This document discusses credit risk issues for lenders and responsible lending practices. It outlines key risks like credit risk, operational risk, and conduct risk. It then discusses responsible lending rules in the UK, Europe, and US that require assessing borrowers' ability to repay and implementing minimum underwriting standards. The document emphasizes that responsible lending aims to benefit borrowers, lenders, and financial stability. Mortgage regulation alone is not enough - lenders must also consider conduct risk and customer outcomes. Responsible lending practices are increasingly important globally and seen as necessary to prevent issues seen in the financial crisis.

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Credit Risk Issues for Lenders
Tony Moroney
Director – Financial Advisory
9th October 2013

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The Risk Landscape
‐ Key risks on our clients’ radar
Credit RiskCredit Risk
Operational RiskOperational Risk
Conduct RiskConduct Risk
Market RiskMarket Risk
Reputational RiskReputational Risk
Technology RiskTechnology Risk
Risk of losses in positions
arising from market price
movement
Risk arising from (lack of)
stakeholder confidence
and trust
Risk arising from
inadequate or failed
information technology
asset
Risk that a borrower will
default on a debt
obligation
Risk of loss from
inadequate or failed
process, people, system
or external event
Risk to the FSA’s
statutory objective of
consumer Protection

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Credit Risk Issues
“The risk of loss of principal or loss of a financial reward stemming from a
borrower's failure to repay a loan or otherwise meet a contractual obligation”.

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•all forms of interactive dialogue, whether face to face, telephone, social media, or online propositions
Distribution
(All Advised
Market)
• those giving advice through the system must comply with minimum standards
Distribution
(Approved
Persons)
• asses the repayment strategies of borrowers through putting clear policy and controls in place along with the
requirement to check repayment vehicles at least once during the term
Interest Only
• mortgages should only be granted where there is no reliance on future property price appreciation
• lenders must verify income and be able to demonstrate that the mortgage is affordable
• lenders must take account of the impact on payments of market expectations of future interest rate increases
Responsible
Lending
The Key Impacts of MMR
‐ Responsible lending comes to the fore

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Responsible Lending
‐ Not uniquely British
• On a global basis, regulators are seeking to implement new mortgage rules which strike the right balance
between protecting consumers while also enabling lenders to comply with reforms.
• In Europe, the European Commission is seeking reforms under its Mortgage Credit Directive and has stated for
the record that:
"The financial crisis has shown the damage that irresponsible lending and borrowing practices can have
on consumers, lenders, the financial system and the economy at large. We are therefore determined to
learn from mistakes to ensure that lending and borrowing takes place in a responsible manner”.
• In the USA, the rules required by the Dodd‐Frank Act of 2010 address head‐on causes of the mortgage
meltdown and ensuing recession:
– “many lenders made high‐risk, often deceptively‐packaged home loans without considering whether
borrowers could repay them ‐ lenders now must assess a mortgage borrower’s ability to repay a loan”.
– the rules’ definition of a safe mortgage—known as a “Qualified Mortgage”— also means that restrictions
on harmful loan terms such as balloon payments, teaser rates and high fees.
• The premise of these regulatory interventions is that if lending is carried out responsibly the best outcome will
be achieved for borrowers, mortgage lenders and the economy as a whole:
– lenders will have lower default rates,
– borrowers will be issued a mortgage in which they are able to meet their repayments and
– governments and the general public will have a stable financial system.

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Financial Stability Board
‐ Espoused Principles for Sound Underwriting Practices
The FSB Principles for Sound Residential Mortgage Underwriting Practices aim to provide a framework for jurisdictions to set minimum
acceptable underwriting standards. The European Banking Authority embraced these principles in June of this year.
1. Effective verification of income and other financial information
• make reasonable inquiries and take reasonable steps to verify a borrower’s underlying income capacity
• maintain complete documentation of the information that leads to mortgage approval
• accurate representation of borrowers’ income and other financial information
2. Reasonable debt service coverage
• appropriately assess borrowers’ ability to service and fully repay their loans without causing the borrower undue
hardship and over‐indebtedness
• make reasonable allowances for committed and other non‐discretionary expenditures in the assessment of
repayment capacity
• make prudent allowances for future negative outcomes
• provide borrowers with sufficient information to clearly understand the main elements which are taken into account
in order to determine a borrower’s repayment capacity, the main characteristics of the loan including the costs, and
risks associated with the loan in order to enable borrowers to assess whether the loan is appropriate to their needs
and financial circumstances
3. Appropriate loan‐to‐value (LTV) ratios
4. Effective collateral management
5. Prudent use of mortgage insurance
6. Implementation framework
7. Effective supervisory tools and powers

