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Part 2 My colleague, Prince Varma, Senior Client Partner — Portfolio Growth and Client Management, shares his advice on the best practices for portfolio risk management in these trying times. Boy; this is an interesting time. Banks today are at a critical threshold — the biggest question that they are trying to answer is, "How do we continue to grow — or at least avoid contracting — without sacrificing profitability or credit quality?” The urge to overcompensate, or engage in ultra conservative lending practices, must be resisted. That said, we are already seeing a trend in which mid-sized and regional lenders are abandoning mid-tier credit. This vacuum is being filled by community banks and credit unions which are implementing aggressive risk-based pricing programs in order to target the small business market. These organizations are also introducing "safe and secure" campaigns that specifically target existing clients of banks in the news — and attempting to entice those clients to switch over. We are strongly urging banks to engage in an analysis of their existing portfolios in order to pinpoint opportunities for expanding their relationships with existing key clients. Many senior executives are expressing apprehension about undertaking new projects given current levels of uncertainty. Our best advice is two-fold.. First, focus on identifying those areas where process remediation will have long term and sustained value. Second, do not allow uncertainty to paralyze your internal improvement efforts. Strong business cases lead to good decisions; don't let fear and apprehension cloud what you know needs to be done.
By: Tom Hannagan Part 2 This post continues my discussion of the reasons for going through the time and trouble to analyze risk-based pricing for loans. For the discussion of the key elements involved in risk-adjusted loan pricing, please visit my earlier posts. In my last blog we discussed reason number one: good corporate governance. Governance, or responsible and disciplined leadership, makes a lot of sense and promotes trust and confidence which has been missing lately in many large financial institutions. The results can be seen in the market in multiples now and are associated with both the struggling companies and, through guilt by association, the rest of the industry. But, let’s move beyond the “soft” reason. The second major justification for going through the effort to risk-adjust loan pricing as a normal part of the lending function is financial. Profit performance By financial, we mean profit performance or bottom line earnings. This reason relies on the key belief that risk has a cost. Just because risk can be difficult to measure and/or is not addressed within GAAP, doesn’t mean it can’t ultimately cost you something. If, for any reason, you believe you can get away with taking on any unmitigated risk without it ever costing anything, do not continue reading this or any of my other posts. You are wasting your valuable time. Risk will surface The saying that “risk will out,” I believe, is true. The question is not if risk will eventually surface, but when, how and how hard it will bite. Risk can be transferred (hedges, swaps and so on), but it doesn’t disappear from the universe. Once risk is created, someone owns it. The news headlines of the past 18 months are replete with stories of huge writedowns of toxic assets. The securitized assets and/or their collateral loans always contained risk – from the moment the underlying loan was closed. The loans and their payment streams were sliced a dozen ways, repackaged and resold. The risk was also sliced up, but like mercury, it all remained in the system. Another familiar casino saying that brings this to mind is: “If you don’t know who the ‘mark’ at the table is, it’s you.” There are now several world class examples of such marks. Some have now failed completely and many more would have without federal intervention. Lending, in the leveraged/banking sense, involves all major types of risk: credit risk, market risk, operational risk and business risk. And, beyond the identifiable and potentially insurable portions of these risks, like any business, it includes the risk of unexpected loss, which needs to be covered by capital. Banks have developed policies and guidelines to mitigate, identify and measure many of their risks. These all fall under the world of risk management and these efforts all cost something. There is no free way to offset risk – other than not doing the loan at all. But lending is the business of banking, isn’t it? Further, the risk mitigation efforts cost more or less depending on the various risk characteristics of the bank’s loan portfolio each loan. For instance, a floating rate loan involves little market risk and requires little if any expense to offset. A five-year fixed rate, interest-only loan involves a lot of market risk and that costs something to offset. Alternatively, a loan with a pass risk rating of ‘2’ involves a much lower likelihood of defaulting than a loan with a pass risk rating of ‘4’. The lower risk loan; therefore, involves less of an ALLL (Allowance for Loan and Lease Losses) reserve and provisioning expense. Also, an owner occupied commercial mortgage is normally much less expensive to monitor than a credit backing a floor plan or construction project. Those cost differences could be reflected in the pricing. Finally, for today, the amount of risk capital needed to back these kinds of differing loan characteristics, for purposes of unexpected loss, is substantially different. If these kinds of differences are not priced into the loans somehow, one of two situations exists: Either the bank is not getting paid for the risk it is incurring; or, If it is, it is charging the lower risk borrowers a rate that pays for added risk-adjusted