A lending strategy refers to the guidelines and practices a lender uses to decide which loans to approve and offer. It encompasses how a lender assesses risk, sets interest rates, and structures loan terms for different types of borrowers and loan products. An effective lending strategy aligns with a lender’s business objectives and risk tolerance.
Why is a lending strategy important?
A sound lending strategy is crucial for several reasons:
- It helps lenders manage risk – By carefully evaluating borrowers and following consistent underwriting standards, lenders can minimize defaults and loan losses.
- It supports profitability – Appropriate risk-based pricing and structuring of loan terms helps ensure loans generate sufficient interest income to cover costs and meet profit goals.
- It attracts borrowers – Competitive pricing and loan terms allow lenders to effectively market products and grow their customer base.
- It meets regulatory requirements – Prudent, non-discriminatory lending aligns with consumer protection regulations and helps avoid fair lending violations.
In short, an intelligent lending strategy is essential for the financial health and sustainable growth of a lending institution.
Key elements of a lending strategy
Some of the most important components of a lending strategy include:
Target market definition
Who does the lender aim to serve? This may include:
- Geographic locations
- Borrower segments, such as consumers, small businesses, corporations, etc.
- Industries for commercial loans
- Product preferences like mortgage, auto, credit card, etc.
Defining a target market allows focused marketing and product development.
Credit risk management
Criteria for assessing a borrower’s willingness and capacity to repay, including:
- Debt-to-income ratio benchmarks
- Minimum credit scores
- Collateral requirements
- Length of credit history
Prudent risk management reduces default frequency.
Pricing models
Methods for setting interest rates and fees to compensate for credit risk and cover costs, such as:
- Cost of funds + margin
- Risk-based pricing tiers by credit score
- Competitor benchmarking
- Cost recovery objectives + profit margin goals
Aligning pricing with risk and costs supports profitability.
Loan structures
How loan amounts, durations, repayment schedules, and features are set for different products based on borrower characteristics and needs. For example:
- Maximum loan-to-value limits for mortgages
- Shorter terms for riskier borrowers
- Variable or fixed rate loans
- Minimum/maximum loan amounts per product
Loan structures influence risk and returns.
Underwriting authority
Delegation of underwriting approval authorities based on employee seniority and skill level. May include:
- Junior underwriters approve loans per set criteria
- Senior underwriters have discretion on exceptions
- Committee or executive approval needed above certain amounts
Aligns approval decisions with appropriate expertise.
Portfolio targets
Guidelines for the ideal loan portfolio mix by product, geography, industry, credit quality, etc. This guides origination strategies.
Monitoring methods
Tracking credit performance trends to identify any needed lending policy adjustments. Metrics may cover:
- Delinquencies by product
- Charge-off rates
- Geographic concentrations
- Specific industry exposures
Monitoring facilitates risk management refinement.
How do lenders develop a lending strategy?
Constructing an effective lending strategy involves:
Reviewing business objectives
Lending strategy should align with the lender’s overall strategic goals. Is the focus on rapid growth or minimising credit losses? What target returns are acceptable? This shapes risk appetite.
Assessing market dynamics
Analysis of economic conditions, competitive landscape, demographics, and other external factors that influence lending environment.
Evaluating existing policies
Do current policies produce desired portfolio characteristics and financial outcomes? If not, what policy changes are needed?
Projecting costs, losses, and returns
These forecasts help determine required loan pricing and credit standards. Models should be based on past experience and current/future expectations.
Simulating different scenarios
Stress testing lending policies across economic scenarios identifies vulnerabilities and guides policy setting.
Reviewing regulatory compliance
Lending activity must adhere to applicable laws and regulations. These constraints shape allowable policies.
Benchmarking competitors
Monitoring competitors’ offerings and successes reveals market gaps to fill and best practices to emulate.
Incorporating executive input
Senior management provides critical perspective on alignment with strategic direction and acceptable risk taking.
Monitoring performance
Backtesting lending policies and tweaking as needed based on results. This positions the lender to capitalize on opportunities and mitigate emerging risks.
Types of lending strategies
Lenders may take different philosophical approaches in developing a lending strategy, with implications for growth, risk, and profitability. Common strategy types include:
Volume-focused strategy
Emphasizes writing as many loans as possible to maximize revenue. May entail higher risk tolerance, flexible underwriting, and minimal pricing premiums for risk. Rewards growth over short-term returns.
Risk averse strategy
Conservative standards minimize credit losses, even if it sacrifices some business. Strict underwriting and higher pricing offset risks. Ideal in unstable economic climates.
Relationship-based strategy
Takes a consultative approach to nurture borrower loyalty. Flexibility on rates/terms rewards good customers. Higher risks mitigated by intimate borrower knowledge.
Niche strategy
Specializes in a narrow product line, client segment, or geography. Customized expertise offsets limited scale. Focuses on dominating a niche rather than competing broadly.
Asset generation strategy
Emphasizes loan portfolio growth, with risks managed by selling or securitizing assets. Generates fee income from sales/servicing while removing assets from balance sheet.