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Responsible Lending in the USA
‐ Ability‐to‐Repay (ATR) Rule
• ATR Requirement operational language
– A creditor shall not engage in a covered transaction unless the creditor makes a reasonable and good
faith determination at or before consummation that the consumer will have a reasonable ability to repay
the loan according to its terms
• Bureau commentary provides guidance
– Whether an ATR is reasonable and in good faith will depend not only on the creditor’s underwriting
standards but on the facts and circumstances of a particular extension of credit and how a creditor’s
standards were applied to those facts and circumstance
• Underwriting Requirements
– Lenders can set their own underwriting standards
– Creditor may determine standards for DTI or monthly residual income in making a good faith
determination of a consumer’s ATR
– Standards must be applied consistently
– Early payment default will often be persuasive evidence that the creditor did not have a reasonable and
good faith belief in the consumer’s ATR
– However, a change in circumstances that cannot reasonably be anticipated from a consumer’s application
or records use for the ATR determination (such as a significant reduction in income due to job loss or a
major medical expense) is not relevant to determining a creditor’s compliance with the ATR Rule

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Ability To Repay Rule
‐ Reasonable and/or in good faith lending?
• Factors that may be evidence that a consumer’s ATR was not reasonable or in good faith
– Consumer defaulted on the loan a short time after consummation or, a short time after recast
– Creditor used underwriting standards that have historically resulted in comparatively high levels of
delinquency and default during adverse economic conditions
– Creditor applied underwriting standards inconsistently or used underwriting standards different from
those used for similar loans without reasonable justification
– Creditor disregarded evidence that the underwriting standards it used are not effective at determining
consumers’ repayment ability
– Creditor disregarded evidence that consumer may have insufficient residual income to cover recurring
obligations and expenses, taking into account consumer’s assets other than the security property, after
making monthly payments for the covered transaction, any simultaneous loans, mortgage‐related
obligations, and any current debt obligations
– Creditor disregarded evidence that the consumer would have the ability to repay only if the consumer
subsequently refinanced the loan or sold the property
– Inconsistent application of underwriting standards may indicate that a creditor is manipulating those
standards to approve a loan despite a consumer’s inability to repay
• None of the preceding factors are requirements that the borrower must prove to establish an ATR violation

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Ability To Repay Rule
‐ Consequences for Failure to Comply
Liability for Failure to Comply with the ATR Rule
• General Truth in Lending Act damages
– Actual damages
– Statutory damages
– Attorneys fees and costs
• Special ATR statutory damages
– Up to sum of all finance charges and fees paid by consumer
• Unless creditor demonstrates the failure was not material
• Foreclosure provision
– When a creditor, or an assignee or other holder initiates a foreclosure action, a consumer may assert an
ATR violation as a matter or defence by recoupment or setoff
– No time limit on the use of this defence

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Responsible Lending
‐ Here to stay!
• Mortgage credit is a key element to allowing consumers to buy and retain their own home.
• Critically, a mortgage is likely to be the single greatest financial commitment the majority of consumers will enter
into in their lifetime.
• However, mortgage credit can also give rise to risks for consumers and these risks need to be mitigated:
– by consumers making responsible borrowing choices;
– by credit institutions taking responsible lending decisions; and
– by competent authorities protecting consumers from poor lending practices.
• The financial crisis has prompted a more comprehensively view of the ways in which the risks can materialise, as
well as the causal linkages between them, including:
– how creditors’ retail conduct might pose a risk also to creditors and to financial stability, for example as a
result of imprudent lending standards which might lead to an expansion of creditors’ balance sheets in the
short term, but may fuel an ‘asset bubble’ in residential properties in the long run that could, if burst, have
a substantial impact on creditors’ viability as going concerns and financial stability more widely (unless
costs are externalised and the system is supported through taxpayer and/or central bank support).
– how creditors’ retail conduct might give rise to consumer detriment and pose a risk to consumer
protection, for example as a result of misleading product disclosure, non‐transparent pricing and product
characteristics, and/or unsuitable advice.
• Mortgage Regulation therefore is only part of the equation; lenders must also look at their credit policies through
the lenses of customer outcomes i.e. Conduct Risk

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Conduct Risk Issues
“Conduct risk is any action of an individual bank or the banking industry that
leads to customer detriment or negatively impacts market stability”.

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Regulation is wider and more intrusive
‐ Conduct Risk management is central
Business Model
Conduct
FCA
Prudential
PRA
Business Strategy
Governance and Control
MI, Customer Feedback and Evidence of Compliance
• Risk
Management
• Stress Testing
• Resilience
• Horizon Scanning
• Individual
Accountability
• NPD
• Customer Focus
• Customer
Outcomes
Market Stability
• Customer protection
• Transparency
• Market Integrity
Risk Management
RegulationBusiness
Evidence
Equal
Standing

