Stay Ahead of the Curve on Credit and Fraud Risk

With fraud becoming a consistent player in recent headlines and a liquidity crunch that’s dragged on, credit unions and other lenders face myriad challenges regarding credit risk and fraud mitigation — and improved underwriting may be the solution. 

Anyone in the lending space knows originations are a challenge right now. Interest rates remain high—although with the promise of cuts to come—and demand has stayed relatively steady, but liquidity is tight for everyone.

The last two years have been some of the most challenging for financial institutions in over a decade, and the unprecedented rate cycle caused difficulties for large and small credit unions and community banks.

Interest rates went up, but demand remained—relatively speaking. If somebody wants to go to school, for example, they need to get a loan, regardless of the rate. So, while loan demand dropped maybe 20-30%, it’s still healthy. That’s where the liquidity challenges come in. Even though there’s the demand, credit unions haven’t necessarily had the capital to fund those loans.

That’s a huge challenge.

Delinquencies are the other side of this coin. The cost of living and inflation are rising, and consumers generally feel the strain. We’ve all seen the news: Delinquencies are up and continuing to rise. Not at the same level as 2008, nothing like that, but definitely up a good 30-40 percent, with auto loans tending to be the last to go. If auto loans start defaulting, it’s typically an indicator of trouble ahead.

Verify to qualify

So, how can lenders avoid delinquency trouble in the first place? Solid underwriting is a good place to start. During economic turbulence, underwriting becomes even more critical to ensuring loan quality and minimizing risk.

Tightening income verification is a critical first step for improving underwriting: make sure they have enough money to pay back that loan. It sounds obvious, but assessing that ability to pay is critical.

Rigorous income verification and prudent underwriting practices to accurately assess borrowers’ repayment capacity are non-negotiables. Financial institutions need to move away from relying on income verification documents provided by the consumer and start going directly to the source itself to get the income information, such as connecting directly to the payroll provider or the bank account — and always be looking for increased first-party fraud.

Everyone wants to earn more money

First-party fraud involves consumers providing false information, particularly inflated income documents. Lenders are starting to see some first-party fraud in the form of fake income documents with inflated incomes, according to the Risk team at LendKey.

This form of fraud poses a significant challenge for lenders, as it undermines the integrity of the underwriting process and increases the risk of default. More notably, while third-party fraud (individuals assuming the identity of legitimate consumers) tends to steal the spotlight, the former has seen a notable increase. But typically it’s not malicious, but more out of desperation. The cost of living crisis, inflation, stagnant wages… People are desperate for a loan.

Of course, there’s a delicate balance between mission and margin for credit unions particularly whose ethos is to support individuals on their financial journey. Credit unions provide access to financial products, including loans, to those who are often overlooked or underserved by other financial institutions precisely because they’re seen as “high risk.” It can be tricky serving those consumers, and the reality is the people who really need the money are not always able to get it.

A measured approach to subprime lending while maintaining portfolio stability can be the best way to go: try testing in small segments of the subprime space and learn from that. Because when you say “subprime,” it’s really FICO’s thing. And FICO does have its flaws. So, can you identify a pocket of consumers whose FICO may be low but whose likelihood to pay is strong? That’s a way credit unions and other financial institutions can “test the waters.”

Collections

The importance of influential collections management in mitigating credit risk and minimizing losses should also be emphasized here. Drawing from industry experience during the 2008 recession, excellent collection strategies, solid monitoring, weekly monitoring, daily monitoring and having a very strong collection process are key.

A comprehensive approach, including in-house collection efforts and strategic outsourcing partnerships, is crucial, particularly for clients lacking dedicated collection teams. Make sure you have a plan, then execute it.

Lenders can navigate this challenging environment by prioritizing income verification, employing robust fraud detection measures, and refining risk assessment practices. Additionally, a well-defined collections strategy, with a blend of in-house expertise and strategic partnerships, can further strengthen a lender’s position. By taking these proactive steps, financial institutions can stay ahead of the curve on credit and fraud risk, ensuring their and their members’ financial health.