Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
Although some institutions develop their own scoring
models, most are built by outside vendors and subsequently
maintained by the institution. Vendors build scoring
models based upon specific information and parameters
provided by bank management. Therefore, management
must clearly communicate with the vendor and ensure that
the scorecard developer clearly understands the bank’s
objectives. Bank management should also adhere closely
to vendor manual specifications for system maintenance
and management, particularly those that provide guidance
for periodically assessing performance of the system.
Scoring models generally become less predictive as time
passes. Certain characteristics about an applicant, such as
income, job stability, and age change over time, as do
overall demographics. One-by-one, these changes will
result in significant shifts in the profile of the population.
Once a fundamental change in the profile occurs, the model
is less able to identify potentially good and bad applicants.
As these changes continue, the model loses its ability to
rank order risk. Thus, institutions must periodically
validate the system’s predictability and refine scoring
characteristics when necessary. These efforts should be
documented.
Institutions initially used credit scoring for consumer
lending applications such as credit card, auto, and
mortgage lending. However, credit scoring eventually
gained acceptance in the small business sector. Depending
on the manner in which it is implemented, credit scoring
for small business lending may represent a fundamental
shift in underwriting philosophy if institutions view a small
business loan as more of a high-end consumer loan and,
thus, grant credit more on the strength of the principals’
personal credit history and less on the fundamental strength
of the business. While this may be appropriate in some
cases, it is important to remember that the income from
small business remains the primary source of repayment for
most loans. Banks that do not analyze business financial
statements or periodically review their lines of credit may
lose an opportunity for early detection of credit problems.
The effectiveness of any scoring system directly depends
on the policies and procedures established to guide and
enforce proper use. Policies should include an overview of
the institution’s scoring objectives and operations; the
establishment of authorities and responsibilities over
scoring systems; the use of a chronology log to track
internal and external events that affect the scoring system;
the establishment of bank officials responsible for
reporting, monitoring, and reviewing overrides; as well as
the provision of a scoring system maintenance program to
ensure that the system continues to rank risk and to predict
default and loss under the original parameters.
Examiners should refer to the Credit Card Specialty Bank
Examination Guidelines and the Credit Card Activities
section of the Examination Modules for additional
guidance on credit scoring systems.
SUBPRIME LENDING
Introduction
There is not a universal definition of a subprime loan in the
industry, but subprime lending is generally characterized as
a lending program or strategy that targets borrowers who
pose a significantly higher risk of default than traditional
retail banking customers. Institutions often refer to
subprime lending by other names such as the nonprime,
nonconforming, high coupon, or alternative lending
market.
Well-managed subprime lending can be a profitable
business line; however, it is a high-risk lending activity.
Successful subprime lenders carefully control the elevated
credit, operating, compliance, legal, market, and reputation
risks as well as the higher overhead costs associated with
more labor-intensive underwriting, servicing, and
collections. Subprime lending should only be conducted
by institutions that have a clear understanding of the
business and its inherent risks, and have determined these
risks to be acceptable and controllable given the
institution’s staff, financial condition, size, and level of
capital support. In addition, subprime lending should only
be conducted within a comprehensive lending program that
employs strong risk management practices to identify,
measure, monitor, and control the elevated risks that are
inherent in this activity. Finally, subprime lenders should
retain additional capital support consistent with the volume
and nature of the additional risks assumed. If the risks
associated with this activity are not properly controlled,
subprime lending may be considered an unsafe and
unsound banking practice.
The term, subprime, refers to the credit characteristics of
the borrower at the loan’s origination, rather than the type
of credit or collateral considerations. Subprime borrowers
typically have weakened credit histories that may include a
combination of payment delinquencies, charge-offs,
judgments, and bankruptcies. They may also display
reduced repayment capacity as measured by credit scores,
debt-to-income ratios, or other criteria. Generally,
subprime borrowers will display a range of credit risk
characteristics that may include one or more of the
following:
DSC Risk Management Manual of Examination Policies 3.2-65 Loans (12-04)
Federal Deposit Insurance Corporation