expenses of the higher risk borrowers. The business risk to the bank then becomes losing the better clients over time in lieu of attracting the riskier deals. This process has a name: adverse selection. The ongoing expenses of risk mitigation and the negative impact of unexpected losses on retained earnings, over time, materially hurt the bank’s earnings. Someone is paying for all of the risks of being in the business of lending and it’s usually one of two groups: the customers or the shareholders. In the worst of cases, it’s also the taxpayers. The idea of risk-based pricing, at the loan level, is to have the clients pay for the risks the bank is incurring on their behalf by pricing the loan appropriately from the beginning. As a result: This tends to protect, and often enhance, the bank’s financial performance; It is clever; It puts some teeth in the bank’s already existing risk management policies; It is justifiable to the client; and It even makes sense to most lending officers. Fortunately, loan pricing analysis is a scalable activity and possible for most any size bank. It is a smarter way of banking than a one-size-fits-all approach — even without considering the governance improvement.
By: Tom Hannagan Part 1 In my last three posts, we have covered the key parts of how risk-based loan pricing works. We have discussed how the key foundational elements involved in risk-adjusted loan pricing can and should relate to the bank’s accounting results and strategic policies. We went from the pricing analysis of an individual loan on a risk-adjusted basis to solving for a bank-wide target or guideline return. We also mentioned how this analysis can be expanded to the client relationship level, both producing a relationship management view of any existing loans and the impact of pricing a renewal or new credit to impact the client-level return. Finally, I mentioned that although this capability can exist (and does in more banks than ever before), it isn’t an easy undertaking in an industry that is historically keyed to volume goals rather than transaction profit (let alone risk-adjusted profit). So, why go through the effort? Moving to a risk-adjusted view of lending and relationship management requires serious thought, effort and resolve. It involves change and teaching lenders a new trick. It even suggests that the lending executive (perhaps the next president of the bank) hasn’t been doing the best job possible to protect and advance the bank’s margins. Any new undertaking involves management risk. And, accurate or not, bank executives are not generally viewed as terrific change agents. Is this concept of risk-based pricing worth all the time and trouble? We think so – for two general reasons. Corporate governance Almost any business, if not any undertaking of any kind, involves risk to some degree. Finance in general, and commercial banking, specifically, involves several kinds of risk. The most obvious risk is repayment or credit risk. Banks have been lending money successfully for a long time. The funny thing is that often, when we’ve studied the actual loan rates of a bank’s portfolio versus the bank’s own risk ratings (or risk grades), we see almost no difference in loan pricing. The banks have credit policies that discuss the different ratings in some detail. And, the banks usually have some sort of provisioning process or ALLL (Allowance for Loan and Lease Losses) logic that uses these differences in risk rating. Loan review guidelines often use the differences in risk rating to gauge the review frequency and depth. So, the banks know what’s going on. They know that a higher risk borrower/loan is less likely to be repaid in full than a lower credit risk borrower/loan. But, the lending operation goes on as if they were all about the same. There seems to be a disconnect (kind of like when my arms and brain disconnect when I swing a golf club). I know if I slow down I’ll hit a better shot, but I still swing way too fast. It seems to me that since the bank has all of these terrific policies in place dealing with credit risk, that good governance would require that credit risk be reflected more fully when loans are marketed, negotiated and agreed to – rather than just when they go awry. I would make the same general argument for management consistency associated with other risk types. If the loan duration is longer, good governance would reflect (pay for) a realistic marginal funding cost of the same duration. This would help to align the loan pricing effort with the guidelines or policies associated with ALCO or Asset and Liability Policy Committee and Interest Rate Risk (IRR) management. If a loan involves higher or lower risk of unexpected loss based on loan/collateral type and risk rating, then the risk capital associated with the loan should vary accordingly. The risk-based allocation of capital will then require different pricing in order for the loan to hit a targeted return. This protection of return, on a risk-adjusted basis, is the final step in good governance – in this case, to protect the shareholders specific contribution (of their equity) to funding the loan in question. Finally, if I were a director, regulator or an auditor (again), and I reviewed all of these fine policies related to risk management, and did not see them reflected in deal pricing, I would have to ask “why?”. It would seem that either executive management doesn’t really believe in their own policies, or they are willing to set them aside when negotiating deals for the added business. Maybe loan management doesn’t want to be bothered by the policies while they’re out there in the “real world” fighting for added loan volume. Either way, there seems to be a governance disconnect. Which I know on the golf course, leads to lost balls and unnecessary poor scores. My second major reason will follow in my next blog.