Cross-selling strategy
Leverages lending to cross-sell other banking products. Modest margins on lending offset by broader client profitability. Deepens client relationships.
The optimal approach depends on the lender’s competitive advantages and market positioning. Elements of multiple strategies may be blended.
How is lending strategy implemented?
Turning strategy into practice requires:
Communicating policies
Lending guidelines must be clearly documented and explained to all personnel through policy manuals, training, and regular communication.
Aligning incentives
Compensation, promotions, and incentives should reward behaviors that reinforce strategic objectives.
Monitoring compliance
Oversight ensures lending decisions adhere to policies. Exceptions tracked and rationalized.
Optimizing processes
Workflows, forms, and technology tools should facilitate efficient execution of lending strategy.
Updating strategies
Lending policies require periodic evaluation and refinement to address changing conditions and performance.
Instilling risk culture
Values, attitudes, and behaviors throughout the organization must promote prudent risk-taking and accountability.
With proper implementation, a lending institution can translate an insightful strategy into a high-performing loan portfolio.
Current trends influencing lending strategies
Several evolving trends are impacting the development of lending strategies, including:
Digital transformation
Online and mobile technologies are enabling more automated, data-driven underwriting, decisioning, and borrower interfaces. This allows faster, lower-cost lending.
Growth of non-bank lenders
Fintech lenders are using technology and innovative underwriting to disrupt lending. Banks must compete with more agile processes and advanced analytics.
Emergence of open banking
Open APIs allow data sharing between financial institutions with customer consent. This enables more holistic underwriting and personalized pricing.
Proliferation of data
Growing availability of credit, commercial, behavioral, and non-traditional data fuels analytical underwriting and micro-segmentation.
Focus on financial inclusion
Using alternative data and tailored products to serve credit invisibles and underbanked communities represents an opportunity for lenders.
Adoption of ESG practices
Lending aligned with environmental, social, and governance objectives is becoming more prominent. This involves updated credit policies and portfolio management.
Ongoing regulatory change
Evolving regulations like CECL accounting standards impact loss forecasting, stress testing, and reserving.
These developments are pushing lenders to constantly re-evaluate their strategies. Agility and innovation are crucial to thriving in this dynamic lending landscape.
Example lending strategies
Below are illustrations of lending strategies for three different fictional institutions:
First National Bank
First National Bank is a large regional bank serving consumers and businesses in the Southwest United States. Its lending strategy focuses on:
- Prudently growing loan portfolio to expand customer relationships and bank earnings
- Leveraging its extensive branch network to originate loans across the Southwest
- Serving prime borrowers with excellent credit to minimize defaults
- Competitive pricing that matches competitors and attracts target borrowers
- Centralized underwriting for consistency, with exceptions approved by senior management
- Monthly monitoring of credit quality, concentrations, and portfolio composition
- Quarterly stress testing to confirm capital adequacy under adverse scenarios
This strategy has produced steady, profitable growth while maintaining a low-risk loan portfolio. The bank tweaks credit policies and pricing as local economic conditions evolve.
Shore Mortgage Company
Shore Mortgage is a specialty mortgage originator focused on jumbo loans for high net worth borrowers. Key elements of its strategy are:
- Caters to affluent borrowers by offering personalized service and flexibility
- Large jumbo mortgage loans, often for luxury properties
- Willingness to structure custom loan features like interest-only periods
- Low loan-to-value ratios below 60% minimize risk
- Higher interest rates than conforming mortgages due to larger balances and customization
- Very selective underwriting emphasizes qualitative factors beyond just credit scores
- Portfolio loans are held long-term instead of sold to investors
This niche strategy delivers strong margins with prudent risk management. Shore Mortgage has carved out a profitable franchise serving high-end borrowers.
Quick Cash Payday Lenders
Quick Cash Payday Lenders operates strip mall storefronts providing payday loans and check cashing services to working class borrowers. Its approach includes:
- Focus on speed and convenience to serve customers needing immediate cash
- Small, short-term loans with single repayment on next payday
- High interest rates compensate for substantial credit risk
- Automated approval decisions and minimal documentation
- Aggressive collections to limit unpaid balances
- No traditional credit checks – ability to repay based on having a job
- Rollover option with additional fees to extend loans
This high-risk strategy facilitates fast access to cash for underbanked consumers. Tight cost controls and aggressive collections minimize, but do not eliminate, defaults.
Conclusion
A lender’s strategy encompasses its target markets, underwriting policies, loan structures, pricing models, implementation practices, and other guidelines used to conduct its business in alignment with its objectives and risk tolerance. An effective strategy requires careful formulation, disciplined execution, and regular re-evaluation to maintain relevance. With a sound strategy guiding its efforts, a lender can profitably serve chosen customer segments while avoiding excessive risk. Lenders today face the challenge of crafting nimble strategies responsive to evolving borrower behaviors, competitive pressures, technological disruptions, regulations, and economic conditions. Those able to do so can gain strategic advantage.
