Jeff Judy

Jeff's Thoughts - March 31 , 2010

Are You Doing More Unsecured Lending Than You Think?

We bankers are a cautious sort, and we like to know what stands behind the loans we make to our customers. We pay a lot of attention to collateral, and every explicit commercial loan negotiation involves some discussion about secondary sources of repayment, if the borrower should end up unable to repay as expected.

But "credit extended to customers" goes well beyond "loans made." And the truth is that, at many institutions, a good deal of credit is routinely extended to bank customers with very little consideration of how the bank will be repaid if expectations are not met.

I'm talking about what is often called "secondary exposure," additional sources of risk that are tucked into customer relationships. You may think of your customer mainly in connection with a loan or line of credit, and not realize that many of the other services you provide to that customer represent additional forms of credit that come with very little protection for the bank.

This additional risk is both more common, and more severe, than is recognized. The total of this secondary exposure can be significant, meaning that when you look beyond the primary exposure in the relationship, you will discover quite a bit of credit that is entirely dependent on the customer performing exactly as agreed.

For instance, cash management services are rife with this sort of thing. Payroll accounts can leave you with wages paid out that you will never recover, once the business suddenly folds. Check processing for your customers seems pretty safe until you get burned by fraudulent activity.

There are many more examples, if you dig around, but the key points are that:

One of the reasons secondary exposure builds up is because we let our "products" do our thinking for us. As we "productize" our services into packages we can explain easily and implement quickly, we focus on what we will do for the customer, and on what fees we will collect for the service. The associated risk, being all on our side, isn't part of the customer discussion, and quickly gets lost.

Don't underestimate how much pain all this unsecured, overlooked credit can cause you. The regulators, who are expanding the breadth of risk they examine, and looking more and more for an "enterprise" wide approach to risk management, are certainly interested in this issue.

If you don't manage risk -- all of your risk -- on the front end, those risks will come back to manage you, to define your options. If you want to avoid some very ugly surprises from secondary exposure, your bank needs to:

  1. Establish a consistent, explicit policy on tolerance for secondary exposure across all products and services;
  2. Educate staff to recognize this additional risk as they manage customer relationships;
  3. Integrate this discussion into the approval process; and
  4. Develop systems to monitor aggregate secondary exposure in the portfolio.

If you habitually equate "credit risk" with the usual obvious term loans, lines of credit, and similar instruments, some of your customers may be on the brink of giving you rather a rude awakening. Broaden your vision of credit risk so you can manage all the risk attached to your customer relationships.