The Profitability Paradox

In the middle of a recession — or what seems like one — you get what I call the profitability paradox. Simply put, banks don’t want to lend to customers who want credit, even though these tend to be the most profitable customers.

How does this work? If a customer asks for credit during a recession, the first thought in a risk manager’s head is, “Wow, they must be in trouble.” This is a natural response, because in a down market uncertainty, unemployment, reduced wages and other factors make both banks and consumers more conservative. People actively seeking credit may have cash flow problems, which means they are higher risk.

At the same time, the entire bank is under pressure to increase or at least maintain return on capital. And profitable customers are often those who need credit and are willing to pay for it.

How do you solve the paradox? The best answer is, look inside your portfolio! Properly managed, your existing portfolio can not only keep the return on capital but even increase it.

But before mining that portfolio for potential credit extensions, you must do three things:

1. Define a methodology to understand each customer’s ability to afford new credit, so you don’t make them an offer they not only can’t refuse, they can’t handle.
2. Compare your existing exposure against the customer’s capacity.
3. Then take a pragmatic approach to increasing exposure with the customer.

It is FICO’s experience that many portfolios offer a big opportunity for cross-selling other products and increasing your share of wallet. Taking these three wise actions will also reduce the overall risk of your portfolio, releasing capital consumption. I will discuss each item in future blog posts. Stay tuned!