Discuss the retail credit risk "dark side" and what is being done to deal with it.
The idea
The dark side of retail credit is the harm that follows when lending growth outruns prudence. Examples are predatory or subprime lending, loans made without verifying income, teaser-rate products that reset to unaffordable payments, over-indebtedness across several lenders, and unfair or discriminatory practices. Originate-to-distribute made it worse, because an originator that sells every loan has little reason to care about its quality. The responses are rules and controls. These include ability-to-repay requirements and income verification, qualifying borrowers at the fully indexed payment rather than the teaser payment, and risk retention by securitisers so they keep a share of the loss. They also include affordability checks using credit bureau data on total debt, fair-lending testing of scorecards for disparate impact, and stress testing. The exam point is that the fix targets incentives and affordability, not just pricing.
A practice question
Which description best fits the so-called dark side of retail credit?
- Excessively tight credit rationing that leaves the bank with unused capital and low profits.Why not: Describes conservative underwriting, which is not the harm associated with the dark side.
- Concentration of lending in a few large corporate names whose defaults are strongly correlated with each other.Why not: A wholesale concentration issue, not a retail conduct and affordability issue.
- Lending to borrowers who cannot afford it, through predatory terms and weak underwriting, harming borrowers and lenders. - correct
- Currency translation losses on foreign subsidiaries' retail books.Why not: A translation accounting issue unrelated to abusive or unaffordable lending.
The dark side is aggressive growth in unaffordable, opaque or abusive lending. Its fixes are affordability rules, incentives and conduct oversight.
A harder one
A mortgage originator sells 100% of its loans into securitisations the day after closing and has loosened underwriting standards. Which mechanism best addresses the misaligned incentive?
- A rule that the originator retain a share of the credit risk, such as 5% of each securitisation. - correct
- A requirement to disclose rating agency fees in the offering document.Why not: Fee disclosure is a transparency measure that does not restore the originator's stake in loan quality.
- A cap on the interest rate charged to the end borrowers of the underlying mortgages.Why not: A price cap does not alter the incentive to originate poor loans.
- A reduction in deposit insurance premiums for those banks that securitise more of their loans.Why not: This would encourage originate-to-distribute, not discourage it.
Originate-to-distribute weakens the incentive to screen. Risk retention (skin in the game) makes the originator bear part of the losses and so aligns the incentive.
The hardest tier
A lender offers a USD 300,000 hybrid mortgage: a 30-year amortising loan at 4.0% fixed for 24 months, then 8.5% for the remaining 336 months, with monthly payments. The borrower earns USD 6,500 per month gross and has other debt payments of USD 500 per month. The lender wants to avoid the payment shock problem. The back-end debt-to-income ratio at the reset payment is closest to:
- 29.7%Why not: Qualifies the borrower at the teaser payment, which is the practice that hides payment shock.
- 34.8%Why not: Uses a front-end ratio: omits the USD 500 of other debt payments from the numerator.
- 42.5% - correct
- 39.2%Why not: Treats the reset payment as interest only and ignores principal amortisation over the remaining term.
After 24 payments of 1,432 the balance is about 289,219. The reset payment over 336 months at 8.5% is about 2,260. Back-end DTI = (2,260 + 500) / 6,500 = 42.5%. Qualify at the fully indexed payment, not the teaser payment.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Credit Scoring and Retail Credit Risk Management
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- State what types of credit risk scoring model exist, which variables they rely on and how they are used.
- Discuss which variables matter when assessing a mortgage borrower, and how a credit scoring model uses cutoff scores together with default and loss rates.
- Explain how a scorecard is measured and monitored over time, drawing on the cumulative accuracy profile (CAP) and accuracy ratio (AR) techniques.
- Lay out the stages of the customer relationship cycle and the trade-off that arises between how creditworthy a client is and how profitable.
- Review what is gained from pricing financial services according to risk.