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'Fairness', ‘Customer Centricity’ and ‘Conduct Risk
‐ Mortgage lenders need to demonstrate fairness and consideration
Marketing &
Acquisition
• Access to a holistic
picture of the customer
through Single Customer
View/CRM system
• Targeted marketing
focused on ‘suitability’,
segmenting customers
using flexible analytics
and modelling tools,
backed up with rich
customer data
Product
Design
• Products demonstrably
satisfying a market or
customer segment need
• Sophistication level
appropriate to the individual
customer requirement/need
• Profitable but not to the
detriment of the customer
• “Fair” open & transparent
charging structure
• Ongoing product reviews
that validate market,
charging structure and
profitability
Risk, Fraud, and Compliance
• Revised risk model that is consistent with an FCA Conduct Risk environment
• Automated MI and audit trails of logic and supporting data to evidence suitability through the lifecycle
Customer
Relationship
Management
• Improved understanding
of customer needs
throughout the lifecycle
using better real-time
customer data with “softer
information” on behaviour
and attitude
• Automated identification of
lifestyle events to prompt
suitability review
Sales & Service
Distribution
• Enhanced decisioning
ensuring products match
latest customer needs
• Automated triggers/
alerts for main servicing
events, driven off up to
date information
• Optimised channels
balancing customer need
with cost to serve
• Increased self servicing
through customer access
to supporting tools
Supporting Functions - Business Services, Technology Services, Finance, HR etc.
• Financial models that reflect the revised product/customer set and suitability based forward projections
• Remuneration model based on customer satisfaction, with roles in place to assure adherence to FCA Conduct Risk principles
Suitability
Advice
Arrears?
Risk

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Conduct Risk
‐ Organisational Readiness
1. Have you an established conduct risk appetite? Is this reflected in your customer and business strategies?
2. How do you identify the areas of your business that conduct risk has the greatest impact?
3. Can you quantify the conduct risk for your current products and back book – and how are you mitigating it?
4. Are your staff aware of their regulatory obligations to your customers?
5. How is conduct risk identified and managed within your overall risk model?
6. How far does your Treating Customers Fairly framework help to mitigate your conduct risk exposure? Have you a clear action
plan covering how, and where, your Treating Customers Fairly framework may need to be improved?
7. What customer feedback do you gather? How does it support your conduct risk management performance?
Definition and Impact
Communication and Understanding
8. Do your new product development activities robustly support the FCA’s conduct requirements?
9. How do you show that your marketing and customer segmentation activities meet conduct obligations?
10. Are you clear on your conduct risk obligations where your products are sold by third parties?
Impact on Business
11. How do complaints and root cause analysis of complaints and arrears to ensure improvements in the way you deliver to your
customers?
12. Aside from in complaint handling, are you undertaking root cause analysis on other sales and servicing activities?
Prevention

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Conduct Risk
– Credit and Risk Policies
1. Measure Conduct Risk separate to Credit Risk and Operational Risk
• use an appropriate risk methodology and establish a Risk Profile
2. Demonstrate due care in assessing a customer's needs including credit needs at the point of sale and
throughout the expected lifetime of the product.
• Is the customer eligible to buy this product and is it suitable for their needs?
3. Formally document the intended Customer's needs at the beginning of the Product Development
Lifecycle. Build in mandatory requirements for evidence of repayment capability and plausibility.
4. Undertake frequent product reviews to confirm products still meet their objective and that those
objectives still meet intended customer needs. In particular, look at mortgage loans that default early.
5. Incorporate Root Cause Analysis from Customer Complaints and Arrears in to the design of new products
and use it to alter and/or remove products and/or change credit criteria.
6. Train all staff at all levels of the organisation, not just customer‐facing staff, and have an appropriate
governance and controls framework supporting Conduct Risk.
7. Evidence, Evidence, Evidence
• How did we consider the customer when designing the product?
• How have we ensured the right customers end up with the right products?
• How have we ensured our risk policy appropriate and delivering the right customer outcomes?
• What have we done to either improve or remove products not delivered on customer outcomes?

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Conclusion
• Mortgage lenders must focus on all the traditional elements of risk, however, since the financial crisis, there has
been a sea change with a real emphasis now on responsible lending – there is no going back!
• Yet credit risk is only one of the lenses a mortgage lender should use when dealing with retail customers;
Conduct Risk and how this manifests itself in customer outcomes is of paramount importance.
• Lenders who take a narrow compliance approach will struggle to provide the evidence now required by the FCA
both in terms of responsible lending and their conduct.
• Boards and executives must now apply the same level of rigour to reviewing customer outcomes as they do to
monitoring the financial performance of the business.
• This includes the need to review new and existing products and services (including mortgage credit) and above
all ‘walk the walk’ as well as ‘talk the talk’ when it comes to the conduct risk agenda.
• Ultimately having responsibility for managing conduct risk throughout the product lifecycle opens the way for
much more retrospective action and reputational risk and as such, should be taken seriously.
• We know that “good profits” come from making sure products and services are suitable for the people they’re
being sold to, they understand what they’re buying and they’re getting appropriate value for money.
• Setting the right tone at the top and embedding a culture of doing the right thing by customers, clients and
counterparties is the only way to get this right.
• Think Credit Risk, Market Risk, Operational Risk, Technology Risk and wrap around this Conduct Risk and the
potential resulting Reputational Risk – this is the mind set now required to succeed in mortgage lending