Dear Gini,

We established our underwriting strategies sometime ago, and we monitor them regularly. Management has asked how we use economic data that may not be part of our current strategies but might suggest changes that our tracking might not detect until some time in the future. For example, an increase in regional unemployment rates might indicate an increase in loan defaults and slow payments in that location. Ideally, we would like to get ahead of the game and make adjustments to our models before we book accounts that negatively impact the performance or our credit portfolio. What do you suggest?

Mr. Vigilant

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Dear Mr. Vigilant,

Kudos for your effort to get ahead of the game. I’ve received this question several times in a variety of ways. The challenge is that scoring models are developed on a sample of historical performance which might be two or more years old when the model is implemented. It’s kind of like driving a car forward while looking at what’s behind you in the rearview mirror. Calamity is bound to strike if you don’t face what’s in front of you.

A best practice when building a risk assessment strategy based on a historical model is to include other non-historical factors that compensate for issues external to the model. Usually you can modify the strategy’s economic based on current conditions. This is true for income levels or adjustments to lines of credit.

So how do you decide what adjustments to make when you account for economic changes, such as inflation rates, unemployment, and other economic indicators? How do you translate rising unemployment into a specific strategy change? How do you know what the actual impact to the economy as a whole and to your portfolio specifically will be? How do you deal with the impact? Do you focus on account management, the originations process or a combination of both? What do you change and how do you estimate the impact of those changes? How many licks to the center of a Tootsie Pop? Sorry about that – got a little carried away with asking questions. However, these questions are important to consider when being ‘vigilant’ about your process.

You can start with the work done in the area of reporting and capital adequacy to meet the Basel accords requirements, including economic stress testing in response to dramatic economic changes. Build upon this analysis to adjust your risk tolerance levels.

Furthermore, our experience indicates the best approach to increasing (or decreasing) risk projected by rising or falling indices is to make changes to cutoff or score breaks. This accounts for the perceived increase or decrease in expected risk levels. You can then anticipate changes in acceptance rates, revenues, and losses. You can easily change back should the predicted economic disaster never materialize. So, get those eyes front and stop always looking in the rearview mirror.

Good luck,
Gini

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