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With the National Automobile Dealers Association (NADA) Show set to kickoff later this week, it seemed fitting to explore how the shifting dynamics of the used vehicle market might impact dealers and buyers over the coming year. Shedding light on some of the registration and finance trends, as well as purchasing behaviors, can help dealers and manufacturers stay ahead of the curve. And just like that, the Special Report: Automotive Consumer Trends Report was born. As I was sifting through the data, one of the trends that stood out to me was the neck-and-neck race between Millennials and Gen X for supremacy in the used vehicle market. Five years ago, in 2019, Millennials were responsible for 33.3% of used retail registrations, followed by Gen X (29.5%) and Baby Boomers (26.8%). Since then, Baby Boomers have gradually fallen off, and Gen X continues to close the already minuscule gap. Through October 2024, Millennials accounted for 31.6%, while Gen X accounted for 30.4%. But trends can turn on a dime if the last year offers any indication. Over the last rolling 12 months (October 2023-October 2024), Gen X (31.4%) accounted for the majority of used vehicle registrations compared to Millennials (30.9%). Of course, the data is still close, and what 2025 holds is anyone’s guess, but understanding even the smallest changes in market share and consumer purchasing behaviors can help dealers and manufacturers adapt and navigate the road ahead. Although there are similarities between Millennials and Gen X, there are drastic differences, including motivations and preferences. Dealers and manufacturers should engage them on a generational level. What are they buying? Some of the data might not come as a surprise but it’s a good reminder that consumers are in different phases of life, meaning priorities change. Over the last rolling 12 months, Millennials over-indexed on used vans, accounting for more than one-third of registrations. Meanwhile, Gen X over-indexed on used trucks, making up nearly one-third of registrations, and Gen Z over-indexed on cars (accounting for 17.1% of used car registrations compared to 14.6% of overall used vehicle registrations). This isn’t surprising. Many Millennials have young families and may need extra space and functionality, while Gen Xers might prefer the versatility of the pickup truck—the ability to use it for work and personal use. On the other hand, Gen Zers are still early in their careers and gravitate towards the affordability and efficiency of smaller cars. Interestingly, although used electric vehicles only make up a small portion of used retail registrations (less than 1%), Millennials made up nearly 40% over the last rolling 12 months, followed by Gen X (32.2%) and Baby Boomers (15.8%). The market at a bird’s eye view Pulling back a bit on the used vehicle landscape, over the last rolling 12 months, CUVs/SUVs (38.9%) and cars (36.6%) accounted for the majority of used retail registrations. And nearly nine-in-ten used registrations were non-luxury vehicles. What’s more, ICE vehicles made up 88.5% of used retail registrations over the same period, while alternative-fuel vehicles (not including BEVs) made up 10.7% and electric vehicles made up 0.8%. At the finance level, we’re seeing the market shift ever so slightly. Since the beginning of the pandemic, one of the constant narratives in the industry has been the rising cost of owning a vehicle, both new and used. And while the average loan amount for a used non-luxury vehicle has gone up over the past five years, we’re seeing a gradual decline since 2022. In 2019, the average loan amount was $22,636 and spiked $29,983 in 2022. In 2024, the average loan amount reached $28,895. Much of the decline in average loan amounts can be attributed to the resurgence of new vehicle inventory, which has resulted in lower used values. With new leasing climbing over the past several quarters, we may see more late-model used inventory hit the market in the next few years, which will most certainly impact used financing. The used market moving forward Relying on historical data and trends can help dealers and manufacturers prepare and navigate the road ahead. Used vehicles will always fit the need for shoppers looking for their next vehicle; understanding some market trends will help ensure dealers and manufacturers can be at the forefront of helping those shoppers. For more information on the Special Report: Automotive Consumer Trends Report, visit Experian booth #627 at the NADA Show in New Orleans, January 23-26.
