Consumer Loans: What To Know About Inherent Risks and Applicable Regulations
Safety and soundness standards play a crucial role in consumer credit. Financial institutions play a dominant role in accelerating economic activities and growth. A banking system that is not functioning hinders economic growth and may send negative shocks throughout the entire economy. Financial institutions earn money in three basic ways: (1) the difference between the interest rate paid for deposits and the interest rate received from loans (spread), (2) interest from securities, and (3) fees for customer services. Financial institutions had relied on overdrafts and non-sufficient fees as a significant source of revenue, but these revenues have declined in 2022.
Consumer loans are the largest asset and predominant source of revenue for financial institutions today, having customers pay interest on their loans at either fixed or variable rates. The most common types of consumer loans are mortgages, credit cards, education loans, home equity loans, and personal loans. Financial institutions create or generate “new” money whenever they make loans. According to the Federal Deposit Insurance Corporation’s 2021 National Survey of Unbanked and Underbanked Households, approximately 95.5 percent of U.S. households had some form of bank account in 2021, and an estimated 72.5 percent had a credit card or bank personal loan. Unfortunately, consumer loans (in particular, unsecured loans) are the greatest source of risk to a financial institution’s safety and soundness.
The Board of Governors of the Federal Reserve System states, in part, “For most banks, loans are the largest and most obvious source of credit risk.” Safety and soundness rating indicates whether a financial institution is robust enough to withstand fluctuations in the economy, or whether it has weaknesses. Safety and soundness are important because financial shocks in one area can spill across financial sectors and even national borders. Credit risk in consumer loans is a crucial indicator of safety and soundness for financial institutions because borrowers’ failure to repay a loan results in financial loss in the form of owed principal and interest. Let’s dive deeper into what that risk entails.
Consumer Credit Risk
Consumer credit risk is the risk of loss due to failure or inability to pay on a credit product (e.g., mortgage, unsecured loan, credit card). Credit risk (also known as default risk) can be measured by credit history, capacity to repay, capital, loan condition, and associated collateral. Causes of credit risk can be a concentration of particular loans, incomplete credit assessment, subjective decisions, and inadequate monitoring, to name a few. The financial crisis of 2007-2008 highlighted the importance of credit risk management as an integral component of sustainability. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) was a direct result of the 2007-2008 financial crisis. The purpose of the Dodd-Frank Act is to prevent excessive risk by financial institutions. That, of course, added more mechanisms to enable the government to regulate and enforce laws against financial institutions. All financial institutions that lend money to individuals/businesses are exposed to credit risk. Financial institutions can face a multitude of credit risks:
- Default risk (unable or unwilling to pay),
- Concentration risk (relying heavily on a particular industry),
- Country risk (country defaulting on its financial obligations),
- Downgrade risk (falling credit rating),
- Institutional risk (breakdown in the legal structure).
In addition, loan purchases from other financial institutions can have a significant impact on sound risk management. Federal banking laws and regulations permit banks to sell mortgages or transfer the serving rights to other banks. The Office of the Comptroller of the Currency goes into detail regarding loan purchasing activities and risk management. Credit risk is inversely associated with bank performance. Capital adequacy ratio, loan loss provision ratio, liquidity ratio, and non-performing loan ratio variables have a significant impact on return on assets (ROA). Credit risk managers need to be cautious about nonperforming loans, loans and advances, and the liquidity ratio because these ratios negatively affect banks' profitability.
Mitigating Consumer Credit Risk
Credit risk mitigation is an attempt by lenders to minimize the risk of losing all of their original investment (loans or debt) due to borrowers (individual or business) defaulting on their interest and principal payments. The underlying intention is to ensure the financial institution remains profitable so that the ability to repay a loan is not jeopardized. One of the most basic and most commonly used methods to mitigate a customer’s credit risk is to require collateral and/or guarantees to secure the debt. A scenario of credit risk with collateral or guarantees is that the customer may sell or double-pledge the collateral without the consent or knowledge of the original lender. A more common scenario to consider in credit risk is declining collateral value (e.g., equipment) which negatively impacts Loan-to Value-Ratio (LTV). An important consideration in declining collateral value is the financial institutions’ risk tolerance. To determine a customer’s creditworthiness, a financial institution typically:
- Checks credit reports,
- Assesses financial reports,
- Evaluates the debt-to-income ratio,
- Conducts credit investigation,
- Performs credit analysis.
In my 20 years working with financial institutions, one of the most significant and most overlooked aspects is assessing the personal financial statement of the applicant. In simple terms, the personal financial statement is a document the customer completes (sometimes with the assistance of a chartered professional accountant (CPA), financial planner, lender, etc.) which provides a snapshot of the personal financial position at a specific point in time. In part, the personal financial statement lists assets, liabilities, and net worth. A financial institution may use the personal financial statement to identify financial risks and provide a warning to avoid risks. In order to avoid surprises of the loan not performing, financial institutions may consider verifying all the information on the personal financial statement in order to avoid complacency when the document was completed by a CPA, financial planner, or another professional (which is dependent on the information provided by the customer). Personal financial statements should be visited often and not just twice a year. Particularly, if the loan terms are modified or extended. The financial institution may consider physically verifying the collateral or using a third party to monitor throughout the duration of the loan to mitigate credit risk.
Consumer Finance Protection
With all the measures financial institutions have to consider when extending credit, it may become overwhelming to identify and keep track of all the laws, regulations, and rules that not only protect consumers but satisfy federal and state regulators. There are a myriad of regulatory bodies, laws, and regulations that protect consumer lending. Financial institutions need to ensure fair and responsible treatment of financial consumers in their purchases, use of financial products, and their dealings with financial service providers. Consumers are encouraged by regulatory bodies to report and file complaints if they experience any unfair practices in their dealings with financial institutions. In 2022, the Consumer Financial Protection Bureau received over one million consumer complaints. Depending on the type of charter they have and their organizational structure, financial institutions may be subject to numerous federal and state banking regulations.
States use a variety of agencies and statutes to enforce consumer financial protection, expanding on federal law in many areas. Section 1042 of the Consumer Financial Protection Act of 2010 authorizes states to enforce its provisions dealing with consumer financial matters. There are state-specific regulatory bodies that oversee the operations of financial institutions within their jurisdiction. These agencies also regulate and license non-traditional financial companies, such as mortgage lenders, pawn shops, and payday lenders. It may be a surprise that state regulators supervise over ¾ of the nation’s banks. Federal and state financial regulators continuously collaborate with one another to ensure the U.S. financial system is safe, sound, and resilient.
Since the start of the year, Regology has tracked more than 1500 changes to laws and regulations around consumer protection using our AI-powered platform. This includes 1,000+ laws, regulations, and rules at the state level and 120+ at the federal level. Consumer credit relies heavily on safety and soundness standards in order for financial institutions to drive healthy economic activities and promote growth. It is difficult to argue the role played by financial institutions in the economy and the importance of their services. In particular, the services provided to businesses that depend on financial institutions to fulfill their running finance requirements. Financial institutions, when performing with adequate capital and following federal and state requirements, are like the blood arteries in the human body and need to maintain a healthy flow. If you would like to learn about an automated way to track and update your list of laws and regulations for the financial industry, please visit our dedicated page or download our free brochure. Regology’s regulatory intelligence platform helps you reap significant ROI by boosting operational efficiencies, automating manual processes, and having all of your state-by-state banking regulations and compliance programs funneled into one consolidated platform.
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