to change that mindset when doing loans with little to no collateral, such as small ticket consumer or credit cards. Charge-off rates of 4%-5% with no collateral? Yes. Get used to it (other than home equity). Or don't do it.

3. Drive down costs. Regulation has driven up costs and made us gun shy. But we can't continue to put $1,100 of resources per year into a consumer loan. Especially if the loan balance is $2,500. How can we possibly make money on that? We can't. The ABA recently conducted a survey on the State of Digital Lending (see chart) that said that, although consumers were happy with how smooth and quick online lending decisions were made, online lenders only received a 26% approval rating, versus 75% for banks. Driving more volume will drive down costs by putting under-utilized resources to work, and digitizing end-to-end will reduce the amount of resources needed for consumer lending. 

4. Price right. Even if banks cut the cost of originating and maintaining consumer loans in half, to $550, what rate will they have to charge to make a reasonable profit? Let's say a reasonable profit is a 1.5% pre-tax profit as a percent of the portfolio. And the non-home equity portion experienced a 4.5% charge-off rate. And the cost of funds for such lending is 1%. If the average loan size was, say, $3,000, the bank would have to charge an effective yield of 25.3% (($550/3,000)+1%+4.5%+1.5%). Those rates get the scrutiny of do-gooders and "champions of the people" that could cause negative press. And keeps community financial institutions out of this business. Take note Pew Charitable Trusts. However, knowing this math, the bank can work at pressing the levers needed to do this lending profitably, at the right price, that benefits borrowers and the banks. And keeps those borrowers out of the hands of the sharks that prey on their misfortune.

Should we give up on consumer lending?

~ Jeff


  1. Jeff -- I'd be interested in knowing the marginal cost of a consumer loan. If it is proprietary, then I respect that. But if the marginal revenue exceeds the marginal cost, then the hurdle rate for getting into the line of business is not as high. I understand the trap associated with marginal profitability, but at the same time, as you noted, fixed costs just get allocated somewhere else if you do nothing.

  2. That would probably be zero Mike. Most resources at community banks that work on consumer lending have primary duties elsewhere, such as branch staff, underwriters/credit, and loan servicing. Consumer is a small part of their duties because it is a small part of the banks' strategy, in my experience.

    The Q behind the Q, is without consumer lending, how much expense can we remove?

    Thank you for the comment!

    ~ Jeff