The automotive industry is constantly changing. Shifting consumer demands and preferences, as well as dynamic economic factors, make the need for data-driven insights more important than ever. As we head into the National Automobile Dealers Association (NADA) Show this week, we wanted to explore some of the trends in the used vehicle market in our Special Report: State of the Automotive Finance Market Report. Packed with valuable insights and the latest trends, we’ll take a deep dive into the multi-faceted used vehicle market and better understand how consumers are financing used vehicles. 9+ model years grow Although late-model vehicles tend to represent much of the used vehicle finance market, we were surprised by the gradual growth of 9+ model year (MY) vehicles. In 2019, 9+MY vehicles accounted for 26.6% of the used vehicle sales. Since then, we’ve seen year-over-year growth, culminating with 9+MY vehicles making up a little more than 30% of used vehicle sales in 2024. Perhaps more interesting though, is who is financing these vehicles. Five years ago, prime and super prime borrowers represented 42.5% of 9+MY vehicles, however, in 2024, those consumers accounted for nearly 54% of 9+MY originations. Among the more popular 9+MY segments, CUVs and SUVs comprised 36.9% of sales in 2024, up from 35.2% in 2023, while cars went from 44.3% to 42.9% year-over-year and pickup trucks decreased from 15.9% to 15.6%. 2024 highlights by used vehicle age group To get a better sense of the overall used market, the segments were broken down into three age groups—9+MY, 4-8MY, and current +3MY—and to no surprise, the finance attributes vary widely. While we’ve seen the return of new vehicle inventory drive used vehicle values lower, it could be a sign that consumers are continuing to seek out affordable options that fit their lifestyle. In fact, the average loan amount for a 9+MY vehicle was $19,376 in 2024, compared to $24,198 for a vehicle between 4-8 years old and $32,381 for +3MY vehicle. Plus, more than 55% of 9+MY vehicles have monthly payments under $400. That’s not an insignificant number for people shopping with the monthly payment in mind. In 2024, the average monthly payment for a used vehicle that falls under current+3MY was $608. Meanwhile, 4-8MY vehicles came in at an average monthly payment of $498, and 9+MY vehicles had a $431 monthly payment. Taking a deeper dive into average loan amounts based on specific vehicle types—as of 2024, current +3MY cars came in at $28,721, followed by CUVs/SUVs ($31,589) and pickup trucks ($40,618). As for 4-8MY vehicles, cars came in with a loan amount of $22,013, CUVs/SUVs were at $23,133, and pickup trucks at $31,114. Used 9+MY cars had a loan amount of $19,506, CUVs/SUVs came in at $17,350, and pickup trucks at $22,369. With interest rates remaining top of mind for most consumers as we’ve seen them increase in recent years, understanding the growth from 2019-2024 can give a holistic picture of how the market has shifted over time. For instance, the average interest rate for a used current+3MY vehicle was 8.0% in 2019 and grew to 10.2% in 2024, the average rate for a 4-8MY vehicle went from 10.3% to 12.9%, and the average rate for a 9+MY vehicle increased from 11.4% to 13.8% in the same time frame. Looking ahead to the used vehicle market It’s important for automotive professionals to understand and leverage the data of the used market as it can provide valuable insights into trending consumer behavior and pricing patterns. While we don’t exactly know where the market will stand in a few years—adapting strategies based on historical data and anticipating shifts can help professionals better prepare for both challenges and opportunities in the future. As used vehicles remain a staple piece of the automotive industry, making informed decisions and optimizing inventory management will ensure agility as the market continues to shift. For more information, visit us at the Experian booth (#627) during the NADA Show in New Orleans from January 23-26.
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