While the search for yield has gotten a lot of attention the past year due to painfully low interest rates and surging deposits, lack of diversification has become an even bigger balance sheet management priority.
Here are three areas where diversification can be a challenge for credit unions and banks — and one big idea for what they can do about it.
It’s no secret that mortgages and home improvement loans have been on the rise over the past year, thanks to low interest rates and changing consumer behavior. Banks and credit unions with expertise in these types of loans have experienced a flurry of activity as a result.
But while an increase in originations is always welcome, for many institutions this created portfolio concentrations in a few areas with similar risk profiles and terms. Consumers have more money available to them due to federal stimulus programs, and credit unions aren’t able to offset increased mortgages with personal unsecured loans and credit cards from their member base.
As a result, too many loans concentrated in a few asset types can also create credit risk because it concentrates borrowers, many of whom carry a similar credit risk profile. In a downturn, the financial situation of this group of borrowers can change quickly––and in tandem.
Credit unions need new sources of loans and borrowers to diversify along asset type and credit risk.
As local fixtures, credit unions and community banks typically make loans in one or two specific geographic areas. Not only does it make for good community relations to lend locally, but there’s also a level of comfort in knowing who your borrowers are. However, in an economic downturn, some areas get hit harder than others — making geographic concentration a bit of a balance sheet gamble.
For example, according to Brookings, the shuttering of hospitality-related businesses early in the pandemic dealt a huge blow to locales like Las Vegas and Orlando, both of which rely heavily on tourism. The increased use of technology during Covid-19, on the other hand, was a boon for tech hubs like Seattle and the Bay Area. The result was significantly higher unemployment rates in Las Vegas and Orlando than in Seattle or San Francisco.
3. Loan sourcing
Credit unions and banks that look outside their own organizations to source loans may be solving their borrower diversification challenge, but they could be running a different risk.
Sourcing loans from external originators or marketplace lenders can introduce asset diversification, especially if that lender offers multiple product types that a financial institution doesn’t typically have access to, such as personal unsecured, solar, or credit card loans. But relying on the same originator or marketplace lender over and over again can expose your financial institution to lender risk. What happens to those loans if the lender runs into financial issues or stops originations?
Balance sheet diversification made easy
Balance sheet diversification may have been less of a priority when normal lending activities naturally resulted in diversified portfolios of loans. But a perfect storm of circumstances has made diversification more elusive. Thankfully, there is a solution available to credit unions and banks that makes diversifying across all four of the above categories easier than it used to be: loan participations.
Loan participations allow the sharing of loans among multiple institutions, giving credit unions and banks access to new, diversified assets. Until recently, loan participations were more challenging and often out of reach for all but the biggest players, but technological innovations have made them easier and more cost-effective than ever. Buyers can enjoy the diversification and other benefits of new loans without the burdens of marketing, origination, or servicing required to process them in-house.
ALIRO is a balance sheet management platform that provides financial institutions access to multiple loan participation deals and sources. ALIRO can help streamline the loan participation process, reducing costs and frictions among buyers and sellers. In general, loan participations conducted through Aliro tend to involve less paperwork and transaction costs, especially when considering its recurring nature.
In addition, ALIRO’s “forward flow” functionality allows buyers and sellers to better plan and anticipate supply and demand in the lending marketplace through recurring loan participations which can help diversify your portfolio.
With tools like loan participations and the ALIRO platform, you can better diversify across assets, geographies, lenders, and loan sources — and keep risk in check.