We all purchase insurance policies for one fundamental reason – to protect against unexpected events. No one plans to have an automobile accident or to have a tree fall on their home, and insurance provides valuable peace of mind that, should significant unexpected events such as these occur, they don’t translate into financial hardships or major life disruptions. Lenders must adopt a similar mindset as they manage the health of their consumer lending portfolios to insulate their existing book of business from potential risk volatility.
As we discussed in part 1 of this blog series, FICO® Resilience Index (FRI) was designed with precisely this capability in mind. Leveraging FICO Resilience Index to refine credit risk decisions during benign economic phases defends against dramatic swings in delinquency rates and provides for a more consistent portfolio management approach over time.
Undoubtedly, systemic financial assistance programs such as federal stimulus payments and the availability of lender-provided payment accommodations have prevented the dramatic increases in delinquencies and losses we witnessed in 2008-9. Impressively, the Federal Reserve reported Q1 2021 delinquency rates on all consumer loans of 1.74%, the lowest mark in the 30+ years it has been tracked.1 Despite this good news, there is widespread skepticism on how far and how fast the pendulum will eventually swing in the opposite direction. According to the Consumer Financial Protection Bureau (CFPB), signs of trouble are already brewing. In March 2021, the CFPB reported that over 11 million US families are behind on their mortgage or rent payments, with homeowners nearly $90 billion in arrears.2
Of course, credit risk is only one aspect of portfolio health. For revolving credit portfolios in particular, proper attention must be directed toward maintaining balance and revenue growth. As was the tactic during the recession over a decade ago, lender response in early 2020 – with few exceptions – was a full cessation of limit increases, balance transfer offers, and other spend incentive programs. The result was further downward pressure on an already cautious consumer spending climate during the pandemic, waning average balances and, along with them, significant reductions in interest and non-interest income that have many lenders grappling with the idea of aggressive spend stimulus programs.
Leveraging FICO® Resilience Index can improve revolving account exposure management strategies by balancing the need to manage credit risk in the face of economic uncertainty while encouraging healthy balance growth. By constraining exposure across more sensitive customer segments, the delinquency impacts associated with unexpected economic downturns are mitigated. At the same time, uninterrupted limit increase programs coupled with spend incentives to the most resilient segments help promote usage, balance, and revenue growth.
Two-layered risk appetite approach to customer management without FICO® Resilience Index
To carry the use case forward a bit, let’s first consider exposure management in an unstressed environment. As we discussed in part 2 of this blog series, which focused on customer acquisition decisions, lenders are more frequently adopting a two-layered risk appetite approach. Recognizing that downturns are a regular part of the economic cycle, a portfolio manager may define their limit increase target population as customer segments with expected default rates below X% and stressed default rates below Y%. For the sake of our credit limit increase illustration, let’s suppose the stated risk appetite requires default rates below 5% during a benign economy and below 7% during stressed economic conditions.
Based on observed industry-wide 90+ days past due default rates for bankcard account management during benign and stressed economic periods (Figure 1), our example risk appetite would mean raising the “normal” limit increase inclusion FICO® Score cutoff from 680 to 720.
Expanding our exposure management illustration to include limit decreases, suppose the stated risk appetite is default rates above 10% during a benign economy and above 15% during stressed economic conditions. Using a two-layered risk appetite statement would mean raising the “normal” limit decrease inclusion FICO® Score cutoff from < 640 to < 660.
Introducing different levels of limit increases and decreases, the complete range of customer treatments by risk appetite may be expressed as shown in Figure 2. Highest risk customers are targeted for limit decreases either to their existing balance or by trimming 50% of their existing available credit, or “open-to-buy” (OTB). Limits within moderate risk ranges are unchanged while low risk segments qualify for different tiers of limit increase amounts.
Applying this strategy to a portfolio with the projected unstressed and stressed economy default rates shown in Figure 3 yields a range of limit increase and decrease actions. The final “dominant” treatment is based on the more restrictive action associated with the FICO® Score band. Here, the more restrictive actions happen to align to those from the stressed scenario, but this may vary depending on the risk appetite statement and the default rates by FICO Score band in each scenario.
Two-layered risk appetite approach to customer management including FICO® Resilience Index
Factoring in FICO® Resilience Index makes our illustrated exposure management treatment significantly more informed and targeted. The table in Figure 4 shows account default rates during an unstressed economy by both FICO® Score and FICO Resilience Index. Again, limit management actions are allocated according to our stated risk appetite during an unstressed economy.
Figure 5 repeats the above exercise, but this time we apply the approach to the stressed economic period.
Finally, our illustration of the combined, or two-layered, risk appetite statement identifies the target populations that meet the required criteria for both the unstressed and stressed economy treatment approaches. Again, the dominant treatment is based on the more restrictive action associated with the FICO® Score band and FICO® Resilience Index quintile between the unstressed and stressed economic scenarios. Figure 6 summarizes the combined treatment approach and highlights the shift in limit action allocation through swap in/out groups and segments that receive a more generous or aggressive action as compared to the original FICO Score-based strategy approach.
Leveraging this approach over time, based on your own risk appetite, enhances portfolio resilience by reducing exposure to sensitive customers whose performance would markedly deteriorate during economic downturns while favoring resilient customers whose performance would be more stable through troubled times.
Relevance to other customer management decisions
Nearly any risk-based decision may be improved by considering the degree to which a stressed economic climate is likely to impact a consumer’s ability to repay their debts. In addition to improving exposure management decisions as illustrated above, FICO® Resilience Index can enhance numerous other customer management decisions (Figure 7), such as:
- Authorizations – Refine transaction approval and decline decisions for over-the-limit transactions based on customer resilience.
- Marketing & Pricing – Target spend incentive campaigns that favor more resilient customer segments. Promote usage and loyalty via product upgrades and deepen customer relationships via cross-sell campaigns in low FICO® Resilience Index ranges.
- Account Renewal – Adjust renewal decisions in customer segments based on likelihood of negative performance during economic downturns.
- Pre-Delinquent Collections – Accelerate collections efforts at the missed payment due for customers who are deemed sensitive based on FICO® Resilience Index. Target resilient customer segments with non-invasive courtesy notifications via digital outreach.
Look out for the final segment of our series in the coming weeks, “Building Resilience into Collections and Recovery.” Please visit the FICO Blog to keep up to date on all of FICO’s latest insights and offerings.
To gain more background about the FICO® Resilience Index, please visit https://www.fico.com/en/products/fico-resilience-index.
1 “Delinquency Rate on Consumer Loans, All Commercial Banks.” FRED, 24 May 2021, http://fred.stlouisfed.org/series/DRCLACBS.
2 “New Report From Consumer Financial Protection Bureau Finds Over 11 Million Families At Risk Of Losing Housing.” Consumer Financial Protection Bureau, 1 Mar. 2021, http://www.consumerfinance.gov/about-us/newsroom/new-report-from-consumer-financial-protection-bureau-finds-over-11-million-families-at-risk-of-losing-housing/.
This blog is co-authored with FICO Senior Principal Consultant, David Binder.
